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Full file at https://fratstock.euChapter 02 - Professional Standards

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CHAPTER 2

Professional Standards

LEARNING OBJECTIVES

Review

Checkpoints

Exercises, Problems,

and Simulations

1. Name the various practice standards for

internal, governmental, and independent

auditors and accounting firms and identify

their sources.

1 46

2. Explain the 10 AICPA generally accepted

auditing standards (GAAS) and explain how

GAAS was or was not followed in specific

fact situations.

40, 41, 42, 44, 45,

50, 51

3. Describe how the audit examination is

affected by auditors’ responsibility for the

general standards and standards of field

work.

2, 3, 4, 5, 6, 7,

8, 9, 10, 11

55

4. List the standards of reporting and identify

how these standards are reflected in the

content of the auditors’ report.

12, 13, 14, 15,

16

43, 47, 48, 56

5. Identify the need for attestation standards and

explain how attestation standards differ from

generally accepted auditing standards.

17, 18 49

6. List and explain the important features of

quality control standards for an accounting

firm.

19, 20, 21 52, 54


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SOLUTIONS FOR REVIEW CHECKPOINTS

2.1 For independent 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.

2.2 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.

2.3 The standard for due professional care is the care that would be exercised by prudent auditors.

The prudent auditor is one who exercises reasonable judgment, who is not expected to be

omniscient, who is presumed to have knowledge special to his or her profession, who is expected

to be aware of his or her own ignorance, and who is expected to possess the skills of the

profession whether a beginner or a veteran.

2.4 Independence 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 publicly traded 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.

2.5 Three elements of planning and supervision considered essential in audit practice are:

A written audit program.

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.


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2.6 The 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.

2.7 Auditors 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.

2.8 As the client’s internal control is more effective (a lower level of control risk), the necessary

effectiveness of auditors’ substantive procedures is reduced (a higher level of detection risk).

Conversely, when the client’s internal control is less effective (a higher level of control risk), the

necessary effectiveness of auditors’ substantive procedures is increased (a lower level of detection

risk).

2.9 Evidence is defined as the information used by auditors on which to base their opinion on the

financial statements.

2.10 External 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.

2.11 In 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.

2.12 Financial Accounting Standards Board, Financial Accounting Standards Advisory Board, and

Governmental Accounting Standards Board statements are the highest level of authoritative

support for GAAP. Textbooks, handbooks, and journal articles are the lowest level.

2.13 Yes. The unqualified opinion sentence in the auditors’ report implies, among other things, that the

accounting principles used by the entity are appropriate in the circumstances.

2.14 Two messages are usually implicit in the auditors’ standard report: (1) the extent and

informativeness of disclosures are adequate, and (2) the accounting principles have been

consistently applied. By implicit, these matters are only mentioned in the auditors’ report if

concerns are noted by auditors.


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2.15 Four types of opinions and their messages:

Type Message

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.

2.16 Investors, creditors and other users tend to assume that financial statements are audited and

“everything is OK” whenever they know a public accountant has been associated with the client’s

financial statements. If an audit examination has not been performed, accountants need to make the

fact known so users will not be mislead (although through no fault of the accountant). If an audit

examination has been performed, accountants must report their work and conclusions for users’

benefit.

2.17 The purpose served by the attestation standards is to guide attestation work in areas other than

audits of financial statements.

2.18 The major differences between attestation standards and generally accepted auditing standards

(GAAS) lie in the areas of practitioner competence, risk of material misstatement, and reporting.

Some other differences are minor ones.

GAAS presume knowledge of accounting and require training and proficiency 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 requirement regarding an understanding of an entity’s overall

environment, including internal control. Some types of subject matter that serve as the basis for an

attestation engagement may not be affected by the client’s internal control in the same sense as a

financial accounting and reporting system.

