Chapter 02 – The Financial Statement Auditing Environment
2-1
CHAPTER 2
THE FINANCIAL STATEMENT AUDITING ENVIRONMENT
2-1 Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3)
government auditors, and (4) forensic auditors.
2-2 Examples of compliance audits include (1) internal auditors determining whether
corporate rules and policies are being followed by departments within the organization, (2)
an examination of tax returns of individuals and companies by the Internal Revenue
Service for compliance with the tax laws, and (3) an audit under the Single Audit Act of
Examples of forensic audits include (1) an examination by an external auditor of cash
disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law
enforcement agency in tracing laundered monies by organized criminals, and (3) an
independent auditor helping identify hidden assets as part of a divorce settlement.
Student answers will likely be less detailed but should capture the general idea of each
type of audit.
2-3 During the late 1990s and early 2000s, accounting firms aggressively sought opportunities
to expand their business in nonaudit services such as consulting. This expansion from their
core audit practice, combined with allegations of auditors refusing to challenge
2-4 The accounting profession’s expansion into new areas, combined with changes in the
overall business environment, resulted in new regulations and guidelines. The scandals of
the late 1990s and early 2000s brought into question the profession’s ability to self–
Chapter 02 – The Financial Statement Auditing Environment
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reporting system and for the profession. Further, somewhat ironically, the SOX-mandated
audit of internal control over financial reporting has brought significant new revenues to
accounting firms.
2-5 Management is responsible to prepare financial statements that fairly present the
company’s financial condition and operations in accordance with established accounting
standards. Note that the auditor’s opinion explicitly states that the financial statements are
the responsibility of management. The auditor is responsible to issue an opinion in regards
to the financial statements prepared by management. In order to issue this opinion, the
2-6 The essential components of the high-level model of business offered in the chapter are:
corporate governance, objectives, strategies, processes, controls, transactions, and
financial statements. Corporate governance is carried out by management and the board of
directors in order to ensure that business objectives are carried out and that company
2-7 The information system must maintain a record of all businesses transactions. It should be
capable of producing accurate financial reports to summarize the effects of the entity’s
transactions. Among other things, internal control is required to ensure that a proper
environment is established and that transactions are appropriately conducted and recorded
2-8 The AICPA issues the following standards:
• Statements on Auditing Standards
• Statements on Standards for Attestation Engagements
• Statements on Standards for Tax Services
Chapter 02 – The Financial Statement Auditing Environment
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2-9 The PCAOB is a quasi-governmental organization overseen by the SEC. It was formed to
provide governmental regulation of the standards used in conducting public company
2-10 The SEC has congressional authority from the original Securities Acts of 1933 and 1934
to establish accounting and auditing standards for publicly traded companies; however, in
the past the SEC has largely delegated this authority to other bodies, including the FASB
and the AICPA’s Auditing Standards Board. The Sarbanes-Oxley Act of 2002 gave the
2-11 The documents most frequently encountered by auditors under the Securities Exchange
Act of 1934 are forms 10-K, 10-Q, and 8-K. Forms 10-K and 10-Q are, respectively,
2-12 The four categories of Principles Underlying an Audit Conducted in Accordance with
GAAS are the purpose and premise of an audit, personal responsibilities of the auditor,
auditor actions in performing the audit, and reporting. The Principles Underlying an
2-13 GAAS is composed of three categories of standards: general standards, standards of field
work, and standards of reporting. The ten GAAS and the SAS are minimum standards of
performance because circumstances of individual engagements may require the auditor to
2-14 Independence is a fundamental 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 02 – The Financial Statement Auditing Environment
Answers to Multiple-Choice Questions
2-15
b
2-20
a
2-16
a
2-21
a
2-17
b
2-22
c
2-18
d
2-23
c
2-19
c
Solutions to Problems
2-24
Item Number
Type of Audit
Type of Auditor
a.
Government
b.
External
c.
