CHAPTER 1
PROFESSIONAL PRACTICE OF ACCOUNTANCY
Questions
1. Generally, to be a CPA one must meet certain education requirements, and pass the CPA exam.
The CPA examination is prepared and graded twice each year. It is generally recognized as an academic examination. It includes multiple-choice questions in the following subjects namely, Theory of Accounts, Practical Accounting I, Practical Accounting II, Auditing Theory, Auditing Problems, Management Services, Business Law and Taxation.
2. Refer to page 11 of the textbook.
3. Refer to page 110 (Section 28 of the Philippine Accountancy Act of 2004) of the textbook.
4. Competencies include both what individual auditors know and what individual auditors and audit teams do. Competencies are evidenced by auditors applying their skills in the delivery of services to clients or supporting the delivery of those services. These competencies categorized as “High Opportunity Competencies” and “Low Opportunity Competencies” are as follows:
High Opportunity Competencies have a high likelihood of being building blocks for selling or delivering new assurance services.
• Analytical Skills • Business Advisory Skills • Business Knowledge • Capacity for Work
• Comprehension of Client’s Business Processes • Communication Skills
• Efficiency
• Intellectual Capability • Learning and Rejuvenation • Marketing and Selling
• Model Building • People Development • Relationship Management • Responsiveness and Timeliness • Technology
• Verification
Low Opportunity Competencies, while important to the delivery of current assurance services, are less likely to be exploited in the development of future services.
• Accounting and Auditing Standards • Administrative Capability
• Managing Audit Risk 5. Refer to page 4 of the textbook.
6. The Philippine Accountancy Act of 2004 (R.A. 9298) Article I, Section 4, paragraphs (a) to (d) spell out the scope of the practice of accountancy as follows:
• Practice of Public Accountancy • Practice in Commerce and Industry • Practice in Education/Academe • Practice in the Government 7. Refer to pages 8 to 10 of the textbook. 8. Refer to page 11 of the textbook. 9. Refer to pages 13 to 14 of the textbook. 10. Refer to pages 14 to 15 of the textbook. 11. Refer to pages 16 to 17 of the textbook.
Professional Practice of Accountancy 1-3
12. This is brought about by the nature of accounting standards and the demand for accounting-related information which have changed in several significant ways. These changes include:
• Global Harmonization of Accounting Standards • Expanded Accountability
• More Detailed Reporting • Increased Risk Reporting • Global Audit Standards
13. (a) While university-level training is important, it is also necessary that professionals continue their education throughout their careers, as accounting and auditing standards will change. In this particular case, the staff member would need to stay abreast of current developments in order to meet the competence and capabilities element of the responsibilities principle.
(b) Auditors need to be both independent in fact and independent in appearance. While a small financial investment might not impair the auditors’ actual state of mind (independence in fact), it is unlikely that financial statement users will perceive the auditor to be independent (independence in appearance). Professional standards would not consider the auditor independent in this case, as no direct financial interests in clients are permitted.
Multiple Choice Questions 1. D
2. C 3. B 4. B
PRACTICE OF PUBLIC ACCOUNTANCY
Questions
1. Refer to page 29 of the textbook. 2. Refer to pages 30 to 35 of the textbook. 3. Refer to page 37 of the textbook. 4. Refer to page 37 of the textbook.
5. The following are the most sought - after services among professional accountants.
A. Assurance Services. Examples are: 1. Independent financial statement audit 2. Reviews
3. Other assurance services (e.g., CPA Web Trust, Business Performance Measurement Service)
B. Non-Assurance Services. Examples are: 1. Agreed-upon procedures
2. Compilation 3. Tax
4. Management consultancy/advisory services 5. Accounting and data processing
6. Other non-assurance services (e.g., Information Technology System Services)
6. In an assurance engagement, a practitioner aims to provide a high or moderate level of assurance that an assertion being made by one party for use by another party can be relied upon while in a consulting engagement, the practitioner aims to provide professional advice on how the limited resources of an enterprise can be put into optimal use in order to attain the company’s objectives.
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7. Examples of assurance engagements on information technology are: a) CPA Web Trust Service
b) Information System Reliability Service
Refer to page 41 of the textbook for a brief discussion of these services. 8. Refer to page 52 of the textbook.
9. Refer to pages 44 to 52 of the textbook. 10. Refer to page 38 of the textbook. 11. Refer to page 47 of the textbook. 12. Refer to pages 52 to 54 of the textbook. 13. Refer to page 36 of the textbook. 14. Refer to pages 56 and 57 of the textbook.
Multiple Choice Questions
1. C 6. C 11. D 2. A 7. D 12. C 3. D 8. D 13. D 4. D 9. D 14. C 5. D 10. C Cases
1. (a) The purpose of CPA reporting on internal control is to provide assurance about whether management’s assertion about internal control is fairly stated in all material respects, based on the control criteria being followed. Thus, for example, an examination provides the highest degree of assurance that information produced by the system will be reliable.
(b) When involved in performing an examination on the effectiveness of internal control a practitioner should:
• Plan the engagement.
• Obtain an understanding of internal control.
• Evaluate the design and operating effectiveness of internal control. • Form an opinion about the fairness of management’s assertion on
2. (a) PSA 100, Assurance Engagements, provide guidance for an engagement such as one on customer satisfaction. They provide guidelines on audits and related services such as examinations and reviews.
