Auditing-Textbook Questions

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Auditing & Assurance Services A S Y S T E M A T I C A P P R O A C H

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William F. Messier, Jr. University of Nevada, Las Vegas

Department of Accounting and

Norwegian School of Economics Department of Accounting, Auditing and Law

Steven M. Glover Brigham Young University

Marriott School of Management School of Accountancy

Douglas F. Prawitt Brigham Young University

Marriott School of Management School of Accountancy

TENTH EDIT ION

Auditing & Assurance Services A S Y S T E M A T I C A P P R O A C H

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AUDITING & ASSURANCE SERVICES: A SYSTEMATIC APPROACH, TENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2012, and 2010. 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 0 DOW/DOW 1 0 9 8 7 6

ISBN 978-0-07-773250-9 MHID 0-07-773250-2

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Library of Congress Cataloging-in-Publication Data

Messier, William F., author. Auditing & assurance services : a systematic approach / William F. Messier, Jr., Steven M. Glover, Douglas F. Prawitt.—Tenth edition. pages cm ISBN 978-0-07-773250-9 (alk. paper) 1. Auditing. I. Glover, Steven M., 1963- author. II. Prawitt, Douglas F. author. III. Title. IV. Title: Auditing and assurance services. HF5667.M46 2016 657’.45–dc23 2015028419

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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William F. Messier, Jr. holds the Kenneth and Tracy Knauss Endowed Chair in Account- ing at the Department of Accounting, University of Nevada, Las Vegas. He is also an Adjunct Professor at the Department of Accounting, Auditing and Law at the Norwegian School of Economics. Professor Messier holds a B.B.A. from Siena College, an M.S. from Clarkson University, and an M.B.A. and D.B.A. from Indiana University. He is a CPA in Florida and has held faculty positions at the University of Florida (Price Waterhouse Professor) and Georgia State University (Deloitte & Touche Professor). Professor Messier was a visiting faculty member at SDA Bocconi in Milan and the Universities of Luxembourg and Michigan. Professor Messier served as the Academic Member of the AICPA’s Auditing Standards Board and as Chair of the AICPA’s International Auditing Standards Subcommittee. He is a past editor of Auditing: A Journal of Practice & Theory and formerly President of the Audit- ing Section of the American Accounting Association. Professor Messier was the recipient of the American Accounting Association’s Outstanding Accounting Educator Award (2015), AICPA’s Distinguished Achievement in Accounting Education Award (2012), AAA Audit- ing Section’s Outstanding Educator Award (2009) and the Distinguished Service in Auditing Award (2008). In 2011, Professor Messier was awarded an honorary doctorate from the Nor- wegian School of Economics and Business Administration. Professor Messier has also served as an expert witness in audit litigation cases.

Professor Steven M. Glover is the K. Fred Skousen Professor and Associate Dean of the Marriott School of Management, Brigham Young University. Professor Glover is a CPA in Utah and holds a PhD and BS from the University of Washington and an AA in Business from BYU – Idaho. He previously worked as an auditor for KPMG LLP and as a director in the national office of PwC LLP. Professor Glover is currently serving on the AICPA Auditing Standards Board and has served on the audit committee of a nonprofit organization. He has served on the board of advisors for technology companies and he actively consults with public companies and public accounting firms. He has also served as an expert witness. Professor Glover is a past President of the Auditing Section of the American Accounting Association and he has been on auditing-related task forces of the AICPA. Professor Glover is or has served on the editorial boards of Auditing: A Journal of Practice & Theory, The Accounting Review, Current Issues in Auditing, and the review board of the AAA/CAQ Access to Audit Personnel Program. He has authored or coauthored over 40 articles and books primarily focused in the areas of auditor decision making, audit education, and audit practice. Together with Professor Prawitt and KPMG, LLP, he co-authored an award-winning monograph designed to acceler- ate the professional judgment of auditors and auditing students, as well as a monograph on professional skepticism commissioned by the Standards Working Group of the GPPC, an international consortium of the six largest public accounting network firms.

Professor Douglas F. Prawitt is the Glen Ardis Professor of Accountancy at the Marriott School of Management, Brigham Young University. Professor Prawitt is a CPA in Utah. He holds a PhD from the University of Arizona, and BS and MAcc degrees from Brigham Young University. Professor Prawitt was awarded the Marriott School’s Teaching Excellence and Outstanding Researcher awards in 1998 and 2000. He received the Merrill J. Bateman Student Choice Teaching Award in 2002, BYU’s Wesley P. Lloyd Award for Distinction in Graduate Education in 2006, and the American Accounting Association’s Deloitte/Wildman Award in 2013.

About the Authors

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Dedications

The authors dedicate this book to the following individuals:

Teddie, Stacy, Brandon, Zachary, Mark, Lindsay, Olive, and Frederick —William F. Messier, Jr.

Tina, Jessica, Andrew, Jennifer, Anna, Wayne, and Penny —Steven M. Glover

Meryll, Nathan, Matthew, Natalie, Emily, AnnaLisa, Leah, George, and Diana —Douglas F. Prawitt

He consults actively with international, regional, and local public accounting firms. He worked extensively over a five-year period with the Committee of Sponsoring Organiza- tions (COSO) on the COSO Enterprise Risk Management Framework and Internal Control over Financial Reporting—Guidance for Smaller Public Companies projects, and served a three-year appointment as a voting member of the AICPA Auditing Standards Board, from 2005–2008. In the fall of 2011, he was appointed to serve a three-year term as a member of the COSO Board and was appointed to serve a second three-year term beginning in 2014. Profes- sor Prawitt also has served in several capacities with the American Accounting Association, including as a member of the editorial boards of Auditing: A Journal of Practice & Theory, Behavioral Research in Accounting, and as associate editor of Accounting Horizons. He has authored or co-authored over 40 articles and books, primarily in the areas of auditor judgment and decision making, and audit practice. Most recently, together with Professor Steve Glover and KPMG, LLP, he co-authored an award-winning monograph designed to accelerate the professional judgment of auditors and auditing students, as well as a monograph on profes- sional skepticism commissioned by the Standards Working Group of the GPPC, an interna- tional consortium of the six largest public accounting firm networks.

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Why a New Edition?

Dear Colleagues and Friends, The pace of change in the financial statement auditing environment continues to accelerate, even as the need for relia- bile, high-quality assurance over financial reporting continues to intensify. The auditing environment is far more com- plex and dynamic today than it was even 10 years ago. Today, for example, financial statement auditors practice in a regulated environment and must deal with three sets of auditing standards: the standards of the PCAOB for audits of U.S. public companies, the standards of the AICPA’s Auditing Standards Board for audits of essentially all other U.S. entities (e.g., private companies, government entities, universities), and the standards of the IFAC’s International Audit- ing and Assurance Standards Board for audits of entities based outside of the United States. And those standards have undergone change at an unprecedented pace, with few signs of slowing. It is difficult enough for us as professors to stay abreast of the unprecedented change and complexity in the auditing environment; it is simply unrealistic to expect our students to be able to grasp all of this while they are working diligently just to learn the fundamentals of financial state- ment auditing.

That is why we have focused our efforts in this new edition to present the fundamentals of auditing in a crisp, clear, and understandable way, helping students navigate the inherent complexity while gaining a deep, intuitive grasp of fundamental auditing concepts. We do this by using simple yet compelling illustrations, examples, and analogies, such as relating the demand for an audit to the desire of a prospective home buyer to hire a house inspector. Our hope is that students will not only understand the important standards and concepts underlying auditing but that they will gain an intuitive grasp of why it is important and how the underlying logic can inform their judgments not only as auditors but as business people. In terms of the three sets of extant auditing standards, we simplify the complexities involved by adopting an approach similar to that taken by all of the major international accounting firms: we start with a base set of standards (in our case, the AICPA’s new body of “clarity” standards, which are at this point very similar to the IAASB standards) and we build on that base by addressing any requirements in the PCAOB standards that require more from the auditor. The AICPA’s clarity standards are newly converged with international auditing standards, which means that by studying this book your students will learn the auditing concepts that underlie an audit performed under any of the three extant sets of standards. All of the major firms have adopted a similar approach because it allows their pro- fessionals to practice effectively in any environment, domestic or international, using a single, merged set of auditing standards, rather than having to learn the specifics of three different sets. Your students will have that same advantage in learning auditing from this book.

Although the auditing environment has become even more complex and demanding, at the same time it is increasingly important that students gain a deep understanding and working knowledge of fundamental auditing concepts and how they are applied. From the beginning we have worked hard to make this book the most up-to-date, “student-friendly” introductory auditing book on the market, and this new edition continues that effort. Some of the ways this book encourages your students (and ours) to think more clearly and deeply about what they are studying are by

1. Expanding the use of “stop and think” phrases at key places throughout the chapters to encourage students to more fully internalize key concepts and facilitate deep learning by your students.

2. Clarifying explanations and adding easy-to-understand examples throughout the book.

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3. Making several chapters more concise and enhancing the focus on key concepts by deleting noncentral detail.

4. Improving end-of-chapter and supplementary materials throughout the book and on the website.

5. Adding a “Professional Judgment” module to the print copy of the book to accelerate the development of pro- fessional judgment abilities in your students. This module is based on the 2013 AAA Wildman Award winning KPMG Professional Judgment monograph, authored by Steve Glover and Doug Prawitt, in collaboration with KPMG leaders and partners.

6. New discussion cases added to Chapters 3 and 6 relating to the misappropriations of assets at Koss Corporation and Dixon, Illinois.

This new edition also contains several important updates including the introduction of industry leader IDEA® software by CaseWare Analytics. IDEA is a powerful and user-friendly data analysis tool designed to help auditors perform data analysis, audit sampling, and other audit procedures efficiently and effectively. Students are introduced to IDEA in the text and through hands-on tutorials, exercises, and problems. This edition also has been updated to reflect changes in auditing standards, such as the PCAOB’s Risk Assessment standards and the AICPA’s newly revised body of “clar- ity” standards, including the “principles underlying an audit conducted in accordance with generally accepted auditing standards.” The book also reflects new developments in how auditors assess materiality, based on research into major firms’ materiality policies by Aasmund Eilifsen and Bill Messier, and includes insights into audit sampling in practice based on research co-authored by Steve Glover. This edition also includes coverage of the newly revised COSO Internal Control-Integrated Framework. Because of their increasing complexity and importance to the audit process, this edi- tion also includes discussions of auditing the tax liability and auditing fair value measurements. The book also includes coverage of professionalism and ethics consistent with the AICPA’s newly reorganized Code of Professional Conduct. Finally, the authors took a hands-on role in improving this edition’s test bank, online quizzes, instructor PowerPoint slides, and the instructor’s manual.

