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AUDITING and Assurance Services An Integrated Approach 14**> C«J‘t*on Th is eBook is provided by www.PlentyofeBooks.net Plenty of eBooks is a blog with an aim of helping people, especially student , who cannot afford to buy some costly books from the market. For more Free eBooks and educational material visit www.PlentyofeBooks.net ARENS ELDER BEASLEY Summary of the Audit Process Accept client and perform initial planning PHASE I Plan and design an audit approach l Understand the client's business and industry I Assess client business risk l Perform preliminary analytical procedures l Set materiality and assess acceptable audit risk and inherent risk I Understand internal control and assess control risk l Gather information to assess fraud risks l Develop overall audit plan and audit program PHASE II Perform tests of controls and substantive tests of transactions No Perform tests of controls* I Perform substantive tests of transactions l Assess likelihood of misstatements in financial statements PHASE III Perform analytical procedures and tests of details of balances PHASE IV Complete the audit and issue an audit report High or n noWn Perform analytical procedures Perform tests of key items Perform additional tests of details of balances Low Medium U k Perform additional tests for presentation and disclosure I Accumulate final evidence l Evaluate results I Issue audit report l Communicate with audit committee and management *The extent of testing of controls is determined by planned reliance on controls. For public companies required to have an audit of internal control, testing must be sufficient to issue an opinion on internal control over financial reporting. FOURTEENTH EDITION AUDITING AND ASSURANCE SERVICES AN INTEGRATED APPROACH Includes coverage of international standards and global auditing issues, in addition to coverage of PCAOB Auditing Standards, the risk assessment SASs, the Sarbanes-Oxley Act, and Section 404 audits. ALVIN A. ARENS Apago P D F Enhancer PricewaterhouseCoopers Emeritus Professor Michigan State University RANDAL J. ELDER Syracuse University MARK S. BEASLEY North Carolina State University Deloitte Professor of Enterprise Risk Management Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo A TRIBUTE TO ALVIN A. ARENS Library of Congress Cataloging-in-Publication Information is available. Arens, Alvin A. Auditing and assurance services: an integrated approach/ Alvin A. Arens, Randal J. Elder, Mark S. Beasley.—14th ed. p. cm. Includes index. ISBN-13: 978-0-13-257595-9 ISBN-10: 0-13-257595-7 1. Auditing. I. Elder, Randal J. II. Beasley, Mark S. III. Title. VP/Editorial Director: Sally Yagan Editor in Chief: Donna Battista Executive Editor: Stephanie Wall Product Development Manager: Ashley Santora Editorial Project Manager: Christina Rumbaugh Editorial Assistant: Brian Reilly Director of Marketing: Patrice Lumumba Jones Marketing Assistant: Ian Gold Senior Managing Editor: Cynthia Zonneveld Production Project Manager: Carol O’Rourke Senior Operations Manager: Diane Peirano Art Director: Anthony Gemmellaro Interior Design: Lisa Delgado & Co. Cover Design: Anthony Gemmellaro Composition: Lynne Wood Printer/Binder: Quebecor World Color/Versailles Typeface: 11/12.5 Minion Regular Apago The auditing profession and audit education lost a great friend, mentor, and leader with the passing of Alvin A. Arens in December 2010. Al’s leadership at national and international levels and his commitment to expanding knowledge through the development of educational materials, resources, articles, and cases profoundly impacted students and professionals in auditing. As founding author of Auditing and Assurance Services: An Integrated Approach, he has shaped classroom instruction and student learning about auditing concepts and their practical implementation around the world. Since the first edition was published in 1976, his textbook has impacted audit education for over 30 years in the U.S. and globally, including six different language translations of the most recent edition. A1 Enhancer PDF was the PricewaterhouseCoopers Auditing Professor and member of the Accounting & Information Systems faculty in the Eli Broad College Credits and acknowledgments borrowed from other sources and reproduced, with Apa of Businessat MichiganState University from 1968 through 