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Solution Manual Principles of Auditing 2nd Edition Hayes
Solution Manual Principles of Auditing 2nd Edition Hayes
Principles of Auditing
An Introduction to
International Standards on
Auditing
Second edition
Rick Hayes
Roger Dassen
Arnold Schilder
Philip Wallage
For further lecturer material
please visit:
www.booksites.net/hayes
ISBN 0 273 68425 6
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Contents
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QUESTIONS
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1-2. What characteristics of the Industrial Revolution were essential for the enhanced
development of the audit profession?
The Industrial Revolution created the demand for services of specialists in bookkeeping
and auditing of internal and external financial reports. It started in Great Britain around
1780. This revolution led 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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1-5. What are the ISA standards that are used by an auditor to guide him through the
first phase of an audit?
The first phase of the audit is client acceptance. ISA 200 gives the objective and general
principles of an audit of financial statements. ISA 210 describes the contents of an
engagement letter. Although the standard does not require use of an engagement letter, the
guidance is provided in a manner that presumes use of an engagement letter. ISA 310
requires a reasonable understanding of the client’s business and industry. ISA 315 requires
understanding the entity’s environment and the risks. The auditor needs to have a level of
knowledge of his or her client’s business and industry that will enable him to identify the
events, transactions, and practices that, in his judgment, may have a significant effect on
the financial information. International standard ISA 510 discusses initial engagements.
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.
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 analyze accounting records. The audit must be planned and
structured in such a way that those carrying out the audit can fully examine and analyze
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; and
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• 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 program 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.
1-8. Name two types of risk in the audit process? Briefly discuss each.
Much of the planning in audits deals with obtaining information to help auditors assess the
risks in the audit process. There are two types of risks in conducting an audit. One type of
risk is the risk that the auditor or audit firm will suffer harm because of a client
relationship, even though the audit report rendered for the client was correct. This is called
business risk. The other type of risk is audit risk, the risk that an auditor may give an
inappropriate audit opinion on financial statements that are materially misstated. For
example, an auditor may give an unqualified opinion on financial statements without
knowing that they are materially misstated.
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1-10. 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 recognized criteria or standards, such as established
laws and regulations, or an organization’s policies and procedures. An operational audit
is a study of a specific unit of an organization for the purpose of measuring its
performance.
Operational audits review all or part of the organization’s operating procedures to
evaluate effectiveness and efficiency of the operation. Efficiency shows how well an
organization uses its resources to achieve its goals. These reviews may not be limited to
accounting. They may include the evaluation of organization structure, marketing,
production methods, computer operations, or in whatever area the organization feels
evaluation is needed. Recommendations are normally made to management for
improving operations.
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• 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, 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 that 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.
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1-13. 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 means 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. For account balances, completeness
means 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, that no liabilities were “off the books” For
presentation and disclosure, completeness means 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.
1-15. What are the four phases of an audit process model? Briefly describe each.
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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 evaluating 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 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.
1-16. Based on the Evaluation and Judgment phase (IV) of the audit process model
the overall conclusions are formed on what judgments?
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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the work of the audit staff, reviews working papers and time budgets, and assists in
drafting the audit report. The senior maintains a continuous record of staff hours in
each phase of the audit examination, maintains professional standards of fieldwork, and
is responsible for preventing excessive staff hours. This work is subject to review and
approval by the manager and partner.
Managers: The manager supervises the audits conducted by the seniors. The
manager helps the seniors plan their audit programs, reviews working papers
periodically, and provides other guidance. The manager is responsible for determining
the audit procedures applicable to specific audits and for maintaining uniform standards
of fieldwork. Often managers have the responsibility of compiling and collecting the
firm’s billings to the audit client. The manager, who typically has at least five years of
experience, needs a broad and current knowledge of tax laws, accounting standards, and
government regulations. A manager is likely to specialize in accounting requirements
of a specific industry.
Partners/Directors: Partners are the owners of the auditing firm. For some firms a
change in legal structure means that those formerly known as partners are Directors.
They are heavily involved in the planning of the audit, evaluation of the results, and
determination of the audit opinion. They maintain contacts with clients, discuss the
objectives and scope of the audit work, resolve controversies that may arise and may
attend the client’s stockholders’ meetings to answer any questions regarding the
financial statements or the auditors’ report. They also review the manager’s audit
working papers, supervise staff, and sign the audit reports. Partners may specialize in a
particular area such as tax laws or a specific industry. The partner is the person who
must make the final decisions involving complex judgments.
1-18. 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 in 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 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 organization’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
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1-22. Describe the Public Interest Oversight Board. Discuss what you think their impact
will be on worldwide auditing
The Public Interest Oversight Board (PIOB) will oversee IFAC standard setting
activities in the areas of audit performance standards, independence, other ethical
standards for auditors, audit quality control, and assurance standards. The PIOB will
decide other areas that might fall within the scope of its oversight after consulting with
the Monitoring Group (MG) and the IFAC Leadership Group (ILG) (see below). The
composition of the PIOB will be selected by the MG. It will be made up of members of
the organizations within the MG or their representatives.
Students can suggest a lot of impacts on worldwide auditing of the PIOB. One
obvious one is that all firms will have to know PIOB standards if they are operating in
countries where the PIOB holds sway. There are the political implications of who is on
the board, what authority they will have, how they impact local markets, etc.
