Audit and Assurance Services Textbook PDF

THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES CHAPTER 1 1-1  CHAPTER 1 LEARNING OBJECTIVES 1-1 Describe auditing. 1-2 Distinguish between auditing and accounting. 1-3 Explain the importance of auditing in reducing information risk. 1-4 List the causes of in...

THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES CHAPTER 1 1-1  CHAPTER 1 LEARNING OBJECTIVES 1-1 Describe auditing. 1-2 Distinguish between auditing and accounting. 1-3 Explain the importance of auditing in reducing information risk. 1-4 List the causes of information risk and explain how this risk can be reduced. 1-5 Describe assurance services and distinguish audit services from other assurance and non-assurance services provided by CPAs. 1-6 Differentiate the three main types of audits. 1-7 Identify the primary types of auditors. 1-8 Describe the requirements for becoming a CPA. 1-2  OBJECTIVE 1-1 Describe auditing. 1-3 NATURE OF 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 (for ex. GAAP or IFRS). Auditing should be done by a competent (knowledgeable and experienced), independent person (the external auditor). 1-4  OBJECTIVE OF CONDUCTING AN AUDIT OF FINANCIAL STATEMENTS The objective of the ordinary audit of financial statements by the independent (external) auditor is: “The expression of an opinion on the fairness with which they present, in all material respects, financial position, results of operations, and cash flows in conformity with Generally Accepted Accounting principles (GAAP)”. 5  THIS DEFINITION INCLUDES SEVERAL KEY WORDS AND PHRASES AS FOLLOWS: 1. Information and Established Criteria. 2. Accumulating and Evaluating Evidence. 3. Competent Independent Person. 4. Reporting. 6  1. INFORMATION AND ESTABLISHED CRITERIA To do an audit, there must be information in a verifiable form and some standards (criteria) by which the auditor can evaluate the information. Criteri FASB a IASB Information can and does take many forms which are: 1. Quantifiable information, including companies’ financial statements and individuals’ federal income tax returns. 2. Subjective information, such as the effectiveness of computer systems and the efficiency of manufacturing operations. 1-5 The criteria for evaluating information also vary depending on the type information being audited as follows:  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).  For the audit of tax returns by the Internal Revenue Service (IRS), the criteria are found in the Internal Revenue Code.  For an audit of Internal Control over Financial Reporting, the criteria will be the Internal Control-Integrated Framework issued by Committee of Sponsoring Organizations of the Treadway Commission (widely known as “COSO”). 8  2. ACCUMULATING AND EVALUATING EVIDENCE Evidence is any information used by the auditor to determine whether the information being audited is stated in accordance with established criteria. Evidence takes many different forms, including: Written Oral Testimony Communication (indication) of the s with auditee (Client) Electronic and Outsiders Observations Documentary by the Data about auditor Transactions 1-9  To satisfy the purpose of the audit, auditors must obtain a sufficient quality and volume 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. 10  3. COMPETENT, INDEPENDENT PERSON The auditor must be:  Qualified to understand the criteria used and must be Competent to know the types and amount of evidence to accumulate to reach the proper conclusion after examining the evidence.  The auditor must also have an independent mental attitude. 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. 11 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 competence of those performing the audit is of little value if they are biased in the accumulation and evaluation of evidence. 12  Independenc Competence e Evaluation of Evidence Proper Conclusion 1-13  4. REPORTING (AUDIT REPORT) The final stage in the auditing process is preparing the audit report, which communicates the auditor’s findings to users. It can be concluded that, an auditor′s ultimate responsibility is to the users of the financial statements. Reports differ in nature, but all must inform readers of the degree of correspondence between the information audited and established criteria. 1-14  OBJECTIVE 1-2 Distinguish between auditing and accounting. 1-15  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. 1-16  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 Accounting principles and rules (Accounting standards) 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. 1-17  Auditors focus on determining whether recorded information properly reflects the economic events that occurred during the accounting period. Auditors must understand Auditing Standards to determine the proper audit procedures. 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. Auditors must understand accounting standards to determine the correspondence between recorded information and established criteria (standards). 1-18  Auditor is an expert in the accumulation and interpretation of audit evidence. It is this expertise that 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. NOTICE: Auditor is an accountant. While accountant is not an auditor. 1-19  OBJECTIVE 1-3 Explain the importance of auditing in reducing information risk. 1-20  ECONOMIC DEMAND FOR AUDITING Information risk reflects the possibility that the information upon which a business decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements. Auditing can have a significant effect on information risk. Auditing of financial information reduces information risk to the users of financial information. 1-21  OBJECTIVE 1-4 List the causes of information risk, and explain how this risk can be reduced. 1-22  CAUSES OF INFORMATION RISK Management asserts (declare) that the statements are fairly stated in accordance with applicable U.S. or international accounting standards. Legally, management is responsible for providing reliable information to users. As society becomes more complex, decision makers are more likely to receive unreliable information (information risk). There are several reasons for this:  Remoteness of information.  Biases and motives of the provider.  Voluminous data.  Complex exchange transactions. 1-23  CAUSES OF INFORMATION RISK Remoteness of information: In a global economy, it is nearly impossible for a decision maker to have firsthand (immediate) knowledge about the organization with which they do business and must rely on information provided by others. When information 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. 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. 1-24  CAUSES OF INFORMATION RISK Voluminous data: Higher volumes of transactions increase the likelihood of undetected errors. If many minor misstatements remain undiscovered, the combined total can be significant. Complex exchange transactions: Transactions between organizations have become increasingly complex and therefore, more difficult to record properly. Complex accounting standards are difficult to interpret and apply. For example, the correct accounting treatment of the acquisition of one entity by another poses relatively difficult accounting problems. 1-25  REDUCING INFORMATION RISK Audited financial statements are provided: The most common way for users to obtain reliable information is to have an independent audit. 1-26 1-18  OBJECTIVE 1-5 Describe assurance services and distinguish audit services from other assurance and non- assurance services provided by CPAs. 1-28 ASSURANCE SERVICES An assurance service is an independent professional service that improves the quality of information for decision makers. In general, 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. 