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AUDITING
AND ASSURANCE
SERVICES
AN INTEGRATED APPROACH
EIGHTEENTH EDITION
ALVIN A. ARENS
Former PricewaterhouseCoopers
Emeritus Professor
Michigan State University
RANDAL J. ELDER
The University of North Carolina at Greensboro
FORVIS Professor and Department Head
MARK S. BEASLEY
North Carolina State University
KPMG Professor of Accounting and Director, Enterprise Risk
Management Initiative
CHRIS E. HOGAN
Michigan State University
Russell E. Palmer Endowed Professor
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1
PART
THE AUDITING
PROFESSION
Chapters 1–5
T
hese first five chapters in PART 1 provide background
for performing financial audits, which is our primary
focus. This background will help you understand why
auditors perform audits the way they do.
●
Chapters 1 and 2 describe assurance services,
including auditing and the role of certified public
accounting (CPA) firms and other organizations in
performing audits of financial statements and other
information.
●
Chapter 3 provides a detailed discussion of audit
reports, which are the final products of audits.
●
Chapters 4 and 5 emphasize the regulation and
oversight of CPA firms through ethical standards
and the legal responsibilities of auditors.
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1
CHAPTER
THE DEMAND FOR
AUDIT AND OTHER
ASSURANCE SERVICES
LEARNING OBJECTIVES
Brown Goes Green
After studying this chapter, you
should be able to
United Parcel Service (UPS) is one of the largest shipment and logistics companies in the world,
delivering more than 24 million packages a day in more than 220 countries. At the peak of the
holiday season, UPS delivers over 30 million packages daily. That’s a lot of packages moved by
planes and delivery trucks, and it obviously comes with a large carbon footprint. The UPS company nickname is “Brown” because of the company’s brown delivery trucks and uniforms, but
that does not capture the company’s commitment to sustainability.
1-1
1-2
1-3
1-4
1-5
1-6
1-7
1-8
Describe auditing.
Distinguish between
auditing and accounting.
Explain the importance
of auditing in reducing
information risk.
List the causes of information
risk, and explain how this
risk can be reduced.
Describe assurance services
and distinguish audit services
from other assurance and
nonassurance services
provided by CPAs.
Differentiate the three
main types of audits.
Identify the primary
types of auditors.
Describe the requirements
for becoming a CPA.
As a global transportation and logistics company, UPS is aware that greenhouse gas emissions create a serious challenge to the environment and economy. The company established aggressive goals,
including achieving carbon neutrality by 2050.
To accomplish this goal,
the company has committed to an increase
in the use of alternative
fuels to 40 percent of
its total ground fuel use
by 2025, and by 2035 to
use 30 percent sustainable aviation fuel, reduce
carbon dioxide emissions
per small package delivered by 50 percent, and
use 100 percent renewable electricity in its facilities. These goals build upon the success
over the past 10 years where the company saw an overall carbon intensity reduction of
15 percent over its baseline at the beginning of the period. In addition to environmental
disclosures, UPS reports on social and governance goals in their comprehensive report.
The UPS Corporate Sustainability Report is prepared in accordance with the Global Reporting
Initiative (GRI) Sustainability Reporting Standards under the Comprehensive option. The increase in sustainability reporting by companies such as UPS has also resulted in increased interest in the accuracy of the reported information, and the GRI recommends external assurance
by accountants or other qualified experts to provide users with increased confidence in the
accuracy of the information. The UPS Corporate Sustainability Report includes an assurance
report from a Big 4 public accounting firm, including a separate assurance report on the company’s global statement of greenhouse gas emissions. Many predict this form of assurance will be
a frequent service performed by tomorrow’s CPAs.
Sources: UPS Corporate Sustainability Report (www.sustainability.ups.com); UPS Form 10-K for
the year ended December 31, 2020 (www.investors.ups.com).
Each chapter’s opening story illustrates important auditing principles based on realistic situations. Some
of these stories are based on public information about real companies, whereas others are fictitious.
Any resemblance in the latter stories to real firms, companies, or individuals is unintended and purely
coincidental.
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T
he opening example involving the UPS Corporate Sustainability Report illustrates the increasingly important
role of auditors in providing assurance on sustainability and other information of interest to a broad range of
stakeholders. Of course, reporting on the financial statements of public companies, as well as private companies,
government units, and nonprofit entities, remains a primary role of auditors. In addition, auditors provide
assurance on internal control over financial reporting for larger public companies.
This chapter introduces auditing and other assurance services provided by auditors, as well as auditors’ role
in society. These services provide value by offering assurance on financial statements, the effectiveness of internal
control, and many other types of information. There is also a discussion of the types of audits and auditors, including the requirements for becoming a certified public accountant (CPA).
NATURE OF AUDITING
We have introduced the role of auditors in society and how auditors provide assurance
on financial statements. Auditors also provide assurance on the effectiveness of internal control over financial reporting, as well as many other types of information such
as corporate sustainability reports. We now examine auditing more specifically using
the following definition:
OBJECTIVE 1-1
Describe auditing.
Auditing is the accumulation and evaluation of evidence about information to determine
and report on the degree of correspondence between the information and established
criteria. Auditing should be done by a competent, independent person.
The definition includes several key words and phrases. For ease of understanding,
we’ll discuss the terms in a different order than they occur in the description.
To do an audit, there must be information in a verifiable form and some standards
(criteria) by which the auditor can evaluate the information. This information can take
many forms. Auditors routinely perform audits of quantifiable information, including
companies’ financial statements and individuals’ federal income tax returns. Auditors
also audit more subjective information, such as the effectiveness of computer systems
and the efficiency of manufacturing operations.
The criteria for evaluating information also vary depending on the information
being audited. In the audit of historical financial statements by CPA firms, the criteria may be U.S. generally accepted accounting principles (GAAP) or International
Financial Reporting Standards (IFRS). This means that in an audit of Apple’s financial statements, the CPA firm will determine whether Apple’s financial statements
have been prepared in accordance with GAAP. For an audit of internal control over
financial reporting, the criteria will be a recognized framework for establishing internal control, such as Internal Control—Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (widely known as COSO).
For the audit of tax returns by the Internal Revenue Service (IRS), the criteria are
found in the Internal Revenue Code. In an IRS audit of Apple’s corporate tax return,
the internal revenue agent uses the Internal Revenue Code as the criteria for correctness, rather than GAAP.
For more subjective information, it is more difficult to establish criteria. Typically,
auditors and the entities being audited agree on the criteria well before the audit starts.
For example, in an audit of the effectiveness of specific aspects of computer operations, the criteria might include the allowable level of input or output errors.
Evidence is any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria. Evidence takes
many different forms, including
Information and
Established Criteria
Accumulating and
Evaluating Evidence
• electronic and documentary data about transactions,
• written and electronic communication with outsiders,
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
3
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• observations by the auditor, and
• oral testimony of the auditee (client).
To satisfy the purpose of the audit, auditors must obtain a sufficient quality and
quantity of evidence. Auditors must determine the types and amount of evidence necessary and evaluate whether the information corresponds to the established criteria.
This is a critical part of every audit and the primary subject of this book.
Competent,
Independent Person
Reporting
The auditor must be qualified to understand the criteria used and must be competent
to know the types and amount of evidence to accumulate in order to reach the proper
conclusion after examining the evidence. The auditor must also have an independent
mental attitude. The competence of those performing the audit is of little value if they
are biased in the accumulation and evaluation of evidence.
Auditors strive to maintain a high level of independence to keep the confidence
of users relying on their reports. Auditors reporting on company financial statements
are often called independent auditors. Even though such auditors are paid fees by
the company, they are normally sufficiently independent to conduct audits that can
be relied on by users. Even internal auditors—those employed by the companies they
audit—usually report directly to top management and the board of directors, keeping
the auditors independent of the operating units they audit.
The final stage in the auditing process is preparing the audit report, which communicates the auditor’s findings to users. Reports differ in nature, but all must inform
readers of the degree of correspondence between the information audited and established criteria. Reports also differ in form and can vary from the highly technical type
usually associated with financial statement audits to a simple oral report in the case of
an operational audit of a small department’s effectiveness.
The key parts in the description of auditing are illustrated in Figure 1-1 using an IRS
agent’s audit of an individual’s tax return as an example. To determine whether the tax
return was prepared in a manner consistent with the requirements of the federal Internal
Revenue Code, the agent examines supporting records provided by the taxpayer and
from other sources, such as the taxpayer’s employer. After completing the audit, the
internal revenue agent issues a report to the taxpayer assessing additional taxes, advising that a refund is due, or stating that there is no change in the status of the tax return.
FIGURE 1-1
Audit of a Tax Return
Information
Competent,
independent
person
Accumulates and
evaluates evidence
Internal
revenue
agent
Examines canceled
checks and other
supporting records
Federal
tax returns
filed by
taxpayer
Report on results
Determines
correspondence
Established criteria
Internal Revenue
Code and
all interpretations
4
Part 1 / THE AUDITING PROFESSION
Report on tax
deficiencies
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DISTINCTION BETWEEN AUDITING AND ACCOUNTING
Many financial statement users and the general public confuse auditing with accounting. The confusion results because most auditing is usually concerned with accounting
information, and many auditors have considerable expertise in accounting matters.
The confusion is increased by giving the title “certified public accountant” to many
individuals who perform audits.
Accounting is the recording, classifying, and summarizing of economic events
in a logical manner for the purpose of providing financial information for decision
making. To provide relevant information, accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the accounting
information. In addition, accountants must develop a system to make sure that the entity’s economic events are properly recorded on a timely basis and at a reasonable cost.
When auditing accounting data, auditors focus on determining whether recorded
information properly reflects the economic events that occurred during the accounting period. Because U.S. or international accounting standards provide the criteria for
evaluating whether the accounting information is properly recorded, auditors must
thoroughly understand those accounting standards.
In addition to understanding accounting, the auditor must possess expertise in the
accumulation and interpretation of audit evidence. That expertise distinguishes auditors from accountants. Determining the proper audit procedures, deciding the number
and types of items to test, and evaluating the results are unique to the auditor.
OBJECTIVE 1-2
Distinguish between auditing
and accounting.
ECONOMIC DEMAND FOR AUDITING
To illustrate the need for auditing, consider the decision of a bank officer in making
a loan to a business. This decision will be based on such factors as previous financial
relationships with the business and the financial condition of the business as reflected
by its financial statements. If the bank makes the loan, it will charge a rate of interest
determined primarily by three factors:
OBJECTIVE 1-3
Explain the importance
of auditing in reducing
information risk.
1. Risk-free interest rate. This is approximately the rate the bank could earn by investing in U.S. treasury notes for the same length of time as the business loan.
2. Business risk for the customer. This risk reflects the possibility that the business will
not be able to repay its loan because of economic or business conditions, such as a
recession, poor management decisions, or unexpected industry competition.
3. Information risk. Information risk reflects the possibility that the information
upon which the business risk decision was made was inaccurate. A likely cause of
the information risk is the possibility of inaccurate financial statements.
Auditing has no effect on either the risk-free interest rate or business risk, but it can
have a significant effect on information risk. If the bank officer is satisfied that there
is minimal information risk because a borrower’s financial statements are audited, the
bank’s risk is substantially reduced and the overall interest rate to the borrower can be reduced. The reduction of information risk can have a significant effect on the borrower’s
ability to obtain capital at a reasonable cost. For example, assume a large company has
total interest-bearing debt of approximately $10 billion. If the interest rate on that debt is
reduced by only 1 percent, the annual savings in interest is $100 million.
As society becomes more complex, decision makers are more likely to receive
unreliable information due to the remoteness of information, biases and motives of the provider, voluminous data, and the existence of complex exchange
transactions.
Remoteness of Information In a global economy, it is nearly impossible for a deci-
sion maker to have much firsthand knowledge about the organization with which they
do business. Information provided by others must be relied upon. When information
Causes of Information
Risk
OBJECTIVE 1-4
List the causes of information
risk, and explain how this risk
can be reduced.
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
5
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is obtained from others, the likelihood of it being intentionally or unintentionally
misstated increases.
Biases and Motives of the Provider If information is provided by someone
whose goals are inconsistent with those of the decision maker, the information
may be biased in favor of the provider. The reason can be honest optimism about
future events or an intentional emphasis designed to influence users. In either
case, the result is a misstatement of information. For example, when a borrower
provides financial statements to a lender, there is considerable likelihood that the
borrower will bias the statements to increase the chance of obtaining a loan. The
misstatement could be incorrect dollar amounts or inadequate or incomplete disclosures of information.
Voluminous Data As organizations become larger, so does the volume of their exchange transactions. This increases the likelihood that improperly recorded information
is included in the records—perhaps buried in a large amount of other information. For
example, if a business overpays a vendor’s invoice by $2,000, it is unlikely to be uncovered
unless the company has instituted data analytical tools or other sophisticated procedures
to find this type of misstatement. If many minor misstatements remain undiscovered,
the combined total can be significant.
Complex Exchange Transactions In the past few decades, exchange transactions
between organizations have become increasingly complex and therefore more difficult to record properly. The increasing complexity in transactions has also resulted
in increasingly complex accounting standards. For example, the correct accounting
treatment of the acquisition of one entity by another poses relatively difficult accounting problems, especially as it relates to fair value estimations. Other examples
include properly combining and disclosing the results of operations of subsidiaries in different industries and properly valuing and disclosing derivative financial
instruments.
Reducing Information
Risk
After comparing costs and benefits, business managers and financial statement users
may conclude that the best way to deal with information risk is simply to have it remain reasonably high. A small company may find it less expensive to pay higher interest costs than to incur the costs of reducing information risk.
For larger businesses, it is usually practical to incur costs to reduce information
risk. There are three main ways to do so.
User Verifies Information The user may go to the business premises to examine
records and obtain information about the reliability of the statements. Normally,
this is impractical because of cost. In addition, it is economically ineff icient for
all users to verify the information individually. Nevertheless, some users perform
their own verification. For example, the IRS does considerable verif ication of
business and individual tax returns to determine whether the tax returns f iled
reflect the actual tax due the federal government. Similarly, if a business intends
to purchase another business, it is common for the purchaser to use a special
audit team to independently verify and evaluate key information of the prospective business.
User Shares Information Risk With Management There is considerable legal prec-
edent indicating that management is responsible for providing reliable information to
users. If users rely on inaccurate financial statements and as a result incur a financial
loss, they may have a basis for a lawsuit against management. A difficulty with sharing
information risk with management is that users may not be able to collect on losses. If
a company is unable to repay a loan because of bankruptcy, it is unlikely that management will have sufficient funds to repay users.
6
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FIGURE 1-2
Relationships Among Auditor, Client, and External Users
Client or audit
committee hires
auditor
Auditor
Auditor issues
report relied upon
by users to reduce
information risk
Provide capital
External
Users
Client
Client provides
financial statements
to users
Audited Financial Statements Are Provided The most common way for users to
obtain reliable information is to have an independent audit. Typically, management of
a private company or the audit committee for a public company engages the auditor to
provide assurances to users that the financial statements are reliable.
External users such as stockholders and lenders who rely on those financial statements to make business decisions look to the auditor’s report as an indication of the
statements’ reliability. Decision makers can then use the audited information on the
assumption that it is reasonably complete, accurate, and unbiased. They value the auditor’s assurance because of the auditor’s independence from the client and knowledge
of financial statement reporting matters. Figure 1-2 illustrates the relationships among
the auditor, client, and financial statement users.
