CHAPTER 1

AUDITING AND THE PUBLIC

ACCOUNTING PROFESSION
Learning Check
1.1 Several common attributes of activities defined as auditing are (a) systematic
process, (b) objectively obtaining and evaluating evidence, (c) assertions about
economic actions and events, (d) degree of correspondence, (e) established
criteria, (f) communicating the results, and (g) interested users.
1.2 A financial statement audit involves obtaining and evaluating evidence about
an entity's financial statements for the purpose of epressing an opinion on
!hether the statements are presented fairly in conformity !ith established
criteria""usually #AA$. %hus, the nature of the auditor's report is an opinion
on the fairness of the financial statements. A compliance audit involves
obtaining and evaluating evidence to determine !hether certain financial or
operating activities of an entity conform to specified conditions, rules, or
regulations. A report on a compliance audit ta&es the form of a summary of
findings or assurance regarding degree of compliance. An operational audit
involves obtaining and evaluating evidence about the efficiency and
effectiveness of an entity's operating activities in relation to specified
objectives. 'eports on such audits include an assessment of efficiency and
effectiveness and recommendations for improvements.
1.( Independent auditors are individual practitioners or members of public
accounting firms !ho render professional auditing services to clients. %hese
services may involve financial statement audits, compliance audits, and
operational audits. Internal auditors are employees of the companies they
audit. %hey are involved in an independent appraisal activity, called internal
auditing, as a service to the organi)ation. *nternal auditors are primarily
concerned !ith compliance and operational audits. Government auditors are
employed by various local, state, and federal governmental agencies. %hey may
be involved in all three types of audits.
1.+ a. %he origin of the company audit as !e &no! it can be lin&ed to ,ritish
legislation during the
industrial revolution in the mid"1-..s. /ompany audits !ere initially
performed by one or more stoc&holders designated by other stoc&holders, but
subse0uent revisions in the legislation permitted the use of outside independent
auditors, giving rise to the formation of auditing firms.
b. %he migration of the company audit to the 1.S. came about as 2nglish and
Scottish investors sent their o!n auditors to chec& on the condition of
American companies, such as bre!eries and railroads, in !hich they had
heavily invested. %his migration occurred in the late 1-..s. %he focus of
these early audits !as on finding errors in the balance sheet accounts and
stemming the gro!th of fraud associated !ith the increasing phenomenon
of professional managers and absentee o!ners.
1.3 Several important milestones in the rise of the 1.S. profession !ere (1) passage
of the first legislation providing for the licensing of /$As by 4e! 5or& state in
1-67, (2) the passage of similar legislation by all of the then forty"eight states
by 1621, (() the establishment of the American *nstitute of Accountants (no!
the A*/$A) in 1618, (+) the publication in 161- of a proposal for uniform
accounting follo!ing a period of rapid gro!th in the public o!nership of
corporate securities and gro!ing recognition of the need for greater uniformity
in financial reporting as !ell as the need to employ accountants !ho understood
reporting re0uirements, (3) the stoc& mar&et crash of 1626 !hich dre! attention
to deficiencies in financial reporting and produced a challenge to the accounting
profession to provide stronger leadership, (7) adoption of a re0uirement by the
4e! 5or& Stoc& 2change in 16(( that all listed corporations obtain an audit
certificate from an independent /$A, and (8) passage of the Securities Act of
16(( and the Securities 2change Act of 16(+ !hich added to the demand for
audit services for publicly o!ned companies.
1.7 a. %hree important changes in audit practice that evolved by the 1.+.s !ere
(1) a shift from detailed verification of accounts to sampling or testing as
the basis for rendering an opinion on the fairness of financial statements,
(2) development of the practice of lin&ing the testing to be done to the
auditor's evaluation of a company's internal controls, and (() deemphasis
of the detection of fraud as an audit objective.
b. *n recent years, the profession has come under increasing pressure to
reverse the deemphasis on detecting fraud as the public's epectation that
the auditor !ill detect fraud persists.
1.8 %he first A*/$A project that is influencing the shape of the accounting
profession in the 21
st
/entury is the A*/$A 9ision $roject. %his project
involved over +... /$As !ho contributed to the development of the /$A
profession, its core values, core competencies, and core services. %he second
A*/$A project !as the Special /ommittee on Assurance Services, that has
mar&et tested ne! services that re0uire assurance provided by /$As.
