Assigned Readings:
Chapter 11. Completing the Audit
Chapter 12. Reports on Audited Financial Statements
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:
Attorney Letters and Litigation— From the SEC’s website (www.sec.gov), access any company’s 10-K and review its footnote disclosures related to pending litigation.
Required:
[Your post must be substantive and demonstrate insight gained from the course material. Postings must be in the student’s own words – do not provide quotes!]
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Auditing &
Assurance Services
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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
any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill
Education, including, but not limited to, in any network or other electronic storage or transmission, or
broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside
the United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 LWI 21 20 19 18 17
ISBN 978-1-259-57328-6
MHID 1-259-57328-1
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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.
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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.
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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.
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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.
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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.
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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
Bharat Merchant,
Baruch College
Clyde Galbraith,
West Chester University
Eddie Metrejean,
Georgia Southern University
Andy Garcia,
Bowling Green State University
Charles Miller,
California Polytech University
David Gelb,
Seton Hall University
Perry Moore,
Lipscomb University
Earl Godfrey,
Gardner-Webb University
Fowler A. Murrell,
Lehman College
Judith G. Grant,
Northern Virginia Community
College at Annandale
Ramesh Narasimhan,
Montclair State University
Emily Elaine Griffith,
The University of Georgia
Richard Hale,
Midway College
James Hansen,
University of Illinois at Chicago
Aretha Hill,
Florida A&M University
Steven C. Hunt,
Western Illinois University
Venkataraman Iyer,
The University of
North Carolina at Greensboro
Vincent Owhoso,
Northern Kentucky University
Dwight M. Owsen
Long Island University Brooklyn
Gary Peters,
University of Arkansas
Byron Pike,
Minnesota State University–Mankato
Marshall Pitman,
University of Texas–San Antonio
Sharon Polansky,
Texas A&M University–Corpus Christi
xxi
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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
Osgood; Product Developers, Rebecca Mann and Randall Edwards; Senior Content
Project Managers, Dana Pauley and Angela Norris; Buyer, Laura Fuller; and Designer,
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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
Dave Sinason
Jerry Strawser
Jay Thibodeau
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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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Contents
Audit Plan
Significant Accounts and Relevant Assertions
Risk of Material Misstatement 287
220
Appendix 5B
Auditor Reports on Internal Control over
Financial Reporting 220
Tests of Operating Effectiveness of Internal
Control 293
Employee Fraud Overview 229
Employee Fraud Red Flags 230
Characteristics of Fraudsters 230
Summary: Control Risk Assessment
The Fraud Triangle (AU-C 315, AS 2401)
Incentive/Pressure 233
Opportunity 233
Attitude/Rationalization 234
235
The Audit of Cash
239
232
Managing People and Pressures in the Workplace 235
Internal Control Activities and Employee
Monitoring 236
Tone at the Top 238
Audit Evidence Used to Test Cash 239
Significant Accounts and Relevant Assertions 243
Risk of Material Misstatement 244
Evaluating the Design and Operating Effectiveness of
Internal Controls 244
Substantive Procedures 250
“Extended Procedures” to Detect Fraud 257
Summary 260
Key Terms 261
Multiple-Choice Questions for Practice and
Review 262
Exercises and Problems 265
Appendix 6A
Internal Control Questionnaires
Appendix 6B
Audit Plans
296
Substantive Analytical Procedures and Tests of
Details 297
Analytical Procedures 300
Confirmation of Accounts and Notes Receivable
Alternative Procedures 305
Additional Notes about Confirmations 306
Dual-Purpose Nature of Accounts Receivable
Confirmations 306
Review for Collectability 306
Cutoff and Sales Returns 307
Audit Risk Model Applied 309
Application in the Field 309
Audit Cases: Extended Audit Procedures
(AS 2301) 310
Summary 317
Key Terms 317
