Chapter 5 Audit Responsibilities and Objectives

Transcription

1 Chapter 5 Audit Responsibilities and Objectives Opening Vignette: When is it Worth Bothering? 1. Since this is an opinion question, students could answer yes or no. The arguments for yes are that it encourages honesty, since employees know that if they do steal or engage in other acts of fraud, that they will be prosecuted. It also encourages employees to do their jobs conscientiously and supports attitudes of honesty and integrity. The arguments for no pertain primarily to cost. Also, questions would arise about whether there are then any penalties for employees who steal. Are they terminated or are other actions taken? 2. Joe might also believe that other controls or actions that save small costs (which could aggregate to large ones) are not worth implementing. He also might believe that it is unimportant to have highly accurate data, since small errors might not have an impact. Joe does not seem to care about unethical behaviour with respect to fraud because he feels that he has no control over his staff s attendance at the job. He seems to have responded to this frustration by deciding that he is not going to care about certain types of unethical behaviour, such as theft of assets. This might mean that Joe is not paying attention to other controls at the organization, and might not even be doing the monitoring that could be part of his job. 3. Diane could ask many questions, but they should focus on several related topics: (1) whether managers and executives are doing monitoring, how and when, (2) how they are providing supervision to their employees (3) what consequences are provided when unethical or illegal behaviour is encountered. Diane should also talk to the other team members and escalate the risks associated with fraud risk for this client. Dianne might ask other managers or executives how they deal with fraud that is detected in their departments. She might also ask about error correction policies and practices, and whether all errors (or at what threshold) errors are corrected. Concept Check Answers C5-1 The auditor cannot conduct the audit if reliance cannot be placed on management. Management is responsible for preparing the financial statements and the underlying records (with internal controls) and provides supporting information to the auditors. Absent this responsibility, the auditor cannot rely upon the financial statements or the underlying records, making it impossible to conduct the audit. C5-2 Management can more readily override internal controls and hide what it has done. This makes it more difficult to detect management fraud. Copyright 2013 Pearson Canada Inc. 1

2 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition C5-3 Indirect-effect illegal acts have an indirect effect on financial statements that may have a material effect that cannot be measured. For example, the company could be subject to large fines due to tax fraud or environmental pollution. C5-4 The auditor annually considers the risk associated with the financial statement audit, and may choose not to conduct a high-risk engagement. C5-5 Clients may need an audit for statutory reasons (for example, because they are public companies or in a regulated industry). They may also require an audit to be accountable to their shareholders or their debt holders, such as a bank. C5-6 The sections of an engagement letter and the relevance of each are listed below. Objectives, scope, and limitations: Describes the type of engagement and the inherent limitations of an audit. May help to limit liability if fraud is present and not detected. Our responsibilities: Describes the auditor s responsibilities during the audit. Helps to describe what will be done for the fee stated. Management s responsibilities: Describes management responsibilities for the various components of internal control, for provision of information, and for the preparation of the financial statements. This section is important as the auditor must rely upon management and be able to have evidence of management assuming responsibility for these areas. Coordination of the audit: Helps explain who will be doing what and when. If the client will be preparing specific working papers, then this information can be identified. Fees: Spells out the charge for the audit. Helps to reduce potential disagreement on fees. C5-7 The auditor identifies risks of various types during the risk assessment phase (for example, risks of potential misstatement of the financial statements, fraud risks). The purpose of risk response is to design audit procedures that help the auditor determine whether the risks have resulted in errors to the financial statements, in the context of materiality and desired assurance (i.e., audit risk). C5-8 Quality control procedures occur during every phase of the audit, by means of supervision, review, and ongoing evaluation of the information that has been gathered or is the results of tests. The information obtained is also evaluated to decide whether the risk assessment needs to be modified. C5-9 General controls are an example of entity-level controls. Since entity-level controls affect all cycles, they will need to be documented and assessed prior to the audit of the cycles. C5-10 Cycles allow the auditor to assess the client's systems and transactions in manageable segments. Dividing the financial statements into smaller segments or components makes the audit more manageable and aids in the assignment of tasks to different Copyright 2013 Pearson Canada Inc. 2

