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SOLUTION MANUAL
to accompany

MODERN AUDITING
&
ASSURANCE SERVICES
5th edition
Prepared by
Philomena Leung, Paul Coram, Barry Cooper and
Peter Richardson

© John Wiley & Sons Australia, Ltd 2011

Solution Manual to accompany Modern Auditing and Assurance Services 5e

Chapter 1 An overview of auditing
Review questions
1
...
A definition from the
Committee on Basic Auditing is as follows:
A systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and
communicating the results to interested users
...
12

What does an audit do?

Accounting is a representation of the economic situation of an entity for a period
which managers are required to represent to users
...
The
auditor’s task is to obtain evidence to validate these assertions and ensure economic
events are appropriately communicated to users
...
13

An audit should be described
...
The procedures will vary dependent on the auditor’s
assessment of the risks of material misstatement
...


Explain how agency theory results in a demand for auditing?

In an agency relationship, investors (as principals) entrust their resources to managers
(as agents)
...
A consequence of this agency problem is that
investors will ‘price protect’ themselves on the assumption that managers are acting
for themselves
...


© John Wiley & Sons Australia, Ltd 2011

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14

How has the accounting profession’s role changed in recent years? What
does the accounting profession currently have responsibility for?

From the earliest days of the accounting profession an important role was to provide a
‘brand name’ to illustrate quality
...
Some of the
specific parts of the accounting profession’s role have included:
· developing standards of practice through research and issuance of standards,
professional education, and the establishment of rules of conduct for members
· ensuring professional conduct and effective self-regulation of quality of service
· maintaining standards of qualifications through accredited courses, examinations,
and practical experience for accountants seeking to become members
...
This has been, in part, a response to some of the corporate
scandals of the early 2000s where there was a large amount of trust lost in the
accounting profession and consequently some of their previous responsibilities have
been taken over by the government
...
The regulation of accountants involved in the corporate reporting
world is now mainly performed by ASIC
...


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One of the first major cases to address some
of these emerging issues for the auditing profession was Kingston Cotton Mill Co
...
279, where Lopes made the following comment on what is required of
an auditor:
It is the duty of an auditor to bring to bear on the work he has to perform
that skill, care and caution that a reasonably competent, careful and cautious
auditor would use
...
It meant that the concepts of risk, materiality
and sampling could be developed in the knowledge that the auditor was not
attempting to provide absolute assurance on a set of financial statements
...
This legal judgement also
outlined that the audit role was not to detect fraud
...
This judgement lessened the auditors’ responsibility in this
area and some have suggested since that it went too far
...
Forsyth (1970) 92 WN NSW (29)
...
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Solution Manual to accompany Modern Auditing and Assurance Services 5e

suspicious circumstances exist
...

Case law has provided important guidance on the auditor’s role and responsibility
over the years
...


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What was the main Australian regulatory response to these problems?

The main regulatory response was through the implementation of the Corporate Law
Economic Reform Program (CLERP) 9 in 2004
...
No longer would the accounting
profession in Australia be responsible for the setting of auditing standards
...
17

How have corporate collapses influenced the role of auditing in recent
years?

The corporate collapses in the US and Australia have had a fundamental impact on the
role of auditing in recent years
...

Significant changes have been made to emphasise the following:
 A clear objective to enhance and maintain the integrity of the profession;
 Clearly address the auditor interest to the public is as important as to the
client, such as safeguarding independence by eliminating complex
relationship with audit clients (i
...
limit to audit only);
 Reiterate ethical governance;
 A clear distinction of audit and non-audit engagements carried out by the
auditor, this leads to legislation and self regulation being established to a ban
on certain non-audit services for audit clients;
 Stronger regulation on auditors and audit firms as well as tougher
enforcement on non-compliance;
 Increasing the forensic nature of audit and stronger awareness of corporate
fraud;
 Relate audit risks to business risk

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ASIC is the statutory
administrative body for the enforcement of the Corporations Act 2001 (revised with
the CLERP Act)
...
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Chapter 1: An overview of auditing

and some non-listed Australian public companies
...
Furthermore ASIC now works closely with the Financial Reporting Council
and ASX in exercising governance regulations and assuring the integrity of business
reporting
...


The Companies Auditors and Liquidators Disciplinary Board is a statutory body
established under the ASIC Act and has the power to impose a penalty on a registered
auditor or liquidator if he/she is found to be guilty of failing to discharge duties
properly
...


