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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 Only CHAPTER 1 INTRODUCTION AND OVERVIEW OF AUDIT AND ASSURANCE LEARNING OBJECTIVES LO 1 Differentiate among assurance, attestation, and audit services. LO 2 Describe the different types of assurance services. LO 3 Explain the demand for audit and assurance services. LO 4 Discuss the different roles of the financial statement preparer and the auditor. LO 5 Identify the roles of different regulators and organizations that affect the audit profession. LO 6 Explain the concepts of reasonable assurance, materiality, and the nature of an unqualified/unmodified report on the audit of financial statements. LO 7 Explain the concept of reasonable assurance and the nature of an unqualified report on internal controls over financial reporting. LO 8 Discuss the audit expectation gap. AUDITING AND ASSURANCE STANDARDS PCAOB AUDITING STANDARDS BOARD Framework for Audits of Public Companies Framework for Audits of Private Companies AS 2201 An Audit of Internal Control Over Financial Reporting that is Integrated with the Audit of Financial Statements AU - C 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards AS 3101 The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion AU - C 700 Forming an Opinion and Reporting on Financial Statements

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    2 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only CHAPTER 1 OUTLINE 1.1 ASSURANCE, ATTESTATION AND AUDIT SERVICES (LO 1) Assurance, attestation, and auditing actually represent different types of services, but they all represent different types of services. They are similar in that they all represent an independent accounting firm verifying information prepared by someone el se against an established set of criteria. At the end of the service, the independent accounting firm provides a written report about the results of the service performed. a common process of an independent accounting firm taking information prepared by so meone else and comparing that information to an established set of criteria. A. Audit Services 1. The purpose of audit services is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly in accordance with an applicable financial reporting framework, which enhances the degree of confi dence that intended users can place in the financial statements 2. Applicable framework may be GAAP, IFRS or Tax Basis 3. The most narrow and specific service related to the requirement that only a CPA may sign an audit opinion 4. Both an attestation and assurance service B. Attestation Services 1. Attestation services are performed when a practitioner, or CPA, is engaged to issue a report on subject matter that is the responsibility of another party. 2. Practitioner is used rather than auditor because attestation services encompass more than just the audit of historical financial statements and may performed by a non - CPA. 3. Includes financial forecasts, reports on financial reporting processes, and reviews. C. Assurance Services 1. Assurance services are defined as independent professional services that improve the quality of information, or its context, for decision makers. 2. Professional must be objective and independent 3. Improving quality enhances relevance and reliability of information

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    3 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only 1.2 DIFFERENT ASSURANCE SERVICES (LO 2) The most common types of assurance services that a practitioner can provide are financial statement audits, compliance audits, operational (performance) audits, and internal audits. Financial Statement Audits Types of audits include required audits of U.S. publicly traded companies mandated by federal law, private companies meeting obligations to creditors other users, where the audited financial statements add a degree of confidence that helps users make informed decisions. A. Limitations of an Audit 1. Not a guarantee that the financial statements are free from error or fraud 2. Judgment is required when selecting and applying accounting methods and auditing estimates 3. Management may not provide the auditors with all the information needed to complete the audit (Scope limitation). 4. Evidence may be withheld or modified by perpetrators of fraud. 5. Auditors use sampling techniques when testing transactions and account balances and a sample may not be a good representation of the population and an auditor may arrive at an incorrect conclusion Compliance Audits A compliance audit involves gathering evidence to determine whether the person or entity under review has followed the rules, policies, procedures, laws and regulations with which they must conform. Operational (Performance) Audits Operational, or performance, audits are concerned with the economy, efficiency and effectiveness of an organization’s activities and are generally conducted by an organization’s internal auditors or they may be outsourced to an external audit firm. PROFESSIONAL ENVIRONMENT Becoming a CPA

