Auditing and Assurance Services, 16th Edition PDF

 Auditing And AssurAnce services An integrAted ApproACh sixteenth edition gloBAl edition Alvin A. Arens Former PricewaterhouseCoopers Emeritus Professor Michigan State University rAndAl J. elder Syracuse University...

 Auditing And AssurAnce services An integrAted ApproACh sixteenth edition gloBAl edition Alvin A. Arens Former PricewaterhouseCoopers Emeritus Professor Michigan State University rAndAl J. elder Syracuse University Professor MArk s. BeAsley North Carolina State University Deloitte Professor of Enterprise Risk Management Chris e. hogAn Michigan State University Professor Boston Columbus Indianapolis New York San Francisco Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Vice President, Business Publishing: Donna Battista Operations Specialist: Carol Melville Editor-in-Chief: Adrienne D’Ambrosio Creative Director: Blair Brown Acquisitions Editor: Ellen Geary Art Director: Jon Boylan Editorial Assistant: Christine Donovan Vice President, Director of Digital Strategy Assistant Acquisitions Editor, Global Editions: and Assessment: Paul Gentile Ananya Srivastava Manager of Learning Applications: Paul DeLuca Associate Project Editor, Global Edition: Amrita Kar Director, Digital Studio: Sacha Laustsen Project Manager, Global Editions: Ruchi Sachdev Digital Studio Manager: Diane Lombardo Manager, Media Production, Global Edition: Vikram Kumar Digital Editor: Sarah Peterson Senior Manufacturing Controller, Production, Global Digital Studio Project Manager: Andra Skaalrud Edition: Trudy Kimber Digital Studio Project Manager: Alana Coles Vice President, Product Marketing: Maggie Moylan Digital Studio Project Manager: Robin Lazrus Director of Marketing, Digital Services and Digital Content Team Lead: Noel Lotz Products: Jeanette Koskinas Digital Content Project Lead: Martha LaChance Executive Field Marketing Manager: Adam Goldstein Full-Service Project Management and Composition: Field Marketing Manager: Natalie Wagner Integra Software Services Product Marketing Assistant: Jessica Quazza Interior Designer: Integra Software Services Team Lead, Program Management: Ashley Santora Cover Designer: Lumina Datamatics Program Manager: Daniel Petrino Cover Photo: (c) kotoffei/Shutterstock Team Lead, Project Management: Jeff Holcomb Printer/Binder: Lego Project Manager: Roberta Sherman Cover Printer: Lego Microsoft and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published as part of the services for any purpose. All such documents and related graphics are provided “as is” without warranty of any kind. Microsoft and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all warranties and conditions of merchantability, whether express, implied or statutory, fitness for a particular purpose, title and non-infringement. In no event shall Microsoft and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from the services. The documents and related graphics contained herein could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Microsoft and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time. Partial screen shots may be viewed in full within the software version specified. Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsonglobaleditions.com © Pearson Education Limited 2017 The rights of Alvin A. Arens, Randal J. Elder, Mark S. Beasley and Chris E. Hogan to be identified as the authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Authorized adaptation from the United States edition, entitled Auditing and Assurance Services Sixteenth Edition: An Integrated Approach, ISBN 978-0-13-406582-3 by Alvin A. Arens, Randal J. Elder, Mark S. Beasley and Chris E. Hogan, published by Pearson Education © 2017. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a license permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC 1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN-10: 1-292-14787-3 ISBN-13: 978-1-292-14787-1 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 Typeset in Albertina MT Pro Regular by Integra Printed and bound by Lego Italy  continuing the LegAcy of ALvin A. Arens Alvin A. Arens: The author team of Randy Elder, Mark Beasley, and newest member of the author team, Chris Hogan, are pleased to continue the outstand- ing legacy of our book’s founding author, Al Arens, in this 16th edition of Auditing and Assurance Services: An Integrated Approach. As was done for the 15th edition, we again dedicate this new edition to Al’s memory. Randy and Mark joined Al as coauthors on this textbook in the 8th edition, and have been honored to continue Al’s leadership in helping shape classroom instruction and student learning about auditing concepts and their practical implementation around the world. Since the first edition was published, this textbook has impacted audit education for over 30 years in the U.S. and glob- ally, including seven different language translations. Al’s leadership at national and international levels and November 24, 1935 – December 6, 2010 his commitment to expanding knowledge through the development of educational materials, including this textbook, continue to inspire us as we strive to advance his legacy for future generations of auditing professionals. Al was the PricewaterhouseCoopers Auditing Professor and member of the Account- ing & Information Systems faculty in the Eli Broad College of Business at Michigan State University from 1968 through 2007. Thus, we are especially pleased to have Chris Hogan, Professor at Michigan State University, join the author team on this edition, continuing the Michigan State connection started by Al. Among his many honors, Al was selected as one of five national auditing educators to hold a Price Waterhouse Auditing professorship, was honored as AICPA Educator of the Year, served on the AICPA Auditing Standards Board, and was President of the American Accounting Association. Al taught accounting, mainly auditing, with a passion that is legendary. He had a heart for sharing his knowledge of auditing with students throughout his career. This 16th edition continues his outstanding legacy in audit education. 3  About the Authors Alvin A. Arens Al Arens, founding author of this textbook, was the PricewaterhouseCoopers Profes- sor of Accounting Emeritus at Michigan State University. In addition to writing books on auditing, he was a coauthor of computerized accounting supplements and he was actively involved in the continuing education of practitioners with local and regional CPA firms. Al was a past president of the American Accounting Association and a former member of the AICPA Auditing Standards Board. He practiced public account- ing with both a local CPA firm and the predecessor firm to Ernst & Young. He received many awards including the AAA Auditing Section Outstanding Educator award, the AICPA Outstanding Educator award, the national Beta Alpha Psi Professor of the Year award, and many teaching and other awards at Michigan State. rAndAl J. elder randy elder, who has served as a coauthor of this textbook since the 8th edition, is Professor of Accounting at Syracuse University. He teaches undergraduate and gradu- ate auditing courses, and has received several teaching awards. His research focuses on audit quality and current audit firm practices and he served as the team leader for the American Accounting Association Auditing Section PCAOB research synthesis teams on audit confirmations and audit sampling. He has extensive public account- ing experience with a large regional CPA firm, frequently teaches continuing educa- tion for a large international CPA firm, and is a member of the AICPA and Michigan Association of CPAs. MArk s. BeAsley Mark Beasley, who has also served as a coauthor of this