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It can be examined in a number of
ways, for example: how often audits are associated with company failure; whether
they get the audit report correct; how much they cost; or whether they provide
economic value in the market
...
Overall, this certainly appears to
be a very successful outcome for auditing
...
04 per cent of auditees’ sales
...
Indeed, in looking at this cost and with
consideration of the number of ‘failures’ it would seem reasonable to describe
auditing as successful
...
This method of measuring also does not pick up if the audit has been deficiently
performed but no problems have been externally observed — which is obviously very
difficult to do
...
20

What are the current implications of the audit expectation gap? Can it be
reduced?

The current implications of the audit expectation gap are the same as it has always
been
...
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Solution Manual to accompany Modern Auditing and Assurance Services 5e

auditing that is difficult to observe
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Reporting internal control
...
In fact, the
most recent iteration of the audit report actually includes a specific disclaimer on
the issue of reporting on internal controls
...
Detection of fraud
...
However, it is still not seen as the core objective of an audit and the
only responsibility that still exists in relation to fraud is material fraud
...
Simply put, the market
expects auditors to pick up instances of fraud
...
Evaluation of going concern
...
However, they make no positive assurance about
what they do in this regard
...

Reducing the gap has traditionally focused on educating users about what an audit
is actually designed to provide
...


© John Wiley & Sons Australia, Ltd 2011

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21 What is an audit?
Required
If an audit is none of the above, what is an audit designed to achieve?
The primary objective of an audit is to express an opinion as to whether the financial
report is prepared, in all material respects, in accordance with an identified financial
reporting framework
...
A definition from the
Committee on Basic Auditing is as follows:
A systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and
communicating the results to interested users
...
The auditor (unlike the directors)
makes no positive assertion about the going concern of the company
...
22 Level of assurance
Required
(a) Why is it impossible for an auditor to provide absolute assurance regarding
subject matter on which they express their opinion?
(b) Explain what type of assurance an auditor should provide in a financial
statement audit
...
The auditor makes a judgement about the risks
of material misstatement and then designs procedures accordingly
...
Even if there was no constraint on cost or time the auditor could not provide
absolute assurance because he or she may misinterpret evidence and because there are
so many account balances that are the product of significant professional judgement
...


© John Wiley & Sons Australia, Ltd 2011

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23 Organisations associated with the profession
Required
Indicate the organisation or organisations associated with each activity
...
CPA Australia and ICAA
2
...
Auditing and Assurance Standards Board (AUASB)
4
...
CPA Australia and ICAA
6
...
AUASB
8
...
Public Sector Accounting Standards Board
10
...
ASIC
12
...


1
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There are two assertions in the audit partner’s view that should be challenged:
Auditor provides assurance on the assets of the firm
This is part of what is provided by the auditor but the auditor provides an opinion on
the whole set of financial statements
...
The auditor also obviously examines the firm’s liabilities and owners
equity
...


© John Wiley & Sons Australia, Ltd 2011

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25 Review of auditing
Required
Discuss the advantages and disadvantages of the responsibility of reviewing audit
work being undertaken by ASIC rather than the audit profession
...
26 Value of auditing
Required
Would you obtain an audit for this company? Explain the reasons for your
decision
...

Agency theory
This is the main theory that underpins auditing
...
In looking at these facts, there are only a few wealthy
businesspeople who have primarily financed the company
...
Therefore there may not be sufficient information asymmetry to warrant an
audit
...

Information hypothesis
This relates to where there is a larger group of investors in a company and is not the
case for this company at the moment
...

Insurance hypothesis
There is only a limited amount that can potentially be recovered from auditors if the
company were to fail
...
The shareholders should be aware that the audit is not designed to provide a
‘guarantee’ on the financial viability of the company
...
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Solution Manual to accompany Modern Auditing and Assurance Services 5e

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The partner is not correct in suggesting that the expectation gap only relates to
unreasonable expectations of users
...
She described it as ‘the audit expectation-performance
gap’
...
a gap between what society expects auditors to achieve and what they can be
reasonably be expected to accomplish (‘reasonableness gap’)
2
...
The performance gap
is further comprised of deficient performance and deficient standards
...
This has been the main component
that the profession has focused on in responding to the expectation gap issue
...
The problem is the expectation gap has not been resolved
which suggests that measures taken thus far have not worked and perhaps more
consideration should be given to the second component of the expectation gap
...
28 Independence and reliability
Required
Based on the series of accounting crises and corporate collapses in the early
2000s, discuss the importance of maintaining independence (and reliability) by
an auditor
...
De Angelo (1981) provided an important definition of
audit quality that states it is the ‘market-assessed joint probability that a given auditor
will both (a) discover the breach in the client’s accounting system, and (b) report the
breach’
...
The regulatory changes in
Australia clearly focused on the second part of this definition (independence)
...

