CHAPTER 1

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

Learning Check

1.1 Several common attributes of activities defined as auditing are (a) systematic process, (b) objectively obtaining and evaluating evidence, (c) assertions about economic actions and events, (d) degree of correspondence, (e) established criteria, (f) communicating the results, and (g) interested users.

1.2 A financial statement audit involves obtaining and evaluating evidence about an entity's financial statements for the purpose of expressing an opinion on whether the statements are presented fairly in conformity with established criteria--usually GAAP. Thus, the nature of the auditor's report is an opinion on the fairness of the financial statements. A compliance audit involves obtaining and evaluating evidence to determine whether certain financial or operating activities of an entity conform to specified conditions, rules, or regulations. A report on a compliance audit takes the form of a summary of findings or assurance regarding degree of compliance. An operational audit involves obtaining and evaluating evidence about the efficiency and effectiveness of an entity's operating activities in relation to specified objectives. Reports on such audits include an assessment of efficiency and effectiveness and recommendations for improvements.

1.3 Independent auditors are individual practitioners or members of public accounting firms who render professional auditing services to clients. These services may involve financial statement audits, compliance audits, and operational audits. Internal auditors are employees of the companies they audit. They are involved in an independent appraisal activity, called internal auditing, as a service to the organization. Internal auditors are primarily

concerned with compliance and operational audits. Government auditors are employed by various local, state, and federal governmental agencies. They may be involved in all three types of audits.

1.4 a. The origin of the company audit as we know it can be linked to British legislation during theindustrial revolution in the mid-1800s. Company audits were initially performed by one or more stockholders designated by other stockholders, but subsequent revisions in the legislation permitted the use of outside independent auditors, giving rise to the formation of auditing firms.

b. The migration of the company audit to the U.S. came about as English and Scottish investors sent their own auditors to check on the condition of American companies, such as breweries and railroads, in which they had heavily invested. This migration occurred in the late 1800s. The focus of these early audits was on finding errors in the balance sheet accounts and stemming the growth of fraud associated with the increasing phenomenon of professional managers and absentee owners.

1.5 Several important milestones in the rise of the U.S. profession were (1) passage of the first legislation providing for the licensing of CPAs by New York state in 1896, (2) the passage of similar legislation by all of the then forty-eight states by 1921, (3) the establishment of the American Institute of Accountants (now the AICPA) in 1917, (4) the publication in 1918 of a proposal for uniform accounting following a period of rapid growth in the public ownership of corporate securities and growing recognition of the need for greater uniformity in financial reporting as well as the need to employ accountants who understood reporting requirements, (5) the stock market crash of 1929 which drew attention to deficiencies in financial reporting and produced a challenge to the accounting profession to provide stronger leadership, (6) adoption of a requirement by the New York Stock Exchange in 1933 that all listed corporations obtain an audit certificate from an independent CPA, and (7) passage of the Securities Act of 1933 and the Securities Exchange Act of 1934 which added to the demand for audit services for publicly owned companies.

1.6 a. Three important changes in audit practice that evolved by the 1040s were (1) a shift from detailed verification of accounts to sampling or testing as the basis for rendering an opinion on the fairness of financial statements, (2) development of the practice of linking the testing to be done to the auditor's evaluation of a company's internal controls, and (3) deemphasis of the detection of fraud as an audit objective.

b. In recent years, the profession has come under increasing pressure to reverse the deemphasis on detecting fraud as the public's expectation that the auditor will detect fraud persists.

1.7 The first AICPA project that is influencing the shape of the accounting profession in the 21st Century is the AICPA Vision Project. This project involved over 4000 CPAs who contributed to the development of the CPA profession, its core values, core competencies, and core services. The second AICPA project was the Special Committee on Assurance Services, that has market tested new services that require assurance provided by CPAs.

1.8 Five core values of the CPA profession are (1) continuing education and lifelong learning, (2) competence, (3) integrity, (4) attunement with broad business issues, and (5) objectivity. Continuing education and lifelong learning is important to ensuring the public confidence in a CPAs ability to maintain cutting edge skills in a rapidly changing environment. CPAs must demonstrate competence in order to earn a client’s trust. This normally consists of a broad competence plus many CPAs develop specialties during their career. Integrity, which means practicing with honesty and acting with professional ethics is critical earning the public trust. Attunement to broad business issues is what separates CPAs from other professionals and allows CPAs to exercise the professional judgment that is so important in accounting. Finally, objectivity and the freedom of bias or conflicts of interest allows CPAs to earn both a client’s and the public’s trust. In combination, these core values have helps CPAs earn a reputation for being a trusted business advisor.

