Principles of Auditing An Introduction To International Standards On Auditing 3rd Edition Hayes Solu 190402061241
Principles of Auditing An Introduction To International Standards On Auditing 3rd Edition Hayes Solu 190402061241
Principles of Auditing An Introduction To International Standards On Auditing 3rd Edition Hayes Solu 190402061241
Contents
Chapters Pages
1. International Auditing Overview 4
2. The Audit Market 24
3. Ethics for Professional Accountants 35
4. An Auditor’s Services 49
5. Client Acceptance 60
6. Main Audit Concepts and Planning the Audit (ISA 300, 315, 320) 73
7. Internal Control and Control Risk 89
8. Analytical Procedures 110
9. Auditor’s Response to Assessed Risk (ISA 330, ISA 500) 129
10. Audit Evidence 147
11. Completing the Audit 163
12. Audit Reports and Communications 182
13. Overview of a Group Audit 208
14. Other Assurance and Non-Assurance Engagements 242
15. Corporate Governance and the Role of the Auditor 251
1-2. What characteristics of the Industrial Revolution were essential for the enhanced
development of the audit profession?
The Industrial Revolution created the demand of services of specialists in bookkeeping and
auditing of internal and external financial reports. It started in Great Britain around 1780. This
revolution lead to the emergence of large industrial companies, with (1) complex bureaucratic
structures and, gradually, (2) the need to look for external funds in order to finance further
expansion: the separation between capital provision and management.
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Income statements are compiled on a yearly basis. The income statement is very valuable to
shareholders and other stakeholders. To increase the confidence these stakeholders in the
credibility of yearly compiled financial statements, the statements must receive an independent
and expert opinion on their fairness. An auditor provides the opinion on credibility.
1-5. Why is the adoption of International Auditing Standards important for developing
nations?
International Auditing Standards encourage and assist developing nations to adopt codified sets
of national auditing standards. The evolution of domestic accounting standards in developing
nations can be expected to flow from the work of the IASB. Many developing countries rely to a
large extent on foreign investment. Foreign investors are more likely to channel funds into a
developing country if they have confidence in the accounting and auditing standards in that
country.
1-7. What is the general definition of an audit? Briefly discuss the key component parts
of the definition.
An audit is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of correspondence
between these assertions and established criteria and communicating the results to interested
users.
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An audit is a systematic approach. The audit follows a structured, documented plan (audit plan).
In the process of the audit, the auditors using a variety of generally accepted techniques
analyse accounting records. The audit must be planned and structured in such a way that those
carrying out the audit can fully examine and analyse all-important evidence.
An audit is conducted objectively. An audit is an independent, objective and expert examination
and evaluation of evidence. Auditors are fair and do not allow prejudice or bias to override their
objectivity. They maintain an impartial attitude.
The auditor obtains and evaluates evidence. The auditor assesses the reliability and sufficiency
of the information contained in the underlying accounting records and other source data by:
• Studying and evaluating accounting systems and internal controls on which he wishes to
rely and testing those internal controls to determine the nature, extent and timing of other
auditing procedures.
• Carrying out such other tests, inquiries and other verification procedures of accounting
transactions and account balances, as he considers appropriate in the particular
circumstances.
The evidence obtained and evaluated by the auditor concerns assertions about economic
actions and events. The basis of evidence-gathering objectives, what the evidence must prove,
are the assertions of management. Assertions are representations by management, explicit or
otherwise, that are embodied in the financial statements. One assertion of management about
economic actions is that all the assets reported on the balance sheet actually exist at the
balance sheet date. The assets are real, not fictitious. This is the existence assertion.
Furthermore, management asserts that the company owns all these assets. They do not belong
to anyone else. This is the rights and obligations assertion.
The auditor ascertains the degree of correspondence between assertions and established
criteria. The audit programme tests most assertions by examining the physical evidence of
documents, confirmation, inquiry and observation. The auditor examines the evidence for the
assertion presentation and disclosure to determine if the accounts are described in accordance
with the applicable financial reporting framework, such as IFRS, local standards or regulations
and laws.
1-9. Discuss the two levels of risk an auditor must consider when designing audit
procedures.
In order to design audit procedures to determine whether financial statements are materially
misstated, the auditor considers the risk at two levels. One level of risk is that the overall
financial statements may be misstated. The second risk is misstatement in relation to classes of
transactions, account balances and disclosures. The risk of material misstatement at the overall
financial statement level often relate to the entity’s control environment (although these risks
may also relate to other factors, such as declining economic conditions). This overall risk may
be especially relevant to the auditor’s consideration of fraud. The auditor also considers the risk
of material misstatement at the class of transactions, account balance and disclosure level.
These considerations directly assist in determining the nature, timing and extent of further audit
procedures.
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1-11. What are the differences and similarities in audits of financial statements, compliance
audits and operational audits?
