Solution Manual For Principles of Auditing and Other Assurance Services, 21st Edition

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Solutions Manual, Chapter1, Page1of13CHAPTER 1The Role of thePublic Accountant in theAmerican EconomyReview Questions1-1The “crisis of credibility” largely arose from the number of companies that restated their previouslyissued financial statements as a result of accounting irregularities and fraud. Especially responsiblewere the very visible Enron and WorldCom fraud cases. Both companies filed for bankruptcy andconstituted the largest companies in American history to do so. The extent of the accountingirregularities and fraud being investigated and disclosed brought into question the effectiveness offinancial statement audits. In addition, the criminal conviction of Arthur Andersen, LLP, one of thethen Big 5 accounting firms, on charges of destroying documentsrelated tothe Enron case broughtinto question the ethical standards of the profession.1-2Assurance services are professional services that enhance the quality of information, or its context,for decision-making. The two types are: (a) those that increasethereliability of information and (b)those that involve putting information in a form or context thatfacilitates decision-making.1-3A financial statement audit is, by far, the most common type of attest engagement. The overallassertion, made by management, most frequently is that the financial statements follow generallyaccepted accounting principles.1-4A large corporation with securities listed on a stock exchange is required by the rules of the stockexchange and by the rules of the SecuritiesandExchange Commission to provide an audit report withthe annual financial statements furnished to its stockholders.It also is required to engage the auditorsto provide an opinion on its internal control.Apart from legal requirements, however, a large listedcorporation recognizes that it must maintain investor confidence inthe reliability ofits financialstatementsand internal control over financial reportingif it is to continue to be able to secure capitalfrom the public. The report by a firm of certified public accountants adds credibility to the financialstatements prepared by the corporation. When a small family-owned enterprise elects to have anaudit, the purpose usually is to use the auditors' report to support an application for a bank loan.

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Solutions Manual, Chapter1, Page2of131-5A report by an independent public accountant concerning the fairness of acompany's financialstatements 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 ortraded over the counter.(6)Sale of an ongoing business.(7)Termination of a partnership.1-6To add credibility to financial statements is to increase the likelihood that they have been preparedfollowing the appropriate criteria, usually generally accepted accounting principles. As such, anincrease in credibility results in financial statements that can be believed and relied upon by thirdparties.1-7Business risk is the risk that the investment will be impaired because a company invested in is unableto 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. Auditorscan directly reduce information risk, but have only limited effect on business risk.1-8At the beginning of the century, the principal objective of auditing was the prevention and detectionof fraud. Audit work centered on the balance sheet, because the income statement was regarded ashighly confidential and not for public disclosure. Today, the principal objective of auditing is to forman opinion on the fairness of financial statements and their conformity with generally acceptedaccounting principles. But the professional standards also require that an audit be designed to providereasonable assurance of detecting material misstatements, due to errors or fraud. Particular emphasisis placed on the income statement which is of great importance to investors. Auditing today also hasthe objectives of meeting the requirements of the Securities and Exchange Commission (SEC)and thePublic Company Accounting Oversight Boardfor public companies.1-9An operational audit attempts to measure the effectiveness and efficiency of a specific unit of anorganization. It involves more subjective judgments than a compliance audit or an audit of financialstatements because the criteria of effectiveness and efficiency of departmental performance are not asclearly established as are many laws and regulations or generally accepted accounting principles.The report prepared after completion of an operational audit is usually directed tomanagement of the organization in which the audit work was done.1-10A compliance audit is an audit to determine whether financial reports or other assertions are incompliance with established criteria. The necessary ingredients are verifiable data and the existenceof standards established by an authoritative body. An operational audit, on the other hand, is a reviewof a department or other unit of a business or governmental organization to measure the effectivenessand efficiency of operations. Internal auditors often perform operational audits as do auditorsemployed by the GovernmentAccountabilityOffice (GAO) of the federal government.1-11Internal auditors must be independent of the department heads and other line executives whose workthey review. However, internal auditors are not independent in the same sense as a public accountingfirm. The public accounting firm serves many clients and the revenue obtained from any one client isonly a small part of the revenue of the firm. Internal auditors, on the other hand, are employees ofone company, and are subject to the restraints inherent in the employer-employee relationship.

