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Auditing & Assurance
Services
Mimi Ditchie Photography/Moment/Getty Images
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TWELFTH EDITION
Auditing & Assurance
Services
A
Mimi Ditchie Photography/Moment/Getty Images
S Y S T E M A T I C
A P P R O A C H
William F. Messier Jr.
Norwegian School of Economics
Department of Accounting, Auditing and Law
Steven M. Glover
Pelion Venture Partners, and
Brigham Young University
Marriott School of Management
School of Accountancy
Douglas F. Prawitt
Brigham Young University
Marriott School of Management
School of Accountancy
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AUDITING & ASSURANCE SERVICES: A SYSTEMATIC APPROACH, TWELFTH EDITION
Published by McGraw Hill LLC, 1325 Avenue of the Americas, New York, NY 10019. Copyright © 2022 by
McGraw Hill LLC. All rights reserved. Printed in the United States of America. Previous editions
© 2019, 2017, 2014, and 2012. No part of this publication may be reproduced or distributed in any form or by
any means, or stored in a database or retrieval system, without the prior written consent of McGraw Hill LLC,
including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance
learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the
United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 LWI 26 25 24 23 22
ISBN 978-1-264-10067-5
MHID 1-264-10067-1
ISBN 978-1-264-46869-0 (loose leaf)
MHID 1-264-46869-5 (loose leaf)
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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.
Library of Congress Cataloging-in-Publication Data
Names: Messier, William F., author. | Glover, Steven M., 1963- author. |
Prawitt, Douglas F., author.
Title: Auditing & assurance services : a systematic approach / William F.
Messier, Jr., 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.
Other titles: Auditing and assurance services
Description: Twelfth edition. | New York, NY : McGraw Hill Education,
[2023] | Includes index.
Identifiers: LCCN 2021029377 (print) | LCCN 2021029378 (ebook) | ISBN
9781264100675 (paperback ; alk. paper) | ISBN 9781264468966 (ebook)
Subjects: LCSH: Auditing.
Classification: LCC HF5667 .M46 2023 (print) | LCC HF5667 (ebook) | DDC
657/.45—dc23
LC record available at https://lccn.loc.gov/2021029377
LC ebook record available at https://lccn.loc.gov/2021029378
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 LLC, and McGraw Hill LLC does not guarantee the
accuracy of the information presented at these sites.
mheducation.com/highered
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About the Authors
Norwegian School of Economics
Professor William F. Messier Jr. is the Norwegian Institute of Public Accountants (DnR)
Professor of Auditing at the Department of Accounting, Auditing and Law at the NHH Norwegian School of Economics. Professor Messier holds a BBA from Siena College, an MS from
Clarkson University, and an MBA and DBA from Indiana University. He is a CPA in Florida and
has held faculty positions at the University of Florida (Price Waterhouse Professor), Georgia
State University (Deloitte & Touche Professor), and University of Nevada, Las Vegas
(Kenneth and Tracy Knauss Endowed Chair in Accounting).
Professor Messier was a visiting faculty member at SDA Bocconi in Milan and the
­ niversities of Luxembourg and Michigan. Professor Messier served as the Academic
U
­Member of the AICPA’s Auditing Standards Board and as Chair of the AICPA’s I­nternational
Auditing Standards Subcommittee. He has served as the Editor of Auditing: A Journal
of Practice & Theory and 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), the Distinguished Service in Auditing Award (2008), and the Department of
Accounting, Kelley School of Business, Indiana University—Academic Excellence Award
(2018). In 2011, Professor Messier was awarded an honorary doctorate from the Norwegian
School of Economics.
Professor Messier’s research has been published in The Accounting Review, Journal of
Accounting Research, Contemporary Accounting Research, Accounting, Organizations and
Society, Auditing: A Journal of Practice & Theory, Management Science, and Decision Sciences. He has also served as an expert witness in audit litigation cases.
Professor Steven M. Glover is the CFO at Pelion Venture Partners and formerly the
Jessica Lund/Pelion
K. Fred Skousen Distinguished Professor and Associate Dean of the Marriott School of
Business, 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 has served on the AICPA Auditing Standards Board and
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 co-authored 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. Professors Glover and Prawitt along with Professor Bill Tayler also worked
with BDO to author the acclaimed BDO Professional Judgment Framework.
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vi
About the Authors
Jaren Wilkey/Brigham Young University
Professor Douglas F. Prawitt is the LeRay McAllister/Deloitte Foundation Distinguished
Professor of Accountancy and Director of the School of Accountancy at the ­Marriott School
of Business, Brigham Young U
­ niversity. 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’s research has been published in The Accounting Review, Journal of
Accounting Research, Contemporary Accounting Research, Auditing: A Journal of Practice &
Theory, Behavioral Research in Accounting, and Organizational Behavior & Human Decision
Processes. Professor Prawitt was awarded the Merrill J. Bateman Student Choice Teaching
Award in 2002, BYU’s Wesley P. Lloyd Award for Distinction in Graduate Education in 2006,
the ­American Accounting Association’s Deloitte/Wildman Award in 2013, the AAA Auditing
Section Innovation in Auditing and Assurance Education Award in 2014, the BYU Marriott
School of Business Outstanding Faculty Award in 2016, and the American Accounting Association’s Outstanding Accounting Educator Award in 2016. He was awarded the American
Accounting Association Gender Issues and Work-Life Balance Section’s KPMG Mentoring
Award in 2020 and the Auditing Section’s Distinguished Service in Auditing Award in 2021.
Prawitt has consulted with international, regional, and local public accounting firms and has
served as an expert witness in audit litigation cases. 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 2020, he was
appointed to a fourth consecutive three-year term as a member of the COSO Board. Professor
Prawitt has served in several capacities with the American Accounting Association, including
as Associate Editor of Accounting Horizons and as Editor of Auditing: A Journal of Practice
& Theory. He has authored or co-authored over 40 articles and books, primarily in the areas
of auditor judgment and decision making, and audit practice. 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. More recently, Prawitt
collaborated with Professors Steve Glover and Bill Tayler to produce BDO LLP’s acclaimed
BDO Professional Judgment Framework.
Dedications
The authors dedicate this book to the following
individuals:
Teddie, Stacy, Brandon, Zachary, Mark, Lindsay,
Olive, and Frederick
—William F. Messier Jr.
Tina, Graham, Emery, and Stella
—Steven M. Glover
Meryll, Nathan, Natalie, Emily, AnnaLisa, Lileah,
George, and Diana
—Douglas F. Prawitt
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Why a New Edition?
Dear Colleagues and Friends,
The pace of change in the financial statement auditing environment continues to accelerate, even as the need for reliable, 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, technology is changing the capabilities of auditors and the way
they do their work, and audit reporting has undergone significant changes.
This new edition reflects a number of major changes in auditing standards. Most importantly, the early chapters were
significantly revised to incorporate new standards on risk assessment and audit evidence. This edition also continues
to increase coverage and hands-on resources in the important emerging area of audit data analytics and data visualization. Concepts regarding audit data analytics are referenced throughout the text and are discussed in-depth in the
updated appendix. The book retains the problems using industry-leading data analytics and visualization software
from IDEA® and Tableau® throughout several chapters and in online resources. While that content helps students
develop competence in using software platforms, it is just as important that students learn how to interpret software
outputs from an audit perspective and continue to add new skills to their toolbox. Thus, this new edition also includes
(1) a more advanced Tableau case that requires interpretation of risks, and (2) an introduction to robotic process automation (RPA) through a simple case to provide students with exposure to the growing area of robotics. In integrating
these new audit technology resources, our focus remains on helping students gain a deep, intuitive grasp of fundamental auditing concepts. We do this by using understandable yet compelling illustrations, examples, and analogies,
such as relating the demand for an audit to the desire of a prospective home buyer to buy a home inspection service in
the first chapter. Our intent is that students will not only understand the important standards and concepts underlying
auditing but that they will gain a strong intuitive grasp of why it is important and how the underlying logic can inform
their judgments not only as auditors but as businesspeople. With this new edition, in addition to a deep understanding
of the fundamentals of auditing, your students will come away with an understanding of the latest auditing standards
and with a strong initiation into the world of audit data analytics, giving them a running head start into today’s financial statement auditing work environment.
We help you and your students navigate a world in which there are three major sets of auditing standards (AICPA,
PCAOB, and IAASB) by focusing on the fundamental concepts underlying financial statement audits. It is important
for you and your students to know that by studying this book, your students will learn the most important, fundamental
auditing concepts that underlie an audit performed under any of the three extant sets of standards.
As the auditing environment becomes more complex and demanding, with technology playing an increasingly central
role, it is even more important that students gain a deep understanding and working knowledge of fundamental auditing concepts and how they are applied. Technology is unlikely to replace auditors in the foreseeable future, but it will
free them from relatively mundane tasks and require them to be able to exercise more insightful professional judgment
in their work. They will need to know how to form the right questions to be answered from their audit data analytics
and draw deep and insightful implications from the results. These abilities will be based on a solid understanding of
accounting, auditing, and business. The fundamentals we focus on in this book will become even more important, not
less, as technology plays a bigger role! From the beginning we have worked hard to make this book the most up-todate, “student-friendly” introductory auditing book on the market; this new edition continues that effort. Some of the
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Why a New Edition?
ways this book encourages your students (and ours) to think more clearly and deeply about what they are studying are
by the use of
1. Audit data analytics throughout the book, both in the chapters and in a stand-alone appendix, and in hands-on
online resources.
2. A focus on key, fundamental concepts.
3. A “Professional Judgment” appendix to accelerate the development of professional judgment abilities in
your students, 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.
4. Clear, easy-to-understand explanations and examples throughout the book.
5. “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.
6. Discussion cases throughout the book to illustrate key concepts and real-world applications.
This new edition continues and enhances the resources available for use with industry leader IDEA software by CaseWare Analytics. IDEA is a powerful and user-friendly data analysis tool designed to help auditors perform audit data
analytics, audit sampling, and other audit procedures efficiently and effectively. Students are introduced to IDEA in the
text through hands-on tutorials, exercises, and problems, including problems regarding visualization and data analytics.
Please note that the underlying dataset has been changed for the 12th edition, reducing concern about students using
prior-year solutions. This edition also continues to provide hands-on resources and exercises that will help introduce
your students to the emerging area of data visualization using Tableau, a market-leading data visualization tool, including a new more advanced problem set linked to the stand-alone appendix. We also provide access to a new case that
uses UiPath to introduce students to robotic process automation (RPA). Solution files and an implementation guide are
also available online for instructors.
This edition also has been updated to reflect the latest changes in auditing standards, such as standards related to understanding the entity, risk assessment, materiality, audit evidence, and accounting estimates. This edition also provides
audit guidance on the FASB’s newest revenue recognition and lease accounting standards. Further, the text discusses
the AICPA’s new attestation standards and the new quality management standards (which replace the prior quality control standards). We have also focused on clarifying and simplifying the book’s exposition, for example, by providing a
simpler, clearer view of the latest audit reporting standards in Chapter 18.
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, especially in view of the many changes in auditing
standards and the advent of audit data analytics.
We are grateful for your loyalty and support of this text and we appreciate the many compliments we have received
regarding past editions. We are especially gratified by the enthusiastic response the text has received as we have done
our best to create a clear, easy-reading, student-friendly auditing textbook. As always, we welcome your feedback and
suggestions, and we hope you will be pleased with the updates we have made in this new edition.
With warm regards,
William F. Messier Jr. Steven M. Glover Douglas F. Prawitt
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hands-on learning experience!
The 12th edition includes the following important features and enhancements:
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New, short videos available on Connect to provide further insight on some of the more challenging
concepts.
An audit data analytics appendix, included at the back of the book for instructors to assign when and
where it makes the most sense in their particular auditing curriculum. This appendix includes a thorough discussion of the AICPA’s Audit Data Analytics Guide. New content on Connect has been developed to support this appendix, including a more advanced Tableau case and an introduction to robotic
process automation, using UiPath.
Audit data analytics coverage throughout the book in chapters where audit technology is most likely to
have a significant impact including new references to robotic process automation.
Hands-on resources to introduce your students to audit data analytics and data visualization, using
IDEA and Tableau—industry-leading data analytics and data visualization software products. Userfriendly, end-of-chapter IDEA and Tableau assignments and problems for hands-on application are
found throughout the book and on Connect.
Revised and expanded datasets for Rogers Company, the hypothetical company used for both IDEA
and Tableau problems.
An Audit Data Analytics Implementation Guide for instructors provides suggestions on how to incorporate the book’s audit data analytics content into the class curriculum.
A “professional judgment” appendix, 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 included in the print version of the book. Additional resources relating to this
appendix are available through KPMG’s University Connection website.
“Stop and Think” questions throughout the book to encourage students to more fully internalize key
concepts.
Increased use of updated Practice Insights that provide a link from the textbook material to the real
world.
Updated to reflect the new AICPA attestation standards.
Updated and clarified coverage of attestation engagements relating to financial forecasts and
projections.
Improved descriptions and layouts for the hands-on EarthWear Mini-Cases that provide students with
opportunities to apply audit professional judgment and practice audit procedures.
Updates to reflect the latest accounting and auditing standards related to understanding the entity, risk
assessment, materiality, audit evidence, and accounting estimates.
Updated and improved test bank questions.
Improved linkage between chapter content and end-of-chapter material.
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Here is a chapter-by-chapter sampling of the improvements made in recent editions:
Chapter 1, An Introduction to Assurance and Financial Statement Auditing
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Now includes an introduction to the emerging audit technologies that are changing the financial statement audit in exciting ways, including audit data analytics, and a preview of the new audit data analytics and data visualization material and resources that will be incorporated into the book and online.
Incorporates new PCAOB audit report format, which places the opinion first, includes a “Basis for
Opinion” section, and addresses critical audit matters (CAMs).
Writing has been streamlined and clarified to provide a more straightforward, focused introduction to
the text.
Chapter 2, The Financial Statement Auditing Environment
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Updated coverage of anticipated changes to the format and nature of the CPA exam, including the
future “CPA Evolution” approach to the exam.
Updated discussion of the role of risk in the business model presented in the chapter to be consistent
with COSO’s new Enterprise Risk Management Framework.
Introduction to and explanation of the PCAOB’s codification of Auditing Standards.
More streamlined focus on the AICPA’s Principles Underlying an Audit of Financial Statements, and
clarified coverage of other areas.
Chapter 3, Audit Planning, Types of Audit Procedures, and Materiality
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Updated for revised standards on terms of the engagement, using the work of internal auditors, use of
specialists, consideration of laws and regulations, and related parties.
Updated discussion of the types of audit procedures.
Updated discussion of materiality based on revised auditing standards.
New and updated practice insights and exhibits.
Chapter 4, Risk Assessment
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The auditor’s risk assessment process and assessing the risk of material misstatement is updated to
reflect changes to the risk assessment standard.
The fraud risk assessment process is updated for recent changes in auditing standards.
A new practice insight and a new exhibit discussing the accounting irregularities related to Luckin
Coffee.
Incorporation of data analytics when discussing types of audit procedures.
Chapter 5, Evidence and Documentation
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Substantial revision to the chapter to reflect the new auditing standard on audit evidence.
Addition of PCAOB management assertions for comparison to AICPA categories.
Substantial revision of the advanced module on analytical procedures.
Discussion of audit data analytics in conjunction with substantive analytical procedures.
Chapter 6, Internal Control in a Financial Statement Audit
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New and updated practice insights and exhibits.
Updated presentation of flowcharts to reflect computerized environments.
Significantly streamlined discussion of the 17 COSO principles.
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Chapter 7, Auditing Internal Control over Financial Reporting
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New and updated practice insights and exhibits.
Improved discussion on the link between understanding entity-specific risks of material misstatement
and the identification of key controls.
New discussion on the need for auditors to consider the entity’s use of RPA/bots in the accounting
process.
Revised end-of-chapter questions.
Chapters 8 and 9, Audit Sampling: An Overview and Application to Tests of Controls, and Audit
­Sampling: An Application to Substantive Tests of Account Balances
∙ Updated and new practice insights and stop-and-think prompts.
∙ Clarification of key terms and challenging concepts.
∙ Improved linkage between text and examples.
∙ Updates to Advanced Module 1 in Chapter 8 to improve links to the main chapter text.
∙ Explanation in Chapter 9 of why population size is a key input for MUS but not for attribute sampling.
Chapters 10–16, Business Process Chapters
∙ Increased discussion on changes in practice regarding detail testing of revenue.
∙ Updates to module on auditing the tax provision based on the effect of recent tax laws.
∙ Updated terminology in flowcharts and surrounding discussion that acknowledge updates to how IT is
used in accounting processes.
∙ Increased emphasis on the link between internal controls and the risk of material misstatement.
∙ Updated discussion of impairment testing.
∙ Incorporation of revised lease standards, including PP&E lead schedule and roll-forward disclosing
new “right-to-use” operating lease assets.
∙ Updated discussion on auditing fair value and estimates based on new audit standards.
∙ New and updated practice insights, exhibits, and stop-and-think prompts.
∙ Revised end-of-chapter questions.
∙ References to audit data analytics and examples as appropriate, including robotic process automation
(RPA).
Chapter 17, Completing the Audit Engagement
∙ New references to audit data analytics in terms of how they can be used in finalizing the audit.
∙ Updated and clarified discussion of letters of audit inquiry (formerly “legal letters).
∙ Streamlined and clarified writing throughout.
∙ Added emphasis on the role of entity policies and procedures over their accounting for such things as contingencies, commitments, and subsequent events as part of their internal control over financial reporting.
∙ Incorporation of FASB accounting standard relating to the requirement for companies to evaluate their
own going-concern status and new AICPA ASB auditing standard guiding auditors in assessing the
entity’s going-concern self-assessment and in making an independent assessment.
Chapter 18, Reports on Audited Financial Statements
∙ Updated to reflect new audit reporting standards, with focus on the PCAOB audit report, including
coverage of CAMs (critical audit matters).
∙ Chapter updated, streamlined, and simplified for greater clarity.
