Chapter1

Auditing:
Integraltothe
Economy

Copyright 2012 South-Western/Cengage Learning

AuditOpinionFormulationProcess
 TheAuditingProfession
Thecapitalmarketsdependonaccurate,reliable,and
objective(neutral)datathatportraytheeconomic
natureofanentitysbusiness
Accountingtransactionsarebecomingincreasingly
complicatedascompaniesengageinmoreelaborate
structuresaswellasintransactionsthataredifficult
tomeasure
Theeconomyisbecomingglobaladaccountingis
movingtowardsglobalharmonization
 TheAuditingProfession
Asaprofession,weareinaperiodofchangein
whichauditorsandaccountantsarecalleduponto
makeprofessionaljudgments
Auditfirmsneedprofessionalswhomakeconsistent
judgmentsacrossawidevarietyofcompanies,
countries,andtypesoftransactions
 LO1:ObjectiveandRoleof
Auditing
Afinancialstatementaudithasbeendefinedasa:
Asystematicprocessofobjectivelyobtainingandevaluating
evidenceregardingassertionsabouteconomicactionsand
eventstoascertainthedegreeofcorrespondencebetween
thoseassertionsandestablishedcriteriaandcommunicating
theresultstointerested
 ObjectiveandRoleofAuditing
Afinancialstatementaudithasbeendefinedasa:
Asystematicprocessofobjectivelyobtainingand
evaluatingevidenceregardingassertionsabout
economicactionsandeventstoascertainthedegree
ofcorrespondencebetweenthoseassertionsand
establishedcriteriaandcommunicatingtheresultsto
interested
 Auditing:ASpecialFunction

Auditingisauniquefunctionthatis
licensedbythegovernmenttopromotethe
effectivefunctioningofthecapitalmarkets.
Butthatuniquelicensecomeswithaprice
accountabilityandresponsibilitytothe
public
 ChallengesoftheProfession
Detectmaterialfraudandassurethatusersof
financialstatementsarefreefromfraud
Complexaccountingtransactionsand
organizationalstructures
Computersystemsarecomplex
Manycompaniesareglobal
Timepressuretogetauditdone
Needtogeneratesufficientauditfees
 NeedforUnbiasedReporting
andIndependentAssurance
Potentialbiasinprovidinginformation
Remotenessbetweenauserandtheorganizationor
tradingpartner
Complexityofthetransactions,information,or
processingsystems
Investorsneedtomanagetheirriskandthereby
minimizefinancialsurprises
Consequencestoinvestors,andothers,ofrelyingon
inaccurateinformationcanbequitesignificant
UsersofAuditedFinancial
Statements
 LO2:ProvidersofPublic
AccountingServices
Thepublicaccountingprofessionincludes:
Solepractitionerfirms
localandregionalfirms
largemultinationalprofessionalservicesfirmssuchasthe
Big4
Theorganizationalstructureofaccountingfirms
variesdramatically
TypicalOrganizationalHierarchyof
CPAFirms
TheorganizationalhierarchyofCPAfirmshasmost
oftentakenapyramidalstructure:
Partners(orowners)formthetopofthepyramidandare
responsiblefortheoverallconductofeachaudit
Managers,whoreviewtheauditworkperformedbystaff
personnel(thebaseofthepyramid)
Seniorsareresponsibleforoverseeingthedaytoday
activitiesonaspecific
Staffpersonneltypicallyspendtwotofouryearsatastaff
level,afterwhichtheyassumeincreasingsupervisory
responsibilities
 KnowledgeandExpertiseNeeded
AccountingandAuditing
KnowledgeoftheClientsIndustry,Business,andRisks
ComputerSkillsandAccountingSystems
InternalControlExpertise
Fraudauditorsneedtobeawareoftheincentivesfor
employees(includingupperlevelmanagement)tocommit
fraud,theopportunitiesthatweakinternalcontrolsmaycreate
thatwillallowafraudtobeperpetratedorconcealed,andthe
rationalizationsthatemployeesmayusetojustifytheiractions
andtocontinueorescalatethefraudovertime
 LO3:OrganizationsAffectingthe
PublicAccountingProfession
Congress:
SarbanesOxleyActof2002
AuditorIndependenceandtheRoleoftheAuditCommittee
RequiredReportingonInternalControloverFinancialReporting
OversightoftheAccountingProfession
PublicCompanyAccountingOversightBoard(PCAOB)
TheSecuritiesandExchangeCommission(SEC)
AmericanInstituteofCertifiedPublicAccountants(AICPA)