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financial reporting framework of other criteria. The auditor, after an objective evidence-
gathering examination, expresses an opinion on the fair presentation of financial
statements.
1-24. Based on ISA 200 what are the general principles governing an audit of financial
statements? Discuss ethics, professional skepticism, audit scope, business risk and
audit risk.
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
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1-26. Auditing Tasks. Each of the following … (12) … used by a creditor. 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:
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to get an accurate picture of how their donations are spent. An audit of how effectively
they meet their goals might be helpful to give credibility to the organization.
(e) A small grocery store in Ponta Grossa, Brazil. Although an audit is not required for
a small store, the bank which makes loans to the grocery store or the partners of the
enterprise may require audited financial statements. A small company can benefit from
an operational audit, for instance, to see if they have proper controls and if the inventory
is handled effectively. The audit might help the company with their income tax.
(f) A local Baptist church in Lubbock, Texas. A compliance audit to determine if the
church is fulfilling the criteria of a non-profit organization might be helpful to tax
authorities and members who make contributions. Traditionally churches have little in
the way of controls, and an operational audit of controls would probably be helpful in
decreasing loss of cash donations. If the church is of a major, organized religion
(Baptist or Catholic, for 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.
B. For each specific audit objective, identify the appropriate management assertion.
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(4) Prepare the planning memorandum and audit program, containing the auditor’s
response to the identified risks.
Phase III, Testing and Evidence: Test for evidence supporting internal controls and
the fairness of the financial statements. Procedures are: (1) Tests of controls; (2)
Substantive tests of transactions; (3) Analytical procedures; (4) Tests of details of
balances. (5) Final evidence accumulation and search for unrecorded liabilities.
Phase IV, Evaluation and Reporting. The phase when the auditor completes the
audit and issues an audit report based on the results of the audit. Procedures include (1)
Evaluate governance evidence; (2) Perform procedures to identify subsequent events;
(3) Review financial statements and other report material; (4) Perform wrap-up
procedures; (5) Prepare Matters of Attention for Partners; (6) Report to the board of
directors; and (7) Prepare Audit report.
The student may choose any of these as the most important. Most students believe
Client Acceptance is the most important because it involves making the decision to
accept a client or not. Choosing the right client can make tremendous differences in the
success of the audit. Phase III, Testing and Evidence is important because it is these
tests that support the fairness of the financial statements.
1-30. 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 year’s work papers.
3. Determine the need for experts or other auditors.
4. Pick audit staff and do a budget
5. Write an 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 program.
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.
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CASES
1-32. Audit Objectives and Financial Statement Accounts. Look at the financial
statements … 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 Valuation and allocation
doubtful accounts
Investments All
Long-term loan receivables All
Property, plant and All
equipment
Goodwill and other existence, rights and obligations, occurrence, valuation and
intangible assets allocation,
Other non-current assets all
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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- existence, rights and obligations, occurrence, completeness,
term debt valuation and allocation
Advance payments existence, rights and obligations, occurrence, valuation and
allocation
Provision for discontinued Valuation and allocation, occurrence
operations
Accrued Product Liability Valuation and allocation, existence, completeness,
Long-term debt existence, rights and obligations, occurrence, completeness,
valuation and allocation
Other Long-term liabilities existence, rights and obligations, occurrence, completeness,
valuation and allocation
SHAREHOLDERS’
EQUITY
Share capital existence, rights and obligations, occurrence, completeness,
valuation and allocation
Other restricted equity occurrence, valuation and allocation
Treasury shares existence, completeness, valuation and allocation
Untaxed reserves Valuation and allocation
1-34. Qualifications of Auditors. From the library get a copy of the EC Eighth
Company Law Directive that is about the qualifications and work of auditors. Based
on the Eighth Directive, answer the following questions.
A. How many years of work experience must an auditor have before he or she can
receive an auditing credential?
A. An auditor must have 3 years of work experience before he or she can receive an
auditing credential.
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1-35. Due Professional Care. Discuss lawsuits resulting from negligence of “Due
professional Care”.
A. Consult the library, a data base like Lexis-Nexis or the Internet for lawsuits
resulting from negligence of “Due Professional Care”. Discuss at least two.
B. Describe briefly the court’s final conclusion and results from the court decision.
A.& B This case is subjective. Students may search a database such as Lexis-Nexis,
ABI Inform, etc. and may find a variety of cases. As an example, a search of Lexis –
Nexis for lawsuits resulting from negligence of “Due Professional Care” in May 2004
yields 191 articles, some of which are below:
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, Iss. 2; p. 66.
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.
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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 & 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 Defenses”. Columbia Business Law
Review. p. 71.
Reid Anthony 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 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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Robert Anthony 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.
Joel Seligman. 1993. “The Fifth Abraham L. Pomerantz Lecture: The New Corporate
Law”, Brooklyn Law Review, Spring. vol 59, p. 1.
Joel Seligman. 1993.”Accounting And The New Corporate Law”. Washington & Lee
Law Review. Summer. no. 50, p. 943.
Lorie Soares, 1988. “Note: The Big Eight, Management Consulting And Independence:
Myth Or Reality?”, Southern California Law Review, no. 61, p. 1511.
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International Auditing and Assurance Standards Board (IAASB). 2003. International Standard on Auditing 200.
“Objective and General Principles Governing an Audit of Financial Statements”. Para.15. International Federation of
Accountants. New York. October.
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