Advance Assurance Services

Advance Assurance Services


Chapter 7. Revenue and Collection Cycle

Chapter 8. Acquisition and Expenditure Cycle

Initial Postings: Read and reflect on the assigned readings for the week. Then post what you thought was the most important concept(s), method(s), term(s), and/or any other thing that you felt was worthy of your understanding in each assigned textbook chapter.Your initial post should be based upon the assigned reading for the week, so the textbook should be a source listed in your reference section and cited within the body of the text. Other sources are not required but feel free to use them if they aid in your discussion.

Also, provide a graduate-level response to each of the following questions:

Payroll Processed by a Service Organization. Assume that you are the audit senior conducting a review of a new client’s payroll system. In the process of interviewing the payroll department manager, she makes the following statement: “We don’t need many controls because our payroll is done outside the company by Automated Information Processing, a service organization.”


  1. Evaluate the payroll department manager’s statement and describe how a service organization affects an auditor’s review of controls. Auditing & Assurance Services Auditing & Assurance Services Timothy J. Louwers, PhD, CPA, CISA, CFF Director of the School of Accounting and KPMG Eminent Professor in Accounting Allen D. Blay, PhD, CPA Associate Professor of Accounting Florida State University David H. Sinason, PhD, CPA, CIA, CFE, CFSA, CRMA PwC Professor of Accountancy Northern Illinois University Jerry R. Strawser, PhD, CPA KPMG Chair of Accounting Texas A&M University Jay C. Thibodeau, PhD, CPA Rae D. Anderson Professor of Accounting Bentley University AUDITING & ASSURANCE SERVICES, SEVENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright 2018 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions 2015, 2013, and 2011. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 LWI 21 20 19 18 17 ISBN 978-1-259-57328-6 MHID 1-259-57328-1 Chief Product Officer, SVP Products & Markets: G. Scott Virkler Vice President Portfolio & Learning Content: Michael Ryan Managing Director: Tim Vertovec Marketing Director: Natalie King Brand Manager: Patricia Plumb Director, Product Development: Rose Koos Associate Director of Digital Content: Kevin Moran Lead Product Developers: Michele Janicek / Kristine Tibbetts Senior Product Developer: Rebecca Mann Product Developer: Randall Edwards Marketing Manager: Cheryl Osgood Digital Product Analyst: Xin Lin Director, Content Design & Delivery: Linda Avenarius Program Manager: Daryl Horrocks Senior Content Project Managers: Dana M. Pauley / Angela Norris Buyer: Laura M. Fuller Design: Matt Diamond Content Licensing Specialists: Shawntel Schmitt / Lori Slattery Cover Image: The-Lightwrighter/Getty Images Compositor: SPi Global Printer: LSC Communications All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Names: Louwers, Timothy J., author. Title: Auditing & assurance services / Timothy J. Louwers, James Madison University, David H. Sinason, Northern Illinois University, Jerry R. Strawser, Texas A&M University, Jay C. Thibodeau, Bentley College, Allen D. Blay. Other titles: Auditing and assurance services Description: Seventh edition. | New York, NY: McGraw-Hill Education, [2018] Identifiers: LCCN 2016042220 | ISBN 9781259573286 (alk. paper) Subjects: LCSH: Auditing. Classification: LCC HF5667 .A815 2018 | DDC 657/.45—dc23 LC record available at The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. Some people come into our lives and quickly go. Some stay awhile and leave footprints on our hearts and we are never quite the same. Anonymous We dedicate this book to the following educators whose footprints we try to follow: Professor Homer Bates (University of North Florida) Professor Stanley Biggs (University of Connecticut) Professor Lewis C. Buller (Indiana State University) Professor Patrick Delaney (Northern Illinois University) Professor William Hillison (Florida State University) Professor John Ivancevich (University of Houston) Professor Richard Kochanek (University of Connecticut) Professor John L. “Jack” Kramer (University of Florida) Professor Jack Robertson (University of Texas at Austin) Professor Robert Strawser (Texas A&M University) Professor Sally Webber (Northern Illinois University) Professor “IBM Jim” Whitney (The Citadel) Meet the Authors Timothy J. Louwers Courtesy James Madison University is the Director of the School of Accounting and KPMG Eminent Professor in Accounting at James Madison University. Professor Louwers received his undergraduate and master’s degrees from The Citadel and his PhD from Florida State University. Prior to beginning his academic career, he worked in public accounting with KPMG, specializing in financial, governmental, and information systems auditing. He is a certified public accountant (South Carolina and Virginia) and a certified information systems auditor. He is also certified in financial forensics. Professor Louwers’s research interests include auditors’ reporting decisions and ethical issues in the accounting profession. He has authored or coauthored more than 60 publications on a wide range of accounting, auditing, and technology-related topics, including articles in the Journal of Accounting Research, Accounting Horizons, the Journal of Business Ethics, Behavioral Research in Accounting, Decision Sciences, the Journal of Forensic Accounting, Issues in Accounting Education, the Journal of Accountancy, the CPA Journal, and Today’s CPA. Some of his published work has been reprinted in Russian and Chinese. He is a respected lecturer on auditing and technology-related issues and has received teaching excellence awards from the University of Houston and Louisiana State University. He has appeared on both local and national television news broadcasts, including MSNBC and CNN news programs. Allen D. Blay Courtesy Kallen M. Lunt is an Associate Professor of Accounting at Florida State University. Professor Blay completed his PhD at the University of Florida in 2000. He teaches auditing at all levels and teaches a seminar in auditing research in the doctoral program. His research interests relate to auditor judgment and decision making. Professor Blay has authored or coauthored publications on a wide range of accounting and auditing topics in journals such as Contemporary Accounting Research, Auditing: A Journal of Practice and Theory, Organizational Behavior and Human Decision Processes, the Journal of Business Ethics, Behavioral Research in Accounting, Issues in Accounting Education, the International Journal of Auditing, and the Journal of Accounting, Auditing, and Finance. He is currently Associate Editor for Issues in Accounting Education and serves on several editorial boards. Professor Blay has been active in the American Accounting Association, serving on the auditing education committee and the annual meeting committee as Accounting, Behavior, and Organizations section chair, among other committees. He is also active in the American Institute of CPAs, serving in various volunteer roles relating to the Uniform CPA Exam. Prior to entering academics, Professor Blay worked in public accounting auditing financial institutions. He currently directs the accounting doctoral program at Florida State University. David H. Sinason Courtesy Northern Illinois University vi is the PwC Professor of Accountancy at Northern Illinois University (NIU) and director of the NIU Internal Audit program. Professor Sinason received a BS in engineering from the University of Illinois, a BS in History from Northern Illinois University, a BBA and MAcc in accounting from the University of North Florida, and a PhD in accounting from Florida State University. He has certifications as a certified public accountant, a certified internal auditor, a certified financial services auditor, and a certified fraud examiner. He also has certification in risk management assurance. Professor Sinason has written more than 50 articles, mostly in the areas of assurance services, fraud prevention and detection, and auditor liability. Meet the Authors vii Professor Sinason has taught in the areas of accounting information systems, auditing and assurance services, and financial accounting. He has received teaching awards at each of the universities where he has taught including the 2002–2003 Department of Accountancy and Northern Illinois University Awards for Excellence in Undergraduate Teaching. Jerry R. Strawser Courtesy Jerry R. Strawser is Executive Vice President and Chief Financial Officer at Texas A&M University and holds the KPMG Chair in Accounting. Prior to his current appointment, Professor Strawser served as dean of Mays Business School at Texas A&M University, interim executive vice president and provost at Texas A&M University, interim dean of the C. T. Bauer College of Business at the University of Houston, and Arthur Andersen & Co. Alumni Professor of Accounting. Professor Strawser has coauthored three textbooks and more than 60 journal articles. In addition to his academic experience, he had prior public accounting experience at two Big Five accounting firms. He has also developed and delivered numerous executive development programs to organizations such as AT&T, Centerpoint Energy, Continental Airlines, ConocoPhillips, Halliburton, KBR, KPMG, Minute Maid, PricewaterhouseCoopers, McDermott International, Shell, Southwest Bank of Texas, and the Texas Society of Certified Public Accountants. Professor Strawser is a certified public accountant in the state of Texas and earned his BBA and PhD in Accounting from Texas A&M University. Jay C. Thibodeau Courtesy Bentley University is the Rae D. Anderson Professor of Accounting at Bentley University. Professor Thibodeau is a certified public accountant and a former auditor. He received his bachelor’s degree from the University of Connecticut in 1987 and his PhD from the University of Connecticut in 1996. He joined the faculty at Bentley in 1996 and has remained there. At Bentley, he serves as the coordinator for all audit and assurance curriculum matters. His off-campus commitments include consulting with the Audit Learning and Development group at KPMG. Professor Thibodeau’s scholarship focuses on audit judgment and decision making and audit education. He is a coauthor of two textbooks and has written more than 40 book chapters and articles for academics and practitioners in journals such as Auditing: A Journal of Practice & Theory, Accounting Horizons, and Issues in Accounting Education. Professor Thibodeau served as the President of the Auditing Section of the American Accounting Association for the 2014/2015 academic year. He served on the Executive Committee for the Auditing Section from 2008 to 2010. He has received national recognition for his work five times. First, for his thesis, winning the 1996 Outstanding Doctoral Dissertation Award presented by the ABO section of the AAA. Three other times, for curriculum innovation, winning the 2001 Joint AICPA/AAA Collaboration Award, the 2003 Innovation in Assurance Education Award, and the 2016 Forensic Accounting Teaching Innovation Award. Finally, for outstanding service, receiving a Special Service Award from the Auditing Section for his work in helping to create the “Access to Auditors” program sponsored by the Center for Audit Quality. Look Beneath the Surface . . . As auditors, we are trained to investigate beyond appearances to determine the underlying facts—in other words, to look beneath the surface. From the Enron and WorldCom scandals of the early 2000s to the financial crisis of 2007–2008 to present-day issues and challenges related to significant estimation uncertainty, understanding the auditor’s responsibility related to fraud, maintaining