∙ Clearer, more understandable coverage of audit reporting when explanatory language is added to the
standard unmodified/unqualified audit report and when comparability issues arise due to changes in
accounting principles, changes in accounting estimates, etc.
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Chapter 19, Professional Conduct, Independence, and Quality Management
∙ Discussion of AICPA’s shift from “quality control” standards to “quality management” standards.
∙ Increased emphasis on the importance of reputation for financial statement auditors, earned through
integrity and reliability.
∙ Updates and clarifications throughout the chapter.
Chapter 20, Legal Liability
∙ Updated for important recent cases and statutory law.
∙ New clarification regarding liability for secondary public offerings.
∙ New practice insight about SPACs and auditor liability.
∙ New learning objective about insights from academic research about auditor legal liability.
Chapter 21, Assurance, Attestation, and Internal Auditing Services
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Updated to reflect new changes to AICPA attestation standards, including newly permitted “direct
examination attestation” engagements in which no management assertion is required, etc.
Replacement of the now obsolete WebTrust and PrimePlus assurance services with expanded coverage of SOC 2 and SOC 3 attestation engagements, including an illustrative SOC 2 examination report,
based on updated AICPA Trust Services Criteria (in the Advanced Module).
Chapter streamlined, simplified, and clarified to focus on important concepts.
Updated and clarified coverage of attestation engagements relating to financial forecasts and projections.
Twelfth Edition Supplements
Instructor Resources include the following:
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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 Audit Data Analytics Problems
Implementation Guide for Audit Data Analytics
Addtional resources include: Links to Professional Resources, Sample Syllabi, Text Updates, and Digital
Image Library
Additional Student Resources include the following:
∙ EarthWear Mini-Cases
∙ Audit Data Analytics Assignments and Problems, by Messier, Glover, and Prawitt
∙ Relevant Accounting and Auditing Pronouncements by chapter
∙ Link to EarthWear Clothiers home page
∙ Link to Willis & Adams, LLP 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.
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xiii
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, and 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.
AACSB Statement
McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Auditing & Assurance Services 12e 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.
The statements contained in Auditing & Assurance Services 12e 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 & Assurance Services 12e and the teaching pack­ uditing & Assurance
age make no claim of any specific AACSB qualification or evaluation, we have within A
Services 12e labeled selected questions according to the six general knowledge and skill guidelines as a helpful starting point.
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How does 12e prepare
your students?
The continuing rapid pace of change in auditing standards and practices, together with the recent emergence of audit data
analytics and data visualization technologies, 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 12th edition, authors Messier, Glover, and Prawitt continue to reinforce the fundamental values central to their
past eleven 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 evidence. The first chapter provides a high-level introduction to what an audit report looks like while avoiding 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. “Practice insights” throughout the book engage students and help them see the application of concepts in a
practical setting. Finally, an audit data analytics module in a stand-alone appendix, together with coverage throughout the book
and hands-on, online resources to introduce students to audit data analytics and data visualization will introduce your students
to the increasingly central role of technology in auditing.
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 reflect the latest accounting and auditing standards,
including accounting standards on revenue and leasing, and auditing standards on reporting and evidence.
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. We believe this will be increasingly true as technology is used
more and more in the audit process. Two of the authors of this textbook worked with KPMG to develop a monograph
designed to accelerate the development of professional judgment in students. We are excited to include a “professional
judgment” appendix as part of the printed material in the text. This appendix 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.
xiv
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32
Part 1 Introduction to Assurance and Financial Statement Auditing
7
Chapter 1 An Introduction to Assurance and Financial Statement Auditing
DISCUSSION CASE
FIGURE 1–1
Overview of the Principal–Agent Relationship Leading to the Demand
Practical applications for
today’s student
LO 1-1, 1-2
1-29
You
recently attended your five-year college reunion. At the main reception, you
for Auditing
encountered an old friend, Dashawn Beagle, who recently graduated from law school
and is now practicing with a large law firm in town. When you told him that you are
a CPA and employed by a regional CPA firm, he made the following statement:
Principal provides capital and hires
“You know, if the securities acts had not been passed by Congress in the 1930s, no
agent to manage resources.
one would be interested in having an audit performed.”
Required:
Draft a one-page memo that highlights your thoughts about Dashawn’s statement
Information asymmetry
that audits only take
because
they are required by law.
andplace
conflicts
of interest
Principal
(Absentee Owner)
lead to information risk
for the principal.
Agent
(Manager)
INTERNET ASSIGNMENT
Real-World Integration and Hands-On Mini-Cases.
LO 1-1, 1-9
Mini EarthWear cases
“Hands-on” mini-cases are integrated throughout the text. The mini-cases are also available in
Connect, giving your students the opportunity to
actually do some common auditing procedures.
6
Practice Insights
Practice Insights in each chapter highlight
important and interesting real-world trends and
practices.
Stop and Think moments
The book asks your student to “stop and think”
at appropriate places to aid their focus on and
understanding of key concepts.
Free IDEA software
1-30
Identify and search the websites of five organizations that provide accounting or
Agent manages resources and
auditing resources.
For each side
identified, prepare a brief summary of the inforis accountable
to principal;
Auditor gathers mation that is available.
Agent
hires(www.pcaobus.org)
auditor
example,
page
producesFor
financial
reports.the PCAOB’s home
evidence to evaluate
to report(you
on themay use the
contains extensive information on the organization’s activities
fairness of agent’s PCAOB site as one of the five). Your five summaries should
fairnessnot
of agent’s
exceed a total of
financial reports. Auditor
financial
reports. Pages
Confirming
one typed page.
issues audit opinion to
Agent pays auditor
Independent
accompany agent’s financial
to reduce principal’s
Auditor
reports, adding credibility to
information risk.
HANDS-ON
CASES
the reports
and reducing
Confirming Pages
principal’s information risk.
EarthWear
Introduction
32
Part 1 Introduction
to Assurance and Financial Statement Auditing
In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis &
Adams, LLP. This introductory activity also provides an opportunity to become familiar with the structure
EarthWearDISCUSSION
Online
CASE
settingOnline
we’vecases.
outlined is very simple, understanding the basics of the owner–
and formatWhile
of the the
EarthWear
manager relationship is helpful in understanding the demand for auditing. Auditing can simiConfirming
Pages
LO 1-1, 1-2
1-29 You
recently
attended
your tofive-year
collegedescription
reunion. of
Atthe
thecase
you
Visit Connect’s
additional
student
resources
find a detailed
andreception,
download
larly
be essential
in
other
economic
relationships.
For
example,
howmain
can
atolender
prevent
Part 1 Introduction to Assurance
and
Financial
Statement
Auditing
encountered
an
old
friend,
Dashawn Beagle, who recently graduated from law school
required
materials.
owners
or management from misusing borrowed funds? One common way is for the lender to
and is now practicing with a large law firm in town. When you told him that you are
place restrictive covenants in the loan agreement. After receiving the loan, management regua CPA and employed by a regional CPA firm, he made the following statement:
larly sends
reports
to show
the lender
that the
requirements
in the debt covenant are
money in the form of thousands
offinancial
small
loans
bonds)
capital
“You
know,
if the(i.e.,
securities
actsso
hadthat
not vast
been amounts
passed by of
Congress
in the 1930s, no
met.
these reports
audited,
the
lender’s
information
is reduced, and the lender
can be raised from a widebeing
variety
ofIfinvestors
andare
creditors.
A public
is arisk
company
one
would
be interested
in having
an
auditcompany
performed.”
may
be
willing
to
lend
at
a
lower
interest
rate
than
would
otherwise
be
the case.
32
Part
1
Introduction
to
Assurance
and
Financial
Statement
Auditing
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,Required:
the growth of the modern corporation led to diverse groups
Draft a in
one-page
memo
that highlights
your thoughts
Dashawn’s
statement
of owners
who are not
directly
involved
running
the business
(stockholders)
andabout
the use
of
DISCUSSION
CASE
Additional
Student
At the heart of a capital-market economy is the flow of reliable information, which investors, crediPractice
that
audits only
take
placecorporation
becausetothey
arearequired
by IDEA
law.basis.
Visit
Connect
for
author-created
problem
material
be completed
using
software.
professional managers hired
owners
to torun
the
on
day-to-day
In gave his view of
tors,by
andthe
regulators
use
make
informed decisions.
Chief
Justice Warren
Burger
Resources I N S I G H T
LO 1-1,
1-2 the
1-29
recently
attended
college
reunion.
At the main
this setting, the
managers
serve
as You
agents
whoaudit
fulfill
a your
stewardship
function
bydecision:
managing
the reception, you
significance
of the
function
in afive-year
1984 Supreme
Court
encountered
an old friend,referred
DashawntoBeagle,
who recently graduated from law school
corporation’s assets for the owners
(who are sometimes
as principals).
By certifying the public reports that collectively depict a corporation’s financial status, the indepenand
is now practicing
aprincipal–agent
large law firm in relationship.
town. When you
told him that you are
INTERNET
AccountingASSIGNMENT
and auditing play
important
roles
in with
this
We’ll
dent auditor
a public
responsibility
relationship with the clia CPA assumes
and employed
by
a regionaltranscending
CPA firm,any
he employment
made the following
statement:
TABLEAU
first explain the roles of accounting
auditing
from
a
conceptual
perspective.
Then
we’llultimate
ent. The and
independent
public
accountant
performing
this special function
owes
allegiance to
“You know,
if the securities
acts of
hadfive
not organizations
been passed by
Congress
in the 1930s, no
LO
1-1,
1-9
1-30
Identify
and
search
the
websites
that
provide
the corporation’s
creditors
and stockholders,
as wellFirst,
as to the
public.to accounting or
useStudent
an analogy involving a house
inspector
to interested
illustrate
the
concepts.
it isinvesting
important
Additional
one
would
be
in
having
an
audit
performed.”
auditing
resources.
For each
side toidentified,
prepare
brief summary
Visit Connect for
author-created
problem
material
be completed
usinga Tableau
software.of the inforunderstand that the relationship
between
an owner
and manager
often results
in information
More than
30 years
the message
is the same—users
of financial
rely on the exterResources
mation
thatlater,
is available.
For example,
the PCAOB’s
home statements
page (www.pcaobus.org)
nal auditor
to Information
act with honor and
integrity in protecting
the public
interest. who
asymmetry between the two
parties.
asymmetry
that
the manager,
Required:
contains
extensive information
onmeans
the organization’s
activities (you may use the
runs the business day-to-day, generally
more
information
about
theyour
“true”
financial
Draft has
a site
one-page
memo
highlights
thoughts
aboutposiDashawn’s
PCAOB
as one
of thethat
five).
Your five
summaries
should
not
exceed astatement
total of
that
auditsthan
onlydoes
take place
because they
are required by law.
tion and results of operations of the
entity
the absentee
owner.
one
typed
page.
HANDS-ON CASES
INTERNET
ASSIGNMENT
Stop and Think:
What negative consequences could information asymmetry have for
the absentee owner? HowEarthWear
do the perspectives
and motives of the manager and absentee
Introduction
LO 1-1,
1-9 elements:
1-30
Identify
andbecome
searchfurther
the
websites
five
organizations
that
provide
accounting
orInc.;
Design
(leaves):
ooyoo/Getty
Images;
(IDEAof
Data
Analysis
Software
logo):
©CaseWare
In
this activity
you will
acquainted
with
EarthWear
Clothiers
and
their
auditors
Willis & IDEA
owner differ?
auditing
resources.
For
eachprovides
side
identified,
prepare
a brief
summary
of the inforAdams,Hands-On
LLP.
This introductory
activity
also
an opportunity
to become
familiar
with the structure
Cases, and
EarthWear
icons):
McGraw
Hill.
EarthWear Online(Practice Insight,
and format
of the that
EarthWear
Online cases.
mation
is available.
For example, the PCAOB’s home page (www.pcaobus.org)
contains extensive information on the organization’s activities (you may use the
Visit
Connect’s
additional
resources
toconflict
find
a detailed
descriptionbetween
ofshould
the casenot
and
to download
Because their goals may
not
coincide,
there
is aof
natural
of summaries
interest
theexceed
PCAOB
site
asstudent
one
the five).
Your
five
a total of
required materials.
mes00671_ch01_001-032.indd
7
05/29/21 03:46 PM
typed
page.seek to maximize their self-interest, the manmanager
and the absentee
owner. Ifone
both
parties
ager may not always act in the best interests of the owner. For example, the risk exists that a
manager may follow the example of Tyco Inc.’s former CEO Dennis Kozlowski, who spent
HANDS-ON CASES
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
EarthWear
Introduction
mes00671_ch01_001-032.indd 32
05/29/21 03:46 PM
In this
you will become
acquainted
with EarthWear
Clothiers
and theirand
auditors Willis &
in order
to inflate
theactivity
company’s
stockfurther
so that
he could
earn larger
bonuses
Additional
Studentthe price of
Visit
Connect
for
author-created
problem
material
to be opportunity
completed using
IDEA software.
Adams,
LLP.
This
introductory
activity
also
provides
tocontracts
become
familiar
with the structure
EarthWear
Online
sellResources
his stock holdings at artificially high prices. To
prevent
this, anmanagers’
often
and format of the EarthWear Online cases.
include requirements for them to report regularly to owners on the quality of their work and
Visit Connect’s
resources
to find a detailed
case and to download
on how well she or he has managed
the additional
owners’student
assets.
Of course,
a set ofdescription
criteriaofistheneeded
toTABLEAU
guide the form and contentrequired
of thematerials.
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
Additional Student
Visit Connect for author-created problem material to be completed using Tableau software.
theResources
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 educational version of IDEA software is available for free with each new book. The authors
wrote chapter-specific IDEA assignments and problems, all of which are found inside Connect, including problems aimed
at introducing students to IDEA’s visualization and audit data analytics tools. Exposing students to IDEA allows them the
opportunity to work with real professional audit software. TheAdditional
Student
Role of
Auditing Visit Connect for author-created problem material to be completed using IDEA software.
Resources
Of course, reporting in accordance with an agreed-upon set of accounting principles doesn’t
solve the problem by itself. The manager is in a position to manipulate the reports because
the manager is responsible
for elements:
reporting
on the
results Images;
of his (IDEA
or her
own
actions,
which
the
Design
(leaves):
ooyoo/Getty
Data
Analysis
Software
logo): ©CaseWare
IDEA Inc.;
TABLEAU
absentee owner cannot directly
It is atCases,
this point
that the
demand
for
auditing arises.
(Practiceobserve.
Insight, Hands-On
and EarthWear
icons):
McGraw
Hill.
Additional Student
If the
manager is honest, it may
very well
be in the manager’s
self-interest
to using
hireTableau
an auditor
Visit Connect
for author-created
problem material
to be completed
software.
Resources
to monitor and independently 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. The auditor’s
role is to determine whether the reports prepared by the manager conform to the contract’s
provisions, adding credibility to the reports and reducing information risk, or the risk that
mes00671_ch01_001-032.indd
32
information
circulated
by a company’s management could be false or misleading. Reducing 05/29/21 03:46 PM
information risk benefits both the owner and the manager by making the manager’s reports
Design elements: (leaves): ooyoo/Getty Images; (IDEA Data Analysis Software logo): ©CaseWare IDEA Inc.;
more credible. Figure 1–1 (Practice
provides
an overview
of this
relationship.
Insight,
Hands-On Cases,
andagency
EarthWear
icons): McGraw Hill.
Tableau
Tableau is a market-leading data analytics and
visualization software that students can download for free. The authors provide instruction on
how to download Tableau and access basic tutorials created by the software provider. Additionally, the authors created
data visualization and audit data analytics problems for the majority of chapters to be answered using Tableau. This
functionality exposes students to cutting-edge technology used in practice.
mes00671_ch01_001-032.indd
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05/29/21 03:46 PM
McGraw Hill Education has partnered with Roger CPA Review (Powered by UWorld), a global leader in CPA Exam
preparation, to provide students a smooth transition from the accounting classroom to successful completion of the CPA
Exam. While many aspiring accountants wait until they have completed their academic studies to begin preparing for
the CPA Exam, research shows that those who become familiar with exam content earlier in the process have a stronger
chance of successfully passing the CPA Exam. Accordingly, students using these McGraw Hill materials will have access
to Roger CPA Review multiple-choice questions supported by explanations written by CPAs focused on exam preparation. McGraw Hill Education and Roger CPA Review are dedicated to supporting every accounting student along their
­journey, ultimately helping them achieve career success in the accounting profession. For more information about the
full Roger CPA Review program, exam requirements, and exam content, visit www.rogercpareview.com.
xv
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Instructors: Student Success Starts with You
Tools to enhance your unique voice
Want to build your own course? No problem. Prefer to use an
OLC-aligned, prebuilt course? Easy. Want to make changes throughout
the semester? Sure. And you’ll save time with Connect’s auto-grading too.
65%
Less Time
Grading
Study made personal
Incorporate adaptive study resources like
SmartBook® 2.0 into your course and help your
students be better prepared in less time. Learn
more about the powerful personalized learning
experience available in SmartBook 2.0 at
www.mheducation.com/highered/connect/smartbook
Laptop: McGraw Hill; Woman/dog: George Doyle/Getty Images
Affordable solutions,
added value
Solutions for
your challenges
Make technology work for you with
LMS integration for single sign-on access,
mobile access to the digital textbook,
and reports to quickly show you how
each of your students is doing. And with
our Inclusive Access program you can
provide all these tools at a discount to
your students. Ask your McGraw Hill
representative for more information.
A product isn’t a solution. Real
solutions are affordable, reliable,
and come with training and
ongoing support when you need
it and how you want it. Visit www.
supportateverystep.com for videos
and resources both you and your
students can use throughout the
semester.
Padlock: Jobalou/Getty Images
Checkmark: Jobalou/Getty Images
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Students: Get Learning that Fits You
Effective tools for efficient studying
Connect is designed to help you be more productive with simple, flexible, intuitive tools that maximize
your study time and meet your individual learning needs. Get learning that works for you with Connect.
