Module 01

Module 1: The assurance process

Overview

Your study of assurance services in AU2 focuses on the audit of financial statements: you develop a clear understanding of how assurance services are performed and why they are necessary.

Module 1 provides historical context and builds on basic auditing concepts you are already familiar with. You learn about recent changes in the environment of public accounting practice, particularly in auditing, and recognize their impact on the roles and responsibilities of the auditor. You also review introductory concepts such as the general framework for assurance engagements; the interrelationship between assurance standards, rules of professional conduct, and ethics (including the CGA-Canada Independence Standard); and the audit process and the audit risk model. Through multimedia activities, you practise applying professional ethical standards and protecting the public interest — two important responsibilities of a CGA.

Case problems can help you practise the skills needed to deal with ethical issues in conducting an audit. Review the nine-step approach to case analysis, presented in "How to analyze a case". You will have an opportunity to practise this approach in the self-test.

When you have completed this module, you should have a good background knowledge of assurance engagements and the context in which auditors currently operate. This foundation will support you in the exercises in later modules. Finally, through your study of auditing concepts and the assurance framework, you should feel more confident in your ability to apply your technical assurance skills and more general problem-solving skills to auditing issues.

(Note that the module mentions CICA Handbook sections that you will study later in the course.)

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Learning objectives

1.1 Identify the ways information risk arises and the reasons why assurance services are considered to be a value-added activity. (Level 1)

1.2 Explain the expectation gap and how the profession is trying to bridge it. (Level 2) 1.3 Discuss the meaning and importance of auditor independence and the threats to it, and identify the safeguards available

to either eliminate these threats or reduce them to an acceptable level. (Level 1)

1.4 Describe an assurance engagement and how the assurance framework is applied. (Level 1)

1.5 Outline the proposed changes to the structure of Canadian auditing standards as a result of the adoption of the Canadian

Standards on Auditing (CASs). (Level 2)

1.6 Apply the ethical principles, codes, and rules relating to association with information and professional conduct. (Levels 1

and 2)

1.7 Describe the audit risk model and how it is used to guide auditors in determining the nature, extent, and timing of

substantive audit procedures. (Level 1)

AU2 - Module 1 Page 1

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This material has been provided for you to review basic concepts from your External Auditing [AU1] or equivalent course. It is essential knowledge for your mastery of the material presented in Advanced External Auditing [AU2].

Basic auditing concepts

Define auditing and the objective of an audit of financial statements

● Auditing is the systematic process of objectively obtaining and evaluating evidence regarding assertions to ascertain the degree of correspondence between assertions and established criteria.

● The objective of an audit of financial statements is to express an opinion as to whether or not the information in the financial statements is presented fairly.

Define information risk and explain how it arises

● Information risk is the risk that the financial statements are false or misleading.

● Information risk arises because of �❍ remoteness of information�❍ bias or motivation of those providing information�❍ high volumes of transactions and data�❍ the complexity of transactions

Explain the purposes of an audit of financial statements

● The purposes of an audit of financial statements include �❍ fulfilling statutory or other requirements�❍ reducing information risk�❍ addressing the asymmetry of information between providers

and users of financial information

Describe the principal activities of a public accounting firm

● The principal activities of a public accounting firm include �❍ audit engagements�❍ review engagements�❍ other assurance services�❍ accounting services�❍ taxation services�❍ consulting services�❍ bankruptcy and receivership engagements

Compare external auditing to internal auditing

● External auditing and internal auditing are similar in a number of ways: �❍ Both require independence.�❍ Both use sampling.


�❍ Both produce reports.�❍ Both function within established standards.

Compare external auditing to internal auditing

● External auditing and internal auditing are different in a number of ways:

�❍ They produce reports for different people.�❍ They have different objectives.�❍ They have different scopes of work.�❍ They have different degrees of concern with day-to-day

operations.�❍ The nature and form of their reports are different.�❍ They are remunerated in different ways.

Describe the operational auditing function in a company

● Operational audits are defined as a review of any part of an organization’s operating procedures and methods for the purpose of evaluating the effectiveness, efficiency, and economy of the unit being audited.

Explain comprehensive auditing for the public sector

● Comprehensive audits generally consist of three parts: �❍ a financial statement (attest) audit�❍ a compliance audit, measuring compliance with relevant

legislation and government regulations and policies�❍ a value for money audit (operational audit), assessing if the

program or unit being audited is providing the output (effectiveness) intended at an appropriate cost (efficiency and economy)

Describe the concept of an assurance engagement

● In an assurance engagement, the auditor issues a written opinion about the subject matter of the engagement for which the accountable party (usually management) is responsible.

● The auditor provides credibility or assurance to the assertions made by the responsible party.

● Financial statement audits are a sub-class of assurance engagements.

Explain the difference between an attest engagement and a direct reporting engagement

● In an attest engagement, the public accountant is expressing an opinion on a written assertion from the responsible party (usually management).

● In a direct reporting engagement, the assertion is implied (not written) and the professional accountant expresses an opinion on the matter in a report using suitable evaluation criteria.


Explain audit engagements in terms of the general framework of assurance engagements

● Audit engagements are attest engagements.

● Management (the asserter) is responsible for the assertions in the financial statements.

● The users are the investors, creditors, and so on, who make decisions based on the financial statements.

● The auditor (the assurer) provides a high level of assurance on the assertions made by management. The audit can only be carried out by suitably qualified, independent public accountants.

Distinguish between audit, review, and compilation engagements

● An audit provides a high level of assurance that financial statements are fair in all material respects.

● Review engagements provide a moderate level of assurance that financial statements are in accordance with appropriate criteria, in all material respects. The accountant’s role is to ensure that the information is plausible (or credible).

● A compilation engagement is used when an accounting firm provides bookkeeping services or prepares financial statements for a client. No assurance is provided by the accountant, but there is an over-riding professional responsibility not to be associated with information that the accountant believes to be misleading.

Describe the components of a standard auditor’s report

● The standard unqualified auditor’s report consists of three paragraphs: �❍ The introductory paragraph identifies the statements reported

upon, states that financial statements are the responsibility of management, and states that the opinion of the financial statements is the responsibility of the auditor.

�❍ If differential reporting is used by the client, this should be identified in the introductory paragraph, with reference to the supporting note disclosure.

�❍ The scope paragraph states that the audit has been completed in accordance with generally accepted auditing standards and sets out some of the audit work done as a basis for the auditor’s opinion.

�❍ The opinion paragraph states the auditor’s opinion of the financial statements.

● In addition, the report must contain a title, the name of the addressee, the city and date of issue, as well as the auditor’s signature.

