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Chapter 1— AN INTRODUCTION TO AUDIT AND OTHER ASSURANCE SERVICES

MULTIPLE CHOICE 1. Assurance services a. Include tax services, compliance audits, and review engagements. b. Are contracts in which the assuror reports on or improves the quality of the information. c. Are offered only by members of the American Institute of Certified Public Accountants. d. Are contracts in which one party makes recommendations on how another party might use information. ANS: B 2. The first significant audit-related legislation in the US was the a. Securities Act of 1933. b. Securities Exchange Act of 1934. c. Joint Stock Companies Act of 1844. d. Companies Act of 1947. ANS: A 3. The essence of the attest function is to a. Offer assurance about subject matter that is the responsibility of another party. b. Examine individual transactions and certify as to the validity of each. c. Ensure the consistent application of correct accounting principles. d. Detect fraud in the client’s financial statements. ANS: A

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4. The market for auditing services is driven by a. The regulations of the Securities and Exchange Commission. b. A demand by external users of financial statements. c. Pronouncements issued by the Auditing Standards Board. d. Congress at the federal level and elected legislative bodies at the state level. ANS: B 5. Which of the following statements is an example of an assertion made by management in an entity's financial statements? a. The financial statements were prepared in an unbiased manner. b. Reported inventory balances reflect all related transactions for the period. c. Reported accounts receivable does not include any uncollectible accounts. d. The scope of the auditors' investigation was not limited in any way by management. ANS: B 6. An independent audit report a. Confirms the accuracy of management's financial statements. b. Guarantees that financial statements are accurate. c. Assures the readers of financial statements that any fraudulent activity has been corrected. d. Provides written assurance that the financial statements are fairly presented. 1

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ANS: D

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7. In a review engagement, a public accounting firm a. Provides limited assurance about whether an entity’s financial statements conform to GAAP. b. Has as a client a large, public company. c. Compiles financial information into the form of financial statements, providing no assurance. d. Performs procedures, which are agreed upon in advance with the client. ANS: A 8. The reason an independent auditor gathers evidence is to a. Evaluate internal controls. b. Detect fraud. c. Evaluate management. d. Form an opinion on the financial statements. ANS: D

OBJ: (AICPA ADAPTED)

9. An independent audit is important to readers of financial statements because it a. Reports on the accuracy of information in the financial statements. b. Measures and communicates the financial data included in financial statements. c. Provides a measure of management's stewardship function. d. Objectively examines and reports on the fair presentation of the financial statements. ANS: D

OBJ: (AICPA ADAPTED)

10. Which of the following criteria is unique to the independent auditor's attest function? a. Independence. b. Familiarity with the particular industry of each client. c. Due professional care. d. General competence. ANS: A

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11. The primary purpose of an independent financial statement audit is to a. Provide a basis for assessing management's performance. b. Comply with state and federal regulatory requirements. c. Assure management that the financial statements are unbiased and free from material misstatement. d. Provide users with an unbiased opinion about the fairness of information reported in the financial statements. ANS: D 12. The audit process is a. A service, which guarantees the accuracy of management’s financial statements. b. A subjective process, which the auditor commences by gathering evidence. c. The only service a CPA is allowed to perform by law. d. Involves gathering and evaluating evidence and reporting an opinion. ANS: D

AN INTRODUCTION TO AUDIT AND OTHER ASSURANCE SERVICES

13. The first authoritative audit standards-setting body empowered to issue auditing pronouncements in the U.S. was the a. The Committee on Auditing Procedure. b. The Auditing Standards Executive Committee. c. The Auditing Standards Board. d. The Accounting and Review Services Committee. ANS: A 14. Which of the following incorrectly matches the authoritative body with its authoritative pronouncements? a. Accounting and Review Services Committee: "Statements on Standards for Accounting and Review Services" b. Auditing Standards Board: "Statements on Auditing Standards" c. Auditing Standards Executive Committee: "Statements on Auditing Procedure" d. Securities and Exchange Commission: "Financial Reporting Releases" ANS: C 15. Statements on Auditing Standards a. Relate to the filing requirements and enforcement activities of the SEC. b. Describe procedures to be applied in specific areas of audit activity to eliminate inconsistencies in audit practice. c. Are intended to limit the degree of auditor judgment needed to fulfill the attest function. d. Interpret standards rather than promulgate specific audit procedures. ANS: D 16. The Sarbanes-Oxley Act a. Applies to public and nonpublic firms. b. Was enacted in response to the debacle in the savings and loan industry. c. Is applicable to consulting engagements, operational audits, review engagements, and agreed-upon procedure engagements. d. Gave authority to the Public Company Accounting Oversight Board to set audit standards for public companies. ANS: D 17. Independent auditing is a a. Branch of accounting which focuses on constructing financial statements. b. Discipline, which emphasizes gathering support for the financial statements and has its roots in logic. c. Professional activity that measures and communicates financial and business data and makes recommendations for its use. d. Governmental regulatory function that prevents the issuance of improper financial information. ANS: B

OBJ: (AICPA ADAPTED)

18. The Auditing Standards Board a. Sets rules and regulations that govern public accounting firms performing audits of public companies.

