Modern Auditing: Assurance Services and the Integrity of Financial Reporting, 8th Edition

Part 1 The Auditing Environment 1

1 Auditing and the Public Accounting Profession-Integrity of Financial Reporting 3

Internal Auditors Uncover Financial Fraud at Worldcom 3

Preview of Chapter 1 4

Auditing and Assurance Services Defined 5

Auditing Defined 6

Types of Audits 8

Types of Auditors 10

Assurance Services Defined 11

Value of Audit and Assurance Services 15

The Demand for Auditing 18

The Roots of Auditing 18

Need for Financial Statement Audits 20

Economic Benefits of an Audit 21

Limitations of an Audit 22

Organizations Associated with the Public Accounting Profession 23

Public Sector Organizations 23

Private Sector Organizations 25

Regulatory Framework for Ensuring High-Quality Services 29

Standard Setting 29

Firm Regulation 33

Inspection and Peer Review 33

Government Regulation 34

Focus on Auditor Knowledge 35

Objective Questions 37

Comprehensive Questions 37

Professional Simulation 41

2 Auditors’ Responsibilities and Reports 42

Auditor Responsibility for Going Concern 42

Preview of Chapter 2 43

Fundamentals Underlying Financial Statement Audits 44

Relationship Between Accounting and Auditing 44

Verifiability, Professional Judgment, and Fair Presentation 45

Independent Auditor Relationships 47

Auditing Standards 50

Generally Accepted Auditing Standards (GAAS) 50

Statements on Auditing Standards (SAS) 54

PCAOB Auditing Standards 54

Assurance Provided by an Audit 55

Auditor Independence 56

Reasonable Assurance 56

Detecting and Reporting Fraud 57

Detecting and Reporting Illegal Acts 59

Evaluation of Internal Control 61

Assurance About a Going Concern 61

A Clean Bill of Health? 62

The Auditor’s Report on Financial Statements 64

The Standard Report on Financial Statements 64

Departures from the Standard Report 68

Other Types of Opinions 69

The Auditor’s Report on Internal Control 72

The Standard Report 72

Departures From the Standard Report 78

Focus on Auditor Knowledge and Audit Decisions 82

Appendix 84

Objective Questions 94

Comprehensive Questions 94

Cases 98

Professional Simulation 100

3 Professional Ethics 101

Independence and Nonaudit Services 101

Preview of Chapter 3 102

Ethics and Morality 103

General Ethics 103

Professional Ethics 104

AICPA Code of Professional Ethics 105

AICPA Professional Ethics Division 106

Composition of the AICPA Code of Professional Conduct 106

Ethical Principles 107

Rules of Conduct 110

Rule 101—Independence 112

Rule 102—Integrity and Objectivity 124

Rule 201—General Standards 124

Rule 202—Compliance with Standards 125

Rule 203—Accounting Principles 125

Rule 301—Confidential Client Information 126

Rule 302—Contingent Fees 127

Rule 501—Acts Discreditable 128

Rule 502—Advertising and Other Forms of Solicitation 129

Rule 503-Commissions and Referral Fees 129

Rule 505-Form of Organization and Name 130

Enforcement of the Rules of Conduct 132

State Boards of Acountancy and Public Companies Accounting Oversight Board 132

Enforcing the AICPA Code of Professional Conduct 132

Focus on Auditor Knowledge and Audit Decisions 134

Objective Questions 137

Comprehensive Questions 137

Cases 140

Professional Simulation 142

4 Auditor’s Legal Liability 144

The Cost of Malpractice 144

Preview of Chapter 4 145

Liability Under Common Law 146

Liability to Clients 146

Liability to Third Parties 147

Common Law Defenses 153

Liability Under Securities Law 155

Securities Act of 1933 155

Securities Exchange Act of 1934 159

Private Securities Litigation Reform Act of 1995 163

Sarbanes-Oxley Act of 2002 165

Other Considerations 168

Liability Under Racketeer Influenced and Corrupt Organizations Act (RICO) 168

Minimizing the Risk of Litigation 169

Summary 170

Focus on Auditor Knowledge 171

Objective Questions 174

Comprehensive Questions 174

Case 177

Professional Simulation 178

Part 2 Auditing Planning 181

5 Overview of the Financial Statement Audit 183

How Much of What Do I Audit? 183

Preview of Chapter 5 183

Overview of the Audit Process 185

Phase I: Perform Risk Assessment Procedures 185

Identify Relevant Financial Statement Assertions 186

Understand the Entity and its Environment 190

Make Decisions About Materiality 193

Perform Analytical Procedures 193

Identify the Risks that May Lead to Material Misstatement, Including the Risk of Fraud 194

