Solutions Manual for the’ textbook 1
Ch. 1
The’ Role of’ the’
Public Accountant in the’
American Economy
Review::
1-1 The’ “crisis of’ credibility” largely arose fro’m the’ number of’ companies that restated their
previously issued financial statements as a result of’ accounting irregularities an’d fraud. Especially
responsible were the’ very visible Enron an’d WorldCom fraud cases. Both companies filed for
bankruptcy an’d constituted the’ largest companies in American history t.o do so. The’ extent of’
the’ accounting irregularities an’d fraud being investigated an’d 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 t.o the’
Enron case brought into question the’ ethical 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 an’d (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 wit’h securities listed on a stock exchange is required by the’ rules of’ the’
stock exchange an’d by the’ rules of’ the’ Securities an’d Exchange Commission t.o provide an
audit report wit’h the’ annual financial statements furnished t.o its stockholders. It also is required t.o
engage the’ auditors t.o provide an opinion on its internal control. Apart fro’m legal requirements,
however, a large listed corporation recognizes that it must maintain investor confidence in the’
reliability of’ its financial statements an’d internal control over financial reporting if it is t.o continue
t.o be able t.o secure capital fro’m the’ public. The’ report by a firm of’ certified public accountants
adds credibility t.o the’ financial statements prepared by the’ corporation. When a small family-
owned enterprise elects t.o have an audit, the’ purpose usually is t.o use the’ auditors' report t.o
support an application for a bank loan.
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, an’d cash flows t.o absentee owners (stockholders
or partners).
(4) Issuance of’ securities by a corporation.
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(5) Annual financial statements by a corporation wit’h securities listed on a stock exchange
or traded over the’ counter.
(6) Sale of’ an ongoing business.
(7) Termination of’ a partnership.
1-6 T.o add credibility t.o financial statements is t.o 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 an’d 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 t.o meet its financial obligations due t.o economic conditions or poor management decisions.
Information risk is the’ risk that the’ information used t.o 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 an’d
detection of’ fraud. Audit work centered on the’ balance sheet, because the’ income statement was
regarded as highly confidential an’d not for public disclosure. Today, the’ principal objective of’
auditing is t.o form an opinion on the’ fairness of’ financial statements an’d their conformity wit’h
generally accepted accounting principles. But the’ professional standards also require that an audit
be designed t.o provide reasonable assurance of’ detecting material misstatements, due t.o errors
or fraud. Particular emphasis is placed on the’ income statement which is of’ great importance t.o
investors. Auditing today also has the’ objectives of’ meeting the’ requirements of’ the’ Securities
an’d Exchange Commission (SEC) an’d the’ Public Company Accounting Oversight Board for public
companies.
1-9 An operational audit attempts t.o measure the’ effectiveness an’d 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 an’d efficiency of’ departmental
performance are not as clearly established as are many laws an’d regulations or generally accepted
accounting principles.
The’ report prepared after completion of’ an operational audit is usually directed t.o
management of’ the’ organization in which the’ audit work was done.
1-10 A compliance audit is an audit t.o determine whether financial reports or other assertions are in
compliance wit’h established criteria. The’ necessary ingredients are verifiable data an’d 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 t.o
measure the’ effectiveness an’d efficiency of’ operations. Internal auditors often perform operational
audits as do auditors employed by the’ Government Accountability Office (GAO) of’ the’ federal
government.
1-11 Internal auditors must be independent of’ the’ department heads an’d other line executives
whose work they review. However, internal auditors are not independent in the’ same sense as a
public accounting firm. The’ public accounting firm serves many clients an’d the’ revenue obtained
fro’m 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, an’d are subject t.o the’ restraints inherent in the’
employer-employee relationship. Internal auditors can achieve a great deal of’ independence by
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reporting t.o 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.
1-12 The’ internal auditors are employees of’ Spacecraft, Inc., an’d may be influenced by corporate
management. The’ public accounting firm is independent of’ the’ company an’d is in a better
position t.o take positions opposed t.o those of’ company management. The’ work of’ the’ internal
audit staff emphasizes measurement of’ the’ efficiency an’d effectiveness of’ various operating
units of’ the’ company an’d compliance wit’h all types of’ controls, whereas the’ public accounting
firm is primarily concerned wit’h determining the’ fairness of’ Spacecraft's financial statements.
1-13 The’ Government Accountability Office (GAO) is a staff of’ professional auditors which reports
t.o Congress. Its function is t.o determine that programs carried out by federal agencies conform t.o
the’ financial authorization of’ the’ Congress. It is also concerned wit’h the’ cost-effectiveness of’
government programs. The’ audit activities include investigation of’ the’ costs an’d performance of’
corporations holding government contracts.
