Chapter 9

Effective audit function

1. How can an effective audit function be achieved?

An effective audit function is achieved by improving the following:
 Auditor selection and client acceptance processes.
 Audit quality and its relation to audit fees.
 Evidence-gathering procedures.
 Integrated audit approach.
 Auditor independence.
 Audit and nonaudit services.
 Audit opinion.
2. Explain the term “expectation gap” in auditing.
Expectation gap is the difference between what the investing public and other users of
audited financial statements believe the responsibilities of auditors are and what
auditors are willing to assume as responsibilities according to their professional
standards.
3. Explain the initiatives to be taken to improve audit quality as well as the
transparency of the audit process and report.
 Publication of audit engagement letters.
 Shareholder rights to question auditors.
 Publication of auditor resignation statements.
 Lead partner’s signature on audit reports.
 Annual shareholder annual ratification of the audit firm.
4. What are the structural factors of accounting that provide opportunities for bias to
influence judgment?
 Ambiguity.
 Attachment.
 Approval.
5. What is the underlying basis of audit firm rotation?
To reduce the likelihood of economic ties and friendship with clients, public
accounting firms must be rotated and clients must be prohibited from rehiring the
accounting firm at the end of the contract for a given period of time.
6. Explain the “pass/fail” approach utilized by the current auditing model.
The pass/fail approach states whether financial statements are presented fairly in
conformity with GAAP (pass) or not (fail) without providing any information
regarding the quality of audited financial statements.
7. What are the three categories in which internal control deficiencies are classified
according to Auditing Standard No. 2?
 Inconsequential deficiencies.
 Significant deficiencies.
 Material weaknesses.
8. Explain the different types of opinions on internal control over financial reporting.
 Unqualified opinion—An unqualified opinion can be rendered when there are no
identified material weaknesses in ICFR and no scope limitations.
  Adverse opinion—An adverse opinion should be rendered when there are
significant deficiencies in the company’s ICFR that result in one or more material
weaknesses.
 Qualified/disclaimer opinion—A disclaimer of opinion should be given when there
is a scope limitation and the auditor cannot express an opinion on management’s
assessment of the effectiveness of the company’s ICFR.
9. What are the four tests used to classify tax planning as aggressive?
 The auditor provides any service related to the plan or opinion.
 The idea was not initiated by the client.
 A significant purpose of the idea was to avoid taxes.
 The plan has a less than 50-50 chance of prevailing if challenged by the IRS.
10. Explain several of the steps followed by the PCAOB for its inspection process.
 Selecting the audit clients based on the PCAOB’s assessment of the likelihood of
material misstatements or significant audit deficiencies.
 Reviewing aspects of the selected audits by each firm.
 Choosing the engagements to review according to the PCAOB’s criteria.
 Retraining the accounting firm to limit or influence the engagement selection
process or any other aspect of inspection review.
 Reviewing the selected audit clients’ financial statements and certain SEC filings.
11. Explain the importance of the inspection report.
 It improves audit effectiveness by identifying and requiring resolution of audit
failures.
 It identifies and properly addresses emerging and common accounting and
auditing issues.
 It improves the audit firm’s system of quality control and evidence-gathering
procedures.
 It assists the PCAOB in establishing appropriate auditing, quality control, and
ethics standards.
 It enhances public trust and investor confidence in the auditing profession.
12. How are PCAOB enforcement investigations coordinated with those of the SEC?
 The PCAOB staff meets frequently with the SEC staff.
 The PCAOB staff attends SEC testimony of auditors.
 The SEC staff sits in on PCAOB testimony without asking questions.
13. When does the audit committee monitor auditor independence and why?
The committee monitors auditor independence during:
 The appointment process by being directly responsible for hiring, firing,
compensating, and overseeing the work of the auditor.
 The planning stages of the audit to ensure that management is not influencing the
audit plan or scope of the audit.
 The evidence-gathering phase of the audit to ensure that the auditor has access to
all information, records, schedules, and financial statements, and the scope of the
audit was not limited.
 The reporting phase to ensure auditor judgment and opinion were not influenced
by management or a sense of loyalty to the company.
14. How can the audit committee ensure proper disclosures of auditor independence?
The committee ensures proper disclosures by receiving auditor independence
confirmation from the company’s independent auditor prior to the filing and
distribution of audited financial statements.
15. Explain the term auditor independence and the principles it is based on.
 Auditor independence is defined as freedom from those pressures and other factors
that compromise, or can reasonably be expected to compromise, an auditor’s ability to
make unbiased and objective audit decisions. It is based on three basic independence
principles:
 Auditors cannot be part of management or its team.
 Auditors cannot audit their own works.
 Auditors cannot serve in advocacy roles as specified by the SEC.
16. Explain the dual testing of controls and substantive tests.
It is an integrated audit approach in which auditors test controls at both the entity-level
and the transaction-level along with substantive tests.
17. What are the four aspects of the financial reporting process that are targeted by
SOX as needing improvement?
 Misstatements or omissions in financial statements.
 Internal control deficiencies.
 Accounting estimates.
 Fraud.
18. What are the six steps for the effective assessment of company-level controls?
 Engage in gap remediation and continuous improvements.
 Test the effectiveness of company-level controls.
 Document and assess company-level controls.
 Obtain input on the design and operation of company-level controls.
 Build an assessment structure for company-level controls.
 Define the project plan and key milestones.

