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Chapter 1

The Demand for Audit and Other Assurance Services

Review Questions

1-1 The relationship among audit services, attestation services, and assurance services is reflected in Figure 1-3 on page 13 of the text. An assurance service is an independent professional service to improve the quality of information for decision makers. An attestation service is a form of assurance service in which the CPA firm issues a report about the reliability of an assertion that is the responsibility of another party. Audit services are a form of attestation service in which the auditor expresses a written conclusion about the degree of correspondence between information and established criteria. The most common form of audit service is an audit of historical financial statements, in which the auditor expresses a conclusion as to whether the financial statements are presented in conformity with generally accepted accounting principles. An example of an attestation service is a report on the effectiveness of an entity’s internal control over financial reporting. There are many possible forms of assurance services, including services related to business performance measurement, health care performance, and information system reliability.

1-2 An independent audit is a means of satisfying the need for reliable information on the part of decision makers. Factors of a complex society which contribute to this need are:

1. Remoteness of information

a. Owners (stockholders) divorced from management b. Directors not involved in day-to-day operations or

decisions

c. Dispersion of the business among numerous geographic

locations and complex corporate structures

2. Biases and motives of provider

a. Information will be biased in favor of the provider

when his or her goals are inconsistent with the decision maker's goals.

3. Voluminous data

a. Possibly millions of transactions processed daily via

sophisticated computerized systems

b. Multiple product lines c. Multiple transaction locations

4. Complex exchange transactions

a. b.

New and changing business relationships lead to innovative accounting and reporting problems

Potential impact of transactions not quantifiable, leading to increased disclosures

1-3 1. Risk-free interest rate This is approximately the rate the bank could earn by investing in U.S. treasury notes for the same length of time as the business loan.

Business risk for the customer This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions such as a recession, poor management decisions, or unexpected competition in the industry.

Information risk This risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements.

2.

3.

Auditing has no effect on either the risk-free interest rate or business risk. However, auditing can significantly reduce information risk.

1-4 The four primary causes of information risk are remoteness of information, biases and motives of the provider, voluminous data, and the existence of complex exchange transactions. The three main ways to reduce information risk are:

1. User verifies the information. 2. User shares the information risk with management. 3. Audited financial statements are provided. The advantages and disadvantages of each are as follows: ADVANTAGES DISADVANTAGES USER VERIFIES 1. User obtains information 1. High cost of INFORMATION desired. obtaining 2. User can be more information. confident of the 2. Inconvenience to qualifications and the person activities of the person providing the getting the information. information because large number of users would be on premises. USER SHARES 1. No audit costs incurred. 1. User may not be INFORMATION able to collect on RISK WITH losses. MANAGEMENT