Auditing

Introduction Independence is a fundamental to the reliability of auditors’ reports. It is an attitude of mind characterized by integrity and an objective approach to professional works. A professional auditor should work both independent and seen to be so. Nowadays, but, the trend of providing non-audit services to audit clients seem to be sweeping accounting firms all over the world; impacts of independence impairment caused by this trend should not be ignored.

The Meaning of Independence The essential feature of an audit is its independence and, if an accountant performs the accountancy work and then checks it himself, this checking cannot be viewed to be an audit because it lacks independence. From ACCA’s Code of Ethics, the definition of Independence is composed of independence of mind and independence in appearance.

In general, independence means an auditor’s opinion must be based on an objective without bias and disinterested assessment of whether the financial statements are presented fairly in conformity with generally accepted accounting principles. The Importance of Independence in relation to the provision of assurance The value of audit derives entirely from its independence. Without independence, auditors’ opinions lack impacts and credibility. The relationship between the auditors and audit clients, however, gives a potential threat to the independence.

Influencing Auditors’ Reports on Clients’ Financial Position due to Conflicts of Interests: Possibilities of conflicts of interest between firms and clients, where situations such as, connections of an audit firm with associated firms, family and other personal relationships, financial interests in audit client, employment with audit clients, provision of non-audit service to audit clients, may consequently affect auditors. Without the strength of character to withstand such pressure, auditors may be unable to express independent opinions.

Preserving Investors Confidence in the Financial Market Public confidence in the capital market relies heavily on the appearance of auditor independence. Auditor independence helps to ensure quality audits and sustain the circulations of investment with the capital market. Investor confidence is eroded if investors and other users of the financial statement information do not perceive that the auditor was independent in both fact and appearance. Giving Constructive Advice

Although there is no formal obligation, a good auditor will be anxious to offer his client assistance on improvements in the financial aspects of the business if he can give an unbiased independent opinion, where added value is brought to clients and to the wider business community. Lowering Litigations Sustaining independence enables the auditors to objectively report on True and Fair Value of any information required to be disclosed in financial accounts, of which the chances of successful negligence lawsuit to a level acceptable will be reduced.

The Nature of other services provided by the auditors In the classification from APB, non-audit services is composed of any engagement where an audit firm provides professional services to an audited client other than the audit of financial statements, and pursuant to those other roles which legislation or regulation specify can be performed by the auditor of the entity.

There are five different natures of non-audit services categorized by activities arising directly from an audit of a company’s financial statements, services required to be provided by the auditor by laws, services provided by auditors because of their familiarity with the client and, as a consequence, their ability to perform them in a timely and cost effective manner, services provided because of the pool of accounting and related financial skills available to accountancy firms, services provided because of the pool of consulting and general business skills available to accountancy firms

Critical Discussion of Ethical Code Requirements Independence is part of the accountant’s code of professional conduct. Under APB Ethical Standards the concept of auditor independence shifted in favor of objectivity and neutrality in the reporting of the financial position and the results of operations, rather than loyalty to a particular party. The Ethical Standards allow audit firms to offer consulting services such as internal auditing and information technology but are subject to certain restrictions, and audit firms are required to disclose fees received from auditing and all non-audit services.

However, without providing clear distinctions which makes grey area exists, the rules should err on the side of caution. Auditors and their clients are likely to continually test the limits of what is permissible, including by litigating restrictions they oppose. UK’s Combined Code on Corporate Governance only recommends that audit committees develop policies to govern the future provision of non-audit services, but does not require a pre-approval of non-audit services by audit committees.

No specific enforcement mechanism ensures that management does not become involved, directly or indirectly, in selecting auditors or determining audit fees and the scope of audit. Ethical code requirements should focus to a greater extent on the issue of to what extent client management may still be able to influence the audit fee and the scope of audit engagement. Explanation of the Current and Emerging Developments

In order to increase revenue, recently, accounting firms not only provides auditing services, other services including bookkeeping, financial information systems design, human resources and management functions, valuation, internal audit, tax, legal, investment banking services and expert services unrelated to audit, also provides. There are several reasons leading to the increasing popularity of providing non-audit service, Price Competition Auditing becomes a low-profit activity that clients increasingly search for the lowest prices and the loosest standards.

Competitive bidding in auditing created pressure to reduce audit engagement hours. To maintain overall revenues, high profitability of the numerous new consulting and other non-audit services is being offered. Horizontal Integration The rapid growth of business enterprises on a worldwide basis provided large accounting firms with an opportunity to become the preferred providers of a wide range of business services, the revenues from non-audit services for audit clients quickly outpaced the fees from auditing-only services.

Audit Effectiveness Providing non-audit services allows accounting firms to perform better audits because they can obtain a better understanding of the client’s systems, which can achieve the cost-effective goal. Criticism and Analysis of Independence Impaired by Provision of Non-audit Services The relative increase in reliance on revenues from non-audit services may have placed increased pressure on auditor independence.

The major accounting firms, seems vigorously opposed reforms to eliminate the growing conflicts of interest arising from auditing and consulting for the same client, because of economic bond which the auditor does not want to lose developed between the client and the accounting firm. In order to be more competitive, accounting firms try to reduce audit fees to attractive customers by reducing engagement hours. But this risk-based auditing approach may not detect fraudulent activities. Some auditors shifted their concept of independence to becoming trusted advisors to the client’s management.

Although acting independence in certain situations is acceptable, too often an auditor’s efforts to help management resulted in concealing true economic performance. It appeared that some auditors ignored their most immediate responsibility to act on behalf of third-party investors or, at a minimum, to be an objective and neutral interpreter of accounting standards. Many non-audit services evolved from requests by audit clients for additional services that their auditors seemed best suited, as well as from the special skills needed to audit new and complex business transactions.

Expanding the scope of the specialists’ activities helped firms attract and retain people with skills that were increasing important to effective auditing. Audit firms’ management consulting practices have expended far beyond the skills required for audit support and the traditional areas related to financial planning and controls. Independence questions can arise when these services are marketed to audit clients. However, it is obvious that major accounting firms keep bearing legal risks by providing non-audit services to audit clients.

Even ethical standard regarding to provision of non-audit services has been revised; firms could argue that advanced technology and improved education enabled accounting firms to provide many non-audit services to their current client. Conclusion and Recommendations Independence, both historically and philosophically, is the foundation of accounting profession and upon its maintenance depending on the profession’s strength and its stature.

From my viewpoint, it is undeniable that Ethical standards put efforts on monitoring auditor independence; but standing at the point of running the business, accounting firms have woven an increasingly complex web of business and financial relationships with their audit clients. The most common case of independence impairment occurs because an auditor becomes so close to the client as to be unable to function objectively. The actual cause of the independence problems, however, generally was not wanton disregard rules.

Instead, internal control problems may have caused many of the breach where the weak internal control system is unable to trace employees’ investments. Despite of regulations, area needs to be addressed to improve the auditor independence is the audit firms’ internal control systems, of which all relationships between each auditor and audit clients should be reviewed from time to time. The nature of the non-audit services providing to audit clients maybe different in different era. It appears that there is more mobility of employees and an increase in dual-career families.

In the foreseeable future, keeping prohibition on non-audit services would help medium-sized accounting firms secure additional non-audit work with major clients. On the other hand, the increasingly competitive auditing market and the complexity of international business practices may cause some auditors to reduce their focus on objective and neutral interpretation of accounting standards in favor of becoming a trusted advisor for clients. MMUBS Reference Book Graham W. Cosserat and Neil Rodda (2009) Modern Auditing, 3rd ed. , John Wiley & Sons, Ltd

Diane Walters and John Dunn (2001) Student‘s Manual of Auditing: The Guide to UK Auditing Practice, 6th ed. , Thomson Learning M. Shere and S. Turley (1991) Current Issues in Auditing, 2nd ed. , Paul Chapman Publishing Ltd Newspaper Article – Internet Copy Editor (2009) ‘Auditor independence important – CMDA’ The Miadhu News. [Online] 4th November. [Accessed on 4th November 2009] http://www. miadhu. com/2009/11/local-news/auditor-independence-important-cmda/ Journal Article – Internet Copy Franklin Strier (2006) ‘Proposals to Improve the Image of the Public Accounting Profession’ CPA Journal, March 2006 Issue http://www. ysscpa. org/cpajournal/2006/306/essentials/p67. htm C. Richard Baker (2005) ‘The Varying Concept of Auditor Independence: Shifting with the Prevailing Environment’ CPA Journal, August 2005 Issue http://www. nysscpa. org/cpajournal/2005/805/infocus/p22. htm Robert H. Colson (2004) ‘CPA Independence, Present and Future’ CPA Journal, April 2004 Issue http://www. nysscpa. org/cpajournal/2004/404/essentials/p80. htm Carolyn L. Lousteau and Mark E. Reid (2003) ‘Internal Control Systems for Auditor Independence’ CPA Journal, January 2003 Issue http://www. nysscpa. rg/cpajournal/2003/0103/features/f013603. htm Deborah L. Lindberg and Frank D. Beck (2004) ‘Before and After Enron: CPA’s Views on Auditor Independence’ CPA Journal, November 2004 Issue http://www. nysscpa. org/cpajournal/2004/1104/essentials/p36. htm Mario Christodoulou (2009) ‘Debate rages on over KPMG’s cut-price Rentokil audit deal’ Accountancy Age, 20 August 2009 http://www. accountacyage. com/accountancyage/news/2248103/debate-rages-kpmg-cut-price Internet Source – Organization NASD Notice to Members 02-19. (2002) Auditor Independence: SEC Review of Auditor Independence Rule. Online] [Accessed on March 2002] http://www. finra. org/web/groups/industry/@ip/@reg/@notice/documents/notices/p003715. pdf Investor Protection (2003) Strengthening the Commission’s Requirements Regarding Auditor Independence. [Online] [Accessed on 20th January 2003] http://www. consumerfed. org/pdfs/011303auditor. pdf Public Oversight Board (2002) Report and Recommendations: Chapter 5: Auditor Independence [Online] [Accessed on March 2002] http://www. pobauditpanel. org/downloads/chapter5. pdf APB (2009) Consultation Paper on audit firms providing non-audit services to

SOLUTIONS FOR REVIEW CHECKPOINTS 1. 1Business risk is the collective risk faced by a company that engages in business. It encompasses all threats to and organization’s goals and objectives. It includes the chance that customers will buy from competitors, that product lines will become obsolete, that taxes will increase, that government contracts will be lost, or that employees will go on strike. 1. 2The conditions of complexity, remoteness, time-sensitivity, and consequences increase demands by outside users for relevant, reliable (useful) information.

They cannot produce the information for themselves because of these conditions. Company managers and accountants produce the information. 1. 3Information risk, in contrast to business risk, is the risk (probability) that the information (mainly financial) disseminated by a company will be materially false or misleading. This risk creates the demand for objective outsiders to provide assurance to decision makers. 1. 4Students can refer to the AAA and AICPA definitions in Chapter 1. Some instructors may want to extend the consideration of definitions to include the internal and governmental definitions (located in Module D).

In response to “What do auditors do? ,” students can refer to Exhibit 1. 2 and respond in terms of: (1) obtaining and evaluating evidence about assertions management makes about economic actions and events, (2) ascertaining the degree of correspondence between the assertions and the appropriate reporting framework, and (3) providing an audit report (opinion). Students can also respond more generally in terms of “lending credibility” to financial statements presented by management (attestation). 1. An attest engagement is: “An engagement in which a practitioner is engaged to issue or does issue a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party. ” To attest means to lend credibility or to vouch for the truth or accuracy of the statements that one party makes to another. The attest function is a term often applied to the activities of independent CPAs when acting as auditors of financial statements. 1. Assurance engagements are independent professional services that improve the quality of information, or its context, for decision makers. Since information (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 information is objective, free from bias, fully informative, and free from material error, intentional or inadvertent. The services of an independent-CPA auditor helps resolve those doubts because the auditor’s success depends upon his independent, objective, and competent assessment of the information (e. . , the conformity of the financial statements with the appropriate reporting framework). The CPA’s role is to lend credibility to the information; hence the outsider will likely seek his independent opinion. 1. 7CPAs serve as independent intermediaries who lend credibility to information. Hence, assurance services are natural extensions of the well-regarded audit and attest services. CPAs can use their expertise in internal control and measurement methods. Assurance services are natural extensions of attestation services, which earlier evolved from financial statement audit services.