Reporting is different because attestations on nonfinancial information do not depend upon

generally accepted accounting principles. The attestation standards speak of “evaluation against

reasonable criteria,” and “conformity with established or stated criteria” and provide flexibility for

attestation engagements and services on a wide variety of informational assertions.

2.19 While GAAS relate to the conduct of individual audit engagements, quality control standards

govern the quality of an accounting firm’s accounting and audit practice as a whole.

Quality Control Standard No. 2 identifies five elements of quality control for an accounting firm.

When a peer review or quality review is conducted, the reviewers evaluate the firm’s statement of

policies and procedures designed to ensure compliance with the five elements. These statements

vary in length and complexity, depending upon the size of the accounting firm.

2.20 This is an example of a policy statement related to engagement performance as it relates to

consultation for assistance with difficult accounting and auditing problems.


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2.21 In addition to the standard setting role previously discussed, one of the primary roles of the Public

Company Accounting Oversight Board (PCAOB) is to monitor firms that audit public entities.

The Board’s goal is to ensure that audit quality is not compromised and that auditors’ performance

continues to meet public expectations. Soon after it began operations in early 2003, the PCAOB

began registering accounting firms providing auditing services to public entities. Firms not

registered are not allowed to conduct audits of public entities. Other PCAOB monitoring activities

include conducting inspections of registered accounting firms (similar to peer reviews), special

investigations, and disciplinary proceedings.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

2.22 a. Incorrect Due professional care is a general standard, not a standard of reporting.

b. Correct This standard is a standard of reporting.

c. Incorrect Sufficiency of evidence is a standard of field work.

d. Incorrect While the auditors’ report does reference the use of GAAS in the audit

examination, this is not one of the standards of reporting.

2.23 a. Incorrect This practice relates to accountants’ competence and training, not due

professional care.

b. Incorrect This practice is a standard of reporting.

c. Incorrect Sufficiency of evidence is a standard of field work and is not related to

due professional care.

d. Correct These practices are a part of due professional care.

2.24 a. Incorrect GAAS relates to the conduct of an audit engagement by auditors.

b. Correct Quality Control Standards are firm- (rather than auditor-) related.

c. Incorrect GAAP relates to accounting, rather than auditing practices.

d. Incorrect International auditing standards govern the conduct of audits conducted

across international borders.

2.25 a. Incorrect Auditors may lack training and proficiency in this case, but (d) is a

better answer.

b. Incorrect Auditors may lack planning and supervision in this case, but (d) is a

better answer.

c. Incorrect Auditors had enough investigative independence to identify the

problem.

d. Correct Auditors let some feelings for the client override their obligations to the

users of the financial statements.

2.26 a. Correct According to the second standard of field work.

b. Incorrect Consulting suggestions are secondary objectives in an audit.

c. Incorrect Information about the entity’s internal control is, at best, indirect

evidence about assertions in the financial statements.

d. Incorrect Information about the entity’s internal control provides auditors with

little opportunity to learn about changes in accounting principles.


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2.27 a. Incorrect External evidence is quite reliable.

b. Correct Representations from management should least affect auditors’

conclusions, as they have not been validated or corroborated by

external parties.

c. Incorrect Auditor-prepared evidence is highest on the scale of appropriateness.

d. Incorrect Although a representation of a client employee, inquiry of the entity’s

legal counsel is considered more reliable than that of entity

management.

2.28 a. Incorrect Inquiry of management should least affect auditors’ conclusions.

b. Incorrect Although very persuasive, auditors’ personal knowledge (choice d)

provides the most persuasive evidence

c. Incorrect Observation 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. Correct Auditors’ personal knowledge provides the most persuasive evidence.

2.29 a. Incorrect Inquires of client personnel are the least reliable form of evidence.

b. Incorrect While more reliable than inquiries (choice a), inspection of internal

documents is a relatively unreliable form of evidence.

c. Incorrect While sales invoices are documents created by external parties, the fact

that these documents were received from client personnel decreases

their reliability.

d. Correct Because the bank statements were received directly from outside

parties, this is a more reliable form of evidence than choice (c).