2007. permission, in this textbook appear on appropriate page within text. Among his many honors, Al was selected as one of five national auditing educators to hold the first Price Waterhouse Auditing professorships, was honored as AICPA Educator of the Year, served on the AICPA’s Auditing Standards Board, and was President of the American Accounting Association. Al taught accounting, mainly auditing, 2008, a passion that is legendary. He had a heart for Copyright © 2012, 2010,with 2006, 2005 by Pearson Education, Inc., Upper Saddle River, sharing his knowledge of auditing with the New Jersey, 07458. Pearsonprofessionals.rights will be Printed in the United States of next generation of Prentice Hall. All He reserved. missed. November 24, 1935 - December 6, 2010 America. This publication is protected by Copyright and permission should be obtained from the publisher14th to any prohibited reproduction, storage in a retrieval system, or transmission leader, This prior edition is dedicated in memory of Al Arens — author, in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. mentor, friend. Pearson Prentice Hall™ is a trademark of Pearson Education, Inc. Pearson® is a registered trademark of Pearson plc Prentice Hall® is a registered trademark of Pearson Education, Inc. Pearson Education Ltd., London Pearson Education Singapore, Pte. Ltd Pearson Education, Canada, Inc. Pearson Education-Japan Pearson Education Australia PTY, Limited Pearson Education North Asia Ltd., Hong Kong Pearson Educación de Mexico, S.A. de C.V. Pearson Education Malaysia, Pte. Ltd Pearson Education Upper Saddle River, New Jersey Prentice Hall is an imprint of 10 9 8 7 6 5 4 3 2 1 ISBN-13: 978-0-13-257595-9 ISBN-10: 0-13-257595-7 www.pearsonhighered.com iii This page intentionally left blank Apago PDF Enhancer 3 AUDIT REPORTS Learning Objectives 45 Standard Unqualified Audit Report 46 Report on Internal Control Over Financial Reporting Under Section 404 of the Sarbanes-Oxley Act 49 Unqualified Audit Report with Explanatory Paragraph or Modified Wording 51 Departures from an Unqualified Audit Report 55 Materiality 56 Discussion of Conditions Requiring a Departure 59 Auditor’s Decision Process for Audit Reports 62 International Accounting and Auditing Standards 65 Summary 65 PREFACE xv i Essential Terms 66 Review Questions 66 Multiple Choice Questions from CPA Examinations 68 Discussion Questions and Problems 69 Internet Problem 3-1: Research Annual Reports 74 THE AUDITING PROFESSION THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES Learning Objectives 3 Nature of Auditing 4 PROFESSIONAL ETHICS Distinction Between Auditing and Accounting 6 Economic Demand for 4 Auditing 6 Learning Objectives 77 Assurance Services 8 What Are Ethics? 78 Ethical Dilemmas 79 Types of Audits 12 Special Need for Ethical Conduct in Professions 82 Code of Professional Conduct Types of Auditors 15 84 Independence 87 Certified Public Accountant 17 IndependenceRule of Conduct andlnterpretationsf 90 Summary 18 Other Rules of Conduct 95 Essential Terms 18 Enforcement 103 Review Questions 19 Apago PDF Enhancer Summary 103 Multiple Choice Questions from CPA Examinations 20 Essential Terms 104 Discussion Questions and Problems 21 Internet Problem Review Questions 104 1-1: CPA Requirements 24 Multiple Choice Questions from CPA Examinations 105 Discussion Questions and Problems 106 Cases 109 Internet Problem 4-1: IESBA Code of Ethics 112 THE CPA PROFESSION Learning Objectives 25 Certified Public Accounting Firms 26 Activities of CPA Firms 27 Structure of CPA Firms 28 LEGAL LIABILITY Sarbanes-Oxley Act and Public Company Accounting OversightLearning Objectives 113 Board 30 Changed Legal Environment 114 Securities and Exchange Commission 30 Distinguishing Business Failure, Audit Failure, and Audit Risk 115 Legal Concepts American Institute of Certified Public Accountants (AICPA) 31 Affecting Liability 116 Liability to Clients 118 International and U.S. Auditing Standards 32 Generally Accepted Auditing Standards 34 Liability to Third Parties Under Common Law 121 Civil Liability Under the Federal Securities Laws 123 Criminal Liability 127 Statements on Auditing Standards 36 The Profession’s Response to Legal Liability 130 Protecting Individual CPAs from Quality Control 37 Legal Liability 130 Summary 131 Essential Terms 132 Review Questions 133 Summary 39 Multiple Choice Questions from CPA Examinations 