City University of Hong Kong Press

Transcription

1 Hong Kong Auditng Economic Theory & Practice Third Edition Ferdinand A. GUL Simon Y. K. FUNG City University of Hong Kong Press

2 Contents at a Glance Detailed Chapter Contents Preface List of Illustrations Acronyms and Abbreviations List of Relevant Standards on Auditing and Assurance in Hong Kong ix xxiii xxv xxxi xxxv 1. Development of the Auditing Profession 1 2. Economic Theory of Auditing and the Development of Standards Rights, Duties and Liabilities of Auditors in Hong Kong Professional Ethics and Auditor Independence Audit Overview and Evidential Matter Risk Analysis and Materiality Control Risk Assessment Audit Sampling and Statistical Tests Auditing in an IT Environment Auditing Transactions and Account Balances Auditing the Revenue and Receipts Cycle Auditing the Purchases and Payments Cycle Auditing the Production Cycle Auditing the Payroll and Personnel Cycle Auditing Other Assets, Equities and Liabilities Profit and Loss Disclosures and Completing the Audit Audit Reporting Practices Internal and Operational Auditing 829 Glossary 857 Bibliography 871 Table of Cases 879 Table of Auditing and Accounting Standards 881 About the Authors 885 Index 887

3 Detailed Chapter Contents 1. Development of the Auditing Profession 1 1 Early Developments The Hong Kong Institute of Certified Public Accountants The Financial Reporting Council 5 2 Influences on the Development of Auditing 6 Auditing in Focus 1.1 The China Element 7 3 Auditing Defined Relationship between Accounting and Auditing Assurance Services 11 4 Types of Auditors Independent Auditors Internal Auditors Government Auditors 14 5 The Accountancy Profession Public Service Specialised Body of Knowledge Admission Requirements International Recognition Continuing Professional Development Self-regulation 18 Auditing in Focus 1.2 PCAOB Inspections of Foreign Auditors 19 Auditing in Focus 1.3 PCAOB Censures Firm for Audit Improprieties Ethical Code 20 6 Organisation of Accounting Practice 20 Auditing in Focus 1.4 Localisation of Audit Partners in China 21 7 Demand for Auditors' Services Regulations External Parties 23 8 Summary 24 Exercise: Review questions and discussion questions 25

4 Hong Kong Auditing 2. Economic Theory of Auditing and the Development of Standards 29 1 Auditing Theory 2 Agency Theory 2.1 Incomplete Contracts 2.2 Agency Problem 3 Agency Theory in the Context of Auditing 3.1 Demands for Audits Auditing in Focus 2.1 Extending the Value of the Outcomes from an Audit Auditing in Focus 2.2 Audit Report Forgery and the Value of Audit 3.2 Choice of High Quality Auditors 3.3 Auditor Specialisation Auditing in Focus 2.3 Auditors' Industry-wide Expertise and Client-specific Expertise 4 Auditing Concepts 4.1 Evidence 4.2 Due Audit Care 4.3 Fair Presentation 4.4 Independence and Ethical Conduct 5 Auditing Standards 5.1 General Standards 5.2 Performance or Field Work Standards 5.3 Reporting Standards 6 Auditing Procedures 7 Main Elements of Auditing Theory 8 Judgement in Auditing 8.1 Representativeness 8.2 Availability 8.3 Anchoring Auditing in Focus 2.4 Techniques to Mitigate Cognitive Biases in Audit Engagements 9 Quality Control 9.1 Client Acceptance and Continuance 10 Summary Appendix 2: HKSA 220 Quality Control for an Audit of Financial Statements Exercise: Review questions and discussion questions

5 Detailed Chapter Contents 3. Rights, Duties and Liabilities of Auditors in Hong Kong 71 1 Statutory Rights, Duties and Obligations of Auditors Statutory Requirements for Appointment, Removal and Resignation of Auditors Statutory Rights and Obligations of Auditors Statutory Duties of Auditors 75 Auditing in Focus 3.1 New Rules on Criminal Liability for Auditors 76 2 Quasi-Legal Duties under the Auditing Standards Detecting Frauds, Errors and Irregularities 79 Auditing in Focus 3.2 Auditing and Fraud Examination Disciplinary Action for Failure to Comply with HKSAs 80 3 Audit Contract between Auditor and Client 81 4 Common Law and Equity' 21 ' Duties Arising from Contract Law Common Law Duties Arising from Tort Law 84 Auditing in Focus 3.3 Lender to sue PwC for 840 million 96 5 Summary 96 Appendix 3A: Guidance on Section 408 of the Companies Ordinance (Chapter 622) 102 Appendix 3B: Legal Consideration 108 Exercise: Review questions and discussion questions Professional Ethics and Auditor Independence Professionalism and Ethical Pronouncements Auditing in Focus 4.1 Responding to Subpoenas 1.1 Close Relationship between Auditor and Client 2 Independence 2.1 Ethical Code 2.2 Tenure and Appointment 2.3 Management Advisory Services Auditing in Focus 4.2 Updates on Consulting 2.4 Perceptions of Auditor Independence 2.5 Auditor Rotation Auditing in Focus 4.3 Mandatory Auditor Rotation: Voices from the Practitioners 3 Discipline Auditing in Focus 4.4 HKICPA Member Reprimanded Due to Misconduct Auditing in Focus 4.5 CPA Charged with Insider Trading via His Wife's Account xi