2.30 c. Correct Initials of the preparer and reviewer provide evidence of due

professional care and planning and supervision.

2.31 a. Incorrect Attestation standards require adequate knowledge of the subject matter.

b. Correct An 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. Incorrect Attestation standards require sufficient evidence is required.

d. Incorrect Attestation standards require independence in mental attitude.

2.32 a. Incorrect EITF positions are in the third level of authoritative support.

b. Incorrect AICPA industry guides are in the second level of authoritative support.

c. Correct FASB statements on standards are in the first level of authoritative

support.

d. Incorrect FASB statements on concepts are in the fourth level of authoritative

support.

2.33 a. Incorrect Internal documents are a relatively low quality of evidence.

b. Incorrect Written representations are the lowest quality of evidence.

c. Incorrect While direct, external evidence is of reasonable quality, it is of lower

quality than direct personal knowledge of the auditor (choice d).

d. Correct Direct, personal knowledge of auditors is the most appropriate form of

evidence.


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2.34 a. Incorrect While it may increase auditors’ knowledge about the client, obtaining

an understanding of a client’s internal control does not directly

influence auditors’ training and proficiency.

b. Incorrect Obtaining an understanding of a client’s internal control does not

directly influence auditors’ independence.

c. Incorrect Obtaining an understanding of a client’s internal control does not

directly help satisfy the quality control standard about audit staff

professional development.

d. Correct The 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.

2.35 b. Correct Given the choices presented, the EITF position is ranked highest on the

GAAP hierarchy (see Exhibit 2.3).

2.36 b. Correct Government auditing standards are issued by the Government

Accountability Office (GAO). Governmental accounting standards are

issued by the Governmental Accounting Standards Board.

2.37 a. Correct Consultation with a specialist demonstrates due professional care if

auditors do not have expertise in the area in question.

b. Incorrect Auditors are experts in financial matters, not areas of art (and other

collectibles) valuation.

c. Incorrect GAAS applies to all audit engagements, including audit engagements

for not-for-profit organizations.

d. Incorrect Since (a) is correct, (d) cannot be correct.

2.38 NOTE TO INSTRUCTOR: Since this question asks students to identify the standard that has not

been violated, the response labeled “correct” has not been violated and those labeled “incorrect”

have been violated.

a. Incorrect Due professional care has not been followed in this case; as a result,

this standard has been violated.

b. Correct The consistency standard relates to the consistent presentation of

financial information, not the consistent presentation of the auditors’

report. As a result, this standard has not been violated.

c. Incorrect In this case, disclosures are not adequate; as a result, this standard has

been violated.

d. Incorrect Footnotes are considered an integral part of the financial statements.

Failure to include an important footnote would be considered a

departure from generally accepted accounting principles, resulting in a

violation of this standard.

2.39 a. Correct Attestation standards differ from generally accepted auditing standards

in that they apply to engagements other than those on the audited


b. Incorrect Attestation standards require that the practitioner be independent.

c. Incorrect Attestation standards may apply to prospective “what if” financial

statements.

d. Incorrect Attestation standards include standards of field work.


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SOLUTIONS FOR EXERCISES AND PROBLEMS

2.40 Audit Engagement Independence

a. Auditors should not follow clients’ suggestions about the conduct of an audit unless the

suggestions clearly do not conflict with their professional competence, judgment,

honesty, independence, or ethical standards. Where there is no disagreement about the

results to be accomplished and the client’s suggestions represent good ideas, auditors can

consider these suggestions. Within professional bounds, mutual agreement with the client

is acceptable. Auditors must never agree to any arrangement that violates generally

accepted auditing standards or the AICPA’s Code of Professional Conduct.

b. The reasons that would not support dividing the assignment of audit work solely

according to assets, liabilities and income and expenses include the following:

1. Work should be assigned to staff members by considering the degree of difficulty

in relation to the technical competence and experience of individual staff

members.