There is no question that independence is important but the quality of the audit
process to pick up errors is also important
...
The authors are
implying that refocusing on reliability would best serve the public interest
...
[my italics]

© John Wiley & Sons Australia, Ltd 2011

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29 Carla’s Coffee Pty Ltd
There are two sets of questions:
1st Set
(a) Who are the various parties with an interest in Carla’s Coffees? Outline
what you think their interests, motivations and concerns would be
...
It appears now
that she wishes to do other things and divest herself of her shares
...

Customers
- Their primary interest would be in the ongoing supply of high quality, fair trade,
organic coffee
...

Northpac Banking Corporation
- The primary interest of the bank would be to ensure that the capital value of their
loan is secure
...

Wendy the CFO
- Her interest would presumably be on her ongoing employment
...
Another
motivation would be maintenance of the value of the company before selling her
shares
...

Dozen Potential Investors
- They would be interested in ensuring the ongoing profitability of the business and
the truth in the previously reported financial statements
...
They would have a number of concerns: (1)
the departure of Carla; (2) accuracy of previously reported financial statements; (3)
the ability of the company to maintain recent high growth; (4) the number of senior
people in the company wanting to sell their shares; and (5) recent bad publicity
...

The dozen potential investors would certainly want an audit
...
An audit provides an
independent evaluation of the financial statements on behalf of the investors
...
Sometimes
under these circumstances the investors would ask for a ‘due diligence’ report which
© John Wiley & Sons Australia, Ltd 2011

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Although the bank has first claim on the assets of the company, they would also be
interested in an audit of the company in this changing environment
...

2nd Set
(a) Assume you have been appointed as an auditor for Carla’s Coffee
...
These are
important figures because the bank loan has a claim on these assets and it will be the
most ‘tangible’ part of the business purchased by the investors
...

Strong growth over five years is impressive but this also creates significant pressure to
maintain this growth
...
The auditor should therefore ensure that only
appropriate revenue has been recorded in the current period and also that all expenses
have been properly recorded
...
They will be making their
investment decision based on the audit
...
The audit does not provide a guarantee on the future viability of a
company but enhances the credibility of information disclosed to increase the
reliability for the users of the financial statements
...
In this case there are two major risks to the company that the auditor
should be aware of and give due consideration to in their planning
...
This is a big risk because often for
these types of businesses there is significant reliance on the founder
...
An integral part of the development of the company has been
associated with the provision of ‘high-quality, fair-trade, organic coffee’
...


© John Wiley & Sons Australia, Ltd 2011

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30 Auditing and the global financial crisis
Required
(a) Find recent research on the ‘audit expectation gap’
...
Some of this research also examined changes to audit
reports that occurred in the late 1980s/early 1990s to evaluate the effect of these
changes on users perceptions
...
and P
...
(1993)
...

Gay, G
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, & Baines, A
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Perceptions of messages conveyed by
review and audit reports
...

Hatherly, D
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Innes, and T
...
1991
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Accounting and Business Research 21 (84): 311-319
...
, Brown, T
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Hatherly
...
The expanded audit report – A research
study within the development of SAS 600, Accounting, Auditing and
Accountability Journal 10 (5): 702-717
...
S
...
C
...
Bankers’ and investors’ perceptions of the
auditor’s role in financial statement reporting: the impact of SAS No
...

Monroe, G
...
Woodliff, 1994, ‘An empirical investigation of the audit
expectation gap: Australian evidence’, Accounting and Finance, 34, 1: 47-74
...
A
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An empirical study of the audit expectation-performance gap
...

McEnroe, J
...
Martens
...
Auditors’ and investors’ perceptions of the
“expectation gap”
...

Research examining the changes to the audit report found the changes to better clarify
auditors and managers responsibilities were picked up by users
...

Further evidence to suggest the expectation gap still existed was due to the fact that
another proposed audit report was put forward by the IAASB in 2003 and adopted
internationally in 2006
...
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Solution Manual to accompany Modern Auditing and Assurance Services 5e

Chong, K
...
Pflugrath, 2008, ‘Do different audit report formats affect
shareholders’ and auditors’ perceptions?’, International Journal of Auditing,
12: 221-241
...
, Moizer, P
...
(1992)
...

Humphrey, C
...
, & M
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The global audit profession and the
international financial architecture: Understanding regulatory relationships at a
time of financial crisis
...

This is still a topical issue
...
(2007)
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London: Institute of Chartered
Accountants in England and Wales (ICAEW)
...
2010
...
Available at:
http://ec
...
eu/internal_market/consultations/2010/green_paper_audit_en
...
The
research does tend to suggest that changes to the audit report will not be effective if
the wording still remains ‘boilerplate’ – which would suggest that more dramatic
changes are needed
...
, S
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McCracken
...
The auditor’s reporting model: A
literature overview and research synthesis
...


© John Wiley & Sons Australia, Ltd 2011

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