(b) Suitable criteria are those that are objective and permit reasonably consistent measurements. In addition, the criteria must be sufficiently complete such that no relevant factors are omitted that would affect a conclusion about the subject matter. Finally, the criteria must measure some characteristic of the subject matter that is relevant to a user’s decision.
(c) INDEPENDENT ACCOUNTANTS’ REPORT
We have examined the accompanying Schedule of Customer Satisfaction Measures for the three years ended December 31, 2013. This schedule is the responsibility of Gonzales, Inc.’s management. Our responsibility is to express an opinion on this schedule based on our examination.
Our examination was conducted in accordance with standards on assurance engagements adopted in the Philippines and, accordingly, included examining, on a test basis, evidence supporting the schedule and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the Schedule of Customer Satisfaction Measures referred to above presents fairly, in all material respects, the levels of customer satisfaction for the three years ended December 31, 2013, in conformity with the measurement and disclosure criteria set forth in Note 1.
Santos & Lopez, LLP March 1, 2014
NOTE TO INSTRUCTOR: If the CPAs believe that the criteria are not understandable by users other than management a paragraph must be added to the report restricting its use.
CHAPTER 3
OVERVIEW OF AUDITING
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 Philippine Financial Reporting Standards (PFRS), as well as Philippine Standards on Auditing (PSA).
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.
Audits of Financial Statements Compliance Audits Operational Audits Purpose To determine whether
the financial statements are presented in accordance with PFRS. To determine whether the client is following specific procedures set by higher authority.
To evaluate whether operating procedures are efficient and effective.
Audits of Financial Statements Compliance Audits Operational Audits Users of Audit Report
Different groups for different purposes – many outside entities.
Authority setting down procedures, internal or external
Management of organization Nature Highly standardized Not standardized, but
very specific and usually objective
Highly nonstandard; often very subjective 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
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
Overview of Auditing 3-3
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 information
1. User obtains information desired. 2. User can be more confident of
the qualifications and activities of the person getting the
information.
1. High cost of obtaining information.
2. Inconvenience to the person providing the information because large number of users would be on premises. Users share
information risk with
management
1. No audit costs incurred. 1. Users may not be able to collect on losses.
Audited financial statements are prepared
1. Multiple users obtain the information.
2. Information risk can usually be reduced sufficiently to satisfy users at reasonable cost. 3. Minimal inconvenience to
management by having only one auditor.
1. May not meet needs of certain users.
2. Cost may be higher than the benefits in some situations, such as for a small company.
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, • biases and motives of the provider, • voluminous data, and
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 84 and 85 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 PAS. 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 financial reporting standards.
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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. 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.”
16. (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.
17. Financial statements audits, operational audits, and compliance audits are similar in that each type of audit involves accumulating and evaluating evidence about information to ascertain and report on the degree of correspondence between the information and established criteria. The differences between each type of audit are the information being examined and the criteria used to evaluate the information. An example of a financial statement audit would be the annual audit of CBN Corporation, in which the external auditors examine ABS-CBN’s financial statements to determine the degree of correspondence between those financial statements and generally accepted accounting principles. An example of an operational audit would be an internal auditor’s evaluation of whether the company’s computerized payroll-processing system is operating efficiently and effectively. An example of a compliance audit would be a BIR
auditor’s examination of an entity’s tax return to determine the degree of compliance with the National Internal Revenue Code.
18. Refer to pages 83 to 84 of the textbook.
19. The text defines internal auditing as an independent appraisal activity in an entity. Internal auditing is itself a control that operates by examining and evaluating the adequacy and effectiveness of other controls. Independence is such an important aspect of internal auditing that the fourth section of the Statement of Responsibilities of Internal Auditing is devoted to independence. Organizations create internal auditing to serve or benefit the organization. The broad objective of internal auditing is to provide assistance to members of the organization to enable the members to meet their responsibilities effectively. Assistance may involve providing counsel or recommendations, analysis, or information. One goal of internal auditing should be to achieve effective control that is worth the cost.
In describing the nature of internal auditing, the Statement of Responsibilities of Internal Auditing indicates that internal auditing functions by examining controls. The scope limits internal auditing’s responsibility for examining and evaluating performance to specific responsibilities that are assigned to individuals or units. Internal auditing examines and evaluates performance to compare the actual performance with plans, specified activities, standards, objectives, policies, and goals. Such evaluations are really evaluations of controls because plans, specified activities, standards, objectives, policies and goals are controls. Internal auditors may be called on to examine areas for which performance criteria have not been specified. When this occurs, internal auditors may select measurable criteria and report their findings in terms of those measurable criteria. For example, if internal auditors were called on to evaluate a credit department, they might present historical information as well as industry information to management as a basis for evaluating the credit department.
20. Independence is the essence of auditing and enables auditors to render impartial and unbiased judgments. The two conditions that contribute to an internal auditor’s independence are organizational status and auditor objectivity. The internal auditors’ status must be such that they are respected throughout the organization. Generally, the more respect management gives to the internal audit function, the greater the attention the whole organization pays to their findings and recommendations. Giving the highest-level person in internal auditing the status of vice president and having that person report to the board of directors’ audit committee give sufficient status to the internal audit function. Objectivity requires that internal auditors have an independent mental attitude and an honest belief in their work product.
Overview of Auditing 3-7
21. COA auditors perform operational or performance audits, compliance audits, and financial audits.
22. An independent auditor is usually a CPA who has received a license to perform the attest function. To be a CPA, one generally must meet certain educational requirements and pass an examination.
