CHAPTER 1
The Role of the
Public Accountant in the
American Economy
Review Questions
1-1 The “crisis of credibility” largely arose from the number of companies that restated their previously
issued financial statements as a result of accounting irregularities and fraud. Especially responsible
were the very visible Enron and WorldCom fraud cases. Both companies filed for bankruptcy and
constituted the largest companies in American history to do so. The extent of the accounting
irregularities and fraud being investigated and disclosed brought into question the effectiveness of
financial statement audits. In addition, the criminal conviction of Arthur Andersen, LLP, one of the
then Big 5 accounting firms, on charges of destroying documents related to the Enron case brought
into question the ethics standards of the profession.
1-2 Assurance services are professional services that enhance the quality of information, or its context,
for decision-making. The two types are: (a) those that increase the reliability of information and (b)
those that involve putting information in a form or context that facilitates decision-making.
1-3 A financial statement audit is, by far, the most common type of attest engagement. The overall
assertion, made by management, most frequently is that the financial statements follow generally
accepted accounting principles.
1-4 A large corporation with securities listed on a stock exchange is required by the rules of the stock
exchange and by the rules of the Securities and Exchange Commission to provide an audit report with
the annual financial statements furnished to its stockholders. It also is required to engage the auditors
to provide an opinion on its internal control. Apart from legal requirements, however, a large listed
corporation recognizes that it must maintain investor confidence in the reliability of its financial
statements and internal control over financial reporting if it is to continue to be able to secure capital
from the public. The report by a firm of certified public accountants adds credibility to the financial
statements prepared by the corporation. When a small family-owned enterprise elects to have an
audit, the purpose usually is to use the auditors' report to support an application for a bank loan.
Solutions Manual, Chapter 1, Page 1 of 13
,1-5 A report by an independent public accountant concerning the fairness of a company's financial
statements is commonly required in the following situations:
(1) Application for a bank loan.
(2) Establishing credit for purchase of merchandise, equipment, or other assets.
(3) Reporting operating results, financial position, and cash flows to absentee owners
(stockholders or partners).
(4) Issuance of securities by a corporation.
(5) Annual financial statements by a corporation with securities listed on a stock exchange or
traded over the counter.
(6) Sale of an ongoing business.
(7) Termination of a partnership.
1-6 To add credibility to financial statements is to increase the likelihood that they have been prepared
following the appropriate criteria, usually generally accepted accounting principles. As such, an
increase in credibility results in financial statements that can be believed and relied upon by third
parties.
1-7 Business risk is the risk that the investment will be impaired because a company invested in is unable
to meet its financial obligations due to economic conditions or poor management decisions.
Information risk is the risk that the information used to assess business risk is not accurate. Auditors
can directly reduce information risk, but have only limited effect on business risk.
1-8 At the beginning of the century, the principal objective of auditing was the prevention and detection
of fraud. Audit work centered on the balance sheet, because the income statement was regarded as
highly confidential and not for public disclosure. Today, the principal objective of auditing is to form
an opinion on the fairness of financial statements and their conformity with generally accepted
accounting principles. But the professional standards also require that an audit be designed to provide
reasonable assurance of detecting material misstatements, due to errors or fraud. Particular emphasis
is placed on the income statement which is of great importance to investors. Auditing today also has
the objectives of meeting the requirements of the Securities and Exchange Commission (SEC) and the
Public Company Accounting Oversight Board for public companies.
1-9 The statement is incorrect. The increasing integrated databases of today, along with available audit
procedures make audited entire populations a possibility in many situations.
1-10 An operational audit attempts to measure the effectiveness and efficiency of a specific unit of an
organization. It involves more subjective judgments than a compliance audit or an audit of financial
statements because the criteria of effectiveness and efficiency of departmental performance are not as
clearly established as are many laws and regulations or generally accepted accounting principles.
The report prepared after completion of an operational audit is usually directed to
management of the organization in which the audit work was done.
1-11 A compliance audit is an audit to determine whether financial reports or other assertions are in
compliance with established criteria. The necessary ingredients are verifiable data and the existence
of standards established by an authoritative body. An operational audit, on the other hand, is a review
of a department or other unit of a business or governmental organization to measure the effectiveness
and efficiency of operations. Internal auditors often perform operational audits as do auditors
employed by the Government Accountability Office (GAO) of the federal government.
1-12 Internal auditors must be independent of the department heads and other line executives whose work
they review. However, internal auditors are not independent in the same sense as a public accounting
Solutions Manual, Chapter 1, Page 2 of 13
, firm. The public accounting firm serves many clients and the revenue obtained from any one client is
only a small part of the revenue of the firm. Internal auditors, on the other hand, are employees of
one company, and are subject to the restraints inherent in the employer-employee relationship.
Internal auditors can achieve a great deal of independence by reporting to the audit committee of the
board of directors, but they cannot achieve the same degree of independence as is possessed by the
external public accounting firm.
1-13 The internal auditors are employees of Spacecraft, Inc., and may be influenced by corporate
management. The public accounting firm is independent of the company and is in a better position to
take positions opposed to those of company management. The work of the internal audit staff
emphasizes measurement of the efficiency and effectiveness of various operating units of the
company and compliance with all types of controls, whereas the public accounting firm is primarily
concerned with determining the fairness of Spacecraft's financial statements.
1-14 The Government Accountability Office (GAO) is a staff of professional auditors which reports to
Congress. Its function is to determine that programs carried out by federal agencies conform to the
financial authorization of the Congress. It is also concerned with the cost-effectiveness of
government programs. The audit activities include investigation of the costs and performance of
corporations holding government contracts.
1-15 Among the many important contributions to auditing literature by the AICPA are the series of
Statements on Auditing Standards (SASs), Statements on Standards for Attestation Engagements
(SSAEs), Industry Audit and Accounting Guides, Audit Guides, Audit Risk Alerts, Statements on
Standards for Accounting and Review Services (SSARSs), , and the Code of Professional Conduct
(only two required).
1-16 A peer review is a critical review of a public accounting firm's practices by another public accounting
firm (or other CPAs functioning as a peer review team). The purpose of a peer review is to encourage
adherence to quality control standards established by the accounting firm and the profession.
1-17 The Securities and Exchange Commission (SEC) is an agency of the federal government and is
responsible for administering a number of acts, including the Securities Act of 1933 and the
Securities Exchange Act of 1934. In meeting this responsibility, the SEC reviews financial
statements of companies offering securities for sale to the public. It is particularly concerned with
requiring full disclosure of financial information and with preventing misrepresentation. Through the
Public Company Accounting Oversight Board, the SEC now oversees public accounting firms that
audit public companies. Included in this oversight process includes development of auditing,
independence, and quality control standards; inspection of performance; and enforcement of the
standards.
The AICPA is the national organization of certified public accountants. It has long been a
leader in accounting and auditing research, in publication of authoritative accounting and auditing
pronouncements and studies, and in promoting high professional standards of practice.
1-18 Services offered by public accounting firms in addition to auditing include other forms of attestation,
tax work, consulting services, litigation support services, fraud investigation services, personal
financial planning and accounting services. This last category includes preparation of financial
statements for smaller companies that have limited accounting personnel and various types of write-
up work. Public accounting firms also perform a variety of other services. Consulting services
include aiding clients in the design of accounting systems, conversion to Information Technology (IT)
systems, preparation of budgets, planning business combinations with other companies, executive
search, and numerous other projects. Public accounting firms are restricted as to the consulting
services that they may provide to audit clients that are public companies.
Solutions Manual, Chapter 1, Page 3 of 13
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