CHAPTER 1
AN INTRODUCTION TO ASSURANCE AND FINANCIAL STATEMENT AUDITING Answers to Review Questions
1-1 The study of auditing is more conceptual in nature compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills to evaluate the relevance and reliability of the systems and processes responsible for financial information, as well as the information itself. To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations.
Understanding auditing can improve the decision making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information.
1-2 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 a cost-effective form of monitoring.
The empirical evidence suggests auditing was demanded prior to government regulation such as statutory audit requirements. Additionally, many private companies and other entities not subject to government auditing regulations also demand auditing.
1-3 The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of information asymmetry that exists between them. 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 and may manipulate the information provided to the owner
accordingly.
1-4 Independence is an important standard for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner.
1-5 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.
Assurance is engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.
Examples of assurance services are assurance (audit) of financial statements, assurance of prospective financial information, assurance of reporting on internal control, assurance of sustainability reporting, and assurance of electronic commerce.
1-6 The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence. 1-7 Materiality: "Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor." (IASB).
Audit risk is defined as the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated (ISA 200).
The audit report states that the auditor obtains “reasonable assurance” whether the financial statements are free from “material” misstatement. The term reasonable assurance informs the reader that there is some level of risk that the audit did not detect all material misstatements. In addition, the auditor’s opinion commonly uses the wording that the financial statements present fairly, “in all material respects.” These phrases communicate to third parties that the audit report is limited to material information.
1-8 On most audits, it is not feasible or cost-effective to audit all transactions. For example, in a small business, the auditor might be able to examine all transactions that occurred during the period. However, it is unlikely that the owner of the business could afford to pay for such an extensive audit. For a large organization, the sheer volume of transactions prevents the auditor from examining every transaction. Thus, there is a trade-off between the exactness or precision of the audit and its cost.
1-9 The major phases of the audit are:
• Client acceptance/continuance and establishing engagement terms • Preplanning
• Assess risks and establish materiality • Plan the audit
• Consider internal control
• Audit business processes and related accounts • Complete the audit
• Evaluate results and issue audit report
1-10 The auditor’s understanding of the entity and its environment includes knowledge about: (1) the nature of the entity, (2) its objectives and strategies, (3) its industry, regulatory, and other external factors, (4) its management, (5) its governance, (6) its measurement and performance process, and (7) its business processes.
1-11 Sometimes auditors will face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of reindeer. Such circumstances require that the auditor possess creativity and innovation when planning and administering audit procedures where little or no precedent exists. Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation.
Solutions to Problems
1-12 The memo should cite the following facts:
• When parties to the agency relationship (contract) do not possess the same amount of information (information asymmetry) there is a natural conflict of interest between the parties. For example, when an owner and manager are negotiating an
employment contract, the owner may assume that the manager likely will use organizational funds for personal uses. Auditing plays an important role in such relationships. The owner and manager will consummate an employment contract only if the manager agrees to be monitored. Auditing can be used to monitor the contract agreed to by the two parties. (P.S. As a lawyer, Lee should be well versed on contract law.)
• Auditing is also used to monitor other types of contracts for which no laws or
regulations require an audit, for example, contracts between management and debt holders.
• There is historical evidence of forms of auditing in the early Greek states and in the United Kingdom during the industrial revolution. Additional evidence for the demand for auditing is also provided by the fact that many private companies and other entities not subject to a statutory audit requirement contract for audits.
1-13 There are two major factors that may make an audit necessary for Greenbloom Garden Centers. First, the company may require long-term financing for its expansion into other cities. Entities such as banks or insurance companies are likely to be the sources of the company’s debt financing. These entities may require audited financial statements before lending significant funds and require audited financial statements during the time period the debt is outstanding. There is information asymmetry between the lender of funds and the owner of the business, and this asymmetry results in information risk to the lender. Even if the business could get funding without an audit, a standard audit report with an unmodified opinion by a reputable auditor might very well reduce the lender’s information risk and make the terms of the loan more favorable to the owner. Second, as the company grows, the family will lose control over the day-to-day operations of the stores. An audit can provide an additional monitoring activity for the family in controlling the expanded operations of the company.
1-14 a. Evidence supporting the financial statements consists of the underlying accounting data and all corroborating information available to the auditor.
b. Management makes assertions about components of the financial statements. For example, an entity's financial statements may contain a line item that accounts receivable are €1,750,000. In this instance, management is asserting, among other things, that the entity owns the receivable and that the receivables are properly valued (i.e., net realizable value). Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue an audit report with an unmodified opinion.
c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor relies on evidence that relates to a different assertion from the one being tested, an incorrect conclusion may be reached about the
management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion.
1-15 The auditor’s understanding is obtained during the first two boxes shown in Figure 1-3— Client Acceptance/Continuance and Pre-Planning. The intervening steps include:
Assess Risks and Establish Materiality In order to properly plan the audit, the audit team must make a preliminary assessment of the client’s business risks and establish a preliminary
judgment about materiality. The audit team relies on these assessments to then assess risk relating to the likelihood of material misstatements in the financial statements. The auditor’s risk assessments and materiality judgment are used to define the scope for the audit.
Plan the Audit In developing the audit plan, the auditor should be guided by (1) the
procedures performed to gain and document an understanding of the entity and (2) the results of the risk assessment process. The auditor may conduct preliminary analytical procedures to identify specific transactions or account balances that should receive special attention due to an increased risk of material misstatement. The auditor should prepare a written audit plan that sets forth, in reasonable detail, the nature, extent, and timing of the audit work. The audit partner or manager should discuss with other members of the audit team the susceptibility of the entity to material misstatements due to error or fraud.
Consider Internal Control When obtaining an understanding of the entity and its
environment, the auditor should gain an understanding of internal control sufficient to assess the risk of material misstatement, plan the audit by performing procedures to understand the design of controls relevant to the audit, and determine whether they have been implemented. The auditor then evaluates the internal controls in order to assess the risk that they will not prevent or detect a material misstatement in the financial statements. (Note that Chapter 7 covers the audit of internal control for public companies in the U.S.)