Internal or external
d.
Internal, external, or forensic
e.
Government, external, or
internal
f.
Internal or external
g.
Government
h.
Government, external, or
forensic
2-25 a.
Brief Description of Generally
Accepted Auditing Standards
Sally Jones’ Actions Resulting in
Failure to Comply with Generally
Accepted Auditing Standards
General Standards:
1. The auditor must have adequate
technical training and proficiency to
perform the audit.
1. It was inappropriate for Jones 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. Although a junior
Chapter 02 – The Financial Statement Auditing Environment
assistant has not completed his
formal education, he may help in the
conduct of the examination as long
as there is proper supervision and
review.
2. The auditor must maintain
independence in mental attitude in all
matters relating to the audit.
2. To satisfy the second general
standard, Jones must be without bias
with respect to the client under
audit. Jones has an obligation for
fairness to the owners, management,
and creditors who may rely on the
report. Because of the financial
interest in whether the bank loan is
granted to Boucher, Jones is not
independent in either fact or
appearance with respect to the
assignment undertaken.
3. The auditor must exercise due
professional care in the performance
of the audit and the preparation of the
report.
3. This standard requires Jones to plan
and perform the audit with due care,
which imposes on Jones and
everyone in her firm 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 by
those assisting in the examination.
Jones 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 the auditor has
advantages for the auditor and the
client. Jones accepted the
engagement without considering the
Chapter 02 – The Financial Statement Auditing Environment
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. Jones did not study the client or its
environment, including 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 by
performing audit procedures to afford
a reasonable basis for an opinion
regarding the financial statements
under audit.
3. Jones acquired little evidence that
would support the fairness of the
financial statements. Jones merely
checked the mathematical accuracy
of the records and summarized the
accounts. Several standard audit
procedures and techniques were
neglected.
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 (GAAP).
1. Jones’ report made no reference to
generally accepted accounting
principles. Because Jones did not
conduct a proper examination, the
report should state that no opinion
can be expressed as to the fair
presentation of the financial
statements in accordance with
GAAP.
2. The auditor must identify in the
auditor’s report those circumstances
in which such principles have not
been consistently observed in the
current period in relation to the
preceding period.
2. Jones’ improper examination would
not enable her to determine whether
accounting principles have been
consistently applied.
3. When the auditor determines that
informative disclosures are not
reasonably adequate, the auditor
must so state in the auditor’s report.
3. Management is responsible for
adequate disclosure in the financial
statements, but when the statements
do not contain adequate disclosures
the auditor should make such
disclosures in the auditor’s report.
Both the statements and the auditor’s
report lack adequate disclosures.
Chapter 02 – The Financial Statement Auditing Environment
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 therefore 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 Jones’ report contains an
expression of opinion, her opinion is
not based on the results of a proper
audit examination. Jones should
disclaim an opinion because she
failed to conduct an examination in
accordance with generally accepted
auditing standards.
b.
Brief Description of Principles Underlying an
Audit
Sally Jones’ Actions Resulting in Failure to
Comply with Principles Underlying an Audit
Purpose and Premise of an Audit:
An audit is to provide an opinion by an auditor on
whether financial statements are presented fairly,
in all material respects, according to the applicable
framework. Management and those charged with
governance are responsible for the preparation and
fair presentation of the financial statements and
for the design, implementation, and maintenance
of internal control over financial reporting. They
are also responsible for providing the auditor with
all information relevant to the preparation of the
financial statements.
Jones expressed an opinion regarding the financial
statements, but not on whether the financial
statements are presented fairly in accordance with
generally accepted accounting principles, or any
other financial reporting framework. Therefore, she
did not fulfill the primary purpose of the audit.
Jones did not ensure that management fulfilled its
responsibilities for the fair presentation of the
financial statements, since that requires making the
appropriate disclosures in the financial statements.