Study anytime, anywhere
Download the free ReadAnywhere app and access
your online eBook, SmartBook 2.0, or Adaptive
Learning Assignments when it’s convenient, even
if you’re offline. And since the app automatically
syncs with your Connect account, all of your work is
available every time you open it. Find out more at
www.mheducation.com/readanywhere
“I really liked this
app—it made it easy
to study when you
don't have your textbook in front of you.”
- Jordan Cunningham,
Eastern Washington University
Everything you need in one place
Your Connect course has everything you need—whether reading on
your digital eBook or completing assignments for class, Connect makes
it easy to get your work done.
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Learning for everyone
McGraw Hill works directly with Accessibility Services
Departments and faculty to meet the learning needs
of all students. Please contact your Accessibility
Services Office and ask them to email
accessibility@mheducation.com, or visit
www.mheducation.com/about/accessibility
for more information.
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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 the Ernst
& Young Foundation and Academic Resource Center for permitting use of selected data analytics
materials; Dr. Brant Christensen of the University of Oklahoma for his assistance in creating videos
and in revising and developing audit data analytics and data visualization resources for the book and
online; Dr. Meghann Cefaratti of Northern Illinois University for her help with updating the Test Bank;
Dr. Ryan Dunn for his help updating the PowerPoints and Instructor’s Manual; Jonathan Liljegren for
revision of the EarthWear Mini-Cases; Dr. Helen Roybark for her review of the end-of-chapter material in Connect; Dr. Ryan Dunn and Dr. Helen Roybark for their review of the chapters, end-of-chapter
and solution manuals; Patti Lopez for her revision of the SmartBook content; and Cathy Allen of Audit
Conduct, LLC, for her careful review of our chapter on professional ethics. Finally, we would like to
extend our gratitude to Isaac Newey and Branden Stuart for their capable research assistance.
xviii
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Brief Contents
PART 1
Chapter 7
Introduction to Assurance and
Financial Statement Auditing 1
Auditing Internal Control over Financial
Reporting 216
Chapter 1
PART 4
An Introduction to Assurance and Financial
Statement Auditing 2
Chapter 2
The Financial Statement Auditing
Environment 34
PART 2
Statistical and Nonstatistical Sampling
Tools for Auditing 257
Chapter 8
Audit Sampling: An Overview and
Application to Tests of Controls 258
Chapter 9
Audit Planning and Basic Auditing
Concepts 65
Audit Sampling: An Application to
Substantive Tests of Account Balances
Chapter 3
PART 5
Audit Planning, Types of Audit Tests,
and Materiality 66
Auditing Business Processes
296
333
Chapter 10
Chapter 4
Auditing the Revenue Process
Risk Assessment 96
334
Chapter 11
Chapter 5
Evidence and Documentation
126
Auditing the Purchasing Process
382
Chapter 12
PART 3
Understanding and Auditing Internal
Control 173
Chapter 6
Internal Control in a Financial
Statement Audit 174
Auditing the Human Resource Management
Process 418
Chapter 13
Auditing the Inventory Management
Process 446
xix
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xx
Brief Contents
Chapter 14
Chapter 20
Auditing the Financing/Investing Process:
Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment 476
Legal Liability 670
Chapter 15
Assurance, Attestation, and Internal
Auditing Services 707
Auditing the Financing/Investing Process:
Long-Term Liabilities, Stockholders’ Equity,
and Income Statement Accounts 502
Chapter 16
Auditing the Financing/Investing Process:
Cash and Investments 524
PART 6
Completing the Audit and Reporting
Responsibilities 557
Chapter 17
Completing the Audit Engagement
558
Chapter 18
Reports on Audited Financial
Statements 594
PART 7
Professional Responsibilities
PART 8
Chapter 21
Assurance, Attestation, and Internal Auditing
Services 708
Appendix A: Professional Judgment
Framework—Understanding and
Developing Professional Judgment in
Auditing 740
(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.)
Appendix B: Data Analytics in the
Audit 750
Index
773
627
Chapter 19
Professional Conduct, Independence, and
Quality Management 628
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Table of Contents
PART 1
Introduction to Assurance and
Financial Statement Auditing 1
Chapter 1
An Introduction to Assurance and Financial
Statement Auditing 2
Tips for Learning Auditing (and How Learning It Will
Benefit You!) 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
Fundamental Concepts in Conducting a Financial
Statement Audit 13
Materiality 14
Audit Risk 15
Audit Evidence Regarding Management
Assertions 15
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 23
Audit Data Analytics 24
Audit Data Analytics (ADA) 25
Financial Technologies 25
mes00671_fm_i-xxxii.indd
xxi
Technology and Professional Judgment
Conclusion 26
Key Terms 27
Review Questions 28
Multiple-Choice Questions 28
Problems 30
Discussion Case 32
Internet Assignment 32
Hands-On Cases 32
IDEA and Tableau 32
25
Chapter 2
The Financial Statement Auditing
Environment 34
Types of Auditors 36
External Auditors 36
Internal Auditors 36
Government Auditors 36
Fraud Auditors 38
Types of Other Audit, Attest, and Assurance
Services 38
Other Audit Services 38
Attest Services 39
Assurance Services 39
Other Non-audit/Non-assurance Services 40
Public Accounting Firms 40
Organization and Composition 40
Two Decades of Challenge and Change for Financial
Statement Auditors 42
Government Regulation 42
Society’s Expectations and the Auditor’s
Responsibilities 43
The Context of Financial Statement
Auditing 43
The Business Entity as the Primary Context of
Auditing 43
A Model of Business 44
Corporate Governance 44
Objectives, Strategies, Processes, Controls,
Transactions, and Reports 46
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A Model of Business Processes: Five Components 46
Organizations That Affect the Public Accounting
Profession 47
Securities and Exchange Commission (SEC) 49
Public Company Accounting Oversight Board
(PCAOB) 49
American Institute of Certified Public Accountants
(AICPA) 50
International Auditing and Assurance Standards
Board (IAASB) 50
Financial Accounting Standards Board (FASB) 50
International Accounting Standards Board (IASB) 51
Auditing Standards 51
Three Sets of Auditing Standards: The Roles of the
ASB, PCAOB, and IAASB 51
Principles Underlying an Audit Conducted in
Accordance with Generally Accepted Auditing
Standards 51
The Nature of Auditing Standards and the
Codification of Standards 54
Ethics, Independence, and the Code of Professional
Conduct 56
Conclusion 56
Key Terms 57
Review Questions 58
Multiple-Choice Questions 59
Problems 61
Discussion Cases 62
Internet Assignments 63
Hands-On Cases 64
IDEA and Tableau 64
PART 2
Audit Planning and Basic Auditing
Concepts 65
Chapter 3
Audit Planning, Types of Audit Tests,
and Materiality 66
Client Acceptance and Continuance 68
Prospective Client Acceptance 68
Client Continuance 69
Preliminary Engagement Activities 70
Determine the Audit Engagement Team
Requirements 70
Assess Compliance with Ethical and Independence
Requirements 70
Establish an Understanding with the Entity 70
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Planning the Audit 75
Audit Strategy and Plan 75
Assess Business Risks 76
Establish Materiality 76
Consider Multilocations or Business Units 76
Assess the Need for Specialists 77
Consider Violations of Laws and Regulations 77
Identify Related Parties 78
Consider Additional Value-Added Services 79
Document the Overall Audit Strategy, Audit Plan,
and Prepare Audit Programs 79
Supervision of the Audit 81
Types of Audit Procedures 81
Risk Assessment Procedures 81
Tests of Controls 81
Substantive Procedures 82
Dual-Purpose Tests 82
Audit Data Analytics 83
Materiality 83
Steps in Applying Materiality 84
An Example 87
Key Terms 88
Review Questions 89
Multiple-Choice Questions 90
Problems 91
Discussion Case 94
Internet Assignments 94
Hands-On Cases 95
IDEA 95
Chapter 4
Risk Assessment 96
Audit Risk 98
The Audit Risk Model 98
Use of the Audit Risk Model 100
The Auditor’s Risk Assessment Process 102
Management’s Strategies, Objectives, and Business
Risks 102
Auditor’s Risk Assessment Procedures 102
Assessing Business Risks 104
Evaluate the Entity’s Risk Assessment Process 107
Assessing the Risk of Material Misstatement 107
Causes and Types of Misstatements 108
The Fraud Risk Assessment Process 109
The Auditor’s Response to the Results of the Risk
Assessments 114
Evaluation of Audit Test Results 115
Documentation of the Auditor’s Risk Assessment
and Response 116
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Communications about Fraud to Management,
the Audit Committee, and Others 116
Key Terms 118
Review Questions 119
Multiple-Choice Questions 119
Problems 121
Discussion Case 123
Internet Assignment 124
Hands-On Cases 125
IDEA and Tableau 125
Chapter 5
Evidence and Documentation
126
The Relationship of Audit Evidence to the Audit
Report 128
Management Assertions 129
Assertions about Classes of Transactions and
Events, and Related Disclosures, for the Period
under Audit 129
Assertions about Account Balances, and Related
Disclosures, at the Period End 131
Understanding Audit Evidence 133
Information Used as Audit Evidence 133
The Sufficiency and Appropriateness of Audit
Evidence 134
The Evaluation of Audit Evidence 136
Audit Procedures for Obtaining Audit Evidence 136
Inspection 137
Observation 138
Inquiry 139
Confirmation 139
Recalculation 140
Reperformance 140
Analytical Procedures 140
Reliability of Evidence 141
The Audit Testing Hierarchy 142
An “Assurance Bucket” Analogy 142
Audit Documentation 145
Purposes of Audit Documentation 145
Content of Audit Documentation 146
Examples of Audit Documentation 147
Format of Audit Documentation 149
Organization of Audit Documentation 149
Ownership of Audit Documentation 150
Audit Document Archiving and Retention 150
Advanced Module: Analytical Procedures 152
Auditor Decision Process-Analytical
Procedures 153
Risk Assessment Analytical Procedures 153
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Substantive Analytical Procedures 153
Final Analytical Procedures 156
Types of Analytical Procedures 157
Key Terms 162
Review Questions 163
Multiple-Choice Questions 164
Problems 166
Discussion Cases 169
Internet Assignment 171
Hands-On Cases 171
IDEA and Tableau 172
PART 3
Understanding and Auditing Internal
Control 173
Chapter 6
Internal Control in a Financial Statement
Audit 174
Introduction 176
Internal Control—an Overview 176
Definition of Internal Control 176
Controls Relevant to the Audit 176
The Effect of Information Technology on Internal
Control 177
The COSO Framework 177
Components of Internal Control 177
Control Environment 179
The Entity’s Risk Assessment Process 180
Control Activities 181
Information and Communication 183
Monitoring of Controls 183
Planning an Audit Strategy 184
Substantive Strategy 186
Reliance Strategy 186
Obtain an Understanding of Internal Control 187
Overview 187
Understanding the Control Environment 188
Understanding the Entity’s Risk Assessment
Process 188
Understanding Control Activities 189
Understanding the Information System and
Communications 190
Understanding Monitoring of Controls 190
Documenting the Understanding of Internal
Control 191
The Effect of Entity Size on Internal Control 192
The Limitations of an Entity’s Internal Control 192
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Assessing Control Risk 194
Identifying Specific Controls That Will Be Relied
Upon 194
Performing Tests of Controls 194
Concluding on the Achieved Level of Control
Risk 195
Documenting the Achieved Level of Control
Risk 195
An Example 196
Substantive Procedures 196
Timing of Audit Procedures 197
Interim Tests of Controls 197
Interim Substantive Procedures 198
Auditing Accounting Applications Processed
by Service Organizations 199
Communication of Internal Control–Related
Matters 200
Advanced Module 1: Types of Controls in an IT
Environment 201
General Controls 201
Application Controls 203
Advanced Module 2: Flowcharting Techniques 205
Symbols 205
Organization and Flow 206
Key Terms 206
Review Questions 207
Multiple-Choice Questions 208
Problems 210
Discussion Cases 212
Hands-On Cases 214
IDEA 214
Chapter 7
Auditing Internal Control over Financial
Reporting 216
Management Responsibilities under Section 404 218
Auditor Responsibilities under Section 404 and
AS 2201 218
Internal Control over Financial Reporting Defined 218
Internal Control Deficiencies Defined 219
Control Deficiency 219
Material Weakness 219
Significant Deficiency 219
Likelihood and Magnitude 220
Management’s Assessment Process 221
Identify Financial Reporting Risks and Related
Controls 221
Consider Which Locations to Include in the
Evaluation 222
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Evaluate Evidence about the Operating
Effectiveness of ICFR 222
Reporting Considerations 223
Management’s Documentation 223
Performing an Audit of ICFR 224
Plan the Audit of ICFR 225
The Role of Risk Assessment and the Risk of
Fraud 226
Scaling the Audit 226
Using the Work of Others 226
Identify Controls to Test 227
Identify Entity-Level Controls 227
Identifying Significant Accounts and Disclosures
and Their Relevant Assertions 228
Understanding Likely Sources of
Misstatements 229
Select Controls to Test 229
Evaluate the Design and Test the Operating
Effectiveness of Controls 230
Evaluating Design Effectiveness of
Controls 230
Testing and Evaluating Operating Effectiveness of
Controls 230
Evaluating Identified Control Deficiencies 234
Examples of Control Deficiency
Evaluation 235
Remediation of a Material Weakness 236
Written Representations 236
Auditor Documentation Requirements 237
Auditor Reporting on ICFR 237
Elements of the Auditor’s Report 237
Unqualified Opinion 238
Adverse Opinion for a Material Weakness 238
Disclaimer for Scope Limitation 241
Other Reporting Issues 242
Management’s Report Incomplete or Improperly
Presented 242
The Auditor Decides to Refer to the Report of
Other Auditors 242
Subsequent Events 242
Management’s Report Contains Additional
Information 242
Reporting on a Remediated Material Weakness
at an Interim Date 242
Additional Required Communications
in an Audit of ICFR 243
Advanced Module 1: Special Considerations for an
Audit of Internal Controls 243
Use of Service Organizations 243
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Safeguarding of Assets 244
Advanced Module 2: Using Technology in the Audit
of ICFR 244
Generalized Audit Software 245
Custom Audit Software 245
Test Data 246
Key Terms 246
Review Questions 247
Multiple-Choice Questions 248
Problems 251
Internet Assignments 256
Hands-On Cases 256
Tableau 256
PART 4
Statistical and Nonstatistical Sampling
Tools for Auditing 257
Chapter 8
Audit Sampling: An Overview and
Application to Tests of Controls 258
Overview of Audit Sampling 260
Definitions and Key Concepts 261
Audit Sampling 261
Sampling Risk 261
Confidence Level 263
Tolerable and Expected Error 263
Audit Evidence Choices That Do and Do Not
Involve Sampling 264
Types of Audit Sampling 265
Nonstatistical versus Statistical Sampling 265
Types of Statistical Sampling Techniques 266
Attribute Sampling Applied to Tests of Controls 267
Planning 267
Performance 275
Evaluation 279
Nonstatistical Sampling for Tests of Controls 283
Determining the Sample Size 283
Selecting the Sample Items 284
Calculating the Computed Upper Deviation Rate 284
Conclusion 285
Advanced Module 1: Considering the Effect on
Sample Size of a Small Population 285
Advanced Module 2: Comparing Terminology for
Attribute Sampling between IDEA and Sampling
Tables 286
Key Terms 286
Review Questions 287
Multiple-Choice Questions 288
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Problems 290
Discussion Case 293
Hands-On Cases 294
IDEA 294
Chapter 9
Audit Sampling: An Application to
Substantive Tests of Account Balances
296
Sampling for Substantive Tests of Details
of Account Balances 298
Monetary-Unit Sampling 299
Advantages 299
Disadvantages 300
Applying Monetary-Unit Sampling 300
Planning 300
Performance 304
Evaluation 306
Nonstatistical Sampling for Tests of Account
Balances 313
Identifying Individually Significant Items 314
Determining the Sample Size 314
Selecting Sample Items 315
Calculating the Sample Results 315
An Example of Nonstatistical Sampling 316
Advanced Module 1: Classic Variables
Sampling 318
Advantages 320
Disadvantages 320
Applying Classical Variables Sampling 320
Advanced Module 2: Comparing Terminology for
Monetary-Unit Sampling between IDEA and
Manual Calculation 324
Key Terms 324
Review Questions 325
Multiple-Choice Questions 326
Problems 327
Discussion Cases 331
Hands-On Cases 332
IDEA 332
PART 5
Auditing Business Processes
333
Chapter 10
Auditing the Revenue Process
Revenue Recognition 337
Overview of the Revenue Process
334
338
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Types of Transactions and Financial Statement
Accounts Affected 339
Types of Documents and Records 341
The Major Functions 345
Key Segregation of Duties 346
Inherent Risk Assessment 347
Industry-Related Factors 347
The Complexity and Contentiousness of
Revenue Recognition Issues 348
The Difficulty of Auditing Transactions and
Account Balances 348
Misstatements Detected in Prior Audits 348
Control Risk Assessment 349
Understand and Document Internal
Control 349
Plan and Perform Tests of Controls 350
Set and Document Control Risk 350
Control Activities and Tests of Controls—
Revenue Transactions 351
Occurrence of Revenue Transactions 351
Completeness of Revenue Transactions 353
Authorization of Revenue Transactions 354
Accuracy of Revenue Transactions 354
Cutoff of Revenue Transactions 354
Classification of Revenue Transactions 354
Presentation of Revenue Transactions and
Events 355
Control Activities and Tests of Controls—Cash
Receipts Transactions 355
Occurrence of Cash Receipts Transactions 355
Completeness of Cash Receipts Transactions 356
Authorization of Cash Discounts 357
Accuracy of Cash Receipts Transactions 358
Cutoff of Cash Receipts Transactions 358
Classification of Cash Receipts 358
Control Activities and Tests of Controls—Sales
Returns and Allowances Transactions 358
Relating the Assessed Level of Control Risk to
Substantive Procedures 359
Auditing Revenue-Related Accounts 359
Substantive Analytical Procedures 360
Tests of Details of Classes of Transactions, Account
­Balances, and Disclosures 361
Completeness 361
Cutoff 363
Existence 364
Rights and Obligations 364
Accuracy, Valuation, and Allocation 365
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Classification 366
