Professional Documents
Culture Documents
Source: “Busy Year Ahead for Oversight Council,” The Bottom Line, March 2003, p. 21.
EXHIBIT 4-2
PUBLIC OVERSIGHT MODEL (CANADA)
Page 122
As noted in Chapter 2, the provincial securities commissions sometimes file complaints with the Professional
Conduct Committees of the provincial institutes or associations. In addition, some securities commissions,
notably the OSC, have been assertive in not accepting financial statements that they consider at odds with GAAP.
The OSC issues staff accounting communiqués (SACs) in which it highlights major problem areas. Any company
attempting to use the disfavoured technique may find that its financial statements are unacceptable to the OSC
even though there is no reservation in the auditor's report.
The OSC is going even further: it plans to increase its supervision of auditors and other financial advisers and to
gain the power to take disciplinary action against them. Although these proposals have yet to be enacted, the OSC
already exerts some control over firms via out-of-court settlements, as indicated in the box below.
Public regulation disciplinary actions are also conducted by the SEC. Its authority comes from its rules of
practice, one of which, Rule 2(e), provides that the SEC can deny, temporarily or permanently, the privilege of
practice before the SEC to any person (1) not qualified to represent others, (2) lacking in character or integrity or
having engaged in unethical or improper professional conduct, or (3) having willfully violated any provision of
the federal securities laws or their rules and regulations. When conducting a “Rule 2(e) proceeding,” the SEC acts
in a quasi-judicial role as an administrative agency.
The SEC penalty bars an accountant from signing any documents filed by an SEC-registered company and
effectively stops the accountant's SEC practice. In a few severe cases, Rule 2(e) proceedings have resulted in
settlements barring not only the individual accountant but also the accounting firm or certain of its practice offices
from accepting new SEC clients for a period.
PREVENTIVE MEDICINE
In response to problems arising from the audit of National Business Systems, Inc., the OSC agreed that the partner
in charge of that audit would not act as the senior or second partner in charge of the audit of a public company for
a year. It was also agreed that procedures and systems would be reviewed by an auditor from another firm and
that the results would be resubmitted to the OSC. Moreover, arrangement was made to have the Toronto office
inspected by a partner from outside Canada to ensure professional standards were met. The firm agreed to pay
$70,000 to cover OSC expenses.
Source: J. Bedard and L. LeBlanc, CA Magazine, November 1991, p. 42.
The OSC and other Canadian regulators have been pushing to have similar disciplinary powers. Clearly, if the
self-regulating process of the institutes is not deterring bad practices, regulators are willing to step in. In 1991,
members of the ICAO approved a proposal giving the institute the power to subject firms to disciplinary action. In
2002, the Ontario legislature passed legislation that not only opened up public practice rights to CGAs and CMAs
but also increased the penalties for auditors associated with misleading reporting.
In the next chapter, we will see how, in reaction to a Supreme Court of Canada ruling in the Hercules v. Ernst &
Young Case, new securities laws that have been passed in some provinces hold auditors firmly liable for any
negligence in financial statement audits. Other regulatory developments include greater independence and
enforcement powers for Ontario and Quebec securities commissions, and increased harmonization procedures
between the Alberta and British Columbia commissions. These structural changes in the regulatory climate are
likely to increase regulatory disciplinary actions against PAs in the future.
Page 123
The Canada Revenue Agency can also discipline PAs as a matter of public regulation. It can suspend or disbar
from practice before it any PA shown to be incompetent or disreputable or who has refused to comply with tax
rules and regulations, as well as levy fines for improper practices. The Revenue Ministry has made public its
willingness to prosecute those accountants it suspects of “deliberate attempt to defraud the federal treasury.”20
20
J. Middlemiss, “Too Many Accountants Guilty of Fraud, Liberals Vow Crackdown on Shady Advisers,” The
Bottom Line, March 1994, p. 1.
According to a study by Brooks and Fortunato, most disciplinary actions by the ICAO stem from violating the
standards affecting the public interest (200 level).21
21
L. Brooks and V. Fortunato, “Disciplines at the ICAO,” CA Magazine, May 1991, p. 45.
Over a roughly three-year period (1988–90), most violations involved just four rules:
Rule Good Reputation of Profession representing 20 percent of all violations 36 violations
201:
Rule Integrity and Due Care representing 16 percent of all violations 29 violations
202:
Rule False and Misleading Representations representing 11 percent of all violations 20 violations
205:
Rule Expressing an Opinion Without Complying with GAAS representing 12 percent of all 21 violations
206: violations
EXAMPLE OF PUBLIC DISCIPLINARY NOTICE
Member Found Guilty of Breaching Rule of Professional Conduct 215
Re: Contingent Fees
A member has been found guilty of a charge of professional misconduct, laid by the professional conduct
committee, under Rule of Professional Conduct 215, for agreeing to render professional services for a fee
contingent on the results.
EXHIBIT 4A-2
BARNES EXAMPLE THREE (AS MODIFIED)
MAJOR FEATURES OF NATURAL LANGUAGE REASONING IN ASSURANCE ENGAGEMENTS IN
SYLLOGISTIC FORM
Argument (1) Argument (2) Argument (3) Argument (4) Argument (5)
Statement Premise 1 Warrant = Major Premise All persons are mortal
Statement Premise 2 Data = Minor Premise Socrates is a person
Statement Conclusion Conclusion = Conclusion Socrates is mortal
• Argument 1 is the most abstract generalization of an argument. It does not distinguish between an
argument and an explanation or any other set of communications or utterances.
• Argument 2 suggests the essential feature of argument structure: some statements (premises 1 and 2)
purport to justify another statement (the conclusion) rationally following from the premises.
• Argument 3 reflects three essential features of argumentation.
• Argument 4 (Aristotle's system) specifies a generalization premise, the major premise, which determines
why the data are relevant to the conclusion. It corresponds to the concept of a “warrant” (in Argument 3),
which links the data premise to the conclusion. Aristotle's syllogisms teach us that the more important
premise is the “warrant” because it determines which data are relevant for the conclusion. Warrants are
also referred to as connecting premises because they connect the data to the conclusion, thereby making
the data relevant to the conclusion. Warrants are usually rules or generalizations of some type involving at
least one quantifier (e.g., “all persons are mortal”). Theories and models are forms of generalizations. A
very common generalization used in everyday reasoning is the conditional form. We frequently argue that
if so and so is true then something else must be, i.e., the “if statement A is true then statement B is true”
type generalizations that are represented symbolically as A Σ B (Garnham and Oakhill 1994, 85, 166).
One of the most important developments in psychology and artificial intelligence of problem solving is
that heuristics used by experts in a variety of fields can be represented in a uniform way as sets of if …
then rules (if certain conditions hold, then perform a certain action, e.g., in accounting for leases there are
special rules for deciding if leases are to be recorded as capital or operating leases). Such rules are known
as productions, and a problem solver or production system can therefore be built from a set of productions
(Ibid, 203).
