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CHAPTER 2

OVERVIEW OF AUDITING

I. Review Questions

1. One definition of auditing is that it is a systematic process by which a competent,


independent person objectively obtains and evaluates 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.

The Philippine Standards on Auditing (PSA) 120 “Framework of Philippine Standards


on Auditing” states the objective of an audit as follows:
“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 financial reporting framework.”

2. This apparent paradox arises from the distinction between the function of auditing and
the function of accounting.

The accounting function is the process of recording, classifying and summarizing


economic events to provide relevant information to decision makers.

The rules of accounting are the criteria used by the auditor for evaluating the
presentation of economic events for financial statements and he or she must therefore
have an understanding of generally accepted accounting principles (GAAP), as well as
generally accepted auditing standards (GAAS).

The accountant need not, and frequently does not, understand what auditors do, unless
he or she is involved in doing audits, or has been trained as an auditor.
2-2 Solutions Manual - Principles of Auditing and Other Assurance Services
3.
Audits of Financial Compliance Operational
Statements Audits Audits

Purpose To determine whether To determine whether To evaluate whether


the financial statements the client is following operating
are presented in specific procedures set procedures are
accordance with GAAP. by higher authority. efficient and
effective.
Users of Different groups for Authority setting down Management of
Audit different purposes – procedures, internal or organization
Report many outside entities. external

Nature Highly standardized Not standardized, but Highly nonstandard;


very specific and often very subjective
usually objective

Performed by:
CPAs Almost universally Occasionally Frequently
COA Auditors Occasionally Frequently Frequently
BIR Auditors Never Universally Never
Internal Auditors Frequently Frequently Frequently

4. The major differences in the scope of audit responsibilities are:


1. CPAs perform audits in accordance with Philippine Standards on Auditing of
published financial statements prepared in accordance with identified and
applicable Statements of Financial Accounting Standards.
2. COA auditors perform compliance or operational audits in order to assure the
Congress of the expenditure of public funds in accordance with its directives and
the law.
3. BIR agents perform compliance audits to enforce the tax laws as defined by
Congress, interpreted by the courts, and regulated by the BIR law.
4. Internal auditors perform compliance or operational audits in order to assure
management or the board of directors that controls and policies are properly and
consistently developed, applied and evaluated.

5. An independent audit is a means of satisfying the need for reliable information on the
part of decision makers. Factors of a complex society which contribute to this need are:
1. remoteness of information
a. owners (stockholders) divorced from management
b. directors not involved in day-to-day operations or decisions
c. dispersion of the business among numerous geographic locations and
complex corporate structures

2. bias and motives of provider


Overview of Auditing 2-3
a. information will be biased in favor of the provider when his goals are
inconsistent with the decision maker.
3. voluminous data
a. possibly millions of transactions processed daily via sophisticated
computerized systems
b. multiple product lines
c. multiple transaction locations
4. complex exchange transactions
a. new and changing business relationships lead to innovative accounting and
reporting problems
b. potential impact of transactions not quantifiable, leading to increased
disclosures

6. The four primary causes of information risk are remoteness of information, bias in
motives of the provider, voluminous data, and existence of complex exchange
transactions.

The three main ways to reduce information risk are:


1. User verifies the information itself.
2. The users share the information risk with management.
3. Have audited financial statements provided.

The advantages and disadvantages of each are as follows:

Advantages Disadvantages
User verifies 1. User obtains information desired. 1. High cost of obtaining information.
information 2. User can be more confident of the 2. Inconvenience to the person
qualifications and activities of the providing the information because
person getting the information. large number of users would be on
premises.

Users share 1. No audit costs incurred. 1. Users may not be able to collect on
information risk losses.
with
management
Audited financial 1. Multiple users obtain the information. 1. May not meet needs of certain users.
statements are 2. Information risk can usually be 2. Cost may be higher than the benefits
prepared reduced sufficiently to satisfy users at in some situations, such as for a
reasonable cost. small company.
3. Minimal inconvenience to
management by having only one
auditor.