a clear perspective, probing for details, and understanding the big picture are indispensable to effective auditing. With the availability of greater levels of qualitative and quantitative information (“big data”), the need for technical skills and challenges facing today’s auditor is greater than ever. The author team of Louwers, Blay, Sinason, Strawser, and Thibodeau has dedicated years of experience in the auditing field to this new edition of Auditing & Assurance Services, supplying the necessary investigative tools for future auditors. Cutting-Edge Coverage The seventh edition of Auditing & Assurance Services continues its tradition as the most up-to-date auditing text on the market. All chapters and modules have been revised to incorporate the latest professional standards, recodifications, and proposals from the International Auditing and Assurance Standards Board, Auditing Standards Board, and Public Company Accounting Oversight Board. To acquaint students with the professional standards, each chapter or module begins with a list of the relevant professional standards that are covered in that chapter. Importantly, this text incorporates the reorganized PCAOB standards effective December 31, 2016. As a team, we use a variety of contacts and resources to stay informed of ongoing developments that affect learning objectives in the financial statement auditing course(s). In fact, changes to key learning goals and objectives are usually prompted by interactions with colleagues from practice. In that spirit, since the publication of our sixth edition, we have been working hard to stay in touch with developments in practice so we can always respond to your needs in the financial statement auditing classroom. Among our many observations, one trend has emerged as a potential sea change in the financial statement auditing process, the “big data” challenge. Indeed, based on our collective observations, we believe that students should be prepared to make the best use possible of relevant data using state-of-the art analytical tools. In fact, the terms big data and data analytics are frequently being used to describe a growing movement among audit professionals. Our collective view is that students must be prepared to meet the “big data” challenge. To help students be prepared, the seventh edition of Auditing & Assurance Services has been revised deliberately to help students critically think about the use of increased data and analytical tools in the financial statement audit. In addition, we would like to help students learn how to effectively document their conclusions in the current “big data” environment. In a recent white paper, PwC (2015)1 lists five “new” skills that will be required of auditors moving forward. Although many of these skills require special statistical or programming knowledge, the first listed skill is one that is applicable to all auditors: “Research and identify anomalies and risk factors in underlying data.” Although 1 “Data Driven: What Students Need to Succeed in a Rapidly Changing Business World.” Available at: viii extraction and analysis from client accounting data are critical skills for newly minted auditors, we are unaware of sufficient materials to assist professors in integrating data analytics into the auditing classroom. Thus, an important goal of the seventh edition is to provide a clear and implementable method to fully integrate a leading data analysis tool, the IDEA data analysis software, into the auditing class. To start, McGraw-Hill Education is excited to announce a partnership with the developers of the IDEA software. We believe that IDEA provides an outstanding platform to illustrate the steps that auditors need to take related to data and data analysis while completing the financial statement audit. Leading auditing professionals have confirmed that using IDEA is an outstanding way for an entry-level auditing professional to begin the journey into the world of “big data” and “data analytics.” Simply stated, big data is manifested in the financial statement auditing process through the use of tools like IDEA. Overall, our revisions related to the big data challenge were designed to provide instructors a set of tools and mechanisms to bring data and analytics into the classroom in a meaningful way. Through the use of these tools, students can be sure they are prepared to enter practice with an appreciation for and knowledge of the increasing importance of data and analytics in the auditing profession. We hope that everyone enjoys our attempts to help students get ready for the big data challenge. Of course, and perhaps most importantly, the seventh edition of Auditing & Assurance Services also continues to be the most up-to-date auditing text on the market. The book has fully integrated the reorganized PCAOB Auditing Standards. In addition, all chapters and modules in the seventh edition have been revised to incorporate the two new standards (AS 2701 and AS 2410) adopted by the PCAOB that relate to the auditor’s work on supplementary information provided in the financial statements and related parties. In addition, all chapters and modules have been revised to incorporate the latest updates from the international standards of auditing (ISAs) and the Auditing Standards Board (ASB). With Auditing & Assurance Services, seventh edition, students are prepared to take on auditing’s latest challenges. The Louwers author team uses a conversational, yet professional tone­—hailed by reviewers as a key strength of the book. Flexible Organization Auditing & Assurance Services teaches students auditing concepts by emphasizing real-life contexts when describing the auditing process. The authors use chapters and modules to “The format allows you to integrate the modules into the chapter material in any way you would find useful.” —Frank J. Beil, University of Minnesota Chapters Modules The 12 chapters cover the auditing process extensively with a multitude of cases designed to give students a better understanding of how a best-practice concept developed from real-world situations. Modules A–H provide instructors additional material that can be used throughout the course. Topics such as fraud, ethics, sampling, and technology are covered in the modules, which are designed to be taught whenever instructors want to introduce the topic in their course. ix achieve this goal. Although the chapters follow a logical sequence that we recommend professors consider for their classes, the modules have been written to be used on a stand-alone basis. In essence, the modules have been deliberately prepared for entirely flexible implementation of these topics without excessive reliance on chapter sequencing. We encourage you to integrate these modules into your syllabi in a manner that best suits your approach to the auditing course. Engage Your Students with Real Examples “The tone of the textbook is in a conversational manner that allows for more studentfriendly reading material.” —Aretha Hill, Florida A&M University An effective accounting textbook integrates real-world scenarios with theoretical discussion. Auditing & Assurance Services places the student in the role of a decision maker, by illustrating the application of auditing concepts using actual situations experienced by accounting firms and companies such as: Each chapter or module opens with a “real-world” example that draws upon concepts discussed within that chapter or module. Finally, a series of mini-cases have been developed for use by instructors to further bring text material to life. These mini-cases feature real situations experienced by the following companies, individuals, or accounting firms [new cases to the seventh edition are noted with an asterisk (*)]. ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ Arthur Andersen (failure of auditors to detect fraud at Enron) Bernie Madoff Investment Securities (failure of auditors and regulators to detect fraud)* Crazy Eddie’s (failure of auditors to detect fraud)* Daily Journal Corporation (auditor changes and reporting on internal control)* General Electric (audit fees and services provided by auditors) General Motors (going-concern report by auditors) HealthSouth Corporation (failure of auditors to detect fraud) KPMG (competition in the audit marketplace) Lehman Brothers (estimation uncertainties in the audit and disclosure concerns)* Parmalat (failure of auditors to detect fraud) Satyam Computer Services Ltd. (failure of auditors to detect fraud) Scott London, KPMG partner (failure of auditor to follow the AICPA Code of Conduct)* Confirming Pages Fraud Awareness CHAPTER 4 The fraud coverage in Auditing & Assurance Services is the most extensive available and is complemented by real-world examples chosen to engage students through the following tools: Management Fraud and Audit Risk ∙ Auditing Insights integrated throughout the text. ∙ Mini-cases that may be assigned to supplement text chapters and modules that expose students to Profit is the result of risks wisely selected. x Frederick Barnard Hawley, American economist (1843–1929) Risk comes from not knowing what you’re doing. Warren Buffett, widely regarded as one of the most successful investors in the world Professional Standards References AU-C/ISA Section AS Section Overall Objectives of the Independent Auditor 200 1001, 1005, 1010, 1015 Consideration of Fraud in a Financial Statement Audit 240 2401 Consideration of Laws and Regulations 250 2405 Communications with Audit Committees 260 1301 Consideration of Internal Control in an Integrated Audit 265 2201 Topic landmark fraud cases at Bernie Madoff Investment Securities, Enron, HealthSouth, Parmalat, PTL Club, and Satyam Computer Services. ∙ Specific discussion of management fraud (Chapter 4), employee fraud (Chapter 6), and the Certified Fraud Examiner Exam (Module D). ∙ Apollo Shoes Case, the only stand-alone fraud audit case on the market (available online). Create a State-of-the-Art Learning Environment: Instructor Resources The author team and McGraw-Hill are dedicated to providing instructors with the best teaching resources available. In addition to the solutions manual, test bank, and PowerPoint Presentations, and the Apollo Shoe Case, the following resources are also available. The Updated Auditor The author team scrutinizes leading business and academic publications for relevant issues and research that sheds light on auditing and the audit process. Recent findings from academic research and discussions from professional literature are drawn from the following publications: ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ ∙ Accounting Horizons Accounting Today Auditing: A Journal of Practice & Theory Behavioral Research in Accounting Bloomberg Businessweek CPA Journal Journal of Accountancy Journal of Accounting and Economics The Accounting Review The Wall Street Journal These excerpts are highlighted throughout the text as Auditing Insights to allow for easy identification and review by instructors and students. In addition to the use of Auditing Insights, on a monthly basis, the author team provides an Updated Auditor briefing, which summarizes the content of relevant business and academic publications on a chapter-by-chapter basis, to allow students to apply current developments in the profession with material discussed in class. The Updated Auditor briefing is available in Connect. With the Updated Auditor, instructors will always be at the cutting edge of auditing practice! xi IDEA Software and Workbook With the availability of unprecedented amounts of quantitative and qualitative information and tools available to access and process that information, it is imperative that students learn and utilize the latest technologies used by auditing professionals. As previously stated, McGraw-Hill Education has forged a partnership with Caseware Analytics