Solution manual auditing theory by cabrera chapter 02

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CHAPTER OVERVIEW OF AUDITING I Review Questions One definition of auditing is that it is a systematic process by which a competent, independent person objectively obtains and evaluates 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 interested users The Philippine Standards on Auditing (PSA) 120 “Framework of Philippine Standards on Auditing” states the objective of an audit as follows: “The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared in all material respects, in accordance with an identified financial reporting framework.” This apparent paradox arises from the distinction between the function of auditing and the function of accounting The accounting function is the process of recording, classifying and summarizing economic events to provide relevant information to decision makers The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events for financial statements and he or she must therefore have an understanding of generally accepted accounting principles (GAAP), as well as generally accepted auditing standards (GAAS) The accountant need not, and frequently does not, understand what auditors do, unless he or she is involved in doing audits, or has been trained as an auditor 2-2 Solutions Manual - Principles of Auditing and Other Assurance Services Audits of Financial Statements Compliance Audits Operational Audits Purpose To determine whether the financial statements are presented in accordance with GAAP To determine whether the client is following specific procedures set by higher authority To evaluate whether operating procedures are efficient and effective Users of Audit Report Different groups for different purposes – many outside entities Authority setting down procedures, internal or external Management of organization Nature Highly standardized Not standardized, but very specific and usually objective Highly nonstandard; often very subjective Performed by: CPAs COA Auditors BIR Auditors Internal Auditors Almost universally Occasionally Never Frequently Occasionally Frequently Universally Frequently Frequently Frequently Never Frequently The major differences in the scope of audit responsibilities are: CPAs perform audits in accordance with Philippine Standards on Auditing of published financial statements prepared in accordance with identified and applicable Statements of Financial Accounting Standards COA auditors perform compliance or operational audits in order to assure the Congress of the expenditure of public funds in accordance with its directives and the law BIR agents perform compliance audits to enforce the tax laws as defined by Congress, interpreted by the courts, and regulated by the BIR law Internal auditors perform compliance or operational audits in order to assure management or the board of directors that controls and policies are properly and consistently developed, applied and evaluated An independent audit is a means of satisfying the need for reliable information on the part of decision makers Factors of a complex society which contribute to this need are: remoteness of information a owners (stockholders) divorced from management b directors not involved in day-to-day operations or decisions c dispersion of the business among numerous geographic locations and complex corporate structures bias and motives of provider Overview of Auditing 2-3 a information will be biased in favor of the provider when his goals are inconsistent with the decision maker voluminous data a possibly millions of transactions computerized systems b multiple product lines c multiple transaction locations processed daily via sophisticated complex exchange transactions a new and changing business relationships lead to innovative accounting and reporting problems b potential impact of transactions not quantifiable, leading to increased disclosures The four primary causes of information risk are remoteness of information, bias in motives of the provider, voluminous data, and existence of complex exchange transactions The three main ways to reduce information risk are: User verifies the information itself The users share the information risk with management Have audited financial statements provided The advantages and disadvantages of each are as follows: Advantages Disadvantages User verifies information User obtains information desired User can be more confident of the qualifications and activities of the person getting the information High cost of obtaining information Inconvenience to the person providing the information because large number of users would be on premises Users share information risk with management No audit costs incurred Users may not be able to collect on losses Audited financial statements are prepared Multiple users obtain the information Information risk can usually be reduced sufficiently to satisfy users at reasonable cost Minimal inconvenience to management by having only one auditor May not meet needs of certain users Cost may be higher than the benefits in some situations, such as for a small company Information risk is the possibility that information upon which a business decision is made is inaccurate Four causes of information risk are: • remoteness of information, • biases and motives of the provider, 2-4 Solutions Manual - Principles of Auditing and Other Assurance Services • • voluminous data, and complex exchange transactions Three primary ways users of information can reduce information risk are: • users can verify the information themselves, • users can share information risk with management, and • users can obtain audited financial statements Four factors that are likely to significantly reduce information risk in the next five to ten years are: • technological advances, • more companies will go on–line, reducing the risk of investors obtaining outdated information, • new accounting and auditing standards, and • auditors will find more efficient and effective audit techniques 10 Refer to pages 45 and 46 of the textbook 11 A report by an independent public accountant concerning the fairness of a company’s financial statements is commonly required in the following situations: (1) Application for a bank loan (2) Establishing credit for purchase of merchandise, equipment, or other assets (3) Reporting operating results, financial position, and cash flows to absentee owners (stockholders or partners) (4) Issuance of securities by a corporation (5) Annual financial statements by a corporation with securities listed on a stock exchange or traded over the counter (6) Sale of an ongoing business (7) Termination of a partnership 12 To add credibility to financial statements is to increase the likelihood that they have been prepared following the appropriate criteria, usually the relevant and applicable SFAS As such, an increase in credibility results in financial statements that can be believed and relied upon by third parties 13 Business risk is the risk that the investment will be impaired because a company invested in is unable to meet its financial obligations due to economic conditions or poor management decisions Information risk is the risk that the information used to assess business risk is not accurate Auditors can directly reduce information risk, but have only limited effect on business risk 14 An operational audit attempts to measure the effectiveness and efficiency of a specific unit of an organization It involves more subjective judgments than a compliance