Chapter 1 Auditing & Assurance Services 9e PDF

Because learning changes everything. ® Chapter 1 Auditing & Assurance Services 9e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter 01 Auditing and Assurance Services “Our sy...

Because learning changes everything. ® Chapter 1 Auditing & Assurance Services 9e © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter 01 Auditing and Assurance Services “Our system of capital formation relies upon the confidence of millions of savers to invest in companies. The auditor’s opinion is critical to that trust." -- James R. Doty, Former Chairman. Public Company Accounting Oversight Board (PCAOB). © McGraw Hill 2  Chapter 1 Learning Objectives 1. Define information risk and explain how the financial statement auditing process helps to reduce this risk, thereby reducing the cost of capital for a company. 2. Define and contrast assurance, attestation, and financial statement auditing services. 3. Describe and define the assertions that management makes about the recognition, measurement, presentation, and disclosure of the financial statements and explain why auditors use them as the focal point of the audit. 4. Define professional skepticism and explain its key characteristics. 5. Describe the organization of public accounting firms and identify the various services that they offer. 6. Describe the audits and auditors in governmental, internal, and operational auditing. 7. List and explain the requirements for becoming a certified public accountant (CPA) and other certifications available to an accounting professional. © McGraw Hill 3  Chapter 1 Learning Objectives 1. Define information risk and explain how the financial statement auditing process helps to reduce this risk, thereby reducing the cost of capital for a company. © McGraw Hill 4  User Demand for Reliable Information Business risk. The risk that an entity will fail to meet its objectives. Today’s environment. People demand information. More complex. Information demanded by remote users. Information demanded in a timelier manner. Has far reaching consequences. Information risk. The probability that the information circulated by a company will be false or misleading. Users demand an independent third-party assessment of the information. © McGraw Hill 5  More Consequences AUDITING INSIGHT Bernard Madoff, a former chairman of the NASDAQ stock market and a respected Wall Street adviser and broker for 50 years, was arrested after his sons turned him in for running “a giant Ponzi scheme,” bilking investors out of billions of dollars. Many investors, including actors, investment bankers, politicians, and sports personalities, lost their life savings. Although some of the world’s most knowledgeable investors fell prey to the scam, numerous red flags were present for all who were wise enough to see them. First, Madoff’s fund returned 13–16 percent per year, every year, no matter how the markets performed. Second, his stated strategy of buying stocks and related options to hedge downside risk could not have occurred because the number of options necessary for such a strategy did not exist. Third, although his firm claimed to manage billions of dollars, its auditing firm had only three employees, including a secretary and a 78-year-old accountant who lived in Florida. Sources: “Fund Fraud Hits Big Names,” The Wall Street Journal, December 13, 2008, pp. A1, A7; “Fees, Even Returns and Auditor All Raised Flags,” The Wall Street Journal, December 13, 2008, p. A7; “Top Broker Accused of $50 Billion Fraud,” The Wall Street Journal, December 12, 2008, pp. A1, A14; “Probe Eyes Audit Files, Role of Aide to Madoff,” The Wall Street Journal, December 23, 2008, pp. A1, A14. © McGraw Hill 6  Chapter 1 Learning Objectives 2. Define and contrast assurance, attestation, and financial statement auditing services. © McGraw Hill 7  The Relationships Among Assurance, Attestation and, Audit Engagements Exhibit 1.2 The Relationships among Assurance, Attestation, and Audit Engagements Access the text alternative for slide images © McGraw Hill 8  Third Party Assurance Exhibit 1.1 Professional Sports Authenticator as Third-Party Assuror Courtesy of Allen Blay © McGraw Hill 9  Assurance Services Assurance services are independent professional services that improve the quality of information, or its context, for decision makers. Examples include: Cybersecurity risk assessment and assurance. XBRL (eXtensible Business Reporting Language) reporting. Evaluation of