for the use of the IDEA data analysis tool. Chapters 3 (audit planning), 4 (risk assessment), 5 (internal control), 7–9 (operating cycle chapters), Module F (attributes sampling), and Module G (variables sampling) have been revised to reference the use of IDEA within the chapter or module. In addition, the seventh edition includes end-of-chapter exercises utilizing authordeveloped databases exclusively for use with Auditing & Assurance Services as well as supplemental materials available in Connect to complement the IDEA workbook and provide hands-on instructions on using the IDEA software. The authors also provide implementation guidance to instructors and detailed solutions and explanations on this new content. Overall, the author team has provided significant resources to prepare students for the auditing environment in 2017 and beyond. Roger CPA Review McGraw-Hill Education has partnered with Roger CPA Review, a global leader in CPA Exam preparation, to provide students a smooth transition from the accounting classroom to successful completion of the CPA Exam. While many aspiring accountants wait until they have completed their academic studies to begin preparing for the CPA Exam, research shows that those who become familiar with exam content earlier in the process have a stronger chance of successfully passing the CPA Exam. Accordingly, students using these McGraw-Hill materials will have access to sample CPA Exam Multiple-Choice questions and Task-based Simulations from Roger CPA Review, with expert-written explanations and solutions. All questions are either directly from the AICPA or are modeled on AICPA questions that appear in the exam. Task-based Simulations are delivered via the Roger CPA Review platform, which mirrors the look, feel and functionality of the actual exam. McGraw-Hill Education and Roger CPA Review are dedicated to supporting every accounting student along their journey, ultimately helping them achieve career success in the accounting profession. For more information about the full Roger CPA Review program, exam requirements and exam content, visit TestGen TestGen is a complete, state-of-the-art test generator and editing application software that allows instructors to quickly and easily select test items from McGraw Hill’s TestGen testbank content and to organize, edit and customize the questions and answers to rapidly generate paper tests. Questions can include stylized text, symbols, graphics, and equations that are inserted directly into questions using built-in mathematical templates. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a test generator system for today’s educators. xii Association to Advance Collegiate Schools of Business (AACSB) Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Auditing & Assurance Services, 7e, recognizes the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the text and test bank to the eight general knowledge and skill guidelines in the AACSB standards. The statements contained in Auditing & Assurance Services, 7e, are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual schools, their mission, and their faculty. Although Auditing & Assurance Services, 7e, and the teaching package make no claim of any specific AACSB qualification or evaluation, we have within Auditing & Assurance Services, 7e, labeled selected questions according to the eight general knowledge and skills areas. MCGRAW-HILL CUSTOMER EXPERIENCE GROUP CONTACT INFORMATION At McGraw-Hill Education, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can contact our Product Specialists 24 hours a day to get product training online. Or you can search the knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094 or visit One of our Technical Support Analysts will be able to assist you in a timely fashion. xiii New to the Seventh Edition of In response to feedback and guidance from numerous auditing accounting faculty, the authors have made many important changes to the seventh edition of Auditing & Assurance Services, including the following: Highlights of Auditing & Assurance Services, 7e ∙ The seventh edition of Auditing & Assurance Services features Connect and SmartBook. ∙ All chapter and modules have been revised to incorporate professional standards adopted through May 2016. In addition, the reorganized PCAOB framework (which becomes effective December 31, 2016) has been utilized throughout the text. ∙ Auditing Insight boxes have been added and updated throughout the textbook to place issues discussed within the text into a real-world context. These boxes incorporate numerous examples from business and academic publications as well as actual company annual reports and audit reports. ∙ Examples using the Caseware IDEA software have been added in Chapters 3, 4, 5, 7, 8, 9, Module F, and Module G. In addition, end-of-chapter exercises using authordeveloped databases exclusively for use with Auditing & Assurance Services as well as supplemental materials to complement the IDEA workbook are provided. ∙ Coverage in the cycle chapters has been standardized to focus on the risk assessment process for each relevant assertion. In addition, the chapters provide a consistent focus on how auditors respond to assessed risk of material misstatement, through the incorporation of easy-to-read tables throughout Chapters 6 through 10 to highlight the key issues and risks faced by auditors in the examination of different accounts. These tables take the students through the risk assessment process for each cycle on a step-by-step basis to mirror the methodology used in current audit practice. ∙ Five new Mini-cases have been added that feature Bernie Madoff Investment Securities (failure of auditors and regulators to detect fraud); Crazy Eddie’s (failure of auditors to detect fraud); Daily Journal Corporation (auditor changes and internal control reporting); Lehman Brothers (estimation uncertainties in the audit and failure to make informative disclosures); and Scott London, KPMG Partner (failure of auditor to follow the AICPA Code of Conduct). Part I: The Contemporary Auditing Environment CHAPTER 1: Auditing and Assurance Services CHAPTER 2: Professional Standards ∙ Our discussion about the CPA exam has been revised to fully reflect the substantial changes being made to the exam as of April 1, 2017. Due primarily to the outsourcing of routine tasks and significant advances in information technology, the job of a newly licensed CPA has changed. The AICPA responded with a revised exam that has an increased emphasis on higher-order skills like problem solving, critical thinking, and analytical ability. The changes are fully described in the text. ∙ Increased our emphasis about the importance of audit quality in the current environment and added an Auditing Insight that describes the audit quality indicators project recently completed by the PCAOB in 2015. ∙ Added a new exhibit that provides an example of the 2014/2015 Sustainability Report for the Coca-Cola Company. We also added a new exhibit that features Mickey Mantle’s baseball card from 1961. ∙ Increased our emphasis on the emergence of big data in the auditing environment and added an Auditing Insight that describes what students need to succeed in a world characterized by big data. ∙ Summarized recent academic research related to the impact of PCAOB inspections and results of inspections on audit quality, client attraction and retention, and audit fee growth rates (including research specifically related to the Deloitte vignette in the introduction of this chapter). ∙ Summarized recent independence issues encountered by EY and KPMG. ∙ McDonald’s 2016 audit report, which demonstrates the contents of an actual audit report and how this report reflects the guidance in the reporting principle. ∙ Included an Auditing Insight regarding controversy over PCAOB inspection of audits of Alibaba Group Holding Limited, which have been impacted by China’s ban of PCAOB inspections. ∙ Summarized PCAOB inspections of 2012, 2013, and 2014 audits conducted by Big Four firms and expanded analysis to summarize the number of audits in which the client’s report on internal control was revised as a result of the inspection. xiv Auditing & Assurance Services Part II: The Financial Statement Audit CHAPTER 3: Engagement Planning ∙ Added a discussion to emphasize the importance of identifying all of the significant accounts and each of the relevant financial statement assertions during the engagement planning process. ∙ Included a new table to help facilitate the understanding of significant accounts and relevant financial statement assertions and to show how this might be documented in the audit work papers. ∙ Added an Auditing Insight to describe the importance of audit quality and why planning is such an important aspect in helping to ensure that the engagement plan has been developed to achieve quality outcomes on the audit. ∙ Added a discussion about the availability of big data on the audit and included a demonstration problem of how to access a client’s data using IDEA. CHAPTER 4: Management Fraud and Audit Risk ∙ Increased focus on the importance of assessing the risk of material misstatement for each relevant financial statement assertion for each significant account and disclosure. This focus is entirely consistent with the audit approaches of each of the largest audit firms in the world. This focus will be very helpful in preparing students to enter the auditing environment in 2017 and beyond. ∙ Added a new easy-to-read table to highlight the importance of identifying “what can go wrong” for each relevant assertion identified in the planning process. This process is instrumental for assessing the risk of material misstatement for each relevant assertion. ∙ Moved our discussion of an audit client’s risk management system to Chapter 5, where it is incorporated into our discussion of the risk assessment component of an effective internal control system as defined by COSO. By moving this section, students are able to better focus on inherent risk assessment in this chapter. ∙ Added an Auditing Insight to illustrate the potential dangers of analyst expectations at Bankrate and an Auditing Insight to illustrate the difficulty involved in auditing percentage of completion estimates at Toshiba. These examples are used to emphasize the importance of considering a client’s business and operating environment during the risk assessment process. ∙ Incorporated newly released PCAOB Auditing Standard 2410 about Related Parties into the chapter. CHAPTER 5: Risk Assessment: Internal Control Evaluation ∙ Fully integrated the specifics of the COSO 2013 update to its internal control framework. The update adds 17 explicit principles that are associated with the five components of internal control (i.e., control environment, risk assessment, control activities, information and communication, and monitoring). The chapter now includes five new exhibits to help clarify and make these principles salient to students. ∙ Added a new easy-to-read table to reinforce the importance of identifying “what can go wrong” to help assess the risk of material misstatement for each relevant assertion that provides a foundation to help identify control activities that might mitigate that risk. This is an important aspect of the audit process employed by each of the large audit firms, and the table is designed to help students better understand that process. ∙ Added a section on internal control testing alternatives with a focus on how auditors can use a tool such as IDEA to test the entire population of control instances in today’s environment. We also added two new problems where students can complete exception tests using IDEA. CHAPTER 6: Employee Fraud and the Audit of Cash ∙ Added two easy-to-read tables to allow for a focus on the risk assessment process for each relevant assertion related to