Attestation and audit services are highly structured and intended to be useful for large groups of decision makers (e. g. , investors, lenders). On the other hand, assurance services are more customized and intended to be useful to smaller, targeted groups of decision makers. In this sense, assurance services bear resemblance to consulting services. 1. 8There are four major elements of the broad definition of assurance services: Independence. CPAs want to preserve their attestation and audit reputations and competitive advantages by preserving integrity and objectivity when performing assurance services.

Professional Services. Virtually all work performed by CPAs is defined as “professional services” as long as it involves some element of judgment based in education and experience. Improving the Quality of Information or its Context. The emphasis is on “information”– CPAs’ traditional stock in trade. CPAs can enhance quality by assuring users about the reliability and relevance of information, and these two features are closely related to the familiar credibility-lending products of attestation and audit services. “Context” is relevance in a different light.

For assurance services, improving the context of information refers to improving its usefulness when targeted to particular decision makers in the surroundings of particular decision problems. For Decision Makers. They are the “consumers” for assurance services, and they personify the consumer focus of new and different professional work. They may or may not be the “client” that pays the fee, and they may or may not be one of the parties to an assertion or other information. The decision makers are the beneficiaries of the assurance services. 1. Accountants record, classify, and summarize (report) a company’s assets, liabilities, capital, revenue, and expense in financial statements. Auditors gather evidence related to the assertions management makes in financial statements and render a report. Accountants produce the financial statements; auditors audit them. 1. 10There are three major classifications of ASB assertions with several assertions in each classification: Transaction Assertions: Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets, liabilities, sales and expenses actually occurred.

Key questions include “Did the recorded sales transactions really occur? ” Completeness and cutoff assertion: The objective is to establish with evidence that all transactions of the period are in the financial statements and all transactions that properly belong in the preceding or following accounting periods are excluded. Completeness also refers to proper inclusion in financial statements of all assets, liabilities, revenue, expense and related disclosures. Key questions related to completeness include: “Are the financial statements (including footnotes) complete? and “Were all the transactions recorded in the right period? ” Accuracy assertion: The objective is to establish with evidence that transactions have been recorded at the correct amount. Key questions relate to “where the expenses recorded at the proper dollar amount? ” Classification assertion: The objective is to establish with evidence that transactions were posted to the correct accounts. Key questions relate to “was this expense recorded in the appropriate account/” Balance Assertions:

Existence assertion: The objective is to establish with evidence that balance represents assets, liabilities, sales, and expenses that are real and in existence at the balance sheet date. Key questions relate to “does this number truly represent assets that existed at the balance sheet date? ” Rights and obligations assertion: The objectives related to rights and obligations are to establish with evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed. Key questions related to this assertion include: “Does the company really own the assets? nd “Are related legal responsibilities identified? ” Completeness assertion: The objective is to establish with evidence that all balances of the period are in the financial statements. Key questions related to completeness include: “Are the financial statements (including footnotes) complete? ” Valuation assertion: The objective is to establish with evidence that balances have been valued correctly. Key questions include “Are the accounts valued correctly? ” and “Are expenses allocated to the period(s) benefited? ” Presentation and Disclosure assertion:

Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets, liabilities, sales and expenses actually occurred. Key questions include “are we properly presenting and disclosing transactions that occurred during this period. Rights and obligations assertion: The objectives related to establishing with evidence the proper presentation of assets, liabilities, revenues and expenses to which the company has a legal right or a legal obligation Key questions related to this assertion include: “Has the company properly presented the assets in its possession? nd “Are related legal responsibilities identified and properly disclosed? ” Completeness assertion: The objective is to establish with evidence that all balances of the period are presented and/or disclosed in the financial statements. Key questions related to completeness include: “Are the financial statements (including footnotes) complete? ” Accuracy and valuation assertion: The objectives are to establish with evidence that balances presented and disclosed in the financial statements have been recorded accurately and have been valued correctly.

Key questions include “Are the accounts valued correctly? ” and “Are expenses allocated to the period(s) benefited? ” Classification and understandability assertion: The objective is to establish with evidence that presentation and disclosures are properly classified on the financial statements and that financial statements including footnotes are understandable to the financial statement users. Key questions relate to “Is this account properly presented in the correct financial statement category” and “are the footnote disclosures presented to promote an understanding of the nature of the account” . 11The ASB’s assertions are important to auditors because they are the focal points for audit procedures. Furthermore, audit procedures are the means to answer the key questions posed by management’s assertions. The ASB assertions are in more detail than the PCAOB assertions and are categorized into transaction assertions, balance assertions, and presentation and disclosure assertions. They include the following additional assertions: cutoff, accuracy, valuation, classification, and understandability. Exhibit 1. 4 explains the difference between ASB and PCAOB assertions. . 12Holding a belief that a potential conflict of interests always exists causes auditors to perform procedures to search for errors or frauds that would have a material effect on financial statements. This tends to make audits more extensive for the auditor and more expensive for the client. The situation is not a desirable one in the vast majority of audits where no errors or frauds exist. However, errors and financial reporting frauds have happened too often. Users of financial statements and audit reports expect auditors to detect material misstatements. . 13Some examples of assurance engagements include: • Internet Website certification (CPA WebTrust) • Accounts receivable review and cash enhancement • Third-party reimbursement maximization • Rental property operations review • Customer satisfaction surveys • Benchmarking/best practices • Evaluation of investment management policies • Fraud and illegal acts prevention and deterrence • Information systems security reviews (SysTrust) • Internal audit strategic review . 14Major areas of public accounting services: • Assurance services (including audit services and other attestation engagements) • Tax consulting services • Consulting services 1. 15Operational 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 objectives, and compliance with company policies. The AICPA views operational auditing as a type of management advisory service offered by public accounting firms. 1. 6The elements of expanded-scope auditing include: (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program results audits. 1. 17Compliance auditing involves a study of an organization’s policies, procedures, and performance in following laws, rules, and regulations. An example is a school’s policies, procedures, and performance in determining eligibility for a free meal program. 1. 18Other kinds of auditors include IRS agents/auditors, state and federal bank examiners, state insurance department auditors, and fraud auditors. 1. 9The purpose of continuing education is to ensure that CPAs in practice maintain their expertise at a sufficiently high level in light of evolving business conditions and new regulations. For CPAs in public practice, 120 hours of continuing education is required every three years, with no less than 20 hours in any one year. For CPAs not in public practice, the general requirement is 120 or fewer (90 in some states) every three years. 1. 20Everything cannot be learned in the classroom, and some on-the-job experience is helpful before a person is foisted off on the public as a licensed professional.

Also, the experience weeds out some persons who do not want to take the trouble to be involved in accounting work. 1. 21State boards administer the state accountancy laws. State boards make physical arrangements to give the CPA examination, collect the examinations, receive the grades from the AICPA grading activity, and notify candidates whether they passed or failed. After satisfying state requirements for education and experience, successful candidates are awarded the CPA certificate by a state board. At the same time, new CPAs must pay a fee to obtain a state license to practice.

Thereafter, state boards of accountancy regulate the behavior of CPAs under their jurisdiction (enforcing state rules of conduct) and supervise the continuing education requirements. 1. 22After becoming a CPA licensed in one state, a person can obtain a CPA certificate and license in another state. The process is known as reciprocity. CPAs can file the proper application with another state board of accountancy, meet the state’s requirements, and obtain another CPA certificate. Many CPAs hold certificates and licenses in several states. From a global perspective, individuals must be licensed in each country.

Similar to CPAs in the United States, “Chartered Accountants” (CAs) practice in Australia, Canada, Great Britain, and India. Efforts are currently underway through NASBA to streamline the reciprocity process so that CPAs can practice across state lines without having to have 50 different licenses. SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS 1. 23a. IncorrectThis is an attestation to the prize promoter’s claims. b. IncorrectThis is an audit engagement to give an opinion on financial statements. c. IncorrectThis is an assurance engagement on newspaper’s circulation data. . IncorrectThis is an assurance engagement on the performance of golf balls. e. CorrectSince attestation and audit engagements are subsets of assurance engagements, all are assurance engagements. 1. 24a. CorrectThis statement characterizes professional skepticism. b. Incorrect“Exclusively an auditor” is not an idea that seems to speak of “skepticism. ” c. IncorrectProfessional obligations” is not an idea that seems to speak of “skepticism. ” d. IncorrectThis is more an assumption of necessity than of skepticism. 1. 25a.

Incorrect While work on a forecast is covered by the attestation standards, the auditors should give assurance or a disclaimer. b. Correct This is the basic definition of attestation–giving a report on reliability of an assertion one party makes to another. c. Incorrect Tax work is not an attestation service. d. Incorrect Litigation and expert witness services are not attestation services. 1. 26a. IncorrectThe objective of environmental auditing is to help achieve and maintain compliance with environmental laws and regulations and to help identify and correct unregulated environmental hazards b.

IncorrectThe objective of financial auditing is to obtain assurance on the conformity of financial statements with generally accepted accounting principles. c. Incorrect The objective of compliance auditing is the entity’s compliance with laws and regulations. d. CorrectOperational auditing refers to the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. 1. 27a.

IncorrectWhile not the primary objective of an operational audit, auditors should still be concerned about compliance with financial accounting standards. b. CorrectThis statement is part of the basic definition of operational auditing. c. IncorrectAn operational audit does not focus on the financial statements. d. IncorrectAnalytical tools and skills are an important part of financial auditing. 1. 28a. CorrectThe proper reference is to the appropriate reporting framework. b. IncorrectThe AICPA does not refer only to the FASB for the appropriate reporting framework. c.

IncorrectThe reference to the SEC is wrong. d. IncorrectThis is an abstract of the AAA definition. 1. 29d. CorrectWhile “complexity,” “remoteness,” and “consequences” are good answers, “skepticism,” or potential conflict of interest, generally drives the demand for audited financial statements. 1. 30d. CorrectSarbanes-Oxley prohibits the provision of all of the services listed in answers a, b, and c, therefore, d (all of the above) is the best response. 1. 31a. IncorrectAuditors do not reduce business risk. b. CorrectAuditors give some assurance that the information risk is low. c.

IncorrectComplexity creates demand for accounting services, but is not an audit objective. d. IncorrectAuditors only indirectly control the timeliness of financial statements. 1. 32d. CorrectAnswers a, b, and c refer to a financial statement audit, an internal controls attestation engagement, and an operational audit, respectively. Compliance refers to following laws, rules, regulations, and policies. 1. 33d. CorrectWhile answers a, b, and c are true, experience, education, and successful completion of the Uniform CPA are all necessary to be licensed as a CPA. 1. 34d. CorrectThe mission of the U. S.

Government Accountability Office is to ensure that public officials are using public funds efficiently, effectively, and economically. 1. 35b,d CorrectThe two categories of performance audits are economy and efficiency audit and program audits. 1. 36c. CorrectReview of credit ratings of customers gives indirect evidence of the collectibility (valuation) of accounts receivable. 1. 37a. IncorrectRhonda’s representations are not sufficient evidence to support assertions made in the financial statements. b. IncorrectDespite Rhonda’s representations, Jones must gather additional evidence to corroborate Rhonda’s assertions. . IncorrectRhonda’s representations are a form of evidence (albeit weak) that should neither be disregarded, nor blindly regarded without professional skepticism. d. CorrectRhonda’s assertions need corroboration. 1. 38a. IncorrectAlthough there is a high level of risk associated with client acceptance, this phrase was created by the authors. b. CorrectInformation risk is the probability that the information circulated by a company will be false or misleading. c. IncorrectMoral hazard is the risk that the existence of a contract will change the behavior of one or both parties to the contract. d.