investment management policies. Internal audit outsourcing. Fraud and illegal acts prevention and deterrence. © McGraw Hill 10  Assurance Elements Independence- no conflicts of interest Professional Service- based on education and experience Improving the Quality of Information or its Context Relevance- should I pay attention Reliability/Credibility- is it trustworthy For Decision Makers- beneficiary of services … not advisory (recommendation). Use skills/experience to provide a recommendation. Assurance focuses on info USED for decision makers © McGraw Hill 11  Attestation Engagements An attestation engagement - The AICPA defines an attestation engagement as a service where a practitioner is requested to examine whether management’s assertations about some type of subject matter can be relied upon. Some financial attestation engagements (other than audits). Financial forecasts and projections. Examination of Management’s Discussion & Analysis. Pro forma financial information. Some non-financial attestation engagements. Effectiveness of internal control systems. Compliance with environmental regulations. Sustainability reporting engagements. © McGraw Hill 12  AAA Definition of Financial Statement Auditing Access the text alternative for slide images. © McGraw Hill 13  Audits Logical, not haphazard, unplanned. TEST??? management assertation by obtaining and reviewing evidence Management makes assertation about the activity and balances within their company when they provide financial statements. The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework, which enhances the degree of confidence that intended users can place in the financial statements. An audit conducted in accordance with GAAS and relevant ethical requirements enables the auditor to form that opinion (AU-C 200.04). © McGraw Hill 14  A Rich History AUDITING INSIGHT Although most of the largest public accounting firms trace their roots to the turn of the 19th century, auditing in the United States has a rich history. When the Pilgrims had a financial dispute with the English investors who financed their trip, an “auditor” was sent to resolve the difference. George Washington sent his financial records to the comptroller of the treasury to be audited before he could be reimbursed for expenditures he made during the Revolutionary War. One of the first Congress’s actions in 1789 was to set up an auditor to review and certify public accounts. Even the “modern” concept of an audit committee is not so modern; the bylaws of the Potomac Company, formed in 1784 to construct locks on the Potomac River to increase commerce, required that three shareholders annually examine the company’s records. Source: D. Flesher, G. Previts, and W. Samson, “Auditing in the United States: A Historical Perspective,” Abacus, John Wiley & Sons. Inc., 2008, pp. 21–39. © McGraw Hill 15  Chapter 1 Learning Objectives 3. Describe and define the assertions that management makes about the recognition, measurement, presentation, and disclosure of the financial statements and explain why auditors use them as the focal point of the audit. © McGraw Hill 16  Sarbanes-Oxley Act of 2002 Management’s Responsibility For Financial Reporting One of its most important provisions clearly indicates that the management team is responsible for the financial reporting process and the financial statements. In fact, Section 302 of the Act states that the key company officials must certify the financial statements. That is, the company CEO and CFO must sign a statement indicating: 1. They have read the financial statements. 2. They are not aware of any false or misleading statements (or any key omitted disclosures). 3. They believe that the financial statements present an accurate picture of the company’s financial condition. Source: U.S. Congress, Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat/ 745 (2002). © McGraw Hill 17  Sarbanes-Oxley and Management’s Responsibility for Financial Reporting 1 AUDITING INSIGHT Congress passed the Sarbanes–Oxley Act in 2002 in an attempt to address a number of weaknesses found in corporate financial reporting as a result of the frauds at companies such as WorldCom and Enron. Although the preparation of the financial statements has always been the responsibility of management, Sarbanes– Oxley has enhanced the disclosure provisions to create a heightened sense of accountability. One of its most important provisions (Section 302) states that key company officials must certify the financial statements. Certification means that the company’s chief executive officer and chief financial officer must sign a statement indicating: 1. They have read the financial statements. 