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13. In 2005, the IMA reported the results of a survey of business, academic, and regulatory
leaders conducted by the Center for Corporate Change that found the corporation’s culture
to be the most important factor influencing the attitudes and behavior of executives. The
results indicate that 88 percent of the representatives who took part in the survey believe
that companies devote little management attention to considering the effect of the culture on
their executives. What are the elements of the corporate culture? How do the standards in
COSO’s Integrated Framework help define a strong control environment?
An important element of the corporate culture is the tone at the top. Management at the top determine how
and how often employees are rewarded and how communications within and outside the company take
place. Employees evaluate management with respect to whether it has been fair and equitable in rewarding
employees? Is top management rewarded on a different system? Is top management always rewarded first?
Are communications honest? It has been said that the performance evaluation policies of a company signal
Corporate culture refers to an organization’s values, beliefs, and behaviors. It is concerned with the beliefs
and values as the basis of which people interpret experiences and behave, individually and in groups.
A company may not be completely able to control its culture, but it can significantly influence its culture.
Company culture can be influenced by the vision of the company and its management, whether the vision is
articulated or not. The reward, pay, and promotion systems influence behavior of employees and culture.
Often times, management does not convey clear visions, goals or expectations to guide employees
behavior. Sometimes, management assumes that the visions, goals and expectations are being conveyed and
Students often enjoy and relate to the movie Office Space. In the movie, a software company treats its
employees unethically. The employees finally get fed up with the treatment and decide to steal from the
company. One employee sets fire to the office. At the end of the day, the office building is destroyed and
14. Kinetics, Inc., included the following footnote in its December 31, 2013, financial statements:
We corrected the misstatement of capitalized advertising costs recorded in 2012 by
adjusting operating expenses for 2013, and crediting the asset account. The result of this
How would you determine whether to include reference to the correction in the audit report?
If reference is needed, how should it affect the type of audit opinion given?
The auditors must determine whether the correction was due to a change in accounting policy or estimate.
Under PCAOB Auditing Standard No. 6, a change in accounting principle, such as from capitalization to
expensing in the Kinetics case, is a change from an accounting principle that is not generally accepted to
If the change is due to an error in estimation, the auditor does not have to make reference to the correction
15. What do you think is meant by the term ethical auditing with respect to principles and rules
of professional conduct in the AICPA Code?
Ethical auditing would include adhering to principles and rules in the AICPA Code. It would include
keeping the public as the most important stakeholder in the audit and displaying the principles of the
AICPA (public interest, integrity, objectivity, independence, and due care) as the virtues to guide decision-
16. Mr. Arty works for Smile Accounting Firm as a senior accountant. Currently he is doing a
review of rental property compliance testing completed by the staff accountants. He is
testing rental receipts and expenses of the property owned by the client. Arty realizes that
the staff accountants tested only two tenants per property instead of the required three by
the audit program based on materiality considerations. However, to request more
information from the client would cause massive delays and the manager on the engagement
is pressing hard for the information before Christmas vacation. Assume the manager
approaches the client, who states that she does not want any additional testing: “I needed the
report yesterday.” The manager points out to Arty that no problems were found from the
testing of the two properties. Moreover, the firm has never had any accounting issues with
respect to the client. Assume the firm decides it is not necessary to do the additional testing.
What would you do if you were Arty? Consider in your answer the ethics of the situation and
reporting obligations of the firm.
The concerns of the manager and the auditing firm are that the evidence provides the basis for the
conclusions drawn; conclusions of various elements of the audit roll up into the final audit report. If the
rental property compliance testing is a significant component of the audit, it could affect the determination
From an ethical perspective, the manager must consider whether omitting this additional property testing
affects the due care standard. At a minimum this could be considered negligence. Even without the
Arty needs to consider that he has the responsibility for the rental property auditing. If the third rental client
is not examined, then the materiality standards are not met. If it is discovered later on that a problem exists
17. What are the auditor’s responsibilities to communicate information to the audit committee
under AICPA and PCAOB standards? If the auditor discovers that the audit committee
routinely ignores such communications especially when they are critical of management’s
use of GAAP in the financial statements, what step(s) might the auditor take at this point.
During the course of the audit, the auditors will discuss with the audit committee matters such as
weaknesses in internal control, proposed audit adjustments, disagreements with management as to
accounting principles, the quality of accounting principles used by the company, and indications of
The auditors are required by both the AICPA and PCAOB to provide written communication of both
significant deficiencies and material weaknesses in internal control to the audit committee. Auditors must
also communicate certain matters relating to fraud, illegal acts, and other matters to the audit committee.