Explain the reasons for reservations in an auditor’s report

● There are two causes for reservation of opinion: �❍ Departure from generally accepted accounting principles, such

as


■ an inappropriate accounting treatment■ an inappropriate valuation■ inadequate disclosure

�❍ A limitation to the scope of the audit caused by ■ client-imposed restrictions■ circumstances

Describe the circumstances in which an auditor would issue an audit report containing an unqualified opinion, a qualified opinion, an adverse opinion, and a denial of opinion

● If the reservation arises because of a departure from GAAP, the auditor will issue an unqualified opinion, a qualified opinion, or an adverse opinion, depending on whether the auditor considers the effect of the departure to be immaterial, material, or highly material.

● If the reservation is caused by a scope limitation, the auditor will issue an unqualified opinion, a qualified opinion, or a denial of opinion, depending on whether the auditor considers the effect of the scope limitation to be immaterial, material, or highly material.

Draft a standard auditor’s report

● An example of a standard auditor’s report is given in CICA Handbook section 5400.22.

● Study carefully the wording of the report and be familiar with the contents of each of the three paragraphs.

Describe in general terms the recommendations concerning the presentation of additional information in the auditor’s report and disclosures for comparative figures

● Section 5701 of the CICA Handbook — Assurance deals with these matters.

● Auditors may be required to include additional information in their reports (for example, to meet statutory requirements).

● Auditors should take care that any additional information and explanations (other than those supporting the opinion given) appear in a paragraph following the opinion paragraph.

● If the comparative figures were not audited, or were audited by other auditors, this should be disclosed in the notes to the financial statements or in the auditor’s report.


1.1 The value added by assurance services

Learning objective

● Identify the ways information risk arises and the reasons why assurance services are considered to be a value-added activity. (Level 1)

Required reading

AU2 Readings Book:

● Reading 1-1: Aspects of information risk (Level 1)

LEVEL 1

This topic provides historical context and underlines the value of assurance services in the current business environment. You will learn about the information risk that financial statement users are subject to and about how the audit attempts to mitigate that risk.

Theoretical foundation

Why are audits or reviews done? The auditor’s role can be traced back to the early days of capital markets. As commerce became more complex, the formation of the trading company introduced the notions of invested capital and dividend distributions, as well as accountability to investors: investors needed someone to assure them that the monies and other wealth entrusted to agents (for example, ships’ captains) by investors were not misappropriated.

In 1897, the UK courts formally established the doctrine of limited liability. One of the consequences of this action was that ownership and management were often separated. As a result, legislation was passed requiring that the reports submitted by companies to their investors and creditors had to be independently verified. Auditors provided this confirmation of the veracity of the company accounts.

As described by modern economic theory, the role of the auditor is to reduce information asymmetry between the "principal" (the owner or owners of the firm) and their "agent" (management). Information asymmetry occurs when at least some relevant information is known to some, but not all, parties involved. It can cause markets to become inefficient, since not all the participants have access to the information they need for decision making. This information asymmetry favours management, since the owners cannot scrutinize everything their agent does. The auditor is expected to report whether the information being provided is reliable.

Information risk

The risk of financial or accounting information being unreliable is an example of


information risk, aspects of which are described in Reading 1-1.

By reducing information risk, audits shift the risk from the users of the statements to the auditors. If the users make decisions based on audited statements and subsequently discover that the auditors failed to detect a material misstatement because they conducted a substandard audit, the auditors may become liable for the consequences. As you learned in your introductory auditing course, the extent to which users may recover their losses from auditors will depend upon their legal status in relationship to the auditor and the degree of negligence on the part of the auditor.

Auditing addresses information risk through the establishment of a fiduciary (or trust) relationship between the auditor and the users of financial statements. This shifting of information risk only works if the auditors are trustworthy. While there can and should be some external oversight of auditors through professional associations, securities regulators, and so on, what determines auditors’ reliability (and makes auditing a value-added activity) is that auditors take this fiduciary responsibility seriously even when they are not watched or policed.

Assurance services also add value through by-products of the engagement work such as the management letter. Also, the knowledge of a particular business gained through performing assurance engagements helps when performing related services for the same business, such as the preparation of tax returns. This increases the value of accounting services provided to the client who is, after all, the one paying the auditor’s fee.


1.2 The expectation gap

Learning objective

● Explain the expectation gap and how the profession is trying to bridge it. (Level 2)

Required reading

AU2 Readings Book:

● Reading 1-2: Bridging the expectation gap (Level 2)

LEVEL 2

This topic considers the "expectation gap" that exists between auditors and financial statement users, how business events in the past decade have affected public confidence in assurance services, and how the profession has responded. The Enron debacle, in 2002, has had a significant effect on auditing standards and guidelines in recent years through the creation of the Sarbanes Oxley Act (see Topic 1.3).

Origins of the expectation gap

The difference between the public's perception of what accountants do and what clients and users of audited financial statements think public accountants should do has been termed the expectation gap. The average investor believes that an audit can provide a financial "clean bill of health." Of course, it does nothing of the sort, but the majority of unsophisticated investors and creditors thinks it does. And therein lies the problem. The auditor's opinion is based on tests and an examination of evidence, and the work performed is done to a standard of reasonable assurance. There are no certainties or absolutes. Errors can still occur and the financial statements could be misstated.

The recession of the late 1970s and the early 1980s heightened the public's interest in the expectation gap; the failure of the Northlands Bank and the Canadian Commercial Bank in 1985 focused attention on the failure of the banks' auditors to detect and warn the public about the conditions at the two banks.

The components of the expectation gap are illustrated in Exhibit 1.2-1.

Exhibit 1.2-1: Components of the expectation gap

Methods for bridging the gap

Writing about the expectation gap in June 1988, William A. Macdonald, chair of the Commission to Study the Public's Expectations of Audits, identified two


components of the expectation gap.1 The "standards gap" represents the difference between the public expectation of audits and what is currently required of auditors by their professional standards. The "performance gap" represents the difference between what the present professional standards require and the public's perception of actual auditor performance. Efforts are needed in three areas to reduce the expectation gap:

● Improve communication so that the public's expectation of audits is closer to the professional requirements and so that the public's perception of performance is closer to the actual performance of auditors.

● Address shortfalls in the standards so that the standards better represent the public's reasonable expectation of auditor performance.

● Address performance issues so that auditors more consistently perform their audits in accordance with the standards.

Activity 1.2-1 illustrates some methods of bridging the expectation gap.

Activity 1.2-1: The expectation gap

1 In 1986, the CICA appointed a commission chaired by William A. Macdonald, a Toronto lawyer, to study what the public expected of its auditors. The Commission was charged with developing conclusions and recommendations to determine how the disparity should be resolved where a gap existed between what the public expected or needed and what auditors could and should reasonably be expected to accomplish. The result was published in a report entitled Report of the Commission to Study the Public's Expectations of Audits. A summary of the report and commentary was published in the July 1988 issue of CAmagazine.


http://lms.cga-canada.org/includedmedia/expectgap_audit.htm

Exhibit 1.2-1: Components of the expectation gap

Source: William A. Macdonald, Chairman, and others, Paragraph 1.20 of the "Report of the Commission to Study the Public’s Expectations of Audits," (Toronto: The Canadian Institute of Chartered Accountants, June 1988). Reproduced with permission.