2. They are not aware of any false or misleading statements (or any key omitted disclosures). 3. They believe that the financial statements present an accurate picture of the company’s financial condition. © McGraw Hill 18  Sarbanes-Oxley and Management’s Responsibility for Financial Reporting 2 Management must also make assertions regarding the effectiveness of the company’s internal controls over financial reporting. In addition, the auditors are required to issue an attestation report (Section 404) on the system of internal controls to provide assurance that the system of internal controls over financial reporting has been designed and is operating effectively. Source: U.S. Congress, Sarbanes–Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745, 2002. © McGraw Hill 19  Used Car For Sale! I am selling my used car for $5,000! What am I implicitly asserting. What are my assertions?? (C/C/E/A/V/RO/PD) © McGraw Hill 20  Management Financial Statement Assertions (PCAOB) Existence OR occurrence – Assets and liabilities included in the accounts exist and recorded transactions are valid and have actually occurred. Completeness – All balances and transactions have been recorded in the financial statements. Valuation OR allocation – Assets, liabilities and recorded transactions have been valued in accordance with G AAP. Rights and obligations – Entity has a legal claim on all assets and revenues reported and has a legal responsibility for all liabilities and expenses. Presentation and disclosure – All accounts are presented in the appropriate place and all information required has been disclosed in the statements and footnotes. © McGraw Hill 21  Management’s Financial Statement Assertions (ASB) 1 Assertions about Classes of Transactions and Events, and Related Disclosures Occurrence – Events giving rise to transactions are valid and have taken place. Cutoff – Refers to management’s need to account for revenue, expense, and other transactions in the proper period. Completeness – All transactions have been recorded and are recorded in the appropriate period. Accuracy – Transactions are recorded at the correct amount. Rights and Obligations – Entity has legal claim on all assets and revenues reported and has a legal responsibility for all liabilities and expenses. Classification – Transactions have been posted to the proper account. Presentation – Disclosures must be presented in accordance with G AAP. © McGraw Hill 22  Management’s Financial Statement Assertions (ASB) 2 Assertions about Account Balances and Related Disclosures Existence – Balances include only assets and liabilities that exist. Completeness – Balances include all items that should be included in accordance with GAAP. Accuracy, valuation and allocation – Balances are reported at the proper amount in accordance with GAAP. Rights and obligations – Entity has legal claim on all assets and revenues reported and has a legal responsibility for all liabilities and expenses. Presentation – Disclosures must be presented in accordance with GAAP. © McGraw Hill 23  Management Assertions 1 Exhibit 1.4 Management Assertions ASB Assertions (1) (2) (3) (4) P CAOB Assertions about Classes of Assertions about Account Key Questions Assertions Transactions and Events, and Balances and Related Related Disclosures Disclosures Existence or Existence Do the assets listed really exist? occurrence Occurrence Did the transactions really occur? Cutoff Did the recorded sales transactions occur in the period? Completeness Completeness Are all accounts recorded on the balance sheet? Completeness Were all transactions recorded on the income statement? Cutoff Are transactions included in the proper period? Valuation or Accuracy, valuation, and Are the balance sheet accounts allocation allocation valued correctly? Accuracy Are the transactions accurately recorded? © McGraw Hill 24  Management Assertions 2 (1) (2) (3) (4) P CAOB Assertions about Classes of Assertions about Account Key Questions Assertions Transactions and Events, and Balances and Related Related Disclosures Disclosures Rights and Rights and obligations Does the company really own the obligations assets? Rights and obligations Are all legal responsibilities to pay the liabilities identified? Presentation and Classification Were all transactions recorded in