Page 8
• Argument 5 sets out a well-known syllogism to illustrate how syllogistic reasoning works. This argument
is expressed in natural language, of the type used in all audit engagements, rather than in an artificial,
symbolic language, such as C++. The statements of Argument 5 align with the major premise, minor
premise, and conclusion of Aristotle's syllogistic framework. The first premise (or warrant) is a
generalization that “explains” why the second premise supports the particular conclusion. Without this
first premise (or warrant), the second premise (data) alone would not “prove” the conclusion. Given the
first warrant, the conclusion follows 100 percent from the data premise. Thus, the relevance of the data in
Argument 5 is determined by the warrant. This reinforces the importance of the warrant in making the data
relevant to the conclusion. Therefore, we should treat warrants and similar generalizations, such as “laws”
or models, as the more important premises in determining the relevancy of the data used.
The differences in deductive and inductive argumentation are noteworthy. A deductive argument is one in
which the conclusion is always true if the premises are true. Traditionally, deduction has been viewed in
philosophy as the ideal way of gaining knowledge (the conclusion) from argumentation. The inductive
probability (the probability of the conclusion being true when the premises are true) for a deductive
argument is always 100 percent. If the inductive probability is less than 100 percent, then we have a non-
deductive argument, which is labelled inductive. Thus, with deductive argumentation, the inductive
probability is always 100 percent; whereas in inductive argumentation, it is less than 100 percent.
Another complication with inductive arguments is that a true conclusion does not necessarily follow from
true premises. Deduction gets 100 percent inductive probability by never going beyond the knowledge that
is already inherent in the premises. But induction, in searching for new truths, goes beyond the premises of
an argument to take the risk of reaching a false conclusion from true premises. In this sense, while
deduction is truth-preserving, induction is truth-creating. For example, the most common argument form
used in the sciences is as follows:
Argument (6) Argument (7) Argument (8)
Major premise A+B Theory All persons are mortal
(warrant)
Minor premise (data) B Data consistent with (verifying) theory Socrates is mortal
Conclusion A Conclude theory is true Socrates is a person
• Arguments 6, 7, and 8 illustrate the formal fallacy of affirming the consequent, and are invalid. They
demonstrate that a true conclusion does not necessarily follow from true premises. The inductive
probability is less than 100 percent, and the argument is therefore inductive. Argument 7 should be
regarded with caution. There may be other reasons for observing data (B) predicted by theory (A) of the
major premise. Hence, we are not 100 percent sure that theory A is true. The reasoning in Argument 7 is
quite familiar in the sciences. Argument 8 illustrates that observing that an object is mortal does not
guarantee it is human. Socrates may be the name of a horse.
Page 9
Consider the following two arguments that are typical of everyday reasoning:
Argument (9) Argument (10)
Warrant: Visitors to Mexico almost never More than half the visitors to Mexico contract
contract malaria Montezuma's revenge
Data: Jack is visiting Mexico Jack is visiting Mexico
Conclusion: Jack will not contract malaria there Jack will not contract Montezuma's revenge there
• Arguments 9 and 10 are inductive arguments. There is a higher inductive probability for Argument 9 than
Argument 10 that is evident from the wording and meaning of the two arguments. But which conclusion
has the higher epistemic probability is not clear because we do not know the probabilities assigned to the
warrants. Thus, epistemic probabilities are a function of additional information that may be available.
They would be represented as additional warrants and data to the argument. For example, if we added to
Argument 10 the evidence that Jack has visited Mexico many times without experiencing Montezuma's
revenge, most would find the conclusion much more likely to be true. The effect of specific wording on
the argument is important. Imagine replacing Mexico with Canada in Arguments 9 and 10. The epistemic
probabilities would be affected considerably, thereby illustrating the potentially important role of natural
language and common sense background information in everyday reasoning, including audit reasoning.
These effects open the way for rhetorical moves that can shift the persuasiveness of the argumentation one
way or the other (Sillince 2000, 1130).
Critical thinking means that we have good reasons to believe a claim or make decisions. Those reasons include
other people's attempts (such as management) to persuade us to take an action or to believe something. Attempts
to persuade may be argumentive or non-argumentive. Most of the latter are referred to as rhetoric, which we will
define here as any attempt to persuade solely through the power of words used (e.g., “you are either with us or
against us”). Rhetoric can be used to assist in providing good reasons, or can be abused to provide bad reasons or
no reasons to accept a claim (conclusion), decision, or action.
Rhetoric makes use of linguistic phenomena, the power of words, in persuading us to accept a claim, decision, or
action. This power is achieved through cognitive meaning (factual) and emotive meaning (negative or positive
overtones) associated with words. Linguistic phenomena include ambiguity, vagueness, metaphor, rhetorical
questions, irony, sarcasm, and generalizations. Critical thinking makes use of language and linguistic phenomena
to develop the reasoning for a claim, decision, or action. Deciding whether rhetoric is used to provide good
reasons is part of critical thinking.
The pejorative use of the word “sophistry” refers to intellectual charlatanisms involving use of language to
deceive people. In ancient Greece the sophists trained students to persuade their audience in either side of an
argument—a very practical skill for the growing litigiousness of Athenian society—leaving the impression that
any reasoning could be used as long as it was effective in influencing people. What mattered was who won the
argument, not who was right.
The study of rhetoric includes positive use of language as by famous authors (e.g., Shakespeare), as well as the
effective use of language to deceive. Rhetoric is a major component in the study of literature.
Our focus in this textbook will not be so much on the bad reasons that are possible for a decision as in good
reasoning, although some common errors in reasoning and attempts at intentional deception will be noted. An
entire book can be written on the types of bad reasoning that have been used throughout history (e.g., the Big Lie
technique used in many dictatorships to blame scapegoats for a nation's problems). Our interest, however, will be
on the potentially bad reasoning that is used in our profession, including within the standards. And we will do this
by first focusing on what makes for good reasons, and then using this good reasoning framework as a benchmark
to easier identify the bad reasoning. In this Appendix we put emphasis on those aspects of good reasons that are
generally independent of the field in which the decision is made (field independent aspects of reasoning). These
more universal elements of reasoning are part of the study of philosophy, especially logic. However, despite the
emphasis in this chapter on the more abstract aspects of good reasoning we nevertheless use important examples
from the PA profession to show how these aspects apply to professional practice.
Page 10
The preceding sections demonstrated that both language and context can have important roles in influencing the
strength of all argumentation, including assurance arguments. These two factors explain why rhetoric is also
important to audit argument evaluation. In its broadest sense, the word rhetoric covers the logic, the language, and
the context of argumentation. But it is up to the PA to use rhetorical principles in effective argumentation and to
expose through skepticism and critical analysis any deception that management and other accountable individuals
attempt through their own rhetoric. Some have developed an analysis of rhetoric as an economic transaction,
using the analogy of “selling” an idea to selling a good. The gist of the analysis is that when information costs are
high (the listeners are uneducated or the information is difficult to understand because it is complex), then
rhetorical devices, such as appealing to the authority of the speaker or using emotional appeals, become more
important (Posner 1995, 501–3).
Perhaps the most important use of rhetorical devices is to aid in making ethical decisions. If rhetoric can be used
to persuade a party in a conflict of interest situation to accept a particular position that is not favourable to him or
her, it may play a useful role in the reporting of that position. The disclosure should then be consistent with the
aims of the agreement. Rhetoric should not, of course, be used to mislead people about the nature of the
agreement.