133 Essential Terms 39 Review Questions 40 Multiple Choice Questions from CPA Examinations 41 Discussion Questions and Problems 42 Internet Problem 2-1: International Auditing and Assurance Standards Board 44 vi CONTENTS CONTENTS v Assess 135 Case Discussion Questions and Problems Client Business Risk 220 Perform Preliminary Analytical Procedures 222 139 Summary 139 Internet Problem 5-1: SEC Enforcementof the Parts of Audit Planning 223 Analytical Procedures 223 Five Types of Analytical Procedures 226 Common Financial Ratios 230 Summary 233 Essential Terms 234 Review Questions 234 Multiple Choice Questions from CPA Examinations 236 Discussion Questions and Problems 237 Cases 243 AUDIT RESPONSIBILITIES AND OBJECTIVES Integrated Case Application — Pinnacle Manufacturing: Part I 245 Learning Objectives 141 ACL Problem 247 Objective of Conducting an Audit of Financial Statements 142 Client Background Information 248 Internet Problem 8-1: Obtain Management’s Responsibilities 143 Auditor’s Responsibilities 144 Financial Statement Cycles 148MATERIALITY AND RISK Setting Audit Objectives 152 9 Management Assertions 153 Learning Objectives 249 Materiality Transaction-Related Audit Objectives 156 250 Set Preliminary Judgment about Materiality 251 Allocate Preliminary Balance-Related Audit Objectives 158 Judgment about Materiality Presentation and Disclosure-Related Audit Objectives 161 to Segments (Tolerable Misstatement) 254 How Audit Objectives Are Met Estimate Misstatement and Compare with Preliminary Judgment 257 161 Audit Risk 258 Summary 163 Audit Risk Model Components 261 Essential Terms 164 Assessing Acceptable Audit Risk 263 Review Questions 165 Assessing Inherent Risk 266 Multiple Choice Questions from CPA Examinations 166 Relationshipof Discussion Questions and Problems 167 Risks to EvidenceandFactorsInfluencing Risks 268 Summary 274PDF Enhancer 274 Review Questions 275 Case 171 Apago Essential Terms Multiple Choice Questions from CPA Examinations 276 Discussion Internet Problem 6-1: International and PCAOB Audit Objectives 172 Questions and Problems 278 Cases 284 Integrated Case Application — Pinnacle Manufacturing: Part II 287 AUDIT EVIDENCE Internet Problem 9-1: Materiality and Tolerable Misstatement 288 THE AUDIT PROCESS 2 Learning Objectives 173 Nature of Evidence 174 Audit Evidence Decisions 175 Persuasiveness of Evidence 176 Types of Audit Evidence 179 Audit Documentation 188 SECTION 404 AUDITS OF Summary 196 Essential Terms 196 Review Questions 197 AND CONTROL RISK INTERNAL CONTROL Multiple Choice Questions from CPA Examinations 198 Discussion Questions and Problems 199 Learning Objectives 289 Cases 204 Internal Control Objectives 290 Management and Auditor Responsibilities for Internal Control 291 COSO Components of Internal Control 294 ACL Problem 206 Obtain and Document Understanding of Internal Control 302 Internet Problem 7-1: Use of Audit SoftwareRisk Fraud Detection Assess Control for 307 and Continuous Auditing 206 of Controls 312 Tests Decide Planned Detection Risk and Design Substantive Tests 315 Section 404 Reporting on Internal Control 315 AUDIT PLANNING AND ANALYTICAL PROCEDURES Evaluating, Reporting, and Testing Internal Control for Nonpublic Companies 317 Learning Objectives 209 Summary 319 Essential Terms 320 Review Questions 322 Planning 210 Multiple Choice Questions from CPA Examinations 324 Accept Client and Perform Initial Audit Planning 211 Understand the Client’s Business and Industry 215 viii CONTENTS CONTENTS vii Discussion Questions and Problems 326 Case 331 Integrated Case Application — Pinnacle Manufacturing: Part III 332 Internet Problem 10-1: Disclosure of Material Weaknesses in Internal Control Over Financial Reporting 333 FRAUD AUDITING Learning Objectives 335 Types of Fraud 336 Conditions for Fraud 337 Assessing the Risk of Fraud 341 Corporate Governance Oversight to Reduce Fraud Risks 345 Responding to the Risk of Fraud 349 Specific Fraud Risk Areas 351 Responsibilities When Fraud is Suspected 356 Summary 360 Essential Terms 361 Review Questions 361 Multiple Choice Questions from CPA Examinations 362 Discussion Questions and Problems 363 Case 368 Integrated Case Application — Pinnacle Manufacturing: Part IV 369 ACL Problem 369 Internet Problem 11-1: Brainstorming About Fraud Risks 370 THE IMPACT OF INFORMATION TECHNOLOGY ONTHEAUDITPROCESS Learning Objectives 371 How Information