Presentation 366
The Confirmation Process—Accounts Receivable 367
Types of Confirmations 368
Timing 369
Confirmation Procedures 370
Alternative Procedures 371
Auditing Other Receivables 371
Evaluating the Audit Findings—
Revenue-Related Accounts 372
Key Terms 372
Review Questions 373
Multiple-Choice Questions 374
Problems 376
Discussion Cases 379
Internet Assignments 380
Hands-On Cases 380
IDEA and Tableau 380
Chapter 11
Auditing the Purchasing Process
382
Expense and Liability Recognition 384
Overview of the Purchasing Process 384
Types of Transactions and Financial Statement
Accounts Affected 385
Types of Documents and Records 386
The Major Functions 389
The Key Segregation of Duties 391
Inherent Risk Assessment 392
Industry-Related Factors 392
Misstatements Detected in Prior Audits 392
Control Risk Assessment 392
Understand and Document Internal Control 392
Plan and Perform Tests of Controls 394
Set and Document Control Risk 394
Control Activities and Tests of Controls—Purchase
Transactions 394
Occurrence of Purchase Transactions 395
Completeness of Purchase Transactions 395
Authorization of Purchase Transactions 397
Accuracy of Purchase Transactions 397
Cutoff of Purchase Transactions 397
Classification of Purchase Transactions 397
Presentation of Purchase Transactions 398
Control Activities and Tests of Controls—Cash
Disbursement Transactions 398
Occurrence of Cash Disbursement
Transactions 398
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Completeness of Cash Disbursement
Transactions 398
Authorization of Cash Disbursement
Transactions 398
Accuracy of Cash Disbursement Transactions 399
Cutoff of Cash Disbursement Transactions 400
Classification of Cash Disbursement
Transactions 400
Control Activities and Tests of Controls—Purchase
Return Transactions 400
Relating the Assessed Level of Control
Risk to Substantive Procedures 401
Auditing Accounts Payable and Accrued Expenses 401
Substantive Analytical Procedures 402
Tests of Details of Classes of Transactions, Account
Balances, and Disclosures 402
Completeness 403
Existence 405
Cutoff 405
Rights and Obligations 405
Accuracy, Valuation, and Allocation 405
Classification 406
Presentation 406
Accounts Payable Confirmations 406
Evaluating the Audit Findings—Accounts Payable
and Related 408
Advanced Module: Auditing the Tax Provision and
Related Balance Sheet Accounts 408
Key Terms 411
Review Questions 411
Multiple-Choice Questions 412
Problems 413
Discussion Case 417
Internet Assignments 417
Hands-On Cases 417
IDEA and Tableau 417
Chapter 12
Auditing the Human Resource Management
Process 418
Overview of the Human Resource
Management Process 420
Types of Transactions and Financial Statement
Accounts Affected 421
Types of Documents and Records 421
The Major Functions 422
The Key Segregation of Duties 424
Inherent Risk Assessment 425
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Control Risk Assessment 426
Understand and Document Internal Control 426
Plan and Perform Tests of Controls 427
Set and Document the Control Risk 427
Control Activities and Tests of Controls—Payroll
Transactions 427
Occurrence of Payroll Transactions 429
Authorization of Payroll Transactions 429
Accuracy of Payroll Transactions 430
Classification of Payroll Transactions 430
Presentation of Payroll Transactions and
Compensation Data 430
Relating the Assessed Level of Control Risk
to Substantive Procedures 430
Auditing Payroll-Related Accounts 431
Substantive Analytical Procedures 431
Tests of Details of Classes of Transactions, Account
­Balances, and Disclosures 432
Payroll Expense Accounts 432
Accrued Payroll Liabilities 433
Evaluating the Audit Findings—Payroll-Related
Accounts 436
Advanced Module: Share-Based Compensation 436
Key Terms 438
Review Questions 438
Multiple-Choice Questions 439
Problems 441
Discussion Cases 443
Internet Assignment 445
Hands-On Cases 445
IDEA and Tableau 445
Chapter 13
Auditing the Inventory Management
Process 446
Overview of the Inventory Management Process 448
Types of Documents and Records 449
The Major Functions 451
The Key Segregation of Duties 452
Inherent Risk Assessment 452
Industry-Related Factors 453
Engagement and Operating Characteristics 453
Control Risk Assessment 453
Understand and Document Internal Control 454
Plan and Perform Tests of Controls 455
Set and Document the Control Risk 455
Control Activities and Tests of Controls—Inventory
Transactions 455
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Occurrence of Inventory Transactions 455
Completeness of Inventory Transactions 457
Authorization of Inventory Transactions 457
Accuracy of Inventory Transactions 457
Cutoff of Inventory Transactions 458
Classification of Inventory Transactions 458
Presentation of Inventory 458
Relating the Assessed Level of Control Risk
to Substantive Procedures 459
Auditing Inventory 459
Substantive Analytical Procedures 460
Auditing Standard Costs 461
Materials 461
Labor 461
Overhead 461
Observing Physical Inventory 461
Tests of Details of Classes of Transactions,
Account Balances, and Disclosures 463
Accuracy 464
Cutoff 465
Existence 465
Completeness 465
Rights and Obligations 465
Valuation, Accuracy, and Allocation 465
Classification and Presentation 466
Evaluating the Audit Findings—Inventory 467
Key Terms 467
Review Questions 468
Multiple-Choice Questions 468
Problems 470
Discussion Case 474
Internet Assignment 475
Hands-On Cases 475
IDEA and Tableau 475
Chapter 14
Auditing the Financing/Investing Process:
Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment 476
Auditing Prepaid Expenses 478
Inherent Risk Assessment—Prepaid Expenses 478
Control Risk Assessment—Prepaid Expenses 478
Substantive Procedures—Prepaid Insurance 479
Substantive Analytical Procedures for Prepaid
Insurance 479
Tests of Details of the Prepaid Insurance 480
Existence and Completeness 480
Rights and Obligations 480
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Valuation 480
Classification 480
Auditing Intangible Assets 480
Inherent Risk Assessment—Intangible Assets 481
Control Risk Assessment—Intangible Assets 482
Substantive Procedures—Intangible Assets 482
Substantive Analytical Procedures for Intangible
Assets 482
Tests of Details of Intangible Assets 483
Auditing the Property Management Process 484
Types of Transactions 484
Overview of the Property Management
Process 485
Inherent Risk Assessment—Property
Management Process 486
Complex Accounting Issues 486
Difficult-to-Audit Transactions 486
Misstatements Detected in Prior Audits 486
Control Risk Assessment—Property
Management Process 487
Occurrence and Authorization 488
Completeness 488
Segregation of Duties 488
Substantive Procedures—Property, Plant, and
Equipment 489
Substantive Analytical Procedures—Property,
Plant, and Equipment 489
Tests of Details of Transactions, Account Balances,
and Disclosures—Property, Plant, and
Equipment 490
Evaluating the Audit Findings—Property, Plant,
and Equipment 494
Key Terms 494
Review Questions 495
Multiple-Choice Questions 495
Problems 497
Discussion Case 499
Internet Assignments 500
Hands-On Cases 500
IDEA and Tableau 500
Chapter 15
Auditing the Financing/Investing Process:
Long-Term Liabilities, Stockholders’ Equity,
and Income Statement Accounts 502
Auditing Long-Term Debt 504
Inherent Risk Assessment—Long-Term
Debt 505
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Control Risk Assessment—Long-Term Debt 505
Assertions and Related Control Activities 505
EarthWear Substantive Procedures—Long-Term
Debt 507
Auditing Stockholders’ Equity 508
Control Risk Assessment—Stockholders’
Equity 510
Assertions and Related Control Activities 510
Segregation of Duties 511
Auditing Capital-Stock Accounts 511
Occurrence and Completeness 511
Valuation 512
Completeness of Disclosures 512
Auditing Dividends 512
Auditing Retained Earnings 513
Auditing Income Statement Accounts 513
Assessing Control Risk for Business Processes—
Income Statement Accounts 514
Substantive Procedures—Income Statement
Accounts 514
Direct Tests of Balance Sheet
Accounts 514
Substantive Analytical Procedures for Income
Statement Accounts 514
Tests of Selected Account Balances 515
Key Terms 516
Review Questions 517
Multiple-Choice Questions 517
Problems 519
Discussion Case 521
Internet Assignment 522
Hands-On Cases 522
IDEA and Tableau 522
PART 6
Chapter 16
Auditing the Financing/Investing Process:
Cash and Investments 524
Auditing Cash 526
Types of Bank Accounts 527
General Cash Account 527
Imprest Cash Accounts 527
Branch Accounts 527
Control Risk Assessment—Cash 528
Substantive Procedures—Cash 528
Substantive Analytical Procedures—
Cash 528
Substantive Tests of Details of Transactions and
Balances—Cash 528
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Auditing the General Cash Account 529
Fraud-Related Audit Procedures 534
Auditing a Payroll or Branch Imprest
Account 537
Auditing a Petty Cash Fund 537
Disclosure Issues for Cash 538
Auditing Investments 539
Control Risk Assessment—Investments 539
Assertions and Related Control
Activities 540
Segregation of Duties 541
Substantive Procedures—Investments 541
Substantive Analytical
Procedures—Investments 541
Tests of Details—Investments 541
Advanced Module: Auditing Fair Value
Measurements 544
Understanding How Management Makes Fair
Value Measurements 545
Considering Whether Specialized Skills or
Knowledge Is Required 546
Testing the Entity’s Fair Value
Measurements 546
Evaluating the Reasonableness of the Fair Value
Measurements 547
Key Terms 547
Review Questions 548
Multiple-Choice Questions 549
Problems 551
Internet Assignment 555
Hands-On Case 555
IDEA and Tableau 556
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Completing the Audit and Reporting
Responsibilities 557
Chapter 17
Completing the Audit Engagement
558
Review for Contingent Liabilities 560
Audit Procedures for Identifying Contingent
Liabilities 561
Letters of Audit Inquiry 561
Commitments 562
Review of Subsequent Events for Audit
of Financial Statements 564
Dual Dating 566
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Audit Procedures for Subsequent Events 567
Review of Subsequent Events for the Audit of Internal
Control over Financial Reporting 567
Final Steps and Evidence Evaluation 568
Final Analytical Procedures 568
Management Representation Letter 568
Audit Work Paper Review 569
Evaluation of Audit Results 572
Evaluating Financial Statement Presentation and
Disclosure 575
Engagement Quality Review 575
Archiving and Retention 575
Going-Concern Considerations 575
Communications with Those Charged with
Governance and Management 579
Communications Regarding the Audit of
Internal Control over Financial Reporting 579
Management Letter 580
Subsequent Discovery of Facts Existing
at the Date of the Auditor’s Report 580
Key Terms 582
Review Questions 582
Multiple-Choice Questions 583
Problems 585
Discussion Cases 589
Internet Assignments 592
Hands-On Cases 592
IDEA and Tableau 592
Chapter 18
Reports on Audited Financial
Statements 594
Reporting on the Financial Statement Audit:
The Standard Unqualified/Unmodified Audit
Report 596
The Standard Unqualified Audit Report for Public
Companies 596
Critical Audit Matters: More Information and
Insight in the Audit Report 596
The Standard Unmodified Audit Report
for Entities Other Than Public Companies 598
Explanatory Language Added to the Standard
Unqualified/Unmodified Financial Statement Audit
Report 599
Explanatory Language to Refer to Reports of Other
Auditors 600
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Substantial Doubt about the Entity’s Ability to
Continue as a Going Concern 600
Lack of Comparability of Financial Statements
between Periods 601
Management Reports on ICFR but Audit of ICFR
Not Required 603
Circumstances in Which the Auditor Wishes to
Emphasize a Matter 604
Departures from an Unqualified/Unmodified Financial
Statement Audit Report 605
Conditions for Departure 605
Types of Financial Statement Audit Opinions 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 608
Scope Limitation 608
Statements Not in Conformity with GAAP 609
Auditor Not Independent 611
Special Reporting Issues 612
Reports on Comparative Financial
Statements 612
Different Reports on Comparative Financial
Statements 612
A Change in Report on the Prior-Period Financial
Statements 612
Report by a Predecessor Auditor 614
Other Information in Documents Containing Audited
Financial Statements 614
Special Reports Relating to Financial Statements 615
Financial Statements Prepared According to Other
Comprehensive Bases of Accounting 615
Specified Elements, Accounts, or Items of a
Financial Statement 616
Compliance Reports Related to Audited Financial
Statements 616
The First Significant Change to the Auditor’s Report
in More Than 70 Years 617
Key Terms 618
Review Questions 619
Multiple-Choice Questions 619
Problems 621
Discussion Case 625
Hands-On Cases 626
IDEA 626
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PART 7
Chapter 20
Professional Responsibilities
627
Chapter 19
Professional Conduct, Independence,
and Quality Management 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 AICPA Code of Professional Conduct:
A Comprehensive Framework for Auditors 636
Principles of Professional Conduct 637
Rules of Conduct 638
Integrity, Objectivity, and Independence 640
Integrity and Objectivity—Framework, Rule, and
Interpretations 640
Independence 641
Other Rules in the Code of Professional Conduct 653
General Standards and Accounting
Principles 653
Confidential Information 654
Fees and Other Types of Remuneration 655
Acts Discreditable 656
Advertising and Other Forms of Solicitation 656
Form of Organization and Name 657
Disciplinary Actions 657
Don’t Lose Sight of the Forest for the Trees 657
Quality Management Standards 658
The New Quality Management Paradigm 658
Managing Quality on Audit and Attestation
Engagements 659
PCAOB Inspections of Registered Public
Accounting Firms 660
Key Terms 661
Review Questions 662
Multiple-Choice Questions 663
Problems 665
Discussion Cases 667
Internet Assignment 669
Hands-On Cases 669
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Legal Liability 670
Introduction 672
Historical Perspective 672
Overview of Auditor Legal Liability 673
Common Law—Clients 675
Breach of Contract—Client Claims 675
Negligence—Client Claims 675
Fraud—Client Claims 677
Common Law—Third Parties 678
Ordinary Negligence—Third-Party Claims 678
Fraud and Gross Negligence—Third-Party Claims 684
Damages under Common Law 685
Statutory Law—Civil Liability 686
Securities Act of 1933 686
Securities Exchange Act of 1934 688
Private Securities Litigation Reform Act of 1995, the
Securities Litigation Uniform Standards Act of 1998,
and the Class Action Fairness Act of 2005 691
Sarbanes-Oxley Act of 2002 693
SEC and PCAOB Sanctions 694
Foreign Corrupt Practices Act 695
Racketeer Influenced and Corrupt Organizations
Act 696
Statutory Law—Criminal Liability 696
Academic Research Regarding Audit-Related
Litigation 698
Key Terms 699
Review Questions 699
Multiple-Choice Questions 700
Problems 703
Discussion Cases 706
Hands-On Cases 706
IDEA 706
PART 8
Assurance, Attestation, and Internal
Auditing Services 707
Chapter 21
Assurance, Attestation, and Internal Auditing
Services 708
Assurance Services 710
Types of Assurance Services
710
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Attestation Engagements 711
Types of Attestation Engagements 712
Financial Forecasts and Projections 714
Types of Prospective Financial Statements 714
Examination of Prospective Financial
Statements 715
Agreed-Upon Procedures for Prospective Financial
Statements 717
Accounting and Review Services 718
Preparation of Financial Statements 719
Compilation of Financial Statements 719
Review of Financial Statements 720
Internal Auditing 723
Internal Auditing Defined 723
The Institute of Internal Auditors 723
IIA Standards 724
Internal Auditors’ Roles 725
Interactions between Internal and External
Auditors 728
Advanced Module: An Example of An Assurance
Service—Trust Services 729
Trust Services 729
Trust Services and SOC 2®, SOC 3®, and SOC
for Cybersecurity® Reports 730
Key Terms 732
Review Questions 733
Multiple-Choice Questions 734
Problems 736
Discussion Case 738
Internet Assignments 738
Hands-On Cases 739
IDEA 739
Appendix A: Professional Judgment
Framework—Understanding and
Developing Professional Judgment in
Auditing 740
(Also visit KPMG’s University Connection website
to access related resources, including videos, minicases, instructor notes, and problems, that were
created to accompany the Deloitte/Wildman awardwinning KPMG Professional Judgment Framework
monograph, on which this module is based.)
Appendix B: Data Analytics in the
Audit 750
Index
773
Design elements: (leaves): ooyoo/Getty Images; (IDEA Data Analysis Software logo): ©CaseWare IDEA Inc.; (Practice Insight, Hands-On
Cases, and EarthWear icons): McGraw Hill.
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PART ONE
Introduction to Assurance
and Financial Statement Auditing
Mimi Ditchie Photography/Moment/Getty Images
CHAPTER 1
An Introduction to Assurance and Financial Statement Auditing
CHAPTER 2
The Financial Statement Auditing Environment
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1
CHAPTER
Mimi Ditchie Photography/Moment/Getty Images
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.
Know the basic definition of a financial statement audit.
Understand the fundamental concepts that underlie
financial statement auditing.
1-5
1-6
1-7
1-8
1-9
Understand why sampling is important in an audit.
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 how technology and audit data analytics are
changing audits in exciting ways.
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 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 1101, Audit Risk (AU-C 200)
PCAOB Auditing Standard 1105, Audit Evidence (AU-C 500)
PCAOB Auditing Standard 1201, Supervision of the Audit
Engagement (AU-C 220)
PCAOB Auditing Standard 2101, Audit Planning (AU-C 300)
PCAOB Auditing Standard 2105, Consideration of Materiality
in Planning and Performing an Audit (AU-C 320)
PCAOB Auditing Standard 2110, Identifying and Assessing
Risks of Material Misstatement (AU-C 315)
PCAOB Auditing Standard 2201, An Audit of Internal Control
Over Financial Reporting That Is Integrated with an Audit of
Financial Statements (AU-C 940)
PCAOB Auditing Standard 2301, The Auditor’s Responses to
the Risks of Material Misstatement (AU-C 330)
PCAOB Auditing Standard 2810, Evaluating Audit Results
(AU-C 450)
PCAOB Auditing Standard 3101, The Auditor’s Report on an
Audit of Financial Statements When the Auditor Expresses an
Unqualified Opinion (AU-C 700, 701)
*References to AU-C and AT-C sections reflect the clarified codification of the Auditing Standards Board (ASB) audit and assurance standards.
