1 The Role of the Public Accountant in the American Economy 1
What Are Assurance Services? 2
The Attest Function 2
Financial Statement Audits 4
What Creates the Demand for Audits? 6
Major Auditing Developments of the 20th Century 8
Types of Audits 11
Types of Auditors 12
The Public Accounting Profession 13
American Institute of Certified Public Accountants 13
The CPA Examination 15
State Boards of Accountancy 16
Financial Accounting Standards Board 16
Governmental Accounting Standard sBoard 16
Federal Accounting Standards Advisory Board 16
Securities and Exchange Commission 17
Independence Standards Board 18
Other Types of Professional Services 18
Organization of the Public Accounting Profession 19
Industry Specialization—The Wave of the Future 20
Responsibilities of the Professional Staff 20
Professional Development for CPA Firm Personnel 22
Seasonal Fluctuations in Public Accounting Work 23
Relationships with Clients 23
2 Professional Standards 33
Generally Accepted Auditing Standards(GAAS) 34
Application of Auditing Standards 35
Training and Proficiency 35
Independence 35
Due Professional Care 36
Standards of Fieldwork—Accumulating and Evaluating Evidence 36
Adequate Planning and Supervision 36
Sufficient Understanding of Internal Control 36
Sufficient Competent Evidential Matter 36
Standards of Reporting 37
Statements on Auditing Standards(SASs) 37
The Auditors'Responsibility for Detecting Misstatements 38
Errors and Fraud 39
Illegal Acts by Clients 39
The Auditors'Report 40
The Introductory Paragraph of the Auditors'Report 41
The Scope Paragraph of the Auditors'Report 42
The Opinion Paragraph of the Auditors'Report 42
Generally Accepted Accounting Principles(GAAP) 44
Other Types of Auditors'Reports 44
The Attestation Standards 46
Quality Controlin CPA Firms 47
Division for CPA Firms 48
The Public Oversight Board 49
Peer Reviews 50
International Accounting and Auditing Standards 50
3 Professional Ethics 62
The Nature of Ethics 63
What Are Ethical Dilemmas? 63
A Framework for Ethical Decisions 63
Making Ethical Decisions—A Professional Example 64
The Need for Professional Ethics 67
Professional Ethics in Public Accounting 68
The AICPA Code of Professional Conduct 68
Section Ⅰ—Principles 69
Preamble 69
Article Ⅰ—Responsibilities 70
Article Ⅱ—The Public Interest 70
Article Ⅲ—Integrity 70
Article Ⅳ—Objectivity and Independence 70
Article Ⅴ—Due Care 70
Article Ⅵ—Scope and Nature of Services 70
Section Ⅱ—Ruies 71
Applicability 71
Rule 101—Independence 71
Analysis of Independence 72
Rule 102—Integrity and Objectivity 79
Analysis of Integrity an dObjectivity 79
Rule 201—General Standards 79
Analysis of General Standards 80
Rule 202—Compliance with Standards 80
Analysis of Compliance with Standards 80
Rule 203—Accounting Principles 81
Analysis of Accounting Principles 81
Rule 301—Confidential Client Information 81
Analysis of Confidential Client Information 82
Rule 302—Contingent Fees 83
Analysis of Contingent Fees 83
Rule 501—Acts Discreditable 84
Analysis of Acts Discreditable 84
Rule 502—Advertising and Other Forms of Solicitation 84
Analysis of Advertising and Other Forms of Solicitation 84
Rule 504—Commissions and Referral Fees 85
Analysis of Commissions and Referral Fees 85
Rule 505—Form of Organization and Name 85
Analysis of Form of Organization and Name 86
Alternative Practice Structures 86
The CPA as Tax Adviser—Ethical Problems 87
Enforcement of Professional Ethics 88
Ethics for Intealal Auditors 88
4 Legal Liability of CPAs 102
Unique Vulnerability of Public Accountants to Lawsuits 103
Definition of Terms 104
Litigation Placed in Perspective 105
CPAs'Liability to Their Clients Under Common Law 106
Auditors'Common Law Liability to Third Parties 108
Ultramares Approach 108
Restatement of Torts Approach 109
Rosenblum Approach 110
Joint and Several Liability 111
Liability to Third Parties Under Statutory Law 111
Securities Act of 1933 111
Securities Exchange ACt of 1934 113
Comparison of the 1933 and 1934 Acts 115
The Racketeer Influenced and Corrupt Organization Act 116
Auditors'Criminal Liability Under the Securities Acts 117
The SEC's Regulation of Accountants 118
CPAs'Liability for Accounting and Review Services 118
The CPAs'Posture in the Age of Litigation 120
5 Audit Evidence and Documentation 135
The Relationship of Audit Risk to Evidence 136
Financial Statement Assertions 136
Audit Risk at the Assertion Level 137
Audit Risk Illustrated 138
Measuring Audit Risk 138
Audit Evidence 139