Technologies Improve Internal Control 372 Assessing Risks of Information Technology 372 Internal Controls Specific to Information Technology 374 Impact of Information Technology on the Audit Process 380 Issues for Different IT Environments 386 Summary 390 Essential Terms 390 Review Questions 392 Multiple Choice Questions from CPA Examinations 392 Discussion Questions and Problems 394 Case 399 ACL Problem 401 Internet Problem 12-1: Assessing IT Governance 402 OVERALL AUDIT PLAN AND AUDIT PROGRAM Learning Objectives 403 Types of Tests 404 Selecting Which Types of Tests to Perform 409 Impact of Information Technology on Audit Testing Evidence 412 Mix 413 Design of the Audit Program 414 Summary of Key Evidence-Related Terms 423 Summary of the Audit Process 424 Essential Terms 428 CHAPTER 13 CONTENTS ix Review Questions 429 Multiple Choice Questions from CPA Examinations 430 Discussion Questions and Problems 431 Cases 436 Internet Problem 13-1: Assessing Effects of Evidence Mix 439 3 APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE AUDIT OF THE SALES AND COLLECTION CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS Learning Objectives 441 Accounts and Classes of Transactions in the Sales and Collection Cycle 442 Business Functions in the Cycle and Related Documents and Records 443 Methodology for Designing Tests of Controls and Substantive Tests of Transactions for Sales 447 Sales Returns and Allowances 458 Methodology for Designing Tests of Controls and Substantive Tests of Transactions for Cash Receipts 459 Audit Tests for the Write-off of Uncollectible Accounts 463 Additional Internal Controls over Account Balances and Presentation and Disclosure 464 Effect of Results of Tests of Controls and Substantive Tests of Transactions 464 summary^£465o PDF Enhancer Essential Terms 466 Review Questions 466 Multiple Choice Questions from CPA Examinations 467 Discussion Questions and Problems 469 Case 474 Integrated Case Application — Pinnacle Manufacturing: Part V 475 ACL Problem 476 Internet Problem 14-1: Revenue Recognition Fraud 476 AUDIT SAMPLING FOR TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS Learning Objectives 477 Representative Samples 478 Statistical Versus Nonstatistical Sampling and Probabilistic Versus Nonprobabilistic Sample Selection 479 Nonprobabilistic Sample Selection Methods 480 Probabilistic Sample Selection Methods 482 Sampling for Exception Rates 484 Application of Nonstatistical Audit Sampling 485 Statistical Audit Sampling 501 Sampling Distribution 501 Application of Attributes Sampling 502 Summary 507 Essential Terms 508 Review Questions 509 x CONTENTS Multiple Choice Questions from CPA Examinations 510 Tests of Controls and Substantive Tests of Transactions 606 Methodology for Designing Discussion Questions and Problems 512 Case 516 Methodology for Designing Tests of Details of Balances for Accounts Payable 612 Integrated Case Application — SummaryManufacturing: Part VI 516 Pinnacle 620 Essential Terms 621 Review Questions 621 Internet Problem 15-1: Applying Statistical Sampling 518 from CPA Examinations 623 Discussion Questions and Multiple Choice Questions Problems 624 Case 630 Internet Problem 18-1: Identifying Accounts Payable Fraud 632 COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE Learning Objectives 519 Methodology for Designing Tests of Details of Balances 520 COMPLETING THE TESTS IN THE ACQUISITION AND Designing Tests of Details of Balances 526 Confirmation VERIFICATION OF SELECTED ACCOUNTS PAYMENT CYCLE: of Accounts Receivable 532 Developing Tests of Details Audit Program 538 Essential Terms 541 ReviewLearning Objectives 633 Questions 542 Multiple Choice Questions fromTypesExaminations 543 in the Acquisition and Payment Cycle 634 CPA of Other Accounts Discussion Questions and Problems 544 Case 550 Property, Plant, and Equipment 634 Audit of Integrated Case Application — Pinnacle Prepaid ExpensesPart VII Audit of Manufacturing: 641 ACL Problem 556 Audit of Accrued Liabilities 644 Internet Problem 16-1: Revenue Recognition 556 Expense Accounts 646 Audit of Income and Summary 649 551 Essential Terms 650 Review Questions 650 Multiple Choice Questions from CPA Examinations 651 Discussion Questions AUDIT SAMPLING FOR TESTS OF and Problems 653 DETAILS OF BALANCES Cases 655 Internet Problem 19-1: Centerpulse Ltd. Fraud 657 Learning Objectives 557 Comparisons of Audit Sampling for