Test Bank Knechel/Salterio/Ballou, Auditing: Assurance & Risk, 3/E

Test Bank Knechel/Salterio/Ballou, Auditing: Assurance & Risk, 3/e

Chapter 1

Chapter 1, Assurance and Auditing

Questions

1. What are the potential consequences of relying on information that is misleading, incomplete, or confusing?

1. Describe the important information risks that investors face when making decisions based on financial reports.

1. Explain why the financial statement audit is important to stakeholders.

1. Briefly explain the natural demand for auditing.

1. Describe the history of auditing prior to the modern era, explaining the evolution of the focus of audits over time.

1. The demand for auditing can develop naturally or can be mandated by government regulation. Which do you think is most important in the evolution of auditing through history?

1. Explain the importance of reliable information for a large manufacturing company, a small business, a not-for-profit entity and a government organization

1. How does the modern business environment impact the need for relevant and reliable data?

1. What two competing forces influence managers’ decisions to misstate (or not misstate) financial results for their own benefit?

1. Information asymmetry may impact managers and stakeholders. Define this term and explain two situations where incentives and information asymmetry may create potentially dysfunctional distrust.

1. Why should stakeholders be knowledgeable about an organization’s approach to ethics?

1. Describe different ways an individual may react when faced with decisions that are ethically questionable?

1. Why does full and complete disclosure discourage unethical decisions?

1. Explain the importance of and the difference between financial literacy and financial experts with regard to the audit committee.

1. Explain the role and importance of the compensation committee.

1. Why is the effectiveness of internal auditors potentially limited?

1. Explain the requirements and limitations of external auditors.

1. What powerful lesson did the auditing profession learn from the Enron/Andersen tragedy?

1. What three conditions must be met before an auditor undertakes an assurance engagement?

1. What four conditions affect an auditor’s attestation engagement?

1. What are the general requirements (legal and otherwise) for becoming a licensed public accountant?

Problems

1. Explain the role of the internal auditors and external auditors in corporate governance.

1. Compare and contrast assurance, attestation and financial statement audit.

1. Describe examples of assurance services and give an illustrative example.

1. Describe the CPA licensing process in the United States.

1. Using the examples of Enron, describe different ways individuals react when faced with decisions that are ethically questionable.
2. Note to Professors: This question can be broadened or narrowed, depending on what actual cases you have discussed or assigned.

1. Which of the following claims is amenable to attestation? What problems does each assertion cause with regard to attestation?
2. “Smith Company’s total assets grew 13% compared to last year.”
3. “Diet Rite’s market share in 2005 increased 46%.”
4. “We, the Islamic Republic of Iran meet the requirements of the International Atomic Energy Agency.”
5. “Pepsi’s products are the best soft drinks available.”
6. “My business lunch expenses today were $43.29.”
7. “The Jones Manufacturing Company is in compliance with all OSHA standards.”
8. “Our new drug will provide the best chance for cancer patients.”
9. “Our lotion reduces the appearance of wrinkles due to aging better than competing products.”

1. Consider the information needs of a locally owned convenience store and a national grocery chain.
2. What information needs are similar?
3. What information needs are different?
4. How does each company collect and process information?

1. How are audits regulated in the USA?

ANSWERS

Questions

1. What are the potential consequences of relying on information that is misleading, incomplete, or confusing?
2. Low quality information can lead to poor decisions. Decisions which rely on inaccurate information may lead to unexpected or unacceptable outcomes, including financial losses.

1. Describe the important information risks that investors face when making decisions based on financial reports.

1. Objectivity: Biased information may entice an investor to purchase shares in a company that is intentionally overvalued.
2. Relevance: Irrelevant information may emphasize facts that appear important but are not relevant to the company’s future prospects
3. Accuracy: Information may be inaccurate, whether by accident or through intentional manipulation by the management of a company.
4. Confidentiality: The company may choose to hide sensitive information from outsiders, especially information that might have a negative impact on the company’s value.
5. Complexity: Complexity renders some accounting difficult to understand, which may be used by a company to confuse investors.

1. Explain why the financial statement audit is important to stakeholders.
2. Honesty and competence: An audit helps keep management honest and motivated to do a good job, because they are being checked.
3. Expertise: Many stakeholders (employees, casual investors, politicians, etc.) are not sufficiently knowledgeable to evaluate the quality of financial statements.
4. Cost of capital: The audit reduces the risk of unreliable information and, therefore, also reduces the risk of surprises and improves investment decisions.
5. Insurance: An audit provides stakeholders with insurance against significant problems with the financial statements, i.e. stakeholders who rely on misstated financial reports may be able to recover some of their losses form the auditor.

1. Briefly explain the natural demand for auditing.
2. Audit and assurance services are in demand because economic forces, human nature, and the need for good decisions recognize that the risks of unreliable information are high and the benefits of the audit mitigate those risks.