IncorrectBusiness risk is the probability an entity will fail to meet its objectives and, ultimately, fail. 1. 39a. CorrectCompleteness includes cutoff which refers to accounting for revenue, expense, and other transactions in the proper period (neither postponing some recordings to the next period nor accelerating next-period transactions into the current-year accounts). 1. 40d. CorrectThe objective related to rights and obligations is to establish with evidence that amounts reported as assets of the company represent its property rights and that the amounts reported as liabilities represent its obligations. . 41b. CorrectManagement’s existence assertion states that reported assets, liabilities, and equities actually exist. 1. 42a. IncorrectUnder Sarbanes-Oxley, professional service firms are prevented from acting in a managerial decision making role for an audit client. b. IncorrectUnder Sarbanes-Oxley, professional service firms are prevented from auditing the firm’s own work on an audit client. c. IncorrectUnder Sarbanes-Oxley, professional service firms may only provide tax consulting service to an audit client with the audit committee’s approval. d.

CorrectSarbanes-Oxley prevents professional service firms from engaging in any of the above listed capacities. 1. 43 d. CorrectReciprocity refers to the process through which CPAs licensed in one state can obtain a CPA certificate and license in another state. 1. 44a. CorrectAuditing is a subset of attestation engagements that focuses on the certification of financial statements. b. IncorrectAuditing is a subset of attestation that provides higher assurance than that provided by an attestation engagement. c. IncorrectConsulting engagements focus on providing clients with advice and decision support. d.

IncorrectAssurance engagements are designed to improve the quality of information, or its context, for decision makers. 1. 45d. CorrectAlthough auditing is a subset of attestation, and attestation is a subset of assurance, the focus of the engagements tends to be very specific. 1. 46d. CorrectCredibility, advancement, and monetary rewards are all reasons to become certified. SOLUTIONS FOR EXERCISES AND PROBLEMS 47. Audit, Attestation, and Assurance Services Students may encounter some difficulty with this matching because the Special Committee on Assurance Services listed many things that heretofore ave been considered “attestation services” (long before assurance services were invented). Maybe this is a good vehicle for discussing the considerable overlap between attestation services (attestation standards) and assurance services. • Real estate demand studies — Assurance service (listed by SCAS but not in the textbook chapter) • Ballot for awards show — Assurance service (listed by SCAS but not in the textbook chapter) [But PwC attested to the Academy Awards ballot results long before assurance services were invented] Utility rate applications — Attestation service (or maybe a consulting service; I’m somewhat surprised the SCAS did not list it as an assurance service. ) • Newspaper circulation audits –Assurance service (listed by SCAS but not in the textbook chapter) [But this work has appeared in prior years in examples of attestation services] • Third-party reimbursement maximization — Assurance service (listed by SCAS and listed in the textbook chapter) • Annual financial report to stockholders — Audit service Rental property operations review — Assurance service (listed by SCAS and listed in the textbook chapter) • Examination of financial forecasts and projections — Attestation service (but also listed by SCAS as an assurance service) • Customer satisfaction surveys– Assurance service (listed by SCAS and listed in the textbook chapter) • Compliance with contractual requirements — Attestation service (but also listed by SCAS as an assurance service) • Benchmarking/best practices — Assurance service (listed by SCAS and listed in the textbook chapter) Evaluation of investment management policies — Assurance service (listed by SCAS and listed in the textbook chapter) • Information systems security reviews — Assurance service (listed by SCAS and listed in the textbook chapter) • Productivity statistics — Attestation service (but also listed by SCAS as an assurance service under various descriptions) • Internal audit strategic review — Assurance service (listed by SCAS and listed in the textbook chapter) • Financial statements submitted to a bank loan officer — Audit service 1. 49 ASB Assertions PCAOB Assertion |Corresponding ASB assertion |Nature of assertion | |Existence or Occurrence |Existence |Balance | | |Occurrence |Transactions | | | |Disclosures | |Rights and Obligations |Rights and Obligations |Balances | | | |Disclosures | |Completeness |Completeness |Transactions | | | |Balances | | | |Disclosures | | |Cutoff Transactions | |Valuation and Allocation |Accuracy |Transactions | | | |Disclosures | | |Valuation |Balances | | | |Disclosures | |Presentation and Disclosure |Classification |Transactions | | | |Disclosures | | |Understandability |Disclosures | 1. 52Identification of Audits and Auditors The responses to this matching type of question are ambiguous. The engagement examples are real examples of external, internal and governmental audit situations. You might point out to students that the distinctions among compliance, economy and efficiency and program results audits are not always clear. The “solution” is shown below in matrix form, showing some engagement numbers in two or three cells. The required schedule follows. |Type of Audit | | |Financial Statement | |Economy, Efficiency |Program | |Auditor | |Compliance | |Results | |Independent CPA |2, 10 | | | | |Internal Auditor | |6, 8 |4, 8 | | |Governmental (GAO) | | |1, 3 |1, 3, 9 | |IRS Auditor | |5 | | | |Bank Examiner | |7 | | | |Proprietary school’s training expenses |Economy and Efficiency Program Results |Governmental (GAO) | |Advertising agency financial statements |Financial statement |Independent CPAs | |Dept. f Defense launch vehicle |Economy and Efficiency or Program Results |Governmental (GAO) | |Municipal services |Economy and Efficiency |Internal auditors | |Tax shelters |Compliance |IRS auditors | |Test pilot reporting |Compliance |Internal auditors | |Bank solvency |Compliance |Bank examiners | |Materials inspection by manufacturer |Compliance or Economy and Efficiency |Internal auditors | |States’ reporting chemical use data |Program goal |Governmental (GAO) | |Sports complex forecast |Financial statement |Independent CPAs |

SOLUTIONS FOR REVIEW CHECKPOINTS 2. 1For independent (external) auditors of financial statements, practice standards are issued by the AICPA Auditing Standards Board (in the form of Statements on Auditing Standards) and the Public Company Accounting Oversight Board (in the form of Auditing Standards). Statements on Auditing Standards are appropriate for the audits of nonpublic entities, while Auditing Standards are appropriate for the audits of public entities. For governmental auditors, the Government Accountability Office issues Government Auditing Standards (also known as the “Yellow Book”). For internal auditors, the Institute of Internal Auditors issues

Statements of Internal Auditing Standards (also known as the “Red Book”). For fraud auditors, the Association of Certified Fraud Examiners issues Professional Standards and Practices for Certified Fraud Examiners. For auditors in other countries, the IFAC International Auditing and Assurance Standards Board issues International Standards on Auditing and Assurance. 2. 2Generally accepted auditing standards are standards that identify necessary qualifications and characteristics of auditors and guide the conduct of the audit examination. Generally accepted accounting principles represent the requirements for the preparation and presentation of financial statements and accompanying footnote disclosures.

These two types of standards are related to one another because a primary objective of a is to allow auditors to conclude whether an entity’s financial statements are prepared and presented in conformity with GAAP. 2. 3The three fundamental principles are: 1. Responsibilities, which involves having appropriate competence and capabilities, complying with relevant ethical requirements, maintaining professional skepticism and exercising professional judgment. 2. Performance, which requires auditors to obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement by: (1) planning the work and properly supervising assistants; (2) determining and applying appropriate material levels; (3) identifying and assessing the risk of material misstatement; and, (4) obtaining sufficient appropriate audit evidence. 3.

Reporting, which requires the auditor to express an opinion as to whether the financial statements are prepared in accordance with the applicable financial reporting framework. Auditing procedures relate to acts to be performed during the engagement. Auditing standards deal with measures of the quality of performance of those acts and the objectives to be attained. Auditing standards are less subject to change and provide the criteria for rejecting, accepting, or modifying auditing procedures in a given circumstance. An example of the relative stability of standards and procedures is found in the change from non-computerized information systems to computerized information systems.

New auditing procedures were required to evaluate computerized information systems, but auditing standards remained unchanged and were the criteria for determining the adequacy of the new auditing procedures. 2. 4Independence in fact represents auditors’ mental attitudes (do auditors truly act in an unbiased and impartial fashion with respect to the client and fairness of its financial statements? ). Independence in appearance relates to financial statement users’ perceptions of auditors’ independence. Auditors can be independent in fact but not perceived to be independent. For example, ownership of a small interest in a public client would probably not influence auditors’ behavior with respect to the client. However, it is likely that third-party users would not perceive auditors to be independent. 2. Due care reflects a level of performance that would be exercised by reasonable auditors in similar circumstances. Auditors are expected to have the skills and knowledge of others in their profession (known as that of a prudent auditor) and are not expected to be infallible. 2. 6Professional skepticism is a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. Professional judgment is the auditors’ application of relevant training, knowledge, and experience in making informed decisions about appropriate courses of action during the audit engagement. Auditors are required to demonstrate professional skepticism and professional judgment throughout the entire audit process. 2. Reasonable assurance recognizes that a GAAS audit may not detect all material misstatements and auditors are not “insurers” or “guarantors” regarding the fairness of the company’s financial statements. The following characteristics of an audit do not permit auditors to provide absolute assurance: • Mistakes and misinterpretations may occur • Management judgments and estimates affect financial reporting • Audit procedures cannot always be relied upon to detect misstatements • Audit engagements must be conducted within a reasonable period of time and so as to achieve a balance between benefit and cost. 2. 8Three elements of planning and supervision considered essential in audit practice are: • A written audit plan. • An understanding of the client’s (auditee’s) business. Policies to allow an audit team member to document disagreements with accounting or auditing conclusions and disassociate him or herself from the matter. 2. 9The timing of the auditors’ appointment is important because auditors need time to properly plan the audit and perform the necessary work without undue pressure from tight deadlines. 2. 10Materiality is the dollar amount that would influence the lending or investing decisions of users; this concept recognizes that auditors should focus on matters that are important to financial statement users. Materiality should be considered in planning the audit, performing the audit, and evaluating the effect of misstatements on the entity’s financial statements. 2. 1Auditors obtain an understanding of a client, including its internal control, as a part of the control risk assessment process primarily in order to plan the nature, timing and extent of substantive audit procedures. A secondary purpose is because of auditors’ responsibilities for reporting on client’s internal controls under Auditing Standard No. 5. 2. 12As the client’s internal control is more effective (a lower level of control risk), auditors may use less effective substantive procedures (a higher level of detection risk). Conversely, when the client’s internal control is less effective (a higher level of control risk), auditors must use more effective substantive procedures (a lower level of detection risk). 2. 13Audit evidence is defined as the information used by auditors in arriving at the conclusion on which the audit opinion is based. 2. 4External documentary evidence is audit evidence obtained from another party to an arm’s-length transaction or from outside independent agencies. External evidence is received directly by auditors and is not processed through the client’s information processing system. External-internal documentary evidence is documentary material that originates outside the bounds of the client’s information processing system but which has been received and processed by the client. Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored within the client’s information processing system. Such evidence is either not circulated to outside parties at all or is several steps removed from third-party attention. 2. 5In general, evidence that is completely external in nature is most reliable, because the client has not influenced its processing. In contrast, evidence that is completely internal in nature is least reliable, as it may represent a fictitious transaction created or modified by client personnel to enhance perceptions of the client’s financial statements. 2. 16As auditors need to achieve lower levels of detection risk, more appropriate evidence needs to be obtained. Thus, auditors should gather higher quality evidence (more reliable evidence). For example, auditors may choose to obtain evidence from external sources rather than internal sources.

