Chapter 2: The Financial Statement Auditing Environment

Based on Auditing & Assurance Services: A Systematic Approach Author: William Messier, Jr

(LO 2-1) Independence

A state of objectivity in fact and in appearance, including the absence of any significant conflicts of interest

(LO 2-1) Why are external auditors called “external?”

They are not employees of the entities they audit

(LO 2-1) What is another name for an external auditor?

Independent Auditor

(LO 2-1) External auditors commonly audit financial statements and conduct compliance, operational, and fraud audits for who?

Publicly traded and private companies, partnerships, universities, government entities, etc.

(LO 2-1) To sign an audit opinion on a public company’s financial statements in most states in the United States, an external auditor must be ____________

Licensed as a CPA

(LO 2-1) Internal Auditors

Auditors who are employees of the organizations that they audit

(LO 2-1) How does the IIA define internal auditing?

• An independent, objective assurance and consulting activity designed to add value and improve an organization’s operations

• Helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes

(LO 2-1) True or False: Internal auditors often conduct audits within their organizations and may assist external auditors with the annual financial statement audit

True

(LO 2-1) Government Auditors are usually considered be a type of ___________ auditor

Internal

(LO 2-1) What agency conducts audits of activities, financial transactions, and accounts of the federal government?

The Government Accountability Office (GAO)

(LO 2-1) True or False: The Government Accountability Office (GAO) assists Congress by performing special audits, surveys, and investigations

True

(LO 2-1) What are the majority of audits conducted by GAO auditors?

Compliance and Operational Audits

(LO 2-1) The IRS, a part of the U.S. Treasury Department, mainly does what?

Examines the books and records of organizations and individuals to determine whether their tax returns are accurate and in compliance with applicable tax laws and regulations

(LO 2-1) Other than the GAO and IRS, what are the other three agencies that conduct audits?

Army Audit Agency, the Defense Contract Audit Agency, and the FBI

(LO 2-1) Fraud Auditors

Auditors that are specially trained in detecting, investigating, and deterring fraud and white-collar crime. They sometimes act as expert witnesses in court cases.

(LO 2-2) In addition to the financial statement audit, what are the four major types of audits?

• Internal Control

• Compliance

• Operational

• Fraud

(LO 2-2) By who are the five major types of audits performed by?

Auditors employed by public accounting firms

(LO 2-2) What gave rise to public companies being required to engage an external auditor to provide an opinion on the effectiveness of internal control over financial reporting, in addition to an opinion on the financial statements?

The Sarbanes-Oxley Act of 2002

(LO 2-2) True or False: An audit of internal control is required for private entities

False

(LO 2-2) Auditing standards require a(n) _____________ of internal control and financial statements due to the interrelated nature of the two

Integrated Audit

(LO 2-2) Integrated Audit

An audit of both financial statements and internal control over financial reporting, provided by the external auditor. Required for public companies.

(LO 2-2) Compliance Audit

Determines the extent to which rules, policies, laws, covenants, or government regulations are followed by the entity being audited

(LO 2-2) Operational Audit (or Performance/Management Audit)

Involves a systematic review of part or all of an organization’s activities to evaluate whether resources are being used effectively and efficiently

(LO 2-2) What is the purpose of an operational audit?

To provide assurance, assess performance, identify areas for improvement, and develop recommendations with respect to operational effectiveness and efficiency

(LO 2-2) Operational audits present different challenges than financial statement audits or compliance audits because ______________

They often require the auditor to identify or create objective, measurable criteria against which to assess effectiveness and efficiency

(LO 2-2) True or False: Some operational audits require specialized skills and expertise

True

(LO 2-2) When an entity employs auditors to assess the efficiency and effectiveness of its use of IT resources, what type of audit is occuring?

Operational Audit

(LO 2-2) What is the purpose of a fraud audit?

To detect or deter fraudulent activities

(LO 2-2) What type of audit might be conducted in business settings in which managers or owners are concerned about fraud, criminal investigations involving money or other assets, or matrimonial disputes involving division of assets?