CONCEPT CHECK
1. What is meant by determining the degree of correspondence between information and
established criteria? What are the criteria for an audit of a company’s financial statements?
2. What are the major causes of information risk? How can information risk be reduced?
ASSURANCE SERVICES
An assurance service is an independent professional service that improves the
quality of information for decision makers. Such services are valued because the assurance provider is independent and perceived as being unbiased with respect to the
information examined. Individuals who are responsible for making business decisions
seek assurance services to help improve the reliability and relevance of the information used as the basis for their decisions.
Assurance services can be done by CPAs or by a variety of other professionals. For example, Consumer Reports, a nonprofit organization, tests a wide variety of products used
by consumers and reports its evaluations of the quality of the products tested in the digital
and print versions of Consumer Reports. The organization provides the information to help
consumers make intelligent decisions about the products they buy. Many consumers consider the information in Consumer Reports more reliable than information provided by the
product manufacturers because Consumer Reports is independent of the manufacturers.
Similarly, the Better Business Bureau’s (BBB) online reliability program, the BBB Accredited
Business Seal, allows Internet shoppers to check BBB information about a company and
be assured the company will stand behind its service. Other assurance services provided
by firms other than CPAs include the Nielsen media ratings for various media platforms.
OBJECTIVE 1-5
Describe assurance services
and distinguish audit services
from other assurance and
nonassurance services
provided by CPAs.
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
7
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SUSTAINABILITY
REPORTING
EXPANDS
GLOBALLY
Companies provide sustainability reports under a
number of terms, including sustainability, corporate
responsibility, and environmental, social, and governance (ESG) reporting. Sustainability reporting continues its tremendous growth, with rapid increases in
reporting in emerging economies, and is now standard practice for many companies around the world.
A recent KPMG survey of the top 100 companies based on revenue in 52 countries found that
80 percent of the 5,200 companies issue corporate
sustainability reports. This is up from 75 percent
in 2017. All industry sectors show a strong rate of
corporate responsibility reporting, with at least
63 percent or more of companies in every industry
sector issuing corporate sustainability reports.
The Americas, including North America and Latin
America, have the highest reporting rate of any region with 90 percent of top 100 companies providing sustainability reports.
Corporate responsibility has become an important element of companies’ business strategies
to create value for shareholders and other stakeholders. Over time, the reporting has expanded
to include additional topics such as risks related
to climate change and the loss of nature and
biodiversity.
Reporting using the Global Reporting Initiative
(GRI) guidelines is increasingly standard, with
75 percent of reports issued by the G250 companies, the world’s largest 250 companies based
on revenue, prepared based on GRI guidelines.
Third-party assurance on corporate responsibility reporting is also becoming standard, with an
underlying trend of 71 percent of the G250 providing external assurance on their responsibility
report. These trends suggest providing assurance on corporate responsibility reporting will
continue to be an area of significant growth for
accounting firms.
Source: KPMG Survey of Sustainability Reporting 2020,
KPMG International.
The need for assurance is not new. CPAs have provided many assurance services for years, particularly assurances about historical financial statement information. As a result of provisions in Section 404 of the Sarbanes–Oxley Act, CPA
firms provide assurance on internal control over financial reporting for larger
public companies. More recently, CPAs have expanded the types of assurance services they perform to include other information of interest to investors, customers, and other interested parties, such as reports on corporate social responsibility
and sustainability reports. For example, businesses and consumers often seek
assurances that companies with which they conduct business produce products
and services in a socially responsible manner. The demand for assurance services
continues to grow as shareholders and other stakeholders seek assurances about
financial and nonfinancial information in addition to information in corporate
financial reports.
Attestation Services
One category of assurance services provided by CPAs is attestation services. An
attestation service is a type of assurance service in which the CPA firm issues a
report about a subject matter or assertion that is made by another party. Primary categories of attestation services include
•
•
•
•
audit of historical financial statements,
audit of internal control over financial reporting,
review of historical financial statements, and
other attestation services that may be applied to a broad range of subject matter.
Audit of Historical Financial Statements In an audit of historical financial
statements, management asserts that the financial statements are fairly stated in accordance with applicable U.S. or international accounting standards. An audit of these
statements is a form of attestation service in which the auditor issues a written report
expressing an opinion about whether the financial statements are fairly stated in accordance with the applicable accounting standards. These audits are the most common
assurance service provided by CPA firms.
Audits are designed to provide reasonable assurance that the financial statements
are free of material misstatements. Reasonable assurance is a high, but not absolute
level of assurance. This level of assurance is usually sufficient to meet the information
8
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needs of financial statement users. Much of this book is about how auditors design
tests to provide this level of assurance, considering the client’s business and industry
and risks of material misstatements in the financial statements.
Publicly traded companies in the United States are required to have audits under
the federal securities acts. Auditor reports can be found in all public companies’
annual financial reports. Most public companies’ audited financial statements can
be accessed over the Internet from the Securities and Exchange Commission (SEC)
EDGAR database or directly from each company’s website. Many privately held companies also have their annual financial statements audited to obtain financing from
banks and other financial institutions. Government and not-for-profit entities often
have audits to meet the requirements of lenders or funding sources.
Audit of Internal Control Over Financial Reporting For an audit of internal control
over financial reporting, management asserts that internal controls have been
developed and implemented following well established criteria. Section 404 of the
Sarbanes–Oxley Act requires public companies to report management’s assessment
of the effectiveness of internal control. The Act also requires auditors for larger public companies to attest to the effectiveness of internal control over financial reporting.
This evaluation, which is integrated with the audit of the financial statements, increases
user confidence about future financial reporting because effective internal controls
reduce the likelihood of future misstatements in the financial statements.
Review of Historical Financial Statements For a review of historical financial
statements, management asserts that the statements are fairly stated in accordance with
accounting standards, the same as for audits. The CPA provides a lower level of assurance for reviews of financial statements compared to a high level for audits; therefore,
less evidence is needed. A review is often adequate to meet financial statement users’
needs. It can be provided by the CPA firm at a much lower fee than an audit because less
evidence is needed. Many nonpublic companies use this attestation option to provide
limited assurance on their financial statements without incurring the cost of an audit.
Other Attestation Services CPAs provide numerous other attestation services.
Typically, the CPA is engaged to provide written assurance about the reliability of an
assertion made by management. Many of these services are natural extensions of the
audit of historical financial statements, as users seek independent assurances about
other types of information. For example, when a bank loans money to a company, the
loan agreement may require the company to engage a CPA to provide assurance about
the company’s compliance with the financial provisions of the loan. The company requesting the loan must assert the loan provisions to be attested to before the CPA can
accumulate the evidence needed to issue the attestation report.
Another type of attestation involves internal controls at service organizations.
Many companies use a third-party service provider to process some of their accounting activities, such as payroll, offsite at a separate IT service center or through cloud
computing. The service provider often engages an auditor to provide an attestation report on the design and effectiveness of controls at the service organization. This report
provides assurance to companies that use the service provider that payroll is accurately
processed. Auditors of companies using the payroll service organization can also rely
on the attestation report by the service company’s auditor to reduce testing of payroll
activities and accounts.
CPAs also provide other assurance services that do not meet the definition of attestation services. These assurance services differ from attestation services in that the CPA
is not required to issue a written report, and the assurance does not have to be about
the reliability of another party’s assertion about compliance with specified criteria.
These other assurance service engagements focus on improving the quality of information for decision makers, just like attestation services.
Other Assurance
Services
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
9
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“AND THE
OSCAR GOES
TO . . .” “THERE
SHE IS, MISS
AMERICA . . .”
“WELCOME TO
THE NEW YORK
STATE LOTTERY . . .”
You probably recognize these statements from the
Academy Awards, the Miss America Pageant, and
the New York State Lottery drawing. Each event
is observed by CPAs from a major accounting firm
to assure viewers that the contests were fairly
conducted. The role of the accounting profession in
providing assurance about the award selection process and winners made headline news in 2017 when
a distracted partner with PricewaterhouseCoopers
(PwC) accidently gave the wrong envelope to the
Best Picture presenters, resulting in the wrong
picture, La La Land, being announced as the top film
instead of Moonlight, the actual winner. Fortunately,
the Academy of Motion Picture Arts and Sciences
recognized PwC’s work over the past 85 years
for the Academy and voted to keep PwC as its
accounting firm of record, although the partner
responsible for the blunder is no longer involved.
PwC redeemed itself with the 2018 awards show,
which went without a hitch. When you become
a member of a CPA firm, you might not win an
Oscar—but you could be on the Oscars!
CPA firms face a larger field of competitors in the market for other assurance
services. Audits and some types of attestation services are limited by regulation to licensed CPAs, but the market for other forms of attestation and assurance is open to
non-CPA competitors. For example, CPAs must compete with market research firms
to assist clients in the preparation of customer surveys and in the evaluation of the reliability and relevance of survey information. However, CPA firms have the competitive
advantage of their reputation for competence and independence.
The types of assurance services that CPAs can provide are almost limitless. A survey of large CPA firms identified more than 200 assurance services that are currently
being provided. Table 1-1 lists some of the other assurance service opportunities for
CPAs. Additional information on the performance of assurance and attestation services is included in Chapter 25.
Nonassurance Services
Provided by CPAs
CPA firms perform numerous other services that generally fall outside the scope of
assurance services. Three specific examples are
1. Accounting and bookkeeping services
2. Tax services
3. Management consulting services
Most accounting and bookkeeping services, tax services, and management
consulting services fall outside the scope of assurance services, although there is
similarity between some consulting and assurance services. While the primary
TABLE 1-1
Other Assurance Services Examples
Other Assurance Services
Service Activities
Controls over and risks related to investments, including policies
related to derivatives
Assess the processes in a company’s investment practices to identify risks
and to determine the effectiveness of those processes
Mystery shopping
Perform anonymous shopping to assess sales personnel dealings with
customers and procedures they follow
Assess risks of accumulation, distribution, and storage of digital
information
Assess security risks and related controls over electronic data, including the
adequacy of backup and off-site storage
Fraud and illegal acts risk assessment
Develop fraud risk profiles and assess the adequacy of company systems and
policies in preventing and detecting fraud and illegal acts
Organic ingredients
Provide assurance on the amount of organic ingredients included in a
company’s products
Compliance with entertainment royalty agreements
Assess whether royalties paid to artists, authors, and others comply with
royalty agreements
ISO 9000 certifications
Certify a company’s compliance with ISO 9000 quality control standards,
which help ensure company products are of high quality
Corporate responsibility and sustainability
Report on whether the information in a company’s corporate responsibility report is consistent with company information and established reporting criteria
10
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purpose of an assurance service is to improve the quality of information, the primary
purpose of a management consulting engagement is to generate a recommendation to
management.
Although the quality of information is often an important criterion in management consulting, this goal is normally not the primary purpose. For example, a CPA
may be engaged to design and install a new information technology system for a client
as a consulting engagement. The purpose of that engagement is to install the new system, with the goal of improved information being a by-product of that engagement.
TYPES OF AUDITS
CPAs perform three primary types of audits, as illustrated with examples in Table 1-2:
1. Operational audit
2. Compliance audit
3. Financial statement audit
An operational audit evaluates the efficiency and effectiveness of any part of an organization’s operating procedures and methods. At the completion of an operational
audit, management normally expects recommendations for improving operations.
For example, auditors might evaluate the efficiency and accuracy of processing payroll
transactions in a newly installed computer system. Another example, where most accountants feel less qualified, is evaluating the efficiency, accuracy, and customer satisfaction in processing the distribution of letters and packages by a company such as
Federal Express.
In operational auditing, the reviews are not limited to accounting. They can include
the evaluation of organizational structure, computer operations, production methods,
marketing, and any other area in which the auditor is qualified. Because of the many
different areas in which operational effectiveness can be evaluated, it is impossible to
characterize the conduct of a typical operational audit. In one organization, the auditor
might evaluate the relevancy and sufficiency of the information used by management
in making decisions to acquire new fixed assets. In a different organization, the auditor
might evaluate the efficiency of the information flow in processing sales.
It is more difficult to objectively evaluate whether the efficiency and effectiveness of operations meets established criteria than it is for compliance and financial
statement audits. Also, establishing criteria for evaluating the information in an operational audit is extremely subjective. In this sense, operational auditing is more like
management consulting than what is usually considered auditing. Operational auditing is discussed in greater depth in Chapter 26.
TABLE 1-2
OBJECTIVE 1-6
Differentiate the three main
types of audits.
Operational Audits
Examples of the Three Types of Audits
Type of Audit
Example
Information
Established Criteria
Available Evidence
Operational audit
Number of payroll records
Evaluate whether the comprocessed in a month,
puterized payroll processcosts of the department,
ing for a Chinese subsidiary
and number of errors
is operating efficiently and
made
effectively
Compliance audit
Determine whether bank
requirements for loan
continuation have
been met
Company records
Loan agreement provisions
Financial statements and
calculations by the auditor
Financial statement
audit
Annual audit of Apple’s
financial statements
Apple’s financial statements
Generally accepted
accounting principles
Documents, records,
and outside sources of
evidence
Company standards for
Error reports, payroll
records, and payroll
efficiency and effectiveprocessing costs
ness in payroll department
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
11
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Compliance Audits
A compliance audit is conducted to determine whether the auditee is following
specific procedures, rules, or regulations set by some higher authority. Following are
examples of compliance audits for a private business.
• Determine whether accounting personnel are following the procedures
prescribed by the company controller.
• Review wage rates for compliance with minimum wage laws.
• Examine contractual agreements with bankers and other lenders to be sure the
company is complying with legal requirements.
• Determine whether a mortgage bank is in compliance with newly enacted
government regulations.
Governmental units, such as school districts, are subject to considerable compliance auditing because of extensive government regulation. Many private and
not-for-profit organizations have prescribed policies, contractual agreements, and
legal requirements that may require compliance auditing. Compliance audits for federally funded grant programs are often done by CPAs and are discussed in detail in
Chapter 26.
Results of compliance audits are typically reported to management, rather than
outside users, because management is the primary group concerned with the extent of
compliance with prescribed procedures and regulations. Therefore, a significant portion of work of this type is often done by auditors employed by the organizational
units. When an organization such as the IRS wants to determine whether individuals
or organizations are complying with its requirements, the auditor is employed by the
organization issuing the requirements.
Financial Statement
Audits
FRAUD
EXAMINERS
USE BIG DATA
AND OTHER
TOOLS TO FIGHT
FINANCIAL
FRAUD
12
A financial statement audit is conducted to determine whether the financial statements (the information being verified) are stated in accordance with specified criteria.
Normally, the criteria are U.S. or international accounting standards, although auditors may conduct audits of financial statements prepared using the cash basis or some
other basis of accounting appropriate for the organization. In determining whether
financial statements are fairly stated in accordance with accounting standards, the auditor gathers evidence to determine whether the statements contain material errors or
other misstatements. The primary focus of this book is on financial statement audits.
According to the Association of Certified Fraud
Examiners (ACFE), businesses lose an estimated
$3.6 billion annually to fraud and financial crime. As
a result, demand for forensic accountants continues
to increase. The ACFE is the world’s largest antifraud organization, with more than 90,000 members.
Certified Fraud Examiners (CFEs) have expertise in
fraud prevention, detection, and deterrence, and are
trained to identify the warning signs of fraud and increased fraud risk. CFEs have a unique skill set that
combines knowledge of complex financial transactions with an understanding of methods, laws, and
investigation of fraud allegations.
Because fraud is increasingly digital, data analytics is one of the best weapons in fraud detection.
