CONTENTS CHAPTER 1:
Auditing: Integral to the Economy, 2
enhanced role of audit committees, 40 Required Audit Communication to the Audit Committee, 42
introduction, 3
audit standard setting, 44
increased demand for accountability, 10
overview of audit process: a standards-based approach, 49
Auditing: A Special Function, 4 Auditing Defined, 5 The Need for Unbiased Reporting, 8 Need for Assurance, 9 Demand for Improved Corporate Governance, 10 Required Reporting on Internal Controls, 11 Audit Standard Setting and Auditor Independence, 12 Public Expectation of Auditors, 12 Audit Standard Setting Moved to a Quasi-Public Board, 12
scope of services: other assurance services, 12 What Is Assurance?, 12
requirements to enter the public accounting profession, 15 the providers of assurance services, 16 The Public Accounting Profession, 16 The Internal Audit Profession, 17 Governmental Auditing Profession, 18
professional and regulatory organizations, 18
The Public Company Accounting Oversight Board, 18 The Securities and Exchange Commission, 19 The American Institute of Certified Public Accountants, 19 Committee of Sponsoring Organizations, 19 Accounting Standard Setters, 19 State Boards of Accountancy, 20 The Institute of Internal Auditors, 20 The U.S. Government Accountability Office, 20 The Court System, 20
Summary, 21 Significant Terms, 21 Review Questions, 22 Multiple-Choice Questions, 24 Discussion and Research Questions, 25 Cases, 31 CHAPTER 2:
Corporate Governance, Audit Standards, 32
corporate governance and auditing, 33 Corporate Governance Responsibilities, 34 Not a Perfect Storm, 37
the sarbanes-oxley act of 2002, 38
The PCAOB, 39 Auditor Independence Provisions, 39 Corporate Responsibility for Financial Reports, 40
Generally Accepted Auditing Standards, 44 Attestation Standards, 47 Future of Audit Standard Setting, 47
Planning the Audit, 49
Summary, 53 Significant Terms, 53 Review Questions, 54 Multiple-Choice Questions, 56 Discussion and Research Questions, 57 Cases, 63
CHAPTER 3:
Understanding and Meeting Ethical Expectations, 64
introduction, 64
Corporate Culture, Ethics, and Organizational Performance, 64 Accepting a Public Trust, 65 Unique Licensure for CPAs, 66
independence: a foundation requirement, 66
Major Threats to Independence, 66 Managing Threats to Independence, 67 Sources of Independence Guidance, 69 SEC’s Principles for Judging Independence and Prohibited Non-Audit Services, 69 AICPA Code of Professional Conduct, 70 AICPA’s Approach to Independence, 73
other important elements of a professional code of ethics, 75
Integrity and Objectivity—Rule 102, 75 Confidentiality—Rule 301, 75 Contingent Fees—Rule 302, 77 Advertising and Other Forms of Solicitation— Rule 502, 77 Commissions and Referral Fees—Rule 503, 77 Form of Organization and Name—Rule 505, 78 Enforcement of the Code, 78
ethical theories: resolving issues that are not black or white, 78 Utilitarian Theory, 78 Rights Theory, 79 An Ethical Framework, 79 Applying the Ethical Framework to the Consolidata Situation, 79
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Contents
Summary, 81 Significant Terms, 81 Review Questions, 82 Multiple-Choice Questions, 83 Discussion and Research Questions, 84 Cases, 89 CHAPTER 4:
Audit Risk and a Client's Business Risk, 92
nature of risk, 93 risk factors affecting the audit, 95 Engagement Risk, 95 Client Acceptance or Retention Decision, 95 Financial Reporting Risk, 98 Accepting New Clients: Minimizing Risk, 99
materiality and audit risk, 101 Materiality, 101
developing an understanding of enterprise and financial reporting risks, 105
Lessons Learned—The Lincoln Savings and Loan Case, 105 Understanding Management’s Risk Management Process, 108 Developing an Understanding of Business and Risks, 108 Preliminary Financial Statement Review: Techniques and Expectations, 113 Risk Analysis and the Conduct of the Audit, 116
Summary, 117 Significant Terms, 117 Review Questions, 118 Multiple-Choice Questions, 120 Discussion and Research Questions, 122 Cases, 129 B I LT R I T E A P P E N D I X :
Biltrite: A Computerized Audit Practice Case, 135
description of the practice case, 135 Description of the Company, 136