If the audit committee ignores such communications or does not take proper action based on the
While not required by the question, the instructor may want to review the requirements of AS 16 of
The auditor should communicate to the audit committee the following.
Significant accounting policies and practices.
Critical accounting policies and practices and reasons for considering them to be critical. Critical
accounting policies and practices are a company's accounting policies and practices that are both
Critical accounting estimates.
Auditor's evaluation of the quality of the company's financial reporting.
Other information in documents containing audited financial statements.
In this case the auditor should discuss with the audit committee, or determine that management has
adequately discussed with the audit committee, the basis for the determination that the uncorrected
misstatements were immaterial, including the qualitative factors considered. The auditor also
Material written communications.
Departure from the auditor's standard report.
The auditor should communicate to the audit committee the following matters related to the
auditor's report:
a. When the auditor expects to modify the opinion in the auditor's report, the reasons for the
b. When the auditor expects to include explanatory language or an explanatory paragraph in the
Disagreements with management
The auditor should communicate to the audit committee any disagreements with management
about matters, whether or not satisfactorily resolved, that individually or in the aggregate could be
significant to the company's financial statements or the auditor's report. Disagreements with
Difficulties encountered in performing the audit.
The auditor should communicate to the audit committee any significant difficulties encountered
a. Significant delays by management, the unavailability of company personnel, or an unwillingness
b. An unreasonably brief time within which to complete the audit;
c. Unexpected extensive effort required by the auditor to obtain sufficient appropriate audit evidence;
18. In Europe, the audit reports use the expression “true and fair view” to characterize the
results of the audit. Do you think there is a meaningful difference between that language and
the “present fairly” statement made in U.S. audit reports? As a user of the financial
statements in each instance, does one expression more than the other give you a greater
comfort level with respect to the conformity of the financial statements with generally
accepted accounting principles? Why or why not?
“Presents fairly in accordance with GAAP” versus “true and fair view” provides an interesting difference.
True and fair sounds like an endorsement or affirmation by the auditors of European GAAP. American
auditors do not defend GAAP but rather depend on GAAP to defend them from criticism. True sounds more
ethical and certainly sounds more precise than fair. The word fairly is used by auditors as a modifier that
19. "Accounting firms and their personnel must continually evaluate their clients' accounting
and related disclosures, putting themselves in investors' shoes.” This statement was made on
February 8, 2012, by Claudius B. Modesti, Director of the PCAOB Division of Enforcement
and Investigations, in reporting on PCAOB’s audits of Medicis Pharmaceutical
Corporation’s fiscal 2005 through 2007 financial statements. Medicis was a client of Ernst &
Young that was undergoing an inspection in accordance with PCAOB’s enforcement
program. The Board found that E&Y and its partners failed to sufficiently audit key
assumptions and placed undue reliance on management's representation that those
assumptions were reasonable. Further, the firm failed to properly evaluate a material
departure from GAAP in the company's financial statements — its sales returns reserve.
PCAOB Chairman, James R. Doty, was quoted as saying: "The auditor's job is to exercise
professional skepticism in evaluating a public company's accounting and in conducting its
audit to ensure that investors receive reliable information, which did not happen in this
case."
Following the audits and PCAOB inspection of EY’s audit of Medicis, the company
corrected its accounting for its sales returns reserve and filed restated financial statements
with the SEC.
What is the link between professional skepticism and Josephson’s Six Pillars of Character
that were discussed in Chapter 1? Given the limited information, which rules of professional
conduct in the AICPA Code were violated by EY? Explain why.
Professional skepticism relates to Josephson’s pillars of trustworthiness, honesty, integrity, reliability, and
responsibility. An auditor that approaches an audit with professional skepticism is being careful,
Given the limited information, it seems possible EY violated the following rules from the AICPA Code:
independence (rule 101), integrity and objectivity (rule 102), due care and competency (rule 201),
compliance with standards (rule 202), accounting principles (rule 203), and acts discreditable (rule 501).
The failure to audit key assumptions and over-reliance on management’s representations illustrate a failure
20. Audit morality includes moral sensitivity, moral judgment, moral motivation, and moral
character. Explain how audit morality plays a key role in determining best audit practice
that influences audit performance.
An auditor needs moral sensitivity to be aware of dilemmas, conflicts of interest, threats to objectivity and
independence; this trait is shown through skepticism. An auditor then needs moral judgment to assess the
effects of conflicting positions on stakeholders; evaluate the ethics of alternatives using moral reasoning
methods; identify alternatives, and evaluate the ethics of each one as a basis for selection. Moral motivation