Audit Business Processes and Related Accounts Based on the knowledge of the entity and its environment, the auditor determines the audit procedures that are necessary to reduce the risk of material misstatement to a low level for the financial statement accounts affected by a particular business process. The individual audit procedures are then directed toward specific assertions in the account balance that are likely to be misstated.
Complete the Audit After the auditor has completed testing the account balances, the sufficiency of the evidence gathered needs to be evaluated. The auditor must obtain sufficient appropriate evidence in order to reach and justify a conclusion on the fairness of the financial statements. The auditor also assesses the possibility of contingencies, and searches for any events subsequent to the balance sheet date that may impact the financial statements. Chapter 17 covers each of these issues in detail.
1-16 a. The major phases of the audit and their descriptions are (also see solution to 1-15, above):
1. Client acceptance/continuance and establish the terms of the engagement. The auditor decides to accept a new client or to retain an existing client. The auditor establishes an
understanding with the client regarding the services to be performed.
2. Preplanning. This phase involves (1) determining the audit engagement team requirements and (2) ensuring the independence of the audit team and audit firm. 3. Establish materiality and assess risks. The auditor establishes the preliminary
judgment about materiality and makes a preliminary assessment of the client’s business risks.
4. Plan the audit. During this phase of the audit, the auditor uses the knowledge of the client to plan the audit and perform preliminary analytical procedures. The purpose is of this phase to plan an effective and efficient audit.
5. Consider internal control. The auditor understands and evaluates the client’s internal controls in order to assess the risk that they will not prevent or detect a material misstatement.
6. Audit business processes and related accounts. The auditor conducts substantive tests, including analytical procedures and the details of the account balances searching for material misstatements.
7. Complete the audit. The auditor searches for contingencies and subsequent events, and performs a final review of the evidence gathered.
8. Issue the audit report. Based on the collection and evaluation of evidence, the auditor issues a report on the fair presentation of the financial statements.
b. While audit procedures may be designed to test a specific assertion, they may
simultaneously provide evidence on another account or assertion. An example would be when an auditor obtains evidence about a client’s transactions affecting the inventory account and whether sales of inventory were included in the proper period. Such evidence may also be relevant to the client’s assertions regarding whether accounts receivable balances were correct at the end of the period.
c. Auditors develop an understanding of an entity's internal control in order to establish the scope of the audit. However, during the course of this work, the auditor may become aware of material weaknesses in the entity's accounting systems. The auditor is required to
communicate this information to management or those charged with governance (e.g., the board of directors). The auditor may also make suggestions on how to correct the weaknesses. The auditor's work on internal control may also have a preventive effect on the entity's
employees. If the employees know that their work will be audited, they are less likely to commit errors or fraud.
Solutions to Discussion Case
1-17 a. In the discussion case the Office of Auditor General (OAG) has examined banks in financial difficulties. In most countries such Office or other regulatory bodies (e.g., a Financial Supervisory Authority) have supervision and examination responsibilities for banks.
These bodies normally exercise their regulatory
supervision and examination duties through on-site and off-site evaluations of banks’ financial condition and safety and soundness practices. On-site evaluations typically involve inquiries of bank management personnel, reviews of bank financial accounting records, and a review of bank operating policies and procedures. Off-site monitoring involves review and analysis of reports such as quarterly reports and other information requested by the regulator.
In the discussion case OAG reviewed the 7 banks with financial difficulties by obtaining and reviewing key documents. This included recent reports and audited financial statements prepared by bank management, and reports of examination and reviews prepared by the regulators. Each of the reports was reviewed, their contents were summarized and analyzed, and the reports were compared to determine if they provided adequate and timely disclosure of the true nature of the banks' financial condition prior to the financial difficulties.
The OAG did not review the specific application of auditing standards used by the independent auditors in reaching their opinion on these banks. The criteria used by OAG to evaluate the adequacy and degree of compliance with the requirements were relevant laws and regulations, as well as the financial reporting framework. Some of the key findings by the OAG were:
• Reports had failed to provide early warnings of impaired asset values. This occurred because existing financial reporting framework had allowed too much latitude in determining the carrying amounts for problem loans and repossessed collateral.
• Pervasive internal control weaknesses had contributed to the financial difficulties. There had been serious breakdowns in corporate governance, including
inadequacies in board of director activities. The OAG also noted that there had been weaknesses in operating management and loan portfolio management.
b. Independent audits are a critical component of corporate governance and can enhance the effectiveness of the examination and supervision process. Audits of quarterly reports will improve the timeliness of reliable financial reports and help identify internal control weaknesses. Thus, such audits can benefit bank examiners in enhancing the safety and soundness of financial institutions.
Solutions to Internet Assignments
1-18 There are numerous Internet sites that contain accounting and auditing information. Following are some suggested sites:
• The International Federation of Accountants (www.ifac.org) web site provides detailed information on the organization, its boards and committees, and its pronouncements, including the IFAC Code of Ethics for Professional Accountants and the International Auditing and Assurance Standards Board’s (IAASB) International Standards on Auditing (ISAs). The IFAC site also includes links to its more than 160 member organizations.
• The International Accounting Standards Board’s (IASB) home page (www.iasb.org/) contains information on the organization, its standards, and its publications.
• The International Organization of Securities Commissions (IOSCO) home site
(www.iosco.org/) contains information about IOSCO, its publications, and links to its member bodies and other relevant organizations.
• The International Organization of Supreme Audit Institutions (INTOSAI) web site
(www.intosai.org/) contains information about INTOSAI, its committees, standards, and links to its member bodies.
• The Institute of Internal Auditors home page (www.theiia.org) contains detailed information on internal auditing.
• The Association of Certified Fraud Examiners home page (www.cfenet.com) contains extensive information on the Association’s certification as Certified Fraud Examiners (CFE). • The European Commission Internal Market DG home site
(europa.eu.int/comm/internal_market/financial-reporting/index_en) contains information on accounting and auditing in the Internal Market in the European Union.