1.9 a. The core competencies associated with the CPA profession include: (a) communication and leadership skills, (b) strategic and critical thinking skills, (c) focus on the customer, client and market, (d) interpretation of converging information, and (e) being technologically adept.

b. The auditing profession has been criticized for communicating primarily through a standard, one-size-fits-all report that communicates little unique information. Further, auditors are often seen as being more reporters of the past than problem solvers with a future orientation. Also they are seen as being standards driven and focuses on numbers and measurement, rather than focused on what the numbers communicate.

c. Auditors use communication skills to raise appropriate inquiries with management and to communicate findings with management, the board of directors, and third parties. Auditors use strategic and critical thinking skills to evaluate the appropriateness of accounting estimates and other information reported in the financial statements. The auditor’s focus on the client and the market allows the auditor to be responsive to both the pubic and the client. Auditors must be able to interpret converging information. The key analytic skill used throughout the audit is the ability to evaluate both financial and nonfinancial information and determine whether financial statements are fairly presented. Finally, auditors must be technologically adept. Auditors must be able to evaluate information systems and internal controls that extensively use new technologies.

1.10 The common attributes of all assurance services are that they are (a) independent profession services that (b) improve the quality of information, or its context, for (c) decision-makers.

1.11 a. The financial statement audit was the first form of assurance that was provided by CPAs. This service was so successful that today CPA assurance services have expanded reviews services, various attest services and a compilation service. The potential for additional services is based in large part on the fact that the financial statement audit has earned the public trust. The logic used by auditor is performing the audit is also used in performing many of these other services.

b. Today auditors provide audit level assurance on financial statements only once a year, and review level assurance quarterly. One important change is the movement toward providing real-time assurance on financial information. An important part of the current audit process is its focus on internal controls. Auditors may likely use this skill to focus more attention on internal controls and attest to the reliability of the financial information systems rather than the financial information itself.

1.12 An attest service is one in which the CPA firm issues a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party. Attest services include audits, examinations, reviews, and agreed-upon procedures.

1.13 Other services performed by CPAs do not result in the expression of an opinion, negative assurance, summary of findings, or any other form of assurance by the CPA firm. These services include accounting services such as technology services, management consulting, financial planning including tax services, and international services.

1.14 (Mislabeled as 1.12 in the text). Four private sector organizations associated with the public accounting profession and their principal activities are as follows: (1) American Institute of Certified Public Accountants which acts on behalf of its members and provides necessary support to assure that CPAs serve the public interest in performing quality professional services (activities include developing standards dealing with professional services, quality control, quality review, and ethical conduct, developing and distributing continuing professional education materials and courses, and providing technical accounting and auditing assistance through a technical information hotline, technical library, and a variety of publications); (2) State Societies of Certified Public Accountants which cooperate with each other and the AICPA in areas of mutual interest such as providing continuing professional education opportunities to members and enforcing ethical standards; (3) Practice Units (CPA firms) which are the organization units through which CPAs render professional services to the public; and (4) Accounting Standard Setting Bodies, principally the Financial Accounting Standards Board (FASB) and Governmental Accounting Standards Board (GASB) whose primary functions are the development of generally accepted accounting principles for business and not-for-profit entities, and state and local governmental entities, respectively.

1.15 (Mislabeled as 1.13 in the text). Four divisions / teams of the AICPA that have a direct impact on auditing are: (1) Division for CPA Firms, (2) Quality Review Team, (3) Auditing Standards Team, and (4) Professional Ethics Team.

1.16 (Mislabeled as 1.14 in the text).

a. A CPA firm may be organized as a proprietorship, partnership, Professional Corporation, or any other form of organization permitted by state law or regulation (including limited liability partnerships (LLPs) and limited liability corporations (LLCs)).

b. CPA firms are often classified into the following four groups: (1) Big Six, (2) Second Tier, (3) Regional, and (4) Local.