Chapter 02 – The Financial Statement Auditing Environment
Responsibilities:
Auditors are responsible for having appropriate
competence and capabilities to perform the audit;
complying with relevant ethical requirements; and
maintaining professional skepticism and
exercising professional judgment, throughout the
planning and performance of the audit.
It was inappropriate for Jones to hire the two
students to conduct the audit, because they do not
have appropriate competence and capabilities.
In order to comply with ethical requirements, Jones
must be without bias with respect to the client under
audit. Because of the financial interest in whether
the bank loan is granted to Boucher, Jones is not
independent in either fact or appearance with respect
to the assignment undertaken.
Neither Jones nor her two assistants exercised
professional skepticism or professional judgment in
performing the audit.
Performance:
The auditor must obtain reasonable assurance
about whether the financial statements as a whole
are free from material misstatement, whether due
to fraud or error. To do so, the auditor must plan
the work and supervise any assistants; determine
an appropriate materiality level; identify and
assess risks of material misstatement based on an
understanding of the entity and its environment,
including its internal control; and obtain sufficient
appropriate audit evidence about whether
misstatements exist. The auditor is unable to
obtain absolute assurance that the financial
statements are free from material misstatements.
Jones failed to supervise the assistants. The work
performed was not adequately planned.
Jones did not study the client or its environment,
including internal control, nor did the assistants.
Consequently, she could not have identified risks of
material misstatements.
Jones acquired little evidence that would support the
fairness of the financial statements. Jones merely
checked the mathematical accuracy of the records
and summarized the accounts. Several standard
audit procedures and techniques were neglected.
Reporting:
Based on an evaluation of the audit evidence
obtained, the auditor expresses an opinion in
accordance with the auditor’s findings, or states
that an opinion cannot be expressed. The opinion
states whether the financial statements are
presented fairly, in all material respects, in
accordance with the applicable financial reporting
framework.
Although Jones’ report contains an expression of
opinion, her opinion is not based on the results of a
proper audit examination. Jones should disclaim an
opinion because she failed to conduct an
examination in accordance with generally accepted
auditing standards.
Jones’ opinion made no reference to the applicable
financial reporting framework. Also, since the
financial statements did not contain adequate
disclosures, they could not have been in accordance
with any financial reporting framework.
2-26
Situation
Applicable
GAAS of
Reporting
Discussion of Relationship
of Client Situation to
Standard of Reporting
a.
The auditor must identify in the
auditor’s report those
circumstances in which such
principles have not been
consistently observed in the
current period in relation to the
preceding period.
A change in accounting principle affects
the consistent application of the
accounting principle. If the change is
material, the auditor should reference the
change in accounting in an explanatory
paragraph to the audit report.
b.
When the auditor determines that
informative disclosures are not
reasonably adequate, the auditor
must so state in the auditor’s
report.
Information essential to a fair presentation
in conformity with GAAP must be
disclosed in the financial statements or the
related footnotes. Assuming that the terms
of loan agreements, such as restrictive
covenants, are material, such information
should be disclosed. If the client refuses to
disclose such essential information, the
auditor should disclose the information
and qualify the audit report.
c.
The auditor must state in the
auditor’s report whether the
financial statements are presented
in accordance with generally
accepted accounting principles
(GAAP).
The improper presentation of material
amounts of minority interest in net income
and retained earnings constitutes a
departure from GAAP. The audit report
should be qualified (or adverse) and the
information should be disclosed by the
auditor.
Solutions to Discussion Cases
2-27 Merry-Go-Round Part I.
a. EY is alleged to have violated all three general standards as well as one, and perhaps
two, of the standards of field work.
• They violated the first general standard in the sense that it appeared that the staff
assigned to the engagement did not have sufficient training or experience for the
Chapter 02 – The Financial Statement Auditing Environment
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violation of the third general standard.
• Poor staff assignments, the leader’s vacation, and the use of inexperienced
an effective implementation strategy, which would be in violation of the third
standard of fieldwork.
b. EY is alleged to have violated the Principles of responsibilities and performance.