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Solutions Manual, Chapter1, Page3of13Internal auditors can achieve a great deal of independence by reporting to the audit committee of theboard of directors, but they cannot achieve the same degree of independence as is possessed by theexternal public accounting firm.1-12The internal auditors are employees of Spacecraft, Inc., and may be influenced by corporatemanagement. The public accounting firm is independent of the company and is in a better position totake positions opposed to those of company management. The work of the internal audit staffemphasizes measurement of the efficiency and effectiveness of various operating units of thecompany and compliance with all types of controls, whereas the public accounting firm is primarilyconcerned with determining the fairness of Spacecraft's financial statements.1-13The GovernmentAccountabilityOffice (GAO) is a staff of professional auditors which reports toCongress. Its function is to determine that programs carried out by federal agencies conform to thefinancial authorization of the Congress. It is also concerned with the cost-effectiveness ofgovernment programs. The audit activities include investigation of the costs and performance ofcorporations holding government contracts.1-14Among the many important contributions to auditing literature by the AICPA are the series ofStatements on Auditing Standards (SASs), Statements on Standards for Attestation Engagements(SSAEs), Industry Audit and Accounting Guides, Audit Guides,Audit Risk Alerts,Statements onStandards for Accounting and Review Services(SSARSs), , and the Code of Professional Conduct(only two required).1-15A peer review is a critical review of a public accounting firm's practices by another public accountingfirm (or other CPAs functioning as a peer review team). The purpose of a peer review is to encourageadherence to quality control standardsestablished by the accounting firm and the profession.1-16The Securities and Exchange Commission (SEC) is an agency of the federal government and isresponsible for administering a number of acts, including the Securities Act of 1933 and theSecurities Exchange Act of 1934. In meeting this responsibility, the SEC reviews financialstatements of companies offering securities for sale to the public. It is particularly concerned withrequiring full disclosure of financial information and with preventing misrepresentation. Through thePublic Company Accounting Oversight Board, the SEC now oversees public accounting firms thataudit public companies. Included in this oversight process includes development of auditing,independence, and quality control standards; inspection of performance; and enforcement of thestandards.The AICPA is the national organization of certified public accountants. It has long been aleader in accounting and auditing research, in publication of authoritative accounting and auditingpronouncements and studies, and in promoting high professional standards of practice.1-17Services offered by public accounting firms in addition to auditing include other forms of attestation,tax work, consulting services, litigation support services, fraud investigation services, personalfinancial planning and accounting services.This last category includes preparation of financialstatements for smaller companies that have limited accounting personnel and various types of write-up work. Public accounting firms also perform a variety of other services. Consulting servicesinclude aiding clients in the design of accounting systems, conversion toInformation Technology (IT)systems, preparation of budgets, planning business combinations with other companies, executivesearch, and numerous other projects. Public accounting firms are restricted as to the consultingservices that they may provide to audit clients that are public companies.