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    4 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only Internal Audits Internal audits are conducted to provide assurance about various aspects of an organization’s activities and the function of internal audit is determined by those charged with governance and management within the organization. The internal audit function often conducts operational audits, compliance audits, internal control assessments and reviews which are often concerned with evaluating and improving risk management, internal control procedures and elements of the governance p rocess. The Institute of Internal Auditors (IIA) certifies internal auditors and provides guidance and standards to aid internal auditors in their work. 1.3 DEMAND FOR AUDIT AND ASSURANCE SERVICES (LO 3) Financial Statement Users The following financial statement users read the financial statements for slightly different reasons. 1. Investors: to determine if the company is viable and can provide a return on the owner’s investment. 2. Suppliers: to determine whether the company can pay for goods or services supplied 3. Customers: to determine if the company will be around to insure continue to provide goods and services. 4. Lenders: to determine if the company is able to make principal and interest payments. 5. Employees: to determine if the company can continue to pay wages and provide benefits. 6. Government: to determine compliance with regulation, payment of taxes and oversight of activities. 7. The general public: to understand the company’s activities in deciding to associate as an employee, vendor or customer. Sources of Demand for Audit and Assurance Services A. There are several reasons why financial statement users would demand an audit of financial statements.

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    5 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only 1. Remoteness: users do not have access to the company under review 2. Complexity: users do not have the expert knowledge to assess the reasonableness of complex transactions estimates and disclosures 3. Competing incentives: management may attempt to present the financial information more favorably 4. Reliability: users are interested in credible, reliable and valid information B. Auditors have financial knowledge and expertise, access to the financial records and are objective in assessing the presentation of the financial information. 1.4 PREPARERS AND AUDITORS (LO 4) Financial statement preparers and auditors have different responsibilities and play different roles in ensuring the financial statements are an accurate representation of the company. Preparer Responsibility Management is responsible for 1. ensuring the information included in the financial statements is presented fairly in compliance with the applicable financial reporting framework. 2. designing, implementing, and maintaining internal control relevant to the preparation and fair presentation of the financial statements. 3. providing the auditors with access to all records, documentation, personnel and information relevant to fair presentation of the financial statements. 4. making estimates for some financial statement items. 5. selecting appropriate accounting policies within the applicable financial reporting framework Auditor Responsibility TEACHING TIP Provide a few examples of other profession or nonprofessional services where the providers of the services are reluctant to give the optimum outcome of their services for fear of misleading customers or clients.

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    6 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only Auditors are responsible for 1. Conducting the audit in accordance with the appropriate auditing standards 2. Planning and performing the audit with professional skepticism 3. Planning and performing the audit with professional judgment. 4. Issuing an opinion on the fair presentation of the financial statements. Assurance Providers Assurance services are provided by accounting and consulting firms such as: the “Big 4” accounting firms, mid - tier firms, regional/local accounting firms, and consulting services firms. 1.5 THE ROLE OF REGULATORS AND REGULATIONS (LO 5) To help summarize the audit standard setting environment in the U.S., Illustration 1.5 provides a diagram of the current audit standard setting structure for the audits of public and private companies. 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 and interpret securities laws. Public Company Accounting Oversight Board (PCAOB) The PCAOB is a non - profit corporation established through the SOX legislation in 2002 with a mission is to oversee the audits of public companies to protect the interests of investors. Specific duties include registering and inspecting audit firms and issuing auditing standards for publicly traded companies. Standards issued by the PCAOB are called Auditing Standards (AS), which provide minimum requirements and guidance for auditing services. Applicable standards discussed throughout the text are listed by number and title at the beginning of each text chapter . American Institute of Certified Public Accountants (AICPA) The AICPA is a private professional membership organization of CPAs representing the accounting profession. Their functions include representing the profession 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 Only before legislative bodies, providing educational materials to its members, setting ethical standards for the profession and creating and grading the Uniform CPA Exam and issuing audit standards for the audits of private companies and not for profit organizations. Audit standards issued by the ASB are called Statements on Auditing Standards (SAS) and new clarity standards include a more comprehensive set of principles underlying an audit conducted in accordance with generally accepted auditing standards (GAAS) which are presented in Illustration 1.3. Financial Accounting Standards Board (FASB) The FASB is a privately funded organization whose mission is to establish financial accounting and reporting standards (GAAP) for nongovernmental entities with the goal of providing information that is useful for decision - making. Their authoritative standa rds of financial reporting are recognized by the SEC, the PCAOB, and the AICPA. Committee on Sponsoring Organizations of the Treadway Commission (COSO) COSO is an independent private sector group that focuses on providing guidance to management and expertise in the areas of internal control, enterprise risk management, and fraud deterrence National Association of State Boards of Accountancy (NASBA) and State Boards of Accountancy NASBA is a professional organization whose mission is to enhance the effectiveness and advance the common interests of its members which are the state boards of accountancy and works to promote the interests of the state boards with legislative and regulat ory bodies, provide education and development opportunities for its members, provides technology support, promotes ethical behavior in the profession and serves as the application center for individuals applying to sit for the CPA exam. Each state legislature has established a state board of accountancy to license and regulate CPAs to protect the public interest and whose functions include: Issuing CPA licenses to individuals who meet all the requirements, adopting and enforcing rules of professional conduct, adopting and enforcing rules regarding continuing professional education requirements and Investigating complaints, PROFESSIONAL ENVIRONMENT International Auditing and Assurance Standards Board (IAASB)

