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Chapter 1

The Demand for Audit and Other Assurance Services

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Review Questions

1-1 The relationship among audit services, attestation services, and assurance services is reflected in Figure 1-3 on page 12 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 accordance with an applicable financial reporting framework such as U.S. GAAP or IFRS. 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. New and changing business relationships lead to innovative

accounting and reporting problems

b. Potential impact of transactions not quantifiable, leading to

increased disclosures

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1-3 1. 2.

3.

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.

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 obtaining INFORMATION desired. information. 2. User can be more confident 2. Inconvenience to the of the qualifications and person providing the activities of the person information because getting the information. large number of users would be on premises. USER SHARES INFORMATION RISK WITH MANAGEMENT AUDITED FINANCIAL STATEMENTS ARE PROVIDED 1. No audit costs incurred. 1. User may not be able to collect on losses. 1. Multiple users obtain the 1. May not meet needs information. of certain users. 2. Information risk can usually 2. Cost may be higher be reduced sufficiently to than the benefits in satisfy users at reasonable some situations, such cost. as for a small 3. Minimal inconvenience to company. management by having only one auditor. 1-2

1-5 To do an audit, there must be information in a verifiable form and some standards (criteria) by which the auditor can evaluate the information. Examples of established criteria include generally accepted accounting principles and the Internal Revenue Code. Determining the degree of correspondence between information and established criteria is determining whether a given set of information is in accordance with the established criteria. The information for Jones Company's tax return is the federal tax returns filed by the company. The established criteria are found in the Internal Revenue Code and all interpretations. For the audit of Jones Company's financial statements the information is the financial statements being audited and the established criteria are generally accepted accounting principles.

1-6 The primary evidence the internal revenue agent will use in the audit of the Jones Company's tax return include all available documentation and other information available in Jones’ office or from other sources. For example, when the internal revenue agent audits taxable income, a major source of information will be bank statements, the cash receipts journal and deposit slips. The internal revenue agent is likely to emphasize unrecorded receipts and revenues. For expenses, major sources of evidence are likely to be cancelled checks and electronic funds transfers, vendors' invoices, and other supporting documentation.

1-7 This apparent paradox arises from the distinction between the function of auditing and the function of accounting. The accounting function is the recording, classifying and summarizing of economic events to provide relevant information to decision makers. The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events for financial statements and he or she must therefore have an understanding of accounting standards, as well as auditing standards. The accountant need not, and frequently does not, understand what auditors do, unless he or she is involved in doing audits, or has been trained as an auditor.

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