Solutions Manual

Principles of Auditing
An Introduction to
International Standards on
Auditing
Second edition

Rick Hayes
Roger Dassen
Arnold Schilder
Philip Wallage
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Contents

1 International Auditing Overview 4

2 The Audit Market 26
3 Ethics for Professional Accountants 39
4 An Auditor’s Services 51
5 Client Acceptance 65
6 Understanding the Entity, Risk Assessment and Materiality 81
7 Internal Control and Control Risk 96
8 Control Risk, Audit Planning and Test of Controls 119
9 Analytical Procedures 141
10 Substantive Testing and Evidence 160
10A Audit Sampling and Other Selective Testing Procedures 184
11 Completing the Audit 189
11A Audit Documentation and Working Papers 215
12 Audit Reports and Communication 219
13 Overview of a Group Audit 248
14 Corporate Governance 277
14A The Combined Code (UK), July 2003: An Example of Auditor’s
Review of Corporate Governance Best Practice 288
14B Governance and Auditing in a Public Interest Context 291

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1 International Auditing Overview

1.14 Questions, Exercises and Cases

QUESTIONS

1.2 Auditing through World History

1-1. Identify and briefly discuss factors that have created the demand for international
auditing.
The practice of modern auditing dates back to the beginning of the modern corporation
at the dawn of the Industrial Revolution. Companies then experienced a growth of
technology, improvement in communications and transportation, and the exploitation of
generally expanding worldwide markets. As a result, the demands of owner-managed
enterprises for capital rapidly exceeded the combined resources of the owners’ savings
and the wealth-creating potential of the enterprises themselves. It became necessary for
industry to tap the savings of the community as a whole. The result has been the growth
of sophisticated securities markets and credit-granting institutions serving the financial
needs of large national and increasingly international corporations.
The flow of investor funds to the corporations and the whole process of allocation of
financial resources through the securities markets have become dependent to a very
large extent upon reports made by management. One of the most important
characteristics of these corporations is the fact that their ownership is almost totally
divorced from their management. Management has control over the accounting systems
of these enterprises. Management is not only responsible for the financial reports to
investors; it also has the authority to determine the precise nature of the representations
that go into those reports. To reduce the investor’s potential lack of confidence about
management’s reports a demand for independent assurance has arisen, called “auditing.”

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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.

1.3 The Auditor, Corporations and Financial Information

1-3. Evaluate this quote: “Every international business, large or small, should have an
annual audit by an independent auditor.” Why should an auditor review the financial
statements of a company each year?
Management can scarcely be expected to take an impartial view of this process. The
financial reports measure the effectiveness of management’s performance of its duties.
Reports have an important influence on management’s salaries, on the value of their
shareholdings in the enterprise, and even on their continued employment with the
company.
Income statements are compiled on a yearly basis. The income statement is very
valuable to shareholders and other stakeholders. To increase the confidence of these
stakeholders in the credibility of annually compiled financial statements, the statements
must receive an independent and expert opinion on their fairness. An auditor provides
the opinion on credibility.

1.4 International Accounting and Auditing Standards

1-4. How do International Financial Reporting Standards (IFRS) differ from
International Standards on Auditing (ISA)?
Financial accounting standards are unique and separate from audit standards. By its
nature, auditing requires that the real world evidence of financial transactions is
compared to financial standards. The standards to which an international auditor
compares financial statements are generally standards in the reporting country (e.g. FAS
in the United States, or national standards in European Union (EU) Member States,
which are based on EU Directives). In the future, companies and auditors in the EU and
other countries will use International Financial Reporting Standards (IFRS), formerly
called International Accounting Standards (IAS), which are set by the International
Accounting Standards Board (IASB).

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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.

1.5 An Audit Defined

1-6. What is the objective of an audit?
An audit is a process, a structured series of tasks, the purpose of which is to provide
evidence to support the claim that the financial statements are fairly stated (give a true and
fair view). To be fairly stated, the statements must conform to accepted accounting
principles (whether these principles are set by government, private organizations or
custom).
The audit process must be planned, staffed and carried out, and the evidence must be
gathered, in a manner that is consistent with professional auditing standards.

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.

1.6 Types of Audits

1-9. How many types of audits are there? Name each and briefly define them.
Audits are typically classified into three types: audits of financial statements,
operational audits, and compliance 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. 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. A compliance audit is a review
of an organization’s procedures and financial records performed to determine whether
the organization is following specific procedures, rules, or regulations set out by some
higher authority.

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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.