Internal auditors are employees of the organization for which they do audits. They may perform financial auditing, compliance auditing, or operational auditing. They are not independent in the sense that external auditors are, although they may attain a degree of independence by their position in the organization.
Governmental auditors are employees of various government agencies who perform financial, compliance, and operational auditing. For example, local governments employ auditors to verify that businesses collect and remit sales tax as required by law.
Multiple Choice Questions
1. D 11. B 21. D 31. D 2. A 12. A 22. B 32. B 3. A 13. C 23. C 33. A 4. D 14. C 24. B 34. D 5. B 15. A 25. B 35. C 6. C 16. D 26. C 36. D 7. B 17. A 27. D 37. B 8. C 18. A 28. C 38. C 9. B 19. D 29. A 39. A 10. D 20. C 30. A 40. B
REGULATION OF THE PRACTICE
OF PUBLIC ACCOUNTANCY
Questions
1. Refer to pages 110 (Section 28 of the Philippine Accountancy Act of 2004) of the textbook.
2. Refer to pages 112 (Sections 34 & 35 of the Philippine Accountancy Act of 2004) of the textbook.
3. Competencies include both what individual auditors know and what individual auditors and audit teams do. Competencies are evidenced by auditors applying their skills in the delivery of services to clients or supporting the delivery of those services. These competencies categorized as “High Opportunity Competencies” and “Low Opportunity Competencies” are as follows:
High Opportunity Competencies have a high likelihood of being building blocks for selling or delivering new assurance services.
• Analytical Skills • Business Advisory Skills • Business Knowledge • Capacity for Work
• Comprehension of Client’s Business Processes • Communication Skills
• Efficiency
• Intellectual Capability • Learning and Rejuvenation • Marketing and Selling • Model Building • People Development • Relationship Management • Responsiveness and Timeliness
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• Technology • Verification
Low Opportunity Competencies, while important to the delivery of current assurance services, are less likely to be exploited in the development of future services.
• Accounting and Auditing Standards • Administrative Capability
• Managing Audit Risk
4. Examples of typical lawsuits against CPAs are
a) Alleged misstatements that the auditor did not detect in the financial statements involving
1) improper or inadequate disclosure 2) inappropriate valuations
b) Alleged failure to detect defalcation as a result of negligence in the conduct of the audit
c) Alleged failure to complete the audit on the agreed-on date d) Alleged inappropriate withdrawal from an audit
5. Indications That Noncompliance May Have Occurred
Examples of the type of information that may come to the auditor’s attention that may indicate that noncompliance with laws or regulations has occurred are listed below:
• Investigation by government departments or payment of fines or penalties.
• Payments for unspecified services or loans to consultants, related parties, employees or government employees.
• Sales commissions or agent’s fees that appear excessive in relation to those ordinarily paid by the entity or in its industry or to the services actually received.
• Purchasing at prices significantly above or below market price.
• Unusual payments in cash, purchases in the form of cashiers’ checks payable to bearer or transfers to numbered bank accounts.
• Payments for goods or services made other than to the country from which the goods or services originated.
• Payments without proper exchange control documentation.
• Existence of an accounting system which fails, whether by design or by accident, to provide an adequate audit trail or sufficient evidence. • Unauthorized transactions or improperly recorded transactions. • Adverse media comment.
6. Refer to page 119 of the textbook.
7. PSA 260 (Clarified), “Communication with Those Charged with Governance” deals with the auditor’s responsibility to communicate with those charged with governance in relation to an audit of financial statements. Although this PSA applies irrespective of an entity’s governance structure or size, particular considerations apply where all of those charged with governance are involved in managing an entity, and for listed entities. This PSA does not establish requirements regarding the auditor’s communication with an entity’s management or owners unless they are also charged with a governance role. 8. The increase in litigation against auditors seems to be happening for two
reasons: a general increase in litigation in society, and the fact that investors and creditors who suffer losses will look for “deep pockets” to pay for those losses. Most accounting firms appear to have “deep pockets.”
9. Due (professional) care is the standard by which the courts and the profession expect a CPA to practice. A CPA who is found to have exercised due professional care in an engagement should not have any liability to others. 10. The four gradations are none, negligence, gross negligence (sometimes referred
to as constructive fraud), and fraud. At one extreme is the auditor who performs an appropriate audit and issues an appropriate report. This auditor’s degree of wrongdoing is “none.” An auditor who commits fraud is at the other extreme, since he or she knows that the financial statements are misstated and yet issues an unqualified opinion. An auditor is negligent if he or she does not do what a reasonably prudent auditor should do in the circumstances. An auditor is grossly negligent if he or she consistently fails to follow the standards of the profession on an engagement.
11. Auditors are responsible to clients for negligence, gross negligence, or fraud. 12. Refer to page 126 of the textbook.
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13. Most courts have held that an auditor has a higher responsibility to communicate information beyond that required by PFRSs and PSAs. Courts have held that compliance with PFRSs is persuasive but not conclusive evidence.
14. An auditor should (a) follow the Philippine Standards on Auditing, the Code of Ethics for Professional Accountants in the Philippines, and where appropriate, PFRSs; (b) establish and follow appropriate quality control procedures; (c) evaluate whether a client has the necessary integrity and appropriate reputation in the community; (d) evaluate carefully why a client wants an audit; (e) conduct the audit with appropriate professional skepticism; (f) provide for appropriate levels of consultation for issues; and (g) provide for appropriate review of the audit.
15. The prudent man concept states that a man is responsible for conducting a job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected to conduct an audit using due care, but does not claim to be a guarantor or insurer of financial statements.