3 members of the audit team. C5-11 There are five cycles used in this text: sales and collection; human resources and payroll ; acquisition and payment; inventory and distribution; capital acquisition and repayment. C5-12 Management assertions are implied or expressed statements by management describing the quality of the information that is included in the underlying records and in the financial statements. Management assertions are directly related to the aceptable accounting principles used in relation to an appropriate financial reporting framework to record transactions and events and disclose information in the financial statements. C5-13 The auditor collects evidence about each of the management assertions that pertain to material events, balances, disclosures, or classes of transactions in the financial statements. To target field work, the auditor uses audit objectives linked to management assertions; these objectives are more detailed than management assertions. C5-14 The three different types of audit objectives are transaction-related, balance-related, and presentation and disclosure-related. Completeness of sales transactions refers to recording all sales transactions (i.e., none are missed). Completeness of inventory balances would mean that all inventory is counted and included in the general ledger account. Complete disclosure of inventory would include disclosure of the types of inventory, the amounts in each type, and any liens or attachments to inventory. Review Questions 5-1 The objective of the ordinary examination of financial statements by the independent auditor is the expression of an opinion on the fairness with which the financial statements present financial position, results of operations, and changes in cash flows in conformity with an acceptable financial reporting framework. The auditor meets that objective by accumulating sufficient appropriate audit evidence to determine whether the financial statements are fairly stated. 5-2 It is management s responsibility to adopt sound accounting policies, maintain adequate internal control, and make fair representations in the financial statements. The auditor s responsibility is to conduct an audit of the financial statements in accordance with generally accepted auditing standards and report the findings of the audit in the auditor s report. 5-3 Two important characteristics of professional skepticism are a questioning mind (to set aside any prior beliefs) and the need to conduct a critical evaluation of the audit evidence (being especially careful when relying upon the representations of management). Copyright 2013 Pearson Canada Inc. 3

4 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition 5-4 Errors are unintentional misstatements of the financial statements. Fraud and other irregularities are intentional misstatements. The auditor is responsible for conducting the audit in accordance with generally accepted auditing standards. In most cases, that will result in finding material errors in the financial statements. In many cases, it will also uncover material fraud and other irregularities. An audit must be designed to provide reasonable assurance of detecting material misstatements in the financial statements. Further, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the engagement. As part of this process, the auditor considers the risks of fraud during the engagement, and examines management s processes to prevent and detect fraud. With fraud, there is an attempt at concealment of fraud and other irregularities, making fraud and other irregularities more difficult to uncover. Auditors, therefore, have less responsibility to detect fraud and other irregularities than errors, but there is still considerable responsibility. The auditors best defence when material misstatements (either errors or fraud) are not uncovered in the audit is that the audit was conducted in accordance with generally accepted auditing standards. 5-5 Employee fraud is the theft of assets by employees. Management fraud is the intentional misstatement of financial information by management or a theft of assets by management. Employee fraud ordinarily occurs because of either inadequate internal control or a violation of that internal control. The best way to prevent employee fraud is through adequate internal control that functions effectively. Many times employee fraud is relatively small in dollar amounts and will have no effect on the fair presentation of the financial statements. There are also the cases of large employee frauds that result in bankruptcy to the company. Management fraud is inherently difficult to uncover because it is possible for one or more members of management to override internal control. Fraud and other irregularities may include misstatements of the financial statements and theft of assets. In many cases, the amounts are extremely large and may affect the fair presentation of the financial statements. In addition, in many cases, it is difficult to detect management fraud. 5-6 Illegal acts were defined in the CICA Handbook Section 5136 as a violation of a domestic or foreign statutory law or government regulation attributable to the entity under audit, or to management or employees acting on the entity s behalf. Two examples of illegal acts are a violation of income tax laws, and a violation of an environmental protection law. CAS 250 uses the term non-compliance with respect to laws and regulations rather than the term illegal acts. CICA Handbook Section 5136 indicated that the auditor s responsibility is to conduct the audit in accordance with GAAS (par. 09). Some specifics that the auditor needs to do are as follows: Identify laws and regulations that are relevant to the client Assess inherent risk with respect to the likelihood of violation Conduct audit procedures in response to assessed inherent risk Make enquiries of management and obtain written representation to that effect Inform the audit committee or equivalent if evidence confirming an illegal act or potential illegal act is present Copyright 2013 Pearson Canada Inc. 4