Fraud Audit

(LO 2-2) True or False: Auditors can provide numerous types of attest services regarding almost any subject matter

True

(LO 2-2) True or False: CPAs can offer a variety of services that provide assurance but that do not qualify as auditing or attestation

True

(LO 2-2) The Sarbanes-Oxley Act prohibits external auditors from providing many forms of nonaudit assurance and ___________ work to public companies for which the auditor also provides a financial statement audit

Consulting

(LO 2-2) What are the three broad categories of non-audit/non-assurance services?

• Tax Preparation and Planning Services

• Management Advisory Services (MAS)

• Compilation and Bookkeeping Services

(LO 2-2) Due to independence requirements, CPA Firms perform MAS primarily for private entities or for public companies for which they do not provide a _______________

Financial Statement Audit

(LO 2-2) When a public account firm prepares financial statements for a company, this service is known as _________

Compilation

(LO 2-3) Relatively small, local public accounting firms are organized as __________, __________, or __________

Proprietorships, General Partnerships, or Corporations

(LO 2-3) Regional, national, and international accounting firms are normally structured as __________ or __________

Limited Liability Partnerships or Limited Liability Companies

(LO 2-3) Structuring public accounting firms as ___________ and ____________ does not provide limited liability for the owners (partners). Under these, aggrieved parties can seek recourse against the CPA firm’s assets and the personal assets of individual partners.

Proprietorships and Ordinary General Partnerships

(LO 2-3) Due to the risk of litigation against CPAs, public accounting firms typically organize as __________ when possible

Corporations

(LO 2-3) Despite the desire to organize as a corporation, why are large national and international public accounting firms generally structured as LLPs?

• Corporations are governed by individual states and they span state boundaries

• Some states do not allow accounting firms to organize as corporations

(LO 2-3) An LLP is generally governed by the laws applicable to ____________ but provides greater personal protection against lawsuits

General Partnerships

(LO 2-3) Under an LLP:

• Partners (are/are not) personally responsible for liabilities arising from other partners’ and most employees’ negligent acts

• The personal assets of the responsible partner(s) and the assets of the of the partnership itself are (vulnerable/not vulnerable) to lawsuits resulting from partners’ or employees’ acts

Are not; vulnerable

(LO 2-3) The typical audit team is composed of what?

A partner, a manager, one or two seniors, and several staff members

(LO 2-3) Who has the authority and decision-making responsibility for auditing matters, including the issuance of the audit report?

The Lead Engagement Partner

(LO 2-3) Selected Duties of a Partner

• Reach agreement with the auditee on the scope of the service to be provided.

• Ensure that the audit is properly planned and that the audit is conducted in accordance with applicable auditing standards.

• Assemble an audit team that has the required skills and experience.

• Supervise the audit team and review the working papers.

• Conclude on the adequacy of audit evidence and sign the audit report.

(LO 2-3) Selected Duties of a Manager

• Ensure that the audit is properly planned, including scheduling of team members.

• Supervise the preparation of and approve the audit program.

• Review the working papers, financial statements, and audit report.

• Recommend key audit judgments to partner, oversee the work of seniors and staff.

• Deal with invoicing and ensure collection of payment for services.

• Inform partner about any auditing or accounting problems encountered.

(LO 2-3) Selected Duties of a Senior/In-Charge

• Assist in the development of the audit plan.

• Prepare budgets.

• Assign tasks to associates and direct the day-to-day performance of the audit.

• Perform procedures, gather and evaluate audit evidence.

• Supervise and review the work of associates.

• Inform the manager about any auditing or accounting problems encountered.

(LO 2-3) Selected Duties of an Associate/Staff

• Perform audit procedures assigned to them by the senior.

• Prepare adequate and appropriate documentation of completed work.

• Inform the senior about any auditing or accounting problems encountered.

(LO 2-4) The Sarbanes-Oxley Act is a product of what scandal?

Enron

(LO 2-5) Due professional care requires that auditors exercise what?

Professional skepticism

(LO 2-5) Professional Skepticism

An attitude that includes a questioning mind and a critical assessment of audit evidence

(LO 2-5) What happens if an auditor fails to exercise due professional care?

They can be held liable for civil damages or criminal penalties

(LO 2-5) _________ is primarily responsible for maintaining effective internal control and for ensuring the fairness of the company’s financial statements.

Management

(LO 2-6) What is the primary determinant of the environment in which auditors operate?

The business or entity being audited