Multiple Choice Questions
1. B 11. A 21. B 31. B 2. C 12. D 22. C 3. A 13. C 23. A 4. B 14. D 24. A 5. A 15. C 25. A 6. C 16. A 26. C 7. A 17. A 27. C 8. C 18. D 28. A 9. A 19. B 29. A 10. B 20. D 30. C
CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS
IN THE PHILIPPINES
Questions
1. There is a special need for ethical behavior by professionals to maintain public confidence in the profession, and in the services provided by members of that profession. The ethical requirements for CPAs are similar to the ethical requirements of other professions. All professionals are expected to be competent, perform services with due professional care, and recognize their responsibility to clients. The major difference between other professional groups and CPAs is independence. Because CPAs have a responsibility to financial statement users, it is essential that auditors be independent in fact and appearance. Most other professionals, such as attorneys, are expected to be an advocate for their clients.
2. Independence in fact exists when the auditor is actually able to maintain an unbiased attitude throughout the audit, whereas independence in appearance is dependent on others’ interpretation of this independence and hence their faith in the auditor.
Activities which may not affect independence in fact, but which are likely to affect independence in appearance are: (Notice that the first two are violations of the Code of Ethics.)
1. Ownership of a financial interest in the audited client. 2. Directorship or officer of an audit client.
3. Performance of management advisory or bookkeeping or accounting services and audits for the same company.
4. Dependence upon a client for a large percentage of audit fees. 5. Engagement of the CPA and payment of audit fees by management. 3. In return for the faith placed in CPAs by the public, CPAs should continually
seek to demonstrate their dedication to professional excellence. The public interest is defined as the community’s collective well-being. CPAs handle ethical conflicts best by acting with integrity, objectivity, and due professional care and by having a genuine interest in serving the public.
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4. An ethical dilemma is a situation that a person faces in which a decision must be made about the appropriate behavior. There are many possible ethical dilemmas that one can face, such as finding a wallet containing money, or dealing with a supervisor who asks you to work hours without recording them.
An ethical dilemma can be resolved using the six-step approach outlined below: 1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the dilemma and how each person or group is affected.
4. Identify the alternatives available to the person who must resolve the dilemma.
5. Identify the likely consequence of each alternative. 6. Decide the appropriate action.
5. Apparently, in ethical philosophy, the word “conscience” is used to describe the “undefinable mental process that yields moral decisions.” A close kin in the political science terms would be “anarchy.”
Conscience might not be a sufficient guide for personal ethics decisions because the individual’s undefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. Exactly the same can be said about professional ethics decisions because a nonhypocritical individual can no more split his behavior between personal life and professional life than he can voluntarily split his own personality.
6. A professional accountant must be prepared to be an agent, spectator, advisor, instructor, judge, and critic.
7. Ethical responsibility for acts of non-CPAs under a CPA’s supervision falls under the latter’s jurisdiction. A CPA shall not permit others to carry out on his behalf, either with or without compensation, acts which, if carried out by the CPA, would place him in violation of the Code of Ethics.
8. The auditor’s gain from having an audit committee is a direct communication pipeline to the board of directors.
9. Serving as a purchasing agent places Ben Santos’ father in an “audit sensitive position.” Accordingly, Santos’ independence is impaired. Also, since Santos is a managerial employee, he can no longer work in the Manila office of the CPA firm. The CPA firm may retain its independence if Santos transfers to another office (or resigns).
10. The CPA firm’s independence would not be impaired as long as Gary Angeles did not personally participate in the audit of this particular client. Once Gary rises to the position in which he becomes a “managerial employee” of the CPA firm, however, he must be transferred to an office which does not participate in this audit if the firm is to remain independent.
11. Historically, compensation for CPAs serving as expert witnesses had to be based on a standard per diem rate or a fixed sum. However, under certain situations, such contingent fees are allowed only from clients for which the CPA does not also provide to the client financial statement audits, reviews or certain compilations, or prospective financial information examinations.
12. Sanchez may only refer certain clients to his wife or to another life insurance agent who will share such a commission with his wife provided that he does not perform assurance as well as nonassurance services.
Multiple Choice Questions
1. D 11. A 21. A 2. B 12. A 22. B 3. D 13. A 23. D 4. A 14. C 24. C 5. A 15. C 25. C 6. C 16. D 26. B 7. A* 17. A 27. D 8. A* 18. C 9. A* 19. A 10. A 20. A
*7. A fee for audit clients which is dependent upon the results achieved by the CPA’s efforts is a contingent fee and is prohibited for audit clients.
*8. An auditor’s independence would not be considered to be impaired with respect to a financial institution in which the auditor maintains a checking account which is fully insured.
*9. The declaration requires the preparer to acknowledge that the return is “true, correct, and complete...based on all information of which the preparer has any knowledge.”