• Fédération des Experts Comptables Européens (FEE) web site (www.fee.be/) contains information about FEE, its publication, and numerous European and international links. • The European Accounting Association’s (EAA) home site (
www.eaa-online.org/associations/eaa/index.asp) contains information on accounting scholars and research activities in Europe.
• The American Institute of Certified Public Accountant’s (AICPA) home page (www.aicpa.org) contains extensive information on the organization's activities.
• The American Accounting Association’s home page (www.aaahq.org) contains information on accounting scholar and research activities in the U.S. and numerous links, including to professional organizations, accounting journals, and education sites.
• The U.S. Securities and Exchange Commission’s (SEC) Edgar Web site (www.sec.gov) contains all filings by public companies with the U.S. Securities and Exchange Commission (SEC). It also contains information on other activities by the SEC.
• The Public Company Accounting Oversight Board’s (PCAOB) web site (www.pcaobus.org/) offers detailed information about the PCAOB and its standards.
• The major public accounting firms and many smaller firms also maintain web sites.
1-19 A search of the Internet will identify a number of potential sources for information on the mail order industry. Some suggestions are:
• Pegasus Research International, LLC (www.mindbranch.com/) maintains a home page that contains statistics on E-commerce and the state of the Internet.
• MarketResearch.Com’s home site (www.marketresearch.com/) provides information on e-commerce and the mail order industry.
• The International Society for Strategic Marketing (www.issm.org) maintains a site that contains information and statistics on international direct marketing.
• Retail Net’s home page (www.retailnet.com/) provides information on the retail marketplace industry, including the catalogue and mail order industry.
• Lastly, a number of the major public accounting firms have industry specialization in retail. The sites of the firms contain information on the retail industry.
CHAPTER 2
THE FINANCIAL STATEMENT AUDITING ENVIRONMENT Answers to Review Questions
2-1 During the late 1990s and early 2000s, firms aggressively sought opportunities to expand their operations in non-audit services such as consulting. This expansion from their core audit practice, combined with allegations of auditors refusing to challenge management’s actions (including widespread earnings management), resulted in tension between regulators and the accounting profession. Auditors’ independence issues gained renewed focus. Major audit firms started reorganizing their portfolio of non-audit services offered. IFAC as well as regulators issued new rules on auditor independence. However, subsequent financial fiascos such as those at Ahold, Enron, Parmalat, WorldCom, Tyco, and many others, caused investors to doubt the fundamental integrity of the financial reporting system. Under pressure to restore the public’s confidence, both the auditors and their professional organizations (e.g. IFAC and IAASB), and regulators took action, resulting in more public oversight of the profession and stricter regulations. The responsiveness of the profession to the needs of the public, investors and regulators will be crucial for future regulatory measures.
2-2 The accounting profession’s expansion into new areas, combined with changes in the overall business environment, resulted in new regulations and guidelines. The scandals of the late 1990s and early 2000s brought into the question the profession’s ability to self-regulate, resulting in more public oversight of the profession and new regulations. While these changes have caused pain and turmoil, they highlight the essential importance of auditing in our
economic system. Ultimately, the “back to basics” emphasis, along with auditing firms’ renewed focus on thorough and effective financial statement audits, will likely prove healthy for the financial reporting systems and for the profession.
2-3 The essential components of the high-level model of business offered in the chapter are: corporate governance, objectives, strategies, processes, controls, transactions, and financial statements. Corporate governance is carried out by management and the board of directors (supervisory board) in order to ensure that business objectives are carried out and that company assets are safeguarded. To achieve its objectives, management must formulate strategies and implement various processes which are in turn carried out through business transactions. The entity’s information and internal control systems must be designed to ensure that these transactions are properly executed, captured, and processed in order to produce accurate financial statements. It is important that the auditor obtain a firm understanding of these components in order to plan the nature, timing, and extent of the audit so that it is efficient and effective.
2-4 The information system must maintain a record of all businesses transactions. It should be capable of producing accurate financial reports to summarize the effects of the entity’s
transactions. Internal control is required to ensure that transactions are appropriately conducted and recorded by the information system and company employees. They provide safeguards to ensure the 1) reliability of financial reporting, 2) compliance with laws and regulations, and 3) the effectiveness and efficiency of operations. Auditing standards require that the auditor obtain an understanding of internal control in planning the nature, timing, and extent of testing.
2-5 The three categories of management assertions cover every aspect of what is needed for a transaction to be handled properly, for a financial statement account to be fairly stated, and
for the financial statements to be presented appropriately and to contain adequate disclosures. The management assertions form the basis for planning and evaluating the evidence that the auditor must obtain about the fairness of the client’s financial statements.
2-6 The five IAASB categories of standards are: International Standards on Quality Control (ISQCs), International Standards on Auditing (ISAs), International Standards on Review Engagements (ISREs), International Standards on Assurance Engagements (ISAEs), and International Standards on Related Services (ISRSs). ISAs are grouped into categories: Introductory Matters (currently no standards), General Principles and Responsibilities, Risk Assessment and Response to Assessed Risks, Audit Evidence, Using Work of Others, Audit Conclusions and Reporting, and Specialized Areas.
2-7 Independence is an important standard for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner.
2-8 Management is responsible to prepare financial statements, in accordance with the applicable financial reporting framework, that fairly present the company’s financial condition and operations. The auditor is responsible to issue an opinion in regards to the financial statements prepared by management. In order to issue this opinion, the auditor must plan and perform the audit in accordance with established standards to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. However, it is important to note that an auditor’s unmodified opinion does not mean that errors or fraud do not exist but rather that there is reasonable assurance that they do not exist in material amounts.
2-9 There are nine elements of the auditor's standard report with an unmodified opinion on the financial statements: (1) the title, (2) the addressee, (3) the introductory paragraph, (4) management’s responsibility, (5) auditor’s responsibility, (6) auditor’s opinion, (7) auditor’s signature, (8) the date of the report, and (9) auditor’s address. In some jurisdictions the auditor has additional responsibilities to report on other matters that are supplementary to expressing an opinion on the financial statements. Such reporting is addressed in a separate section after the auditor’s opinion on the financial statements.