Tests of Details of Balances and for Tests of Controls and AUDITOF TestsofPAYROLLANDPERSONNEL CYCLE Substantive THE Transactions!!!558ancer Nonstatistical Sampling 559 Monetary Unit Sampling 567 Variables Sampling 578 20 Learning Objectives 659 Illustration Using Difference Estimation 583 Summary 589 Essential Terms 590 Accounts and Transactions in the Payroll and Personnel Cycle 660 Review----------------' Questions 590 Business Functions in the Cycle and Multiple Choice Questions from CPA Examinations 592 DiscussionRelated Documents and Records 660 Methodology for Designing Questions and Problems 593 Cases 598 ACL Problem 599 Tests of Controls and Substantive Tests of Transactions 664 Methodology for Designing Tests of Details of Balances 668 Internet Problem 17-1: Monetary Unit Sampling Considerations 599 Summary 672 Essential Terms 673 Review Questions 673 Multiple Choice Questions from CPA Examinations 674 Discussion Questions and Problems 675 Case 679 Internet Problem 20-1: Risks of Outsourcing the Payroll Function 680 AUDIT OF THE INVENTORYTHE AUDIT APPLICATION OF AND WAREHOUSING CYCLE 21 ----------------' PROCESS TO OTHER CYCLES 4 Learning Objectives 681 Business Functions in the Cycle and Related Documents and Records 682 Parts of the Audit of Inventory 684 Audit of Cost Accounting 686 Analytical Procedures 689 Physical ACQUISITION AND PAYMENT CYCLE: AUDIT OF THEObservation of Inventory 689 Audit of Pricing and Compilation 693 Integration of CHAPTER the CONTROLS AND Essential Terms 699 TESTS OFTests 697 Summary 699SUBSTANTIVE TESTS OF TRANSACTIONS, AND ACCOUNTS PAYABLE Learning Objectives 601 Accounts and Classes of Transactions in the Acquisition and Payment Cycle 602 Business Functions in the Cycle and Related Documents and Records 603 xii CONTENTS CONTENTS xi Review Questions 700 Multiple Choice Questions from CPA Examinations 701 Discussion Questions and Problems 702 Case 708 Internet Problem 21-1: Using Inventory Count Specialists 710 AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE Learning Objectives 711 Accounts in the Cycle 712 Notes Payable 713 Owners’ Equity 716 Summary 723 Essential Terms 723 Review Questions 724 Multiple Choice Questions from CPA Examinations 725 Discussion Questions and Problems 726 Internet Problem 22-1: Overview of the NYSE 730 AUDIT OF CASH BALANCES Learning Objectives 731 Cash in the Bank and Transaction Cycles 732 Types of Cash Accounts 734 Audit of the General Cash Account 735 Fraud-Oriented Procedures 742 Audit of the Imprest Payroll Bank Account Âpago PDF Enhancer Audit of Imprest Petty Cash 747 Summary 747 Essential Terms 748 Review Questions 748 Multiple Choice Questions from CPA Examinations 749 Discussion Questions and Problems 750 Internet Problem 23-1: Check Clearing for the 21st Century Act 755 COMPLETING THE AUDIT 5 COMPLETING THE AUDIT Learning Objectives 757 Perform Additional Tests for Presentation and Disclosure 758 Review for Contingent Liabilities and Commitments 759 Review for Subsequent Events 764 Final Evidence Accumulation 767 Evaluate Results 771 Issue the Audit Report 776 Communicate with the Audit Committee and Management 776 Subsequent Discovery of Facts 778 Summary 779 CONTENTS xiii Essential Terms 779 Review Questions 780 Multiple Choice Questions from CPA Examinations 781 Discussion Questions and Problems 783 Case 787 Internet Problem 24-1: Audit Committee Responsibilities 787 OTHER ASSURANCE AND NONASSURANCE SERVICES CHAPTER OTHER ASSURANCE SERVICES Learning Objectives 789 Review and Compilation Services 790 Review of Interim Financial Information for Public Companies 795 Attestation Engagements 796 WebTrust and SysTrust Services 799 Reports on Controls at Service Organizations 800 Prospective Financial Statements 801 Agreed-Upon Procedures Engagements 803 Other Audits or Limited Assurance Engagements 804 Summary 806 Essential Terms 807 Review Questions 808 MultipleChoiceQuestionsfromCPAExaminations 809 Discussion Questions and Problems 810 Internet Problem 25-1: Accounting and Review Services Committee 814 INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING Learning Objectives 815 Internal Financial Auditing 816 Governmental Financial Auditing 819 Operational Auditing 821 Summary 829 Essential Terms 829 Review Questions 830 Multiple Choice Questions from CPA, CIA, and CMA Examinations 831 Cases 833 Internet Problem 26-1: Institute of Internal