Auditin Audrey A. Gramling Kennesaw State University Larry E. Rittenberg University of Wisconsin Madison Karla M. Johnstone University of Wisconsin Madison /% SOUTH-WESTERN *% CENGAGE Learning- Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States
Contents CHAPTER 1 Auditing: Integral to the Economy, 2 Importance of Audit Judgment, 2 Increased Globalization of Accounting and Auditing, 5 INTRODUCTION^ Auditing Defined, 6 Auditing: A Special Function, 9 Failures Within the Profession, 10 The Need for Unbiased Reporting, 11 Need for Assurance, 12 CHANGES IN THE PROFESSION: INCREASED DEMAND FOR ACCOUNTABILITY, 13 Demand for Improved Corporate Governance, 13 Required Reporting on Internal Controls, 14 Audit Standard Setting and Auditor Independence, 15 Public Expectations of Auditors, 15 SCOPE OF SERVICES: OTHER ASSURANCE SERVICES, 15 What Is Assurance?, 15 REQUIREMENTS TO ENTER THE PUBLIC ACCOUNTING PROFESSION, 18 Accounting and Auditing Expertise, 18 Internal Control Expertise, 18 Knowledge of Business and Its Risks, 19 ' Understanding Accounting System Complexity, 19 THE PROVIDERS OF ASSURANCE SERVICES, 19 The Public Accounting Profession, 19 The Internal Audit Profession, 20 The Governmental Auditing Profession, 21 PROFESSIONAL AND REGULATORY ORGANIZATIONS, 22 The Public Company Accounting Oversight Board, 22 The Securities and Exchange Commission, 22 The American Institute of Certified Public Accountants, 23 International Auditing and Assurance Standards Board, 23 Committee of Sponsoring Organizations, 23 Accounting Standard Setters, 24 State Boards of Accountancy, 24 The Institute of Internal Auditors, 24 The U.S. Government Accountability Office, 24 The Court System, 25 All chapters contain the following end-of-chapter elements: Summary Significant Terms Selected References to Relevant Professional Guidance Review Questions Multiple-Choice Questions Discussion and Research Questions Cases CHAPTER S Corporate Governance and Audits, 36 CORPORATE GOVERNANCE AND AUDITING, 38 Corporate Governance Responsibilities and Failures, 39 The Sarbanes-Oxley Act of 2002, 43 Required Audit Firm Communication to the Audit Committee, 46 Importance of Good Governance to the Audit, 47 AUDIT STANDARD SETTING, 48 Generally Accepted Auditing Standards and IAASB Principles, 51 Fundamental Principles of IAASB Auditing Standards, 54 Standards for Other Audit Engagements, 55 Future of Audit Standard Setting, 56 OVERVIEW OF THE AUDIT PROCESS: A STANDARDS-BASED APPROACH, 57 Phase II: Understanding the Client, 58 Phases III and IV: Obtaining Evidence, 60 Phase V: Wrapping up the Audit and Making Reporting Decisions, 61 FORD AND TOYOTA CASE 76 CHAPTER 3 Judgmental and Ethical Decision-Making Frameworks and Associated Professional Standards, 78 INTRODUCTION, 79 Decision-Making, Ethics, and Organizational Performance, 79 A GENERAL DECISION-MAKING FRAMEWORK, 80 A Framework for Professional Decision-Making, 80 AN ETHICAL DECISION-MAKING FRAMEWORK, 82 Accepting a Public Trust, 82 Ethical Theories, 83 An Ethical Framework, 84 THE SARBANES-OXLEY ACT OF 2002 AS A REACTION TO ETHICAL LAPSES, 86 APPROACHES TO PROFESSIONAL CODES OF ETHICS, 90 International Ethics Standards Board for Accountants, 90 AICPA Code of Professional Conduct, 90 Independence Rules of the SEC and the PCAOB, 97 FURTHER CONSIDERATIONS REGARDING AUDITOR INDEPENDENCE, 98 Major Threats to Independence, 99 Managing Threats to Independence, 101 Important Role of Audit Committees, 103 FORD AND TOYOTA CASE 118 XII