module i: assessment of inherent risk, 147 Study of the Business and the Industry, 147 Requirements, 148
CHAPTER 5:
Audit Evidence: A Framework, 150
overview of the audit model, 150 assertion model for financial statement audits, 152
gathering sufficient, appropriate evidence, 154 Sufficiency, 156 Reliability of Audit Evidence, 156 Nature of Audit Testing, 160 Audit Procedures, 161
audit programs and documenting audit evidence, 167 Audit Program Development, 167 Documenting Audit Evidence, 168
auditing account balances affected by management’s estimates, 173 Evidence, 173 Importance of Quality Review, 174
Summary, 174 Significant Terms, 174 Review Questions, 175 Multiple-Choice Questions, 176 Discussion and Research Questions, 178 Cases, 185
CHAPTER 6:
Internal Control over Financial Reporting, 188
a framework for control, 189 COSO: Internal Control, Integrated Framework, 189 The Need for Control, 190
internal control and financial reporting, 191 Components of an Internal Control System, 192 Control Environment, 194 Risk Identification and Assessment, 200 Control Activities, 200 Information and Communication, 202 Monitoring, 202
auditor evaluation of internal controls, 204
Auditor Assessment of Internal Controls as a Basis for Subsequent Audit Testing, 206 Linking of Financial Statement Assertions to Specific Control Activities, 211
documenting the auditor’s understanding of an organization’s internal controls, 216 Summary, 219 Significant Terms, 219 Review Questions, 220 Multiple-Choice Questions, 222 Discussion and Research Questions, 224 Cases, 233
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Contents CHAPTER 7:
Performing an Integrated Audit, 238
introduction—expanded audit requirements, 239 Framework for Audit Evidence in an Integrated Audit, 239 Audit Report on Internal Control over Financial Reporting, 240
planning the integrated audit, 245
A Top-Down, Risk-Based Approach, 246 Integrated Audit: Searching for Audit Efficiency, 250
conducting an integrated audit, 254 Evaluating Internal Control over Financial Reporting, 255 Testing Control Activities, 257
example—integrated audit, 260
Identifying Material Account Balances and Processes, 260 Evaluating Design and Testing, 261 Auditor Testing of Controls, 262 Auditor Assessment of Controls and Implications for the Financial Statement Audit, 263 Looking Forward: Reducing 404 Compliance Costs, 263
Summary, 264 Significant Terms, 264 Review Questions, 264 Multiple-Choice Questions, 266 Discussion and Research Questions, 267 Cases, 275
CHAPTER 8:
Computerized Systems: Risks, Controls, and Opportunities, 278 introduction, 278 overview of computerized accounting systems, 279 Identifying Types of Computer Software and Associated Risks, 279 Interconnected Systems—The Virtual Private Network, 281
general and application controls, 282
General Controls, 283 Program Development and Program Changes, 284 Controlling Access to Equipment, Data, and Programs, 284 Data Transmission Controls, 287 Application Controls, 287 Overview of Computer Controls Risk Assessment, 291
electronic commerce, 294
EDI: A Popular Type of E-Commerce, 295
computer-aided audit techniques, 297 Integrated Test Facility:Testing Correctness of Processing, 297
Tracing Transactions through the System:The Tagging and Testing Approach, 299 Selecting Recorded Data for Testing: Generalized Audit Software, 300
audit approaches for e-commerce, 304 Risk Analysis, 304
Summary, 305 Significant Terms, 305 Review Questions, 306 Multiple-Choice Questions, 308 Discussion and Research Questions, 309 Cases, 317 B I LT R I T E P R AC T I C E C A S E ,
320
module ii: assessment of control risk, 320 Control Environment, Accounting Information System, and Control Procedures, 320
CHAPTER 9:
Auditing for Fraud, 332
fraud and auditor responsibilities: a historical evolution, 332
Magnitude of Fraud, 333 Fraud Defined, 334 Evolution of Fraud and Auditor Responsibility, 336 Financial Reporting Frauds—The Second COSO Report, 338
auditing standards—more responsibility, 339
A Proactive Approach to Fraud Detection, 339 Conducting the Financial Statement Audit—Fraud Awareness, 340
audit procedures when fraud risk is high, 357
