Chapter 01 - Auditing and Assurance Services

CHAPTER 01

Auditing and Assurance Services

LEARNING OBJECTIVES

Review Multiple Exercises, Problems,

Checkpoints Choice and Simulations

1. Define information risk and explain how the

financial statement auditing process helps to
1, 2, 3 29, 31, 38 65*
reduce this risk, thereby reducing the cost of
capital for a company.

2. Define and contrast assurance, attestation, and

4, 5, 6, 7, 8 23, 25, 28, 44, 50 60, 65*
financial statement auditing services.

3. Describe and define the assertions that

36, 39, 40, 41, 45,
management makes about the recognition,
46, 47, 48, 49, 52,
measurement, presentation, and disclosure of 9, 10, 11 62, 63, 67, 68, 69
53, 54, 55, 57, 58,
the financial statements and explain why
59
auditors use them as a focal point of the audit.

4. Define professional skepticism and explain its

12 24, 37 61
key characteristics.

5. Describe the organization of public accounting

firms and identify the various services that 13, 14 30, 42, 56 72
they offer.

6. Describe the audits and auditors in

governmental, internal, and operational 15, 16, 17, 18 26, 27, 32, 34, 35 64, 66
auditing.

7. List and explain the requirements for

becoming a certified public accountant (CPA)
19, 20, 21, 22 33, 43, 51 70, 71
and other certifications available to an
accounting professional.

(*) Item relates to multiple learning objectives

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Chapter 01 - Auditing and Assurance Services

SOLUTIONS FOR REVIEW CHECKPOINTS

1.1 Business risk is the risk that an entity will fail to meet its business objectives. When assessing business risk,
a professional must consider all possible threats to an entity’s goals and objectives. Some illustrative
examples include the risk that: 1) its existing customers will start buying products or services from its
primary competitors; 2) its product lines will become obsolete; 3) its taxes will increase; 4) key government
contracts will be lost; 5) key employees will leave the entity; and many other examples exist.

1.2 To help minimize business risk and take advantage of other opportunities presented in today’s competitive
business environment, decision makers such as chief executive officers (CEOs) demand timely, relevant,
and reliable information. There are at least four environmental conditions that increase demand for reliable
information. First, complexity which implies that events and transactions in today’s global business
environment can be complicated. Most investors do not have the level of expertise needed to properly
account for complex transactions. Second is remoteness which implies that decision makers are often
separated from current and potential business relationships due to distance and time. For example, investors
may not be able to visit distant locations to check up on their investments. Third is time-sensitivity which
implies that in today’s economic environment, investors and other users of financial statements need to
make decisions more rapidly than ever before. As a result, the ability to promptly obtain high-quality
information is essential. Fourth is a consequence which implies that decisions may very well involve
significant investments. As a result, the consequences can be severe if information cannot be obtained

1.3 Of all the different risks discussed in the chapter up to this point, information risk is the one that is most
likely to create the demand for independent and objective assurance services is information risk or the
probability that the information circulated by an entity will be false or misleading. Because the primary
source of information for investors and creditors is the company itself, an incentive exists for that
company’s management to make their business or service appear to be better than it actually may be, to put
their best foot forward. As a result, preparers and issuers of financial information (directors, managers,
accountants, and other people employed in a business) might benefit by giving false, misleading, or overly
optimistic information. This potential conflict of interest between information providers and users which
provides the underlying basis for the demand for reliable information.

1.4 The four major elements of the broad definition of assurance services are

Independence. CPAs want to preserve their reputation and competitive advantage by always preserving
integrity and objectivity when performing assurance services.

Professional services. Virtually all work performed by CPAs is defined as “professional services” as long
as it involves some element of judgment based on education and experience.

Improving the quality of information or its context. The emphasis is on “information,” CPAs’ traditional
area of expertise. CPAs can enhance quality by assuring users about the reliability and relevance of
information, and these two features are closely related to the familiar credibility-lending products of
attestation and audit services. “Context” is relevance in a different light. For assurance services, improving
the context of information refers to improving its usefulness when targeted to particular decision makers in
the surroundings of particular decision problems.

For decision makers. As the “consumers” of assurance services, decision makers are the beneficiaries of the
assurance services. Decision makers may or may not be the “client” that pays the fee and may or may not
be one of the parties to an assertion or other information, but they personify the consumer focus of new and
different professional work.

1.5 An assurance services engagement is any assignment that improves the quality of information, or its
context, for decision makers. Because information (e.g., financial statements) are prepared by managers of
an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical

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Chapter 01 - Auditing and Assurance Services

that the information truly is objective, free from bias, fully informative, and free from material error,
intentional or inadvertent. The services of an independent auditor helps resolve those doubts because the
auditor’s success depends upon his or her independent, objective, and competent assessment of the
information (e.g., the conformity of the financial statements with the appropriate reporting framework). The
independent auditor’s role is to lend credibility to the information; hence, the outsider will likely seek his or
her independent opinion about the financial statements.

1.6 An attestation engagement is “an engagement in which a practitioner is engaged to issue or does issue a
written communication that expresses a conclusion about the reliability of a written assertion that is the
responsibility of another party” (SSAE 10, AT 101.01). To attest means to lend credibility or to vouch for
the truth or accuracy of the statements that one party makes to another. The attest function is a term often
applied to the activities of independent CPAs when acting as auditors of financial statements.

1.7 An assurance service engagement is one that improves the quality of information, or its context, for
decision makers. Thus, an attestation service engagement is one type of an assurance service. Another way
of thinking about the issue is to remember that the financial statement audit engagement is one type of an
attestation service. Please see exhibit 1.3 in the text which depicts the relationship among assurance,
attestation, and auditing engagements.

1.8 According to the American Accounting Association, “Auditing is a systematic process of objectively
obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the
degree of correspondence between the assertions and established criteria and communicating the results to
interested users.” In effect, auditors add reliability to the information that is provided to interested users. Of
course, this definition is focused on an external reporting context. Students may also discuss how
governmental and internal auditors operate as well.

In response to “What do auditors do?” students can respond by stating that auditors (1) obtain and evaluate
evidence about assertions made by management about economic actions and events, (2) ascertain the
degree of correspondence between the assertions and the appropriate reporting framework, and (3) issue an
audit report (opinion). Students can also respond more generally by stating that auditors essentially lend
credibility to the financial statements presented by management.

1.9 Financial accounting refers to the process of recording, classifying, summarizing, and reporting about a
company’s assets, liabilities, capital, revenues, and expenses in the financial statements in accordance with
the applicable financial reporting framework (e.g., GAAP). In so doing, the management team is making
several assertions about the financial statements. The financial accounting process is the responsibility of
the management team.

Financial statement auditing refers to the process whereby professional auditors gather evidence related to
the assertions that management makes in the financial statements, evaluates the evidence and concludes on
the fairness of the financial statements in a report.

They differ because accountants produce the financial statements in accordance with the applicable
financial reporting framework. After this is complete, financial statement auditors then perform procedures
to ascertain whether the financial statements have been prepared in accordance with the applicable financial
reporting framework.

1.10 The two major classifications of ASB assertions with several assertions in each classification are:

Assertions About Classes of Transactions and Events, and Related Disclosures

Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets,
liabilities, sales, and expenses occurred. Key questions include “Did the recorded sales transactions really
occur?”

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Chapter 01 - Auditing and Assurance Services

Completeness assertion: The objective is to establish with evidence that all transactions of the period that
should be are included in the financial statements (including footnotes). Completeness also refers to proper
inclusion in financial statements of all revenue, expense, and related disclosures. Key questions related to
completeness include “Are the revenue and expense account balances complete?” and “Were all the
transactions that should be included reflected properly in the footnote disclosures?”

Cutoff assertion: The objective is to establish with evidence that all transactions that properly belong in the
preceding or following accounting periods are excluded. And, that only those transactions that should be
included in the financial statements are included. A key question related to the cutoff assertion includes
“Were all the transactions recorded in the right period?”

