NINTH EDITION A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT

Transcription

1 NINTH EDITION AUDITING A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT Kar la M. Johnstone University of Wisconsin Madison Audrey A. Gramling Bellarmine University Larry E. Rittenberg University of Wisconsin Madison f * SOUTH-WESTERN 4% CENGAGE Learning* Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States

2 PREFACE, xxiii ABOUT THE AUTHORS, xxxiü CHAPTER 1 Auditing: Integral to the Economy, 2 Overview of the External Auditing Profession, 3 Introduction to the External Auditing Profession, 3 External Auditing: A Special Function, 4 The Need for Unbiased Reporting and Independent Assurance, 6 Overall Objectives in Conducting an Audit, 7 Overview of the Audit Opinion Formulation Process, 8 Parties Involved in Preparing and Auditing Financial Statements, 9 Providers of External Auditing Services, 9 Skills and Knowledge Needed to Enter the External Auditing Profession, 10 Organizations Affecting the External Auditing Profession, 11 Audit Quality, 14 Audit Firm Culture, 15 Skills and Qualities of the Engagement Team, 15 Effectiveness of the Audit Process, 16 Reliability and Usefulness of Audit Reporting, 16 Factors Outside the Control of Auditors That Affect Audit Quality, 16 Achieving Audit Quality and Minimizing Lawsuits, 16 Auditor Independence Requirements, 17 Review Programs, 19 Engagement Letters, 20 vii

3 viii Contents Client Acceptance/Continuance Decisions, 20 Audit Firm Limitations, 21 Audit Documentation, 21 Summary and Next Steps, 21 Significant Terms, 21 True-False Questions, 23 Multiple-Choice Questions, 24 Review and Short Case Questions, 26 Contemporary and Historical Cases, 28 Application Activities, 30 Academic Research Case, 3 1 CHAPTER 2 The Risk of Fraud and Mechanisms to Address Fraud: Regulation, Corporate Governance, and Audit Quality, 32 Fraud Defined, 34 Misstatements Arising From Misappropriation of Assets, 34 Misstatements Arising from Fraudulent Financial Reporting, 34 The Fraud Triangle, 35 Incentives or Pressures to Commit Fraud, 37 Opportunities to Commit Fraud, 37 Rationalizing the Fraud, 38 Recent History of Fraudulent Financial Reporting, 38 Examples of Recent Frauds and Implications for External Auditors, 38 The Third COSO Report, 41 The Enron Fraud: A Key Driver of Regulatory Change, 42 An Overview of the Auditor's Fraud-Related Responsibilities and Users' Expectations, 44 The Sarbanes-Oxley Act of 2002 as a Regulatory Response to Fraud, 45 The Post Sarbanes-Oxley World: A Time of Improved Corporate Governance, 49 What Is Corporate Governance? 49 Principles of Effective Corporate Governance, 50 Responsibilities of Audit Committees, 53 Summary and Next Steps, 53 Significant Terms, 54 True-False Questions, 54 Multiple-Choice Questions, 55 Review and Short Case Questions, 58

4 Contents ix Contemporary and Historical Cases, 63 Application Activities, 67 Academic Research Cases, 69 Ford and Toyota, 70 CHAPTER 3 Internal Control over Financial Reporting: Management 7 s Responsibilities and Importance to the External Auditors, 72 Importance of Internal Control Over Financial Reporting, 74 Importance of Internal Control to the External Audit, 74 Defining Internal Control, 75 Components and Principles of Internal Control, 77 COSO Component: Control Environment, 78 COSO Component: Risk Assessment, 81 COSO Component: Control Activities, 83 COSO Component: Information and Communication, 87 COSO Component: Monitoring, 88 Management's Responsibilities Related to Internal Control Over Financial Reporting, 90 Documentation of Internal Control, 91 Reporting on Internal Control Over Financial Reporting, 91 Evaluating Internal Control Over Financial Reporting, 92 Summary and Next Steps, 97 Significant Terms, 97 True-False Questions, 99 Multiple-Choice Questions, 100 Review and Short Case Questions, 1 03 Contemporary and Historical Cases, 1 10 Application Activities, Academic Research Cases, 1 12 Ford and Toyota, CHAPTER 4 Professional Liability and the Need for Quality Auditor Judgments and Ethical Decisions, 114 The Legal Environment and the Effects of Lawsuits on Audit Firms, 116 Liability Doctrines, 116