While we are very much aware of the extra investment required when a book rolls to a new edition, we believe that we owe it to our colleagues and students to provide the most up-to-date materials possible so their hard work and energy in teaching and studying represents an investment in the latest, most current concepts, delivered in the most understand- able way possible. We are confident that the changes made in this edition will make it easier for you to teach effectively and for your students to learn more efficiently and more deeply.

Thank you for your support of this text and the many compliments we have received regarding past editions. We are gratified by the enthusiastic response the text has received as we have done our best to create a clear, easy-reading, student-friendly auditing textbook. As always, we welcome your feedback and suggestions, and we hope you will be pleased with the updates we have made in this new edition.

With warm regards,

William F. Messier, Jr. Steven M. Glover Douglas F. Prawitt

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The 10th Edition includes the following important features and enhancements:

∙ A “professional judgment” module, designed to accelerate the development of the student’s profes- sional judgment and based on the AAA Deloitte/Wildman Award-winning KPMG Professional Judg- ment monograph, is now included in the print version of the book. Additional resources relating to this module are available through KPMG’s University Connection website.

∙ Increased use of “Stop and Think” questions throughout the book to encourage students to more fully internalize key concepts.

∙ User-focused, user-friendly improvements. ∙ Chapter 2 has been updated for recent changes in the audit environment, Chapter 3 presents the latest

information available on major firms’ audit guidance relating to materiality, Chapter 6 reflects COSO’s new internal control framework, and Chapter 19 includes coverage of professional conduct consistent with the AICPA’s newly reorganized Code of Professional Conduct.

∙ Increased use of Practice Insights that provide a link from the textbook material to the real world. ∙ The introduction of IDEA audit software. IDEA is a powerful and user-friendly data analysis tool

designed to help auditors perform data analysis, audit sampling, and other audit procedures efficiently and effectively. IDEA is illustrated in Chapters 8 and 9 and there are end-of-chapter IDEA assignments and problems for hands-on application throughout the book.

∙ Improved descriptions of the hands-on EarthWear Mini-Cases that provide students with opportunities to apply audit professional judgment and practice audit procedures.

∙ Clarified explanations of technical business and accounting jargon. ∙ Improved linkage between chapter content and end-of-chapter material. ∙ References to auditing standards reflect the new codification of AICPA ASB clarity standards.

Here is a sampling of the improvements made in recent editions:

Chapter 1, An Introduction to Assurance and Financial Statement Auditing ∙ Discussion of fundamental concepts of auditing streamlined and clarified

Chapter 2, The Financial Statement Auditing Environment ∙ Updated to reflect changes in audit environment ∙ Includes AICPA’s “principles underlying an audit” in addition to PCAOB’s traditional set of “generally

accepted auditing standards”

Chapter 3, Audit Planning, Types of Audit Tests, and Materiality ∙ Revised engagement letter for an integrated audit ∙ Discussion of the current practices of the major auditing firms based on a recent article by Aasmund

Eilifsen and Bill Messier

Chapter 4, Risk Assessment ∙ Improved presentation of the risk assessment process ∙ Revised presentation of the fraud risk assessment process ∙ Addition of a new case based on the fraud at Koss Corporation

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Chapter 5, Evidence and Documentation ∙ Revised Advanced Module on the use of substantive analytical procedures

Chapter 6, Internal Control in a Financial Statement Audit ∙ New discussion case about the fraud in Dixon, Illinois ∙ An extension of the Koss Corporation fraud that considers the control deficiencies

Chapter 7, Auditing Internal Control over Financial Reporting ∙ Easier to understand explanations of the important steps in the audit of internal control over

financial reporting

Chapter 8, Audit Sampling: An Overview and Application to Tests of Controls ∙ Introduction of industry leading IDEA auditing software to this edition of the book with illustrations of

how to use IDEA for attribute sampling within the chapter. ∙ Updated for academic research examining audit sampling in practice

Chapter 9, Audit Sampling: An Application to Substantive Tests of Account Balances ∙ Introduction of industry leading IDEA auditing software to this edition of the book with illustrations of

how to use IDEA for monetary unit sampling within the chapter. ∙ Updated for academic research examining audit sampling in practice

Chapters 10–16, Business Process Chapters ∙ Revised for enhanced clarity and brevity ∙ Clarified illustrations linking assertions to possible misstatements to example controls and tests

of controls ∙ Updated exhibits and practice insights for recent events

Chapter 17, Completing the Audit Engagement ∙ Improved examples to illustrate the possible self-fulfilling prophecy effects of going concern opinions,

and to explain the role and impact of commitments in completing an audit ∙ Clarified discussion of auditor’s responsibility for subsequent events ∙ Enhanced discussion of evaluation of misstatements in light of qualitative materiality considerations ∙ New coverage of iron curtain versus roll-over methods of assessing materiality of misstatements

Chapter 18, Reports on Audited Financial Statements ∙ Updated for recent developments including the new “clarified” form of the ASB audit report

Chapter 19, Professional Conduct, Independence, and Quality Control ∙ Updated for changes in the newly reorganized AICPA Code of Professional Conduct ∙ Discussion of quality control and peer review/inspection updated for recent changes in

relevant standards

Chapter 20, Legal Liability ∙ Updated for important recent cases and statutory law

Chapter 21, Assurance, Attestation, and Internal Auditing Services ∙ Updated standards relating to practitioner independence in compilation engagements ∙ Attestation reports updated for new AICPA standards ∙ Updated to reflect changes in IIA standards ∙ Updated to reflect changes to structure around Trust Services principles and practices

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Tenth Edition Supplements

Connect instructor resources library offers:

∙ Solutions Manual, revised by William F. Messier, Jr., Steven M. Glover, and Douglas F. Prawitt ∙ Instructor’s Manual ∙ Test Bank with AACSB, AICPA, and Bloom’s Taxonomy tags ∙ Instructor PowerPoint Presentations ∙ EarthWear Mini-Case Solutions ∙ Solutions to IDEA Solutions

Addtional resources include: Links to Professional Resources, Sample Syllabi, Text Updates, and Digital Image Library

Connect student resources include: ∙ EarthWear Mini-Cases ∙ IDEA Assignments and Problems, by Messier, Glover, and Prawitt ∙ Student PowerPoint Presentations ∙ Relevant Accounting and Auditing Pronouncements by chapter ∙ Link to EarthWear Clothiers home page ∙ Link to Willis & Adams, CPAs home page

Assurance of Learning Ready Many educational institutions today are focused on the notion of assurance of learning, an important ele- ment of some accreditation standards. The Messier, Glover, and Prawitt Auditing and Assurance Services: A Systematic Approach book is designed specifically to support your assurance of learning initiatives with a simple, yet powerful, solution.

Each chapter in the book begins with a list of numbered learning objectives, which appear throughout the chapter as well as in the end-of-chapter assignments. Each test bank question for Auditing and Assurance Services: A Systematic Approach maps to a specific chapter learning outcome/objective listed in the text. Each test bank question also identifies topic area, level of difficulty, Bloom’s Taxonomy level, AACSB and AICPA skill areas. You can use Connect to easily query for learning outcomes/objectives that directly relate to the learning objectives for your course.

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The continuing rapid pace of change in auditing standards and practices, together with the recent crises in the financial markets, has had a significant effect on the auditing profession. In this ever-changing environment, it is crucial that stu- dents learn from the most up-to-date, student-friendly resources. As always, the author team of Auditing & Assurance Services: A Systematic Approach is dedicated to providing the most current professional content and real-world applica- tion, as well as helping students develop professional judgment and prepare for the CPA exam.

In their 10th edition, authors Messier, Glover, and Prawitt continue to reinforce the fundamental values central to their past nine editions:

Student Engagement. The authors believe students are best served by acquiring a strong understanding of the basic concepts that underlie the audit process and how to apply those concepts to various audit and assurance services. The primary purpose for an auditing text is not to serve as a reference manual but to facilitate student learning, and this text is written accordingly. The text is accessible to students through straightforward writing and the use of engaging, relevant real-world examples, illustrations, and analogies. The text explicitly encourages students to think through fundamental concepts and to avoid trying to learn auditing through rote memorization. Students are prompted by the text to “stop and think” at important points in the text, in order to help them apply the principles covered. Consistent with this aim, the text’s early chapters avoid immersing students in unnecessary detail such as the minutia relating to all the complexities of audit reporting, focusing instead on students’ intuition relating to the fundamental audit concepts of materiality, audit risk, and audit evidence relating to management assertions. The first chapter provides a high-level introduction to what an audit report looks like while avoiding immersion in unnecessary detail. It also lays out a clear explanation and illustration of the demand for assurance and provides an understandable overview of the auditing process from start to finish. A case involving EarthWear Clothiers, a mail-order retailer, is integrated throughout the book and additional student resources and includes free student access to several useful hands-on mini-cases, with full solutions available to the instructor. Finally, “practice insights” throughout the book engage students and help them see the application of concepts in a practical setting.

A Systematic Approach. The text continues to take a systematic approach to the audit process by first introducing the three underlying concepts: audit risk, materiality, and evidence. This is followed by a discussion of audit planning, the assessment of control risk, and a discussion of the nature, timing, and extent of evidence necessary to reach the appropriate level of detection risk. These concepts are then applied to each major business process and related account balances using a risk-based approach. The text has been revised to include the risk assessment process included in the standards adopted by the Auditing Standards Board and the International Auditing and Assurance Standards Board, as well as the PCAOB’s newly adopted Risk Assessment Standards.

Decision Making. In covering these important concepts and their applications, the book focuses on critical judg- ments and decision-making processes followed by auditors. Much of auditing practice involves the application of auditor judgment. If a student understands these basic concepts and how to apply them to an audit engagement, he or she will be more effective in today’s dynamic audit environment. Two of the authors of this textbook recently worked with KPMG to develop a monograph designed to accelerate the development of professional judgment in students. We are very excited to include in this edition a “professional judgment” module as part of the printed material in the text. This module is based on the KPMG Professional Judgment monograph, which was awarded the 2013 AAA Deloitte/Wildman award for the work published within the most recent five-year period that has had the most significant impact on the practice of professional accountancy. Access to additional directly related resources, including videos, mini-cases, and problems, are available on KPMG’s University Connection website for integration into the auditing course, as instructors see fit.

How does 10e prepare your students?

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Free IDEA software

The educational version of IDEA software is avail- able for free with each new book. IDEA is new to this edition and the authors wrote chapter-specific IDEA assignments and problems, all of which are found inside Connect. Exposing students to IDEA allows them the opportunity to work with real professional audit software.

Real-World Integration and Hands-On Mini-Cases.

Mini EarthWear cases “Hands-on” mini-cases are integrated throughout the text. Enhanced case descriptions and a new mini-case on the search for unrecorded liabilities were added this edition. The mini-cases are also available in Connect, giving your students the opportunity to actually do some common audit- ing procedures.