Accuracy assertion: The objective is to establish with evidence that transactions have been recorded at the
correct amount. Key questions include “Were the expenses recorded at the proper dollar amount?”

Classification assertion: The objective is to establish with evidence that transactions were posted to the
correct accounts. Key questions include “Was this expense recorded in the appropriate account?”

Presentation assertion: The objective is to establish with evidence that the information has been properly
presented and described, and that the disclosures are clearly expressed. Key questions include “Was the
information in the disclosure properly presented and disclosed?”

Assertions about Account Balances and Related Disclosures

Existence assertion: The objective is to establish with evidence that the balance represents assets,
liabilities, sales, and expenses that are real and in existence at the balance sheet date. Key questions include
“Does this number truly represent assets that existed at the balance sheet date?”

Completeness assertion: The objective is to establish with evidence that all balances of the period are in the
financial statements. Key questions related to completeness include “Are the asset and liability accounts in
the financial statements complete?”

Rights and obligations assertion: The objectives related to rights and obligations are to establish with
evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed. Key
questions related to this assertion include “Does the company really own the assets? And “Are related legal
responsibilities identified?”

Accuracy, Valuation and Allocation assertions: The objective is to establish with evidence that balances
have been valued correctly. Key questions include “Are the account balances accurate?” “Are the accounts
valued correctly?” and “Are expenses allocated to the period(s) benefited?”

Presentation assertion: The objective is to establish with evidence that the balance sheet amounts, and
related footnote disclosures are complete, properly presented and are understandable to the financial
statement users. Key questions relate to “Is the account properly presented in the correct financial statement
category” And, “are the footnote disclosures complete and presented to promote an understanding of the
nature of the account?”

1.11 In general, management’s financial statement assertions are important to auditors because they are used
when assessing risks by determining the different types of misstatements that could occur for each assertion
related to each significant account and disclosure. Next, auditors use the assertions to develop audit
procedures that are appropriate to mitigate the risk of material misstatement for each assertion. In essence,
the key questions that must be answered about each of the relevant assertions become the focal points for
audit procedures. Audit procedures are the means to answer the key questions posed by management’s
financial statement assertions. In fact, the procedures are completed to provide the evidence necessary to
persuade the auditor that there is no material misstatement related to each of the relevant assertions
identified for an engagement.

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Chapter 01 - Auditing and Assurance Services

The ASB assertions differ from the PCAOB assertions in that they provide greater detail and clarity for
auditors to conceptualize the type of misstatements that may exist in the financial statements. Thus, the
PCAOB assertions are more general than the ASB assertions. Importantly, the PCAOB recognizes that
their assertions are more general and do allow auditors to use the more granular and specific ASB
assertions when completing the audit. As a result, largely each of the firms auditing public companies with
international operations feature the ASB assertions to guide their auditing processes. Importantly, a student
of auditing will note that the ASB assertions are in direct alignment with the PCAOB assertions. This is
illustrated in the text in Exhibit 1.4

1.12 By having a belief that a potential conflict of interest always exists between the auditor and the
management team, auditors will be skeptical when completing the audit. Indeed, even though the vast
majority of audits do not contain fraud, auditors have no choice but to consider the possibility of fraud on
every audit. Stated simply, errors and financial reporting frauds have happened in the past, and users of
financial statements and audit reports expect auditors to detect material misstatements if they exist.

Indeed, auditing firms have long recognized the importance of exercising professional skepticism when
making professional judgments. As a student of auditing, you can expect to encounter difficult economic
transactions as an auditor. When a difficult transaction is encountered, auditors must take the time to fully
understand the economic substance of that transaction and then critically evaluate, with skepticism, the
evidence provided by the client to justify its accounting treatment. There are no shortcuts allowed. Rather,
auditors must always hold a belief that a potential conflict of interest exist between the auditor and
management, and they must be unbiased and objective when making their professional judgments.

1.13 Generally speaking, assurance services involve the lending of credibility to information, whether financial
or nonfinancial. CPAs have assured vote counts (e.g., Baseball Hall of Fame), dollar amounts of prizes that
sweepstakes have claimed to award, accuracy of advertisements, investment performance statistics, and
characteristics claimed for computer software programs. Some specific examples of assurance service
engagements performed on nonfinancial information include

 eXtensible Business Reporting Language (XBRL) reporting.

 Enterprise risk management assessment.

 Information risk assessment and assurance.

 Third-party reimbursement maximization.

 Rental property operations review.

 Customer satisfaction surveys.

 Evaluation of investment management policies.

 Fraud and illegal acts prevention and deterrence.

 Internal audit outsourcing.

1.14 THERE ARE THREE MAJOR AREAS OF PUBLIC ACCOUNTING SERVICES

 Financial Statement Audit and other types of Assurance services.

 Tax services.
 Consulting and Advisory services.

1.15 Operational auditing is the study of business operations for the purpose of making recommendations about
the economic and efficient use of resources, effective achievement of business objectives, and compliance
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Chapter 01 - Auditing and Assurance Services

with company policies. The AICPA views operational auditing as a type of consulting or advisory service
offered by public accounting firms.

1.16 The GAGAS issued by the GAO is very clear on this point. Specifically, the elements of expanded-scope
auditing include (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program
results audits.

1.17 Compliance auditing involves a study of an organization’s policies, procedures, and, ultimately, its
performance in following applicable laws, rules, and regulations. An example would be a school district’s
policies and procedures related to a meal program for its students. In these types of situations, there would
be a demand for a compliance audit which would be designed to ensure that the school district complies
with the stated policies and procedures of the program.

1.18 Other kinds of auditors include Internal Revenue Service auditors who are required to audit the taxable
income and deductions taken by taxpayers in tax returns and determine their correspondence with the
standards found in the Internal Revenue Code. They also might have to audit for fraud and tax evasion.
Other examples include state and federal bank examiners who are responsible for auditing banks, savings
and loan associations, and other financial institutions for evidence of solvency and compliance with
banking and other related laws and regulations.

1.19 The purpose of the continuing education requirement is to ensure that CPAs in practice maintain their
expertise at a sufficiently high level in light of evolving business conditions and new regulations. For CPAs
in public practice, 120 hours of continuing education is required every three years with no less than 20
hours in any one year. For CPAs not in public practice, the general requirement is 120 or fewer (90 in some
states) every three years.

1.20 Not everything can be learned in the classroom, and some on-the-job experience is helpful before a person
is able to be held out to the public as a licensed professional. Also, the experience requirement tends to
“weed out” those individuals who are just looking to become certified without ever being involved in actual
accounting work.

1.21 State boards administer the state accountancy laws and are responsible for ensuring that candidates have
passed the CPA examination and satisfied the state requirements for education and experience before being
awarded a CPA certificate. At the same time, new CPAs must pay a fee to obtain a state license to practice.
Thereafter, state boards of accountancy regulate the behavior of CPAs under their jurisdiction (enforcing
state rules of conduct) and supervise the continuing education requirements. As a result, the state boards
play an important role in the CPA certification and licensure process.

1.22 After becoming a CPA licensed in one state, a person can obtain a CPA certificate and license in another
state. The process is known as reciprocity. CPAs can file the proper application with another state board of
accountancy, meet the state’s requirements, and obtain another CPA certificate. Many CPAs hold
certificates and licenses in several states. From a global perspective, individuals must be licensed in each
country. Similar to CPAs in the United States, chartered accountants (CAs) practice in Australia, Canada,
Great Britain, and India.

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Chapter 01 - Auditing and Assurance Services

SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS

1.23
a. Incorrect This is an attestation to the prize promoter’s claims. Because attestation and
audit engagements are subsets of assurance engagements, this is an example of
an assurance engagement. However, each response is an example of an
assurance engagement; thus, the answer is (e).
b. Incorrect This is an audit engagement to give an opinion on financial statements. Because
attestation and audit engagements are subsets of assurance engagements, this is
an example of an assurance engagement. However, each response is an example
of an assurance engagement; thus, the answer is (e).
c. Incorrect This is an assurance engagement on a newspaper’s circulation data. Because
attestation and audit engagements are subsets of assurance engagements, all are
assurance engagements. Thus, the answer is (e).
d. Incorrect This is an assurance engagement on the performance of golf balls. Because
attestation and audit engagements are subsets of assurance engagements, all are
assurance engagements. Thus, the answer is (e).
e. Correct Because attestation and audit engagements are subsets of assurance
engagements, all of the responses are examples of assurance engagements.