5 Class Action Lawsuits, 117 Contingent-Fee Compensation for Lawyers, 117 Audits Viewed as an Insurance Policy: The Expectations Gap, 117 Applicable Laws and Causes of Legal Action, 117 Laws from Which Auditor Liability Is Derived and Causes of Legal Action, 117 Parties that May Bring Suit against Auditors, 118 Auditor Liability under Common Law and Contract Law, 119 Common-Law Liability to Clients: Breach of Contract, 119 Common-Law Liability to Third P., -l'es, 120 Auditor Liability un- /Law, 122 Securities Act of 1933, 123 Securities Exchange Act of 1934, 123 Summary of Auditor Liability to Third Parties under Common and Statutory Law, 12J A Framewor Decision Making, 125 Importance of Prolcs^'i^i SL-pucism in Making Professional Judgments, 128 A Framework lo; Emica! Decision Making, 130 Resolving Ethical Dilemmas, 130 Applying the Ethical Decision Making Framework, 131 Professional Guidance on Decision Making, 13Ä IESBA's Code of Ethics, 134 A1CPA Code of Professional Conduct, 134 Summary and Next Steps, 1 39 Significant Terms, 1 39 True-False Questions, 142 Multiple-Choice Questions, 143 Review and Short Case Questions, 145 Contemporary and Historical Cases, 152 Application Activities, 153 Academic Research Cases, 154 Ford and Toyota, 1 55 CHAPTER 5 Professional Auditing Standards and the Audit Opinion Formulation Process, 156 Professional Auditing Standards, 158 Auditing Standards Issued by the AICPA, 158 Auditing Standards Issued by the IAASB, 159

6 Sufficiency of Audit Evidence, 233 Sample Sizes, 235 Additional Evidence Considerations, 236 Evidence Needed for Auditing Management Estimates, 236 Using a Specialist/Expert to Assist with Obtaining Evidence, 237 Evidence Needed for Related-Party Transactions, 238 Documenting Audit Evidence, 239 Documenting Planning and Risk Assessment Procedures, 240 Documenting Audit Work Performed, 240 Documenting Significant Issues and Their Resolution, 241 Copies of Documents, 241 Auditor-Generated Memos, 242 Characteristics of Quality Audit Documentation, 242 Revisions and Retention of Audit Documentation, 243 Audit Programs, 243 Summary and Next Steps, 244 Significant Terms, 244 True-False Questions, 246 Multiple-Choice Questions, 247 Review and Short Case Questions, 251 Contemporary and Historical Cases, 255 Application Activities, 262 Academic Research Cases, 263 Ford and Toyota, 264 ACL, 264 CHAPTER 7 Planning the Audit: Identifying and Responding to the Risks of Material Misstatement, 266 Assessing Materiality, 268 Materiality Guidance, 268 SEC Views on Materiality, 270 Changes in Materiality Judgments Throughout the Audit Opinion Formulation Process, 270 Identifying and Assessing Risks of Material Misstatement, 271 Assessing Factors Affecting Inherent Risk, 272 Assessing Factors Affecting Control Risk, 279 Analytical Procedures and Brainstorming Activities to Assess the Risks of Material Misstatement, 282 Responding to Identified Risks of Material Misstatement, 286 Determining Detection Risk and Audit Risk, 286

7 Contents xiii Planning Audit Procedures to Respond to the Assessed Risks of Material Misstatement, 289 Summary and Next Steps, 292 Significant Terms, 292 True-False Questions, 293 Multiple-Choice Questions, 294 Review and Short Case Questions, 297 Contemporary and Historical Cases, 305 Application Activities, 31 2 Academic Research Cases, 313 Ford and Toyota, 315 CHAPTER 8 Specialized Audit Tools: Sampling and Generalized Audit Software, 316 Overview of Sampling and GAS as Tools for Gathering Audit Evidence, 31 8 Objectives of Sampling and Risks Associated with Sampling, 319 Nonsampling and Sampling Risks, 320 Nonstatistical and Statistical Sampling, 322 Attributes Sampling, 323 Steps in Attributes Sampling, 324 Nonstatistical Sampling Approach to Testing Controls, 334 Using Sampling to Gather Evidence about Misstatements in Account Balances and Associated Assertions, 335 Steps in Sampling Account Balances and Associated Assertions, 335 Nonstatistical Sampling for Substantive Tests of Account Balances and Associated Assertions, 339 Statistical Sampling for Substantive Tests of Account Balances and Associated Assertions: Monetary Unit Sampling (MUS), 340 Using Generalized Audit Software to Obtain Evidence, 347 Tasks Performed by GAS, 348 Benefits of using GAS, 350 Summary and Next Steps, 351 Significant Terms, 351 True-False Questions, 354 Multiple-Choice Questions, 355 Review and Short Case Questions, 358 Academic Research Case, 365

