Ethical Obligations and Decision Making in Accounting, 4/e 1
Chapter 5 Discussion Questions
Suggested Discussion and Solutions
1. What are the objectives of audit risk assessment, and why is it important in
assessing the likelihood that fraud may occur? Explain why risk assessment
performed during audit planning sets the tone for the entire audit
engagement.
Risk assessment is the process of estimating the likelihood of adverse conditions
occurring. It is a “what is the worst that can happen” analysis? Auditors should conduct
risk assessments on the likelihood of fraud, errors and misstatements, ethical tone of top
management, and the ability of the company remaining in business as a going concern. If
management is also conducting risk assessments, opportunities for frauds will be lessened
as internal controls are strengthened through due diligence measures. The objectives of
Extended Discussion
According to PwC’s A Practical Guide to Risk Assessment1, risk assessment provides a
mechanism for identifying which risks represent opportunities and which represent
potential pitfalls. Done right, a risk assessment gives organizations a clear view of
variables to which they may be exposed, whether internal or external, retrospective or
forward-looking. A good assessment is anchored in the organization’s defined risk
appetite and tolerance, and provides a basis for determining risk responses. A robust risk
assessment process, applied consistently throughout the organization, empowers
management to better identify, evaluate, and exploit the right risks for their business, all
while maintaining the appropriate controls to ensure effective and efficient operations
and regulatory compliance.
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2. Distinguish between an auditor’s responsibilities to detect and report errors,
illegal acts, and fraud. What role does materiality have in determining the
proper reporting and disclosure of such events?
Auditors have a responsibility to plan and perform the audit to obtain reasonable
assurance that the financial statements are free of material misstatement. Reasonable
assurance is obtained when audit risk (risk that the auditor will issue a standard opinion
when financial statements contain material misstatements) is at a low level. During the
planning phase of the audit the auditors should assess the risk of material misstatement
whether from errors, fraud or illegal acts. Based upon the assessment, they should
3. AU–C 240 points to three conditions that enable fraud to occur. Briefly
describe each condition. How does one’s propensity to act ethically as
described by Rest’s model of morality influence each of the three elements of
the Fraud Triangle?
AU-C 240 incorporates the fraud triangle of opportunity, pressure/incentives and
rationalization in organizing prevention. Opportunity is the act being possible or
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relatively easy including access to commit the fraud. It can also lead to top management
override of internal controls. Pressure can be either an individual’s need for money or
rewards and punishments applied to the employee by the firm; perceived need to meet
financial analysts’ earnings expectations; and desire for higher bonus and enhancement of
stock option value. Rationalization is developing excuses to justify doing something
generally wrong so that one does not feel too much guilt such as it will only happen this
one time.
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Extended Discussion
Instructors may want to review the GVV model in this question since it links to the
following rationalizations for unethical actions.
Expected or Standard Practice: “Everyone does this, so it’s really standard practice. It’s
even expected.”
Materiality: “The impact of this action is not material. It doesn’t really hurt anyone.”
4. What is the ethical value of applying the fraud triangle to assess the risk of
material misstatements in the financial statements?
The ethical value of applying the fraud triangle to assess the risk of material
misstatements in the financial statements is it provides a process of thinking through
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5. All companies are vulnerable to fraud, but small businesses are particularly
vulnerable. Why do you think this may be the case? What signs of possible
fraud may be more pronounced in small businesses when compared to larger
ones?
Small businesses are more vulnerable to fraud for a variety of reasons including:
• Small businesses typically have a weaker set of internal controls than larger ones.
o It is not uncommon to lack an adequate segregation of duties
o One person (i.e., bookkeeper) may have unfettered access to checking
account and be responsible for the bank reconciliation
o Inventory controls are weak making it easier to misappropriate product
6. Explain the content of each section of the audit report. Evaluate the
importance of each section with respect to the users of financial reports.