An unqualified audit report for a public company also contains an explanatory paragraph referring to the audit of internal control, as illustrated in this chapt
2-10 Examples of compliance assurance (audits) include (1) internal auditors
determining whether corporate rules and policies are being followed by departments within the organization, and (2) an examination of tax returns of individuals and companies by the tax authorities for compliance with the tax laws.
Examples of operational assurance (audits) include (1) assurance (an audit) by the Medicines Control Agency to determine the efficiency and effectiveness of procedures for introducing new medicine to the market, (2) internal auditors examining the effectiveness and efficiency of funds being spent on the entity’s computer resources, and (3) a university hiring an external auditor to examine the effectiveness and efficiency of student advisory services.
Examples of forensic assurance (audits) include (1) an examination by an external auditor of cash disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law
enforcement body in tracing laundered monies by organized criminals, and (3) an independent auditor helping identify hidden assets as part of a divorce settlement.
2-11 Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3) government auditors, and (4) forensic auditors.
2-12 The Public Interest Oversight Board (PIOB) is an independent body charged with the oversight of the public interest activities of IFAC. The IFAC Council is responsible for deciding constitutional questions and electing the IFAC Board. The IFAC Board is responsible for setting policy and overseeing IFAC operations, the implementation of programs, and the work of IFAC committees and task forces. The Compliance Advisory Panel (CAP) is the IFAC
administration’s instrument to oversee the implementation and operation of the Member Body Compliance Program. The Forum of Firms (FOF) is an organization of international audit firms that perform audits of financial statements that are used across national borders. The
Transnational Auditors Committee (TAC) is the executive committee of FOF. The
International Auditing and Assurance Standards Board (IAASB) develops and issues the international standards on auditing, assurance, quality control, and related services, as well as practice statements. The Ethics Committee issues ethics standards. The Education
Committee develops guidelines related to the education of accountants. The International Public Sector Accounting Standards Board (IPSASB) issues International Public Sector Accounting Standards. The Professional Accountants in Business (PAIB) develops good practice guidelines on issues affecting professional accountants in business, including guidelines on corporate code of ethical conduct. Statements on Standards for Tax Services 2-13 The International Accounting Standards Board (IASB) publishes the International
Financial Reporting Standards (IFRSs) and has adopted the International Accounting Standards (IASs). IFAC and IAASB strongly support the work of IASB in the setting and promotion of the international accounting standards. When a particular financial reporting framework or specific accounting rules are referred to in an ISA, the reference is to IASs/IFRSs.
The International Organization of Securities Commissions (IOSCO) organizes national securities commissions. IOSCO cooperate closely with IFAC. (For example, IOSCO participates in the IAASB Consultative Advisory Group (CAG) and in the selection of the members of IFAC Public Interest Oversight Board (PIOB).) IFAC has sought IOSCO’s endorsement of the IAASB standards for use in all the capital markets regulated by IOSCO members.
The International Organization of Supreme Audit Institutions (INTOSAI) assembles national Supreme Audit Institutions. INTOSAI cooperates closely with IAASB in projects relevant for public sector auditing. INTOSAI has issued Auditing Standards to financial audits in the public sector. In its goal of developing guidelines for financial audits for application of the Standards, IOSCO has resolved that the guidelines should, as far as possible, draw upon the ISAs.
Solutions to Problems 2-14
Brief References to IFAC Code of Ethics and International Standards on Auditing
Sally Jones’ Actions Resulting in Failure to Comply with IFAC Code of Ethics and International Standards on Auditing
IFAC Code of Ethics:
1. The IFAC Code of Ethics requires that the accountant performs his or her professional responsibilities with
competence. A professional accountant should also take steps to ensure that those working under his or her authority in a professional capacity have
appropriate training and supervision.
1. It was inappropriate for Jones to hire the two students to conduct the audit. The examination must be conducted by persons with proper education and experience in the field of auditing. Although a junior assistant has not completed his formal education, he may help in the conduct of the examination as long as there is proper supervision and review.
2. The IFAC Code of Ethics requires that practitioners should be both
independent of mind and in appearance for audits. Independence is related to the basic principles of integrity and objectivity as well as professional scepticism. Contingent fees for audit engagements create unacceptable self-interest and advocacy threats.
2. To satisfy the IFAC Code, Jones must be without bias with respect to the client under audit. Jones has an
obligation for fairness to the owners, management, and creditors who may rely on the report. Because of the financial interest in whether the bank loan is granted to Boucher, Jones is not independent in either fact or
appearance with respect to the assignment undertaken. 3. The IFAC Code of Ethics requires
that the accountant performs his or her professional responsibilities with diligence. Diligent means that the professional accountant and those working under his or her authority should observe technical and professional standards.
IFAC Code requires Jones to perform the audit with diligence, which imposes on Jones and everyone in Jones's organization a responsibility to observe the auditing standards.
International Standards on Auditing: 1. Auditing standards requires that the engagement partner is satisfied that the engagement team has the
appropriate capabilities and competence to perform the audit (ISA 220). The
1. Jones accepted the engagement without considering the availability of competent staff. In addition, Jones failed to supervise the assistants. The work performed was not adequately
engagement partner shall also take responsibility for direction, supervision and performance of the audit (ISA 220). The auditor shall plan the audit so that the engagement will be performed in an effective manner (ISA 300).
planned.
2. The auditor shall obtain an understanding of internal control relevant to the audit (ISA 315).
2. Jones did not study internal control, nor did the assistants. There appears to have been no audit
examination at all. The work performed was more an accounting service than it was an auditing service.
3. The auditor shall obtain sufficient appropriate evidence to be able to draw reasonable conclusions on which to base the audit opinion (ISA 500).
3. Jones acquired little evidence that would support the fairness of the financial statements. Jones merely checked the mathematical accuracy of the records and summarized the accounts. Standard audit procedures and techniques were not performed. 4. The report shall state that the
audit was conducted in accordance with the ISAs or relevant national standards (ISA 700).