8 Contents xv Overview of Cash Accounts, 440 Cash Management Techniques, 441 Relevant Financial Statement Assertions, 442 Performing Risk Assessment Procedures for Cash Accounts, 442 Identifying Inherent Risks, 442 Identifying Control Risks, 444 Performing Preliminary Analytical Procedures, 452 Responding to Identified Risks of Material Misstatement, 452 Obtaining Evidence about Internal Control Operating Effectiveness for Cash, 453 Selecting Controls to Test and Performing Tests of Controls, 454 Considering the Results of Tests of Controls, 457 Obtaining Substantive Evidence about Cash Accounts, Disclosures, and Assertions, 457 Substantive Analytics for Cash Accounts, 458 Substantive Tests of Details for Cash Accounts, 458 Auditing Marketable Securities, 465 Significant Accounts and Relevant Assertions, 465 Identify and Assess Inherent, Fraud, and Control Risks Relevant to Marketable Securities, 466 Analytical Procedures for Marketable Securities, 467 Tests of Controls and Substantive Tests of Details for Marketable Securities, 468 Summary and Next Steps, 471 Significant Terms, 471 True-False Questions, 472 Multiple-Choice Questions, 474 Review and Short Case Questions, 477 Contemporary and Historical Cases, 490 Application Activities, 497 Academic Research Cases, 498 Ford and Toyota, 499 CHAPTER 11 Auditing Inventory, Goods and Services, and Accounts Payable: The Acquisition and Payment Cycle, 500 Significant Accounts and Relevant Assertions, 502 Activities Involved in the Acquisition and Payment Cycle, 503 Relevant Financial Statement Assertions, 503

9 Contents xvü Selecting Controls to Test and Performing Tests of Controls, 571 Considering the Results of Tests of Controls, 571 Obtaining Substantive Evidence about Accounts, Disclosures, and Assertions for Long-Lived Asset Accounts and Related Expenses, 572 Substantive Analytical Procedures, 572 Substantive Tests of Details for Tangible Assets Testing Current Period Additions, 572 Substantive Tests of Details for Tangible Assets Testing Current Period Deletions, 574 Substantive Procedures Related to Depreciation Expense and Accumulated Depreciation for Tangible Assets, 574 Substantive Tests of Details for Natural Resources and the Related Expense Accounts, 576 Substantive Tests of Details for Intangible Assets, 577 Substantive Procedures Related to Asset Impairment, 577 Substantive Procedures Related to Leases, 578 Performing Substantive Fraud-Related Procedures, 579 Documenting Substantive Procedures, 579 Summary and Next Steps, 579 Significant Terms, 580 True-False Questions, 580 Multiple-Choice Questions, 581 Review and Short Case Questions, 583 Contemporary and Historical Cases, 590 Application Activities, 591 Academic Research Case, 592 Ford and Toyota, 593 CHAPTER 13 Auditing Debt Obligations and Stockholders' Equity Transactions, 594 Significant Accounts, Disclosures, and Relevant Assertions, 596 Debt Obligations, 596 Stockholders' Equity, 597 Performing Risk Assessment Procedures for Debt Obligations and Stockholders' Equity Transactions, 598 Identifying Inherent Risks, 599 Identifying Fraud Risk Factors, 599 Identifying Control Risks, 601 Performing Preliminary Analytical Procedures, 602 Responding to Identified Risks of Material Misstatement, 602