In addition, for lower levels of detection risk, auditors need to gather more sufficient evidence. Because sufficiency relates to the quantity of evidence, a greater number of transactions or components of an account balance should be examined. 2. 17A financial reporting framework is a set of criteria used to determine the measurement, recognition, presentation, and disclosure of material items in the financial statements. The financial reporting framework is related to auditors’ reporting responsibilities because this framework serves as the basis against which the financial statements are evaluated and the auditors’ opinion on the financial statements is expressed. 2. 18Four types of opinions and their conclusions: Type | |Conclusion | |Unqualified opinion | |Financial statements are presented in conformity with GAAP. | |Adverse opinion | |Financial statements are not presented in conformity with GAAP. | |Qualified opinion | |Financial statements are presented in conformity with GAAP, except for one or | | | |more departures or issues of concern. | |Disclaimer of opinion | |An opinion cannot be issued on the financial statements. | 2. 19The auditors’ report is dated at the point when all significant procedures have been completed by auditors and auditors have gathered sufficient appropriate evidence.

This date is referred to as the audit completion date. 2. 20Public accountants should issue a report when they are associated with financial statements because users may mistakenly assume that an audit has been conducted and that the entity’s financial statements are fairly presented according to GAAP. 2. 21The purpose served by the attestation standards is to guide work in attestation areas and engagements other than audits of financial statements. 2. 22The major differences between attestation standards and generally accepted auditing standards (GAAS) lie in the areas of practitioner competence, materiality and the risk of material misstatement, and reporting.

GAAS presume knowledge of accounting and require competence and capabilities as auditors (meaning auditors of financial statements). The attestation standards are more general, requiring training and proficiency in the “attest function” and knowledge of the “subject matter of the assertions. ” The attestation standards have no specific requirement for determining materiality levels or obtaining and understanding of the entity and its environment to assess the risk of material misstatement. Because attestation engagements may cover information not confined to accounting and financial assertions, these activities may not be appropriate for all attest engagements.

Reporting is different because attestations on nonfinancial information do not depend upon generally accepted accounting principles. In addition, GAAS do not address two reporting issues (stating significant reservations about the engagement and indicating that the report is only intended for specified parties) that are important reporting aspects for attestation engagements. 2. 23A system of quality control provides firms with reasonable assurance that the firm and its personnel (1) comply with professional standards and applicable regulatory and legal requirements and (2) issue reports that are appropriate in the circumstances. The six elements of a system of quality control are: . Leadership responsibilities for quality within the firm (“tone at the top”) 2. Relevant ethical requirements 3. Acceptance and continuance of clients 4. Human resources 5. Engagement performance 6. Monitoring 24. In deciding whether to accept or continue an engagement with a client, firms should consider: • The integrity of the client and the identity and business reputation of its owners, key management, related parties, and those charged with governance. • Whether the firm possesses the competency, capability, and resources to perform the engagement. • Whether the firm can comply with the necessary legal and ethical requirements.

If firms decide to withdraw from an engagement, the firm should document significant issues, consultations, conclusions, and the basis for any conclusions related to the decision to withdraw. 25. Typically, firms that audit nonpublic companies have peer reviews conducted through the AICPA’s Center for Public Company Audit Firms Peer Review Program. While firms that are subject to PCAOB review requirements can elect to have peer reviews conducted under this program, most choose not to do so. 2. 26The PCAOB’s monitoring role for firms providing auditing services to public entities includes registering public accounting firms and conducting inspections of registered public accounting firms (similar to peer reviews). 2. 7The frequency of PCAOB inspections depends upon the number of audits conducted by member firms. For firms performing audits for more than 100 public companies, inspections are required on an annual basis. For those performing audits for fewer than 100 public companies, inspections are conducted every three years. SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 2. 28a. CorrectGathering audit evidence is a component of the performance principle. b. IncorrectWhile reasonable assurance is related to gathering audit evidence, this is not one of the categories of principles c. IncorrectThe reporting principle relates to the contents of the auditors’ report d.

IncorrectThe responsibilities principle relates to the personal integrity and professional qualifications of auditors. 2. 29a. IncorrectThis practice relates to accountants’ competence and capabilities, not due care. b. IncorrectThis practice relates to the reporting principle. c. IncorrectSufficiency of evidence relates to the performance principle and not due care. d. CorrectThese practices are a part of due care. 2. 30a. IncorrectGAAS relates to the conduct of audit engagements and not overall professional services. b. CorrectStandards within a system of quality control are firm- (rather than auditor-) related. c. IncorrectGAAP relates to accounting and financial reporting, rather than auditing practices. d.

IncorrectInternational auditing standards govern the conduct of audits conducted across international borders. 2. 31a. IncorrectRelying more extensively on external evidence is related to the appropriateness (or quality) of evidence. b. IncorrectFocusing on items with more significant financial effects on the financial statements is related to materiality. c. CorrectProfessional skepticism is characterized by appropriate questioning and a critical assessment of audit evidence. d. IncorrectFinancial interests are most closely related to auditors’ independence. 2. 32a. CorrectAuditors study internal control to determine the nature, timing, and extent of substantive tests. b.

IncorrectConsulting suggestions are secondary objectives in an audit. c. IncorrectInformation about the entity’s internal control is, at best, indirect evidence about assertions in the financial statements. d. IncorrectInformation about the entity’s internal control provides auditors with little opportunity to learn about changes in accounting principles. 2. 33a. IncorrectExternal evidence is considered to be relatively reliable. b. CorrectManagement representations should least affect auditors’ conclusions, as they have not been validated or corroborated by external parties. c. IncorrectAuditor-prepared evidence is considered to be the most reliable form of evidence. d.

IncorrectAlthough a representation of a client employee, inquiry of the entity’s legal counsel is considered more reliable than that of entity management. 2. 34a. IncorrectInquiry of management should least affect auditors’ conclusions. b. IncorrectAlthough very persuasive, auditors’ personal knowledge (choice d) provides the most persuasive evidence c. IncorrectObservation of a client’s procedures provides evidence on the effectiveness of the client’s internal control, but not the existence assertion for newly-acquired computer equipment. d. CorrectAuditors’ personal knowledge provides the most persuasive evidence. 2. 35a. IncorrectInquires of client personnel are the least reliable form of evidence. b.

IncorrectWhile more reliable than inquiries (choice a), inspection of internal documents is relatively low in terms of reliability. c. IncorrectWhile sales invoices are documents created by external parties, the fact that these documents were received from client personnel decreases their reliability. d. CorrectBecause the statements were received directly from outside parties, this is a more reliable form of evidence than choice (c). 2. 36a. IncorrectDocumentation of this nature would not be related to independence. b. IncorrectWhile the quality of the documentation and the conclusions included in the documentation might provide information about competence and capabilities, choice (c) is more appropriate. c.

Correct Initials of the preparer and reviewer provide evidence that the documentation was reviewed, which relates to planning and supervision. d. IncorrectWhile the quality of the documentation and the conclusions included in the documentation might provide information about sufficient appropriate evidence, choice (c) is more appropriate 2. 37NOTE TO INSTRUCTOR: Since this question asks students to identify the requirement that is not included in attestation standards, the response labeled “correct” is not included in attestation standards and those labeled “incorrect” are included in attestation standards. a. IncorrectAttestation standards require adequate knowledge of the subject matter. b.

CorrectAn understanding of the client’s environment (including internal control) is not required under attestation standards, because internal control may not always be relevant to the subject matter of the attestation. c. IncorrectAttestation standards require sufficient evidence to be gathered. d. IncorrectAttestation standards require independence in mental attitude. 2. 38NOTE TO INSTRUCTOR: Since this question asks students to identify the concept that is least related to due care, the response labeled “correct” is least related to due care and those labeled “incorrect” are more related to due care. a. IncorrectDue care requires the level of skills and knowledge of others in the auditors’ profession, which would require independence in fact. b. IncorrectSee choice (a) above. c. IncorrectDue care refers to the performance of a “prudent” auditor. d.

CorrectDue care recognizes that mistakes and misinterpretations may occur during the audit. 2. 39a. IncorrectInternal documents are a relatively low quality of evidence. b. IncorrectManagement representations (and the related verbal inquiries) are the lowest quality of evidence. c. IncorrectWhile direct, external evidence is of reasonable quality, it is of lower quality than direct personal knowledge of the auditor (choice d). d. CorrectDirect, personal knowledge of auditors is the most appropriate form of evidence. 2. 40a. IncorrectWhile it may increase auditors’ knowledge about the client, obtaining an understanding of a client’s internal control does not directly influence auditors’ competence and capabilities. b.

IncorrectObtaining an understanding of a client’s internal control does not directly influence auditors’ independence. c. IncorrectObtaining an understanding of a client’s internal control does not directly help satisfy the quality control standard about audit staff professional development. d. CorrectThe primary purpose of obtaining an understanding of a client’s internal control is to plan the nature, timing, and extent of substantive audit procedures on an engagement. 2. 41d. CorrectIndependence confirmations would ensure that all firm personnel are independent with respect to that firm’s clients, which is related to the “Relevant Ethical Requirements” element of a system of quality control.

It would not relate to acceptance and continuance of clients (a), engagement performance (b), or monitoring (c). 2. 42b. CorrectGovernment auditing standards are issued by the Government Accountability Office (GAO). Governmental accounting standards are issued by the Governmental Accounting Standards Board. 2. 43a. CorrectConsultation with a specialist demonstrates due care if auditors do not have expertise in the area in question. b. IncorrectAuditors are experts in financial matters, not areas of art (and other collectibles) valuation. c. IncorrectGAAS applies to all audit engagements, including audit engagements for not-for-profit organizations. d. IncorrectSince (a) is correct, (d) cannot be correct. 2. 4NOTE TO INSTRUCTOR: Since this question asks students to identify the topic that is not been addressed in the auditors’ report, the response labeled “correct” is not addressed in the auditors’ report and those labeled “incorrect” are addressed in the auditors’ report. a. IncorrectThe responsibilities of the auditor and management are provided in the introductory paragraph. b. CorrectAuditors provide reasonable (but not absolute) assurance in an audit engagement (this is noted in the scope paragraph of the auditors’ report). c. IncorrectA description of the audit engagement is provided in the scope paragraph of the auditors’ report. d. IncorrectThe auditors’ opinion on internal control over financial reporting is provided in the internal control paragraph of the auditors’ report. 2. 45a.

CorrectAttestation standards differ from generally accepted auditing standards in that they apply to engagements other than those on historical audited financial statements. b. IncorrectAttestation standards require that the practitioner be independent. c. IncorrectAttestation standards may apply to prospective “what if” financial statements. d. IncorrectAttestation standards include requirements related to evidence. SOLUTIONS FOR EXERCISES AND PROBLEMS 2. 47Performance Principle The important elements of the performance principle and their relation to the C. Reis Company audit are: 1. Auditors must plan the work and appropriately supervise any assistants.

Fulfilling this element would include the preparation of an audit plan for accounts receivable and reviewing it with the assistant prior to beginning the examination. These tasks were not done. Also, the completed audit documentation should have been reviewed to determine whether an adequate examination was performed. The illustration states that this procedure was followed. 2. Auditors must determine and apply appropriate materiality levels throughout the audit. This scenario did not address the process through which materiality levels were determined, so potential strengths and weaknesses related to materiality cannot be assessed. 3. Auditors must identify and assess risks of material misstatement.

This element requires auditors to 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. The case presented did not reference any work on the internal control. Complete reliance upon prior-year audit documentation in lieu of an evaluation of the existing internal control is improper, because changes may have been implemented to the system and controls by the client. 4. Auditors must obtain sufficient appropriate audit evidence.

The assistant’s preparation of audit documentation, confirmation requests, and other procedures seem to fulfill the requirements of this standard if the audit work is properly performed and is of sufficient scope. 2. 48Time of Appointment and Planning From a theoretical viewpoint (and, in fact, from a practical viewpoint as well) such short notice of a request for an audit causes difficulties with planning the audit work, establishing staffing requirements, and reviewing the work; all of these features are important elements in the exercise of due care. The December 26 – January 20 period is a serious time constraint for an initial audit engagement.