textbook since the 8th edition, is the Deloitte Professor of Enterprise Risk Management and Professor of Accounting at North Carolina State University. He has taught undergraduate and graduate auditing courses, and has received several teaching awards including membership in NC State’s Academy of Outstanding Teachers. He has extensive professional audit experience with the predecessor firm to Ernst & Young and has extensive standards-setting experience working with the Auditing Standards Board as a Technical Manager in the Audit and Assurance Division of the AICPA. He served on the ASB Fraud Standard Task Force responsible for developing SAS 99, the ASB Antifraud Programs and Controls Task Force, and the Advisory Council overseeing the COSO Enterprise Risk Management— Integrated Framework project. He served over seven years as a member of the COSO Board, representing the AAA. Chris e. hogAn We are pleased to have Chris hogan join us as a coauthor for this 16th edition. Chris is a Professor of Accounting in the Eli Broad College of Business at Michigan State University. We are thrilled to continue the Michigan State connection started by Al Arens. Chris teaches graduate auditing and her research focuses on internal controls and integrated audits, audit firm client portfolios, and the impact of regulation on audit markets. Chris has auditing experience with Price Waterhouse, one of the pre- decessor firms to PricewaterhouseCoopers, LLP. She has served in multiple leadership roles within the American Accounting Association, including serving as President of the Auditing Section and on the Audit Committee of the AAA. 4  contents prefACe 17 pArt The AudiTing Profession 1 The demAnd for AudiT And oTher ChApter leArning oBJeCtives 27 AssurAnce services 1 Nature of Auditing 28 Distinction Between Auditing and Accounting 30 Economic Demand for Auditing 30 Assurance Services 32 Types of Audits 36 Types of Auditors 38 Certified Public Accountant 40 Summary 41 Essential Terms 41 Review Questions 42 Multiple Choice Questions from CPA Examinations 42 Discussion Questions and Problems 44 The cPA Profession ChApter leArning oBJeCtives 48 Certified Public Accounting Firms 49 2 Structure of CPA Firms 51 Sarbanes–Oxley Act and Public Company Accounting Oversight Board 53 Securities and Exchange Commission 54 American Institute of Certified Public Accountants (AICPA) 55 International and U.S. Auditing Standards 56 Organization of U.S. Auditing Standards 58 Quality Control 62 Summary 64 Essential Terms 65 5  Review Questions 65 Multiple Choice Questions from CPA Examinations 66 Discussion Questions and Problems 68 ChApter AudiT rePorTs 3 leArning oBJeCtives 70 Standard Unmodified Opinion Audit Report for Nonpublic Entities 71 Conditions for Standard Unmodified Opinion Audit Report 74 Standard Audit Report and Report on Internal Control Over Financial Reporting Under PCAOB Auditing Standards 74 Unmodified Opinion Audit Report with Emphasis-of-Matter Explanatory Paragraph or Nonstandard Report Wording 78 Modifications to the Opinion in the Audit Report 82 Materiality 84 Discussion of Conditions Requiring a Modification of Opinion 87 Auditor’s Decision Process for Audit Reports 90 International Accounting and Auditing Standards 92 Summary 93 Essential Terms 93 Review Questions 94 Multiple Choice Questions from CPA Examinations 95 Discussion Questions and Problems 96 ChApter ProfessionAl eThics 4 leArning oBJeCtives 102 What Are Ethics? 103 Ethical Dilemmas 104 Special Need for Ethical Conduct in Professions 107 Code of Professional Conduct 109 Independence Rule 113 Sarbanes–Oxley and Related Independence Requirements 117 Other Rules of Conduct 120 Enforcement 127 Summary 129 Essential Terms 129 Review Questions 129 Multiple Choice Questions from CPA Examinations 130 Discussion Questions and Problems 132 Cases 135 quizz 1 6 CONTENTS  legAl liAbiliTy ChApter leArning oBJeCtives 138 Changed Legal Environment 139 5 Distinguishing Business Failure, Audit Failure, and Audit Risk 140 Legal Concepts Affecting Liability 141 Liability to Clients 143 Liability to Third Parties Under Common Law 146 Civil Liability Under the Federal Securities Laws 148 Criminal Liability 154 The Profession’s Response to Legal Liability 155 Summary 156 Essential Terms 156 Review Questions 157 Multiple Choice Questions from CPA Examinations 158 Discussion Questions and Problems 160 Case 164 The AudiT Process pArt 2 AudiT resPonsibiliTies And objecTives ChApter leArning oBJeCtives 166 Objective of Conducting an Audit of Financial Statements 167 6 Management’s Responsibilities 168 Auditor’s Responsibilities 169 Professional Skepticism 172 Professional Judgment 174 Financial Statement Cycles 176 Setting Audit Objectives 181 Management Assertions 182 Transaction-Related Audit Objectives 185 Balance-Related and Presentation and Disclosure-Related Audit Objectives 186 How Audit Objectives Are Met 190 Summary 192 Essential Terms 192 Review Questions 193 Multiple Choice Questions from CPA Examinations 194 Discussion Questions and Problems 196 CONTENTS 7  ChApter AudiT evidence 7 leArning oBJeCtives 219 Nature of Evidence 220 Audit Evidence Decisions 221 Persuasiveness of Evidence 222 Types of Audit Evidence 225 Analytical Procedures 232 Common Financial Ratios 236 Audit Documentation 239 Summary 247 Essential Terms 247 Review Questions 248 Multiple Choice Questions from CPA Examinations 249 Discussion Questions and Problems 251 Case 258 ACL Problem 259 ChApter AudiT PlAnning And mATeriAliTy 8 leArning oBJeCtives 260 Planning 261 Accept Client and Perform Initial Audit Planning 262 Understand the Client’s Business and Industry 266 Perform Preliminary Analytical Procedures 271 Materiality 274 Materiality for Financial Statements as a Whole 275 Determine Performance Materiality 278 Estimate Misstatement and Compare with Preliminary Judgment 281 Summary 283 Essential Terms 283 Review Questions 285 Multiple Choice Questions from CPA Examinations 287 Discussion Questions and Problems 289 Case 296 Integrated Case Application—Pinnacle Manufacturing: Part I 297 ACL Problem 300 ChApter Assessing The risk of mATeriAl 9 missTATemenT leArning oBJeCtives 301 Audit Risk 302 Risk Assessment Procedures 303 8 CONTENTS Considering Fraud Risk 307 Identification of Significant Risks 308 Audit Risk Model 309 Assessing Acceptable Audit Risk 313 Assessing Inherent Risk 316 Relationship of Risks to Evidence and Factors Influencing Risks 318 Relationship of Risk and Materiality to Audit Evidence 323 Summary 324 Essential Terms 324 Review Questions 324 Multiple Choice Questions from CPA Examinations 326 Discussion Questions and Problems 328 Cases 332 Integrated Case Application—Pinnacle Manufacturing: Part II 334 Assessing And resPonding ChApter leArning oBJeCtives 337 To frAud risks 10 Types of Fraud 338 Conditions for Fraud 339 Assessing the Risk of Fraud 343 Corporate Governance Oversight to Reduce Fraud Risks 347 Responding to the Risk of Fraud 351 Specific Fraud Risk Areas 353 Responsibilities When Fraud Is Suspected 359 Documenting the Fraud Assessment 363 Summary 363 Essential Terms 364 Review Questions 364 Multiple Choice Questions from CPA Examinations 365 Discussion Questions and Problems 367 Case 372 Integrated Case Application—Pinnacle Manufacturing: Part III 373 ACL Problem 374 inTernAl conTrol And coso frAmework ChApter leArning oBJeCtives 375 Internal Control Objectives 376 11 Management and Auditor Responsibilities for Internal Control 377 COSO Components of Internal Control 379 Internal Controls Specific to Information Technology 389 CONTENTS 9  Impact of IT Infrastructure on Internal Control 395 Summary 397 Essential Terms 397 Review Questions 399 Multiple Choice Questions from CPA Examinations 400 