5 CAS 250 has similar requirements that include assessing the actions that the client is taking to determine compliance with its regulatory framework. The auditor s assessment of the client s actions consist of primarily inquiry of management and inspection of correspondence with regulatory or licensing organizations. The auditor is also required to remain alert (an example of the use of professional skepticism). These actions are described in CAS 250, paragraphs 12 to Prior to accepting a client, the auditor should investigate the client. The primary purpose is to evaluate the integrity of the client and the possibility of management fraud. The auditor should be especially concerned with the possibility of management fraud since it is difficult to uncover. The auditor does not want to needlessly expose him- or herself to the possibility of a lawsuit for failure to detect such fraud. 5-8 An engagement letter is an agreement between the public accounting firm and the client concerning the conduct of the audit and related services. It should state what services will be provided, whether any restrictions will be imposed on the auditor s work, deadlines for completing the audit, and assistance to be provided by client personnel. The engagement letter also informs the client that the auditor is not responsible for the discovery of fraud. 5-9 Refer to Figure 5-1. Students would use the left column of to describe the phase and could list any of the actions from the right column of to provide an example of an activity completed in the phase The cycle approach is a method of dividing the audit such that closely related types of transactions and account balances are included in the same cycle. For example, sales, sales returns, cash receipts transactions, and the accounts receivable balance are all a part of the sales and collection cycle. The advantages of dividing the audit into different cycles are to divide the audit into more manageable parts, to aid in the assignment of tasks to different members of the audit team, and to help in keeping closely related parts of the audit together There is a close relationship between each of these accounts. Sales, sales returns and allowances, and cash discounts all affect accounts receivable. Allowance for uncollectible accounts is closely tied to accounts receivable and should not be separated. Bad debts is closely related to allowance for uncollectible accounts. To separate these accounts from each other implies that they are not closely related. Including them in the same cycle helps the auditor keep their relationship in mind. Note however that although the goods and services tax is related to sales, it is included in the acquisition and payment cycle because it is essentially a flow-through account and because the unremitted tax represents a liability Entity level controls are part of the control environment, and could also be part of general computer controls. They affect all cycles. Corporate governance controls, an example of entity level controls, include policies and procedures over all transactions. If the quality of entity level controls is poor, then the auditor might expect transaction level controls to also be poor. Copyright 2013 Pearson Canada Inc. 5

6 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition 5-13 General audit objectives follow from and are closely related to management assertions. Audit objectives, however, are intended to provide a framework to help the auditor accumulate sufficient appropriate audit evidence required by the third examination standard. Audit objectives are more useful to auditors than management assertions because they are more detailed and more closely related to helping the auditor accumulate sufficient appropriate audit evidence All three of these groups of specific audit objectives follow from the general audit assertions. However, the specific audit objectives are varied for the type of audit testing being done. Transaction-related audit objectives apply to transactions and how they are processed. Balance-related audit objectives are used for year-end balances, while presentation and disclosure-related audit objectives are used to assess the quality of the presentation and disclosure of the figures, descriptions and notes in the financial statements Recording Misstatement Repair expense is recorded in the wrong accounting period. Expense is capitalized as a capital asset rather than expensed as a repair. Transaction-related Audit Objective Violated Cutoff: Transaction near the balance sheet date is recorded in the proper period. Classification: Transactions included in the client s records are properly classified Two presentation and disclosure assertions are affected. If disclosures are incomplete, then the presentation and disclosure audit objective of completeness has not been met, which pertains to the management assertion of completeness. If the statements are difficult to read, then the presentation and disclosure objective of understandability has been violated, which corresponds to the management assertion of understandability also The existence objective deals with whether amounts included in the financial statements actually exist. Completeness is the opposite of existence. The completeness objective deals with whether all amounts that should be included have actually been included. In the audit of accounts receivable, an invalid (or non-existent) account receivable will lead to overstatement of the accounts receivable balance. Failure to include a customer s account receivable balance, that is a violation of completeness, will lead to understatement of the accounts receivable balance For the specific objective, all recorded capital assets exist at the balance sheet date; the management assertion and the general balance-related audit objective are existence. Discussion Questions and Problems 5-19 a. 1. The function of the auditor in the audit of financial statements is to provide users of the statements with an informed opinion as to the fairness with which the statements portray Copyright 2013 Pearson Canada Inc. 6

