CHAPTER 1
AN INTRODUCTION TO AUDITING
AND ASSURANCE SERVICES
Answers to Review Questions
1-1 There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between the owner and manager. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be the most cost-effective form of monitoring.
The empirical evidence suggests auditing was demanded prior to government regulation. In 1926, independent auditors audited 82 percent of the companies on the New York Stock Exchange. Additionally, many private companies and municipalities not subject to government regulations such as the Securities Act of 1933 and Securities Exchange Act of 1934 also demand auditing.
1-2 The agency relationship between an owner and manager produces a natural conflict of interest because of the information asymmetry that exists between the manager and the absentee owner. That is, the manager generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner.
1-3 Auditing (broadly defined) is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.
Attest services occur when a practitioner is engaged to issue or does issue a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. Assurance services are independent professional services that improve the quality of information, or its context, for decision makers.
1-4 The phrase systematic process implies that there should be a well-planned approach for conducting an audit that involves objectively obtaining and evaluating evidence.
1-5 The four elements in the accountability cycle are: governance, measurement, management systems, and reporting. Governance includes an independent board of directors who hold the chief executive officer and his management team accountable to the corporation’s shareholders and outside constituencies. Measurement is concerned with meshing nonfinancial measures with financial ones to measure performance. Corporations establish objectives and critical success factors, and then measure their performance against those factors. Management systems focus on planning and control. Planning and control starts with the corporate strategy and leads to objectives and critical success factors, and the establishment of measures. Management plans initiatives to achieve the objectives, and establishes targets and budgets for each initiative. Reporting involves two levels. First, there is detailed internal reporting based on various measures that are seldom disclosed to external parties. Second, there is the required financial reporting to shareholders and regulatory agencies.
1-6 Major pension funds, such as TIAA-CREF and CalPERS control significant amounts of stock, and thus are concerned that corporate managers being held accountable for their performance to stockholders. These groups play a major part in implementing reforms in the area of corporate governance.
1-7 Auditors add value to information in the accountability cycle by increasing the reliability and credibility of information. Auditors can provide assurance on an entity’s activities and its reporting.
1-8 Examples of compliance audits include (1) company auditors determining whether corporate rules and policies are being followed by departments within the organization, (2) an examination of tax returns of individuals and companies by the Internal Revenue Service for compliance with the tax laws, and (3) an audit under the Single Audit Act of 1984 to determine whether an entity receiving federal assistance is in compliance with applicable laws or regulations.
Examples of operational audits include (1) an audit by the GAO of the Food and Drug Administration to determine the efficiency and effectiveness of procedures for introducing new drugs to the market, (2) an entity examining the effectiveness and efficiency of funds being spent on computer resources, and (3) a university examining the effectiveness and efficiency of student advisory services.
Examples of forensic audits include (1) an examination of cash disbursements for payments to unauthorized vendors, (2) assistance in tracing laundered monies by organized criminals, and (3) identifying hidden assets as part of a divorce settlement.
1-9 Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3) government auditors, and (4) forensic auditors.
1-10 The issues currently affecting the audit process are: expanded services, litigation, earnings management and fraud, independence issues, and globalization.
Answers to Multiple-Choice Questions
1-11 / B / 1-16 / A1-12 / B / 1-17 / D
1-13 / A / 1-18 / C
1-14 / B / 1-19 / D
1-15 / C / 1-20 / B
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