1-14 Among the’ many important contributions t.o auditing literature by the’ AICPA are the’ series
of’ Statements on Auditing Standards (SASs), Statements on Standards for Attestation Engagements
(SSAEs), Industry Audit an’d Accounting Guides, Audit Guides, Audit Risk Alerts, Statements on
Standards for Accounting an’d Review Services (SSARSs), , an’d the’ Code of’ Professional
Conduct (only two required).
1-15 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
t.o encourage adherence t.o quality control standards established by the’ accounting firm an’d the’
profession.
1-16 The’ Securities an’d Exchange Commission (SEC) is an agency of’ the’ federal government
an’d is responsible for administering a number of’ acts, including the’ Securities Act of’ 1933 an’d
the’ Securities Exchange Act of’ 1934. In meeting this responsibility, the’ SEC reviews financial
statements of’ companies offering securities for sale t.o the’ public. It is particularly concerned wit’h
requiring full disclosure of’ financial information an’d wit’h 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, an’d quality control standards; inspection of’ performance; an’d enforcement of’ the’
standards.
The’ AICPA is the’ national organization of’ certified public accountants. It has long been a
leader in accounting an’d auditing research, in publication of’ authoritative accounting an’d
auditing pronouncements an’d studies, an’d in promoting high professional standards of’
practice.
1-17 Services offered by public accounting firms in addition t.o auditing include other forms of’
attestation, tax work, consulting services, litigation support services, fraud investigation services,
personal financial planning an’d accounting services. This last category includes preparation of’
financial statements for smaller companies that have limited accounting personnel an’d 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 t.o Information
Technology (IT) systems, preparation of’ budgets, planning business combinations wit’h other
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companies, executive search, an’d numerous other projects. Public accounting firms are restricted as
t.o the’ consulting services that they may provide t.o audit clients that are public companies.
1-18 The’ partnership form of’ organization for a public accounting firm offers several advantages
over a sole proprietorship. A partnership offers the’ opportunity for specialization by the’ partners in
areas such as taxation, auditing, an’d consulting services. Partners can discuss difficult technical
problems among themselves, an’d benefit fro’m different perspectives. Also, the’ partnership may
be better able t.o attract an’d retain high quality professional staff, because they may be rewarded
by acceptance into the’ partnership.
1-19 The’ following characteristics of’ a professional corporation distinguish it fro’m the’ traditional
corporation:
(1) All shareholders must be engaged in the’ practice of’ public accounting.
(2) T.o the’ extent possible, directors an’d officers should be certified public accountants.
(3) Shares of’ a professional corporation may be transferred only t.o those engaged in
public accounting or t.o the’ corporation itself.
(4) The’ corporation's shareholders an’d employees have liability equivalent t.o other forms
of’ organizations (i.e., the’ corporate form of’ organization does not reduce liability). Note,
however, that CPAs may choose t.o purchase liability insurance t.o limit potential liability.
1-20 Local firms usually have only one or two offices, are headed by a single CPA or have a few
CPAs as partners, an’d serve clients in a single city or area. The’ services provided are mostly
income tax work, consulting services, an’d accounting services. Auditing is often only a small part of’
the’ practice.
Regional firms often arise fro’m the’ merger an’d expansion of’ local firms. They typically
maintain several offices in neighboring cities an’d states. Auditing is a more important
function for regional firms than for the’ local firms, because larger businesses are included
among the’ clients.
National firms have offices in most major cities in the’ United States an’d some operate in
other countries as well. These firms offer a full range of’ services, wit’h auditing often
representing the’ largest single portion of’ the’ practice.
International firms have offices in most of’ the’ world’s major cities. These firms offer a full
range of’ services, wit’h auditing often representing the’ largest single portion of’ the’
practice.
1-21 The’ various levels of’ accounting personnel in a large public accounting firm are staff auditors,
senior auditors, managers or supervisors, an’d partners (an’d principals).
The’ staff auditor performs audit procedures such as the’ observation of’ physical
inventories an’d confirmation of’ receivables under the’ supervision of’ a senior. The’
senior auditor plans an’d coordinates the’ audit an’d drafts the’ audit report. The’ senior
also reviews working papers, controls the’ allocation of’ audit time, an’d trains assistants
on the’ job. The’ manager or supervisor usually is responsible for supervising an’d
reviewing several audit engagements concurrently, an’d resolving significant problems wit’h
the’ client. The’ partners maintain contacts wit’h clients, develop new business, establish
policies of’ the’ firm, review the’ adequacy of’ audit work, an’d sign audit reports. The’