1.3 Auditor independence

Learning objective

● Discuss the meaning and importance of auditor independence and the threats to it, and identify the safeguards available to either eliminate these threats or reduce them to an acceptable level. (Level 1)

Required reading

AU2 Readings Book:

● Reading 1-3: The auditor’s institutional environment (Level 1)

Ethics Readings Handbook:

● Unit C3, CGA-Canada's Independence Standard (Level 1)● Unit C3, Guidance bulletin for practitioners: Independence and assurance

engagements (Level 1) (For all ethics-related readings in this course, it is assumed that you are already familiar with Section A and Units C1, C2, C3, C4, and C6 of Section C of the Ethics Readings Handbook. ERH readings are accessible through the Course Modules link.)

LEVEL 1

The CGA-Canada Independence Standard, issued in late 2004, was based on the conceptual framework advanced in the International Federation of Accountants (IFAC) Code of Professional Ethics and provides detailed guidance for CGAs in public practice.

On completion of this topic, you should have a working knowledge of the new rules and be able to apply them to situations which might arise in practice. The Sarbanes-Oxley Act of 2002 in the United States introduced many changes to the auditing profession, which will be discussed in upcoming modules. In particular, note section 103 (page 11), which deals with auditing, quality control, and independence standards and rules. Exhibit 1.3-1 provides a summary of key sections 302 and 404. (This material is not examinable.)

Exhibit 1.3-1: Sarbanes-Oxley requirements primer

Independence standards

Effective January 1, 2004, the CICA introduced new and very specific rules and prohibitions for their members through their Code of Professional Conduct. Those rules combined a legislated framework with the CA Institute's responsibility to police and discipline CA members when offences are committed. CGA-Canada also


http://www.cga-education.org/2008-09/redir.asp?page=m06t04.IFAC&course=AU2

http://www.cga-education.org/2008-09/redir.asp?page=m01t03.sarbanesoxleyact&course=AU2

issued its Independence Standard (ERH, Unit C3) in December 2004 to be applicable to assurance and specified auditing procedures engagements when the report is dated on or after December 31, 2004. Both standards conform to Chapter 8 of the IFAC Code of Professional Ethics and make use of the code's conceptual framework.

Independence issues for privately held companies

Many of the new regulations contained in CGA-Canada’s Independence Standard apply only to auditors of publicly traded companies, not to those of privately held entities. In the case of publicly traded entities, there is a responsibility to the unsophisticated investor who relies, in whole or in part, on published financial statements for investment decisions.

Privately held companies are different because the risk is substantially lower. The owner is usually part of the management team, and lenders and creditors are knowledgeable business people who rely on the personal character and capacity of the owners.

For these smaller companies, the consulting aspect has been an increasingly important component of the accountant/client relationship. As a percentage of revenue, and in absolute numbers, the audit is becoming a smaller part of the accountant/client relationship. This is particularly critical for small- and medium-sized business enterprises (SMEs), where the accountant is seen as a financial advisor. The firm looks to the accountant for assistance with a gamut of activities including financial planning, tax advice, and information technology issues. The various independence standards permit the provision of some services to those clients whose securities are not publicly traded but prohibit the provision of such services for publicly traded assurance clients. Paragraphs 4.63 to 4.123 of the Independence Standard set out in detail where these prohibitions apply to listed and unlisted assurance clients.

CGA-Canada has issued guidance to the sole practitioner and small firm on the application of the new independence standard to the audit of non-listed companies. This is also found in Unit C3 of the Ethics Reading Handbook (under the Resources tab).


Exhibit 1.3-1: Sarbanes-Oxley requirements primer


Source: IT Control objectives for Sarbanes-Oxley: The importance of IT in the design, implementation and sustainability of internal control over disclosure and financial reporting, The IT Governance Institute, April 2004, page 13 and 14. Reproduced with permission.


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http://www.isaca.org/Template.cfm?Section=Downloads10&CONTENTID=20317&TEMPLATE=/ContentManagement/ContentDisplay.cfm

1.4 A general assurance framework

Learning objective

● Describe an assurance engagement and how the assurance framework is applied. (Level 1)

Required reading

AU2 Readings Book:

● Reading 1-4: The assurance framework and specialized engagements (Level 1)

● Reading 1-5: CGA-Canada Auditing guideline No. 1, Audit Evidence (Level 1)

CICA Handbook:

● "Introduction to assurance and related services," including Appendix (preceding section 5020) (Level 1)

● Paragraphs 5025.01-.15 and 5025.32-.42 (Level 1)● Paragraphs 5300.20-.22 (CAS 500) (Level 1)

Begin by reading the required material from the CICA Handbook, then Reading 1-4, which discusses applying the assurance framework to an engagement other than a financial statement audit. You will learn more about other types of assurance engagements in Topic 9.3.

LEVEL 1

As you learned in AU1 (or an equivalent course), financial statement audits are a type of assurance engagement. You should be able to explain how financial statement audits fit within the general assurance framework. This topic will refresh your knowldge of assurance engagements and related terminology as well as the differences between audit, review, and compilation engagements. The CICA Handbook provides recommendations for assurance engagements in general (assurance standards), as well as specific recommendations for audits (generally accepted auditing standards or GAAS).

Assurance engagement framework

Assurance engagements are performed according to an established set of procedures. This framework is a dynamic tool that enables practitioners to constantly assess their engagement approach to ensure that nothing is overlooked.

This framework requires practitioners to plan procedures around five specific areas:


● Define the engagement scope: What is the focus of the engagement?● Identify the risk of the scope area: What could go wrong?● Specify the engagement objective or assertion: Why is assurance needed

on this subject matter?● Define the engagement criteria: How can the objective be validated?● Specify/define the tests: How will the subject matter be evaluated against

the criteria?

The "introduction to assurance and related services recommendations" preceding the assurance recommendations in the CICA Handbook explicitly defines this framework, since changes in the nature of attest services mean that audits are now distinct from other assurance engagements.

The distinctions are explained in section 5025.05, which defines both assurance engagements (attest engagements and direct reporting engagements) and related services, and outlines the roles of the participants in each (paragraph 5025.07). The appendix to the "Introduction to assurance and related services" shows that there are two levels of assurance: a high level for audits and a moderate level for reviews. Related services provide no assurance (paragraphs 5025.14–.15).

In financial statement audits, the assurance engagement framework is typically implicit in the audit program. The CICA Handbook standards are not meant to supersede such specific audit and review standards, but to provide guidance for assurance engagements where specific standards do not exist (paragraph 5025.02). Understanding the assurance engagement framework facilitates the development of these specialized programs.