The greatest difficulties involve due care as well as the ability to appropriately perform the engagement (planning and supervision, determining materiality levels, identifying and assessing risks of material misstatement, and obtaining sufficient appropriate evidence). In view of the short notice and the time constraint, there may be some question as to whether an audit could be adequately completed by January 20. 2. 55Principles Case Study | | | | |Responsibilities | | | | | | | |1.

Auditors are responsible for appropriate competence and | |1. It was inappropriate for Holmes to hire the two students to | |capabilities to perform the audit. | |conduct the audit. The examination must be conducted by persons | | | |with proper education and experience in the field of auditing. | | | |Inexperienced persons can assist, if they are supervised. | |2. Auditors are responsible for complying with relevant ethical | |2. To satisfy the independence requirement, Holmes must be | |requirements. |without bias with respect to the client under audit. Because of | | | |the financial interest in the bank loan, Holmes is neither | | | |independent in fact nor appearance with respect to the assignment | | | |undertaken. In addition, because of a number of actions (hiring | | | |unqualified individuals, failure to supervise those individuals, | | | |etc. ), Holmes did not appear to exhibit due care. | | | | | | | | | | |3. The fact that Holmes merely accepted the financial statements | | | |without questioning any evidence demonstrates lack of professional| |3. Auditors are responsible for maintaining professional | |skepticism (as well as a lack of good professional judgment). | |skepticism and exercising professional judgment throughout the | | | |planning and performance of the audit. | | | | | | |Performance | | | | | | | |1. The auditor must adequately plan the work and must properly | |1. This element recognizes that early appointment of auditors has | |supervise any assistants. |advantages for auditors and the client. Holmes accepted the | | | |engagement without considering the availability of staff. In | | | |addition, Holmes failed to supervise the assistants. The work | | | |performed was not adequately planned. | | | | | |2. The auditor must determine and apply appropriate materiality | |2.

There was no discussion that appropriate materiality levels | |level or levels. | |were determined or applied for the audit by either Holmes or the | | | |two accounting students. Thus, compliance with this element is | | | |difficult to assess. | |3. The auditor must assess the risk of material misstatement based| |3. Holmes did not study the client’s internal control nor did the | |on the entity and its environment. | |assistants. There appears to have been no audit examination at | | | |all.

The work performed was more an accounting service than it was| | | |an auditing service. | | | | | |4. The auditor must obtain sufficient appropriate audit evidence | |4. No evidence was obtained to support the financial statements. | |about whether material misstatements exist. | |The auditors merely checked the mathematical accuracy of the | | | |records and summarized the accounts. Standard audit procedures and| | | |techniques were not performed. | | | | |Reporting | | | | | | | |1. Based on evaluation of the evidence obtained, the auditor | |1. Because a proper examination was not conducted, the report | |expresses an opinion in accordance with the auditor’s findings, or | |should indicate that no opinion can be expressed as to the fair | |states that an opinion cannot be expressed, in the form of a written | |presentation of the financial statements in accordance with | |report. The opinion states whether the financial statements are | |generally accepted accounting principles. |prepared, in all material respects, in accordance with the | | | |appropriate financial reporting framework. | | | | | | | 2. 57System of Quality Control a. Leadership responsibilities for quality within the firm b. Engagement performance c. Human resources d. Monitoring e. Human resources f. Relevant ethical requirements g. Acceptance and continuance of clients h. Leadership responsibilities for quality within the firm i. Engagement performance SOLUTIONS FOR REVIEW CHECKPOINTS 12. Management prepares a report on the effectiveness of internal control over financial reporting. The auditors prepare reports on (1) the entity’s financial statement and other disclosures and (2) the effectiveness of the entity’s internal control over financial reporting. These can be presented as two separate reports or a combined report. 2. Management’s report on internal control over financial reporting consists of the following major components: • A statement indicating that management is responsible for establishing and maintaining adequate internal control over financial reporting. • A statement identifying the framework used by management to assess the effectiveness of the entity’s internal control. Management’s opinion on the effectiveness of the entity’s internal control, including an explicit statement as to whether the internal control over financial reporting is effective. • A statement that the registered accounting firm auditing the financial statements (auditor) has issued an attestation report on the entity’s internal control over financial reporting. 12. 3The auditors’ report serves to communicate to users three specific statements with respect to the financial statements, the conduct of the audit, and the entity in general. First, the report indicates whether the financial statements are presented in conformity with GAAP. Second, auditors use their report to indicate any unusual aspects of the audit examination.

Third, even if the financial statements are fairly presented and no problems were noted in the conduct of the audit, the auditors can use the report to communicate information useful to decision makers that may not appear on the face of the financial statements. 12. 4Nine important elements of the auditors’ standard report are: 1. Title. The title should contain the word independent, as in “Independent Registered Public Accounting Firm” or “Independent Auditors”. 2. Address. The report shall be addressed to the client, which occasionally may be different from the auditee. 3. Notice of Audit. A sentence should identify the financial statements and indicate that they were audited. This appears in the introductory paragraph. 4. Responsibilities.

The report should state management’s responsibility for the financial statements and the auditors’ responsibility for the report. These statements are also in the introductory paragraph. 5. Description of the Audit. The second paragraph (scope paragraph) should declare that the audit was conducted in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB) and describe the principal characteristics of an audit, including a statement of belief that the audit provided a reasonable basis for the opinion. 6. Opinion. The report shall express an opinion (opinion paragraph) regarding conformity of the financial statements with accounting principles generally accepted in the United States of America. 7. Internal Control.

The report should reference the auditors’ examination, report, and opinion on the client’s internal control over financial reporting. 8. Signature. The auditors (partner of the audit team) shall sign the report, manually or otherwise. 9. Date. The report shall be dated using the date

ABSTRACT

Auditing is a dynamic profession in constant search for ways to meet the growing public demand for quality services. Audit is not an inquisition and its mission is not of fault-finding. The research paper describes the various aspects of an auditing. Auditing is a vast ocean, and some of the important elements have been described in this paper. It covers the definition, types and the basic objectives of auditing. The modern methods for analysis of audits using computer software have also been presented. In order to specify the scope of the audit, an example of a state financial audit has been taken into consideration. An introduction to the appropriation audit has also been described along with the major differences between the internal audits of a socialist economy (say china) & capitalist economy (say Germany) has been described in this paper.

                   “Auditing is one that can be regarded as truly interdisciplinary”

Understanding of auditing

Definition:-

            Auditing is a systematic process of objectively obtaining and evaluating the 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 the interested users.

Objective Of an audit:-

            “TO PROVIDE REASONABLE BASIS FOR EXPRESSING AN OPINION REGARDING THE FINANCIAL STATEMENTS TAKEN AS A WHOLE”.

History of Auditing:-

            Prior to 1500 AD, nearly all accounting was concerned with accounting for the activities of government and the only form of auditing was the keeping of separate records by two different scribes. The objective of maintaining such records was primarily to detect fraud (e.g. to prevent defalcations within the treasuries), to minimize the erroneous recording of transactions, and to ensure the honesty of those responsible for the custody of resources. Internal controls were nonexistent, although during the period 1500-1850, there was recognition that standardized systems of accounting could reduce the possibility of fraud.

The industrial revolution (1750-1850) was the catalyst of a great period of economic growth in Great Britain, one feature of which was the passing of management from owners to professional managers. This led, in the period 1850 to 1905, to an increased demand for auditors who were independent of management and who were engaged to detect not only clerical (office) errors, but also management fraud. Consequently, auditors began to periodically report on the work they had performed to the owners of an entity, and thus the concept of what is now referred to as the “independent auditor’s report” emerged. T was during this time that the concept of ‘testing’ evolved. That is, auditors selected “a few haphazard cases” (to use the words in the often quoted “London and General Bank case” decision) where it was not economically feasible to physically examine all transactions that took place. The use of testing is recognized as one of the limitations of a modern day audit. Also, controls over cash were first recognized during this period as was the control inherent in double-entry bookkeeping. However, the recognition of the benefits of such controls did not affect the extent of auditors’ procedures.

In India during the 1913 Indian Companies Act has for the first time appointed an accounted as an auditor.

Steps Present In an Audit Process:-

 Scheduling an opening conference to discuss the audit objectives, timing, and report format and distribution.
Assessing the soundness of the internal controls or business systems and operations.
Testing the internal controls to ensure proper operation.
Discussing with management all preliminary observations.
Discussing with management the draft audit report and their responses, if available, prior to release of the final audit report.
Following up on critical issues rose in audit reports to determine if they have been successfully resolved.
Types of Audit:-

1)      Financial audit

2)      Operational audit

3)      Information Systems (IS) audit

4)      Integrated audit

5)      Investigative audit

6)       Follow audit

1) Financial audit:-

A historically oriented, independent evaluation performed for the purpose of attesting to the fairness and accuracy of financial data.

2) Operational audit:-A future-oriented, systematic, and independent evaluation of organizational activities. Financial data may be used, but the primary sources of evidence are the operational policies and achievements related to organizational objectives. Internal controls and efficiencies may be evaluated during this type of review.

3) Information systems audit: There are three types of IS audits namely.

3.1) General Controls Review: –

A review of the controls which govern the development, operation, maintenance, and security of application systems in a particular environment. This type of audit might involve reviewing a data center, an operating system, a security software tool, or processes and procedures (such as the procedure for controlling production program changes).

3.2) Application controls review: –

A review of controls for a specific application system. This would involve an examination of the controls over the input, processing, and output of system data. Data communications issues, program and data security, system change control, and data quality issues are also considered.

3.3) System Development review:-

      A review of the development of a new application system. This involves an evaluation of the development process as well as the product. Consideration is also given to the general controls over a new application, particularly if a new operating environment or technical platform will be used.

4) Integrated audit:-

This is a combination of an operational audit, department review, and IS audit application controls review. This type of review allows for a very comprehensive examination of a functional operation within the University.

5) Investigative audit:-

This is an audit that takes place as a result of a report of unusual or suspicious activity on the part of an individual or a department. It is usually focused on specific aspects of the work of a department or individual. All members of the campus community are invited to report suspicions of improper activity to the Director of Internal Auditing Services on a confidential basis.

7)      Follow up audit:-

These are audits conducted approximately six months after an internal or external audit report has been issued. They are designed to evaluate corrective action that has been taken on the audit issues reported in the original report. When these follow-up audits are done on external auditors’ reports, the results of the follow-up are reported to those external auditors.

MANAGEMENT AUDIT:- This is an independent activity which aims to determine what the management is doing for the fulfillment of the organization’s objectives. This may be defined as follows:

“A comprehensive and constructive examination of plans and objectives means of operation of an organization, institution or a branch of government.

Management audit is like a secret agent which keeps an eye on all levels of administration of a firm to ensure sound management thought which thus helps in maintaining effective relationship with the outside world.

Differences between Management audit & financial

MANAGEMENT AUDIT

1)      It appraises past and simultaneously makes a future oriented approach.

2)      It reports about the performance of management during that particular period.

3)       It is concerned with the financial and other critical objectives of the firm

FINANCIAL AUDIT

1)       It is confined to historical records of past performance

2)       It reports whether the financial statements show a fair view of state of affairs of a company on a particular date.

3)       It is primarily concerned with financial aspect

Major Components of an audit:-

The compliance aspect of auditing in the above block diagram is to ensure that the company is pertaining to the rules and regulations and is also following the laws and ordinances that govern the handling of the general finances such as those pertaining to taxes, spending, investing and borrowing.

Terminology of Auditing

1)      Footing: – The process of proving the totals of the verticals columns of figures.

2)      Cross footing: – The process of proving the totals of the horizontal rows of figures.

3)      Reconcile: – To establish relation between two sets of independently maintained, but related records.

4)      Voucher: – The term used to describe a document which is supporting a transaction.

Modern Techniques of Auditing:-

      Computer Assisted Techniques for Fraud Detection:-

Computer technology gives auditors a new set of techniques for examining the automated business environment. In fact, the detection of fraud is a perfect application for computer-assisted audit tools and techniques (CAATTs).