Develop Preliminary Audit Strategies 199

Understand Internal Control 199

Phase II: Assess the Risk of Material Misstatement 202

Relate Risk Factors to Potential Financial Statement Misstatements 202

Determine the Magnitude of Potential Misstatements 203

Determine the Likelihood of Material Misstatments 203

Determine Significant Inherent Risks 204

Phase III: Respond to Assessed Risks 205

Staffing and Supervision 206

Nature of Audit Tests 206

Timing of Audit Tests 207

Extent of Audit Tests 208

Respond to Significant Inherent Risks 208

Phase IV: Perform Further Audit Procedures 209

Further Risk Assessment Procedures 210

Test of Controls 210

Substantive Tests 211

Phase V: Evaluate Evidence 212

Reevaluate Risk Assessment Procedures 212

Determine the Significance of Findings 212

Form and Document Conclusions 213

Phase VI: Communicate Audit Findings 214

The Auditor’s Opinion 214

Other Required Communications 215

Other Assurance Service Findings 215

Focus on Auditor Knowledge 217

Focus on Audit Decisions 218

Objective Questions 219

Comprehensive Questions 219

Professional Simulation 225

6 Audit Evidence 227

Sunbeam Corporation 227

Preview of Chapter 6 228

Audit Evidence and Assertions 229

Audit Evidence Defined 229

Assertions and Specific Audit Objectives 231

Sufficient Competent Evidence 236

Sufficiency of Audit Evidence 237

Competency of Audit Evidence 238

Audit Procedures 241

Inspection of Documents and Records 241

Inspection of Tangible Assets 243

Observation 244

Inquiry 244

Confirmation 245

Recalculation 245

Reperformance 245

Analytical Procedures 246

Computer-Assisted Audit Techniques 246

Four Decisions About Audit Procedures 247

Staffing and Supervising the Audit 248

Nature of Audit Procedures 248

Timing of Audit Procedures 249

Extent of Audit Procedures 249

Documenting Audit Decisions and Audit Evidence 251

Audit Programs 251

Working Papers 254

Preparing Working Papers 259

Working Paper Files 260

Focus on Auditor Knowledge and Audit Decisions 261

Objective Questions 263

Comprehensive Questions 263

Cases 268

Professional Simulation 269

7 Accepting the Engagement and Planning the Audit 270

ZZZZ Best: Client Acceptance and Client Resignation 270

Preview of Chapter 7 271

Client Acceptance and Retention 272

Evaluate the Integrity of Management 273

Identify Special Circumstances and Unusual Risks 275

Assess Competence to Perform the Audit 276

Evaluate Independence 278

Making the Decision to Accept or Decline the Audit 279

Prepare the Engagement Letter 279

Audit Planning and Risk Assessment Procedures 283

Steps in Performing Risk Assessment Procedures 284

Understanding the Entity and Its Environment 285

Industry, Regulatory, and Other External Factors 286

The Nature of the Entity, Including its Selection and Application of Accounting Policies 291