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b. Is an arm of the Financial Accounting Standard Board. c. Is a senior technical body of the AICPA designated to issue authoritative auditing pronouncements for nonpublic companies. d. Reports directly to the Securities and Exchange Commission. ANS: C 19. The first authoritative auditing pronouncement in the U.S. was a. Statement on Auditing Procedures No. 1, "Extensions of Auditing Procedures." b. Statement on Auditing Standards No. 1, "Codification of SASs." c. Auditing Standard No.1, “References in Auditors’ Reports to the Standards of the PCAOB.” d. The Sarbanes-Oxley Act. ANS: A 20. An operational audit is designed to a. Assess the efficiency and effectiveness of management's operating procedures. b. Assess the presentation of management's financial statements in accordance with generally accepted accounting principles. c. Determine whether management has complied with applicable laws and regulations. d. Determine whether the audit committee of the board of directors is effectively discharging its responsibility to oversee management's operations. ANS: A 21. The purpose of a compliance audit for a governmental entity is to determine whether a. Financial statements comply with GAAP and whether the entity is operating efficiently. b. Financial statements comply with GAAP and the entity has complied with applicable laws and regulations. c. The entity has complied with applicable laws and regulations. d. Financial statements comply with GAAP. ANS: B 22. Information risk is a. The company’s cost of capital. b. The cost a company incurs to issue and service equity and debt. c. The risk that the information in financial statements is materially misstated. d. The risk of the client not being able to pay off a bank loan. ANS: C 23. Which statement below concerning assurance services and consulting services is not true? a. Assurance services may be performed by independent nonprofit institutions, public accounting firms, or consulting firms. b. Consulting services recommend uses for information. c. Assurance services report on or improve the quality of information. d. Consulting services involve reporting on the quality of written assertions made by the client. ANS: D

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ESSAY 1. Define auditing. ANS: Auditing 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. 2. What is the economic value of a financial statement audit? ANS: Financial statement audits reduce information risk (the risk that information in financial statements is misstated materially). In turn, lowering information risk reduces a company's cost of capital (the cost a company incurs to issue equity or debt instruments). 3. Describe two attestation services that are common performed by public accounting firms. ANS: (1) (2)

Agreed-upon procedures: An engagement in which the attester (or auditing firm) examines an item using procedures agreed upon by the contracting parties. Reviews: An attestation service for financial statements in which the public accounting firm provides limited assurance about whether an entity's financial statements conform to generally accept accounting principles.

4. What regulation is in place to monitor the performance of public accounting firms performing audits of public companies? ANS: The Sarbanes-Oxley Act assigns responsibility to the Public Company Accounting Oversight Board to regulate public accounting firms, which perform audits of public companies. The PCAOB has the authority to fine, censure, suspend, or bar from practice firms that violate the Sarbanes-Oxley Act or standards issued by the PCAOB. PROBLEM 1. In your role of Chief Financial Officer, you have been requested to explain to the Board of Directors why audits of the company are performed by (a) internal auditors, (b) independent auditors, and (c) governmental auditors. The Board believes that the company's internal auditors should perform all audits of the company. What are the issues that you will explain to the Board? ANS: It is important to explain the differences in the roles of the three types of auditors and the purpose of each different form of audit: I. Internal auditors are auditors employed by the company to assess the efficiency and effectiveness of management's operations. Internal auditors perform operational audits. Operational audits focus on information systems and operating procedures, not on recorded dollar amounts or reported financial information. Operational audits may

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address an entity's entire scope of operations or selected procedures. II. Independent auditors or governmental auditors perform compliance audits. Compliance audits may be designed to determine whether an entity's statements are presented fairly in accordance with GAAP. They might also be designed to determine whether the entity has complied with applicable laws and regulations that may have a material effect on financial statements. III. Independent auditors perform financial statement audits. Financial statement audits are an attestation service in which an independent auditor offers assurance about management's written financial statement assertions. It is imperative that the Board of Directors understands that the different types of auditors have different areas of professional expertise and authority and that the different types of audits serve different purposes. 2. The AICPA's "CPA Vision Project: 2011 and Beyond," contemplates values and competencies that improve an assurer's ability to judge the quality of information assured. List and define the Core Values, Competencies, and Services outlined within the CPA Vision Project. ANS: I.

Core Values: • • • • •

II.

Core Competencies: • • • • •

III.