Discussion Questions and Problems 401 Case 405 ChApter Assessing conTrol risk And rePorTing 12 on inTernAl conTrols leArning oBJeCtives 407 Obtain and Document Understanding of Internal Control 408 Assess Control Risk 411 Tests of Controls 417 Decide Planned Detection Risk and Design Substantive Tests 421 Auditor Reporting on Internal Control 422 Evaluating, Reporting, and Testing Internal Control for Nonpublic and Smaller Public Companies 425 Impact of IT Environment on Control Risk Assessment and Testing 426 Summary 430 Essential Terms 430 Review Questions 432 Multiple Choice Questions from CPA Examinations 433 Discussion Questions and Problems 435 Case 443 ACL Problem 445 Integrated Case Application—Pinnacle Manufacturing: Part IV 445 ChApter overAll AudiT sTrATegy And AudiT 13 ProgrAm leArning oBJeCtives 448 Types of Tests 449 Selecting Which Types of Tests to Perform 454 Evidence Mix 458 Design of the Audit Program 459 Summary of Key Evidence-Related Terms 467 Summary of the Audit Process 469 Summary 473 10 CONTENTS Essential Terms 473 Review Questions 474 Multiple Choice Questions from CPA Examinations 475 Discussion Questions and Problems 476 Cases 482 APPlicATion of The AudiT Process To pArt The sAles And collecTion cycle 3 AudiT of The sAles And collecTion cycle: ChApter TesTs of conTrols And subsTAnTive TesTs of TrAnsAcTions 14 leArning oBJeCtives 486 Accounts and Classes of Transactions in the Sales and Collection Cycle 487 Business Functions in the Cycle and Related Documents and Records 488 Methodology for Designing Tests of Controls and Substantive Tests of Transactions for Sales 492 Sales Returns and Allowances 503 Methodology for Designing Tests of Controls and Substantive Tests of Transactions for Cash Receipts 504 Audit Tests for Uncollectible Accounts 508 Effect of Results of Tests of Controls and Substantive Tests of Transactions 508 Summary 509 Essential Terms 510 Review Questions 510 Multiple Choice Questions from CPA Examinations 512 Discussion Questions and Problems 514 Case 519 Integrated Case Application—Pinnacle Manufacturing: Part V 520 ACL Problem 521 AudiT sAmPling for TesTs of conTrols And ChApter subsTAnTive TesTs of TrAnsAcTions leArning oBJeCtives 522 15 Representative Samples 523 Statistical Versus Nonstatistical Sampling and Probabilistic Versus Nonprobabilistic Sample Selection 524 CONTENTS 11  Sample Selection Methods 525 Sampling for Exception Rates 528 Application of Nonstatistical Audit Sampling 529 Statistical Audit Sampling 543 Application of Attributes Sampling 546 Summary 552 Essential Terms 552 Review Questions 553 Multiple Choice Questions from CPA Examinations 554 Discussion Questions and Problems 556 Case 561 Integrated Case Application—Pinnacle Manufacturing: Part VI 561 ACL Problem 563 ChApter comPleTing The TesTs in The sAles And 16 collecTion cycle: AccounTs receivAble leArning oBJeCtives 564 Methodology for Designing Tests of Details of Balances 565 Designing Tests of Details of Balances 571 Confirmation of Accounts Receivable 577 Developing Tests of Details Audit Program 583 Summary 587 Essential Terms 587 Review Questions 587 Multiple Choice Questions from CPA Examinations 589 Discussion Questions and Problems 590 Case 597 Integrated Case Application—Pinnacle Manufacturing: Part VII 598 ACL Problem 603 ChApter AudiT sAmPling for TesTs of deTAils 17 of bAlAnces leArning oBJeCtives 604 Comparisons of Audit Sampling for Tests of Details of Balances and for Tests of Controls and Substantive Tests of Transactions 605 Nonstatistical Sampling 606 Monetary Unit Sampling 615 Variables Sampling 623 Illustration Using Difference Estimation 628 12 CONTENTS Summary 631 Essential Terms 632 Review Questions 632 Multiple Choice Questions from CPA and CIA Examinations 633 Discussion Questions and Problems 635 Cases 640 ACL Problem 642 APPlicATion of The AudiT Process pArt To oTher cycles 4 AudiT of The AcquisiTion And ChApter PAymenT cycle: TesTs of conTrols, subsTAnTive TesTs of TrAnsAcTions, 18 And AccounTs PAyAble leArning oBJeCtives 644 Accounts and Classes of Transactions in the Acquisition and Payment Cycle 645 Business Functions in the Cycle and Related Documents and Records 646 Methodology for Designing Tests of Controls and Substantive Tests of Transactions 649 Methodology for Designing Tests of Details of Balances for Accounts Payable 656 Summary 664 Essential Terms 664 Review Questions 665 Multiple Choice Questions from CPA Examinations 666 Discussion Questions and Problems 668 Case 674 comPleTing The TesTs in The AcquisiTion ChApter And PAymenT cycle: verificATion of selecTed AccounTs 19 leArning oBJeCtives 676 Types of Other Accounts in the Acquisition and Payment Cycle 677 Audit of Property, Plant, and Equipment 677 Audit of Prepaid Expenses 685 CONTENTS 13  Audit of Accrued Liabilities 688 Audit of Income and Expense Accounts 689 Summary 693 Essential Terms 693 Review Questions 693 Multiple Choice Questions from CPA Examinations 694 Discussion Questions and Problems 696 Cases 699 ChApter AudiT of The PAyroll And Personnel cycle 20 leArning oBJeCtives 702 Accounts and Transactions in the Payroll and Personnel Cycle 703 Business Functions in the Cycle and Related Documents and Records 703 Methodology for Designing Tests of Controls and Substantive Tests of Transactions 706 Methodology for Designing Substantive Analytical Procedures and Tests of Details of Balances 712 Summary 716 Essential Terms 716 Review Questions 716 Multiple Choice Questions from CPA Examinations 717 Discussion Questions and Problems 719 Case 723 ChApter AudiT of The invenTory And 21 wArehousing cycle leArning oBJeCtives 725 Business Functions in the Cycle and Related Documents and Records 726 Parts of the Audit of Inventory 729 Audit of Cost Accounting 731 Substantive Analytical Procedures 734 Physical Observation of Inventory 735 Audit of Pricing and Compilation 737 Integration of the Tests 741 Summary 743 Essential Terms 743 Review Questions 744 Multiple Choice Questions from CPA Examinations 745 Discussion Questions and Problems 746 Case 753 14 CONTENTS  AudiT of The cAPiTAl AcquisiTion And ChApter leArning oBJeCtives 755 rePAymenT cycle 22 Accounts in the Cycle 756 Notes Payable 757 Owners’ Equity 761 Summary 767 Essential Terms 767 Review Questions 768 Multiple Choice Questions from CPA Examinations 768 Discussion Questions and Problems 770 AudiT of cAsh And finAnciAl insTrumenTs ChApter leArning oBJeCtives 776 Types of Cash and Financial Instruments Accounts 777 23 Cash in the Bank and Transaction Cycles 779 Audit of the General Cash Account 780 Fraud-Oriented Procedures 788 Audit of Financial Instruments Accounts 793 Summary 796 Essential Terms 796 Review Questions 797 Multiple Choice Questions from CPA Examinations 798 Discussion Questions and Problems 799 comPleTing The AudiT pArt 5 comPleTing The AudiT ChApter leArning oBJeCtives 806 Perform Additional Tests for Presentation and Disclosure 807 24 Review for Contingent Liabilities and Commitments 808 Review for Subsequent Events 813 Final Evidence Accumulation 817 Evaluate Results 821 Issue the Audit Report 825 Communicate with the Audit Committee and Management 825 Subsequent Discovery of Facts 827 Summary 829 CONTENTS 15  Essential Terms 829 Review Questions 830 Multiple Choice Questions from CPA Examinations 831 Discussion Questions and Problems 833 Case 837 pArt oTher AssurAnce And nonAssurAnce 6 services ChApter oTher AssurAnce services 25 leArning oBJeCtives 839 Review, Compilation, and Preparation Services 840 Review of Interim Financial Information for Public Companies 846 Attestation Engagements 847 Reports on Controls at Service Organizations (SOC Reports) 851 Prospective Financial Statements 853 Agreed-Upon Procedures Engagements 854 