Auditors 837 APPENDIX: ACL INSTALLATION AND INSTRUCTIONS 838 INDEX 843 xiv CONTENTS and new standards covering auditor responsibilities related to supplementary information included in financial statements (SAS Nos. 119 and 120). We are committed to continually providing you with up-to-date content in this dynamic global auditing environment and will keep you updated with highlights posted on our Web site of major changes in new standards as they are issued. Emphasis on International Issues Consistent with the convergence toward international accounting and auditing standards, this edition contains integrated APPROACH FOR RISK ASSESSMENT auditing INTEGRATED coverage of developments related to international standards and emphasizes issues affecting audits of multi-national entities. Chapter 1 AND AUDIT DECISION-MAKING introduces the importance of considering international auditing standards developments, followed by discussion in Chapter 2 about the role of the International Auditing and Auditing and Assurance Services: An Integrated Approach is an introductionissuance of international auditing standards and Assurance Standards Board (IAASB) in the to auditing and other assurance services. It is intended for either a one-quarter or one-semester course atstandards to international standards. the Auditing Standards Board’s efforts to converge U.S. the undergraduate or graduate level. This book is also appropriate for introductory professional companies reporting under Chapter 3 highlights implications for auditor reports on development courses for CPA firms, internal auditors, and government auditors. International Financial Reporting Standards (IFRS) and describes the SEC’s current roadmap The primary emphasis in this text is on the auditor’s the use of IFRS for financial finanproposal for embracing decision-making process in a reporting by U.S. public companies. cial statement audit, as well as Several chapters throughout the book include and internal an integrated audit of both financial statements text or mid-chapter vignette coverage of control over financial reporting international accelerated filer public companies. We believe required for issues, and international issues are also addressed in homework problems, that the most fundamental concepts in auditing concern determining the nature and amount of including Internet problems. evidence the auditor should gather after considering the unique circumstances of each engageThe requirements of the Sarbanes-Oxley Act of given audit ment. If students 5 auditing understand the objectives to be accomplished in a2002 and the PCAOB’s Auditing Standard 5 Coverage of AS of and (AS 5) and the decisions to be filer they companies, to area, the Assessment the Riskrisks related to the engagement,that impact accelerated made,publicshould be ableand the risk assessment standards issued by the Auditing Standards Board are integrated throughout the text. Chapter 2 determine the Standards appropriate evidence to gather and how to evaluate the evidence obtained. emphasizes the importance of understanding the client’s Our objective is to provide up-to-date coverage of globally recognized auditing concepts business and its environment, including internal control. We also real-world settings. The with practical examples of the implementation of those concepts in introduce the PCAOB’s new risk assessment standards. Chapter 3 highlights reporting on internal controls over financial reporting for auditors of collective experience of the author team in the practice of auditing is extensive. All three accelerated filer public companies and describes audit firms authors have worked in the auditing profession involving both large international the permanent exemption of that reporting requirement for non-accelerated filers that resulted from the and regional firms. All three authors have taught extensively in continuing education for passage of the 2010 federal financial reform legislation. We have always emphasized understanding the client’s business either large international or small CPA firms and they have been involved in standards setting and industry in PCAOB. Oneauthorcurrently serves as one activities of the Auditing Standards Boardandtheplanning, andwe incorporatetherisk assessment procedures required by the of the board members of the risk assessment Sponsoring Organizations of planning