The Entity’s Objectives, Strategies, and Related Business Risks 294

Measurement and Review of the Entity’s Financial Performance 295

Illustrative Case Study 295

Focus on Auditor Knowledge and Audit Decisions 302

Objective Questions 303

Comprehensive Questions 303

Cases 308

Professional Simulation 312

8 Materiality Decisions and Performing Analytical Procedures 314

What Size of Misstatement is Material? 314

Preview of Chapter 8 315

Materiality Decisions 316

The Concept of Materiality 316

Preliminary Judgments About Materiality 317

Materiality and the Evaluation of Evidence 322

Performing Analytical Procedures 324

Identify Calculations and Comparisons to Be Made 325

Develop an Expectation Range 328

Perform the Calculations 329

Analyze Data and Identify Significant Differences 329

Investigate Significant Unexpected Differences 330

Determine Effects on Audit Planning 330

Illustrative Case Study 330

Focus on Auditor Knowledge and Audit Decisions 336

Appendix 8 338

Objective Questions 340

Comprehensive Questions 340

Comprehensive Case 343

Professional Simulation 348

9 Audit Risk, Including the Risk of Fraud 350

Fraud is on the Rise: Results of the KPMG Fraud Survey 2003

Preview of Chapter 9 351

Audit Risk—An Overview 352

Assessing the Risk of Fraud 353

How Significant is Fraud? 353

Fraud Defined 353

The Fraud Triangle 355

Auditing for Fraud 360

The Audit Risk Model 364

Illustrating the Audit Risk Model 364

Assessing the Components of Audit Risk 366

Relationship Between Audit Risk and Audit Evidence 371

Preliminary Audit Strategies 373

Components of Preliminary Audit Strategies 374

Three Basic Preliminary Audit Strategies 374

Focus on Auditor Knowledge and Audit Decisions 379

Objective Questions 381

Comprehensive Questions 381

Cases 386

Professional Simulation 387

10 Understanding Internal Control 389

The Importance of Internal Control 389

Preview of Chapter 10 390

Introduction to Internal Control 391

Definition and Components 391

Entity Objectives and Related Internal Control Relevant to an Audit 392

Limitations of an Entity’s System of Internal Control 393

Roles and Responsibilities 394

Components of Internal Control 396

Control Environment 397

Risk Assessment 402

Information and Communication 404

Control Activities 405

Monitoring 413

Antifraud Programs and Controls 414

Applications of Components to Small and Midsized Entities 415

Summary 416

Understanding Internal Control 422

What to Understand About Internal Control 422

Effects of Preliminary Audit Strategies 425

Procedures to Obtain an Understanding 426

Documenting the Understanding 429

Flowcharts 430

Focus on Auditor Knowledge and Audit Decisions 436

Appendix 10a 438

Appendix 10b 447

Appendix 10c 453

Objective Questions 456

Comprehensive Questions 456

Cases 461

Professional Simulation 463

Part 3 Audit Testing Methodology 465

11 Audit Procedures in Response to Assessed Risks: Tests of Controls 467

Internal Controls at Enron 402

Preview of Chapter 11 468

Process for Assessing Control Risk 469

Consider Knowledge Acquired from Procedures to Obtain an Understanding 470

Identify Potential Misstatements 470

Identify Necessary Controls 471

Perform Tests of Controls 474

Evaluate Evidence and Make Assessment 475

Assessing Control Risk in an Information Technology Environment 476

Strategies for Performing Tests of Controls 476

Computer-Assisted Audit Techniques 478

Assessing Information Technology Controls 481

Effects of Preliminary Audit Strategies 484

Primarily Substantive Approaches 484

Lower Assessed Level of Control Risk 487

Designing Tests of Controls 487

Nature of Tests of Controls 488

Timing of Tests of Controls 489

Extent of Tests of Controls 491

Staffing Tests of Controls 492

Audit Programs for Tests of Controls 492

Dual-Purpose Tests 492

Additional Considerations 495

Assessing Control Risk for Account Balance Assertions Affected by a Single Transaction Class 495

Assessing Control Risk for Account Balance Assertions Affected by Multiple Transaction Class 495