2. Sequence of work performed on an examination should be in accordance with an

overall audit plan.

3. It is impossible to segregate work areas by major captions because often a close

relationship exists among a number of accounts in more than one category. For

example, interest and dividend income are normally based on an asset

(investments) and interest expense is normally based on a liability (long-term

debt).

4. Often a single form of audit documentation is desirable to provide evidence with

respect to balances in accounts of various types, such as an insurance analysis

supporting premium disbursements, the insurance expense portion, and the

prepaid insurance balance.

5. Duplication of staff effort would be more likely to occur if assignments were

made on such a basis.

6. Frequently, the scope of work regarding a single account requires simultaneous

participation by the staff, such as in the observation of inventories.

Many audit operations are not susceptible to division by category, as for example

investigating internal control, testing transactions, and preparing the report.

c. The audit staff member whose uncle owns the advertising agency should not be assigned

to examine the client’s advertising account. The accounting firm is responsible for

avoiding relationships which might suggest a conflict of interest. Regardless of whether

this staff member could be independent and unbiased in such a situation (independence in

fact), external parties will likely be influenced in their thinking by the fact that the uncle

is the owner of the advertising agency (the staff member would not have independence in

appearance). Even if a problem of ethics were not involved, it would be unwise for the

accounting firm to assign this staff member because the client’s attitude could change

significantly and the firm’s position would be jeopardized if difficulties later arose in

connection with the contract. Any situation in which bias exists or might arise should be

avoided.


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2.41 Standards of Field Work

The three generally accepted standards of field work and their relation to the illustration are as

follows:

1. The first standard of field work is that auditors must adequately plan the work and must

properly supervise any assistants. Fulfilling this standard would include the preparation

of an audit program for accounts receivable and reviewing it with the assistant prior to

beginning the examination. These things 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. The second standard of field work is that auditors must 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.

3. The third standard of field work is that auditors must obtain sufficient appropriate audit

evidence through audit procedures performed to afford a reasonable basis for an opinion

regarding the financial statements under audit. 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.

2.42 Time 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, with establishing staffing

requirements, and with reviewing the work; all of these features are important elements in the

exercise of due audit care. The December 26 - January 20 period is a serious time constraint for

an initial audit engagement. The greatest difficulties involve the third general standard (due

professional care) and the three standards of field work. In view of the short notice and the time

constraint, there may be some question as to whether an audit could be completed with due

professional care by January 20.

2.43 Standards of Reporting


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You must determine whether an unqualified opinion satisfies the standards of reporting, in

particular:

a. Determine whether the financial statements are presented in conformity with generally

accepted accounting principles (GAAP).

1. Read the footnote description of accounting policies.

2. Use a GAAP checklist.

3. Review the audit documentation for any indication of accounting policies not

described in the footnote or ones apparently not in conformity with GAAP.

4. Refer to SAS criteria concerning the “meaning of present fairly” (SAS 69)

regarding determinations that:

(i) The accounting principles are generally acceptable, having

authoritative support.

(ii) The accounting principles are appropriate in the circumstances.

(iii) The financial statements are informative.

(iv) The information is reasonably summarized.

(v) Material adjustments have not been waived without appropriate

justification.

b. Determine whether any accounting changes have been made and whether accounting

principles have been applied consistently.

c. Determine whether the footnote disclosures are adequate to inform users of any material

information evident in the audit documentation.

The fourth standard of reporting is not referenced above. However, the fact that an opinion has

been prepared would satisfy this standard.

2.44 GAAS in a Computerized Environment

The first general standard requires auditors to be properly trained and proficient. In an audit of a

computerized accounting system, adequate training and proficiency must be directly related to

information technology and controls in a computerized environment. In particular, auditors should

be knowledgeable of what computer systems do, how to test the operations of a computerized

accounting system, and how to use documentation unique to a computerized accounting system.