Audits of financial statements examine financial statements to determine if they give a true and
fair view or fairly present the financial statements in conformity with specified criteria. A
compliance audit measures the compliance of the client with some established criteria. The
performance of a compliance audit is dependent upon the existence of verifiable data and of
recognised criteria or standards, such as established laws and regulations, or an organisation’s
policies and procedures. An operational audit is a study of a specific unit of an organisation for
the purpose of measuring its performance.
Operational audits review all or part of the organisation’s operating procedures to evaluate
effectiveness and efficiency of the operation. Efficiency shows how well an organisation uses its
resources to achieve its goals. These reviews may not be limited to accounting. They may
include the evaluation of organisation structure, marketing, production methods, computer
operations or in whatever area the organisation feels evaluation is needed. Recommendations
are normally made to management for improving operations.
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1. Assertions about classes of transactions and events for the period under audit:
• Occurrence – Transaction and events that have been recorded have occurred and
pertain to the entity. For example, management asserts that a recorded sales
transaction was effective during the year under audit.
• Completeness – All transactions and events that should have been recorded have been
recorded. For example, management asserts that all expense transactions are
recorded, none were excluded.
• Accuracy – Amounts and other data relating to recorded transactions and events have
been recorded appropriately. For example, management asserts that sales invoices
were properly extended and the total amounts that were thus calculated were input into
the system exactly.
• Cutoff – Transactions and events have been recorded in the correct accounting period.
For example, management asserts that expenses for the period are recorded in that
period and not in the next accounting period.
• Classification – Transactions and events have been recorded in the proper accounts.
For example, management asserts that expenses are not recorded as assets.
2. Assertions about account balances at the period end.
• Existence – Assets, liabilities and equity interests exist. For example, management
asserts that inventory in the amount given exists, ready for sale at the balance sheet
date.
• Rights and obligations – An entity holds or controls the rights to assets and liabilities are
the obligations of the entity. For example, management asserts that the company has
the legal rights to ownership of the equipment they use and that they have an obligation
to pay the notes that finance the equipment.
• Completeness – All assets, liabilities and equity interests that should have been
recorded, have been recorded. For example, management asserts that all liabilities are
recorded and included in the financial statements and that no liabilities were ‘off the
books’.
• Valuation and allocation – Assets, liabilities and equity interests are included in the
financial statements at appropriate amounts and any resulting valuation or allocation
adjustments are appropriately recorded. For example, management asserts that their
accounts receivable are stated at face value, less an allowance for doubtful accounts.
3. Assertions about presentation and disclosure.
• Occurrence and rights and obligations – Disclosed events, transactions and other
matters have occurred and pertain to the entity. For example, management asserts
those events that did not occur have not been included in the disclosures.
• Completeness – All disclosures that should have been included in the financial
statements have been included. For example, management asserts that all disclosures
that are required by IFRS are made.
• Classification and understandability – Financial information is appropriately presented
and described and disclosures are clearly expressed. For example, management
asserts that all long-term liabilities listed on the balance sheet mature after one
operating cycle or one year and that any special conditions pertaining to the liabilities
are clearly disclosed.
• Accuracy and valuation – Financial and other information are disclosed fairly and at
appropriate amounts. For example, management asserts that account balances are not
materially misstated.
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1-14. What is the existence assertion? The rights and obligation assertion? The
completeness assertion?
Existence is an assertion about account balances that assets, liabilities and equity interests
exist. For example, management asserts that inventory in the amount given exists, ready for
sale, at the balance sheet date. One assertion of management about economic actions is that
all the assets reported on the balance sheet actually exist at the balance sheet date. The assets
are real, not fictitious.
Rights and obligations is also an assertion about account balances, that an entity holds or
controls the rights to assets, and liabilities are the obligations of the entity. For example,
management asserts that the company has the legal rights to ownership of the equipment they
use and that they have an obligation to pay the notes that finance the equipment.
Depending on whether the assertions are about classes of transactions, account balances or
presentation and disclosure, the definition of completeness may differ. For classes of
transactions, completeness is all transactions and events that should have been recorded and
have been recorded. For example, management asserts that all expense transactions are
recorded, none were excluded. For account balances, completeness is all assets, liabilities and
equity interests that should have been recorded and have been recorded. For example,
management asserts that all liabilities are recorded and included in the financial statements that
no liabilities were ‘off the books’. For presentation and disclosure completeness is all
disclosures that should have been included in the financial statements and have been included.
For example, management asserts that all disclosures that are required by IFRS are made.
1-16. What are the four phases of an audit process model? Briefly describe each.
The phases of the audit are: (1) client acceptance; (2) planning the audit; (3) testing and
evidence; and (4) evaluation and reporting. Illustration 1.5 shows the four-phase audit process
and its major sub-components.
The process of (1) client acceptance involves evaluation of the client’s background, selecting
personnel for the audit and evaluate the need and requirements for using the work of other
professionals.