1.- :ive core values of the /$A profession are (1) continuing education and
lifelong learning, (2) competence, (() integrity, (+) attunement !ith broad
business issues, and (3) objectivity. /ontinuing education and lifelong learning
is important to ensuring the public confidence in a /$As ability to maintain
cutting edge s&ills in a rapidly changing environment. /$As must demonstrate
competence in order to earn a client;s trust. %his normally consists of a broad
competence plus many /$As develop specialties during their career. *ntegrity,
!hich means practicing !ith honesty and acting !ith professional ethics is
critical earning the public trust. Attunement to broad business issues is !hat
separates /$As from other professionals and allo!s /$As to eercise the
professional judgment that is so important in accounting. :inally, objectivity
and the freedom of bias or conflicts of interest allo!s /$As to earn both a
client;s and the public;s trust. *n combination, these core values have helps
/$As earn a reputation for being a trusted business advisor.
1.6 a. %he core competencies associated !ith the /$A profession include< (a)
communication and leadership s&ills, (b) strategic and critical thin&ing
s&ills, (c) focus on the customer, client and mar&et, (d) interpretation of
converging information, and (e) being technologically adept.
b. %he auditing profession has been critici)ed for communicating primarily
through a standard, one"si)e"fits"all report that communicates little uni0ue
information. :urther, auditors are often seen as being more reporters of
the past than problem solvers !ith a future orientation. Also they are seen
as being standards driven and focuses on numbers and measurement,
rather than focused on !hat the numbers communicate.
c. Auditors use communication skills to raise appropriate in0uiries !ith
management and to communicate findings !ith management, the board of
directors, and third parties. Auditors use strategic and critical thinking
skills to evaluate the appropriateness of accounting estimates and other
information reported in the financial statements. %he auditor;s focus on
the client and the market allo!s the auditor to be responsive to both the
pubic and the client. Auditors must be able to interpret converging
information. %he &ey analytic s&ill used throughout the audit is the ability
to evaluate both financial and nonfinancial information and determine
!hether financial statements are fairly presented. :inally, auditors must
be technologically adept. Auditors must be able to evaluate information
systems and internal controls that etensively use ne! technologies.
1.1. %he common attributes of all assurance services are that they are (a)
independent profession services that (b) improve the 0uality of information, or
its contet, for (c) decision"ma&ers.
1.11 a. %he financial statement audit !as the first form of assurance that !as
provided by /$As. %his service !as so successful that today /$A
assurance services have epanded revie!s services, various attest services
and a compilation service. %he potential for additional services is based in
large part on the fact that the financial statement audit has earned the
public trust. %he logic used by auditor is performing the audit is also used
in performing many of these other services.
b. %oday auditors provide audit level assurance on financial statements only
once a year, and revie! level assurance 0uarterly. =ne important change
is the movement to!ard providing real"time assurance on financial
information. An important part of the current audit process is its focus on
internal controls. Auditors may li&ely use this s&ill to focus more attention
on internal controls and attest to the reliability of the financial information
systems rather than the financial information itself.
1.12 An attest service is one in !hich the /$A firm issues a !ritten communication
that epresses a conclusion about the reliability of a !ritten assertion that is the
responsibility of another party. Attest services include audits, eaminations,
revie!s, and agreed"upon procedures.
1.1( =ther services performed by /$As do not result in the epression of an
opinion, negative assurance, summary of findings, or any other form of
assurance by the /$A firm. %hese services include accounting services such as
technology services, management consulting, financial planning including ta
services, and international services.
1.1+ (>islabeled as 1.12 in the tet). :our private sector organi)ations associated
!ith the public accounting profession and their principal activities are as
follo!s< (1) American *nstitute of /ertified $ublic Accountants !hich acts on
behalf of its members and provides necessary support to assure that /$As serve
the public interest in performing 0uality professional services (activities include
developing standards dealing !ith professional services, 0uality control, 0uality
revie!, and ethical conduct, developing and distributing continuing
professional education materials and courses, and providing technical
accounting and auditing assistance through a technical information hotline,
technical library, and a variety of publications)? (2) State Societies of /ertified
$ublic Accountants !hich cooperate !ith each other and the A*/$A in areas of
mutual interest such as providing continuing professional education
opportunities to members and enforcing ethical standards? (() $ractice 1nits
(/$A firms) !hich are the organi)ation units through !hich /$As render
professional services to the public? and (+) Accounting Standard Setting ,odies,
principally the :inancial Accounting Standards ,oard (:AS,) and
#overnmental Accounting Standards ,oard (#AS,) !hose primary functions
are the development of generally accepted accounting principles for business
and not"for"profit entities, and state and local governmental entities,
respectively.