Characteristics of Financial Reporting Frauds, 357 Characteristics of Defalcations, 358 Audit Procedure and Evidence Considerations, 359 Using the Computer to Analyze the Possibility of Fraud, 362 Responsibilities for Detecting and Reporting Illegal Acts, 363
forensic accounting, 363 Summary, 364 Significant Terms, 365 Review Questions, 365 Multiple-Choice Questions, 368 Discussion and Research Questions, 369 Cases, 377 CHAPTER 10:
Audit Sampling, 382
introduction, 382
Overview of Audit Sampling, 383
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Contents
Non-Sampling and Sampling Risk, 384 Selecting a Sampling Approach, 386
testing control effectiveness and compliance, 387 Attribute Estimation Sampling, 388 Nonstatistical Sampling, 397
sampling to test for account balance misstatements, 397 Substantive Sampling Considerations, 397 Nonstatistical Sampling, 400 Probability Proportional to Size Sampling, 401 Error Evaluation Terminology, 406 No Misstatements in the Sample, 406 Misstatements in the Sample, 407 Frequent Misstatements Found, 409 Unacceptable Sample Results, 409 Comparison of Sample Evaluation—PPS and Nonstatistical Sampling, 410
Summary, 411 Significant Terms, 411 Review Questions, 413 Multiple-Choice Questions, 414 Discussion and Research Questions, 415 Cases, 423
Audit Steps for an Integrated Audit, 444
example: an integrated audit of sales and receivables, 445 Develop an Understanding of Internal Controls, 445 Identify Important Controls, 445 Design and Perform Tests of Internal Controls, 446 Evaluate Accounts for Unusual Activity, 446 Determine Year-End Tests, 446
linking internal controls and audit assertions, 447
Control Structure Regarding Returns, Allowances, and Warranties, 449 Importance of Credit Policies Authorizing Sales, 449
substantive testing in the revenue cycle, 452 Planning for Direct Tests of Transactions and Account Balances, 453 Audit Objectives and Assertions, 453
substantive tests of revenue, 453
appendix 10a: effect of population size (finite adjustment factor), 424 B I LT R I T E P R AC T I C E C A S E ,
auditing internal controls and account balances—the integrated audit of revenue, 442
427
module iii: control testing—sales processing, 427 Requirements, 428
module iv: pps sampling—factory equipment additions, 428 Requirements, 429
CHAPTER 11:
Auditing Revenue and Related Accounts, 430 introduction, 431
The Cycle Approach, 431 Overview of the Revenue Cycle, 431
Substantive Tests of Accounts Receivable, 455 Standard Accounts Receivable Audit Procedures, 456 Related-Party Receivables, 464 Non-Current Receivables, 464 Sold, Discounted, and Pledged Receivables, 464 Few but Large Sales—Confirmation of Sales, 464 Fraud Indicators and Audit Procedures, 465 Allowance for Doubtful Accounts, 466
Summary, 467 Significant Terms, 467 Review Questions, 468 Multiple-Choice Questions, 470 Discussion and Research Questions, 473 Cases, 486
appendix 11a: regression analysis, 490 B I LT R I T E P R AC T I C E C A S E ,
module v: accounts receivable aging analysis, 492 Requirements, 492
business risk and business environment, 435
CHAPTER 12:
analytical analysis for possible misstatements, 439
introduction, 494
Revenue Recognition, 435 Fraud Risk Factors—Revenue Recognition, 438
Comparison of Revenue Trend with Industry Trends, 439 Compare Cash Flow from Operations with Net Income, 440 Other Analytical Procedures, 440 Regression Analysis, 441
492
Audit of Acquisition Cycle and Inventory, 494 Overview of the Acquisition Cycle, 494 Business Risk and Business Analysis, 495 Analytical Analysis for Misstatements, 496
audit of the acquisition cycle, 497 Overview of Control Procedures and Control Risk Assessment, 497
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Contents
Testing Controls over Accounts Payable and Related Expenses, 501 Substantive Tests of Accounts Payable, 502 Audits of Expense Accounts, 503
integrated audit of inventory and cost of goods sold, 506 Internal Controls for Inventory, 507 Key Processes and Risks, 507 Substantive Tests of Inventory and Cost of Goods Sold, 510
module viii: dallas dollar bank—bank reconciliation, 578 Requirements, 578
module ix: analysis of interbank transfers, 578 Requirements, 578
module x: analysis of marketable securities, 579