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Cases
1. a. Interpretation – Honorary Directorships and Trusteeships Ela will not be considered independent unless:
1. the position is in fact purely honorary, and
2. listings of directors show she is an honorary director, and 3. she restricts participation strictly to the use of her name, and 4. she does not vote or participate in management functions. b. Interpretation – Retired Partners and Firm
Independence: Since Monte is still active with the firm as an ex-officio member of the income tax advisory committee, meeting monthly, his situation would impair the appearance of the firm’s independence. Monte should either resign from the Palm board or cease his association with the accounting firm.
c. Interpretation – Accounting Services
CPA Benitez must be careful to know whether outsiders would perceive relationships that would indicate status as an employee, hence impairing the appearance of independence. In particular, CPA Benitez must
1. Not have any business connection with Hernan Corporation or with Mike Hernan that would in fact impair independence, objectivity and integrity, and
2. Impress Mike Hernan (and the board of directors) that they must be able and willing to accept primary responsibility for the financial statements as their own, and
3. Not take managerial responsibility for conducting operations of the Hernan Corporation (although Benitez’s supervision of the bookkeeper seems to have this characteristics), and
4. Conduct the audit in conformity with PSA and not fail to audit records simply because they were processed under Benitez’s supervision. d. Interpretation – Effect of Family Relationships on Independence
Jack’s wife’s interest is attributed to him, and he would not be independent. The financial interest is considered direct.
e. Interpretation
Jack is still not independent, so long as the daughter is a dependent child. The financial interest is considered direct.
f. Interpretation
Still not enough. The grandfather (either Jack’s father or his father-in-law) is considered a nondependent close relative, but the appearance of independence is impaired. The grandfather’s investment is material (50 percent) in relation to his net financial resources.
2. a. Pee and Co. / United Furniture, Inc.: This is a judgment call. In this case, the services can be considered temporary, mechanical in nature and performed on a one-time emergency basis. For these reasons, the SEC would probably not consider independence impaired.
b. Renson & Co. / Spectrum Corporation Laser Division: The SEC would consider independence impaired because of the extent of the bookkeeping services and the relative size of the Division. The only solution that might work is to have another accounting firm audit the Laser Division financials so that Renson & Co. can write a report “in reliance on the work of other independent auditors.”
c. Reyes & Co. / Valley Bank: The SEC would consider independence impaired because of the family relation of Annabelle, her connection with Valley’s financial statements and the fact that Kris is a “member” (partner) in the audit firm. (The PICPA would probably also consider independence impaired because of the apparent closeness of the two sisters and the “audit sensitivity” of Annabelle’s job).
d. Cruz & Reyes / Jonas Tomas / Starex Money Market Fund: Jonas is a “member” since he is a manager and will provide audit services to SMMF. Cruz & Reyes’ independence is impaired since Jonas holds a direct financial interest.
3. Violation of Code of Professional Ethics? Yes No
Since Bella had an employment relationship with the client during part of the period covered by the financial statements, her independence is impaired.
4. Violation of Code of Professional Ethics? Yes No
This is a violation. It is a contingent fee agreement.
5. Although her decision will not be popular with the audit staff, Tracy Ong should thank the client but decline the offer, both for her and for the staff. She should explain that an outsider who had knowledge of all of the relevant facts might view the free use of a condominium as a sizable “gift” to the auditors, which might influence their independent mental attitude. Thus, we believe that to
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maintain an appearance of independence, the auditors should not accept this offer.
6. No. CPAs may refuse client access to their working papers for any valid business purpose. Therefore, a CPA may require that fees be paid before working papers including such adjusting entries and supporting analysis are provided to the client.
7. The answers provided in this section are based on the assumption that the traditional legal relationship exists between the CPA firm and the third party user. That is, there is no privity of contract, the known versus unknown third party user is not a significant issue, and high levels of negligence are required before there is liability.
a. False. There was no privity of contract between Tan and Cañada, therefore, ordinary negligence will usually not be sufficient for a recovery.
b. True. If gross negligence is proven, the CPA firm can and probably will be held liable for losses to third parties.
c. True. See a.
d. False. Gross negligence (constructive fraud) is treated as actual fraud in determining who may recover from the CPA.
e. False. JC is an unknown third party and will probably be able to recover damages only in the case of gross negligence or fraud.
Assuming a liberal interpretation of the legal relationship between auditors and third parties, the answers to a and d would probably both be true. The other answers would remain the same.
8. Yes. Normally a CPA firm will not be liable to third parties with whom it has neither dealt nor for whose benefit its work was performed. One notable exception to this rule is fraud. When the financial statements were fraudulently prepared, liability runs to all third parties who relied upon the false information contained in them. Fraud can be either actual or constructive. Here, there was no actual fraud on the part of Dantes or the firm in that there was no deliberate falsehood made with the requisite intent to deceive. However, it would appear that constructive fraud may be present. Constructive fraud is found where the auditor’s performance is found to be grossly negligent. That is, the auditor really had either no basis or so flimsy a basis for his or her opinion that he or she has manifested a reckless disregard for the truth. Dantes’ disregard for standard auditing procedures would seem to indicate such gross negligence and, therefore, the firm is liable to third parties who relied on the financial statements and suffered a loss as a result.
9. a. Yes. Carlos was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance, and damage to the bank as a result thereof. If the action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Carlos under either theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he or she was damaged indirectly, his or her own fraudulent actions led to his or her loss, and the equitable principle of “unclean hands” precludes him or her from obtaining relief.
c. Yes. Carlos had knowledge that the financial statements did not follow financial reporting standards and willingly prepared an unqualified opinion. The financial statements were not in accordance with financial reporting standards. That is a criminal act because there was an intent to deceive. 10. a. Base, Umapas & Cañada is potentially liable to its client because of the
possible negligence of its agent, the in-charge accountant on audit, in carrying out duties that were within the scope of his or her employment. Should there be a finding of negligence, liability would be limited to those losses that would have been avoided had reasonable care been exercised. There being no evidence of the assumption of a greater responsibility, the in-charge accountant’s conduct is governed by the usual standard; that is, that the accountant perform his or her duties with the profession’s standards of competence and care. A question of fact arises as to whether the duty of reasonable care was breached when the in-charge accountant failed to investigate further after being apprised by a competent subordinate of exceptions to 6 percent of the vouchers payable examined. Moreover, a question of causation arises as to whether further actions by the in-charge accountant would have disclosed the fraud. If both lack of due care and causation are established, recovery for negligence will be available to the client.
b. In a properly organized liability partnership, the partner(s) and staff responsible for the engagement and the firm would be liable, as discussed in part a. However, other partners would not be liable.
