Lecture Notes For Auditing: A Practical Approach with Data Analytics, 1st Edition

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1|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyCHAPTER 1INTRODUCTION AND OVERVIEW OF AUDITAND ASSURANCELEARNING OBJECTIVESLO 1Differentiate among assurance, attestation, and audit services.LO 2Describe the different types of assurance services.LO 3Explain the demand foraudit and assurance services.LO 4Discuss the different roles of the financial statement preparer and the auditor.LO 5Identify the roles of different regulators and organizations that affect the auditprofession.LO 6Explain the concepts of reasonable assurance, materiality, and the nature of anunqualified/unmodified report on the audit of financial statements.LO 7Explain the concept of reasonable assurance and the nature of an unqualified report oninternal controls over financial reporting.LO 8Discuss the audit expectation gap.AUDITING AND ASSURANCE STANDARDSPCAOBAUDITING STANDARDS BOARDFramework for Audits of Public CompaniesFramework for Audits of Private CompaniesAS 2201An Audit of Internal Control Over Financial Reportingthat isIntegrated with the Audit of Financial StatementsAU-C 200Overall Objectives of the Independent Auditor andthe Conduct of an Audit in Accordance with GenerallyAccepted Auditing StandardsAS 3101The Auditor’s Report on an Audit of FinancialStatements When the Auditor Expresses an Unqualified OpinionAU-C 700Forming an Opinion and Reporting on FinancialStatements

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2|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyCHAPTER 1 OUTLINE1.1ASSURANCE, ATTESTATION AND AUDIT SERVICES (LO1)Assurance, attestation, and auditing actually represent different types of services,but they all represent different types of services. They are similar in that they allrepresent an independent accounting firm verifying information prepared bysomeone else against an established set of criteria. At the end of the service, theindependent accounting firm provides a written report about the results of theservice performed. a common process of an independent accounting firm takinginformation prepared by someone else and comparing that information to anestablished set ofcriteria.A.Audit Services1.The purpose of audit services is to provide financial statement users with anopinion by the auditor on whether the financial statements are presented fairly inaccordance with an applicable financial reporting framework, which enhances thedegree of confidence that intended users can place in the financialstatements2.Applicable framework may be GAAP, IFRS or TaxBasis3.The most narrow and specific service related to the requirement that only a CPAmay sign an auditopinion4.Both an attestation and assuranceserviceB.AttestationServices1.Attestation servicesare performed when a practitioner, or CPA, is engaged toissue a report on subject matter that is the responsibility of anotherparty.2.Practitioner is used rather than auditor because attestation services encompassmore than just the audit of historical financial statements and may performed bya non-CPA.3.Includes financial forecasts, reports on financial reporting processes, andreviews.C.Assurance Services1.Assurance servicesare defined as independent professional services thatimprove the quality of information, or its context, for decisionmakers.2.Professional must be objective andindependent3.Improving quality enhances relevance and reliability ofinformation

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3|© 2019 John Wiley and Sons, Inc.For Instructor Use Only1.2DIFFERENT ASSURANCE SERVICES (LO2)The most common types of assurance services that apractitioner can provideare financial statement audits, compliance audits, operational (performance)audits, and internalaudits.Financial StatementAuditsTypes of audits include required audits of U.S. publicly traded companiesmandated byfederal law, private companies meeting obligations to creditorsother users, where the audited financial statements add a degree of confidencethat helps users make informed decisions.A.Limitations of an Audit1.Not a guarantee that the financial statements are free from error orfraud2.Judgment is required when selecting and applying accounting methods andauditingestimates3.Management may not provide the auditors with all the information needed tocomplete the audit (Scopelimitation).4.Evidence may be withheld or modified by perpetrators offraud.5.Auditors use sampling techniques when testing transactions and accountbalances and a sample may not be a good representation of the populationand an auditor may arrive at an incorrectconclusionCompliance AuditsAcompliance auditinvolves gathering evidence to determine whether theperson or entity under review has followed the rules, policies, procedures, lawsand regulations with which they mustconform.Operational (Performance)AuditsOperational, or performance, auditsare concerned with the economy,efficiency and effectiveness of an organization’s activities and are generallyconducted by an organization’s internal auditors or they may be outsourced to anexternal auditfirm.PROFESSIONALENVIRONMENTBecoming a CPA