cash. For each relevant assertion, students can see how the risk of material misstatement was assessed and how the auditors might respond to the assessed risks with tests of control and substantive tests. The step-by-step process mirrors the methodology used in current audit practice. ∙ Improved the flow and organization of the chapter by integrating the section on controls designed to mitigate the risk of employee fraud into the section on internal control testing for the cash account. In addition, the section on proof of cash has been moved to the extended fraud procedures section to better align the chapter with current audit practice. ∙ Added an Auditing Insight describing the fraud perpetrated by a controller at a Pepsi-Cola Bottler and how he escaped to the Appalachian trail for an extended period of time. CHAPTER 7: Revenue and Collection Cycle ∙ Revised format tracking the audit process beginning with identification of significant accounts and relevant assertions. ∙ Added four new tables outlining risks and tracking them through the audit process, including tests of controls and substantive procedures. ∙ Updated discussion of revenue recognition restatements. ∙ Increased discussion of risks related to data breaches, including an Auditing Insight on the Target Corp. data breach. ∙ Added a discussion of the new revenue recognition standards, including examples from financial statements of Apple Inc. xv ∙ Updated PCAOB inspection findings through the latest inspection reports. ∙ Includes a focus on data and analytics that integrates several IDEA exercises, including new authorcreated content and end-of-chapter materials. CHAPTER 8: Acquisition and Expenditure Cycle ∙ Revised format tracking the audit process beginning with identification of significant accounts and relevant assertions. ∙ Added five new tables outlining risks and tracking them through the audit process, including tests of controls and substantive procedures. ∙ Increased discussion of risks related to accounts payable. ∙ Updated PCAOB inspection findings through the latest inspection reports. ∙ Includes a focus on data and analytics that integrates several IDEA exercises, including new authorcreated content and end-of-chapter materials. CHAPTER 9: Production Cycle ∙ Revised format tracking the audit process beginning with identification of significant accounts and relevant assertions. ∙ Added six new tables outlining risks and tracking them through the audit process, including tests of controls and substantive procedures. ∙ Extensive discussion of the production process and key reports of interest to the auditors. ∙ Updated PCAOB inspection findings through the latest inspection reports. ∙ Includes a focus on data and analytics that integrates several IDEA exercises, including new author-created content and end-of-chapter materials. CHAPTER 10: Finance and Investment Cycle ∙ Revised format tracking the audit process beginning with identification of significant accounts and relevant assertions. ∙ Added five new tables outlining risks and tracking them through the audit process, including tests of controls and substantive procedures. ∙ Added a new Auditing Insight regarding Verizon’s purchases, including the recent proposed purchase of Yahoo! ∙ Added a new Auditing Insight describing offbalance-sheet risk for Citigroup. ∙ Expanded discussion of auditing accounting estimates and fair values, with discussion of extreme estimation uncertainty and an Auditing Insight on the Lehman Brothers collapse. ∙ Added a discussion of blockchain technology and Bitcoin transactions. ∙ Updated PCAOB inspection findings through the latest inspection reports. CHAPTER 11: Completing the Audit ∙ New introductory vignette discusses Valeant’s year-end financial troubles and the effect on the auditors trying to complete the company’s audit. Added discussion of AS 16’s increased responsibilities to communicate with those charged with governance. CHAPTER 12: Reports on Audited Financial Statements ∙ New introductory vignette discusses KPMG’s report on the audit of Rolls-Royce and the identification of critical audit matters in this report. ∙ Discuss recently approved and proposed standards of audit report disclosures and practices related to critical audit matters, naming of the engagement partner, and audits of group financial statements. ∙ Summarize recent academic research related to the disclosure of critical audit matters, disclosure of engagement partner identity, receipt and issuance of going concern reports, and inclusion of explanatory paragraphs in otherwise unmodified audit opinions. ∙ Included examples from recent auditors’ reports of Abbott Laboratories, Alaska Air, Best Buy Co. Inc., Caesars Entertainment Corporation, The Coca-Cola Company, General Electric, Harris Teeter Supermarkets Inc., The Kroger Co., Penske Automotive Group, and Softbank Corp. to illustrate how auditors modify their reports for situations encountered in practice. ∙ Include results of an Audit Analytics research report summarizing 15 years of data regarding going-concern reports. Part III: Stand-Alone Modules MODULE A: Other Public Accounting Services ∙ New section added on PCAOB broker–dealer standards, including an Auditing Insight describing compliance issues that led to the new standards. xvi ∙ Updated for the revised standards on accounting and review services, including a section on preparation engagements. ∙ A new table clarifies the differences between preparation engagements and services that are not preparation engagements. MODULE B: Professional Ethics ∙ Opened the module with the story of disgraced former KPMG partner Scott London who sacrificed his career to share confidential client information with a friend. ∙ Added a discussion of Aristotelian virtue ethics to already existing discussions of Kantian categorical imperatives and utilitarianism. ∙ Added a discussion of the role of the PCAOB’s Division of Enforcement and Investigations. MODULE C: Legal Liability ∙ Updated the introductory vignette on litigation involving BDO Seidman for its audits of E.S. Bankest to include the ultimate resolution of this litigation. ∙ Updated the summary of major settlements involving Big Four accounting firms to include settlements occurring since 2008. ∙ Expanded the discussion of academic research examining auditor litigation to include recent studies that investigated the factors affecting the litigation risk faced by audit firms. MODULE D: Internal Audits, Governmental Audits, and Fraud Examinations ∙ Updated the coverage of the reliance of Congress on the GAO. ∙ Discussed the variety of services provided by internal auditors. ∙ Added Benford’s law to the fraud investigation discussion. MODULE E: Overview of Sampling ∙ New introductory vignette involve the recent U.S. Supreme Court ruling on use of sampling methods to determine monetary damages against Tyson Foods in an employment dispute. ∙ Revised walk-through example of the use of sampling to address a nonauditing issue. ∙ Auditing Insight addresse how sampling risk affected predictions in the 2015 United Kingdom general elections for David Cameron and the Conservative Party. ∙ Included a brief example of sampling in the evaluation of internal control to illustrate the major steps and decisions made in the sampling process. MODULE F: Attributes Sampling of attributes sampling in the audit engagement to place the attributes sampling process in context. ∙ IDEA is used in the determination of sample size, selection of sample items, and evaluation of sample results to supplement the use of AICPA sampling tables. ∙ Additional end-of-chapter items provide students with the opportunity to use IDEA in various stages of the attributes sampling process. ∙ Summarized a recent academic study that surveyed the sampling practices of six international accounting firms with respect to establishing parameters and selecting sample items. MODULE G: Variables Sampling ∙ Introductory section provides an overview of the audit engagement, the use of the audit risk model, and the role of variables sampling in the audit engagement to place the variables sampling process in context. ∙ IDEA is used in the determination of sample size, selection of sample items, and evaluation of sample results to supplement the use of formulae in MUS. ∙ Additional end-of-chapter items to provide students with the opportunity to use IDEA in various stages of MUS applications. ∙ Auditing Insight summarize the results of a recent academic study that surveyed the sampling practices of six international accounting firms. ∙ Previous content on classical variables sampling and nonstatistical sampling has been expanded and relocated into appendixes to provide instructors with flexibility in addressing these topics. MODULE H: Auditing and Information Technology ∙ Significantly revised (and simplified) the module throughout to reinforce how the client’s use of automated transaction processing systems affects the major stages of the audit team’s study and evaluation of internal control. ∙ Provided an example of how students encounter IT general and app controls when using a smartphone. ∙ Added additional end-of-chapter material that requires students to identify tests of controls that would be used to evaluate the operating effectiveness of general and automated application controls. ∙ Introductory section provide an overview of the audit engagement, the use of the audit risk model, and the role xvii Required=Results ©Getty Images/iStockphoto McGraw-Hill Connect® Learn Without Limits Connect is a teaching and learning platform that is proven to deliver better results for students and instructors. 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Over 8 billion questions have been answered, making McGraw-Hill Education products more intelligent, reliable, and precise. Acknowledgments OUR SINCEREST THANKS . . . The American Institute of Certified Public Accountants (AICPA) has generously given permission for liberal quotations from official pronouncements and other AICPA publications, all of which lend authoritative sources to the text. In addition, several publishing houses, professional associations, and accounting firms have granted permission to quote and extract from their copyrighted material. Their cooperation is much appreciated because a great amount of significant auditing thought exists in this wide variety of sources. A special acknowledgment is due to the Association for Certified Fraud Examiners (ACFE). It has been a generous contributor to the fraud auditing material in this text. The authors also acknowledge the valuable inclusion of the educational version of IDEA software in the seventh edition, which significantly enhances the practical application of the book. Also, the authors are particularly grateful to Meghann Cefaratti (Northern Illinois University), Brad Roof (James Madison University), and Yigal Rechtman (Pace University) for their many insightful comments over the past several years. The feedback they contributed while teaching from our text has contributed greatly to the clarity and accuracy of subsequent editions. A special thanks to Michael K. Shaub for his valuable critique of Chapter 5 and to Steven Dwyer, Suzanne McLaughlin, and Frank Wimer for the example developed to help explain the difference between general and application controls in Module H. Thanks to Helen Roybark for her help with the preparation of the instructor PowerPoint presentations. We are sincerely grateful for the valuable input of all those who helped guide our developmental decisions for the past seven editions of Auditing & Assurance Services: Dawn P. Addington, Central New Mexico Community College LuAnn Bean, Florida Institute of Technology Michael D. Akers, Marquette University Frank J. Beil, University of Minnesota Fatima Alali, California State University–Fullerton Marie Blouin, Penn