1.24
a. Correct The management team is generally trying to put its “best foot forward” when
reporting their financial statement information. The auditor must make sure that
the management team does not violate the accounting rules when doing so. IN
essence, this statement characterizes why professional skepticism is required to
be exercised by auditors.
b. Incorrect “Exclusively in the capacity of an auditor” is not an idea that relates to an
attitude of professional skepticism.
c. Incorrect Professional obligations are not related to an attitude of professional skepticism.
d. Incorrect While it is true that financial statement and financial data are verifiable, this
does not related to the reasons why an auditor needs to begin an audit with an
attitude of professional skepticism.

1.25
a. Incorrect While work on a forecast would potentially be covered by the attestation
standards, the auditors must provide assurance about some type of management
assertion in an attestation engagement.
b. Correct This is the basic definition of an attestation service, as articulated in the book
and the professional standards.
c. Incorrect Since there is no assurance about any management assertion when preparing a
tax return with information that has not been reviewed or audited, this type of
tax work is not considered an attestation service.
d. Incorrect Since there is no assurance about any management assertion when giving expert
testimony about particular facts in an income tax case, this type of work is not
considered an attestation service.

1.26
a. Incorrect The objective of environmental auditing is to help achieve and maintain
compliance with environmental laws and regulations and to help identify and
correct unregulated environmental hazards. This answer is therefore incorrect.
b. Incorrect The objective of financial auditing is to obtain assurance on the conformity of
financial statements with generally accepted accounting principles. This answer
is therefore incorrect.

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Chapter 01 - Auditing and Assurance Services

c. Incorrect The objective of compliance auditing is the entity’s compliance with laws and
regulations. This answer is therefore incorrect.
d. Correct Operational auditing refers to the study of business operations for the purpose of
making recommendations about the economic and efficient use of resources,
effective achievement of business objectives, and compliance with company
policies.

1.27
a. Incorrect This is not the primary objective of an operational audit. However, while
completing an operational audit, a professionally skeptical auditor should still be
concerned about compliance with financial accounting standards.
b. Correct This statement exactly characterizes the goal of an operational audit. In addition,
the statement is part of the basic definition of operational auditing.
c. Incorrect An operational audit does not focus on the financial statements of an entity.
d. Incorrect While analytical tools and skills may be used during an operational audit, they
are also a very important aspect of financial auditing.

1.28
a. Correct According to the AICPA definition found in AU 200 (paragraph 11) and in your
book, “the purpose of an audit is to enhance the degree of confidence that
intended users can place in the financial statements. This is achieved by the
expression of an opinion by the auditor on whether the financial statements are
prepared, in all material respects, in accordance with an applicable financial
reporting framework. As a result, this is the correct response.
b. Incorrect The AICPA definition is not limited to the FASB for the appropriate reporting
framework that is used as the benchmark when completing an audit. The
definition is general enough to include other financial reporting frameworks as
well, such as IFRS.
c. Incorrect The AICPA definition does not focus on the SEC as an appropriate reporting
framework to be used as a benchmark when completing an audit. The definition
is focused on the “applicable” financial reporting framework, such as GAAP or
IFRS. The reference to the SEC is wrong.
d. Incorrect This phrase is not referenced in the AICPA definition found in the auditing
standards. This phrase is found in the AAA definition of the audit found in this
book.

1.29
a. Incorrect While complexity is an important condition that increases the demand for
reliable information, the potential conflict of interest between management and
the bank is far and away the biggest factor driving the demand for audited
financial statements.
b. Incorrect While remoteness is an important condition that increases the demand for
reliable information, the potential conflict of interest between management and
the bank is far and away the biggest factor driving the demand for audited
financial statements.
c. Incorrect While the consequences of making a bad decision are an important condition
that increases the demand for reliable information, the potential conflict of
interest between management and the bank is far and away the biggest factor
driving the demand for audited financial statements.
d. Correct The potential conflict of interest between management and the bank is far and
away the biggest factor driving the demand for audited financial statements.
Consider for example a company that was desperate for cash in order to survive.
Would it be possible that the management team would present unreliable
financial statements to the bank in order to get a desperation loan? Because of

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Chapter 01 - Auditing and Assurance Services

this possibility, a financial statement audit is needed to add credibility to the

financial statements.

1.30
a. Incorrect According to Section 201 of the Sarbanes-Oxley Act, bookkeeping services are
prohibited.
b. Incorrect According to Section 201 of the Sarbanes-Oxley Act, internal audit services are
prohibited.
c. Incorrect According to Section 201 of the Sarbanes-Oxley Act, valuation services are
prohibited.
d. Correct Sarbanes-Oxley prohibits the provision of all of the services listed in answers a,
b, and c; therefore, d (all of the above) is the best response.

1.31
a. Incorrect Financial statement auditors do not reduce business risk.
b. Correct After completing a financial statement audit, information risk has been reduced
for investors.
c. Incorrect Complexity creates demand for accounting services but is not an objective of the
financial statement audit.
d. Incorrect Auditors do not directly control the timeliness of financial statements.
Management must first provide the information to be audited.

1.32
a. Incorrect A financial statement opinion is the objective of a financial statement audit, not
a compliance audit.
b. Incorrect A basis for a report on internal control is the objective of an internal control
audit under Section 404 of the Sarbanes-Oxley Act, not a compliance audit.
c. Incorrect A study of effective and efficient resources is the objective of an operational
audit, not a compliance audit.
d. Correct A compliance audit refers to procedures that are designed to ascertain that the
company’s personnel are following laws, rules, regulations, and policies.

1.33
a. Incorrect While successful completion of the Uniform CPA is necessary to be licensed as
a CPA, a candidate also requires the proper experience and proper education.
Thus, letter (d.) is correct.
b. Incorrect While proper experience is necessary to be licensed as a CPA, a candidate also
requires the successful completion of the Uniform CPA and proper education.
Thus, letter (d.) is correct.
c. Incorrect While proper education is necessary to be licensed as a CPA, a candidate also
requires the successful completion of the Uniform CPA and proper experience.
Thus, letter (d.) is correct.
d. Correct A candidate requires the successful completion of the Uniform CPA, proper
experience and proper education to be licensed as a CPA.

1.34
a. Incorrect The GIAA is not responsible for monitoring the use of public funds by public
officials. This is the responsibility of the GAO.
b. Incorrect The CIA is not responsible for monitoring the use of public funds by public
officials. This is the responsibility of the GAO.
c. Incorrect The SEC is not responsible for monitoring the use of public funds by public
officials. This is the responsibility of the GAO.
d. Correct The mission of the U.S. Government Accountability Office is to ensure that
public officials are using public funds efficiently, effectively, and economically.

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Chapter 01 - Auditing and Assurance Services

1.35
a. Incorrect A financial audit is typically not included as part of a performance audit.
b. (&d) Correct The two categories of performance audits are economy and efficiency audits and
program audits.
c. Incorrect A compliance audit is typically not included as part of a performance audit.
d. (&b) Correct The two categories of performance audits are economy and efficiency audits and
program audits.

1.36
a. Incorrect A review of credit ratings of customers would not provide evidence about the
completeness of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
b. Incorrect A review of credit ratings of customers would not provide evidence about the
existence of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
c. Correct A review of credit ratings of customers’ gives indirect evidence of the
collectability of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
d. Incorrect A review of credit ratings of customers would not provide evidence about the
rights of accounts receivable. Because GAAP requires the accounts receivable
balance to be valued at the amount expected to be collected from customers, the
review of credit ratings relates to valuation.
e. Incorrect A review of credit ratings of customers would not provide evidence about the
occurrence of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.