1.7 Types of Auditors

1-11. What are the three types of auditors? Briefly define them.
There are three basic types of auditors: independent auditors, government auditors and
internal auditors. The independent auditor is an auditor who is not part of the entity
being audited. Independent auditors are typically certified either by a professional
organization or the government. The independent auditor specializes in auditing
financial statements, performing review assignments or doing compilations of financial
statements.
A wide variety of governmental agencies at national, regional, and local level use
auditors to determine compliance with laws, statutes, policies, and procedures.
Many large companies and organizations maintain an internal auditing staff. Internal
auditors are employed by individual companies to investigate and appraise the
effectiveness of company operations for management. Much of their attention is often
given to the appraisal of internal controls.

1.8 Setting Audit Objectives Based on Management Assertions

1-12. What are the financial statement assertions made by management according to
ISA 500?
According to ISA 500, financial statement assertions are assertions by management,
explicit or otherwise, that are embodied in the financial statements. They can be
categorized as follows:
(1) Assertions about classes of transactions and events for the period under audit:

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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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• Accuracy and valuation – financial and other information is disclosed fairly

and at appropriate amounts. For example, management asserts that account
balances are not materially misstated.

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.

1.9 The Audit Process Model

1-14. How can one compare the empirical scientific cycle to the financial audit
process?
One can liken the financial audit process to the empirical scientific cycle. The empirical
scientific cycle is a systematic process of experimenting that starts with a research
question, then a plan for an empirical test of the question is made, the test is done,
feedback is analyzed, and the scientist makes a judgment. The scientist’s opinion is that
the experimental hypothesis is false or not false, or perhaps that the test is inconclusive.
A financial audit is a systematic process that begins with a client’s request for an audit
of financial statements, followed by a plan of the audit, and after testing for evidence,
the process culminates in a judgment or opinion. The auditors’ judgment is whether the
financial statements are unqualified as to their fairness, qualified, or disclaimed.

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.

1.10 International Public Accountancy Firms

1-17. List the four basic positions within the organizational structure of an audit firm and
describe the duties of each position.
Staff Accountants (or Junior Assistants then Senior): Typically the first position of
someone entering the public accounting profession is that of staff accountant (also
called assistant or junior accountant). The staff accountant often performs the more
detailed routine audit tasks. The assistants attend training programs that are either
developed “in house” or sponsored by the professional organizations.
Senior Accountants (or Supervisor): The senior (“in-charge”) auditor or
“supervisor” is in charge of audit fieldwork and typically has two or more years
experience in public auditing. The senior is responsible for planning the audit and
conducting the audit engagement at the client’s place of business. The senior supervises

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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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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 United States began
in 1898. In 1957 there was a merger between Cooper Brothers & Co (UK), McDonald,
Currie and Co (Canada), and Lybrand, Ross Bros, & 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.

PROBLEMS AND EXERCISES

1.2 Auditing through World History

1-19. History of Auditing. In this chapter, the history of auditing has been briefly
described, from an international perspective. Identify the major differences with the
developments specific for your country and try to explain these based on differences in
the economic system or development.
The answer to this question is specific to the country where instruction takes place. The
students should identify the major differences between the developments specific to
their country and to explain these in terms of differences in the economic system of
their country and the general international accounting development.

1.3 The Auditor, Corporations and Financial Information

1-20. Expectations Gap The general public thinks that an auditor guarantees the
accuracy of financial statements. Is this true? Why? What other things does the
public believe about audited financial statements?
An auditor does not guarantee the accuracy of financial statements. The auditor
guarantees that there is no “material” misstatement.
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.

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1.4 International Accounting and Auditing Standards

1-21. International Auditing Standards. The London, Tokyo and New York Stock
Exchange, among others, require an annual audit of the financial statements of
companies whose securities are listed on it. What are the possible reasons for this?
The London, Tokyo and New York Stock Exchange, among others, require an annual
audit of the financial statements of companies whose securities are listed on them in
order to:
1. To increase the confidence of investors.
2. Lend reliability and credibility to the financial statements and reports accompanying
audited statements.
3. Provide a reliable and consistent basis for decision-making.
4. Provide a basis for comparison of companies in diverse industries.
5. Protect investor interests.
6. Track the spending of a department compared to the budget.
7. Check to see if internal controls on allocation of keys works.
8. Check data input and security controls on computer operations.

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.

1.5 An Audit Defined

1-23. Objectives of an Audit. Tracy Keulen, the sole owner … audit is considered
important.
REQUIRED
A. Describe the objectives of the independent audit.
A. An independent audit is an examination of the financial statements in accordance with
certain auditing standards such as International Standards on Auditing. The objective of an
audit of financial statements is to enable the auditor to express an opinion whether the
financial statements are prepared, in all material respects, in accordance with an identified

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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.