6 Hong Kong Auditing 3.1 Practice Promotion Clients' Monies The Economics of Compliance with Ethical Rules Ethics and Moral Development Theory Summary 145 Appendix 4: Code of Ethics for Professional Accountants Section 290 Independence Audit and Review Engagements 147 Exercise: Review questions and discussion questions Audit Overview and Evidential Matter Overview of the Audit Process Client Acceptance and Continuance 162 Auditing in Focus 5.1 Risk of Being a Successor Auditor: The Gase of BDO Seidman Development of the Audit Strategy Detailed Flanning Sufficient and Appropriate Evidence Reports Evidential Matter 174 Auditing in Focus 5.2 Auditor Quits Due to Lack of Evidence Nature of Evidence 175 Auditing in Focus 5.3 Risks to Auditors on Evidence Based on 'State's Secrets' Obtaining Evidence 179 Auditing in Focus 5.4 Quick Tips for an Audit Interview Evaluation of Evidence Working Papers Summary 196 Appendix 5A: Example of an Audit Engagement Letter 198 Appendix 5B: HKSA 315 Identifying and Assessing the Risks of Material Misstatement tbrough Understanding the Entity and Its Environment 202 Exercise: Review questions, discussion questions and case studies Risk Analysis and Materiality 225 Auditing in Focus 6.1 Cost to Audit High Risk Clients Materiality 228 xii

7 Detailed Chapter Contents 2 Audit Risk InherentRisk 231 Auditing in Focus 6.2 Indicators of Management Integrity Control Risk Detection Risk Relationship between Materiality and Audit Risks Assessing Risks of Material Misstatement Evaluating Audit Results Risk of Material Error Inherent and Control Risks Environmental Factors Nature of Account Items Risk-driven Audits Application in Practice 240 Auditing in Focus 6.3 Measures to Manage Audit Risks Business Risks Systems-based Audits Accrual Accounting Process Operating Cycle Risk Analysis of a Business as a Going Concern Third Party Support Indications of Going Concern and Mitigating Factors 251 Auditing in Focus 6.4 Deloitte Issues Going Concern Notice to Embattles General Motor Audit Risks and Audit Fee Determination Summary 254 Appendix 6A: HKSA 320 Materiality in Flanning and Performing an Audit 257 Appendix 6B: Example of Flanning and Evaluating the Substantive Work for Accounts Receivable 262 Appendix 6C: HKSA 570 Going Concern 264 Appendix 6D: Going Concern Problems 267 Exercise: Review questions, discussion questions and case studies Control Risk Assessment Nature and Importance of Internal Control Objectives of Internal Control The Internal Control Structure 282 xiii

8 Hong Kong Auditing 2 Methodology for the Study of Internal Control Preliminary Review Gathering Information, Understanding and Preliminary Evaluation of Controls Tests of Controls Final Evaluation of Controls Limitation of Internal Control Communication of Weaknesses in Internal Control Fraud and Errors 297 Auditing in Focus 7.1 Criminal Minds Risk of Fraud or Error Procedures where Error or Fraud are Suspected 300 Auditing in Focus 7.2 Gloal Survey on Fraud Sarbanes-Oxley Act 302 Auditing in Focus 7.3 Unhappy loth Birthday Summary 304 Appendix 7A: Key Provisions of the Hong Kong Corporate Governance Code 305 Appendix 7B: Example of Corporate Governance Report 312 Appendix 7C: Internal Control Questionnaire 331 Appendix 7D: Example of Management Certification on Internal Controls under Section 302 of Sarbanes-Oxley Act Exercise: Review questions and discussion questions Audit Sampling and Statistical Tests Statistics as an Audit Tool 'Precision'and'Reliability' Advantages of Statistical Sampling Audit Process and Statistical Sampling Population and Sampling Units Risk and Audit Uncertainty Methods of Sample Selection 352 Auditing in Focus 8.1 Haphazard Sampling Sample Size Compliance Testing Attribute Estimation Sampling Discovery Sampling Substantive Testing Variable Sampling Mean-per-unit Estimation Probability-proportional-to-size (PPS) Sampling 374 xiv