Rhetoric helps to make PAs aware of the power of language in influencing people's beliefs. For example,
accounting labels, such as “assets,” “expenses,” and “losses” send signals to users about how well resources have
been managed. Thus, accounting terminology itself has an important rhetorical effect. To maintain relevance, PAs
will need to be aware of rhetorical impact. This relevance of rhetoric can only increase as accountability becomes
more important in society (i.e., the audit society evolves).
A good illustration of an application of rhetorical principles in accounting can be found in accounting firms'
written responses to a company's invitation for alternative opinions on an accounting matter (see Amernic 1996).7
7
Amernic, J. 1996. “The Rhetoric Versus the Reality, Or Is the Reality “More” Rhetoric? A Case Study of Public
Accounting Firms' Responses to a Company Invitation for Alternative Opinions on an Accounting Matter,”
Critical Perspectives in Accounting, February/April, 57–77.
The raw data came from a regulatory agency's files, and the correspondence makes it evident that accounting
firms were engaging in the use of rhetoric in these specific situations. The “winning” firm's arguments would
clearly affect the accounting for the case and might even become part of the audit working paper file justifying the
accounting (Amernic 1996).
Context includes not only the immediate physical circumstances of the engagement but also broader features,
such as reputation of the person making the argument, and social aspects of the accountability relationship being
reported on. For example, tone of voice and body language can convey the strength of convictions. In some
situations, context itself may be the message and override anything that is said or written, regardless of the
strength of the logic of the expressed argument. Consider, for example, an arguer who loses credibility, such as an
auditor who lacks the appearance of independence. Ultimately, arguments are intended to persuade—and thus add
credibility. If they fail this acid test, so fails the assurance engagement. This is why the most important ethical
principle is to maintain the reputation of the profession.
Emotions are important for reasoning because they help shape the basic goals of reasoning and influence our
intuition. This does not mean advanced mathematics or logic are intuitive, however, instead these types of mental
tools are learned and have evolved to solve more complex problems.8
8
Pinker, Steven, How the Mind Works. WW Norton 8 Co.: New York; 1997, pp. 338–341.
Page 11
The primary role of the emotions seems to be to decide on the ranking of objectives that triggers thinking and
actions (Pinker 1997, 73). Emotions seems to be indispensable to coordinating the various mental modules and
are therefore essential for all human reasoning (Pinker 1997, 70). This helps explain why the mind does not
always seem to follow logical rules. Formal logic can give trivial truths yet miss consequential ones. Other
complications include the meaning of words and language understanding in specific contexts, background
knowledge of the reason or his or her implicit assumptions, uncertainties, and special mental modules inference
rules tailored to specific contexts, especially the cheater detection inference rules.9
9
Ibid., p. 338.
It is therefore not surprising that philosophers long ago concluded that reasoning depends on three basic appeals
—its logic, its emotional quality, and the reasoner's perceived character. The persuasiveness of the reasoning to a
particular audience is determined by all three appeals. The latter two appeals are frequently based on the
rhetorical aspects of the reasoning. An auditor would have to consider all three aspects of the reasoning. For
example, the auditor's perceived character is influenced by the perceived independence and objectivity of the
auditor.
Imbedded in the above standardized framework format is the assumption that reaching the goal involves some
decision making. In fact as we will see the end result of critical thinking is reaching some kind of decision,
whether it is reaching a decision on an adjusting entry, or wording to choose in note or engagement report
disclosure. This has traditionally been referred to as professional judgment. Professional judgment is part of
critical thinking. The following are key principles of professional judgment identified in a 1995 CICA research
study:
1. Definition of professional judgment: professional judgment in public accounting is the application of
relevant knowledge and experience within the context provided by auditing and accounting standards and
rules of professional conduct, in reaching business decisions where a choice must be made between
alternative possible courses of action.
2. The goal in developing a framework for professional judgment is to assist auditors in properly exercising
judgments in carrying out professional standards, in forming judgments on specific assertions and on
financial statements as a whole, and in rendering an opinion as to whether the financial statements are
presented fairly.
3. Key concepts for professional judgment are the audit task environment, auditor characteristics, evidence,
the decision-making process in auditing, and qualitative attributes of professional judgment.
4. Principles: Assess the level of assurance needed, assess the materiality, identify the subject matter, assess
the accountability relationships, identify the goals of the engagement, justify the conclusion reached in
terms of relevance of the conclusion to the goals and reliability of the conclusion.
We explain these principles and concepts in later chapters. The above framework is also consistent with the
broader framework for critical thinking.
The reason there is no true theory of professional judgment is because there's no set of universally acceptable
hypotheses that are capable of verification through observation in the audit setting. For example, there is no
universally acceptable set of social laws or behavioural laws on which to base a theory of professional judgment
in auditing.10
10
Audi, R, The Cambridge Dictionary of Philosophy, Cambridge University Press, 1995, p. 612.
Because many effects in auditing are based on intentional, meaningful actions dependent on context rather than
physical cause and effect relationships, general laws are difficult to establish. As a consequence, the logic used in
audit professional judgment involves less formal reasoning that includes evaluation of thought processes as well
as the intentions behind the thought processes.11
11
Ibid., p. 636.
Many options may need to be considered, each with positive and negative consequences for a given intention and
context. As a result most reasoning in auditing is not as mathematical and abstract (i.e., universal) as in the
physical sciences. Of course, when appropriate, more rigorous mathematical or logical tools can always be
included as part of professional judgment.
Page 12
So the key to professional judgment are the standards of the profession combined with the critical thinking
concept. We will be studying the GAAS and related guidelines throughout the rest of this book.
In summary, critical thinking involves use of the following principles that should be actively considered in
analyzing a controversy or issue facing the auditor (such as a disagreement with management on a financial
reporting issue). The principles having a dominant ethical component are marked with an “E.” As you can see all
of the principles other than the strict logical ones have an important ethics component. In particular note how
important a questioning mind is. It represents a mental attitude that incorporates the rest of the critical thinking
principles. It should be clear that skepticism is a key part of critical thinking through the questioning mind
concept. Thus critical thinking takes traditional audit virtues and extends these to a more holistic approach to
judgment.
It is important to be aware of various elements of critical thinking which we briefly review here and summarize in
a series of principles.
Principles of Critical Thinking
1. Critical thinking has a purpose that leads somewhere, has implications and consequences, settles some
question or solves a problem.
2. Critical thinking requires an enquiring mind that identifies an important issue or controversy, considers
what are the goals in light of the many perspectives possible on the issue, and decides on the best goal in
the circumstances. Critical thinking identifies the claims that need to be justified to achieve a goal
3. Critical thinking is used to persuade someone (including yourself) to accept a claim. Of course others may
try to persuade you to accept another claim. And you and others are aware you may have these conflicting
claims. You try to resolve this in a cooperative way via the critical thinking process, in which you and
others are open minded and receptive to being persuaded by good reasoning.
1. Critical thinking is based on reasoning using argumentation. The argumentation supports or justifies a
claim related to resolving a controversy or issue.
2. Critical thinking is expressed through and shaped by language, which can be used to develop concepts and
ideas.
3. Critical thinking requires being aware of the power of language, how this power can be manipulated, and
the importance of specific words chosen to persuade. The words chosen reflect value judgments and have
emotional content which is communicated to the listener. This is part of the persuasion process.