Where the ASB has a standard that is similar to a Public Company Accounting Oversight Board (PCAOB) standard, the AU-C reference is included
in parentheses after the PCAOB standard.
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An Introduction to Assurance
and Financial Statement Auditing
W
e welcome you to the world of auditing, and we invite you to invest
your best efforts to learn the extremely practical and useful concepts
that underlie this respected profession! These concepts will be valuable to you regardless of what you plan to do in your future career. You will learn
in this chapter that auditing consists of a set of practical conceptual tools that
help accounting professionals 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. 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 auditors can benefit greatly from
an understanding of financial statement auditing and its underlying concepts.
Learning these tools is valuable to any business decision maker.
This is a particularly exciting time to learn about auditing and to be an
auditor—the profession is in the early stages of a sea change in the way audits
are carried out. Advances such as audit data analytics and artificial intelligence
are dramatically changing the work auditors do. These changes will place a
premium not only on auditors’ ability to use technology, but also on their ability
to generate penetrating insights by exercising professional judgment. Having
a solid understanding of fundamental business, accounting, and auditing concepts will become even more important in a world of advancing technology.
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 can add
value by increasing the reliability and credibility of an entity’s financial statements:
Aliyah Menendez, 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. Menendez 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. Menendez discovered that the state’s
laws for government grants require that recipients be audited to ensure that existing funds
are being used appropriately. Ms. Menendez 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
founded five years ago by George and Jimmy Steinburker. Thanks to their hard work and the
3
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Part 1 Introduction to Assurance and Financial Statement Auditing
help of a venture capital firm, the company was now ready to go public. However, they knew that the company’s financial statements needed to be audited by a reputable public accounting firm in order to comply
with regulatory requirements and 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 will have
additional assurance that the financial statements report honestly and accurately and will
be more willing to rely on those statements. Auditors can also provide valuable assurance
for the effectiveness of an entity’s internal control. Consider the following example:
EarthWear Clothiers is a successful e-commerce retailer of high-quality clothing for outdoor
sports. 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, LLP, 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, LLP 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.
We start by helping you understand in general terms why there is a demand for auditing, a subset of the broader set of assurance services that accounting professionals can
provide. We then compare auditing to a home inspection service to provide an intuitive
understanding of the role auditing plays. Finally, we give you an overview of the financial
statement auditing process.
Tips for Learning Auditing (and How Learning
It Will Benefit You!)
LO 1-1
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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 the adequacy 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
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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.
Studying auditing isn’t like what you’ve done in your financial accounting courses. You
may have been able to do well in those classes by focusing on memorizing rules. But you’ll
do much better in your auditing course if you take a different approach. 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.
The Demand for Auditing and Assurance
LO 1-2
To put it simply, an audit is a service that provides assurance to investors, creditors, or other
stakeholders that a company is being honest about its financial information and that the
information is reliable. We will go into more detail regarding what exactly an audit is later
in the chapter. Many of the largest companies spend millions of dollars each year for the
annual audit. In view of that fact, 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. As the world
has developed and companies have become larger, the need to raise capital and expand has
increased.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
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.
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Part 1 Introduction to Assurance and Financial Statement Auditing
money in the form 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 who fulfill a stewardship function by managing the
corporation’s assets for the owners (who are sometimes referred to as principals).
Accounting and auditing play important roles in this principal–agent relationship. We’ll
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, who
runs the business day-to-day, 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. To prevent this, managers’ contracts often
include requirements for them to report regularly to owners on the quality of their work and
on how well she or he has managed the owners’ assets. Of course, a set of criteria is needed
to guide 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. The manager is in a position to manipulate the reports because
the manager is responsible for reporting on the results of his or her own actions, which the
absentee owner cannot directly observe. 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 independently 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. The auditor’s
role is to determine whether the reports prepared by the manager conform to the contract’s
provisions, adding credibility to the reports and reducing information risk, or the risk that
information circulated by a company’s management could be false or misleading. Reducing
information risk benefits both the owner and the manager by making the manager’s reports
more credible. Figure 1–1 provides an overview of this agency relationship.
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
Overview of the Principal–Agent Relationship Leading to the Demand
for Auditing
FIGURE 1–1
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 manages resources and
is accountable to principal;
produces financial reports.
Independent
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.
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. Auditing can similarly be essential in other economic relationships. For example, how can a lender prevent
owners or management from misusing borrowed funds? One common way is for the lender to
place restrictive covenants in the loan agreement. After receiving the loan, management regularly sends financial reports to show the lender that the requirements in the debt covenant are
being met. If these reports are audited, the lender’s information risk is reduced, and the lender
may be willing to lend at a lower interest rate than would otherwise be the case.
Practice
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:
INSIGHT
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.
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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 reputation for 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 other parties, such as the company’s stock owners or outside
lenders. The role of the Certified Public Accountant is discussed in more detail in Chapter 2.
An Assurance Analogy: The Case of the
House Inspector
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. 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 expertise to validate the seller’s
assertions, the buyer can 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. Before reading on, test your intuition—what characteristics would you like your inspector to possess? What characteristics would you look for
in the service provided by the inspector?
Desired Characteristics of the House Inspection Service
Now that you have identified some of the characteristics of a good inspector, which likely
include competence, honesty, and objectivity, consider the key characteristics of the service
he or she will provide. Keep in mind that some of the seller’s assertions are more important
than others. For example, is knowing whether the lights in the master bedroom are working as
important to you as knowing about whether there is dry rot in the house’s structure? Think for
a moment about how the answer to this question affects what the service should focus on and
how the inspection should be conducted. 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. Be sure to
pause for a moment to compare your thinking with ours.
Certainly home inspections and other assurance services must focus on the assertions
that are most important, and they must be conducted in a timely and cost-effective manner.
Some assertions are more important than others because of their potential risk or cost. For
example, a house inspector should recognize the signs that indicate an increased risk of a
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
Important Characteristics of House Inspectors and Inspections
TABLE 1–1
Desirable Characteristics of House Inspectors
• Competent—they possess the required training, expertise, and experience to evaluate the property for sale.
• Objective—they have no reason to side with the seller; they are independent of the seller’s influence.
• Honest—they will conduct themselves with integrity, and they will share all of their findings with the buyer.
• Skeptical—they will not simply take the seller’s assertions at face value; they will conduct their own analysis and testing.
• Responsible and/or liable—they should stand behind their assessment with a guarantee and/or be subject to litigation if they fail to act with due care.
Desirable Characteristics of a House Inspection Service
• Timely—the results of the service are reported in time to benefit the decision maker.
• Reasonably priced—the costs of the services must not exceed the benefits. For this to occur the service provider will likely need to focus attention on
the most important and risky assertions and likely can’t provide absolute assurance.
• Complete—the service addresses all of the most important and risky assertions made by the seller.
• Thorough—the service provides some degree of confidence that it will uncover any significant problems.
• Systematic and reliable—the service is based on a systematic process, and the conclusions are based on reliable evidence. In other words, another
comparable inspector would likely find similar issues and come to similar conclusions.
• Informative—the service provides a sense for how likely mechanical or structural failure is in the near future and provides an estimate of the cost to
repair known defects or failures.
leaky roof. If those signs are present, he or she should investigate further, because damage
caused by a leaky roof can be very expensive to repair. At the same time, just because the
seller asserts that he or she recently lubricated all the door and window hinges doesn’t mean it
would be wise to pay the inspector to validate this assertion.
Stop and Think: How might a house inspection be similar to a financial statement audit?
Relating the House Inspection Analogy to Financial
Statement Auditing
Now that we have discussed some of the basic characteristics of house inspectors and their
services, let’s consider how these relate to financial statement auditors. The demand for the
assurance provided by a house inspector comes from information asymmetry and conflicts of
interest between the buyer and the seller. Information asymmetry and conflicts of interest also
exist between managers of companies and potential investors. For example, if managers are
overly optimistic or if they wish to inflate their bonus compensation, they may unintentionally
or intentionally overstate the company’s earnings and assets (e.g., by understating the allowance for doubtful accounts or by claiming to have more cash than they really have).
One important difference between our house inspector example and financial statement
auditing is that the buyer of a home typically hires the inspector, presumably because if the
seller were to hire the inspector, the buyer would be less confident that the inspector is objective and independent. However, as was discussed previously, the companies selling stocks
or bonds to the public typically hire the auditor to report on the financial information that
the companies periodically share with their stock and bond holders. To raise capital in the
marketplace, companies often sell many small parcels of stocks and bonds to a large number
of investors. Suppose a financial statement audit of a given company would cost $500,000.
Under such circumstances, it obviously doesn’t make sense for each individual investor to
arrange for an audit. Instead, the company hires and pays for the auditor because a reputable
independent auditor’s opinion can provide assurance to thousands of potential investors. By
purchasing the assurance provided by an audit, the company can sell its stocks and bonds to
prospective owners and creditors at more favorable prices, significantly reducing the cost
of capital. In fact, studies indicate that audits save companies billions of dollars in costs of
obtaining capital; for example, by getting lower interest rates on loans.5
5
For example, see M. Minnis, “The Value of Financial Statement Verification in Debt Financing: Evidence from
Private U.S. Firms,” Journal of Accounting Research 49 (2011), pp. 457–506.
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Part 1 Introduction to Assurance and Financial Statement Auditing
Given that the seller of stocks and bonds typically hires the auditor, consider just how
crucial a strong reputation is to an independent auditor. Four large international accounting
firms dominate the audits of large publicly traded companies, auditing over 90 percent of the
revenue produced by all such companies in the United States. One reason these firms dominate the audits of large companies is because they have well-known names and strong reputations. Entities who buy assurance from these firms know that potential investors and creditors
will recognize the auditing firm’s name and reputation and feel assured that they will benefit
from a reduction in information risk.
When investors have reason to doubt whether an audit firm is truly objective or performs
high-quality work, the audit firm’s reputation suffers, and the value of the assurance they provide through their audit reports decreases. In fact, Arthur Andersen, the once highly regarded
member of the former “Big 5” international accounting firms, failed in 2002 at least in part
because the firm lost its reputation as a high-quality, objective auditor whose opinion could
be relied upon by investors and creditors. Later in the book we will discuss some changes
enacted over the past several years to strengthen the independence of financial statement auditors, including prohibiting auditors from providing many kinds of consulting services to their
public audit clients.
Management Assertions and Financial Statements
We’ve seen why a home buyer might want to get independent assurance about a home seller’s
assertions. But what assertions does a company make to potential investors about the stocks
or bonds it is trying to sell? Some of the most important assertions entities make to investors
are implicit in the entities’ financial statements. Immediately after this chapter you will find a
set of financial statements for EarthWear, a hypothetical seller of high-quality outdoor clothing. We’ll use EarthWear examples and exercises throughout the book to illustrate important
audit concepts and techniques. The assertions EarthWear makes to potential investors in its
published financial statements are similar to those made by any company. For example, EarthWear lists the asset account “Cash” on its balance sheet and indicates that the account’s yearend balance was $48.9 million.
Stop and Think: Consider for a moment what implicit assertions the company is
making about cash.
An obvious answer is that EarthWear’s management is asserting that the cash is really
there—that it “exists.” They are also implicitly asserting that all the cash that the company
owns is included in the records—in other words, the financial records are “complete” with
respect to the company’s cash. Finally, management is asserting that the cash amount is fairly
and accurately recorded, and that no other parties have valid claims to the cash. Assertions
such as these are implicit for each account in the financial statements.
Financial statement assertions are management’s expressed or implied claims about
information reflected in the financial statements. Assertions are central to auditing because
they are the focus of the auditor’s evidence collection efforts. In other words, much of what
auditors do revolves around collecting and evaluating evidence about management’s financial
statement assertions.
One of the main tasks of the auditor is to collect sufficient appropriate evidence that
management’s assertions regarding the financial statements are correct. If you were to audit
EarthWear, how would you go about collecting evidence for the cash account? The process is
really quite logical and intuitive. First, you would carefully consider the most important assertions the company is making about the account, and then you would decide what evidence
you would need to substantiate the truthfulness of each important assertion. For example, to
ensure the cash exists, you might examine bank statements or send a letter to the bank requesting confirmation of the balance. To ensure the cash hasn’t been pledged or restricted, you
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
might review the minutes of key management meetings to look for discussions or agreements
on this issue.
We will discuss management assertions in greater depth in Chapter 5, but it is important
that you spend some time to understand Table 1–2, which lists all of the management assertions that auditors focus on in an audit. This presentation divides management assertions
into two aspects of information reflected in the financial statements: transactions and related
disclosures, and account balances and related disclosures. For example, EarthWear’s management asserts, among other things, that ­transactions relating to inventory actually occurred,
that they are complete (i.e., no valid transactions were left out), that they are classified properly (e.g., as an asset rather than an expense), and that they are recorded accurately and in the
correct period. Similarly, management asserts that the inventory represented in the inventory
account balance exists, that the entity owns the inventory, that the balance is complete, and
that the inventory is properly valued. Understanding the assertions in terms of transactions
and account balances helps the auditor focus on the different types of audit procedures needed
to test management’s assertions in these two categories. Chapter 5 discusses the types of procedures available to the auditor in more detail.
Once you have finished auditing the important assertions relating to each account
included in the company’s financial statements, you will need to report your findings to the
company’s shareholders and to the investing public because EarthWear is publicly traded.
Now, instead of EarthWear’s auditor, imagine you are a prospective investor in EarthWear. As an investor, would the reputation of the company’s auditor matter to you? Would
you want to know that the audit firm used an appropriate, well-recognized audit approach to
gather sufficient, appropriate evidence? What if the lead partner on the audit were a close
relative of EarthWear’s president? Considering these questions makes it easy to see that the
desired characteristics of auditors and audit services are similar to those relating to house
inspectors and house inspection services.
Summary of Management Assertions by Category*
TABLE 1–2
Assertions about classes of transactions and events, and related disclosures, for the period
under audit:
• Occurrence: Transactions and events that have been recorded or disclosed have occurred, and such transactions
and events pertain to the entity.
• Completeness: All transactions and events that should have been recorded have been recorded, and all related
disclosures that should have been included in the financial statements have been included.
• Authorization: All transactions and events have been properly authorized.**
• Accuracy: Amounts and other data relating to recorded transactions and events have been recorded appropriately,
and related disclosures have been appropriately measured and described.
• Cutoff: Transactions and events have been recorded in the correct accounting period.
• Classification: Transactions and events have been recorded in the proper accounts.
• Presentation: Transactions and events are appropriately aggregated or disaggregated and clearly described, and
related disclosures are relevant and understandable in the context of the requirements of the applicable financial
reporting framework.
Assertions about account balances, and related disclosures, at the period end:
• Existence: Assets, liabilities, and equity interests exist.
• Rights and obligations: The entity holds or controls the rights to assets, and liabilities are the obligations of
the entity.
• Completeness: All assets, liabilities, and equity interests that should have been recorded have been recorded, and
all related disclosures that should have been included in the financial statements have been included.
• Accuracy, valuation, and allocation: Assets, liabilities, and equity interests have been included in the financial
statements at appropriate amounts, and any resulting valuation or allocation adjustments have been appropriately
recorded, and related disclosures have been appropriately measured and described.
• Classification: Assets, liabilities, and equity interests have been recorded in the proper accounts.
• Presentation: Assets, liabilities, and equity interests are appropriately aggregated or disaggregated and clearly
described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.
*See Table 5–2 for a reconciliation of these AICPA management assertions with the PCAOB’s list of assertions.
**International and AICPA auditing standards consider Authorization to be a subset of the Occurrence assertion and thus do not list it
separately. We list Authorization as a separate assertion about classes of transactions and events for instructional clarity.
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Part 1 Introduction to Assurance and Financial Statement Auditing
We hope the analogy of house inspectors and auditors as assurance providers has
helped you understand the basic intuition behind the necessary characteristics of auditors
and auditing and why auditing is in demand, even when it is not required by law. We will
refer back to this analogy occasionally throughout the book to remind you of this basic
intuition. As you study this book, we encourage you to consider how the concepts you are
learning relate to important characteristics of auditors and the services they offer. Keep the
big picture in mind!
Auditing, Attest, and Assurance Services Defined
LO 1-3
Accounting professionals perform various services that provide assurance about the reliability
and relevance of information given by one party to another. The broadest category of such
services is simply assurance services—independent professional services intended to help
decision makers by improving the quality or context of the information they use.
Attest services are a subset of assurance services. Attest services are assurance services
that involve reporting on an assertion or other subject matter that is the responsibility of another
party. Notice that attest services are not limited to economic events or actions. The subject
matter of attest services can take many forms, including evaluating and reporting on aspects
of prospective information, budgets, analyses, systems and processes, and even the particular
actions of specific parties. One particular, specialized kind of attest service is “auditing.”
Let’s take a moment now to more carefully define “auditing.” In general terms, auditing
involves objectively obtaining and evaluating evidence to assess another party’s assertions
that a particular set of information has been recorded and presented in accordance with a predetermined set of criteria, together with the issuance of a report that indicates the degree of
correspondence between the assertions and the criteria.6
Note that an audit involves “objectively obtaining and evaluating evidence to assess
another party’s assertions” about the way a set of information has been recorded and presented.
In other words, auditors search for audit evidence relating to assertions made by another party,
and they objectively evaluate the relevance and validity of the evidence they find in relation
to those assertions. The type and quantity of evidence varies between audits, but the process
of obtaining and evaluating evidence makes up most of an auditor’s activities on any audit.
As our analogy about a home inspection illustrates, auditors organize their evidence gathering
around relevant assertions implicit in the information one party is presenting to another; in
financial statement auditing, these are the management assertions we discussed earlier.
