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T E N T H E D I T I O N Auditing & Assurance Services A S Y S T E M A T I C A P P R O A C H William F. Messier, Jr. University of Nevada, Las Vegas Department of Accounting and Norwegian School of Economics Department of Accounting, Auditing and Law Steven M. Glover Brigham Young University Marriott School of Management School of Accountancy Douglas F. Prawitt Brigham Young University Marriott School of Management School of Accountancy
AUDITING & ASSURANCE SERVICES: A SYSTEMATIC APPROACH, TENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2012, and 2010. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 ISBN 978-0-07-773250-9 MHID 0-07-773250-2 Senior Vice President, Products & Markets: Kurt L. Strand Vice President, General Manager, Products & Markets: Marty Lange Vice President, Content Design & Delivery: Kimberly Meriwether David Managing Director: Tim Vertovec Marketing Director: Brad Parkins Brand Manager: Nichole Pullen Director, Product Development: Rose Koos Director of Digital Content: Patricia Plumb Lead Product Developer: Ann Torbert Product Developer: Jonathan Thornton Marketing Manager: Michelle Nolte Market Development Manager: Erin Chomat Digital Product Analyst: Xin Lin Director, Content Design & Delivery: Linda Avenarius Program Manager: Daryl Horrocks Lead Content Project Managers: Pat Frederickson and Brian Nacik Buyer: Susan K. Culbertson Design: Debra Kubiak Content Licensing Specialists: Carrie Burger and Shannon Manderscheid Cover Image: © Danita Delimont/Getty Images Compositor: SPi Global Printer: R. R. Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Messier, William F., author. Auditing & assurance services : a systematic approach / William F. Messier, Jr., Steven M. Glover, Douglas F. Prawitt.—Tenth edition. pages cm ISBN 978-0-07-773250-9 (alk. paper) 1. Auditing. I. Glover, Steven M., 1963- author. II. Prawitt, Douglas F. author. III. Title. IV. Title: Auditing and assurance services. HF5667.M46 2016 657’.45–dc23 2015028419 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. mheducation.com/highered
About the Authors William F. Messier, Jr. holds the Kenneth and Tracy Knauss Endowed Chair in Account- ing at the Department of Accounting, University of Nevada, Las Vegas. He is also an Adjunct Professor at the Department of Accounting, Auditing and Law at the Norwegian School of Economics. Professor Messier holds a B.B.A. from Siena College, an M.S. from Clarkson University, and an M.B.A. and D.B.A. from Indiana University. He is a CPA in Florida and has held faculty positions at the University of Florida (Price Waterhouse Professor) and Georgia State University (Deloitte & Touche Professor). Professor Messier was a visiting faculty member at SDA Bocconi in Milan and the Universities of Luxembourg and Michigan. Professor Messier served as the Academic Member of the AICPA’s Auditing Standards Board and as Chair of the AICPA’s International Auditing Standards Subcommittee. He is a past editor of Auditing: A Journal of Practice & Theory and formerly President of the Audit- ing Section of the American Accounting Association. Professor Messier was the recipient of the American Accounting Association’s Outstanding Accounting Educator Award (2015), AICPA’s Distinguished Achievement in Accounting Education Award (2012), AAA Audit- ing Section’s Outstanding Educator Award (2009) and the Distinguished Service in Auditing Award (2008). In 2011, Professor Messier was awarded an honorary doctorate from the Nor- wegian School of Economics and Business Administration. Professor Messier has also served as an expert witness in audit litigation cases. Professor Steven M. Glover is the K. Fred Skousen Professor and Associate Dean of the Marriott School of Management, Brigham Young University. Professor Glover is a CPA in Utah and holds a PhD and BS from the University of Washington and an AA in Business from BYU – Idaho. He previously worked as an auditor for KPMG LLP and as a director in the national office of PwC LLP. Professor Glover is currently serving on the AICPA Auditing Standards Board and has served on the audit committee of a nonprofit organization. He has served on the board of advisors for technology companies and he actively consults with public companies and public accounting firms. He has also served as an expert witness. Professor Glover is a past President of the Auditing Section of the American Accounting Association and he has been on auditing-related task forces of the AICPA. Professor Glover is or has served on the editorial boards of Auditing: A Journal of Practice & Theory, The Accounting Review, Current Issues in Auditing, and the review board of the AAA/CAQ Access to Audit Personnel Program. He has authored or coauthored over 40 articles and