4. Critical thinking requires making important assumptions and reasons explicit so that they are open to
scrutiny by others. This is the best path to truth and knowledge and these are the ultimate goals of a
questioning mind.12
12
See www.criticalthinking.org; Fisher, Alex, Critical Thinking, an Introduction, Cambridge University
Press, 2001; and, Hughes, William, Critical Thinking, 2nd ed, Broadview Press: Peterborough, 1996.
These principles can be viewed as ideals in the ways issues and controversies should be analyzed. They will rarely
be achieved exactly in professional practice, usually under some very formal conditions using very precise
language and concepts. Nevertheless, they can be useful guides to action in the sense they help achieve
accountability for one's claims and any decisions that result from them.
We saw in Chapter 2 that a special type of accountability, three-party accountability, is central to the assurance
concept. So critical thinking in an assurance engagement requires that the audit provide three-party accountability
in the audit reasoning process. For example, the context in an assurance engagement means that the auditor needs
to be aware of the three-party accountability and that at least three different perspectives on an accounting issue
are possible.
Page 13
The above principles are very general in that they can be applied to any discipline or field of study. In this respect
the principles are independent of the field. To apply these principles to a specific field such as auditing requires
the addition of audit and accounting specific concepts and principles. But these more specific parts of audit
thinking should ideally conform with the framework of critical thinking as much as possible. We will illustrate
how this is done shortly with a concrete example. But first it may be useful to compare these principles relative to
the earlier discussion. Simply being aware of these and similar principles goes a long way towards becoming a
critical thinker.
The first principle states that critical thinking has an objective and tries to be practical. The second principle states
that this objective is identified with a questioning mind that takes into account different perspectives. Implicit here
is some kind of social context involving communication. This idea came from the ancient concept of discourse,
open debate, and discussion making the alternative viewpoints clear to all. The basic idea is to resolve conflicting
viewpoints. The contexts of politics, courtroom, and open debate on any social issue are the paradigm cases. But
critical thinking takes the conventions that evolved in these settings and applies them to reasoning on any subject
matter in any context. The key idea is that it involves an issue with conflicting viewpoints and a reasonable
decision must be made. This is really a problem that arises in ordinary daily reasoning when dealing with people
and life's problems. Except most times it is sufficient to deal with the problem informally, using intuition and
“common sense.” When you think about it, however, common sense is largely a sharing of norms of acceptable
behaviour (like no smoking in classrooms). In this sense and the sense of trying to learn the process of critical
thinking, the exercise is one of cooperation for the common good by those affected by the issue, but always in a
specific context.
Principles three and four focus on how to achieve the objective of resolving the issue. Principle three
acknowledges that what is really at stake is persuasion of people. For example, management may be trying to
persuade investors and the auditors task is to reduce the risk of deception in management's persuasion attempt to
acceptable levels. How is this achieved? We use the time tested technique from philosophy called argumentation
to reduce this risk. So what critical thinking is saying is that argumentation is the way we establish our claims.
The princpal claims of interest in auditing are the ones made by management about the financial statements.
These management claims are verified in the auditor's report. But the audit report is itself a claim, which we call a
conclusion or opinion, about the results of the audit. This claim also needs to have a supporting argument. This is
why we are interested in arguments that the auditor will make to support his or her opinion (the auditor's claim).
Although the profession has traditionally not thought of it this way, the increased attention to quality control, new
types of audit engagements, and increased auditor accountability to the accountability boards is putting increased
expectations for auditors to justify their conclusions on stronger philosophical grounds. This accountability is
achieved by justifying one's conclusions better, and that means paying more attention to the structure of sound
argumentation, including the ethical issues as part of the reasoning.
The fourth principle is probably the least familiar and least intuitive. That is why we spend so much time on
argumentation. The fourth principle says we reason by argumentation. As explained in the argument concept
discussed earlier, this means to provide good reasons for a conclusion, claim, or action. Arguments can be stated
in an infinite number of forms but the reasoning process itself can be put into a standard form. Doing this in real
life situations can be quite difficult and we have discussed the most basic issues already. A major complication is
that many reasons in an argument are themselves claims that in turn may need a supporting argument in order to
be justified for use as a valid reason. But the point is we can reconstruct all arguments in a standard form such as
a syllogism and then apply the analysis to that form. So what critical thinking says is that the critical thinker must
be prepared to defend his or her reasons and assumptions if they are called into question by an opponent such as a
court or an accountability board. In other words the auditor must be prepared to justify their decisions and
judgments.
Page 14
Argumentation takes place in all levels of social life, although not as formally as discussed here. There can be
arguments among friends, in a court of law, in the political arena, and among experts. Auditors have to be
prepared to argue among experts and it is these situations where more formality and uses of professional standards
and concepts come to the fore. Debates are a form of argumentation that bring together various techniques of
persuasion, right choice of words, demeanour, tone of voice, as well as intelligence. In a courtroom or regulatory
hearing or dealing with a client or the media, debating skills can be useful for auditors as well as lawyers and
politicians.
In debating teams or clubs or even in business case competitions, the arguer must be prepared to argue on an
issue. The major point of such debates is not necessarily to find the truth but to improve debating techniques
generally. But the debate needs a focus, an issue, which is what principle two is about.
The point of debate is to convince or persuade another party of the correctness of a claim. This is an essential
element of all critical thinking and why we have the third and fourth principles. Also, being aware that there are
different viewpoints and that good arguments recognize these viewpoints need to be taken into account in
justifying a claim. And it may turn out that no one viewpoint can dominate. This is summarized in Exhibit 4A-3.
For example, in Exhibit 4A-3 can you identify the three parties in three-party accountability? Refer back to
Exhibit 2-4 in Chapter 2. Management (circle 2) is the accountable party that makes the assertion to the users
(circles 1, 3, 4, 5, and 6), and these assertions are verified by the PA (circle 3). Who wins the debate is decided in
large part on who has the burden of proof in establishing a claim. This is largely determined by social
conventions. For example, under criminal law in the Ango-American system an accused is presumed innocent
until the state can establish guilt “beyond a reasonable doubt.” When the state has done this it has met its burden
of proof in court. If not, the accused does not have to prove that he is innocent and so wins the case (i.e., wins the
debate). Critical thinking is thus a disciplined thinking that takes into account various social norms and other
contextual factors in the reasoning process. The remaining principles clarify other aspects of critical thinking.
EXHIBIT 4A-3
MULTIPLE POINTS OF VIEW WITH RESPECT TO A GIVEN SET OF FACTS
Page 15
The fifth principle recognizes that a major influence on viewpoint or perspective are the words and concepts one
uses. It is important to be aware that choice of words affect value judgments and taking an ethical position. For
example, calling somebody a pig is not necessarily a description of physical appearances but instead may be used
metaphorically to reflect a value judgment of a person's character—for example management as “pigs at the
trough.” It is very important in critical thinking to be aware of the power of language to reflect such value
judgments and, if you disagree, to address that issue in your argumentation so the language used already reflects
the perspective taken. For another example, that financial statements “present fairly.”
Another influence of viewpoint are the concepts used. Concepts are important in that they help us assign meaning
to our senses and information that we use. Immanuel Kant's views on this have been very influential in computer
science and artificial intelligence. These views can be summarized in the saying “Concepts without data are
empty and that data without concepts are blind.” What this means is that you need both concepts and data to make
sense of the world, including in critical thinking. In other words, concepts provide meaning to our observations
and evidence and without concepts we have no way of knowing how useful or relevant our evidence is, including
audit evidence.