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Solutions Manual, Chapter1, Page4of131-18The partnership form of organization for a public accounting firm offers several advantages over asole proprietorship. A partnership offers the opportunity for specialization by the partners in areassuch as taxation, auditing, and consulting services. Partners can discuss difficult technical problemsamong themselves, and benefit from different perspectives. Also, the partnership may be better ableto attract and retain high quality professional staff, because they may be rewarded by acceptance intothe partnership.1-19The following characteristics of a professional corporation distinguish it from the traditionalcorporation:(1)All shareholders must be engaged in the practice of public accounting.(2)To the extent possible, directors and officers should be certified public accountants.(3)Shares of a professional corporation may be transferred only to those engaged in publicaccounting or to the corporation itself.(4)The corporation's shareholders and employees have liability equivalent to other forms oforganizations (i.e., the corporate form of organization does not reduce liability). Note,however, that CPAs may choose to purchase liability insurance to limit potential liability.1-20Local firms usually have only one or twooffices, are headed by a single CPA or have a few CPAs aspartners, and serve clients in a single city or area. The services provided are mostly income tax work,consulting services, and accounting services. Auditing is often only a small part of the practice.Regional firms often arise from the merger and expansion of local firms. They typicallymaintain several offices in neighboring cities and states. Auditing is a more important function forregional firms than for the local firms, because larger businesses are included among the clients.National firms have offices in most major cities in the United States and some operate in othercountries as well. These firms offer a full range of services, with auditing often representing thelargest single portion of the practice.International firms have offices in most of the world’s major cities. These firms offer a fullrange of services, with auditing often representing the largest single portion of the practice.1-21The various levels of accounting personnel in a large public accounting firm arestaff auditors, seniorauditors, managers or supervisors, and partners (and principals).Thestaff auditorperforms audit procedures such as the observation of physical inventoriesand confirmation of receivables under the supervision of a senior. The senior auditor plans andcoordinates the audit and drafts the audit report. The senior also reviews working papers, controls theallocation of audit time, and trains assistants on the job. The manager or supervisor usually isresponsible for supervising and reviewing several audit engagements concurrently, and resolvingsignificant problems with the client. The partners maintain contacts with clients, develop newbusiness, establish policies of the firm, review the adequacy of audit work, and sign audit reports.The engagement partner is responsible for performance of the audit in accordance with professionalstandards. A partner also devotes time to the recruitment and development of staff, to AICPA andother professional group activities, to educational and other civic activities, and generally topromoting an environment in which the firm can prosper. The position of principal, which is oftenheld by top-ranking consulting personnel who do not hold the CPA certificate, has responsibilitiessimilar to those of a partner.1-22The most significant responsibilities of a partner in a public accounting firm include (only threerequired:•Assume ultimate responsibility for the audits assigned to him or her•Sign audit reports•Review the audit work for compliance with firm and professional standards

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Solutions Manual, Chapter1, Page5of13•Maintain relations with audit clients•Establishing firm policies•Staff recruitment and development1-23An accounting association becomes an accounting network when member firms share one or more ofthe following with other member firms:(1) common brand name; (2) common control; (3)profits; (4)common business strategy; (5)significant professional resources; (6) commonquality control policies and procedures.1-24The International Auditing and Assurance StandardsBoardestablishesInternational Standards onAuditing(ISAs)International Standards on Quality Control(ISQC)and standards for other assuranceand related services. Its pronouncements are meant to foster the development of consistentworldwide professional standards. Its standards do not to override the national auditing standards ofits members.Questions Requiring Analysis1-25(a)The Sarbanes-Oxley Act of 2002 made significant reforms in the regulation system for publicaccounting firms that audit public companies. It contains provisions toughening penalties forcorporate fraud, restricting the types of consulting CPAs may perform for audit clients, andcreating the Public Company Accounting Oversight Board (PCAOB) to oversee theaccounting profession.(b)Primary regulation of public accounting firms that audit public companies is provided by thePCAOB and the Securities and Exchange Commission (SEC). With respect to the practicesof these firms, the PCAOB has the responsibility for:(1)Establishing or adopting auditing, quality control, andethicalstandards,(2)Registering public accounting firms,(3)Performing inspections of the practices of registered,(4)Conducting investigations and disciplinary proceedings of registered firms, and(5)Sanctioning registered firms.The SEC investigates violations of the securities laws, including allegations of fraudulentfinancial reporting and public accounting firm audit deficiencies. In addition, the state boardsof accountancy may revoke any public accounting firm’slicense to practice.(c)Primary regulation of public accounting firms that are not under the PCAOB’s inspectionprogram rests with the AICPA and the state boards of accountancy. Members of the AICPAin public practice must practice with a firm that participates in a practice review program.Firms can meet this requirement by enrolling the AICPA Peer Review Program, whichrequires the firm to have a peer review every three years.Ethical violations are investigatedand enforced by the AICPA and the state boards of accountancy.