19. Explain Auditing Standard No. 3: Audit Documentation.
AS No. 3 governs audit documentation by requiring the auditor to prepare and
maintain—for at least seven years—audit documentation in sufficient detail to support
the conclusion reached in their reports.
20. What is the PCAOB proposed standard on auditor independence and what
circumstances consider auditor independence impairment?
The PCAOB proposed standard on auditor independence identifies four circumstances
that would be considered an impairment of auditor independence when performing tax
services for their audit clients. These circumstances are:
 Registered auditors perform tax services on contingent fee arrangements for their audit
clients.
 Auditors provide aggressive tax planning.
 Auditors perform aggressive tax shelters.
 Auditors provide tax services to top executives of audit clients.

Discussion Questions
1. “The public trust in auditors’ judgments and reputation is vital in regarding the
audit function as value-added services that lend credibility to published financial
reports.” Do you agree or disagree with the given statement? Explain your answer.
The audit function is considered value-added when it lends credibility to published
financial statements by reducing the information risk associated with those statements.
When auditors provide assurance services, they are providing their opinion by
utilizing their professional judgment. Public trust in such a judgment depends on the
reputation of the auditor and the firm with which he or she is employed. If the public
does not trust the reputation of the firm or the judgment of the auditor, questions may
 arise regarding the accuracy of the object of assurance. Thus, if the auditor or firm is
considered to be untrustworthy, their services may not be considered value-added or
helpful to the organization or its stakeholders.
2. According to the author, an auditor has two responsibilities: to express and opine on
the true and fair presentation of financial statements in conformity with GAAP, and at
the same time, to assess the quality of the reports. Do you feel it is possible for an auditor
to discharge both duties? Explain your answer.
This audit function can be achieved by improving the following: (1) the auditor
selection and client acceptance process; (2) audit quality and its relation to audit fees;
(3) evidence-gathering procedures; (4) the integrated audit approach; (5) auditor
independence; (6) audit and nonaudit services; and (7) the audit opinion.
3. Confidence and public trust in auditors have been reduced due the concern that
auditors serve the interests of management who write their checks rather than the
shareholders who eventually pay their fees. Do you agree or disagree? Explain your
answer.
The wave of financial scandals along with financial restatements by high-profile
public companies and related audit failures eroded public trust and investor confidence
in financial reports and audit functions. Many concerns have been raised regarding the
challenges confronting the accounting profession in the aftermath of these scandals
and the related regulatory responses. Since the passage of SOX, the audit committee is
responsible for compensating the audit firm rather than management. Hopefully this
and other measures will improve corporate governance and thus boost investor
confidence and public trust in auditors.
4. Explain the importance of public accounting firms in a capital market.
Auditors attest to the statements of management, within material respects, giving
credibility to management’s statements and allowing stakeholders to make decisions
regarding with reasonably accurate management representations. If the representations
of management were not seen as credible, investors and other stakeholders could not
rely on information from management. This would lead to inefficient markets and a
volatile economy. Thus, the services of public accounting firms are important to the
function of the markets and the economy through reducing information risk associated
with the information disseminated to the capital markets.
5. Do you think it is right to eliminate incentives that cause auditor self-serving biases
in order to improve the quality of the audit? Substantiate your answer.
Eliminating any conflicts of interest the auditor may experience is helpful in
improving the quality of the audit. This improves the auditor’s objectivity, and also
aids in establishing the auditor’s credibility. When auditor objectivity is enhanced, the
quality of the audit is improved.
6. Is there any difference between tax planning and abusive tax shelters? Explain your
point of view.
There is no standard or law defining the term “tax shelter” or differentiating between
“tax planning,” which is a legitimate means of reducing tax liability, and “abusive tax
shelter,” which is illegal. Nonetheless, abusive tax shelters are characterized as
“transactions in which a significant purpose is the avoidance or evasion of federal,
state, or local tax in a manner not intended by the law.”
7. Explain why auditor independence is backbone of the auditing profession.
Auditor independence lends credibility to the auditor and maintains a solid reputation
for the firm in which he or she is employed. If auditor independence is impaired, the
reputation of the auditor and the auditing firm could be placed in jeopardy due to legal
actions taken by regulatory bodies against the firm and decreased confidence in audit
reports issued by the firm.
8. Explain how internal auditors are important in performing the integrated audit.
Effective communication between the audit committee, internal auditors, and other
corporate governance participants is an important part of the integrated audit process.
The audit committee should meet with the company’s CFO, internal auditor,