InternationalAuditingandAssuranceStandardsBoard
(IAASB)
 OrganizationsAffectingthePublic
AccountingProfession
CommitteeofSponsoringOrganizations(COSO)
AccountingStandardSetters:
Generallyacceptedaccountingprinciples(GAAP)setbyFinancial
AccountingStandardsBoard(FASB),withapprovalbytheSecurities
andExchangeCommission(SEC)
InternationalFinancialReportingStandards(IFRS)setbythe
InternationalAccountingStandardsBoard(IASB)
StateBoardsofAccountancy
TheCourtSystem
LO4:AuditStandardSettinginthe
PublicAccountingProfession
AuditorsintheUnitedStatesfollowauditing
guidanceissuedbytheAICPA,PCAOB,andIAASB
Auditingstandardssetbythesevariousauthorities
haveacommonobjectivetoprovideassuranceto
thepublicthatauditsareconductedinaprofessional
manner
 OverallAuditGuidanceIssuedby
theAICPAandtheIAASB
Theguidance,whichisalmostidentical,
recognizesthattheobjectiveofanauditisto
obtainreasonableassuranceaboutwhetherthe
financialstatementsarefreefrommaterial
misstatementandtoreportonthefinancial
statementsbasedontheauditorsfindings
 OverallAuditGuidanceIssuedby
theAICPAandtheIAASB
Incompletingtheseobjectives,theauditor:
Complieswithrelevantethicalrequirements
Plansandperformsanauditwithprofessionalskepticism
Exercisesprofessionaljudgment
Obtainssufficientappropriateevidenceonwhichtobasetheauditors
opinion
Conductstheauditinaccordancewithprofessionalauditingstandards
Thisoverallguidanceissupplementedwithspecificauditing
standards(SASsissuedbytheAICPAandISAsissuedbythe
IAASB)
 AuditingStandardsIssuedbythe
AICPA
Tenstandardsthatfallwithinthreecategories:
Generalstandardsapplicabletotheauditorandauditfirm
Fieldworkstandardsapplicabletotheconductoftheaudit
Reportingstandardsapplicabletocommunicatingtheauditors
opinion
ThetenstandardsweredevelopedbytheASBoftheAICPA
andhavebeenadoptedbythePCAOB
TheAICPAisworkingonconvergingitsstandardswiththose
oftheIAASB.Aspartofthatconvergence,thetenstandards
willbereplacedbyprinciples
 GeneralStandards
1. Theauditbeperformedbyindividualshaving
adequatetechnicaltrainingandproficiencyasan
auditor
2. Auditorsbeindependentintheirmentalattitudein
conductingtheaudit(independenceinfact)andbe
perceivedbyusersasindependentoftheclient
(independenceinappearance)
3. Theauditbeconductedwithdueprofessionalcare
whichisastandardofcarethatwouldbeexpectedof
areasonablyprudentauditor
 FieldworkStandards
1. Anauditbeproperlyplannedandsupervised
2. Auditorsdevelopanunderstandingoftheclients
controlsasanimportantprerequisitetodeveloping
specificaudittests
3. Auditorsobtainsufficientappropriateauditevidence
byperformingauditprocedurestoprovidea
reasonablebasisfortheauditopinionbeing
provided
 ReportingStandards
Theauditortostateexplicitlywhetherthefinancial
statementsarefairlypresented
Theauditor,toidentify,intheauditorsreport,those
circumstancesinwhichaccountingprincipleshavenot
beenconsistentlyobservedinthecurrentperiodin
comparisontotheprecedingperiod
Theauditortoreviewdisclosuresforadequacy
Theauditortoexpressanopiniononthefinancial
statementsasawholeorstatethatanopinioncannot
beexpressed
 PrinciplesGoverninganAudit
ConductedinAccordanceGAAS
Inplaceofthetenstandards,theAICPAhas
nowdevelopedfundamentalprinciplesinfour
categories
PurposeofanAuditandPremiseUponWhichan
AuditIsConducted
Responsibilities
Performance
Reporting
 PurposeofanAuditandPremise
UponWhichanAuditIsConducted
1. Thepurposeofanauditistoenhancethedegreeof
confidencethatuserscanplaceinthefinancialstatement
Thispurposeisachievedwhenanauditorexpressesanopiniononthe
financialstatements
2. Anauditisbasedonthepremisethatmanagementhas
responsibilitytopreparethefinancialstatements,maintain
internalcontroloverfinancialreporting,andprovidethe
auditorwithrelevantinformationandaccesstopersonnel
 Responsibilities
1. Auditorsareresponsibleforhavingtheappropriate
competenceandcapabilitiestoperformtheaudit,should