disclosure the correct accounts? Presentation Are the disclosures understandable to users? Presentation Are all required footnote disclosures included? © McGraw Hill 25  Management Assertions and Their Relationship to the Financial Statements (see page 19 of text) Exhibit 1.5 Management Assertions and Their Relationship to the Financial Statements Access the text alternative for slide images © McGraw Hill 26  Management Assertions and Their Relationship to the Financial Statements (see page 19 of text) Exhibit 1.5 Management Assertions and Their Relationship to the Financial Statements Access the text alternative for slide images © McGraw Hill 27  Chapter 1 Learning Objectives 4. Define professional skepticism and explain its key characteristics. © McGraw Hill 28  Professional Skepticism Is defined as having an attitude that “includes a questioning mind and a critical assessment of evidence.” Inquiry alone is never enough. The auditor must obtain sufficient corroborative evidence. Unusual financial trends need investigation. Documents are always checked for authenticity or possible alteration. Ask questions, get answers, then verify the answers. Must be skeptical because a potential conflict of interest always exists between the auditor and the client. Management wants to portray the company and its operations in the best possible light. Auditors want to make sure that this portrayal is fair and accurate. © McGraw Hill 29  A Professional Judgment Process 1. Clarify the issues and objectives. 2. Consider the possible alternatives. 3. Gather and evaluate the relevant evidence. 4. Reach an audit conclusion. 5. Carefully document rationale for the professional judgment reached. Source: “Elevating Professional Judgment in Accounting and Auditing: The K PMG Professional Judgment Framework” (Montvale, NJ: K MPG, 2011). © McGraw Hill 30  Chapter 1 Learning Objectives 5. Describe the organization of public accounting firms and identify the various services that they offer. © McGraw Hill 31  Public Accounting Servies Auditing and Assurance Services Financial Statement Auditing Services. Non-audit and Attestation Engagements. Compilations. Reviews. Tax Services. Advisory Services. © McGraw Hill 32  Baseball Hall of Fame AUDITING INSIGHT For baseball fans, the annual Hall of Fame vote has always been a source of fun and entertainment which is quite often accompanied by spirited conversation regarding the criteria that a player needs to meet to gain admittance into the Hall. The Baseball Writers’ Association of America is responsible for the voting and only those writers that maintain 10 consecutive years following a team are eligible to vote. But, do you know who verifies that eligible voters are properly registered, has signed a code of conduct, and verifies the actual count of votes? You may have guessed it, one of the largest audit firms in the world, EY. So, although you might disagree with the final outcome from time to time, you can be assured that the appropriate process was followed and an accurate count was conducted each and every year! Source: “2022 BBWAA Hall of Fame Ballot Features 30 Former Players,” Baseball Hall of Fame, November 22, 2021 (online source). © McGraw Hill 33  Public Accounting Firm Organization Exhibit 1.6 Public Accounting Firm Organization Access the text alternative for slide images © McGraw Hill 34  Revenues for the Big Four CPA Firms Exhibit 1.7 Revenues for the Big Four CPA Firms Deloitte EY KPMG PwC Total revenues (in billions) $50.2 $40.0 $32.1 $45.1 Auditing and assurance services revenues $10.4 $13.6 $11.4 $17.0 (in billions and as a percent of revenue) 21% 34% 36% 38% Tax revenues $ 8.9 $10.5 $ 7.1 $11.1 (in billions and as a percent of revenue) 18% 26% 22% 24% Advisory services revenues $30.9 $15.9 $13.6 $17.0 (in billions and as a percent of revenue) 61% 40% 42% 38% Source: “Deloitte 2021 Total Revenue,” Deloitte L LP, 2021 (online source); “E Y 2021 Total Revenue,” Ernst & Young LLP, 2021 (online source); P wC 2021 Total Revenue,” PricewaterhouseCoopers L LP, 2021 (online source); K PMG 2021 Total Revenue,” KPMG LLP, 2021 (online source). © McGraw Hill 35  Prohibited Professional Services In summary, Sarbanes-Oxley prohibits professional service firms from performing any client services for audit clients in which the auditors may find themselves making management decisions or auditing their own firm’s work. Specifically, Sarbanes-Oxley prohibits professional service firms from providing any of the following services to an audit client: 1. bookkeeping and related services. 