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4|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyInternalAuditsInternal auditsare conducted to provide assurance about various aspects ofanorganization’s activities and the function of internal audit is determined bythosecharged with governanceand management within theorganization.The internal audit function often conducts operational audits, compliance audits,internal control assessments and reviews which are often concerned withevaluating and improving risk management, internal control procedures andelements of the governance process.The Institute of Internal Auditors (IIA) certifies internal auditors and providesguidance and standards to aid internal auditors in theirwork.1.3DEMAND FOR AUDIT AND ASSURANCE SERVICES (LO3)Financial StatementUsersThe following financial statementusers read the financial statements for slightlydifferent reasons.1.Investors: to determine if the company is viable and can provide a return on theowner’sinvestment.2.Suppliers: to determine whether the company can pay for goods or services supplied3.Customers: to determine if the company will be around to insure continue to providegoods and services.4.Lenders: to determine if the company is able to make principal and interestpayments.5.Employees: to determine if the company can continue to pay wages and providebenefits.6.Government: to determine compliance with regulation, payment of taxes andoversight ofactivities.7.The general public: to understand the company’s activities in deciding to associateas an employee, vendor orcustomer.Sources ofDemand for Audit and AssuranceServicesA.There are several reasons why financial statement users would demand an audit offinancialstatements.

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5|© 2019 John Wiley and Sons, Inc.For Instructor Use Only1.Remoteness: users do not have access to the company under review2.Complexity: users do not have the expert knowledge to assess thereasonableness of complex transactions estimates and disclosures3.Competing incentives: management may attempt to present the financialinformation more favorably4.Reliability: users are interested in credible, reliable and valid informationB.Auditors have financial knowledge and expertise, access to the financial records andare objective in assessing the presentation of the financialinformation.1.4PREPARERS AND AUDITORS (LO4)Financial statement preparers and auditors havedifferent responsibilities andplay different roles in ensuring the financial statements are an accuraterepresentation of the company.PreparerResponsibilityManagement is responsiblefor1.ensuring the information included in the financial statements is presentedfairlyin compliance with the applicable financial reportingframework.2.designing, implementing, and maintaining internal control relevant to thepreparation and fair presentation of the financialstatements.3.providing the auditors with access to all records, documentation,personnel and information relevant to fair presentation of the financialstatements.4.making estimates for some financial statementitems.5.selecting appropriate accounting policies within the applicable financialreporting frameworkAuditorResponsibilityTEACHING TIPProvide a few examples of other profession ornonprofessional services wherethe providers of the services are reluctant to give the optimum outcome of theirservices for fear of misleading customers or clients.

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6|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyAuditors are responsiblefor1.Conducting the audit in accordance with the appropriate auditingstandards2.Planning and performing the audit with professionalskepticism3.Planning and performing the audit withprofessionaljudgment.4.Issuing an opinion on the fair presentation of the financialstatements.Assurance ProvidersAssurance services are provided by accounting and consulting firms such as: the“Big 4” accounting firms, mid-tier firms, regional/local accounting firms, andconsulting servicesfirms.1.5THE ROLE OF REGULATORS AND REGULATIONS (LO5)To help summarize the audit standard setting environment in the U.S., Illustration1.5 provides a diagram of the current audit standard setting structure for theaudits of public and privatecompanies.Securities and Exchange Commission (SEC)The SEC is a federal government agency whose mission is to protect investors,maintain fair and efficient markets, facilitate capital formation, enforce andinterpret securitieslaws.Public Company Accounting Oversight Board(PCAOB)The PCAOB is a non-profit corporation established through the SOX legislation in2002 with a mission is to oversee the audits of public companies to protect theinterests of investors. Specific duties include registering and inspecting auditfirms and issuing auditing standards for publicly tradedcompanies.Standards issued by the PCAOB are called Auditing Standards (AS), whichprovide minimum requirements and guidance for auditing services. Applicablestandards discussed throughout the text are listed by number and title at thebeginning of each text chapter.American Institute of Certified Public Accountants(AICPA)The AICPA is a private professional membership organization of CPAsrepresenting the accounting profession. Their functions include representing theprofession before rule-making bodies, acting as an advocate for the profession