complywithethicalrequirements,andmaintainprofessional
skepticismthroughouttheaudit
 Performance
1. Theauditorneedstoobtainreasonableassuranceasto
whetherthefinancialstatementsarefreefrommaterial
misstatement
2. Obtainingreasonableassurancerequirestheauditortoplan
andsupervisethework,determinematerialitylevels,identify
risksofmaterialmisstatement,anddesignandimplement
appropriateauditresponsestotheassessedrisks
3. Anaudithasinherentlimitationssuchthattheauditorisnot
abletoobtainabsoluteassuranceaboutwhetherthefinancial
statementsarefreefrommisstatement
 Reporting
Theauditorexpressesanopinionastowhetherthefinancial
statementsarefreeofmaterialmisstatementorstatesthatan
opinioncannotbeexpressed
 AuditingStandardsIssuedbythe
IAASB
Asof2010,theIAASBauditingstandardscomprisethirtysix
InternationalStandardsonAuditing(ISAs)
Over100countrieshavenationalauditingstandardsthatare
basedontheISA
ItisexpectedthatthestandardsoftheAICPAandIAASBwill
converge
 AuditingStandardsIssuedbythe
PCAOB
ThePCAOB,whichcameintoexistencein2002,issues
auditingstandardsthatapplytoauditorsofU.S.public
companies
Asof2010,thePCAOBhasissuedfifteenAuditingStandards
(ASs)
Further,thePCAOBadoptedtheAICPAstandardsthatwere
inplaceonApril16,2003(referredtoasinterimstandards)
Publiccompanyauditorsmustfollowthesestandardsofthe
AICPAunlesstheyhavebeensupersededbyaPCAOB
standard
 LO5:TheAuditOpinion
FormulationProcess
PhasesIandII:MakingClientDecisionsandGainingan
UnderstandingoftheClient
PhasesIIIandIV:ObtainingEvidence
ManagementAssertions
AuditProcedurestoTestAssertions
PhaseV:WrappingUptheAuditandMakingReporting
Decisions
 LO6:OtherAssuranceand
AttestationServices
Assurancevs.Attestationvs.Audit
Sometimesthetermsassurance,attestation,andaudit
areusedinterchangeably,However,theydifferon
twofundamentaldimensions:
Existenceofanoutsidethirdpartythatreliesonthe
auditorsopinion
Natureofservicesprovided
 AssuranceServices
Thebroadestservice
TheAICPAsSpecialCommitteeonAssurance
Servicesdefinesassuranceservicesasindependent
professionalservicesthatimprovethequalityof
information,oritscontext,fordecisionmakers
Theitemsonwhichassuranceisprovidedcanrange
fromfinancialstatementstocomputersystem
integritytoqualityofproductsandservicesbeing
soldtocompliancewithregulatoryrequirements
 AssuranceServices
Theassurancecanbeoninformationorprocesses
Examplesofassuranceservicesthathavebeen
performedbyauditingfirmsinclude:
Theadequacyoftheprocessforcapturingandreporting
medicaldata
Theadequacyandreasonablenessoftheeconomicplansto
buildanewconventioncenterinamajorU.S.city
 AssuranceServices
Alltypesofassuranceservicesinvolvethreecritical
components:
Informationoraprocessonwhichtheassuranceserviceis
provided
Auseroragroupofuserswhoderivevaluefromthe
assuranceservicesprovided
Anassuranceserviceprovider
 ProvidersofAssuranceServices
ManyregionalandlocalCPAfirmsprovideavarietyof
assuranceservicestobothauditandnonauditclients
Thelargepublicaccountingfirmsmayprovideconsulting
servicesbuttheyarenotallowedtoprovidesuchservicesfor
theirpubliclytradedauditclients
Smalleraccountingfirmsthatdonothavepublicclients
followstandardsdevelopedbytheAICPAregardingservices
thattheymayperformforanauditclient
Manysmallerpublicaccountingfirmsprovideinformation
systemsconsulting,financialplanning,taxplanning,and
internalauditservicestobothauditclientsandnonaudit
clients
 LevelsofAssuranceProvided
TheIAASBhastakenatwoprongedapproachtothe
levelofassuranceprovidedthatultimatelyparallels
theapproachdevelopedintheUnitedStates
TheIAASBidentifiestwolevelsofassurancethat
canbeprovided:
Reasonableassurance
Limitedassurance
 LevelsofAssuranceProvided
TheIAASBhastakenatwoprongedapproachtothe
levelofassuranceprovidedthatultimatelyparallels
theapproachdevelopedintheUnitedStates
TheIAASBidentifiestwolevelsofassurancethat
canbeprovided:
