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Solution Manual for Auditing and Assurance Services A Systematic
Approach 7th Edition Messier, Glover, Prawitt
Complete downloadable file at:
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Services-A-Systematic-Approach-7th-Edition-Messier,-Glover,-Prawitt
Answers to Review Questions
2-1 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
managements actions, resulted in conflict between regulators and the accounting
profession. Subsequent financial fiascos such as those at Enron, WorldCom, Tyco, and
many others, caused investors to doubt the fundamental integrity of the financial reporting
system. Under pressure to restore the publics confidence, Congress passed the Sarbanes-
Oxley Act and created the PCAOB in 2002.
2-2 The accounting professions 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 the question the professions ability to self-
regulate, resulting in new legislation. While these changes have caused pain and turmoil,
they highlight the essential importance of auditing in our economic system. Ultimately,
the back to basics emphasis, along with auditing firms renewed focus on thorough and
effective financial statement audits, will likely prove healthy for the U.S. financial
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.
2-3 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
assets are safeguarded. To achieve its objectives, management must formulate strategies
and implement various processes which are in turn carried out through business
transactions. The entitys information and internal control systems must be designed to
ensure that these transactions are properly executed, captured, and processed in order to
produce accurate financial statements. It is important that the auditor obtain a firm
understanding of these components in order to understand relevant risks and to plan the
nature, timing, and extent of the audit so that it is efficient and effective.
2-4 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 entitys
transactions. Among other things, internal control is required to ensure that a proper
environment is established and that transactions are appropriately conducted and recorded
by the information system and company employees. Effective internal control provides
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safeguards to ensure the (1) reliability of financial reporting, (2) compliance with laws and
regulations, and (3) the effectiveness and efficiency of operations. Auditing standards
require that the auditor obtain an understanding of the clients environment, including its
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internal control, in planning the nature, timing, and extent of testing.
2-5 The three categories of management assertions (balances, transactions, and disclosures)
cover every aspect of what is needed for a transaction to be handled properly, for a
financial statement account to be fairly stated, and for the financial statements to be
presented appropriately and to contain adequate disclosures. The management assertions
form the basis for planning and evaluating the evidence that the auditor must obtain about
the fairness of the clients financial statements. They help the auditor ensure that all the
bases are covered in the process of collecting and evaluating evidence to form an opinion
on the fairness of the financial statements.
2-6 GAAS is composed of three categories of standards: general standards, standards of
fieldwork, 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 perform audit work beyond that specified in GAAS and the SAS in order to
appropriately issue an opinion that a set of financial statements is fairly presented. As a
result, the auditor needs to use professional judgment in following all standards.
2-7 Independence is a fundamental principle for auditors. If an auditor is not independent of
the client, users may lose confidence in the auditors ability to report objectively and
truthfully on the financial statements, and the auditors work loses its value. From an
agency perspective, if the principal (owner) knows that the auditor is not independent, the
owner will not trust the auditors work. Thus, the agent will not hire the auditor because
the auditors report will not be effective in reducing information risk from the perspective
of the owner.
2-8 Management is responsible to prepare financial statements that fairly present the
companysfinancialconditionandoperationsinaccordancewithestablishedaccounting
standards.Notethattheauditorsopinionexplicitlystatesthatthefinancialstatementsare
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 auditor must plan and perform the audit in accordance with established
standardstoobtainreasonableassurancethatthefinancialstatementsarefreeofmaterial
misstatement,whethercausedbyerrororfraud.However,itisimportanttonotethatan
auditorsunqualifiedopiniondoesnotmeanthaterrorsorfrauddonotexistbutratherthat
thereisreasonableassurancethattheydonotexistinmaterialamounts.
2-9 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
1984 to determine whether an entity receiving federal assistance is in compliance with
applicable laws and regulations.
Examples of operational audits include (1) an audit by the GAO of the Food and Drug
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Administration to determine the efficiency and effectiveness of procedures for introducing
new drugs to the market, (2) internal auditors examining the effectiveness and efficiency
of funds being spent on the entitys computer resources, and (3) a university hiring an
external auditor to examine the effectiveness and efficiency of student advisory services.
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.
2-10 Auditors can be classified under four types: (1) external auditors, (2) internal auditors,
(3) government auditors, and (4) forensic auditors.
2-11 The AICPA issues the following standards:
Statements on Auditing Standards
Statements on Standards for Attestation Engagements
Statements on Standards for Accounting and Review Services
Statements on Quality Control Standards
Standards for Performing and Reporting on Peer Reviews
Statements on Standards for Consulting Services
Statements on Standards for Tax Services
2-12 ThePCAOBisaquasigovernmentalorganizationoverseenbytheSEC.Itwasformedto
provide governmental regulation of the standards used in conducting public company
auditsbecauseofaperceivedfailureoftheprofessiontoadequatelyregulateitself.