4. Jones’s report made no
reference to the ISAs. Because Jones did not conduct a proper examination, the report should state that no opinion can be expressed as to the fair
presentation of the financial statements in accordance with the financial
reporting framework. 5. The report shall state that the
audit includes evaluating the
appropriateness of accounting policies used and the reasonableness of accounting estimates made by
management, as well as evaluating the overall presentation of the financial statements (ISA 700).
5. Jones’s improper examination would not enable her to determine whether accounting principles have been consistently applied.
76. The report shall contain either an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons therefore should be stated. In all cases where an auditor's name is associated with financial statements, the
. Although the Jones report contains an expression of opinion, such opinion is not based on the results of a proper audit examination. Jones should disclaim an opinion because she failed to conduct an examination in accordance with ISAs.
report should contain a clear-cut indication of the character of the auditor’s work, if any (ISA 700). 2-29
2-15
Circumstance Type of Opinion
1. The financial statements are affected by a departure from the financial reporting framework.
1. The auditor should express a qualified or adverse opinion.
2. The auditor has a scope limitation due to a lack of evidence.
2. The auditor should express a qualified opinion or disclaim an opinion. 2-16
Item Number
Type of Audit Type of Auditor
a. Operational Government
b. Financial statement External
c. Compliance or operational Internal or external
d. Forensic Internal, external or forensic
e. Operational Government, external, or
internal
f. Operational Internal or external
g. Compliance Government
h. Compliance or forensic Government, external or
forensic
Solutions to Discussion Case 2-17 Part I.
There are arguments both for and against having formal standards for independent auditors who consult. Advantages include potential increase in public trust, some assurance that a minimal level of service quality would be attained, and perhaps more guidance for consultants (to allow them to perform more effective consulting engagements). The primary disadvantage
would result from the fact that auditors who consult compete with consulting firms comprised of non-auditors. If standards were not thought out carefully, perhaps the standards would put auditors at a disadvantage relative to non-auditors in the sense that auditors would be subject to standards that constrain their activities or perhaps result in their not being able to compete with non-auditors in the area of fees. Note that Part A of the IFAC Code of Ethics applies to all professional accountants. (A professional accountant is an individual who is a member of an IFAC body.) Part B of IFAC Code of Ethics applies to all professional accountants in public practice. (A professional accountant in public practice is a professional accountant, irrespective of functional classification (e.g. audit, tax or consulting) in a firm that provides professional services.) Part B of the Code includes certain restrictions in providing consulting services to audit clients. These restrictions and IFAC Code of Ethics are covered in a later chapter. 2-18 Part II.
a. In one sense, E&Y acted unethically. That is, they should have disclosed the nature of these relationships to MGR. In another sense, it is difficult to ascertain whether these
relationships caused E&Y to act unethically. Specifically, was E&Y’s advice affected by their relationship with the landlord? Is this relationship the reason that E&Y’s cost-cutting
suggestions did not go farther? These questions point out the importance of independence in fact and appearance, even when acting in a consulting capacity. Even if E&Y acted ethically, this relationship creates the appearance of impropriety.
b. As mentioned in Part a, the relationship with Rouse could have caused E&Y to hesitate to suggest that the stores for which Rouse was the landlord be closed for fear of losing business from Rouse. Their relationship with Swidler could have made E&Y feel that they could not lose the engagement under any circumstances, thereby explaining their apparently lackadaisical attitude towards the engagement.
Solutions to Internet Assignments
2-19 The IFAC’s homepage contains links to IFAC members via ‘About IFAC’. Members are typical a national professional organization that has its own homepage, containing information about the organization, its mission and activities. All IAASB exposure drafts are accessible using the link ‘Exposure Drafts’. By using the link ‘Standards and Guidance’ IFAC Handbook of International Auditing, Assurance, and Ethics Pronouncements can be downloaded after
registration. Detailed information about IAASB and the Ethics Committee are found using the link ‘IFAC Boards and Committees’.
2-20 A search of the homepage of many companies will include links to their latest financial information. Examining the independent auditor’s report and financial statements will allow the student have a better idea as to how the chapter’s information is applied in real companies.
CHAPTER 3
RISK ASSESSMENT AND MATERIALITY Answers to Review Questions
3-1 Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Auditor’s business risk is the auditor’s exposure to loss or injury to professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on. In simple terms, audit risk is the risk that an auditor will issue an unmodified opinion on materially misstated financial statements, while auditor’s business risk relates to the auditor's exposure to financial loss and damage to his or her professional reputation.
3-2 Inherent risk and control risk differ from detection risk in that inherent risk and control risk exist independently of the audit. The levels of inherent risk and control risk are functions of the client and its environment, and the auditor has little control over these risks. The auditor can control detection risk through the scope (nature, timing and extent) of the audit procedures performed. Thus, detection risk has an inverse relationship with inherent risk and control risk. 3-3 Sampling risk refers to the fact that, in many instances, the auditor does not examine 100 percent of the account balance or class of transactions. Since only a subset of the population is examined, it is possible that the sample drawn is not representative of the
population and a wrong conclusion may be made on the fairness of the account balance. Non-sampling risk occurs because an auditor may use an inappropriate audit procedure, fail to detect a misstatement when applying an appropriate audit procedure, or misinterpret an audit result.
3-4 In understanding of the entity and its environment, the auditor gathers knowledge about: (1) industry, regulatory, and other external factors; (2) the nature of the entity; (3) its objectives and strategies, and related business risks; (4) measurement and review of the entity’s financial performance; (5) internal control.
3-5 Some examples of conditions and events that may indicate the existence of business risks are:
• Significant changes in the entity such as large acquisitions, reorganizations or other unusual events.
• Significant changes in the industry in which the entity operates.
• Significant new products or services or significant new lines of business. • New locations.
• Significant changes in the IT environment. • Operations in areas with unstable economies. • High degree of complex regulation.