in Chapter 8 and throughout the text. Committee of standards in our coverage of the Treadway Chapter 10 emphasizes perspectives about the integration of Commission (COSO). These experiences provide unique the importance of considering internal control as part of the risk assessment process and the chapter also highlights important concepts in AS 5 affecting the auditing concepts in real-world settings. audit of purpose is to integrate the most important internaAs the title of this book reflects, ourinternal control over financial reporting for large public companies. Subsequent chapters that logical manner to assist students in understand tionally recognized concepts of auditing in a focus on the transaction cycles include extensive coverage of internal controls to ing audit decision making and help students understandin today’sauditor’s consideration of internal controls is integrated for evidence accumulation how the complex, global auditing audits of the financial statements auditing and controls over financial reporting. environment. For example, developments related to international and internal issues affecting The risk environment are described throughout the book auditing in a global and economically volatile assessment standards include three categories of assertions related to transac tions and events, account balances, and presentationconcepts and emphasized in selected mid-chapter vignettes and homework problems. Key and disclosures. These are described in Chapter in standards issued by of the audit in Chapter 13, and related to risk assessment as emphasized 6, related to the phasesthe Auditing Standards Board applied to transaction cycles and and of account balances throughout the are Additional (ASB) and the International Auditingtests Assurance Standards Board (IAASB) text.integrated tests the auditor performs to into all of the planning chapters,address presentation and dealing with a particular transactionin Chapter 24 on completing the as well as each chapter disclosure objectives are discussed audit. cycle and related accounts. Internal control is related to tests of controls and sub stantive tests of transactions that are performed infirms are increasingly using and an integrated perform audit testing including tests for CPA a financial statement audit audit software to audit of ACL Problems financial statements and internal control over financial reporting,problems using ACL inthe fraud. We have included selected with an emphasis on several chapters in the text. Many requirements of PCAOB Auditing Standards. audit software to perform audit sampling, and we have included an ACL CPA firms use Tests of controls and substantive tests of transactions are, in turn, related problem on of details of financial statement bal ances for the are related to the topic of the to the tests audit sampling in Chapter 17. These problems area. Audit sampling is applied chapter evaluation of audit evidence audit software is used to perform specific types of audit to the so that students can see how rather than treated as a separate topic. Risk assessment, tests. Additional guidance for students on the use of issuesis included both on the text Web site technology, fraud, and auditing of internal control ACL are integrated throughout the chapters. as an appendix to the text. The educational version of ACL software is included with and every new copy of this edition. KEY FEATURES IN THE FOURTEENTH EDITION Hillsburg Hardware L_____________________________________________________________________________________________________________________________________________________________ the text. Financial statements and other information included in the annual report are used in Annual Report examples throughout the text to illustrate chapter concepts. The annual report also includes New auditing standards are released without regard to textbook revision cycles. As auditing Current Coverage management’s report on internal control required by Section 404a and the auditor’s report The annual report for the Hillsburg Hardware Company is included as a four-color insert to A instructors, we appreciate how critical it is to have the most current content available. This required by Section 404b consistent with PCAOB Auditing Standard No. 5. edition includes coverage of PCAOB Auditing Standard No. 7, Engagement Quality Review, xvi PREFACE xv The