1.37
a. Incorrect Rhonda’s representations are not sufficient evidence to support assertions made
in the financial statements.
b. Incorrect Despite Rhonda’s representations, Jones must gather additional evidence to
corroborate Rhonda’s assertions.
c. Incorrect Rhonda’s representations are a form of evidence (albeit weak) that should
neither be disregarded nor blindly regarded without professional skepticism.
d. Correct Rhonda’s assertions are nice. However, to be considered as sufficient to
conclude that all expenses have been recorded, they will need corroboration with
documentary evidence. Thus, this is the correct response.

1.38
a. Incorrect Although there is a high level of risk associated with client acceptance, this
phrase was created by the authors.
b. Correct By definition, information risk is the probability that the information circulated
by a company will be false or misleading.
c. Incorrect Moral hazard is the risk that the existence of a contract will change the behavior
of one or both parties to the contract.
d. Incorrect Business risk is the probability an entity will fail to meet its strategic objectives.

1.39
a. Correct This is clearly a test of the completeness as the assertion always includes any
issues of transaction cutoff, which means that the recording of all revenue,
expense, and other transactions must be included in the proper period in
accordance with GAAP.

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Chapter 01 - Auditing and Assurance Services

b. Incorrect This is not an existence test. This is clearly a test of the completeness as the
assertion always includes any issues of transaction cutoff, which means that the
recording of all revenue, expense, and other transactions must be included in the
proper period in accordance with GAAP.
c. Incorrect This is not a test of valuation. This is clearly a test of the completeness as the
assertion always includes any issues of transaction cutoff, which means that the
recording of all revenue, expense, and other transactions must be included in the
proper period in accordance with GAAP.
d. Incorrect This is not a test of rights and obligations. This is clearly a test of the
completeness as the assertion always includes any issues of transaction cutoff,
which means that the recording of all revenue, expense, and other transactions
must be included in the proper period in accordance with GAAP.
e. Incorrect This is not an occurrence test. This is clearly a test of the completeness as the
assertion always includes any issues of transaction cutoff, which means that the
recording of all revenue, expense, and other transactions must be included in the
proper period in accordance with GAAP.

1.40
a. Incorrect This is not a completeness test. This is clearly a test related to rights and
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
b. Incorrect This is not an existence test. This is clearly a test related to rights and
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
c. Incorrect This is not a test of valuation. This is clearly a test related to rights and
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
d. Correct This is clearly a test related to rights and obligations as the question that must be
answered with evidence is to establish that amounts reported as assets of the
company represent true assets that it really does own and that the amounts
reported as liabilities truly represent its obligations. Goods on consignment, by
definition, are not owned by the company. Thus, there is a risk that the company
is recording assets that they do not own on their balance sheet.
e. Incorrect This is not an occurrence test. This is clearly a test related to rights and
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.

1.41
a. Incorrect This is not a test of completeness. This is a test of existence which is completed
by auditors to answer the question as to whether the transactions recorded as an
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Chapter 01 - Auditing and Assurance Services

asset really represent assets that exist and did add value to the company’s
equipment as compared to routine repair and maintenance expenses under
GAAP. Management’s existence assertion states that the reported assets actually
exist. If an addition to the equipment account cannot be located or identified as
adding value to the equipment balance, it is possible that the amount should
have been classified as repair and maintenance expenses under GAAP.
b. Correct This is a test of existence. This test is completed by auditors to answer the
question as to whether the transactions recorded as an asset really represent
assets that exist and did add value to the company’s equipment as compared to
routine repair and maintenance expenses under GAAP. Management’s existence
assertion states that the reported assets actually exist. If an addition to the
equipment account cannot be located or identified as adding value to the
equipment balance, it is possible that the amount should have been classified as
repair and maintenance expenses under GAAP.
c. Incorrect This is not a test of valuation. This is a test of existence which is completed by
auditors to answer the question as to whether the transactions recorded as an
asset really represent assets that exist and did add value to the company’s
equipment as compared to routine repair and maintenance expenses under
GAAP. Management’s existence assertion states that the reported assets actually
exist. If an addition to the equipment account cannot be located or identified as
adding value to the equipment balance, it is possible that the amount should
have been classified as repair and maintenance expenses under GAAP.
d. Incorrect This is not a test of rights and obligations. This is a test of existence which is
completed by auditors to answer the question as to whether the transactions
recorded as an asset really represent assets that exist and did add value to the
company’s equipment as compared to routine repair and maintenance expenses
under GAAP. Management’s existence assertion states that the reported assets
actually exist. If an addition to the equipment account cannot be located or
identified as adding value to the equipment balance, it is possible that the
amount should have been classified as repair and maintenance expenses under
GAAP.
e. Incorrect This is not a test of occurrence. This is a test of existence which is completed by
auditors to answer the question as to whether the transactions recorded as an
asset really represent assets that exist and did add value to the company’s
equipment as compared to routine repair and maintenance expenses under
GAAP. Management’s existence assertion states that the reported assets actually
exist. If an addition to the equipment account cannot be located or identified as
adding value to the equipment balance, it is possible that the amount should
have been classified as repair and maintenance expenses under GAAP.

1.42
a. Incorrect Under Sarbanes-Oxley, public accounting firms are prevented from acting in a
managerial decision-making role for an audit client.
b. Incorrect Under Sarbanes-Oxley, public accounting firms are prevented from auditing the
firm’s own work on an audit client.
c. Incorrect Under Sarbanes-Oxley, public accounting firms may only provide tax consulting
services to an audit client with the audit committee’s approval.
d. Correct Sarbanes-Oxley prevents public accounting firms from serving an audit client in
any of the preceding listed roles. As a result, each of the responses a, b, and c is
incorrect and letter d is the correct response.

1.43
a. Incorrect Substantial equivalency does not refer to the financial statement auditing
process. The term relates to the practice of public accountancy in states other
than a CPA’s state of licensure.

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Chapter 01 - Auditing and Assurance Services

b. Incorrect Substantial equivalency does not refer to consulting services. The term relates to
the practice of public accountancy in states other than a CPA’s state of licensure.
c. Incorrect Substantial equivalency does not refer to other professional organizations. The
term relates to the practice of public accountancy in states other than a CPA’s
state of licensure.
d. Correct Substantial equivalency relates to the practice of public accountancy in states
other than a CPA’s state of licensure. Under the concept of substantial
equivalency, as long as the licensing (home) state requires (1) 150 hours of
education, (2) successful completion of the CPA exam, and (3) one year of
experience, a CPA can practice (either in person or electronically) in another
substantial equivalency state without having to obtain a license in that state.

1.44
a. Correct Auditing is a subset of attestation engagements that focuses on the certification
of financial statements. The subject matter is the set of financial statements from
management and the criteria is GAAP in the United States.
b. Incorrect That is not true. Auditing is one example of an attest engagement. The level of
assurance provided is not lower for an attestation engagement.
c. Incorrect That is not true. The auditor is not allowed to provide management support for
its audit clients. Rather, consulting engagements can focus on providing clients
with advice and decision support.
d. Incorrect The definition provided is the one for assurance engagements, which is quite
broad and includes all engagements that are designed to improve the quality of
information, or its context, for decision makers.

1.45
a. Correct Management is more likely to overstate assets and understate liabilities. As a
result, when auditing an asset balance, the most relevant assertions are likely to
be either existence or valuation. In this situation, because of the nature of cash
and the fact that is no foreign currency translation calculation, the existence
assertion is clearly the most important assertion.
b. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion for the cash balance. Since management is more likely to
overstate assets, when auditing an asset balance, the most relevant assertions are
likely to be either existence or valuation. In this situation, because of the nature
of cash and the fact that is no foreign currency translation calculation, the
existence assertion is clearly the most important assertion.
c. Incorrect Although valuation is an important assertion, it is not the most relevant assertion
for the cash balance. In this situation, because of the nature of cash and the fact
that is no foreign currency translation calculation, the existence assertion is
clearly the most important assertion. If however, there was a foreign currency
translation adjustment, valuation of cash would also be relevant.
d. Incorrect Although occurrence is an important assertion, it is not the most relevant
assertion for any balance sheet account. Rather, the occurrence assertion is more
closely related to income statement accounts because the question that needs to
be answered with evidence is whether the transaction really did occur in
accordance with GAAP. In this situation, because of the nature of cash and the
fact that is no foreign currency translation calculation, the existence assertion is
clearly the most important assertion.