2. design or implementation of financial information systems. 3. appraisal or valuation services. 4. actuarial services. 5. internal audit outsourcing. 6. management or human resources services. 7. investment or broker/dealer services. 8. legal and expert services (unrelated to the audit). Professional service firms may provide client tax services (with some restrictions) and other non-prohibited services to audit clients if the company’s audit committee has approved them in advance. © McGraw Hill 36  No Audit? When can you not provide audit services? When: Tax consulting on aggressive interpretations of tax laws or “listed” transactions (see U.S. Treasury Dept) Contingent fees are involved Providing tax services for key company executives Corporate tax return is generally ok © McGraw Hill 37  Is There Room for Public Accounting Firms? AUDITING INSIGHT There are some that say it is only a matter of time until the Big 4 public accounting firms become a dominant force in the lucrative corporate legal services marketplace. A recent research study noted that “the Big 4 accounting firms have expanded their legal service arms to historic proportions over the last decade.” And, even though “most of the Big 4’s revenue from legal services is presently generated outside the U.S.,” it appears to be only a matter of time until that changes. In fact, When the American Bar Association passed a resolution in February 2020 which encouraged state bar associations to look at new ways to access legal services, there are now some states that are considering allowing non-lawyers to own firms that provide legal services, which would appear to open the door for accounting firms to enter the market. Of course, there are very strict regulatory issues to deal with, in particular, in regards to whether a firm can remain independent if they are also performing a financial statement audit of a client. But, this line of service appears to be a promising avenue for growth. Source: B.E. Brewster, J.H. Grenier D.N. Herda, M.E. Marshall, “Big 4 Firms as Legal Service Providers: Implications for Audit Practice and Future Research Directions,” Accounting Horizons, September, 2021, pp. 93–112. © McGraw Hill 38  Chapter 1 Learning Objectives 6. Describe the audits and auditors in governmental, internal, and operational auditing. © McGraw Hill 39  Other Kinds of Engagements and Information Professionals Internal Auditing Reviews of internal control systems to ensure compliance with company policies, plans, and procedures; Compliance with laws and regulations; Appraisals of the economy and efficiency of operations; Reviews of effectiveness in achieving program results in comparison to established objectives and goals. Governmental Auditing. US Government and Accountability Office (GAO). Regulatory Auditors. IRS © McGraw Hill 40  GAO Engagement Examples The Capitol Police Need Clearer Emergency Procedures and a Comprehensive Security Risk Assessment Process (GAO-22-105001, February 17, 2022). Enhanced Data Capabilities, Analysis, Sharing, and Risk Assessments Needed for Disaster Preparedness (GAO-22-104289, February 02, 2022). FY 2021 and FY 2020 Consolidated Financial Statements of the U.S. Government (GAO-22-105122, February 17, 2022). Challenges Facing DOD in Strategic Competition with China (GAO-22- 105448, February 15, 2022). Agencies Need to Assess Adoption of Cybersecurity Guidance (GAO- 22-105103, February 09, 2022). © McGraw Hill 41  Chapter 1 Learning Objectives 7. List and explain the requirements for becoming a certified public accountant (CPA) and other certifications available to an accounting professional. © McGraw Hill 42  Become a Professional and Get Certified! Education (150 hours/sit after 120). Examination. Experience (1 year public/2 year private). State Certificate and License. Skill Sets and Your Education. © McGraw Hill 43  Certification Requirements 1 Exhibit 1.8 Certification Requirements Certified Public Certified Certified Certified Fraud Certified Accountant (CP Information Internal Auditor Examiner (CFE) Management A) Systems Auditor (CIA) Accountant (CMA) (CISA) Education Level Varies by state; No specific degree Generally, Generally, Bachelor’s degree, Generally 150 requirement bachelor’s bachelor’s or pass the CPA, hours. However, degree or its degree or its CFA, CIA or CFE check with your educational educational examination state board of equivalent equivalent