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7|© 2019 John Wiley and Sons, Inc.For Instructor Use Onlybefore legislative bodies, providing educational materials to its members, settingethical standards for the profession and creating and grading the Uniform CPAExam and issuing audit standards for the audits of private companies and not forprofitorganizations.Audit standards issued by the ASB are called Statements on Auditing Standards(SAS) and new clarity standards include a more comprehensive set ofprinciplesunderlying an audit conducted in accordance with generally accepted auditingstandards (GAAS)which are presented in Illustration1.3.Financial Accounting Standards Board(FASB)The FASB is a privately funded organization whose mission is to establishfinancial accounting and reporting standards (GAAP) for nongovernmentalentities with the goal of providing information that is useful for decision-making.Their authoritative standards of financial reporting are recognized by the SEC,the PCAOB, and theAICPA.Committee on Sponsoring Organizations of the TreadwayCommission(COSO)COSO is an independent private sector group that focuses on providing guidanceto management and expertise in the areas of internal control, enterprise riskmanagement, and frauddeterrenceNational Association of State Boards of Accountancy (NASBA) and State Boardsof AccountancyNASBA is a professional organization whose mission is to enhance theeffectiveness and advance the common interests of its members which are thestate boards of accountancy and works to promote the interests of the stateboards with legislative and regulatory bodies, provide education anddevelopment opportunities for its members, provides technology support,promotes ethical behavior in the profession and serves as the application centerfor individuals applying to sit for the CPAexam.Each state legislature has established a state board of accountancy to licenseand regulate CPAs to protect the public interest and whose functions include:Issuing CPA licenses to individuals who meet all the requirements, adopting andenforcing rules ofprofessional conduct, adopting and enforcing rules regardingcontinuing professional education requirements and Investigating complaints,PROFESSIONAL ENVIRONMENTInternational Auditing and Assurance Standards Board (IAASB)

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8|© 2019 John Wiley and Sons, Inc.For Instructor Use Onlyconducting hearings, and taking appropriate disciplinary actions, such assuspension or revocation of the CPAlicense.1.6AUDIT REPORT ONFINANCIAL STATEMENTS (LO6)The independent auditor’s report is used to communicate the audit firm’s opinionabout a company’s financial statements to interestedusers.Reasonable Assurance and the Financial StatementsThe auditor is only required to obtainreasonable assuranceabout whether thefinancial statements as a whole are free from material misstatement, whetherdue to fraud or error. Reasonable assurance is a high, but not absolute, level ofassurance.The auditor does not “guarantee” or “certify” that the financial statements are100% accurate because that is considered absolute assurance which is notpossible with content that is subjective, audits must be completed in areasonable amount of time and the auditors use sampling techniques, notexamining 100% of a company’s transactions.Audit risk is the risk the auditors will give the wrong opinion and is reduced byunderstanding the factors influencing audit risk–inherent risks, internal controlrisksand risks associated with detecting and obtaining sufficient, competentreliable evidence to support the auditopinion.TEACHING TIPSelect a state and go their CPA licensing website and review the guidelines setforth for the requirements in acquiring and renewing CPA licenses. Explain therole of NASBA.

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9|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyMateriality and the FinancialStatementsAlthough financial statements contain approximations, they must reflect areasonable degree of precision. However, accounting is not precise, noraccurate, so, if a potential misstatement of the financial statements is significantenough to influence or make a difference in the judgment, or consequentialactivities of a financial statement user, it is considered material.Materiality is a relative concept, and it differs from company to company and fromyear to year for a given company. Auditors donotdesign an audit to look forimmaterialmisstatements because such misstatements would not influence afinancial statement user’s decisions.The Auditor's Report on FinancialStatementsA.The basic components of the auditors unqualified reportinclude:1.Title: "Report of Independent Registered Public AccountingFirm."2.Addressed to theshareholders and the board of directors3.Opinion on the Financial Statements with the company name, the financialstatements named, the date of, or period covered, a statement indicating that thefinancial statements and notes were audited and an opinion that the financialstatements present fairly, in all material respects, the financial position of thecompany as of the balance sheet date and the results of its operations and itscash flows for the period then ended in conformity with the applicable financialreporting framework(GAAP).4.A section "Basis for Opinion" with the following elements: responsibility of thecompany's management versus the auditor, audit was conducted in accordancewith the standards of the PCAOB, PCAOB standards require that the auditor planand perform the auditto obtain reasonable assurance about whether the financialstatements are free of material misstatement, whether due to error or fraud andhat the auditincluded.5.A statement that the auditor believes that the auditprovides a reasonable basisfor the auditor's opinion and the auditor is a public accounting firm registered withthe PCAOB (United States) and is required to be independent with respect to thecompany.6.Communication regarding critical audit matters relating to the audit of the currentperiod's financialstatements.7.Proper signature and date with year auditor began audits ofcompany

