978-0077862213 Chapter 5 Solution Manual Part 2

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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