State University–Harrisburg Sylvia Anderson, University of Maryland University College David Blum, Moraine Park Technical College Jeffrey J. Archambault, Marshall University xx Russell F. Briner, University of Texas at San Antonio Jack Armitage, University of Nebraska–Omaha Alexander K. Buchholz, Brooklyn College of the City University of New York MaryAnne Atkinson, Central Washington University Suzanne M. Busch, California State University–East Bay Dereck D. Barr, The University of Mississippi Eric Carlsen, Kean University Acknowledgments Meghann Cefaratti, Northern Illinois University Keith Jones, George Mason University John Critchett Madonna University Bonita K. Peterson Kramer, Montana State University–Bozeman Karl Dahlberg, Rutgers University Joseph M. Larkin, St. Joseph’s University John E. Delaney, Southwestern Texas University Rose Layton, University of Southern California Marcus Mason Doxey, University of Kentucky Pamela Legner, College of DuPage Raymond Elson, Valdosta State University Philip Levine, Berkeley College Tom English, Boise State University R. D. Licastro, Penn State University–University Park Patricia Feller, Nashville State Community College Maureen Mascha, Marquette University Marilyn Fisher, Corinthian Colleges Dorothy McMullen, Rider University Diana R. Franz, University of Toledo Heidi H. Meier, Cleveland State University John Gabelman, Columbus State Community College Bharat Merchant, Baruch College Clyde Galbraith, West Chester University Eddie Metrejean, Georgia Southern University Andy Garcia, Bowling Green State University Charles Miller, California Polytech University David Gelb, Seton Hall University Perry Moore, Lipscomb University Earl Godfrey, Gardner-Webb University Fowler A. Murrell, Lehman College Judith G. Grant, Northern Virginia Community College at Annandale Ramesh Narasimhan, Montclair State University Emily Elaine Griffith, The University of Georgia Richard Hale, Midway College James Hansen, University of Illinois at Chicago Aretha Hill, Florida A&M University Steven C. Hunt, Western Illinois University Venkataraman Iyer, The University of North Carolina at Greensboro Vincent Owhoso, Northern Kentucky University Dwight M. Owsen Long Island University Brooklyn Gary Peters, University of Arkansas Byron Pike, Minnesota State University–Mankato Marshall Pitman, University of Texas–San Antonio Sharon Polansky, Texas A&M University–Corpus Christi xxi xxii Acknowledgments Kathy Pollock, Indiana University–Purdue University Fort Wayne Duane Ponko, Indiana University of Pennsylvania Dwayne Powell, Arkansas State University Abdul Qastin, North Carolina A&T State Linda Quick, University of South Carolina Hema Rao, SUNY–Oswego Jason T. Rasso, University of South Florida Yigal Rechtman, Pace University Barbara Reider, University of Montana Raymond Reisig, Pace University John Rigsby, Mississippi State University Pamela Roush, University of Central Florida Maria Sanchez, Rider University Kristen Kelli Saunders, University of South Carolina Tammi Schaefer, University of South Carolina Bunney L. Schmidt, Utah Valley State College Timothy Andrew Seidel, University of Arkansas Carol Shaver, Louisiana Tech University Jaysinha Shinde, Eastern Illinois University Adrianne Slaymaker, Metropolitan State University Duane Smith, Brescia University Beverly Strachan, Troy University at Montgomery Iris Stuart, California State University Christine N. Todd, Colorado State University–Pueblo John Trussel, Penn State University–Harrisburg Jerry L. Turner, University of Memphis Frank Venezia, State University at Albany Barbara Vinciguerra, Moravian College Bobby Waldrup, University of North Florida Rick Warne, University of Cincinnati J. Donald Warren Jr., Rutgers University Christian Wurst, Temple University Tu Xu, Georgia State University Xu Zhaohui, University of Houston–Clear Lake Lin Zheng, Northeastern Illinois University Douglas Ziegenfuss, Old Dominion University In addition, we would like to recognize our outstanding staff at McGraw-Hill: Managing Director, Tim Vertovec; Brand Manager, Pat Plumb; Marketing Manager, Cheryl Osgood; Product Developers, Rebecca Mann and Randall Edwards; Senior Content Project Managers, Dana Pauley and Angela Norris; Buyer, Laura Fuller; and Designer, Matt Diamond. For their encouragement, assistance, and guidance in the production of this book, we are grateful. Acknowledgments xxiii Few understand the enormous commitment of time and energy that it takes to put together a textbook. As authors, we are constantly scanning The Wall Street Journal and other news outlets for real-world examples to illustrate theoretical discussions, rereading and rewriting each other’s work to make sure that key concepts are understandable, and double-checking our solutions to end-of-chapter problems. Among the few who do understand the time and energy commitment are our family members (Barbara Louwers; Kristin, Jackson, Elijah, Jonah, Ansley, and Laney Grace Blay; Karen, Matthew, Joshua, and Adam Sinason; Susan and Meghan Strawser; and Ellen, Jenny, Eric, and Jessica Thibodeau) who uncomplainingly endured endless refrains of, “I just need a couple more minutes to finish this section.” Words cannot express our gratitude to each of them for their patience and unending support. Tim Louwers Allen Blay Dave Sinason Jerry Strawser Jay Thibodeau Brief Contents PART ONE The Contemporary Auditing Environment 1. Auditing and Assurance Services 2. Professional Standards PART THREE Stand-Alone Modules Please refer to pages xviii–xxiii for guidance on when to best integrate these modules. 1 40 A. Other Public Accounting Services 583 B. Professional Ethics PART TWO The Financial Statement Audit 3. Engagement Planning C. Legal Liability 75 4. Management Fraud and Audit Risk 117 E. Overview of Sampling 9. Production Cycle 227 279 11. Completing the Audit 336 443 500 12. Reports on Audited Financial Statements 540 xxiv G. Variables Sampling 835 H. Auditing and Information Technology 394 10. Finance and Investment Cycle 762 F. Attributes Sampling 795 6. Employee Fraud and the Audit of Cash 8. Acquisition and Expenditure Cycle 676 D. Internal Audits, Governmental Audits, and Fraud Examinations 720 5. Risk Assessment: Internal Control Evaluation 173 7. Revenue and Collection Cycle 628 CASES C1 INDEX I1 883 Contents PART ONE Chapter 2 Professional Standards 40 THE CONTEMPORARY AUDITING ENVIRONMENT Introduction 41 Generally Accepted Auditing Standards (GAAS) 42 Fundamental Principle: Responsibilities 45 Fundamental Principle: Performance 48 Fundamental Principle: Reporting 54 Evaluating the Quality of Public Accounting Firms’ Practices 56 Chapter 1 Auditing and Assurance Services 1 User Demand for Reliable Information 2 Information Risk in a Big Data World Auditing, Attestation, and Assurance Services 4 3 Definition of Financial Statement Auditing Auditing in a Big Data Environment 6 Attestation Engagements 7 Assurance Services 9 Examples of Assurance Services 10 5 Management’s Financial Statement Assertions Existence or Occurrence (Existence, Occurrence) Rights and Obligations (Rights and Obligations) 14 Completeness (Completeness, Cutoff) 15 Valuation and Allocation (Accuracy or Valuation) 15 Presentation and Disclosure (Classification, Understandability) 15 Importance of Assertions 17 Professional Skepticism 18 Public Accounting 21 Assurance Services 21 Tax Services 23 Consulting and Advisory Services 12 13 Summary 60 Key Terms 61 Multiple-Choice Questions for Practice and Review 63 Exercises and Problems 66 Appendix 2A Referencing Professional Standards 73 PART TWO THE FINANCIAL STATEMENT AUDIT Chapter 3 Engagement Planning 75 Introduction 76 Pre-Engagement Activities (AU-C 300, AS 2101) 23 Other Kinds of Engagements and Information Professionals 24 Internal Auditing 24 Governmental Auditing 25 Regulatory Auditors 26 Become a Professional and Get Certified! 26 Education 27 Examination 27 Experience 28 State Certificate and License 29 Skill Sets and Your Education 30 System of Quality Control 56 PCAOB Inspection of Firms 58 Summary 31 Key Terms 31 Multiple-Choice Questions for Practice and Review 32 Exercises and Problems 37 Client Acceptance or Continuance 77 Compliance with Independence and Ethical Requirements 79 Engagement Letters 80 Audit Plan (AU-C 300, AS 2101) 82 Materiality (AU-C 320, AS 2105) 87 77 Staffing the Audit Engagement 83 Considering the Work of Internal Auditors (AU-C 610, AS 2605) 84 Using the Work of an Audit Specialist (AU-C 620, AS 1210) 85 Use of IT Auditors 85 Time Budget 85 Materiality Calculation 89 Audit Procedures for Obtaining Audit Evidence (AU-C 500, AS 1105) 90 1. Inspection of Records and Documents 93 2. Inspection of Tangible Assets 96 xxv xxvi Contents 3. Observation 96 4. Inquiry 96 5. Confirmation 97 6. Recalculation 97 7. Reperformance 97 8. Analytical Procedures Inquiry of Audit Committee, Management, and Others within the Company 145 98 Planning in a Computerized Environment 99 Effect of Client’s Computerized Processing on Audit Planning 100 Computer-Assisted Audit Techniques (CAATs) 102 Audit Documentation (AU-C 230, AS 1215) 104 Permanent Files 104 Current Files 105 Audit Documentation Arrangement and Indexing 106 Summary 108 Key Terms 109 Multiple-Choice Questions for Practice and Review 110 Exercises and Problems 114 Chapter 4 Management Fraud and Audit Risk Introduction 118 Audit Risk (AU 320, AS 1101) Audit Risk 119 Inherent Risk 120 Control Risk 120 Detection Risk 120 Audit Risk Model 120 Fraud and Other Significant Risks (AU 330, AS 2301) 147 Communication of Fraud Risks 148 Auditors’ Responsibilities for Noncompliance with Laws and Regulations (AU 250, AS 2405) 149 Audit Strategy Memorandum 151 Summary 152 Key Terms 152 Multiple-Choice Questions for Practice and Review 154 Exercises and Problems 158 Appendix 4A Selected Financial Ratios 169 Appendix 4B 117 119 Fraud Risk (AU-C 240, AS 2401) Fraud 126 Types of Fraud 128 Overall Assessment and Documentation of Inherent Risk Assessment (AU 500, AS 1105, AU 265, AS 2201) 146 Document Risk Assessment 147 124 128 Inherent Risk Assessment—“What Could Go Wrong?” (AU 315, AS 2110) 130 Other Definitions Related to Fraud Understanding the Client’s Business and Its Environment 132 Industry, Regulatory, and Other External Factors 132 The Nature of the Company 133 Related Parties 133 Selection and Application of Accounting Principles, Including Related Disclosures 134 Company Objectives, Strategies, and Related Business Risks 135 Company Performance Measures 137 Gathering Information and Preliminary Analytical Procedures 137 General Business Sources 137 Company Sources 138 Information from Client Acceptance or Continuance Evaluation, Audit Planning, Past Audits, and Other Engagements 138 Preliminary Analytical Procedures (AU 520, AS 2110) 138 Audit Team Brainstorming Discussions 144 Sample Audit Memorandum 170 Chapter 5 Risk Assessment: Internal Control Evaluation 173 Introduction 174 Internal Control Defined 175 Management Versus Auditors’ Responsibility for Internal Control 176 Auditors’ Internal Control Responsibilities 176 Components of Internal Control 179 Control Environment 180 Risk Assessment 181 Control Activities 183 Information and Communication 187 Monitoring 188 Limitations of Internal Control 190 Internal Control Evaluation 191 Phase 1: Understand and Document the Client’s Internal Control 192 Phase 2: Assess the Control Risk (Preliminary) 197 Phase 3: Identify Controls to Test and Perform Tests of Controls 199 Responsibilities in Public Company Audits Required by PCAOB Auditing Standard No. 2201 203 Requirements 204 Internal Control Communications 207 Summary 208 Key Terms 209 Multiple-Choice Questions for Practice and Review 210 Exercises and Problems 214 Appendix 5A Contents Audit Plan Significant Accounts and Relevant Assertions Risk of Material Misstatement 287 220 Appendix 5B Auditor Reports