Chapter 1: Audit and Assurance Services

1-6
Describe the nature of the evidence the tax inspector will use in the audit of Techno
Company’s tax return.

Answers
The primary evidence the tax inspector will use in the audit of the Techno Company’s tax return
includes all available documentation and other information available in Techno’s office or from
other sources. For example, when the tax inspector audits taxable income, a major source of
information will be bank statements, the cash receipts journal and deposit slips. The tax inspector
is likely to emphasize unrecorded receipts and revenues. For expenses, major sources of
evidence are likely to be cancelled checks, vendors’ invoices and other supporting
documentation.

1-7
In the conduct of audits of financial statements, it would be a serious breach of
responsibility if the auditor did not thoroughly understand accounting. However, many
competent accountants do not have an understanding of the auditing process. What causes
this difference?

Answers
This apparent paradox arises from the distinction between the function of auditing and the
function of accounting. The accounting function is the recording, classifying and summarizing of
economic events to provide relevant information to decision makers. The rules of accounting are
the criteria used by the auditor for evaluating the presentation of economic events for financial
statements and he or she must therefore have an understanding of International Financial
Reporting Standards and relevant national accounting standards, as well as auditing standards.
The accountant need not, and frequently does not, understand what auditors do, unless he or she
is involved in doing audits, or has been trained as an auditor.

1-8
What are the differences and similarities in audits of financial statements, compliance
audits, forensic audit and operational audits?

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Answers:
The differences and similarities between different types of audits are set out in the table below.

Audits of
Operational Compliance financial Forensic
audits audits statements audits
Purpose To evaluate To determine To determine To investigate
whether whether the whether the cases of fraud in
operating client is overall financial financial
procedures are following statements are statements,
efficient and specific presented in accounting
effective procedures set by accordance with records and
a higher specified criteria documents used
authority in an
organization’s
operations
Users of Management of Authority setting Different groups Different groups
audit report organization down for different for different
procedures, purposes—many purposes—many
internal or outside entities outside entities
external
Nature Highly Not standardized, Highly Highly
nonstandard; but specific and standardized nonstandard;
often subjective usually objective always objective
Performed by: Almost
CPAs Frequently Occasionally universally Never
GAO auditors Frequently Frequently Occasionally Occasionally
Tax inspectors Never Universally Never Occasionally
Internal auditors Frequently Frequently Frequently Occasionally

1-9
List three examples of specific operational audits that can be conducted by an internal
auditor in a manufacturing company.

Answers:
Three examples of specific operational audits that could be conducted by an internal auditor in a
manufacturing company are:

1. Examine employee time cards and personnel records to determine if sufficient information is
available to maximize the effective use of personnel.
2. Review the processing of sales invoices to determine if it could be done more efficiently.
3. Review the acquisitions of goods to determine if they are being purchased at the lowest
possible cost considering the quality needed.
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1-15 The following questions deal with audits by audit firms. Choose the best response.
a. Which of the following best describes why an independent auditor is asked to express an
opinion on the fair presentation of financial statements?
(1) It is difficult to prepare financial statements that fairly present a company’s financial
position, operations, and cash flows without the expertise of an independent auditor.
(2) It is management’s responsibility to seek available independent aid in the appraisal of
the financial information shown in its financial statements.
(3) The opinion of an independent party is needed because a company may not be
objective with respect to its own financial statements.
(4) It is a customary courtesy that all stockholders of a company receive an independent
report on management’s stewardship of the affairs of the business.
b. Independent auditing can best be described as
(1) a branch of accounting.
(2) a discipline that attests to the results of accounting and other functional operations
and data.
(3) a professional activity that measures and communicates financial and business data.
(4) a regulatory function that prevents the issuance of improper financial information.
c. Which of the following professional services is an attestation engagement?
(1) A consulting service engagement to provide computer-processing advice to a client.
(2) An engagement to report on compliance with statutory requirements.
(3) An income tax engagement to prepare federal and state tax returns.
(4) The compilation of financial statements from a client’s financial records.
d. In performing an attestation engagement, an auditor typically
(1) supplies litigation support services.
(2) assesses control risk at a low level.
(3) expresses a conclusion about an assertion.
(4) provides management consulting advice.