Documenting the Assessed Level of Control Risk 497

Communicating Internal Control Matters 498

Focus on Auditor Knowledge and Audit Decisions 500

Objective Questions 502

Comprehensive Questions 502

Cases 508

Professional Simulation 511

12 Audit Procedures in Response to Assessed Risks: Substantive Tests 513

The Importance of Risk Assessment Procedures and Audit Programs 523

Preview of Chapter 12 514

Assessing the Risk of Material Misstatement 515

Steps for Assessing the Risk of Material Misstatement 515

Determining Detection Risk 518

Designing Substantive Tests 520

Performing Further Audit Procedures 520

Using Information Technology to Support Substantive Tests 520

Audit Choices in the Design of Substantive Tests 523

Special Considerations in Designing Substantive Tests 533

Developing Audit Programs for Substantive Tests 535

A General Framework for Developing an Audit Program for Substantive Tests 535

Focus on Auditor Knowledge and Audit Decisions 540

Objective Questions 542

Comprehensive Questions 542

Professional Simulation 549

13 Audit Sampling 551

What is an Appropriate Sample Size? 551

Preview of Chapter 13 552

Basic Audit Sampling Concepts 553

Nature and Purpose of Audit Sampling 553

Uncertainty and Audit Sampling 553

Sampling Risk and Nonsampling Risk 553

Nonstatistical and Statistical Sampling 555

Tests of Controls 558

Tests of Controls That Do Not Involve Audit Sampling 558

Framework for Audit Sampling for Tests of Controls 559

Substantive Tests 566

Substantive Tests That Do Not Involve Audit Sampling 566

Framework for Audit Sampling for Substantive Tests 567

Summary 582

Focus on Auditor Knowledge and Audit Decisions 583

Appendix 13a 585

Appendix 13b 593

Appendix 13c 604

Objective Questions 609

Comprehensive Questions 609

Cases 616

Professional Simulation 623

Part 4 Auditing The Transaction Cycles 625

14 Auditing the Revenue Cycle 627

What is the Most Frequent Cause of Financial Statement Restatements? 627

Preview of Chapter 14 628

Risk Assessment Procedures in the Revenue Cycle 629

Develop Audit Objectives 629

Understand the Entity and Its Environment 630

Inherent Risk, Including the Risk of Fraud 633

Analytical Procedures 634

Consideration of Internal Control Components 636

Control Activities for Credit Sales Transactions 639

Common Documents and Records 640

Functions and Control Activities 640

Illustrative System for Credit Sales 644

Control Activities for Cash Receipts Transactions 647

Common Documents and Records 647

Functions and Central Activities 648

Illustrative System for Cash Receipts 651

Control Activities for Sales Adjustment Transactions and Other Controls 651

Common Documents and Records 651

Function and Control Activities 651

Other Controls in the Revenue Cycle 653

Revenue Cycle Tests of Controls 654

Substantive Tests of Accounts Receivable 655

Determining Detection Risk 655

Designing Substantive Tests 658

Other Assurance Services 672

Focus on Audit Decisions 672

Objective Questions 675

Comprehensive Questions 675

Cases 679

Comprehensive Case 679

Professional Simulations 684

15 Auditing the Expenditure Cycle 688

Poor Internal Controls Result in a Material Understatement of Accounts Payable and Net Income 688