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    8 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only conducting hearings, and taking appropriate disciplinary actions, such as suspension or revocation of the CPA license. 1.6 AUDIT REPORT ON FINANCIAL STATEMENTS (LO 6) The independent auditor’s report is used to communicate the audit firm’s opinion about a company’s financial statements to interested users. Reasonable Assurance and the Financial Statements The auditor is only required to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. Reasonable assurance is a high, but not absolute, level of assurance. The auditor does not “guarantee” or “certify” that the financial statements are 100% accurate because that is considered absolute assurance which is not possible with content that is subjective, audits must be completed in a reasonable amount of time and t he auditors use sampling techniques, not examining 100% of a company’s transactions. Audit risk is the risk the auditors will give the wrong opinion and is reduced by understanding the factors influencing audit risk – inherent risks, internal control risks and risks associated with detecting and obtaining sufficient, competent reliable evidence to support the audit opinion. TEACHING TIP Select a state and go their CPA licensing website and review the guidelines set forth for the requirements in acquiring and renewing CPA licenses. Explain the role of NASBA.

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    9 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only Materiality and the Financial Statements Although financial statements contain approximations, they must reflect a reasonable degree of precision. However, accounting is not precise, nor accurate, so, if a potential misstatement of the financial statements is significant enough to influence or make a difference in the judgment, or consequential activities of a financia l statement user, it is considered material. Materiality is a relative concept, and it differs from company to company and from year to year for a given company. Auditors do not design an audit to look for immaterial misstatements because such misstatements would not influence a financial statement user’s decisions. The Auditor's Report on Financial Statements A. The basic components of the auditors unqualified report include: 1. Title: "Report of Independent Registered Public Accounting Firm." 2. Addressed to the shareholders and the board of directors 3. Opinion on the Financial Statements with the company name, the financial statements named, the date of, or period covered, a statement indicating that the financial statements and notes were audited and an opinion that the financial statements present fair ly, in all material respects, the financial position of the company as of the balance sheet date and the results of its operations and its cash flows for the period then ended in conformity with the applicable financial reporting framework (GAAP). 4. A section "Basis for Opinion" with the following elements: responsibility of the company's management versus the auditor, audit was conducted in accordance with the standards of the PCAOB, PCAOB standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud and hat the audit included. 5. A statement that the auditor believes that the audit provides a reasonable basis for the auditor's opinion and the auditor is a public accounting firm registered with the PCAOB (United States) and is required to be independent with respect to the company. 6. Communication regarding critical audit matters relating to the audit of the current period's financial statements. 7. Proper signature and date with year auditor began audits of company