Practical applications for the modern student

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know, if the securities acts had not been passed by Congress in the 1930s, no one would be interested in having an audit performed.”

Required: Draft a memo that highlights your thoughts about Lee’s statement that audits only

take place because they are required by law.

INTERNET ASSIGNMENT

LO 1-1, 1-9 1-30 Using an Internet browser, identify five Internet sites that contain accounting or auditing resources. For each site identified, prepare a brief summary of the types of information that are available. For example, the PCAOB’s home page (www.pcaobus.org) contains extensive information on the organization’s activities (you may use the PCAOB site as one of the five). Your five summaries should not exceed a total of one typed page.

HANDS-ON CASES

EarthWear Online

EarthWear Introduction In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis and Adams. This introductory activity also provides an opportunity to become familiar with the structure and format of the EarthWear Online cases.

Visit Connect’s additional student resources to find a detailed description of the case and to download required materials.

Additional Student Resources

Visit Connect for author-created problem material to be completed using IDEA software.

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adds credibility to the report and reduces information risk, or the risk that information cir- culated by a company’s management will be false or misleading. Reducing information risk potentially benefits both the owner and the manager. Figure 1–1 provides an overview of this agency relationship.

While the setting we’ve outlined is very simple, understanding the basics of the owner– manager relationship is helpful in understanding the demand for auditing. The principal– agent model is a powerful conceptual tool that can be extrapolated to much more complex employment and other contractual arrangements. For example, how can a lender prevent management from taking the borrowed funds and using them inappropriately? One way is to place restrictive covenants in the debt agreement with which the entity and its management must comply. Again, this arrangement gives rise to a demand for the auditing of information reported by management to the lender.

Overview of the Principal–Agent Relationship Leading to the Demand for Auditing

F I G U R E 1 – 1

Auditor gathers evidence to evaluate fairness of agent’s financial reports. Auditor issues audit opinion to accompany agent’s financial reports, adding credibility to the reports and reducing principal’s information risk.

Principal provides capital and hires agent to manage resources.

Information asymmetry and conflicts of interest lead to information risk

for the principal.

Agent is accountable to principal; provides financial reports. Agent hires auditor

to report on the fairness of agent’s

financial reports. Agent pays auditor

to reduce principal’s information risk.

Auditor

Agent (Manager)

Principal (Absentee Owner)

Practice  I N S I G H T

At the heart of a capital-market economy is the flow of reliable information, which investors, credi- tors, and regulators use to make informed decisions. Chief Justice Warren Burger gave his view of the significance of the audit function in a 1984 Supreme Court decision:

By certifying the public reports that collectively depict a corporation’s financial status, the indepen- dent auditor assumes a public responsibility transcending any employment relationship with the cli- ent. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.

More than 30 years later, the message is the same—users of financial statements rely on the external auditor to act with honor and integrity in protecting the public interest.

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know, if the securities acts had not been passed by Congress in the 1930s, no one would be interested in having an audit performed.”

Required: Draft a memo that highlights your thoughts about Lee’s statement that audits only

take place because they are required by law.

INTERNET ASSIGNMENT

LO 1-1, 1-9 1-30 Using an Internet browser, identify five Internet sites that contain accounting or auditing resources. For each site identified, prepare a brief summary of the types of information that are available. For example, the PCAOB’s home page (www.pcaobus.org) contains extensive information on the organization’s activities (you may use the PCAOB site as one of the five). Your five summaries should not exceed a total of one typed page.

HANDS-ON CASES

EarthWear Online

EarthWear Introduction In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis and Adams. This introductory activity also provides an opportunity to become familiar with the structure and format of the EarthWear Online cases.

Visit Connect’s additional student resources to find a detailed description of the case and to download required materials.

Additional Student Resources

Visit Connect for author-created problem material to be completed using IDEA software.

Practice Insights Practice Insights in each chapter highlight important and interesting real-world trends and practices.

AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Auditing and Assurance Services 10e recognizes the curricula guidelines detailed in the AACSB stan- dards for business accreditation by connecting selected questions in the text and test bank to the six general knowledge and skill guidelines in the AACSB standards. The statements contained in Auditing and Assurance Services 10e 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, the mission of the school, and the faculty. While Auditing and Assurance Services 10e and the teaching package make no claim of any specific AACSB qualification or evaluation, we have within Auditing and Assurance Services 10e labeled selected questions according to the six general knowledge and as a helpful starting point.

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McGraw-Hill Connect® Learn Without Limits Connect is a teaching and learning platform that is proven to deliver better results for students and instructors.

Connect empowers students by continually adapting to deliver precisely what they need, when they need it, and how they need it, so your class time is more engaging and effective.

Mobile

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SmartBook® Proven to help students improve grades and study more efficiently, SmartBook contains the same content within the print book, but actively tailors that content to the needs of the individual. SmartBook’s adaptive technology provides precise, personalized instruction on what the student should do next, guiding the student to master and remember key concepts, targeting gaps in knowledge and offering customized feedback, and driving the student toward comprehension and retention of the subject matter. Available on smartphones and tablets, SmartBook puts learning at the student’s fingertips—anywhere, anytime.

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First and foremost, we thank our families for their continuous and unfailing support. We would like to acknowledge the American Institute of Certified Public Accountants for permission to quote from auditing standards, the Code of Professional Conduct, the Uniform CPA Examination, and the Journal of Accountancy. We would like to thank CaseWare IDEA for granting permission to distribute the educational version of IDEA software with our textbook. We would also like to thank Cassy Budd of Brigham Young University for her help with updating the Test Bank, Instructor’s Manual, Quizzes, and PowerPoints; and Jonathan Liljegren for revision of the EarthWear Mini-Cases. Finally, we would like to extend our gratitude to Christina Brenchley, Scott Jackson, and Andrew Glover for their research assistance.

Acknowledgments

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Brief Contents

PART 1 Introduction to Assurance and Financial Statement Auditing 1

Chapter 1 An Introduction to Assurance and Financial Statement Auditing 2

Chapter 2 The Financial Statement Auditing Environment 36

PART 2 Audit Planning and Basic Auditing Concepts 67

Chapter 3 Audit Planning, Types of Audit Tests, and Materiality 68

Chapter 4 Risk Assessment 98

Chapter 5 Evidence and Documentation 128

PART 3 Understanding and Auditing Internal Control 177

Chapter 6 Internal Control in a Financial Statement Audit 178

Chapter 7 Auditing Internal Control over Financial Reporting 220

PART 4 Statistical and Nonstatistical Sampling Tools for Auditing 261

Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls 262

Chapter 9 Audit Sampling: An Application to Substantive Tests of Account Balances 300

PART 5 Auditing Business Processes 337

Chapter 10 Auditing the Revenue Process 338

Chapter 11 Auditing the Purchasing Process 386

Chapter 12 Auditing the Human Resource Management Process 422

Chapter 13 Auditing the Inventory Management Process 450

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Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment 480

Chapter 15 Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income Statement Accounts 506

Chapter 16 Auditing the Financing/Investing Process: Cash and Investments 528

PART 6 Completing the Audit and Reporting Responsibilities 561

Chapter 17 Completing the Audit Engagement 562

Chapter 18 Reports on Audited Financial Statements 596

PART 7 Professional Responsibilities 627

Chapter 19 Professional Conduct, Independence, and Quality Control 628

Chapter 20 Legal Liability 672

PART 8 Assurance, Attestation, and Internal Auditing Services 707

Chapter 21 Assurance, Attestation, and Internal Auditing Services 708

Advanced Module: Professonal Judgment Framework—Understanding and Developing Professional Judgment in Auditing 748 (Also visit KPMG’s University Connection website for relevant resources, including videos, mini-cases, instructor notes, and problems, that were created to accompany the AAA Deloitte/ Wildman award-winning KPMG Professional Judgment Framework monograph, on which this module is based.)

Index 757

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Table of Contents

PART 1 Introduction to Assurance and Financial Statement Auditing 1

Chapter 1 An Introduction to Assurance and Financial Statement Auditing 2

Tips for Learning Auditing 4 The Demand for Auditing and Assurance 5

Principals and Agents 5

The Role of Auditing 6

An Assurance Analogy: The Case of the House Inspector 8

Seller Assertions, Information Asymmetry, and

Inspector Characteristics 8

Desired Characteristics of the House Inspection

Service 8

Relating the House Inspection Analogy to

Financial Statement Auditing 9

Management Assertions and Financial

Statements 10

Auditing, Attest, and Assurance Services Defined 12 Auditing 12

Attestation 13

Assurance 13

Fundamental Concepts in Conducting a Financial Statement Audit 14

Materiality 14

Audit Risk 15

Audit Evidence Regarding Management Assertions 16

Sampling: Inferences Based on Limited Observations 16

The Audit Process 17 Overview of the Financial Statement Auditing

Process 17

Major Phases of the Audit 18

The Unqualified/Unmodified Audit Report 21

Other Types of Audit Reports 22

Conclusion 23 Key Terms 24 Review Questions 25 Multiple-Choice Questions 25 Problems 27 Discussion Case 28 Internet Assignment 29 Hands-On Cases 29

Chapter 2 The Financial Statement Auditing Environment 36

Types of Auditors 38 External Auditors 38

Internal Auditors 38

Government Auditors 39

Forensic Auditors 40

Types of Other Audit, Attest, and Assurance Services 40

Other Audit Services 40

Attest Services 41

Assurance Services 41

Other Nonaudit Services 42

Public Accounting Firms 42 Organization and Composition 42

A Decade of Challenge and Change for Financial Statement Auditors 44

Government Regulation 44

Society’s Expectations and the Auditor’s Responsibilities 45

The Context of Financial Statement Auditing 45 The Business Entity as the Primary Context of

Auditing 45

A Model of Business 46 Corporate Governance 46

Objectives, Strategies, Processes, Controls,

Transactions, and Reports 48

A Model of Business Processes: Five

Components 48

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Organizations That Affect the Public Accounting Profession 49

Securities and Exchange Commission (SEC) 51

Public Company Accounting Oversight Board

(PCAOB) 51

American Institute of Certified Public Accountants

(AICPA) 51

International Auditing and Assurance Standards

Board (IAASB) 52

Financial Accounting Standards Board

(FASB) 52

International Accounting Standards Board

(IASB) 52

Auditing Standards 52 Three Sets of Auditing Standards: The Roles of the

ASB, PCAOB, and IAASB 53

The 10 Generally Accepted Auditing Standards 53

Principles Underlying an Audit Conducted in

Accordance with Generally Accepted Auditing

Standards 55

Statements on Auditing Standards and the AU

Codification 55

Ethics, Independence, and the Code of Professional Conduct 57

Conclusion 58 Key Terms 58 Review Questions 59 Multiple-Choice Questions 60 Problems 62 Discussion Cases 64 Internet Assignments 65 Hands-On Cases 66