Applying the assurance framework to a financial statement audit

When this framework applies to a financial statement audit, the scope is normally the financial statements prepared by management. In engagements other than financial statement audits, the scope could be any subject matter an accountable party is responsible for or chooses to report on to another party. (For example, a promoter must report to his backer on the number of patrons attending a concert.)

Risk is related to the level of assurance provided in the report, which, in turn, depends on the needs of the users and the nature of the subject matter. The objective in an assurance engagement is to evaluate evidence, or to perform tests relating to a subject matter or assertion, in order to provide a conclusion. This conclusion will have a high or moderate level of assurance regarding whether the assertion is supported by suitable criteria, which are developed by the professional accountant.

Management assertions

When providing assurance, one objective is to either confirm or refute management’s assertions that the matter under consideration is fairly presented in all material respects. In a financial statement audit, assertions are management’s implicit or explicit representations embodied in the financial statements. The goal is to test the veracity of management assertions regarding the existence or occurrence, completeness, rights and obligations, recognition, measurement, presentation, and disclosure of the various elements and related disclosures making up the financial statements.


Management’s assertions can be classified into those relating to classes of transactions and events, those relating to account balances at the period end, and those relating to presentation and disclosure (paragraph 5300.21 [CAS 500]).

Work through Activity 1.4-1 to check your knowledge of these classifications.

Activity 1.4-1: Management assertions

Audit criteria and tests

Audit criteria are benchmarks used to evaluate the subject matter. In a financial statement audit, the criterion for evaluating management’s assertions is GAAP. In non-financial statement audits, the criteria may have to be developed using the characteristics and sources outlined in paragraphs 5025.32–.42 of the Handbook. The criteria need to support the audit objective.

Audit tests involve performing procedures to evaluate the subject matter against the criteria. Sometimes one audit step will evaluate more than one criterion. Activity 1.4-2 shows one possible assurance engagement framework applied to the audit of cash and bank balances in a financial statement audit. It illustrates how the audit tests evaluate the cash accounts (subject matter) against the criteria, how the criteria support the audit objective, and that the audit objective tests management’s assertions. If everything is satisfactory, the auditor achieves assurance on the audit objective. If not, either management must make revisions, or the auditor must decide whether the inability to reach a positive conclusion is material for the financial statements.

Activity 1.4-2: Auditing cash and bank balances

Firms generally develop audit programs for use in performing financial statement audits or use or modify audit programs developed by others. No two engagements will be exactly the same, so standard audit programs must be modified to suit the audit engagement in light of the particular materiality and risk considerations.


http://lms.cga-canada.org/includedmedia/management_assertions/management_assertions.html

http://lms.cga-canada.org/includedmedia/auditing_cash_and_bank_balances_part1/auditing_cash_and_bank_balances_part1.html

1.5 Auditing and assurance standards

Learning objective

● Outline the proposed changes to the structure of Canadian auditing standards as a result of the adoption of the Canadian Standards on Auditing (Level 2)

Required reading

Online articles:

● Article 1.5-1: Adopting international standards on auditing (ISAs) (Level 2)

LEVEL 2

The Canadian Auditing and Assurance Standards Board (AASB) is adopting the International Standards on Auditing (ISAs) issued by the International Auditing and Assurance Standards Board. After the adoption of the ISAs, those sections in the CICA Handbook — Assurance dealing with the audit of financial statements will be called "Canadian Auditing Standards" (CASs). When released, the new Handbook is expected to contain the following separate series of standards and guidance:

●

Canadian Auditing Standards (CASs)●

Canadian Auditing Practice Statements (CAPSs)●

Canadian Review Engagement Standards (CRESs)●

Canadian Review Engagement Practice Statements (CREPSs)●

Canadian Assurance Engagement Standards (CAESs)●

Canadian Assurance Engagement Practice Statements (CAEPSs)●

Canadian Public Sector Assurance Engagement Standards (CPSAESs)● Canadian Related Services Standards (CRSSs)● Canadian Related Services Practice Statements (CRSPSs)● Canadian Standards on Securities Regulations Matters (CSSRMs)● Canadian Securities Regulations Matters Practice Statements (CSRMPs)

In January 2008, the new Standards were expected to come into effect for financial periods beginning on or after December 15, 2009. Because of the potential for confusion as to what standards are being used, early adoption of the new standards is not permitted. As described in Article 1.5-1, there will not be a one-to-one mapping between sections of the current Assurance Handbook and the new Canadian Auditing


http://www.cga-education.org/2008-09/redir.asp?course=au2&page=m01t05.isa

Standards. Some sections will be retained and moved to the other series listed above. References in these module notes are to the current standards, with parenthetical references to the proposed Canadian Auditing Standards, where the future location of material on that matter is known.

Current assurance standards

The Handbook has defined standards for assurance engagements in section 5025. In addition, standards are provided for audits in paragraph 5100.02 (CAS 210) and for review engagements in paragraph 8100.15. If you need a refresher on standards for audits, review section 5100. Compilation engagements are not part of assurance engagments, but are a related service. Section 5021 addresses the authority of auditing and assurance standards and other guidance.

The standards for assurance engagements, audits, and reviews are similar, and you can see some common themes running through these standards.


1.6 Professional standards and ethics

Learning objective

● Apply the ethical principles, codes, and rules relating to association with information and professional conduct. (Levels 1 and 2)

Required reading

AU2 Readings Book:

● Reading 1-6: Standards and ethics (Level 1)

CICA Handbook:

● Section 5020 (Level 1)● Section 5021 (Level 1)● Paragraphs 5025.16-.58, 5100.02 (CAS 200), 8100.15, and 9200.16

(Levels 1 and 2)

Ethics Reading Handbook:

●

Unit C3, CGA-Canada's Code of Ethical Principles and Rules of Conduct (Level 1)

Before looking at the standards and ethics principles behind an assurance engagement, it is critical that you understand the concept of association with information and its associated responsibilities. You should already be familiar with the standards for audits. Review part A of Reading 1-6 for more information on section 5020 of the CICA Handbook. Part B of Reading 1-6 gives an analysis of general standards, performance and examination standards, reporting standards, evidence and procedures standards, and communication standards.

LEVEL 1 Association with information

When you perform services for clients, you become associated or involved with information issued by your clients. When a CGA is associated with financial information, users may see this as increasing the reliability of that information, and may therefore increase their reliance on it. Consequently, you need to be aware of what this association implies and of the professional responsibilites of being "associated." The CICA Handbook notes that you can become associated with an organization or with information issued by that enterprise in three ways (paragraph 5020.01):


Through actual association by an action taken by you with information issued by an enterprise.

2. Through indication, either written or verbal, but without your knowledge or consent, by the enterprise or a third party that you were involved with the information issued by the enterprise.