books primarily focused in the areas of auditor decision making, audit education, and audit practice. Together with Professor Prawitt and KPMG, LLP, he co-authored an award-winning monograph designed to acceler- ate the professional judgment of auditors and auditing students, as well as a monograph on professional skepticism commissioned by the Standards Working Group of the GPPC, an international consortium of the six largest public accounting network firms. Professor Douglas F. Prawitt is the Glen Ardis Professor of Accountancy at the Marriott School of Management, Brigham Young University. Professor Prawitt is a CPA in Utah. He holds a PhD from the University of Arizona, and BS and MAcc degrees from Brigham Young University. Professor Prawitt was awarded the Marriott School’s Teaching Excellence and Outstanding Researcher awards in 1998 and 2000. He received the Merrill J. Bateman Student Choice Teaching Award in 2002, BYU’s Wesley P. Lloyd Award for Distinction in Graduate Education in 2006, and the American Accounting Association’s Deloitte/Wildman Award in 2013. v
vi About the Authors He consults actively with international, regional, and local public accounting firms. He worked extensively over a five-year period with the Committee of Sponsoring Organiza- tions (COSO) on the COSO Enterprise Risk Management Framework and Internal Control over Financial Reporting—Guidance for Smaller Public Companies projects, and served a three-year appointment as a voting member of the AICPA Auditing Standards Board, from 2005–2008. In the fall of 2011, he was appointed to serve a three-year term as a member of the COSO Board and was appointed to serve a second three-year term beginning in 2014. Profes- sor Prawitt also has served in several capacities with the American Accounting Association, including as a member of the editorial boards of Auditing: A Journal of Practice & Theory, Behavioral Research in Accounting, and as associate editor of Accounting Horizons. He has authored or co-authored over 40 articles and books, primarily in the areas of auditor judgment and decision making, and audit practice. Most recently, together with Professor Steve Glover and KPMG, LLP, he co-authored an award-winning monograph designed to accelerate the professional judgment of auditors and auditing students, as well as a monograph on profes- sional skepticism commissioned by the Standards Working Group of the GPPC, an interna- tional consortium of the six largest public accounting firm networks. Dedications The authors dedicate this book to the following individuals: Teddie, Stacy, Brandon, Zachary, Mark, Lindsay, Olive, and Frederick —William F. Messier, Jr. Tina, Jessica, Andrew, Jennifer, Anna, Wayne, and Penny —Steven M. Glover Meryll, Nathan, Matthew, Natalie, Emily, AnnaLisa, Leah, George, and Diana —Douglas F. Prawitt
Why a New Edition? Dear Colleagues and Friends, The pace of change in the financial statement auditing environment continues to accelerate, even as the need for relia- bile, high-quality assurance over financial reporting continues to intensify. The auditing environment is far more com- plex and dynamic today than it was even 10 years ago. Today, for example, financial statement auditors practice in a regulated environment and must deal with three sets of auditing standards: the standards of the PCAOB for audits of U.S. public companies, the standards of the AICPA’s Auditing Standards Board for audits of essentially all other U.S. entities (e.g., private companies, government entities, universities), and the standards of the IFAC’s International Audit- ing and Assurance Standards Board for audits of entities based outside of the United States. And those standards have undergone change at an unprecedented pace, with few signs of slowing. It is difficult enough for us as professors to stay abreast of the unprecedented change and complexity in the auditing environment; it is simply unrealistic to expect our students to be able to grasp all of this while they are working diligently just to learn the fundamentals of financial state- ment auditing. That is why we have focused our efforts in this new edition to present the fundamentals of auditing in a crisp, clear, and understandable way, helping students navigate the inherent complexity while gaining a deep, intuitive grasp of fundamental auditing concepts. We do this by using simple yet compelling illustrations, examples, and analogies, such as relating the demand for an audit to the desire of a prospective home buyer to hire a house inspector. Our hope is that students will not only understand the important standards and concepts underlying auditing but that they will gain an intuitive grasp of why it is important and how the underlying logic can inform their judgments not only as auditors but as