1-29  Assurance services can be provided by CPAs or other professionals. For example, Consumers Union, a nonprofit organization, tests a wide variety of products used by consumers and reports their evaluations of the quality of the products tested in consumer reports. CPAs have provided many assurance services, particularly assurances about historical financial statement information. Section 404 of the Sarbanes-Oxley Act now requires CPA firms to provide assurance on internal control over financial reporting for larger public companies. 1-30 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. The demand for assurance services continues to grow as shareholders and other stakeholders seek assurance about financial and nonfinancial information. 31  ATTESTATION SERVICES One category of assurance services provided by CPAs is attestation (confirmation) services. An attestation service is a type of assurance service in which the CPA firm issues a report about the reliability of an assertion that is made by another party. Primary categories of attestation services include: 1. Audits of historical financial statements (Auditing) 2. Audits of internal control over financial reporting (Auditing) 3. Reviews of historical financial statements 4. Other attestation that may be applied to a broad range of subject matter. 1-32 1. Audit of historical financial statements, management asserts that the 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. 33 have audits. Many privately held companies also have their annual financial statement audited to obtain financing from banks and other financial institutions. 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. 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 needs of financial statements users. 34 management asserts that internal controls have been developed and implemented following well established criteria. Sarbanes–Oxley Act requires public companies to report management’s assessment of the effectiveness of internal control. The Act also requires auditors 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. 35 3. 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 compared to high level for audits. 36  What are the differences between audit and review of financial statements? Audit F.S Review F.S The CPA provides a lower level The CPA provides a of assurance higher level of Less evidence is needed. assurance. It can be provided by the CPA More evidence is firm at a much lower fee than needed. an audit. Nonpublic companies use this It can be provided by attestation option to provide the CPA firm at a limited assurance on their much higher fee financial statements without than a review.. incurring the cost of an audit. 37 4. Other Attestation Services. CPAs provide numerous other attestation services. 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. 38 Another type of attestation involves internal control 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. The service provider often engages an auditor to provide an attestation report provides assurance to companies that use the service provider that payroll is accurately processed. 39  OTHER ASSURANCE SERVICES Most of the other assurance services that CPAs provide do not meet the formal definition of attestation services. The CPA is not required to issue a written report. The assurance does not have to be about the reliability of another party’s assertion about compliance with specified criteria. Notice: 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. 1-40 1-41  NON-ASSURANCE SERVICES PROVIDED BY CPA Non-assurance services: 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 There is some common area of overlap between consulting and assurance services. While the primary 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 1-42  OBJECTIVE 1-6 Differentiate the three main types of audits. 1-43 PRIMARY TYPES OF AUDITS PERFORMED BY CPA FIRMS 1. Operational audit 2. Compliance audit 3. Financial statement audit 1-44 1. 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. 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. 1-45 2. Compliance audit—Determines whether the auditee (company-client) is following specific procedures, rules, or regulations set by some higher authority. The following are examples of compliance audits for a private business: 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. Many private and not-for-profit organizations have prescribed policies, contractual agreements, and legal requirements that may require compliance auditing. 1-46 Governmental units, such as school districts, are subject to considerable compliance auditing because of extensive government regulation. 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. 47 3. Financial statement audit—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. Publicly traded companies in the US are required by law to have financial statements audits. A financial statement audit is conducted to determine whether the financial statements (the information being verified) are stated in accordance with specified criteria. The criteria are normally U. S. GAAP or international accounting standards. The auditor gathers evidence to determine whether the statements contain material errors or other misstatements. 1-48  OBJECTIVE 1-7 Identify the primary types of auditors. 1-49 IDENTIFY THE PRIMARY TYPES OF AUDITORS The primary types of auditors: 1. Certified public accounting firms 2. Government accountability office auditors 3. Internal revenue agents 4. Internal auditors 1-50  1.CERTIFIED PUBLIC ACCOUNTING FIRMS (CPA FIRMS) Responsible for auditing the published historical financial statements of all publicly traded companies, most other large companies, many smaller companies, and noncommercial organizations. It is common to use the terms auditor and CPA firm. The word “certified” reflects the fact that auditors who express audit opinions must be licensed as Certified Public Accountants—CPAs CPA firms are often called external auditors or independent auditors to distinguish them from internal auditors. 1-51 2.GOVERNMENT ACCOUNTABILITY OFFICE AUDITORS An auditor working for the U. S. Government Accountability Office (GAO). The GAO report to and is responsible solely to Congress. GAO audits much of the financial information prepared by various federal government agencies before its submission to Congress. 1-52 3. INTERNAL REVENUE AGENTS The IRS is responsible for enforcing the federal tax laws. 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. 1-53 4. INTERNAL AUDITORS Internal auditors are employed by all types of organizations to audit for management with oversight by the board of directors. To maintain independence from other business functions, the internal audit group typically reports directly to the president (CEO), 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. 1-54 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 (External Auditors). Many internal auditors are involved in operational auditing or have expertise in evaluating computer systems. 1-55 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. 56  OBJECTIVE 1-8 Describe the requirements for becoming a CPA. 1-57 REQUIREMENTS FOR BECOMING A CPA  Becoming a CPA is regulated by state law through the licensing boards of each state. Three general requirements must be met, though the specifics differ among states.  The three requirements are: 1. Education 2. Uniform CPA examination 3. Experience 1-58 1-59