This is reflected in arguments by the fact that the most important reasons (major premises) are usually conceptual
ones, based on some assumed model, theory, or principle. These major premises determine what data is relevant
in an argument. For example, in auditing you will learn about management assertions. These are the major points
at issue in financial reporting. They in turn are embedded in the theory and assumptions of accrual accounting,
which determine the kind of data needed to verify the assertions. For example, much of financial reporting is
based on historical cost. So, to verify assertions related to historical cost auditors need evidence on what the client
actually paid for various items. This means the relevant evidence the auditor needs to gather is driven by historical
cost accounting theory. This illustrates that the evidence is less important then the historical cost accounting
theory because without the theory we would not know what evidence to gather. For this reason audit evidence is
treated as a minor premise in audit argumentation and in critical thinking. The historical cost concept is what
gives meaning and relevance to the audit procedures that involve gathering evidence about records related to what
was actually paid.
Making this relationship between concepts and evidence explicit is a necessary component of critical thinking.
But critical thinking is also practical. It does not necessarily question everything, but must be ready to respond if
challenged. Normally it is sufficient to refer to authoritative sources such as GAAP rather than reproducing all the
arguments used in accounting theory. However, auditors must be prepared to defend the appropriateness of their
accounting choices in case someone questions their actions (such as the CPAB or a court of law). Critical thinking
means that auditors should be prepared and anticipate such eventualities and this is a major reason why it is
important to be aware of other viewpoints. The fact that it is the auditor who uses the words “present fairly”
requires nothing less from the perspective of the critical thinker. As more people question the auditor's role and
the quality of financial reporting, a structured critical thinking approach is probably the best way to rationally
justify one's claims and decisions in a particular engagement.
Being aware of the framework and an understanding of its components is the first step to being a critical thinker.
Applying these concepts and principles to a specific situation is the best way to understand them better. Keep in
mind, however, that the framework is very general and applies to all fields of study. To be a critical thinker in a
particular field such as auditing requires combining these critical thinking concepts and principles with the more
field specific ones in accounting and auditing. This is most evident in the explicit argumentation that is developed
to support an audit conclusion.
You will not need to make all your assumptions, concepts, and principles explicit because your audience may
accept the vast majority of your reasons. It is only a few contentious reasons that normally are the centre of
controversy. Most people will agree with or accept most of your reasons without question. This is because in a
society we share much common knowledge (the ‘obvious’ or ‘common sense’) and many social conventions (that
we often take for granted such as a shared language and all its conventions for efficient communication).
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A good critical thinker should be able to anticipate which reasons are going to be controversial (i.e., be able to
understand the perspectives of others) and sharpen the argument to explain why a reason is appropriate in a
particular case.
These notions are perhaps best explained by example so we will look at one here. One that combines ethics with
corporate governance and therefore incorporates topics we study. The case is described below.
The Boeing Affair: Analysis Using Critical Thinking
The box below is an editorial regarding the Boeing Company's decision to fire its president and CEO on March 9,
2005. The editorial is an example of a typical argument used in everyday reasoning. But the argument is not in
standard form, not even the standard, simplified three statement syllogistic form. According to our principles we
need to identify what is the point at issue, the various viewpoints, what is the conclusion or claim, what reasons
are given for supporting the conclusion, are these reasons acceptable, how well do the reasons support the claim.
In the process of doing this we need to consider the context of this controversy and the use of language, choice of
words, choice of examples (part of data premise) in trying to persuade us to accept its conclusion.
BOEING'S MORALITY SQUAD
He didn't force her to have an affair with him. He didn't use his influence to raise her pay or boost her career. She
didn't work directly for him. He didn't try to hide the affair once he was confronted. The affair has no effect on the
business performance of the company. What, then, was Harry Stonecipher's crime?
Boeing Co. forced its president and chief executive officer to resign this week over a consensual affair with a
female executive. The airplane maker said the affair violated its strict code of conduct. That was significant
because Boeing brought Mr. Stonecipher out of retirement to put its ethical house in order after a previous CEO,
Phil Condit, had to quit after scandals involving illegal discussions with an Air Force official, and documents
from a rival company that came into Boeing's hands. Those were serious breaches of business ethics and, in order
to clean house, Mr. Stonecipher had to be above approach. But did he have to be a saint?
Personal ethics and business ethics are different things. When did it become the province of company directors to
pass judgment on the purely personal conduct of executives? If every businessman who cheated on his wife were
subject to firing, the unemployment lines would be full of men in suits. Women in suits, for that matter.
We are on a very slippery slope here. First it was doctors whose love lives became open to scrutiny and censure,
subject to the harshest treatment for the crime of dating a patient. Then it was politicians who came under the gun,
witness the ridiculous Clinton-Lewinsky “scandal.” Now top businessmen are being watched by the adultery
police. Where does it stop?
What goes on in a marriage—or outside of it—should be a matter for a man and his wife or a woman and her
husband, not the company board.
Source: “Boeing's Morality Squad,” The Globe and Mail, March 9, 2005, p. A16.
The controversy or point at issue here seems to be whether or not a private consensual relationship should be of
concern to the board of directors, and by extension to the shareholders and other stakeholders. The conclusion of
the editorial is that this is a private matter between the two employees and is not of concern to the board or any
stakeholders.
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The main reason (major premise) given for their argument is that business ethics and personal ethics are two
different things and in this case there is no overlap. The editorial goes on to provide some examples (data
premises) that seem to be primarily for the purpose of justifying the major premise, not necessarily working with
it to support the conclusion. Thus the reasons do not seem to work well to support the conclusion.
In particular, the editorial indicates there is an aspect of this situation that could affect shareholders, namely, that
Boeing had recent problems of business ethics in the past and that the CEO was hired primarily to address these
problems. Yet the editorial seems to ignore the fact this might create an overlap between the private ethic and the
corporate ethic.
Moreover the editorial seems to dismiss the corporate code of conduct, which it characterizes as “strict.” A strict
code of ethics is not surprising given the company's past ethical problems (part of the context). Anyway, strict or
not if management is expected to abide by it then should not something be done about it when it is violated? From
the shareholder viewpoint this could indicate a serious business risk (bad “tone at the top”) under the
circumstances. This perspective is apparently missed by the editorial.
In fact digging further into the situation we can obtain more evidence (data premises) in the form of the actual
wording of Boeing's press release on the subject at the SEC's website. According to the press release: “The board
determined that the CEO's action was inconsistent with Boeing's code of conduct” and that “the facts reflected
poorly on the CEO's judgment and would impair his ability to lead the company.”
It is instructive to note that the board learned of the CEO's affair through anonymously forwarded emails between
the CEO and the other manager. Somebody within the company was not only aware of the relationship but felt
concerned enough about the emails to send them to the board. Apparently to at least some employees this created
a conflict of interest between the CEO and other managers. It would have looked a lot better if the CEO would
have informed the board of his potential violation on his own rather than wait until someone informed the board
anonymously. Perhaps it was this lack of judgment and leadership that caused the board to act the way it did,
especially in light of the company's recent other ethical problems.