Contents xiii CHAPTER 4 Audit Risk, Business Risk, and Audit Planning, 120 NATURE OF RISK, 121 MANAGING ENGAGEMENT RISK THROUGH CLIENT ACCEPTANCE AND RETENTION DECISIONS, 124 Management Integrity, 124 Independence and Competence of the Audit Committee and Board, 126 Quality of Management's Risk Management Process and Controls, 126 Regulatory and Reporting Requirements, 127 Participation of Key Stakeholders, 127 Existence of Related-Parry Transactions, 127 The Financial Health of the Organization, 127 Summary: High-Risk Audit Clients, 128 The Purpose of an Engagement Letter, 129 MANAGING AUDIT RISK, 130 Materiality, 130 Understanding the Audit Risk Model, 131 PLANNING THE AUDIT USING THE AUDIT RISK MODEL, 135 Lessons Learned: The Lincoln Savings and Loan Case, 135 Developing an Understanding of the Business and Risks, 137 Understanding Management's Risk Management and Control Processes, 141 Risk Analysis and the Conduct of the Audit, 142 PRELIMINARY FINANCIAL STATEMENT REVIEW: USING ANALYTICAL TECHNIQUES TO IDENTIFY AREAS OF HEIGHTENED RISK, 144 Assumptions Underlying Analytical Techniques, 144 A Process for Performing Analytical Procedures, 145 Types of Analytical Procedures, 146 FORD AND TOYOTA CASE 7 70 BILTRITE PRACTICE CASE 1 73 CHAPTER S Internal Control over Financial Reporting, 190 IMPORTANCE OF INTERNAL CONTROL TO FINANCIAL STATEMENT AUDITS, 191 COSO: A FRAMEWORK FOR INTERNAL CONTROL, 192 Components of Internal Control, 193 Risk Assessment, 195 Control Environment, 197 Control Activities, 200 Information and Communication, 203 Monitoring, 204 Examples of Common Internal Control Activities, 204 Common Control Activities, 205 IT Controls Integrated into Internal Control Evaluations, 206 MANAGEMENT EVALUATION OF INTERNAL CONTROLS, 212 AUDITOR EVALUATION OF INTERNAL CONTROLS, 213 Understand the Client's Internal Controls, 213 Identify Controls to Test, 219 Make a Plan to Test the Controls and Execute That Plan, 219 Consider the Results of Control Testing, 221 DOCUMENTING THE AUDITOR'S UNDERSTANDING AND ASSESSMENT OF AN ORGANIZATION'S INTERNAL CONTROLS, 222 MANAGEMENT REPORTS ON INTERNAL CONTROL OVER FINANCIAL REPORTING, 223 FORD AND TOYOTA CASE 249 CHAPTER 6 Performing an Integrated Audit, 250 EVOLUTION IN STANDARDS ON CONDUCTING INTEGRATED AUDITS, 252 AUDIT REPORTS ON INTERNAL CONTROL OVER FINANCIAL REPORTING, 253 Unqualified Opinion on Internal Control over Financial Reporting, 253 Adverse Audit Opinion on Internal Control over Financial Reporting, 253 STEPS IN AN INTEGRATED AUDIT, 256 Framework for Audit Evidence in an Integrated Audit, 256 Implementing the Integrated Audit Within the Audit Opinion Formulation Process, 257 INTEGRATED AUDIT EXAMPLE: JUDGING THE SEVERITY OF CONTROL DEFICIENCIES AND IMPLICATIONS FOR THE FINANCIAL STATEMENT AUDIT, 270 Management's Assessment of Controls, 271 Auditor Assessment of Controls, 272 FORD AND TOYOTA CASE 290 BILTRITE PRACTICE CASE 291 CHAPTER 7 Audit Evidence: A Framework, 304 OVERVIEW OF THE AUDIT MODEL, 305 ASSERTION MODEL FOR FINANCIAL STATEMENT AUDITS, 307 GATHERING SUFFICIENT, APPROPRIATE EVIDENCE, 308 Sufficiency, 310 Reliability of Audit Evidence, 311 Nature of Audit Testing, 314 Audit Procedures, 315 AUDIT PROGRAMS AND DOCUMENTING AUDIT EVIDENCE, 321 Audit Program Development, 321 Documenting Audit Evidence, 322 AUDITING ACCOUNT BALANCES AFFECTED BY MANAGEMENT'S ESTIMATES, 328 Evidence Used in Auditing Management's Estimates, 329 FORD AND TOYOTA CASE 347