Other Audits or Limited Assurance Engagements 855 Summary 857 Essential Terms 858 Review Questions 859 Multiple Choice Questions from CPA Examinations 860 Discussion Questions and Problems 861 ChApter inTernAl And governmenTAl finAnciAl 26 AudiTing And oPerATionAl AudiTing leArning oBJeCtives 866 Internal Financial Auditing 867 Governmental Financial Auditing 870 Operational Auditing 873 Summary 880 Essential Terms 880 Review Questions 881 Multiple Choice Questions from CPA, CIA, and CMA Examinations 881 Discussion Questions and Problems 884 index 888 Credits 896 16 CONTENTS  PrefAce Integrated approach For rIsk assessment and audIt decIsIon makIng Auditing and Assurance Services: An Integrated Approach is an introduction to auditing and other assurance services. It is intended for either a one-quarter or one-semester course at the undergraduate or graduate level. This book is also appropriate for introductory professional development courses for CPA firms, internal auditors, and government auditors. The primary emphasis in this text is on the auditor’s decision-making process in a financial statement audit, as well as an integrated audit of both financial state- ments and internal control over financial reporting required for accelerated filer public companies. We believe that the most fundamental concepts in auditing con- cern determining the nature and amount of evidence the auditor should gather after considering the unique circumstances of each engagement. If students of auditing understand the objectives to be accomplished in a given audit area, the risks related to the engagement, and the decisions to be made, they should be able to determine the appropriate evidence to gather and how to evaluate the evidence obtained. Our objective is to provide up-to-date coverage of globally recognized audit- ing concepts with practical examples of the implementation of those concepts in real-world settings. The collective experience of the author team in the practice of auditing is extensive. We have all worked in the auditing profession involving both large international audit firms and regional firms. Members of our author team have taught extensively in continuing education for either large international or small CPA firms and have been involved in standards setting activities of the Auditing Standards Board and the PCAOB. One author served over seven years as one of the board mem- bers of the Committee of Sponsoring Organizations of the Treadway Commission (COSO). These experiences provide unique perspectives about the integration of auditing concepts in real-world settings. As the title of this book reflects, our purpose is to integrate the most important internationally recognized concepts of auditing in a logical manner to assist stu- dents in understanding audit decision making and evidence accumulation in today’s complex, global auditing environment. For example, developments related to issues affecting auditing in a global and economically volatile environment are described throughout the book and are emphasized in selected mid-chapter vignettes and homework problems. Key concepts related to risk assessment as emphasized in stan- dards issued by the Auditing Standards Board (ASB) and the International Auditing and Assurance Standards Board (IAASB), including emphasis on significant risks, are integrated into all of the planning chapters, as well as each chapter dealing with a particular transaction cycle and related accounts. Our coverage of internal control is related to tests of controls and substantive tests of transactions that are performed in a financial statement audit and an integrated audit of financial statements and internal control over financial reporting, with an emphasis on the requirements of PCAOB Auditing Standards. Tests of controls and substantive tests of transactions are, in turn, related to the tests of details of financial statement balances for the area. Audit sampling is applied to the evaluation of audit evidence rather than treated as a separate topic. Risk assessment, technology, fraud, and auditing of internal control issues are integrated throughout the chapters. 17 What’s neW In thIs edItIon New auditing standards are released without regard to textbook revision cycles. As audit- Current Coverage ing instructors, we appreciate how critical it is to have the most current content available. This edition includes complete coverage of the AICPA Clarity Project, including guidance in the recently issued SAS No. 130 An Audit of Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial Statements and new PCAOB standards including Standard No. 18, Related Parties. 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. As part of the effort to converge U.S. auditing standards with international standards, the AICPA Clarity Projects AICPA Auditing Standards Board (ASB) recently completed its Clarity Project to redraft most of the existing GAAS standards to not only align them with the ISAs, but to also make them easier to read, understand, and apply. Chapter 2 provides an overview of the major implications of the clarified standards, including the new principles that provide the framework to help auditors fulfill the objectives of the audit of financial statements in accordance with AICPA auditing standards and the new Codification of Statements on Auditing Standards. Chapter 3 contains examples of the new standard auditor’s report format updated by the Clarified SASs. All remaining chapters of the textbook reflect the various revisions resulting from the issuance of the Clarity standards. The AICPA’s Accounting and Review Services Committee (ARSC) has largely completed a similar Clarity Project affecting compilation and review standards with the issuance of SSARS No. 21, Statement on Standards for Accounting and Review Services: Clarification and Recodification. In redrafting SSARS, the ARSC used similar redrafting standards as those used by the Auditing Standards Board. Changes resulting from the redrafting of SSARS are addressed in Chapter 25. Additionally, that chapter also high- lights forthcoming changes in Statements on Standards for Attestation Engagements (SSAEs) resulting from the AICPA’s Clarity Project affecting attestation standards, which was recently voted for final issuance by the ASB. The AICPA recently restructured its Code of Professional Conduct to align it with inter- Coverage of Revised national standards. The organization of the Code now presents the Principles as part AICPA Code of of the Preface and then includes Rules for members in public practice separately Professional Conduct from Rules for members in business and others. Chapter 4 has been substantially revised to provide an overview of the key elements of the revised Code based on this new structure. With the profession’s continued focus on the importance of applying appropriate lev- Expanded Coverage of els of professional skepticism, we have expanded coverage of this topic in Chapter 6, Professional Skepticism along with integrated coverage in later chapters, including Chapter 10, which ad- and Auditor Judgment dresses the auditor’s responsibilities for detecting fraud. We discuss the importance of a questioning mindset and the need to critically evaluate audit evidence to strengthen student awareness of the elements of effective professional skepticism. To assist auditors with maintaining an appropriate level of professional skepti- cism when making professional judgments during an audit, this edition features the Center for Audit Quality’s Professional Judgment Resource, which outlines key elements of a process that auditors apply when making professional judgments. Chapter 6 illustrates an effective decision-making process that guides auditors’ thinking to help them be aware of their own judgment tendencies, traps, and biases. We have added homework problems that expose students to this judgment framework and a number of the common traps and biases. 