Auditing: a practical approach

Solutions manual

to accompany

Auditing: a practical approach

3^rd edition

by

Moroney, Campbell and Hamilton

Prepared by

Jane Hamilton

© John Wiley & Sons Australia, Ltd 2017

Solutions of workshop 1

1. What does ‘assurance’ mean in the financial reporting context? Who are the three parties relevant to an assurance engagement?

An assurance engagement (or service) is defined as ‘an engagement in which an assurance practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria’ (Framework for Assurance Engagements, para. 8; International Framework for Assurance Engagements, para. 7).

In the financial reporting context ‘assurance’ relates to the audit or review of an entity’s financial report.

An audit provides reasonable assurance about the true and fair nature of the financial reports, and a review provides limited assurance. The audit contains a positive expression of opinion (e.g. ‘in our opinion the financial reports are in accordance with (the Act) including giving a true and fair view…), while the review contains a negative expression of opinion (e.g., ‘we have not become aware of any matter that makes us believe that…the financial reports are not in accordance with (the Act)… including giving a true and fair view..’).

An auditor may also perform agreed upon procedures for a client, but these do not provide any assurance. The client determines the nature, timing and extent of procedures and no opinion is provided to a third-party user.

The assurance practitioner is an auditor working in public practice providing assurance on financial reports of publicly listed companies, or other entities. Intended users are the people for whom the assurance provider prepares their report (e.g. the shareholders). The responsible party is the person or organisation (e.g. a company) responsible for the preparation of the subject matter (e.g. the financial reports).

2. What qualities must an ‘assurer’ have in order for you to feel that their statement has high credibility?

An assurer must have the knowledge and expertise to assess the truth and fairness of the information being presented by the preparers. Auditors of financial reports need to be trained accountants with detailed knowledge about the complex technical accounting and disclosure issues required to assess the choices made by the financial report preparers. When undertaking an audit, the auditor should use professional scepticism, professional judgement and due care.

Auditors should be independent of the client. Independent auditors have no incentives to aid the entity in presenting their results in the best possible light. They are concerned with ensuring that the information contained in the financial report is reliable and free from any significant (material) misstatements (error or fraud). A user needs to believe that the auditor is acting independently. This means that not only should auditors be independent (i.e. not have any undue personal or financial incentive to protect the client), auditors should avoid doing anything that would cause a reasonable person to doubt their independence.

3. Explain the ‘audit expectation gap’. Why do you think auditors do not give users what they want?

The audit expectation gap occurs when there is a difference between the expectations of assurance providers and the users of the financial reports. If a gap exists, it means that the users’ beliefs do not align with what the auditor’s performance in the audit. A gap usually occurs when the users of financial reports want more than the auditor provides. The users could be unrealistic in their views. Some examples of unrealistic expectations are:

• the auditor provides complete assurance
• the auditor guarantees the future viability of the entity
• an unmodified audit opinion means that the accounts are completely accurate
• if any fraud exists, the auditor would definitely find it
• the auditor has checked every transaction.

In reality, the auditor:

• provides reasonable assurance only,
• does not guarantee the future viability of the entity,
• provides an unmodified opinion when the auditor believes there are not material misstatements in the financial report
• does not guarantee that no fraud exists, although the auditor will take reasonable steps to try to uncover any fraud,
• tests only a sample of transactions.

Auditors do not give users what they want because the users’ expectations are unreasonable. However, users’ expectations could be reasonable, but beyond what current standards require. This suggests that audit standards could be improved and strengthened in order to meet user expectations in the future.

In addition, it is possible that some auditors do not give users what they require because the auditors are not following the standards. In these cases, the auditors are potentially liable to be sued or face prosecution.

4. What is the difference between reasonable assurance and limited assurance?

Reasonable assurance is the highest level of assurance. It means that the auditor has conducted audit procedures and gathered sufficient and appropriate evidence to provide an opinion on the truth and fairness of the financial reports. The auditor states, in an unqualified opinion, that they believe that the reports do provide a true and fair view of the financial position and performance of the client. Limited assurance is a lower level of assurance. The auditor performs a more limited set of audit procedures and gathers less evidence. The auditor provides an opinion stated in the negative form. They state that they have found no evidence which makes them believe that the financial reports do not provide a true and fair view of the financial position and performance of the client. Reasonable assurance is provided in an audit, limited assurance is provided in a review.

5. Describe the objective of an independent financial statement audit.

The objective of an independent financial statement audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework, which enhances the degree of confidence that intended users can place in the financial statements. The financial statements subject to audit are those of the entity, prepared and presented by management of the entity with oversight from those charged with governance. The audit of the financial statements does not relieve management or those charged with governance of their responsibilities.

6. Explain the system of reviewing the quality of audits performed by registered company auditors.

The two main bodies that regulate auditors are ASIC and the CALDB.