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11. Ordinarily, users of financial statements, other than those who contracted for the audit and those known in advance to the auditor, may not recover for ordinary negligence by the auditor in the performance of an audit. Recovery of damages by third parties must usually be based on fraud. Actual knowledge of falsity (scienter) is also generally required for an action based on fraud; however, this requirement may be satisfied by the auditor’s reckless disregard for the truth or gross negligence.
It appears that the three deficiencies in the audit by Gonzales & Esteban might be sufficient to satisfy either approach. Failure to check the existence of certain receivables, collectibility of other receivables, and existence of security investments, taken collectively if not individually, appear to show a reckless disregard for the truth by the auditor. In fact, the audit probably lacks sufficient competent evidential matter as a reasonable basis for an opinion regarding the financial statements under examination.
The audit appears to have been conducted in a woefully inadequate fashion, without regard to the usual auditing standards and procedures necessary to exercise due professional care. Therefore, the auditors were grossly negligent in the performance of their duties.
12. Corpuz has stated that the CPA firm has “reviewed the books and records of Flores Ventures,” when in fact no such “review” has occurred. A “review” of financial statements consists of limited investigatory procedures designed to provide statement users with a limited degree of assurance that the financial statements are in conformity with financial reporting standards. Corpuz’s actions are similar to issuing an auditors’ report without first performing an audit. Such an action may well be considered an act of criminal fraud, intended to mislead users of the financial statements. If the financial statements of Flores Ventures turn out to be misleading, there is little doubt that any court would find the CPA firm guilty of at least constructive fraud and liable to any third party who sustains a loss as a result of reliance upon the statements.
The fact that Corpuz violated Vasquez’s policy of submitting all reports for Vasquez’s review would not lessen the CPA firm’s liability. The concept of mutual agency allows Corpuz, as a partner, to commit the firm to contracts, including auditors’ reports and accountants’ reports. The fact that this report was not submitted for Vasquez’s review might be introduced as evidence against Corpuz in the event he is accused of criminal fraud.
13. (1) Yes, but only to the extent of P70,000. Beta is a third-party beneficiary of the contract between Mega and its auditors, and may therefore recover from the auditors losses caused by the CPAs’ ordinary negligence. However, the original P50,000 loan was made prior to Beta’s reliance upon the negligently audited financial statements. Thus, the auditors’ negligence was
not the proximate cause of this portion of Beta’s loss. The auditors’ negligence may, however, be considered the proximate cause of the P70,000 loss incurred as a result of reliance upon the misleading statements. (2) The prospects for Manila’s recovery of its P30,000 loss are substantially less than those of Beta. Manila was not a third-party beneficiary to the contract. Thus, in many jurisdictions following Ultramares, Manila cannot recover losses attributable to the CPAs’ ordinary negligence. Similarly, it is doubtful that Manila would qualify as a foreseen third party as necessary under the Restatement approach. Even in a jurisdiction accepting the Rosenblum precedent, which allows third parties to recover losses caused by the auditors’ ordinary negligence, Manila would have to prove that it was a “foreseeable third party relying upon the financial statements for routine business purposes.” It is questionable whether the loan by Manila was either “reasonably foreseeable” or “routine,” as Manila was a customer of Mega, not a lender.
CHAPTER 6
MANAGEMENT OF A
PUBLIC ACCOUNTANCY PRACTICE
Questions
1. The special function performed by the public accounting profession is the attestation to the fairness of the financial statements of clients. The special function ensures the reliability and integrity of the financial reporting system. Judge Burger described the special function as "certifying the public reports that collectively depict a corporation's financial status," which involves "a public responsibility transcending any employment relationship with the client." 2. Complexity affects the demand for auditing services in that both users and
management need the expertise of professionals who understand the underlying economic substance of transactions and financial instruments and, thus, who have the ability to determine the appropriate accounting best to "fairly" portray the economic substance of an organization's activities and financial condition. The business environment in which the auditor must function is increasingly complex. The major forms of complexity relate to:
a. Computer systems, which are becoming increasingly interdependent across organizations.
b. Increased complexity of financial instruments and transactions entered into by organizations.
c. The economic environment in which we all must operate. The changing environment includes such items as the increased need to have a global outlook in providing goods and services and the need to be attuned to societal regulations in such areas as environmental protection.
3. For the most part, local CPA firms are subject to the same auditing and accounting standards as the large international CPA firms. The differences relate to whether the audit firms have (a) public clients, or (b) international clients. If a firm has public clients, then the firm is subject to the standards of the PCAOB. If a firm has clients that are domiciled in other countries, then they should utilize international auditing standards. If the audit firm only has non-pubic clients, then they are subject to auditing standards promulgated by the PICPA.
4. A network of accounting firms is a body to which individual CPA firms come together to pursue common interests. The services generally provided by the network include:
• centralized staff that provides accounting and auditing expertise to its members on a world-wide basis,
• a referral service for audit firms that have clients in different parts of the country or world,
• a referral service for a firm to utilize when clients desire expertise or consulting services that the audit firm does not provide.