PART 2 Audit Planning and Basic Auditing Concepts 67

Chapter 3 Audit Planning, Types of Audit Tests, and Materiality 68

Client Acceptance and Continuance 70 Prospective Client Acceptance 70

Client Continuance 71

Preliminary Engagement Activities 71 Determine the Audit Engagement Team

Requirements 71

Assess Compliance with Ethical and Independence

Requirements 72

Establish an Understanding with the Entity 72

Planning the Audit 78 Audit Strategy and Plan 78

Assess Business Risks 78

Establish Materiality 78

Consider Multilocations or Business Units 79

Assess the Need for Specialists 79

Consider Violations of Laws and

Regulations 79

Identify Related Parties 80

Consider Additional Value-Added Services 81

Document the Overall Audit Strategy, Audit Plan,

and Prepare Audit Programs 81

Supervision of the Audit 83 Types of Audit Tests 83

Risk Assessment Procedures 83

Tests of Controls 83

Substantive Procedures 84

Dual-Purpose Tests 84

Materiality 85 Steps in Applying Materiality 86

An Example 88

Key Terms 90 Review Questions 90 Multiple-Choice Questions 91 Problems 92 Discussion Case 95 Internet Assignments 95 Hands-On Cases 96

Chapter 4 Risk Assessment 98

Audit Risk 100 The Audit Risk Model 100

Use of the Audit Risk Model 102

The Auditor’s Risk Assessment Process 104 Management’s Strategies, Objectives, and Business

Risks 104

Auditor’s Risk Assessment Procedures 105

Assessing Business Risks 106

Evaluate the Entity’s Risk Assessment

Process 109

Assessing the Risk of Material Misstatement 109 Causes and Types of Misstatements 110

The Fraud Risk Assessment Process 111

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Examples of Audit Documentation 148

Format of Audit Documentation 150

Organization of Audit Documentation 151

Ownership of Audit Documentation 151

Audit Document Archiving and

Retention 151

Substantive Analytical Procedures 154

Final Analytical Procedures 162

Short-Term Liquidity Ratios 163

Activity Ratios 163

Profitability Ratios 164

Coverage Ratios 165

Key Terms 165 Review Questions 166 Multiple-Choice Questions 167 Problems 169 Discussion Cases 172 Internet Assignment 174 Hands-On Cases 174

PART 3 Understanding and Auditing Internal Control 177

Chapter 6 Internal Control in a Financial Statement Audit 178

Introduction 180 Internal Control—an Overview 180

Definition of Internal Control 180

Controls Relevant to the Audit 180

The Effect of Information Technology on Internal

Control 181

The COSO Framework 181 Components of Internal Control 181

Control Environment 182

The Entity’s Risk Assessment Process 185

Control Activities 186

Information and Communication 188

Monitoring of Controls 189

Planning an Audit Strategy 189 Substantive Strategy 191

Reliance Strategy 192

Obtain an Understanding of Internal Control 193 Overview 193

Understanding the Control Environment 193

The Auditor’s Response to the Results of the Risk Assessments 115

Evaluation of Audit Test Results 117 Documentation of the Auditor’s Risk Assessment and

Response 118 Communications about Fraud to Management, the

Audit Committee, and Others 118 Key Terms 120 Review Questions 121 Multiple-Choice Questions 121 Problems 123 Discussion Case 125 Internet Assignment 126 Hands-On Cases 127

CHAPTER 5 Evidence and Documentation 128

The Relationship of Audit Evidence to the Audit Report 130

Management Assertions 131 Assertions about Classes of Transactions and

Events during the Period 131

Assertions about Account Balances at the Period

End 133

Assertions about Presentation and

Disclosure 134

The Concepts of Audit Evidence 135 The Nature of Audit Evidence 135

The Sufficiency and Appropriateness of Audit

Evidence 135

The Evaluation of Audit Evidence 137

Audit Procedures for Obtaining Audit Evidence 138 Inspection of Records or Documents 138

Inspection of Tangible Assets 139

Observation 140

Inquiry 140

Confirmation 141

Recalculation 141

Reperformance 142

Analytical Procedures 142

Scanning 142

Reliability of the Types of Evidence 142 The Audit Testing Hierarchy 143

An “Assurance Bucket” Analogy 145

Audit Documentation 146 Functions of Audit Documentation 146

Content of Audit Documentation 147

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Control Deficiency 223

Material Weakness 223

Significant Deficiency 223

Likelihood and Magnitude 223

Management’s Assessment Process 225 Identify Financial Reporting Risks and Related

Controls 225

Consider Which Locations to Include in the

Evaluation 226

Evaluate Evidence about the Operating

Effectiveness of ICFR 226

Reporting Considerations 226

Management’s Documentation 227

Performing an Audit of ICFR 228 Plan the Audit of ICFR 229

The Role of Risk Assessment and the Risk of

Fraud 229

Scaling the Audit 230

Using the Work of Others 230

Identify Controls to Test 231 Identify Entity-Level Controls 231

Identifying Significant Accounts and Disclosures

and Their Relevant Assertions 232

Understanding Likely Sources of

Misstatements 232

Select Controls to Test 233

Evaluate the Design and Test the Operating Effectiveness of Controls 234

Evaluating Design Effectiveness of Controls 234

Testing and Evaluating Operating Effectiveness of

Controls 234

Evaluating Identified Control Deficiencies 236 Examples of Control Deficiency Evaluation 237

Remediation of a Material Weakness 239 Written Representations 239 Auditor Documentation Requirements 240 Auditor Reporting on ICFR 240

Elements of the Auditor’s Report 241

Unqualified Report 241

Adverse Report for a Material Weakness 241

Disclaimer for Scope Limitation 242

Other Reporting Issues 244 Management’s Report Incomplete or Improperly

Presented 244

The Auditor Decides to Refer to the Report of

Other Auditors 244

Subsequent Events 245

Understanding the Entity’s Risk Assessment

Process 194

Understanding the Information System and

Communications 195

Understanding Control Activities 195

Understanding Monitoring of Controls 195

Documenting the Understanding of Internal

Control 196

The Effect of Entity Size on Internal Control 196

The Limitations of an Entity’s Internal

Control 197

Assessing Control Risk 199 Identifying Specific Controls That Will Be Relied

Upon 199

Performing Tests of Controls 199

Concluding on the Achieved Level of Control

Risk 200

Documenting the Achieved Level of Control

Risk 200

An Example 200

Substantive Procedures 201 Timing of Audit Procedures 202

Interim Tests of Controls 202

Interim Substantive Procedures 203

Auditing Accounting Applications Processed by Service Organizations 203

Communication of Internal Control–Related Matters 204

General Controls 206

Application Controls 207

Symbols 209

Organization and Flow 210

Key Terms 211 Review Questions 211 Multiple-Choice Questions 212 Problems 214 Discussion Cases 216 Hands-On Cases 218

Chapter 7 Auditing Internal Control over Financial Reporting 220

Management Responsibilities under Section 404 222 Auditor Responsibilities under Section 404 and AS5 222 Internal Control over Financial Reporting

Defined 222 Internal Control Deficiencies Defined 223

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Key Terms 290 Review Questions 291 Multiple-Choice Questions 292 Problems 294 Discussion Case 297 Hands-On Cases 298

Chapter 9 Audit Sampling: An Application to Substantive Tests of Account Balances 300

Sampling for Substantive Tests of Details of Account Balances 302

Monetary-Unit Sampling 303 Advantages 304

Disadvantages 304

Applying Monetary-Unit Sampling 304

Planning 304

Performance 308

Evaluation 310

Nonstatistical Sampling for Tests of Account Balances 318

Identifying Individually Significant Items 318

Determining the Sample Size 318

Selecting Sample Items 319

Calculating the Sample Results 319

An Example of Nonstatistical Sampling 320

Advantages 324

Disadvantages 324

Applying Classical Variables Sampling 324

Key Terms 328 Review Questions 329 Multiple-Choice Questions 330 Problems 331 Discussion Cases 335 Hands-On Cases 336

PART 5 Auditing Business Processes 337

Chapter 10 Auditing the Revenue Process 338

Revenue Recognition 341 Overview of the Revenue Process 342

Types of Transactions and Financial Statement

Accounts Affected 343

Types of Documents and Records 345

Management’s Report Contains Additional

Information 245

Reporting on a Remediated Material Weakness at

an Interim Date 245

Additional Required Communications in an Audit of ICFR 245

Use of Service Organizations 246

Safeguarding of Assets 247

Generalized Audit Software 247

Custom Audit Software 248

Test Data 249

Key Terms 249 Review Questions 250 Multiple-Choice Questions 251 Problems 253 Internet Assignments 259 Hands-On Cases 259

PART 4 Statistical and Nonstatistical Sampling Tools for Auditing 261

Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls 262

Overview of Audit Sampling 264 Definitions and Key Concepts 265

Audit Sampling 265

Sampling Risk 265

Confidence Level 267

Tolerable and Expected Error 267

Audit Evidence Choices That Do and Do Not

Involve Sampling 268

Types of Audit Sampling 269 Nonstatistical versus Statistical Sampling 269

Types of Statistical Sampling Techniques 270

Attribute Sampling Applied to Tests of Controls 271 Planning 271

Performance 279

Evaluation 283

Nonstatistical Sampling for Tests of Controls 287 Determining the Sample Size 287

Selecting the Sample Items 288

Calculating the Computed Upper Deviation

Rate 288

Conclusion 289

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Timing 372

Confirmation Procedures 373

Alternative Procedures 374

Auditing Other Receivables 374 Evaluating the Audit Findings—Revenue-Related

Accounts 375 Key Terms 375 Review Questions 376 Multiple-Choice Questions 377 Problems 379 Discussion Cases 382 Internet Assignments 383 Hands-On Cases 383

