ACCT 401 SEU Audit Attestation and Assurance Services Questions

College of Administration and Finance Sciences
Instructions – PLEASE READ THEM CAREFULLY
• The Assignment must be submitted on Blackboard (WORD format only) via
allocated folder.
• Assignments submitted through email will not be accepted.
• Students are advised to make their work clear and well presented; marks may be
reduced for poor presentation. This includes filling your information on the
cover page.
• Students must mention question number clearly in their answer.
• Late submission will NOT be accepted.
• Avoid plagiarism, the work should be in your own words, copying from
students or other resources without proper referencing will result in ZERO
marks. No exceptions.
• All answers must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism.
• Submissions without this cover page will NOT be accepted.
Assignment Question(s):
(Marks 15)
IMPORTANT NOTES: Answer in your OWN words, DO NOT COPY from slides,
fellow students, or internet sources without proper citation.
Q1. What is the difference between audit, attestation, and assurance services? And how do the
answers provide value to stakeholders?
Your answer should have a minimum of 400 words. (5 Marks)
College of Administration and Finance Sciences
Q2. How can auditors effectively plan an audit in a dynamic and uncertain environment? Provide an
example to describe your answer.
Your answer should have a minimum of 400 words. (5 Marks)
College of Administration and Finance Sciences
Q3. In your opinion, what are the benefits of assessing the effectiveness of internal controls over
financial statements ICFR to the audit process, other than being a requirement of PCAOB?
Your answer should have a minimum of 300 words. (5 Marks)
Auditing & Assurance
Services
A
S Y S T E M A T I C
A P P R O A C H
TENTH EDITION
Auditing & Assurance
Services
A
S Y S T E M A T I C
A P P R O A C H
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
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
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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
About the Authors
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 M
­ ichigan.
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 Auditing 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 Auditing 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 Norwegian 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 accelerate 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 M
­ arriott
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.
v
vi
About the Authors
He consults actively with international, regional, and local public accounting firms. He
worked extensively over a five-year period with the Committee of Sponsoring Organizations (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. Professor 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 professional skepticism commissioned by the Standards Working Group of the GPPC, an international consortium of the six largest public accounting firm networks.
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
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 reliabile, high-quality assurance over financial reporting continues to intensify. The auditing environment is far more complex 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 Auditing 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 statement 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 professionals 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.
vii
viii
Why a New Edition?
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 professional 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 “clarity” 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 edition 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 understandable 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
Give your students an intuitive,
hands-on learning experience!
The 10th Edition includes the following important features and enhancements:
∙
∙
∙
∙
∙
∙
∙
∙
∙
∙
A “professional judgment” module, designed to accelerate the development of the student’s professional judgment and based on the AAA Deloitte/Wildman Award-winning KPMG Professional Judgment 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
ix
x
Give your students an intuitive, hands-on learning experience!
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
Give your students an intuitive, hands-on learning experience!
xi
Tenth Edition Supplements
Connect instructor resources library offers:
∙
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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 element 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.
How does 10e prepare
your students?
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 students 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 application, 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.
xii
Rev. Confirming Pages
Chapter 1
7
An Introduction to Assurance and Financial Statement Auditing
Practical applications for the
modern student
FIGURE 1–1
Overview of the Principal–Agent Relationship Leading to the Demand
Chapter 1 for
AnAuditing
Introduction to Assurance and Financial Statement Auditing
29
know, if the securities acts had not been passed by Congress in the 1930s, no one
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INTERNET ASSIGNMENT
LO 1-1, 1-9
1-30
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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 auditing procedures.
is accountable
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
29
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employment and other contractual arrangements. For example, how can a lender prevent
INTERNET ASSIGNMENT
LO 1-1, 1-9
Additional Student
Resources Practice
Practice Insights
INSIGHT
Practice Insights in each chapter highlight
important and interesting real-world trends and
practices.
Free IDEA software
management from taking the borrowed funds and using them inappropriately? One way is to
place
covenants
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are available. For example, the PCAOB’s home page
(www.pcaobus.org) contains extensive information on the organization’s activities
Visit Connect(you
for author-created
problem material to be completed using IDEA software.
may use the PCAOB site as one of the five). Your five summaries should not
At the heart of a capital-market economy is the flow of reliable information, which investors, creditors, andexceed
regulators
use of
to one
maketyped
informed
a total
page.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-
HANDS-ON CASES
dent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to
EarthWear
Introduction
the corporation’s
creditors and stockholders, as well as to the investing public.
EarthWear Online
In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis and
More
thanThis
30 introductory
years later, activity
the message
is the same—users
statements
on the external
Adams.
also provides
an opportunityoftofinancial
become familiar
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the structure
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auditor
honorOnline
and integrity
formattoofact
the with
EarthWear
cases. in protecting the public interest.
Visit Connect’s additional student resources to find a detailed description of the case and to download
required materials.
Additional Student
Resources
mes32502_ch01_001-034.indd 7
Visit Connect for author-created problem material to be completed using IDEA software.
09/30/15 02:33 PM
The educational version of IDEA software is available 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.