Preview of Chapter 15 689

Risk Assessment Procedures in the Expenditure Cycle 690

Develop Audit Objectives 691

Understand the Entity and Its Environment 691

Inherent Risk, Including the Risk of Fraud 692

Analytical Procedures 695

Consideration of Internal Control Components 696

Control Activities—Purchase Transactions 699

Common Documents and Records 700

Functions and Control Activities 701

Illustrative System for Purchase Transactions 706

Control Activities—Cash Disbursement Transactions 707

Common Documents and Records 708

Functions and Control Activities 708

Illustrative System for Cash Disbursement Transactions 710

Control Activities for Purchase Adjustment Transactions and Other Controls 712

Common Documents and Records 712

Functions and Control Activities 713

Other Controls in the Expenditure Cycle 713

Test of Controls 714

Substantive Tests of Accounts Payable Balances 715

Determining Detection Risk for Tests of Details 715

Designing Substantive Tests 718

Other Assurance Services 725

Focus on Audit Decisions 726

Objective Questions 728

Comprehensive Questions 729

Cases 734

Professional Simulations 738

16 Auditing the Production and Personnel Services Cycles 742

Overstating Inventory and Profits 742

Preview of Chapter 16 743

Auditing the Production Cycle 744

Audit Objectives 744

Understanding the Entity and Its Environment 745

Analytical Procedures 746

Inherent Risk 749

Consideration of Internal Controls 749

Preliminary Audit Strategies 757

Substantive Tests of Inventory 757

Auditing the Personnel Service Cycle 769

Audit Objectives 770

Understanding the Entity and Its Environment 770

Analytical Procedures 772

Inherent Risk 772

Consideration of Internal Controls 773

Preliminary Audit Strategies 780

Substantive Tests of the Personnel Services Cycle 782

Other Services in the Production and Personnel Services Cycles 786

Focus on Audit Decisions 787

Objective Questions 790

Comprehensive Questions 790

Cases 797

Professional Simulations 801

17 Auditing the Investing and Financing Cycles 801

Worldcom and Enron: Lessons for the Investing and Financing Cycles 804

Preview of Chapter 17 805

Nature of the Investing and Financing Cycles 806

Overview of the Investing and Financing Cycles 806

Understanding the Entity and Its Environment 807

The Investing Cycle 807

Audit Objectives 809

Analytical Procedures 810

Inherent Risk 810

Consideration of Internal Controls 811

Preliminary Audit Strategies 812

Substantive Tests for Plant Assets 814

The Financing Cycle 821

Audit Objectives 821

Analytical Procedures 821

Inherent Risk 821

Consideration of Internal Controls 822

Preliminary Audit Strategies for Long-Term Debt 824

Substantive Tests of Long-Term Debt 826

Preliminary Audit Strategies for Shareholders’Equity 831

Substantive Tests of Stockholders’ Equity 832

Other Services 838

Focus on Audit Decisions 838

Objective Questions 841

Comprehensive Questions 841

Cases 843

Professional Simulations 844

18 Auditing Investments and Cash Balances 847

Where’s the Cash? Auditor’s Uncover Massive Fraud 847

Preview of Chapter 18 847

Auditing Investments 849

Overview of Investments 849

Audit Objectives 850

Understanding the Entity and Its Environment 850

Analytical Procedures 851

Inherent Risk 851

Consideration of Internal Controls 852

Preliminary Audit Strategies 854

Substantive Tests of Short-Term and Long-Term Investments 856

Auditing Cash Balances 862

Relationship of Cash Balances to Transaction Cycles 862

Audit Objectives 862

Analytical Procedures 864

Inherent Risk 864

Consideration of Internal Controls 865

Preliminary Audit Strategies for Investments 865

Substantive Tests of Cash Balances 867

Other Related Services 878

Focus on Audit Decisions 879

Objective Questions 881

Comprehensive Questions 882

Cases 887

Professional Simulation 888

Part 5 Completing The Audit Other Services and Reports 891

19 Completing the Audit and Postaudit Responsibilities 893

Auditor’s Responsibilities for Events Occurring After Balance Sheet Date 893

Preview of Chapter 19 893

Completing the Fieldwork 895

Making Subsequent Events Review 896

Reading Minutes of Meetings 898

Obtaining Evidence Concerning Litigation, Claims, and Assessments 898

Obtaining Client Representation Letter 900

Performing Analytical Procedures 901

Evaluating the Findings 904

Making Final Assessment of Materiality and Audit Risk 904

Evaluating Going Concern 905

Making Technical Review of Financial Statements 907

Formulating Opinion and Drafting Audit Report on the Financial Statements 908

Formulating Opinion and Drafting Audit Report on the Internal Controls Over Financial Reporting 908

Making Final Review(s) of Working Papers 909

Communicating with the Client 910

Communicating Internal Control Matters 910

Communicating Matters Pertaining to Conduct of Audit 913

Preparing Management Letter 914

Postaudit Responsibilities 916

Subsequent Events Between Report Date and Issuance of Report 916

Discovery of Facts Existing at Report Date 917

Discovery of Omitted Procedures 917

Focus on Audit Decisions 918

Objective Questions 922

Comprehensive Questions 922

Cases 926

Professional Simulations 929

20 Attest and Assurance Services, and Related Reports 933

A Busy Day with Lots of Questions 933

Preview of Chapter 20 934

Overview of Attest and Assurance Services 935

Universe of Assurance Services 935

Financial Statement Audits 935

Levels of Assurance 936

Types of Engagements 937

Other SAS Engagements 937

Special Reports 937

Other Comprehensive Bases of Accounting 939

Specified Elements, Accounts, or Items of a Financial Statement 940

Compliance Reports Related to Audited Financial Statements 942

Accepting and Performing Attest Engagements 943

Attestation Standards 944

Engagements Performed Under Attestation Standards 946

SSAE 101 Engagements 946

Agreed-Upon Procedures Engagements 951

Reporting on Prospective Financial Information 953

Compliance Attestations 955

Accounting and Review Services 958

Review of Financial Statements 959

Compilation of Financial Statements 961

Other Assurance Services 964

CPA Risk Advisory 965

CPA Performance View 967

CPA ElderCare 969

Focus on Audit Decisions 971

Objective Questions 974

Comprehensive Questions 974

Case 979

Professional Simulation 980

21 Internal, Operational, and Governmental Auditing 983

Understanding the Risk of Fraud in Governmental Audits 983

Preview of Chapter 21 984

Internal Auditing 985

Internal Auditing Defined 985

Evolution of Internal Auditing 986

IIA Code of Ethics 986

IIAAttribute and Performance Standards 986

Relationship with External Auditors 990

Operational Auditing 991

Operational Auditing Defined 991

Phases of an Operational Audit 992

Standards for Independent Public Accountants 995

Governmental Auditing 996

Types of Government Audits 996

Generally Accepted Government Auditing Standards (GAGAS) 997

Reporting on Compliance with Laws and Regulations 1003

Reporting on Internal Control 1005

The Single Audit Act 1006

Objectives of the Act 1006

Applicability and Administration 1006

Scope of an Audit Under the Single Audit Act 1007

Focus on Auditor Knowledge 1011

Objective Questions 1013

Comprehensive Questions 1013

Cases 1017

Professional Simulation 1018

Index 1020