B. Identify five ways in which an independent audit may be beneficial to Keulen.

B. An independent audit can also be beneficial:
1. To serve as a basis for the extension of credit.
2. To supply credit rating agencies with required information.
3. To determine if accounting records and reporting meet accounting standards
(such as International Financial Reporting Standards (IFRS)).
4. To serve as a basis for preparation of tax returns.
5. To establish amounts of losses from fire, theft, and burglary.
6. To establish a good basis for management decision making.
7. To determine amounts receivable or payable under
a. agreements for bonuses based on profits.
b. contracts for sharing expenses.
c. cost-plus contracts.
8. To provide data for proposed changes in financial structure or to supply proper
financial data in the event of a proposed sale or merger.
9. To assist the company in risk assessment.
10. To serve as a basis for changes in accounting or recording practices.
11. To serve as a basis for action in bankruptcy and insolvency cases.
12. To determine proper execution of trust agreements.
13. To determine the effectiveness of information and communication systems.
14. To furnish estates with information in order to obtain proper settlements and
avoid costly litigation.
15. To provide a review of many aspects of the organization’s activities and
procedures.
16. To help companies improve their monitoring of risk, controls, and efficiency.
17. To establish and/or improve systems of internal control.
18. To provide important aid in case of tax audits and court actions.
19. To discourage employees from planning errors or irregularities, by making
them aware of auditor presence.
20. To enhance the credibility of reports accompanying financial statements.
21. To provide industry-wide comparisons.
22. To provide a realistic look at inventories.
23. To review adequacy of insurance coverage.
24. To provide the professional knowledge of an external auditor, which is
generally superior to the client’s bookkeeping experience.

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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auditor’s professional responsibilities are: independence, integrity, objectivity,

professional competence and due care, confidentiality, professional behavior and
technical standards.
ISA 200 further states that the auditor should conduct an audit in accordance with
International Standards on Auditing. The auditor would plan and perform the audit with
an attitude of professional skepticism recognizing that circumstances may exist which
cause the financial statements to be materially misstated.
The term scope of an audit refers to the audit procedures deemed necessary in the
circumstances to achieve the objective of the audit. ISA 200 states: “The procedures
required to conduct an audit in accordance with ISAs should be determined by the
auditor having regard to the requirements of ISAs, relevant professional bodies,
legislation, regulation and, where appropriate, the terms of the audit engagement and
reporting requirements.”
Companies face a variety of business risks. Management is responsible for
identifying such risks and responding to them. The auditor is concerned primarily with
risks that may affect the financial statements.
The risk that causes the greatest concern by the auditor is the risk that the auditor
gives a clean audit opinion when the financial statements are materially misstated
(known as audit risk). The newest revision of ISA 200 states, “The auditor should plan
and perform the audit to reduce audit risk to an acceptably low level that is consistent
with the objective of an audit.” The components of audit risk are inherent risk, control
risk, and detection risk.

1.6 Types of Audits

1-25. Operational Audits. List four examples of specific operational audits that could be
conducted by an internal audit in a manufacturing company. Describe how you would
conduct each.
Four specific operation audits that could be conducted by an internal auditor at a
manufacturing company include:

1. A review of the operational effectiveness of the receiving department.

2. A review of the operations of the computer system.
3. An audit of the operation of production methods.
4. A review of how manufacturing workers use material.
5. A review of the time it takes to receive payments on accounts receivable.
6. A review of the time between receiving an order and shipping the goods.
7. A determination of the time it takes to handle a customer complaint.
8. Review of the reliability of suppliers.

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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EXAMPLE TYPE OF AUDITOR TYPE OF AUDIT

1 Independent auditor Financial statements
2 Government auditor Compliance
3 Internal auditor Operational
4 Internal auditor Operational
5 Government or independent or Compliance or financial
internal auditor statements
6 Internal auditor Compliance or operational
7 Internal or independent or Compliance
government
8 Independent auditor Financial statements
9 Government or independent Compliance
auditor
10 Independent auditor Financial statements
11 Government auditor Operational
12 Internal or independent auditor Financial statements

1.7 Types of Auditors

1- 27. Independent External Auditor. Give reasons why … (f) … Lubbock, Texas
The following organizations should have annual audits by an independent external
auditor because:
(a) The U.S. Federal Reserve Board. The financial statements should show a true and
fair view for its users. An operational audit could show how efficient and effective the
organization is, especially the control procedures. An audit might determine
compliance with the laws, statutes, policies and procedures of the U.S. government. An
audit of such a sensitive organization might help protect the U.S. public against large
banking disasters.
(b) A retail company traded on the London Stock Exchange (LSE). A financial
statement audit could be useful to provide consistent information to prospective
investors. Present shareholders need a report that monitors the company because they
have limited control. The investors may want to know if the company meets LSE’s
Code of Best Practice.
(c) Walt Disney Company. The U.S. Securities and Exchange Commission requires
that all publicly traded companies (like Disney) be audited. Walt Disney has investors
and runs operations all over the world. Stakeholders are concerned that the company
complies with relevant regulations and statutory requirements and that there is adequate
disclosure.
(d) Amnesty International is a not-for-profit organization, which raises funds
internationally and must comply with certain regulations to retain a tax-free status. A
financial audit might be important to people who contribute to the organization in order

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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.