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 standards 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.
mes32502_ch01_001-034.indd
29
09/30/15 02:33 PM
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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xiii
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Acknowledgments
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.
xvi
Brief Contents
PART 1
Chapter 7
Introduction to Assurance and
Financial Statement Auditing 1
Auditing Internal Control over Financial
Reporting 220
Chapter 1
PART 4
An Introduction to Assurance and Financial
Statement Auditing 2
Chapter 2
The Financial Statement Auditing
Environment 36
PART 2
Statistical and Nonstatistical Sampling
Tools for Auditing 261
Chapter 8
Audit Sampling: An Overview and
Application to Tests of Controls 262
Chapter 9
Audit Planning and Basic Auditing
Concepts 67
Audit Sampling: An Application to
Substantive Tests of Account Balances
Chapter 3
PART 5
Audit Planning, Types of Audit Tests, and
Materiality 68
337
Chapter 10
Chapter 4
Auditing the Revenue Process
Risk Assessment 98
338
Chapter 11
Chapter 5
Evidence and Documentation
Auditing Business Processes
300
128
Auditing the Purchasing Process
386
Chapter 12
PART 3
Understanding and Auditing Internal
Control 177
Chapter 6
Internal Control in a Financial
Statement Audit 178
Auditing the Human Resource Management
Process 422
Chapter 13
Auditing the Inventory Management
Process 450
xvii
xviii
Brief Contents
Chapter 14
Chapter 20
Auditing the Financing/Investing Process:
Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment 480
Legal Liability 672
Chapter 15
Assurance, Attestation, and Internal
Auditing Services 707
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
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
PART 7
Professional Responsibilities
PART 8
627
Chapter 19
Professional Conduct, Independence, and
Quality Control 628
757
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
Problems 27
Discussion Case 28
Internet Assignment 29
Hands-On Cases 29
25
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
xix
xx
Table of Contents
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
xxi
Table of Contents
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
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
xxii
Table of Contents
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
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
xxiii
Table of Contents
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
Key Terms 290
Review Questions 291
Multiple-Choice Questions
Problems 294
Discussion Case 297
Hands-On Cases 298
292
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
xxiv
Table of Contents
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
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
xxv
Table of Contents
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
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
xxvi
Table of Contents
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
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
xxvii
Table of Contents
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
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 16
Chapter 17
Auditing the Financing/Investing Process:
Cash and Investments 528
Completing the Audit Engagement
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
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
xxviii
Table of Contents
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
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
xxix
Table of Contents
Other Responsibilities and Practices 655
Disciplinary Actions 657
Don’t Lose Sight of the Forest for the Trees
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
Discussion Cases 706
Hands-On Cases 706
657
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
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
xxx
Table of Contents
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
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
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
1
CHAPTER
1
LEARNING OBJECTIVES
Upon completion of this chapter you will
1-1
1-2
1-3
1-4
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.
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.
Understand the relationships among auditing, attestation,
and assurance services.
Know the basic definition of a financial statement audit.
1-5
1-6
1-7
1-8
1-9
Understand three fundamental concepts that underlie
financial statement auditing.
Be able to explain why on most audit engagements an
auditor tests only a sample of transactions that occurred.
Be able to describe the basic financial statement auditing
process and the phases in which an audit is carried out.
Know what an audit report is and understand the nature
of an unqualified report.
Understand why auditing demands logic, reasoning, and
resourcefulness.
RELEVANT ACCOUNTING AND
AUDITING PRONOUNCEMENTS*
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)
*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.
An Introduction to Assurance
and Financial Statement Auditing
Y
ou 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 investors to doubt the integrity of the nation’s financial reporting system, including 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 financial 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, credible, 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 reliability, 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 statements. 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
3
4
Part 1   Introduction to Assurance and Financial Statement Auditing
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 investors 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 enterprise. By adding an audit to each situation, the users of the financial statements have additional 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 effectiveness 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 certify 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 verify that EarthWear’s controls are operating effectively. Willis & Adams issues a report to the public expressing 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 general 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.
Tips for Learning Auditing
LO 1-1
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 thoroughly 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 business decisions. An important implication is that learning this framework makes the study of
Chapter 1   An Introduction to Assurance and Financial Statement Auditing
5
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 auditing, as well as “how” auditing is carried out.
As you saw in the introduction to this chapter, reliable information is important for managers, 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
LO 1-2
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 certain 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 independent 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 minimal. 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
1
See 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.
2
G. J. Costouros, “Auditing in the Athenian State of the Golden Age (500–300 BC),” The Accounting Historian
Journal (Spring 1978), pp. 41–50.
3
G. J. Benston, “The Value of the SEC’s Accounting Disclosure Requirements,” The Accounting Review (July 1969),
pp. 515–32.
4
Also 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.
6
Part 1   Introduction to Assurance and Financial Statement Auditing
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 generally 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 manager 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 herself against the possibility of improper use of resources by reducing the manager’s compensation 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 accounting 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 assuming 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 accountable 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 conform to the contract’s provisions. Thus, the auditor’s verification of the financial information
7
Chapter 1   An Introduction to Assurance and Financial Statement Auditing
FIGURE 1–1
Overview of the Principal–Agent Relationship Leading to the Demand
for Auditing
Principal provides capital and hires
agent to manage resources.
Principal
(Absentee Owner)
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.
Information asymmetry
and conflicts of interest
lead to information risk
for the principal.
Agent is accountable to principal;
provides financial reports.
Auditor
Agent
(Manager)
Agent hires auditor
to report on the
fairness of agent’s
financial reports.
Agent pays auditor
to reduce principal’s
information risk.
adds credibility to the report and reduces information risk, or the risk that information circulated 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.
Practice
INSIGHT
At the heart of a capital-market economy is the flow of reliable information, which investors, creditors, 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 independent auditor assumes a public responsibility transcending any employment relationship with the client. 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.
8
Part 1   Introduction to Assurance and Financial Statement Auditing
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.
An Assurance Analogy: The Case of the
House Inspector
LO 1-2
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, information 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 foundation 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 walkthrough 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 inspection (including financial statement audits). Certainly home inspections and other assurance
Chapter 1   An Introduction to Assurance and Financial Statement Auditing
TABLE 1–1
9
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 …