Chapter 1: Assurance Services 2
Introduction 3
A.Need for Assurance 3
Potential Bias in Providing Information 3
Remoteness of Users 3
Complexity 4
Need for Assurance Regarding Information and Operations 4
B.The Special Role of Financial Statement Audits 12
Auditing Defined 13
The Need for Unbiased Reporting 15
Requirements to Enter the Public Accounting Profession 16
The Public Accounting Profession 17
C.The Providers of Assurance Services 17
The Internal Audit Profession 18
Governmental Auditing Profession 19
D.Other Professional and Regulatory Organizations 20
The American Institute of Certified Public Accountants 20
State Boards of Accountancy 21
The Securities and Exchange Commission 21
The Institute of Internal Auditors 22
The U.S.General Accounting Office 22
The Court System 22
Summary 22
Significant Terms 23
Review Questions 24
Multiple-Choice Questions 25
Discussion and Research Questions 26
Cases 31
Chapter 2: Corporate Governance, Serving Client and Public Interests, and Audit Professionalism 34
A.Corporate Governance: Serving Client and Public Interests 35
Roles of Interested Parties 35
Who Is the Audit Client? 35
Audit Committees 36
Serving the Public s Interests 38
Framework for Quality 40
Assuring Quality 40
B.Maintaining Professionalism: Standards 41
Need for Professional Standards 41
Generally Accepted Auditing Standards 42
Standards for Other Audit Engagements 47
C.Maintaining Professionalism: Ethical Framework 50
Importance of Ethical Conduct 50
AICPA Code of Professional Conduct 50
Ethical Theories: Resolving Issues That Are Not Black or White 60
An Ethical Framework 61
D.Maintaining Professionalism: Ensuring Quality 63
Quality Control Standards and External Peer Reviews 63
Summary 64
Internal Peer Review Programs 64
Significant Terms 65
Review Questions 66
Multiple-Choice Questions 67
Discussion and Research Questions 69
Cases 76
Chapter 3: The Audit Process 80
A.Overview of Audit Process 81
Developing an Understanding with the Client 81
The Audit Process 84
Overall Materiality versus Individual Account Materiality 92
Materiality Approaches 92
B.Materiality and Audit Risk 92
Risk of Material Misstatement 93
Risk Concepts 93
The Profession s Audit Risk Model: Practice Implications 96
Illustration of the Audit Risk Model 98
Limitations of the Audit Risk Model 99
C.Management Assertions 101
Financial Statement Assertions 101
Assertions for Other Assurance Services 103
D.Audit Evidence and Procedures 104
Relevance 104
Persuasiveness 104
Examples of Audit Programs 105
Sufficiency 105
Relationship Among Audit Procedures and Assertions 105
Summary 108
Significant Terms 109
Review Questions 109
Multiple-Choice Questions 111
Discussion and Research Questions 113
Chapter 4: Understanding Business Risk: A Framework for Audit Planning 120
A.Business Risk: Audit lmplications 121
What Is Risk? 121
The Relationship of Business Risk to the Audit Process 123
B.Using Analytical Tools to Develop Expectations 134
Assumptions Underlying Analytical Techniques 135
Trend Analysis 137
Ratio Analysis 138
Commonly Used Financial Ratios 138
C.Risk Analysis: Auditor Responsibility for Detecting and Reporting Fraud and Other Misstatements 140
Responsibilities for Detecting Errors 142
Responsibilities for Detecting and Reporting Fraud 142
Responsibilities for Discovering Fraud 142
Fraud Risk Assessment 144
Detecting Fraud: Matching Procedures to the Risk 145
Reporting on Detected Defalcations 145
Responsibilities for Detecting and Reporting Illegal Acts 146
Reporting on Fraudulent Financial Statements 146
Linkage to Direct Tests of Account Balances 147
Quality of Accounting Principles Used 147
D.Risk Analysis and the Conduct of the Audit 147
Summary 149
Significant Terms 149
Appendix 4A: Regression and Time Series Analysis 149
Review Questions 155
Multiple-Choice Questions 157
Discussion and Research Questions 158
Case 168
Chapter 5: Evaluating the Integrity and Effectiveness of the Client s Controi Systems 170
Internal Control 171
A.A Framework for Control 171
The Need for Control 172
B.A Framework for Understanding and Evaluating Internal Controls 179
Components of an Internal Control System 180
Understanding and Evaluating Accounting Information Systems 187
C.Control Risk Assessment 197
Phase 1—Obtain an Understanding 198
Phase 2—Make Preliminary Assessment of Control Risk 205
Phase 3—Perform Test of Controls 206
Phase 4—Update Assessment of Control Risk and Need for Substantive Testing 206
Review Questions 208
Significant Terms 208
Summary 208
Multiple-Choice Questions 210
Discussion and Research Questions 212