3. Through assumption by a third party that you are involved with the information issued by the enterprise.

Work through Activity 1.6-1 to test your understanding of the concept of association with information.

Activity 1.6-1: Association with information

Concepts

Auditors provide value to the users of financial information because of some fundamental underlying concepts:

● the standards used to perform assurance engagements● the evidence required and the procedures used to perform assurance

engagements● the communications about the work done● the rules of professional conduct and their enforcement by the CGA

Association

Ethics and dealing with ethical issues

Professional standards and ethics are intermingled. Society relies on everyone to act ethically, but particular onus is placed on professional accountants to do so. Note how the ethical principle in the Code entitled "Responsibilities to Society" requires the public accountant to act with integrity. Because users make decisions about the allocation of resources based on the opinions rendered by public accountants, the business world relies on CGAs and other professional accountants to do their work with integrity and due care.

Review Exhibit 1.6-1 for a better understanding of the three categories of standards governing the performance of audits.

Exhibit 1.6-1: Summary of standards

CGA-BC provides links to two useful ethics articles:

● In your best interest is an article on due diligence, written for CGAs and CGA students.

● Corruption proofing your career outlines ethical dilemmas in the workplace.


http://lms.cga-canada.org/includedmedia/association_with_information/flash_quiz_client.html

http://www.cga-education.org/2008-09/redir.asp?course=au2&page=m01t06.cgabc

This material has been provided for you to review basic concepts from your External Auditing [AU1] or equivalent course. It is essential knowledge for your mastery of the material presented in Advanced External Auditing [AU2].

Standards

There are three broad categories of standards that auditors must follow in their work. You should be familiar with the main components of each type of standard.

Professional standards

Professional standards are those you follow in completing an audit. The most important is GAAS or, in the case of other assurance engagements, the standards set out for that type of engagement. The most common source of professional standards in Canada is the CICA Handbook on Assurance and Related Services.

Ethical standards

A professional should understand and follow ethical standards, namely, those documented in the CGA-Canada Code of Ethical Principles and Rules of Conduct. You are expected to be familiar with the rules and understand how to interpret and apply them in different situations. The ethical principles are grouped under six main themes including your responsibility to the public, to clients and employers, to the profession, to truth and honesty, and to maintaining your expertise. The sixth group covers the ethical principles that are unique to accountants in public practice.

Legal obligations

The third category of standards that you should be familiar with is the legal obligations of the auditor. These obligations arise from your contract with the client and your duty to the users of the client’s financial statements. The obligations can be met by following professional standards such as GAAS, and by documenting that you have used appropriate professional judgment when faced with problematic situations.

You may want to review the three elements of "negligence" that must be brought forward by a plaintiff to prove a claim against the auditor. First, the auditor had a duty to the plaintiff by virtue of the client-auditor relationship. Second, the auditor failed to meet the necessary duty of care. Third, the plaintiff experienced losses directly as a result of that failure.

GAAS — General standard

There are three sections to GAAS: general standard, examination standards, and reporting standards. The general standard addresses the quality of the audit work. Accepting an engagement for which you do not have the necessary experience or training, or while you are not sure you have enough staff time available for the job, would violate the general standard.


The general standard also requires that the work be done with due care. In order to prove that due care was exercised, the auditor has to fully document the work done and the decisions and judgments made in the course of completing the audit. Without this documentation, there is no evidence available that due care was taken.

Last, but certainly not least, the general standard requires an objective state of mind. Objectivity cannot be stressed enough.

GAAS — Examination standards

There are three examination standards.

Planning and supervision

The audit must be planned and properly executed so as to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. You should properly supervise any staff assistants. The audit file should contain documentation of the planning and supervision to show evidence that GAAS was met. Additional guidance is provided in new Section 5150 — Planning, which establishes standards and provides guidance on the considerations and activities applicable to planning an audit of financial statements.

Understanding of the entity and its environment

The second examination standard requires that the auditor obtain an understanding of the entity and its environment, including internal control, sufficient to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures. Even though the auditor may be planning to use a substantive approach to obtaining audit evidence, the auditor's understanding of the entity and its environment and the main components of the internal control systems must still be described and understood. This understanding must also be documented.

Evidence

Evidence must be gathered and placed in the audit file to support the report. The evidence is needed in order to show that the auditor’s final opinion is justified. It is important that this evidence is consistent with the final opinion expressed, and internally consistent as well. If apparently contradictory evidence is obtained, such contradictions must be resolved by obtaining more evidence until the truth of the matter is established. The hierarchy of evidence must also be taken into consideration. Evidence obtained from third parties is more reliable than that obtained from the client; documentary evidence is more reliable than oral evidence, and so on.

GAAS — Reporting standards

The reporting standards spell out the details of what is to be included in the auditor’s report:

● identification of the financial statements reported upon


● difference between the auditor’s and management’s responsibility● scope of examination (that is, testing)● an opinion (or reason why there is no opinion)

If an opinion is expressed, it should �❍ state whether the financial statements present fairly, in all material

respects, the financial position, results of operations and cash flow�❍ identify the basis of accounting (GAAP) used

● any reservations in the opinion

You should become familiar with these details and, when learning them, note that the purpose of including each of the items is to avoid confusion about what the auditor has examined and what conclusion has been drawn.


Exhibit 1.6-1: Summary of standards


1.7 The audit risk model

Learning objective

● Describe the audit risk model and how it is used to guide auditors in determining the nature, extent, and timing of substantive audit procedures. (Level 1)

Required reading

AU2 Readings Book:

● Reading 1-7: The audit process and the audit risk model (Level 1)

CICA Handbook:

● Section 5095 (CAS 200) (Level 1)

LEVEL 1

This topic provides a review of the main activities in the audit process, from planning the audit to issuing the correct report. You will examine the complexities of these steps, as well as issues such as communicating with the client, in future modules.

There have been changes in the presentation of the audit risk model in the post-Enron era. Exhibit 1.7-1 provides an overview of the components of the audit risk model. Make sure that you fully understand how auditors use it to develop substantive tests for gathering sufficient appropriate evidence.

Exhibit 1.7-1: Components of audit risk

The evaluation of the risk of material misstatement (and its components, inherent risk and control risk) will be discussed in Modules 2 and 3. There are detailed questionnaires and model working papers that assist auditors in setting an appropriate audit risk level and in assessing the related risks. One source of these documents is the forms from CGA-Canada's Public Practice Manual which you will use in Module 2 and later modules of the course.


http://lms.cga-canada.org/includedmedia/components_audit_risk/components_audit_risk.html

Module 1 summary

1.1 Identify the ways information risk arises and the reasons why assurance services are considered to be a value-added activity. (Level 1)

●

Information risk arises because of�❍ potentially significant financial consequences to the user from

reliance upon information which is materially misstated�❍ preparers' biases and conflicts of interest�❍ remoteness of information (from the user)�❍ large volumes and complexity of data�❍ the possibility of misstatement due to human error, breakdown of

controls, and/or employee fraud

● Assurance services add value by reducing information risk to the users of financial information (by transferring that risk to the professional accountant).