1. Describe the history of auditing prior to the modern era, explaining the evolution of the focus of audits over time.
2. Collection: Auditors worked in ancient times as tax collectors, ensuring the monarch or government was able to collect the required payments.
3. Stewardship: In the 1800s, the economic wealth of the British empire was located all over the world. Therefore, local stewards were needed to look after the interests of those (families, banks, individuals) who owed the wealth. Early audits, which generally took place in these far flung locations, were meant to ensure that assets were properly handled on behalf of the owners. Thus, the focus was on stewardship.
4. Equity Markets: In the 1900s, the equity markets grew and outsiders and small investors began owning stock. These stakeholders were more concerned with future profitability than stewardship. Accounting evolved to the accrual basis and auditing became focused on earnings and profitability, as well as verifying financial results.

1. The demand for auditing can develop naturally or can be mandated by government regulation. Which do you think is most important in the evolution of auditing through history?
2. Clearly, over long periods of history, the need for auditing has arisen naturally from economic activity (empire needing to collect taxes, family interests demanding stewardship of wealth, stakeholders needing earnings and profitability information, creditors desiring information on the financial condition of borrowers) and is not solely the by-product of government regulation.

1. Explain the importance of reliable information for a large manufacturing company, a small business, a not-for-profit entity and a government organization
2. Most organizations have a great deal in common, such as procuring capital, acquiring productive assets, providing products or services, collecting payments and providing adequate results for stakeholders. All organizations, whether large or small businesses, not-for-profit entities or government organizations, need relevant and reliable information to achieve quality decisions. This is true regardless of entity size or the level of computerization or formality of its accounting information systems.

1. How does the modern business environment impact the need for relevant and reliable data?
2. Modern businesses operated in a global marketplace with real-time decision-making, high competition and a focus on future performance. Many industries are characterized by closely coupled supply chains from suppliers through to customers, reduced international barriers, and blurred boundaries between integrated entities. Reporting has become more frequent, if not continuous, requiring dynamic information regardless of the complexity of the business. In this environment, relevant and reliable data is essential. Good information may lead to wealth development but poor information will invariably lead to failure.

1. What two competing forces influence managers’ decisions to misstate (or not misstate) financial results for their own benefit?
2. Incentives are motivational forces (bonuses, contingent compensation, etc.) that motivate managers to achieve objectives. Incentives may also motive a manager to lie or cook the books in order to appear to meet goals
3. Ethical principles define norms of behavior or conduct as well as inappropriate actions and activities.

1. Information asymmetry may impact managers and stakeholders. Define this term and explain two situations where incentives and information asymmetry may create potentially dysfunctional distrust.
2. Information asymmetry exists when one party, such as a manager, knows more about the reliability of the information provided than another party, such as a stakeholder, who used that information.
3. i.Adverse selection is when a purchaser of some good or service cannot distinguish among good and bad alternatives. If the purchaser is very uncomfortable with this information asymmetry, he may disassociate himself with the seller. It is the lack of information or the ability to distinguish the quality of the information that dooms the relationship, not the actual quality of the good or service.

ii. Moral hazard describes how someone behaves when no one can observe their actions or decisions. Managers who are not accountable may have an inclination to shirk or cheat. In financial reporting, this means stakeholders will not have enough information to discern whether management is doing a good job.

1. Why should stakeholders be knowledgeable about an organization’s approach to ethics?
2. Organizations and their culture can have a huge impact on individual’s behavior by communicating the need for ethical considerations to those in the organization and implementing decisions that are consistent with reasonable standards of ethical behavior.

1. Describe different ways an individual may react when faced with decisions that are ethically questionable?
2. Collusion/Loyalty: One reaction is to remain loyal to the potentially unethical decision makers, choosing to passively collude by looking the other way or to actively collude to help in the activities.
3. Quitting/Leaving: Another reaction is to remove one’s self from the questionable situation by quitting or leaving, without informing other stakeholders about the circumstances.
4. Speaking up/Whistle-blowing: The most difficult reaction is to voice concern or to warn others about unethical practices. This is an attempt to change the organization’s unethical practices without regard to the potential personal price.

[student could use Enron or WorldCom frauds to identify real examples of each]

1. Why does full and complete disclosure discourage unethical decisions?
2. Full and complete disclosure about organization performance as well as an organization’s ethical norms will result in fewer individuals willing to make unethical decisions which will most likely be noticed and will make them appear in a negative light. Managers with ethical norms are less likely to take advantage of information asymmetry and are more likely to choose wisely when faced with an ethical dilemma.

1. Explain the importance of and the difference between financial literacy and financial experts with regard to the audit committee.
2. Financial literacy describes individuals who are able to read and understand reasonably complex financial statements for a given organization.
3. A financial expert has served or is serving in an accounting role and has an in-depth understanding of the organization’s financial statements.
4. At least one audit committee member must be a financial expert. All audit committee members must be financially literate.
5. Financial literacy and expertise are crucial to the ability of the auditors and the audit committee to communicate effectively, and to produce reliable financial reports.