The auditors’ report begins with a title that includes the word “independent” and is
addressed to the person or persons who retained the auditors. Independence is the
backbone of the audit so a clear statement sends a signal to readers that they can rely on
the audit report and opinion given. In the case of corporations, the selection of an
auditing firm is usually made by the audit committee of the board of directors and ratified
by the stockholders so that the report is addressed to these groups.
The standard report consists of an introductory sentence indicating the financial
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(4) the audit includes evaluating the appropriateness of accounting policies used and
reasonableness of significant accounting estimates made by management; and (5)
whether the auditor believes that the audit evidence gathered is sufficient and appropriate
7. Give one example each of when an auditor might render an unmodified
opinion and include an emphasis-of-matter paragraph and other-matter
paragraph. What is the value of such paragraphs in the audit report?
“Unmodified” is never itself seen in the opinion, but it represents the auditor’s opinion
that the statements are both fair and follow Generally Accepted Accounting Principles.
Certain situations may call for adding an additional paragraph: either an emphasis-of-
matter or other-matter paragraph. An emphasis-of-matter is a paragraph in the auditor’s
report that refers to a matter appropriately presented or disclosed in the financial
statements (e.g., going concern, litigation uncertainty, subsequent events, etc.). It is added
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“Qualified” acts as a caution to financial statement readers to take care when comparing
the company’s current statements to past statements and other companies’ financials.
Qualification means the basis of qualification is material, i.e., large enough or important
enough that proper knowledge and understanding would, should, or at least might,
change investor assessments of the firm’s financial statements as a basis for investment
or corporate governance decisions. Material could be defined as something big enough to
tip an investment decision and might be guessed at by dollars or by percentages, but also
8. The following statement expresses the conclusion of XYZ auditors with
respect to the company’s investment in ABC. Assume that all amounts are
material. What kind of audit opinion should be rendered given this
statement? Explain the reasoning behind your answer.
XYZ’s investment in ABC, a foreign subsidiary acquired during the year and
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accounted for by the equity method, is carried at $120,000 on the statement of
financial position as at December 31, 2015, and XYZ’s share of ABC’s net income
of $20,000 is included in XYZ’s income for the year then ended. We were unable
9. Rationalization for fraud can fall under two categories: “no harm” and “no
responsibility.” Assume an employee is directed by management to reduce
recorded expenses at year-end by insignificant amounts individually, but
which are material in total. How might the employee justify her actions if
questioned by the auditor with respect to no harm and no responsibility?
What stage of moral development in Kohlberg’s model is best illustrated by
the employee’s actions? Why?
The employee is not embezzling or benefiting from this fraud; it is more of a
management fraud of the financial statement to meet market expectations. Thus, the
employee would respond very well to auditor questioning since the amounts did not
personally benefit her. Of the two rationalizations, the employee is probably using “no
responsibility” since she is following the orders of her superiors. If management is
pressing her hard to record the reduction to expenses, she may inform the auditors about
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10. What do you think is meant by the term ethical auditing with respect to the
principles and rules of professional conduct in the AICPA Code?
Some students may assume this question is addressing social responsibility issues
including labor practices. However, reference to the AICPA Code means to answer it in
the context of the Principles and Rules of Conduct in the Code.
11.
Some criticize the accounting profession for using expressions in the audit
report that seem to build in deniability should the client commit a fraudulent
act. What expressions enable the CPA to build a defense should the audit
wind up in the courtroom? Do you see anything wrong with these expressions
from an ethical point of view?
Some of the expressions or statements in the audit opinion that enable the CPA to build a
defense are “These financial statements are the responsibility of the Company’s
management;” “on a test basis;” “reasonable assurance;” “material;” “in all material
respects;” and “assessing.” These expressions warn that the audit does not examine
12.
Do you think the concept of materiality is incompatible with ethical
behavior? Consider in your answer how materiality judgments affect risk
assessment in the audit of financial statements.