1.2 Explain the expectation gap and how the profession is trying to bridge it. (Level 2)

● The expectation gap is the difference between users' expectation of what accountants and auditors should do and/or provide and users' perception of the services actually provided by accountants and auditors.

● To narrow the gap, the profession has sought to increase the trust that users place on financial statements and accompanying practitioners' reports.

● Improvements in communication, improvements in assurance standards, and better enforcement of compliance with those standards all help increase user trust and close the gap.

● A consistent set of criteria makes it easier for public accountants to communicate a reasonable expectation of their work to users. Common standards, required evidence for various types of engagements, agreed procedures for various types of engagements, and a code of ethics and rules of conduct provide an environment more conducive to understanding and trust.

1.3 Discuss the meaning and importance of auditor independence and the threats to it, and identify the safeguards available to either eliminate these threats or reduce them to an acceptable level. (Level 1)

● Auditor independence includes independence in fact and independence in appearance. Those performing assurance engagements must be free of any influence, interest, or relationship in respect of the client's affairs which impairs the member's professional judgment or objectivity, or which, in the view of a reasonable observer, may have that effect.

● Threats to auditor independence include self-interest, self-review, advocacy, familiarity, and intimidation threats.

● Methods of eliminating or reducing such threats include safeguards created


by the profession, legislation, or regulation, safeguards within the assurance client, and safeguards within the firm's own systems and procedures.

● Where a threat is so significant that no safeguard can reduce it to an acceptable level, the public accountant should not perform an assurance engagement for that client.

1.4 Describe an assurance engagement and how the assurance framework is applied. (Level 1)

● An assurance engagement is any engagement where a practitioner provides a conclusion on a subject matter for which an accountable party is responsible. Assurance engagements include audits and reviews of financial statements.

● The assurance framework requires practitioners to plan procedures around five specific tasks:

�❍ Define the engagement scope.�❍ Identify the risk of the scope area.�❍ Specify the engagement objective or assertion.�❍ Define the engagement criteria.�❍ Specify the tests to be carried out.

1.5 Outline the proposed changes to the structure of Canadian auditing standards as a result of the adoption of the Canadian Standards on Auditing. (Level 2)

● The sections of the CICA Handbook – Assurance that deal with the audit of financial statements will be replaced with new Canadian Auditing Standards which are effectively identical in content to the International Standards on Auditing issued by the International Auditing and Assurance Standards Board.

● Other sections of the current Assurance Handbook will be set out in a number of separate series of standards and guidance.

● The new standards are expected to come into effect for financial periods beginning on or after December 15, 2009.

1.6 Apply the ethical principles, codes, and rules relating to association with information and professional conduct. (Levels 1 and 2)

● A public accountant becomes associated with information �❍ by some action taken by the accountant with respect to the

information, such as performing a service or consenting to the use of his or her name (actual association)

�❍ when the enterprise or a third party, without the accountant's knowledge, indicates the accountant was involved with the information

�❍ when a third party assumes the accountant is involved with the information

● There are a number of professional responsibilities that arise from

associating oneself with information: �❍ Comply with the professional rules of conduct.�❍ Comply with the appropriate standards from the CICA Handbook.


�❍ Communicate appropriately the extent of involvement with the information.

● The ethical guidelines for CGAs and CGA students are set out in the CGA-

Canada Code of Ethical Principles and Rules of Conduct. Students should be familiar with the Rules of Conduct and their application in practice.

1.7 Describe the audit risk model and how it is used to guide auditors in determining the nature, extent, and timing of substantive audit procedures. (Level 1)

● Audit risk (AR) is the risk that the auditor will issue an inappropriate audit opinion (usually an unqualified audit report) when the financial statements are materially misstated. Audit risk is a function of the risk of material misstatement (RMM) of the financial statements (prior to the audit) and the risk that the auditor will not detect such misstatement (DR).

● The risk of material misstatement has two components: inherent risk (IR) is the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming that there are no related controls, and control risk (CR) is the risk that internal controls, established by management to either prevent or detect and correct material misstatements, will fail to do so.

● The auditor determines the amount of audit risk that he or she is prepared to accept, then assesses the risk of material misstatement (or inherent risk and control risk) and can solve the audit risk equation for the desired detection risk. The equation can be written as

DR = AR RMM or DR = AR

IR × CR

● In practice, the auditor is more likely to use assessments of high, moderate, and low than numerical values. The benefit of the audit risk model is not that it gives precise mathematical values but that it requires the auditor to focus attention on each component of the model in turn in determining the nature, extent, and timing of substantive audit procedures to be performed.


Module 1 self-test

Question 1

Why is it so important that CGAs who associate themselves with financial information clearly indicate the nature of the association? Solution

Question 2

One of the goals of the current auditor’s report is to reduce the expectation gap. Indicate whether or not you think each of the following phrases makes the role of the auditor clearer to the user:

a. "These financial statements are the responsibility of the company’s management."

b. "Our responsibility is to express an opinion on these financial statements based on our audit."

c. The words "in all material respects" were added to the opinion paragraph.

Solution

Question 3

Frank Dorrance, a senior audit manager for Bright and Lorren, a public accounting firm, has recently been informed that the firm hopes to promote him to partner within the next year or two. Frank excels at dealing effectively with all people, including client personnel, professional staff, partners, and potential clients. He has recently built a bigger home for entertaining and has joined the city’s most prestigious golf and tennis club. He is excited about his future with the firm. Frank has recently been assigned to the audit of Machine International Corp., a large wholesale company that ships goods throughout the world. It is one of Bright and Lorren’s most prestigious clients. During the audit, Frank determines that Machine International Corp. uses a method of revenue recognition called "bill and hold" that has been questioned by the Ontario Securities Commission (OSC). After considerable research, Frank concludes that the method of revenue recognition is not appropriate for Machine International Corp. Frank discusses the matter with the engagement partner, Maria da Silva, who concludes that the accounting method has been used for more than 10 years by the client and is appropriate, especially considering that the client does not file with the OSC. Da Silva is certain the firm would lose the client if the revenue recognition method was found inappropriate. Frank argues that the revenue recognition method was appropriate in previous years, but that the OSC ruling makes it inappropriate in the current year. Frank recognizes the partner’s responsibility to make the final decision, but he feels strongly that the revenue recognition method is inappropriate. Da Silva is willing to write Frank a letter stating that she takes full responsibility for making the final decision if a legal dispute ever arises. She concludes by saying, "Frank, partners must act like partners, not like loose cannons trying to make life difficult for their partners. You have some growing up to do before I would feel comfortable with you as a partner."