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    10 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only B. Modifications to the standard report will occur under the following circumstances: 1. Material departures from GAAP 2. Scope limitations imposed by client or inherent in audit engagement 3. Lack of independence by the auditor 1.7 AUDIT REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING (LO 7) PCAOB Auditing Standard 2201 An Audit of Internal Control Over Financial Reporting (ICFR) that is Integrated with an Audit of Financial Statements states that auditors must conduct an integrated audit for public companies. This means auditors must plan and perform their work to achieve the objectives of both the financial statement audit and the audit of the effectiveness of ICFR simultaneously. Reasonable Assurance and Internal Controls Effective ICFR provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements, but auditors cannot provide absolute assurance about the effectiveness of internal controls for the same reasons they cannot provide absolute assurance on the fai r presentation of the financial statements. For this reason, using professional judgment, auditors select the most critical internal controls over financial reporting and test the effectiveness of those controls . The Auditor's Report on Internal Control Over Financial Reporting Similar to the financial statement audit report, PCAOB AS 2201 requires a standard format report to be used for all audits of effectiveness of ICFR including PROFESSIONAL ENVIRONMENT PCAOB Releases New Audit Report TEACHING TIP Provide examples of critical audit matters (CAM), both as an example of audit risk 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 Only 1) an opinion on the effectiveness of ICFR, 2) reference to COSO, 3) management versus auditor responsibility, and 4) scope of audit and definition and 5) limitations of ICFR. 1.8 THE AUDIT EXPECTATION GAP (LO 8) The audit expectation gap occurs when there is a difference between the expectations of auditors and financial statement users. A. The gap is caused by unrealistic user expectations such as: 1. the auditor is providing complete assurance 2. the auditor is guaranteeing the future viability of the entity 3. an unmodified audit opinion is an indicator of complete accuracy of the financial statements 4. the auditor will definitely find any and all fraud 5. the auditor has checked all transactions. B. The reality is that: 1. an auditor provides reasonable assurance 2. the audit does not guarantee the future viability of the entity 3. an unmodified opinion indicates the auditor believes there are no material misstatements in the financial statements 4. the auditor will assess the risk of fraud and conduct tests to try to uncover any fraud, but there is no guarantee the auditor will find all material fraud, should one have occurred 5. the auditor tests a sample of transactions. C. The audit expectation gap can be reduced by: 1. auditors performing their duties appropriately, complying with auditing standards and meeting the minimum standards of performance that should be expected of all auditors 2. inspections of audits to ensure that auditing standards have been applied correctly 3. auditing standards being reviewed and updated on a regular basis to enhance the work being done by auditors 4. education of financial statement users as to the responsibilities of preparers and auditors of financial statements 5. assurance providers reporting accurately the level of assurance being provided

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    1 2 KEY TERMS REVIEW Assurance services Attestation services Audit risk Audit services Compliance audit Integrated audit Internal audit Material weakness Materiality Operational (performance) audit Professional judgment Professional skepticism Reasonable assurance Those charged with governance