The issue of privacy that the editorial focused on is a legitimate one. Privacy like confidentiality is a right that
does exist but is not an absolute right. For example, if there were guidelines in the corporate code of conduct that
both parties to the affair should have conformed to as part of the employment agreement, then they are both
obligated to abide by it. The seriousness of the violation is then a legitimate concern of the board. Boeing is so
dependent on government contracts that it could probably not afford a further loss of reputation regarding
compliance with its own code of conduct. The board probably considered various alternative scenarios of where
this state of affairs could end up and concluded the risks were too high. Research in ethics shows that being able
to visualize alternative scenarios is a key skill in ethical decision making. The editorial did not seem to take this
into account in reaching its conclusion.
In summary the editorial fails to:
1. consider the risk perspective of shareholders and others
2. consider the consequences of further ethical failure to Boeing
3. consider that personal and business ethics can overlap and in that case it is appropriate for the professional
to consider the consequences in terms of risk to the company
4. consider alternative scenarios and the consequences for the company (lack of moral imagination)
As a result, the editorial's conclusion is not well supported by the reasons given. In addition note how the editorial
uses language to minimize the seriousness of overlap between business and personal ethics. “But did he have to
be a saint?” “adultery police” CEO's “crime” and “What goes on in a marriage” all suggest digressions from the
main point of what to do if there is an overlap. The point is there seems to have been a violation of the corporate
code and that is the real issue here. The above statements are smokescreens that tend to distract from addressing
this issue. The editorial can even be accused of trying to sensationalize the board's activities, possibly to
encourage wider readership of the editor's page—yet another perspective to consider in this context of the
argument.
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Note that the board is not asking the other executive to step down, nor is the board asking the CEO to terminate
the relationship. This suggests their real concern is with the leadership of the CEO in failing to abide by the code
and, worse, appearing to hide this failure.
Finally, this case also illustrates the importance of corporate codes of conduct in strengthening governance. The
code is there for a reason: it sets out expectations of behaviour as part of the terms of employment. If the code of
conduct has specific rules or restrictions about what to do when there is an office romance and employees
willingly accepted abiding by the rules, the breaches of the code constitute grounds for terminating the
employer/employee relationship. Don't be surprised to find such codes being used by PA firms that employ you.
DISCUSSION CASES
1. Find Boeing's press release at the SEC's website related to the resignation of its CEO on March 9, 2005.
After reading the press release, would your analysis of The Globe and Mail editorial change?
1. Find the report of Nortel's special investigation of its accounting in 2001, 2002, and 2003. Again, the
SEC's website is a good source. Based on this report do you think some of the audit opinions in those
years were justified? Use the critical thinking principles discussed in the Appendix.
1. Using utility theory and Kantian ethics, develop an alternative critical thinking analysis of The Globe and
Mail editorial on the Boeing company.
Critical Thinking that Integrates Accounting and Auditing Theory
The auditor's unqualified report claims that the financial statement “present fairly” in conformity with Canadian
GAAP. Note that this is a claim the auditor makes and therefore he or she is fully responsible for being able to
justify this claim if challenged. Note that merely citing references to the Handbook may not be sufficient to
support such a claim since the Handbook does not define fairness of presentation. All the Handbook provides
guidance on is GAAP and GAAS.
So how do we know when this claim is justified? As you will see the rest of this book is devoted to gathering
sufficient appropriate evidence to help support this claim. However, you will also need to make use of the GAAP
that you learned in your accounting courses as part of the justification for this claim. Furthermore, you need to
consider other issues such as the role of ethics and you may need to consider whether the hidden assumptions of
accounting theory apply in the circumstances in order to fully support this claim from a critical thinking
perspective. Critical thinking helps explain why auditors can't be replaced by computer chips.
You can think of the accounting issues in auditing as consisting of two basic parts: 1, whether the financial
reporting is in conformity with GAAP and 2, whether the financial reporting is fairly presented. Historically, most
auditors assumed that if sufficient appropriate evidence showed that the financial statements were within a
material amount of GAAP numbers then this justified an unqualified opinion. However, as accounting standards
become more “principles based” and accounting standard-setters put more focus on the meaning of fair
presentation, auditors need to focus on fairness of presentation within GAAP. In other words there is increasing
appreciation that not all GAAP results in fair presentation in all circumstances. So auditors are expected to make
decisions about the proper application of GAAP in the circumstances. And if GAAP is vague on an issue that
further complicates the auditor's critical thinking.
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Auditing and accounting standards are becoming more integrated but the process of integration is not yet
complete. In the past, the two sets of standards tended to be developed independent of one another thereby
creating two sets of fairly independent criteria or two professional “silos” of knowledge. This silo effect has been
reflected in your courses—you probably have separate courses in financial accounting and separate ones in
auditing. This silo effect explains why there are some inconsistencies between accounting and auditing, for
example, some argue that there are differences between accounting and auditing materialities, some wonder why
auditing is risk-based whereas accounting is not even though both have their own set of uncertainties. There are
also some important differences in basic qualitative criteria. The four principal qualitative characteristics of
financial reporting under CICA Handbook, paragraph 1000.18 are understandability, relevance, reliability, and
comparability. In contrast, the assurance section 5025.36 of the Handbook lists five qualitative characteristics:
relevance, reliability, neutrality, understandability, and completeness.
Under existing standards the auditor is assumed to use something like critical thinking (what the profession has
historically referred to as “professional judgment”) and to justify fairness of presentation in the circumstances.
For example, the completeness concept of section 5025 doesn't seem to be quite captured by any of the concepts
of section 1000. So does this mean fair presentation incorporates the completeness concept in financial reporting?
Current standards and conceptual frameworks give no definite answer.
As auditing and accounting reasoning become increasingly integrated it is also becoming evident that the fairness
of presentation concept needs clarification. For example, some feel that fairness refers to the completeness of
disclosure, others to the appropriateness of the accounting in the circumstances, and others to how well the
accounting deals with the disclosure of what we have called accounting uncertainties in Chapter 3. These different
concepts illustrate the importance of being aware of different perspectives on an issue.
As an illustration of the difficulties in identifying fairness of presentation criteria on a specific issue, we continue
our discussion of going-concern problem disclosures from Chapter 3. Going concern is an example of a type of
uncertainty that we refer to as accounting uncertainty. It is labelled as an accounting uncertainty because GAAP is
based on the going-concern assumption and the appropriate accounting for when this assumption is violated is
also a topic of accounting theory.
Accounting uncertainties relate to the client's economic substance and the auditor's role is to verify that the
financial reporting fairly presents this economic substance. But as noted in Chapter 3 the only Handbook guidance
with respect to this is that if any going-concern problems are not “adequately disclosed” only then does the
auditor issue an accounting deficiency reservation of opinion. But what constitutes going-concern “problems”?
What is “adequate disclosure”? The standards provide very little guidance as to what these terms mean, so the
auditor must rely on “professional judgment” (also not defined).
As indicated in Chapter 3 several CICA exposure drafts and research studies suggest that this may be an issue of
the degree of uncertainty regarding going concern. For example, would you expect disclosure of going-concern
problems if three out of four companies in similar situations failed within the next year? Would your answer
change if the odds were changed to one in a trillion chance of failing within the next year (this is less than the
chance that you will be struck by lightning in the next year)?