Answers:
a. (3) b. (2) c. (2) d. (3)

1-16 The following questions deal with types of audits and auditors. Choose the best
response.
a. Operational audits generally have been conducted by internal auditors and government
accountability office auditor but may be performed by certified public accountants. A
primary purpose of an operational audit is to provide
(1) a means of assurance that internal accounting controls are functioning as planned.
(2) a measure of management performance in meeting organizational goals.
(3) the results of internal examinations of financial and accounting matters to a
company’s top-level management.
(4) aid to the independent auditor, who is conducting the audit of the financial
statements.
b. In comparison to the external auditor, an internal auditor is more likely to be concerned
with
(1) internal administrative control.
(2) cost accounting procedures.

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 (3) operational auditing.
(4) internal control.
c. Which of the following best describes the operational audit?
(1) It requires the constant review by internal auditors of the administrative controls as
they relate to the operations of the company.
(2) It concentrates on implementing financial and accounting control in a newly
organized company.
(3) It attempts and is designed to verify the fair presentation of a company’s results of
operations.
(4) It concentrates on seeking aspects of operations in which waste could be reduced by
the introduction of controls.
d. Compliance auditing often extends beyond audits leading to the expression of opinions
on the fairness of financial presentation and includes audits of efficiency, economy,
effectiveness, as well as
(1) accuracy.
(2) evaluation.
(3) adherence to specific rules or procedures.
(4) internal control.

Answers:
a. (2) b. (3) c. (4) d. (3)

1-17 The list below indicates various audit, attestation, and assurance engagements
involving auditors.
1. A report indicating whether a governmental entity has complied with certain government
regulations.
2. A report on the effectiveness of internal control over financial reporting as required by
Section 404 of the Sarbanes–Oxley Act.
3. A report on compliance with a royalty agreement.
4. An evaluation of the effectiveness of key measures used to assess an entity’s success in
achieving specific targets linked to an entity’s strategic plan and vision.
5. An auditor’s report on whether the financial statements are fairly presented in accordance
with International Financial Reporting Standards (IFRS)
6. A report on the examination of a financial forecast.
7. An electronic seal indicating that an electronic seller observes certain practices.
8. A review report that provides moderate assurance about whether financial statements are
fairly stated in accordance with Local Accounting Standards
9. A report about management’s assertion on the effectiveness of controls over the
availability, reliability, integrity, and maintainability of its accounting information
system.
a. For each of the services listed above, indicate the type of service from the list that
follows.
(1) An audit of historical financial statements.
(2) An attestation service other than an audit service.
(3) An assurance service that is not an attestation service.

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 b. For each of the services listed above, indicate the type of auditor or other experts who may
be hired to provide such service?

Answers:

Type of service Type of auditor

1. (2) An attestation service other than an audit service GAO auditor or audit bureau
2. (2) An attestation service other than an audit service CPA
3. (2) An attestation service other than an audit service CPA
4. (3) An assurance service that is not an attestation service CPA or internal auditor
5. (1) An audit of historical financial statements CPA
6. (2) An attestation service that is not an audit service CPA
7. (2) An attestation service other than an audit service CPA
8. (2) An attestation service other than an audit service CPA
9. (2) An attestation service other than an audit service CPA or internal auditor

Cases
1-20
Adel Bassam works at the National Bank of Kuwait. According to the bank’s records, there is
currently an outstanding loan of $380,000 to Nosco Transportation Services, a company that
schedules Trucks trips between Kuwait capital and Baghdad. The company recently missed a
loan payment, and Adel is becoming concerned about whether Nosco will be able to repay the
full amount of the loan. According to the documents held by the bank, the collateral on the loan
consists of 20 large trucks. Each truck has an average estimated value of $25,000. As part of his
investigation of the company, Adel wants to make sure that these trucks still exist.
Adel decides that the best way to handle the situation would be to hire an auditor to count
the buses. Adel therefore engages the services of Talal abou Taha, CPA, who Adel knows has an
extensive background in auditing automobile, bus, and trucking companies. Adel gives Talal the
trucks’ registration information, which was provided to the bank when the original loan
documents were signed. He then asks him to investigate the company and write a report that
includes the following information:
1. Which of the 20 registered trucks is parked in Nosco’s parking lot on the night of August 31,
2011.
2. If Nosco Transportation Services actually owns or is responsible for maintaining the trucks.
3. The physical condition of each truck, using the guidelines poor, good, and excellent.