7 financial position, the results of operations, and cash flows in accordance with an acceptable financial reporting framework. The financial reporting framework presumes that accounting principles were applied on a basis consistent with that of the preceding year. 2. The responsibility of the independent auditor is to express an opinion on the financial statements he or she has examined. Since the financial statements are the representation of management, responsibility rests with management for the proper recording of transactions in books of account and computing records, for the safeguarding of assets, and for the substantial accuracy and adequacy of the financial statements. In developing the basis for his or her opinion, the auditor is responsible for making an examination that conforms to generally accepted auditing standards. These standards constitute the measure of the adequacy of his or her examination. The qualified professional accountant must exercise judgment in selecting the procedures he or she uses in the examination and in arriving at an opinion. In presenting himself or herself to the public as an independent auditor, he or she makes himself or herself responsible for having the capabilities expected of a qualified person in that profession. Such qualifications do not include those of an appraiser, business valuator, expert in materials, expert in styles, insurer, or lawyer. The public accountant is entitled to rely upon the judgment of experts in these other areas of knowledge and skill. b. Audits cannot be expected to provide the same degree of assurance for the detection of material management or employee fraud as is provided for an equally material error. The difficulty of detecting fraud, because of the effort at concealment by employees or management, makes fraud more difficult for auditors to find. The cost of providing equally high assurance for detection of management fraud and errors is economically impractical for both auditors and society. Auditors do, however, have considerable responsibility for finding material management and employee fraud, as the risks of fraud must be explicitly considered. In recent years there has been increased emphasis on auditors responsibility to evaluate factors that may indicate an increased likelihood that management fraud may be occurring. For example, assume that management is dominated by a president who makes most of the major operating and business decisions himself. He has a reputation in the business community for making optimistic projections about future earnings and then putting considerable pressure on operating and accounting staff to make sure those projections are met. He has also been associated with other companies in the past that have gone bankrupt. These factors, considered together, may cause the auditor to conclude that the likelihood of management fraud is fairly high. In such a circumstance, the auditor should put increased emphasis on searching for material management fraud. The auditor may also uncover circumstances during the audit that may cause suspicions of management fraud. For example, the auditor may find that management lied about the age of certain inventory items. When such circumstances are uncovered, the auditor must evaluate their implications and consider the need to modify audit evidence. The auditor would also need to consider how this affects the decisions regarding management integrity and whether the audit can be conducted with a presumption of management integrity. Adequate internal control (including processes to identify risks of fraud and mitigate such risks) should be the principal means of thwarting and detecting fraud. To rely entirely on an Copyright 2013 Pearson Canada Inc. 7