The audit firm must (2) plan its work to enable it to conduct an effective audit in an efficient and
timely manner. Plans should be based on knowledge of the client’s business.
(3) The audit should be performed with due professional care by persons who have adequate
training, experience and competence in auditing.
The auditor should (4) review and assess the conclusions drawn from audit evidence on which
he will base his opinion of the financial information. This review and assessment involves
forming an overall conclusion as to whether: (a) the financial information has been prepared
using acceptable accounting policies, consistently applied; (b) the financial information complies
with relevant regulations, and statutory requirements; (c) the view presented by the financial
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information as a whole is consistent with the auditor’s knowledge of the business of the entity;
and (d) there is adequate disclosure of all material matters relevant to the proper presentation of
the financial information.
1-17. Based on the Evaluation and Judgement phase (IV) of the audit process model the
overall conclusions are formed on what judgements?
The auditor should review and assess the conclusions drawn from audit evidence on which he
will base his opinion of the financial information. This review and assessment involves forming
an overall conclusion as to whether: (a) the financial information has been prepared using
acceptable accounting policies, consistently applied; (b) the financial information complies with
relevant regulations and statutory requirements; (c) the view presented by the financial
information as a whole is consistent with the auditor’s knowledge of the business of the entity;
and (d) there is adequate disclosure of all material matters relevant to the proper presentation of
the financial information.
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1-19. Name the Big Four international audit firms and give a brief history of each.
The Big Four are: Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers.
Three founders established Deloitte: William Welch Deloitte, George Touche and Admiral Nobuzo
Tohmatsu. Deloitte was founded 1845 by W.W. Deloitte in a location opposite the Bankruptcy
Court in Basinghall Street, London. In 1893, Deloitte opened offices in the United States. In
1990, Deloitte Touche Tohmatsu was created following a number of earlier mergers. In 2003,
the names of Touche and Tohmatsu were dropped, leaving Deloitte as the firm’s full name.
The founders of Ernst & Young were Arthur Author Young who had an interest in investments
and banking which led to the foundation in 1906 of Arthur Young & Co in Chicago, US and A.C.
Ernst, who was a bookkeeper while still in high school, joined his brother and started Ernst &
Ernst in 1903. In 1989, the firms they started combined to create Ernst & Young.
KPMG was formed in 1987 with the merger of Peat Marwick International (PMI) and Klynveld
Main Goerdeler (KMG) and their individual member firms. Spanning three centuries, the
organisation’s history can be traced through the names of its principal founding members –
whose initials form the name ‘KPMG’.
William Barclay Peat founded the accounting firm William Barclay Peat & Co. in London in 1870.
James Marwick founded the accounting firm Marwick, Mitchell & Co. with Roger Mitchell in New
York City in 1897. Piet Klynveld founded the accounting firm Klynveld Kraayenhof & Co in
Amsterdam in 1917.
Dr Reinhardt Goerdeler is credited with laying much of the groundwork for the KMG merger.
In 1850, Samuel Lowell Price started an accounting business in London. In 1865, William H.
Holyland and Edwin Waterhouse joined him in partnership, and by 1874 the company name
changed to Price, Waterhouse & Co. The firm opened a New York City office in 1890. In 1854,
William Cooper established his own practice in London, which seven years later became
Cooper Brothers. The firm’s history in the US began in 1898. In 1957, there was a merger
between Cooper Brothers & Co (UK), McDonald, Currie and Co (Canada), and Lybrand, Ross
Bros and Montgomery (US), forming Coopers & Lybrand. In 1990, Coopers & Lybrand merged
with Deloitte Haskins & Sells. Finally, in 1998 Price Waterhouse and Coopers & Lybrand
merged worldwide to become PricewaterhouseCoopers.
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The public may believe audited financial statements are based on examination of 100% of the
evidence, that the statements are free from fraud, that there is no questionable practice that is
not disclosed. As this is not necessarily true, an expectation gap may exist between what the
public expects and what auditors assure.
1-23. Describe the International Federation of Accountants (IFAC). Discuss the function of
the groups within IFAC.
International Standards on Auditing (ISAs) are developed by the International Federation of
Accountants (IFAC) through its International Auditing and Assurance Standards Board (IAASB).
The efforts of IFAC, founded in 1977, are directed towards developing international technical,
ethical and educational guidelines for auditors, and reciprocal recognition of practitioners’
qualifications. The membership of IFAC member bodies represents several million accountants
in public and private practice, education, academe and government service.
There are several important groups within IFAC. The IFAC Council is responsible for overall
governance of IFAC. The IFAC Board oversees the management of the organisation, takes
action to enhance the transparency of certain IFAC activities, and overseas expansion of its size
to include more member bodies. The standard-setting activities of the IFAC are carried out by
the International Auditing and Assurance Standards Board (IAASB), the Ethics Committee, the
Education Committee and the Public Sector Committee with an interest in governmental
financial reporting.