2-13 TheSEChascongressionalauthorityfromtheoriginalSecuritiesActsof1933and1934
toestablishaccountingandauditingstandardsforpubliclytradedcompanies;however,in
thepasttheSEChaslargelydelegatedthisauthoritytootherbodies,includingtheFASB
andtheAICPAsAuditingStandardsBoard.TheSarbanesOxleyActof2002gavethe
SECthemandatetoactivelyregulatethepublicaccountingprofessionbyestablishingand
overseeingthePCAOBanditsstandardsettingprocessrelatingtotheauditsofpublic
companies. TheSEChasauthoritytoimplementandoverseestandardsrelatingtoall
aspects of the audits of public companies, including standards relating to auditor
independence(suchastherequirementforauditfirmstorotateauditpartnersoffaudit
engagementseveryfiveyears).
2-14 Thedocuments most frequently encountered by auditors under the Securities Exchange
Act of 1934 are forms 10K, 10Q, and 8K. Forms 10K and 10Q are, respectively, annual
and quarterly reports, which include the audited financial statements periodically filed
with the SEC by a publicly traded entity. An 8K is filed whenever a significant event
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occurs which may be of interest to investors, such as a change of independent auditors.
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Answers to Multiple-Choice Questions
2-15 D 2-20 A
2-16 A 2-21 B
2-17 C 2-22 A
2-18 C 2-23 A
2-19 C
Solutions to Problems
2-24
Brief Description of Generally Sally Jones' Actions Resulting in
Accepted Auditing Standards Failure to Comply with Generally
Accepted Auditing Standards
General Standards:
1. The auditor must have 1. It was inappropriate for Jones to hire
adequate technical training and the two students to conduct the
proficiency to perform the audit. audit. The examination must be
conducted by persons with proper
education and experience in the field
of auditing. Although a junior
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 2. To satisfy the second general
independence in mental attitude in all standard, Jones must be without bias
matters relating to the audit. 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.
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3. The auditor must exercise due 3. This standard requires Jones to plan
professional care in the performance and perform the audit with due care,
of the audit and the preparation of the which imposes on Jones and
report. everyone in Jones's organization a
responsibility to observe the
standards of fieldwork 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 Fieldwork:
1. The auditor must adequately plan the 1. This standard recognizes that early
work and must properly supervise appointment of the auditor has
any assistants. advantages for the auditor and the
client. Jones accepted the
engagement without considering the
availability of competent staff. In
addition, Jones failed to supervise
the assistants. The work performed
was not adequately planned.
2. The auditor must obtain a sufficient 2. Jones did not study the client or its
understanding of the entity and its environment, including internal
environment, including its internal control, nor did the assistants. There
control, to assess the risk of material appears to have been no audit
misstatement of the financial examination at all. The work
statements whether due to error or performed was more an accounting
fraud, and to design the nature, service than it was an auditing
timing, and extent of further audit service.
procedures.
3. The auditor must obtain sufficient 3. Jones acquired little evidence that
appropriate audit evidence by would support the fairness of the
performing audit procedures to afford financial statements. Jones merely
a reasonable basis for an opinion checked the mathematical accuracy
regarding the financial statements of the records and summarized the
under audit. accounts. Several standard audit
procedures and techniques were
neglected.
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Standards of Reporting: 1. Jones's report made no reference to
generally accepted accounting
1. The auditor must state in the principles. Because Jones did not
auditors report whether the financial conduct a proper examination, the
statements are presented in report should state that no opinion
accordance with generally accepted can be expressed as to the fair
accounting principles (GAAP). presentation of the financial
statements in accordance with
GAAP.
2. The auditor must identify in the 2. Jones's improper examination would
auditors report those circumstances not enable her to determine whether
in which such principles have not accounting principles have been
been consistently observed in the consistently applied.
current period in relation to the
preceding period.
3. When the auditor determines that 3. Management is responsible for
informative disclosures are not adequate disclosure in the financial
reasonably adequate, the auditor statements, but when the statements
must so state in the auditors report. 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.
4. The auditor must either express an 4. Although the Jones report contains an
opinion regarding the financial expression of opinion, such opinion is
statements, taken as a whole, or state not based on the results of a proper
that an opinion cannot be expressed, audit examination. Jones should
in the auditors report. When the disclaim an opinion because she
auditor cannot express an overall failed to conduct an examination in
opinion, the auditor should state the accordance with generally accepted
reasons therefore in the auditors auditing standards.
report. In all cases where an auditors
name is associated with financial
statements, the auditor should clearly
indicate the character of the auditors
work, if any, and the degree of
responsibility the auditor is taking, in
the auditors report.