1.13 (>islabeled as 1.1( in the tet). :our divisions @ teams of the A*/$A that
have a direct impact on auditing are< (1) Aivision for /$A :irms, (2) Buality
'evie! %eam, (() Auditing Standards %eam, and (+) $rofessional 2thics %eam.
1.17 (>islabeled as 1.1+ in the tet).
a. A /$A firm may be organi)ed as a proprietorship, partnership, $rofessional
/orporation, or any other form of organi)ation permitted by state la! or
regulation (including limited liability partnerships (CC$s) and limited
liability corporations (CC/s)).
b. /$A firms are often classified into the follo!ing four groups< (1) ,ig Si,
(2) Second %ier, (() 'egional, and (+) Cocal.
1.18 (>islabeled as 1.13 in the tet). Si public sector organi)ations associated !ith
the public accounting profession and one or t!o principal activities of each are
as follo!s< (1) State ,oards of Accountancy !hich administer state
accountancy la!s in each state including oversight of the licensing of /$As and
monitoring compliance !ith codes of professional ethics, mandatory continuing
professional education re0uirements, and other positive enforcement programs?
(2) Securities and 2change /ommission !hich (a) regulates the distribution of
securities offered for public sale and the subse0uent trading of securities on
stoc& echanges and over"the"counter mar&ets and (b) eerts considerable
influence over auditing and the public accounting profession as !ell as the
establishment of #AA$ for companies under its jurisdiction? (() 1.S. #eneral
Accounting =ffice (#A=) !hich has the authority to issue standards pertaining
to the audit of governmental organi)ations, programs, activities, and functions?
(+) *nternal 'evenue Service !hich administers and enforces the federal ta
la!s? (3) State and :ederal /ourts !hich (a) reach judgments as to !hether
/$A firms have adhered to standards of performance established by the
profession itself and (b) in some cases have ruled that the profession's standards
are not ade0uate for the protection of the public? and (7) 1.S. /ongress !hich
influences the profession through investigative and monitoring activities aimed
at determining !hether the profession is meeting its responsibilities to the
public, and through the passage of ta la!s and other legislation affecting the
performance of professional services.
1.1- (>islabeled as 1.18 in the tet).
a. %he purpose of the profession's multilevel regulatory frame!or& is to help
assure 0uality in the performance of audits and other professional services.
b. %he four components of the profession's multilevel regulatory frame!or&
are<
Standard"setting. %he private sector establishes standards for accounting,
auditing,
ethics, and 0uality control to govern the conduct of /$As and /$A firms.
:irm regulation. 2ach /$A firm adopts policies and procedures to assure
that
practicing accountants adhere to professional standards.
Self"or peer regulation. %he A*/$A has implemented a comprehensive
program of
self"regulation including mandatory continuing professional education,
peer revie!, audit failure in0uiries, and public oversight.
#overnment regulation. =nly 0ualified professionals are licensed to
practice, and
auditor conduct is monitored and regulated by state boards of
accountancy, the S2/, and the courts.
1.16 (>islabeled as 1.1- in the tet). %he five elements of 0uality control are (1)
independence, integrity and objectivity, (2) personnel management, (()
acceptance and continuance of engagements, (+) engagement performance, and
(3) monitoring.
1.2. (>islabeled as 1.16 in the tet).
a. %he t!o sections of the A*/$A Aivision for :irms are (1) the S2/
$ractice Section and (2)
the $rivate /ompanies $ractice Section.
b. 1ni0ue membership re0uirements of the S2/ $ractice Section include (1)
rotating audit partners on S2/ engagements periodically, (2) having an
audit partner other than the partner in charge of the S2/ engagement
revie! and concur in the audit report before it is issued, and (() refraining
from performing certain proscribed management consulting services for
S2/ audit clients.