Cloud computing allows companies to consolidate
data across locations and search for and detect
unusual patterns in real time. The ACFE’s 2020
Report to the Nations survey finds that proactive
data monitoring and analysis can reduce the median
loss from fraud and the median duration of fraud by
33 percent. However, they report that fewer than
Part 1 / THE AUDITING PROFESSION
half of companies in their survey that experienced
fraud had proactive data monitoring and analysis in
place as a fraud prevention and detection control.
Fraud examiners perform a variety of forensic investigations such as examining books and records to
detect and trace fraudulent transactions, interviewing suspects to obtain information and confessions,
writing investigation reports, testifying at trials, and
understanding factors that motivate individuals to
commit fraud. Forensic accountants often work
side-by-side with criminal justice and law enforcement personnel, as well as computer specialists, in
conducting fraud examinations. Such examinations
may relate to financial statement fraud, asset misappropriations, money laundering, bribery, or, more
recently, theft of information via computer hacking,
and a long list of other fraudulent activities.
Sources: The Association of Certified Fraud Examiners website (www.acfe.org); Report to the Nations Global Study
on Occupational Fraud and Abuse, Association of Certified
Fraud Examiners, 2020 (www.acfe.org).
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As businesses increase in complexity, it is no longer sufficient for auditors to
focus only on accounting transactions. An integrated approach to auditing considers both the risk of misstatements and operating controls intended to prevent misstatements. The auditor must also have a thorough understanding of the entity and its
environment. This understanding includes knowledge of the client’s industry and its
regulatory and operating environment, including external relationships, such as with
suppliers, customers, and creditors. The auditor also considers the client’s business
strategies and processes and critical success factors related to those strategies. This
analysis helps the auditor identify business risks associated with the client’s strategies
that may affect whether the financial statements are fairly stated.
TYPES OF AUDITORS
Several types of auditors are in practice today. The most common are certified public
accounting firms, government accountability office auditors, internal revenue agents,
and internal auditors.
Certified public accounting firms are responsible for auditing the historical financial
statements of all publicly traded companies, most other reasonably large companies,
and many smaller companies and noncommercial organizations. Because of the widespread use of audited financial statements in the U.S. economy, as well as businesspersons’ and other users’ familiarity with these statements, it is common to use the terms
auditor and CPA firm synonymously, even though several different types of auditors
exist. The title certified public accounting firm reflects the fact that auditors who express
audit opinions on financial statements must be licensed as CPAs. CPA firms are often
called external auditors or independent auditors to distinguish them from internal auditors.
A government accountability office auditor is an auditor working for the
U.S. Government Accountability Office (GAO), a nonpartisan agency in the legislative
branch of the federal government. Headed by the Comptroller General, the GAO reports to and is responsible solely to Congress.
The GAO’s primary responsibility is to perform the audit function for Congress, and
it has many of the same audit responsibilities as a CPA firm. The GAO audits much of the
financial information prepared by various federal government agencies before it is submitted to Congress. Because the authority for expenditures and receipts of governmental
agencies is defined by law, there is considerable emphasis on compliance in these audits.
An increasing portion of the GAO’s audit efforts are devoted to evaluating the operational efficiency and effectiveness of various federal programs. Also, because of the
immense size of many federal agencies and the similarity of their operations, the GAO
has made significant advances in developing better methods of auditing through the
widespread use of highly sophisticated statistical sampling and computer risk assessment techniques.
In many states, experience as a GAO auditor fulfills the experience requirement
for becoming a CPA. In those states, if an individual passes the CPA examination and
fulfills the experience stipulations by becoming a GAO auditor, they may then obtain
a CPA certificate.
As a result of their great responsibility for auditing the expenditures of the federal government, their use of advanced auditing concepts, their eligibility to be CPAs,
and their opportunities for performing operational audits, GAO auditors are highly
regarded in the auditing profession.
The IRS, under the direction of the Commissioner of Internal Revenue, is responsible for enforcing the federal tax laws as they have been defined by Congress and
OBJECTIVE 1-7
Identify the primary types of
auditors.
Certified Public
Accounting Firms
Government
Accountability Office
Auditors
Internal Revenue Agents
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
13
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interpreted by the courts. A major responsibility of the IRS is to audit taxpayers’
returns to determine whether they have complied with the tax laws. These audits are
solely compliance audits. The auditors who perform these examinations are called
internal revenue agents.
It might seem that the audit of returns for compliance with the federal tax laws is
a simple and straightforward problem, but nothing is farther from the truth. Tax laws
are highly complicated, and there are hundreds of volumes of interpretations. The tax
returns being audited vary from the simple returns of individuals who work for only
one employer and take the standard tax deduction to the highly complex returns of
multinational corporations. Taxation problems may involve individual income taxes,
gift taxes, estate taxes, corporate taxes, trusts, and so on. An auditor involved in any
of these areas must have considerable tax knowledge and auditing skills to conduct
effective audits.
Internal Auditors
Internal auditors are employed by all types of organizations to audit for management
with oversight by the board of directors, much as the GAO does for Congress. Internal
auditors’ responsibilities vary considerably, depending on the employer. Some internal
audit staffs consist of only one or two employees doing routine compliance auditing.
Other internal audit staffs may have more than 100 employees who have diverse responsibilities, including many outside the accounting area. Many internal auditors are
involved in operational auditing or have expertise in evaluating computer systems.
To maintain independence from other business functions, the internal audit group
typically reports directly to the president, another high executive officer, or the audit
committee of the board of directors. However, internal auditors cannot be entirely independent of the entity as long as an employer–employee relationship exists. Users
from outside the entity are unlikely to want to rely on information verified solely by
internal auditors because of their lack of independence. This lack of independence is
the major difference between internal auditors and CPA firms.
In many states, internal audit experience can be used to fulfill the experience
requirement for becoming a CPA. Many internal auditors pursue certification as a
certified internal auditor (CIA), and some internal auditors pursue both the CPA and
CIA designations.
CERTIFIED PUBLIC ACCOUNTANT
OBJECTIVE 1-8
Describe the requirements
for becoming a CPA.
CPA Licensure
Requirements
14
Use of the title certified public accountant (CPA) is regulated by state law through
the licensing departments of each state. Within any state, the regulations usually differ
for becoming a CPA and retaining a license to practice after the designation has been
initially achieved. CPA licensure requires the “three E’s” of education, examination,
and experience as summarized in Figure 1-3. The CPA examination is uniform among
the 50 states and other jurisdictions (Washington, DC; Puerto Rico; the U.S. Virgin
Islands; and Guam); however, education and experience requirements vary among the
jurisdictions.
For a person planning to become a CPA, it is essential to know the requirements in
the state where they plan to obtain and maintain the CPA designation. The best source
of that information is the State Board of Accountancy for the state in which the person plans to be certified. The National Association of State Boards of Accountancy
(NASBA) website (www.nasba.org) provides information on licensure requirements
and links to the website of each state board. It is possible to transfer the CPA designation from one state to another, but additional requirements often must be met for
formal education, practice experience, or continuing education.
The CPA examination consists of four sections and places emphasis on testing a
candidate’s higher-order cognitive skills such as critical thinking and analytical ability.
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FIGURE 1-3
Three Requirements for Becoming a CPA
Educational
Requirement
Normally, an undergraduate or
graduate degree with a major
in accounting, including a
minimum number of accounting
credits. Most states
now require 150 semester
credit hours (225 quarter
credits) for licensure as a CPA.
Some states require fewer
credits before taking the
examination but require 150
semester credits before
receiving the CPA certificate.
Uniform CPA
Examination Requirement
Experience
Requirement
Computer-based examination
offered at various testing
centers. Exam covers content
that a newly licensed CPA must
possess. Some states also
require a separate ethics
examination. Signif icant changes
to the CPA exam incorporating
a “core” plus “discipline”
approach are effective January
2024.
Varies widely from no
experience to 2 years, including
auditing. Some states include
experience working for
governmental units or in
industry, including internal
auditing.
Through January 2024, the four sections of the exam are Auditing and Attestation,
Business Environment and Concepts, Financial Accounting and Reporting, and
Regulation. Changes to the exam structure effective January 2024 are discussed in the
next section on CPA Evolution. All sections of the exam include multiple-choice questions and task-based simulations in addition to written responses in some sections.
Candidates are presented with questions that test the knowledge and skills that a newly
licensed CPA must possess. They build upon the following set of knowledge and skills:
• Critical thinking, problem solving, analytical ability, professional skepticism,
•
•
•
•
•
and adaptability
Strong understanding of the business environment and processes
Effective communication skills
Well-developed research skills
Ability to analyze data
Ethics and professional responsibilities
Information about the CPA examination can be found in the Uniform CPA
Examination Blueprints document, which can be downloaded from the CPA examination site found on the AICPA website (www.aicpa.org). The AICPA also publishes
selected examination questions with unofficial answers indexed to the content specification outlines of the examination. Some of the questions and problems at the end of
the chapters in this book are based on past CPA examinations. They are designated as
“based on AICPA questions.”
The American Institute of Certified Public Accountants (AICPA), working together
with the National Association of State Boards of Accountancy (NASBA), recently completed a significant revision of the CPA exam and licensure process, referred to as CPA
Evolution. The new process, effective January 2024, recognizes that the role of CPAs
has changed and that a deeper skill set and greater knowledge of emerging technologies are necessary. The revised licensure process is focused on “Core and Disciplines”
as the components of the CPA exam as shown in Figure 1-4 on the next page. The
“Core” content consists of accounting, audit and attestation, and tax sections covering
concepts that should be familiar to newly licensed CPAs. Each of these three core areas
will also have coverage of technology concepts. The “Disciplines” content consists of a
focus on one of three areas to be selected by the individual seeking licensure: Business
CPA Evolution
Licensure and Exam
Requirements
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
15
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Bus
ine
ss
Tax complianc
ea
nd
g
nin
n
la
a
eporting
nd r
is a
lys
na
p
FIGURE 1-4
CORE
ACCT : AUDIT : TAX
Technology
or
ro
CPA
l
s
I
nf
=
m
ati
c
on s
y st e m s a n d
t
on
Source: Evolution of CPA (www.evolutionofcpa.org)
analysis and reporting, Tax compliance and planning, or Information systems and
controls. Every individual taking the CPA exam will take the three core sections of
the exam and will choose one discipline area that will cover a much deeper dive of the
relevant content. However, the CPA license is the same regardless of which discipline
area is selected for the exam.
Most young professionals who want to become CPAs start their careers working
for a CPA firm. After they become CPAs, many leave the firm to work in industry,
government, or education. They may continue to be CPAs but often give up their right
to practice as independent auditors. To maintain the right to practice as independent
auditors in most states, CPAs must meet defined continuing education and licensing
requirements. Therefore, it is common for accountants to be CPAs who do not practice as independent auditors.
CONCEPT CHECK
1. What are the similarities and differences among the three main types of audits?
2. What are the major differences in the scope of the audit responsibilities for CPAs, GAO
auditors, IRS agents, and internal auditors?
SUMMARY
This chapter defined auditing and distinguished auditing from accounting. Audits are valuable because they reduce information risk, which lowers the cost of obtaining capital. The
chapter also described attestation and assurance services, which include reports such as
audits of historical financial statements and reports on the effectiveness of internal control
over financial reporting. The chapter furthermore outlined different types of audits and
auditors and requirements for becoming a CPA.
16
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ESSENTIAL TERMS
Accounting—the recording, classifying,
and summarizing of economic events in
a logical manner for the purpose of providing financial information for decision
making
Assurance service—an independent professional service that improves the quality
of information for decision makers
Attestation service—a type of assurance
service in which the CPA firm issues a report about a subject matter or assertion
that is the responsibility of another party
Audit of historical financial statements—a form of attestation service in
which the auditor issues a written report
stating whether the financial statements
are in material conformity with accounting standards
Audit report—the communication of audit findings to users
Auditing—the accumulation and evaluation of evidence about information to
determine and report on the degree of correspondence between the information and
established criteria
Certified public accountant—a person
who has met state regulatory requirements, including passing the Uniform CPA
Examination, and has thus been certified;
a CPA may have as his or her primary responsibility the performance of the audit
function on historical financial statements
of commercial and noncommercial financial entities
Compliance audit—(1) a review of an organization’s financial records performed
to determine whether the organization is
following specific procedures, rules, or
regulations set by some higher authority;
(2) an audit performed to determine
whether an entity that receives financial
assistance from the federal government has
complied with specific laws and regulations
CPA Evolution—a recently completed
effort of the American Institute of Certified Public Accountants (AICPA), working
together with the National Association of
State Boards of Accountancy (NASBA),
that significantly revised the CPA exam and
licensure process
Financial statement audit—an audit
conducted to determine whether the overall financial statements of an entity are
stated in accordance with specified criteria
(usually U.S. or international accounting
standards)
Government accountability office
auditor—an auditor working for the
U.S. Government Accountability Office
(GAO); the GAO reports to and is responsible solely to Congress
Independent auditors—certified public
accountants or accounting firms that perform audits of commercial and noncommercial entities
Information risk—the risk that information upon which a business decision is
made is inaccurate
Internal auditors—auditors employed
by a company to audit for the company’s
board of directors and management
Internal control over financial reporting—an engagement in which the auditor reports on the effectiveness of internal
control over financial reporting; such
reports are required for accelerated filer
public companies under Section 404 of the
Sarbanes–Oxley Act
Internal revenue agents—auditors who
work for the Internal Revenue Service
(IRS) and conduct examinations of taxpayers’ returns
Operational audit—a review of any part
of an organization’s operating procedures
and methods for the purpose of evaluating
efficiency and effectiveness
Review of historical financial statements—a form of attestation in which a
CPA firm issues a written report that provides less assurance than an audit as to
whether the financial statements are in material conformity with accounting standards
Sarbanes–Oxley Act—a federal securities law passed in 2002 that provides for
additional regulation of public companies
and their auditors; the Act established the
Public Company Accounting Oversight
Board and also requires auditors of larger
public companies to audit the effectiveness
of internal control over financial reporting
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
17
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REVIEW QUESTIONS
1-1 (OBJECTIVE 1-1) What are the information and established criteria for the audit of Jones
Company’s tax return by an internal revenue agent? What are they for the audit of Jones
Company’s financial statements by a CPA firm?
1-2 (OBJECTIVE 1-2) In the conduct of audits of financial statements, it would be a serious
breach of responsibility if the auditor did not thoroughly understand accounting. However,
many competent accountants do not have an understanding of the auditing process. What
causes this difference?
1-3 (OBJECTIVE 1-3) Discuss changes in accounting and business operations over the last
decade that have increased the need for independent audits.
1-4 (OBJECTIVE 1-3) Distinguish among the following three factors impacting a loan interest
rate: risk-free interest rate, business risk, and information risk. Which one or ones does the
auditor reduce by performing an audit?
1-5 (OBJECTIVE 1-4) Identify the three main ways information risk can be reduced. What are
the advantages and disadvantages of each?
1-6 (OBJECTIVE 1-4) Explain how the increased use of fair value accounting might increase
information risk.
1-7 (OBJECTIVE 1-5) Explain audit services, attestation services, and assurance services, and
give examples of each.
1-8 (OBJECTIVE 1-5) Why might an organization seek the assurance of a CPA about information presented in the organization’s corporate sustainability report?
1-9 (OBJECTIVES 1-1, 1-7) Describe the nature of the evidence the internal revenue agent will
use in the audit of Jones Company’s tax return.
1-10 (OBJECTIVES 1-6, 1-7) List five examples of specific operational audits that can be
conducted by an internal auditor in a manufacturing company.