independent auditor, and legal counsel to discuss the integrated audit of annual
financial statements, including management’s assessment of the effectiveness of
ICFR, auditor report on management’s assessment, and audit of annual financial
statements, to evaluate the overall integrity and quality of financial reports before they
are filed or distributed.
9. Do you think auditors are solely responsible for any audit failure? What steps would
you, as an auditor, take to ensure that you are minimally blamed for a business failure?
Auditors may not always be solely to blame for audit failures, since unethical behavior
and earnings management schemes may sometimes be kept hidden from auditors even
when due diligence is used in the audit process. However, sometimes auditors may
look the other way when fraud is perpetrated by members of the audited organization.
In such cases, the auditors would be responsible for the audit failure. Auditors can
practice due diligence and take steps to enhance independence from the client to
decrease the occurrence of possible audit failures.
10. “Critics argue that any contractual provisions that limit the external auditor’s
liability or require waiving the right to a jury trial may have detrimental effects on
auditor impartiality, objectivity, and quality.” Express your views on the given
statement.
Some may argue that auditor liability should be limited on the grounds that such a
limitation could protect auditors from the consequences of auditing an organization
that has engaged in fraudulent activities or unethical behavior without catching such
activity. Others may argue that a limitation of auditor liability would result in
decreased audit quality, since the consequences of providing the wrong opinion are
lessened.
11. Discuss briefly the steps established by the PCAOB for its inspection process.
The inspection process consists of: (1) selecting audit clients based on the PCAOB’s
assessment of the likelihood of material misstatements or significant audit
deficiencies; (2) reviewing aspects of the selected audits by each firm; (3) choosing
the engagements to review according to the PCAOB’s criteria; (4) retraining the
accounting firm to limit or influence the engagement selection process or any other
aspect of inspection review; (5) reviewing the selected audit clients’ financial
statements and certain SEC filings; (6) selecting certain higher-risk areas for review
(e.g. revenue recognition, confirmation); (7) reviewing the selected areas of revenues,
reserves or estimated liability, income taxes, related party transactions, derivatives,
supervision of work performed by foreign affiliates, internal control assessment and
documentation, and risk assessment; (8) analyzing end-of-the year closing and
adjusting entries, particularly adjustments that were suggested by the auditor and were
not booked by the client; (9) reviewing written communications between the auditor
and the client’s management; (10) reviewing written communication between the
auditor and the client’s audit committee; (11) conducting an interview with the
 chairperson of the audit committee of the selected audit client; (12) discussing
unresolved aspects of the inspection process with the personnel from the firm’s
national offices if the issues cannot be resolved through review of work papers and
discussion with the engagement team; (13) selecting additional audits if necessary to
follow leads to the root of audit deficiencies (e.g., other audits performed by the same
audit partner or engagement team); (14) reviewing other work performed by internal
reviewers who missed the reviewed partner’s errors; (15) identifying and resolving
audit deficiencies and problems early in their development; (16) inviting the public
accounting firm to comment on the discovered potential material accounting errors
and significant audit deficiencies; (17) discussing the discovered audit problems with
audit firm representatives including members of the engagement team, the firm
representative responsible for the inspection process, national office experts, the
managing partner, or the firm’s CEO; (18) addressing audit problems, lack of
performing necessary audit procedures, and quality control requirements; (19)
disclosing the public portion of the inspection report on the PCAOB Web site; and
(20) disclosing the nonpublic portion of the inspection report primarily regarding the
firm’s quality control system and other PCAOB communication to the audit firm and
out of public view unless the firm fails to take proper action to correct the identified
audit failures in due time.
12. Explain the importance of auditor independence in the auditing profession and to
society and the investing community.
Auditor independence establishes and maintains the credibility of the auditing
profession, and instills confidence in the investing community and society regarding
the work of audit professionals. Confidence in the work of audit professionals may
dwindle if such independence were impaired, calling into question the value-adding
nature of such audit services.
13. How do external auditors lend credibility to the corporate governance structure?
The independent auditor assurance function provides reasonable assurance that
financial statements are free from material misstatements due to error and fraud, and
expresses an opinion on the fair presentation of financial statements in conformity
with GAAP. Registered auditors are also required to express an opinion on
management’s assessment of the effectiveness of the design and operation of ICFR as
well as an opinion on the effectiveness of internal control itself. The auditor assurance
function is intended to lend credibility to financial reports and reduce information risk
that financial reports are biased, misleading, inaccurate, or incomplete.