10 xviii Contents Obtaining Evidence about Internal Control Operating Effectiveness for Debt Obligations and Stockholders' Equity Transactions, 603 Obtaining Substantive Evidence in Auditing Debt Obligations and Stockholders' Equity Transactions, 603 Substantive Analytical Procedures Debt Obligations, 603 Substantive Tests of Details Debt Obligations, 605 Substantive Tests of Details Stockholders' Equity Transactions, 606 Performing Substantive Fraud-Related Procedures, 608 Documenting Substantive Procedures, 609 Summary and Next Steps, 609 Significant Terms, 609 True-False Questions, 610 Multiple-Choice Questions, 61 1 Review and Short Case Questions, 61 3 Contemporary and Historical Cases, 616 Application Activities, 61 8 Academic Research Case, 61 9 CHAPTER 14 Activities Required in Completing a Quality Audit, 620 Review Activities, 622. Reviewing, Summarizing, and Resolving Detected Misstatements, 622 Reviewing Contingencies, 625 Reviewing Significant Estimates, 627 Reviewing the Adequacy of Disclosures, 629 Auditors' Responsibilities Regarding Clients' Noncompliance with Laws and Regulations, 630 Evaluating the Going-Concern Assumption, 632 Performing Analytical Review of the Financial Statements, 635 Evaluating Management Representations, 637 Reviewing Subsequent Events and Subsequently Discovered Facts, 640 Consideration of Omitted Procedures Discovered after the Report Date, 644 Performing an Engagement Quality Review, 644 Communicating with Management and the Audit Committee (And Those Charged with Governance), 645 Responsibilities of External Auditors to Communicate with the Audit Committee, 645 Communicating with Management via the Management Letter, 647

11 Contents xix Issues Relating to Audit Firm Portfolio Management, Audit Partner Rotation, and Audit Firm Rotation, 649 Client Acceptance and Continuance Decisions, 649 Partner Rotation and Audit Firm Rotation, 653 Summary and Next Steps, 656 Significant Terms, 656 True-False Questions, 658 Multiple-Choice Questions, 660 Review and Short Case Questions, 666 Contemporary and Historical Cases, 674 Application Activities, 679 Academic Research Case, 682 Ford and Toyota, 683 CHAPTER 15 Audit Reports on Financial Statements, 684 Principles Underlying Audit Reporting, 686 Standard Unqualified Audit Reports on Financial Statements, 686 Standard Unqualified Audit Reports: U.S. Public Companies, 686 Standard Unqualified Audit Reports: U.S. Nonpublic Companies and Non-U.S. Companies, 690 Unqualified Audit Reports with Explanatory Language, 691 Explanatory Language: Justified Departure from GAAP, 691 Explanatory Language: Inconsistent Application of GAAP, 691 Explanatory Language: Substantial Doubt About the Client Being a Going Concern, 692 Explanatory Language: Emphasis of a Matter, 693 Explanatory Language: Reference to Other Auditors, 695 Qualified Reports, Adverse Reports, and Disclaimers, 697 Qualified Audit Reports, 698 Adverse Audit Reports, 700 Audit Reports with a Disclaimer of Opinion, 701 Comparisons of Modifications to the Standard Unqualified Audit Report, 704 Audit Reports on Internal Control Over Financial Reporting, 704 Elements of Management's Annual Report on Internal Control Are Incomplete or Improperly Presented, 705

12 XX Contents Restriction on the Scope of the Engagement, 705 Auditor Refers to the Report of Other Auditors as the Basis, in Part, for the Auditor's Own Report, 705 Other Information Contained in Management's Annual Report on ICFR, 705 Management's Annual Certification Pursuant to Section 302 of the Sarbanes-Oxley Act Is Misstated, 705 Summary and Next Steps, 708 Significant Terms, 708 True-False Questions, 709 Multiple-Choice Questions, 710 Review and Short Case Questions, 71 2 Contemporary and Historical Cases, 721 Application Activities, 723 Academic Research Cases, 724 Ford and Toyota, 725 CHAPTER 1 6 Advanced Topics Concerning Complex Auditing Judgments, 726 Complex Auditing Judgments, 728 Identifying Complex Judgments in the Financial Statements, 728 Making Materiality Judgments, 729 Purpose of Materiality Judgments and Common Benchmarks and Thresholds, 730 Common Difficulties in Making Materiality Judgments, 733 Evaluating Misstatements, 734 Subjective Differences between the Auditor and the Client, 735 Aggregating and Netting Misstatements, 736 Intentional Misstatements, 736 Considerations Regarding Selective Correction of Misstatements, 736 Considering Misstatements in the Statement of Cash Flows, 737 Regulatory Guidance Concerning Materiality Judgments, 737 Assessing Long-Term Liabilities Involving Significant Subjective Judgment, 737 Warranty Reserves, 738 Pension Obligations and Other Postemployment Benefits, 739 Auditing Merger and Acquisition Activities, 740 Valuing the Assets and Liabilities of an Acquisition, 740 Measuring Restructuring Charges, 742