CHAPTER 14:
Audit of Long-Lived Assets and Related Expense Accounts, 582
535
module vi: sales and purchases cutoff tests, 535 Requirements, 535
module vii: search for unrecorded liabilities, 535 Requirements, 536
CHAPTER 13:
Audit of Cash and Other Liquid Assets, 538 introduction, 538
Overview of Cash Accounts Affected, 538 Types of Marketable Security Accounts, 539 Business Risk and Business Environment, 540 Planning for Audits of Cash and Marketable Securities, 540
audit of cash, 543
Evaluating Control Risk: Cash Accounts, 543 Understanding and Testing Internal Controls, 546 Substantive Testing of Cash Balances, 546 Integrated Audit of Cash, 555
audit of marketable securities and financial instruments, 556
Audits of Marketable Securities, 556 Audits of Commercial Paper, 556 Audits of Other Short-Term Securities, 556 Other Financial Instruments and Derivatives, 557 Application of Concepts: Audit of Financial Hedges, 560
Summary, 562 Significant Terms, 563 Review Questions, 564 Multiple-Choice Questions, 565 Discussion and Research Questions, 567 Cases, 576
578
Requirements, 579
Summary, 517 Significant Terms, 517 Review Questions, 517 Multiple-Choice Questions, 520 Discussion and Research Questions, 522 Cases, 531 B I LT R I T E P R AC T I C E C A S E ,
B I LT R I T E P R AC T I C E C A S E ,
business risk and business environment, 582 analytical analysis for possible misstatements, 584
Analyze Industry Trends and Changes in Product Lines, 584 Analyze Depreciation for Consistency and Economic Activity, 585
integrated audit of fixed assets and related expenses, 585
Evaluating Control Risk and Control Effectiveness, 586 Controls for Intangible Assets, 586 Basic Audit Procedures and Impact of Auditor’s Assessment of Internal Controls, 587 Tests of Property Additions and Disposals, 589 Asset Impairment, 592 Discontinued Operations, 593 Depreciation Expense and Accumulated Depreciation, 593 First-Time Audits, 594
intangible assets, 594 natural resources, 595 leases: a special consideration, 596 Motivation to Lease, 596 Proper Accounting Treatment, 597 Audit Approach, 598
Summary, 598 Significant Terms, 598 Review Questions, 598 Multiple-Choice Questions, 600 Discussion and Research Questions, 601 Cases, 606 B I LT R I T E P R AC T I C E C A S E ,
608
biltrite bicycles, inc., 608 module xi: plant asset additions and disposals, 608 Requirements, 608
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Contents
CHAPTER 15:
Audit of Acquisitions, Related Entity Transactions, Long-Term Liabilities, and Equity, 610 business risk and business environment, 611 mergers and acquisitions, 611
Acquisition—Asset Valuation Issues, 611 Testing for Goodwill Impairment, 614 Restructuring Charges: Good Business or an Opportunity to Manipulate Reported Earnings, 618
transactions with related entities, 619 Accounting for Transactions with Related Entities, 619 Related-Entity Transactions and Small Businesses, 620 Audit Approach for Related-Entity Transactions, 620 Variable Interest Entities, 621 Disclosure of Significant Relationships, 622
audits of long-term liabilities and owner’s equity, 623
Liabilities with Significant Subjective Judgments, 623 Bonds and Stockholder’s Equity, 625
Summary, 628 Significant Terms, 629 Review Questions, 629 Multiple-Choice Questions, 630 Discussion and Research Questions, 632 Cases, 638 B I LT R I T E P R AC T I C E C A S E ,
Summary, 663 Significant Terms, 663 Review Questions, 664 Multiple-Choice Questions, 665 Discussion and Research Questions, 666 Cases, 671 B I LT R I T E P R AC T I C E C A S E ,
676
module xiv: working trial balance, 676 CHAPTER 17:
Communicating Audit and Attestation Results, 678
audit reports, 679
Expression of an Opinion, 679 Association with Financial Statements, 680 Types of Audit Reports, 680 Modifications of the Standard Unqualified Report, 681 Modifications Not Affecting the Opinion, 682 Modifications Affecting the Opinion, 685 Reports on Comparative Statements, 690 International Reporting, 691 Summary of Audit Report Modification, 693
reviews and compilations, 693
Public/Non-Public Companies, 694 Procedures Common to All Levels of Service, 694 Reviews, 695 Compilations, 698
641