Materiality alone is not incompatible with ethical behavior. Many professions use
estimates or confidence intervals to determine amounts. Materiality is used in audits in
order to keep a cost-benefit approach to accounts and amounts. If cash balance is off
$100, it could cost the auditors more than $100 to find and correct the error. However,
materiality can pose an ethical problem if the auditor finds material differences and
13. According to GAAS, the auditor must evaluate the control deficiencies that
he has become aware of to determine whether those deficiencies, individually
or in combination, are significant deficiencies or material weaknesses. What
is the purpose of the auditor’s evaluation of internal controls in these
contexts with respect to conducting an audit in accordance with established
standards?
Strong internal controls of management help to mitigate the risk of potential
misstatements in the financial statements. If there are deficiencies in controls, it affects
the necessary assurance needed from the auditors’ substantive testing. Deficiencies could
also cause the auditor to do more testing or change the method of testing. Understanding
14. Mr. Arty works for Smile Accounting Firm as a senior accountant. Currently
he is doing a review of rental property compliance testing of rental receipts
and expenses of the property owned by the client. He determines 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 now. The
manager did approach the client, who stated that she “needed the report
yesterday.” The manager reminds Arty that no problems were found from
the testing of the two properties, in past years the work papers called for just
two properties to be reviewed, the firm has never had any accounting issues
with respect to the client and he is confident the testing is sufficient. Explain
the manager’s explanations and the judgment tendencies discussed in
Chapter 4.
Auditors may have their own biases that cloud decision making and alter final choices.
They may be easy going and avoid conflicts at all costs, which would not make for a very
good auditor who needs to have a questioning mind and be willing to critically assess
audit data. Mr. Arty needs to take measures to ensure he doesn’t fall into these judgment
traps; unfortunately for him it appears the manager is pushing him to do just that by being
biased towards the interests of the client.
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Judgment triggers can lead to accepting a solution to the problem before it is properly
identified and evaluated. Biased judgments might be made because of judgment
tendencies. Mr. Arty needs to do more auditing to be fully confident that no problems
exist with the rental compliance testing. A third tenant should be looked at in accordance
with the audit program. Audit programs are set up to enhance professional judgment.
The tendency for decision makers to put more weight on information that is consistent
with their initial beliefs or preferences is the confirmation tendency. The auditor trusts the
client based on past experiences and is more willing to accept the copies. However, in
many instances, we cannot know something to be true unless we explicitly consider how
and why it may be false. Confirmation bias in auditing may occur when auditors over-
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 of whether the financial statements are
15. Auditing standards require that a “brainstorming” session should be held at
the beginning of each audit to help identify steps to assess the possibility that
material misstatements/fraud in the financial statements exist. Discuss how
brainstorming sessions might enhance audit judgments, professional skepticism,
and decision making. Consider the groupthink dimension in your discussion.
An exchange of ideas or “brainstorming” is a group activity so group think would be
affected. This may be a positive or negative feature depending on the goals of the group
and efforts of the leader to have such discussions that might enhance professional
judgment and sharpen professional skepticism. Discussing the possibility of material
misstatements in the financial statements can help to overcome potential judgment biases
and common judgment tendencies that could influence decision making.
The discussion among the audit team members about the susceptibility of the entity’s
financial statements to material misstatement due to fraud should include a consideration
of the known external and internal factors affecting the entity that might (a) create
incentives/pressures for management and others to commit fraud, (b) provide the
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The discussion among the audit team members should emphasize the need to maintain a
questioning mind and to exercise professional skepticism in gathering and evaluating
evidence throughout the audit. This should lead the audit team members to continually be
alert for information or other conditions that indicate a material misstatement due to fraud
16. Discuss the link between skeptical judgment and skeptical action and Rest’s
Four-Component Model of Ethical Decision Making.
Rest’s second component is the ability to make ethical judgments. In auditing,
professional judgment should have skepticism built in. Auditors should critically examine
and assess management’s representations and financial information and data provided by
the client to support representations. Good judgment is required by Rest’s model using
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 management fraud or other illegal acts by corporate officer.