13 Contents xxi Auditing Management's Fair Value Estimates and Related Impairment Judgments, 743 The Accounting Model for Fair Value Estimates, 743 Audit Considerations for Fair Market Estimates and Related Impairments, 747 Auditing Financial Instruments, 751 Overview of Financial Instruments, 751 Audit Considerations for Financial Instruments, 754 Assessing Deficiencies in Internal Control over Financial Reporting, 756 Assessing Likelihood and Magnitude of Potential Misstatements, 757 Evaluating a Client's Internal Audit Function, 759 An Overview of Internal Auditing, 759 Evaluating the Quality of the Client's Internal Audit Function, 763 Summary and Next Steps, 766 Significant Terms, 766 True-False Questions, 768 Multiple-Choice Questions, 769 Contemporary and Historical Cases, 783 Application Activities, 785 Academic Research Cases, 787 Ford and Toyota, 788 ACL, 788 Using ACL to Perform Benford Analysis, 789 CHAPTER 1 7 Other Services Provided by Audit Firms, 790 Attestation Services Provided by Audit Firms, 791 Subject Matter of an Attestation Engagement, 791 Components of Attestation Services and Parties Involved in Attestation Services, 792 Levels of Assurance Provided in an Attestation Engagement, 792 Professional Standards for Attestation Engagements, 793 Reviews and Compilations, 794 Reviews, 794 Compilations, 798 Reviews of Interim Financial Information for Public Companies, 800 Review Procedures for Interim Financial Information, 800 Reporting on Interim Financial Statements, 801

14 Special Considerations for Reporting, 801 AU-C Section 800: Special Considerations Audits of Financial Statements Prepared in Accordance with Special-Purpose Frameworks, 803 AU-C Section 805: Special Considerations Audits of Single Financial Statements and Specific Elements, Accounts, or Items of a Financial Statement, 805 AU-C Section 806: Reporting on Compliance with Aspects of Contractual Agreements or Regulatory Requirements in Connection with Audited Financial Statements, 807 Attestation on Agreed-Upon Procedures, Financial Forecasts and Projections, and Pro Forma Financial Information, 809 SSAEs No. 10 and 11, AT Section 201: Agreed-Upon Procedures Engagements, 809 SSAEs No. 10 and 17, AT Section 301: Financial Forecasts and Projections, 812 SSAE No. 10, AT Section 401: Reporting on Pro Forma Financial Information, 816 Forensic Accounting, 6 i d Sustainability Reporting and Assurance, 819 Reporting on Sustainability Activities and Outcomes, 820 Providing Assurance on Sustainability Reporting, 825 Summary, 828 Significant Terms, 829 True-False Questions, 831 Multiple-Choice Questions, 832 Review and Short Case Questions, 835 Application Activities, 838 Academic Research Case, 839 ACL APPENDIX, 841 CASE INDEX, 857 INDEX, 859