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Required:
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1-25. Based on ISA 200, what are the general principles governing an audit of financial
statements. Discuss ethics and professional scepticism.
ISA 200 states that an auditor should comply with the Code of Ethics for Professional Accountants
issued by IFAC (see Chapter 3). The ethical principles governing the auditor’s professional
responsibilities are: independence, integrity, objectivity, professional competence and due care.
The auditor would plan and perform the audit with an attitude of professional scepticism
recognising that circumstances may exist which causes the financial statements to be materially
misstated. The auditor shall exercise professional judgement in planning and performing an
audit of financial statements. Professional scepticism is an attitude that includes a questioning
mind, being alert to conditions which may indicate possible misstatement due to error or fraud,
and a critical assessment of evidence.
1-27. Auditing tasks. Each of the following represents tasks that auditors frequently perform:
1. Compilation of quarterly financial statements for a small business that does not have
any accounting personnel capable of preparing financial statements.
2. Review of tax return of corporate president to determine whether she has included all
taxable income.
3. Review of the activities of the receiving department of a large manufacturing
company, with special attention to the efficiency of the materials inspection.
4. Evaluation of a company’s computer system to determine whether the computer is
being used effectively.
5. Examination on a surprise basis of Topanga Bank. Emphasis placed on verification of
cash and loans receivable and observation of the California banking code.
6. Examination of vacation records to determine whether employees followed company
policy of two weeks’ paid vacation annually.
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7. Audit of a small college to determine that the college had followed requirements of a
bond indenture agreement.
8. Examination of financial statements for use by stockholders when there is an internal
audit staff.
9. Audit of a German government agency to determine if the agency has followed
policies of the German government.
10. Audit of annual financial statements to be filed with the SEC.
11. Examination of a French government grant to a private company to determine
whether it would have been feasible to accomplish the same objective at less cost
elsewhere.
12. Audit of a statement of cash receipts and disbursements to be used by a creditor.
Required:
A. For each of the above, identify the most likely type of auditor (independent, government
or internal) and the most likely type of audit (financial, compliance or operational).
The most likely type of auditor and the type of audit for each of the examples are:
1-28. Internal and External Audit. Khaled Al-Zubari, an executive recruiter, is a member of the
board of directors of Mantilla Corporation. At a recent board meeting, called to discuss the
financial plan for 20X4, Mr Al-Zubari discovered two planned expenditures for auditing. In
the controller’s department budget he found an internal audit activity, and in the treasurer’s
budget he found an estimate for the 20X4 annual audit by the company’s external auditing
firm. Mr Al-Zubari could not understand the need for two different expenditures for auditing.
Since the fee for the annual external audit was less than the cost of the internal audit
activity, he proposed eliminating the internal audit function.
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Required:
A. Explain to Mr Al-Zubari the different purposes served by the two audit activities.
Auditing done by internal auditors is done on a continuous basis and concentrates primarily on
adherence to management policies, protection against losses from fraud and inefficient
performance, creation and testing of controls, assistance in inventory counts and tests of the
accounting system. They perform mostly operational and some compliance audits.
B. What benefits does the audit firm doing an audit of financial statements derive from
the existence of an internal audit function? (CMA adapted)
Effective internal auditors significantly reduce control risk, thereby reducing the amount of
substantive testing required during the audit. The external auditor may reduce the staff time on
the audit by using the work of internal auditors. Without an internal audit function the
independent auditor’s time and fees would be increased. External auditors typically consider
internal auditors as effective if they are independent of the operating units being evaluated,
competent and well trained, and have performed relevant audit tests of the internal control
structure. SAS 65 and ISA 610 allow the external auditor to use the internal auditor for direct
assistance in the audit.
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example) a financial audit by the district administration might be required from time to time.
A compliance audit might determine if they are using their donated money for the
requirements of their congregation.
Required:
A. Explain the differences among management assertions and specific audit objectives
and their relationships to each other.
Management assertions are implied or expressed representations by management about the
classes of transactions and related accounts in the financial statements. ISA 500 classifies three
categories of assertions containing nine assertions which are stated in the problem. Specific
audit objectives are determined by the auditor for each management assertion. These are done
for each account balance to help the auditor determine the specific amount of evidence needed
for that account to satisfy the audit objectives.
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B. For each specific audit objective, identify the appropriate management assertion.
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report material; (4) Perform wrap-up procedures; (5) Prepare Matters for Attention of Partners.
(6) Report to the board of directors; and (7) Prepare Audit report.
INSTRUCTOR’S NOTE: Any of the four phases may be thought to be the most important, and a
choice of any one of them is correct as long as the student explains it well.
1-32. Audit Process Model. Based on the standard Audit Process Model, trace the
procedures an auditor would use to audit a retail clothing business (continuing
client) from the initial client contact to the audit opinion.