7. Information risk is the possibility that information upon which a business decision is
made is inaccurate. Four causes of information risk are:
 remoteness of information,
2-4 Solutions Manual - Principles of Auditing and Other Assurance Services
 biases and motives of the provider,
 voluminous data, and
 complex exchange transactions.

8. Three primary ways users of information can reduce information risk are:
 users can verify the information themselves,
 users can share information risk with management, and
 users can obtain audited financial statements.

9. Four factors that are likely to significantly reduce information risk in the next five to ten
years are:
 technological advances,
 more companies will go on–line, reducing the risk of investors obtaining outdated
information,
 new accounting and auditing standards, and
 auditors will find more efficient and effective audit techniques.

10. Refer to pages 45 and 46 of the textbook.

11. A report by an independent public accountant concerning the fairness of a company’s


financial statements is commonly required in the following situations:
(1) Application for a bank loan.
(2) Establishing credit for purchase of merchandise, equipment, or other assets.
(3) Reporting operating results, financial position, and cash flows to absentee
owners (stockholders or partners).
(4) Issuance of securities by a corporation.
(5) Annual financial statements by a corporation with securities listed on a stock
exchange or traded over the counter.
(6) Sale of an ongoing business.
(7) Termination of a partnership.

12. To add credibility to financial statements is to increase the likelihood that they have
been prepared following the appropriate criteria, usually the relevant and applicable
SFAS. As such, an increase in credibility results in financial statements that can be
believed and relied upon by third parties.

13. Business risk is the risk that the investment will be impaired because a company
invested in is unable to meet its financial obligations due to economic conditions or poor
management decisions. Information risk is the risk that the information used to assess
business risk is not accurate. Auditors can directly reduce information risk, but have
only limited effect on business risk.

14. An operational audit attempts to measure the effectiveness and efficiency of a specific
unit of an organization. It involves more subjective judgments than a compliance audit
or an audit of financial statements because the criteria of effectiveness and efficiency of
departmental performance are not as clearly established as are many laws and
regulations or generally accepted accounting principles.
Overview of Auditing 2-5

The report prepared after completion of an operational audit is usually directed to


management of the organization in which the audit work was done.
15. A compliance audit is an audit to determine whether financial reports or other
assertions are in compliance with established criteria. The necessary ingredients are
verifiable data and the existence of standards established by an authoritative body. An
operational audit, on the other hand, is a review of a department or other unit of a
business or governmental organization to measure the effectiveness and efficiency of
operations. Internal auditors often perform operational audits as do auditors employed
by the Commission on Audit (COA) of the national government and public practitioners
as part of their consultancy services.
16. The first quoted sentence overstates the case. Although annual audits by CPA firms
are universal practice for large corporations, they are not essential to many small
businesses. The financial statements of large corporations go to many stockholders
(often hundreds of thousands) who demand the assurance of reliability supplied
through independent audits by CPA firms. Moreover the SEC and the stock exchanges
require that listed companies have annual audits.

For a small business concern, the primary need for annual financial statements is to
support an application for a bank loan. If a small business does not need to borrow, or
can obtain borrowed funds without providing audited statements, the cost of an audit
may not be justified.

Often a small business can obtain from a CPA firm specialized services other than an
audit, which are more useful and may cost less. Examples are the review or
compilation of financial statements, installation of a computer based accounting system,
or a study of internal control. Thus, the second quoted sentence, as well as the first, is
too sweeping to be correct. A decision not to have an audit is not always “false
economy.”
17. (a) An example of possible bias on the part of the provider of financial information is the
situation in which an individual or business entity applies for a bank loan. In such
circumstances, there is an incentive to overstate assets, income, and owner’s
equity, and to overlook or minimize liabilities. Distortions of this type give the
appearance of greater financial strength.

(b) A bank loan officer may insist that a prospective borrower provide audited financial
statements. This provides assurance that the data in the financial statements have
been examined by independent competent persons.