3-6 Auditing standards define errors as unintentional misstatements or omissions of amounts or disclosures in financial statements. Fraud is defined as intentional misstatements that can be classified into two types: (1) misstatements arising from fraudulent financial reporting and (2) misstatements arising from misappropriation of assets. Examples of errors include mistakes in gathering or processing from which financial statements are prepared, unreasonable accounting estimates arising from oversight or misinterpretation of facts, and mistakes in the application of accounting principles. Fraud includes intentional manipulation,
falsification, or alteration of accounting records or supporting documents from which the financial statements are prepared; misrepresentation in, or intentional omission from, the financial statements of events, transactions, or other significant information; intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure; and theft of assets such as cash or inventory.
3-7 The audit risk model has a number of limitations. First, the model assumes that its components are independent of one another while they are likely to be dependent in the real world. Second, since the auditor assesses inherent risk and control risk, such assessments may be higher or lower than the actual inherent risk and control risk that exist for the client. Third, the model does not separately take into account fraud risk. Last, the audit risk model does not consider the possibility of non-sampling risk.
3-8 Professional standards provide very little specific guidance on how to assess what is material to a reasonable user. As a result, auditing firms should develop policies and
procedures to assist their auditors in establishing materiality judgments for clients in order to minimize the variability of such judgments by firm personnel. In other words, firms would prefer to have their auditors establish similar materiality judgments for clients with similar
circumstances.
3-9 The three major steps in applying materiality are:
Step 1: Plan a preliminary judgment about materiality. The auditor establishes a preliminary judgment about materiality by choosing a base, or bases, which is multiplied by a percentage factor to determine the initial quantitative judgment about materiality. This amount can be adjusted for qualitative factors that may be relevant for the engagement.
Step 2: Determine tolerable misstatement. This step involves determining tolerable
misstatement based on planning materiality. Tolerable misstatement is the amount of planning materiality that is allocated to the account balances or classes of transactions so that the auditor can plan the scope of audit procedures for the individual account balance or class of
transactions.
Step 3: Estimate likely misstatements and compare the totals to the preliminary judgment about materiality. The auditor estimates likely misstatements and compares the aggregate misstatements (i.e. likely misstatements and known misstatements) to the preliminary judgment about materiality. When the aggregate misstatements are less than the preliminary judgment about materiality, the auditor concludes that the financial statements are fairly presented. Conversely, when the aggregate misstatements are greater than the planned judgment about materiality, the auditor should request that the client adjust the financial statements.
3-10 Total assets or total revenues are better bases for determining materiality for many entities because these factors are more stable and less variable from year to year than is net income (profit). Difficulties arise when using net income, or a variant of net income, as a base when the entity is close to breaking even or experiencing a loss.
3-11 Qualitative factors that may affect the establishment of the preliminary judgment about materiality (step 1) are shown in Table 3-12. Many of these qualitative factors are cited in ISA 320 ‘Materiality in the Identification and Evaluation of Misstatements’ (exposure draft).
3-12 Qualitative factors that may affect the establishment of the evaluation of materiality (step 3) are shown in Table 3-12. Many of these qualitative factors are cited in ISA 320 ‘Materiality in the Identification and Evaluation of Misstatements’ (exposure draft).
Solutions to Problems 3-13
a.
1. is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
2. Inherent risk is the susceptibility of an assertion to material misstatement, assuming no related internal controls. Control risk is the risk that material misstatements that could occur will not be prevented or detected by the internal controls. Detection risk is the risk that the auditor will not detect a material misstatement that exists in the financial
statements.
3. Inherent risk and control risk differ from detection risk in that they exist independently of the audit of financial statements, whereas detection risk relates to the auditor's
procedures and can be changed at the auditor's discretion. Detection risk has an inverse relationship to inherent and control risk.
b.
1. Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.
2. Materiality is affected by the nature and amount of an item in relation to the nature and amount of items in the financial statements under examination, and the auditor's judgment as influenced by the auditor's perception of the needs of a reasonable person who will rely on the financial statements. A number of qualitative factors also affect materiality.
3. The auditor's judgment about materiality for planning purposes may be different from materiality for evaluation purposes because the auditor, when planning an audit, cannot anticipate all of the circumstances that may ultimately influence judgment about materiality in evaluating the audit findings at the completion of the audit. If significantly lower materiality levels become appropriate in evaluating the audit findings, the auditor should reevaluate the sufficiency of the audit procedures already performed.
3-14
Client No. Detection Risk
2 10%
3 80%
4 25%
3-15
Client No. Detection Risk
1 Moderate 2 High 3 Low 4 Low 3-16 3-17
a. Two factors are particularly important in assessing the risk of material misstatement for Johnson. First, one individual, who also has majority control of the stock, dominates the decision making in the company. This factor should lead to a higher assessment for the risk of material misstatement because there is no review of important decisions and actions may be taken that are not in the best interest of the company or its stockholders. Second, Johnson is expanding rapidly throughout the southeast. Such expansion may result in material
misstatements since decision making may become decentralized without adequate internal control. The increase in the risk of material misstatement due to these two factors will result in a lower determination of detection risk and an increase in the scope of the auditor's work.
b. A number of the risk factors are present for Close-Moor stores. First, the company is experiencing a slowdown in sales. Second, there has been turnover in two financial positions within the company. Third, the president of the company is aggressive and places undue emphasis on meeting earnings expectations. These factors lead to an increased assessment for the risk of material misstatement, resulting in a lower assessment of detection risk and more substantive testing.
c. The factors affecting the assessment of the risk of material misstatement for MaxiWrite all relate to industry characteristics. First, the industry is very competitive, which can lead to price-cutting and its related effects on revenues. Second, the industry is affected by changes in technology, and MaxiWrite is not one of the industry leaders in technology. Its products usually are not competitive with the industry leaders in terms of performance. Third, the company is not as profitable or financially strong as the major companies in the industry. The industry factors result in an increased assessment of the risk of material misstatement for MaxiWrite, leading to a lower determination of detection risk and more substantive tests.