Based on the standard Audit Process Model, the procedures an auditor would use to audit a
retail clothing business (continuing client) from the initial client contact to the audit opinion are:
1. Acquire knowledge of the client and the industry.
2. Review prior years’ work papers.
3. Determine the need for experts or other auditors.
4. Pick audit staff and do a budget.
5. Write and engagement letter spelling out the services to be performed.
6. Obtain more detailed company and industry information; perform procedures to obtain
knowledge about internal controls. For a retail grocery store this would include examining
transactions at the point of sale (cash register) and inventory.
7. Access risk and set materiality.
8. Plan the audit and design the audit programme.
9. Perform tests of control and substantive tests (including analytical procedures).
10. Do closing procedures including management representation letters and legal letters.
11. Prepare matters for the attention of partners.
12. Prepare report for board of directors.
13. Based on the evidence, develop an audit opinion and a management letter to the client.
Required:
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Cases
1-34. Audit objectives and financial statement accounts. Look at the financial statements of
a major public company. Pick three accounts and discuss the financial statement assertions
that might be associated with those accounts. For example, the financial statement
assertions might be associated with ‘Accrued Product Liability’ are valuation, existence,
completeness and understandability. Valuation relates to product liability because a
judgement (estimate) must be made regarding the expected cost of defective products.
In the table is a list of typical accounts on a balance sheet and the financial statement assertions
(existence, rights and obligations, occurrence, completeness, valuation and allocation, accuracy,
cutoff, classification and understandability) that might be associated with those accounts.
Typically, financial statement assertions are associated with balance sheet accounts, but if the
student uses income statement accounts this is okay. The student should discuss why the
accounts are associated with that assertion. It could be argued that all objectives should be
included in all accounts.
Assets Assertions
Short-term investments All
Bank and cash All
Inventories All
Accounts receivable All
less allowances for doubtful accounts Valuation and allocation
Investments All
Long-term loan receivables All
Property, plant and equipment All
Goodwill and other intangible assets Existence, rights and obligations, occurrence,
valuation and allocation
Other non-current assets All
Liabilities
Accounts payable Existence, rights and obligations, occurrence,
completeness, valuation and allocation
Accrued liabilities All
Short-term borrowings Existence, rights and obligations, occurrence,
completeness, valuation and allocation
Current portion of long-term debt Existence, rights and obligations, occurrence,
completeness, valuation and allocation
Advance payments Existence, rights and obligations, occurrence,
valuation and allocation
Provision for discontinued operations Valuation and allocation, occurrence
Accrued Product Liability Valuation and allocation, existence and
completeness
Long-term debt Existence, rights and obligations, occurrence,
completeness, valuation and allocation
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1-36. Qualifications of Auditors. From the library get a copy of the EC Eighth Company Law
Directive which is about the qualifications and work of auditors.
Required:
Based on the Eighth Directive, answer the following questions.
A. How many years of work experience must an auditor have before he can receive an
auditing credential?
An auditor must have 3 years of work experience before he or she can receive an auditing
credential.
1-37. Due Professional Care. Discuss lawsuits resulting from negligence of ‘Due professional
Care’.
Required:
A. Consult the library, a database like LexisNexis or the internet for lawsuits resulting
from negligence of ‘Due Professional Care’. Discuss at least two.
B. Describe briefly the courts final conclusion and results from the court decision.
A. & B. This case is subjective. Students may search a database such as LexisNexis, ABI
Inform, etc. and may find a variety of cases. As an example, a search of LexisNexis for lawsuits
resulting from negligence of ‘Due Professional Care’ in May 2004 yields 191 articles, some of
which are below:
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American Bankruptcy Institute Journal, 1995 ‘The CPA as Expert Witness – Does Liability
Loom?’ American Bankruptcy Institute Journal 1995.
Dennis Applegate, 2004 ‘Training New Auditors’, The Internal Auditor, Altamonte Springs, Apr.
Vol. 61, Issue. 2, p. 66.
Lawrence R. Bard, 1992 ‘Note: A Distinct-Responsibility Approach To Accountants’ Primary
Liability Under Rule 10b-5’, George Washington Law Review, November, 1992, No. 61, p. 193.
Roger J. Buffington, 1997 ‘Note: A Proposed Standard of Common Law Liability for The
Public Accounting Profession’, Southern California Interdisciplinary Law Journal, Summer,
No. 5, p. 485.
William J. Casazza, 1985 ‘Recent Development: Rosenblum, Inc. V. Adler: Cpas Liable At
Common Law To Certain Reasonably Foreseeable Third Parties Who Detrimentally Rely On
Negligently Audited Financial Statements’, Cornell Law Review, January, Vol. 70, p. 335.
Lewis P. Checchia, 1993 ‘Accountants’ Liability to Third Parties under Bily V. Arthur Young &
Company: Does A Watchdog Need Protection?’, Villanova Law Review, No. 38, p. 249.