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10|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyB.Modifications to the standard report will occur under the followingcircumstances:1.Material departures fromGAAP2.Scope limitations imposed by client or inherent in auditengagement3.Lack of independence by theauditor1.7AUDIT REPORT ON INTERNAL CONTROLS OVER FINANCIALREPORTING (LO7)PCAOB Auditing Standard 2201 An Audit of Internal Control Over FinancialReporting (ICFR) that isIntegrated with an Audit of Financial Statements statesthat auditors must conduct an integrated audit for public companies. This meansauditors must plan and perform their work to achieve the objectives of both thefinancial statement audit and the auditof the effectiveness of ICFRsimultaneously.Reasonable Assurance and InternalControlsEffective ICFR providesreasonable assuranceregarding the reliability offinancial reporting and the preparation of financial statements, but auditorscannot provide absolute assurance about the effectiveness of internal controls forthe same reasons they cannot provide absolute assurance on the fairpresentation of the financial statements. For this reason, using professionaljudgment, auditors select the mostcriticalinternal controls over financialreporting and test the effectiveness of those controls.The Auditor's Report on Internal Control Over FinancialReportingSimilar to the financial statement audit report, PCAOB AS 2201 requires astandard format report to be used for all audits of effectiveness of ICFR includingPROFESSIONALENVIRONMENTPCAOB Releases New Audit ReportTEACHING TIPProvide examples of critical audit matters (CAM), both as anexample of auditrisk and illustrate the value of including CAMs in the audit report.

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11|© 2019 John Wiley and Sons, Inc.For Instructor Use Only1) an opinion on the effectiveness of ICFR, 2) reference to COSO, 3)management versus auditor responsibility, and 4) scope of audit and definitionand 5) limitations ofICFR.1.8THE AUDIT EXPECTATION GAP (LO8)The audit expectation gap occurs when there is a difference between theexpectations of auditors and financial statementusers.A.The gap is caused by unrealistic user expectations suchas:1.the auditor is providing completeassurance2.the auditor is guaranteeing the future viability of theentity3.an unmodified audit opinion is an indicator of complete accuracy of the financialstatements4.the auditor will definitely find any and allfraud5.the auditor has checked alltransactions.B.The reality isthat:1.an auditor provides reasonableassurance2.the audit does not guarantee the future viability of theentity3.an unmodified opinion indicates the auditor believes there are no materialmisstatements in the financialstatements4.the auditor will assess the risk of fraud and conduct tests to try to uncover anyfraud, but there is no guarantee the auditor will find all material fraud, should onehave occurred5.the auditor tests a sample oftransactions.C.The audit expectation gap can bereducedby:1.auditors performing their duties appropriately, complying with auditing standardsand meeting the minimum standards of performance that should be expected ofall auditors2.inspections of audits to ensure that auditing standards have been appliedcorrectly3.auditing standards being reviewed and updated on a regular basis to enhancethe work being done byauditors4.education of financial statement users as to the responsibilities of preparers andauditors of financial statements5.assurance providers reporting accurately the level of assurance beingprovided

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12KEY TERMS REVIEWAssurance servicesAttestation servicesAudit riskAudit servicesCompliance auditIntegrated auditInternal auditMaterial weaknessMaterialityOperational (performance) auditProfessional judgmentProfessional skepticismReasonable assuranceThose charged with governance