• They violated the Principle of responsibilities in the sense that it appeared that the
staff assigned to the engagement did not have sufficient training or experience for
assistants were not properly supervised, which violates the Principle of
performance. Also, the inadequate nature of EY’s recommendations suggests that
they likely did not gain a sufficient understanding of the entity and its operations.
c. There are arguments both for and against having formal standards for CPAs who
consult. Advantages include potential increase in public trust, some assurance that a
sense that CPAs would be subject to standards that constrain their activities or
perhaps result in their not being able to compete with non-CPAs in the area of fees.
Note that CPAs face certain restrictions in providing consulting services to audit
clients. These restrictions are covered in a later chapter.
2-28 Merry-Go-Round Part II.
a. In one sense, EY acted unethically. That is, it should have disclosed the nature of
these relationships to MGR. In another sense, it is difficult to ascertain whether these
relationships caused EY to act unethically. Specifically, was EY’s advice affected by
Chapter 02 – The Financial Statement Auditing Environment
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losing business from Rouse. Its relationship with Swidler could have made EY feel
that it could not lose the engagement under any circumstances, thereby possibly
explaining its apparently lackadaisical attitude towards the engagement.
Solutions to Internet Assignments
2-29 A search of the GAO’s homepage will identify recent audits conducted by this agency.
2-30 a. According to its website, the AICPA’s mission is to “provide members with the
resources, information, and leadership that enable them to provide valuable services in
the highest professional manner to benefit the public as well as employers and clients.”
b. The SEC’s website states that its mission is “to protect investors, maintain fair, orderly,
attempt to restore confidence in the capital markets, Congress passed the Securities Act
of 1933. One year later, the SEC was created by the Securities Exchange Act of 1934.
d. The PCAOB’s website provides information on the Board’s organization, policies, and
standards. It also indicates that the Board uses an expert advisory group to help the Board
develop standards. Though many observers dispute this claim, the Board asserts that its
the Chief Auditor is responsible for developing these standards.
e. The International Auditing Practices Committee (IAPC) was founded in 1978. During
its first meeting, the group agreed to issue its publications as guidelines rather than
standards. The IAPC’s initial work focused on three areas: object and scope of audits of
financial statements, engagement letters, and general auditing guidelines. During this
Chapter 02 – The Financial Statement Auditing Environment
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concern, and management representations.
Auditing, or ISAs, were born.
In 2001, IAPC was renamed as the International Auditing and Assurance Standards
Board (IAASB). The IAASB then embarked on its first joint project with a national
standard setter, the AICPA, which resulted in the development of the suite of audit risk
standards.
In 2003, IFAC approved a series of reforms designed to strengthen the IAASB’s
standard-setting processes so that it are properly responsible to the public interest. By
2007, the IAASB had become arguably the most transparent auditing standard setter in
the world.
To encourage greater use of its standards and facilitate translation, in 2004 the IAASB
launched a project designed to improve the clarity of its pronouncements. It revised its
drafting conventions to make the ISAs more readily understood. By the end of 2008, the
IAASB had approved all final redrafted auditing standards. The IAASB is currently
working on revising its standards for assurance engagements other than audits.
f. The IASB is the independent accounting standard-setting body of the IFRS Foundation.
The IASB is composed of 16 experts with an appropriate mix of recent practical
All meetings of the IASB are held in public and are broadcast through the internet. In
fulfilling its standard-setting duties, the IASB follows a thorough, open and transparent
process of which the publication of consultative documents, such as discussion papers
Chapter 02 – The Financial Statement Auditing Environment
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and exposure drafts for public comment is an important component. The IASB engages
closely with stakeholders around the world, including investors, analysts, regulators,
business leaders, accounting standard-setters, and the accountancy profession.
The SEC has not yet reached a decision as to how, or even whether, the U.S. will adopt