Reasonableassurance
Limitedassurance
 LevelsofAssuranceProvided
TheIAASBhastakenatwoprongedapproachtothe
levelofassuranceprovidedthatultimatelyparallels
theapproachdevelopedintheUnitedStates
TheIAASBidentifiestwolevelsofassurancethat
canbeprovided:
Reasonableassurance
Limitedassurance
 LevelsofAssuranceProvided
Reasonableassuranceengagementsareengagementsin
whichapractitionerexpressesaconclusiondesignedto
enhancethedegreeofconfidenceoftheintendedusersother
thantheresponsiblepartyabouttheoutcomeoftheevaluation
ormeasurementofasubjectmatteragainstcriteria
Alimitedassuranceengagementisoneinwhichthe
objectiveistoprovidelessassurancebydoinglessworkthat
maybeappropriatelyunderstoodbyallinvolvedparties
IntheUnitedStates,alimitedassuranceengagementrelatedto
financialstatementsisreferredtoasareview
 AttestationServices
Attestationservicesareasubsetofassuranceservices
andalwaysinvolveareportthatgoestoexternal
users
Forexample,theauditormightprovideareportto
thirdpartiesaboutthequalityofacompanysinternal
controlsovercompliancewithregulation
Thenarrowestattestationserviceistheauditofa
companysfinancialstatements
 AttestationServices
Anauditisasubsetoftheotherservicesthatan
auditorcanprovide
 ProfessionalStandardsforNon
AuditAssuranceEngagements
Attestationstandards
Compilationandreviewstandards
TheIAASBhasalsoissuedstandardsthatcanbe
usedbyauditorswhoareperformingassertionbased
assuranceservices(whattheAICPAwouldrefertoas
attestationstandards)
 LO7:OtherAuditingProfessions
TheInternalAuditProfession
TheGovernmentalAuditingProfession
 TheInternalAuditProfession
Internalauditingisdefinedas:
Anindependent,objectiveassuranceand
consultingactivitydesignedtoaddvalueandimprove
anorganizationsoperations.Ithelpsanorganization
accomplishitsobjectivesbybringingasystematic,
disciplinedapproachtoevaluateandimprovethe
effectivenessofriskmanagement,control,and
governanceprocesses.
 ServicesProvidedbyInternal
Auditors
Internalauditorsmayprovidebothassuranceandconsulting
services
Specificassuranceservicesthatinternalauditorsperformfor
anorganizationinclude:
Effectivenessofacompanysprocessforidentifyingandmanaging
risk
Qualityofanorganizationsgovernanceprocesses
Effectivenessandefficiencyofanorganizationscontrolprocesses
Effectivenessandefficiencyofoperations,withsuggestionsfor
operationalimprovements
Complianceofcompanyoperationswithcompanypoliciesand/or
regulatorypolicies
 ServicesProvidedbyInternal
Auditors
Onetypeofinternalauditactivityinvolvestheanalysisof
companyoperations,oftenreferredtoasanoperationalaudit
Operationalauditsaredesignedtoevaluatetheeffectiveness,
economy,andefficiencywithwhichresourcesareemployed
andcanbeappliedtovirtuallyeveryfacetofanorganizations
operations
 InstituteofInternalAuditors
TheInstituteofInternalAuditors(IIA)isavoluntary
organizationdedicatedtoenhancingtheprofessionalismand
statusoftheinternalauditingprofession
Withmorethan170,000memberslocatedinover100
countries,theIIAisresponsibleforissuingstandardsforthe
profession
TheIIAadministerstheCertifiedInternalAuditor(CIA)
programandhasestablishedapeerreviewprocesstohelp
ensurethatthepracticeofinternalauditingaroundtheglobeis
consistentwiththeprofessionalstandards
 TheGovernmentalAuditing
Profession
Governmentalauditorsareemployedbyvariousfederal,state,
andlocalagenciesandperformallthetypesofauditsthat
internalauditorsperform
TheU.S.GovernmentAccountabilityOfficeplacesan
emphasisonperformanceaudits.Theseauditsdetermine:
Whethertheentityisacquiring,protecting,andusingitsresources
economicallyandefficiently
Thecausesofinefficienciesoruneconomicalpractices;(3)whetherthe
entityhascompliedwithlawsandregulations
Theextenttowhichthedesiredresultsorbenefitsestablishedbythe
legislatureorotherauthorizingbodyarebeingachieved
Theeffectivenessoforganizations,programs,activities,orfunctions