1.17 (Mislabeled as 1.15 in the text). Six public sector organizations associated with the public accounting profession and one or two principal activities of each are as follows: (1) State Boards of Accountancy which administer state accountancy laws in each state including oversight of the licensing of CPAs and monitoring compliance with codes of professional ethics, mandatory continuing professional education requirements, and other positive enforcement programs; (2) Securities and Exchange Commission which (a) regulates the distribution of securities offered for public sale and the subsequent trading of securities on stock exchanges and over-the-counter markets and (b) exerts considerable influence over auditing and the public accounting profession as well as the establishment of GAAP for companies under its jurisdiction; (3) U.S. General Accounting Office (GAO) which has the authority to issue standards pertaining to the audit of governmental organizations, programs, activities, and functions; (4) Internal Revenue Service which administers and enforces the federal tax laws; (5) State and Federal Courts which (a) reach judgments as to whether CPA firms have adhered to standards of performance established by the profession itself and (b) in some cases have ruled that the profession's standards are not adequate for the protection of the public; and (6) U.S. Congress which influences the profession through investigative and monitoring activities aimed at determining whether the profession is meeting its responsibilities to the public, and through the passage of tax laws and other legislation affecting the performance of professional services.

1.18 (Mislabeled as 1.17 in the text).

a. The purpose of the profession's multilevel regulatory framework is to help assure quality in the performance of audits and other professional services.

b. The four components of the profession's multilevel regulatory framework are:

Standard-setting. The private sector establishes standards for accounting, auditing, ethics, and quality control to govern the conduct of CPAs and CPA firms.

Firm regulation. Each CPA firm adopts policies and procedures to assure that practicing accountants adhere to professional standards.

Self-or peer regulation. The AICPA has implemented a comprehensive program of self-regulation including mandatory continuing professional education, peer review, audit failure inquiries, and public oversight.

Government regulation. Only qualified professionals are licensed to practice, and auditor conduct is monitored and regulated by state boards of accountancy, the SEC, and the courts.

1.19 (Mislabeled as 1.18 in the text). The five elements of quality control are (1) independence, integrity and objectivity, (2) personnel management, (3) acceptance and continuance of engagements, (4) engagement performance, and (5) monitoring.

1.20 (Mislabeled as 1.19 in the text).

a. The two sections of the AICPA Division for Firms are (1) the SEC Practice Section and (2) the Private Companies Practice Section.

b. Unique membership requirements of the SEC Practice Section include (1) rotating audit partners on SEC engagements periodically, (2) having an audit partner other than the partner in charge of the SEC engagement

review and concur in the audit report before it is issued, and (3) refraining from performing certain proscribed management consulting services for SEC audit clients.

1.21 (Mislabeled as 1.19 in the text). The Quality Control Inquiry Committee (QCIC) is responsible for determining whether lawsuits alleging audit deficiencies brought against firms enrolled in the SEC Practice Section suggest (1) an aberrational error which no quality control system can totally eliminate, (2) a shortcoming in the charged firm's quality controls or its compliance with them, or (3) a shortcoming in professional standards. The Public Oversight Board (POB) closely monitors the work of the SEC Practice Section and recommends improvements for strengthening the Section's self-regulatory activities. The POB also distributes an annual report on its activities to all interested parties.

Objective Questions

1.21 1. b 2. d 3. a1.22 1. b 2. c 3. d1.23 1. b 2. d 3. b

Comprehensive Questions

1.24 (Estimated time - 20 minutes)

a. Internal auditing is an independent appraisal activity performed by employees of the company being audited. The objective of internal auditing is to assist management in the effective discharge of its responsibilities. External auditing is done by independent, external auditors for the purpose of expressing an opinion on the fairness of the company's financial statements. Governmental auditing is done by government auditors to determine (1) fairness of financial reports, (2) compliance with applicable laws and regulations, (3) efficiency and economy of operations, and (4) effectiveness in achieving program results.

b. Practice standards for independent, internal, and government auditors are established by the American Institute of Certified Public Accountants, Institute of Internal Auditors, and the U.S. General Accounting Office, respectively.

c. The audits serve different purposes and are made by different types of auditors. Auditing only by internal auditing will not satisfy the requirements of stock exchanges and the SEC for independent audits by external auditors. Moreover, internal audits will not satisfy all government requirements for audits, particularly in the area of compliance with applicable laws and regulations. In sum, each type of auditing is necessary.