Types of Evidence 139
Audit Procedures 147
The Nature of Audit Procedures 147
Timing of Audit Procedures 147
Extent of Audit Procedures 149
The Cost of Audit Procedures 149
Analytical Procedures 149
Developing an Expectation 150
Timing of Analytical Procedures 153
Extent of Analytical Procedures 154
Evidence on Accounting Estimates 154
Evidence on Related-Party Transactions 155
Documentation 156
Functions of Working Papers 157
Confidential Nature of Working Papers 158
Ownership of Audit Working Papers 159
Working Papers and Auditors'Liability 159
Types of Working Papers 159
Organization of Working Papers 162
Guidelines for Preparation of Working Papers 164
Computer-Generated Working Papers 164
The Review of Audit Working Papers 166
6 Planning the Audit;Designing Audit Programs 184
Obtaining Clients 185
Submitting a Proposal 186
Communication with Predecessor Auditors 188
Engagement Letters 189
Audit Planning 189
Obtaining an Understanding of the Client's Business 189
Developing an Overall Audit Strategy 193
Audit Plans 203
Time Budgets for Audit Engagements 204
Planning a Recurring Engagement 204
Designing Audit Programs 205
The Audit Trail 205
Organization of the Audit Program 206
Objectives of Audit Programs 209
General Objectives of Audit Programs for Asset Accounts 210
Substantiation of Account Balances 211
Existence of Assets 211
Rights to the Assets 211
Establishing Completeness 212
Valuation of Assets 213
Clerical Accuracy of Records 213
Financial Statement Presentation and Disclosure 213
An Illustration of Audit Program Design 213
Audit Process 215
Timing of Audit Work 217
Appendix 6A—Selected Internet Addresses 227
Appendix 6B—Illustrative Audit Case:Keystone Computers ＆ Networks,Inc. 228
Part Ⅰ:Audit Planning 228
7 Internal Control 239
The Meaning of Internal Control 240
The Foreign Corrupt Practices Act of 1977 242
Means of Achieving Internal Control 242
The Control Environment 242
Integrity and Ethical Values 243
Commitment to Competence 243
Board of Directors or Audit Committee 243
Management Philosophy and Operating Style 243
Organizational Structure 244
Assignment of Authority and Responsibility 246
Human Resource Policies and Procedures 246
Risk Assessment 247
The Accounting Information and Communication System 247
Control Activities 248
Performance Reviews 248
Information Processing 249
Physical Controls 249
Segregation of Duties 250
Monitoring 251
The Internal Audit Function 251
Limitations of Internal Control 252
The Auditors'Consideration of Internal Control 252
Obtaining an Understanding of Internal Control to Plan the Audit 253
Assess Control Risk 260
Decision Aids for Audit Program Modification 263
Consideration of the Work of Internal Auditors 266
Communication of Control-Related Matters 267
Internal Control in the Small Company 267
8 Consideration of Internal Control in a Computer Environment 284
Nature of Computer Systems 286
Characteristics of Various Types of Computer Systems 287
Impact of Computers on the Audit Trail 289
Internal Control in a Computer Environment 290
Organizational Structure of the Information System Function 291
Computer-Centered Fraud 294
Internal Auditing in a Computer Environment 295
Control Activities in a Computer System 295
General Control Activities 296
Application Control Activities 299
User Control Activities 300
Controlin Microcomputer Systems 301
The Auditors'Consideration of Internal Controlin a Computer Environment 301
Obtaining an Understanding of Computerized Internal Control 302
Documenting Computerized Internal Control 302
Assessing Control Risk—Testing Computer System Controls 304
Substantive Testing with Computers 308
Using Audit Software:An Illustration 310
Computer Service Centers and Outsourced Computer Processing 310
9 Audit Sampling 325
Comparison of Statistical and Nonstatistical Sampling 326
Selecting a Random Sample 327
Other Methods of Sample Selection 330
Stratification 330
Types of Statistical Sampling Plans 331
Allowance for Sampling Risk(Precision) 332
Sample Size 332
Audit Sampling for Tests of Controls 333
Sampling Risk for Tests of Control 333
Attributes Sampling 334
Determine the Objective of the Test 335
Define the Attributes and"Deviation"Conditions 335
Define the Population 336
Specify the Risk of Assessing Control Risk Too Low and the Tolerable Deviation Rate 336
Estimate the Expected Population Deviation Rate 336
Determine the Sample Size 337
Select the Sample 339
Test the Sample Items 339