1-11 (OBJECTIVES 1-5, 1-6) What knowledge does the auditor need about the client’s business
in an audit of historical financial statements? Explain how this knowledge may be useful in
performing other assurance or consulting services for the client.
1-12 (OBJECTIVE 1-8) Identify the four parts of the Uniform CPA Examination prior to and
after January 2024.
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
1-13 (OBJECTIVES 1-1, 1-3, 1-5) The following questions deal with audits by CPA firms. Choose
the best response.
a. Which of the following best describes why an independent auditor is asked to express
an opinion on the fair presentation of financial statements?
(1) The opinion of an independent party is needed because a company may not be
objective with respect to its own financial statements.
(2) It is management’s responsibility to seek available independent aid in the
appraisal of the financial information shown in its financial statements.
(3) It is difficult to prepare financial statements that fairly present a company’s
financial position, operations, and cash flows without the expertise of an independent auditor.
(4) It is a customary courtesy that all stockholders of a company receive an independent report on management’s stewardship of the affairs of the business.
b. Which of the following professional services is an attestation engagement?
(1) A consulting service engagement to provide computer-processing advice to a client
(2) The preparation of financial statements from a client’s financial records
(3) An income tax engagement to prepare federal and state tax returns
(4) An engagement to report on compliance with statutory requirements
18
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c. Which of the following attributes is likely to be unique to the audit work of CPAs as
compared to the work performed by practitioners of other professions?
(1) Independence
(3) Due professional care
(2) Competence
(4) Complex body of knowledge
1-14 (OBJECTIVES 1-6, 1-7) The following questions deal with types of audits and auditors.
Choose the best response.
a. Operational audits generally have been conducted by internal auditors and governmental audit agencies but may be performed by certified public accountants. A primary
purpose of an operational audit is to provide
(1) a means of assurance that internal accounting controls are functioning as
planned.
(2) the results of internal examinations of financial and accounting matters to a
company’s top-level management.
(3) a measure of management performance in meeting organizational goals.
(4) aid to the independent auditor who is conducting the audit of the financial
statements.
b. Which of the following best describes the operational audit?
(1) It requires the constant review by internal auditors of the administrative controls
as they relate to the operations of the company.
(2) It concentrates on implementing financial and accounting control in a newly
organized company.
(3) It focuses on verifying the fair presentation of a company’s results of operations.
(4) It concentrates on seeking aspects of operations in which waste could be reduced
by the introduction of controls.
c. Compliance auditing often extends beyond audits leading to the expression of opinions
on the fairness of financial presentation and includes audits of efficiency, economy,
effectiveness, and
(1) adherence to specific rules or procedures.
(2) accuracy.
(3) evaluation.
(4) internal control.
MULTIPLE CHOICE QUESTIONS FROM
BECKER CPA EXAM REVIEW
1-15 (OBJECTIVES 1-15, 1-16) The following questions deal with assurance services and types
of audits. Choose the best response.
a. Which of the following is considered an assurance engagement?
(1) Bookkeeping
(2) Preparation
(3) Compilation
(4) Audit
b. Which of the following engagements is most likely to be considered an operational audit?
(1) The auditor determines whether the organization is following provisions of laws
and regulations.
(2) The auditor examines information presented in an entity’s financial statements
to determine whether the financial statements are presented fairly in accordance
with the applicable financial reporting framework.
(3) The auditor evaluates the organization’s efficiency in processing payments.
(4) The auditor assists the client in preparation of financial statements.
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Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
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c. In a financial statement audit, the auditor obtains a reasonable level of assurance
about whether the financial statements are free of material misstatement in order to
express an opinion. To obtain reasonable assurance, the auditor must
(1) have prior experience in the industry in which the audit client operates.
(2) examine all documents available that support the financial statements.
(3) obtain sufficient audit evidence.
(4) test controls around significant transaction cycles.
DISCUSSION QUESTIONS AND PROBLEMS
1-16 (OBJECTIVE 1-5) The list below indicates various audit, attestation, and other engagements involving auditors.
1. A report on the effectiveness of internal control over financial reporting as required
by Section 404 of the Sarbanes–Oxley Act.
2. An examination report on whether a company’s statement of greenhouse gas emissions is presented in conformity with standards issued by the World Business Council
for Sustainable Development and the World Resources Institute.
3. An auditor’s report on whether the financial statements are fairly presented in accordance with International Financial Reporting Standards.
4. An engagement to help a company structure a merger transaction to minimize the
taxes of the combined entities.
5. A report stating whether the company has complied with restrictive covenants related to officer compensation and payment of dividends contained in a bank loan
agreement.
6. A report on the effectiveness of internal controls at a company that provides payroll
processing for other companies.
7. A review report that provides limited assurance about whether financial statements
are fairly stated in accordance with U.S. GAAP.
8. An evaluation of the voting process and certification of the outcome for Rolling Stone
Magazine’s “Greatest Singer of All Time” poll.
9. A report indicating whether a governmental entity has complied with certain government regulations.
10. A report about management’s assertion on the effectiveness of controls over the availability, reliability, integrity, and maintainability of its accounting information system.
11. An evaluation of the effectiveness of key measures used to assess an entity’s success
in achieving specific targets linked to an entity’s strategic plan and vision.
Required
20
a. Explain the relationships among audit services, attestation services, and other assurance and nonassurance services provided by CPAs.
b. For each of the services listed above, indicate the type of service from the list that
follows.
(1) An audit of historical financial statements
(2) An attestation service other than an audit service
(3) An assurance or nonassurance service that is not an attestation service
1-17 (OBJECTIVE 1-3) Monterrey Corporation has an existing loan in the amount of $7 million
with an annual interest rate of 6.5%. The company provides an internal company-prepared
financial statement to the bank under the loan agreement. Two competing banks have
offered to replace Monterrey Corporation’s existing loan agreement with a new one.
Southwest National Bank has offered to loan Monterrey $7 million at a rate of 5.5% but
requires Monterrey to provide financial statements that have been reviewed by a CPA
firm. First City Bank has offered to loan Monterrey $7 million at a rate of 4.5% but requires Monterrey to provide financial statements that have been audited by a CPA firm.
Monterrey Corporation’s controller approached a CPA firm and was given an estimated
cost of $45,000 to perform a review and $80,000 to perform an audit.
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a. Explain why the interest rate for the loan that requires a review report is lower than
that for the loan that does not require a review. Explain why the interest rate for the
loan that requires an audit report is lower than the interest rate for the other two loans.
b. Calculate Monterrey Corporation’s annual costs under each loan agreement, including interest and costs for the CPA firm’s services. Indicate whether Monterrey should
keep its existing loan, accept the offer from Southwest National Bank, or accept the
offer from First City Bank.
c. Assume that Southwest National Bank has offered the loan at a rate of 5.5% with a
review, and the cost of the audit has increased to $125,000 due to new auditing standards requirements. Indicate whether Monterrey should keep its existing loan, accept
the offer from Southwest National Bank, or accept the offer from First City Bank.
d. Discuss why Monterrey may desire to have an audit, ignoring the potential reduction
in interest costs.
e. Explain how a strategic understanding of the client’s business may increase the value
of the audit service.
Required
1-18 (OBJECTIVES 1-3, 1-4, 1-5) In-class Discussion Consumer Reports is a nonprofit organization that provides information and counsel on consumer goods and services. A major
part of its function is the testing of different brands of consumer products that are purchased on the open market and then the reporting of the results of the tests in Consumer
Reports, a digital and monthly print publication. Examples of the types of products it tests
are crossover SUVs, residential dehumidifiers, flat-screen TVs, and blue jeans.
a. In what ways are the services provided by Consumer Reports similar to assurance
services provided by CPA firms?
b. Compare the concept of information risk introduced in this chapter with the information risk problem faced by a buyer of an automobile.
c. Compare the four causes of information risk faced by users of financial statements as
discussed in this chapter with those faced by a buyer of an automobile.
d. Compare the three ways users of financial statements can reduce information risk
with those available to a buyer of an automobile.
Required
1-19 (OBJECTIVE 1-1) In-class Discussion James Burrow is the loan officer for the National
Bank of Dallas. National has a loan of $525,000 outstanding to Regional Delivery Service,
a company specializing in delivering products of all types on behalf of smaller companies. National’s loan collateral is 25 small delivery trucks with an average original cost of
$34,000.
Burrow is concerned about the collectibility of the outstanding loan and whether the
trucks still exist. He therefore engages Samantha Altman, CPA, to count the trucks, using
registration information held by Burrow. She was engaged because she spends most of her
time auditing automobile and truck dealerships and has extensive specialized knowledge
about used trucks. Burrow requests that Altman issue a report stating the following:
1. Which of the 25 trucks is parked in Regional’s parking lot on the night of June 30, 2023.
2. Whether all of the trucks are owned by Regional Delivery Service.
3. The condition of each truck, using the guidelines of poor, good, and excellent.
4. The fair market value of each truck, using the current “blue book” for trucks, which
states the approximate wholesale prices of all used truck models, and also using the
poor, good, and excellent condition guidelines.
a. For each of the following parts of the definition of auditing, state which part of the
preceding narrative fits the definition:
(1) Information
(2) Established criteria
(3) Accumulating and evaluating evidence
(4) Competent, independent person
(5) Reporting results
b. Identify the greatest difficulties Altman is likely to have doing this audit.
Required
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1-20 (OBJECTIVE 1-7) Five college seniors with majors in accounting are discussing alternative career plans. The first senior plans to become an internal revenue agent because his
primary interest is income taxes. He believes the background in tax auditing will provide
him with better exposure to income taxes than will any other available career choice. The
second senior has decided to go to work for a CPA firm for at least 5 years, possibly as a
permanent career. She believes the variety of experience in auditing and related fields offers a better alternative than any other available choice. The third senior has decided on a
career in internal auditing with a large industrial company because of the many different
aspects of the organization with which internal auditors become involved. The fourth senior plans to become an auditor for the GAO because they believe that this career will provide excellent experience in computer risk assessment techniques. The fifth senior would
like to ultimately become a certified fraud examiner but is not sure where the best place is
to begin his career so that he can achieve this long-term goal.
Required
a. What are the major advantages and disadvantages of each of the types of auditing
careers?
b. What do you think is the best early career choice for the senior interested in ultimately
becoming a certified fraud examiner?
c. What other types of auditing careers are available to those who are qualified?
1-21 (OBJECTIVES 1-6, 1-7) In the normal course of performing their responsibilities, auditors
often conduct audits or reviews of the following:
1. The computer operations of a large corporation to evaluate whether the internal
controls are likely to prevent misstatements in accounting and operating data.
2. Financial statements for use by stockholders when there is an internal audit staff.
3. A bond indenture agreement to make sure a company is following all requirements
of the contract.
4. Internal controls at a casino to ensure the casino is in compliance with federal and
state regulations.
5. Computer operations of a corporation to evaluate whether the computer center is
being operated as efficiently as possible.
6. Annual statements for the use of management.
7. Operations of the IRS to determine whether the internal revenue agents are using
their time efficiently in conducting audits.
8. Statements for bankers and other creditors when the client is too small to have an
audit staff.
9. Financial statements of a branch of the federal government to make sure that the
statements present fairly the actual disbursements made during a period of time.
10. Disbursements of a branch of the federal government for a special research project
to determine whether the expenditures were consistent with the legislative bill that
authorized the project.
11. Federal income tax returns of an officer of a private corporation to determine whether
he or she has included all taxable income in his or her return.
12. Federal income tax returns of a corporation to determine whether the tax laws have
been followed.
Required
a. For these 12 examples, state the most likely type of auditor (CPA, GAO, IRS, or internal) to perform each.
b. In each example, state the type of audit (financial statement audit, operational
audit, or compliance audit).
1-22 (OBJECTIVES 1-3, 1-5) Dave Czarnecki is the managing partner of Czarnecki and Hogan,
a medium-sized local CPA firm located outside of Chicago. Over lunch, he is surprised
when his friend Juarez Foley asks him, “Doesn’t it bother you that your clients don’t look
forward to seeing their auditors each year?” Dave responds, “Well, auditing is only one of
22
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several services we provide. Most of our work for clients does not involve financial statement audits, and our audit clients seem to like interacting with us.”
a. Identify ways in which a financial statement audit adds value for clients.
b. List services other than audits that Czarnecki and Hogan likely provides.
c. Assume Czarnecki and Hogan has hired you as a consultant to identify ways in which
they can expand their practice. Identify at least one additional service that you believe
the firm should provide and explain why you believe this represents a growth opportunity for CPA firms.
Required
1-23 (OBJECTIVE 1-5) In-class Discussion There are many types of information that require
assurance. Individually or in groups, identify the following types of assurance services.
a. Identify three or more assurance services that are likely to be provided only by public
accounting firms.
b. Identify three or more assurance services that are likely to be provided by assurance
providers other than public accounting firms.
c. Identify three or more assurance services that may be provided by public accounting
firms or other assurance providers.
1-24 (OBJECTIVE 1-5) Research As discussed in the chapter-opening vignette and on page
8, companies are increasingly issuing reports on corporate social responsibility. Visit the
Global Reporting Initiative website (www.globalreporting.org) and answer the following
questions.
a. What is the vision and mission of the Global Reporting Initiative?
b. What is a sustainability report? Explain the use of sustainability reports in integrated
reporting.
c. Explain the two “in accordance” GRI guideline reporting options. What is the GRI
guidance on assurance for “in accordance” reports?
1-25 (OBJECTIVE 1-8) Research Individuals are licensed as CPAs by individual states.
Information on the requirements for each state can be found through links to websites of
each state board of accountancy that are provided on the NASBA website (www.nasba.
org). The Uniform CPA Examination is administered by the AICPA, and information on
CPA examination requirements can be found on the AICPA website (www.aicpa.org).
a. Identify the education requirements to be eligible to sit for the CPA exam in your
state. Include any specific educational content requirements.
b. List the work experience requirements in your state. Is experience in industry as an
accountant or an internal auditor sufficient to be eligible to become a CPA?
c. List any frequently asked questions (FAQ), if there are any, related to experience and
education requirements for your state, along with a summary of the responses.
d. What are the Elijah Watts Sells awards?
e. What was the passing rate for each exam section in the most recent quarter?
Required
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2
CHAPTER
THE CPA PROFESSION
LEARNING OBJECTIVES
Good Auditing Includes Good Client Service
After studying this chapter, you should
be able to
“It has been a good week,” thought Latoya Wilson, as she wrapped up a few items for the audit
of Solberg Paints. Just a few months earlier, she graduated from State University and had already
passed three parts of the CPA examination. Still, Latoya did not think her transition to professional life had been all that smooth, and she was surprised at how much there still was to learn.
But she had made great progress on the Solberg engagement.
2-1
2-2
2-3
2-4
2-5
2-6
2-7
2-8
Describe the nature of CPA
firms and what they do.
Describe the structure
of CPA firms.
Understand the role of the
Public Company Accounting
Oversight Board and the
effects of the Sarbanes–Oxley
Act on the CPA profession.
Summarize the role
of the Securities and
Exchange Commission in
accounting and auditing.
Describe the key functions
performed by the AICPA.
Understand the role of
international auditing
standards and their relation
to U.S. auditing standards.
Use U.S. auditing standards
as a basis for further study.
Identify quality control
standards and practices within
the accounting profession.