xiv Contents CHAPTER B Tools to Gather Audit Evidence, 348 OVERVIEW OF APPROACHES TO GATHERING AND EVALUATING AUDIT EVIDENCE, 350 Sampling: One Approach, 350 Other Approaches, 351 Overview of Audit Sampling, 352 TESTING CONTROL EFFECTIVENESS AND COMPLIANCE, 355 Attribute Estimation Sampling, 356 Nonstatistical Sampling, 365 SAMPLING TO TEST FOR ACCOUNT BALANCE MISSTATEMENTS, 366 Substantive Sampling Considerations, 366 Nonstatistical Sampling, 369 Monetary Unit Sampling (MUS), 370 USING GENERALIZED AUDIT SOFTWARE TO PERFORM SUBSTANTIVE TESTS, 379 Generalized Audit Software, 379 ANALYTICAL PROCEDURES AS A SUBSTANTIVE TEST, 383 Assumptions Underlying Analytical Techniques, 383 The Effectiveness of Substantive Analytical Procedures, 384 Application of Analytical Procedures to Substantive Testing, 385 Analytical Procedures Are Not Client Estimates, 385 FORD AND TOYOTA CASE 404 CHAPTER 9 Auditing for Fraud, 408 FRAUD AND AUDITOR RESPONSIBILITIES: A HISTORICAL EVOLUTION, 409 Magnitude of Fraud, 410 Fraud Defined, 411 Evolution of Fraud and Auditor Responsibility, 414 Financial Reporting Frauds The Second COSO Report, 417 General Characteristics of Financial Reporting Frauds, 418 AUDITING STANDARDS MORE RESPONSIBILITY, 419 A Proactive Approach to Fraud Detection, 420 Conducting the Financial Statement Audit Fraud Awareness, 420 FORENSIC ACCOUNTING, 443 FORD AND TOYOTA CASE 465 CHAPTER 1O- Auditing Revenue and Related Accounts, 466 INTRODUCTION, 468 The Cycle Approach, 468 Overview of the Revenue Cycle, 469 AUDITING INTERNAL CONTROLS AND ACCOUNT BALANCES THE INTEGRATED AUDIT OF REVENUE, 473 Audit Stepsforan Integrated Audit, 473 EXAMPLE: AN INTEGRATED AUDIT OF SALES AND RECEIVABLES, 474 Consider the Risk of Misstatement in the Revenue Cycle (Steps 1 and 2), 474 Perform Preliminary Analytical Procedures (Step 3), 477 Develop an Understanding of Internal Controls (Step 4), 477 Identify Important Controls (Step 5), 478 Design and Perform Tests of Internal Controls and Analyze the Results of the Tests of Controls (Steps 6 and 7), 478 Perform Substantive Tests (Step 8), 479 PERFORMING THE INTEGRATED AUDIT OF THE REVENUE CYCLE, 479 Consider the Risks Related to Revenue Recognition (Steps 1 and 2), 479 Perform Preliminary Analytical Procedures (Step 3), 484 Linking Internal Controls and Financial Statement Assertions for the Revenue Account (Steps 4 and 5), 486 Design and Perform Tests of Internal Controls and Analyze the Results of the Tests of Controls (Steps 6 and 7), 489 Perform Substantive Tests in the Revenue Cycle (Step 8), 493 FORD AND TOYOTA CASE 541 BILTRITE PRACTICE CASE 542 CHAPTER 11 Audit of Acquisition and Payment Cycle and Inventory, 546 INTRODUCTION, 547 Significant Accounts and Relevant Assertions in the Acquisition and Payment Cycle, 548 PERFORMING THE INTEGRATED AUDIT OF THE ACQUISITION AND PAYMENT CYCLE, 549 Consider the Risks Related to the Acquisition and Payment Cycle (Steps 1 and 2), 551 Perform Preliminary Analytical Procedures for Possible Misstatements (Step 3), 552 Linking Internal Controls and Financial Statement Assertions for Accounts in the Payment and Acquisition Cycle (Steps 4. and 5), 552 Design and Perform Tests of Controls and Analyze Results of Tests of Controls (Steps 6 and 7), 557 Perform Substantive Testing of the Accounts in the Acquisition and Payment Cycle (Step 8), 558 COMPLEXITIES RELATED TO INVENTORY AND COST OF GOODS SOLD, 563 Risks and Controls Related to Inventory and Cost of Goods Sold, 564 Substantive Tests of Inventory and Cost of Goods Sold, 567 FORD AND TOYOTA CASE 598 BILTRITE PRACTICE CASE 599 CHAPTER 12 Audit of Cash and Other Liquid Assets, 600 INTRODUCTION, 601 Overview of Cash Accounts, 601 Overview of Financial Instruments and Marketable Security Accounts, 602 Relevant Financial Statement Assertions, 603