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1|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyCHAPTER 2PROFESSIONALISM AND PROFESSIONALRESPONSIBILITIESLEARNING OBJECTIVESLO 1Explain what it means to be a professional and how these traits apply to auditors.LO 2Explain the structure of the AICPA Code of Professional Conduct.LO 3Apply the conceptual framework approach to ethical decision for members in publicpractice.LO 4Evaluate the ethical behavior needed to comply with rules of conduct on integrity andobjectivity.LO 5Evaluate the ethical behavior needed to comply with rules of conduct on Independence.LO 6Evaluate the ethical behavior needed to comply with rules of conduct on generalstandards.LO 7Evaluate the ethical behavior needed to comply with other rules of conduct for membersin public practice.LO 8Evaluate an auditor’s legal liability under common law.LO 9Evaluate an auditor’s legal liability under statutorylaw.AUDITING AND ASSURANCESTANDARDSPCAOB ETHICS AND INDEPENDENCE STANDARDSAICPA ETHICAL STANDARDS3501: Definitions of Terms Employed in Section 3, Part 5 of the RulesAICPA Code of Professional Conduct3502:Responsibility to Not Knowingly or Recklessly Contribute to Violations3520:Auditor Independence3521:Contingent Fees3522:Tax Transactions3523:Tax Services for Persons in Financial Reporting Oversight Roles3524:Audit CommitteePre-approval of Certain Tax Services3525:Audit Committee Pre-approval of Non-audit Services Related to InternalControl over Financial Reporting3526:Communication with Audit Committees Concerning Independence

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2|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyCHAPTER 2 OUTLINE2.1PROFESSIONALISM AND ACCOUNTING (LO1)Professional accountants are individuals who worked hard to obtain expertise intheir field through education, experience and training. They are acknowledged inthe community as members dedicated to serving the public interest, adhering tostandards of practice as well as a stringent Code of Conduct.The rise of regulation in thefield of accounting was precipitated by some majorcases of fraudulent financial reporting as well as CPAs entering the field ofconsulting. The federal government now plays a more active oversight role forboth corporations and independent auditors, whomowe allegiance to the wideband of stakeholders who are dependent on reliable financial information formaking critical decisions.2.2THE STRUCTURE OF THEAICPA CODE OFPROFESSIONALCONDUCT (LO2)Professional ethics represent a commitment by a profession to abide by ethicalprinciples and rules of conduct and is a key element that separates recognizedprofessions from other occupations. Codes must be both idealistic and practicalin purposes, practical & enforceable and to be meaningful, they must strike abalance of being above the law but below the ideal.Components of the AICPA Code of Conduct1.Principlesexpress the basic tenets of ethicalconduct and providethe framework for the rules that govern the performance of themember’s professionalresponsibilities.2.Rules of Conductestablish minimum standards of acceptable conductin the performance of professionalservices.3.Interpretationsprovide additional guidance regarding the scopeand applicability of the rules ofconduct.PROFESSIONAL ENVIRONMENTThe Ethics of WorldCom: Misplaced Motives, Weaknesses, and Heroism

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3|© 2019 John Wiley and Sons, Inc.For Instructor Use OnlyStructure of the Code presented in Illustration 2.12.3APPLY THE CONCEPTUAL FRAMEWORK TO ETHICALDECISION MAKING FOR MEMBERS IN PUBLIC PRACTICE (LO3)In the absence of a rule or an interpretation, a CPA should use the conceptualframework to evaluate what to do. The Code of Professional Ethics and theConceptual Framework relate to all the work performed by CPAs in publicpractice, audit engagements, tax engagements, accounting services performedfor clients, or consulting engagements.A CPA should evaluate whether a relationship or circumstance would lead areasonable and informed third party, who is aware of the relevant information, toconclude there is a threat to the CPA’s compliance and the threat is not capableof being reduced to an acceptable level.In situations where there is not a specific rule or interpretation that relates to arelationship or circumstance, the CPA should follow the steps (See Illustration2.2. for more detail)A.Step 1:IdentifyThreats1.AdverseInterestThreat2.AdvocacyThreat3.Familiaritythreat4.Management participationthreat5.Self-interestthreat6.Self-reviewthreat7.Undue influencethreatB.Step 2:Evaluate the Significance of theThreat.C.Step 3:Identify and ApplySafeguardsD.Step 4:Evaluate the Effectiveness ofSafeguardsE.Step 5:Document Threats andSafeguardsTEACHING TIPIllustrate how to search for provisions in the Code by accessing the Code onlinetoshow how to use the drop-down menus to find Code interpretations.

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