Marie L. Coppolino, 1995 ‘Financial Services Regulation: A Mid-Decade Review: Note: Checkosky,
Rule 2(E) and The Auditor: How Should The Securities And Exchange Commission Define Its
Standard Of Improper Professional Conduct?’ Fordham Law Review, No. 63, p. 2227.
Faculty, 1996 The Judge Advocate General’s School, ‘Tjagsa Practice Note: Contract Law
Notes’, Army Lawyer, p. 34.
Julie Faussie, 1994 ‘Note: Limiting Liability In Public Accounting Suits: A Desperate Appeal
From A Beleaguered Profession’, Valparaiso University Law Review, Spring, No. 28, p. 1041.
Cathy A. Gay, 1994 ‘Note: Cenco, Inc. V. Seidman & Seidman: A Futile Attempt to Deter
Management Fraud’, Duke Law Journal, p. 141.
Richard A. Glaser and Leslee M. Lewis, 1995 ‘Redefining the Professional: The Policies and
Unregulated Development of Consultant Malpractice Liability’, University of Detroit Mercy Law
Review, Spring, No. 72, p. 563.
Willis W. Hagen II, 1988 ‘Forum: Accountants’ Common Law Negligence Liability To Third
Parties’, Columbia Business Law Review, p. 181.
Jack E. Karns, Edwin A. Doty and Steven S. Long 1995, ‘Accountant and Attorney Liability as
‘Sellers’ of Securities Under Section 12(2) of the Securities Act of 1933: Judicial Rejection of the
Statutory, Collateral Participant Status Cause of Action’, Nebraska Law Review, No. 74, p. 1.
Gary Lawson and Tamara Mattison, 1991 ‘A Tale of Two Professions: The Third-Party Liability
of Accountants and Attorneys for Negligent Misrepresentation’, Ohio State Law Journal, No. 52,
p. 1309.
Jeffrey N. Leibell, 1991 ‘Note: Accountants’ Liability in The Savings And Loan Crisis: An
Argument In Favor Of Affirmative Defences’, Columbia Business Law Review, p. 71.
Reid A. Muoio, 1994 ‘An Independent Auditor’s Suit for Wrongful Discharge’, Albany Law Review,
Vol. 58, p. 413.
Denise M. Orlinski, 1994. ‘An Accountant’s Liability to Third Parties: Bily V. Arthur Young & Co.’
DePaul Law Review, Spring, Vol. 43, p. 859.
Richard W. Painter and Jennifer E. Duggan, 1996 ‘Lawyer Disclosure of Corporate Fraud:
Establishing a Firm Foundation’, Southern Methodist University Law Review, September/
October, No. 50, p. 225.
Richard S. Panttaja, 1994 ‘Accountants’ Duty To Third Parties: A Search For A Fair Doctrine Of
Liability’, Stetson Law Review, Summer, No. 23, p. 927.
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Hayes, Gortemaker and Wallage, Principles of Auditing, 3rd edition, Solutions Manual on the Web
Robert A. Prentice, 1995 ‘Can The Contributory Negligence Defence Contribute To A Defusing Of
The Accountants’ Liability Crisis?’ Wisconsin International Law Journal, Spring, No 13, p. 359.
Robert A. Reiley, 1997 ‘Symposium: Environmental Law And Business In The 21st Century:
The New Paradigm: ISO 14000 and Its Place in Regulatory Reform’, The Journal of Corporation
Law, Spring, No. 22, p. 535.
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CHAPTER 2
2.2 Introduction
2-1. What areas that an auditor audits is the responsibility of management?
Management is not only responsible for the financial and internal control reports to investors,
but also has the authority to determine the precise nature of the representations that go into
those reports.
2-3. Give a brief description of the agency theory as applied to both the demand and the
supply of audit services.
In the agency theory, the auditor will make a trade-off between:
• The probability of detecting errors, measured by the costs of an extra hour of work by audit
personnel.
• Auditor independence, measured by the loss likely to be incurred by the auditor as a result
of losing a client following the qualification of the auditor’s report.
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• The expected costs of an audit failure, measured by the loss likely to be incurred by the
auditor as a result of the detection by outside stakeholders that the auditor has either failed
to detect or report a (material) misstatement. These costs might include the costs of
litigation and (opportunity) costs due to the loss of present or potential clients (because of
bad reputation). These latter costs as a result of reputation damage have been
demonstrated in several empirical studies, which showed that audit firms having suffered a
public rebuke were confronted with a decline in their market share.
2-6. Describe the activities off the International Forum of Independent Audit Regulators
(IFIAR).
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2-10. What measures are possibilities to reduce auditors’ unlimited legal liability?
• A limit or cap on claims (a maximum settlement amount) is known in advance and limits
settlements. Liability is now capped in Austria, Belgium, Germany, Greece and Slovenia.