Contents xv INTEGRATED AUDIT OF CASH, 604 Consider the Risks Related to Cash (Steps 1 and 2), 605 Perform Preliminary Analytical Procedures to Identify Possible Misstatements in the Cash Accounts (Step 3), 607 Identify.Typical Internal Controls over Cash (Steps 4 and 5), 607 Design and Perform Tests of Controls and Analyze Results of Tests of Controls (Steps 6 and 7), 615 Perform Substantive Testing of Cash Balances (Step 8), 617 COMPLEXITIES RELATED TO THE AUDIT OF MARKETABLE SECURITIES AND FINANCIAL INSTRUMENTS, 623 Introduction, 623 Audits of Commercial Paper, 624 Audits of Investments in Equity and Debt Securities, 624 Audits of Derivative Instruments, 626 Audits of Financial Hedges, 629 FORD AND TOYOTA CASE 650 BILTRITE PRACTICE CASE 651 CHAPTER 13 Audit of Long-Lived Assets and Related Expense Accounts, 654 INTRODUCTION, 655 Significant Accounts and Relevant Assertions in the Long-Lived Asset Cycle, 655 PERFORMING THE INTEGRATED AUDIT OF LONG- LIVED ASSETS AND RELATED EXPENSES, 656 Consider the Risks Related to Long-Lived Assets (Steps 1 and 2), 657 Perform Preliminary Analytical Procedures for Possible Misstatements (Step 3), 659 Linking Internal Controls and Financial Statement Assertions for Long-Lived Assets and Related Expenses (Steps 4 and 5), 660 Design and Perform Tests of Controls and Analyze Results of Tests of Controls (Steps 6 and 7), 661 Perform Substantive Testing of the Long-Lived Assets and Related Accounts (Step 8), 662 SPECIAL TOPICS, 672 Intangible Assets and Natural Resources, 672 Leases, 673 FORD AND TOYOTA CASE 688 BILTRITE PRACTICE CASE 689 CHAPTER 14 Audit of Long-Term Liabilities, Equity, Acquisitions, and Related- Entity Transactions, 690 INTRODUCTION: BUSINESS RISK AND SUBJECnVE JUDGMENTS, 692 LONG-TERM LIABILITIES AND OWNERS' EQUITY, 692 Long-Term Liabilities with Significant Subjective Judgments, 692 Bonds and Stockholders' Equity, 694 MERGERS AND ACQUISITIONS, 699 Acquisition Asset Valuation Issues, 700 Audit Procedures for Restructuring Charges and Goodwill Impairment, 702 TRANSACTIONS WITH RELATED ENTITIES, 707 Accounting for Transactions with Related Entities, 708 Related-Entity Transactions and Small Businesses, 708 Audit Approachfor Related-Entity Transactions, 708 Variable Interest Entities, 711 Disclosure of Other Significant Relationships, 712 FORD AND TOYOTA CASE 729 BILTRITE PRACTICE CASE 730 CHAPTER 15 Completing the Audit, 734 AUDIT QUALITY AND COMPLETING THE AUDIT, 735 Evaluating the Going-Concern Assumption, 736 Evaluating Management Representations, 740 Summarizing and Resolving Possible Adjustments, 741 Reviewing Contingencies, 745 Reviewing Significant Estimates, 746 Evaluating Adequacy of Disclosures, 748 Performing Analytical Review of the Audit and Financial Statements, 749 Performing an Engagement Quality Review, 750 Communicating with Management via the Management Letter, 751 Communicating with the Audit Committee, 752 Assessing Subsequent Events, 753 FORD AND TOYOTA CASE 771 BILTRITE PRACTICE CASE 772 CHAPTER 16 Auditors' Reports, 774 LEVELS OF ASSURANCE PROVIDED BY AUDITORS, 776 AUDIT REPORTS ON FINANCIAL STATEMENTS AND INTERNAL CONTROL OVER FINANCIAL REPORTING, 776 Reporting on Internal Control over Financial Reporting, 777 EXPRESSION OF AN OPINION ON THE FINANCIAL STATEMENTS, 778 Standard Unqualified Audit Report, 779 Modifications to the Standard Unqualified Report Not Affecting the Opinion, 780 Modifications to the Standard Unqualified Report Affecting the Opinion, 783 Audit Reports on Comparative Statements, 788 Summary of Audit Report Modifications, 789 OTHER REPORTS RELATED TO FINANCIAL STATEMENT INFORMATION, 789 Reviews and Compilations for Nonpublic Companies, 789 Reviews of Interim Financial Information for Public Companies, 795 Special Reports, 798