Required

a. What are the ethical issues here? What should Frank do? Using the nine-step approach to case analysis shown in "How to analyze a case", state your opinion of what Frank should do.

b. Assume the role of Frank Dorrance, and write a memo to Maria da Silva summarizing the issues and explaining your point of view, recommendation, and plans. Your memo should be between 400 and 500 words. (Note: You should be familiar with memo preparation from Business Communication [CM1] or an equivalent course. On an assignment or exam, a memo such as this one would be worth approximately 18 to 24 marks, including up to 5 marks for correct presentation in memo format, clarity, and professionalism in writing.)

Source: W. Morley Lemon, Alvin A. Arens, and James K. Loebbecke, Auditing: An Integrated Approach, Canadian Fifth Edition (Toronto: Prentice-Hall Canada Inc., 1993), page 95, Case 3 33. Solution

Question 4

Independence has been a cornerstone of external auditing for more than a century.

a. Why is independence so essential to auditors?

b. Compare the importance of independence of professional public accountants with that of other professionals, such as lawyers or physicians.

c. Explain the difference between independence in appearance and in fact.

d. Explain how each of the following could affect independence (i) in fact and (ii) in appearance, and (iii) evaluate the social consequences of prohibiting auditors from each situation (for example, increased auditing costs passed on to customers).


http://www.mycgaonline.org/bbcswebdav/institution/How%20To/HowTo/caseanalysis/analyzeacase.htm

1. The auditor owns stock in a client company.2. The person who performs the audit also does bookkeeping for an audit client.3. The auditor recommends adjusting entries to the client’s financial statements and also prepares the financial

statements, including footnotes, for the client.4. Accountants working for a different department than the audit department provide management services to an

audit client.5. The same audit team, except for the assistants, performs the annual audit five years in a row.6. The same public accounting firm performs the audit 10 years in a row.7. The audit committee selects the public accounting firm.

Solution


Self-test 1

Question 1 solution

Users of financial statements with which CGAs have associated themselves (that is, the CGAs have performed services with respect to the financial statements or have permitted their names to be associated with the financial statements) are entitled to place reliance on those financial statements. For instance, the users should be able to assume, in the case of a review engagement, that the financial statements are plausible.

Furthermore, if financial statements that had been reviewed by a public accountant were presented to a bank with a request for a loan, the bank’s lending officer would assume that the financial statements are not materially misleading and that there are no serious omissions. Moreover, the fact that a CGA has been associated with the financial statements adds credibility to them in the eyes of the loan officer.

As professionals, CGAs have a responsibility to make clear to any users of financial statements, or to users of other financial information with which the CGAs have been involved, what their involvement was. It is not up to the user to determine the impact of the CGA’s involvement if the CGA fails to make that clear.

So that the user does not make unwarranted assumptions about the effect and meaning of the CGA’s association, it is important that the CGA "appropriately communicate the nature and extent of his or her involvement with the information" (CICA Handbook — Assurance, paragraph 5020.10). For example, if only review procedures have been performed with moderate assurance, you want to make sure that the user doesn’t think an audit with high assurance has been performed.


Self-test 1

Question 2 solution

a. The phrase clearly tells readers of the financial statements and the auditor’s report that management has the responsibility for preparing the financial statements and for the disclosures therein.

b. This phrase makes it clear that the auditor’s role is to express an opinion on the financial statements. The combination of the phrase in (a) and this phrase clearly defines the roles of management and the auditor. The phrase also indicates that the auditor’s role does not go beyond the expression of an opinion.

c. This phrase tells readers of the financial statements and the auditor’s report that there is a degree of imprecision in the financial statements and that the financial statements "present fairly" with that degree of imprecision.


Self-test 1

Question 3 solution

a. This case is designed to illustrate a situation where a senior manager has a difference of opinion with a partner (Maria) concerning a client’s revenue recognition accounting policy. Both Frank and Maria believe they are right.

Applicable steps from the nine-step approach to case analysis are discussed below.

Identify problems and issues.

Frank, a senior audit manager, believes the revenue recognition method that Machine International Corp. has used for a number of years is no longer appropriate because of a recent ruling by the Ontario Securities Commission (OSC). Maria, the partner on the audit, reviews the situation and concludes that, because the method has been used for 10 years and because Machine International Corp. does not file with the OSC, the revenue recognition method is acceptable.

Maria states that she will take responsibility for the decision. Although Frank says the method is inappropriate, you do not know whether it results in a material misstatement.

Generate alternatives.

Frank’s alternatives are to (1) speak to another partner, (2) agree with Maria and accept Machine International Corp.’s accounting, or (3) resign from the audit and possibly the firm.

Select the decision criteria.

Frank should consider his choice in the context of what a professional with integrity would do. For example, when faced with a choice, most professionals would put their responsibility to the profession and society ahead of personal advancement.

The chosen alternative must consider the needs and interests of all stakeholders and be ethically sound (in compliance with CGA-Canada’s Code of Ethical Principles and Rules of Conduct).

Analyze and evaluate the alternatives.

Frank should consider the stakeholders and their various motivations in making his decision about how to deal with the issue:

● Frank wants to be partner, but does that mean he should go along with whatever the partner thinks is right? What about what is right for the client, the other partners, and the firm?


● Maria thinks the accounting method is appropriate and is certain the

firm would lose its client if the current accounting method were deemed inappropriate. She is motivated to keep the client and thinks she can absolve Frank of any responsibility for his conclusions by writing a letter.

● Machine International Corp. is a large international company and hence would have many diverse financial statement users. It is likely motivated to show healthy, stable, operating results by staying with the same accounting method it has used for the past 10 years. A change in accounting policy will probably show poorer results for the year of change. You don’t know if management or the board of directors is aware that its method of revenue recognition is under question, or what the effect of a change in policy will have on the financial statements.

● The other partners at Bright and Lorren may want to keep one of their "most prestigious clients" at all costs, or may disagree with Maria da Silva’s position.

What does CGA-Canada’s Code of Ethical Principles and Rules of Conduct say about the issue? Rule R303 requires adherence to acknowledged principles and standards. Is the OSC ruling such a standard? Read Rule R303 and reach your own conclusion. What do the principles say? Would using the "bill and hold" method result in misleading information? If so, Frank shouldn’t be associated with these statements even if it placed him in a difficult situation with his employer. This is true regardless of the fact that Maria da Silva has written a disclaimer of responsibility.

Frank should also determine the possible consequences of each alternative:

● Speak to another partner and/or write a statement for the file summarizing his conclusions. Inform other partners if Maria refuses to include the statement in the working papers. Frank will maintain his integrity but he may lose any chance of advancement at Bright and Lorren. Maria could be right and Frank could endanger his career. If the partner he talked to sided with Maria, Frank could lose his job. If the partner sided with Frank, Maria’s future could be affected.