Chapter 11 Auditing the Purchasing Process 386

Expense and Liability Recognition 388 Overview of the Purchasing Process 388

Types of Transactions and Financial Statement

Accounts Affected 389

Types of Documents and Records 390

The Major Functions 393

The Key Segregation of Duties 395

Inherent Risk Assessment 396 Industry-Related Factors 396

Misstatements Detected in Prior Audits 396

Control Risk Assessment 396 Understand and Document Internal Control 396

Plan and Perform Tests of Controls 398

Set and Document Control Risk 398

Control Activities and Tests of Controls—Purchase Transactions 398

Occurrence of Purchase Transactions 399

Completeness of Purchase Transactions 399

Authorization of Purchase Transactions 400

Accuracy of Purchase Transactions 401

Cutoff of Purchase Transactions 401

Classification of Purchase Transactions 401

Control Activities and Tests of Controls—Cash Disbursement Transactions 402

Occurrence of Cash Disbursement

Transactions 402

Completeness of Cash Disbursement

Transactions 402

Authorization of Cash Disbursement Transactions 402

Accuracy of Cash Disbursement Transactions 402

Cutoff of Cash Disbursement Transactions 403

The Major Functions 349

Key Segregation of Duties 350

Inherent Risk Assessment 351 Industry-Related Factors 351

The Complexity and Contentiousness of Revenue

Recognition Issues 352

The Difficulty of Auditing Transactions and

Account Balances 352

Misstatements Detected in Prior Audits 352

Control Risk Assessment 353 Understand and Document Internal Control 353

Plan and Perform Tests of Controls 354

Set and Document Control Risk 354

Control Activities and Tests of Controls—Revenue Transactions 355

Occurrence of Revenue Transactions 355

Completeness of Revenue Transactions 357

Authorization of Revenue Transactions 357

Accuracy of Revenue Transactions 357

Cutoff of Revenue Transactions 358

Classification of Revenue Transactions 358

Control Activities and Tests of Controls—Cash Receipts Transactions 358

Occurrence of Cash Receipts Transactions 358

Completeness of Cash Receipts Transactions 359

Authorization of Cash Discounts 360

Accuracy of Cash Receipts Transactions 361

Cutoff of Cash Receipts Transactions 361

Classification of Cash Receipts 361

Control Activities and Tests of Controls—Sales Returns and Allowances Transactions 361

Relating the Assessed Level of Control Risk to Substantive Procedures 362

Auditing Revenue-Related Accounts 362 Substantive Analytical Procedures 363 Tests of Details of Classes of Transactions, Account

Balances, and Disclosures 364 Completeness 364

Cutoff 366

Existence 367

Rights and Obligations 367

Valuation and Allocation 368

Classification 369

Other Presentation and Disclosure

Assertions 369

The Confirmation Process—Accounts Receivable 370 Types of Confirmations 371

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Authorization of Payroll Transactions 433

Accuracy of Payroll Transactions 433

Classification of Payroll Transactions 434

Relating the Assessed Level of Control Risk to Substantive Procedures 434

Auditing Payroll-Related Accounts 434 Substantive Analytical Procedures 434 Tests of Details of Classes of Transactions, Account

Balances, and Disclosures 435 Payroll Expense Accounts 436

Accrued Payroll Liabilities 437

Evaluating the Audit Findings— Payroll-Related Accounts 439

Key Terms 441 Review Questions 442 Multiple-Choice Questions 442 Problems 444 Discussion Cases 446 Internet Assignment 448 Hands-On Cases 448

Chapter 13 Auditing the Inventory Management Process 450

Overview of the Inventory Management Process 452 Types of Documents and Records 453

The Major Functions 455

The Key Segregation of Duties 456

Inherent Risk Assessment 456 Industry-Related Factors 457

Engagement and Operating Characteristics 457

Control Risk Assessment 457 Understand and Document Internal Control 459

Plan and Perform Tests of Controls 459

Set and Document the Control Risk 459

Control Activities and Tests of Controls— Inventory Transactions 459

Occurrence of Inventory Transactions 460

Completeness of Inventory Transactions 461

Authorization of Inventory Transactions 461

Accuracy of Inventory Transactions 461

Cutoff of Inventory Transactions 462

Classification of Inventory Transactions 462

Relating the Assessed Level of Control Risk to Substantive Procedures 462

Auditing Inventory 463 Substantive Analytical Procedures 464

Classification of Cash Disbursement

Transactions 404

Control Activities and Tests of Controls—Purchase Return Transactions 404

Relating the Assessed Level of Control Risk to Substantive Procedures 404

Auditing Accounts Payable and Accrued Expenses 405

Substantive Analytical Procedures 405 Tests of Details of Classes of Transactions, Account

Balances, and Disclosures 406 Completeness 406

Existence 409

Cutoff 409

Rights and Obligations 409

Valuation 409

Classification and Understandability 410

Other Presentation Disclosure Assertions 410

Accounts Payable Confirmations 411 Evaluating the Audit Findings—Accounts Payable and

Related 412 Key Terms 414 Review Questions 415 Multiple-Choice Questions 416 Problems 417 Discussion Case 421 Internet Assignments 421 Hands-On Cases 421

Chapter 12 Auditing the Human Resource Management Process 422

Overview of the Human Resource Management Process 424

Types of Transactions and Financial Statement

Accounts Affected 425

Types of Documents and Records 425

The Major Functions 426

The Key Segregation of Duties 428

Inherent Risk Assessment 429 Control Risk Assessment 430

Understand and Document Internal Control 430

Plan and Perform Tests of Controls 431

Set and Document the Control Risk 431

Control Activities and Tests of Controls—Payroll Transactions 431

Occurrence of Payroll Transactions 433

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Auditing the Property Management Process 488 Types of Transactions 488

Overview of the Property Management

Process 489

Inherent Risk Assessment—Property Management Process 490

Complex Accounting Issues 490

Difficult-to-Audit Transactions 490

Misstatements Detected in Prior Audits 490

Control Risk Assessment—Property Management Process 491

Occurrence and Authorization 491

Completeness 492

Segregation of Duties 492

Substantive Procedures—Property, Plant, and Equipment 493

Substantive Analytical Procedures—Property,

Plant, and Equipment 493

Tests of Details of Transactions, Account Balances,

and Disclosures—Property, Plant, and

Equipment 494

Evaluating the Audit Findings—Property, Plant, and Equipment 497

Key Terms 498 Review Questions 498 Multiple-Choice Questions 499 Problems 501 Discussion Case 503 Internet Assignments 503 Hands-On Cases 504

Chapter 15 Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income Statement Accounts 506

Auditing Long-Term Debt 508 Inherent Risk Assessment—Long-Term Debt 509 Control Risk Assessment—Long-Term Debt 509

Assertions and Related Control Activities 509

EarthWear Substantive Procedures—Long-Term Debt 511

Auditing Stockholders’ Equity 512 Control Risk Assessment—Stockholders’ Equity 514

Assertions and Related Control Activities 514

Segregation of Duties 515

Auditing Capital-Stock Accounts 515 Occurrence and Completeness 515

Auditing Standard Costs 465 Materials 465

Labor 465

Overhead 465

Observing Physical Inventory 466 Tests of Details of Classes of Transactions, Account

Balances, and Disclosures 467 Accuracy 468

Cutoff 469

Existence 469

Completeness 469

Rights and Obligations 469

Valuation and Allocation 469

Classification and Understandability 470

Other Presentation and Disclosure

Assertions 470

Evaluating the Audit Findings—Inventory 471 Key Terms 471 Review Questions 472 Multiple-Choice Questions 472 Problems 474 Discussion Case 478 Internet Assignment 479 Hands-On Cases 479

Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment 480

Auditing Prepaid Expenses 482 Inherent Risk Assessment—Prepaid Expenses 482 Control Risk Assessment—Prepaid Expenses 482 Substantive Procedures—Prepaid Insurance 483

Substantive Analytical Procedures for Prepaid

Insurance 483

Tests of Details of the Prepaid Insurance 484

Existence and Completeness 484

Rights and Obligations 484

Valuation 484

Classification 484

Auditing Intangible Assets 484 Inherent Risk Assessment—Intangible Assets 485 Control Risk Assessment—Intangible Assets 486 Substantive Procedures—Intangible Assets 486

Substantive Analytical Procedures for Intangible

Assets 486

Tests of Details of Intangible Assets 487

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Tests of Details—Investments 546

Understanding How Management Makes Fair

Value Measurements 550

Considering Whether Specialized Skills or

Knowledge Is Required 550

Testing the Entity’s Fair Value

Measurements 550

Evaluating the Reasonableness of the Fair Value

Measurements 551

Key Terms 551 Review Questions 552 Multiple-Choice Questions 553 Problems 555 Internet Assignment 559 Hands-On Case 559

PART 6 Completing the Audit and Reporting Responsibilities 561

Chapter 17 Completing the Audit Engagement 562

Review for Contingent Liabilities 564 Audit Procedures for Identifying Contingent

Liabilities 565

Legal Letters 565

Commitments 567 Review of Subsequent Events for Audit of Financial

Statements 568 Dual Dating 570

Audit Procedures for Subsequent Events 571

Review of Subsequent Events for the Audit of Internal Control over Financial Reporting 571

Final Steps and Evidence Evaluation 572 Final Analytical Procedures 572

Representation Letter 573

Working Paper Review 573

Final Evaluation of Audit Results 576

Evaluating Financial Statement Presentation and

Disclosure 578

Independent Engagement Quality Review 579

Archiving and Retention 579

Going Concern Considerations 579

Communications with Those Charged with Governance and Management 582

Valuation 516

Completeness of Disclosures 516

Auditing Dividends 516 Auditing Retained Earnings 517 Auditing Income Statement Accounts 517 Assessing Control Risk for Business Processes—

Income Statement Accounts 518 Substantive Procedures—Income Statement

Accounts 518 Direct Tests of Balance Sheet Accounts 518

Substantive Analytical Procedures for Income

Statement Accounts 518

Tests of Selected Account Balances 519

Key Terms 520 Review Questions 521 Multiple-Choice Questions 521 Problems 523 Discussion Case 525 Internet Assignment 526 Hands-On Cases 526

Chapter 16 Auditing the Financing/Investing Process: Cash and Investments 528

Auditing Cash 530 Types of Bank Accounts 531

General Cash Account 531

Imprest Cash Accounts 531

Branch Accounts 531

Control Risk Assessment—Cash 532 Substantive Procedures—Cash 532

Substantive Analytical Procedures—Cash 532

Substantive Tests of Details of Transactions and

Balances—Cash 532

Auditing the General Cash Account 533

Fraud-Related Audit Procedures 538

Auditing a Payroll or Branch Imprest

Account 541

Auditing a Petty Cash Fund 541

Disclosure Issues for Cash 542

Auditing Investments 543 Control Risk Assessment—Investments 543

Assertions and Related Control Activities 544

Segregation of Duties 545

Substantive Procedures—Investments 545 Substantive Analytical

Procedures—Investments 545

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Report by a Predecessor Auditor 613

Other Information in Documents Containing Audited Financial Statements 613

Special Reports Relating to Financial Statements 614 Financial Statements Prepared According to a

Special Purpose Framework 614

Specified Elements, Accounts, or Items of a

Financial Statement 615

Compliance Reports Related to Audited Financial

Statements 615

Big Changes Coming to Audit Reporting 616 Key Terms 618 Review Questions 618 Multiple-Choice Questions 619 Problems 621 Discussion Case 625 Hands-On Cases 626