1.21 (>islabeled as 1.16 in the tet). %he Buality /ontrol *n0uiry /ommittee
(B/*/) is responsible for determining !hether la!suits alleging audit
deficiencies brought against firms enrolled in the S2/ $ractice Section suggest
(1) an aberrational error !hich no 0uality control system can totally eliminate,
(2) a shortcoming in the charged firm's 0uality controls or its compliance !ith
them, or (() a shortcoming in professional standards. %he $ublic =versight
,oard ($=,) closely monitors the !or& of the S2/ $ractice Section and
recommends improvements for strengthening the Section's self"regulatory
activities. %he $=, also distributes an annual report on its activities to all
interested parties.
Objective Questions
1.21 1. b 2. d (. a
1.22 1. b 2. c (. d
1.2( 1. b 2. d (. b
Comprehensive Questions
1.2+ (2stimated time " 2. minutes)
a. *nternal auditing is an independent appraisal activity performed by employees of the
company being audited. %he objective of internal auditing is to assist management
in the effective discharge of its responsibilities. 2ternal auditing is done by
independent, eternal auditors for the purpose of epressing an opinion on the
fairness of the company's financial statements. #overnmental auditing is done by
government auditors to determine (1) fairness of financial reports, (2) compliance
!ith applicable la!s and regulations, (() efficiency and economy of operations, and
(+) effectiveness in achieving program results.
b. $ractice standards for independent, internal, and government auditors are
established by the American *nstitute of /ertified $ublic Accountants, *nstitute of
*nternal Auditors, and the 1.S. #eneral Accounting =ffice, respectively.
c. %he audits serve different purposes and are made by different types of auditors.
Auditing only by internal auditing !ill not satisfy the re0uirements of stoc&
echanges and the S2/ for independent audits by eternal auditors. >oreover,
internal audits !ill not satisfy all government re0uirements for audits, particularly in
the area of compliance !ith applicable la!s and regulations. *n sum, each type of
auditing is necessary.
1.23 (2stimated time " (. minutes)
a. Type of Audit b. Type of Auditor(s) c. rimary !ecipient(s)
1. :inancial statement (1) *ndependent(1) Stoc&holders, investors,
regulatory agencies, and
general public
2. =perational (() *nternal (2), *ndependent(1) Senior >anagement
(. /ompliance (2) #overnment " *'S (+) *'S
+. =perational (() #overnment " #A= (() /ongress
3. :inancial statement (1) *ndependent (1) /reditors
7. =perational (() *nternal (2) >anagement
8. /ompliance (2) #overnment " #A= (() /ongress
-. /ompliance (2) *ndependent (1), *nternal (2),
and #overnment " #A= (()
/ongress
6. :inancial Statement
(1)
*ndependent (1) /iti)ens, tapayers
1.. =perational (() #overnment " #A= (() /ongress
11. /ompliance (2) *ndependent (1), *nternal (2) ,ondholders
12. /ompliance (2) *nternal (2), *ndependents
(1)
>anagement
1.27 (2stimated time " 2. minutes)
Dhen /$As audit the value of inventory reported in the financial statements they are
communicating the total pictures !ith clarity and objectivity. /$As step up the value
chain by translating comple information into critical &no!ledge !hen they use
information from the financial statements, such as inventory turnover and benchmar& a
client;s performance against others in the industry. /$As anticipate and create
opportunities !hen they identify ho! a client might improve its inventory turnover, for
eample by advising the client;s management on ho! it might identify and eliminate
slo! moving inventory. :inally, /$A in industry designs path!ays to transform vision
into reality by ta&ing the steps that increase inventory turnover. %he independent /$A
ho!ever, must ta&e care to not etend services beyond advisory services to ma&ing
management decisions.
1.28 (2stimated time " (. minutes)
Core "a#ue
$mportance to
%inancia# &tatement 'ser
$mportance to the
(oard of )irectors
Continuing
*ducation and
Life#ong
Learning
:inancial statement users
epect that auditors are
&no!ledgeable about current
professional standards
(#AA$ and #AAS) and
their application to the client.
%he ,oard of Airectors epects
that auditors are not only
&no!ledgeable in #AA$ and
#AAS but are familiar !ith
current developments in their
industry.