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Solutions Manual, Chapter1, Page6of131-26(a)Audits of financial statements of a corporation contemplating issuing debenture bonds mayfacilitate the transaction through reducing information risk—the risk that the informationused to make the investment decision is materially misstated. Misstatements of the financialstatements may occur due to accidental errors, lack of knowledge of accounting principles,unintentional bias, or by deliberate falsification of the statements.(b)When financial statements have not been audited a "credibility gap" may exist in thatmanagement can hardly be expected to be impartial and unbiased in their preparation. Thiscredibility gap may lead to a situation in which investors find the information risk too greatand they decide not to invest in the bonds. If they do decide to invest in the bonds, theinvestors will likely demand a higher rate of return.1-27The Public Company Accounting Oversight Board was created because of the concerns about thecredibility of the public accounting profession that occurred in the later part of 2001 and the early partof 2002. Thelarge number of public company restatements due to accountingirregularities and fraudcaused the investing public and Congress to question the effectivenessof audits. In addition, theconviction of Arthur Andersen LLP of destruction of evidence related to the Enron case causedCongress to question the profession’s ethical principles.The Public Company Accounting OversightBoard has the responsibility to overseeand discipline public accounting firms that audit publiccompanies. Specifically, the PCAOB has the responsibility for:(1)Establishing or adopting auditing, quality control, andethicalstandards,(2)Registering public accounting firms,(3)Performing inspections of the practices of registered,(4)Conducting investigations and disciplinary proceedings of registered firms, and(5)Sanctioning registered firms.1-28(a)An example of possible bias on the part of the provider of financial information is thesituation in which an individual or business entity applies for a bank loan. In suchcircumstances, there is an incentive to overstate assets, income, and owner's equity, and tooverlook or minimize liabilities. Distortions of this type give the appearance of greaterfinancial strength.(b)A bank loan officer may insist that a prospective borrower provide audited financialstatements. This provides assurance that the data in the financial statements have beenexamined by independent competent persons.Objective Questions1-29Multiple Choice Questions(a)(3)Both sets of standards requireindependence.(b)(1)The client's management is primarily responsible for representations contained in thefinancial statements. The independent auditors are responsible for performing theiraudit in accordance with generally accepted auditing standards.(c)(1)The most important benefit of having an annual audit by a public accounting firm isto provide assurance to investors and other outsiders that the financial statements aredependable. The expansion of the securities markets has tremendously increased theneed for verification of financial statements performed by competent, independent

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Solutions Manual, Chapter1, Page7of13persons. Answer (2) is incorrect because management cannot avoid responsibility forthe financial statements by retaining independent auditors. Answer (3) gives norecognition to the fact that many nonpublic corporations and other business entitieshave no obligation to file audited financial statements with governmental agencies. Italso disregards the fact that large corporations which secure capital from the generalpublic would continue to provide audited statements even though there were no suchrequirements by governmental agencies. Answer (4) is unacceptable because itimplies that an audit is designed to detect illegal acts without regard to type or size.(d)(2)The PCAOB ordinarily does not review financial reports filed with the Securities andExchange Commission—although, if they so desire, they may review such reports toaccomplish their other responsibilities. The other three replies are all explicitresponsibilities of the PCAOB.(e)(4)The Public Company Accounting Oversight Board was given the authority by theSarbanes-Oxley Act of 2002 to establish or adopt auditing standards for audits ofpublic companies.(f)(4)Governmental auditing often extends to audits of efficiency, effectiveness, andcompliance (with laws, regulations,etc.). The other responses, adequacy, evaluation,and accuracy, are terms not typically used to summarize the scope of governmentalauditing.(g)(3)Normally, the higher in an organization an internal auditor reports, the greater thedegree of independence. Accordingly, reporting to the audit committee of the boardof directors increases the likelihood that the internal auditor will be able to actindependently of those being audited. Answers (1) and (2) may lead to a lesserdegree of independence because when an internal auditor reports to the financialvice-president or the controller they cannot objectively review their work. Answer(4) is incorrect because it is generally not practical or effective for the internal auditorto report to stockholders on a timely basis.(h)(4)Ethical scandals at the AICPA was not one of the causes of the passage of theSarbanes-Oxley Act of 2002. All of the other responses contributed to passage of theAct.(i)(3)TheFederal Accounting Standards Advisory Boardestablishes accounting standardsfor United States governmental agencies.The Governmental Accounting StandardsBoard establishes accounting standards for state and local government entities.(j)(4)Forensic audits are usually performed whenfraudhas been found or is suspected.Answer (1) is incorrect because it overstates the nature of most audits by suggestingthat all audits are forensic in nature. Answer (2) is wrong in that CPA firms (or lawfirms) may perform forensic audits. Answer (3) is incorrect because whilecompliance audits may find fraud, they are not directed at fraud as are forensicaudits.(k)(1)Because the auditors’ purposes for considering internal control are to (a) plan theaudit and (b) to determine the nature, timing, and extent of the tests to be performed,answer (1) is correct.