True or False
1. According to modern company law, effective reporting and accounting are essential for
effective governance.
2. The Securities Exchange Act of 1934 requires that companies offering stock to the public
in raising capital must have their financial statements audited by an independent public
accountant.
3. Corporate governance reforms do not mandate external auditors to be independent.
4. The IAASB defines reasonable assurance as absolute in nature.
5. Technical competencies are considered to be the auditors’ knowledge of relevant
professional standards, rules, laws, and regulations.
6. Reporting competencies are the auditor’s ability to choose appropriate evidence-gathering
procedures.
7. When considering the audit function as a value-added service, public trust in auditors’
judgments and reputation is very important.
8. One of the primary purposes of corporate governance reforms is to improve the quality
and credibility of financial statement audits and audit reports.
9. One of the missions of the CPCAF is to provide leadership through sponsoring public
forums and periodic meetings with interested groups.
10. Ethics education is sufficient to have an impact on bias.
11. The nature and extent of management’s documentation of internal controls in providing
reasonable support for management’s assessment plays an important role in performing tests
of controls.
12. PCAOB standards allow public accounting firms to provide tax shelter services to their
audit clients that impair their independence.
13. Conducting an interview with the chairperson of the audit committee of the selected audit
client is part of the inspection process followed by the PCAOB.
14. The audit committee is directly responsible for hiring and compensating the company’s
independent auditor.
15. Independent auditors can gather information not provided by management through
inquiries of the audit committee.
16. Communications from the audit committee to the independent auditor do not include
formal approval of audit and permissible nonaudit services.
17. SOX, SEC-related rules, and PCAOB standards are intended to strengthen auditor
independence by linking audit partner compensation to audit quality and not to revenues
received.
18. The evidence-gathering phase requires an auditor to review work papers to ensure that the
audit was conducted in accordance with PCAOB audit standards.
19. The materiality concept has an important role in assessing the reasonableness of
accounting estimates.
20. Public companies are exempted from filing the 11-K report with the SEC.
21. When an independent auditor issues an adverse opinion indicating that there is a material
weakness in internal control, a stand-alone audit engagement may be desired.

True or False
1. True
2. True
3. False
4. False
5. True
6. False
7. True
8. True
9. True
10. False
11. True
12. False
13. True
14. True
15. True
16. False
17. True
18. True
19. True
20. False
21. True