Required
The fair market value of each truck, based on Sabour Engineering Office Valuation, which
estimates the approximate wholesale prices of all used bus models, using the poor, good, and
excellent conditions guidelines established in Part 3.
a. For each of the following parts of the definition of auditing, state which part of the
preceding narrative fits the definition:

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 (1) Information
(2) Established criteria
(3) Accumulating and evaluating evidence
(4) Competent, independent person
(5) Reporting results
b. What difficulties might Talal encounter when performing this audit?
Answers
a. The following parts of the definition of auditing are related to the narrative:
1. Talal abou Taha is being asked to issue a report about qualitative and quantitative
information for the trucks. The trucks and their value are therefore the information with
which he is concerned.
2. There are three established criteria which must be evaluated and reported by Taha:
existence of the buses on the night of August 31, 2011, ownership of each bus by Nosco
Transportation Services, and physical condition of each truck. He will use the last of
these criteria to assess the fair market value of each truck.
3. Taha will accumulate and evaluate four types of evidence:
▪ count the buses to determine their existence
▪ use registrations documents held by Adel Bassam for comparison to the
serial number on each truck to determine ownership.
▪ examine the trucks to determine each truck’s physical condition—he can
examine the truck’s condition himself or hire an expert to do so
▪ examine the Sabour Engineering Office Valuation to determine the fair
market value of each truck.

4. Talal abou Taha, CPA, appears qualified, as a competent, independent person. He is a

CPA, and he spends most of his time auditing car, bus, and trucking companies, and has
experience that is consistent with the nature of the engagement.
5. The report results are to include:
▪ which of the 20 trucks are parked in Nosco's parking lot the night of August
31
▪ whether all of the trucks are owned by Nosco Transportation Services
▪ the condition of each truck, using established guidelines
▪ fair market value of each truck using the Sabour Engineering Office
Valuation

b. There are only two parts of this audit that will be difficult for Taha. First, evaluating the
condition of the trucks, using the guidelines of poor, good, and excellent. This can be highly
subjective. If he uses a different criterion than the Sabour Engineering Office Valuation, the
fair market value will not be meaningful. His experience will be essential in applying the
guidelines. Second, determining the fair market value unless it is clearly defined in the
Sabour Engineering Office Valuation for each condition.
1-21
In the normal course of performing their responsibilities, auditors often conduct audits or
reviews of the following:
1. Computer operations of a corporation to evaluate whether the computer centre is being
operated as efficiently as possible.

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 2. Operations of the tax authority to determine whether the tax inspectors are using their
time efficiently in conducting audits.
3. Financial statements of a branch of the government to make sure that the statements
present fairly the actual disbursements made during a period of time.
4. Financial statements fraud to be investigated for reporting purposes to stockholders.
5. The computer operations of a large corporation to evaluate whether the internal controls
are likely to prevent misstatements in accounting and operating data.
6. Individual Income tax return of an officer of the corporation to determine whether he or
she has included all taxable income in his or her return.
7. Annual statements for the use of management.
8. Disbursements of a branch of the government for a special research project to determine
whether it would have been possible to accomplish the same research results at a lower
cost to the taxpayers.
9. Statements for bankers and other creditors when the client is too small to have an audit
staff.
10. Corporate Income tax returns of a corporation to determine whether the tax laws have
been followed.
11. Disbursements of a branch of the government for a special research project to determine
whether the expenditures were consistent with the legislative bill that authorized the
project.
12. A bond indenture agreement to make sure a company is following all requirements of the
contract.

Required
a. For these 12 examples, state the most likely type of auditor (CPA, GAO or Audit bureau,
internal auditors or Forensic auditor) to perform each.
b. In each example, state the type of audit (financial statement audit, operational audit,
compliance audit or forensic audit).

Answers:
The most likely type of auditor and the type of audit for each of the examples are:

Example Type of auditor Type of audit

1. Internal auditor or CPA Operational
2. GAO or audit bureau Operational
3. GAO or audit bureau Financial statements
4. Forensic Forensic
5. Internal auditor or CPA Financial statements
6. Tax inspector Compliance
7. Internal auditor or CPA Financial statements
8. GAO or audit bureau Operational
9. CPA Financial statements

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 10. Tax inspector Compliance
11. GAO or audit bureau Compliance
12. Internal auditor or CPA Compliance

Case 1-22(Bonus) :As a manager responsible for the expected new audit clients, you visited
Al Abor company which is a limited liability company that manufactures the supplies of
many specialized materials in the construction industry. Mr Mounir, the executive manager
and the holder of the majority stocks, asked your office to audit the company and provide the
company with the financial consultancy. During your first meeting you realized that:

• The sales figure increased from US$4 million to US$7million in the last two years and
the company was profitable. In addition there is expected growth as Mr Mounir has the
following plans:

1- Increase the company’s customers through making certain materials available for the
public through the trade of construction materials.
2- Expand the products base through building a factory overseas to manufacture the
components of Carbonates Silicon. Mr Mounir directly negotiated the prices with each of
the suppliers and the customers.