The auditor uses the evidence collected “to assess another party’s assertions that a particular set of information has been recorded and presented in accordance with a predetermined
set of criteria.” While different types of “criteria” are used in various kinds of audits, generally accepted accounting principles (GAAP) usually serve as the basis for evaluating management’s assertions in the context of a financial statement audit in the United States.
The last part of the definition—auditors’ communication of their conclusions to interested parties—relates to the report auditors provide to the intended users of the information
that has been audited. These reports vary depending on the type and purpose of the audit and
the nature of the auditor’s findings. In the case of a financial statement audit, very specific
types of reports are prescribed by auditing standards to communicate the auditor’s findings.
We will show you what a standard audit report relating to a company’s financial statements
looks like later in this chapter.
6
Adapted from American Accounting Association, Committee on Basic Auditing Concepts, “A Statement of Basic
Auditing Concepts” (Sarasota, FL: AAA, 1973).
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
This text focuses primarily on financial statement auditing because it represents the
major type of assurance (and attest) service offered by most public accounting firms. But keep
in mind that the approaches, concepts, methods, and techniques used for financial statement
audits are also very relevant for other attest and assurance service engagements. Chapters 2
and 21 describe examples of audit, attest, and other types of services commonly offered by
different kinds of auditors, including internal auditors.
Fundamental Concepts in Conducting a Financial
Statement Audit
LO 1-4
Figure 1–2 presents a simplified overview of the process for conducting a financial statement
audit from start to finish. Take a moment to think through the steps in this figure. The auditor gathers evidence about the business transactions that have occurred and about the account
balances into which the transactions have been accumulated. The auditor uses this evidence to
compare the assertions contained in the financial statements to the criteria required by financial
statement users in preparing them (e.g., GAAP). The auditor’s report communicates to the user
the degree of correspondence between the assertions and the criteria. Be sure you understand
Figure 1–2 before you continue reading! Taking a moment to think through these concepts will
help you make sense of the three fundamental concepts underlying a financial statement audit,
which we will explain next.
An Overview of the Financial Statement Auditing Process
FIGURE 1–2
Management
Terms of Engagement
Implements internal
controls
Conducts
transactions
Accumulates transactions
into account balances
Obtains evidence
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e
enc
d
Evi
se
As
ns
Determines overall fairness
of financial statements
on
ati
unic
m
Com
Tests management
assertions against criteria
(GAAP)
o
rti
Prepares financial
statements
Issues financial statements
to users
Auditor
Issues audit report
to accompany
financial statements
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Part 1 Introduction to Assurance and Financial Statement Auditing
The conceptual and procedural details of a financial statement audit build on three fundamental concepts: materiality, audit risk, and evidence relating to management’s financial
statement assertions. The auditor’s assessments of materiality and audit risk influence the
nature, timing, and extent of the audit evidence to be gathered. This section briefly discusses
the concepts of materiality, audit risk, and audit evidence. Chapters 3 through 5 cover each
of these concepts in greater depth, but your study of those chapters will be easier and more
effective if you take the time now to understand the concepts of materiality, audit risk, and
audit evidence at a general level.
Materiality
Materiality refers to the amount by which a set of financial statements could be misstated
without affecting the judgment of a reasonable person. For example, suppose a company’s
earnings per share (EPS) is $4.50 but due to an unintentional error the company mistakenly
reports EPS of $4.52. This very small difference is unlikely to affect an investor’s decisions
in any significant way. Thus, the auditor will likely consider the difference to be immaterial.
One of the auditor’s first tasks in planning an audit is to make a judgment about just how
big a misstatement would have to be before it would significantly affect users’ judgments.
This judgment is important because it helps determine how much work the auditor will need
to do—very small misstatements are much more difficult to find than very large ones! The
concept of materiality is important because it simply isn’t practical or cost beneficial for auditors to try to find every single misstatement in a set of financial statements, no matter how
small or insignificant.
The Financial Accounting Standards Board has provided the following definition of
materiality:
The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgement of a
reasonable person relying upon the report would have been changed or influenced by the inclusion
or correction of the item.7
The focus of this definition is on the users of the financial statements. In planning the
engagement, the auditor assesses the magnitude of a misstatement that may affect users’ decisions. This materiality assessment helps the auditor determine the nature, timing, and extent
of audit procedures used to collect audit evidence. Generally, the lower the level at which the
auditor assesses materiality, the greater the amount of evidence the auditor must gather. Let’s
relate the concept of materiality to our house inspector analogy—we would not be willing
to pay a house inspector to validate the remaining life on lightbulbs or thoroughly test every
cabinet hinge. These items are not material to the buyer’s decision.
While other factors must be considered in determining materiality, a common rule of
thumb is that total (aggregated) misstatements of more than about 5 percent of income before
tax would cause the financial statements to be materially misstated. Suppose the auditor
decides that the financial statements of a client with $8 million in pre-tax income would be
materially misstated if total misstatements exceed 5 percent of income, or $400,000. The
auditor would design audit procedures precise enough that they would be very likely to detect
misstatements that, either by themselves or in combination with other misstatements, might
exceed the materiality threshold of $400,000. When testing is complete for all accounts, the
auditor will evaluate the audit results and ask the company to adjust its financial records for
identified misstatements. The auditor will issue a clean audit opinion if the auditor’s estimate
of remaining, unadjusted misstatements in all the accounts add up to less than overall materiality of $400,000. This is why the wording of the standard auditor’s report indicates that the
7
Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 8, Chapter 3: “Qualitative
Characteristics of Useful Accounting Information.”
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
financial statements “present fairly in all material respects . . .” As we will explain in the next
section, there can be no guarantee that the auditor will uncover all material misstatements. In
fact, the auditor provides no assurance that immaterial misstatements, and only reasonable
assurance that material misstatements, will be detected.
Stop and Think: In the example in the preceding paragraph, the auditor assessed materiality at $400,000. Would the auditor have to do more work or less work if the materiality assessment were to decrease to $300,000? We will dive further into this concept
later in this chapter, under the “Sampling” heading.
Audit Risk
The second major concept involved in auditing is audit risk, which is the risk that the auditor
may mistakenly give a “clean” opinion on financial statements that are materially misstated.
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated.8
Auditing standards make it clear that an audit provides reasonable assurance that
the financial statements do not contain material misstatements. The phrase “reasonable
­assurance” implies that even when the auditor does a good job, there is some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect
it. The auditor plans and conducts the audit to achieve an acceptably low level of audit risk. The
auditor controls the level of audit risk through the effectiveness and extent of the audit work
conducted. The more effective and extensive the audit work (and thus the type and amount of
audit evidence collected), the lower the risk that a misstatement will go undetected and that the
auditor will issue an inappropriate report. But it is important to understand that the concept of
reasonable assurance means that an auditor could conduct an audit completely in accordance
with professional auditing standards and still fail to detect material misstatements. A house
inspector cannot absolutely guarantee the absence of any significant problems without inordinate cost. Similarly, due to cost constraints and the sheer impossibility of investigating every
item reflected in an entity’s financial statements, the risk that an auditor will mistakenly issue
an inappropriate opinion on materially misstated financial statements cannot be driven to zero
at reasonable cost, though it should be low. Even careful and competent auditors can only offer
reasonable, rather than absolute, assurance.
Audit Evidence Regarding Management Assertions
The third major concept involved in auditing is evidence regarding management’s assertions,
or, more simply, audit evidence. Most of the auditor’s work in arriving at an opinion on the
financial statements consists of obtaining and evaluating audit evidence relating to management’s assertions. The information gathered by the auditor to be used as audit evidence can
take different forms, including oral or visual information, as well as paper or electronic documents, and can originate from within the entity or from other outside parties.
As illustrated earlier in our discussion about EarthWear, management’s assertions are
used as a framework to guide the collection of audit evidence. The assertions, in conjunction with the assessment of materiality and audit risk, are used by the auditor to determine
the nature, timing, and extent of evidence to be gathered. Once the auditor has obtained
8
Adapted from AS 1101, Materiality in Planning and Performing an Audit, and AU-C 200, Overall Objectives of
the Independent Auditor and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards.
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Part 1 Introduction to Assurance and Financial Statement Auditing
sufficient appropriate evidence that the management assertions can be relied upon for each
significant account and disclosure, the auditor has reasonable assurance that the financial
statements are fairly presented. Note the two key descriptors of audit evidence: sufficient
and appropriate.
The sufficiency of audit evidence simply refers to the quantity of evidence the auditor
obtains—does the auditor have enough evidence to justify a conclusion as to whether management’s assertions are presented fairly? The appropriateness of audit evidence refers to the
quality of the evidence. Evidence is considered appropriate when it provides information that
is both relevant and reliable. Relevance refers to whether the evidence relates to the specific
management assertion being tested. Reliability refers to the diagnosticity of the evidence. In
other words, can a particular type of evidence be relied upon to signal the true state of the
account balance or assertion being examined? Using the house inspection example, inspecting the foundation of a house may not give us relevant evidence about whether the roof leaks.
Likewise, evidence about the roof that is obtained by standing on the ground and looking up
likely would not be as reliable as evidence obtained by climbing up on the roof or by inspecting the attic space.
Sufficiency and appropriateness of audit evidence are interrelated in that they jointly
affect the persuasiveness of audit evidence. While the auditor has a professional responsibility to obtain “sufficient appropriate evidence,” the auditor seldom has the luxury of obtaining
completely conclusive evidence about the true state of a particular management assertion.
In most situations, the auditor is able to obtain only persuasive evidence that the assertion is
presented fairly.
Sampling: Inferences Based on Limited
Observations
LO 1-5
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You might ask why the auditor relies on concepts such as materiality and audit risk in designing an audit. Why not test all account balances and all transactions that occurred during the
period so that audit risk can be driven to zero, even for immaterial misstatements? The main
reason is the cost and infeasibility of such an audit. In a very small business, the auditor might
be able to examine all transactions that occurred during the period and all the accounts that
exist at the end of the period and still issue the audit report in a reasonable amount of time.
However, it is unlikely that the owner of the business could afford to pay for such an extensive
audit. For a large organization, the sheer volume of transactions, which might well reach into
the millions, prevents the auditor from examining every transaction. Similarly, ending account
balances can reflect millions of individual items (e.g., individual inventory items making
up the ending inventory account). Thus, just as with a house inspection, there is a trade-off
between the exactness or precision of the audit and its cost.
To deal with the problem of not being able to examine every transaction and account,
the auditor selects a subset of transactions and accounts to examine. Many times the auditor, based on previous audits, understanding of the entity’s system of internal control, and
knowledge of the client’s industry, is aware of items in an account balance that are more
likely to contain misstatements. For example, the auditor’s prior knowledge may indicate that
individual accounts receivable involving certain types of customers are more likely to contain misstatements. The auditor can use this knowledge to specifically select those particular accounts receivable for examination. When the auditor has no special knowledge about
which particular transactions or items may be misstated, he or she uses random sampling
procedures that increase the likelihood of obtaining a sample that is representative of the
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
17
population of transactions or account items. In such cases, the auditor uses the laws of probability to make inferences about potential misstatements based on examining a sample of
transactions or items.
The size of the subset of items the auditor examines is primarily a function of materiality
and the desired level of assurance for the account or assertion being examined. There is an
inverse relation between sample size and materiality, and a direct relation between sample size
and desired level of assurance. For example, if an auditor assesses a small materiality amount
for an account, a larger sample will be needed than if materiality were a larger amount. This
occurs because the auditor must gather more evidence (a larger sample) to have a reasonable
likelihood of detecting smaller errors. You can think of materiality as the “fineness of the
auditor’s filter.” A lower materiality amount requires the auditor to use a finer filter in order
to detect smaller errors, and it takes more work to create a finer filter. Similarly, as the desired
level of assurance increases for a given materiality amount, the sample size necessary to test
an assertion becomes greater.
As you will see in later chapters, auditors’ increasing use of data analytics will sometimes
allow for the testing of entire populations, eliminating the need for sampling. This is especially the case where the auditor’s testing is entirely focused on electronic records that can
be accessed, prepared, and evaluated with the use of specialized audit software. However, in
cases where the auditor’s testing needs to tie auditee records to information from outside parties or to physical items, such as inventory, sampling will continue to be widely used.
The Audit Process
LO 1-6
Now that we have explained some of the fundamental concepts of auditing, let’s summarize
the logical thought processes underlying a financial statement audit and then walk through the
major phases of an audit. Be sure and take some time here—a thorough understanding of this
section will be a great help to you in understanding subsequent chapters!
Overview of the Financial Statement Auditing Process
Consider the auditor’s task from a logical perspective. The end product of an auditor’s work is
an opinion indicating whether or not the client’s financial statements are free of material misstatement. What might an auditor do to obtain the information needed to develop and support
that opinion? The auditor must first obtain a thorough understanding of the client, its business
and industry, and its information system. The auditor must understand the risks the client
faces, how it deals with those risks, and what remaining risks are most likely to result in a
material misstatement in the financial statements. Armed with this understanding, the auditor
plans procedures that will produce evidence helpful in developing and supporting his or her
opinion on the financial statements.
To understand this process intuitively, consider what financial statements are made of.
From your financial accounting courses, you know that accounting systems capture, record,
and summarize individual transactions. Entities must design and implement controls to
ensure that those transactions are initiated, captured, recorded, and summarized appropriately. These individual transactions are grouped and summarized into various account balances, and finally, financial statements are formed by organizing meaningful collections of
those account balances (e.g., current liabilities). We have just identified three stages in the
accounting process that take place in the preparation of financial statements: internal controls
are implemented to ensure that the client’s information system appropriately captures and
records individual transactions, which are then collected into ending account balances. This
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Part 1 Introduction to Assurance and Financial Statement Auditing
summary might seem like an oversimplification, but it will help you understand the stages of
a client’s accounting process on which auditors focus to collect evidence.
Keep in mind that the auditor’s job ultimately is to express an opinion on whether the
financial statements are presented fairly. It makes sense, then, that the auditor can design
procedures to collect direct information about the ending account balances that make up the
financial statements. For example, an auditor might confirm the ending balance of the cash
account by contacting the client’s bank, or the auditor might verify the ending balance of
the inventory account by physically examining individual inventory items that make up the
ending balance. But remember—account balances are made up of transactions that occurred
over the past year (or earlier). If the auditor designs procedures to test whether the transactions were captured and handled properly, the auditor can obtain indirect information about
whether the ending account balances are likely to be presented fairly. This information is
clearly one step removed from the ending account balances themselves. But we can even back
up one more step. If the auditor designs procedures to test whether the entity’s internal control over financial transactions is effective, the auditor can obtain additional indirect information regarding whether the account balances are presented fairly.
Carefully think through the logic in this last step: if controls are effective, then the transactions will probably be captured and summarized properly, which means in turn that the
account balances are likely to be free of material misstatement. Thus, information about internal control is even more indirect than information about transactions, but it is useful information nonetheless! In fact, while it is indirect, evidence about internal control is often a
relatively cost-effective form of audit evidence.
To summarize, the auditor can collect evidence in each of three different stages in a
client’s accounting system to help determine whether the financial statements are presented
fairly: (1) the system of internal control put in place by the client to ensure proper handling of
transactions (e.g., evaluate and test the controls); (2) the transactions that affect each account
balance (e.g., examine a sample of the transactions that happened during the period); and
(3) the ending account balances themselves (e.g., examine a sample of the items that make
up an ending account balance at year-end). Evidence that relates directly to ending account
balances is usually the highest-quality evidence, but it is also the costliest to obtain. Thus,
an auditor will usually rely on a combination of evidence from all three stages in forming
an audit opinion regarding the fairness of the financial statements. On which of these three
areas it is best to focus depends on the circumstances, and this is generally left to the auditor’s
discretion. Chapters 3 and 5 address the types of procedures and evidence available to the
auditor in more detail.
Major Phases of the Audit
The audit process can be broken down into a number of audit phases (see Figure 1–3). While
the figure suggests that these phases are sequential, they are actually quite iterative and interrelated in nature. Phases often include audit procedures designed for one purpose that provide
evidence for other purposes, and sometimes audit procedures accomplish purposes in more
than one phase. Figure 1–3 shows the specific chapters where each of these phases is discussed in detail.
Client Acceptance/Continuance Professional standards require that auditors establish
policies and procedures for deciding whether to accept new audit clients and to retain current clients. The purpose of such policies is to minimize the likelihood that an auditor will
be associated with clients that lack integrity. If an auditor is associated with a client that
lacks integrity, the risk increases that material misstatements may exist and not be detected
by the auditor. For a prospective new client, the auditor is required to confer with the predecessor auditor and frequently conducts background checks on top management. The knowledge that the auditor gathers during the acceptance/continuance process provides valuable
understanding of the entity and its environment, thus helping the auditor assess risk and plan
the audit.
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
19
Major Phases of an Audit
FIGURE 1–3
Client acceptance/
continuance
(Chapter 3)
Preliminary
engagement activities
(Chapter 3)
Plan the audit
(Chapters 3, 4, and 5)
Consider and audit internal
control (Chapters 6 and 7)
Audit business processes
and related accounts
(e.g., revenue generation)
(Chapters 10–16)
Complete the audit
(Chapter 17)
Evaluate results and issue
audit report (Chapters 1 and 18)
Preliminary Engagement Activities There are generally three preliminary engagement
activities: (1) determine the audit engagement team requirements, (2) ensure the independence of the audit firm and audit team, and (3) establish an understanding with the client
regarding the services to be performed and the other terms of the engagement.
Once the decision has been made to accept an audit engagement, the auditor begins
preliminary engagement activities by updating his or her understanding of the entity and
its environment. This understanding includes the nature of the entity and the industry in
which it operates, how it measures its own performance, the nature of its information system, and the quality of its internal control. The auditor’s understanding of the entity and its
environment helps in assessing the risk of material misstatement and in setting the scope of
the audit.