Evaluate the Sample Results 339
Document the Sampling Procedure 341
Detailed Illustration of Attributes Sampling 341
Other Statistical Attributes Sampling Approaches 343
Nonstatistical Attributes Sampling 345
Audit Sampling for Substantive Tests 345
Sampling Risk for Substantive Tests 346
Classical Variables Sampling 346
Mean-per-Unit Estimation 347
Controlling Sampling Risk 347
Determination of Sample Size 348
Evaluation of Sample Results 349
Illustration of Mean-per-Unit Estimation 350
Ratio and Difference Estimation 354
Illustration of Ratio and Difference Estimation 355
Nonstatistical Sampling for Substantive Tests 356
Illustration of Nonstatistical Sampling 357
Appendix 9A:Probability-Proportional-to-Size(PPS)Sampling 370
Determination of Sample Size 370
Controlling Sampling Risk 371
Method of Sample Selection 372
Evaluation of Sample Results 372
Illustration of PPS Sampling 373
Considerations in Using PPS Sampling 375
Appendix 9B:Audit Risk 376
10 Cash and Financial Investments 382
Cash 383
Sources and Nature of Cash 383
The Auditors'Objectives in the Audit of Cash 383
How Much Audit Time for Cash? 385
Internal Control over Cash Transactions 385
Internal Control over Cash Receipts 386
Internal Control over Cash Disbursements 388
Audit Working Papers for Cash 392
Audit Program for Cash 394
Interim Audit Work on Cash 407
Financial Investments 407
The Auditors'Objectives in Examination of Financial Investments 408
Intemal Control over Financial Investments 409
Intemal Control Questionnaire 410
Audit Program for Financial Investments 410
Substantive Tests for Financial Investments 411
11 Accounts Receivable,Notes Receivable,and Revenue 429
Receivables 430
Sources and Nature of Accounts Receivable 430
Sources and Nature of Notes Receivable 430
The Auditors'Objectives in Auditing Receivables and Revenue 430
Internal Control of Accounts Receivable and Revenue 431
Control Environment 431
Risk Assessment 432
Monitoring 432
Revenue Cycle—Accounting System and Control Activities 432
Internal Control over Notes Receivable 436
Audit Working Papers for Receivables and Revenue 437
Audit Program for Receivables and Revenue 437
Interim Audit Work on Receivables and Revenue 463
Appendix 11A Illustrative Audit Case:Keystone Computers ＆ Networks,Inc. 477
Part Ⅱ:Consideration of Internal Control 477
Obtaining and Documenting an Understanding of the Revenue and Cash Receipts Cycle 478
Testing Controls and Assessing Control Risk 478
Appendix 11B Illustrative Audit Case:Keystone Computers ＆ Networks,Inc. 492
Part Ⅲ: Substantive Tests—Accounts Receivable and Revenue 492
12 Inventories and Cost of Goods Sold 496
Sources and Nature of Inventories and Cost of Goods Sold 497
The Auditors'Appreach to Auditing Inventories and Cost of Goods Sold 497
Internal Control over Inventories and Cost of Goods Sold 499
Control Environment 499
Risk Assessment 499
Monitoring 500
Purchases and Production Cycles—Accounting Systern and Control Activities 500
Audit Working Papers for Inventories and Cost of Goods Sold 505
Audit Program for Inventories and Cost of Goods Sold 505
Problems Associated with Inventory of First Year Audit Clients 525
13 Property,Plant,and Equipment:Depreciation and Depletion 538
The Auditors'Approach to Auditing Property,Plant,and Equipment 539
Contrast with Audit of Current Assets 539
Internal Control over Plant and Equipment 540
Audit Working Papers 541
Initial Audits and Repeat Engagements 543
Audit Program for Property Plant,and Equipment 543
Depreciation 552
The Auditors'Perspective Toward Depreciation 552
The Auditors'Objectives in Auditing Depreciation 552
Audit Program—Depreciation Expense and Accumulated Depreciation 553
Testing the Client'sProvision fo rDepreciation 554
Examination of Natural Resources 554
Examination of Intangible Assets 555
Examination of Plant and Equipment in Advance of the Balance Sheet Date 555
14 Accounts Payable and Other Liabilities 567
Accounts Payable 568
Sources and Nature of Accounts Payable 568
The Auditors'Approach to Auditing Accounts Payable 568
Internal Control over Accounts Payable 569
Audit Working Papers for Accounts Payable 571
Audit Program 571
Other Liabilities 585
Amounts Withheld from Employees'Pay 585
Sales Taxes Payable 585
Unclaimed Wages 585
Customers'Deposits 586
Accrued Liabilities 586
Balance Sheet Presentation 590
Time of Examination 590
Appendix 14A Illustrative Audit Case:Keystone Computers ＆ Networks,Inc. 600
Part Ⅳ:Consideration of Internal Control 600