• An accounting office was assigned in the beginning of this year to help to monitor the
credit and to state more formal accounting systems and procedures, and that the computer
will provide the essential information about sales, customers, Inventory and salaries.
• Mr Mounir’s step brother wrote the computer program to satisfy the company’s
requirement. Some purchases require the conversion of foreign currency and this has to
be recorded manually. At the end of each month there are small differences but the
accounts to monitor the customers and suppliers are not adjusted.
• The annual budget estimates the actual revenues and the actual expenses less than
necessary, because the increasing growth is more than expected, and the management’s
accounts are prepared infrequently on an irregular basis.

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 • For the managerial accounting purposes the sales cost is calculated as a percentage of the
sales value of the products’ different categories. Historically this method proved that it is
reasonably reliable when compared with the year-end evaluation of the annual
inventory’s physical examination.
• The production lines profit margin became increasingly variable at the current time also
Al Abor Company faces a high level of spoiled products, and these materials are returned
to the warehouses as they cannot be sold for cash with a discount.
• Mr. Mounir is negotiating a bank loan to fund the costs of planned new buildings, and the
contracts with the contractors and the work has started. The bank waits for the profit
forecasts before the final approval on a loan amounting to US$6 million
• Al Abor company tends increasingly to skip the facilitation of the agreed upon bank’s
overdraft. Mr. Mounir said that large receivables from one of the customers are expected
at the end of this month which will be used to pay the tax liability and pay an amount of
US$90000 in the loan’s account.
• Recently Mr. mounir was married and he bought an expensive apartment and a new car.
He is satisfied with the accounting organization that currently audit the annual financial
statements, and he said that the failure of adjusting the general ledgers is due to that, also
he claimed that the organization was incapable of suggesting how to increase his rewards
against his personal needs.

Required:

a- Identify and describe the major activity risks associated with Al Abor Company.
b- Identify and comment on the factors that should affect the auditor’s decision if the audit
office should present a proposal to audit this company.
c- Justify the appropriate audit strategy of the first audit of Al Abor building.
d- Suggest two types of procedures that Al Abor Company should directly implement to
improve its accounting procedures and the financial monitoring.

Answer 1-22
a. There are a number of risks associated with differences existing between customers and
suppliers’ accounts balances due to the manual recording of the transactions in foreign
currencies resulting in probability that such accounts’ balances are not reliable. Also,
risks are related to accounts balances for expenses and revenues which may not be
reliable as management delay the preparation of these accounts as they prepare them
infrequently and on an irregular basis. Moreover, high risk is associated with the
company’s inventory due to high level of spoiled products and the large returns of such
products to the company’s warehouses as they cannot be sold for cash without a discount
resulting in either losses sustained by the company’s operations or significant reduction
in the company’s profit figures. Management’s attitude is one of overconfidence in their
assessment of the liquidity position of the company, as they have high expectations that

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 large receivables from one of the customers are expected at the end of the current month
to pay both the tax liability and some of finance expenses. There is always the probability
of customers’ defaulting on their payment of debts which may result in inability of the
company to pay its tax and other liabilities which may affect the bank decision to grant
the loan to the company to construct the new building.
b. The audit firm should assess the integrity of the management of the company given the
management attitude toward expansion and the strategies and plans followed by
management to satisfy the bank’s requirements for the loan. Also, the audit firm should
understand the specific characteristics of this family owned business with all related risks.
c. The audit firm should give significant attention to the audit of the following financial
statements cycles: Sales and collection cycle including accounts receivable, sales, bad
debts expenses, sales returns, sales discount, cash collected; purchase and payment cycle
including purchases, accounts payable, inventory, cost of goods sold and other expenses.
d. The audit firm should properly implement segregation of duties for function of the
recording of the company transactions for sales and purchases and the audit and follow up
of receivables and payables. Also, independent checks on performance should be
undertaken by employees other than those performing operational activities and recording
the related business transactions to ensure proper monitoring of the company’s activities.

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