18 Preface The requirements of the Sarbanes–Oxley Act of 2002 and the PCAOB Auditing Expanded Coverage Standard 5 (AS 5) that impact accelerated filer public companies, and the risk assess- on Risk Assessment ment standards issued by the Auditing Standards Board are integrated throughout the Procedures and text. Chapter 2 emphasizes the importance of understanding the client’s business and Understanding Internal its environment, including internal control. Chapter 3 highlights reporting on internal Control controls over financial reporting for auditors of accelerated filer public companies. We have always emphasized understanding the client’s business and industry in planning. For the 16th edition we reorganized Chapters 8–12 to include expanded coverage of the auditor’s performance of risk assessment procedures, including the identification of significant risks. Chapter 9 addresses the performance of risk assess- ment procedures to address the risk of material misstatement, followed in Chapter 10 with discussion of assessing and responding to the risk of fraud. Our coverage in Chapters 11 and 12 of internal controls, including coverage of IT general and application controls, has been restructured to reflect key elements of COSO’s 2013 revision of its Internal Control—Integrated Framework and to better inte- grate the auditor’s consideration of both manual and automated controls. Chapter 11 introduces students to important elements of effective internal controls, including those related to IT, while Chapter 12 outlines the auditor’s responsibilities to under- stand the design and operating effectiveness of internal control, and also highlights auditor reports on internal control over financial reporting. Subsequent chapters that focus on the transaction cycles include extensive coverage of internal controls to help students understand how the auditor’s consideration of internal controls is integrated for audits of the financial statements and internal controls over financial reporting. Chapter 1 introduces the importance of considering international auditing standards Emphasis on developments, followed by discussion in Chapter 2 about the role of the International International Issues Auditing and Assurance Standards Board (IAASB) in the issuance of international standards on auditing (ISAs) and the Auditing Standards Board’s efforts to con- verge U.S. standards to international standards. Chapter 3 highlights implications for auditor reports on companies reporting under International Financial Reporting Standards (IFRS). Several chapters throughout the book include text or mid-chapter vignette coverage of international issues, and international issues are also addressed in homework problems. With the increasing volume and complexity of various types of financial instruments Coverage of Financial and challenges associated with fair value accounting, Chapter 23 addresses issues as- Instruments sociated with auditing financial instruments and obtaining sufficient appropriate audit evidence for fair value account estimates. We believe this guidance will help strengthen student understanding of the challenges associated with auditing financial instruments. With more organizations taking advantage of cloud computing options and third Service Organization party IT service providers, there is a greater need for information about the design and Controls (SOC) Reports operating effectiveness of internal controls provided by these external service pro- viders. This 16th edition contains expanded coverage of service organization control (SOC) reports issued by service center auditors. Both Chapters 12 and 25 reflect the new guidance for service auditors reporting on internal controls at service organiza- tions, including coverage of the different types of reports provided in SOC 1, SOC 2, and SOC 3 engagements. Preface 19  The issuance of SSARS No. 21 introduced a new type of nonattest engagement service New Coverage of that allows nonissuers to engage a CPA to help management prepare monthly, quar- Preparation Service terly, or annual financial statements without providing any assurance on the financial Engagements statements or issuing a report, even if the financial statements are expected to be used by, or provided to, a third party. Chapter 25 describes this new type of service and dis- tinguishes it from compilation and review engagement requirements. A new feature in the 16th edition is the inclusion of Concept Checks periodically New Concept Checks within each chapter that highlight short-answer questions to help students recap con- tent covered within different sections of the chapter. These short in-chapter review questions are intended to help call student attention to key concepts as they read the material in the chapter. We are excited about the inclusion of a number of changes to the end-of-chapter home- Expanded Homework work material for all chapters. For the 16th edition, we have partnered with Becker CPA Material Review to include new multiple choice problems from their CPA exam preparation materials. These problems, which are included in all 26 chapters, are labeled with the Becker logo. Additionally, each chapter identifies new or revised Discussion Questions and Problems that instructors can use in class to generate discussion about important topics addressed in each chapter. These problems are highlighted by an “in-class” dis- cussion icon in the margin next to the related homework problem. Each chapter also identifies homework problems that require students to research standards and other material using the Internet. While many of these research problems expose students to standards, such as those on the PCAOB Web site, other problems require students to examine recently issued financial statements or other corporate filings, or they expose students to best practices thought papers as part of the assignment. Sample problems, assignable in MyAccountingLab, provide an introduction to the CPA Exam format and an opportunity for early practice with CPA exam–style questions. CPA firms expect auditors to analyze data using spreadsheets and audit software. A Data Analysis Problems number of the problems in the text can be completed using Excel templates avail- able on the text Web site. These problems are indicated by a spreadsheet icon in the margin next to the problem. CPA firms increasingly emphasize data analytics and increasingly use audit software to perform audit testing including tests for fraud. We have included selected problems using ACL in several chapters in the text. These problems are related to the topic of the chapter so that students can see how audit software is used to perform specific types of audit tests. Guidance for students on the use of ACL is included on the text Web site. The annual report for the Hillsburg Hardware Company is included as an insert to the Hillsburg Hardware text. Financial statements and other information included in the annual report are Annual Report used in examples throughout the text to illustrate chapter concepts. The annual re- port also includes management’s report on internal control required by Section 404a and the auditor’s report required by Section 404b, consistent with PCAOB Auditing Standard No. 5. The Pinnacle Manufacturing integrated case is based on a large, multi-division com- Pinnacle Manufacturing pany. The case has been revised and expanded to now consist of seven parts included Integrated Case 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. 