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Solutions Manual, Chapter1, Page8of13(l)(2)A compliance audit measures the compliance of an organization with establishedcriteria such as laws and regulations. Answer (2) is correct because it addressespolicies and procedures on environmental laws and regulations.1-30(1)Phrases moreapplicable to an audit performed in 1900:(a)Complete review of all transactions.(c)Auditors' attention concentrated on balance sheet.(f)Auditing procedures to prevent or detect fraud on the part of all employees andmanagers.(l)Bankers and short-term creditors as principal users of audit reports.(2)Phrases more applicable to an audit performed today:(b)Assessment of internal control.(d)Emphasis upon use of sampling techniques.(e)Determination of fairness of financial statements.(g)Registration statement.(h)Fairness of reported earnings per share.(i)Influence of stock exchanges and the investing public upon the use of independentauditors.(j)Concern about fraudulent financial reporting.(k)Generally accepted auditing standards.(m)Pressure for more disclosure.(n)Auditing for compliance with laws and regulations.1-31PublicationSponsor1.Statements on Auditing Standards (SASs)c. AICPA2.The Journal of Accountancyc. AICPA3.Regulation S-Xb. SEC4.Statements on Standards for Accounting and Review Services (SSARS)c. AICPA5.Financial Reporting Releases (FRRs)b. SEC6.Accounting and Reporting Standards for Corporate Financial Statementsd. FASB7.Accounting and Reporting Standards forGovernmental Entitiesg. GASB8.Industry Accounting and Auditing Guidesc. AICPA9.Audit Risk Alertsc. AICPA10.The Tax Advisorc. AICPA11. Auditing Standardsh. PCAOB

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Solutions Manual, Chapter1, Page9of131-32DefinitionsColumn OneColumn Two1.Quality controle.PeerReview2.Operational audith.Measurement of effectiveness andefficiency of a unit of an organization3.Internal controli.Basis for sampling and testing4.GeneralAccountabilityOfficej.Auditing staff reporting to Congress5.Disclosurec.Material information6.Critical characteristic that must be maintained by theaccounting professiond.Credibility7.Public Company Accounting OversightBoarda.Regulation of auditors of publiccompanies8.Securities and Exchange Commissionf.Registration statement9.Audited financial Statementsb.Opinion10.Compilation of financial statementsg.Accounting service1-33StatementType ofEngagementa.When financial statements are involved this is referred to as an audit.Eb.The term “we are not aware of any material modifications that should bemade” is often included in the report.Rc.The report issued provides a summary ofprocedures followed and findings.Ad.The report issued provides “reasonable assurance.”Ee.The procedures involved are generally limited to inquiry and analyticalprocedures.Rf.The report issued provides “absolute assurance.”Ng.The reportprovides “limited assurance.”Rh.The procedures followed are agreed upon with the specified user or users.Ai.This type of engagement provides more assurance than a review.Ej.The CPA need not be independent to perform this service.N1-34Definitionsa.1Agreed-upon procedures engagementb.9Reviewc.3Attest engagementd.4Audit of financial statementse.7Integrated auditf.2Assurance servicesg.6Examination1-35Definitionsa.8Securities and Exchange Commissionb.2Assertionc.9Statements on Auditing Standardsd.4Financial reporting framework.e.7Sarbanes-Oxley Act of 2002f.6Public Company Accounting Oversight Boardg.1American Institute of Certified Public Accountantsh.11Suitable criteria.