audit or an audit of financial statements because the criteria of effectiveness and efficiency of departmental performance are not as clearly established as are many laws and regulations or generally accepted accounting principles Overview of Auditing 2-5 The report prepared after completion of an operational audit is usually directed to management of the organization in which the audit work was done 15 A compliance audit is an audit to determine whether financial reports or other assertions are in compliance with established criteria The necessary ingredients are verifiable data and the existence of standards established by an authoritative body An operational audit, on the other hand, is a review of a department or other unit of a business or governmental organization to measure the effectiveness and efficiency of operations Internal auditors often perform operational audits as auditors employed by the Commission on Audit (COA) of the national government and public practitioners as part of their consultancy services 16 The first quoted sentence overstates the case Although annual audits by CPA firms are universal practice for large corporations, they are not essential to many small businesses The financial statements of large corporations go to many stockholders (often hundreds of thousands) who demand the assurance of reliability supplied through independent audits by CPA firms Moreover the SEC and the stock exchanges require that listed companies have annual audits For a small business concern, the primary need for annual financial statements is to support an application for a bank loan If a small business does not need to borrow, or can obtain borrowed funds without providing audited statements, the cost of an audit may not be justified Often a small business can obtain from a CPA firm specialized services other than an audit, which are more useful and may cost less Examples are the review or compilation of financial statements, installation of a computer based accounting system, or a study of internal control Thus, the second quoted sentence, as well as the first, is too sweeping to be correct A decision not to have an audit is not always “false economy.” 17 (a) An example of possible bias on the part of the provider of financial information is the situation in which an individual or business entity applies for a bank loan In such circumstances, there is an incentive to overstate assets, income, and owner’s equity, and to overlook or minimize liabilities Distortions of this type give the appearance of greater financial strength (b) A bank loan officer may insist that a prospective borrower provide audited financial statements This provides assurance that the data in the financial statements have been examined by independent competent persons II Multiple Choice Questions d a a d (PSAs) b 10 c b c b d III Comprehensive Cases 11 12 13 14 15 b a c c a 16 17 18 19 20 d a a d c 21 d 2-6 Solutions Manual - Principles of Auditing and Other Assurance Services Case a The major advantages and disadvantages of a career as a BIR agent, CPA, or an internal auditor are: Employment Advantages Disadvantages BIR agent Extensive training in individual, corporate, gift, trust, and other taxes is available with concentration in area chosen On-hand experience with sophisticated selection techniques Experience limited to taxes No experience with operational or financial statement auditing Training is not extensive with any business enterprise CPA Extensive training in audit of financial statements, compliance auditing and operational auditing Opportunity for experience in auditing, tax counseling, and management consulting practices Experience in a diversity of enterprises and industries with the opportunity to specialize in a particular industry Exposure to taxes and to the business enterprise may not be as in-depth as the BIR agent or the internal auditor Likely to be less exposed to operational auditing than is likely for internal auditors Internal Auditor Extensive exposure to all segments of the enterprise with which employed Constant exposure to one industry presenting opportunity for expertise in that industry Likely to have exposure to compliance, financial and operational auditing Little exposure to taxation and the audit thereof Experience is limited to one enterprise, usually within one or a limited number of industries Overview of Auditing 2-7 b Other auditing careers that are available are: COA auditor Auditors within many of the branches of the government Auditors for many local government units Case The most likely type of auditor and the type of audit for each of the examples are: Example 10 11 12 Case Type of Auditor COA CPA; Internal Auditor Internal auditor; CPA CPA CPA COA CPA COA CPA; Internal Auditor Internal auditor or CPA CPA or COA CPA; BIR Type of Audit Compliance Operational Compliance Financial statements Tax audit; FS audit Financial statements Financial statements Operational audit Financial statements Operational audit Operational audit Compliance a The overriding objective of an independent audit is to provide reasonable assurance that the financial statements fairly reflect the economic substance of the transactions and events reflected in those statements To this end, the auditor tests management’s assertions as embodied in the financial statements, and renders an opinion concerning fairness Testing involves gathering and evaluating evidence relating to the assertions The opinion assumes the form of an audit report formulated and issued at the conclusion of the examination b An independent audit may be beneficial to Lyn Cruz in the following ways: Correction of identified weaknesses in the accounting system may improve the quality of financial reporting; The independent auditor may be able to assist Lyn in improving physical safeguards over assets; An independent audit may facilitate Lyn’s efforts in raising new capital; The audit may identify a need for improved budgeting and performance reporting, thus improving control over costs and revenues; Although not designed for this purpose, the audit may disclose defalcations by employees; To determine amounts receivable or payable under bonus, profit sharing, and pension plans; lease agreements; royalty agreements; and other contracts and agreements; To serve as an error and/or irregularity prevention device by making employees aware of audit coverage Case Types of Auditors and Services Performed 2-8 Solutions Manual - Principles of Auditing and Other Assurance Services Topic 10 Type of Auditor CPA CPA Internal auditor; CPA COA Bank examiner CPA CPA Internal auditor; CPA BIR; CPA CPA; COA Class of Work Audit of financial statements Audit of financial statements Operational audit Operational audit Compliance audit Mngt advisory services Audit of financial statements Operational audit Compliance audit Compliance audit ... and/or irregularity prevention device by making employees aware of audit coverage Case Types of Auditors and Services Performed 2-8 Solutions Manual - Principles of Auditing and Other Assurance Services... agents perform compliance audits to enforce the tax laws as defined by Congress, interpreted by the courts, and regulated by the BIR law Internal auditors perform compliance or operational audits... risk are: • remoteness of information, • biases and motives of the provider, 2-4 Solutions Manual - Principles of Auditing and Other Assurance Services • • voluminous data, and complex exchange
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