PART 7 Professional Responsibilities 627

Chapter 19 Professional Conduct, Independence, and Quality Control 628

Ethics and Professional Conduct 630 Ethics and Professionalism Defined 630

Theories of Ethical Behavior 631

Example—an Ethical Challenge 632

An Overview of Ethics and Professionalism in Public Accounting 634

A Tale of Two Companies 634

Standards for Auditor Professionalism 635

The Newly Revised AICPA Code of Professional Conduct: A Comprehensive Framework for Auditors 636

Principles of Professional Conduct 638

Rules of Conduct 639

Integrity, Objectivity, and Independence 640 Integrity and Objectivity—Framework, Rule, and

Interpretations 640

Independence 641

Other Sections of the Code of Professional Conduct 653

General Standards and Accounting

Principles 653

Responsibilities to Clients 654

Communications Regarding the Audit of Internal

Control over Financial Reporting 583

Management Letter 584

Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report 584

Key Terms 585 Review Questions 586 Multiple-Choice Questions 586 Problems 588 Discussion Cases 592 Internet Assignments 595 Hands-On Cases 595

Chapter 18 Reports on Audited Financial Statements 596

Reporting on the Financial Statement Audit: The Standard Unqualified/Unmodified Audit Report 598

The Standard Unqualified Audit Report for Public

Companies 598

The Standard Unmodified Audit Report for All

Entities Other Than Public Companies 599

Explanatory Language Added to the Standard Unqualified/Unmodified Financial Statement Audit Report 600

Modified Wording for Opinion Based in Part on

the Report of Another Auditor 600

Circumstances Requiring Explanatory Language

in an Additional Paragraph 601

Departures from an Unqualified/Unmodified Financial Statement Audit Report 604

Conditions for Departure 605

Types of Financial Statement Audit Reports Other

Than Unqualified/Unmodified 605

The Effect of Materiality on Financial Statement

Reporting 606

Discussion of Conditions Requiring Other Types of Financial Statement Audit Reports 607

Scope Limitation 607

Statements Not in Conformity with GAAP 609

Auditor Not Independent 610

Special Reporting Issues 611 Reports on Comparative Financial Statements 611

Different Reports on Comparative Financial

Statements 611

A Change in Report on the Prior-Period Financial

Statements 612

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Discussion Cases 706 Hands-On Cases 706

PART 8 Assurance, Attestation, and Internal Auditing Services 707

Chapter 21 Assurance, Attestation, and Internal Auditing Services 708

Assurance Services 710 Types of Assurance Services 711

Attest Engagements 711 Types of Attest Engagements 712

Attestation Standards 713 General Standards 713

Standards of Fieldwork 715

Standards of Reporting 715

Reporting on an Entity’s Internal Control over Financial Reporting (ICFR) 715

Conditions for Conducting an Engagement

Relating to ICFR 716

Examination Engagement on an Entity’s

ICFR 716

Reporting on Management’s Assertion about

Internal Control 716

Financial Forecasts and Projections 717 Types of Prospective Financial Statements 717

Examination of Prospective Financial

Statements 718

Agreed-Upon Procedures for Prospective Financial

Statements 719

Compilation of Prospective Financial

Statements 720

Accounting and Review Services 722 Compilation of Financial Statements 723

Review of Financial Statements 724

Internal Auditing 726 Internal Auditing Defined 727

The Institute of Internal Auditors 727

IIA Standards 727

Code of Ethics 728

Internal Auditors’ Roles 729

Internal Audit Product Offerings 732

Interactions between Internal and External

Auditors 732

Other Responsibilities and Practices 655

Disciplinary Actions 657

Don’t Lose Sight of the Forest for the Trees 657

Quality Control Standards 658 System of Quality Control 659

Elements of Quality Control 659

PCAOB Inspections of Registered Public

Accounting Firms 661

Key Terms 661 Review Questions 663 Multiple-Choice Questions 663 Problems 666 Discussion Cases 668 Internet Assignment 669 Hands-On Cases 670

Chapter 20 Legal Liability 672

Introduction 674 Historical Perspective 674

Overview of Auditor Legal Liability 675

Common Law—Clients 677 Breach of Contract—Client Claims 677

Negligence—Client Claims 677

Fraud—Client Claims 679

Common Law—Third Parties 680 Ordinary Negligence—Third-Party Claims 680

Fraud and Gross Negligence—Third-Party

Claims 686

Damages under Common Law 687

Statutory Law—Civil Liability 688 Securities Act of 1933 688

Securities Exchange Act of 1934 689

Private Securities Litigation Reform Act of 1995,

the Securities Litigation Uniform Standards Act

of 1998, and the Class Action Fairness Act of

2005 693

Sarbanes-Oxley Act of 2002 695

SEC and PCAOB Sanctions 695

Foreign Corrupt Practices Act 697

Racketeer Influenced and Corrupt

Organizations Act 697

Statutory Law—Criminal Liability 698 Key Terms 699 Review Questions 700 Multiple-Choice Questions 700 Problems 703

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Advanced Module: Professonal Judgment Framework—Understanding and Developing Professional Judgment in Auditing 748 (Also visit KPMG’s University Connection website to access related resources, including videos, mini-cases, instructor notes, and problems, that were created to accompany the Deloitte/Wildman award-winning KPMG Professional Judgment Framework monograph, on which this module is based.)

Index 757

Advanced Module: Examples of Assurance Services— Trust Services and PrimePlus Services 734

Trust Services 734

Trust Services and SOC 2 and SOC 3

Reports 735

CPA WebTrust 735

CPA PrimePlus Services 738

Key Terms 739 Review Questions 739 Multiple-Choice Questions 740 Problems 742 Discussion Case 746 Internet Assignments 746 Hands-On Cases 747

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PART ONE

Introduction to Assurance and Financial Statement Auditing

CHAPTER 1 An Introduction to Assurance and Financial Statement Auditing

CHAPTER 2 The Financial Statement Auditing Environment

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CHAPTER

1 1-1 Understand why studying auditing can be valuable to you

whether or not you plan to become an auditor, and why it is different from studying accounting.

1-2 Understand the demand for auditing and be able to explain the desired characteristics of auditors and audit services through an analogy to a house inspector and a house inspection service.

1-3 Understand the relationships among auditing, attestation, and assurance services.

1-4 Know the basic definition of a financial statement audit.

1-5 Understand three fundamental concepts that underlie financial statement auditing.

1-6 Be able to explain why on most audit engagements an auditor tests only a sample of transactions that occurred.

1-7 Be able to describe the basic financial statement auditing process and the phases in which an audit is carried out.

1-8 Know what an audit report is and understand the nature of an unqualified report.

1-9 Understand why auditing demands logic, reasoning, and resourcefulness.

AU-C 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with GAAS AU-C 210, Terms of Engagement AU-C 450, Evaluation of Misstatements Identified During an Audit AU-C 700, Forming an Opinion and Reporting on Financial Statements AU-C 705, Modifications to the Opinion in the Independent Auditor’s Report AU-C 706, Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report PCAOB Auditing Standard No. 1, References in Auditors’ Reports to the Standards of the Public Company Accounting Oversight Board PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements

PCAOB Auditing Standard No. 8, Audit Risk (AU-C 200) PCAOB Auditing Standard No. 9, Audit Planning (AU-C 300) PCAOB Auditing Standard No. 10, Supervision of the Audit Engagement PCAOB Auditing Standard No. 11, Consideration of Materiality in Planning and Performing an Audit (AU-C 320) PCAOB Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement (AU-C 315) PCAOB Auditing Standard No. 13, The Auditor’s Responses to the Risks of Material Misstatement (AU-C 330) PCAOB Auditing Standard No. 15, Audit Evidence (AU-C 500)

LEARNING OBJECTIVES

Upon completion of this chapter you will

RELEVANT ACCOUNTING AND AUDITING PRONOUNCEMENTS*

*References to AU-C sections have been updated to reflect the new, clarified codification of ASB standards. Where the ASB has a standard that is similar to a PCAOB standard, the AU-C reference is included in parentheses after the PCAOB standard.

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An Introduction to Assurance and Financial Statement Auditing

You will learn in this chapter that auditing consists of a set of practical conceptual tools that help accounting professionals to find, organize, and evaluate evidence about the assertions of another party. The demand for capable accountants and auditors of high integrity has never been greater. Opportunities for auditors are plentiful and rewarding and can lead to attractive career opportunities in other areas. Those who practice as auditors often later go into financial management, becoming controllers, chief financial officers (CFOs), and even chief executive officers (CEOs). But even those who do not plan to become an auditor can benefit greatly from an understanding of financial statement auditing and its underlying concepts. Learning these tools is valuable to any business decision maker.

The past decade has been challenging for the auditing profession. In the early 2000s, a series of high-profile accounting frauds began to cause inves- tors to doubt the integrity of the nation’s financial reporting system, includ- ing the role of the external auditor. To restore investor confidence, Congress passed the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act in July 2002—the most significant legislation related to finan- cial statement audits of public companies since the Securities Acts of 1933 and 1934. The implications of the Sarbanes-Oxley Act are discussed throughout the text in appropriate places. While the public scrutiny, government reforms, and establishment of a regulated process for creating auditing standards for public companies have been challenging for accountants and auditors, the events of the last several years have also served as powerful reminders of just how critical the roles of accounting and auditing are in our society.

We live in a time when the amount of information available for decision makers via electronic databases, the Internet, and other sources is rapidly expanding, and there is a great need for the information to be reliable, cred- ible, relevant, and timely. High-quality information is necessary if managers, investors, creditors, and regulatory agencies are to make informed decisions. Auditing and assurance services play an important role in ensuring the reliabil- ity, credibility, and relevance of business information.

The following examples present situations that illustrate how auditing increases the reliability and credibility of an entity’s financial statements:

Sara Thompson, a local community activist, has been operating a not-for-profit center that provides assistance to abused women and their children. She has financed most of her operations from private contributions. Ms. Thompson applied to the State Health and Human Services Department requesting a large grant to expand her two shelters to accommodate more women. In completing the grant application, Ms. Thompson discovered that the state’s laws for government grants require that recipients be audited to ensure that existing funds are being used appropriately. Ms. Thompson hired a CPA to audit the center’s financial state- ments. Based on the center’s activities, the intended use of the funds, and the auditor’s clean report, the grant was approved.

Conway Computer Company is a wholesaler of computer products. The company was started by George and Jimmy Steinbuker five years ago. Two years ago, a venture capital

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Tips for Learning Auditing

You will find that the study of auditing is different from any of the other accounting courses you have taken in college, and for good reason. Most accounting courses focus on learning the rules, techniques, and computations required to prepare and analyze financial information. Auditing, on the other hand, focuses on learning the analytical and logical skills necessary to evaluate the relevance and reliability of financial information as well as of the systems and processes responsible for recording and summarizing that information. As such, you will find the study of auditing to be much more conceptual in nature than your other accounting courses. This is simply due to the nature of auditing. Thus, we will periodically prompt you to “stop and think” about the concepts being discussed throughout the book. Seeking to thor- oughly understand and apply principles as you read them will greatly improve your success in studying auditing.