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Solutions Manual, Chapter1, Page10of131-36TopicType of AuditorClass of Work1CPAAudit of financial statements2CPAAudit of financial statements3Internal auditorOperational audit4GAOOperational audit5Bank examinerCompliance audit6CPAConsulting services7CPAAudit of financial statements8Internal auditorOperational audit9IRSCompliance audit10CPACompliance audit11GAOCompliance audit12CPAAccounting servicesProblems1-37SOLUTION: Feller Company (estimated time: 20 minutes)(a)Farber should explain to Feller that an independent audit is an examination of the financialstatements in accordance with generally accepted auditing standards. The objective of anaudit is to render an opinion on the fairness with which the financial statements presentfinancial position, results of operations, and cash flows in conformity with generally acceptedaccounting principles. The CPA, after an objective evidence-gathering audit, expresses anopiniononthe fair presentation of financial statements. An independent expert is needed tolend credibility to the financial statements. It would not be meaningful for a company toreport on itself without the attestation of an independent party because the company itselfmight not be objective.(b)Farber should inform Feller of the following ways in which an independent audit can bebeneficial to (only five required):(1)Serve as a basis for the extension of credit.(2)Supply credit rating agencies with required information.(3)Serve as a basis for preparation of tax returns.(4)Establish amounts of losses from fire, theft, burglary, and so forth.(5)Determine amounts receivable or payable under various agreements.(6)Provide data for possible sale or merger.(7)Serve as a basis for action in bankruptcy and insolvency cases.(8)Determine proper execution of trust agreements.(9)Furnish estates with information to obtain proper settlements and avoid costlylitigation.(10)Improve internal control.(11)Provide aid in cases of tax audits, court actions, and so forth.(12)Discourage employees from perpetrating errors and fraud.(13)Provide industry-wide comparisons.(14)Assist in analysis of adequacy of insurance coverage.(15)Provide the professional knowledge of an external auditor, which may help companyin a number of ways.1-38SOLUTION: Peters & Ferrel (Estimated time: 20 minutes)

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Solutions Manual, Chapter1, Page11of13Peters is taking a very narrow view of the CPA's role in the American economy. The reserved, aloofattitude recommended by Peters was perhaps justified a half-century or more ago when the primaryobjective of many audits was the discovery of errors, defalcations, and other forms of fraud.In the current era, the auditors' role has changed from that of a "detective" to that ofaccounting experts whose breadth of experience in the audit of many companies enables them to offerclients constructive advice which leads to compliance with accounting principles, improvedaccounting methods, better financial administration, and more profitable operation.To fulfill this broader role of advisers as well as impartial reviewers, the auditors need thecooperation of client personnel at all levels. They need managers and employees to speak freely oftheir problems and to explain fully why certain operating methods are followed. The audit will be farmore effective if client personnel are willing to identify problem areas. This kind of two-waycommunication between the client and the auditors will be possible only if the client views theauditors as approachable, cordial individuals with a sincere interest in helping the client.The auditors can be independent and objective without being cold and impersonal. Theyshould never convey the impression that they regard the client's employees as potential embezzlers.Neither should they take over office equipment or accounting records in a manner that suggests lackof consideration for the convenience and status of the client's staff.The development of social relationships with the client outside the office, as advocated byFerrel, is helpful to the CPA partner as it is to the architect, the physician, the attorney, and membersof other professions. The successful CPA will usually be an active community leader, well known incivic organizations, social clubs, educational circles, and many other related areas. The CPA not onlyattracts new clients but contributes to the advancement of the total environment in which the CPA'sprofessional talents are employed.The most difficult issue posed by Peters and Ferrel is whether the development of very closefriendships between the CPA and staff on the one side and the client and staff on the other may causethe CPA to lose independence to some degree. This possibility cannot be easily dismissed. Inassessing relationships with the client, the CPA must not only consider the fact of being independent,but also the recognition of independence by the public. The CPA must ask the question: Would anoutsider having full knowledge of the relationships between the CPA and a client have doubts aboutthe CPA's independence?This hard-to-define narrow path between cordial CPA-client relations on the one hand and thethreat of loss of public confidence in the CPA's independence on the other demands that the CPAexercise care and judgment in social relationships with clients. Partners, who by the very nature oftheir responsibilities must meet with business executives on their own ground, tend to develop socialcontacts with clients. Presumably, partners in a public accounting firm have demonstrated thematurity, judgment, and breadth of view that will enable them to maintain a proper balance betweenfriendship with clients and professional independence.When the element of sex enters the picture, the formulation of precise rules of conductbecomes more difficult, if not impossible. Assume, for example, that a female executive and partowner of a client company and a male partner of the company's public accounting firm are known tobe constant companions during off business hours. The public would probably find it difficult tobelieve that the CPA would be truly independent in auditing the business in which his friend playedsuch an important role.