Audit software can highlight those transactions which are having a high level of fraudulent activity. With this software millions of transactions can be examined, previous year data can be compared for anomalies.

It helps the auditors to focus their efforts on areas of greatest risk and exclude low risk transactions.

Today’s audit software makes “what if” analysis easy to formulate and perform. Auditors can form an initial hypothesis, test that hypothesis, and revise it as necessary, based on the results of interactive analyses.

Types of analysis using software: –

1)      Digital analysis

2)      Ratio analysis

3)      Benford’s law

1)      Digital Analysis: -It involves the searching of invoices with even dollar amounts such as 200$ or 50004.The existence of such even numbered amount may be a symptom of fraud and must be thus examined carefully.

Case study: – Travel expenses had always been a concern for the auditors of X Company since it was an area where the controls were weak. Employees had a maximum per diem rate when traveling but had to

Submit receipts to cover the actual expenses. Maximums were also established for meals: breakfast $10.00, lunch $20.00, dinner $30.00, and hotel lodging $100.00. The auditors configured the audit software to identify meal expenses that were multiples of $10.00. These transactions were compared to receipts to ensure that the amounts expensed were appropriate. A detailed review determined that many travelers were charging the maximum rates for meals even though their receipts did not justify the amounts

2)      Ration analysis: –

Auditors concerned about prices customers were being charged for products could calculate the ratio of the maximum sales price to the minimum sales price for each product. If the ratio is close to 1.0, they can be sure that there is little variance between the highest and lowest prices charged to customers. However, if the ratio is large this could indicate that a customer was being charged too much or too little for the product. A large ratio indicates that the maximum value is significantly larger than the second highest value. Companies with max/max2 ratios of 5.0 or higher would be of interest to auditors and fraud examiners because they represent a significant deviation from the norm. This is particularly true if a company has a large number of transactions within a small dollar range, except for the maximum amount. For example, a suspicious pattern would be 100 transactions, 99 of which are between $1,000 and $2,000, with the highest at $12,000 (a max/max2 ratio of 6.0)

                  Case study: –

The auditors reviewed the patient billing system at Company Y to determine if the appropriate charges were being assessed by health care providers. An initial analysis of the data was performed to calculate the ratio of the highest and lowest charges for each procedure. A judgment was made that procedure with a max/min ratio of greater than 1.30 be noted and subjected to additional review.

For a particular quarter, three procedures had ratios higher than 1.30, the highest being 1.42. A filter was used to identify the records related to the three procedures in question, and additional analysis was performed. This quickly determined that one doctor was charging significantly more than the other doctors for the same procedures. A comparison of charges from the billing system with payments in the accounts receivable system revealed that the doctor was skimming off the patient payments. The amount recorded in the receivable system was in line with the usual billing amount for the procedures. The doctor was unable to justify the higher prices or explain the difference in the billing and the receivable systems.

The third ratio compares data from different years, departments or operating areas, and the like. For example, the ratio of last year’s purchases to current year’s purchases for each supplier can point to symptoms of fraud such as kickbacks in the contracting section. If the total purchase from a supplier has gone from $100,000 to $400,000–a ratio of 4.0–further analysis may be in order.

3)      Benford’s Law: -More advanced techniques take data analysis to another level, examining the actual frequency of the digits in the data. Benford’s Law, developed by Frank Benford’s in the 1920s, predicts the occurrence of digits in data. Benford’s Law concludes that the first digit in a large population of transactions (10,000 plus) will most often be a 1. Less frequently will the first digit be a 2; even less frequently a 3. Benford calculated the occurrence of each numeral appearing as the first digit and found that it decreased inversely with its value. Benford’s Law calculates the expected frequencies (rounded to three decimal places) for first and second digits

Case study: – The auditors for Z Company were investigating possible fraud in the contracting section, where thousands of contracts were raised every month. They used Benford’s Law to examine the first two digits of the contract amount. The results of their analysis revealed that the digits 49 were in the data more often than expected. Classifying on the contracting officer for all contracts with 49 as the first two digits determined that the contracting manager was raising contracts for $49,000 $49,999 to avoid contracting regulations. Contracts under $50,000 could be sole-sourced; contracts greater than $50,000 had to be submitted to the bidding process. He was raising contracts just under the financial limit and directing them to a company owned by his wife.

Consider an audit report by an accountant general of a state. Its scope will have the following features:

            Scope of an Audit: – The scope of audit extends to the transactions of both State and Union Government offices located within the territorial jurisdiction of that particular place or region. The various aspects it covers are as follows: -.

1)      Certification audit: -Certification of finance and the appropriation of accounts prepared by the A&E office and expenditure incurred by the state government on various projects sponsored by the central government and International Development Agencies like World Bank and UNFFA.

2)      Audit of expenditure: -Examine the efficiency and correctness of the expenditure and the correctness of their accountal.

3)      Audit of stores and stocks: -To ensure that departmental rules/regulations governing procurement/ purchase, receipt, issue, custody, condemnation, sale and stock taking of stores are strictly followed and  to assess the quality of store management

4)      Audit of loans, interest and other borrowings: – To ensure that:
(i)    the transactions are within such limits if any prescribed and are in tune with the authority that govern them;
(ii)    the transactions are correctly reflected in the accounts;
(iii)  the balances relating to these accounts represent amounts which are realizable and there exists a mechanism for periodic confirmation of balances.

APPROPRIATION AUDIT: –

         INTRODUCTION : -In accordance with the provision of Article 204 of the Constitution of India, soon after the grants under Article 203 are made by the State Legislature, an Appropriation Bill is introduced to provide for appropriation out of the Consolidated Fund of the State. The Appropriation Bill passed by the State Legislature contains authority to appropriate sums from the Consolidated Fund of the State for the specified services. Subsequently, supplementary or additional grants can also be sanctioned by subsequent Appropriation Acts in terms of Article 205 of the Constitution of India.

2.1.2 The Appropriation Act includes the expenditure which has been voted by the Legislature on various grants, in terms of Articles 204 and 205 of the Constitution of India, and also the expenditure which is required to be charged on the Consolidated Fund of the State. The Appropriation Accounts are prepared every year, indicating the details of amounts on various specified services actually spent by Government vis-à-vis those authorized by the Appropriation Act.

2.1.3 The objective of appropriation audit is to ascertain whether the expenditure actually incurred under various grants is within the authorization given under the Appropriation Act, and ensure that the expenditure required to be charged under the provisions of the Constitution is so charged. It also ascertains whether the expenditure so incurred is in conformity with the law.

Internal Auditing:-

Definition: – An ongoing appraisal of the financial health of a company’s operations by its own employees is known as internal auditing. Employees who carry out this function are called internal auditors.

During an internal audit, internal auditors will evaluate and monitor a company’s risk management, reporting, and control practices and make suggestions for improvement.

Internal auditing covers not only an organization’s finance function, but all the operations and systems in a firm. While internal auditors are typically accountants, this activity can also be carried out by other professionals who are well-versed with a company’s functions and the relevant regulatory requirements.

While internal audit is one of the most important function and procedure for internal control of the firms’ normal operations from the perspective of financial terms, however, different nations, due to their stages of economic developments (developed nations vs. developing nations), unique governmental regulations, and different societal and cultural traditions, have implemented different internal audit systems and approaches.  This paper describes a comparative study exploring some key differences between the internal audit system in China and its counterpart in Germany – from the following five important aspects: the origin and development of internal audit, the structure of internal audit system, the relationship between firms’ internal audit and the government agency, the responsibility and accountability of internal audit, and the quality of internal auditors.  Based on the comparative analysis, four suggestions are made for future improvement on the internal audit system in China, along with managerial discussions.

a COMPARATIVE STUDY ABOUT INTERNAL AUDITING APPROACH          BETWEEN GERMANY AND CHINA:-

As the Chinese economic reform started in 1980s, the demand for a better internal control of enterprises forced the need of a formal internal audit and the development of a complete internal audit system.  While internal audit has been recognized as an important function and procedure for internal control of the firms’ normal operations from the perspective of financial terms, however, different nations, due to their stages of economic developments (developed nations vs. developing nations), unique governmental regulations, and different social and cultural traditions, have implemented different internal audit systems and approaches.  From a historical and comparative view of point, while the internal audit process in China has only started two decades ago and been actually developed during last ten years with many weaknesses and problems to be further addressed and improved, the internal audit in Germany, in comparison, has been evolved and developed over the last hundred years and its internal audit system has been well established and proven to be an effective internal control tool for enterprises in Germany. As such, it is believed that Chinese internal audit professionals can learn important and meaningful lessons from a comparative analysis between the two internal audit systems.  That is the primary motivation for this research.  This following report describes a comparative study exploring some key differences between the internal audit systems in China (communist economy) and its counterpart Germany(capitalist economy)

The four, main differences which have been described below are:-

1)      the origin and development of internal audit

2)      the structure of internal audit system

3)      the relationship between firms’ internal audit and the government agency

4)      the responsibility and accountability of internal audit, and

            In China, the development and establishment and of firms’ internal audit has been pushed by the rapid development and growth of national market economy along with the implementation of government’s administrative policies (Jou 1997). In August 1983, the State Council approved and circulated the Request for Instructions on Several Issues Concerning audit Work by the National Audit Office, requiring the conduct of internal audit through setting up internal audit units within competent departments exercising unified leadership of their subsidiaries or with many subsidiaries, and large- and medium-sized enterprises and undertakings.  In 1987, Chinese Institute of Internal Auditors was established, and it joined International Institute of Internal Auditors in December in the same year. In 1988, The State Council issued People’s Republic of China’s Auditing Standards, in which chapter VI stipulated the establishment and responsibilities of internal audit units, and the relationship between internal audit units and government audit institutions in its internal audit.  In 1994, The State Council issued The Law of Auditing, and it also determined the legal status for internal audit. In 1995, The China National Audit Office published The Regulations on Internal Audit, making more specific rules on internal audit. In 2003, The China National Audit Office implemented The China National Audit Office’s Regulations on Internal Audit (2003), Which improved the regulations issued in 1994. On the other hand, the internal audit professionals have increased dramatically since 1987, and there are more than 10 test centers established up for the qualification examination of CIA (certified Internal Auditor). At the end of 2001, there were about 76,000 internal audit units in China with 193,000 certified professionals.

            In Germany, the establishment and development of internal auditing is the product of rapid development of the market economy and the changing objectives of internal audit (Wang 2003). The first modern internal audit department emerged in Friedrich Krupp Company in 1875. The internal audit developed quickly in Germany in sixty years after the middle of 20th century. At beginning, the objective of internal audit was checking error and protecting malpractices. Along with the development of economy, the structure of business companies becomes complicated, and the need to strengthen internal control and management was intensified. So the objective of internal audit is changed to improving economic benefits of company. The internal auditors are not only the member of management team, but also the protectors of company.  Currently, there are about 50,000 certified professionals in the internal audit units in Germany.

(2) The Structure and Establishment of Internal Audit System:

            Based on the current international practice, there are three different system structures of establishment of internal audit units in a business enterprise. In the first structure, the internal audit unit is established parallel to the Board of Directors and is directed by the leader of the monitoring committee. In comparison, under the second structure, the internal audit unit is established parallel to the other departments in the company and is administered by the Board of Directors. Finally, with the third structure, the internal audit unit is placed inside the finance unit, as internal auditing is one of key functions of the finance department. Under the first structure, the internal auditors can keep independence during the audit process as the internal audit unit can set up and do auditing work without outside interference and any influences from other departments. Under the second structure, the internal auditors’ independence is limited and it is difficult for internal audit unit to audit the other departments at the same level. Under the third structure, it is obvious that the internal auditors can hardly keep independence during the audit process because finance department has financial supervisory function on its subsidiary and other departments and the internal audit is also one function of finance department.