• standard audit programs and/or procedure’s manuals for the member audit firms.
In some cases, the network can be a network of firms that are not otherwise affiliated. In other cases, the network firms all operate under one common name, e.g. Grant Thornton International.
5. a. Professional skepticism represents a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. When employing professional skepticism, auditors will not simply accept all evidence provided and assume that clients are unquestionably honest. However, the statement that “you really have to question everything the client tells you” is a bit exaggerative and goes beyond the concept of professional skepticism.
b. It is correct that internal evidence is generally of lower quality than external evidence. However, the necessary quality of evidence depends upon the risk of material misstatement and the effectiveness of the client’s internal control. In this case, the staff auditor’s statement that internal evidence is obtained because of time and cost considerations is not appropriate, unless the risk of material misstatement permits lower quality of evidence because of other reasons.
c. While appropriate planning will allow audits to be conducted on a timely basis, it is not appropriate for auditors to ignore transactions and events between the interim date (in this case, November 1) and the client’s fiscal year end. Some testing would need to be performed following the year end for transactions occurring between November 1 and December 31.
d. While the primary purpose of evaluating internal control is to determine the nature, timing, and extent of substantive tests, auditors must still conduct some study of internal control to ensure that the condition of the client’s internal control has not changed from prior years. If it has, the substantive tests performed by auditors may no longer be appropriate. In addition, for
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public companies, auditors are required to study internal control and report on the effectiveness of the client’s internal controls under Auditing Standard No. 5.
e. For departures from PFRS, the choice among opinions would be between a qualified opinion (for less material departures) and an adverse opinion (for more material departures).
f. While the concept of materiality does consider dollar amounts and their effects on users’ decisions, qualitative factors also need to be considered when assessing materiality. For example, a small dollar amount (in absolute terms) may influence a company’s ability to meet its earnings expectations or report higher earnings than in previous years. Situations such as this need to be considered as well as the absolute dollar amount of an item in assessing materiality.
Multiple Choice Questions
1. D 2. D 3. D 4. D 5. A Cases
1. (1) Auditing does not involve the creation of goods. However, it does serve a worthwhile purpose in our society because it enhances the flow of reliable financial information needed to conduct commerce in our economy. It also assists in the conduct of government by providing reliable information for tax purposes and regulatory purposes. Audits have been legally mandated to ensure objective information. However, research has indicated that audits would be required even if not mandated. The initial audits performed in conjunction with the settlement of the new world arose because of owners' need to have an independent assessment of the returns earned by their managers.
(2) The accounting profession did provide early warning signals of the potential problems within many industries. However, it clearly failed in other areas. Some of the problems were related to the impreciseness of accounting principles (e.g. Enron) while others were more closely related to regulatory failures (e.g. Savings & Loan Industry). However, many of the failures were due to systematic problems in the accounting profession that has been addressed by Sarbanes-Oxley.
(3) Finding fraud may be important. However, many misstatements that are made in conjunction with an organization's financial statements are not intentional but are simply the result of errors. The audit function is designed to detect material misstatements -- whether they are due to errors or fraud. Thus, the audit function is actually broader than the colleague had desired. Ensuring that a financial statement contains no material misstatements also ensures that the auditor addresses the likelihood that material fraud may also have occurred.
(4) There is a potential problem with the auditors being hired by management. The Sarbanes-Oxley Act requires companies that are publicly traded to have an audit committee composed of independent directors (nonmembers of management) that have the responsibility for evaluating the performance of the auditors. The audit committee should exist to present the views and interests of outside owners of the organization and provide effective insulation against undue pressure by management on the audit function. The SEC is very cognizant of independence issues and periodically addresses actions or relationships that they believe may impair the auditor’s independence.
(5) PFRS represents rules and conventions that are acceptable at one point in time. Much of the diversity in accounting principles is necessary to reflect real economic differences between organizations and the types of transactions in which the organization is engaged. Beyond this argument, differences such as Weighted Average / FIFO accounting have evolved over the years. The profession attempts to mitigate the potential problems associated with the diversity by providing disclosure of the differences and by developing other procedures to make it difficult for firms to change accounting principles. Thus, the financial statements of a company should be comparable over a period of time.
(6) It seems that this individual really wants to have a career in auditing. External auditing has changed; in today's environment, the auditor must thoroughly understand a company's business in order to audit it. A key function of internal auditors is to add value through their recommendations. (7) The external audit is designed to present an opinion on the fairness of a
company’s financial statement in accordance with PFRS. It is not directly designed to assess the performance of management, although the financial statements may provide some evidence on the performance of management. (8) Auditors operate in an environment in which they must have a sense of trust with management – at least to the extent that confidential or proprietary information is not made public. Thus, if all recommendations made to management were to be made public, management might simply ask that
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recommendations no longer be made. Further, it must be recognized that many of the recommendations made to improve operations are informal in nature and might not be based on thorough study of a particular area. Auditors may justifiably fear litigation from recommendations made public that were made only on informal observations.
(9) Congress, in developing the Sarbanes-Oxley Act believes this statement is true. Maintaining adequate controls is a significant part of corporate governance. Congress believes the owner (shareholder) should receive reports on the quality of controls implemented by management. In the first three years of public reports on internal control, there has been a dramatic change in the quality of controls in many organizations. During the first year of Sarbanes-Oxley, approximately 16% of the companies received adverse reports on the quality of their internal controls. This percentage has gone down dramatically.