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Part 1 Introduction to Assurance and Financial Statement Auditing
The engagement partner or manager forms an audit team composed of members who
have the appropriate audit and industry experience for the engagement, determines whether
specialists (e.g., tax specialists) are needed, and makes sure that the audit firm and individual team members are free from prohibited relationships that might threaten the auditor’s
objectivity.
Finally, the auditor establishes an understanding with the client regarding the services to
be performed and the terms of the engagement, including such considerations as timing of the
audit and expected audit fees. Chapter 3 addresses the preliminary engagement activities of
the audit process in more detail.
Plan the Audit Proper planning is important to ensure that the audit is conducted in
an effective and efficient manner. In order to plan the audit properly, the audit team must
determine materiality and make a preliminary assessment of the client’s business risks. The
audit team relies on these judgments to then assess risk relating to the likelihood of material
misstatement in the financial statements, referred to as risk of material misstatement, or
RMM. Audit planning should take into account the auditor’s understanding of the entity’s
system of internal control (discussed next). The outcome of the auditor’s planning process
is a written audit plan that sets forth the nature, timing, and extent of the audit procedures to
be performed. You will learn about the issues that are involved in this phase of the audit in
Chapters 3, 4, and 5.
Consider and Audit Internal Control An entity’s system of internal control is put in
place by the company’s board of directors and management to help the company achieve
reliable financial reporting, effective and efficient operations, and consistent compliance
with applicable laws and regulations. The quality of an entity’s internal control over financial
reporting is of direct relevance to auditors. As part of obtaining an understanding of the entity
and its environment, the auditor obtains an understanding of internal control to help the auditor assess risk and identify areas where financial statements might be misstated. The assessment of internal control will be more thorough if the client is a public company because for
public companies, the auditor is required to report on both the company’s internal control
over financial reporting and the company’s financial statements. Chapter 6 covers the role of
internal control in a financial statement audit, and Chapter 7 specifically addresses the audit
of internal control over financial reporting for public companies. Later chapters apply the process of considering and auditing internal control in the context of various business processes.
Audit Business Processes and Related Accounts Auditors usually organize audits
by grouping financial statement accounts according to the business processes that primarily affect those accounts. For example, sales revenue and accounts receivable are both part
of a company’s sales and collection process and are audited together. The auditor applies
audit procedures to the accounts in order to obtain audit evidence about management’s assertions relating to each account and reduce the risk of undetected material misstatement to an
appropriately low level. On most engagements, actually conducting the planned audit tests
comprises most of the time spent on a financial statement audit or an audit of internal control
over financial reporting. For public company clients, the audit of internal control is done in
an integrated way with the financial statement audit. This topic is addressed in Chapter 7 and
throughout the book where appropriate.
Complete the Audit After the auditor has finished gathering audit evidence relating to
management’s financial statement assertions, the auditor assesses the sufficiency and appropriateness of the evidence and obtains additional evidence where deemed necessary. In this
phase, the auditor also addresses a number of issues, including the possibility of undisclosed
contingent liabilities, such as lawsuits, and searches for any events subsequent to the balance
sheet date that may impact the financial statements. Chapter 17 discusses the completion
phase of the audit in detail.
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
LO 1-7
21
Evaluate Results and Issue Audit Report The final phase in the audit process is to
evaluate results and choose the appropriate audit report to issue. The auditor’s report, also
known as the audit opinion, is the main product or output of the audit. Just as the report of a
house inspector communicates the inspector’s findings to a prospective buyer, the audit report
communicates the auditor’s findings to the users of the financial statements.
After completion of the audit work, the auditor determines if the preliminary assessments
of risks were appropriate in light of the evidence collected and whether sufficient evidence
was obtained. The auditor then aggregates the total known and estimated uncorrected misstatements and determines whether they cause the financial statements to be materially misstated. If the uncorrected misstatements are judged to be material, the auditor will request that
the client correct the misstatements. If the client refuses, the auditor issues an opinion that
clearly indicates that the financial statements are materially misstated and explains the nature
of the misstatement. If the uncorrected misstatements are insignificant enough that they do
not cause the financial statements to be materially misstated, or if the client is willing to correct the misstatements, the auditor issues an unqualified (i.e., “clean”) report.
The Unqualified/Unmodified Audit Report
The unqualified/unmodified audit report is by far the most common type of report.9 In
this context, unqualified/unmodified means that, because the financial statements are free of
material misstatements, the auditor does not find it necessary to qualify or modify (i.e., specify
any exceptions to) the audit opinion. This is a point that students often get confused about, so
please pause for a moment here and make sure you understand that an unqualified/unmodified
audit opinion is an opinion that the financial statements are free of material misstatement. In
other words, an unqualified/unmodified opinion is a “clean” opinion. While it is fairly common for the auditor to find misstatements needing correction, audit clients are almost always
willing to make the adjustments necessary to receive a clean opinion. Exhibit 1–1 presents an
audit report issued on EarthWear Clothier’s financial statements. This report covers financial
statements that include balance sheets for two years and statements of income, stockholders’
equity, and cash flows for three years. The audit report presented in Exhibit 1–1 is the standard type of unqualified audit opinion issued for publicly traded companies.
Take a moment to read through the report and see if you can find all the bulleted items,
below. You will see that the title refers to the “Independent Registered Public Accounting
Firm” issuing the audit report. The report is addressed to the shareholders and the board of
directors.
The body of the report begins with a section titled “Opinion on the Financial Statements”
indicating the name of the company being audited, the financial statements covered by the
report, and the auditor’s opinion concerning the fairness of financial statements. Note the
phrase “present fairly . . . in conformity with U.S. generally accepted accounting principles,”
indicating the criteria against which the auditor assesses management assertions. Also, note
that the opinion section contains the phrase “in all material respects,” emphasizing that the
auditor is only responsible for detecting misstatements that are large enough to affect the decisions of a reasonable user of the financial statements.
For a public company audit, the auditor is also responsible to report on the company’s
internal control over financial reporting (ICFR). You will learn about the audit of ICFR in
detail in Chapter 7. The report on ICFR can be combined with the financial statement audit
report or it can be presented separately. When the auditor’s opinion on a public company’s
financial statements is presented separately from the auditor’s report on the client’s internal
control over financial reporting, as is the case in Exhibit 1–1, the report must indicate the
auditor’s opinion on the audit of internal control in an explanatory paragraph immediately
following the opinion on the financial statements.
The second section, titled “Basis for Opinion,” communicates to the users, in very general terms, what an audit entails. This section starts by stating that the financial statements
9
A “clean” audit report is referred to as “unqualifed” by PCAOB auditing standards and as “unmodified” by AICPA
and international auditing standards. See Chapters 2 and 18.
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Part 1 Introduction to Assurance and Financial Statement Auditing
The Auditor’s Standard Unqualified Report–Comparative Financial
Statements (with explanatory paragraph)
EXHIBIT 1–1
Report of Independent Registered Public Accounting Firm
To the shareholders and the board of directors of EarthWear Company
Opinion on the Financial Statements
We have audited the consolidated balance sheets of EarthWear Clothiers (the “Company”) as of December 31, 2021 and 2020, and the related
consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2021, and
the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects,
the financial position of the Company as of December 31, 2021 and 2020, and the results of its operations and its cash flows for each of the three years
in the period ended December 31, 2021, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the PCAOB, EarthWear Clothier’s internal control over financial reporting as of December
31, 2021, based on the criteria established in Internal Control—Integrated Framework, issued in 2013 by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO). Our report on EarthWear’s internal control over financial reporting, dated February 15, 2022, expresses an
unqualified opinion.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial
statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States)
(“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules
and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included
performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing
procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in
the financial statements. Our audits also included evaluating accounting principles used and significant estimates made by management, as well as
evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or
required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and
(2) involved especially challenging, subjective, or complex audit judgments. The communication of critical audit matters does not alter in any way our
opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing separate opinions on
the critical audit matter or on the accounts or disclosures to which it relates.
Critical Audit Matter
IT systems and controls
We place a high level of reliance on the Company’s IT systems and key
internal controls. As a result, a significant proportion of our audit effort
was conducted in this area at local, regional, and international levels and
at the company’s shared service centers. Our focus was on understanding and validating the impacts of key changes being made to the control
environment.
As indicated in EarthWear’s financial statement disclosures, the Company
has continued to devote considerable resources to the development of
key business and related IT controls to ensure a robust system of internal control.
Auditor Response
We conducted detailed end-to-end walkthroughs of the finance processes, utilizing our understanding from the prior year to reassess
the design effectiveness of the key internal controls and to identify
changes.
We then conducted testing of the operating effectiveness of these controls to obtain evidence that they operated throughout the year.
In response to the changes and control enhancements made during
the year, we performed the following:
•
•
•
•
reviewed the design of the standard controls to ensure they mitigated the relevant financial reporting risks and tested samples
from the periods immediately prior to and post implementation;
where systems changed during the year, tested IT general controls and data migration processes;
tested the enhanced user access management controls; and
tested controls relating to and performed additional substantive
procedures on key general ledger account reconciliations and
manual journals.
Willis & Adams
Willis & Adams, LLP
We have served as the Company’s auditor since 1975.
Boise, Idaho
February 15, 2022
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
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are the responsibility of management and that the auditor has a responsibility to express an
opinion. In addition to indicating that the audit was conducted in accordance with applicable
auditing standards by an independent public accounting firm registered with the PCAOB,
it emphasizes the fact that the audit provides only reasonable assurance that the financial
statements contain no material misstatements, whether due to error or fraud. The second
paragraph in this section is sometimes referred to as the scope paragraph. This paragraph
discloses that an audit involves a performance of procedures to assess and respond to risks
of material misstatement, an examination of evidence on a test basis (i.e., at least sometimes
based on samples rather than examining entire populations), an assessment of accounting
principles and significant estimates, and an overall evaluation of financial statement presentation. Note that the scope paragraph also indicates the standards under which the audit was
conducted—in this case the standards of the PCAOB, because EarthWear is a publicly traded
company. Audit reports for nonpublic companies refer instead to “generally accepted auditing
standards.” Finally, this section of the report expresses the auditor’s judgment that the audit
provides a reasonable basis for the opinion expressed in the first section of the report.
The third section, titled “Critical Audit Matters,” identifies matters arising from the
audit that involve especially challenging, subjective, or complex auditor judgment, and how
the auditor responded to those matters. As noted in the start of the section, only matters that
are communicated to the audit committee are included in this section. Note the repeated use
of the phrase “material to the financial statements,” reemphasizing the concept of materiality as it relates to auditor responsibility. Each critical audit matter is described, including the
considerations that led to the matter’s identification, as well as how each critical audit matter
was addressed in the audit. Public company audit reports are required to include critical audit
matters (sometimes referred to as CAMs).10
The financial statement audit report concludes with the signature of the CPA firm providing the audit, a statement containing the year the auditor began serving as the company’s
auditor, the city and state in which the report was issued, and the date of the report.
Other Types of Audit Reports
For an audit report to be unqualified, the audit must be done in accordance with applicable
standards (e.g., the standards of the PCAOB for public company audits), the auditor must be
independent, there must be no significant limitations imposed on the auditor’s procedures,
and the client’s financial statements must be free of material departures from GAAP, whether
from error or fraud. If any one of these conditions is not met, the auditor issues a report that
appropriately conveys to the reader the nature of the report and the reasons why the report is
not unqualified.
For example, suppose a client’s financial statements contain a misstatement that the auditor considers material and the client refuses to correct the misstatement. The auditor will
likely qualify the report, explaining that the financial statements are presented fairly except
for the misstatement identified by the auditor. If the misstatement is considered so material
that it pervasively affects the interpretation of the financial statements, the auditor will issue
an adverse opinion, indicating that the financial statements are not presented fairly and should
not be relied upon.
Other types of reports are available to the auditor as well, depending on the circumstances. For example, if the auditor is unable to obtain all the necessary information to conclude whether a particular account is presented fairly (a “scope limitation”), the auditor will
qualify the report, indicating that the financial statements are presented fairly except for the
fact that the auditor was unable to obtain sufficient appropriate evidence about the particular account. If the scope limitation is so pervasive that it limits the ability of the auditor to
conclude on the financial statements as a whole (e.g., the client’s financial records were all
10
Audit reports for non-public entities may include “Key Audit Matters” or KAMs, which are conceptually similar
to the CAMs that are required for public company audit reports. However, non-public entity audit reports are not
required to include KAMs unless the auditor is specifically engaged to assess them.
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Part 1 Introduction to Assurance and Financial Statement Auditing
destroyed in a fire), the auditor will issue a “disclaimer of opinion,” indicating that it is not
possible to express an opinion on the fairness of the financial statements.
The audit report represents the culmination of the audit process and is the way the auditor
communicates his or her opinion about a client’s financial statements with outside parties. For
now, just focus on the basic components of the audit report. We’ll cover the different types
of financial statement audit reports in detail in Chapter 18. Our experience is that while it is
helpful to get an idea of what an audit report looks like early on, students find it more intuitive to learn the fundamental concepts of auditing and how an audit is conducted before being
immersed in the details of audit reporting.
Audit Data Analytics
LO 1-8
Practice
A report by PwC titled “2021 AI Predictions” gives some insight into likely practical implications of
rapidly advancing accounting and auditing technology. The report indicates that while accounting
and auditing jobs may change as AI use becomes more prevalent, these jobs won’t go away. For
example, PwC financial statement auditors are using AI-driven technologies to audit cash by taking
over the tedious task of identifying and organizing relevant data from client bank statements, leaving
more time for auditors to analyze data and information and exercise professional judgment.
As a result, PwC predicts, fundamental skills including skepticism, judgment, analytical abilities, as well as auditors’ knowledge of business, technical accounting, and fundamental auditing
concepts, will become even more vital. PwC believes that AI is unlikely to be able to replace these
higher-level skills and abilities in the foreseeable future.
INSIGHT
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As we mentioned earlier in this chapter, many audit processes are being transformed by the
use of audit data analytics and other emerging audit technologies. These are exciting developments as technology eventually will automate much of the more tedious work that auditors
have traditionally done, leaving more time for them to better understand the businesses they
are auditing and the underlying risks related to financial reporting. Emerging audit technologies, including audit data analytics, promise to make audit associates’ work more interesting
and challenging, and have the potential to dramatically enhance the effectiveness and the
value of the external audit. A whole host of technologies are emerging that promise to have
dramatic effects on business and on the financial statement audit, including robotic process
automation, distributed blockchain databases, and artificial intelligence; you will need to stay
up to date on these more advanced technologies as their uses and implications emerge in the
coming years. Because audit data analytics is already reshaping the audit, we aim to give you
a solid foundation in understanding and applying this aspect of emerging audit technology in
this book.
This section gives a very brief overview of what audit data analytics is, and how technology promises to reshape what auditors do and how they do it. Appendix B at the back of this
book covers audit data analytics in greater detail. In addition to Appendix B, several chapters
provide specific examples of how audit data analytics are being applied to show you how that
technology continues to shape the way audit work is done. Several chapters also have handson cases that use data analysis techniques such as data visualization using Tableau®. This section will provide you the basic understanding you need to take advantage of the data analytics
discussions throughout this text.
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Audit Data Analytics (ADA)
The unprecedented improvements in computer-based analytics are fundamentally changing
the way audits are being conducted. Computerization and cognitive technologies are allowing
for greater precision, higher-quality information, and more in-depth analysis in audits. Audit
data analytics, which is a key part of these emerging audit technologies, can be defined as
follows:
Audit data analytics is using analysis, modeling, and visualization to discover and analyze patterns, anomalies, and other information in data in the context of the audit.
This definition alludes to some significant changes in the audit process. First, the methods
auditors use to assess risk and gather evidence are becoming much more heavily dependent on
“analysis, modeling, and visualization” of large sets of data. Digital automation is allowing
auditors to analyze and understand enormous sets of information instead of relying solely on
samples to extrapolate the effectiveness of accounting processes and the accuracy of account
balances. Predictive audit data analytics also work to combine firm, industry, and market
data to provide auditors a deeper understanding of business risks and enhanced expectations
of what account balances ought to be, making it easier for auditors to identify numbers that
might be off. In terms of visualization, data can be presented to users of financial statements,
management, and the audit team in ways that match their various needs and interests, including helping auditors spot patterns that don’t match up with their knowledge of the client’s
business. Data analytics is also rapidly redefining the concepts of discovering and analyzing
“patterns” and “anomalies” in an audit.
When applying data analytics to the audit process, the AICPA recommends a five-step
process to plan, perform, and evaluate results: (1) plan the ADA, (2) access and prepare
the data to be used in the ADA, (3) consider the relevance and reliability of the data used,
(4) perform the ADA, and (5) evaluate and interpret the results of the ADA. A thorough
discussion of each of these steps is provided in Appendix B, and examples of how to apply
ADAs are found throughout the book, with additional online resources as assigned by your
instructor.
Financial Technologies
The ability for auditors to better organize and analyze information using data analytics is
facilitated by rapid advances in electronic technologies used by many businesses. Paper files
and hard-copy documents are quickly being replaced with digital files on cloud-based servers, especially among larger companies. Robotic process automation (RPA) is also gaining broader acceptance as a way to automate mundane, repetitive tasks, thereby freeing up
accountants and auditors to spend time on more value-adding services. Auditors must understand risks associated with the cloud-based and increasingly automated IT infrastructure in
today’s rapidly changing digital environment. At the same time, with greater use of emerging
technologies, audit trails can be created automatically.
Among other technologies, blockchain represents the potential to resolve many issues
surrounding the growing use of digital data. Blockchain allows for the use of decentralized,
distributed digital ledgers that record economic transactions. This technology allows for
enhanced transparency of transactions, increased operating efficiency, and greater reliability
of data and data trails. Blockchain technologies eventually may very well lead to important
changes in the business world, including financial statement auditing.