8 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition independent auditor s examination for the detection of employee fraud would require expanding audit field work to the extent that the cost might be prohibitive. Moreover, the examination might not uncover certain types of fraud involving unrecorded transactions, forgeries, or collusion. Good internal controls and fidelity bonds probably supply the more effective and economic safeguards against fraud. Similar to what is done for assessing the likelihood of material management fraud, the auditor should also evaluate the likelihood of material employee fraud. That is normally done initially as a part of understanding the entity s internal control and assessing control risk. Audit evidence should be expanded when the auditor finds an absence of adequate controls or failure to follow prescribed procedures, if he or she believes material fraud or other irregularities could result. The independent auditor is not an insurer or guarantor. His or her implicit obligation in an engagement is that the examination be made with due professional skill and care in accordance with generally accepted auditing standards. That fraud, existing during the period covered by the independent auditor s examination, was discovered later, does not on its own indicate negligence by the auditor. c. If the independent auditor s examination uncovers circumstances arousing suspicion as to the existence of fraud, he or she should weigh their effect on the opinion on the financial statements. When he or she believes the amount of the possible fraud is material, the matter must be investigated before an opinion is given. The auditor is also required to communicate results to the appropriate level of management, and potentially to regulatory authorities as well True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the auditor must not accept management s representations blindly. The auditor must, whenever possible, obtain competent evidential matter to support the representations of management. As an example, if management represents that certain inventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the inventory is being sold at a price that is higher than the company s cost plus selling expenses. If management represents an account receivable as being fully collectible, the auditor should be able to examine subsequent payments by the customer or correspondence from the customer that indicates a willingness and ability to pay Note to instructor: Use the fraud triangle in Chapter 9 to facilitate discussion of this material. a. Management fraud is often called fraudulent financial reporting, and is the intentional misstatement or omission of amounts or disclosures by management with the intent to deceive users. In contrast, defalcations, which are also called misappropriation of assets, involve theft of an entity s assets, and normally involve employees and others below the management level. b. The auditor s responsibility to detect management fraud is the same as for other errors that affect the financial statements. The auditor should design the audit to detect errors and fraud that are material to the financial statements. c. The auditor should evaluate the potential for management fraud using the fraud triangle of incentives/pressures, opportunities, and attitudes/rationalization (discussed in Chapter 9): Copyright 2013 Pearson Canada Inc. 8

9 Incentives/pressures: Auditors should evaluate incentives and pressures that management or other employees may have to misstate financial statements, including: o declines in the financial stability or profitability of the company due to economic, industry or company operating conditions o pressure to meet debt repayment or debt covenant terms o net worth of managers or directors is materially threatened by financial performance Opportunities: Circumstances provide an opportunity for management to misstate financial statements, such as: o Financial statements include significant accounting estimates that are difficult to verify o Ineffective board of director or audit committee oversight o High turnover in accounting personnel or ineffective accounting, internal audit, or information systems personnel Attitudes/rationalization: An attitude, character, or set of values exist that allows management to rationalize committing a dishonest act, for example: o inappropriate or ineffective communication of entity values o history of violations of securities laws or other laws and regulations o aggressive or unrealistic management goals or forecasts. d. There are potentially many factors that should heighten an auditor s concern about the existence of management fraud. The factors (1) of an intended public placement of securities, and (2) management compensation dependent on operating results are both factors that affect incentives to manipulate financial statements. The auditor should be alert for other incentives, such as the existence of debt covenants or planned use of stock to acquire another company that may provide incentives to manipulate the financial statements. The third factor of weak internal control reflects both an opportunity for misstatement of financial statements, and an attitude that allows rationalization of actions to misstate the financial statements. As additional examples, the auditor should be alert to the potential to use accounting estimates or discretion over the timing of revenues to misstate financial statements. The auditor should also consider the attitude of management, and whether they are overly aggressive or have previously violated securities laws or other regulations. In addition to the risk factors from the fraud triangle, the auditor should consider other signals of the potential existence of management fraud. These signals may include unusual changes in ratios or other performance measures, as well as unusual or inconsistent results of enquiries of management and communication among the audit team The auditor should obtain a signed engagement letter this year, even though this is a repeat engagement. Explanations: There has been a significant change in the senior management of the client (both controller and president are new). Both new senior managers appear to lack understanding of the audit process and issues, since they requested a reduced fee but then changed their mind after Tim explained the audit process to them. Copyright 2013 Pearson Canada Inc. 9