John Hernandez was the audit senior on the Solberg Paints audit, and he had a reputation as a
patient teacher and supervisor. Latoya was not disappointed. At the start of the engagement,
John told her, “Don’t be afraid
to ask questions. If you see
anything that seems unusual,
let’s discuss it. And most importantly, if you have any ideas
that will help the client, bring
them up. The client expects us
to deliver more than an audit
report.”
“I’d say I delivered,” thought
Latoya. She found an error in
the way the company had calculated LIFO inventory that
was going to save the client a significant amount of taxes. But her biggest contribution almost
did not happen. Latoya read as much as she could about paint manufacturers and learned about
some new production control methods that seemed like they could apply to Solberg. She was
afraid to bring it up, thinking that she couldn’t possibly know anything that the client didn’t
already know, but John encouraged her to discuss it with the client. The result was that the
client wanted to meet further with Latoya’s firm to better understand how they could improve
their production processes.
By Friday, the audit was basically completed, and the partner, Bill Marlow, and Latoya were discussing a few last-minute items from his review of the audit files. Latoya was surprised to hear
him say to her, “What are you doing on the 15th? We’re going to meet with the client to discuss
our audit findings. You’ve made a real contribution on this audit, and I’d like you to join our call.”
Latoya tried not to show her excitement too much, but she couldn’t hide the smile on her face.
Yes, it had been a good week.
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We learned in the first chapter that auditing plays an important role in society by reducing information risk and
facilitating access to capital and that audit firms provide additional, value-added service to their clients. As the
opening story to this chapter demonstrates, audit professionals at all experience levels serve as valued advisors to
their clients. This chapter describes the organization of CPA firms and the types of services they provide. We also
discuss the effects on auditing of the Sarbanes–Oxley Act and the Public Company Accounting Oversight Board
(PCAOB), as well as other standards and regulatory agencies that influence auditor performance.
CERTIFIED PUBLIC ACCOUNTING FIRMS
Except for certain governmental organizations, the audits of most financial statements
in the United States are done by CPA firms. The legal right to perform audits is granted
to CPA firms by regulation in each state. CPA firms also provide many other services
to their clients, such as tax and advisory services.
OBJECTIVE 2-1
Describe the nature of CPA
firms and what they do.
It is estimated that more than 46,000 CPA firms exist in the United States. These firms
range in size from one person to more than 60,000 partners and staff. Table 2-1 provides
revenue and other data for some of the largest accounting firms in the United States.
Three size categories are used to describe CPA firms: Big Four international firms, national and regional firms, and local firms.
Types of CPA Firms
• Big Four international firms. The four largest CPA firms in the United States are
called the “Big Four” international CPA firms. They are the first four firms listed
in Table 2-1. These four firms have offices throughout the United States and
throughout the world. The Big Four firms audit nearly all of the largest companies
both in the United States and worldwide and many smaller companies as well.
TABLE 2-1
2021
Size by
Revenue
Revenue and Other Data for the Largest CPA Firms in the United States
Net Revenue—
U.S. Only
(in $ millions)
Firm
Partners
Professionals
U.S.
Offices
Percentage of
Total Revenue
From Accounting
and Auditing/
Taxes/Management
Consulting and Other
BIG FOUR
1
Deloitte
$ 23,157.0
5,932
89,342
126
27/17/56
2
PwC
$ 18,000.0
3,800
NA
91
36/27/37
3
Ernst & Young
$ 15,820.0
3,600
38,800
101
28/29/43
4
KPMG(1)
$ 9,570.0
2,335
30,060
99
30/29/41
NATIONAL/REGIONAL(2)
5
RSM US
$ 2,788.8
1,022
9,456
84
31/35/34
6
Grant Thornton
$ 1,918.5
595
6,737
53
33/26/41
7
BDO USA
$ 1,800.0
670
6,152
65
46/31/23
8
CliftonLarsonAllen
$ 1,188.0
892
4,636
120
32/35/33
9
Crowe Horwath
$
933.2
335
3,220
36
32/30/38
$
824.7
472
2,328
107
30/26/44
10
CBIZ/MHM
(3)
LOCAL
50
Anchin
$
106.0
57
242
1
25/55/20
75
Aronson
$
60.8
37
184
1
39/37/24
(1) KPMG’s office figure comprises business offices, rather than every physical location.
(2) Only the six largest national/regional firms are listed.
(3) Office figures are for CBIZ; MHM has 25 offices.
NA – Data not available.
Source: Data from Accounting Today (www.accountingtoday.com)
Chapter 2 / THE CPA PROFESSION
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• National/Regional firms. National CPA firms in the United States have offices in
most major cities, while regional firms have several offices in a state or region
and serve a large radius of clients. The six largest of the national/regional firms are
listed in Table 2-1 (p. 25). These firms are large but considerably smaller than the
Big Four. The national/regional firms perform the same services as the Big Four
firms and compete directly with them for clients. Many of these firms are affiliated with firms in other countries and therefore have an international capability.
• Local firms. Some local firms have only one office and serve clients primarily
within commuting distances, while others may have several offices. The larger
local firms compete for clients with other CPA firms, including national, regional,
and Big Four firms. Many of the large local firms are affiliated with associations
of CPA firms to share resources for such things as technical information and
continuing education. Many of these firms also have international affiliations.
Most small local CPA firms have fewer than 25 professionals in a single-office
firm. They perform audits and related services primarily for smaller businesses
and not-for-profit entities, although some have one or two clients with public
ownership. Many small local firms do not perform audits and primarily provide
accounting and tax services to their clients.
Activities of CPA
Firms
As discussed in Chapter 1, CPA firms provide audit services, as well as other attestation and assurance services. Additional services commonly provided by CPA firms include accounting and bookkeeping services, tax services, and management consulting
and risk advisory services. CPA firms continue to develop and offer new products and
services, such as business valuation, forensic accounting, corporate responsibility and
sustainability reporting, and information technology (IT) advisory services.
• Accounting and bookkeeping services. Many small clients with limited accounting
staff rely on CPA firms to prepare their financial statements. Some small clients lack the personnel or expertise to use accounting software to maintain their
own accounting records. Thus, CPA firms perform a variety of accounting and
bookkeeping services to meet the needs of these clients. In some cases, the CPA
firm is engaged by the client to help them prepare financial statements mostly
for management’s internal use. In many cases in which the financial statements
are to be given to a third party, the client may engage the CPA to compile financial statements that are accompanied by a compilation report, which indicates
the CPA assembled the statements but provides no assurance to third parties. In
other situations, the client may engage the CPA to provide some assurance on
those statements by performing a review or even an audit of the financial statements. As Table 2-1 shows, attestation services and accounting and bookkeeping services are a major source of revenue for most large CPA firms.
• Tax services. CPA firms provide advice and prepare corporate and individual tax
returns for both audit and nonaudit clients. Almost every CPA firm performs
tax services, which may include estate tax, gift tax, tax planning, and other aspects of tax services. For many small firms, such services are far more important
to their practice than auditing, as most of their revenue may be generated from
tax services.
• Management consulting and risk advisory services. Most CPA firms provide certain services that enable their clients to operate their businesses more effectively. These
services are called management consulting, management advisory services, or
risk advisory services. These services range from simple suggestions for improving the client’s accounting system to advice in risk management, internal controls,
information technology and e-commerce system design, mergers and acquisitions
due diligence, business valuations, and actuarial benefit consulting. A number of
26
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GROWTH IN
CONSULTING
GENERATES
CALLS FOR FIRM
BREAKUPS
In the period immediately preceding the passage of
the Sarbanes–Oxley Act (SOX), three of the Big
4 firms sold or spun off their consulting practices.
Prior to SOX, consulting and advisory services were
the largest source of revenue for the Big 4 firms.
However, after the dispositions of these consulting
practices, auditing again became the major source
of revenue for the Big 4—but not for long. In the
years since the passage of SOX, the Big 4 firms have
rebuilt their consulting practices. Advisory services
are once again the largest source of revenue for the
Big 4, and these services are growing much faster
than auditing revenues. Although SOX restricts firms
from providing many nonaudit services to public
company audit clients, the firms have developed new
services, and increasingly provide services to companies that are not public audit clients.
The rise of consulting has once again raised
concerns by regulators. In 2013, the PCAOB
expressed interest in the growing size of the
consulting practices, but it has not taken any action
since then. There are rules in the European Union
that limit the amount of nonaudit fees that can be
earned from public clients to 70 percent of the audit
fee. But, in 2020, the Financial Reporting Council
that regulates accountants in the United Kingdom
sent a letter to the seven biggest UK accounting
firms asking them to separate their audit practices
and put in place independent boards to make
changes to how they run their audit business. That
would make the audit units of these seven firms
financially independent from other business units,
ending profit sharing between audit and other entities.
Proponents argue that the magnitude of revenues
from consulting and advisory services creates
incentives for firms to lose their focus on the
importance of performing audit services. Opponents
argue, however, that the performance of consulting
services provides audit firms in-depth exposure to
business, industry, and technology developments
that helps strengthen the firms’ expertise needed
for performing audit engagements.
Sources: Madison Marriage, “Probe Urged Into Break-Up
of Big Four Accountants,” Financial Times (March 16, 2018)
(www.ft.com); Michael Rapoport, “How Did the Big Four
Auditors Get $17 Billion in Revenue Growth? Not From
Auditing” The Wall Street Journal (April 7, 2018) (www.wsj.
com); Nina Trentmann, “U.K. Regulator Asks Accounting
Firms to Wall Off Audit Practice, Install Separate Board,”
The Wall Street Journal (February 28, 2020) (www.wsj.com).
organizations outsource or co-source their internal audit function to CPA firms.
Many large CPA firms have departments involved exclusively in management consulting and risk advisory services with little interaction with the audit or tax staff.
Although the Sarbanes–Oxley Act and the SEC restrict auditors from providing
many consulting services to public company audit clients, some services are allowed,
and audit firms are not restricted from providing most consulting services to private
companies and public companies that are not audit clients. Table 2-1 shows that management consulting and other risk advisory services are a significant source of revenue for most accounting firms.
STRUCTURE OF CPA FIRMS
CPA firms vary in the nature and range of services offered, which affects the organization and structure of the firms. Three main factors influence the organizational structure of all firms:
OBJECTIVE 2-2
Describe the structure of
CPA firms.
1. The need for independence from clients. Independence permits auditors to remain unbiased in drawing conclusions about the financial statements.
2. The importance of a structure to encourage competence. Competence permits auditors
to conduct audits and perform other services efficiently and effectively.
3. The increased litigation risk faced by auditors. Audit firms continue to experience increases in litigation-related costs. Some organizational structures afford a degree
of protection to individual firm members.
Six organizational structures are available to CPA firms. Except for the proprietorship, each structure results in an entity separate from the CPA personally, which helps
promote auditor independence. The last four organizational structures provide some
protection from litigation loss.
Organizational
Structures
Proprietorship Only firms with one owner can operate in this form. Oneowner firms were traditionally organized as proprietorships, but most have
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changed to other organizational forms with more limited liability because of litigation risks.
General Partnership This form of organization is the same as a proprietorship, ex-
cept that it applies to multiple owners. This organizational structure has also become
less popular as other forms of ownership that offer some legal liability protection became authorized under state laws.
General Corporation The advantage of a corporation is that shareholders are liable
only to the extent of their investment in the corporation. Most CPA firms do not organize
as general corporations because they are prohibited by law from doing so in most states.
Professional Corporation A professional corporation (PC) provides professional services and is owned by one or more shareholders. PC laws in some states offer personal
liability protection similar to that of general corporations, whereas the protection in
other states is minimal. This variation makes it difficult for a CPA firm with clients in
different states to operate as a PC.
Limited Liability Company A limited liability company (LLC) combines the most
favorable attributes of a general corporation and a general partnership. An LLC is
typically structured and taxed like a general partnership, but its owners have limited
personal liability similar to that of a general corporation. All states have LLC laws, and
most also allow accounting firms to operate as LLCs.
Limited Liability Partnership A limited liability partnership (LLP) is owned by one
or more partners. It is structured and taxed like a general partnership, but the personal liability protection of an LLP is less than that of a general corporation or an LLC.
Partners of an LLP are personally liable for the partnership’s debts and obligations,
their own acts, and acts of others under their supervision. Partners are not personally
liable for liabilities arising from negligent acts of other partners and employees not
under their supervision. It is not surprising that all of the Big Four firms and many
smaller firms now operate as LLPs.
Hierarchy of a Typical
CPA Firm
TABLE 2-2
The organizational hierarchy in a typical CPA firm includes partners or shareholders, managers, supervisors, seniors or in-charge auditors, and assistants. A new employee usually
starts as an assistant and spends 2 or 3 years in each classification before achieving partner
status. The titles of the positions vary from firm to firm, but the structure is similar in all.
When we refer in this text to the auditor, we mean the person performing some aspect of
an audit. It is common to have one or more auditors from each level on larger engagements.
Table 2-2 summarizes the experience and responsibilities of each classification
level within CPA firms. Advancement in CPA firms is fairly rapid, with evolving duties and responsibilities. In addition, audit staff members usually gain diversity of
experience across client engagements. Because of advances in audit technology, as
well as offshoring of more basic tasks, beginning assistants on the audit are rapidly
given greater responsibility and challenges.
Staff Levels and Responsibilities
Staff Level
Average Experience
Staff assistant
0–2 years
Performs most of the detailed audit work.
Senior or in-charge auditor
2–5 years
Coordinates and is responsible for the performance of audit procedures, including supervising and reviewing staff work.
Manager and senior manager
5–10 years
Helps the in-charge plan and manage the audit, reviews the in-charge’s work, and manages
relations with the client. A manager may be responsible for more than one engagement
at the same time.
Partner
10+ years
Reviews the overall audit work and is involved in significant audit decisions. A partner is
an owner of the firm and therefore has the ultimate responsibility for conducting the
audit and serving the client.
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Typical Responsibilities
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The hierarchical nature of CPA firms helps promote competence. Individuals at each
level of the audit supervise and review the work of others at the level just below them in
the organizational structure. A new staff assistant is supervised directly by the senior or
in-charge auditor. The staff assistant’s work is then reviewed by the in-charge as well as
by the manager and partner. Many firms have additional roles for individuals interested
in alternative career paths, such as a director position for an individual who wants to remain at a firm in an executive position but may not be interested in becoming a partner.
CONCEPT CHECK
1. State the four major types of services CPAs perform, and explain each.
2. Identify the six organizational structures available to CPA firms. Why are most CPA
firms not organized as general partnerships?
SARBANES–OXLEY ACT AND PUBLIC COMPANY
ACCOUNTING OVERSIGHT BOARD
The Sarbanes–Oxley Act is considered by many to be the most important legislation
affecting the auditing profession since the 1933 and 1934 Securities Acts. The provisions of the Act dramatically changed the relationship between publicly held companies and their audit firms.
The Sarbanes–Oxley Act established the Public Company Accounting
Oversight Board (PCAOB), appointed and overseen by the SEC. The PCAOB provides oversight for auditors of public companies; establishes auditing, attestation, and
quality control standards for public company audits; and performs inspections of
audit engagements as well as the quality controls at audit firms performing those audits. As a result of the 2010 Dodd-Frank financial reform legislation, auditors of brokers and dealers registered with the SEC are also required to register with the PCAOB,
are subject to inspections, and must follow PCAOB auditing and attestation standards.
The PCAOB conducts inspections of registered accounting firms to assess their compliance with the rules of the PCAOB and SEC, professional standards, and each firm’s own
MEASURING
AUDIT QUALITY
Has audit quality improved since the passage and
implementation of the Sarbanes–Oxley Act? This
is a question that is of interest to regulators, audit
firms, and users of financial statements. Many point
to examples such as a decline in the frequency of
financial statement restatements as evidence of
improvement. However, PCAOB audit engagement
inspection findings, which are publicly available, continue to document deficiencies in the audit process.
