1.1 What is the “special function” that auditors perform?

Whom does the public

accounting profession serve in performing this special function?

The “special function” is when an independent auditor assumes a public responsibility

transcending any employment relationship with the client. The public accountant that performs
this function owes ultimate allegiance to the corporation’s creditors and stockholders as well as
to the investing public. They are also known and should be viewed as guardians of the capital
markets. Certified public accountants serve a number of different parties, but the most important
is the public, as represented by investors, lenders, workers, and others who make decisions based
on financial information about an organization. They also serve management, financial
institutions, taxing authorities, investors, regulatory agencies, labor and labor unions,
bondholders, court system, vendors, retired employees.

1.2 Describe the audit opinion formulation process. What are the key steps within each of

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the five phases in the process?

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An auditor must make a decision that carries a very low risk of being in error. To minimize
this risk the auditor pays a great deal of attention to client selection and retention. Once the

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client is accepted, the auditor needs to thoroughly understand the client’s business, its
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industry, its competition, and its management and governance processes to determine the
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likelihood that financial account might be in error. The auditor with also gain an
understanding of the client’s internal control over financial reporting, and in some audits, will
decide to test those controls. Then the testing of account balances occurs. Finally, the auditor
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will makes a decision about (a) whether enough evidence has been gathered to support an
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audit opinion and (b) why type of opinion should be issued.

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Phases I and II: Making Client Decisions and Gaining and Understanding of the Client
• The client’s business and the industry within which it operates
• Business risks the company faces and how it affects it
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• Fraud risks
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• Management compensation plans used a motivators

• Appropriate levels of materiality
• Quality of design in internal controls
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• Managements approach to assessing internal controls

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• Accounting policies and procedures

• Financial statement items more likely to require adjustments
Phase III and IV: Obtaining Evidence
• Management Assertions
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• Audit Procedure to Test Assertions

Phase V: Wrapping up the Audit and Making Reporting Decisions
• Adjust financial statements
• Report that they are either misrepresented or not
• OR not enough evidence has been gathered to report on the financials

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 1.3 What failure was Congress trying to address in passing the Sarbanes-Oxley Act of
2002? Identify some ways in which that Act affected the public accounting profession.

There were several failures that Congress was trying to address by passing the Sarbanes-
Oxley Act:
• The failure of one of the largest public accounting firms in the world (Arthur
Andersen & Co.)
• Four of the largest bankruptcies in history--- each of the bankruptcies occurred in the
companies where financial statement misrepresentation had taken place
• Billions of dollars in investment and retirement fund losses
• A sense that auditors were not independent of management
• A question as to whether the public accounting profession could sufficiently govern
itself to ensure that it would always act in the public interest
This act affected the public company audit firms in the areas of:

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• Auditor independence and the role of the audit committee

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• Required reporting on internal control over financial reporting

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• Oversight of the accounting profession

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1.4 How does a financial statement audit differ from broader assurance services with
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respect to providing reports to third parties? Explain in terms of the scope of the
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activity and the potential users.

Broader assurance services it is optional, but not required to report to a third party. It can
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only include the report to the party requesting the assurance. The scope of the broader
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assurance services can include; business processes, control processes, risk analysis, non-
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financial performance data, and financial information. The audited financial statements
are provided to third-party users have a vest interest in the organization. The scope of the
audited financial statements are the financial assertions made by management, quality of
internal control, compliance with regulatory requirements, or a wide variety of other
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items where there is a market for such services.

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1.5 The term professional judgment is used throughout the chapter. In what ways might an
auditor be called upon to exercise professional judgment in the course of performing an
audit? To what extent does professional judgment rely on principles rather than rules?
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Explain.
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 1.6 What factors create a need for independent assurance? Explain how these factors are
important to the public accounting profession.

• Potential bias in providing information, that is, management may want to convey a better
impression of the financial data than real circumstances merit
• Remoteness between a user and the organization or trading partner
• Complexity of the transactions, information, or processing systems such that it is difficult to
determine their proper presentation without a review by an independent expert
• Consequences to investors, and others of relying on inaccurate information can be quite
significant

Each of these factors is important because statement cannot favor one over the other. All users
are important. Capital markets are built on transparent financial reporting. The financial
statements reflect, within the limits of the accounting model, a true and fair view of the

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organizations financial results. These factors eliminate that risk that information provided by

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management may not be accurate. It creates trust with the public.

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1.7 A financial statement audit involves attesting to management assertions by reference to
pre-established criteria. What serves as the criteria to judge the fairness of financial
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statements? Explain why “reference to criteria” is important to the audit function and
the results communicated by the audit function.
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The pre-established criterion is GAAP, this serves as the criteria to judge the fairness of
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the financial statements. The references to these criteria are important to the audit
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function because they are guidelines of all companies within the United States to make
sure they are reporting the same and with this criteria it makes it easier for audits to be
uniform and treat each company the same, as well as, pick out the companies that may be
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doing illegal things with their financial reporting. The results reported by audit function
are a ways that the public can be reliable on that company.
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1.8 How does complexity affect (1) the demand for auditing services and (2) the
performance of auditing services?
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Complexity affects the demand for auditing services because of the vast amount of
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transactions, information, and processing systems it requires a high demand of very skilled
auditors because companies do not want to face lawsuits if their financial reports are
misrepresented. It is difficult to determine their proper presentation without a review by an
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independent expert. Third party users depend on managers and auditors to deal with such
complexities as financial instruments, derivatives, long-term contracts, and other complex
transactions to ensure that their performance of the auditing services are fairly presented and
fully disclosed in financial statements.

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 1.9 Compare the AICPA’s “ten generally accepted auditing standards” (historically used)
with the newly issued “Principles Governing an Audit in Accordance with Generally
Accepted Auditing Standards”.

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1.10 Who is the more important user of an auditor’s report on a company’s financial
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statements: company management, the company’s shareholders, or the company’s
creditors? Briefly explain your rationale and indicate how auditors should resolve
potential conflicts in the needs of the three parties.
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The most important user is the public, which are the company’s shareholder. These people
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are the most important because they are the ones who make decisions based on the financial
information about the organization.
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1.11 How does an audit enhance the quality of the financial statements and
management’s reports on internal control? Does an audit ensure a fair presentation of a
company’s financial statements or that internal control systems are free of material
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weaknesses? Explain.
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The auditor’s job is to obtain reasonable assurance about whether management’s statements
are materially accurate and to provide a publically available report based on the auditor’s
findings. The audited financial statements are provided to third-party users who have a vested
interest in the organization. For the auditors to complete their job; management has
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responsibilities for (a) preparing and presenting financial statements in accordance with the
applicable financial reporting framework, (b) designing, implementing, and maintaining internal
control over financial reporting, and (c) providing that auditors with information relevant to the
financial statements. An audit is designed to give a reasonable or positive assurance that the

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 statements are materially accurate presentation of the company’s performance and financial
condition.

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