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Chapter01 - Tutorial - Ans: Answers To Review Questions

There is demand for auditing in free market economies due to the natural conflict of interest between owners and managers and the information asymmetry that exists between them. Auditing provides a cost-effective way for owners to monitor managers and helps address this principal-agent problem. Empirical evidence also shows auditing was demanded before government regulations and that private companies also voluntarily obtain audit and assurance services. The auditor obtains evidence to evaluate management's assertions about financial statement accounts and balances. Relevant and reliable evidence helps the auditor determine if the assertions are met to issue an audit report with an unmodified opinion. The major phases of an audit include client acceptance, planning, internal control evaluation, substantive testing, and issuing an audit report.

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55 views3 pages

Chapter01 - Tutorial - Ans: Answers To Review Questions

There is demand for auditing in free market economies due to the natural conflict of interest between owners and managers and the information asymmetry that exists between them. Auditing provides a cost-effective way for owners to monitor managers and helps address this principal-agent problem. Empirical evidence also shows auditing was demanded before government regulations and that private companies also voluntarily obtain audit and assurance services. The auditor obtains evidence to evaluate management's assertions about financial statement accounts and balances. Relevant and reliable evidence helps the auditor determine if the assertions are met to issue an audit report with an unmodified opinion. The major phases of an audit include client acceptance, planning, internal control evaluation, substantive testing, and issuing an audit report.

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shaz
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© © All Rights Reserved
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Chapter01_Tutorial_Ans

Answers to Review Questions

1-2 There is a demand for auditing in a free-market economy because in the agency
relationship there is a natural conflict of interest between an absentee owner and a manager
and due to the information asymmetry that exists between the owner and manager. As a
result, the agent agrees to be monitored as part of his/her employment contract. Auditing
appears to be a cost-effective form of monitoring.
The empirical evidence suggests auditing was demanded prior to government
regulation such as statutory audit requirements. Additionally, many private companies and
other entities not subject to government auditing regulations also purchase various forms of
auditing and assurance services.

1-3 There is a natural conflict of interest in the agency relationship between an owner
and manager because of differences in the two parties’ goals. For example, the manager
may spend funds on excessive personal benefits or favour entity growth at the expense of
stockholders values. If both parties seek to maximize their own self-interest, it is likely that
the manager will not act in the best interest of the owner and may manipulate the information
provided to the owner accordingly.

Solutions to Problems

1-13 The memo should cite the following facts:


 There is a historical relationship between accounting and auditing.
 The parties to the agency relationship (contract) do not possess the same amount of
information (information asymmetry) and have a natural conflict of interest. For
example, when an owner and manager are negotiating an employment contract, the
owner may assume that the manager likely will use organizational funds for personal
uses. Auditing plays an important role in such relationships. The owner and
manager will consummate an employment contract only if the manager agrees to be
monitored. Auditing can be used to monitor the contract agreed to by the two parties.
(P.S. As a lawyer, Lee should be well versed on contract law.)
 Auditing is also used to monitor other types of contracts for which no laws or
regulations require an audit, for example, contracts between management and debt
holders.
 There is historical evidence of forms of auditing in the early Greek states and in
Europe during the industrial revolution.
 Additional evidence for the demand for auditing is also provided by the fact that many
private companies and other entities not subject to a statutory audit requirement
contract for audits.

1-14 There are two major factors that may make an audit necessary for Greenbloom
Garden Centres. First, the company may require long-term financing for its expansion into
other cities. Entities such as banks or insurance companies are likely to be the sources of
the company’s debt financing. These entities may require audited financial statements
before lending significant funds and require audited financial statements during the time
period the debt is outstanding. There is information asymmetry between the lender of funds
and the owner of the business, and this asymmetry results in information risk to the lender.
Even if the business could get funding without an audit, an audit report with an unmodified
opinion by a reputable auditor might very well reduce the lender’s information risk and make
the terms of the loan more favourable to the owner. Second, as the company grows, the
family will lose control over the day-to-day operations of the stores. An audit can provide an
additional monitoring activity for the family in controlling the expanded operations of the
company.

1-15
a Evidence that assists the auditor in evaluating financial statement assertions consists of
the underlying accounting data and any additional information available to the auditor,
whether originating from the client or externally.

b Management makes assertions about elements of the financial statements. For example,
an entity's financial statements may contain a line item that accounts receivable amount to
€1,750,000. In this instance, management is asserting, among other things, that the
receivables exist, the entity owns the receivables, and the receivables are properly valued.
Audit evidence helps the auditor determine whether management’s assertions are being
met. If the auditor is comfortable that he or she can provide reasonable assurance that all
assertions are met for all accounts, he or she can issue an audit report with an unmodified
opinion. In short, the assertions are a conceptual tool to help the auditor ensure that she or
he all relevant aspects.

c In searching for and evaluating evidence, the auditor should be concerned with the
relevance and reliability of evidence. If the auditor mistakenly relies on evidence that does
not relate to the assertion being tested, an incorrect conclusion may be reached about the
management assertion. Reliability refers to the ability of evidence to signal the true state of
the assertion, i.e. whether it is actually being met or not.

1-16
a The major phases of the audit and their descriptions are:

1. Client acceptance/continuance. The auditor decides to accept a new client or to


retain an existing client.
2. Preliminary engagement activities. This phase involves (1) determining the audit
engagement team requirements, (2) ensuring the independence of the audit team
and audit firm, and (3) establishing an understanding with the client regarding the
services to be performed and the other terms of the engagement.
3. Plan the audit. During this phase of the audit, the auditor uses the knowledge of the
entity to plan the audit (i.e. to set forth the overall audit strategy and the nature,
extent and timing of the audit work). The purpose of this phase is to plan an effective
and efficient audit.
4. Consider internal control. The auditor understands and evaluates the entity’s internal
controls in order to assess the risk that they will be prevented, or detect and correct a
material misstatement.
5. Audit business processes and related accounts. The auditor conducts substantive
tests, including analytical procedures and the details of the account balances,
searching for material misstatements.
6. Complete the audit. The auditor searches for contingencies and subsequent events,
and performs a final review of the evidence gathered.
7. Evaluate results and issue the audit report. Based on the collection and evaluation of
evidence, the auditor issues a report on whether the financial statements are fairly
presented.

b While audit procedures may be designed to test a specific assertion, they often
simultaneously provide evidence on another account or assertion. An example would be
when an auditor obtains evidence about an entity’s transactions affecting the inventory
account and whether shipments of inventory to customers were included in the proper
period. Such evidence may also be relevant to the entity’s assertions regarding whether
accounts receivable balances were correct at the end of the period.

c Auditors develop an understanding of an entity's internal control in order to establish the


scope of the audit. However, during the course of this work, the auditor may become aware
of deficiencies in internal control. The auditor is required to communicate significant
deficiencies to those charged with governance (e.g. the board of directors) and
management. The auditor may also make suggestions on how to correct the deficiencies.
The auditor's work on internal control may also have a preventive effect on the entity's
employees. If the employees know that their work will be examined, they are less likely to
commit errors or fraud.

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