            In China, all internal audit units are structured into the business enterprises according to either the second or the third structures described above. Comparatively, in Germany, all internal audit units are established based on the first structure.  As such, the internal audit units in Germany can keep much more independence during the audit process than their Chinese counterparts in China.

(3) The Relationship between Internal Audit and Government:

            In China, the internal audit units in the government owned companies have a close relationship with the government regulation agency. All business internal audit units are established according to the government’s administrative guidelines. The No. 29 Standards in National Auditing Law regulates the establishment of internal audit units, and the internal audit units in government owned companies must be guided and supervised by local government. This standard clarifies the legal relationship between business internal audit units and government audit agency and does not lay down rigid rules for setting up of internal audit functions allowing for difference between business internal audit units and government audit agencies.  That is, in China, a business internal audit unit is under dual-supervision. One is from the leadership of its own department or enterprise, and another is from the guidance and supervision of the state auditing departments, which represent the government (Jou 1997; and Cai 1997).

            In comparison, there is no law or regulations about establishment of internal audit units in Germany. The internal audit units are set up as self-discipline mechanism of enterprises, and the internal audit units in any business entities will not be supervised by local government (He 2001). In fact, the Internal Auditor Association in Germany functions as a bridge and bond between government and business and professional enterprises. Through enacting audit standards, Internal Auditor Association functions in communicating audit work experience, conveying audit messages, developing related working theory, and guiding internal audit practice.

(4) The Responsibility, Accountability, and Content of Internal Audit:

            The article No. 9 in The Regulations on Internal Audit published by the China National Audit Office regulates the responsibilities of internal auditors in China: (1) the internal auditors should audit the economic activities about public finance revenue, the public finance expenditure, financial revenue, and financial expenditure in the enterprises and their subordinates. (2) The internal auditors should audit the management and application of capital inside budget and outside the budget. (3) The internal auditors should audit the accountability of leaders during their terms of office.  (4) The internal auditors should audit project construction. (5) The internal auditors should examine and evaluate soundness and efficiency of internal control system and risk management. (6) The internal auditors should do operational or performance auditing.  (7) And finally, the internal auditors should perform other auditing works required and regulated by laws or regulations. From the standards listed above, it can be seen that the China’s internal audit systems pay more attention on financial audit and compliance audit – a single function. That is, the internal audit stresses on supervision function only, checking out violation of rules and regulations, but ignoring how to strengthen the ability of administration, or improve service efficiency to help business managers make related important decisions.

In Germany, the responsibilities of internal auditors include: (1) determining whether the internal control and monitoring system are perfect and effective; (2) evaluating the economic benefits enterprises; (3) evaluating whether the laws and regulations are observed (Wang 1999). In addition, the internal auditors also provide services, such as consulting, guiding the departments to improve operations and helping them to resolve the problems. The Germany’s internal audit systems focus more on management audit and performance audit – with multiple functions including both supervision and providing service.

Works Cited

1)      Dhruba and   Duttachowdhury. Principles of audit and internal auditing. Calcutta, 1988

2)      Accountant General of Nagaland. <Http://www.agnagaland.gov.in/sofaudit.htm>

3)      The five principles of auditing Http://www.springerlink.com/home/main.mpx

4)      Ray Whittington. Principles of auditing and other assurances

5)      Chen, W. & Sun, S., (1997) “Unification of independence, authoritativeness and efficiency organizational form of internal audit”, Managerial Auditing Journal, Vol.12, Iss.4/5, p.196.

6)      Cai, Chuanbing (1997). “Internal audit under the socialist market economy system”, Managerial Auditing Journal, Vol.12, Iss.4/5. p.210.

7)      He, Yijian (2001). “Internal Audit in Germany”, China Auditing, Vol. 7.

8)      Jou, Jianwua (1997). “The present situation and developing trends of Chinese internal auditing”, Managerial Auditing Journal, Vol.12.

9)      Wang, Liqing (2003), “The new development of internal audit module in Germany”, Sichuan Accounting, Vol. 8.

10)  Wang, Jingyan (1999). “The introduction and think of internal audit in Germany”, Guangdong Auditing, Vol. 5.

11)  The China National Audit Office’s Regulations on Internal Audit, May 1st, 2003.

12)  The Law of Auditing in People’s Republic of China (1995).  January 1, 1995.

The communication and review plan includes a formal process for finalizing and reporting the findings and recommendations of reviews and documenting arrangements for follow-up work. The arrangements for closing the project, and the outputs required, will be documented in the audit terms of reference and will follow a formal process and timetable. A reporting protocol covers the Structure and format of final reports, Arrangements for availability and publishing of final reports and regular and ad-hoc reporting to the Chief Executive Team and the Performance & Audit Committee.

Reviews will be approved by senior management and the audit element will be approved by the Performance and Audit Committee. Each review will have defined arrangements for closure. This will include any post evaluation and post implementation reviews required. Developing nations like India, China, and Mexico are gaining access to connected computing. The next generation of users represents a vast business opportunity for the computer industry. Intel is taking a leading role in identifying how technology can be applied in emerging markets—markets with very different needs than those in a typical Western country.

Capitalizing on that opportunity requires new products and services that meet the needs of emerging markets. Intel’s successful technology products are focused on solving real-world needs. That requires suppliers to determine what their users really care about, the context in which they use technology, and the problems they are trying to solve using technology. Aided by traditional market research techniques such as surveys and focus groups helps identify trends and informs Intel about what computer users are doing. Intel Corporation has a fiscal year that ends on the last Saturday in December.

Fiscal year 2001, a 52-week year, ended on December 29, 2001. Fiscal year 2000 was a 53-week year that ended on December 30, while 1999, a 52-week year, ended on December 25. The next 53-week year will end on December 31, 2005. In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets. ” Beginning in the first quarter of fiscal 2002, the company will no longer amortize goodwill, but will perform impairment tests annually or earlier if indicators of potential impairment exist.

All other intangible assets continue to be amortized over their estimated useful lives. Based on acquisitions completed as of June 30, 2001, application of the goodwill non-amortization provisions is expected to result in a decrease in amortization of approximately $1. 6 billion for fiscal year 2002. Effective as of the beginning of 2001, Intel adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, which requires the company to recognize all derivative instruments as either assets or liabilities on the balance sheet at fair value.

“The cumulative effect of the adoption of SFAS No. 133 was an increase in income before taxes of $45 million, which is included in interest and other, net for 2001. The adoption did not have a material effect on other comprehensive income. “(Intel, 2006) Highly liquid debt securities (Cash and cash equivalents) with insignificant interest rate risk and with original maturities of three months or less are classified as cash and cash equivalents.

STRENGTHS, WEAKNESSES, MARKET CONCERNS AND REGULATORY ISSUES

In 2004, 75% of Intel’s revenues originated from outside US, up 50% in five years. Processors designed for the mobile computing market segment increase more than 35% 2005. In high performance computing, Intel chip’s power almost 66% of the world’s fastest supercomputers. Internally, the company realizes improvement is needed regarding internal controls regarding implementation of new and existing requirements. However, Intel vulnerably appears in their stock position.

Second-quarter profit tumbled 57% on lower sales, as it faced increased competition and cut prices to clear out excess inventory. Last month, Intel rolled out new chip architecture in a bid to win back market share it lost in 2005 to AMD. The overhaul includes new chips for corporate servers, desktop and laptop computers. “The traditional regulatory structure relied on self-regulation by members, combined with general oversight by the Securities and Exchange Commission (SEC). ” (Macey, 2005).

Intel has the choice of observing from afar or use their considerable influence to accelerate the process and direction of regulatory issues on the political, social and financial level. They will benefit. If they don’t, the aggressive entrepreneurs will use the above tactic to legislate market share from the established companies to their favor.

REFERENCE(S)

Red R. Samar, Publication Date: September 17, 2004, Intel Shifts Course on Microprocessors. Newspaper Title: Manila Bulletin.. Page Number: NA. COPYRIGHT 2004 Manila Bulletin Publishing Corp. ; COPYRIGHT 2004 Gale Group

Source Article

Information Systems Risk and Audit Planning by Jean C. Bedard, Lynford Graham and Cynthia Jackson.  International Journal of Auditing. Int. J. Audit. 9: 147–163 (2005)

The purpose of the above research article is to provide empirical evidence on the nature and frequency of client characteristics affecting audit planning relevant to systems risk, and to assess the association of these characteristics with auditors’ systems risk assessments and audit planning decisions.

Research Definition

From Wikipedia: The word research derives from Middle French; its literal meaning is ‘to investigate thoroughly’. Research is often described as an active, diligent, and systematic process of inquiry aimed at discovering, interpreting, and revising facts. This intellectual investigation produces a greater understanding of events, behaviors, or theories, and makes practical applications through laws and theories. The term research is also used to describe a collection of information about a particular subject, and is usually associated with science and the scientific method.

Keeping the above definitions of research in mind the article “Information Systems Risk and Audit Planning” by Jean C. Bedard, Lynford Graham and Cynthia Jackson can be categorized as a research article as the writers seem to have followed the basic structure and completed the investigative requirements. The researchers have attempted to provide empirical evidence on the consideration of information systems risk in a financial statement audit. This is a key issue because the importance of information systems to businesses has increased steadily over the past decade, as has the importance of internal control to companies and to their auditors.

Research Method

The writers have used empirical research to approach this topic as also identified in the article itself. The basic aim of the article was to provide empirical evidence on the consideration of information systems risk in a financial statement audit. To perform the study, they described the types of client characteristics identified by the auditors as being relevant to planning, and relate those characteristics to systems risk  assessments and testing plans. Generally, empirical research is any research that bases its findings on direct or indirect observation as its test of reality. In this research initially focus groups consisting of partners and managers of the participating organization were employed which helped to determine the research task. This seems to be an appropriate method espcially when specific statements from the firm’s decision aid for risk identification and assessment had to be identified. In ranking risk areas on appropriateness for the study, the focus groups considered such factors as the importance of the risk area in audit planning, its application to a broad range of clients, and its potential for differentiating more from less risky clients. Among these issues are the two systems risk areas considered in this study, previously described: (1) whether top management sufficiently oversees and addresses the risks related to data security and EDP system security for critical information systems; and (2) whether there are weaknesses in the relevance, completeness, timeliness and reliability of management information used by the company to monitor enterprise activity.

Finally, data for this study were collected from auditors serving on engagement teams for various clients of two accounting firms (now among the Big 4), in the presence of one of the authors. Selection and scheduling of participants were accomplished with the assistance of a contact person at each firm, who was only aware that the study concerned audit planning. Due to client confidentiality concerns, the authors were unaware of the identity of the clients on which the participants were responding. Participants responded to a questionnaire about characteristics of one of their actual clients, which was selected in advance of the research session.

Research Questions and their Effectiveness

In the article three research questions have been formulated to acquire understanding of the research problem:

1.      What is the nature of systems risk factors identified by auditors as important in engagement planning?

2.      Which types of client characteristics are associated with differences in risk assessments?

3.      Which types of risk factors are associated with planning specific types of audit tests?

The first research question concerns the nature of client risk characteristics present in a representative sample of audit clients. The second research question relates to the association of client characteristics and risk assessments within each risk area. Auditing standards note that auditors should respond to engagement risks by increasing their risk assessments and altering the nature, timing, and extent of audit procedures. The third and final research question considers the role of system risk factors in planning audit tests. As noted previously, auditing standards indicate that auditors should adjust the audit plan to reflect client risk factors.

The above research questions seem satisfactory to warrant an answer and also are inline with the research objective specified at the start of the article: “To provide empirical evidence on the consideration of information systems risk in a financial statement audit.” This has been stated since the first question instigates an answer which covers the initial planning phase when risk assessment for any client is being done and also the identification of client characteristics to understand the differences is being carried out in the second question and finally the understanding of risk factors which may be related to EDP or Management information quality risk assessment.

The rationale for the study has been effectively incorporated in the Background section with the research questions which forms a basis for their justification. As the reader goes through the research paper it can be appreciated that the authors have clearly specified their objective initially and they have also clearly mentioned the research questions and their importance to the study and how each of the three questions helps to solve the research task.