1. B 6. C
2. D 7. D
3. C 8. D
4. B 9. A
d. The risk of material misstatement should be increased for the Focus Bank for the
following reasons. First, the audit firm has been the bank's auditors for only two years. Second, there has been contentious accounting issues related to loan loss reserves and the value of collateral. Third, prior audits have indicated the presence of misstatements in the loan loss reserve. Based on these risk factors, detection risk should be set lower and increased substantive tests performed.
3-18
a. Pitts has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error or fraud. If Pitts's risk factor assessment indicates that fraud may be present, she might respond as follow:
• Increase professional scepticism by questioning and critically assessing audit evidence.
• Assign more experienced auditors who have the knowledge, skill, and ability to commensurate with the increased risk of the engagement.
• Consider management's selection and application of significant accounting policies, particularly those related to revenue recognition, asset valuation, or capitalizing versus expensing.
• Modify the nature, timing and extent of audit procedures to obtain more reliable evidence and use increased samples sizes or more extensive analytical procedures.
Pitts should document the risk of material misstatement for all material accounts and classes of transactions. The auditor’s documentation includes the following:
• The nature and results of the communication among engagement personnel that
occurred in planning the audit regarding the risks of material misstatement due to fraud. • The steps performed in obtaining and supporting knowledge about the entity’s business
and its environment. The documentation should include: the risks identified, an
evaluation of management’s response to such risks, and the auditor's assessment of the risk of fraud after considering the entity’s response.
• The nature, timing, and extent of the procedures performed in response to the risks of material misstatement due to fraud and the results of that work.
• Fraud risks or other conditions that caused the auditor to believe that additional audit procedures or other responses were required to address such risks or other conditions. • The nature of the communications about fraud made to management, those in charge
with governance, and others.
b. If Pitts had evidence that suggested that fraud might exist, the matter should be brought to the attention of an appropriate level of management. If the fraud involved senior
management or the fraud causes a material misstatement of the financial statements, Pitts should report it directly to those in charge with governance ( e.g. the board of directors or the audit committee). In addition, Pitts should reach an understanding with those in charge with governance regarding the expected nature and extent of communications about
misappropriations perpetrated by lower-level employees.
Pitts has no responsibility to disclose the fraud to parties other than the client's senior management and those in charge with governance because of ethical or legal obligations of confidentiality. However, the auditor’s legal responsibilities vary by country and in certain circumstances the duty of confidentiality may be overridden by statute, the law or courts of law. The IFAC Code of Ethics for Professional Accountants provides guidance on circumstances
where auditors should disclose confidential information or when such disclosure may be appropriate. (Chapter 19 discusses the IFAC Code of Ethics.)
To a funding agency or other specified agency in accordance with requirements for the audits of entities that receive governmental financial assistance.
3-19
Client No. PJM (rounded)
1 $€54,800
2 $3€10,000
3 $€2,835,000
4 $€38,700,000
Solution to Discussion Cases 3-20
a. Materiality and audit risk both would likely be set at very low levels. Investors and creditors to assess their investments in light of MGR’s difficulties probably will use the financial statements quite extensively. In addition, the auditors likely would set audit risk quite low because there is a high risk of litigation against the auditor should MGR declare bankruptcy. The auditor would set audit risk low to minimize the risk of rendering an inappropriate audit opinion.
b. Inventory is the account that most likely is misstated. Inventory already has been written down, and MGR’s trouble generating sales suggests that further inventory write-downs are likely. This explanation represents an inherent risk factor because it involves business factors that affect valuation. There also are motivations to overvalue inventory (to inflate financial position), which also represents an inherent risk factor.
c. MGR’s motivations to misstate its financial position to mask its difficulties certainly create a motivation to commit fraud; this represents a high likelihood of fraudulent financial reporting. Misappropriation of assets (theft) also is a possibility because MGR’s inventory likely is
attractive to its employees. However, fraudulent financial reporting would be of greater concern to the auditors.
d. Auditor’s business risk would be very high because of the likelihood that the client will go out of business as well as the likelihood that the client will commit fraud.
e. The entity’s business risk also is high because of its continuing financial difficulties. 3-21
a. First, it is important to understand that the fraud at Cendant involved fraudulent financial reporting as opposed to misappropriation of assets. All three aspects of the fraud triangle are present in this situation. Incentives include pressure to meet analysts’ expectations. A weak control system, a lax auditor, and the presence of many
accounting estimates present opportunities for fraud. Rationalization is created by an ‘everybody does it’ attitude and a weak commitment by management to accurate financial reporting.
b. Signals that fraud may have been occurring include the fact that Cendant always met analysts’ expectations, top management implemented inadequate controls, the growth of large favourable adjustments, constant revisions of reserves, and inadequate
Solutions to Internet Assignments 3-22
a. Jones would use the total assets of €29,611,000 as the base in Exhibit 3-4. Using this amount, the preliminary judgment of materiality is €176,000 (rounded). This amount is
determined by using the planning materiality of €85,500 (the amount over €10 million but not over €30 million) and adding €90,400 to it. The €90,400 was determined by using the excess over €10 million and multiplying it by .00461 (€19.611 million x .00461).
b. There are a number of sites on the Internet that contain information on the paging (telecommunications) industry. Unfortunately, many of these sites sell their data at relatively high prices. Two sites that contained such information are: Info Edge (www.info-edge.com), and The Strategis Group (www.strategisgroup.com). The Personal Communications Industry Association (PCIA) (www.pcia.com) and the Canadian Wireless Telecommunications
Association (CWTA) (www.cwta.ca) have homepages that contain information on the industry. Another source of information is the homepages of other companies that operate in the paging industry.
c. The memo describing Calabro Paging Services’ client business risk should include the following factors:
• Highly competitive industry, with price being the primary means of differentiation among service providers.
• There are many licensed companies with the industry undergoing consolidation through merger and acquisition.
• The industry requires substantial funds to finance the maintenance and growth of operations and customer base.
• Many smaller companies in the industry are losing money. • There are significant risks to changing technology.
• Many of Calabro’s competitors are larger and better financed. • The industry is subject to regulation.