on Internal Control over Financial Reporting 220 Tests of Operating Effectiveness of Internal Control 293 Employee Fraud Overview 229 Employee Fraud Red Flags 230 Characteristics of Fraudsters 230 Summary: Control Risk Assessment The Fraud Triangle (AU-C 315, AS 2401) Incentive/Pressure 233 Opportunity 233 Attitude/Rationalization 234 235 The Audit of Cash 239 232 Managing People and Pressures in the Workplace 235 Internal Control Activities and Employee Monitoring 236 Tone at the Top 238 Audit Evidence Used to Test Cash 239 Significant Accounts and Relevant Assertions 243 Risk of Material Misstatement 244 Evaluating the Design and Operating Effectiveness of Internal Controls 244 Substantive Procedures 250 “Extended Procedures” to Detect Fraud 257 Summary 260 Key Terms 261 Multiple-Choice Questions for Practice and Review 262 Exercises and Problems 265 Appendix 6A Internal Control Questionnaires Appendix 6B Audit Plans 296 Substantive Analytical Procedures and Tests of Details 297 Analytical Procedures 300 Confirmation of Accounts and Notes Receivable Alternative Procedures 305 Additional Notes about Confirmations 306 Dual-Purpose Nature of Accounts Receivable Confirmations 306 Review for Collectability 306 Cutoff and Sales Returns 307 Audit Risk Model Applied 309 Application in the Field 309 Audit Cases: Extended Audit Procedures (AS 2301) 310 Summary 317 Key Terms 317 Multiple-Choice Questions for Practice and Review 318 Exercises and Problems 322 Appendix 7A Internal Control Questionnaires 332 Appendix 7B Audit Plan 334 Chapter 8 Acquisition and Expenditure Cycle 279 Introduction 280 Revenue and Collection Cycle: Typical Activities 280 301 276 278 Chapter 7 Revenue and Collection Cycle Revenue Recognition 287 Collectability of Accounts Receivable 290 Customer Returns and Allowances 290 Entity-Level Controls in the Revenue and Collections Cycle 291 Control Considerations at the Account and Assertion Level 291 228 Fraud Prevention 285 Internal Control Activities and Design Evaluation 290 Chapter 6 Employee Fraud and the Audit of Cash 227 Introduction xxvii Receiving and Processing Customer Orders, Including Credit Granting 281 Delivering Goods and Services to Customers 282 Billing Customers and Accounting for Accounts Receivable 282 Management Reports and Data Files in the Revenue and Collection Cycle 283 336 Introduction 337 Acquisition and Expenditure Cycle: Typical Activities 338 Purchasing Goods and Services 338 Receiving the Goods or Services 340 Recording the Asset or Expense and Related Liability 341 Significant Accounts and Relevant Assertions Accounts Payable Expenses 343 342 341 Risk of Material Misstatement 344 Internal Control Activities and Design Evaluation 346 Entity-Level Controls 346 Control Considerations 346 xxviii Contents Custody 348 Periodic Reconciliation Chapter 10 Finance and Investment Cycle 348 Testing of Operating Effectiveness of Internal Control 349 Tests of Controls Introduction 444 Finance and Investment Cycle: Typical Activities 445 349 Substantive Analytical Procedures and Tests of Details 351 Open Purchase Orders 443 Financing the Entity through Debt and Stockholder Equity 446 Financial Planning (1) 447 Raising Capital (2) 447 Investing Transactions: Investments and Intangibles (3) 449 351 Audit Risk Model Applied 359 Fraud Cases: Extended Audit Procedures (ISA/AS 2301) 361 Audit Issues in the Expense and Acquisition Cycle 364 Summary 365 Key Terms 365 Multiple-Choice Questions for Practice and Review 366 Exercises and Problems 369 Appendix 8A Significant Accounts and Relevant Assertions Risk of Material Misstatement 453 Appendix 8B Internal Control Activities and Design Evaluation 458 Internal Control Questionnaires Audit Plans Fair Market Value 454 Related-Party Transactions 455 Lease Accounting 455 Loan Covenants 456 Impairments 457 Presentation and Disclosure 457 377 380 Appendix 8C The Payroll Cycle Control Considerations Control over Accounting Estimates 463 Authorization 464 Record Keeping 464 Custody 465 Summary: Control Risk Assessment 465 382 Substantive Analytical Procedures and Tests of Details 466 394 Phar-Mor Inc. 395 Production Cycle: Typical Activities 396 Significant Accounts and Relevant Assertions 400 Risk of Material Misstatement 402 Internal Control Activities and Design Evaluation 404 Testing of Operating Effectiveness of Internal Control 408 Substantive Analytical Procedures and Tests of Details 411 Inventory Circumstances Audit Risk Model Applied 416 421 Fraud Case: Extended Audit Procedures (AS 2301) Summary 423 Key Terms 425 Multiple-Choice Questions for Practice and Review 426 Exercises and Problems 429 Appendix 9A Internal Control Questionnaires Appendix 9B Audit Plans 441 460 Tests of Operating Effectiveness of Internal Control 460 Multiple-Choice Questions for Practice and Review 390 Exercises and Problems 392 Chapter 9 Production Cycle 452 439 421 Auditing Fair Value Measurements (AS 2502) 472 Derivative Instruments, Hedging Activities, and Investments in Securities (AS 2503) 473 Long-Term Liabilities and Related Accounts 474 Stockholders’ Equity: Substantive Procedures 476 Auditing Stock-Based Compensation Plans 476 Fraud Cases: Extended Audit Procedures (AS 2301) 477 Summary 482 Key Terms 484 Multiple-Choice Questions for Practice and Review 484 Exercises and Problems 488 Appendix 10A Internal Control Questionnaires 496 Appendix 10B Substantive Audit Plans 497 Chapter 11 Completing the Audit 500 Introduction 501 Audit Timeline 502 Procedures Performed During Fieldwork 504 Contents Completing Substantive Procedures 504 Attorney Letters 505 Written Representations 509 Ability to Continue as a Going Concern 512 Adjusting Entries and Financial Statement Disclosure 513 Audit Documentation Review 516 Subsequent Events and Subsequently Discovered Facts 517 Subsequent Events 517 Subsequently Discovered Facts Omitted Procedures 521 Communications with Individuals Charged with Governance 521 Management Letter 523 Summary of Audit Communications 523 Summary 524 Key Terms 524 Multiple-Choice Questions for Practice and Review 525 Exercises and Problems 528 Chapter 12 Reports on Audited Financial Statements 540 544 Conditions That Require Modifications to the Auditors’ Standard (Unmodified) Report 547 Departures from GAAP 547 Scope Limitations 549 Audits of Group Financial Statements 553 Auditors’ Reports Referencing Other Matters Encountered During the Audit 556 Consistency 556 “Going-Concern” Uncertainties 556 Other Information Accompanying Audited Financial Statements 557 Required Supplementary Information 558 Other Modifications 559 Summary: Emphasis-of-Matter and OtherMatter Paragraphs 559 560 Comparative Financial Statements 560 Summary Financial Statements 562 Supplementary Information 563 Disclaimers of Opinion 563 Summary 564 Key Terms 566 STAND-ALONE MODULES 583 585 Introduction to Attestation Engagements 585 Applying Agreed-Upon Procedures 588 Prospective Financial Information and Pro Forma Financial Information 588 An Examination of an Entity’s Internal Control over Financial Reporting That Is Integrated with an Audit of Its Financial Statements (AT 501) 590 Compliance Attestation 591 Broker–Dealer Compliance 592 Management’s Discussion and Analysis 594 Service Organizations 594 Unaudited Financial Statements: Reviews, Compilations, and Preparation Engagements Review Services 598 Compilation Services 602 Preparation of Financial Statements 603 Summary of Audits, Reviews, and Compilations Introduction 541 Overview of Auditors’ Reports 542 Other Reporting Topics PART THREE Introduction 585 Attestation Engagements 519 The Standard Report 543 Auditors’ Reports for Public Entities Types of Opinions 546 Multiple-Choice Questions for Practice and Review 567 Exercises and Problems 569 Module A Other Public Accounting Services Responsibilities Following the Audit Report Release Date 521 xxix 598 604 Responsibilities Related to Reporting on Interim Financial Information 604 Other Topics: Special and Restricted-Use Reports 606 Specified Elements, Accounts, or Items 606 Special-Purpose Frameworks 607 Reports on Application of Requirements of an Appropriate Financial Reporting Framework 609 Assurance Services 611 Why Develop New Assurance Services? 611 Definition: Assurance Services 612 eXtensible Business Reporting Language (XBRL) 613 Enhanced Business Reporting 613 Integrated Reporting 613 Trust Services 614 Sustainability Reporting 615 Summary 616 Key Terms 617 Multiple-Choice Questions for Practice and Review 618 Exercises and Problems 621 Module B Professional Ethics Introduction 629 General Ethics 630 628 xxx Contents An Ethical Decision Process 631 Philosophical Principles in Ethics 632 Auditors’ Defenses under the Securities Act Section 13: Statute of Limitations 690 Section 17: Antifraud 690 Section 24: Criminal Liability 690 The Imperative Principle 632 The Principle of Utilitarianism (or Consequentialism) 634 The Generalization Argument 634 Virtue Ethics 634 Ethical Codes of Conduct The Securities Exchange Act of 1934 (Securities Exchange Act) 691 635 U.S. Securities and Exchange Commission (SEC) 636 The Public Company Accounting Oversight Board (PCAOB) 636 The International Federation of Accountants (IFAC) 636 The Professional Ethics Executive Committee (PEEC) of the American Institute of CPAs (AICPA) 637 An Emphasis on Independence 639 American Institute of Certified Public Accountants 639 SEC and PCAOB Independence Rules 646 Other Effects of Sarbanes–Oxley on Auditor Independence 648 Government Accountability Office (GAO) Independence Requirements 649 AICPA Rules of Conduct: Integrity and Objectivity, Responsibilities to Clients, and Other Responsibilities 650 Integrity and Objectivity Rule 650 General Standards Rule 652 Compliance with Standards Rule 651 Accounting Principles Rule 652 Confidential Client Information Rule 652 Fees and Other Types of Remuneration 654 Acts Discreditable Rule 656 Advertising and Other Forms of Solicitation Rule Form of Organization and Name Rule 658 The International Ethics Standards Board for Accountants (IESBA) Code 659 657 Consequences of Violating the Code of Professional Conduct 659 Summary 662 Key Terms 663 Multiple-Choice Questions for Practice and Review 663 Exercises and Problems 667 688 Summary 703 Key Terms 704 Multiple-Choice Questions for Practice and Review 705 Exercises and Problems 710 Module D Internal Audits, Governmental Audits, and Fraud Examinations 720 Introduction 721 “External,” Governmental, and Internal Audits Internal Audits 723 Fraud Examinations 686 Liability Under Statutory Law 687 The Securities Act of 1933 (Securities Act) 688 Section 11: Civil Liability 697 Sarbanes–Oxley 697 Racketeer Influenced and Corrupt Organizations Act 698 Aiding and Abetting 699 Organization of Accounting Firms as Limited Liability Partnerships 699 Proportionate Liability 700 Class-Action Suits 700 Auditors’ Liability Caps 702 Other Developments 702 722 732 Types of Governmental Audits 734 Audit Procedures—Economy, Efficiency, and Program Results Audits 735 GAO Government Auditing Standards 737 Single Audit Act of 1984 and Amendments of 1996 GAO Audit Reports 739 680 Liability to Clients 680 Liability to Third Parties 681 Liability for Compilation and Review Services Summary of Auditors’ Liability to Clients and Third Parties 695 The Changing Landscape of Auditors’ Liability Governmental Audits 676 The Legal Environment 678 Liability Under Common Law Section 10 and Rule 10(b)-5: Antifraud 691 Section 18: Civil Liability 693 Auditors’ Defenses under the Securities Exchange Act 693 Section 32: Criminal Liability 694 Foreign Corrupt Practices Act (FCPA) 694 Independence 723 Value-Added Audit 725 Scope of Service 726 Internal Audit Standards 730 Internal Audit Reports 731 Self-Regulatory Discipline 659 Public Regulation Discipline 660 Module C Legal Liability 689 741 The Art of Fraud Examinations 743 Fraud Examiner Responsibilities 745 Building a Fraud Case 747 Protecting the Evidence 747 Obtaining Litigation Support 747 Summary 747 Key Terms 749 738 Contents Multiple-Choice Questions for Practice and Review 749 Exercises and Problems 753 Appendix F.A Module E Overview of Sampling AICPA Sample Evaluation Tables AICPA Sample Size Tables 832 Appendix F.B 762 Introduction 762 What Is Sampling? 