Implications and Key Limitations of the Research

One of the major limitations of this type of research is the confidential nature of information with which the researchers deal with and the obvious reluctance being shown by the managers and partners participant organization to share such information.

Another limitation is that the researchers examined the auditors’ memories of client conditions – essentially, the researchers studied how auditors assess risk and plan tests in light of conditions that they identify. Thus, in contrast to behavioral experiments, the design of this study could not assess memory accuracy. An alternative means of addressing the questions studied is through an archival study of audit workpapers. In contrast to this study of individual responses, audit workpapers capture the end product of group decisions. Further research should address whether the results of this study hold using behavioral and/or archival approaches.

Despite the key role of information systems in corporate control and in financial statement audits, the authors could not find any research which could provide evidence on the nature of risk characteristics commonly present in business systems, and the implications of such risks for audit planning. This study addressed this research gap by examining two crucial areas of information systems risk: EDP security and management information quality. These risk-areas encompass the physical and electronic integrity of client systems, and the appropriateness of information contained in those systems, respectively.

Identification of Research Conclusions and Results

The conclusions and results of the study have been mentioned twice which informs the reader about researchers’ intentions and the level of achievement of research objectives. Initially the article summary informs the reader about the main findings and finally their description can be found in the Discussion section.

The main findings of the study encompass two major aspects. The first is the lack of significant association between risk factors and risk assessments in the EDP security risk area, while strong associations were found in management information quality. The second is that control environment factors affect planning in management information quality, but not in EDP security. The recent high-profile cases of corporate fraud, featuring possible management override of controls, emphasize that auditors must react appropriately to issues of information system security and management style/competence. Thus, the results support the recent emphasis on internal controls in US and international auditing standards.

 This study addresses this research gap by examining two crucial areas of information systems risk: EDP security and management information quality. To address this issue, the researchers asked participating auditors to document the frequency of specific client characteristics in these two risk areas, which they consider when planning for an actual client engagement. The researchers also asked that they provide a risk assessment within each risk area, and to plan audit procedures to address the identified risks. Results show that auditors predominately identified client characteristics that would increase systems risk (i.e., negative characteristics, commonly termed risk factors), although some positive characteristics that would decrease systems risk were also identified. The most frequent risk factors identified in the area of EDP security are related to system security controls, outdated systems, and management style/attitude. In the management information area, the most frequently identified risk factors relate to the nature of information produced by client systems, followed by factors relating to management style/attitude and management competence.

Areas of Further Research

As mentioned in the article that in contrast to behavioral experiments, the design of this study could not assess memory accuracy. An alternative means of addressing the questions studied is through an archival study of audit workpapers. In contrast to this study of individual responses, audit workpapers capture the end product of group decisions. Further research should address whether the results of this study hold using behavioral and/or archival approaches.

Overall Effectiveness of the Exercise

This exercise proved to be a tremendous learning experience as far as understanding of research articles and the way they should be approached is concerned. To write a critique on a research article requires a thorough understanding of the basics of writing a research article, various research methods to use and how to conduct the research itself with an appropriate research design.

References

     Jean C. Bedard, Lynford Graham & Cynthia Jackson. (2005) Information Systems Risk and Audit Planning.  International Journal of Auditing. Int. J. Audit. 9: 147–163 (2005)

Required

Through a memorandum, explain to the directors

1. Why Is the need for an audit. (5 marks)
2. how the auditor off public company may be appointed under the companies Act (5 marks)
3. What are the rights and powers of an auditor under the Companies Act (10 marks )
4. The responsibilities of the directors in relation to the accounting ,fraud and internal controls functions of Brian Ltd. (10 marks )

Question  2

The maintenance of auditor Independence Is vital to the credibility of the audit In the minds of the users of the financial statements .

Professional regulations has been seen as being one of the more acceptable methods of acceptable methods of achieving auditor independence than state regulations although certain sections of the Companies ‘s Act have a bearing on such independence.

1. state and explain the two sides of auditor independence (8 marks )
2. Explain the circumstance that may threaten auditor ‘ Independence and objectivity(10 marks )
3. Explain mom the measures that auditors may Implement In order to deal with the threats (12 marks)

Question 3

The directors of Mellon Manufacturing have asked your firm to act as their auditors for the year ended 30 September.

They will be asking their existing auditors to resign, as they do not provide a cost effective service. The partner proposed for appointment to Mellon Manufacturing holds a membership certificate and a certificate of registration as a registered auditor through the COCA. The proposed partner is scheduled for routine Investigation by the COCA regulation monitoring unit.

1. Describe the investigations you would carry out and ethical matters you would consider before you can accept the appointment as the company’s auditor. (8 marks)
2. Explain why it is important that an auditor should send a letter of engagement to the client prior to undertaking an audit. (4 marks)
3. Briefly describe the main contents of a letter of engagement which you would send to the directors of Mellon Manufacturing. (8 marks)

The Sarbanes–Oxley Act of 2002 contains eleven titles that deal with regulations of public auditing and accounting standards in the United States. The second chapter is concerned with external audit independence to limit conflict of interest, new auditor approval requirements, audit partner rotation plus auditing reporting standards. The nine sections also limits auditing firm from providing non-audit services to the same client. The regulatory and oversight watchdog is the Securities and Exchange Commission. The relationship between an auditor (Ben) and audit client’s employee, Anita violates the act and thus professional objectivity of Ben in carrying out his audit tank might be impaired. The SEC will, on receipt of such information, declare the audit report prepared as unprofessional. Thus further legal measures may be undertaken to ensure total integrity of the audit report. The audit manager, Pete, in his talk with audit client general manager’s former husband, Allan, over the audit details, violates the legal barrier that exists between the auditing firm and the audit client. Since these two incidences violate the accounting role or financial reporting oversight role of the act, the SEC will need to evaluate such a process and attest to its integrity (Kuschnik, Bernhard, 2008)

For every auditing firm, prior to undertaking the audit process, there are essential preliminaries that the firm undertakes before auditing a client.

• Client acceptance or continuation. Whether there is an audit task for an existing or new client, the auditing firm determines if it should accept the task or not. The audit firm assesses whether it would be in the best interest to associate itself with the new client or whether the benefits associated with the existing client outweighs the challenges. XYZ CPAs will therefore, evaluate the past financial disclosures of Smackey Dog Foods, Inc and weigh the risks to its reputation.
• The audit firm should promptly determine the reason for the auditing process. For an auditing firm, clear details on the auditing need to be established so that it is known early whether the audit report is for securing credit facilities from a bank or not.
• Obtain an understanding with the client. This is essential in minimizing misunderstandings between the concerned parties. It is a legal requirement that auditors obtain an understanding with the client in a written form.
• Develop an overall audit strategy. For XYZ CPA, this strategy will involve assessing where the risks seem to be concentrated, estimating the resources needed for the exercise and number of audit staff required.

When such initial evaluations have been carried out, XYZ CPA, in carrying out its auditing, will follow the four phases. Phase one involves acceptance of the audit engagement. After evaluating the audit risk, auditor business risk and the client business risk, the auditing firm accepts the engagement. This acceptance may also depend on integrity of client, assessment of competence to perform the tasks, evaluation of independence plus the timing of auditing. Last step in accepting the engagement involves the drafting of the engagement letter, which serves as the contractual agreement between the auditor and the client. This letter involves the financial statements to be audited, professional standards to be followed by the auditor, the basis for computation of fee payable plus other billing arrangements.

The second phase of audit process is planning the audit. This planning depends on size and complexity of the client plus. Also past knowledge and experience with the client also hastens this phase. Steps in this phase include obtaining an understanding of the client business. This involve structure of management, business goals, tour of Smackey Dog Foods, Inc’s premise, other interested parties to the business and the core process and operating cycle. Management will also be expected at this phase to furnish the audit firm with all the entity resources plus the associated customers, markets and the source of competition.

Third phase involves the auditing itself.  This involves performing analytical procedures, which is the evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. Involves deciding which calculations will be made like ratio analysis, comparison of closing balances with previous balances. It also involves development of expectations based on trend analysis. Smackey Dog Foods, Inc, the audit firm will look at the accounts receivable and other accounts like the return inwards to check how projected sales are falling and why internal control weakness like the gap that is left by allowing Ken to monitor and supervise himself

Phase four is the reporting of the findings to the client, which forms the end of the attestation period. The draft report if presented to the client for response, which will be included in the final report. This report contains all the scope of the exercise. When the auditing is forensic related, the report includes details of suspected culpable individuals.

On identification of internal control flaws in the financial statements, the audit firm will communicate to the client whenever there is deficiency, significant deficiency or material weakness in the internal controls. This deficiency will be communicated by XYZ CPA to the management in writing. Internal control process charges staff and management with provision of assurance towards an entity meeting its objectives in financial reporting, effectiveness and efficiency of operations and guarding of assets against unauthorized acquisitions, use or disposal. First internal control problem relates to the prepayment of sales commissions.

The projected sales are always off by 11% which means that revenue and associated expenditure are not matching and hence Smackey Dog Foods, Inc is paying for more than it should. Secondly, the unauthorized acquisition of bags of the premium Best Boy Gourmet dog food by Henry is a serious case of theft that the management should be concerned with. Such practice eats into the revenue of the company.

In auditing the accounts receivable, various confirmation tests will be run. The confirmation types consist of positive and negative confirmations. For positive, the recipient ir required to respond to the audit query whether the balance of account is correct or incorrect while in negative, the recipient responds only if balance is incorrect. Positive confirmation is the best type as it excludes any ambiguity that arises due to unanswered questions. Confirmations that are to be made are for those accounts with old unpaid items, which follow the aging schedule.  with those that are in arrears for over 120 days first followed by 90-120 days, up to the current one that has just gone into arrears. Also accounts written off during the year under review plus those that registers zero balances will need confirmation details.  A schedule of accounts to be confirmed is prepared which shows confirmation number, name of account, address of account, receivable balances, balance confirmed, the difference plus the reason for the balance, if any. Such ways ensures that reliability of revenue figure can be established and return inwards, if any calculated.

For auditor choosing a sample size, the most important factors to consider includes, the level of tolerable misstatement, the inherent and control risk associated with such a choice, achieved detection of risk from such procedures and type of confirmation that is to be adopted by the auditor.

In dealing with real assets with the legal encumbrances, auditors need to have a confirmation of all the information and details over items and rights over them. These assets should be studied in detail to establish whether they are being used for the purpose they were meant for. The main concern is whether such encumbrances have been treated as assets or expenses in the appropriation account, but when the legal matters are settled, the value for such should be checked in relations to the accruals in purchases.

Attestation of the client’s inventory is very important to the validity of any auditing report. This inventory can be compared with the closing stock to establish the correct value of sales revenue. Such practice will help the auditor verify in there has been any cases of unauthorized access to an entity’s products.

Among the documents that would used in the auditing of the inventory and warehouse cycle includes the purchases ledger, to determine the true cost of the raw materials, invoices, to show the correct quantities of raw material bought. Also, all the documentation that pertains storage of the raw material, processing of goods, the storage of final goods and the shipment of goods produced. The biggest internal flow is that only one person is dealing with the production and shipment of Smackey Dog Food’s regular line of product, which gives him the chance to defraud the company.

The relationship between an auditor (Ben) and audit client’s employee, Anita makes the professional conduct of the entire audit process doubtful, which might be challenged especially when an adverse report is prepared. The auditing firm is fully liable before a legal system, whenever mistakes that border on professionalism are detected in their reports which might give ground for litigations.

References

1. Kuschnik, Bernhard ;( 2008) The Sarbanes Oxley Act: “Big Brother is watching” you or
2. Adequate Measures of Corporate Governance Regulation?  Rutgers Business Law
3. Journal [2008], 64 – 95; available at http://businesslaw.newark.rutgers.edu