Learning auditing essentially helps you understand how to gather and assess evidence so you can evaluate assertions (or claims) made by others. This text is filled with the tools and techniques used by financial statement auditors in practice. You’ll find that the “tool kit” used by auditors consists of a coherent, logical framework, together with techniques useful for analyzing financial data and gathering evidence about others’ assertions. Acquiring this conceptual tool kit can be valuable in a variety of settings, including practicing as an auditor, running a small business, providing consulting services, and even making executive busi- ness decisions. An important implication is that learning this framework makes the study of

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firm acquired 40 percent of the company and thus provided capital for expansion. Conway Computer’s revenues and profits increased by 25 percent in each of the last two years, and the Steinbuker brothers and the venture capital firm decided to take the company public through a stock sale. However, they knew that the company’s financial statements needed to be audited by a reputable public accounting firm before a registration statement could be filed with the Securities and Exchange Commission and in order for inves- tors to trust the stock offering. The company hired a major public accounting firm to perform its audits and the company successfully sold stock to the public.

These situations show the importance of auditing to both private and public enter- prise. By adding an audit to each situation, the users of the financial statements have addi- tional assurance that the financial statements report honestly and accurately, and they will be more willing to rely on those statements. Auditors can also provide valuable assurance for operating information, information systems reliability and security, and the effective- ness of an entity’s internal control. Consider the following example:

EarthWear Clothiers is a successful mail-order retailer of high-quality clothing for outdoor sports. Over the last few years the company has expanded sales through its Internet site. EarthWear’s common stock is listed and traded on NASDAQ. Securities laws require company officials to cer-

tify that they have properly designed, implemented, and tested internal control over their accounting and reporting information systems. EarthWear’s public accounting firm, Willis & Adams, examines the design and documentation of EarthWear’s internal control on a yearly basis and conducts independent tests to ver- ify that EarthWear’s controls are operating effectively. Willis & Adams issues a report to the public express- ing its opinion as to whether EarthWear’s internal control is well designed and operating effectively. Thus, stockholders, creditors, and other stakeholders can have greater confidence in the financial reports issued by EarthWear’s management.

Most readers of an introductory auditing text initially have little understanding of what auditing and assurance services entail. Thus, we start by helping you understand in gen- eral terms why there is a demand for auditing and assurance services. We then compare auditing to other well-known forms of assurance to provide an intuitive understanding of the economic role auditing plays. Finally, we define auditing, attestation, and assurance services and give you an overview of the financial statement auditing process.

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auditing valuable to you as a future accountant or business decision maker, whether or not you plan to become a financial statement auditor.

While the concepts and techniques you will learn in this book will be useful to you regardless of your career path, our experience is that students frequently fall into the trap of defining auditing in terms of memorized lists of rules, tools, and techniques. The study of auditing and the related concepts and techniques will make a lot more sense if you build your intuition of why audits are needed, if you understand the necessary characteristics of audits and auditors, and if you focus on what an auditor does, and why. Don’t fall into the trap of attempting to study auditing through rote memorization! Instead, pause frequently to be sure you understand both “what?” and “why?” as you study the concepts and techniques of audit- ing, as well as “how” auditing is carried out.

As you saw in the introduction to this chapter, reliable information is important for man- agers, investors, creditors, and regulatory agencies to make informed decisions. Auditing helps ensure that information is reliable, credible, and relevant. In fact, the assurance provided by auditing is vital to the proper functioning of our economic system!

The Demand for Auditing and Assurance

In view of the fact that many of the largest companies spend millions of dollars each year for their annual audit, it is worth asking why an entity would decide to spend so much money on an audit?1 Some might answer that audits are required by law. While true in cer- tain circumstances, this answer is far too simplistic. Audits are often utilized in situations where they are not required by law, and audits were in demand long before securities laws required them. In fact, evidence shows that some forms of accounting and auditing existed in Greece as early as 500 BC.2 However, the development of the corporate form of business and the expanding world economy over the last 200 years have given rise to an explosion in the demand for the assurance provided by auditors. In 1926, several years prior to the Securities Acts of 1933 and 1934, which required audits for publicly traded companies in the United States, 82 percent of the companies on the New York Stock Exchange were audited by inde- pendent auditors.3

Principals and Agents The demand for auditing can be understood as the need for accountability when business owners hire others to manage their businesses, as is typical in modern corporations. Until the late 18th and early 19th centuries, most organizations were relatively small and were owned and operated as sole proprietorships or partnerships. Because businesses were generally run by their owners and borrowing was limited, accountability to outside parties often was mini- mal. The birth of modern accounting and auditing occurred during the industrial revolution, when companies became larger and needed to raise capital to finance expansion.4 Over time, capital markets developed, enabling companies to raise the investment capital necessary to expand to new markets, finance expensive research and development, and fund the buildings, technology, and equipment needed to deliver products to market. A capital market allows a public company to sell small pieces of ownership (i.e., stocks) or to borrow money in the form

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1See G. L. Sundem, R. E. Dukes, and J. A. Elliott, The Value of Information and Audits (New York: Coopers & Lybrand, 1996), for a more detailed discussion of the demand for accounting information and auditing. 2G. J. Costouros, “Auditing in the Athenian State of the Golden Age (500–300 BC),” The Accounting Historian Journal (Spring 1978), pp. 41–50. 3G. J. Benston, “The Value of the SEC’s Accounting Disclosure Requirements,” The Accounting Review (July 1969), pp. 515–32. 4Also see M. Chatfield, A History of Accounting Thought (Hinsdale, IL: Dryden Press, 1974), for a discussion of the historical development of accounting and auditing. See D. L. Flesher, G. J. Previts, and W. D. Samson, “Auditing in the United States: A Historical Perspective,” ABACUS (2005), pp. 21–39, for a discussion of the development of auditing in the United States.

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of thousands of small loans (i.e., bonds) so that vast amounts of capital can be raised from a wide variety of investors and creditors. A public company is a company that sells its stocks or bonds to the public, giving the public a valid interest in the proper use of the company’s resources. Thus, the growth of the modern corporation led to diverse groups of owners who are not directly involved in running the business (stockholders) and the use of professional managers hired by the owners to run the corporation on a day-to-day basis. In this setting, the managers serve as agents for the owners (who are sometimes referred to as principals) and fulfill a stewardship function by managing the corporation’s assets.

Accounting and auditing play important roles in this principal–agent relationship. We first explain the roles of accounting and auditing from a conceptual perspective. Then we’ll use an analogy involving a house inspector to illustrate the concepts. First, it is important to understand that the relationship between an owner and manager often results in information asymmetry between the two parties. Information asymmetry means that the manager gener- ally has more information about the “true” financial position and results of operations of the entity than does the absentee owner.

Stop and Think: What negative consequences could information asymmetry have for the absentee owner? How do the perspectives and motives of the manager and absentee owner differ?

Because their goals may not coincide, there is a natural conflict of interest between the manager and the absentee owner. If both parties seek to maximize their self-interest, the man- ager may not always act in the best interests of the owner. For example, the risk exists that a manager may follow the example of Tyco Inc.’s former CEO Dennis Kozlowski, who spent Tyco funds on excessive personal benefits such as $6,000 shower curtains, or Andrew Fastow, the former CFO of Enron, who pleaded guilty to manipulating the reported earnings of Enron in order to inflate the price of the company’s stock so that he could earn larger bonuses and sell his stock holdings at artificially high prices. The owner can attempt to protect him or her- self against the possibility of improper use of resources by reducing the manager’s compensa- tion by the amount of company resources that the owner expects the manager to consume. But rather than accept reduced compensation, the manager may agree to some type of monitoring provisions in his or her employment contract, providing assurance to the owner that he or she will not misuse resources. For example, the two parties may agree that the manager will periodically report on how well he or she has managed the owner’s assets. Of course, a set of criteria is needed to govern the form and content of the manager’s reports. In other words, the reporting of this financial information to the owner must follow some set of agreed-upon principles in holding the manager accountable. As you can see, one primary role of account- ing information is to hold the manager accountable to the owner—hence the word accounting.

The Role of Auditing Of course, reporting in accordance with an agreed-upon set of accounting principles doesn’t solve the problem by itself. Because the manager is responsible for reporting on the results of his or her own actions, which the absentee owner cannot directly observe, the manager is in a position to manipulate the reports. Again, the owner adjusts for this possibility by assum- ing that the manager will manipulate the reports to his or her benefit and by reducing the manager’s compensation accordingly. It is at this point that the demand for auditing arises. If the manager is honest, it may very well be in the manager’s self-interest to hire an auditor to monitor and report to the owner on his or her activities. The owner likely will be willing to invest more in the business and to pay the manager more if the manager can be held account- able for how he or she uses the owner’s invested resources. As the amount of capital involved and the number of potential owners increase, the potential impact of accountability also increases. The auditor’s role is to determine whether the reports prepared by the manager con- form to the contract’s provisions. Thus, the auditor’s verification of the financial information

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adds credibility to the report and reduces information risk, or the risk that information cir- culated by a company’s management will be false or misleading. Reducing information risk potentially benefits both the owner and the manager. Figure 1–1 provides an overview of this agency relationship.

While the setting we’ve outlined is very simple, understanding the basics of the owner– manager relationship is helpful in understanding the demand for auditing. The principal– agent model is a powerful conceptual tool that can be extrapolated to much more complex employment and other contractual arrangements. For example, how can a lender prevent management from taking the borrowed funds and using them inappropriately? One way is to place restrictive covenants in the debt agreement with which the entity and its management must comply. Again, this arrangement gives rise to a demand for the auditing of information reported by management to the lender.

Overview of the Principal–Agent Relationship Leading to the Demand for Auditing

F I G U R E 1 – 1

Auditor gathers evidence to evaluate fairness of agent’s financial reports. Auditor issues audit opinion to accompany agent’s financial reports, adding credibility to the reports and reducing principal’s information risk.

Principal provides capital and hires agent to manage resources.

Information asymmetry and conflicts of interest lead to information risk

for the principal.

Agent is accountable to principal; provides financial reports. Agent hires auditor

to report on the fairness of agent’s

financial reports. Agent pays auditor

to reduce principal’s information risk.