763 Module G Variables Sampling The Basic Steps Involved with Sampling Definition of Variables Sampling 836 Monetary Unit Sampling (MUS) 837 When Should Sampling Be Used? 764 Sampling Risk versus Nonsampling Risk 764 Statistical Sampling versus Nonstatistical Sampling 766 Planning 767 Performing 768 Documenting the Sampling Procedure Use of Sampling in the Audit 772 767 771 Study and Evaluation of Internal Control 773 Substantive Procedures 775 Summary: Sampling Risks for Audit Sampling 777 An Overview of Audit Sampling 777 Planning (Steps 1–3) 777 Performing 777 Evaluate Sample Results (Step 7) 779 Documenting the Sampling Procedure 779 Example of Audit Sampling 779 Summary 780 Key Terms 780 Multiple-Choice Questions for Practice and Review 782 Exercises and Problems 785 Module F Attributes Sampling Introduction Role of Attributes Sampling in the Audit Planning Role of Variables Sampling in the Audit 797 Other Variables Sampling Approaches 849 Variables Sampling: Documenting 850 Summary 851 Key Terms 852 Multiple-Choice Questions for Practice and Review 853 Exercises and Problems 856 Appendix G.A 872 Classical Variables Sampling Appendix G.C 799 Step 4: Determine the Sample Size 800 Step 5: Select the Sample Items 805 Step 6: Measure the Sample Items 806 Calculating the Upper Limit Rate of Deviation Making the Evaluation Decision 810 Qualitative Evaluation of Deviations 811 Documenting 812 Other Attributes Sampling Methods 813 Summary 814 Key Terms 814 Multiple-Choice Questions for Practice and Review 815 Exercises and Problems 819 874 881 Module H Auditing and Information Technology 883 796 Step 7: Evaluating the Sample Results 808 836 Steps 1–3: Planning 839 Step 4: Determine the Sample Size 839 Step 5: Select the Sample Items 842 Step 6: Measure the Sample Items 844 Step 7: Evaluate the Sample Results 845 Appendix G.B Step 1: Determine the Objective of Sampling 797 Step 2: Define the Characteristic of Interest 797 Step 3: Define the Population 798 Performing 835 Nonstatistical Sampling 796 834 Introduction 836 AICPA MUS Tables 795 xxxi 808 Introduction 884 Information Technology (IT) Systems Reliance on It Controls 887 885 General Controls 887 Automated Application Controls 894 Output Controls 896 Assessing Control Risk in an It Environment 898 Testing Controls in an It Environment 900 End-User Computing and Other Environments 901 End-User Computing Control Considerations Service Organizations 903 Computer Abuse and Computer Fraud 904 901 Preventive, Detective, and Damage-Limiting Controls 905 Computer Forensics 907 Summary 907 Key Terms 908 Multiple-Choice Questions for Practice and Review 908 Exercises and Problems 910 xxxii Contents Cases Andersen: An Obstruction of Justice? C1 PTL Club—The Harbinger of Things to Come? C5 GM: Running on Empty? C11 Unhealthy Accounting at HealthSouth C14 KPMG: How Many Firms? C17 Something Went Sour at Parmalat C20 GE: How Much Are Auditors Paid? C23 Satyam Computer Services Ltd.—India’s Enron C26 Auditor Changes at Daily Journal Corporation C30 London Has Fallen C33 Lehman Brothers: Subprime Accounting? C34 Bernard L. Madoff: The Fraud of the Century C37 When the Music Stops: Crazy Eddie’s C40 Index I1 CHAPTER 1 Auditing and Assurance Services Our system of capital formation relies upon the confidence of millions of savers to invest in companies. The auditor’s opinion is critical to that trust. James R. Doty, Chairman, Public Company Accounting Oversight Board (PCAOB) Professional Standards References AU-C/ISA Section AS Section Overall Objectives of the Independent Auditor 200 1001, 1005, 1010, 1015 Consideration of Fraud in a Financial Statement Audit 240 2401 Audit Evidence 500 1105 Attestation Standards AT 101 AT 101 Compliance Auditing Considerations in Audits of Recipients of Governmental Financial Assistance 935 6110 Topic LEARNING OBJECTIVES You are about to embark on a journey of understanding how auditors work to keep the capital markets safe and secure for the investing public. You should know that students demonstrate success in the auditing course quite differently than they do in other accounting courses. For example, when taking financial accounting, students typically demonstrate success by correctly identifying the proper journal entry for a given set of facts and circumstances. In auditing, success is typically demonstrated by completing multiple-choice, shortanswer, and simulation-type questions based on the professional standards that regulate the auditing process. Overall, this book provides you with a comprehensive set of materials that will allow you to master these professional auditing standards. Chapter 1 provides an introduction to the auditing and assurance profession. Your objectives are to be able to: LO 1-1 Define information risk and explain how the financial statement auditing process helps to reduce this risk, thereby reducing the cost of capital for a company. LO 1-2 Define and contrast financial statement auditing, attestation, and assurance services. LO 1-3 Describe and define the assertions that management makes about the recognition, measurement, presentation, and disclosure of the financial statements and explain why auditors use them as the focal point of the audit. 1 2 Part One The Contemporary Auditing Environment LO 1-4 Define professional skepticism and explain its key characteristics. LO 1-5 Describe the organization of public accounting firms and identify the various services that they offer. LO 1-6 Describe the audits and auditors in governmental, internal, and operational auditing. LO 1-7 List and explain the requirements for becoming a certified public accountant (CPA) and other certifications available to an accounting professional. USER DEMAND FOR RELIABLE INFORMATION LO 1-1 Define information risk and explain how the financial statement auditing process helps to reduce this risk, thereby reducing the cost of capital for a company. In 2002, the Sarbanes–Oxley Act was passed as a direct response to a wave of major financial statement frauds that had just occurred at companies like Enron, WorldCom, and Tyco. While the law was passed many years ago, the effect of this landmark legislation on financial statement auditing has been far reaching. Perhaps the most important change ushered in by the law is that financial statement auditing of public companies is regulated. Specifically, the Public Company Accounting Oversight Board (PCAOB) is now responsible for setting all audit standards to be followed on audits of public companies. In addition, the PCAOB is required to perform inspections of the audit work completed and the quality control processes employed by audit firms. As a direct result, accounting students should know that if they plan to work as financial statement auditors, they will be entering a world that is focused on audit quality. Consider the following Auditing Insight. AUDITING INSIGHT Audit Quality In July 2015, the PCAOB released a concept statement that detailed 28 different indicators of audit quality. The indicators were categorized within three broad categories. The first category, audit professionals, focused on measures such as partner workload and industry expertise of professionals. The second category, audit process, focused on measures such as compliance with independence requirements and PCOAB inspection results. The third category, audit results, focused on measures such as number of client restatements and client frauds. The list is a clear indication to students that quality matters more than anything else in their future work as auditing professionals. Source: PCAOB Concept Release on Audit Quality Indicators: Release No.2015-005, July 1, 2015. Available at Docket%20041/Release_2015_005.pdf. Why is audit quality so important? Well, both investors and creditors depend on reliable financial statement information to make their investment and lending decisions about a company. As a result, the confidence of investors and creditors is shaken each and every time that audit quality is compromised. In fact, before we think about audit quality any further, we must first explain the vital role that financial statement auditors play in supplying key decision makers with useful, understandable, and timely information. When you have a better understanding of why auditing is so critical to help ensure the liquidity of the world’s capital markets, we will then explore in detail the process auditors take to help ensure that audit quality is achieved. Because many of you are likely planning to enter the public accounting profession and work as an auditor, we hope that you will work hard to acquire this knowledge so that you may do your part in playing a key role in maintaining the public’s confidence in both the auditing profession and the capital markets. Chapter 1 Auditing and Assurance Services 3 Information Risk in a Big Data World All businesses make a countless number of decisions each and every day. Decisions to purchase or sell goods or services, lend money, enter into employment agreements, or buy or sell investments depend in large part on the quality of useful information. These decisions affect business risk, which is the risk that an entity will fail to meet its objectives. For example, business risk includes the chance a company takes that customers will buy from competitors, that product lines will become obsolete, that taxes will increase, that government contracts will be lost, or that employees will go on strike. If the company fails to meet its objectives enough times, the company may ultimately fail. To minimize these risks and take advantage of other opportunities presented in today’s competitive business environment, decision makers such as chief executive officers (CEOs) demand timely, relevant, and reliable information. Similarly, investors and creditors demand highquality information to make educated financial decisions. Information professionals such as accountants and auditors help satisfy this demand. In recent years, as a result of ever-increasing computing power, the decision-making environment is rapidly being transformed into one that is characterized by the availability of significant amounts of data and information. Let’s face it, the amount of information that organizations are seeking to manage is larger than anyone could have possibly imagined just 10 years ago. You are entering a world where upper management teams are placing more emphasis than ever on how to make sense of this seemingly ever-increasing availability of data and information. To help you prepare for this “big data” challenge, we will be drawing upon this theme in multiple chapters throughout this book. There are at least four environmental conditions in this “big data” world that increase user demand for relevant and reliable information: 1. Complexity. Events and transactions in today’s global business environment are numerous and often very complicated. You may have studied derivative securities and hedging activities in other accounting courses, but investors and other decision makers may not have your level of expertise when dealing with these complex transactions. Furthermore, these decision makers are not trained to collect, compile, and summarize the key operating information themselves. They need the services provided by information professionals to help make the information more understandable for their decision processes. 