20 Preface  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 open- ing vignette featuring a Big 4 public accounting firm’s assurance report contained in the Corporate Sustainability Report issued by United Parcel Service (UPS), to help students see the increasingly important role of auditors in providing assur- ance on a broad range of information important to key stakeholders. Chapter 1 in- troduces key provisions of the Sarbanes–Oxley 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 responsibili- ties of the International Auditing and Assurance Standards Board (IAASB) and the PCAOB and how those responsibilities differ from those of the AICPA Auditing Standards Board (ASB). Chapter 2 provides in-depth coverage of the AICPA Clarity Project and resulting changes to AICPA auditing standards. Chapter 3 provides a detailed discussion of audit reports issued under AICPA and PCAOB standards, in- cluding a separate section on the report on internal control over financial report- ing 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 ap- plicable to each condition under varying levels of materiality. Chapter 4 explains ethical dilemmas, professional ethics, and independence, and it features the newly revised AICPA Code of Professional Conduct. Chapter 5 ends this part with an investi- gation of auditors’ legal liability. Part 2, The Audit Process (Chapters 6–13) The first two of these chapters deal with auditor and management responsibilities, professional skepticism, a profes- sional judgment framework for auditor decision making, audit objectives, gen- eral 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 com- pany’s business and its industry as part of the auditor’s risk assessment procedures, using analytical procedures as an audit tool, and making preliminary judgments about materiality. Chapter 9 provides expanded coverage of the auditor’s perfor- mance of risk assessment procedures used to assess the risk of material misstate- ment due to fraud or error and how the auditor responds to risks of significant misstatement with further audit procedures. Fraud auditing is the focus of Chapter 10, which builds upon risk assessment concepts covered in the previous chapter to illustrate how risk assessment includes the assessment of fraud risk. The chapter also includes specific examples of fraud and discusses warning signs and proce- dures performed in response to heightened fraud risk. Chapter 11 outlines the key components of an effective system of internal controls over financial reporting, consistent with the 2013 revision of COSO’s Internal Control—Integrated Framework. Because most internal control systems are heavily dependent on information tech- nologies, this chapter integrates coverage of IT general controls and application controls. Chapter 12 shows how effective internal controls can reduce planned au- dit evidence in the audit of financial statements, and it outlines procedures auditors perform as tests of those controls to support a low control risk assessment. The chapter also 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 state- ment audit. Chapter 13 summarizes Chapters 6 through 12 and integrates them with the remainder of the text. Preface 21  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 the audit of internal control over financial reporting. Students also learn to apply audit sampling to the audit of sales, cash receipts, and accounts receivable. Chapter 15 begins with a general discussion of audit sampling for tests of controls and substantive tests of transactions. Similarly, Chapter 17 begins with general sampling concepts for tests of details of balances. The next topic in each chapter is extensive coverage of nonstatistical sampling. The last part of each chapter covers statistical sampling techniques. Part 4, Application of the Audit Process to Other Cycles (Chapters 18–23) Each of these chapters deals with a specific transaction cycle or part of a transaction cycle in much the same manner as Chapters 14 through 17 cover the sales and collection cycle. Each chapter in Part 4 demonstrates the relationship of internal controls, tests of controls, and substantive tests of transactions for each broad category of transac- tions to the related balance sheet and income statement accounts. We integrate dis- cussion of implications related to the audit of internal control throughout all these transaction cycle chapters. Cash and financial instruments are studied late in the text to demonstrate how the audit of cash and financial instrument balances is related to most other audit areas. Part 5, Completing the Audit (Chapter 24) This part includes only one chapter, which deals with performing additional tests to address presentation and disclosure objectives, summarizing all audit tests, reviewing audit documentation, obtaining management representations in an integrated audit of financial statements and inter- nal control, communicating with those charged with governance, and all other as- pects of completing an audit. Part 6, Other Assurance and Nonassurance Services (Chapters 25 and 26) The last two chapters deal with various types of engagements and reports, other than the audit of financial statements using generally accepted account- ing principles. Topics covered include assurance services; review, compilation, and preparation services; agreed-upon procedures engagements; attestation engagements; other audit engagements; internal financial auditing; governmental financial auditing; and operational auditing. This edition also includes expanded coverage of service organization control (SOC) reports on internal controls at external service providers. supplements Instructor’s Resource Center www.pearsonglobaleditions.com/arens This password-protected site is accessible from the catalog page for Auditing and Assurance Services, 16th ed., and hosts the following resources: 22 Preface Image Library The Image Library allows access to most of the images and illustra- tions featured in the text. Instructor’s Resource Manual Suggestions for each chapter include: Homework problems, how learning objectives correlate with chapter problem material, and vi- sual aids that can be added to PowerPoint slides or used on document cameras or overhead projectors. Chapters have been designed so that their arrangement and se- lection provide maximum flexibility in course design. Sample syllabi and suggested term projects are provided. Solutions Manual Included are detailed solutions to all the end-of-chapter exercises, problems, and cases. Guidelines for responses to review questions and discussion questions are offered. Test Item File & TestGen The Test Item File includes multiple choice exercises, true/false responses, essay questions, and questions related to the chapter vignettes. To assist the instructor in selecting questions for use in examinations and quizzes, each question has been assigned one of three difficulty ratings—easy, medium, or challenging. In addition, questions that uniquely relate to the integrated audits of large public companies or to the provisions of the Sarbanes–Oxley Act and Section 404 have been separately labeled for easy identification by the professor. TestGen testing software is an easy-to-use computerized testing program. It can create exams as well as evaluate and track student results. All Test Item File questions are available in the TestGen format. PowerPoint Slides PowerPoint presentations are available for each chapter of the text. Instructors have the flexibility to add slides and/or modify the existing slides to meet course needs. Enhanced Companion Web Site Pearson’s Learning on the Internet Partnership offers the most expansive