module xii: estimated liability for product warranty, 641 Requirements, 641
module xiii: mortgage note payable and note payable to bank two, 642 Requirements, 642
CHAPTER 16:
Completing the Audit, 644
assessing the quality of the audit, 645 Analytical Review of the Audit and Financial Statements, 645 Concurring Partner Review, 645
other considerations in the final review stage of the audit, 646
Contingencies, 646 Adequacy of Disclosures, 647 Management Representations, 649 Management Letter, 652 Evaluating the Effects of Substantive Testing Results, 652 Evaluating the Going Concern Assumption, 654 Review of Significant Estimates, 657 Communicating with the Audit Committee, 658 Subsequent Events, 659
reports on other financial information, 699
Special Reports, 699 Interim Financial Information, 703 Financial Reports on the Internet, 705
the world of attestation services, 705 reports on other financial and non-financial information, 706 Summary, 707 Significant Terms, 707 Review Questions, 708 Multiple-Choice Questions, 709 Discussion and Research Questions, 712 Case, 722 B I LT R I T E P R AC T I C E C A S E ,
724
module xv: audit report, 724 Requirements, 724
CHAPTER 18:
Professional Liability, 726
the legal environment, 726
Joint and Several Liability, 728 Audit Time and Fee Pressures, 728 Audits Viewed as an Insurance Policy, 728
Contents
Contingent-Fee Compensation for Lawyers, 728 Class Action Suits, 729
legal concepts, 729
Causes of Legal Action, 730 Parties That May Bring Suit Against Auditors, 730 Liability to Clients, 731 Common-Law Liability to Third Parties, 732 Statutory Liability to Third Parties, 734 Liability Issues of Multi-National CPA Firms, 737 Liability Impact of Internet Dissemination of Audited Financial Information, 738 Summary of Auditor Liability to Third Parties, 738
approaches to mitigating liability exposure, 738
Continuing Education Requirement, 738 Policies to Help Ensure Auditor Independence, 739 Prohibited Services, 739 Restrictions on Non-Audit Services for Audit Clients, 739 Auditor Independence Programs, 740
quality control programs, 740 Quality Control Standards, 740 External Inspections/Peer Reviews, 740 Internal Peer Review, 741
defensive auditing, 741
Engagement Letters, 741 Client Screening, 741 Evaluating the Firm’s Limitations, 742 Maintaining Accurate and Complete Audit Documentation, 742 Limited-Liability Partnerships, 742 Role of Insurance, 742 Tort Reform, 742
effect of court cases on auditing standards and practice, 743 Engagement Letters, 743 Audit Procedures, 743 Subsequent Events, 744 Related-Entity Transactions, 744
Summary, 745 Significant Terms, 745 Review Questions, 746 Multiple-Choice Questions, 747 Discussion and Research Questions, 749 Cases, 753 CHAPTER 19:
Internal Auditing and Outsourcing, 756
internal auditing: a unique profession, 757
Internal Auditing Defined, 757 Internal Auditing and Regulatory Recommendations, 764
breadth of internal auditing, 765
Internal Auditing Contrasted with External Auditing, 765 Multitude of Internal Audit Groups, 765
Internal Audit Outsourcing, 767 Value-Added Internal Auditing, 767 Risk Analysis, 768 Information Reliability, 768 Control Effectiveness, 768 Effectiveness and Efficiency of Operations, 768 Regulatory and Other Compliance Audits, 772 Fraud Investigations, 773
internal auditing and sarbanes-oxley, 773 internal audit standards and the iia, 773 Internal Audit Standards, 773 IIA’s Code of Ethics, 774 Reporting Fraud, 775
Summary, 776 Significant Terms, 776 Review Questions, 777 Multiple-Choice Questions, 778 Discussion and Research Questions, 780 Cases, 786
ACL APPENDIX:
ACL Basics, Tutorial and Cases, 788 data files, 788 getting started, 788 acl basics, 788
(1) Create a New Project, 789 (2) Open an Existing Project, 789 Basic Activities, 789 Delete Files, 792 Close Projects, 793
acl tutorial, 793
Start-Up, 793 Husky Tutorial Case, 793 Audit Procedures, 793
acl case 1—fraud, 815 acl case 2—benford’s law case, 815 Using ACL to Perform Benford Analysis, 816 The Case, 816 Required, 816
introduction to acl cases 3 and 4—accounts receivable and inventory, 817 acl case 3—accounts receivable, 817 acl case 4—inventory, 819
Case Index, 821 Index, 823
xix