2. Remoteness. Decision makers are usually separated from current and potential business partners not only by a lack of expertise but also by distance and time. Investors may not be able to visit distant locations to check up on their investments. They need to employ full-time information professionals to do the work they cannot do for themselves. 3. Time sensitivity. Today’s economic environment requires businesses, investors, and other financial information users to make decisions more rapidly than ever before. The ability to promptly obtain high-quality information is essential to businesses that want to remain competitive in our global business environment. 4. Consequences. Decisions can involve a significant investment of resources. The consequences are so important that reliable information, obtained and verified by information professionals, is an absolute necessity. Enron’s aftermath provides a graphic example of how decisions affect individuals’ (as well as companies’) financial security and well-being. Enron’s stock dropped from $90 to $0.90 in little more than a year, leaving employees who had invested their life savings in the company virtually penniless. To put this drop in perspective, an investor’s $5 million investment in Enron stock in 2000 (enough for an enjoyable retirement) was worth only $50,000 a year later. A further complication in effective decision making is the presence of information risk. Information risk is the probability that the information circulated by a company will be false or misleading. Decision makers usually obtain their information from companies or organizations with which they want to conduct business, to provide 4 Part One The Contemporary Auditing Environment AUDITING INSIGHT The Consequences of Fraudulent Financial Information Bernard Madoff, a former chairman of the NASDAQ stock market and a respected Wall Street adviser and broker for 50 years, was arrested after his sons turned him in for running “a giant Ponzi scheme,” bilking investors out of billions of dollars. Many investors, including actors, investment bankers, politicians, and sports personalities, lost their life savings. Some who had already retired, now in their 70s and 80s, were forced to go back to work. Others lost their retirement homes. Charities and pensions that had invested heavily were wiped out. Although some of the world’s most knowledgeable investors fell prey to the scam, numerous red flags were present for all who were wise enough to see them. First, Madoff’s fund returned 13–16 percent per year, every year, no matter how the markets performed. Second, his stated strategy of buying stocks and related options to hedge downside risk could not have occurred because the number of options necessary for such a strategy did not exist. Third, although his firm claimed to manage billions of dollars, its auditing firm had only three employees, including a secretary and a 78-year-old accountant who lived in Florida. Sources: “Fund Fraud Hits Big Names,” The Wall Street Journal, December 13, 2008, pp. A1, A7; “Fees, Even Returns and Auditor All Raised Flags,” The Wall Street Journal, December 13, 2008, p. A7; “Top Broker Accused of $50 Billion Fraud,” The Wall Street Journal, December 12, 2008, pp. A1, A14; “Probe Eyes Audit Files, Role of Aide to Madoff,” The Wall Street Journal, December 23, 2008, pp. A1, A14. loans, or to buy or sell stock. Because the primary source of information is the target company itself, an incentive exists for that company’s management to make its business or service appear to be better than it actually is, to put its best foot forward. As a result, preparers and issuers of financial information (directors, managers, accountants, and other people employed in a business) might benefit by giving false, misleading, or overly optimistic information. This potential conflict of interest between information providers and users, along with financial statement frauds such as those of Enron and WorldCom, leads to a natural skepticism on the part of users. Thus, they depend on information professionals to serve as independent and objective intermediaries who will lend credibility to the information. This lending of credibility to information is known as providing assurance. When the assurance is provided for specific assertions made by management, we refer to the assurance provided as attestation. When the assertions are embodied in a company’s financial statements, we refer to the attestation as auditing. More specifically, when their work is completed, the auditors supply an opinion as to whether the financial statements and related footnotes are presented fairly in all material respects. The actual compilation and creation of the financial statements is completed by the company’s accountants. REVIEW CHECKPOINTS 1.1 What is a business risk? 1.2 What conditions increase the demand for reliable information? 1.3 What risk creates a demand for independent and objective outsiders to provide assurance to decision makers? AUDITING, ATTESTATION, AND ASSURANCE SERVICES LO 1-2 Define and contrast financial statement auditing, attestation, and assurance services. Now that you understand why decision makers need independent information professionals to provide assurance on key information, we further define auditing and expand the discussion of attestation and assurance services in this section, and explain their roles in today’s information economy. Chapter 1 Auditing and Assurance Services 5 Definition of Financial Statement Auditing The focus of this book is on the financial statement auditing process, by far and away the most common type of auditing and assurance service provided in today’s market. Many years ago, the American Accounting Association (AAA) Committee on Basic Auditing Concepts provided a very useful general definition of auditing as follows: Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users.1 A closer look at the definition reveals several ideas that are important to any type of auditing engagement. Auditing is a systematic process. It is a purposeful and logical process and is based on the discipline of a structured approach to reaching final decisions. It has a logical starting point, proceeds along established guidelines, and has a logical conclusion. It is not haphazard, unplanned, or unstructured. The process involves obtaining and evaluating evidence. Evidence consists of all types of information that ultimately guide auditors’ decisions and relate to assertions made by management about economic actions and events. When beginning a financial statement audit engagement, an independent auditor is provided with financial statements and other disclosures by management. In doing so, management essentially makes assertions about the financial statement balances (that the inventory on the balance sheet really does exist, that revenue transactions recorded on the income statement really did occur, that the list of liabilities on the balance sheet is complete, etc.) as well as assertions that the financial statement disclosures are fairly presented. AUDITING INSIGHT Although most of the largest public accounting firms (collectively referred to as the “Big Four”) trace their roots to the turn of the 19th century, auditing in the United States has a rich history. When the Pilgrims had a financial dispute with the English investors who financed their trip, an “auditor” was sent to resolve the difference. George Washington sent his financial records to the Comptroller of the Treasury to be audited before he could be reimbursed for expenditures he made during the Revolutionary War. One of the first Congress’s actions in 1789 was to set up an auditor to review and certify public accounts. Even the “modern” concept of an audit committee is not so modern; the bylaws of the Potomac Company, formed in 1784 to construct locks on the Potomac River to increase commerce, required that three shareholders annually examine the company’s records. Source: D. Flesher, G. Previts, and W. Samson, “Auditing in the United States: A Historical Perspective,” Abacus 41 (2005), pp. 21–39. External auditors generally begin their work with a focus on these assertions (explicit representations) made by management about the financial statement amounts and information disclosed in footnotes, and then they set out to obtain and evaluate evidence to prove or disprove these assertions or representations. Other types of auditors, however, often are not provided with explicit representations. For example, an internal auditor may be assigned to evaluate the cost effectiveness of the company’s policy to lease, rather than to purchase, heavy equipment. A governmental auditor may be assigned to determine whether goals of providing equal educational opportunities to all have been achieved with federal grant funds. Oftentimes, the latter two types of auditors must develop the explicit performance criteria or benchmarks for themselves. The purpose of obtaining and evaluating evidence is to ascertain the degree of correspondence between the assertions made by the information provider and the established criteria. Auditors will ultimately communicate their findings to interested users. 1 American Accounting Association Committee on Basic Auditing Concepts, A Statement of Basic Auditing Concepts (Sarasota, FL: American Accounting Association, 1973). 6 Part One The Contemporary Auditing Environment To communicate in an efficient and understandable manner, auditors and users must have a common basis for measuring and describing financial information. This basis is the established criteria essential for effective communication. Established criteria may be found in a variety of sources. For independent auditors, the criterion is whatever the applicable financial reporting framework is, whether it is Generally Accepted Accounting Principles (GAAP) in the United States or International Financial Reporting Standards (IFRS) in other jurisdictions. Internal Revenue Service (IRS) auditors rely heavily on criteria specified in the Internal Revenue Code. Governmental auditors may rely on criteria established in legislation or regulatory agency rules. Bank examiners and state insurance board auditors look to definitions, regulations, and rules of law. Internal and governmental auditors rely a great deal on financial and managerial models of efficiency and effectiveness. Of course, all auditors rely to some extent on the sometimes elusive criteria of general truth and fairness. Exhibit 1.1 depicts an overview of financial statement auditing. The AAA definition already presented is broad and general enough to encompass external, internal, and governmental auditing. The more specific viewpoint of external auditors in public accounting practice is reflected in the following statement about the financial statement audit made by the American Institute of Certified Public Accountants (AICPA), the public accounting community’s professional association: The purpose of an audit is to enhance the degree of confidence that intended users can place in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. In the case of most general purpose frameworks, that opinion is on whether the financial statements are presented fairly, in all material respects, in accordance with the framework. An audit conducted in accordance with generally accepted auditing standards and relevant ethical requirements enables the auditor to form that opinion. (AU-C 200.11) Auditing in a Big Data Environment The auditing environment is rapidly being transformed into an environment characterized by the availability of significant amounts of data and cutting-edge analytical tools. As a direct result, entry-level professionals are being asked to join public accounting firms EXHIBIT 1.1 Overview of Financial Statement Auditing Management assertions about economic actions and events Footnotes Statement of Cash Flows Income St…

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