1.8 Setting Audit Objectives Based on Management Assertions

1-28. Management Assertions and Audit Objectives. The following are management
… (h) … payable discounts is taken.
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.

B. For each specific audit objective, identify the appropriate management assertion.

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SPECIFIC AUDIT OBJECTIVE MANAGEMENT

ASSERTION
a. Existing accounts payable are included in the accounts 4. Completeness
payable balance on the balance sheet date.
b. Accounts payable are recorded in the proper account. 5. Valuation and
allocation
c. Acquisition transactions in the acquisition and payment 7. Cutoff
cycle are recorded in the proper period.
d. Accounts payable representing the accounts payable 5. Valuation and
balance on the balance sheet date agree with related allocation
subsidiary ledger amounts, and the total is correctly added 6. Accuracy
and agrees with the general ledger.
e. Accounts in the acquisition and payment cycle are 2. Occurrence
properly disclosed according to IASs. 3. Rights and
obligations
f. Accounts payable representing the accounts payable 5. Valuation and
balance on the balance sheet date are valued at the correct allocation
amount.
g. Accounts payable exist. 1. Existence
h. Any allowances for accounts payable discounts is taken. 5. Valuation and
allocation

1.9 The Audit Process Model

1-29. Audit Process Model. What are the four Phases of an Audit? Discuss each.
Determine which is the most important of the four and explain why.
The four phases of the audit process model are: Phase I, Client Acceptance; Phase II,
Planning; Phase III, Testing and Evidence; and Phase IV, Evaluation and Reporting.
Phase I, Client Acceptance: The client acceptance phase of the audit plan, Phase I,
involves determining both acceptance of a client and acceptance by a client as well as
deciding on acquiring a new client or continuation of relationship with an existing one
and the type and amount of staff required. The procedures involved in this process are:
(1) Evaluate the client’s background and reasons for the audit. (2) Determine whether
the auditor is able to meet the ethical requirements regarding the client. (3) Determine
need for other professionals. (4) Communicate with predecessor auditor. (5) Prepare
client proposal. (6) Select staff to perform the audit, and (7) Obtain an engagement
letter.
Phase II, Planning: Determine the amount and type of evidence and review required
to give the auditor assurance that there is no material misstatement of the financial
statements. Procedures are: (1) Perform audit procedures to understand the entity and its
environment, including the entity’s internal control; (2) Assess the risks of material
misstatements of the financial statements. (3) Determine materiality; and

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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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1.10 International Public Accountancy Firms

1-31. Auditor Responsibility. Four friends who are auditing student’s … client’s
responsibility. Which student is correct and why?
Yalanda is correct. The CLIENT has the responsibility for the adequacy of disclosure in
the financial statements and footnotes. The financial statements are the responsibility of
management – the auditor’s responsibility is to lend them credibility. The partner in
charge of the audit is the most responsible for the correctness of the audit. If the proper
procedures are not followed it is the partner in charge who must take the blame. Even
though the staff auditor may draft the wording of the disclosure footnotes and suggest
modifications in the financial statements, they are not responsible for the adequacy of
disclosure.

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

1-33. International Standards on Auditing (ISA). Download the latest version of

Handbook Of International Auditing, Assurance, And Ethics Pronouncements from the
IFAC website www.IFAC.org. Pick one ISA and discuss how that standard would
influence the work of an auditor.
Students may pick any of the standards and may have different things to say. This is
meant as an open question to get the student familiar with the IFAC handbook. It is
downloadable and free, so everyone should have a copy.

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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B. How many years of education must an auditor have before certification?

B. An auditor must have a university or similar level degree before certification.

C. Name some of the requirements for the work of auditors.

C. Examples are competence, independence.

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.

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

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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 & 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 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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Robert A. Prentice. 1995. “Can The Contributory Negligence Defense Contribute To A

Defusing Of The Accountants’ Liability Crisis?”. Wisconsin International Law Journal.
Spring. no 13, p. 359.

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.

Jodi B. Scherl. 1994. “Comment: Evolution Of Auditor Liability To Noncontractual

Third Parties: Balancing The Equities And Weighing The Consequences”. The
American University Law Review. Fall, number 44, p. 255.

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.
1
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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