As indicated in the Chapter 3 literature review on going concern, the key issue seems to be the level of uncertainty
or risk that the company will fail in the next year. If that risk is high enough then disclosure is required in the
notes to the company's financial statements. If higher still then the company may be required to change its basis of
accounting. The prior literature suggests the following conditions are crucial thresholds:
1. significant doubt (20–50 percent probability of failure)
2. substantial doubt (50 percent to almost virtually certain probability of failure)
3. virtually certain
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The accounting logic of the existing literature suggests that if condition 1 holds then a company needs to disclose
its going-concern problems in the notes to the financial statements and if it fails to do so then an audit reservation
of opinion would be required. Under the new CAS 706, there is an additional requirement under conditions 1 and
2 for the auditor to add an explanatory paragraph even if the uncertainty is adequately disclosed in the notes.
Under condition 3 the auditor would need to insist on a change to the basis of accounting (e.g., from historical
cost to liquidation basis).
This logic suggests an important aspect of critical thinking in public accounting and that is that auditor judgments
about accounting uncertainties can have a big impact on what is considered fair presentation. Audit judgments
will need to be integrated with accounting judgments in order to justify the auditor's report. In particular, relative
to critical thinking concepts, an important warrant to be considered in auditor justification is along the lines of the
following:
Warrant on integrated critical thinking for auditors with regard to going-concern uncertainties: The degree
of uncertainty with respect to going concern (and contingencies and perhaps other estimates) affects not only the
audit report but also the proper form of accounting disclosure.
Note that this warrant does not exist in the Handbook. It is one that a critical thinking auditor would need to
consider, in combination with criteria on thresholds as discussed above, in deciding if proposed disclosures by a
client present fairly. Critical thinking is the type of thinking needed for the increasing demands in the post-Enron
world of more quality in financial reporting.
In deciding on the degree of acceptable uncertainties for specific disclosures auditors need to consider a very
important issue in their critical thinking—this is the problem of the “self-fulfilling prophecy.” This problem refers
to the fact that if the auditor were to insist on disclosure of going-concern risks (or even for contingencies such as
lawsuits) then the mere act of disclosing can cause the bad outcome that is disclosed, for example by creating
financing problems for the company and thereby pushing it over the brink into failure (that's why it's call self-
fulfilling prophecy). The client might even sue the auditor if the disclosure is perceived as causing the failure. For
this reason auditors have some reluctance in disclosing these problems.
However, the self-fulfilling prophecy problem looks at the issue of going-concern disclosure from only one
perspective—that of management. What about the perspective of prospective investors who are the ones relied on
to prevent the company from going under? Do they need to be appropriately informed of the risks of their
potential investment? So the other perspective on the issue of going-concern problem disclosures is that of the
investors expected to supply the additional capital. These two perspectives create an ethical dilemma for the
auditor because they both need to be considered in deciding on the amount of disclosure that results in fair
presentation for all parties concerned. Thus focusing only on the self-fulfilling prophecy problem is not true
critical thinking. Similar issues arise whenever an accounting standard is argued as having harmful effects on
particular industries (e.g., the enormous resistance put up by high tech companies against the expensing of stock
option compensation). It is usually better to have such issues sorted out at the standard-setting level within
accounting standards. But as in the case of going-concern problems if the standard-setters have not yet resolved
this, then the burden is left on the practising auditor to sort this out within the context of a specific engagement.
This is when critical thinking becomes very important and the basis for documentation in the audit files. Such
documentation of critical thinking can be useful in showing due care in case the auditor's judgment is ever
questioned in the court or by CPAB.
Have auditors been doing a good job of implementing a critical thinking perspective in the case of going-concern
problems? You be the judge. Studies in Canada have shown that half of audited companies that fail did not have
any indication of going-concern problems in the immediately preceding audited financial statements. If you
invested in a company that failed within a few months of your investment and there was no indication of problems
in its audited financial statements would you consider those financial statements as fairly presented (e.g., think
back to the Thai restaurant example from Chapter 1)? Would you consider them to have “high” assurance that the
financial statements are not misleading? Keep in mind that when a company fails the actual realized values for its
assets are usually pervasively materially different from what was reported in the financial statements. So when
auditors fail to detect going-concern problems 50 percent of the time, are they providing high assurance that there
are no material misstatements for the failing companies? These are the types of questions a critical-thinking
auditor needs to ask.
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REVIEW CHECKPOINTS
1. Are auditors providing high assurance when they fail to disclose going-concern problems for failing
companies?
1. What is wrong with the self-fulfilling prophecy argument from the auditor's perspective?
1. Identify the perspectives possible and the resulting arguments regarding the expensing of stock option
compensation.
1. How does the auditor know if the disclosure of going-concern problems is complete, i.e., what criteria tell
the auditor that the client needs to disclose going-concern problems?
1. What do you think fair presentation should mean in addition to not being materially misstated from a
GAAP number? Can you defend your decision to the rest of the class?
Objectivity vs. Independence
A final issue we will consider here is the relationship of the more traditional concepts of objectivity and
independence to critical thinking. A competent auditor needs to collect and evaluate audit evidence in an impartial
way. He or she must be convinced by the facts of the situation. This is what seeking the truth means in critical
thinking. The part of critical thinking that considers other perspectives on an issue is also part of being impartial.
Being aware of others perspectives does not mean you approve of that perspective. For example, later you will
learn that sometimes auditors need to “think like a crook” in order to detect deceptions in financial reporting. This
does not mean the auditor approves of the way the crook is thinking. What it does mean is that the auditor will
anticipate what ways a crook might try to deceive and the best procedures to detect these activities.
This attitude of impartiality is what we call being objective. Objectivity is a state of mind. Evidence of it is
apparent in the form of the quality of critical thinking that is documented in the audit files. Independence is a
precondition of objectivity. Independence in appearance is an indication to third parties of independence in fact.
Impairment of independence threatens the perceived objectivity and therefore the perceived quality of critical
thinking (e.g., the thinking may be viewed as biased). The quality of the critical thinking affects the quality of the
audit and the audited financial statements.
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Chapter 4
1. Failure to FollowGAAS. It's going to be a long night! First thing this morning, the senior partner of your
three-partner firm, Peters, Peters and Paul (“PPP”), called you into her office to tell you that she had a
confidential but exciting assignment for you. The firm has been retained to review the audit working
papers of another firm in connection with its audit of TVB Software (TVB), a public company. That firm,
Yeller, Louder and Soft (YLS), had performed the audit of TVB for the last two years, since the date it
went public. It appears that the bank did not renew TVB's loan when it matured some six months ago and
TVB was unable to obtain other financing. As a result, your firm's client lost a good portion of the $2
million he had invested in the shares of TVB. Your client is suing the auditors of TVB, alleging that they
failed to perform the audit in accordance with generally accepted auditing standards (GAAS), and that as a
result, your client relied on financial statements that were not correct when he made his decision to hold
on to his TVB shares. The last audited statements are included in Exhibit 4.63-1.
Victoria Smyth, the partner, has reviewed the contents of YLS's working papers. Her notes are in Exhibit
4.63-2. You have been asked to review these notes and prepare a report identifying any departures from
GAAS to support your client's view that the audit was not conducted in accordance with GAAS. In this
regard, you should note whether each instance is a clear departure from GAAS or whether the matter is
grey and, therefore, subject to potential challenge in court. Victoria is also concerned that your firm may
have some professional responsibilities under the Rules of Professional Conduct in connection with this
agreement. She would like you to identify these for her.