10 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition The client is expanding into a new area of business exporting to Asia, which will likely bring more complicated accounting and audit issues. There are changes in GAAP this year as the client can no longer use differential reporting AUDIT ACTIVITIES a Examine invoices supporting recorded fixed asset additions b Review industry databases to assess the risk of material misstatement in the financial statements. c Summarize misstatements identified during testing to assess whether the overall financial statements are fairly stated. d Test computerized controls over credit approval for sales transactions. e Send letters to customers confirming outstanding accounts receivable balances. f Perform analytical procedures comparing the client with similar companies in the industry to gain an understanding of the client s business and strategies. g Compare information on purchases invoices recorded in the acquisitions journal with information on receiving reports. AUDIT PHASE Phase 5 Tests of control OR Phase 6 Substantive tests Phase 2 Client risk profile Phase 7 Ongoing evaluation, quality control and final evidence gathering Phase 5 Tests of control Phase 6 Substantive tests Phase 2 Client risk profile Phase 5 Tests of control OR Phase 6 Substantive tests 5-24 a. Cycle Balance Sheet Accounts Income Statement Accounts Sales and collection Accounts receivable Cash Notes receivable trade Allowance for doubtful accounts Interest receivable Sales Bad debt expense Interest income Acquisition and payment Income tax payable Accounts payable Unexpired (prepaid) insurance Furniture and equipment Cash Accumulated amortization of furniture and equipment Inventory Property tax payable Income tax expense Advertising expense Travel expense Purchases Property tax expense Amortization expense furniture and equipment Telephone and fax expense Insurance expense Copyright 2013 Pearson Canada Inc. 10

11 Payroll and personnel Inventory and distribution Capital acquisition and repayment Cash Accrued sales salaries Inventory Bonds payable Common stock Cash Notes payable Retained earnings Prepaid interest expense Rent expense Sales salaries expense Salaries, office and general Purchases Interest expense b. The general ledger accounts are not likely to differ much between a retail and a wholesale company unless there are departments for which there are various categories. There would be large differences for a hospital or government unit. A government unit would use the fund accounting system and would have entirely different titles. Hospitals are likely to have several different kinds of revenue accounts, rather than sales. They are also likely to have such things as drug expense, laboratory supplies, etc. At the same time, even a government unit or a hospital will have certain accounts such as cash, insurance expense, interest income, rent expense, that are common to most types of businesses a. The first objective (existence) concerns the possibility that there are included on the list of accounts payable, amounts that should not be included because there is no payable to such vendor. The objective concerns only the overstatement of accounts payable. The second objective (completeness) concerns the possibility of accounts payable that should be included but that have not been included. This objective concerns only the possibility of understated accounts payable. b. For accounts payable, the auditor is usually most concerned about understatements. An understatement of accounts payable is considered, by most auditors, more important than overstatements because of potential legal liability. The completeness objective is therefore normally more important in the audit of accounts payable. The auditor is also concerned about overstatements of accounts payable. The existence objective is also therefore important in accounts payable, but usually less so than the completeness objective. Copyright 2013 Pearson Canada Inc. 11

12 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition 5-26 AUDIT PROCEDURE A B C D E F G H I J K L TRANSACTION RELATED AUDIT OBJECTIVE 1. Occurrence 3. Accuracy (summarization and posting) 3. Accuracy (summarization and posting) 2. Completeness 4. Cutoff 3. Accuracy (summarization and posting) BALANCE- RELATED AUDIT OBJECTIVE 8. Completeness (detail tie-in) 9. Valuation and 10. Allocation 6. Existence 9. Valuation and 10. Allocation 6. Existence PRESENTATION AND DISCLOSURE AUDIT OBJECTIVE 11. Occurrence and 12. Rights and obligations 13. Completeness 16. Classification and 17. Understandability Copyright 2013 Pearson Canada Inc. 12

13 Professional Judgment Problem 5-27 Audit Phase Execution problem Recommendation for improvement 2 Client risk profile 3 Plan the audit 4 Design further audit procedures 5 Tests of controls 6 Substantive tests 7 Ongoing evaluation, quality control and final evidence gathering 8 Complete quality control and issue audit report - analytical review may not have been complete (it should have shown that the tax provision was a different percentage) - inadequate staff has been assigned - specialist staff has not been assigned to help with the tax provision - junior staff do not understand the technical issues that they need to deal with at the audit - audit procedures to deal with the tax provision were not provided - these tests may have been poorly done due to inadequate supervision - these tests may have been poorly done due to inadequate supervision - staff conducting field tests were inadequately supervised - tax provision was not adequately reviewed, resulting in errors - final analytical review may not have been conducted, which may have detected the problem with the tax provision - the incorrect audit report was issued, as the tax provision was materially in error - as discussed above, the tax provision was in error (not checked in final review by sufficiently competent personnel) 1. be sure to carefully conduct analytical review and have the results assessed by competent personnel 2. identify complex areas that require specialist assistance and are prone to error 3. if supervisors did not have enough time to supervise staff, then managers or partners should have gone out to the client instead 4. assign the tax department to review complex tax sections before the audit is finalized See 4. above See 3. above See 3. above See 3. and 4. above 5. be sure to have second partner review or high risk review for engagements and high risk areas See 4. and 5. above Copyright 2013 Pearson Canada Inc. 13