II. Multiple Choice Questions


1. d 6. c 11. b 16. d 21. d
2. a 7. b 12. a 17. a
3. a 8. c 13. c 18. a
4. d (PSAs) 9. b 14. c 19. d
5. b 10. d 15. a 20. c

III. Comprehensive Cases


2-6 Solutions Manual - Principles of Auditing and Other Assurance Services

Case 1. a. The major advantages and disadvantages of a career as a BIR agent, CPA, or
an internal auditor are:

Employment Advantages Disadvantages

BIR agent 1. Extensive training in 1. Experience limited to


individual, corporate, gift, taxes.
trust, and other taxes is 2. No experience with
available with concentration operational or financial
in area chosen. statement auditing.
2. On-hand experience with 3. Training is not extensive
sophisticated selection with any business
techniques. enterprise.

1. Extensive training in audit of


financial statements,
compliance auditing and 1. Exposure to taxes and to
operational auditing. the business enterprise
2. Opportunity for experience in may not be as in-depth as
auditing, tax counseling, and the BIR agent or the
CPA management consulting internal auditor.
practices. 2. Likely to be less exposed
3. Experience in a diversity of to operational auditing
enterprises and industries than is likely for internal
with the opportunity to auditors.
specialize in a particular
industry.

1. Extensive exposure to all


segments of the enterprise
with which employed. 1. Little exposure to taxation
Internal 2. Constant exposure to one and the audit thereof.
Auditor industry presenting 2. Experience is limited to
opportunity for expertise in one enterprise, usually
that industry. within one or a limited
3. Likely to have exposure to number of industries.
compliance, financial and
operational auditing.
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b. Other auditing careers that are available are:


1. COA auditor
2. Auditors within many of the branches of the government
3. Auditors for many local government units

Case 2. The most likely type of auditor and the type of audit for each of the examples are:
Example Type of Auditor Type of Audit
1. COA Compliance
2. CPA; Internal Auditor Operational
3. Internal auditor; CPA Compliance
4. CPA Financial statements
5. CPA Tax audit; FS audit
6. COA Financial statements
7. CPA Financial statements
8. COA Operational audit
9. CPA; Internal Auditor Financial statements
10. Internal auditor or CPA Operational audit
11. CPA or COA Operational audit
12. CPA; BIR Compliance

Case 3. a. The overriding objective of an independent audit is to provide reasonable


assurance that the financial statements fairly reflect the economic substance of the
transactions and events reflected in those statements. To this end, the auditor tests
management’s assertions as embodied in the financial statements, and renders an
opinion concerning fairness. Testing involves gathering and evaluating evidence
relating to the assertions. The opinion assumes the form of an audit report
formulated and issued at the conclusion of the examination.

b. An independent audit may be beneficial to Lyn Cruz in the following ways:


1. Correction of identified weaknesses in the accounting system may improve
the quality of financial reporting;
2. The independent auditor may be able to assist Lyn in improving physical
safeguards over assets;
3. An independent audit may facilitate Lyn’s efforts in raising new capital;
4. The audit may identify a need for improved budgeting and performance
reporting, thus improving control over costs and revenues;
5. Although not designed for this purpose, the audit may disclose defalcations
by employees;
6. To determine amounts receivable or payable under bonus, profit sharing, and
pension plans; lease agreements; royalty agreements; and other contracts
and agreements;
7. To serve as an error and/or irregularity prevention device by making
employees aware of audit coverage.

Case 4. Types of Auditors and Services Performed


2-8 Solutions Manual - Principles of Auditing and Other Assurance Services
Topic Type of Auditor Class of Work
1 CPA Audit of financial statements
2 CPA Audit of financial statements
3 Internal auditor; CPA Operational audit
4 COA Operational audit
5 Bank examiner Compliance audit
6 CPA Mngt. advisory services
7 CPA Audit of financial statements
8 Internal auditor; CPA Operational audit
9 BIR; CPA Compliance audit
10 CPA; COA Compliance audit