A.

Short Questions

1. Why should auditors act as though there is always a potential conflict of interest between the
auditor and the management of the enterprise under audit?

The auditor must act as though there is always a potential conflict of interest between the auditor and
the management of the enterprise so that he may perform procedures to search for errors or frauds
that would have material effect on financial statements. This tends to make more extensive for the
auditor and more expensive for the client.

2. What benefits are claimed for auditors' preliminary assessment of materiality as a matter of
audit planning? Is Php500,000 a material amount of misstatements to leave uncorrected in the
financial statements?

The benefits of preliminary assessment of materiality help fine tune the audit for effectiveness and
efficiency, as well as help auditors avoid underperforming or overperforming audit services. 500,000
may be a material amount if it arises from an illegal act and based on absolute size. Based on relative
size, it is not material if it is less than 5% of a relevant base; it may be material if it is between 5%
and 10%; and material if it is 10% or more of the relevant base.

3. Give examples of conditions or events which increase the risk of fraud or error.

Conditions or events that may increase the risk of fraud and error include:

 Questions with respect to the integrity of or competence of management

 Unusual pressures within or on an entity
 Unusual transactions
 Problems in obtaining sufficient appropriate audit evidence

4. PSA 320 states that the auditor should consider materiality and its relationship with audit
risk when conducting an audit. Explain briefly the relationship between materiality and audit
risk.

There is an inverse relationship between levels of audit risks and materiality. That is, the higher the
audit risk, the lower the materiality level required and vice versa. (b) to reduce detection risk by
modifying the nature, timing and extent of planned substantive procedures.

5. In what ways was the auditing profession partially responsible for corporate governance
failures in the past decade?

Some of the ways in which the auditing profession was partially responsible for corporate
governance failures in the past decade were:

 Too concerned about creating “revenue enhancement” opportunities for the firm, and less
concerned about their core services or talents
 Applying the “push” accounting standards to the limit to help clients achieve earnings goals
  Using more audit shortcuts such as inquiry and analytical procedures instead of direct testing
of account balance
 Relied on management representations instead of testing management representations
 Too often ‘advocates’ of management rather than protectors of users

6. An audit committee should be composed of outside directors. Define "independent

directors" within the context of audit committee.

An independent director is not a member of management, legal counsel, a major vendor, outside
service provider, former employee, or others who may have a personal relationship with management
that might impair their objectivity or independence. The audit committee is responsible for assessing
the independence of the external auditor and engage only auditors it believes are independent.

7. Identify the specific items that must be communicated by the external auditor to the audit
committee every engagement.

Specific items that must be communicated by the external auditor to the audit committee every
engagement may include:

• All adjustments that were not made during the course of the audit
• Difficulties in conducting the audit
• The auditor’s assessment of the accounting principles used and overall fairness of the
financial presentation
• The client’s consultation with other auditors
• Any consultation with management before accepting the audit engagement
• Significant deficiencies in internal control.

8. How would an auditor go about assessing the quality of an organization's corporate

governance? Consider the policy that a company may have good governance.

The auditor may observe how the audit committee function by participating in meetings and taking
note of the quality of the audit committee questions and responses, interact with management
regarding issues related to audit, review the minutes of the board of directors meetings to determine
if their consistency with good governance, review internal audit reports, review compensation plan
for top management, and review management’s statements to the financial press to determine their
consistency with the company’s operations.

B. Case

One of the criticisms of corporate governance in the last decade was that there was a failure in
corporate governance.
a. Define the term corporate governance and identify the major parties involved in corporate
governance as well as their roles.
Corporate governance is defined as the system by which companies are directed and controlled.
Boards of directors are responsible for the governance of their companies. The shareholders' role in
governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate
governance structure is in place.
b. Identify the failures in corporate governance that took place in the past decade. Include the
failures of each major party in the process.

• Stockholders: Focused on short-term prices; failed to perform long-term growth analysis;

abdicated all responsibilities to management as long as stock price increased.
• Board of directors: inadequate oversight of management; non-independent, often dominated
by management; did not spend sufficient time or have sufficient expertise to perform duties;
continually re-priced stock options when market price declined.
• Management: fraudulent financial reporting; pushing accounting concepts to achieve
reporting objective; viewed accounting as a tool, not a framework for accurate reporting
• Audit committee: did not have expertise or time to provide effective oversight of audit
functions
• External auditors: pushed accounting concepts to the limit to help organizations achieve
earnings objectives; promoted personnel based on ability to sell “non-audit products”;
replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and
analytics
• Internal auditors: focused efforts on ‘operational audits’ and assumed that financial auditing
was addressed sufficiently by the external audit function; reported primarily to management
with little effective reporting to the audit committee

c. Briefly explain why there is a relationship between corporate governance and risk to the
auditor.

This relationship exists because there is more likelihood that the organization will have
misstatements in its financial statements because there is a lack of commitment to a strong
organizational structure and oversight. In addition, there is greater risk to the auditor because the
governance structure is not designed to prevent or detect such misstatements.