Internet-based support available. Our Web site provides a wealth of resources for students and faculty. Periodically, faculty will be able to ac- cess electronic summaries and PowerPoint slides of the most recent changes to pro- fessional standards and summaries of major issues affecting the auditing profession. This will help instructors to stay informed of emerging issues. MyAccountingLab® MyAccountingLab is an online homework, tutorial, and assess- ment program designed to work with this text to engage students and improve re- sults. Within its structured environment, students practice what they learn, test their understanding, and receive immediate feedback to help them better absorb course material and understand difficult concepts. acknoWledgments We acknowledge the American Institute of Certified Public Accountants for per- mission to quote extensively from Statements on Auditing Standards, the Code of Professional Conduct, Uniform CPA Examinations, and other publications. The willing- ness of this major accounting organization to permit the use of its materials is a sig- nificant contribution to the book and audit education. Preface 23  We gratefully acknowledge the contributions of the following reviewers for their suggestions and support in the 16th edition as well as previous editions: Sherri Anderson, Sonoma State University Jason MacGregor, Baylor University Stephen K. Asare, University of Florida John Mason, University of Alabama–Tuscaloosa David Baglia, Grove City College Heidi H. Meier, Cleveland State University Brian Ballou, Miami University Alfred R. Michenzi, Loyola College in Maryland William E. Bealing, Jr., Bloomsburg University Charles R. (Tad) Miller, California Polytechnic Stanley F. Biggs, University of Connecticut State University, San Luis Obispo Robert Braun, Southeastern Louisiana University Lawrence C. Mohrweis, Northern Arizona Joe Brazel, North Carolina State University University Billy Brewster, University of Texas–Arlington Norma Montague, Wake Forest University Frank Buckless, North Carolina State University Curtis Mullis, University of Alabama Joseph V. Calmie, Thomas Nelson Community Patricia M. Myers, Brock University College Kathy O’Donnell, SUNY Buffalo Eric Carlsen, Kean College of New Jersey Kristine N. Palmer, Longwood College David Chan, St. John’s University Vicki S. Peden, California State Polytechnic Freddie Choo, San Francisco State University University, Pomona Karl Dahlberg, Rutgers University Ron Reed, University of Northern Colorado Frank Daroca, Loyola Marymount University Pankaj Saksena, Indiana University South Bend Stephen Del Vecchio, University of Central Cindy Seipel, New Mexico State University Missouri Scott Showalter, North Carolina State University Todd DeZoort, University of Alabama–Tuscaloosa Philip H. Siegel, Troy University Magdy Farag, California State Polytechnic Robert R. Tucker, Fordham University University, Pomona Barb Waddington, Eastern Michigan University William L. Felix, University of Arizona Karl Wang, University of Mississippi Michele Flint, Daemen College Jeanne H. Yamamura, University of Nevada, David S. Gelb, Seton Hall University Reno Stephanie Geter, University of Cincinnati Doug Ziegenfuss, Old Dominion University David Gilbertson, Western Washington University We especially thank the Pearson book team John Giles, North Carolina State University for their hard work and dedication, including Ellen Lori Grady, Bucks County Community College Geary, Acquisitions Editor; Daniel Petrino, Program Charles L. Holley, Virginia Commonwealth Manager; Christine Donovan, Editorial Assistant; University Donna Battista, Vice President of Business Publishing; Steve Hunt, Western Illinois University Maggie Moylan, Vice President, Product Marketing; Greg Jenkins, Virginia Tech University Natalie Wagner, Senior Field Marketer; Jessica Quazza, James Jiambalvo, University of Washington Product Marketing Assistant; Ashley Santora, Team Ambrose Jones, III, University of North Carolina– Lead, Program Management; Roberta Sherman, Greensboro Project Manager; and Jeff Holcomb, Team Lead, David S. Kerr, University of North Carolina at Project Management. Charlotte A. A. A. William R. Kinney, Jr., University of Texas at R. J. E. Austin M. S. B. W. Robert Knechel, University of Florida C. E. H. Pearson would like to thank and acknowledge Loo Choo Hong (Wawasan Open University), Eric Leung (The Chinese University of Hong Kong), Jeff NG (The Chinese University of Hong Kong), Junaid Shaikh (Curtin University) and A. Ramin (Khazar University) for contributing to the Global Edition, and Raymond Wong Kin Ho (The Chinese University of Hong Kong), Mabel Lam (The Open University of Hong Kong) and Helen S.M. Wong (The Hong Kong Polytechnic University) for reviewing the Global Edition. 24 Preface  Summary of the Audit Process PHASE I Accept client and perform Plan and design an initial audit planning audit approach Understand the client’s business and industry Perform preliminary analytical procedures Set preliminary judgment of materiality and performance materiality Identify significant risks due to fraud or error Assess inherent risk Understand internal control and assess control risk Finalize overall audit strategy and audit plan PHASE II Plan Perform tests of to reduce No controls and assessed level of substantive tests control of transactions risk? Yes Perform tests of controls* Perform substantive tests of transactions Assess likelihood of misstatements in financial statements PHASE III Perform substantive High or Low Medium unknown analytical procedures and tests of details Perform substantive of balances analytical procedures Perform tests of key items Perform additional tests of details of balances PHASE IV Perform additional tests for Complete the presentation and disclosure audit and issue an Accumulate final evidence audit report Evaluate results Issue audit report Communicate with audit committee and management * The extent of tests 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. 25  1 começa aqui The AudiTing Part 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.  1 The deMAnd for AudiT Chapter And oTher AssurAnCe serViCes Monozukuri by KOBELCO Learning ObjeCtives Kobe Steel, Ltd. (KOBELCO), one of Japan’s leading steelmakers and supplier of aluminum and After studying this chapter, you should copper products, has been around for more than a century since their establishment in 1905. be able to apart from involving themselves in the metal industry, KOBELCO has interests in wholesale 1-1 Describe auditing. power supply, machinery, construction machinery, real estate, and electronic materials. 1-2 Distinguish between auditing KOBELCO conducts Corporate Social responsibility (CSr) activities that contribute to the and accounting. environment and society through monozukuri (or manufacturing). the literal translation of 1-3 Explain the importance of monozukuri is ‘production’. ‘Mono’ means the the thing which is made and ‘Zukuri’ means the auditing in reducing information risk. act of making. the closest concept in 1-4 List the causes of information the English language to monozukuri is risk, and explain how this risk ‘craftsmanship’. this is a key element can be reduced. of the company’s philosophy. Japan 1-5 Describe assurance services is a country that is prone to many and distinguish audit services natural disasters like typhoons, earth- from other assurance and quakes and landslides. the company nonassurance services provided aims to protect lives and livelihoods by CPas. from these disasters. It is constantly 1-6 Differentiate the three main developing technology in different types of audits. fields using the monozukuri concept. 