XVI Contents ATTESTING TO OTHER INFORMATION PROVIDED BY MANAGEMENT, 802 Attestation Example: Attesting to Financial Reporting Using XBRL, 802 Agreed-Upon Procedures, 803 Prospective Financial Statements, 803 Pro Forma Financial Information, 803 Compliance Attestation, 804 FORD AND TOYOTA CASE 825 BILTRITE PRACTICE CASE 826 CHAPTER 17 Professional Liability, 828 THE LEGAL ENVIRONMENT, 829 Liability Doctrines, 830 Audit Time and Fee Pressures, 831 Audits Viewed as an Insurance Policy, 831 Contingent-Fee CompensationforLawyers, 831 Class Action Suits, 832 BASIC LEGAL CONCEPTS, 832 Causes of Legal Action, 833 Parties That May Bring Suit Against Auditors, 834 LEGAL PRECEDENCE: LIABILITY TO CLIENTS AND THIRD PARTIES UNDER COMMON LAW AND STATUTORY LAW, 834 Common-Law Liability to Clients Breach of Contract, 834 Common-Law Liability to Third Parties, 836 Statutory Liability to Third Parties, 838 Liability Issues of Multinational CPA Firms, 842 Liability Impact of Internet Dissemination of Audited Financial Information, 842 Liability: Always a Changing Landscape, 843 Summary of Auditor Liability to Third Parties, 843 MINIMIZING LIABILITY EXPOSURE, 843 Policies to Help Assure Auditor Independence, 843 Quality-Control Programs, 844 Review Programs, 845 Continuing Education Requirement, 846 Defensive Auditing, 846 CHAPTER 18 Advanced Topics Concerning Complex Auditing Judgments, 862 COMPLEX AUDIT JUDGMENTS, 863 MATERIALITY JUDGMENTS, 866 Purpose of Materiality Judgments and Common Benchmarks and Thresholds, 866 Common Difficulties in Making Materiality Judgments, 869 ASSESSING WHETHER MISSTATEMENTS ARE MATERIAL, 871 Aggregating and Netting Misstatements, 871 Evaluating Uncorrected Misstatements, 871 Subjective Differences Between the Auditor and Client, 872 Recent Regulatory Changes Concerning Materiality Judgments, 872 Intentional Misstatements, 873 Misstatements in the Statement of Cash Flows, 873 Known vs. Projected Misstatements, 873 CONCLUSIONS ABOUT INTERNAL CONTROL DEFICIENCIES, 874 Nature of Material Weaknesses in Internal Control, 874 Critical Criteria in Assessing Materiality of Internal Control Weaknesses, 875 EVALUATING A CLIENT'S INTERNAL AUDIT FUNCTION, 877 Internal Auditing Contrasted with External Auditing, 878 Staffing an Internal Audit Function, 879 Evaluating the Quality of Client's Internal Audit Function, 879 Effect of Internal Audits Work on the External Audit, 881 AUDITING FAIR VALUE ESTIMATES, 881 THE ACCOUNTING MODEL FOR FAIR VALUE ESTIMATES, 882 ISSUES IN AUDITING ADJUSTMENTS TO FAIR MARKET AND IMPAIRMENTS, 883 Fair Value Estimates, 884 Impairments, 885 FORD AND TOYOTA CASE 905 ACL APPENDIX ACL Basics, Tutorial, and Cases, 906 Data Files, 906 Getting Started, 906 ACL BASICS, 906 (1) Create a New Project, 906 (2) Open an Existing Project, 907 Basic Activities, 907 Sampling Size, Selection, Evaluation, 909 Saving Files, 910 Sort, 910 Stratify, 910 Summarize, 910 Verify, 911 Views, 911 Delete Files, 911 Close Projects, 911 ACL TUTORIAL, 911 StartUp, 911 Husky Tutorial Case, 911 ACL CASE 1 FRAUD, 928 ACL CASE 2 BENFORD'S LAW CASE, 929 Using ACL to Perform Benford Analysis, 929 The Case, 929 INTRDDUCTIONTO ACL CASES 3 AND 4 ACCOUNTS RECEIVABLE AND INVENTORY; 930 ACL CASE 3 ACCOUNTS RECEIVABLE, 930 Audit Program, 931 ACL CASE 4 INVENTORY, 931 Case Index, 933 Index, 934