Cases 220
Chapter 6: Computer-Based Processing: Developing an Audit Assessment Approach 224
A.Introduction 225
Overview of Computerized Accounting Systems 225
The New Telecommunications Era: The Virtual Private Network 231
B.General and Application Controls 233
General Control Concepts 233
Application Control Procedures 245
Gaining an Understanding of the Control Structure 253
C.Overview of Control Risk Assessment Process 253
Testing the Effectiveness of Control Procedures 254
D.Electronic Data Interchange and Electronic Commerce 257
Risks and Control Considerations 260
Application Controls 260
Evaluating Controls in EDI: An Illustration 262
Electronic Commerce 264
Summary 265
Significant Terms 266
Review Questions 267
Multiple-Choice Questions 269
Discussion and Research Questions 271
Cases 276
Chapter 7: Direct Tests of Account Balances 278
A.Overview of Evidence for Directly Testing Financial Statement Items 279
Approach to Gathering Evidence 283
Nature of Audit Testing 284
B.Audit Procedures 286
Overview of Audit Procedures 286
Commonly Used Audit Procedures for Direct Tests of Account Balances 292
Timing of Procedures 296
Extent of Procedures 296
Audit Program Development 297
C.Audit Programs and Documenting Audit Evidence 297
Documenting Audit Evidence 298
Importance of Quality Review 303
Summary 306
Significant Terms 306
Review Questions 306
Multiple-Choice Questions 308
Discussion and Research Questions 310
Cases 317
Chapter 8: Auditing Computerized Information Systems 320
A.Computer Audit Tools to Test Computer Processing 321
Overview of a Comprehensive Approach to Computerized Data Processing 321
Test Data: Auditing through the Computer 323
Approaches to Address Correctness of Processing 323
Integrated Test Facility 326
Concurrent Processing Methodologies 327
Embedded Audit Modules 330
Relative Advantages of ITF, Concurrent Processing, and Embedded Audit Modules 331
B.Using the Computer to Help Test Accounting Records 333
Generalized Audit Software 335
Custom-Designed Software 337
C.Unique Audit Approaches for Electronic Commerce 338
Risk Analysis 338
Detailed Testing of Account Balances—Using Computerized Audit Techniques 339
The Process and Control Audit 339
D.Use of Personal Computing in Conducting an Audit 342
Traditional Uses of Personal Computers: Word Processing and Spreadsheets 343
Expanded Uses of Personal Computing Software for Audit Purposes 343
Unique Problems: Auditing a Client s Spreadsheet 346
Summary 347
Significant Terms 347
Review Questions 348
Multiple-Choice Questions 350
Discussion and Research Questions 352
Cases 358
Chapter 9: Auditing Revenue and Reiated Accounts 360
Overview of Revenue Cycle 361
A.Introduction 361
B.Assessment of Environment Risk 367
Audit Steps 367
Inherent Risk 368
The Control Environment: Effect on Sales 371
Developing an Understanding of Internal Controls 372
Monitoring Controls 374
Control Structure Regarding Returns, Allowances, and Warranties 374
Importance of Credit Policies Authorizing Sales 377
Assessing and Documenting Environment Risk 378
Planning for Direct Tests of Account Balances 381
C.Substantive Testing in the Revenue Cycle 381
Audit Objectives and Assertions 384
Standard Accounts Receivable Audit Procedures 386
Allowance for Doubtful Accounts 399
Analytical Procedures for Revenue Cycle Accounts 401
Notes Receivable 402
Summary 403
Significant Terms 403
Review Questions 404
Multiple-Choice Questions 406
Discussion and Research Questions 409
Cases 421
Chapter 10: Audit Sampling 426
A.Introduction 427
Overview of Audit Sampling 428
Nonsampling and Sampling Risk 428
Nonstatistical Sampling Using Audit Software 430
Selecting a Sampling Approach 431
Sampling to Test Controls 432
Substantive Sampling Considerations 433
B.Nonstatistical Sampling 438
Determining Sample Size 438
Selecting the Sample 438
Evaluating the Sample Results 438
C.Probability Proportional to Size Sampling 441
Overview of PPS Sample Design 442
Sample Size and Selection 444
Sample Evaluation 447
Summary 453
Significant Terms 453
Appendix 1OA: Sampling to Test Controls 456
Appendix 1OB: Classical Sampling Methods 469
Review Questions 478
Multiple-Choice Questions 480
Discussion and Research Questions 482
Case 490
A.Audit of the Acquisition Cycle 492
Chapter 11: Audit of Acquisition Cycle and Inventory 492
Overview of Control Procedures and Control Risk Assessment 494
Testing Controls over Accounts Payable and Related Expenses 499
Substantive Tests of Accounts Payable 500
Audits of Expense Accounts 501
B.Audit of Inventory and Cost of Goods Sold 502
Internal Controls for Inventory 504