The second general standard relates to auditor independence. The training and proficiency

standard contributes to satisfaction of the independence standard by enabling auditors to make

their decisions and judgments. Otherwise, auditors might be inclined to subordinate their

judgments to other persons, possibly to client personnel. When auditors lack training and

proficiency, it is virtually impossible to maintain an operational independence over audit

decisions. An independence of mental attitude is futile if actual decisions are subordinated to

others.

The third general standard requires due professional care. The exercise of due professional care

requires a critical review of the work at every level of supervision and the decisions made by

auditors. Lacking the requisite skills and lacking independent decisions, the due professional care

expected of auditors at operational, supervisor, and review levels cannot be delivered.


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The first standard of field work requires adequate planning and supervision of assistants. Training

and proficiency in computerized accounting systems auditing is necessary for planning access to

computerized records and programs and conducting appropriate audit procedures. The planning

should provide for an early examination of the computerized accounting system so that further

procedures involving non-computer controls and accounting features may be planned should they

depend upon computer control procedures.

2.44 GAAS in a Computerized Environment (Continued)

The second standard of field work relates to assessing the risk of material misstatement, which

includes assessing both inherent risk and control risk. Training and proficiency are very important

for being able to obtain an understanding of a computerized accounting system’s internal controls.

Client personnel will expect audit personnel to be capable of working with a computer system.

The third standard of field work requires auditors to obtain sufficient appropriate audit evidence to

provide a basis for an opinion on financial statements. Documentary evidence relating to a

computerized accounting system includes program flowcharts, logic diagrams, and decision tables

that are not normally used in non-computerized systems. Since these types of documentation are a

part of the evidence, they must be understood by auditors; this understanding comes through

training and proficiency in their use.

2.45 Authoritative Support

SAS 69 (1992), amended by SAS 91 (1999), specifies the hierarchy of sources of authoritative

support. Refer to Exhibit 2.3 in Chapter 2.


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2.46 Sources of Professional Standards:

Description

Source

a. Definition of a financial statement audit for a

private entity

a. AICPA Auditing Standards Board

b. Guidance for reporting on internal control for a

public entity

b. PCAOB

c. Standards for the practice of internal auditing c. Institute of Internal Auditors

d. Generally accepted government auditing

standards

d. U.S. Government Accountability Office

e. Standards of financial accounting e. Financial Accounting Standards Board

f. Auditing standards for public entities f. PCAOB (with AICPA Auditing Standards

Board serving as Interim Standards)

g. Auditing standards for private entities g. AICPA Auditing Standards Board

h. Guidance for lending credibility to nonfinancial

information

h. AICPA Auditing Standards Board

(attestation standards)

i. Auditing standards for foreign entities i. IFAC International Auditing and Assurance

Standards Board

2.47 Auditors’ Reports

a. For scope limitations, the auditors’ report would be modified as follows:

The scope paragraph would be modified to indicate that “except for” the matter of

the scope limitation, the audit was conducted in accordance with generally accepted

auditing standards (for a qualified opinion). The scope paragraph would be omitted if

auditors issued a disclaimer of opinion.

An explanatory paragraph would be added to the auditors’ report to describe the

nature of the scope limitation, including dollar effects.

The opinion paragraph would be modified to either indicate that “except for” the

effects of adjustments that might have been identified, the financial statements are

prepared according to GAAP (qualified opinion) or to disclaim an opinion

(disclaimer of opinion).

Auditors can issue either a qualified opinion or a disclaimer of opinion when scope

limitations exist (assuming these limitations are material).

b. For departures from GAAP, the auditors’ report would be modified as follows:

An explanatory paragraph would be added to describe the nature of the departure

from GAAP, including dollar effects.


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The opinion paragraph would be modified to indicate either that “except for” the

effects of the departure from GAAP, the financial statements are prepared according

to GAAP (qualified opinion) or that the financial statements are not prepared

according to GAAP (adverse opinion).