9 Detailed Chapter Contents 5 Summary 385 Appendix 8A: Statistical Sample Size for Compliance Testing 387 Appendix 8B: Attribute Sampling Evaluation of Sample Results 388 Appendix 8C: Discovery Sampling for Attributes 393 Exercise: Review questions and discussion questions Auditing in an IT Environment Impact of IT Systems on Auditors 408 Auditing in Focus 9.1 Technology'Outstripping Audit Capacity' Characteristics of IT Systems Organisational Structure Nature of Processing Design and Procedura! Aspects Internal Controls in an IT System General IT Controls Defined Application Controls Defined Batch Processing and Online Processing Compared Distributed Processing System Auditing Standards in an IT Environment Study of IT Controls The Internal Control Structure Preliminary Assessment of Control Risk Compliance Testing in an IT Environment Reassessment of Control Risk 445 Auditing in Focus 9.2 $20 million Australian Dollar Fraud at Clive Peeters You Need One Payroll Manager Auditing in an IT Environment Using CAATs Audit Tasks Performed by Computer Programmes 448 Auditing in Focus 9.3 Using Audit Tools to Detect Fraud Considerations in the Use of CAATs Summary 454 Exercise: Review questions, discussion questions and case studies Auditing Transactions and Account Balances Financial Report Assertions 482 xv

10 Hong Kong Auditing 2 Tests of controls Control Objectives and Assertions Preliminary Assessment of Control Risk Auditing Techniques in Tests of Controls Review of Preliminary Assessment of Control Risk Substantive Tests / Procedures Auditing Techniques in Substantive Tests Risk Assessments and Substantive Testing Timing of Substantive Tests Types of Substantive Tests 490 Auditing in Focus 10.1 Assessing Financial Statement Fraud Risk Relationship between Tests of Controls and Substantive Tests Dual Purpose Tests Summary 501 Exercise: Review questions, discussion questions and case studies Auditing the Revenue and Receipts Cycle Description of the Revenue and Receipts Cycle Understanding the Internal Control Structure Revenue and Receipts Cycle Activities Internal Control Objectives and Control Procedures Preliminary Assessment of Control Risk Tests of Controls Tests of Sales Transactions Tests of Cash Receipts Transactions Review of Preliminary Assessment of Control Risk Substantive Audit Procedures Substantive Tests of Sales Transactions 530 Auditing in Focus 11.1 Fraud Risks on Sales Substantive Tests of Accounts Receivable 532 Auditing in Focus 11.2 Forecasting Accounts Receivable Collections: Advanced Technology 540 Auditing in Focus 11.3 Fraud Risks on Accounts Receivable Auditing the Sales and Cash Receipts System in an IT Environment Overview of the Computer Application System Computer-assisted Tests Summary 546 Exercise: Review questions and discussion questions 547 xvi

11 Detailed Chapter Contents 12. Auditing the Purchases and Payments Cycle Description of the Purchases and Payments Cycle Understanding the Internal Control Structure Purchases and Payments Cycle Activities Internal Control Objectives and Control Procedures Preliminary Assessment of Control Risk Tests of Controls Tests of Purchases Transactions Tests of Cash Payments Transactions Review of Preliminary Assessment of Control Risk Substantive Audit Procedures Substantive Tests of Purchases Transactions 579 Auditing in Focus 12.1 Fraud Risks on Purchasing Substantive Tests of Accounts Payable 582 Auditing in Focus 12.2 Fraud Risks on Accounts Payable Auditing the Purchases and Payments System in an IT Environment Overview of the Computer Application System Computer-assisted Tests Summary 590 Exercise: Review questions, discussion questions and case studies Auditing the Production Cycle Description of the Production Cycle Understanding the Internal Control Structure Production Cycle Activities Internal Control Objectives and Control Procedures Preliminary Assessment of Control Risk Tests of Controls for Manufacturing Transactions Occurrence Completeness Accuracy, Cut-off and Classification Review of Preliminary Assessment of Control Risk Substantive Audit Procedures Substantive Tests of Manufacturing Transactions Substantive Tests of Inventory Account Balances 620

