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Advance Assurance Services Discussion

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.”

Required:

  • Evaluate the payroll department manager’s statement and describe how a service organization affects an auditor’s review of controls.
  • www.downloadslide.net
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    Auditing &
    Assurance Services
    www.downloadslide.net
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    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
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    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
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    Some ancillaries, including electronic and print components, may not be available to customers outside
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    This book is printed on acid-free paper.
    1 2 3 4 5 6 7 8 9 LWI 21 20 19 18 17
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    MHID 1-259-57328-1
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    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 https://lccn.loc.gov/2016042220
    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.
    mheducation.com/highered
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    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)
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    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.
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    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.
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    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:
    http://www.pwc.com/us/en/faculty-resource/assets/PwC-Data-driven-paper-Feb2015.pdf.
    viii
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    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
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    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
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    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
    CFO.com
    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!
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    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
    www.rogercpareview.com.
    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
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    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 www.mhhe.com/support.
    One of our Technical Support Analysts will be able to assist you in a timely fashion.
    xiii
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    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
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    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
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    ∙ 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.
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    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
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    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
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    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
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    Baruch College
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    Seton Hall University
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    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
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    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
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    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
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    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
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    Jay Thibodeau
    www.downloadslide.net
    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
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    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
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    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
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    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
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    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
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    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
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    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
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    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
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    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
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    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
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    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 http://pcaobus.org/Rules/Rulemaking/
    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.
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    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
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    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.
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    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).
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    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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