Auditors can issue either a qualified opinion or an adverse opinion when departures from

GAAP are noted (assuming these departures have a material effect on the financial

statements).

2.48 Association with Financial Statements

The consequence of being associated with financial statements is that the fourth standard of

reporting is invoked, which requires an indication of the nature of the examination and degree of

responsibility auditors are assuming to be clearly indicated in the report.

a. Associated Issue the auditors’ report.

b. Not associated Tax returns are an exception.

c. Associated Issue a disclaimer of opinion (public entity).

Issue a compilation report (nonpublic entity).

d. Not associated CPA is associated with accounting records but not with


e. Associated Issue a disclaimer of opinion (public entity).

f. Associated Issue a disclaimer of opinion (auditors should have requested

that the client not print the auditors’ name in this way.)

g. Not associated Nothing needs to be done so long as client doesn’t mention

auditors in the interim statement document.


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2.49 Investment Performance Attestation

1, 2. Proficiency in the attest function and knowledge of the subject matter: Accountants must

be persons who know and understand investment statistics, operations of mutual funds,

and SEC rules regarding expenses.

3. Reasonable criteria: Accountants must determine whether standards exist for presentation

of investment return statistics and expense ratios, or they must be able to assess the

reasonableness of management’s presentation of criteria. In addition, accountants must

determine whether the statistics can be evaluated against reasonable criteria that are

understandable by users of the advertisements.

4. Independence: Accountants must determine that they have independence in relation to

Mystery Capital Management and its officers and directors.

5, 6, 7. Due care, planning and supervision, sufficient evidence: Accountants must conduct the

field work carefully to obtain the evidence necessary in the circumstances.

8,10. Report: The accountants’ report must identify the performance statistics and expense

ratios and relate them to the criteria upon which they are based.

9. Reservations: If accountants have any misgivings about misrepresentation of the statistics

and ratios management presents, these representations must be stated in the report.

11. Limitation on use of report: In some cases, the report may be intended solely for the

information and use of specified parties. As a result, it may not be appropriate for this

report to be presented in the entity’s advertisements.


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2.50 Auditing Standards Case Study

General Standards

1. The auditor must have adequate technical

training and proficiency to perform the audit.

1. It was inappropriate for Holmes to hire the two

students to 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. The auditor must maintain independence in

mental attitude in all matters relating to the

audit.

3. The auditor must exercise due professional

care in the performance of the audit and the

preparation of the report.

2. To satisfy the second general standard, Holmes

must be 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.

3. This standard requires performing the audit

with due care, which imposes on everyone a

responsibility to observe the standards of field

work and reporting. Exercise of due care

requires critical review at every level of

supervision of the work done and the judgments

exercised. Holmes did not review the work or

the judgments of the assistants and clearly

failed to adhere to this standard.

Standards of Field Work

1. The auditor must adequately plan the work and

must properly supervise any assistants.

1. This standard recognizes that early appointment of

auditors has 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 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.

2. Holmes did not study the client’s internal control

nor did the 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.

3. The auditor must obtain sufficient appropriate

audit evidence through audit procedures

performed to afford a reasonable basis for an

opinion regarding the financial statements

under audit.

3. No evidence was acquired to support the financial

statements. The auditors merely checked the

mathematical accuracy of the records and

summarized the accounts. Standard audit

procedures and techniques were not performed.


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2.50 Auditing Standards Case Study (Continued)

Standards of Reporting

1. The auditor must state in the auditor’s report

whether the financial statements are presented

in accordance with generally accepted

accounting principles.

1. The report made no reference to generally accepted

accounting principles. Because a proper

examination was not conducted, the report should

state no opinion can be expressed as to the fair

presentation of the financial statements in

accordance with generally accepted accounting

principles.

2. The auditor must identify in the auditor’s

report those circumstances in which such

principles have not been consistently observed

in the current in relation to the preceding

period.