12 Hong Kong Auditing 7 Audit of Beginning Inventory on First Time Engagement Inventories Taken Prior to Balance Sheet Date Audit Steps for Observing Physical Inventory Before Observation Düring Observation After Observation 628 Auditing in Focus 13.1 Fraud Risks on Inventories Audit of Inventory in an IT Environment Summary 632 Appendix 13: HKSA 501 Audit Evidence Specific Considerations for Selected Items 633 Exercise: Review questions, discussion questions and case studies Auditing the Payroll and Personnel Cycle Description of the Payroll and Personnel Cycle Understanding the Internal Control Structure Payroll and Personnel Cycle Activities Internal Control Objectives and Control Procedures Preliminary Assessment of Control Risk Tests of Controls for Payroll Transactions Occurrence Completeness Accuracy, Cut-off and Classification Review of Preliminary Assessment of Control Risk 664 Auditing in Focus 14.1 Fraud Risks on Payroll Substantive Audit Procedures Substantive Tests of Payroll Transactions Substantive Tests of Payroll Balances Auditing the Payroll System in an IT Environment Summary 669 Exercise: Review questions, discussion questions and case studies 671 XVÜi

13 Detailed Chapter Contents 15. Auditing Other Assets, Equities and Liabilities Fixed Assets Internal Controls Substantive Tests Computer-assisted Substantive Tests 695 Auditing in Focus 15.1 Fraud Risks on Assets Other Asset Balances Tests of Cash 696 Auditing in Focus 15.2 Fraud Risks on Cash Tests of Pre-payments Tests of Investments Owners' Equity Internal Controls Tests of Owners' Equity Dividends Liabilities Current Liabilities Long-term Liabilities 711 Auditing in Focus 15.3 Fraud Risks on Liabilities Accounting Estimates 713 Auditing in Focus 15.4 Accounting for Goodwill Impairments and Implications for Auditors Summary 717 Appendix 15: Bank Confirmation Request 718 Exercise: Review questions, discussion questions and case studies Profit and Loss Disclosures and Completing the Audit Profit and Loss Disclosures Information to Be Presented Profit and Loss for the Period Completing the Audit Subsequent Events Legal Representation Letters 744

14 Hong Kong Auditing 2.3 Client Representation Letters 745 Auditing in Focus 16.1 Risk in Insufficient Evidence Analytical Procedures Overall Assessment of Audit Risk Review of Working Papers Review of Presentation and Disclosures Review of Statement of Cash Flows 749 Auditing in Focus 16.2 Material Weaknesses in Internal Control Related to the Statement of Cash Flows Summary 751 Appendix 16A: (A) Example of a Solicitor's Letter 752 Appendix 16A: (B) Paragraph A23-1, HKSA 501 Audit Evidence Specific Considerations for Selected Items 753 Appendix 16B: HKSA 580 Written Representations 754 Appendix 16C: Example of a Management Representation Letter (HKSA 580 Appendix 2) 756 Exercise: Review questions, discussion questions and case studies Audit Reporting Practices Auditor's Reporting Responsibility Applicable Financial Reporting Framework Forming an Opinion on the Financial Statements Circumstances when Applying the Financial Reporting Framework Results in Misleading Financial Statements Unmodified Reports Title of Report and Addressee The Introductory Paragraph Managements Responsibility for the Financial Statements Auditor's Responsibility Auditor's Opinion Other Reporting Responsibilities Signature, Date of Audit Report and Auditor's Address 787 Auditing in Focus 17.1 Calls for Changes in Standardised Format of Auditor's Reports Modified Reports Matters that Do Not Affect the Auditor's Opinion Matters that Affect the Auditor's Opinion Summary 807 Appendix 17A: XBRL New Language for Business Reporting 808 Appendix 17B: Standard Unmodified Audit Report For a Company Incorporated in Hong Kong 813 Exercise: Review questions and discussion questions 816 XX

15 Detailed Chapter Contents 18. Internal and Operational Auditing Internal Auditing Essentials for Effective Internal Auditing Use of Internal Auditing Work 832 Auditing in Focus 18.1 More Risk Management Responsibilities for Internal Auditors 835 Auditing in Focus 18.2 Challenges of Internal Auditing Operational Auditing Comparison of Operational and Financial Auditing Conducting the Operational Audit Operational Audits for Specific Areas Operational Auditing as a Management Service Engagement 846 Auditing in Focus 18.3 Continuous Auditing and New Challenges to Auditors Summary 849 Exercise: Review questions and discussion questions 850 xxi