1.25 (Estimated time - 30 minutes)

a. Type of Audit b. Type of Auditor(s) c. Primary Recipient(s)

1. Financial statement (1) Independent(1) Stockholders, investors, regulatory agencies, and general public

2. Operational (3) Internal (2), Independent(1) Senior Management

3. Compliance (2) Government - IRS (4) IRS

4. Operational (3) Government - GAO (3) Congress

5. Financial statement (1) Independent (1) Creditors

6. Operational (3) Internal (2) Management

7. Compliance (2) Government - GAO (3) Congress

8. Compliance (2) Independent (1), Internal (2),

and Government - GAO (3)

Congress

9. Financial Statement (1)

Independent (1) Citizens, taxpayers

10. Operational (3) Government - GAO (3) Congress

11. Compliance (2) Independent (1), Internal (2) Bondholders

12. Compliance (2) Internal (2), Independents (1)

Management

1.26 (Estimated time - 20 minutes)

When CPAs audit the value of inventory reported in the financial statements they are communicating the total pictures with clarity and objectivity. CPAs step up the value chain by translating complex information into critical knowledge when they use information from the financial statements, such as inventory turnover and benchmark a client’s performance against others in the industry. CPAs anticipate and create opportunities when they identify how a client might improve its inventory turnover, for example by advising the client’s management on how it might identify and eliminate slow moving inventory. Finally, CPA in industry designs pathways to transform vision into reality by taking the steps that increase inventory turnover. The independent CPA however, must take care to not extend services beyond advisory services to making management decisions.

1.27 (Estimated time - 30 minutes)

Core ValueImportance to

Financial Statement UserImportance to the Board of Directors

Continuing Education and Lifelong Learning

Financial statement users expect that auditors are knowledgeable about current professional standards (GAAP and GAAS) and their application to the client.

The Board of Directors expects that auditors are not only knowledgeable in GAAP and GAAS but are familiar with current developments in their industry.

Competence Financial statement users expect auditors to be able to evaluate the fairness of presentation in the financial statements, given GAAP and the entity’s performance.

The Board of Directors expects that auditors can evaluate fair presentation in the financial statements, the quality of the entity’s internal control, and often the performance of their entity’s against others in the industry.

Integrity Financial statement users expect auditors to be independent of management and they expect an honest opinion on the entity’s financial statements.

The Board of Directors expects auditors to be independent of management and to provide honest opinions on the entity’s financial performance and the quality of its internal controls.

Core ValueImportance to

Financial Statement UserImportance to the Board of Directors

Attuned to broad business issues

Financial statement users expect auditors to be able to evaluate the fair presentation of accounting estimates and needed disclosures given the current business environment.

The Board of Directors expects that auditors to be able to evaluate the impact of current business developments on the entity’s financial performance, its internal control, and often they look to the auditor for recommendations on how to be more competitive in the industry.

Objectivity Financial statement users except auditors to be free of conflicts of interest and make objective decisions even if it is not in entity’s interest, or the short-term interest of the auditor.

The Board of Directors expects that auditors are free of conflicts of interest and independent of senior management.

1.28 (Estimated time - 20 minutes)

1. State boards of accountancy 10. State societies of CPAs2. FASB and GASB 11. SEC, state and federal courts3. AICPA 12. GASB4. SEC 13. AICPA5. AICPA, state societies of CPAs,

and state boards of accountancy

14. State boards of accountancy

6. FASB 15. AICPA7. State boards of accountancy 16. Practice units8. SEC 17. GAO9. AICPA 18. IRS

1.29 (Estimated time - 20 minutes)a. The four sets of standards in the private sector and the standard setting

bodies are: (1) accounting by the FASB and GASB, (2) auditing by the AICPA, (3) professional ethics by the AICPA, and (4) quality control by the AICPA.

b. The other components of the regulatory framework are: (1) firm regulation that occurs within the public accounting firm through day-to-day monitoring of the actions of the firm's professional staff by the firm's management; (2) self-regulation, also called peer regulation, that relates to the activities of professional entities outside the firm such as the AICPA's Division for CPA firms and its Quality Review Division; and (3) governmental regulation that occurs at both the state and federal levels through activities that range from positive enforcement programs to punitive actions. This type of regulation is done by state boards of accountancy, the SEC, and state and federal courts of law.

1.30 (Estimated time - 30 minutes)

Policy/Procedure

Element(a)

Purpose of Policy / Procedure

(b)

AdditionalProcedure

(c)

1. Personnel Management

Personnel should have the qualifications to fulfill responsibilities they may be called upon to assume in the future.

Establish qualifications necessary for each level of responsibility in the firm.