Required
Prepare the report requested by Victoria Smyth.
(ICAO adapted)
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TVB Software Balance Sheet As at December 31 (in thousands of dollars)
20X3 20X2
Assets
Current Assets
Prepaids $ 237 $ 410
Accounts receivable 6,146 5,410
Inventory 13,904 9,382
20,287 15,202
Other Assets
Fixed assets 13,640 14,975
Goodwill 4,084 4,310
Other assets 6,950 7,010
24,674 26,295
$44,961 $41,497
Liabilities and Shareholder Equity
Current Liabilities
Bank indebtedness $ 4,940 $ 1,749
Accounts payable 10,641 5,940
Deferred revenue 140 3,643
Current portion of long-term debt 1,400 1,400
17,121 12,732
Long-term Debt 18,210 19,990
Share Capital 8,500 8,500
Retained Earnings 1,130 275
Total Liabilities and Capital $44,961 $41,497
TVB Software Income Statement For the years ended December 31 (in thousands of dollars)
20X3 20X2
Sales $21,724 $31,490
Cost of Sales 15,908 20,130
Gross Margin 5,816 11,360
Sales and Administrative Expenses
Salaries 1,760 3,170
Research costs 304 3,775
Marketing and sales 501 2,607
Interest 1,739 1,889
Other 657 16
4,961 11,457
Net Income Before Taxes 855 (97)
Income Taxes — 203
Net Income $ 855 ($ 300)
TVB Software For the year ended December 31, 20X3
From Note 1—Accounting Policies
Goodwill
Goodwill is amortized to income over its 40-year life.
From Note 7—Fixed Assets
Fixed assets comprises.
Cost December 31, 20X3 Accumulated Debt Book Value
Computer Equipment $29,790 $26,100 $ 3,690
Furniture and Fixtures 10,650 7,700 2,950
Building 11,000 4,000 7,000
Total $51,440 $37,800 $13,640
EXHIBIT 4.63-1
EXTRACTS FROM AUDITED FINANCIAL STATEMENTS
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“PRIVILEGED”
Victoria Smyth's notes on review of audit working papers of TVB Software prepared by Yeller, Louder 8 Soft
1. I reviewed YLS's working papers at their office. The audit report for the year ended December 31, 20X3
was signed by YLS on February 20, 20X4.
The working papers were neat and appeared to be well organized. All of the files have been prepared by
audit staff and have been reviewed by a YLS junior audit partner, though not the one who signed the
financial statements. This is the only public company audited by YLS.
I asked to review the files of the previous year but was told that YLS only retains one year of files. The
20X2 files had been destroyed. I reminded YLS that the 20X2 files had now been subpoenaed by the
Court.
2. The audit was staffed by two YLS CAs. Neither had performed audits of a software company before, but
one of them had several years of auditing experience. The other CA had recently qualified and had spent
the previous two years working for a government internal auditor's department. The audit partner told me
that he wasn't concerned about this other CA because he was related to TVB's CFO and, hence, had a good
knowledge of some of the workings of the company.
3. The audit was fully substantive in nature. All three of YLS's files contain working papers documenting the
results of its substantive testing. Each section of the work contains a checklist of substantive tests. The
tests appear to have been developed specifically for this assignment. The steps on the checklists appear to
be signed off and cross-referenced to the appropriate working papers.
4. The first file is called the “TOP FILE” and contains several memos to file. The most significant of these
are as follows:
1. Materiality. A short memo sets materiality at $400,000. The memo notes that the company is not
currently profitable although it is expected to be in the near future. As a result, it is more
appropriate to use balance sheet numbers to determine materiality. Once the company becomes
profitable, YLS would expect to use normalized income as a basis for materiality. Thus, one per
cent of total assets is approximately $400,000.
2. Plan. A short memo sets out that the audit will be fully substantive against a materiality of
$400,000 and follow the approach used in the previous year, including the tailored audit programs
developed that year.
3. Engagement letter, signed by the client.
4. Legal letters to each of TVB's lawyers, each with a standard reply.
5. A standard management representation letter, containing no unusual or tailored paragraphs.
5. Prepaids. As these amounts were not material, YLS only compared this year's schedule to that of the
previous year. There were no unusual items on either of the schedules.
6. Accounts receivable. The audit work in this section included a confirmation of the 15 largest accounts and
10 other accounts selected at random, covering 79% of the population. All but two of the confirmations
(totalling $326,000) were received back with no problems noted. In view of the satisfactory result on the
other confirmations, no additional procedures were carried out in relation to these two items.
A review was done to identify subsequent payments, and as at the date of the audit opinion, 85 percent of
the receivables had been collected. Of the remaining accounts, none were above $100,000, so no further
work was carried out.
Procedures were carried out to ensure that balances outstanding at year end related to shipments before
year-end. These procedures included agreeing amounts to invoices and shipping documents.
7. Inventory. The inventory consisted of software packages, most of which were manufactured by TVB, and
some purchased for modification and resale.
YLS attended the inventory count at year-end and reviewed the procedures necessary to achieve a proper
cut-off. As a result of these procedures, YLS found cut-off errors that resulted in an overstatement of sales
of $182,500. They concluded that, as this amount was not material, no adjustment was necessary. They
also reviewed the inventory valuation by reviewing the process for allocating costs to specific products.
This is a very complex process and the audit work seems to be detailed and thorough with much
recomputation and testing in the files. They concluded that the allocation methodology was appropriate in
the circumstances. They did not identify any errors.
8. Fixed assets. YLS's work was limited to reviewing the schedule of purchases (there were none above
$100,000) and recomputing the depreciation for the year.
9. Goodwill. YLS recomputed the amortization for the year.
10. Bank indebtedness. YLS confirmed the amount of the bank indebtedness and the long-term debt, which is
also owing to the bank. The confirmation noted that the debt was up for renewal in June of the following
year. There is a note in the file that company management was confident that the debt would be renewed
for a five-year term. As well, the file contained copies of some internal TVB memoranda, written over a
four-month period in 20X3, summarizing management's meetings with the bank and supporting the view
that the debt would likely be renewed. On this basis, YLS concurred with management's view that the debt
should continue to be classified as long-term debt.
11. Accounts payable. The files contained a confirmation of 100% of the accounts payable. All of the replies
were in the file and all discrepancies had been followed up. As a result of these procedures, YLS
concluded that accounts payable were understated by $232,000 but that, as this amount was immaterial, no
adjustment was required.
12. Income taxes. Very detailed work was carried out in this section by a tax manager from YLS. The review
appears very thorough and amounts are reconciled down to the penny.
13. Profit and loss. YLS carried out analytical procedures, comparing the current year's results to those of the
previous year on an account-by-account basis. Explanations were obtained from management for all
variances over $50,000 or 5 percent of the previous year's balance.
The file includes a detailed review of all invoices paid to outside consultants, including several other
accounting firms, and copies of their reports. One of the assignments relates to a “business review” of
TVB carried out at the request of the bank. The report for that assignment is not in the file.
EXHIBIT 4.63-2
TVB SOFTWARE