One of the difficulties in answering whether
audit quality has improved is that there is no
agreed-upon definition, or measurement, of audit
quality. The auditing profession’s standards describe
quality as a function of many aspects, including leadership within the firms (“tone at the top”), independence, integrity, objectivity, personnel management,
client acceptance and continuation policies and
procedures, engagement performance, and monitoring. Over the past several years, the PCAOB,
the AICPA’s Center for Audit Quality, and many of
the large audit firms have proposed potential “Audit
Quality Indicators,” or AQIs, that may be informative about performance on individual audit engagements and at the firm level. But no formal guidance
OBJECTIVE 2-3
Understand the role of the
Public Company Accounting
Oversight Board and the
effects of the Sarbanes–Oxley
Act on the CPA profession.
has been issued that requires measurement of and
reporting on audit quality.
Many audit firms voluntarily publish annual audit
quality reports that highlight a number of firm characteristics to provide some indication of their efforts
to ensure audits performed are of high quality. These
reports are targeted to key stakeholders, particularly
audit committees of the board of directors of existing
and potential clients. The premise underlying such
reporting is that buyers of audit services—especially
audit committees—will have information to use
as part of auditor hiring and retention decisions.
Examples of measures reported in these voluntary
reports include data about the percentage of audit
hours generated by specialists, the number of hours
of digital audit training completed during the year, and
factors used to evaluate partners and managing directors, among other performance metrics.
Sources: CAQ Approach to Audit Quality Indicators, Center for
Audit Quality (www.thecaq.org); “Concept Release on Audit
Quality Indicators,” PCAOB Release No. 2015-005 (July 1,
2015) (www.pcaobus.org). “Our Commitment to Audit
Quality,” EY (November 2021) (www.ey.com).
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quality control policies. The PCAOB annually inspects accounting firms that audit more
than 100 issuers (public companies) and performs inspections of other registered firms
that perform audits of issuers at least once every three years. The largest eight firms listed
in Table 2-1 (p. 25) are inspected annually. Any violations could result in disciplinary action
by the PCAOB and be reported to the SEC and state accountancy boards.
SECURITIES AND EXCHANGE COMMISSION
OBJECTIVE 2-4
Summarize the role of the
Securities and Exchange
Commission in accounting
and auditing.
The Securities and Exchange Commission (SEC), an agency of the federal government, assists in providing investors with reliable information upon which to make
investment decisions. The Securities Act of 1933 requires most companies planning
to issue new securities to the public to submit a registration statement to the SEC for approval. The Securities Exchange Act of 1934 provides additional protection by requiring public companies and others to file detailed annual reports with the commission.
The commission examines these statements for completeness and adequacy before
permitting the company to sell its securities through the securities exchanges.
Although the SEC requires considerable information that is not of direct interest
to CPAs, the Securities Acts of 1933 and 1934 require financial statements, accompanied by the opinion of an independent public accountant, as part of a registration
statement and subsequent reports.
Of special interest to auditors are several specific reports that are subject to the
reporting provisions of the Securities Acts. The most important of these are as follows:
• Form S-1. “S” forms apply to the Securities Act of 1933 and must be completed
and registered with the SEC when a company plans to issue new securities to
the public. The S-1 form is the general form used when there is no specifically
prescribed form. The others are specialized forms. For example, S-11 is for registration of securities of certain real estate companies.
• Form 8-K. This report is filed to report significant events that are of interest to public investors. Such events include the acquisition or sale of a subsidiary, a change
in officers or directors, an addition of a new product line, or a change in auditors.
• Form 10-K. This report must be filed annually within 60 to 90 days after the close of
each fiscal year, depending on the size of the company. Extensive detailed financial
information, including audited financial statements, is contained in this report.
• Form 10-Q. This report must be filed quarterly for all publicly held companies.
It contains certain financial information and requires auditor reviews of the
financial statements before filing with the commission.
Because large CPA firms usually have clients that must file one or more of these
reports each year, and the rules and regulations affecting filings with the SEC are extremely complex, most CPA firms have specialists who spend a large portion of their
time ensuring that their clients satisfy all SEC requirements.
The SEC has considerable influence in setting generally accepted accounting principles (GAAP) and disclosure requirements for financial statements due to its authority for specifying reporting requirements considered necessary for fair disclosure to
investors, such as the requirement to file financial statement data in XBRL format. The
SEC has power to establish rules for any CPA associated with audited financial statements submitted to the commission. The attitude of the SEC is generally considered in
any major change proposed by the Financial Accounting Standards Board (FASB), the
independent organization that establishes U.S. GAAP.
The SEC requirements of greatest interest to CPAs are set forth in the commission’s Regulation S-X, Staff Accounting Bulletins, and Accounting and Auditing
Enforcement Releases. These publications constitute important regulations, as well as
decisions and opinions on accounting and auditing issues affecting any CPA dealing
with publicly held companies.
30
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AMERICAN INSTITUTE OF CERTIFIED PUBLIC
ACCOUNTANTS (AICPA)
CPAs are licensed by the state in which they practice, but a significant influence on
CPAs is exerted by their national professional organization, the American Institute
of Certified Public Accountants (AICPA). Membership in the AICPA is restricted to
CPAs, but not all members are practicing as independent auditors. Many members formerly worked for CPA firms but are currently working in government, industry, and
education. AICPA membership is voluntary, so not all CPAs join. With over 430,000
CPAs, the AICPA is the largest professional association for CPAs in the United States.
In 2017, the American Institute of CPAs joined with the Chartered Institute
of Management Accountants (CIMA) to form the Association of International
Certified Professional Accountants. This association is also referred to as the
AICPA and represents over 669,000 CPAs and Chartered Global Management
Accountants (CGMA). Throughout this text, the abbreviation AICPA refers to the
American Institute of Certified Public Accountants unless otherwise noted.
The AICPA sets professional requirements for CPAs, conducts research, and publishes materials on many different subjects related to accounting, auditing, attestation
and assurance services, management consulting services, and taxes. The AICPA also
promotes the accounting profession through organizing national advertising campaigns, promoting new assurance services, and developing specialist certifications to
help market and ensure the quality of services in specialized practice areas. The association currently offers six specialty designations, including information technology
and financial forensics.
The AICPA sets standards and rules that all members and other practicing CPAs must
follow. Four major areas in which the AICPA has authority to set standards and make
rules are as follows:
OBJECTIVE 2-5
Describe the key functions
performed by the AICPA.
Establishing Standards
and Rules
1. Auditing standards. The Auditing Standards Board (ASB) of the AICPA is responsible for issuing pronouncements on auditing matters in the U.S. for all entities
other than publicly traded companies and broker-dealers registered with the SEC.
ASB pronouncements are called Statements on Auditing Standards (SASs).
They are further discussed later in this chapter and throughout the text.
2. Preparation, compilation, and review standards. The Accounting and Review
Services Committee is responsible for issuing pronouncements of the CPA’s
responsibilities when associated with financial statements of privately owned
companies that are not audited. These pronouncements are called Statements
on Standards for Accounting and Review Services, and they provide guidance
for performing preparation, compilation, and review services. In both a preparation service and a compilation service, the accountant helps the client prepare
financial statements without providing any assurance. When a client engages
a CPA to perform a compilation service, the CPA issues a compilation report;
however, in a preparation service no report is issued by the CPA, but the face
of the financial statements must include a statement that “no assurance is provided.” In a review service, the accountant mostly performs inquiry and analytical procedures that provide a reasonable basis for expressing limited assurance
on the financial statements.
3. Other attestation standards. Statements on Standards for Attestation Engagements
are standards that may be used to provide assurance on nonfinancial information
and are also used to develop standards for specific attestation services. For example, detailed standards have been developed for reports on prospective financial information in forecasts and projections. Attestation standards are studied in
Chapter 25.
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4. Code of Professional Conduct. The AICPA Professional Ethics Executive Committee
sets rules of conduct that CPAs are required to meet. The rules and their relationships to ethical conduct are the subject of Chapter 4.
Other AICPA Functions
In addition to administering the CPA examination, the AICPA performs many educational and other functions for CPAs. The association supports research by its own
research staff and provides grants to others. It also publishes a variety of materials,
including journals such as the Journal of Accountancy and Financial Management, industry
audit guides for several industries, periodic updates of the Codification of Statements on
Auditing Standards, and the Code of Professional Conduct.
CPAs must meet continuing education requirements to maintain their licenses to
practice and to stay current on the extensive and ever-changing body of knowledge in
accounting, auditing, attestation and assurance services, management consulting and
risk advisory services, and taxes. The AICPA provides a considerable number of seminars and educational aids in a variety of subjects, such as online continuing education
opportunities and reference materials in its CPExpress online learning library and its
daily email alerts about emerging professional issues.
INTERNATIONAL AND U.S. AUDITING STANDARDS
OBJECTIVE 2-6
Understand the role of
international auditing
standards and their relation
to U.S. auditing standards.
International
Standards on Auditing
32
Auditing standards provide requirements and application and other explanatory
material to aid auditors in fulfilling their professional responsibilities in the audit of
historical financial statements. They include consideration of professional qualities
such as competence and independence, reporting requirements, and evidence. The
three main sets of auditing standards are International Standards on Auditing, AICPA
auditing standards for entities other than public companies, and PCAOB Auditing
Standards.
International Standards on Auditing (ISAs) are issued by the International
Auditing and Assurance Standards Board (IAASB) of the International Federation of
Accountants (IFAC). IFAC is the worldwide organization for the accountancy profession, with over 180 member organizations in 135 countries, representing more than
3 million accountants throughout the world. The IAASB works to improve the uniformity of auditing practices and related services throughout the world by issuing
pronouncements on a variety of audit and attest functions and by promoting their
acceptance worldwide.
ISAs do not override a country’s regulations governing the audit of financial or
other information, as each country’s own regulations generally govern audit practices. These regulations may be either government statutes or statements issued by
regulatory or professional bodies, such as the Australian Auditing and Assurance
Standards Board or Spain’s Instituto de Contabilidad y Auditoría de Cuentas.
Most countries, including the United States, base their auditing standards on ISAs,
modified as appropriate for each country’s regulatory environment and statutory
requirements.
The Auditing Standards Board in the U.S. has revised its audit standards to converge with the international standards. In addition, the PCAOB considers existing international standards in developing its standards. As a result, U.S. standards are mostly
consistent with international standards, except for certain requirements that reflect
unique characteristics of the U.S. environment, such as legal and regulatory requirements. For example, PCAOB Standard AS 2201 addresses audits of internal control
over financial reporting required by the Sarbanes–Oxley Act.
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Auditing standards for private companies and other entities in the United States are
established by the Auditing Standards Board (ASB) of the AICPA. These standards
are referred to as Statements on Auditing Standards (SASs). Because the ASB has
harmonized its agenda with the IAASB, the AICPA auditing standards are similar
to the ISAs, although there are some differences. When developing a new SAS, the
ASB uses the ISA as the base standard and then modifies that base standard only
when modifications are appropriate for the U.S. environment. If an auditor in the
United States is auditing historical financial statements in accordance with ISAs,
the auditor must meet any ISA requirements that extend beyond the requirements in
the AICPA standards.
Prior to passage of the Sarbanes–Oxley Act, the ASB established auditing standards in the U.S. for private and public companies. The PCAOB now has responsibility
for auditing standards for U.S. public companies and broker-dealers registered with
the SEC, while the ASB continues to provide auditing standards for private companies
and other entities. The AICPA auditing standards are also referred to as U.S. generally
accepted auditing standards (GAAS).
Standards issued by the PCAOB apply only to the audits of U.S. public companies
and other SEC registrants, including brokers and dealers, and are referred to as “the
standards of the Public Company Accounting Oversight Board (United States)” in
the audit reports of public companies. When referenced in this text, we refer to
these standards as PCAOB Auditing Standards. The PCAOB initially adopted existing auditing standards established by the ASB as interim audit standards. Since
the PCAOB also considers international auditing standards when developing new
standards, auditing standards for U.S. public and private companies are mostly
similar.
Figure 2-1 summarizes the relations among international auditing standards,
AICPA auditing standards, and PCAOB auditing standards. International auditing
standards as adopted by standard-setting bodies in individual countries apply to
audits of entities outside the United States. AICPA auditing standards are similar to international auditing standards and apply to the audits of private companies and other
entities in the United States. PCAOB auditing standards apply to audits of U.S. public
companies and other SEC registrants, including broker-dealers.
The overlapping ovals illustrate that there are more similarities than differences
in the three sets of standards. The auditing concepts illustrated throughout this book
are generally applicable to all audits. When we refer to “auditing standards,” the term
applies to all audits unless otherwise noted.
FIGURE 2-1
AICPA Auditing
Standards
PCAOB Auditing
Standards
Relation of U.S. and International Auditing Standards
International
Standards on
Auditing
AICPA Auditing
Standards
PCAOB
Auditing Standards
Applicable to entities
outside the United States
Applicable to private
entities in the United States
Applicable to U.S. public
companies and other SEC
registrants, including
broker-dealers
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ORGANIZATION OF U.S. AUDITING STANDARDS
OBJECTIVE 2-7
Use U.S. auditing standards as
a basis for further study.
All SASs issued by the AICPA are given two classification numbers: an SAS and an
AU-C three-digit number that indicates its location in the Codification of Auditing
Standards. For example, the Statement on Auditing Standards, Understanding the Entity
and its Environment and Assessing the Risks of Material Misstatement, is SAS No. 145 and
AU-C 315. The SAS number identifies the order in which it was issued in relation to
other SASs; the AU-C number identifies its location in the AICPA Codification of all
SASs. The AU-C section numbering is equivalent to the ISA numbers, and it is more
common to refer to AICPA standards by their AU-C reference.
PCAOB auditing standards follow a four-digit numbering scheme. For example,
AS 2100 identifies standards for Audit Planning and Risk Assessment under the
broader category of Audit Procedures. One of the three standards in this category is
AS 2105, Consideration of Materiality in Planning and Performing an Audit. The PCAOB website includes a reference tool that identifies the analogous AICPA and IAASB standards
for each PCAOB auditing standard.
The Preface to the Codification of Auditing Standards issued by the ASB contains
“Principles Underlying an Audit in Accordance with Generally Accepted Auditing
Standards” (referred to as the principles). The principles underlying an audit provide a framework to help auditors fulfill the following two objectives when conducting an audit of financial statements:
1. Obtain reasonable assurance about whether the financial statements as a whole
are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are
presented fairly, in all material respects, in accordance with an applicable financial reporting framework; and
2. Report on the financial statements, and communicate as required by GAAS, in
accordance with the auditor’s findings.
While the principles are not requirements and do not carry any authority, they
are used as a framework to provide the structure for the Codification. This structure is
organized around the following principles, which are summarized in Figure 2-2:
•
•
•
•
Purpose of an audit (Purpose)
Personal responsibilities of the auditor (Responsibilities)
Auditor actions in performing the audit (Performance)
Reporting (Reporting)
We use the ASB principles as a basis for discussing the content of U.S. auditing
standards since this framework is relevant to all audits.
Purpose
34
The purpose of an audit is to provide financial statement users with an opinion issued
by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. That
opinion enhances the users’ degree of confidence they can place in the information
presented in the financial statements.