2. (a) There seems to be a misinterpretation on the part of many users that a "clean" audit opinion means that the company is in good health. This, unfortunately, is a miscommunication. A "clean" audit opinion means only that the financial statements are fairly presented, not that they represent a company that is in good financial health. The audit function provides data that are "fairly presented" in accordance with PFRS, but such information alone does not constitute all the information an informed user should know about a company.
(b) The auditor is a guarantor only of following auditing standards in determining whether the statements are fairly presented, in all material respects, in accordance with financial reporting standards. Fair presentation is guaranteed only within the context of PFRS.
(c) This question and should encourage a widely ranging discussion by users. Topics that might be addressed include these:
1. The potential deficiencies in PFRS.
2. The ability to detect fraud when management has attempted to cover it up.
3. The responsibilities of users to perform their own work and to not expect someone else to make decisions for them.
4. The overall responsibility of management for the integrity of the financial statements.
5. The value of reports on internal control.
SYSTEM OF QUALITY CONTROL FOR PUBLIC
ACCOUNTANCY FIRMS
Questions
1. Refer to page 292 of the textbook.
2. Refer to pages 293 and 294 of the textbook.
3.
Refer to pages 293 and 294 of the textbook.4. a. Leadership responsibilities for quality within the firm b. Engagement performance
c. Human resources d. Monitoring e. Human resources
f. Relevant ethical requirements g. Acceptance and continuance of clients
h. Leadership responsibilities for quality within the firm i. Engagement performance
Multiple Choice Questions
1. A 6. B 11. D 16. C
2. D 7. A 12. B 17. B
3. D 8. D 13. C 18. C
4. B 9. B 14. C 19. D
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Cases
1. MORALES, CABRERA, & CO., CPAs 1. a. Hiring / Professional requirements
b. To ensure that personnel who will be performing audits have adequate technical training and proficiency.
c. New accountants hired must have an accounting degree from an accredited school.
2. a. Advancement / Professional requirements
b. To ensure personnel are qualified to do the tasks they are assigned.
c. An in-charge accountant must have served as a staff auditor on an audit in the client’s industry.
3. a. Skills and Competence
b. To ensure that personnel continue to be updated on changes in accounting or auditing standards.
c. Personnel will participate in forty hours of continuing education per year. 4. a. Consultation
b. To ensure that personnel have access to persons with more experience in dealing with problems they have encountered.
c. For each industry for which the office has a client, a specialist will be identified.
5. a. Independence
b. To ensure that personnel meet PICPA guidelines for independence.
c. Firm personnel must list their investments. Personnel must report any stock acquisitions.
6. a. Supervision
b. To ensure that work performed meets the firm’s standard of quality. c. Staff personnel are to follow firm guidelines for working paper
development. 7. a. Inspection / Review
b. To verify that quality control procedures are being followed. c. Inspect the audit programs for all engagements.
8. a. Acceptance and retention of clients
b. To minimize the risk associated with clients.
9. a. Assigning personnel to engagements
b. To ensure that personnel posses the degree of technical training and proficiency required for an engagement.
c. To be eligible to be senior on an engagement, a person must have had experience in the industry.
2. Auditing standards indicate that auditors should report major issues discussed with the entity’s management prior to being retained as auditor, including discussions regarding the application of accounting principles and auditing standards. Discussion of such matters may place pressure on the auditor to yield to management’s view. Making the audit committee members aware of such matters should enable them to better monitor the auditor’s independence. Standards do not preclude clients from making suggestions about audit staff. Clients frequently make requests to have persons on the audit who have experience in the industry. If a client requests that minority persons not be assigned to an audit, however, the auditor must carefully consider the ethical implications of that request.
CHAPTER 8
PHILIPPINE STANDARDS ON AUDITING
Questions
1. Foreign public accounting firms have found that to retain their multinational clients, they have had to develop the capacity to provide services worldwide. Although the roots of at least two of the big firms in the United States are traceable to European ancestry, public accounting firm involvement in international activities has paralleled the gradual involvement of businesses in international activities. In the early 1900s, some public accounting firms established representative offices in foreign countries. As business activity expanded, the firms opened offices in foreign cities. During the 1970s, some countries forced these firms to close their offices. To be able to serve their clients, the firms established correspondent relationships with locally owned accounting firms; in these relationships, local partners remain separate, local, autonomous organizations. Because domestic and foreign partners in a correspondent relationship agree to follow a common code of ethics and practice guidelines, each is able to rely on the work the other performs. A big firm auditing a U.S. business with significant activities in France, for example, would rely on its Paris office to audit the activities of the business in France.
The largest firms have organized worldwide partnerships to achieve a greater uniformity of quality, to facilitate management of personnel, and to coordinate research and professional development of personnel. Many small public accounting firms establish correspondent relationships with foreign public accounting firms or join a federation. Firms in a federation call on one another to perform services for clients, following agreed-upon standards in conducting the work they do for one another.
2. Yes. According to paragraph 10 of the Preface to Philippine Standards on Auditing and Related Services, “an auditor may, in exceptional circumstances, judge it necessary to depart from a PSA in order to more effectively achieve the objective of an audit. When such a situation arises, the auditor should be prepared to justify the departure.”
3. No. According to paragraph 14 of the Preface to the Philippine Standards on Auditing and Related Services, “PAPSs are issued to provide practical assistance to auditors in implementing the PSAs or to promote good practice. These Statements are not intended to have the authority of the PSAs.”