1.46
a. Incorrect This evidence would provide evidence about management’s assertion about
rights and obligations and perhaps existence. However, this evidence would not
help to value the investment in accordance with GAAP.

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Chapter 01 - Auditing and Assurance Services

b. Incorrect While this evidence would potentially be helpful to value an investment in

another company, it is not the best answer. If a quote was available from an
independent source, this would be a better form of evidence for valuation.
c. Incorrect This evidence would provide evidence about management’s assertion about
existence and perhaps rights and obligations. However, this evidence would not
help to value the investment in accordance with GAAP.
d. Correct Always remember that management is more likely to overstate assets. As a
result, when auditing an asset balance like investments, a relevant assertion is
likely to be valuation. In this situation, to answer the question of what the
investment should be valued at in the balance sheet, an auditor would first seek
to obtain a market quotation from an independent source like the Wall Street
Journal.

1.47
a. Incorrect This test is not related to presentation and disclosure. A cutoff test is clearly a
test of the completeness assertion as the test is designed to insure that all
transactions that should have been included in accordance with GAAP have
been recorded.
b. Correct A cutoff test is clearly a test of the completeness assertion as the test is designed
to insure that all transactions that should have been included in accordance with
GAAP have been recorded.
c. Incorrect This test is not related to rights and obligations. A cutoff test is clearly a test of
the completeness assertion as the test is designed to insure that all transactions
that should have been included in accordance with GAAP have been recorded.
d. Incorrect This test is not related to existence. A cutoff test is clearly a test of the
completeness assertion as the test is designed to insure that all transactions that
should have been included in accordance with GAAP have been recorded.

1.48
a. Incorrect This test is designed to test the completeness assertion for the inventory account.
It does not provide any evidence related to the rights and obligations assertion.
b. Correct This is clearly a test related to rights and obligations as the question that must be
answered with evidence is to establish that the inventory reported as assets really
is owned by the company. Goods on consignment, by definition, are not owned
by the company. Thus, there is a risk that the company is recording assets that
they do not own on their balance sheet.
c. Incorrect This test is designed to test the completeness assertion for sales revenue. It does
not provide evidence related to the rights and obligations assertion for inventory.
d. Incorrect This test is designed to test the presentation and disclosure assertion for
inventory purchase commitments. It does not provide evidence related to the
rights and obligations assertion for inventory.

1.49
a. Incorrect Management is far more likely to understate liabilities than to overstate them.
As a result, when auditing the accrued liabilities account, existence or
occurrence is not as likely to be violated. Rather, the most relevant assertion is
likely to be completeness.
b. Correct Management is more likely to understate liabilities. As a result, when auditing
the accrued liabilities account, the most relevant assertion is likely to be
completeness.
c. Incorrect Management is far more likely to understate liabilities. As a result, when
auditing the accrued liabilities account, the most relevant assertion is likely to be
completeness. Presentation and disclosure may be relevant. However, it is not as
likely to contain a material misstatement as completeness.

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Chapter 01 - Auditing and Assurance Services

d. Incorrect Management is far more likely to understate liabilities than to overstate them.
As a result, when auditing the accrued liabilities account, the most relevant
assertion is likely to be completeness. Valuation may be relevant. However, it is
not as likely to contain a material misstatement as completeness.

1.50
a. Incorrect This is not correct as an auditing engagement refers to an examination of the
financial statements to determine whether the information has been presented in
accordance with GAAP. Also, a consulting engagement is one where the
professional provides advice and decision support.
b. Incorrect This is not correct as a consulting engagement is one where the professional
provides advice and decision support. Also, an assurance engagement can
include many more types of information than just the financial statements.
c. Incorrect This is not correct as an auditing engagement refers to an examination of the
financial statements to determine whether the information has been presented in
accordance with GAAP. Also, a consulting engagement is one where the
professional provides advice and decision support.
d. Correct This is correct as an auditing engagement refers to an examination of the
financial statements to determine whether the information has been presented in
accordance with GAAP and an attestation engagement can include a financial
statement audit. In addition, An assurance engagement can apply to all types of
information and a consulting engagement is one where the professional provides
advice and decision support.

1.51
a. Incorrect Credibility is a reason to become certified. Because all three responses are
reasons, (d) is correct.
b. Incorrect Advancement and promotion are reasons to become certified. Because all three
responses are reasons, (d) is correct.
c. Incorrect Monetary reward is a reason to become certified. Because all three responses are
reasons, (d) is correct.
d. Correct Credibility, advancement, and monetary rewards are all reasons to become
certified.

1.52
a. Incorrect Although existence or occurrence is an important assertion, it is not the most
relevant assertion for retained earnings. Restrictions on retained earnings from
loans, agreements or state law would need to be disclosed in the footnotes to the
financial statements. As a result, presentation and disclosure is clearly the most
important assertion.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for retained earnings. Restrictions on retained earnings from loans,
agreements or state law would need to be disclosed in the footnotes to the
financial statements. As a result, presentation and disclosure is clearly the most
important assertion.
c. Incorrect Although valuation is an important assertion, it is not the most relevant assertion
for retained earnings. Restrictions on retained earnings from loans, agreements
or state law would need to be disclosed in the footnotes to the financial
statements. As a result, presentation and disclosure is clearly the most important
assertion.
d. Correct Restrictions on retained earnings from loans, agreements or state law would
need to be disclosed in the footnotes to the financial statements. As a result,
presentation and disclosure is clearly the most important assertion.

1.53

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Chapter 01 - Auditing and Assurance Services

a. Correct Management is more likely to overstate assets and understate liabilities. As a

result, when auditing an asset balance, the most relevant assertions are likely to
be either existence or valuation. In this situation, because of the nature of
accounts receivable and the fact that valuation is not an option, the existence
assertion is clearly the most important assertion.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for the accounts receivable balance. Since management is more likely
to overstate assets and understate liabilities. As a result, when auditing an asset
balance, the most relevant assertions are likely to be either existence or
valuation. In this situation, because of the nature of accounts receivable and the
fact that valuation is not an option, the existence assertion is clearly the most
important assertion.
c. Incorrect Although presentation and disclosure is an important assertion, it is not the most
relevant assertion for the accounts receivable balance. Since management is
more likely to overstate assets and understate liabilities. As a result, when
auditing an asset balance, the most relevant assertions are likely to be either
existence or valuation. In this situation, because of the nature of accounts
receivable and the fact that valuation is not an option, the existence assertion is
clearly the most important assertion.
d. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion for the accounts receivable balance. Since management is
more likely to overstate assets and understate liabilities. As a result, when
auditing an asset balance, the most relevant assertions are likely to be either
existence or valuation. In this situation, because of the nature of accounts
receivable and the fact that valuation is not an option, the existence assertion is
clearly the most important assertion.