Multiple Choice Questions

1. Independent auditors are required to document their assessment of reasonable
assurance through the use of:
a. The materiality concept.
b. The audit risk model.
c. Both (a) and (b).
d. Neither (a) or (b).
2. External auditors are not and should not be expected to provide absolute assurance
regarding reliability of financial statements primarily because of:
a. The nature and limitation of evidence-gathering procedures.
b. Management assertions and financial representations that are not certain by nature.
c. The possibility of false documentation.
d. All of the above.
3. According to academic studies conducted for audit quality, which of the following
statement(s) is (are) correct:
a. Big accounting firms are perceived as more likely to disclose a discovered error.
b. There is a negative relationship between auditor tenure and the discovery of material
misstatements for the early years.
c. Financial reporting quality is negatively affected by having a large audit firm audit
financial statements.
d. All of the above.
4. SOX adds stipulations surrounding employee affiliation between clients and
auditors. For example, the audit staff is prohibited from accepting a key financial
position with the audit clients for at least:
a. Five years.
b. Three years.
c. Two years.
d. One year.
5. An advantage of the pass/fail audit approach is that:
a. It does not reflect the quality of the financial statements.
b. It does not provide relevant or useful information to investors regarding the quality of
the company as an investment or credit risk.
c. It is standard pass/fail language that provides uniformity and improves comparability.
d. It focuses on fair presentation rather than true and accurate presentation of financial
position and results of operations.
6. A company’s ability to initiate, measure, authorize, and report financial information
in accordance with GAAP is affected by:
a. Significant deficiencies in internal control.
b. Inconsequential deficiencies in internal control.
c. Material weaknesses in internal control.
d. None of the above.
7. PCAOB AS No. 3 requires auditors to prepare and maintain audit documentation in
sufficient detail for at least:
a. Three years.
b. Five years.
 c. Four years.
d. Seven years.
8. Audit firms are permitted to perform which of the following tax services for their
audit clients?
a. Routine tax return preparation and tax compliance.
b. General tax planning and advice.
c. Employee personal tax services.
d. All of the above.
9. Sections 201 and 202 of SOX require that all audit and permissible nonaudit services
performed by the company’s independent auditor must be approved by the:
a. Audit committee.
b. Board of directors.
c. CEO.
d. None of the above.
10. Rotation requirements for audit partners other than the lead and concurring
partners involved in an engagement are:
a. Maximum of seven years on and subject to a two-year timeout.
b. Maximum of two years on and subject to a seven-year timeout.
c. Maximum of five years on and subject to a one-year timeout.
d. Maximum of three years on and subject to a two-year timeout.
11. The PCAOB proposed standards and Section 201 on auditor independence prohibit
registered auditors from participating in which of the following activities?
a. Financial information system design and implementation.
b. Internal auditing outsourcing engagements when acting as external auditor.
c. Managerial duties.
d. All of the above.
12. Section 206 of SOX prohibits:
a. Auditors from performing an audit where the CEO or other senior financial executive
was employed by the auditor during the preceding year.
b. Auditors from providing any nonaudit services to the company contemporaneously
with audit services.
c. Lead audit or concurring partner and reviewing partner from rotating off the audit
every five years.
d. Auditors from reporting to the audit committee all critical accounting policies and
practices used.
13. Auditor independence provisions along with listing standards of national stock
exchanges and auditing best practices are designed to supply which of the following
benefits to corporate governance?
a. Reduce potential conflicts of interest between auditors and their client’s management.
b. Replace self-regulation and peer reviews.
c. Limit the type of nonaudit services public accounting firms can perform.
d. None of the above.
14. The evidence-gathering activities of an integrated audit engagement consist of:
a. Tests of controls performed on ICFR.
b. Substantive tests performed on account balances and transactions.
c. Both (a) and (b).
d. Neither (a) nor (b).
15. Trend in earnings used by auditors to establish planning materiality is an example of
which of the following?
a. Quantitative factor.
 b. Qualitative factor.
c. Allocation factor.
d. None of the above.
16. If a detected misstatement is considered to be material then the auditor should:
a. Ask management to correct the misstatement.
b. Use quantitative analysis to solve to problem.
c. Perform tests of controls.
d. Decide on the materiality of the detected misstatements.
17. Controlling the detection risk is the primary responsibility of the:
a. Management.
b. Auditor.
c. CEO.
d. Controller.
18. Company-level controls identified by COSO are related to the company’s:
a. Control environment.
b. Board of directors’ effectiveness.
c. Management competency.
d. All of the above.
19. Which of the following is (are) guidelines provided by the PCAOB?
a. Communication with audit clients regarding internal control issues should be
minimized.
b. Use of a bottom-up approach of focusing on company-level controls should be
implemented.
c. Audits of internal control and financial statements should be integrated.
d. All of the above.
20. Establishing and overseeing an independent Audit Inspection Unit is the
responsibility of which of the following boards?
a. Professional Oversight Board (POB), formerly Professional Oversight Board for
Accountancy (POBA).
b. Auditing Practices Board (APB).
c. Accountancy Investigation and Discipline Board (AIDB).
d. Both APB and AIDB.
21. Independent auditors are subject to which of the following liabilities?
a. Civil liability.
b. Criminal liability.
c. Both civil and criminal liabilities.
d. Neither civil nor criminal liability.
22. The adopted Interim Professional Standards are existing standards promulgated by
the AICPA and are classified by the PCAOB into five categories out of which rule 3300T
stands for:
a. Interim Attestation Standards.
b. Interim Quality Control Standards.
c. Interim Ethics Standards.
d. Interim Auditing Standards.

Multiple Choice Questions

1. c.
2. d.
3. a.
4. d.
5. c.
6. a.
7. d.
8. d.
9. a.
10. a.
11. d.
12. a.
13. a.
14. c.
15. b.
16. a.
17. b.
18. d.
19. c.
20. a.
21. c.
22. a.