ASIC registers auditors, processes annual statements from registered auditors, enforces independence requirements and provides a whistle blowing facility for the reporting of contraventions of the Corporations Act. ASIC conducts an audit inspection program to report on audit quality and make recommendations for continued improvement. ASIC visits a selection of firms annually to gain an understanding of their policies and procedures in relation to their independence, audit quality, methodologies and training programs.

The Companies Auditors and Liquidators Disciplinary Board (CALDB) responds to an application by ASIC that an auditor has breached the Corporations Act or the ASIC Act. The CALDB will be involved when it is believed an auditor has not carried out their duties properly, is not a fit and proper person, is subject to disqualification or should not remain registered for some other reason. In response, the CALDB may cancel or suspend the individual’s registration, give the individual a warning or ask them to make an undertaking to improve their conduct.

White (2008) describes ASIC’s audit inspection program. The inspection process concentrates on an audit firm’s compliance with auditing standards, and their independence and quality control systems. The process includes:

• reviewing and undertaking limited testing of the firm’s independence and quality control systems
• interviewing the leaders of the audit firm, human resources personnel and selected partners and staff
• examining the firm’s audit methodology for compliance with auditing standards
• reviewing the conduct of aspects of selected audit and review engagements.

The program finishes with an exit meeting and ASIC sends the audit firm a confidential report of their findings. ASIC publishes a public report summarising all their findings.

(White, L. ‘Audit Inspections: What is the role of ASIC’s audit inspection team’, Charter (May 2008), volume 79, No. 4: 66.)

(See asic.gov.au for further information)

7. Explain the difference between the IAASB and the AUASB.

The AUASB is the Auditing and Assurance Standards Board of Australia.

“The Auditing and Assurance Standards Board (AUASB) is an independent, statutory agency of the Australian Government, responsible for developing, issuing and maintaining auditing and assurance standards.

The mission of the AUASB is to develop, in the public interest, high-quality auditing and assurance standards and related guidance, as a means to enhance the relevance, reliability and timeliness of information provided to users of auditing and assurance services.”

(http://www.auasb.gov.au/About-the-AUASB.aspx)

The AUASB also works with other standard setters around the world, including the IAASB. The IAASB sets international auditing standards, focusing on audit, quality control, review, other assurance, and related services engagements. It was established by the IFAC Board (International Federation of Accountants) to function as an independent standard setting body under the auspices of IFAC and subject to the oversight of the Public Interest Oversight Board (PIOC).

(http://www.ifac.org/auditing-assurance/about-iaasb/terms-reference)

8. An assurance engagement involves evaluation or measurement of subject matter against criteria. What criteria are used in a financial report audit?

An auditor evaluates the contents of a financial report against the standards and laws that apply to that type of financial report. Listed public companies must abide by the Corporations Act, the Australian Accounting Standards (AASB) and the listing rules of the ASX. Certain companies must also abide by additional specific legislation, depending on their industry or legal status. In addition, if a company is listed in another country, foreign exchange listing rules and laws could apply to the financial report.

Auditing standards control the way an audit is conducted, they are not the criteria against which the financial report is evaluated.

9. Explain the difference between the (1) auditor’s responsibility and (2) director’s responsibility for the financial reports being audited.

The directors of the company and the auditors have separate and distinct responsibilities. The directors are responsible for maintaining the accounting systems and preparing the reports, and the auditors are responsible for conducting an audit of these reports by evaluating their contents against the criteria of the accounting standards and relevant legislation. The auditor’s responsibilities do not include preparing the reports and the auditor must use judgement when choosing procedures and evaluating the evidence.

10. Explain the meaning of ‘true and fair’ presented in the audit report.

A true and fair view refers to the consistent and faithful application of accounting standards in accordance with the financial reporting framework when preparing the financial report (ASA 200, para 13). Australian companies must prepare their financial report in compliance with accounting standards (s. 296 of the Corporations Act). If compliance with accounting standards does not give a true and fair view, a company should provide additional information in the notes to the financial report.

11. Find an example of a financial report review report (refer to figure 1.3 in your textbook) issued by an auditor for a publicly listed company.

Required

(a) What level of assurance is provided by the financial report review?

(b) Why would a review be appropriate for a set of half-yearly financial reports?

(a) What level of assurance is provided by the financial report review?

A review provides limited assurance. The auditor does adequate work to report whether or not anything came to their attention, which would lead them to conclude that the information being assured is not true and fair. Less work is done for a review than for an audit. The auditor provides a negative opinion (nothing came to their attention… not..) for a review.

(b) Why would a review be appropriate for a set of half-yearly financial reports?

To be able to comment on the appropriateness of a review for half-yearly reports, the differences between an audit and a review (and annual and half-yearly reports) should be identified.