• In some countries, a system of proportionate liability is under study. In such a system, an
audit firm is not liable for the entire loss incurred by plaintiffs (as is the case under joint and
several liability), but only to the extent to which the loss is attributable to the auditor. The US
has a system of proportionate liability, but only under the federal acts.
• To make insurance of all liability risks compulsory using new legislation was one of the
recommendations of an EU commission.
• Exclude certain activities with a higher risk profile from the auditors’ liability. A mechanism to
achieve this outcome would be to introduce so-called safe harbour provisions by legislation.
• In order to protect the personal wealth of audit partners, some audit firms are structured as
a limited liability partnership (e.g. in the UK).
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ISA 400 requires the auditor to obtain an understanding of a company’s accounting and internal
control systems, sufficient to plan the audit and develop an effective audit approach. However,
testing the adequacy of the internal controls is not required. If the audit objectives can more
efficiently be met by substantive testing, it is acceptable not to examine the internal control
structure.
The expectation gap surveys show high expectations of the auditor’s role in testing whether a
satisfactory system of internal control is being operated. These expectations clearly exceed the
auditor’s current duties, although developments such as the suggestions made in the COSO
and Cadbury reports might help reduce the gap between expectations and practice.
As far as reporting on the effectiveness and functioning of internal controls is concerned, there
has been much discussion in Europe, Canada and the United States. Support for reporting is
the belief that users of financial information have a legitimate interest in the condition of the
controls over the accounting system and management’s response to the suggestions of the
auditors for correction of weaknesses. Those who argue against reporting on controls say that
such reporting would increase the cost of audit attestation, increase auditor (and director)
liability, and is not a relevant information.
2-12. Describe the historical shift in the audit profession’s attitude towards the auditor’s
responsibilities regarding fraud.
Several reasons have been given for auditors evolution away from fraud responsibilities, but the
most important reasons are (1) the acceptance that the audit of the financial statements on
behalf of the third parties is an art of its own and justifies the existence of auditors and (2) the
acceptance that an investigation aimed at finding any kind of fraud is extremely labourious,
expensive and not practical, considering the increases in size and complexity of the companies,
as well as their improved self or internal controls.
The current position of the audit profession is described in ISA 240. According to this standard,
the responsibility for the prevention and detection of fraud and error rests with management
through the implementation and operation of an adequate system of internal control. The auditor
should consider risk of fraud in the planning and audit procedure design.
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maintain a sound system of internal control to safeguard shareholders’ investment and the
company’s assets’. Provision D.2.1 states that: ‘The directors should, at least annually, conduct
a review of the effectiveness of the group’s system of internal control and should report to
shareholders that they have done so. The review should cover all controls, including financial,
operational and compliance controls and risk management’.
2-14. Discuss the following statement: ‘Auditors should not be allowed to combine an
audit for one client with advisory services to that client’.
Most audit firms expect that consultancy fees will become more and more important, whereas
the more ‘mature’ audit and accounting market will stabilise at the current level. Eventually, the
non-recurring tax and consultancy work might become more important than the recurring audit
and accounting services, requiring significant modifications to the management and the
marketing techniques of ‘audit’ firms.
This strategy of diversification by audit firms might jeopardise the auditor’s independence, for
two reasons:
• in addition to losing audit fees, the auditor might also lose consultancy fees in case of
‘dismissal’ as an auditor after a technical dispute with a client;
• an auditor might lose his objectivity, if he has to make a judgement, in his audit function, on
ideas that were implemented on the basis of his (or his colleague’s) advice.
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The principals, agents, prices, principal’s risks and the limitation of the risks are given for each
situation A, B, C and D below:
Situation A B C D
Principals Pasadena Current employer Shang-Zu Vite et Juste
Bank Instituto Milanese
Agents Alhambra Mario Auditorio Yu-Chang Merci
Construction
Company
Prices Interest and Salary Bonus Cost of goods
loan
Principal’s risks Loan default Poor work Manipulate profits Non-payment of
loss of company amount owed
skills
Limit risks Contract Contract Internal controls Contract
A. In most countries audits are legally required for every type of company.
In most countries audits are now legally required for some types of companies. For example, in
the US and European Union, large, and in some cases medium-sized enterprises are required
by law to provide audited financial statements. The European Union audit rules apply to all
companies that are required to be audited by the individual countries, which may vary. In the
Netherlands, companies with more than 50 employees, and/or assets greater than 3.1 million
euro, and/or net sales greater than 6.2 million euro. The major bourses (including NYSE,
NASDAQ, London Stock Exchange, Tokyo NIKKEI and Frankfurt DAX) have listing rules that
require all listed companies to have their annual report audited.
B. The PCAOB sanctions firms but not individuals for violations of laws, regulations and
rules.
The board oversees and investigates the audits and auditors of public companies and sanction
both firms and individuals for violations of laws, regulations and rules.
C. The European eighth Directive objective is to register all auditors and audit firms and
make such information accessible to the public.