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2-25
Applicable Discussion of Relationship
Situation GAAS of of Client Situation to
Reporting Standard of Reporting
a. The auditor must identify in A change in accounting principle
the auditors report those affects the consistent application of the
circumstances in which such accounting principle. If the change is
principles have not been material, the auditor should reference
consistently observed in the the change in accounting in an
current period in relation to the explanatory paragraph to the audit
preceding period. report.
b. When the auditor determines Information essential to a fair
that informative disclosures are presentation in conformity with GAAP
not reasonably adequate, the must be disclosed in the financial
auditor must so state in the statements or the related footnotes.
auditors report. 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 The improper presentation of material
auditors report whether the amounts of minority interest in net
financial statements are income and retained earnings
presented in accordance with constitutes a departure from GAAP.
generally accepted accounting The audit report should be qualified
principles (GAAP). (or adverse) and the information
should be disclosed by the auditor.
2-26
Item Number Type of Audit Type of Auditor
a. Operational Government
b. Financial statement External
c. Compliance or operational or Internal or external
possibly internal control
d. Forensic Internal, external, or forensic
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e. Operational Government, external, or
internal
f. Operational Internal or external
g. Compliance Government
h. Compliance or forensic Government, external, or
forensic
Solutions to Discussion Cases
2-27 Merry-Go-Round Part I.
a. E&Y is alleged to have violated all three general standards as well as one, and
perhaps two, of the standards of fieldwork.
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
engagement.
E&Ys relationship with MGRs landlords and attorneys likely caused them to
violate the second general standard, which requires independence in mental
attitude.
The turnaround teams slow performance, the fact that the leader of the team took
a vacation at a critical time, and the insufficient cost-cutting recommendations
suggest that E&Y did not exercise due professional care, which would be in
violation of the third general standard.
Poor staff assignments, the leaders vacation, and the use of inexperienced
personnel all suggest that the engagement was not adequately planned and that
assistants were not properly supervised, a violation of the first standard of
fieldwork.
Finally, E&Ys inadequate recommendations suggests that they likely did not
gather enough information about MGRs operations to allow them to implement
an effective implementation strategy, which would be in violation of the third
standard of fieldwork.
b. 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
minimal level of service quality would be attained, and perhaps more guidance for
consultants (to allow them to perform more effective consulting engagements). The
primary disadvantage would result from the fact that CPAs who consult compete with
consulting firms comprised of non-CPAs. If standards were not thought out carefully,
perhaps the standards would put CPAs at a disadvantage relative to non-CPAs in the
sense that CPAs would be subject to standards that constrain their activities or perhaps
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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, E&Y acted unethically. That is, they should have disclosed the nature
of these relationships to MGR. In another sense, it is difficult to ascertain whether
these relationships caused E&Y to act unethically. Specifically, was E&Ys advice
affected by their relationship with the landlord? Is this relationship the reason that
E&Ys cost-cutting suggestions did not go farther? These questions point out the
importance of independence in fact and appearance, even when acting in a consulting
capacity. Even if E&Y acted ethically, this relationship creates the appearance of
impropriety.
b. As mentioned in Part a, the relationship with Rouse could have caused E&Y to
hesitate to suggest that the stores for which Rouse was the landlord be closed for fear
of losing business from Rouse. Their relationship with Swidler could have made
E&Y feel that they could not lose the engagement under any circumstances, thereby
possibly explaining their apparently lackadaisical attitude towards the engagement.
Solutions to Internet Assignments
2-29 a. According to its website, the AICPAs 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 SECs website states that its mission is to protect investors, maintain fair, orderly,
and efficient markets, and facilitate capital formation. They go on to emphasize that
their purpose is to promote and sustain economic growth. The site also mentions that the
SEC promotes the disclosure of important market information, maintains fair dealing,
protects against fraud, and enforces its authority.
c. During the 1920s many people began investing heavily in the stock market without
fully thinking about the risk that they were taking upon themselves. As a result of poor
investment choices and unreliable information, the stock market crashed in 1929. In an
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.
The PCAOBs website provides information on the boards 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
standards are also developed in an open, public process to allow all parties of interest to
comment. Section 103 of the Sarbanes-Oxley Act empowers the PCAOB to set auditing
standards for audits of public companies.
2-30 A search of the GAOs homepage will identify recent audits conducted by this agency.
2-11