accountancy Experience Varies by state; 5 years of Generally 2 years 2 years of 2 continuous years Generally 1-2 professional of internal professional of professional years working information system auditing experience for experience in under a CPA. (IS) auditing, experience or its certification management Check with your control, or security equivalent for accounting and/or state board of work experience certification. May financial accountancy for certification. be less with a management Some substitutions Master’s degree. and waivers are May be more possible. without a degree. © McGraw Hill 44  Certification Requirements 2 Certified Public Certified Certified Certified Fraud Certified Accountant (CP Information Internal Auditor Examiner (CFE) Management A) Systems Auditor (CIA) Accountant (CMA) (CISA) Exam Coverage 1. Auditing and 1. The process of 1. Essentials of 1. Fraud 1. Financial attestation auditing internal prevention planning, (AUD) information auditing and performance, 2. Financial systems 2. Practice of deterrence and analytics accounting 2. Governance internal 2. Financial 2. Strategic and reporting and auditing transactions financial (FAR) management of 3. Business and fraud management 3. Regulation IT knowledge of schemes (REG) 3. Information internal 3. Investigation 4. Business systems auditing 4. Law environment acquisition, and concepts development, (BEC) and implementation 4. Information systems operations, and business resilience 5. Protection of information assets © McGraw Hill 45  Certification Requirements 3 Certified Public Certified Certified Certified Fraud Certified Accountant (CP Information Internal Auditor Examiner (CFE) Management A) Systems Auditor (CIA) Accountant (CMA) (CISA) Test Length 4 parts, 16 1 part, 4 hours 3 parts, 6.5 4 parts (2 hours 2 parts (100 mc hours (150 mc questions) hours (325 mc each part - 100 questions and two questions) questions each); 30-minute essays, 8 total hours each) 8 hours Passing Score 75% 450 (on an 800- 600 (on a 750- 75% 360 per part (on a point scale) point scale) 500-point scale) Test Dates On demand On demand On demand Self-administered On demand during the months of Jan, Feb, May, Jun, Sep, and Oct Administering American Information Institute of Association of Institute of Certified Body Institute of Systems Audit and Internal Auditors Certified Fraud Management Certified Public Control Association Examiners Accountants Accountants Board of Examiners Website www.aicpa.org www.isaca.org www.theiia.org www.acfe.com www.imanet.org © McGraw Hill 46  The Uniform CPA Examination Candidates will have 16 hours to complete the four parts of the exam: Auditing and Attestation (AUD); Financial Accounting and Reporting (FAR); Regulation (REG); and Business Environment and Concepts (BEC). The CPA exam includes multiple-choice questions and task- based simulations (except for BEC, which also includes graded written communication). The task-based simulations allow higher-order skills to be more accurately tested and measured, an important goal for the new exam. © McGraw Hill 47  Auditing and Attestation Section (AUD) Candidates will have four hours to complete the AUD section of the CP A exam. It will include 72 multiple-choice questions and 8-9 task-based simulations. The summary blueprint for the AUD section is provided below: Content Area Allocation Weight Ethics, Professional Responsibilities, and General Principles 15–25% Assessing Risk and Developing a Planned Response 25–35% Performing Further Procedures and Obtaining Evidence 30–40% Forming Conclusions and Reporting 10–20% Skill Allocation Weight Evaluation 5–15% Analysis 20–30% Application 30–40% Remembering and Understanding 25–35% Source: https://www.aicpa.org/resources/download/learn-what-is-tested-on-the-cpa-exam. Summary blueprints for REG, FAR, and BEC can also be found at this site. © McGraw Hill 48  The New Uniform CPA Examination Substantial changes to the CPA exam are coming in 2024. The proposed changes in the CPA exam are part of the CPA Evolution, a broader initiative to reimagine the CPA licensure model. The exam is expected to include three new sections: Business Analysis and Reporting (BAR); Information and Systems Control (ISC); and Tax Compliance and Planning (TCP). We encourage you to stay in close touch with changes to the CPA Exam as they occur. © McGraw Hill 49  End of Main Content Because learning changes everything. ® www.mheducation.com © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.