1. Explain the role and importance of the compensation committee.
2. The compensation committee oversees the award of compensation to the management team. The committee must also provide stakeholders with reports explaining the amount and nature of compensation paid to the management team. Recent excessive and complex compensation packages offered to high level executives have brought such committees under heavy scrutiny.

1. Why is the effectiveness of internal auditors potentially limited?
2. The effectiveness of internal auditors may be limited ifthey actually work for the managers they audit.

1. Explain the requirements and limitations of external auditors.
2. To be useful, an auditor must be free of conflicts of interest, possess adequate expertise, be able to evaluate information reliability, and understand informational context.
3. Auditors, like managers, are also faced with incentives to act unethically.
4. Auditors are paid by the organizations they audit.
5. Auditors face cost constrains and time pressure to finish an audit on time and at a profit.

1. What powerful lesson did the auditing profession learn from the Enron/Andersen tragedy?
2. No amount of revenue can justify abdicating or appearing to abdicate the auditor’s professional responsibilities.
3. Auditors must be able to recognize ethical problems and react appropriately.

1. What three conditions must be met before an auditor undertakes an assurance engagement?
2. The auditor has adequate knowledge of the context in which assurance is to be given.
3. The subject matter of the assurance can be examined with an objective evaluation process.
4. The auditor is independent and objective in regards to the information and its context.

1. What four conditions affect an auditor’s attestation engagement?
2. An assertion must be made by one party, the accuracy of which is of interest to another party.
3. Agreed-upon and objective criteria must exist which can be utilized to assess the accuracy of the assertion. All parties must agree on this.
4. The assertion must be amenable to verification by an independent party.
5. The accountant must prepare a written conclusion about the accuracy of the assertion.

1. What are the general requirements (legal and otherwise) for becoming a licensed public accountant?
2. a minimum level of education
3. passing an exam (CPA, CA, etc).
4. work experience
5. continuing education
6. technical competence(including a deep understanding of financial statements and GAAP)
7. independence
8. good judgment

Problems

1. Explain the role of the internal auditors and external auditors in corporate governance.
2. Internal auditors are primarily responsible for overseeing the effectiveness and efficiency of operations. This includes monitoring the reliability of organizational processes that transform information. The quality of the internal audit function directly impacts the level of control within an organization. In the United States, all publicly-owned companies have an internal audit function that reports directly to the audit committee of the board of directors.
3. The external auditors play a critical role in corporate governance because the external auditors are independent, unlike the internal auditors. They provide an important assurance about the quality of information available to the Board and to stakeholders. The external auditor is a trusted arbiter of the organization’s information, who evaluates, as an independent third-party, the objectivity, relevance, reliability and understandability of corporate information. This results in a reduction of the potential impact of information asymmetry and questionable ethics.

1. Compare and contrast assurance, attestation and financial statement audit.
2. Assurance involves professional services provided by a practitioner for the purpose of improving the quality of information, or the context in which it is used, so that users of the information are able to make better decisions.
3. Attestation is a subset of assurance that involves providing assurance about the reliability of specific information provided by one party to another. The professional provides an opinion on the reliability of information that has been provided by one party. The professional does not generate original information, which is the responsibility of the party generating the information on which the attestation is being given.
4. Financial statement audits are a subset of attestation, and they provide assurance about the reliability of the information contained in the financial report issued by management in accordance with GAAP. The auditor reports the results of the audit to the shareholders.

1. Describe some examples of assurance services and give an illustrative example.{Note: The instructor can specify a minimum number of examples to be provided.}
2. Financial statement audits provide assurance about the reliability of the information contained in the financial report issued by management in accordance with GAAP.
3. Electronic commerce assurance provides assurance that web sites are legitimate and that transactions with be properly processed with appropriate security and confidentiality.
4. Ethics audits evaluate management compliance with ethical norms.
5. Software audits test the reliability of commercial software.
6. Royalty audits determine proper amounts for licensing fees or royalty payments.
7. Utilization audits verify key operating data such as occupancy rates or attendance levels.
8. Investment performance audits verify yields on managed portfolios and mutual funds.
9. Cost audits verify data used in computing reimbursements under cost-sharing contracts.
10. Environmental audits test compliance with environmental laws and regulations.

1. Describe the CPA licensing process in the United States.
2. Each U.S. state has a licensing board that administers CPA licenses.
3. Most states require a degree in accounting that includes 150 semester-hours of credit, including a specified number of hours in accounting. States vary on the specifics, but many CPA candidates pursue a Masters of Accountancy or similar graduate degree.
4. Each candidate must successfully complete the nationally administered CPA examination, passing all four parts of the exam within an 18-month period.
5. Most states require two years of public accounting work experience, but the amount could be as little as none.
6. Licensed CPAs must participate in continuing education in accounting, auditing and professional ethics.

1. Using the examples of Enron, describe different ways individuals react when faced with decisions that are ethically questionable.

{Note: This question can be broadened or narrowed, depending on what actual cases you have discussed or assigned. These are only representative examples, below}