An audit is conducted based on the premise that management is responsible
for the preparation of the financial statements in accordance with the applicable
financial reporting framework selected by management and that management has
designed, implemented, and maintained internal control relevant to the preparation
and presentation of financial statements that are free of material misstatements. An
auditor also presumes that management will provide the auditor access to all information relevant to the preparation and presentation of financial statements, including unrestricted access to persons within the entity from whom the auditor may
obtain audit evidence.
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FIGURE 2-2
AICPA Principles Underlying an Audit
Purpose of an Audit
• Provide an opinion about the financial
statements
Responsibilities
• Possess appropriate competence and
capabilities
• Comply with ethical requirements
• Maintain professional skepticism and
exercise professional judgment
Performance
• Obtain reasonable assurance about
whether financial statements are free
of material misstatement
• Plan work and supervise assistants
• Determine and apply materiality level
or levels
• Identify and assess risks of material
misstatement based on understanding of entity and its environment,
including internal controls
• Obtain sufficient appropriate audit
evidence
Reporting
• Express opinion on financial statements
in a written report
• Whether financial statements are
presented fairly in accordance with
financial reporting framework
Principles related to the auditor’s responsibilities in the audit stress important personal qualities that the auditor should possess.
Appropriate Competence and Capabilities Auditors are responsible for having
appropriate competence and capabilities to perform the audit. This is normally
interpreted as requiring the auditor to have formal education in auditing and accounting, adequate practical experience for the work being performed, and continuing professional education. Court cases clearly demonstrate that auditors must
be technically qualified and experienced in those industries in which their clients
are engaged.
In any case in which the CPA or the CPA’s assistants are not qualified to perform
the work, a professional obligation exists to acquire the requisite knowledge and skills,
suggest someone else who is qualified to perform the work, or decline the engagement.
Responsibilities
Comply with Relevant Ethical Requirements The AICPA Code of Professional Conduct
outlines the ethical requirements for CPAs who practice in accounting firms or work in
organizations as part of management. The Code and auditing standards stress the need
for independence in an audit engagement. Of particular importance are requirements
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for CPA firms to follow several practices to increase the likelihood of independence
of all personnel. For example, there are established procedures on larger audits when
there is a dispute between management and the auditors. Specific methods to ensure
that auditors maintain their independence and comply with other relevant ethical requirements are studied in Chapter 4.
Maintain Professional Skepticism and Exercise Professional Judgment Auditors
are responsible for maintaining professional skepticism and exercising professional
judgment throughout the planning and performance of the audit. Auditing standards
describe professional skepticism as an attitude that includes a questioning mind, being
alert to conditions that might indicate possible misstatements due to fraud or error,
and a critical assessment of audit evidence. Simply stated, auditors are to remain alert
for the possibility of the presence of material misstatements whether due to fraud or
error throughout the planning and performance of an audit.
In making judgments about the presence of material misstatements, auditors are
responsible for applying relevant training, knowledge, and experience in making informed decisions about the courses of action that are appropriate in the circumstances
of the audit engagement. Auditors are responsible for fulfilling their duties diligently
and carefully.
Performance
Responsibilities related to the performance of the audit relate to auditor actions concerning evidence accumulation and other activities during the actual conduct of the
audit. To express an opinion on the financial statements, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. To obtain reasonable assurance, the
auditor fulfills several performance responsibilities.
Adequate Planning and Supervision The auditor is responsible for sufficiently
planning an audit to ensure an adequate audit and proper supervision of assistants.
Supervision is essential in auditing because a considerable portion of the audit is done
by less experienced staff members.
Determine and Apply Materiality Levels Because the auditor’s opinion is about
whether the financial statements contain material misstatements, the auditor is responsible for determining and applying an appropriate materiality level or levels
throughout the audit. A misstatement is considered material if knowledge of the
misstatement will affect a decision of a reasonable user of the financial statements.
Chapters 3 and 8 discuss how auditors determine and apply materiality levels.
Assess Risks of Material Misstatement To adequately perform the audit, the auditor
is responsible for assessing the risks that the financial statements contain material misstatements and then performing further audit procedures in response to those risks to
determine whether material misstatements exist. To adequately assess the risk of material misstatements, the auditor must have an understanding of the client’s business
and industry. This understanding helps the auditor identify significant client business
risks that impact the risk of significant misstatements in the financial statements. For
example, to audit a bank, an auditor must understand the nature of the bank’s operations, federal and state regulations applicable to banks, and risks affecting significant
accounts such as loan loss reserves.
One of the most widely accepted concepts in the theory and practice of auditing is
the importance of the client’s system of internal control for mitigating client business
risks, safeguarding assets and records, and generating reliable financial information.
If the auditor is convinced that the client has an excellent system of internal control,
one that includes adequate internal controls for providing reliable data, the amount
of audit evidence to be accumulated can be significantly less than when controls are
36
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not adequate. In some instances, internal control may be so inadequate as to preclude
conducting an effective audit.
Sufficient Appropriate Evidence The auditor is responsible for obtaining sufficient
appropriate audit evidence about whether material misstatements exist by designing and implementing appropriate responses to the assessed risks. Decisions about
how much and what types of evidence to accumulate for a given set of circumstances
require professional judgment. A major portion of this book is concerned with the
study of evidence accumulation and the circumstances affecting the amount and
types needed.
The principles related to reporting note that the auditor is responsible for expressing
an opinion in the form of a written report about whether the financial statements
are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. This opinion is based on the evaluation of audit evidence
obtained and the auditor’s findings. If an opinion cannot be expressed, the auditor’s
report should state that conclusion.
The principles underlying auditing standards are too general to provide meaningful
guidance, so auditors turn to the auditing standards issued by the AICPA and the
PCAOB for more specific guidance. In this book, we refer to these pronouncements
as auditing standards, and we distinguish between AICPA and PCAOB standards
only when there are substantive differences. Auditing standards are regarded as
authoritative literature, and every member who performs audits of historical financial
statements is required to follow them under the AICPA Code of Professional Conduct.
The AICPA and the PCAOB issue new statements when an auditing problem arises
of sufficient importance to warrant an official interpretation. At this writing, SAS
145 was the last standard issued by the AICPA, and release 2018-006 that replaces
part of AS 1210 was the last standard issued by the PCAOB and incorporated into
the text materials, but readers should be alert to subsequent standards that influence
auditing requirements.
Although the auditing standards are authoritative guidance for members of the profession, they provide less direction to auditors than might be assumed. A limited
number of specific audit procedures are required by the standards, and there are
no specific requirements for auditors’ decisions, such as determining sample size,
selecting sample items from the population for testing, or evaluating results. Many
practitioners believe that the standards should provide more clearly defined guidelines for determining the extent of evidence to be accumulated. Such specificity
would eliminate some difficult audit decisions and provide a line of defense for a
CPA firm charged with conducting an inadequate audit. However, highly specific
requirements could turn auditing into mechanistic evidence gathering, devoid of
professional judgment. From the point of view of both the profession and the users
of auditing services, there is probably greater harm in defining authoritative guidelines too specifically than too broadly.
The AICPA principles and the auditing standards should be viewed by practitioners as minimum standards of performance rather than as maximum standards or ideals. At the same time, the existence of auditing standards does not mean the auditor
must always follow them blindly. If an auditor believes that the requirement of a standard is impractical or impossible to perform, the auditor is justified in following an
alternative course of action, provided that sufficient appropriate evidence is obtained.
Similarly, if the issue in question is immaterial in amount, it is also unnecessary to
follow the standard. However, the burden of justifying departures from the standards
falls on the auditor.
Reporting
Principles Versus
Auditing Standards
Standards of
Performance
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ENHANCING
AUDIT QUALITY
Over the past decade, the AICPA’s Enhancing Audit
Quality initiative has provided a focused effort on
factors that will drive audit quality in the future.
This initiative is centered on a roadmap outlined
in the AICPA’s Six-Point Plan to Improve Audits that
is focused on integrating quality improvement
throughout the audit process, from pre-licensure
through enforcement. The six points in the plan are
as follows:
1.
2.
3.
4.
5.
6.
Pre-licensure
Standards and ethics
CPA learning and support
Peer review
Practice monitoring of the future
Enforcement
The Six-Point Plan uses a data-driven approach
to obtain insights into quality trends supporting
development of resources for improving audit quality. The Enhancing Audit Quality initiative gathers
data from the AICPA Peer Review Program and
monitors actions of standards setters and prevailing environmental trends to identify areas where
quality challenges may arise and to pinpoint areas
for focus. Examples of improvements resulting from
this initiative include revisions to the Uniform CPA
Examination that address higher-order skills required of future CPAs and the release of a Guide to
Data Analytics that describes how new and emerging
technologies can be used throughout the audit process to enhance audit quality.
Most recently, the initiative has focused on
addressing challenges triggered by the global
pandemic and its disruption of how audits are
performed, particularly the shift to remote work
and new financial reporting challenges that have
emerged. For example, the AICPA launched a number of educational resources in the form of blogs,
podcasts, articles, and quizzes to address COVID-19
challenges, such as observing inventories virtually,
considering the financial impact of the governmentsponsored Paycheck Protection Program (PPP) loans
to help businesses during the pandemic, and evaluating unique issues triggered by the pandemic when
auditing revenue.
Source: Enhancing Audit Quality: 2020 Highlights and Progress
(www.aicpa.org).
When auditors desire more specific guidelines, they must turn to less authoritative sources, including textbooks, journals, and technical publications. Materials
published by the AICPA, such as the Journal of Accountancy and industry audit guides,
furnish assistance on specific questions. We provide further study of the standards
and make frequent reference to specific standards throughout the text.
CONCEPT CHECK
1. What is the role of the Public Company Accounting Oversight Board?
2. What roles are played by the American Institute of Certified Public Accountants for its
members?
3. Describe the relations among international auditing standards, AICPA auditing standards,
and PCAOB auditing standards.
QUALITY CONTROL
OBJECTIVE 2-8
Identify quality control
standards and practices
within the accounting
profession.
38
For a CPA firm, quality control comprises the methods used to ensure that the
firm meets its professional responsibilities to clients and others. These methods
include the organizational structure of the CPA firm and the procedures the firm
establishes. For example, a CPA firm might have an organizational structure that
ensures the technical review of every engagement by a partner who has expertise
in the client’s industry. Auditing standards require each CPA firm to establish quality control policies and procedures. The standards recognize that a quality control
system can provide only reasonable assurance, not a guarantee, that professional
standards are followed.
Quality control is closely related to but distinct from auditing standards. To
ensure that the principles in auditing standards are followed on every audit, a CPA
firm follows specific quality control procedures that help it meet those standards
consistently on every engagement. Quality controls are therefore established
for the entire CPA firm, whereas auditing standards are applicable to individual
engagements.
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TABLE 2-3
Elements of Quality Control
Element
Summary of Requirements
Example of a Procedure
Leadership responsibilities for
quality within the firm (“tone
at the top”)
The firm should promote a culture that quality is essential in
performing engagements and should establish policies and
procedures that support that culture.
The firm’s training programs emphasize the
importance of quality work, and this is reinforced in performance evaluation and compensation decisions.
Relevant ethical requirements
The firm should establish policies and procedures to provide
reasonable assurance that the firm, personnel, and others
subject to independence requirements maintain independence
when required by relevant ethical requirements.
Each partner and employee must complete an
“independence assessment” annually, dealing with such things as stock ownership and
membership on boards of directors.
Acceptance and continuation of
client relationships and specific
engagements
Policies and procedures should be established for deciding whether A client evaluation online assessment, dealing
to accept or continue a client relationship or specific engagement.
with such matters as predecessor auditor
These policies and procedures should minimize the risk of
comments and evaluation of management,
must be completed for every new client beassociating with a client whose management lacks integrity.
fore acceptance.
The firm should also only undertake engagements that can be
completed with professional competence.
Human resources
Each professional must be evaluated on every
Policies and procedures should be established to provide the firm
engagement using the firm’s individual enwith reasonable assurance that it has sufficient personnel with
gagement evaluation system.
the competence, capabilities, and commitment to ethical principles necessary to
• perform engagements in accordance with professional standards
and applicable legal and regulatory requirements, and
• enable the firm to issue reports that are appropriate in the
circumstances.
Engagement performance
The firm should establish policies and procedures to provide
reasonable assurance that engagements are performed in accordance with professional standards and applicable legal and
regulatory requirements, and that the firm issues reports that
are appropriate in the circumstances.
Monitoring
The firm should establish a monitoring process designed to provide The quality control partner must test the qualreasonable assurance that the policies and procedures relating to
ity control procedures at least annually to
the system of quality control are relevant and adequate, and are
ensure the firm is in compliance.
operating effectively.
The firm’s director of accounting and auditing is
available for consultation and must approve
all engagements before their completion.
Each firm should document its quality control policies and procedures. Procedures
should depend on such things as the size of the firm, the number of practice offices,
and the nature of the practice. The quality control procedures of a 150-office international firm with many complex, multinational clients should differ considerably from
those of a five-person firm specializing in small audits in one or two industries.
The system of quality control should include policies and procedures that address
six elements. These are listed in Table 2-3 with brief descriptions and procedural examples that firms might use to satisfy the requirement.
Elements of Quality
Control
It should be noted that public accounting firms must be enrolled in an AICPA-approved
practice-monitoring program for members in the firm to be eligible for membership
in the AICPA. Practice-monitoring, also known as peer review, is the review, by
CPAs, of another CPA firm’s compliance with its quality control system. The purpose
of a peer review is to determine and report whether the CPA firm being reviewed has
developed adequate quality control policies and procedures and follows them in practice. Unless a firm has a peer review, all members of the CPA firm lose their eligibility
for AICPA membership.
The AICPA Peer Review Program is administered by the state CPA societies under
the overall direction of the AICPA peer review board. Reviews are conducted every
three years, and are normally performed by a CPA firm selected by the firm being
reviewed, although the firm can request that it be assigned a reviewer through the
administering state society. Firms required to be registered with and inspected by
the PCAOB must be reviewed by the AICPA National Peer Review Committee to
Chapter 2 / THE CPA PROFESSION
Peer Review
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FIGURE 2-3
Relationships Among Auditing Standards, Quality Control,
AICPA Practice Centers, and Peer Review
Quality control
standards
Standards applicable to a
CPA firm to aid in satisfying
auditing standards
Audit practice
and quality centers
Organizations intended to
help firms meet quality
control standards and audit
standards
Auditing standards
Standards applicable to
each audit
Peer review
Method to determine
whether a CPA firm meets
quality control standards
evaluate the non-SEC portion of the firm’s accounting and auditing practice that is
not inspected by the PCAOB. After the review is completed, the reviewers issue a report stating their conclusions and recommendations. Results of the peer review are
included in a public file by the AICPA.
Peer review benefits individual firms by helping them meet quality control standards, which, in turn, benefits the profession through improved practitioner performance and higher-quality audits. A firm having a peer review can further benefit if the
review improves the firm’s practice, thereby enhancing its reputation and effectiveness and reducing the likelihood of lawsuits. Of course, peer reviews are expensive to
conduct, so the benefits come at a cost.
Audit Practice and
Quality Centers
The AICPA has established audit practice and quality centers as resource centers to improve audit practice quality. The Center for Audit Quality (CAQ) is a public policy
organization affiliated with the AICPA serving investors, public company auditors,
and the capital markets. The Center’s mission is to foster confidence in the audit process and to make public company audits even more reliable and relevant for investors.
The Private Companies Practice Section provides practice management information
to firms of all sizes.