14 Instructor s Solutions Manual for Arens et al., Auditing, Canadian 12 th Edition Case 5-28 a. A review provides limited assurance about the fair presentation of financial statements in accordance with an acceptable financial reporting frameworkd but far less assurance than an audit. Presumably, the bank decided that the assurances provided by a review were needed before a loan could be approved, but an audit was not necessary. A review includes a PA firm performing analytical procedures, making inquiries about the fair presentation of the statements, and examining the information for reasonableness. Because of a PA firm s expertise in accounting, the accountant from the PA firm can often identify incorrect presentations in the financial statements that have been overlooked by the accountant for the company. Reviews are common for smaller privately-held companies with relatively small amounts of debt. The bank probably did not require an audit because the additional cost of an audit was greater than the benefit the bank perceived. In many cases, the decision as to whether to have a review or an audit is negotiated between the company seeking a loan and the bank loan officer. Both the company and the bank have options in negotiating such things as the amount of the loan, the rate of interest, and whether to require an audit or a review. The bank can reject the loan request and the company can go to other banks that want to make loans. Frequently, banks have a list of PA firms in which they have considerable confidence due to their reputation in the community or past work they have done for other bank customers. b. Because the amount of the loans from the bank to Ritter increased, the bank probably wanted additional assurance about the reliability of the financial statements. It is also likely that Rene Ritter negotiated the one percent reduction of the interest rate by offering to have an audit instead of a review. A one percent reduction in the interest rate saves Ritter $40,000 annually compared to the $15,000 additional fee for an audit. c. Rene referred to the PA firm as partners in a professional sense, not a business sense. The PA firm had provided many consulting and tax services, as well as providing review and audit services over the entire business life of the company. Rene recognized that these professional services had contributed to the success of the business and she chose to acknowledge those contributions during her retirement comment. Assuming that the PA firm retained an attitude of independence throughout all audits and reviews, no violation of professional independence standards occurred. Most well run PA firms provide consulting, tax, and assurance service for their privately held clients without violating independence requirements. d. As the external auditor, the firm of Gonzalez & Fineberg provides the shareholders, creditors, and management an independent opinion as to the fair presentation of the financial statements. Given the potential biases present when management prepares the financial statements, the shareholders and creditors must consider the potential for information risk that might be present. The independent audit conducted by Gonzalez & Fineberg helps shareholders and creditors reduce their information risk. Management also benefits by having the external auditors independently assess the financial statements even though those statements are prepared by management. Due to the complexities involved in preparing financial statements in accordance with an acceptable financial reporting framework, the potential for misstatement on Copyright 2013 Pearson Canada Inc. 14

15 the part of management increases the need for an objective examination of those financial statements by a qualified independent party. e. The auditor is responsible for obtaining reasonable assurance that material misstatements are detected, whether those misstatements are due to errors or fraud. To obtain reasonable assurance, the auditor is required to gather sufficient, appropriate evidence. Auditors chief responsibility to shareholders, creditors, and management is to conduct the audit in accordance with auditing standards in order to fulfill their responsibilities of the engagement. Ongoing Small Business Case 5-29 a. [Three general ledger accounts are listed for each cycle; others are possible] Financial statement cycle Sales and collection Acquisition and payment Payroll and personnel Capital acquisition and repayment Likely general ledger accounts Cash in bank Due from Credit Card Clearing Agency GST payable (or HST payable) Cash in bank Due to Credit Card Supplies Cash in bank Wage expense Employee benefits Cash in bank Share capital Retained earnings (or deficit) b. The student would use flowchart symbols to describe how sales are processed. c. Using Table 5-6, the student could describe any of the assertions listed under the columns titled Audit Objectives about transactions or events. Copyright 2013 Pearson Canada Inc. 15