Competence :inancial statement users
epect auditors to be able to
evaluate the fairness of
presentation in the financial
statements, given #AA$ and
the entity;s performance.
%he ,oard of Airectors epects
that auditors can evaluate fair
presentation in the financial
statements, the 0uality of the
entity;s internal control, and
often the performance of their
entity;s against others in the
industry.
$ntegrity :inancial statement users
epect auditors to be
independent of management
and they epect an honest
opinion on the entity;s
financial statements.
%he ,oard of Airectors epects
auditors to be independent of
management and to provide
honest opinions on the entity;s
financial performance and the
0uality of its internal controls.
Core "a#ue
$mportance to
%inancia# &tatement 'ser
$mportance to the
(oard of )irectors
Attuned to
broad business
issues
:inancial statement users
epect auditors to be able to
evaluate the fair presentation
of accounting estimates and
needed disclosures given the
current business
environment.
%he ,oard of Airectors epects
that auditors to be able to
evaluate the impact of current
business developments on the
entity;s financial performance,
its internal control, and often
they loo& to the auditor for
recommendations on ho! to be
more competitive in the industry.
Objectivity :inancial statement users
ecept auditors to be free of
conflicts of interest and
ma&e objective decisions
even if it is not in entity;s
interest, or the short"term
interest of the auditor.
%he ,oard of Airectors epects
that auditors are free of conflicts
of interest and independent of
senior management.
1.2- (2stimated time " 2. minutes)
1. State boards of accountancy 1.. State societies of /$As
2. :AS, and #AS, 11. S2/, state and federal courts
(. A*/$A 12. #AS,
+. S2/ 1(. A*/$A
3. A*/$A, state societies of /$As,
and state boards of accountancy
1+. State boards of accountancy
7. :AS, 13. A*/$A
8. State boards of accountancy 17. $ractice units
-. S2/ 18. #A=
6. A*/$A 1-. *'S
1.26 (2stimated time " 2. minutes)
a. %he four sets of standards in the private sector and the standard setting
bodies are< (1) accounting by the :AS, and #AS,, (2) auditing by the
A*/$A, (() professional ethics by the A*/$A, and (+) 0uality control by the
A*/$A.
b. %he other components of the regulatory frame!or& are< (1) firm
regulation that occurs !ithin the public accounting firm through day"to"
day monitoring of the actions of the firm's professional staff by the firm's
management? (2) self"regulation, also called peer regulation, that relates
to the activities of professional entities outside the firm such as the
A*/$A's Aivision for /$A firms and its Buality 'evie! Aivision? and (()
governmental regulation that occurs at both the state and federal levels
through activities that range from positive enforcement programs to
punitive actions. %his type of regulation is done by state boards of
accountancy, the S2/, and state and federal courts of la!.
1.(. (2stimated time " (. minutes)
o#icy+
rocedure
*#ement
(a)
urpose of o#icy +
rocedure
(b)
Additiona#
rocedure
(c)
1. $ersonnel
>anagement
$ersonnel should have the
0ualifications to fulfill
responsibilities they may be
called upon to assume in the
future.
2stablish 0ualifications
necessary for each
level of responsibility
in the firm.
2. 2ngagement
$erformance
Dor& at all levels should be
supervised to assure that it
meets the firm's standards
of 0uality.
2stablish procedures
for revie!ing !or&ing
papers and reports.
(. $ersonnel
>anagement
Dor& is assigned to people
!ho have the technical
training for the assignment
and personnel should see&
assistance, !hen necessary,
from persons having
appropriate epertise,
judgment, and authority
*dentify areas and
speciali)ed situations
for !hich consultation
is re0uired.
o#icy+
rocedure
*#ement
(a)
urpose of o#icy +
rocedure
(b)
Additiona#
rocedure
(c)
+. *ndependence,
*ntegrity and
=bjectivity
All professionals should be
independent of clients.
>onitor compliance
!ith independence
rules.
3. >onitoring Aetermine that procedures
relating to the other
elements are being
effectively applied.
$rovide for reporting
inspection results to
appropriate
management levels in
the firm.
7. $ersonnel
>anagement
=nly individuals !ho
possess the 0ualities of
integrity, competency, and
motivation should be hired.
>aintain a recruiting
program to obtain ne!
hires at the entry level.