Assurance: reasonable vs. limited

Opinion: positive vs. negative

Procedures: nature, timing and extent – review procedures are a subset of those performed for an audit

Reports: annual reports vs. half-year – AASB 134 requires a limited set of disclosures for half-yearly (interim) reporting, and ASRE 2410 requires a limited level of work for a review of interim reports.

Half-yearly reporting is more limited than annual reporting and thus a lower level of assurance is appropriate.

12. What non-audit services could a chartered accounting firm provide to its listed company clients? Explain why a company would buy these services from its audit firm instead of another consulting firm.

As discussed in detail in chapter 2 of the text, there are potential conflicts of interest if an audit firm also performs other work for a client. For example, an accounting firm could provide consulting services on installation of a computer system, and then be engaged to audit the client’s accounting records that were produced by that system. There is potential for the auditor to miss mistakes in the accounting reports through either ignorance (not realising there was a fundamental error in the system that affected the accuracy of the accounting reports) or bias (deciding not to pursue an issue that potentially was caused by the accounting firm’s consulting work not being sufficiently rigorous).

However, provided the audit firm was not effectively auditing its own work in the manner described above, its consulting division could provide a valuable service to the company because it was familiar with the company and could understand its needs and how best to meet them.

Possible non-audit services that could be provided by a chartered accounting firm to its listed company clients include:

• Tax advice
• Strategy development advice
• Finance advice
• Supply chain management
• IT services – systems
• Risk management
• Sustainability reporting and assurance
• Finance and actuarial services

13. Big-4 vs. non-Big-4 Assurance providers

Section 301 of the Corporations Act requires companies to have their financial reports audited. Academic research suggests that Big-4 auditors charge higher fees than other auditors and their audit reports are more credible than those issued by other auditors.

Required

In times of economic recession would you expect:

(a) the demand for audits to increase or decrease?

(b) clients to shift from large (Big-4) auditors to smaller auditors, or from smaller auditors to Big-4 auditors? Why or why not?

(a) the demand for audits to increase or decrease?

Financial report audits are mandatory for most companies, so overall demand is largely fixed or determined by economic conditions affecting the number of companies. However, for organisations that are not required by legislation to have an audit, there are two opposing pressures in times of economic recession. First, cost-cutting would result in fewer audits. Second, organisations with less credible financial reports will face most difficulty in borrowing during a credit squeeze. This suggests that demand for auditing will increase in difficult times, because an audit will increase the credibility of the reports and thus increase access to external finance.

(b) Clients to shift from large (Big-4) auditors to smaller auditors, or from smaller auditors to Big-4 auditors? Why or why not?

Shifting from a smaller auditor to a Big 4 auditor would increase both costs and financial reporting credibility for a company. Therefore, it can be argued that firms with greater need to reduce costs will shift ‘down’ from Big 4 auditors to smaller auditors, but firms with greater need for credibility (and financial advice) will shift ‘up’ from smaller auditors to Big 4 auditors.

14. Demand for assurance

In 2002, the audit firm Arthur Andersen collapsed following charges brought against it in the United States relating to the failure of its client, Enron. Some other clients announced that they would be dismissing Arthur Andersen as their auditor even before it was clear that Arthur Andersen would not survive.

Required

Using the theories outlined in this chapter on the demand for audit, explain some reasons why these clients took this action.

The three theories discussed in the chapter are agency theory, the information hypothesis and the insurance hypothesis.

Agency theory suggests that there are incentives to hire an auditor to assess the truth and fairness of the information contained in the financial report. The auditor reports to the members on the truth and fairness of the financial report prepared by the manager. The good quality managers are willing to have the audit of their reports because it allows them to distinguish themselves from poor quality managers (auditing is a bonding activity). Shareholders are willing to pay the audit fee (i.e. the audit fee is paid by the company, reducing the profit available to distribute to the shareholders) to monitor the managers (who are their agents). Good quality auditors are more highly valued for this bonding and monitoring function than poor quality auditors. Andersen’s lowered their quality through their involvement with Enron, leading some companies to prefer another auditor. It has been suggested that companies taking early action to dismiss Arthur Anderson could have protected their share price by retaining their financial reporting credibility. Ultimately, all Andersen’s clients had to find another auditor.

The information hypothesis suggests that financial report users value higher quality information. Higher quality auditors are associated with higher quality financial reports. Therefore, when Andersen’s quality was called into question by their association with Enron, their client companies that valued higher quality auditors switched to another auditor.

The insurance hypothesis suggests that investors insure against their losses from company failure by purchasing an audit. When Andersen’s credibility was damaged by the Enron affair, there was doubt about their ability to survive and provide the insurance for such losses. The insurance factor is ‘impounded’ into share prices, so when the insurance cover is lost the share price should fall. This means that companies that were more sensitive to the loss of the insurance cover were more likely to dismiss Andersen’s early.

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