In addition to these firm resources, the AICPA has established audit quality centers for governmental audits and employee benefit plan audits. Figure 2-3 summarizes
the relationships among auditing standards, quality control, the audit practice and
quality centers, and peer review in ensuring audit quality.
SUMMARY
This chapter discussed the nature of the CPA profession and the activities of CPA firms.
Because CPA firms play an important social role, several organizations, including the
PCAOB, SEC, and AICPA, provide oversight to increase the likelihood of appropriate audit
quality and professional conduct. These are summarized in Figure 2-4. Shaded circles in
the figure indicate items discussed in this or the last chapter. The AICPA Code of Professional
Conduct provides a standard of conduct for practitioners and is discussed in Chapter 4.
The potential for legal liability is also a significant influence on auditor conduct and is
discussed in Chapter 5.
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FIGURE 2-4
Ways the Profession and Society Encourage CPAs to
Conduct Themselves at a High Level
Auditing
standards
CPA
examination
Quality
control
Continuing
education
requirements
Conduct
of
CPA firm
personnel
Legal
liability
AICPA
practice and
quality centers
Peer review
PCAOB
and
SEC
Code of
Professional
Conduct
ESSENTIAL TERMS
American Institute of Certified Public
Accountants (AICPA)—a voluntary organization of CPAs that sets professional
requirements, conducts research, and publishes materials relevant to accounting, auditing, advisory services, and taxes
Association of International Certified
Professional Accountants (AICPA)—
Association that combines the American
Institute of Certified Public Accountants
and the Chartered Institute of Management Accountants (CIMA)
Center for Audit Quality (CAQ)—a
public policy organization with a mission
to foster confidence in the audit process
and to make public company audits even
more reliable and relevant for investors
Chartered Global Management Accountant (CGMA)—Management accounting designation established by the
American Institute of Certified Public Accountants and Chartered Institute of Management Accountants
Chartered Institute of Management
Accountants (CIMA)—The leading and
largest professional body of management
accountants; the CIMA joined with the
American Institute of Certified Public
Accountants to create the Association of
International Certified Professional Accountants
Generally accepted auditing standards
(GAAS)—refers to AICPA auditing standards developed and issued in the form of
Statements on Auditing Standards (SASs)
and codified in AU-C sections in the Codification of Auditing Standards
International Standards on Auditing
(ISAs)—statements issued by the International Auditing and Assurance Standards
Board of the International Federation of
Accountants to promote international acceptance of auditing standards
Peer review—the review by CPAs of a
CPA firm’s compliance with its quality
control system
Principles underlying an audit—framework helpful in understanding and explaining an audit; provides a structure
for the Codification of Statements on Auditing
Standards
Public Company Accounting Oversight Board (PCAOB)—board created by
the Sarbanes–Oxley Act; oversees auditors
of public companies and broker-dealers,
including establishing auditing, attestaChapter 2 / THE CPA PROFESSION
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tion, and quality control standards and
performing inspections of registered accounting firms
Quality control—methods used by a CPA
firm to ensure that the firm meets its professional responsibilities to clients and others
Securities and Exchange Commission
(SEC)—a federal agency that oversees the
orderly conduct of the securities markets;
the SEC assists in providing investors in public corporations with reliable information
upon which to make investment decisions
Statements on Auditing Standards
(SASs)—pronouncements issued by the
Auditing Standards Board of the AICPA
applicable to audits of entities other than
public issuers
REVIEW QUESTIONS
2-1 (OBJECTIVES 2-1, 2-2, 2-8) What major characteristics of the organization and conduct of
CPA firms permit them to fulfill their social function competently and independently?
2-2 (OBJECTIVE 2-3) What is the role of the Public Company Accounting Oversight Board
(PCAOB)? How does the PCAOB provide oversight of audit firms?
2-3 (OBJECTIVE 2-4) Describe the role of the SEC in society and discuss its relationship with
and influence on the practice of auditing.
2-4 (OBJECTIVE 2-5) What are the purposes of the AICPA Statements on Standards for Attestation
Engagements?
2-5 (OBJECTIVES 2-3, 2-5, 2-6) Who is responsible for establishing auditing standards for audits
of U.S. public companies? Who is responsible for establishing auditing standards for audits of U.S. private companies? Explain.
2-6 (OBJECTIVE 2-6) Describe the role of International Standards on Auditing. What is the
relationship between International Standards on Auditing and U.S. auditing standards?
2-7 (OBJECTIVES 2-4, 2-7) Distinguish between auditing standards and generally accepted accounting principles, and give two examples of each.
2-8 (OBJECTIVE 2-7) The Responsibilities principle requires that auditors be responsible for
having appropriate competence and capabilities to perform the audit. What are the various ways in which auditors can fulfill this principle?
2-9 (OBJECTIVE 2-7) Auditing standards have been criticized by different sources for failing to provide useful guidelines for conducting an audit. The critics believe the standards
should be more specific to enable practitioners to improve the quality of their performance. Evaluate this criticism of auditing standards.
2-10 (OBJECTIVE 2-8) What is meant by the term quality control as it relates to a CPA firm?
2-11 (OBJECTIVE 2-8) The following is an example of a CPA firm’s quality control procedure
requirement: “Any person being considered for employment by the firm must have completed a basic auditing course and have been interviewed and approved by an audit partner
of the firm before he or she can be hired for the audit staff.” Which element of quality control does this procedure affect and what is the purpose of the requirement?
2-12 (OBJECTIVE 2-8) State what is meant by the term peer review. What are the implications of
peer review for the profession?
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
2-13 (OBJECTIVE 2-7) The following questions deal with auditing standards. Choose the best
response.
a. Which of the following best describes what is meant by U.S. auditing standards?
(1) Acts to be performed by the auditor
(2) Measures of the quality of the auditor’s performance
(3) Procedures to be used to gather evidence to support financial statements
(4) Audit objectives generally determined on audit engagements
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b. The Responsibilities principle underlying AICPA auditing standards includes a
requirement that
(1) the audit be adequately planned and supervised.
(2) the auditor’s report state whether or not the financial statements conform to
generally accepted accounting principles.
(3) professional judgment be exercised by the auditor.
(4) informative disclosures in the financial statements be reasonably adequate.
c. Who establishes auditing standards applicable to private companies and other nonpublic entities in the U.S.?
(1) The Private Company Audit Standards Board
(2) The Financial Accounting Standards Board
(3) The Auditing Standards Board of the AICPA
(4) The Public Company Accounting Oversight Board
2-14 (OBJECTIVE 2-8) The following questions concern quality control standards. Choose the
best response.
a. The nature and extent of a CPA firm’s quality control policies and procedures
depend on
The CPA
Firm’s Size
The Nature of the
CPA Firm’s Practice
Cost–Benefit
Considerations
(1)
Yes
Yes
Yes
(2)
Yes
Yes
No
(3)
Yes
No
Yes
(4)
No
Yes
Yes
b. Which of the following is an element of a CPA firm’s quality control system that
should be considered in establishing its quality control policies and procedures?
(1) Complying with laws and regulations
(2) Using statistical sampling techniques
(3) Managing human resources
(4) Considering audit risk and materiality
c. One of a CPA firm’s basic objectives is to provide professional services that conform
with professional standards. Reasonable assurance of achieving this objective is provided through
(1) continuing professional education.
(2) a system of quality control.
(3) a system of peer review.
(4) compliance with generally accepted reporting standards.
MULTIPLE CHOICE QUESTIONS FROM
BECKER CPA EXAM REVIEW
2-15 (OBJECTIVES 2-3, 2-4, 2-6, 2-7) The following questions address CPA firms and entities that
regulate them. Choose the best response.
a. An auditor of an entity subject to the rules of the SEC must conduct the financial
statement audit in accordance with
(1) PCAOB standards.
(2) Statements on Standards for Accounting and Review Services.
(3) International Auditing Standards.
(4) Generally Accepted Government Auditing Standards.
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b. Which of the following provides authoritative guidance for the auditor of a nonpublic
company?
(1) An article in the Journal of Accountancy that discusses new audit requirements
(2) Information obtained from continuing professional education programs
(3) Publication from state CPA societies that provides questions and answers on
frequently asked audit questions
(4) Statements on Auditing Standards
c. The Public Company Accounting Oversight Board (PCAOB) has the duty to
(1) select the public accounting firm for the issuer’s annual audit.
(2) establish rules related to the preparation of audit reports for nonissuers.
(3) conduct investigations concerning registered public accounting firms.
(4) conduct disciplinary proceedings for nonpublic accounting firms.
DISCUSSION QUESTIONS AND PROBLEMS
Required
2-16 (OBJECTIVE 2-7) In-class Discussion Sarah O’Hann enjoyed taking her first auditing
course as part of her undergraduate accounting program. While at home during her semester break, she and her father discussed the class, and it was clear that he didn’t really
understand the nature of the audit process as he asked the following questions:
a. What is the main objective of the audit of an entity’s financial statements?
b. Given the CPA firm is auditing financial statements, why would they need to understand anything about the client’s business?
c. What does the auditor do in an audit other than verify the mathematical accuracy of
the numbers in the financial statements?
d. The audit represents the CPA firm’s guarantee about the accuracy of the financial
statements, right?
e. Isn’t the auditor’s primary responsibility to detect all kinds of fraud at the client?
If you were Sarah, how would you respond to each question?
2-17 (OBJECTIVE 2-8) For each of the following procedures taken from the quality control
manual of a CPA firm, identify the applicable element of quality control from Table 2-3 on
page 39.
a. All potential new clients are reviewed before acceptance. The review includes consultation with predecessor auditors and background checks. All new clients are
approved by the firm management committee, including assessing whether the
firm has the technical competence to complete the engagement.
b. The partners accept responsibility for leading and promoting a quality assurance culture within the firm and for providing and maintaining a quality assurance manual
and all other necessary practical aids and guidance to support engagement quality.
c. Each office of the firm shall be visited at least annually by review persons selected by
the director of accounting and auditing. Procedures to be undertaken by the reviewers are illustrated by the office review program.
d. Appropriate accounting and auditing research requires adequate technical reference
materials. Each firm professional has online password access through the firm’s
website to electronic reference materials on accounting, auditing, tax, SEC, and other
technical information, including industry data.
e. Audit engagement team members enter their electronic signatures in the firm’s engagement management software to indicate the completion of specific audit program
steps. At the end of the audit engagement, the engagement management software will
not allow archiving of the engagement file until all audit program steps have been
electronically signed.
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f. At all stages of any engagement, an effort is made to involve professional staff at appropriate levels in the accounting and auditing decisions. Various approvals of the
manager or senior accountant are obtained throughout the audit.
g. Each audit engagement must include a concurring partner review of critical audit
decisions.
h. No employee will have any direct or indirect financial interest, association, or relationship (for example, a close relative serving a client in a decision-making capacity)
not otherwise disclosed that might be adverse to the firm’s best interest.
i. Individual partners submit the nominations of those persons whom they wish to be
considered for partner. To become a partner, an individual must have exhibited a high
degree of technical competence; must possess integrity, motivation, and judgment;
and must have a desire to help the firm progress through the efficient dispatch of the
job responsibilities to which they are assigned.
j. Through our continuing employee evaluation and counseling program and through
the quality control review procedures as established by the firm, educational needs
are reviewed and formal staff training programs modified to accommodate changing
needs. At the conclusion of practice office reviews, apparent accounting and auditing
deficiencies are summarized and reported to the firm’s director of personnel.
2-18 (OBJECTIVES 2-6, 2-7) In-class Discussion You have been asked to make a presentation in
your International Business class about how globalization is impacting the auditing profession. In preparation, you met with your auditing professor and discussed these questions:
a. What organization is responsible for establishing auditing standards internationally?
b. What organizations are responsible for establishing U.S. auditing standards used by
CPA firms when auditing financial statements prepared by organizations based in the
U.S.?
c. To what extent are AICPA auditing standards and international auditing standards
similar?
d. What is the process the AICPA Auditing Standards Board (ASB) uses to develop
AICPA auditing standards?
e. To what extent are PCAOB auditing standards impacted by international standards?
f. What auditing standards should an audit firm follow when they audit a client located
in a foreign country that is listed on both a foreign stock exchange and a U.S. stock
exchange?
Briefly outline key points that you would make in your presentation to address these
questions.
Required
2-19 (OBJECTIVE 2-6) For each engagement described below, indicate whether the engagement is likely to be conducted under international auditing standards, AICPA auditing
standards, or PCAOB auditing standards.
a. An audit of a public company headquartered in the U.S. listed only on U.S. exchanges.
b. An audit of a not-for-profit organization with operations in Pennsylvania.
c. An audit of a private company in the U.S. with public debt traded on a U.S. exchange.
d. An audit of a U.S. private company to be used for a loan from a publicly traded bank.
e. An audit of a German private company with public debt in Germany.
f. An audit of an international nonprofit relief agency headquartered in Switzerland.
g. An audit of a U.S. broker-dealer registered with the SEC.
h. An audit of a Mexico-based company whose stock is listed on stock exchanges in the
U.S. and whose financial statements will be filed with the SEC.
i. An audit of a U.S. public company that is a subsidiary of a Japanese company that will
be used for reporting by the parent company in Japan.
Chapter 2 / THE CPA PROFESSION
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Required
2-20 (OBJECTIVE 2-7) Ray, the owner of a small company, asked Holmes, a CPA, to conduct
an audit of the company’s records. Ray told Holmes that an audit was to be completed in
time to submit audited financial statements to a bank as part of a loan application. Holmes
immediately accepted the engagement and agreed to provide an auditor’s report within
three weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if the loan was granted.
Holmes hired two accounting students to conduct the audit and spent several hours
telling them exactly what to do. Holmes told the students not to spend time reviewing
internal controls but instead to concentrate on proving the mathematical accuracy of
the ledger accounts and summarizing the data in the accounting records that supported
Ray’s financial statements. The students followed Holmes’s instructions and after two
weeks gave Holmes the financial statements, which did not include footnotes. Holmes reviewed the statements and prepared an unmodified auditor’s report. The report did not
refer to generally accepted accounting principles or to the consistent application of such
principles.
Briefly describe each of the principles underlying AICPA auditing standards and indicate how the action(s) of Holmes resulted in a failure to comply with each principle.
Organize your answer as follows:*
Brief Description of Principle
Holmes’s Actions Resulting in Failure to
Comply With the Principle
2-21 (OBJECTIVE 2-6, 2-7) Research The following questions require you to access AICPA
standards (www.aicpa.org), PCAOB auditing standards (pcaobus.org), and IAASB auditing standards (www.iaasb.org).
a. Your audit supervisor stated it was important for you to understand AU-C 315. Which
organization is the source of the standard? What is the subject of the standard?
b. The PCAOB website has a reference tool that allows you to find analogous ASB standards and IAASB standards. What is the analogous AICPA (ASB) standard for PCAOB
AS 2305? What is the analogous IAASB standard? Explain.
c. Your audit supervisor indicated that you would be relying on work done by internal
auditors and suggested that you look at SAS No. 128. What AU-C section is associated with SAS No. 128?
2-22 (OBJECTIVE 2-1) In-class Discussion Review the information in Table 2-1 on page 25
and discuss the following:
a. For the largest 10 firms listed in the table, how many firms generate the largest percentage of their revenue from consulting? Discuss why some firms may have larger
consulting practices than other firms.
b. In recent years, consulting has been the fastest-growing revenue source for the largest
audit firms. Discuss whether you believe the growth in consulting improves or negatively impacts audit quality.
*
46
Based on AICPA question paper, American Institute of Certified Public Accountants.
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