1.54
a. Incorrect Although rights and obligations is an important assertion, it is not the assertion
being tested in this situation. Most importantly, the auditor did not select items
for testing from any financial statement records. Rather, the auditor selected
items to be tested from the warehouse, without considering the financial
statement records. As a result, this is a test that is designed specifically to test
whether all items that should be recorded on the financial statements actually are
included on the financial statements. Thus, the assertion being tested is the
completeness assertion. The absolute key to understanding this question is to
focus on how the items were selected for testing.
b. Correct Most importantly, the auditor did not select items for testing from any financial
statement records. Rather, the auditor selected items to be tested from the
warehouse, without considering the financial statement records. As a result, this
is a test that is designed specifically to test whether all items that should be
recorded on the financial statements actually are included on the financial
statements. Thus, the assertion being tested is the completeness assertion. The
absolute key to understanding this question is to focus on how the items were
selected for testing.
c. Incorrect Although existence is an important assertion, it is not the assertion being tested
in this situation. Most importantly, the auditor did not select items for testing
from any financial statement records. Rather, the auditor selected items to be
tested from the warehouse, without considering the financial statement records.
As a result, this is a test that is designed specifically to test whether all items that
should be recorded on the financial statements actually are included on the
financial statements. Thus, the assertion being tested is the completeness
assertion. The absolute key to understanding this question is to focus on how the
items were selected for testing.
d. Incorrect Although valuation is an important assertion, it is not the assertion being tested
in this situation. Most importantly, the auditor did not select items for testing
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Chapter 01 - Auditing and Assurance Services

from any financial statement records. Rather, the auditor selected items to be
tested from the warehouse, without considering the financial statement records.
As a result, this is a test that is designed specifically to test whether all items that
should be recorded on the financial statements actually are included on the
financial statements. Thus, the assertion being tested is the completeness
assertion. The absolute key to understanding this question is to focus on how the
items were selected for testing.

1.55
a. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion when testing the pension footnote. The question specifically
relates to testing the information contained in the pension footnote. When testing
the footnote disclosures, the presentation and disclosure is likely to be the most
important assertion being tested.
b. Incorrect Although existence is an important assertion, it is not the most relevant assertion
when testing the pension footnote. The question specifically relates to testing the
information contained in the pension footnote. When testing the footnote
disclosures, the presentation and disclosure is likely to be the most important
assertion being tested.
c. Correct The question specifically relates to testing the information contained in the
pension footnote. When testing the footnote disclosures, the presentation and
disclosure is likely to be the most important assertion being tested.
d. Incorrect Although valuation is an important assertion, it is not the most relevant assertion
when testing the pension footnote. The question specifically relates to testing the
information contained in the pension footnote. When testing the footnote
disclosures, the presentation and disclosure is likely to be the most important
assertion being tested.

1.56
a. Incorrect Since there is no assurance about any management assertion provided when
completing an engagement to implement an ERP system, this is not considered
an attestation service. This is a consulting service.
b. Incorrect Since there is no assurance about any management assertion provided when
completing an engagement to develop a more efficient payroll process, this is
not considered an attestation service. This is a consulting service.
c. Correct This is an attestation service. In order to assess the effectiveness of an internal
control system, the assurance provider would have to attest to management’s
assertion that the internal control was effective in accordance with the COSO
framework, as this is the most common way of expressing the effectiveness of
an internal control system. As a result, this is the definition of an attestation
service, as articulated in the book and the professional standards.
d. Incorrect Since there is no assurance about any management assertion when assisting the
client in an IRS audit, this type of work is not considered an attestation service.

1.57
a. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion for the revenue account. Management is more likely to
overstate revenue to improve profitability. As a result, when auditing the
revenue account, the most relevant assertions are likely to be either
existence/occurrence or valuation. In this situation, because of the nature of
revenue and the fact that accuracy is more closely related to valuation, the
valuation assertion is clearly the most important assertion. In addition, the
existence/occurrence option is not an available option.
b. Correct Valuation and allocation is the PCAOB assertion that is most likely to be tested.
In general, management is more likely to overstate revenue to improve

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Chapter 01 - Auditing and Assurance Services

profitability. As a result, when auditing the revenue account, the most relevant
assertions are likely to be either existence/occurrence or valuation. In this
situation, because of the nature of revenue and the fact that accuracy is more
closely related to valuation, the valuation assertion is clearly the most important
assertion. In addition, the existence/occurrence option is not an available option.
c. Incorrect Although presentation and disclosure is an important assertion, it is not the most
relevant assertion for the revenue account. Management is more likely to
overstate revenue to improve profitability. As a result, when auditing the
revenue account, the most relevant assertions are likely to be either
existence/occurrence or valuation. In this situation, because of the nature of
revenue and the fact that accuracy is more closely related to valuation, the
valuation assertion is clearly the most important assertion. In addition, the
existence/occurrence option is not an available option.
d. Incorrect Although completion is an important assertion, it is not the most relevant
assertion for the revenue account. Management is more likely to overstate
revenue to improve profitability. As a result, when auditing the revenue account,
the most relevant assertions are likely to be either existence/occurrence or
valuation. In this situation, because of the nature of revenue and the fact that
accuracy is more closely related to valuation, the valuation assertion is clearly
the most important assertion. In addition, the existence/occurrence option is not
an available option.

1.58
a. Incorrect Although existence is an important assertion, it is not the most relevant assertion
for goodwill account in this situation. By definition, impairment of goodwill is
an accounting charge that companies record when the goodwill
account's carrying value on the balance sheet exceeds its fair value. As a result,
when auditing the goodwill account to determine whether it is impaired or not,
the most relevant assertion is clearly valuation.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for goodwill account in this situation. By definition, impairment of
goodwill is an accounting charge that companies record when the goodwill
account's carrying value on the balance sheet exceeds its fair value. As a result,
when auditing the goodwill account to determine whether it is impaired or not,
the most relevant assertion is clearly valuation.
c. Incorrect Although presentation and disclosure is an important assertion, it is not the most
relevant assertion for goodwill account in this situation. By definition,
impairment of goodwill is an accounting charge that companies record when the
goodwill account's carrying value on the balance sheet exceeds its fair value. As
a result, when auditing the goodwill account to determine whether it is impaired
or not, the most relevant assertion is clearly valuation.
d. Correct Valuation is the correct answer. By definition, impairment of goodwill is an
accounting charge that companies record when the goodwill account's carrying
value on the balance sheet exceeds its fair value. As a result, when auditing the
goodwill account to determine whether it is impaired or not, the most relevant
assertion is clearly valuation.

1.59
a. Correct Rights and obligations is the correct answer. By definition, consignment
inventory is a business model where a product is sold by a retail store but the
title/ownership of the product is retained by a third party until the product is
actually sold by the retailer. As a result, when auditing the inventory account of
an audit client that sells consigned inventory, the rights and obligations assertion
is the most relevant assertion to be audited since ownership of the inventory is in
question.

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Chapter 01 - Auditing and Assurance Services

b. Incorrect Although completeness is an important assertion, it is not the most relevant

assertion for the inventory account in this situation. By definition, consignment
inventory is a business model where a product is sold by a retail store but the
title/ownership of the product is retained by a third party until the product is
actually sold by the retailer. As a result, when auditing the inventory account of
an audit client that sells consigned inventory, the rights and obligations assertion
is the most relevant assertion to be audited since ownership of the inventory is in
question.
c. Incorrect Although existence or occurrence is an important assertion, it is not the most
relevant assertion for the inventory account in this situation. By definition,
consignment inventory is a business model where a product is sold by a retail
store but the title/ownership of the product is retained by a third party until the
product is actually sold by the retailer. As a result, when auditing the inventory
account of an audit client that sells consigned inventory, the rights and
obligations assertion is the most relevant assertion to be audited since ownership
of the inventory is in question.
d. Incorrect Although valuation or allocation is an important assertion, it is not the most
relevant assertion for the inventory account in this situation. By definition,
consignment inventory is a business model where a product is sold by a retail
store but the title/ownership of the product is retained by a third party until the
product is actually sold by the retailer. As a result, when auditing the inventory
account of an audit client that sells consigned inventory, the rights and
obligations assertion is the most relevant assertion to be audited since ownership
of the inventory is in question.

SOLUTIONS FOR EXERCISES AND PROBLEMS

1.60 Audit, Attestation, and Assurance Services

Students may encounter some difficulty with this matching question because the Special Committee on
Assurance Services (SCAS) listed many things that heretofore have been considered “attestation services”
(long before assurance services were invented). As a result, we believe that this question is a good vehicle
for discussing the considerable overlap that exists between attestation and assurance services.