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Solutions Manual, Chapter1, Page12of13In-Class Team Case1-39SOLUTION: Types of Services Provided by CPAs (Estimated time: 15 minutes)The following are typical replies relating to this very general question. Thepurpose of this teamexercise is to consider employment options within the profession of accounting. Students willtypically have many concerns relating to this topic and an early discussion may provide them withhelpful background information.(a)Tax services performed by public accounting firms fall into the categories of compliancework and tax planning. Compliance work involves preparing the federal, state, and local taxreturns of clients. Tax planning involves consulting with clients on how to structure theirbusiness affairs to minimize the amount and postpone the payment of taxes. Tax work whileworking for a corporation is similar in that it deals with compliance and with planning. Itdiffers, however, in that the work will be performed for the one company, and not the broadrange of clients typical of a public accounting firm. This obviously has advantages in termsof developing expertise related to the company.Taxation work for the General Accounting Office will relate primarily to studies ofgeneral compliance with tax laws. Internal Revenue Service deals completely withcompliance with various federal tax laws.(b)Public accounting firms have historically emphasized the auditing of financial statements,although expansion of the attest function to a number of other areas is currently occurring.Auditing work with corporations generally involves working in the internal auditingdepartment of that corporation. In addition to auditing financial information, internalauditing staff members devote a significant amount of time to operational and complianceaudits.The auditing work with the General Accounting Office includes both compliance andoperational audits. Internal Revenue Service auditing work is, as indicated, related tocompliance with various federal tax laws.(c)Public accounting firms become involved with systems design both through audits andthrough consulting services. In audits, CPAs must analyze their clients' internal control, aswell as make recommendations for improvements. However, public accounting firms thataudit public companies may not perform systems consulting for those clients. Similarly,internal auditors for corporations, as well as information technology specialists becomeinvolved in systems design.The General Accounting Office and the Internal Revenue do not typically becomeinvolved in systems design beyond that needed to perform compliance audits, and in the caseof the GAO, operational audits.Research and Discussion Case1-40SOLUTION: Smith & Co. (Estimated time: 30 minutes)(a)The following arguments might be advanced in favor of allowing public accounting firms tosell ownership interests to non-accountants through incorporation:•Access to capital is improved and will lead to anefficient allocation of resources withinthe economy.

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Solutions Manual, Chapter1, Page13of13•Because public accounting firms compete against companies that are allowed to obtaincapital in such a manner, they should not be constrained to capital available fromaccountants and loans.•The fact that in this case the CPAs own 51 percent of the stock limits any possiblenegative effects on service quality which might result from non-accountant involvement.•From the perspective of the public accounting firm, the possibility of liability that islimited to the amount of corporate assets is appealing.•CPAs compete internationally, and it does not serve this country's interests to limit theirability to obtain capital.(b)The following arguments might be advanced in favor of the restriction of firm ownership:•The professional yet personal nature of the service involved may be affected negativelyas shareholders exert pressure on CPAs which negatively affects the quality of theirwork.•Any limits on personal liability may negatively affect those harmed by negligentperformance by the firm.•Limiting public accounting firms to sole practitioner, partnership and professionalcorporation status has served the public well over the years and there appear to be onlylimited advantages to allowing public ownership.(c)There is no obvious answer to this case. Note that the situation today is very much unsettledas few states currently allow traditional incorporation under any circumstances.However,the traditional ability of CPAs to obtainadequate capital leads us to question whether thepossible advantages of traditional incorporation are adequate to overcome the fairlysignificant arguments against it.