Substantive Testing of Inventory and Cost of Goods Sold 509
Cost of Goods Sold 516
Summary 517
Significant Terms 517
Review Questions 518
Multiple-Choice Questions 520
Discussion and Research Questions 522
Cases 530
Chapter 12: Auditing Liquid Assets 532
A.Introduction 532
Cash Accounts Affected 533
Types of Marketable Security Accounts 534
Planning for Audits of Cash and Marketable Securities 534
B.Audits of Cash Accounts 538
Evaluating Control Risk: Cash Accounts 538
Understanding and Testing Internal Controls 542
Substantive Testing of Cash Balances 546
Operational Audits of Cash 551
C.Marketable Securities and FinanciaI Instruments 553
Audits of Marketable Securities 553
Audits of Other Short-Term Securities 553
New Financial Instruments and Marketable Securities 556
Summary 559
Significant Terms 560
Review Questions 560
Multiple-Choice 562
Discussion and Research Questions 564
Cases 572
A.Audit of Property, Plant, and Equipment 574
Chapter 13: Audit of Other Assets and Long-Term Financing 574
First-Time Audits 575
Inherent Risks 575
Evaluating Control Risk and Control Effectiveness 578
Tests of Property Additions and Disposals 579
Audit Considerations for Capitalized Leases 581
Asset Impairment 581
Depreciation Expense and Accumulated Depreciation 581
Natural Resources 582
B.Audits of Mergers and Acquisitions 583
An Overview of Accounting Issues Associated with Mergers and Acquisitions 583
Audits of Mergers and Acquisitions 584
C.Audits of Financing Activities 587
Bonds 588
Common Stock and Owner s Equity 589
Summary 592
Significant Terms 592
Review Questions 592
Multiple-Choice Questions 594
Discussion and Research Questions 595
Cases 604
Chapter 14: Completing the Audit 606
A.Final Review of the Audit 607
Contingencies 607
Adequacy of Disclosures 609
Management Representation Letter 612
Management Letter 614
Summarizing Possible Adjustments 615
Evaluating the Going Concern Assumption 615
Review of Major Estimates 620
Analytical and Quality Review of the Audit 621
Communicating with the Audit Committee 622
B.Subsequent Events 623
Normal Review of Subsequent Events 623
Subsequent Discovery of Facts Existing at the Date of the Auditor s Report 625
Summary 627
Significant Terms 627
Consideration of Omitted Procedures after the Report Date 627
Review Questions 628
Multiple-Choice Questions 628
Discussion and Research Questions 630
Case 634
Chapter 15: Communicating Levels of Assurance 636
A.Audits, Reviews, and Compilations of Historical Financial Statements 637
Audit Reports 637
Reviews and Compilations 653
B.Reports on Other Financial Information 659
Special Reports 659
Interim Financial Information 663
Changing Information Needs of Investors and Creditors 666
C.Reports on Non-Financial and Other Information 666
Reports on Internal Control 667
Reporting on Evolving Assurance Services 671
Summary 675
Significant Terms 675
Review Questions 676
Multiple-Choice Questions 678
Discussion and Research Questions 680
Case 690
Chapter 16: Professional Liability 692
A.The Legal Environment Affecting Litigation against Auditors 692
Audit Time and Fee Pressures 694
Joint and Several Liability 694
Audits Viewed as an Insurance Policy 695
Contingent-Fee Compensation for Lawyers 695
Class Action Suits 695
B.Legal Concepts 695
Causes of Legal Action 696
Parties That May Bring Suit against Auditors 697
C.Approaches to Mitigating Liability Exposure 705
Continuing Education Requirement 705
Membership Requirements for Firms 705
Quality Control Programs 706
Defensive Auditing 707
Role of Insurance 709
Tort Reform 710
Effect of Court Cases on Auditing Standards and Practice 711
Summary 712
Significant Terms 713
Review Questions 714
Multiple-Choice Questions 715
Discussion and Research Questions 717
Cases 720
Chapter 17: Internal and Value-Added Auditing 724
A.Internal Auditing 724
Internal Auditing Defined 725
B.Scope of Value-Added Internal Auditing 732
The Institute of Internal Auditors Code of Ethics 732
Reporting Company Fraud 732
Operational Auditing 735
Information Systems Audits 741
Compliance Audits 742
Financial Reporting and Control Audits 742
Program and Performance Audits 743
C.Trends in Value-Added and Internal Auditing 744
Global Internal Auditing 744
Outsourcing Internal Auditing 745
Internal Auditing by Any Other Name 745
Review Questions 746
Significant Terms 746
Summary 746
Multiple-Choice Questions 747
Discussion and Research Questions 749
Case 755
Appendix: IDEA Tutorial and Cases 756
Tutorial 756
IDEA Case 1—Fraud 843
IDEA Case 2—Accounts Receivable 844
IDEA Case 3—Inventory 845
Case Index 847
Index 848