15 Performing Risk Assessment Procedures in the Acquisition and Payment Cycle, 504 Identifying Inherent Risks, 504 Identifying Control Risks, 506 Performing Preliminary Analytical Procedures, 513 Responding to Identified Risks of Material Misstatement, 515 Obtaining Evidence about Internal Control Operating Effectiveness in the Acquisition and Payment Cycle, 517 Selecting Controls to Test and Performing Tests of Controls, 517 Considering the Results of Tests of Controls, 517 Obtaining Substantive Evidence about Accounts, Disclosures, and Assertions in the Acquisition and Payment Cycle, 518 Substantive Tests of Inventory and Cost of Goods Sold, 518 Substantive Tests of Accounts Payable and Related Expense Accounts, 529 Summary and Next Steps, 535 Significant Terms, 536 True-False Questions, 537 Multiple-Choice Questions, 538 Review and Short Case Questions, 541 Contemporary and Historical Cases, 550 Application Activities, 555 Academic Research Cases, 556 Ford and Toyota, 558 ACL, 558 CHAPTER 12 Auditing Long-Lived Assets: Acquisition, Use, Impairment, and Disposal, 560 Significant Accounts, Disclosures, and Relevant Assertions, 561 Activities in the Long-Li ved Asset Acquisition and Payment Cycle, 562 Relevant Financial Statement Assertions, 563 Performing Risk Assessment Procedures for Long-Lived Assets, 563 Identifying Inherent Risks, 563 Identifying Control Risks, 565 Performing Preliminary Analytical Procedures, 567 Responding to Identified Risks of Material Misstatement, 569 Obtaining Evidence about Internal Control Operating Effectiveness for Long-Lived Asset Accounts and Related Expenses, 571

16 CHAPTER 9 Auditing the Revenue Cycle, 366 Significant Accounts, Disclosures, and Relevant Assertions, 368 Processing Revenue Transactions, 368 Performing Risk Assessment Procedures in the Revenue Cycle, 372 Identifying Inherent Risks, 372 Identifying Control Risks, 379 Performing Preliminary Analytical Procedures, 384 Responding to Identified Risks of Material Misstatement, 386 Obtaining Evidence about Internal Control Operating Effectiveness in the Revenue Cycle, 386 Selecting Controls to Test and Performing Tests of Controls, 386 Considering the Results of Tests of Controls, 389 Obtaining Substantive Evidence about Accounts, Disclosures, and Assertions in the Revenue Cycle, 389 Revenue: Substantive Analytical Procedures, 390 Revenue: Substantive Tests of Details, 391 Accounts Receivable: Substantive Procedures Based on the Aged Trial Balance, 392 Accounts Receivable: Substantive Tests of Details Confirmations, 393 Accounts Receivable: Substantive Procedures for the Allowance Account, 400 Accounts Receivable: Other Substantive Procedures, 401 Performing Substantive Fraud-Related Procedures, 402 Documenting Substantive Procedures, 403 Summary and Next Steps, 404 Significant Terms, 404 True-False Questions, 405 Multiple-Choice Questions, 406 Review and Short Case Questions, 409 Contemporary and Historical Cases, 424 Application Activities, 434 Academic Research Cases, 435 Ford and Toyota, 436 ACL, 436 CHAPTER 1 0 Auditing Cash and Marketable Securities, 438 Significant Accounts and Relevant Assertions, 440

17 Contents xi Auditing Standards Issued by the PCAOB, 159 Comparison of the Auditing Standards, 159 Principles Underlying the Auditing Standards, 159 The Audit Opinion Formulation Process, 161 An Overview of the Phases in the Audit Opinion Formulation Process, 162 Important Concepts Affecting the Audit Opinion Formulation Process, 163 Phase I Making Client Acceptance and Continuance Decisions, 168 Phase II Performing Risk Assessment, 169 Phase III Obtaining Evidence about Internal Control Operating Effectiveness, 175 Summary of Audit Decisions Prior to Determining Substantive Procedures, 180 Phase IV Obtaining Substantive Evidence about Accounts, Disclosures, and Assertions, 182 Phase V Completing the Audit and Making Reporting Decisions, 185 Audit Example: Assessing Control Design Effectiveness, Implementation, and Operating Effectiveness, 187 Management Assessment of Controls, 187 Auditor Assessment of Controls, 188 Summary and Next Steps, 1 89 Significant Terms, 1 89 True-False Questions, 1 91 Multiple-Choice Questions, 1 92 Review and Short Case Questions, 196 Contemporary and Historical Cases, 203 Application Activities, 204 Academic Research Cases, 205 Appendix, 206 CHAPTER 6 A Framework for Audit Evidence, 212 Obtaining Sufficient Appropriate Audit Evidence, 214 Appropriateness of Audit Evidence, 215 Relevance of Audit Evidence, 215 Reliability of Audit Evidence, 218 Type and Timing of Audit Procedures, 221 Type of Audit Procedures, 221 Timing of Procedures, 227 Performing Substantive Analytical Procedures, 228