1-7 Identify the primary types of auditors. It is important to note that natural 1-8 Describe the requirements disasters management is costly. It for becoming a CPa. was estimated that S$14.5 to $34.6 billion lost in the 2011 tōhoku earthquake and tsunami. 15,893 people were confirmed dead, 6,152 were injured, and 2,572 people are still reported missing. any repeat of the tōhoku earthquake and tsunami will be devastating to Japan. Monozukuri disaster protective technologies could hopefully mitigate both human tragedy and monetary losses from similar disasters in the future. KOBELCO established a Compliance Committee to advise the board of directors to facilitate discussion, make proposals, and conduct follow-up verification related to important CSr issues (especially environmental management activities). KOBELCO has adopted specific CSr guidelines in the form of their Corporate Code of Ethics. the CSr Committee compiles information con- cerning the CSr activities and publishes it each year in the form of the Kobe Steel Group Sustain- ability report. For example, KOBELCO donated 200 million yen and relief goods in the form of construction equipment valued at 100 million yen to the tōhoku earthquake and tsunami relief. the company requires their corporate auditing system to be strong and independent as required in the Companies act of Japan. the audit and Supervisory Board would have inde- pendent members that are independent of the Board of Directors and members from within the management. apart from the external auditors, the company engages a team of Internal auditors who operate as an independent entity in the company. Sources: KOBELCO’s CSr website http://www.kobelco.co.jp/english/about_kobelco/csr/index. html (accessed 9 October 2015), Sa Partners (2012) toyota’s Monozukuri, Sa Partners LLP, Caerphilly, United Kingdom apartners.com/wp-content/uploads/2012/08/Toyotas-Monozukuri.pdf (accessed 9 October 2015). 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 re- semblance in the latter stories to real firms, companies, or individuals is unintended and purely coincidental. The opening example involving KOBELCO illustrates the increasingly important role CSR and corporate governance reporting, compliance and assurance to a broad range of stakeholders. Of course, reporting on the finan- cial 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 con- trol, 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 ObjeCtive 1-1 We have introduced the role of auditors in society and how auditors provide assurance Describe auditing. on financial statements. Auditors also provide assurance on the effectiveness of inter- nal 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: 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 Information and (criteria) by which the auditor can evaluate the information. This information can take established Criteria 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 cri- teria may be U.S. generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS). This means that in an audit of Apple’s finan- cial 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 inter- nal 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. Typi- cally, 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 informa- accumulating and tion being audited is stated in accordance with the established criteria. Evidence takes evaluating evidence many different forms, including: Electronic and documentary data about transactions Written and electronic communication with outsiders 28 Part 1 / THE AUDITING PROFESSION  Observations by the auditor 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. The auditor must be qualified to understand the criteria used and must be competent Competent, Independent to know the types and amount of evidence to accumulate in order to reach the proper person 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 commu- reporting nicates 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 estab- lished 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 in the audit report is the evaluation of IRS agent’s audit of an individual’s tax return as an example. To determine whether the accounts, to see if the accounts the tax return was prepared in a manner consistent with the requirements of the fed- are ok or not. eral 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 Federal tax returns Competent, filed by independent Accumulates and taxpayer person evaluates evidence Report on results Internal Examines cancelled Determines Report on tax revenue checks and other correspondence deficiencies agent supporting records Established criteria Internal Revenue Code and all interpretations Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES 29 distiNctioN BetweeN auditiNg aNd accouNtiNg ObjeCtive 1-2 Many financial statement users and the general public confuse auditing with account- ing. The confusion results because most auditing is usually concerned with accounting Distinguish between auditing and 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 account- ing 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. 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. ecoNomic demaNd for auditiNg ObjeCtive 1-3 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 Explain the importance of auditing in reducing relationships with the business and the financial condition of the business as reflected information risk. by its financial statements. If the bank makes the loan, it will charge a rate of interest determined primarily by three factors: 1. Risk-free interest rate. This is approximately the rate the bank could earn by invest- ing 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 competition in the industry. 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 unreli- Causes of Information able information. There are several reasons for this: remoteness of information, biases risk and motives of the provider, voluminous data, and the existence of complex exchange transactions. 30 Part 1 / THE AUDITING PROFESSION  Causes of information risk: remoteness of Information In a global economy, it is nearly impossible for a deci- ObjeCtive 1-4 sion maker to have much firsthand knowledge about the organization with which they List the causes of information do business. Information provided by others must be relied upon. When information risk, and explain how this risk is obtained from others, the likelihood of it being intentionally or unintentionally mis- can be reduced. stated 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 misstate- ment 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 reasonably 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 dif- ficult 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 exam- ples include properly combining and disclosing the results of operations of subsid- iaries in different industries and properly valuing and disclosing derivative financial instruments. Solutions for information risk: After comparing costs and benefits, business managers and financial statement users reducing Information may conclude that the best way to deal with information risk is simply to have it remain risk 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 inefficient for all users to verify the information individually. Nevertheless, some users perform their own verification. For example, the IRS does considerable verification of business and indi- vidual tax returns to determine whether the tax returns filed 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 manage- ment will have sufficient funds to repay users. Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES 31  Figure 1-2 relationships among auditor, Client, and External Users Auditor Client or audit Auditor issues