Registering all audit firms would make audit firms more accountable, but would require a larger
bureaucracy and increased cost burden on government. It is primarily a matter of does the cost
exceed the benefit?
D. Three areas of audit regulation that are essential are (1) the independence of the
profession; (2) opening up the audit market; and (3) creating a more integrated
European market and stepping up its supervision.
These areas are suggested by EU Minister Michael Barnier. He said that the EU’s first concern
is the quality and credibility of auditing. Further, the independence of auditors is ‘the condition
sine qua non for their reports being fully trusted’. He feels that there is a need to restrict – or
even prohibit – non-audit services being provided by audit firms to audited clients and that
common EU rules in this area are needed. He proposed the concept of ‘pure audit firms’
(i.e. firms not allowed to provide services other than auditing) which would have the benefit of
opening up these non-audit markets to a whole range of smaller audit firms that have no chance
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faced with the predominance of the major audit firms. Barnier put it this way, ‘I am not happy
that the audit market is so dominated by four firms whilst there are at least as many other firms
wanting to break into this market in Europe’. Barnier believes, ‘It is unacceptable that an auditor
has to pass additional examinations in each country where he wishes to work’. He suggests
some solutions, for example, the automatic recognition of firms already licensed in other
Member States, the award of a European quality label demonstrating the holder’s ability to audit
large companies, or by harmonising auditing standards at the European Union level.
B. The FRC has broad oversight for setting accounting standards in the public and
private sectors.
The Financial Reporting Council (FRC), with the responsibility for the broad oversight of the
accounting standard setting process for the private, public and not-for-profit sectors.
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and other accounting regulation in various countries. The Coca-Cola Company has a strong
countervailing governance structure in place, in line with ISS criteria, that provides a satisfactory
counterbalance to the combined Chairman and CEO post. There is a lead director, the board is
2/3 independent, all key committees are independent and governance guidelines are established.
The second tier firms have small to mid-sized firms as clients. A typical client might be a large
family-owned and controlled firm or a start up with a large market. They depend on the second
tier firm for both accounting and auditing expertise, but also management and personal advise.
Second tier firms may specialise in particular industries. For example, Grant Thornton practices
in consumer and industrial products; technology; financial services and institutions; not-for-
profit; construction, real estate and hospitality; global public sector (including local, state, federal
and international governments); health care; and private equity. A client of Grant Thornton (in
2013) is Meridian Bioscience Inc., fully integrated life science company that manufactures,
markets and distributes a broad range of innovative diagnostic test kits, purified reagents and
biopharmaceutical enabling technologies whose shares are traded on NASDAQ.
Required:
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In spite of the fact that the loan was received, Upseerin went bankrupt within 2 years. The
bank is suing Sundback to recover its losses on the loan and the lessor is suing
Sundback to recover uncollected rents.
Required:
Answer the following, setting forth reasons for any conclusions stated.
Required:
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• Express a qualified or an adverse opinion on the financial statements if they are materially
affected by an error or irregularity and are not revised.
• Disclaim or qualify an opinion on the financial statements and communicate the findings to
the audit committee or the board of directors if the scope of the audit has been restricted
concerning a possible irregularity.
• Consider notification of outside parties concerning irregularities in certain circumstances.
A. Corporate governance
COSO set a framework for control environment where those in corporate governance must set
the ‘tone’ of the organisation including personnel, communications and setting an example.
SOX required CEOs and CFOs to verify that controls are effective and the financial statements
present fairly in all material respects the company finances and fraud has been reported to
board of directors. The board of directors needs to have a financial expert and a code of ethics.
B. Audit firms
COSO did not address audit firms specifically but set out a framework for internal control
evaluation.
C. Internal controls
COSO was entirely about internal controls. It set a framework for evaluating controls and
suggested ‘best practice’.
Case
2-23. Legal responsibilities of auditors. Pick five countries. Assume that you are the head of
an international commission to determine legal responsibilities of accountants in various
countries. Use your university library and the internet to research accounting in these five
countries.
Required:
A. List the country, concept of independence and functions generally not allowed.
The student may pick any five countries.
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Requirement A would be a list of those companies, the applicable concept of independence and
functions generally not allowed.
B. List the ethical standards, enforcement, legal liabilities and responsibility for the
detection of fraud.
Requirement B, a list the ethical standards, enforcement, legal liabilities and responsibility for
the detection of fraud, would resemble Chapter 3, Illustration 3.1.
C. Using the library, LexisNexis or internet find one recent legal case in each country
that impacts auditor independence or resulted from fraud. Summarise each case.
Requirement C – the cases found will vary according to where the student looked and the
country involved. For each country they should find and summarise one recent legal case that
impacts auditor independence or resulted from fraud.
D. Write a brief comparing the recent legal case and auditor ethical standards in each
country.
Requirement D – the brief comparing the recent legal case and auditor ethical standards in each
country may or may not be in a specific format.
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