Continuing Education and Lifelong Learning - CPAs believe in continuing education beyond certification and believe it is important to continually acquire new skills and knowledge. Competence - CPAs are able to perform high-quality work in a capable, efficient, and appropriate manner. Integrity - CPAs conduct themselves with honesty and professional ethics. Attuned to Broad Business Issues - CPAs are in tune with the overall realities of the business environment. Objectivity - CPAs are able to deal with information free of distortions, personal bias, or conflicts of interest.

Communications and Leadership Skills - Able to give and exchange information within meaningful context and with appropriate delivery and interpersonal skills. Able to influence, inspire, and motivate others to achieve results. Strategic and Critical Thinking Skills - Able to link data, knowledge, and insight together to provide quality advice for strategic decision-making. Focus on the Customer, Client, and Market - Able to anticipate and meet the changing needs of clients, employers, customers, and markets better than competitors. Interpretation of Converging Information - Able to interpret and provide a broader context using financial and nonfinancial information. Technologically Adapt - Able to utilize and leverage technology in ways that add value to clients, customers, and employees.

Core Services: • •

Assurance and Information Integrity - Provide a variety of services that improve and assure the quality of information, or its context, for business decision-making. Management Consulting and Performance Management - Provide advice and

AN INTRODUCTION TO AUDIT AND OTHER ASSURANCE SERVICES

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insight on the financial and nonfinancial performance of an organization's operational and strategic process through broad business knowledge and judgment. Technology Services - Provide services that leverage technology to improve objectives and decision making, including business application processes, system integrity, knowledge management, system security, and integration of new business processes and practices. Financial Planning - Provide a variety of services to organizations and individuals that interpret and add value by utilizing a wide range of financial information. These include everything from tax planning and financial statement analysis to structuring investment portfolios and complex financial statements. International Services - Provide services to support and facilitate commerce in the global market.

TRUE/FALSE 1. The Auditing Standards Board issues authoritative pronouncements for public company audits. ANS: F The PCAOB issues such pronouncements. 2. The Securities and Exchange Commission is a federal agency, which regulates the registration and exchange of securities under the Securities Acts of 1933 and 1934. ANS: T The SEC regulates such activities. 3. A compliance audit is typically performed for governmental entities or for contractors, which must comply with federal requirements. ANS: T A compliance audit is most often performed for governmental entities such as municipalities or school districts and for contractors, which must comply with federal requirements. 4. A state auditor is a type of independent auditor. ANS: F A state auditor is a type of governmental auditor. 5. In an agreed-upon procedures engagement, the client might not be the responsible party. ANS: T In an agreed-upon procedures engagement, the client might engage the practitioner to report on a responsible party’s assertion. 6. In an agreed-upon procedures engagement, the assertion of the responsible party must be in writing. ANS: F The assertion might be in writing, but does not need to be.

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7. Examples of consulting services include reviews of financial statements and agreed-upon procedures engagements. ANS: F Reviews and agreed-upon procedures engagements are both types of attestation services. 8. A core value of CPAs is the ability to be objective about information. ANS: T Objectivity is a Core Value in the AICPA’s CPA Vision Project: 2011 and Beyond. 9. The client in the audit of a public company is management. ANS: F The Board of Directors is the client in the audit of a public company. 10. Internal auditors should report to the audit committee of the board of directors to be most effective. ANS: T Reporting to the audit committee of the board of directors helps to assure independence from the activities being examined. MATCHING a. b. c. d. e. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 1. 2. 3. 4. 5. 6. 7. 8.

AICPA ARSC FASB ASB PCAOB

f. g. h. i. j.

CAP SEC GASB IFAC AAA

A global federation of accountants An independent standard-setting body, which issues authoritative standards for governmental entities A senior technical committee of the AICPA, which issues SASs Issues Financial Reporting Releases and Accounting and Auditing Enforcement Releases The body, which issues Statements on Standards for Accounting and Review Services Responsible for setting auditing standards for public company audits Issued Statements on Auditing Procedure from 1939-1972 A professional trade association of CPAs An organization of accounting educators Issues Statements of Financial Accounting Standards ANS: ANS: ANS: ANS: ANS: ANS: ANS: ANS:

I H D G B E F A

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9. ANS: J 10. ANS: C SHORT ANSWER 1. Define information risk and explain the impact, which audits have on this risk. ANS: Information risk is the risk that information in financial statements is materially misstated. Audits add value by reducing information risk, thereby reducing the company’s cost of capital. 2. Besides investors, list other parties who may demand an audit. ANS: Employees Management Employee pension plan participants Post-retirement benefit plan participants Dividend and cash investment plan participants Labor unions Suppliers Stock exchanges Regulatory agencies Taxing authorities 3. Discuss the responsibility of management versus that of the auditor for the financial statements. ANS: The financial statements are the responsibility of management; the information in them is management’s representations. In contrast, the auditor is responsible for expressing an opinion on the financial statements of management.