Multiple-Choice Questions for Practice and
Review 318
Exercises and Problems 322
Appendix 7A
Internal Control Questionnaires 332
Appendix 7B
Audit Plan
334
Chapter 8
Acquisition and Expenditure Cycle
279
Introduction 280
Revenue and Collection Cycle: Typical
Activities 280
301
276
278
Chapter 7
Revenue and Collection Cycle
Revenue Recognition 287
Collectability of Accounts Receivable 290
Customer Returns and Allowances 290
Entity-Level Controls in the Revenue and
Collections Cycle 291
Control Considerations at the Account and
Assertion Level 291
228
Fraud Prevention
285
Internal Control Activities and Design Evaluation 290
Chapter 6
Employee Fraud and the Audit
of Cash 227
Introduction
xxvii
Receiving and Processing Customer Orders, Including
Credit Granting 281
Delivering Goods and Services to Customers 282
Billing Customers and Accounting for Accounts
Receivable 282
Management Reports and Data Files in the Revenue and
Collection Cycle 283
336
Introduction 337
Acquisition and Expenditure Cycle: Typical
Activities 338
Purchasing Goods and Services 338
Receiving the Goods or Services 340
Recording the Asset or Expense and Related
Liability 341
Significant Accounts and Relevant Assertions
Accounts Payable
Expenses 343
342
341
Risk of Material Misstatement 344
Internal Control Activities and Design Evaluation 346
Entity-Level Controls 346
Control Considerations 346
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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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Contents
Completing Substantive Procedures 504
Attorney Letters 505
Written Representations 509
Ability to Continue as a Going Concern 512
Adjusting Entries and Financial Statement
Disclosure 513
Audit Documentation Review 516
Subsequent Events and Subsequently
Discovered Facts 517
Subsequent Events 517
Subsequently Discovered Facts
Omitted Procedures 521
Communications with Individuals Charged with
Governance 521
Management Letter 523
Summary of Audit Communications 523
Summary 524
Key Terms 524
Multiple-Choice Questions for Practice and
Review 525
Exercises and Problems 528
Chapter 12
Reports on Audited Financial
Statements 540
544
Conditions That Require Modifications to
the Auditors’ Standard (Unmodified)
Report 547
Departures from GAAP 547
Scope Limitations 549
Audits of Group Financial Statements 553
Auditors’ Reports Referencing Other Matters
Encountered During the Audit 556
Consistency 556
“Going-Concern” Uncertainties 556
Other Information Accompanying Audited
Financial Statements 557
Required Supplementary Information 558
Other Modifications 559
Summary: Emphasis-of-Matter and OtherMatter Paragraphs 559
560
Comparative Financial Statements 560
Summary Financial Statements 562
Supplementary Information 563
Disclaimers of Opinion 563
Summary 564
Key Terms 566
STAND-ALONE MODULES
583
585
Introduction to Attestation Engagements 585
Applying Agreed-Upon Procedures 588
Prospective Financial Information and Pro Forma
Financial Information 588
An Examination of an Entity’s Internal Control over
Financial Reporting That Is Integrated with an Audit
of Its Financial Statements (AT 501) 590
Compliance Attestation 591
Broker–Dealer Compliance 592
Management’s Discussion and Analysis 594
Service Organizations 594
Unaudited Financial Statements: Reviews,
Compilations, and Preparation Engagements
Review Services 598
Compilation Services 602
Preparation of Financial Statements 603
Summary of Audits, Reviews, and Compilations
Introduction 541
Overview of Auditors’ Reports 542
Other Reporting Topics
PART THREE
Introduction 585
Attestation Engagements
519
The Standard Report 543
Auditors’ Reports for Public Entities
Types of Opinions 546
Multiple-Choice Questions for Practice and Review 567
Exercises and Problems 569
Module A
Other Public Accounting Services
Responsibilities Following the Audit
Report Release Date 521
xxix
598
604
Responsibilities Related to Reporting on Interim
Financial Information 604
Other Topics: Special and Restricted-Use
Reports 606
Specified Elements, Accounts, or Items 606
Special-Purpose Frameworks 607
Reports on Application of Requirements of an Appropriate
Financial Reporting Framework 609
Assurance Services
611
Why Develop New Assurance Services? 611
Definition: Assurance Services 612
eXtensible Business Reporting Language (XBRL) 613
Enhanced Business Reporting 613
Integrated Reporting 613
Trust Services 614
Sustainability Reporting 615
Summary 616
Key Terms 617
Multiple-Choice Questions for Practice and
Review 618
Exercises and Problems 621
Module B
Professional Ethics
Introduction 629
General Ethics 630
628
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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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