Pinnacle Manufacturing integrated case is based on a large, multi-division company. The case has been revised and expanded to now consist of seven parts included at the end of the chapter to which that part relates. Each part of the case is designed to give students hands-on experience, and the parts of the case are connected so that students will gain a better understanding of how the parts of the audit are integrated by the audit process. Pinnacle Manufacturing Integrated Case All chapters include an Internet-based case/homework assignment that requires students to use the Internet to research relevant auditing issues. All chapters include several new or revised problems. The use of bullets and numbering and a large font size enhance the readability of the text and help students retain key concepts. New and Revised Homework Problems ORGANIZATION The text is divided into six parts. The chapters are relatively brief and designed to be easily read and comprehended by students. Part 1, The Auditing Profession (Chapters 1-5) The book begins with an opening vignette, featuring the WorldCom fraud, to help students begin to see the connection between recent frauds and the responsibilities for auditing internal control and other requirements of the Sarbanes-Oxley Act. Chapter 1 introduces key provisions of the Act, including the creation of the PCAOB and Section 404 internal control reporting requirements. Chapter 2 covers the CPA profession, with particular emphasis on the standards setting responsibilities of the International Auditing and Assurance Standards Board (IAASB) and the PCAOB and how those responsibilities differ from those of the Auditing Standards Board (ASB) of the AICPA. Chapter 3 provides a detailed discussion of audit reports, including a separate section on the report on internal control over financial reporting for an accelerated filer public company. The chapter also emphasizes conditions affecting the type of report the auditor must issue and the type of audit report applicable to each condition under varying levels of materiality. Chapter 4 explainsethicaldilemmas, professional ethics, independence, and the AICPA Code of Professional Conduct. Chapter 5 ends this part with an investigation of auditors’ legal liability. Part 2, The Audit Process (Chapters 6-13) The first two of these chapters deal with auditor and management responsibilities, audit objectives, general concepts of evidence accumulation, and audit documentation, including the management assertions and evidence concepts in the risk assessment standards. Chapter 8 deals with planning the engagement, including understanding the company’s business and its industry as part of risk assessment procedures, and using analytical procedures as an audit tool. Chapter 9 introduces materiality and risk and how the auditor responds to risks of significant misstatement with further audit procedures. Chapter 10 shows how effective internal controls can reduce planned audit evidence in the audit of financial statements. Most of the chapter describes how auditors of accelerated filer public companies integrate evidence to provide a basis for their report on the effectiveness of internal control over financial reporting with the assessment of control risk in the financial statement audit. Fraud auditing is the focus of Chapter 11 and describes the auditor’s responsibility for assessing fraud risk and detecting fraud. The chapter also includes specific examples of fraud and discusses warning signs and procedures to detect fraud. Chapter 12 addresses the most important effects of information technology on internal controls in businesses, risks the auditor must consider, and audit evidence changes. Chapter 13 summarizes Chapters 6 through 12 and integrates them with the remainder of the text. Part 3, Application of the Audit Process to the Sales and Collection Cycle (Chapters 14-17) These chapters apply the concepts from Part 2 to the audit of sales, cash receipts, and the related income statement and balance sheet accounts. The appropriate audit procedures for accounts in the sales and collection cycle are related to internal control and audit objectives for tests of controls, substantive tests of transactions, and tests of details of balances in the context of both the audit of financial statements and audit of internal control over financial reporting. PREFACE xvii