3-23 The answers to this Internet assignment will be a function of the company assigned by the instructor. However, the responses to the questions will be found in the sources cited in the problem and will be similar to those in the questionnaire provided by your instructor or
downloaded from the book’s website. For example, we have used companies in the pharmaceutical industry for this assignment.
CHAPTER 4
AUDIT EVIDENCE AND AUDIT DOCUMENTATION Answers to Review Questions
4-1 Auditors typically divide the financial statements into components or segments in order to make the audit more manageable. A component can be a financial statement account or a transaction process. This approach allows the auditor to gather evidence by examining the processing of related transactions through the accounting system from their origin to their ultimate disposition in the accounting journals and ledgers. Thus, the auditor can examine an accounting transaction from the time it is initiated by the entity until its final recording in the financial statement accounts.
4-2 There is a top-down relationship from the financial statements to the audit procedures. The financial statements contain management's assertions about the various financial
statement components. The auditor tests each relevant management assertion and then
conducts audit procedures to gather evidence to test whether the assertions are being met. The results from applying audit procedures provide the evidence that supports the fair presentation of management’s assertions and the auditor's report (see Figure 4-1).
4-3
Assertions about classes of transactions and events for the period under audit:
Assertion Definition
Occurrence Transactions and events that have been recorded have occurred and pertain to the entity (sometime referred to as validity).
Completeness All transactions and events that should have been recorded have been recorded.
Authorization All transactions and events have been properly authorized. Accuracy Amounts and other data relating to recorded transactions and
events have been recorded appropriately.
Cutoff Transactions and events have been recorded in the correct accounting period.
Classification Transactions and events have been recorded in the proper accounts.
4-4
Assertions about account balances at the period end:
Assertion Definition
Existence Assets, liabilities, and equity interests exist. Rights and
Obligations
The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.
Completeness All assets, liabilities and equity interests that should have been recorded have been recorded.
Valuation and Allocation
Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts, and any
resulting valuation or allocation adjustments are appropriately recorded.
4-5 Audit evidence is all the information used by the auditor in arriving at the conclusions on which the audit opinion is based, and includes the information contained in the accounting records underlying the financial statements and other information. Corroborating or other
evidence includes both written and electronic information such as cheques, records of electronic transfers, invoices, contracts, minutes, confirmations, and written representations. It also
includes information obtained by the auditor through inquiry, observation, inspection, and physical examination.
4-6 Audit evidence is usually persuasive rather than convincing for two reasons. First, since an audit must be completed in a reasonable amount of time and at a reasonable cost, the auditor examines only a sample of the transactions that compose the class of transactions or account balance. Second, due to the nature of evidence, auditors must often rely on evidence that is not perfectly reliable. The types of audit evidence examined by the auditor have different degrees of reliability, and even highly reliable evidence has weaknesses. Therefore, the
evidence obtained by the auditor seldom provides absolutely convincing about an audit objective.
4-7 The types of audit procedures and their definitions are: (1) Inspection of records or documents consists of examining internal and external records or documents that are in paper form, electronic form, or other media. (2) Inspection of physical assets consists of physical examination of assets. (3) Reperformance is the auditor's independent execution of
procedures or controls that were originally performed as part of the entity’s internal control, either manually or through the use of CAATs. (4) Recalculation consists of checking the mathematical accuracy of documents and records. (5) Scanning is the review of accounting data to identify significant or unusual items. (6) Inquiry consists of seeking information of knowledgeable persons, both financial and non-financial, throughout the entity and outside the entity. (7) Observation consists of looking at a process or procedure being performed by others. (8) Confirmation is the process of obtaining a representation of information or of an existing condition directly from a third party. (9) Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data (ISA 520).
4-8 Vouching refers to first selecting an item for testing from the accounting journals or ledgers and then examining the underlying source document. Thus, the direction of testing is from the journals or ledgers back to the source documents. Vouching provides evidence that items included in the accounting journals or ledgers have occurred (are valid). Tracing refers to
first selecting an accounting transaction (a source document) and then following it into the journal or ledger. The direction of testing in this case is from the source documents to the journals or ledgers and tests whether transactions that occurred are recorded (completeness) in the accounting records.
4-9 Corroborating evidence is obtained for inquiry and for observation because these audit procedures typically are not from independent sources and therefore are not considered to be highly reliable. For example, the auditor might follow up the client's responses concerning the internal controls over the raw-material storeroom by conducting tests of the control procedures to verify their existence and effectiveness.
4-10 Inspection of tangible assets, reperformance, and recalculation are generally considered of high reliability because the auditor has direct knowledge about them. Inspection of records and documents, scanning, confirmation, and analytical procedures are generally considered to be of medium reliability. The reliability of inspection of records and documents depends primarily on whether a document is internal or external. Scanning depends on the auditor’s ability to identify anomalous items using judgment or CAATs. The reliability of confirmations is affected by the form of the confirmation, prior experience with the entity, the nature of the information being confirmed, and the intended respondent. The reliability of analytical
procedures may be affected by the quality of the client's internal control system. Finally, inquiry and observation are generally low-reliability types of evidence since both require further
corroboration by the auditor.
It should be understood, however, that levels of reliability for the types of evidence should be considered as general guidelines. The reliability of the types of evidence may vary considerably across entities, and it is subject to a number of exceptions.
4-11
It is important that the audit documentation or working papers be organized or indexed in such a way that members of the audit team or firm can find relevant audit evidence. When the auditor performs audit work on one working paper and supporting information is obtained from another working paper, the auditor cross-references the information on each working paper. This process of indexing and cross-referencing provides a trail from the financial statements to the individual working papers that can be easily followed members of the audit team or firm. Today, much of this cross-referencing is facilitated by the use of electronic working paper programs. Solutions to Problems 4-12 a. 5 b. 4 c. 1 d. 2 e. 3 4-13 a. 8 g. 7 b. 1 h. 3 c. 3 i. 8 d. 6 j. 1/3 e. 9 k. 5 f. 2