2. The report makes no reference to the consistent

application of accounting principles. The improper

audit would not enable auditors to know whether

such implicit reporting was appropriate.

3. When the auditor determines that informative

disclosures are not reasonably adequate, the

auditor must so state in the auditor’s report.

3. Without footnotes, the financial statements cannot

contain adequate disclosure. Holmes’ report should

have referenced the lack of appropriate footnote

disclosures.

4. The auditor must either express an opinion

regarding the financial statements taken as a

whole, or state that an opinion cannot be

expressed, in the auditor’s report. When the

auditor cannot express an overall opinion, the

auditor should state the reasons therefor in the

auditor’s report. In all cases where an auditor’s

name is associated with financial statements,

the auditor should clearly indicate the

character of the auditor’s work, if any, and the

degree of responsibility the auditor is taking,

in the auditor’s report.

4. Although the report contains an expression of

opinion, such an opinion is not based on the results

of a proper audit examination. Holmes should

disclaim an opinion for failure to conduct an

examination in accordance with generally accepted

auditing standards.


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2.51 Generally Accepted Auditing Standards

a. This situation is related to the second standard of reporting, which addresses the

consistent application of accounting principles. Because the change in accounting

standards is considered to be reasonable and has been properly accounted for and

disclosed, this change does not represent a departure from GAAP. However, the change

in accounting principle should be mentioned in the auditors’ report, based on the second

standard of reporting.

b. This situation is related to the first general standard, which addresses the training and

proficiency of auditors. In this case, auditors can accept this engagement assuming that

they take appropriate measures to obtain the knowledge necessary to perform the audit

and understand important issues affecting this client. It is important to note that the

existence of industry-specific accounting issues will require auditors to obtain the

knowledge necessary to complete the engagement.

c. This situation is related to the first standard of reporting, which addresses the conformity

of the financial statements with GAAP. If the client elects to treat these leases as

operating leases in violation of GAAP, auditors should issue either a qualified or adverse

opinion, depending upon the materiality of the departure from GAAP.

d. This situation is related to the first standard of field work, which indicates that the audit

should be properly planned. In this case, auditors should evaluate whether the client’s

deadline will allow an audit to be properly planned and conducted according to generally

accepted auditing standards. The fact that this would be an initial audit makes this

possibility even more questionable than usual.

e. This situation is related to the third standard of field work, which requires auditors to

obtain sufficient appropriate audit evidence. Given the low level of control risk, auditors

would then proceed to perform the necessary auditing procedures, which provide the

basis for their opinion on the client’s financial statements.

f. This situation is related to the second general standard, which requires auditors to be

independent. In this particular case, the fact that one of the partner’s husband is an officer

of the prospective client would likely result in the firm declining this particular

engagement because of a lack of independence.

g. This situation is related to the fourth standard of reporting, which requires auditors to

provide an indication of their work when their name is associated with financial

statements. Auditors can allow the financial statements to be printed on their letterhead,

assuming they prepare a report disclaiming an opinion on the fairness of these financial

statements.

2.51 Generally Accepted Auditing Standards (Continued)

h. This situation is related to both the first standard of reporting (conformity of the financial

statements with GAAP) and third standard of reporting (adequacy of disclosures).

Auditors should insist upon disclosure of the potential litigation and, if the client refuses,

issue either a qualified opinion or adverse opinion, depending upon the materiality of the

omission of the disclosures. In addition, the auditors’ report should provide information

regarding the omitted disclosures.


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i. This situation is related to the second standard of field work, which requires auditors to

obtain an understanding of their clients and internal controls. Once this understanding has

been obtained, auditors would then proceed to perform the necessary substantive audit

procedures.

j. This situation is related to the third general standard, which addresses due professional

care. An important element of due professional care is critical review of work performed

by persons at various levels within the firm. Because the supervisor’s review of the work

performed by the assistant indicates that the work supports the opinion on the financial

statements, no further actions are necessary.