 Real estate demand studies: Assurance service

 Ballot for awards show: Assurance service

 Utility rates applications: Assurance service

 Newspaper circulation audits: Assurance service

 Third-party reimbursement maximization: Assurance service

 Annual financial report to stockholders: Audit service

 Rental property operations review: Assurance service

 Examination of financial forecasts and projections: Attestation service

 Customer satisfaction surveys: Assurance service

 Compliance with contractual requirements: Attestation service

 Benchmarking/best practices: Assurance service

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Chapter 01 - Auditing and Assurance Services

 Evaluation of investment management policies: Assurance service

 Information systems security reviews: Assurance service

 Productivity statistics: Assurance service

 Internal audit strategic review: Assurance service

 Financial statements submitted to a bank loan officer: Audit service

1.61 Professional Skepticism

In general, students should note that they always need to maintain their level of professional skepticism on
the financial statement audit. There may be times when skepticism should increase. However, even when it
might seem that you can reduce your skepticism, auditors should always maintain their professional
skepticism.

a) The chair of the board of your audit client proposed that the company hire its sales manager as their new
financial controller.

Increase

b) The financial controller at your client mentions that she has just been on maternity leave for three months
and no bank reconciliations were completed during the time she was out of the office.

Increase

c) While auditing the Accounts Receivable account for your audit client, you notice that there is a large
amount that is well past due on the aged accounts receivable schedule.

Increase

d) While auditing the year-end investment balances, you find that your client’s investment balance exactly
agrees to the statement from the investment custodian. The custodian is a large bank.

Stay the same

e) The new chair of the board of Adams Corporation decided to fire the entire internal audit department. The
chair believed that the work completed by the annual auditor was enough auditing and that they were
already paying enough to the external auditors.

Increase

f) While auditing the inventory balance at your audit client, you visited the client’s warehouse during their
inventory count. You observed the count and found that the client made no mistakes during your
procedures.

Stay the same

g) The sales manager in charge of the Northeast region retired. She was replaced in the region by the assistant
sales manager in the same region.

Stay the same

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Chapter 01 - Auditing and Assurance Services

h) While auditing the Interest Expense account, you notice that there was no increase in the amount during the
current year. However, you noticed that the long-term debt amount doubled during the current year.

Increase

i) While auditing the inventory balance at your audit client, you perform test counts at their warehouse. While
you are counting, you notice a storage bin of inventory that is covered in dust with damaged products.
These items are stored near the garbage dumpsters.

Increase

j) You are auditing cash and during your review of the bank statements you notice unusual cash transfers
between two bank accounts which are inconsistent with the client’s business.

Increase

k) While auditing accounts payable, the accounts payable clerk told you that the audit client implemented
three new internal control procedures. You tested each new control and found that no exceptions in your
testing concluding that the controls are operating effectively.

Stay the same

l) The chair of the board of your audit client decided to double the staff of the internal audit department from
10 professionals to 20 professionals. The chair wanted to have the largest internal audit department in the
industry and the increase will let the department complete more internal control audits throughout the year.

Stay the same

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Chapter 01 - Auditing and Assurance Services

1.62 Management Assertions

PCAOB Assertion Corresponding ASB assertion Nature of assertion

Existence or Occurrence Existence Balance

Occurrence Transactions
Cutoff Transactions
Rights and Obligations Rights and Obligations Balances
Completeness Completeness Transactions
Balances
Cutoff Transactions
Valuation and Allocation Accuracy Transactions
Balances
Valuation and Allocation Balances
Presentation and Disclosure Presentation Transactions
Balances
Transactions
Classification
Balances

1.63 Management Assertions

Existence or Occurrence - Assertions about existence or occurrence address whether assets or liabilities of the
entity exist at a given date and whether recorded transactions have occurred during a given period. For example,
management asserts that Accounts Receivable on the balance sheet represent valid amounts actually owed to the
company at year end that are due in exchange for goods or services from the company.

Completeness - Assertions about completeness address whether all transactions and accounts that should be
presented in the financial statements are so included. For example, management asserts that all amounts that should
be recorded and included in the financial statements as accounts receivable actually have been recorded (i.e. no
accounts are omitted).

Valuation or Allocation - Assertions about valuation or allocation address whether asset, liability, equity, revenue,
and expense components have been included in the financial statements at appropriate amounts. For example,
management asserts that Accounts Receivable are stated at net realizable value and the allowance for uncollectible
accounts is adequate.

Rights and Obligations - Assertions about rights and obligations address whether assets are the rights of the entity
and liabilities are the obligations of the entity at a given date. For example, management asserts that the Accounts
Receivable on the balance sheet really are owned by the company. As a result, they have not factored (i.e., sold) any
of the balances that are listed on the balance sheet.

Presentation and Disclosure - Assertions about presentation and disclosure address whether particular components
of the financial statements are properly classified, described, and disclosed. For example, management asserts that
the presentation of accounts receivable and the related allowance for doubtful accounts have been presented and are
disclosed in accordance with GAAP.

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Chapter 01 - Auditing and Assurance Services

1.64 Other Types of Auditing

For each of the following scenarios, please indicate whether it would be most appropriate to use an internal auditor,
a governmental auditor, or a regulatory auditor:

a) The Department of Defense for the United States plans to audit the cost accounting report for a contract signed
with a key supplier.

Governmental

b) Bigdeal Corporation manufactures paper and paper products and is trying to decide whether to purchase Smalltek
Company. Bigdeal wants to obtain a report on the operational efficiency and effectiveness of the Smalltek sales,
production, and research and development departments.

Internal

c) The FDIC plans to audit the collectability of loans at a bank that they insure.

Regulatory

d) The board of directors would like an efficiency audit completed of its manufacturing plant operations.

Internal

e) The city of New York would like an audit done of a major construction project to make sure that the taxpayer’s
funds were used in an efficient manner.

Governmental

f) A federal bank examiner decides to audit a bank to determine whether it will remain solvent in the upcoming
year.

Regulatory

g) The CEO of Franklin Corporation wants to hire an auditor to take responsibility for auditing the company’s
compliance with environmental laws and regulations.

Internal

h) The IRS would like to audit the tax returns of a popular restaurant chain.

Regulatory

i) The state of Ohio decided to audit the use of educational grants awarded to cities and towns in the state to make
sure the funds were spent in accordance with the grant program.

Governmental

j) The Department of the Interior for the United States plans to audit the use of funds spent by all National Parks.
Governmental

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Chapter 01 - Auditing and Assurance Services

1.65 Auditor as Guarantor. Loot Starkin appears to be uninformed on the following key points:

The auditors did not prepare the Dodge Corporation Inform your neighbor that Dodge management is
financial statement. primarily responsible for preparing the financial
statements and deciding upon the appropriate
accounting principles.

An unqualified opinion does not mean that an Tell your neighbor that the financial statements
investment is safe. Rather, it merely means that the are a historical record of the business’
financial statements are free of material misstatement. performance. The value of Loot’s investment
depends on future events, including the many
factors that affect market prices. Thus, the
financial statements are just one piece of
information that should be analyzed. Tell Loot
that the unqualified opinion means only that the
statements conform to the appropriate reporting
framework (e.g., GAAP) and that the financial
statements are free of material misstatement.

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Chapter 01 - Auditing and Assurance Services

1.66 Identification of Audits and Auditors

The responses to this matching type of question are ambiguous. The engagement examples are real examples of
external, internal, and governmental audit situations. You might point out to students that the distinctions among
compliance, economy and efficiency, and program results audits are not always clear. The “solution” is shown in the
following matrix form, showing some engagement numbers in two or three cells. The required schedule follows.