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    1 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only CHAPTER 2 PROFESSIONALISM AND PROFESSIONAL RESPONSIBILITIES LEARNING OBJECTIVES LO 1 Explain what it means to be a professional and how these traits apply to auditors. LO 2 Explain the structure of the AICPA Code of Professional Conduct. LO 3 Apply the conceptual framework approach to ethical decision for members in public practice. LO 4 Evaluate the ethical behavior needed to comply with rules of conduct on integrity and objectivity. LO 5 Evaluate the ethical behavior needed to comply with rules of conduct on Independence. LO 6 Evaluate the ethical behavior needed to comply with rules of conduct on general standards. LO 7 Evaluate the ethical behavior needed to comply with other rules of conduct for members in public practice. LO 8 Evaluate an auditor’s legal liability under common law. LO 9 Evaluate an auditor’s legal liability under statutory law. AUDITING AND ASSURANCE STANDARDS PCAOB ETHICS AND INDEPENDENCE STANDARDS AICPA ETHICAL STANDARDS 3501: Definitions of Terms Employed in Section 3, Part 5 of the Rules AICPA Code of Professional Conduct 3502: Responsibility to Not Knowingly or Recklessly Contribute to Violations 3520: Auditor Independence 3521: Contingent Fees 3522: Tax Transactions 3523: Tax Services for Persons in Financial Reporting Oversight Roles 3524: Audit Committee Pre - approval of Certain Tax Services 3525: Audit Committee Pre - approval of Non - audit Services Related to Internal Control over Financial Reporting 3526: Communication with Audit Committees Concerning Independence

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    2 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only CHAPTER 2 OUTLINE 2.1 PROFESSIONALISM AND ACCOUNTING (LO 1) Professional accountants are individuals who worked hard to obtain expertise in their field through education, experience and training. They are acknowledged in the community as members dedicated to serving the public interest, adhering to standards of practice as well as a stringent Code of Conduct. The rise of regulation in the field of accounting was precipitated by some major cases of fraudulent financial reporting as well as CPAs entering the field of consulting. The federal government now plays a more active oversight role for both corporations and independent auditors, whom owe allegiance to the wide band of stakeholders who are dependent on reliable financial information for making critical decisions. 2.2 THE STRUCTURE OF THE AICPA CODE OF PROFESSIONAL CONDUCT (LO 2) Professional ethics represent a commitment by a profession to abide by ethical principles and rules of conduct and is a key element that separates recognized professions from other occupations. Codes must be both idealistic and practical in purposes, pract ical & enforceable and to be meaningful, they must strike a balance of being above the law but below the ideal. Components of the AICPA Code of Conduct 1. Principles express the basic tenets of ethical conduct and provide the framework for the rules that govern the performance of the member’s professional responsibilities. 2. Rules of Conduct establish minimum standards of acceptable conduct in the performance of professional services. 3. Interpretations provide additional guidance regarding the scope and applicability of the rules of conduct. PROFESSIONAL ENVIRONMENT The Ethics of WorldCom: Misplaced Motives, Weaknesses, and Heroism

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    3 | © 2019 John Wiley and Sons, Inc. For Instructor Use Only Structure of the Code presented in Illustration 2.1 2.3 APPLY THE CONCEPTUAL FRAMEWORK TO ETHICAL DECISION MAKING FOR MEMBERS IN PUBLIC PRACTICE (LO 3) In the absence of a rule or an interpretation, a CPA should use the conceptual framework to evaluate what to do. The Code of Professional Ethics and the Conceptual Framework relate to all the work performed by CPAs in public practice, audit engagements, ta x engagements, accounting services performed for clients, or consulting engagements. A CPA should evaluate whether a relationship or circumstance would lead a reasonable and informed third party, who is aware of the relevant information, to conclude there is a threat to the CPA’s compliance and the threat is not capable of being reduced to an acceptable level. In situations where there is not a specific rule or interpretation that relates to a relationship or circumstance, the CPA should follow the steps (See Illustration 2.2. for more detail) A. Step 1: Identify Threats 1. Adverse Interest Threat 2. Advocacy Threat 3. Familiarity threat 4. Management participation threat 5. Self - interest threat 6. Self - review threat 7. Undue influence threat B. Step 2: Evaluate the Significance of the Threat. C. Step 3: Identify and Apply Safeguards D. Step 4: Evaluate the Effectiveness of Safeguards E. Step 5: Document Threats and Safeguards TEACHING TIP Illustrate how to search for provisions in the Code by accessing the Code online to show how to use the drop - down menus to find Code interpretations.

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