8. $ersonnel
>anagement
$ersonnel should have the
&no!ledge re0uired to
fulfill assigned
responsibilities.
$rovide $rograms to
develop epertise in
speciali)ed areas and
industries.
-. 2ngagement
$erformance
$ersonnel should have the
technical training and
proficiency re0uired by the
engagement.
$ermit partner in
charge of engagement
to approve
assignments.
6. Acceptance
and
/ontinuance
of /lients and
2ngagements.
%he firm should not be
associated !ith clients
!hose management lac&s
integrity.
2stablish revie!
procedures for
continuing a client.
1.(1 (2stimated time " (. minutes)
a. $racticing /$As associated !ith firms that audit S2/ clients cannot retain
membership in the A*/$A unless their firms enroll in the S2/ $ractice
Section of the Aivision for /$A firms. =ther practicing /$As cannot retain
membership in the A*/$A unless their firms submit to a practice monitoring
program that conforms to the re0uirements of the Buality 'evie! Aivision.
b. %he t!o sections of the A*/$A Aivision for :irms are the S2/ $ractice
Section and the $rivate /ompanies $ractice Section. %he objectives that
are common to both sections are<
*mprove the 0uality of service (or practice) by /$A firms through the
establishment of practice re0uirements for member firms.
2stablish and maintain an effective system of self"regulation of
member firms by means of mandatory peer revie!s, re0uired
maintenance of appropriate 0uality controls, and the imposition of
sanctions for failure to meet membership re0uirements.
%he follo!ing membership re0uirements are common to both sections<
Adhere to 0uality control standards established by the A*/$A.
Submit to peer revie!s of the firm's accounting and audit practice
every three years or at such additional times as designated by the
eecutive committee, the revie!s to be conducted in accordance !ith
revie! standards established by the section's peer revie! committee.
(4ote " At the time this manual !ent to press, as noted in the
footnote on page 2( of the tet, the A*/$A !as in the process of
combining the peer revie! process for the $rivate /ompanies
$ractice Section !ith the 0uality revie! program of the Buality
'evie! Aivision.)
2nsure that all professionals in the firm resident in the 1nited States,
including /$As and non"/$As, participate in at least 2. hours of
continuing professional education every year and in at least 12.
hours every three years.
c. %he peer revie! objective for both sections is to improve future practice.
Eo!ever, !hen a firm fails to ta&e the corrective action considered
necessary by the section, the section can impose sanctions. %he peer
revie! teams are re0uired to ma&e a revie! of the firm's accounting and
auditing services and to report on their findings to the section. %he findings
are included in the public files of each section.
d. %he Buality /ontrol *n0uiry /ommittee (B/*/) and the $ublic =versight
,oard ($=,) are involved !ith the S2/ $ractice Section. :irms in this
practice section must report all litigation or regulatory proceedings involving
audits of public companies to the B/*/ !ithin (. days of receiving the
complaint. %he B/*/ then has the responsibility to determine !hether the
allegations in a case suggest (1) an aberrational error that no system can
totally eliminate, (2) a shortcoming in the charged firm's 0uality controls or
its compliance !ith them, or (() a shortcoming in professional standards.
Dhen the last t!o situations eist, the case is not closed until the B/*/
concludes that the firm has addressed the !ea&ness or the shortcomings
have been reported to the appropriate standard setting body for its
consideration. %he $=, enhances the effectiveness and credibility of the
S2/ $ractice Section's self"regulatory activities by closely monitoring the
!or& of the Section. *ts responsibilities include directly overseeing each peer
revie! conducted by the Section and all B/*/ in0uiries alleging audit
failures.
e. %he primary activities of the Buality 'evie! Aivision are to (1) establish
and conduct, in cooperation !ith state /$A societies, a 0uality revie!
program for firms engaged in the practice of public accounting and not
enrolled in one of the Sections of the A*/$A Aivision for :irms, and (2)
conduct revie!s of firms enrolled in the program. (Note - Again, in
accordance with the footnote on page 2 of the te!t, at the time this manual
went to press the AI"#A was in the process of merging the peer review
activity of the #rivate "ompanies #ractice $ection of the %ivision for "#A
&irms into the 'uality (eview %ivision.)
!esearch Questions
:or the reasons specified in the introduction to this manual, solutions are not provided
for this category of 0uestions.