Technology and Professional Judgment
You will not need to be an expert in technology and computer programming to be successful
in your career as a financial statement auditor, but you will need to be comfortable using a
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Part 1 Introduction to Assurance and Financial Statement Auditing
variety of software tools and you will need to develop a practical knowledge of how to use
audit data analytics to query, organize, and interpret information. The good news is that audit
data analytics will increasingly streamline the more tedious, mundane tasks that audit associates have traditionally carried out. At the same time, increased use of technology will make
it more and more important for audit professionals to be able to reason through challenging
business, accounting, and auditing concepts, not less! Increasing use of audit data analytics
places an even greater premium on auditors’ ability to ask the right questions and to insightfully evaluate the answers yielded by the data. Such reasoning requires a solid understanding
of the toolkit of fundamental auditing concepts we will share with you throughout this book.
Conclusion
LO 1-9
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You can see from this chapter that a good financial statement auditor needs to understand
not only accounting but also the concepts and techniques of gathering and evaluating evidence to assess management’s financial statement assertions. In addition, an auditor needs
a deep understanding of business in general as well as of technology and the specific industries in which his or her clients operate. This is why professionals with auditing experience
frequently have attractive opportunities to move into other areas of business and management. Chief executive officers, business owners, chief financial officers, consultants, and
controllers are often former auditors.
This chapter is designed to help you develop an intuitive understanding of basic auditing
concepts. As you study auditing, you will need to commit some details to memory. But we
can’t emphasize this enough: you will understand and appreciate the details of the auditing
process much more fully if you make a serious effort to understand at an intuitive, commonsense level why financial statement auditing is in demand, the fundamental concepts and
logic underlying an audit, and the basic process by which it is carried out.
Keep in mind that auditing is a fundamentally logical process of thinking and
­reasoning—don’t be hesitant to exercise your common sense and reasoning skills! You will
benefit much more from your reading of this text (and likely do better on exams) if you
study it with a reasoning, inquisitive approach, rather than merely attempting to memorize
details. As you learn new auditing concepts, take some time to understand the underlying
logic and how the concepts interrelate with other concepts. As you learn about auditing procedures, ask yourself how and why the procedure might yield relevant evidence, and think
of other ways you might obtain useful evidence. Rote memorization alone is not a good way
to study auditing!
Being a good auditor sometimes requires imagination and innovation. For example, a
few years back an auditor was faced with figuring out how to verify a client’s assertion
regarding the existence of inventory. The problem was that the “inventory” consisted of
­thousands of head of cattle on a ranch covering dozens of square miles. There was no standard procedure manual for the auditor to refer to—he simply had to figure out an effective
and efficient way to obtain persuasive evidence that the cattle existed in the numbers asserted
by the ranch’s management.
In the end, the auditor decided to fly a drone over the ranch and systematically take
photos to obtain a count of the cattle. He also evaluated veterinary records to see if the number of required annual vaccinations delivered by the vet approximated the number of cattle
counted in the photos. Finally, he did some calculations based on average bovine birth and
death rates, taking into account recorded purchases and sales of livestock during the year.
Using this combination of procedures, the auditor was able to obtain persuasive evidence supporting management’s assertion regarding inventory.
We hope this example helps illustrate that auditing is much more than memorizing rules,
techniques, or procedures and is really more about analysis and problem-solving. This is
why you will need to approach the study of auditing differently from most other accounting
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
27
courses. We can promise you this—in learning the concepts and techniques of auditing, you
will not only acquire the tools to become an effective financial statement auditor, you will also
learn new ways of reasoning and analyzing that will be highly useful to you in many different
contexts and settings.
KEY TERMS
Assertions. Representations, explicit or otherwise, with respect to the recognition, measurement, presentation, and disclosure of information in the financial statements, which are inherent in management, representing that the financial statements are prepared in accordance with
the applicable financial reporting framework. Assertions are used by the auditor to consider
the different types of potential misstatements that may occur when identifying, assessing, and
responding to the risks of material misstatement.
Assurance services. Independent professional services that improve the quality of information,
or its context, for decision makers. Encompasses attest services and financial statement audits.
Attest services. Services provided by a practitioner engaged to issue a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. Encompasses financial statement audits.
Audit data analytics. Using analysis, modeling, and visualization to discover and analyze
patterns, anomalies, and other information in data in the context of the audit.
Audit evidence. All the information used by the auditor in arriving at the conclusions on
which the audit opinion is based. Audit evidence is information to which audit procedures
have been applied and consists of information that corroborates or contradicts assertions in
the financial statements.
Audit risk. The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.
Auditing. A systematic process of (1) objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence
between those assertions and established criteria and (2) communicating the results to interested users.
Information asymmetry. The concept that the manager generally has more information
about the true financial position and results of operations of the entity than the absentee
owner does.
Information risk. The risk that information circulated by a company’s management could be
false or misleading.
Materiality. The maximum amount by which the auditor believes the financial statements
could be misstated and still not affect the decisions of users.
Misstatement. A departure from the applicable reporting framework (e.g., GAAP) that, if
material, causes the financial statements to not be presented fairly. Misstatements may be
classified as fraud (intentional), other illegal acts such as noncompliance with laws and regulations (intentional or unintentional), and errors (unintentional).
Reasonable assurance. The concept that an audit done in accordance with auditing standards
may fail to detect a material misstatement in a client’s financial statements. In an auditing
context this term has been defined to mean a high but not absolute level of assurance.
Reporting. The end product of the auditor’s work, indicating the auditing standards followed
and expressing an opinion as to whether an entity’s financial statements are fairly presented in
accordance with agreed-upon criteria (e.g., GAAP).
Risk of material misstatement (RMM). The risk that the financial statements are materially
misstated prior to the audit.
Unqualified/unmodified audit report. A “clean” audit report, indicating the auditor’s opinion that a client’s financial statements are fairly presented in accordance with agreed-upon
criteria (e.g., GAAP).
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Part 1 Introduction to Assurance and Financial Statement Auditing
Additional Student
Resources
Visit Connect for additional student resources that will allow you to assess your understanding of
chapter concepts.
REVIEW QUESTIONS
LO 1-1
1-1
LO 1-2
1-2
LO 1-2
1-3
LO 1-2
1-4
LO 1-3
LO 1-3
LO 1-4
1-5
1-6
1-7
LO 1-6
LO 1-6
LO 1-7
1-8
1-9
1-10
LO 1-8
1-11
LO 1-9
1-12
Why is studying auditing different from studying other accounting topics? How
might understanding auditing concepts prove useful for consultants, business managers, and other business decision makers?
Discuss why there is a demand for auditing services in a free-market economy. What
evidence suggests that auditing would be demanded even if it were not required by
government regulation?
What is meant by the statement “The agency relationship between absentee owners
and managers produces a natural conflict of interest”?
Why is independence such an important requirement for auditors? How does independence relate to the agency relationship between owners and managers?
Define auditing, attest, and assurance services.
How does auditing relate to assurance and attest services?
Define audit risk and materiality. How are these concepts reflected in the auditor’s
report?
What are the major phases of an audit?
What are the primary elements involved in the planning phase of an audit?
Identify the three main sections of the auditor’s standard unqualified report for a
public company.
Discuss why the emergence of advanced audit technologies, such as audit data analytics,
is placing an even greater premium on auditors’ knowledge of fundamental business,
accounting, and auditing concepts, and on their ability to exercise professional judgment.
Briefly discuss why auditors must often exercise creativity and innovation in auditing financial statements. Give an example different from the one offered in the chapter’s conclusion.
MULTIPLE-CHOICE QUESTIONS
All applicable questions are available with Connect.
®
LO 1-2, 1-3
1-13
An independent audit adds value to the communication of financial information
because the audit
a. Confirms the exact accuracy of management’s financial representations.
b. Lends credibility to the financial statements.
c. Guarantees that financial data are fairly presented.
d. Assures the readers of financial statements that any fraudulent activity has been
corrected.
LO 1-2, 1-3
1-14
Which of the following best describes the reason why an independent auditor is often
retained to report on financial statements?
a. Management fraud may exist, and it is more likely to be detected by independent
auditors than by internal auditors.
b. Different interests may exist between the entity preparing the statements and the
persons using the statements, and thus outside assurance is needed to enhance the
credibility of the statements.
c. A misstatement of account balances may exist, and all misstatements are generally corrected as a result of the independent auditor’s work.
d. An entity may have a poorly designed internal control system.
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing
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LO 1-3
1-15
Which of the following best describes relationships among auditing, attest, and
assurance services?
a. Attest is a type of auditing service.
b. Auditing and attest services represent two distinctly different types of services—
there is no overlap.
c. Auditing is a type of assurance service.
d. Assurance is a type of attest service.
LO 1-3
1-16
Which of the following statements relating to attest and assurance services is not correct?
a. Independence is an important attribute of assurance service providers.
b. Assurance services can be performed to improve the quality or context of information for decision makers.
c. Financial statement auditing is a form of attest service but it is not an assurance
service.
d. In performing an attest service, the CPA determines the correspondence of the
subject matter (or an assertion about the subject matter) against criteria that are
suitable and available to users.
LO 1-4, 1-6
1-17
For what primary purpose does the auditor obtain an understanding of the entity and
its environment?
a. To determine the audit fee.
b. To decide which facts about the entity to include in the audit report.
c. To plan the audit and determine the nature, timing, and extent of audit procedures
to be performed.
d. To limit audit risk to an appropriately high level.
LO 1-4, 1-5
1-18
Which of the following statements best describes how materiality is related to audit
evidence in a financial statement audit?
a. Materiality refers to the “material” from which audit evidence is developed.
b. The higher the level at which the auditor assesses materiality, the greater the
amount of evidence the auditor must gather.
c. The lower the level at which the auditor assesses materiality, the greater the
amount of evidence the auditor must gather.
d. The level of materiality has no bearing on the amount of evidence the auditor
must gather.
LO 1-6
1-19
Which of the following is the most important reason for an auditor to gain an understanding of an audit client’s system of internal control over financial reporting?
a. Understanding a client’s system of internal control can help the auditor assess risk
and identify areas where financial statement misstatements might be more likely.
b. Understanding a client’s system of internal control can help the auditor make
valuable recommendations to management at the end of the engagement.
c. Understanding a client’s system of internal control can help the auditor sell consulting services to the client.
d. Understanding a client’s system of internal control is not a required part of the
audit process.
LO 1-6
1-20
Preliminary engagement activities include
a. Understanding the client and the client’s industry.
b. Determining audit engagement team requirements.
c. Ensuring the independence of the audit team and audit firm.
d. All of the above.
LO 1-7
1-21
Which of the following statements best describes what is meant by an unqualified
audit opinion?
a. An unqualified auditor’s opinion indicates that in the auditor’s opinion the client’s
financial statements are not fairly enough presented in accordance with agreedupon criteria to qualify for a clean opinion.
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Part 1 Introduction to Assurance and Financial Statement Auditing
b. An unqualified auditor’s opinion indicates that the auditor is not qualified to
express an opinion that the client’s financial statements are fairly presented in
accordance with agreed-upon criteria.
c. An unqualified auditor’s opinion indicates that the auditor is expressing different
opinions on each of the basic financial statements regarding whether the client’s
financial statements are fairly presented in accordance with agreed-upon criteria.
d. An unqualified auditor’s opinion indicates that in the auditor’s opinion the client’s
financial statements are fairly presented in accordance with agreed-upon criteria,
with no need for the inclusion of qualifying phrases.
LO 1-7
1-22
LO 1-7
1-23 A client has used an inappropriate method of accounting for its pension liability on the
balance sheet. The resulting misstatement is material, but the auditor does not consider
its effect to be pervasive. The auditor is unable to convince the client to alter its accounting treatment. The rest of the financial statements are presented fairly in the auditor’s
opinion. Which kind of audit report should the auditor issue under these circumstances?
a. Standard unqualified opinion.
b. Qualified opinion due to departure from GAAP.
c. Adverse opinion.
d. No opinion at all.
The auditing standards that are used to guide the conduct of the audit are
a. Implicitly referred to in the critical audit matters section of the auditor’s standard
report.
b. Explicitly referred to in the critical audit matters section of the auditor’s
standard report.
c. Implicitly referred to in the basis for opinion section of the auditor’s
standard report.
d. Explicitly referred to in the basis for opinion section of the auditor’s standard report.
e. Implicitly referred to in the opinion section of the auditor’s standard report.
f. Explicitly referred to in the opinion section of the auditor’s standard report.
PROBLEMS
All applicable problems are available with Connect.
LO 1-2
1-24
®
Greenbloom Garden Centers is a small, privately held corporation that has two stores
in Orlando, Florida. The Greenbloom family owns 100 percent of the company’s stock,
and family members manage the operations. Sales at the company’s stores have been
growing rapidly, and there appears to be a market for the company’s sales concept—
providing bulk garden equipment and supplies at low prices. The controller prepares
the company’s financial statements, which are not audited. The company has no debt
but is considering expanding to other cities in Florida. Such expansion may require
long-term borrowings and is likely to reduce the family’s day-to-day involvement in all
of the company’s operations. The family does not intend to sell stock in the company.
Required:
Discuss the factors that may make an audit necessary and potentially valuable for the
company. Be sure to consider the concept of information risk.
LO 1-2, 1-3, 1-4
mes00671_ch01_001-032.indd
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1-25
You were recently hired by the CPA firm Honson & Hansen. Before you start working, the firm requires that you participate in the first-year staff training course. The
instructor asks you to prepare answers for the following questions:
a. How is audit evidence defined?
b. How is the collection of audit evidence related to management assertions?
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31
c. What are the two key characteristics of audit evidence that an auditor must consider when evaluating the quality of the evidence? Describe the meaning of each
of these characteristics in the context of auditing.
LO 1-6
1-26
Young Company has a 7 percent annual interest rate on its bank loan which the
company is in the process of repaying. The loan currently has a principal balance
of $15 million. Young Company provides financial statements to the bank in order
to meet the bank’s loan requirements. Young prepares its financial statements with
some help from a local CPA, who provides advice in preparing journal entries and
closing the books. Young Company approached several other banks and found two
that were willing to offer loans at competitive rates. Country Valley Bank offers
a 6 percent annual interest rate for small businesses that involve a CPA in helping
prepare their financial statements. Community Bank offers a 4.5 percent rate on its
loan but would require that Young Company have its financial statements separately
audited by an independent CPA firm each year to get that lower rate. Young Company
reached out to a local CPA firm and received an estimate of $145,000 annually to
provide an independent audit opinion on Young’s financial statements each year.
a. Using your understanding of the steps in the audit process described in Chapter 1,
describe why Community Bank is willing to offer a lower interest rate to Young
Company if it receives an audit of its financial statements.
b. Calculate the annual costs of the loan for Young Company under each loan scenario. Be sure to include the costs of interest and of hiring the CPA or CPA firm.
Use these analyses to justify your recommendation as to whether Young Company should keep its current loan or accept one of the new loan offers.
c. Assume Young Company accepts the loan offer from Community Bank and hires
a CPA firm to perform a financial statement audit. As part of auditing Young’s
financial statements, an audit requires that the auditor obtain an understanding
of the entity’s internal control over financial reporting. Why might Community
Bank be interested in the work conducted by auditors in this phase of the audit?
d. Now assume Young Company does not have an option to refinance its loan, given
its agreement with its current bank. Is there any reason Young Company might
still choose to have its financial statements audited by a CPA firm?
LO 1-7
1-27
Many companies post their financial statements and auditor’s report on their home
pages, generally under a heading labeled “investor relations.” Use one of the Internet
search engines to do the following:
a. Visit apple’s (www.apple.com) and Microsoft’s (www.microsoft.com) home
pages and review their financial statements, including their auditors’ reports.
(Hint: Look for the auditor’s opinion in the company’s annual report under an
“investor relations” or “investors” tab.)
b. Search the web for the home page of a non-U.S. company and review its financial
statements, including its auditor’s report. For example, BMW’s website (www
.bmwgroup.com, under Investor Relations) allows a visitor to download the annual
report, which includes the financial statements and accompanying audit report as
a .pdf file. Identify the auditing standards followed by the company’s auditors.
c. Compare the standard U.S. audit report with the audit report for the non-U.S.
company (e.g., BMW). Note that in some cases, non-U.S.-based companies’
reports use a U.S. audit report.
d. Visit the SEC’s website (www.sec.gov), and find the link for Edgar Search tools.
Find, download, and print the auditor’s report for a U.S. company of your choice.
Identify whether or not the audit report is an unqualified, or “clean,” opinion and
explain how you could tell.
LO 1-7
1-28
Using the audit report included in Chapter 1, identify and briefly explain the phrases
or words that indicate to the users that the financial statements are not necessarily an
“exact” representation of the results of operations and financial position of a company.
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Part 1 Introduction to Assurance and Financial Statement Auditing
DISCUSSION CASE
LO 1-1, 1-2
1-29
You recently attended your five-year college reunion. At the main reception, you
encountered an old friend, Dashawn Beagle, who recently graduated from law school
and is now practicing with a large law firm in town. When you told him that you are
a CPA and employed by a regional CPA firm, he made the following statement:
“You know, if the securities acts had not been passed by Congress in the 1930s, no
one would be interested in having an audit performed.”
Required:
Draft a one-page memo that highlights your thoughts about Dashawn’s statement
that audits only take place because they are required by law.
INTERNET ASSIGNMENT
LO 1-1, 1-9
1-30
Identify and search the websites of five organizations that provide accounting or
auditing resources. For each side identified, prepare a brief summary of the information that is available. For example, the PCAOB’s home page (www.pcaobus.org)
contains extensive information on the organization’s activities (you may use the
PCAOB site as one of the five). Your five summaries should not exceed a total of
one typed page.
HANDS-ON CASES
EarthWear Introduction
In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis &
Adams, LLP. This introductory activity also provides an opportunity to become familiar with the structure
and format of the EarthWear Online cases.
EarthWear Online
Visit Connect’s additional student resources to find a detailed description of the case and to download
required materials.
Additional Student
Resources
Visit Connect for author-created problem material to be completed using IDEA software.
TABLEAU
Additional Student
Resources
Visit Connect for author-created problem material to be completed using Tableau software.
Design elements: (leaves): ooyoo/Getty Images; (IDEA Data Analysis Software logo): ©CaseWare IDEA Inc.;
(Practice Insight, Hands-On Cases, and EarthWear icons): McGraw Hill.
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