2. Engagement Performance

Work at all levels should be supervised to assure that it meets the firm's standards of quality.

Establish procedures for reviewing working papers and reports.

3. Personnel Management

Work is assigned to people who have the technical training for the assignment and personnel should seek assistance, when necessary,

Identify areas and specialized situations for which consultation is required.

Policy/Procedure

Element(a)

Purpose of Policy / Procedure

(b)

AdditionalProcedure

(c)

from persons having appropriate expertise, judgment, and authority

4. Independence, Integrity and Objectivity

All professionals should be independent of clients.

Monitor compliance with independence rules.

5. Monitoring Determine that procedures relating to the other elements are being effectively applied.

Provide for reporting inspection results to appropriate management levels in the firm.

6. Personnel Management

Only individuals who possess the qualities of integrity, competency, and motivation should be hired.

Maintain a recruiting program to obtain new hires at the entry level.

7. Personnel Management

Personnel should have the knowledge required to fulfill assigned responsibilities.

Provide Programs to develop expertise in specialized areas and industries.

8. Engagement Performance

Personnel should have the technical training and proficiency required by the engagement.

Permit partner in charge of engagement to approve assignments.

9. Acceptance and Continuance of Clients and Engagements.

The firm should not be associated with clients whose management lacks integrity.

Establish review procedures for continuing a client.

1.31 (Estimated time - 30 minutes)

a. Practicing CPAs associated with firms that audit SEC clients cannot retain membership in the AICPA unless their firms enroll in the SEC Practice Section of the Division for CPA firms. Other practicing CPAs cannot retain

membership in the AICPA unless their firms submit to a practice monitoring program that conforms to the requirements of the Quality Review Division.

b. The two sections of the AICPA Division for Firms are the SEC Practice Section and the Private Companies Practice Section. The objectives that are common to both sections are:

Improve the quality of service (or practice) by CPA firms through the establishment of practice requirements for member firms.

Establish and maintain an effective system of self-regulation of member firms by means of mandatory peer reviews, required maintenance of appropriate quality controls, and the imposition of sanctions for failure to meet membership requirements.

The following membership requirements are common to both sections:

Adhere to quality control standards established by the AICPA.

Submit to peer reviews of the firm's accounting and audit practice every three years or at such additional times as designated by the executive committee, the reviews to be conducted in accordance with review standards established by the section's peer review committee. (Note - At the time this manual went to press, as noted in the footnote on page 23 of the text, the AICPA was in the process of combining the peer review process for the Private Companies Practice Section with the quality review program of the Quality Review Division.)

Ensure that all professionals in the firm resident in the United States, including CPAs and non-CPAs, participate in at least 20 hours of continuing professional education every year and in at least 120 hours every three years.

c. The peer review objective for both sections is to improve future practice. However, when a firm fails to take the corrective action considered necessary by the section, the section can impose sanctions. The peer review teams are required to make a review of the firm's accounting and auditing services and to report on their findings to the section. The findings are included in the public files of each section.

d. The Quality Control Inquiry Committee (QCIC) and the Public Oversight Board (POB) are involved with the SEC Practice Section. Firms in this practice section must report all litigation or regulatory proceedings involving audits of public companies to the QCIC within 30 days of receiving the complaint. The QCIC then has the responsibility to determine whether the allegations in a case suggest (1) an aberrational error that no system can totally eliminate, (2) a shortcoming in the charged firm's quality controls or its compliance with them, or (3) a shortcoming in professional standards. When the last two situations exist, the case is not closed until the QCIC concludes that the firm has addressed the weakness or the shortcomings have been reported to the appropriate standard setting body for its consideration. The POB enhances the effectiveness and credibility of the SEC Practice Section's self-regulatory activities by closely monitoring the work of the Section. Its responsibilities include directly overseeing each peer review conducted by the Section and all QCIC inquiries alleging audit failures.

e. The primary activities of the Quality Review Division are to (1) establish and conduct, in cooperation with state CPA societies, a quality review program for firms engaged in the practice of public accounting and not enrolled in one of the Sections of the AICPA Division for Firms, and (2) conduct reviews of firms enrolled in the program. (Note - Again, in accordance with the footnote on page 23 of the text, at the time this manual went to press the AICPA was in the process of merging the peer review activity of the Private Companies Practice Section of the Division for CPA Firms into the Quality Review Division.)

Research Questions

For the reasons specified in the introduction to this manual, solutions are not provided for this category of questions.