2.52 Quality Control Standards

a. Personnel management (advancement and performance)

b. Engagement performance

c. Engagement performance (consultation)

d. Personnel management (assignments)

e. Personnel management (hiring)

f. Personnel management (professional development)

g. Monitoring

h. Independence, integrity and objectivity

i. Acceptance and continuance of clients

2.53 Relative Appropriateness of Evidence

a. Audit evidence obtained from independent sources outside the client provides greater

assurance of reliability (competency) than that which is secured solely within the client.

b. Accounting data and financial statements developed under satisfactory conditions of

internal control are more reliable (competent) than those which are developed under

unsatisfactory conditions of internal control.

c. Direct personal knowledge obtained by the independent auditors through physical

examination, observation, computation, and inspection is more persuasive than

information obtained indirectly.

2.54 Public Company Accounting Oversight Board Inspection Reports (Internet Exercise)

a. The major information contained in inspection reports include (1) a summary of audit

deficiencies identified by the PCAOB’s inspection, (2) a description of the inspection

process (Appendix B), and (3) the accounting firm’s response to the draft inspection

report. While the results of the PCAOB’s inspection of the firm’s quality control systems

are not provided in the portion of the report available to the “public” (via the PCAOB’s

website), these results will be made public by the PCAOB if the firm does not

satisfactorily address deficiencies within one year of the date of the report.


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b. The PCAOB’s inspection of firm’s quality control systems include practices, policies,

and procedures in the following areas:

Tone at the top

Partner evaluation, compensation, admission, assignment of responsibilities, and

disciplinary actions

Independence implications of nonaudit services; business ventures, alliances,

and arrangements; personal financial interests; and commissions and contingent

fees

Client acceptance and retention

Consultations on accounting, auditing, and SEC matters

The firm’s internal inspection program

Establishing and communicating audit policies, procedures, and methodologies

Supervision by U.S. audit teams of the work performed by foreign affiliates on

foreign operations of U.S. issuer audit clients

c – f. The answers here will depend up on the report selected by the student. It is important to

emphasize that event the largest and most sophisticated accounting firms have audit

deficiencies. One interesting exercise is to randomly assign your students to reports

(ensuring that all Big Four firms are covered) and compare the types and magnitude of

deficiencies identified. In addition, having students evaluate whether the firm’s response

is appropriate in the circumstances is an interesting classroom exercise.

2.55 Kaplan CPA Exam Simulation: Generally Accepted Auditing Standards.

To: Kelly, CPA

From: Engagement Partner, CPA

Planning

Auditors must adequately plan the work and must properly supervise any assistants. An audit

program must be developed prior to substantive testing to ensure that adequate planning has

occurred. Also, all evidence is to be recorded within the audit documentation, and then the

documentation is reviewed by qualified personnel (i.e., partner in charge of the engagement) to

ensure proper supervision.

Internal Control

Auditors must obtain sufficient appropriate audit evidence through audit procedures performed to

afford a reasonable basis for an opinion regarding the financial statements under audit. Auditors

need to make an assessment of control risk. If control risk is assessed as high, auditors will need

to gather more evidence than anticipated or gather better quality evidence. The opposite would be

true if control risk is assessed as low.


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2.56 Kaplan CPA Exam Simulation: GAAP Hierarchy.

Authoritative

Body

Pronouncements

Pronouncements

of Bodies

Composed of

Expert

Accountants

Other

Accounting

Literature

1. AICPA Practice Bulletins (cleared by FASB) X

2. FASB Statements and Interpretations X

3. AICPA Issues Papers and Technical Practice

Aids

X

4. APB Opinions X

5. Consensus Positions of the FASB Emerging

Issues Task Force

X

6. AICPA Accounting Research Bulletins X

7. FASB Technical Bulletins X

8. APB Statements X

9. FASB Concepts Statements X

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