Type of Audit
Engagement
Financial Economy and Program
Auditor Statement Compliance Efficiency Results
Independent CPA 2, 10
Internal auditor 6, 8 4, 8
Governmental (GAO)
auditor 1, 3 1, 3, 9
IRS auditor 5
Bank examiner 7

Type of Audit Type of Auditor

1. Proprietary school’s training Economy and efficiency or Governmental (GAO)
expenses program results auditors
2. Advertising agency financial Financial statement Independent CPAs
statements
3. Dept. of Defense launch Economy and efficiency or Governmental (GAO)
vehicle program results auditors
4. Municipal services Economy and efficiency Internal auditors
5. Tax shelters Compliance IRS auditors
6. Test pilot reporting Compliance Internal auditors
7. Bank solvency Compliance Bank examiners
8. Materials inspection by Compliance or Economy and Internal auditors
manufacturer Efficiency
9. States’ reporting chemical use Program goal Governmental (GAO)
data auditors
10. Sports complex forecast Financial statement Independent CPAs

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Chapter 01 - Auditing and Assurance Services

1.67 Financial Assertions and Audit Objectives

By definition, management financial statement assertions give rise to questions that can be answered with
evidence. The objectives for the audit of Spillane’s securities investments at December 31 are to obtain
evidence about the assertions implicit in the financial presentation, specifically:

1. Existence. Obtain evidence that the securities are bona fide and held by Spillane or a responsible
custodian.

Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually
took place during the year under audit.

2. Completeness. Obtain evidence that all the securities purchase transactions were recorded.

3. Rights. Obtain evidence that Spillane owned the securities.

Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan.

4. Valuation. Obtain evidence of the cost and market value of the securities held at December 31.
Decide whether any write-downs to market are required by the appropriate reporting framework.

5. Presentation and disclosure. Obtain evidence of the committed nature of the assets, which should
mean they should be in a noncurrent classification like the loan. Obtain evidence that restrictions
on the use of the assets are disclosed fully and agree with the loan documents.

1.68 Financial Statement Assertions and Possible Misstatements

Relevant
Possible Misstatement/Risk Assertions

a) Revenue is overstated because the

controller made up fraudulent invoices and
recorded them. Occurrence
b) Revenue is understated because the
accountant closed the sales cycle a week early
to go on vacation. Completeness
c) Accounts Receivable is overstated because
the accounts receivable clerk forgot to apply
available discounts. Valuation or Allocation
d) Accounts Receivable is overstated because
sales are falsified. Existence
e) Travel expense is overstated because the
sales force charged personal expenses on their
corporate credit card. Occurrence
f) Accounts Payable is understated because
the office manager lost an invoice for
supplies received so it was never recorded. Completeness
g) The cash balance is understated because
funds held in Japan were converted to $USD
at the wrong rate. Valuation or Allocation

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Chapter 01 - Auditing and Assurance Services

Relevant
Possible Misstatement/Risk Assertions
h) The cash balance recorded on the financial
statements is overstated because the treasurer
is stealing from the company. Existence
i) Inventory is overstated because it is held
on consignment but included in the inventory
balance. Rights and Obligations
j) The cost of goods sold is overstated
because time sheets have not been submitted
for each job. Valuation or Allocation
k) Long Term Debt is overstated due to
misclassification by management. Presentation and Disclosure

1.69 Financial Statement Assertions and Audit Procedures

Relevant
Audit Procedure Assertions Significant Account

a) The auditor sends a letter to

the bank confirming the amount
of cash in the bank account. Existence Cash
b) The auditor takes a shipping
document and traces it to the
sales invoice and sales journal Completeness Revenue
c) The auditor selects items
from the company's inventory
list and observes those items in
the warehouse Existence Inventory
d) The auditor compares prices
on a vendor invoice to an
approved price list from the
vendor. Valuation or allocation Accounts Payable
e) The auditor reviews recorded
expenses with vendor invoices. Valuation or allocation Expenses
f) The auditor determines
whether inventory has been
pledged as collateral for a loan. Presentation or Disclosure Inventory
g) The auditor reads the Board
of Directors minutes for
approval of stock options. Presentation or Disclosure Common Stock
h) The auditor reviews lease
agreements to evaluate whether
they have been recorded
properly. Completeness Capitalized Leases
i) The auditor selects inventory
items at a retail store to
determine whether any are held
on consignment. Rights and obligations Inventory
j) The auditor sends letters to
customers to confirm amounts
owed to the company Existence Accounts Receivable
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Chapter 01 - Auditing and Assurance Services

1.70 Internet Exercise: Professional Certification

These answers will depend on the student’s state of residence. Many states have recently reduced the
experience requirements by either (1) reducing or eliminating an audit experience requirement and/or (2)
reducing the experience requirement in lieu of additional education. For a quick link to each state, visit the
National Association of State Boards of Accountancy (www.nasba.org).

1.71 Internet Exercise: Professional Certification

The Institute of Internal Auditors does a good job explaining the benefits of becoming a certified internal
auditor. The exam consists of four parts: the Internal Audit Activity’s Role in Governance, Risk, and
Control; Conducting the Internal Audit Engagement; Business Analysis and Information Technology; and
Business Management Skills. You must have at least a bachelor’s degree to sit for this exam.

The Institute of Management Accountants also does a good job of explaining the benefits of the
certification. The parts of the exam include Business Analysis, Management Accounting and Reporting,
Strategic Management, and Business Applications. You must have at least a bachelor’s degree to sit for this
exam.

The Association of Certified Fraud Examiners also does a good job of explaining the benefits of the
certification. The areas of study tested on the exam include criminology and ethics, financial transactions,
fraud investigation, and legal elements of fraud. You must have at least a bachelor’s degree to sit for this
exam.

The Information Systems Audit and Control Association website explains the benefits of becoming
certified. You must have at least an associates’ degree to sit for this exam.

1.72 Internet Exercise: Services Offered by the Big Four Public Accounting Firms

These answers will depend on the specific service picked by each student. Each of the firms now offers a
multitude of different services. Thus, these answers are likely to differ substantially. The goal of the
question is to expose students to the wide range of services. So, as long as the student lists two services that
are in alignment with the instructor’s experience, credit should be awarded.

Apollo Shoes Questions

1) List three relevant facts about Apollo Shoes that you think might have an impact on the financial
statement audit.
This question is designed to get the students to examine the Apollo Shoes Form 10K with a critical
mindset. There are a number of allowable responses to this question. Three prominent responses would be:

a. Accounts Receivable increased significantly from the prior year.

b. Inventory increased significantly from the prior year.
c. The line of credit balance increased significantly from the prior year.

2) Define what is meant by a significant account or disclosure.

A financial statement account or footnote disclosure is considered significant if there is a chance that the
account or footnote disclosure could contain a material misstatement. As a result, an auditor will have to
conduct some procedures on each significant account or disclosure.

3) Identify at least two significant accounts or disclosures from the financial statements of Apollo
Shoes. What makes each item significant?

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Chapter 01 - Auditing and Assurance Services

This question is designed to get the students to examine the Apollo Shoes Trial Balance with a critical
mindset. There are a number of allowable responses to this question. Two prominent responses would be:

a. Accounts Receivable is significant because of the magnitude of the account in relation to total
assets for Apollo Shoes.
b. Inventory is significant because of the magnitude of the account in relation to total assets for
Apollo Shoes.

4) Define what is meant by a relevant assertion.

A relevant assertion is "a management assertion is relevant if there is a reasonable possibility that a
material misstatement exists related to that assertion for the significant account or footnote disclosure being
audited.”

5) Identify at least one relevant assertion for each of the significant accounts or disclosures
previously identified from the financial statements of Apollo Shoes. What makes each assertion
relevant?

Once again, there are a number of allowable responses to this question. Two responses that related back to
the suggested solution for question #3 would be:

a. Valuation of Accounts Receivable is relevant because of the significant increase in

receivables compared to last year. Importantly, this increase occurred without a significant
increase in sales. What happened? Why are they unable to collect their receivables this year as
compared to last year? Should the allowance for doubtful accounts be increased? As a result
of these questions, the risk of material misstatement for this assertion is high.
b. Existence of Inventory is relevant because the inventory balance is a material amount and the
auditor must make sure that the inventory does really exist. The inventory balance increased
significantly compared to last year. Why? The professional standards require that we conduct
a physical inventory observation to validate the existence of inventory. As a result of these
considerations, the risk of material misstatement for this assertion is high.

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