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Solutions Manual,Chapter 2, Page1of14CHAPTER 2Professional StandardsReview Questions2-1The Sarbanes-Oxley Act of 2002 created the PCAOB and gave this body authority to developauditing standards for the audits of public companies. The AICPA has theauthority,based on generalacceptance (and adoption by state boards of accountancy and other regulatory bodies),to developauditing standards for audits of nonpublic companies.2-2Generally accepted accounting principles are accounting principles which have substantialauthoritative support, such as approval by the Governmental Accounting Standards Board or theFinancial Accounting Standards Board. These standards provide the criteria (financial reportingframework) for financial reporting, including the nature and content of financial statements.Generally accepted auditing standards are those issued by the AICPA’s Auditing Standards Board(ASB). GAAS are the standards for the auditor’s work in fulfilling the overall objectives of afinancial statement audit. GAAS address the general responsibilities of the auditor, as well as theauditor’s further considerations relevant to the application of those responsibilities.2-3A financial reporting framework is a set of criteria used to determine measurement, recognition,representation, and disclosure of all material items appearing in the financial statements; for exampleUnited States GAAP or IFRS. It is important to anaudit because it is through consideration of thatframework on which the auditor basis his or her opinion on the financial statements.2-4Generally accepted auditing standards are theStatements on Auditing Standardsissued by theAuditing Standards Board.2-5In the context of the audit of financial statements, professional skepticism includes maintaining aquestioning mind, being alert to conditions that may indicate possible misstatement due to fraud orerror, and a critical assessment of audit evidence.Throughout the audit the auditors should be alertfor: (1) audit evidence that contradicts other audit evidence, (2) information that raises a questionabout the reliability of documents and responses to inquiries, (3) conditions indicating possible fraud,and (4) circumstances suggesting the need for additional audit procedures beyond those ordinarilyrequired.

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Solutions Manual,Chapter 2, Page2of142-6The auditors' responsibilities concerning the detection of noncompliance with laws by clients dependson the relationship of the law or regulation to the financial statements. Certain laws and regulations,such as income tax laws, have a direct effecton the amounts and disclosures included in the financialstatements. The auditors have a responsibility to design their audit to obtain reasonable assurance ofdetecting material violations of these laws and regulations.Many other laws and regulations, such as occupational safety and health laws, do not have adirect effect on the amounts included in the financial statements. An audit carried out in accordancewith generally accepted auditing standards is not designed todetect client noncompliance with theseother laws.Although an audit is not designed to provide reasonable assurance of detectingnoncompliance with other laws, the CPAs should be aware of the possibility that they have occurredand investigate those identified. When they become aware of noncompliance with laws, the auditorsshould communicate the situation to the audit committee of the board of directors to remedy thesituation and make appropriate modifications to the financial statements. If management fails to takeappropriate action, the auditors should consider withdrawing from the engagement.2-7The first sentence of the quotation is correct. The completion of an audit of financial statements by aCPA following generally acceptedauditing standards and satisfying the CPA provides the basis forexpression of an unmodified opinion on the fairness of financial statements.The second sentence of the quotation is in error. Auditors never express an opinion (eitherqualified or unmodified) on the fairness of financial statements without first performing an audit. Theaudit provides the basis for the expression of an opinion.Such factors as audits made in prior years,confidence in management, and a "quick review" of the current year's financial statements are not anacceptable substitute for appropriate audit procedures.2-8The management of Pike Company is primarily responsible for the fairness of the company's financialstatements. The retention of certified public accountants to perform an audit and express an opinionon the statements does not relieve management of its obligation to give an honest and completeaccounting of its conduct of corporate affairs.

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