Auditor

Agent (Manager)

Principal (Absentee Owner)

Practice  I N S I G H T

At the heart of a capital-market economy is the flow of reliable information, which investors, credi- tors, and regulators use to make informed decisions. Chief Justice Warren Burger gave his view of the significance of the audit function in a 1984 Supreme Court decision:

By certifying the public reports that collectively depict a corporation’s financial status, the indepen- dent auditor assumes a public responsibility transcending any employment relationship with the cli- ent. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.

More than 30 years later, the message is the same—users of financial statements rely on the external auditor to act with honor and integrity in protecting the public interest.

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In summary, auditing is demanded because it plays a valuable role in monitoring the contractual relationships between the entity and its stockholders, managers, employees, and debt holders. Certified public accountants have been charged with providing audit services because of their traditional reputation of competence, independence, objectivity, and concern for the public interest. As a result, they are able to add credibility to information produced and reported by management to outside parties. The role of the Certified Public Accountant is discussed in more detail in Chapter 2.

Before we discuss financial statement auditors further, let’s illustrate the concepts we’ve just covered using an analogy: buying a home. In the purchase of an existing house, informa- tion asymmetry usually is present because the seller typically has more information about the house than does the buyer. There is also a natural conflict of interest between the buyer and the seller. Sellers generally prefer a higher selling price and may be motivated to overstate the positive characteristics and understate or remain silent about the negative characteristics of the property they have for sale. In other words, there is information risk to the buyer.

Seller Assertions, Information Asymmetry, and Inspector Characteristics To support the asking price, sellers typically make assertions about their property. For instance, the seller of an older home might declare that the roof doesn’t leak, that the founda- tion is sound, that there is no rot or pest damage, and that the plumbing and electrical systems are in good working order. Fortunately, many sellers are honest and forthcoming, but this is not always the case. The problem is that the buyer often does not know if she or he is dealing with an honest seller or if the seller has the necessary expertise to evaluate all the structural or mechanical aspects of the property. Lacking the necessary expertise to validate the seller’s assertions, the buyer can logically reduce information risk by hiring a house inspector.

Stop and Think: Imagine for a moment that you are buying a house and are wisely considering hiring an inspector. Test your intuition—what characteristics would you like your inspector to possess?

Desired Characteristics of the House Inspection Service Now that you have identified some of the characteristics of a good inspector, which likely included competence, honesty, and objectivity, consider the key characteristics of the service he or she will provide. Are some of the seller’s assertions more important than others? For instance, you are probably not equally concerned with the assertions that there is no structural rot and that the lightbulbs in the master bathroom are working. Depending on what you are willing to pay, the inspection could theoretically range from the extremes of driving past the house to taking the home entirely apart, board by board. How thorough do you want the inspector to be? Do you want the inspector to issue a “pass-fail” grade based on a quick walk- through or would you like more details, such as careful examination of the furnace and air conditioner? As you can see, there are many factors to take into account in deciding on the nature and extent of the assurance service you want to buy. In Table 1–1 we have listed what we think are desirable characteristics of a house inspector and of the service provided by an inspector. Pause for a moment to compare your thinking with ours.

The concepts contained in Table 1–1 are in fact fundamental to most forms of inspec- tion (including financial statement audits). Certainly home inspections and other assurance

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An Assurance Analogy: The Case of the House Inspector

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services must focus on the assertions that are most important, and they must be conducted in a timely and cost-effective manner. Some assertions are more important than others because of their potential risk or cost. For example, a house inspector should recognize the signs that indicate an increased risk of a leaky roof. If those signs are present, he or she should investi- gate further, because damage caused by a leaky roof can be very expensive to repair. At the same time, just because the seller asserts that he or she recently lubricated all the door and window hinges doesn’t mean it would be wise to pay the inspector to validate this assertion.

Stop and Think: How might a house inspection be similar to a financial statement audit?

Relating the House Inspection Analogy to Financial Statement Auditing Now that we have discussed some of the basic characteristics of house inspectors and their services, let’s consider how these relate to financial statement auditors. As noted previously, the demand for the assurance provided by a house inspector comes from information asym- metry and conflicts of interest between the buyer and the seller. Information asymmetry and conflicts of interest also exist between managers of companies and potential investors. For example, if managers are overly optimistic or if they wish to inflate their bonus compensa- tion, they may unintentionally or intentionally overstate the company’s earnings and assets (e.g., by understating the allowance for doubtful accounts or by claiming to have more cash than they really have). One important difference between our house inspector example and financial statement auditing is that the buyer of a home typically hires the inspector. In other words, the buyer identifies and hires the inspector rather than hiring someone that the seller recommends—presumably because by hiring an inspector directly, they increase the likeli- hood that the inspector will be objective and independent.

However, as was discussed previously, the companies selling stocks or bonds to the pub- lic typically hire and pay the auditor, rather than the other way around. To raise capital in the marketplace, companies often sell many small parcels of stocks and bonds to a large number of investors. Suppose a financial statement audit of a given company would cost $500,000. Under such circumstances, it obviously doesn’t make sense for each individual investor to pay for an audit. Instead, the company hires and pays for the auditor because a reputable indepen- dent auditor’s opinion can provide assurance to thousands of potential investors. In addition, recall from our previous discussion that the initial demand for auditing comes not from the principal but from the agent. By purchasing the assurance provided by an audit, the company can sell its stocks and bonds to prospective owners and creditors at more favorable prices,

Important Characteristics of House Inspectors and Inspections

Desirable Characteristics of House Inspectors • Competent—they possess the required training, expertise, and experience to evaluate the property for sale. • Objective—they have no reason to side with the seller; they are independent of the seller’s influence. • Honest—they will conduct themselves with integrity, and they will share all of their findings with the buyer. • Skeptical—they will not simply take the seller’s assertions at face value; they will conduct their own analysis and testing. • Responsible and/or liable—they should stand behind their assessment with a guarantee and/or be subject to litigation if they fail to act with due care.

Desirable Characteristics of a House Inspection Service • Timely—the results of the service are reported in time to benefit the decision maker. • Reasonably priced—the costs of the services must not exceed the benefits. For this to occur the service provider will likely need to focus attention on

the most important and risky assertions and likely can’t provide absolute assurance, even with respect to important seller assertions. • Complete—the service addresses all of the most important and risky assertions made by the seller. • Effective—the service provides some degree of certainty that it will uncover significant risks or problems. • Systematic and reliable—the service is based on a systematic process, and the conclusions are based on reliable evidence. In other words, another

comparable inspector would likely find similar issues and come to similar conclusions. • Informative—the service provides a sense for how likely mechanical or structural failure is in the near future and provides an estimate of the cost to

repair known defects or failures.

T A B L E 1 – 1

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significantly reducing the cost of capital. In fact, studies indicate that audits save companies billions of dollars in costs of obtaining capital; for example, by getting lower interest rates on loans and selling stock at higher prices.

Given that the seller of stocks and bonds typically hires the auditor, consider just how crucial a strong reputation is to an independent auditor. Four large, international accounting firms dominate the audits of large publicly traded companies, auditing over 95 percent of the revenue produced by all such companies in the United States. One reason these firms domi- nate the audits of large companies is because they have well-known names and strong reputa- tions. Entities who buy assurance from these firms know that potential investors and creditors will recognize the auditing firm’s name and reputation and feel assured that they therefore face reduced information risk.

The fact that the entity being audited typically hires and pays the auditor also highlights just how important auditor objectivity and independence are to the investing public. In fact, Arthur Andersen, the once highly regarded member of the former “Big 5” international accounting firms, failed in 2002 at least in part because the firm lost its reputation as a high- quality, objective auditor whose opinion could be relied upon by investors and creditors. Later in the book we will discuss some changes enacted over the past several years to strengthen the independence of financial statement auditors, including prohibiting auditors from providing many kinds of consulting services to their public audit clients.

Management Assertions and Financial Statements We’ve seen that home sellers make a number of different assertions about which a home buyer might want independent assurance. What assertions does a company that is selling its stocks or bonds make? Some of the most important assertions entities make to investors are implicit in the entities’ financial statements. Immediately after this chapter you will find a set of financial statements for EarthWear, a hypothetical seller of high-quality outdoor cloth- ing. We’ll use EarthWear examples and exercises throughout the book to illustrate important audit concepts and techniques. Let’s consider what assertions EarthWear makes to potential investors when it publishes its financial statements. For example, EarthWear lists the asset account “Cash” on its balance sheet and indicates that the account’s year-end balance was $48.9 million.

Stop and Think: Consider for a moment what assertions the company is making about cash.

An obvious answer is that EarthWear’s management is asserting that the cash is really there—that it “exists.” They are also implicitly asserting that all the cash that the company owns is included in the records—in other words, the financial records are “complete” with respect to the company’s cash. Finally, management is asserting that the cash amount is fairly and accurately recorded, and that no other parties have valid claims to the cash. Such asser- tions are implicit for each account in the financial statements.

Financial statement assertions are management’s expressed or implied claims about information reflected in the financial statements. Assertions are central to auditing because they are the focus of the auditor’s evidence collection efforts. In other words, much of what auditors do revolves around collecting and evaluating evidence about management’s financial statement assertions.

One of the main tasks of the auditor is to collect sufficient appropriate evidence that management’s assertions regarding the financial statements are correct. If you were to audit EarthWear, how would you go about collecting evidence for the cash account? The process is really quite logical and intuitive. First, you would carefully consider the most important asser- tions the company is making about the account, and then you would decide what evidence you would need to substantiate the truthfulness of each important assertion. For example, to ensure the cash exists, you might examine bank statements or send a letter to the bank

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requesting confirmation of the balance. To ensure the cash hasn’t been pledged or restricted, you might review the minutes of key management meetings to look for discussions or agree- ments on this issue.

We will discuss management assertions in greater depth in Chapter 5, but for now take a look at Table 1–2, which lists all of the management assertions that auditors focus on in an audit. This presentation divides management assertions into three aspects of information reflected in the financial statements: transactions, account balances, and presentation and dis- closure. For example, EarthWear’s management asserts, among other things, that transactions relating to inventory actually occurred, that they are complete (i.e., no valid transactions were left out), that they are classified properly (e.g., as an asset rather than an expense), and that they are recorded accurately and in the correct period. Similarly, management asserts that the inventory represented in the inventory account balance exists, that the entity owns the inven- tory, that the balance is complete, and that the inventory is properly valued. Finally, manage- ment asserts that the financial statements properly present the inventory (e.g., inventory is appropriately listed as a current asset on the balance sheet) and that all required disclosures having to do with inventory (e.g., a footnote indicating that the company uses the FIFO inventory method) are complete, accurate, and understandable. Understanding the assertions in terms of transactions, account balances, and presentation and disclosure is helpful because the three categories help the auditor focus on the different types of audit procedures needed to test the assertions in the three different categories. Chapter 5 discusses the types of proce- dures available to the auditor in more detail.

 
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