978-0077732509 Chapter 1 Solution Manual

Chapter 01 – An Introduction to Assurance and Financial Statement Auditing

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CHAPTER 1

AN INTRODUCTION TO ASSURANCE AND FINANCIAL

STATEMENT AUDITING

Answers to Review Questions

1-1 The study of auditing is more conceptual in nature compared to other accounting courses.

Rather than focusing on learning the rules, techniques, and computations required to

prepare financial statements, auditing emphasizes learning a framework of analytical and

logical skills to evaluate the relevance and reliability of the systems and processes

information—an important task in many different contexts.

1-2 There is a demand for auditing in a free-market economy because the agency relationship

between an absentee owner and a manager produces a natural conflict of interest due to

the information asymmetry that exists between the owner and manager. As a result, the

agent agrees to be monitored as part of his/her employment contract. Auditing appears to

companies seek out financial statement audits in order to secure financing for their

operations. Companies preparing to go public also benefit from having an audit.

1-3 The agency relationship between an owner and manager produces a natural conflict of

interest because of differences in the two parties’ goals and because of the information

maximize their own self-interest, the manager may not act in the best interest of the owner

and may manipulate the information provided to the owner accordingly.

1-4 Independence is a bedrock principle for auditors. If an auditor is not independent of the

client, users may lose confidence in the auditor’s ability to report objectively and

truthfully on the financial statements, and the auditor’s work loses its value. From an

Chapter 01 – An Introduction to Assurance and Financial Statement Auditing

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1-5 Auditing (broadly defined) is a systematic process of (1) objectively obtaining and

evaluating evidence regarding assertions about economic actions and events to ascertain

the degree of correspondence between those assertions and established criteria and (2)

1-6 The phrase systematic process implies that there should be a well-planned, logical

approach for conducting an audit that involves objectively obtaining and evaluating

1-7 Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately

modify his or her opinion on financial statements that are materially misstated (AU 320,

PCAOB AS No. 12). Materiality is defined as “the magnitude of an omission or

misstatement of accounting information that, in the light of surrounding circumstances,

makes it probable that the judgment of a reasonable person relying on the information

would have been changed or influenced by the omission or misstatement” (AU 320,

PCAOB AS No. 11).

The concept of materiality is reflected in the wording of the auditor’s standard audit

material misstatement could be present in the financial statements and the auditor will fail

to detect it.

1-8 For most audits, it is not feasible or cost-effective to audit all transactions. For example, in

a small business, the auditor might be able to examine all the transactions that occurred

the exactness or precision of the audit and its cost.

1-9 The major phases of the audit are:

• Client acceptance/continuance and establishing an understanding with the client

• Preliminary engagement activities

• Plan the audit

Chapter 01 – An Introduction to Assurance and Financial Statement Auditing

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1-10 Plan the audit: During this phase of the audit, the auditor uses knowledge about the client

and any controls in place to plan the audit and perform preliminary analytical procedures.

1-11 The four paragraphs of the auditor’s standard unqualified report for a public company

client are: (1) the introductory paragraph, (2) the scope paragraph, (3) the opinion

1-12 Auditors frequently face situations where no standard audit procedure exists, such as the

example from the text of verifying the inventory of cattle. Such circumstances require that

the auditor exercise creativity and innovation when planning and administering audit

procedures where little or no guidance or precedent exists. Every client is different, and

Answers to Multiple-Choice Questions

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b

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a

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b

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d

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c

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d

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c

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d

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b

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c

Solutions to Problems

1-24 There are two major factors that may make an audit necessary for Greenbloom Garden

Centers. First, the company may require long-term financing for its expansion into other

cities in Florida. Entities such as banks or insurance companies are likely to be the sources

of the company’s debt financing. These entities normally require audited financial

statements before lending significant funds and generally require audited financial

statements during the time period the debt is outstanding. There is information asymmetry

operations of the company.

Chapter 01 – An Introduction to Assurance and Financial Statement Auditing

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1-25 a. Evidence that assists the auditor in evaluating financial statement assertions consists

of the underlying accounting data and any additional information available to the

auditor, whether originating from the client or externally.

b. Management makes assertions about components of the financial statements. For

example, an entity’s financial statements may contain a line item that accounts

receivable amount to $1,750,000. In this instance, management is asserting, among

about the management assertion. Reliability refers to the ability of evidence to signal

the true state of the assertion, i.e., whether it is actually being met or not.

1-26 a. The major phases of the audit and their descriptions are:

1. Client acceptance/continuance. The auditor decides to accept a new client or

to retain an existing client.

2. Preliminary engagement activities. This phase involves (1) determining the

audit engagement team requirements, (2) ensuring the independence of the

subsequent events, and performs a final review of the evidence gathered.

7. Evaluate results and issue the audit report. Based on the collection and

evaluation of evidence, the auditor issues a report on whether the financial

statements are fairly presented.

b. While audit procedures may be designed to test a specific assertion, they often

simultaneously provide evidence on another account or assertion. An example would

be when an auditor obtains evidence about a client’s transactions affecting the

inventory account and whether shipments of inventory to customers were included in

Chapter 01 – An Introduction to Assurance and Financial Statement Auditing

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the proper period. Such evidence may also be relevant to the client’s assertions

regarding whether accounts receivable balances were correct at the end of the period.

c. Auditors develop an understanding of an entity’s internal control in order to establish

the scope of the audit. However, during the course of this work, the auditor may

become aware of weaknesses in the entity’s accounting systems. The auditor is

1-27 A search of the homepage of most public companies will include links to their latest

financial information or 10–K filings. The SEC’s homepage will also include this

information along with any other recent filings. Examining the independent auditor’s

1-28 Scope paragraph: “These standards require that we plan and perform the audit to obtain

reasonable assurance about whether the financial statements are free of material

misstatement.” The use of the term reasonable assurance indicates that there is no

guarantee that the financial statements are correct, only reasonable assurance. Also the

indicates that the audit is not “proof” that the financial statements are exact, only that

there is reasonable evidence about their accuracy.

Opinion paragraph: “…the consolidated financial statements referred to above present

Solution to Discussion Case

1-29 The memo should cite the following facts:

• There is a historical relationship between accounting and auditing.

• When parties to the agency relationship (contract) do not possess the same amount of

information (information asymmetry) there is a natural conflict of interest between

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and manager will consummate an employment contract only if the manager agrees to

many private companies and municipalities not subject to the securities acts contract

for audits.

Solution to Internet Assignment

1-30 There are numerous Internet sites that contain accounting information. Following are

some suggested sites:

• The AICPA’s home page (www.aicpa.org) contains extensive information on the

organization’s activities. For example, it contains the entire report of the Special

• The Government Accountability Office’s website (formerly the General Accounting

Office, (www.gao.gov) provides detailed information on the GAO’s activities and

allows users to obtain copies of GAO reports.

• The SEC’s Edgar website (www.sec.gov) contains all filings by public companies

with the SEC. It also contains information on other activities by the SEC.

• The PCAOB’s website (www.pcaobus.org) offers detailed information about the

PCAOB and the standards it has proposed and established.

• The major public accounting firms and many smaller firms also maintain websites.