● Agree with Maria and accept Machine International Corp.’s accounting. The client will use a possibly inappropriate accounting method, and Bright and Lorren could face potential liability. Investors in Machine International Corp. could make bad investment decisions and lose money. Frank’s integrity would be compromised. He could find himself in even more compromising situations in the future if Maria perceived that he is lacking in moral fibre. Frank must also consider the possibility that Maria, with her greater experience, is right. If she is right, he could be very embarrassed.

● Resign from the audit and possibly the firm.

Frank will maintain his integrity but will be unemployed. The client


will continue to use a possibly inappropriate accounting method, and Bright and Lorren could face potential liability. Maria could be right, in which case Frank’s action would be wasted.

Make a recommendation or decision.

Consider all the possibilities and their implications and make a choice. It is important that your choice be made thoughtfully, taking into account the analysis you have done.

Frank should, as a minimum, tell another partner. Before he does so, however, he should tell Maria what he proposes to do so she can present her side of the issue. He should be respectful of the position of all other partners in the firm. Most, if not all, of the other partners in the firm would probably appreciate Frank’s willingness to express his opinion regarding the inappropriateness of the revenue recognition method used by the client.

b.

Bright and Lorren Certified General Accountants

INTER-OFFICE MEMO

Date: April 15, 2008

From: Frank Dorrance

To: Maria da Silva

Re: Machine International Corp.

Maria, further to our discussions, I would like to take this opportunity to set out the issues and my recommendations regarding the "bill and hold" revenue recognition method at Machine International Corp. As you are aware, the public perception of the fairness of financial statements has suffered over the past few years, especially in the wake of the U.S. financial scandals. The implementation of the Sarbanes-Oxley Act of 2002 in the United States and the corresponding CSA initiatives means that we, as professional accountants, must not only do the right thing, but must also be perceived to be doing the right thing. The conceptual framework in place in both Canada and the United States sets up a process for revenue recognition by focusing on four principles. Under these principles, revenue can be realized only when there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. I’ve done a fair bit of research and I am convinced that the "bill and hold" situation at Machine International Corp. is exactly the sort of thing that the OSC has questioned, so we need to be sensitive to the regulators’ ruling.


I realize that Machines International Corp. does not file with the OSC, so it could be argued that the views of the regulators are not relevant. However, whatever we do must consider the needs and interests of all stakeholders and be ethically sound (in compliance with CGA-Canada’s Code of Ethical Principles and Rules of Conduct). I am concerned that, if anything ever went wrong at Machines International Corp., we could be criticized by one of the minority shareholders for failing to act appropriately. In addition, there is the matter of association. We are associated with those financial statements, and CGA-Canada’s Code of Ethical Principles and Rules of Conduct expressly forbids us to be associated with information that is possibly false and/or misleading. I’m not saying that the statements are misleading; but if it turned out that they were and we hadn’t done anything, we could face serious repercussions. I feel strongly that this issue should be discussed with another partner. Therefore, I respectfully request your approval to discuss this issue with Norm. He has a great deal of experience in matters such as this, and I feel that he may be able to help us resolve the issue. I want what’s best for the firm. I feel I have a duty to all stakeholders — at Bright and Lorren, at Machines International Corp., and in the public — to make sure that we do the right thing. Please let me know your thoughts on this at your earliest convenience


Self-test 1

Question 4 solution

1. Independence is essential to auditors because users of financial statements expect an unbiased viewpoint in the public accountant’s attestation to the fairness of the financial statements. If the users believe that the auditors are not independent, the value of the audit function is reduced and probably eliminated.

2. Most other professionals (lawyers, doctors, dentists, and so on) represent their clients and perform services intended primarily to benefit their clients. They must be independent and objective in the advice that they give, in part because their clients or patients do not usually have the knowledge to challenge their recommendations. Usually, however, their interests and those of their clients are aligned. This is similar to the position that a public accountant is in when preparing tax returns or giving tax advice. When performing an audit or a review, however, the public accountant is performing a service meant to benefit mainly the users of the financial statements, who include people other than the client. The interests of the accountant (in serving this larger user group) may conflict with those of the client. In this sense, the independence of accountants is similar to that of judges: for both, a non-advocacy, unbiased, and impartial position is essential.

3. Independence in appearance is how independent auditors appear to fair-minded observers or outsiders such as users of financial statements. Independence in fact refers to whether auditors have maintained an attitude of independence throughout the engagement. For example, auditors could possibly maintain an attitude of independence in fact even though they held shares in a company and performed the audit. Auditors would not likely be independent in appearance in such a situation. Both independence in appearance and fact are essential, and the rules of professional conduct concern both.

4.

Independence in fact

Independence in appearance

Social consequences

1. It may cause auditors to permit misstatement to enhance personal wealth.

Users may perceive that auditors would permit misstatements to enhance personal wealth.

There are no social consequences to auditors not being permitted to own shares in companies they audit.


2. Accountants might assume they did the bookkeeping correctly and may not perform the audit with due care.

Users may perceive that auditors may not independently audit their own work.

Some clients find it less expensive to have bookkeeping services performed by an outside service. It is often less expensive to have this done by the auditor because the auditor will already be knowledgeable about the business.

3. A careful independent check of the entries or preparation of the statements may not be done because the auditor originally prepared the statements.

Users may believe that auditors may not independently audit their own work or that of staff from their own firm.

Many clients lack technical expertise in auditing. Having services performed by the auditor is sometimes the least costly alternative.

4. Auditors may be reluctant to criticize an accounting system originally recommended by their own public accounting firm. Additionally, if the firm obtained considerable revenue from management services, the firm may fear the loss of the client and, in this way, the client may control the work of the auditors.

Users may perceive either of the two concerns listed under independence in fact.

A public accounting firm gains considerable knowledge about a client and its business during the audit. Due to this knowledge, management services can often be provided by the same firm at a lower cost than another firm or management consultants.

5. Auditors may become complacent due to familiarity and, therefore, not carefully evaluate potential misstatements.

Users may perceive the possibility of complacency.

Knowledge gained by the audit team about a client’s business is essential to evaluate possible misstatements in the financial statements and to plan the audit. It is costly for a new audit team to obtain that knowledge.


6. The accounting firm may become complacent due to familiarity and, therefore, not carefully evaluate potential misstatements.

Users may perceive the possibility of complacency.

The conclusions reached above about the audit team are also applicable to public accounting firms. The cost of obtaining the knowledge to a new firm is even greater because of confidentiality requirements and communication difficulties between firms.

7. Auditors may be unwilling to disagree with the audit committee for fear of being terminated.

Users may perceive that the auditors are unwilling to disagree with management.

Someone has to select the auditor. The audit committee is the body that must evaluate the effectiveness and cost of alternative auditors.


Documents

Module 01