15 Debt and Equity Capital 604
Interest-Bearing Debt 605
Sources and Nature of Interest-Bearing Debt 605
The Auditors'Approach to Auditing Interest-Bearing Debt 605
Internal Control over Interest-Bearing Debt 606
Audit Working Papers 607
Audit Program for Interest-Bearing Debt 607
Time of Examination—Interest-Bearing Debt 614
Equity Capital 614
Sources and Nature of Owners'Equity 614
The Auditors'Approach to Auditing Owners'Equity 615
Internal Control over Owners'Equity 615
Control of Capital Stock Transactions by the Board of Directors 615
Independent Registrar and Stock Transfer Agent 616
The Stock Certificate Book and Stockholders Ledger 616
Internal Control over Dividends 617
Audit Working Papers for Owners'Equity 617
Audit Program—Capital Stock 618
Retained Earnings and Dividends 621
Time of Examination—Stockholders'Equity 622
Financial Statement Presentation of Stockholders'Equity 622
Audit of Sole Proprietorships and Partnerships 622
16 Auditing Operations and Completing the Audit 634
Auditing Operations 635
The Auditors'Approach to Examining Operations 635
Revenue 636
Relationship of Revenue to Balance Sheet Accounts 636
Miscellaneous Revenue 636
Expenses 637
Relationship of Expenses to Balance Sheet Accounts 637
Substantive Tests for Selling,General,and Administrative Expenses 637
The Audit of Payroll 640
Internal Control over Payroll 640
Description of Internal Control for Payroll 644
Audit Program for Payroll 644
Audit of the Statement of Cash Flows 645
Completing the Audit 646
Search for Unrecorded Liabilities 646
Review the Minutes of Meetings 646
Perform Final Analytical Procedures 646
Perform Procedures to Identify Loss Contingencies 647
Perform the Review for Subsequent Events 651
Obtain Representation Letter 654
Evaluating Audit Findings 655
Reviewing the Engagement 656
Responsibilities for Other Information in the Financial Report 658
Opinion Formulation and Report Issuance 659
Communicating with the Audit Committee 660
Post-Audit Responsibilities 660
The Auditors'Subsequent Discovery of Facts Existing at the Date of Their Report 660
Subsequent Discovery of Omitted Audit Procedures 661
17 Auditors'Reports 675
Financial Statements 676
Financial Statement Disclosures 677
Comparative Financial Statements 677
The Auditors'Standard Report 678
Expression of an Opinion 679
The Unqualified Opinion 680
Qualified Opinions 685
Adverse Opinions 688
Disclaimer of Opinion 689
Summary of Auditors'Reports 691
Two or More Report Modifications 691
Different Opinions on Different Statements 691
Reporting on Comparative Financial Statements 691
Reports to the SEC 694
18 Special Reports and Accounting and Review Services 712
Special Reports 713
Financial Statements Prepared for Use in Other Countries 718
Audits of Personal Financial Statements 718
Reviews of the Interim Information of Public Companies 719
Review Services for Nonpublic Companies 721
Accountants'Reports on Comparative Statements 724
Letters for Underwriters 725
Condensed Financial Statements 726
Accounting Services 726
Compilation Engagement for Financial Statements of Nonpublic Companies 726
Other"Association"with the Financial Statements of Public Companies 729
19 Other Assurance Services 742
Assurance Services 743
The Demand for Assurance Services 744
Attestation Standards 746
The Criteria 747
Attestation Risk and Materiality 749
The Character of the Engagement 750
Assurance Service Examples 752
Assurance on Prospective Financial Statements 752
Assurance on Internal Control over Financial Reporting 754
Assurance on Compliance 757
Assurance on Management's Discussion and Analysis 757
Assurance on Electronic Commerce—WebTrust 757
Assurance on System Reliability—SysTrust 761
Elder Care Services 764
Future Assurance Services 765
20 Internal,Operational,and Compliance Auditing 775
Internal Auditing 776
What Is the Purpose of Internal Auditing? 776
Evolution of Internal Auditing 776
Professional Standards of Internal Auditing 778
Certification of Internal Auditors 782
Operational Auditing 783
Objectives of Operational Audits 783
General Approach to Operational Audits 783
Compliance Auditing 787
Attesting to Compliance with Laws and Regulations 787
Compliance Auditing of Federal Financial Assistance Programs 790
Audits in Accordance with Generally Accepted Auditing Standards 790
Audits in Accordance with Government Auditing Standards 791
Audits in Accordance with the Single Audit Act 793
Compliance Auditing—A Summary 798