business people. In terms of the three sets of extant auditing standards, we simplify the complexities involved by adopting an approach similar to that taken by all of the major international accounting firms: we start with a base set of standards (in our case, the AICPA’s new body of “clarity” standards, which are at this point very similar to the IAASB standards) and we build on that base by addressing any requirements in the PCAOB standards that require more from the auditor. The AICPA’s clarity standards are newly converged with international auditing standards, which means that by studying this book your students will learn the auditing concepts that underlie an audit performed under any of the three extant sets of standards. All of the major firms have adopted a similar approach because it allows their pro- fessionals to practice effectively in any environment, domestic or international, using a single, merged set of auditing standards, rather than having to learn the specifics of three different sets. Your students will have that same advantage in learning auditing from this book. Although the auditing environment has become even more complex and demanding, at the same time it is increasingly important that students gain a deep understanding and working knowledge of fundamental auditing concepts and how they are applied. From the beginning we have worked hard to make this book the most up-to-date, “student-friendly” introductory auditing book on the market, and this new edition continues that effort. Some of the ways this book encourages your students (and ours) to think more clearly and deeply about what they are studying are by 1. Expanding the use of “stop and think” phrases at key places throughout the chapters to encourage students to more fully internalize key concepts and facilitate deep learning by your students. 2. Clarifying explanations and adding easy-to-understand examples throughout the book. vii
viii Why a New Edition? 3. Making several chapters more concise and enhancing the focus on key concepts by deleting noncentral detail. 4. Improving end-of-chapter and supplementary materials throughout the book and on the website. 5. Adding a “Professional Judgment” module to the print copy of the book to accelerate the development of pro- fessional judgment abilities in your students. This module is based on the 2013 AAA Wildman Award winning KPMG Professional Judgment monograph, authored by Steve Glover and Doug Prawitt, in collaboration with KPMG leaders and partners. 6. New discussion cases added to Chapters 3 and 6 relating to the misappropriations of assets at Koss Corporation and Dixon, Illinois. This new edition also contains several important updates including the introduction of industry leader IDEA® software by CaseWare Analytics. IDEA is a powerful and user-friendly data analysis tool designed to help auditors perform data analysis, audit sampling, and other audit procedures efficiently and effectively. Students are introduced to IDEA in the text and through hands-on tutorials, exercises, and problems. This edition also has been updated to reflect changes in auditing standards, such as the PCAOB’s Risk Assessment standards and the AICPA’s newly revised body of “clar- ity” standards, including the “principles underlying an audit conducted in accordance with generally accepted auditing standards.” The book also reflects new developments in how auditors assess materiality, based on research into major firms’ materiality policies by Aasmund Eilifsen and Bill Messier, and includes insights into audit sampling in practice based on research co-authored by Steve Glover. This edition also includes coverage of the newly revised COSO Internal Control-Integrated Framework. Because of their increasing complexity and importance to the audit process, this edi- tion also includes discussions of auditing the tax liability and auditing fair value measurements. The book also includes coverage of professionalism and ethics consistent with the AICPA’s newly reorganized Code of Professional Conduct. Finally, the authors took a hands-on role in improving this edition’s test bank, online quizzes, instructor PowerPoint slides, and the instructor’s manual. While we are very much aware of the extra investment required when a book rolls to a new edition, we believe that we owe it to our colleagues and students to provide the most up-to-date materials possible so their hard work and energy in teaching and studying represents an investment in the latest, most current concepts, delivered in the most understand- able way possible. We are confident that the changes made in this edition will make it easier for you to teach effectively and for your students to learn more efficiently and more deeply. Thank you for your support of this text and the many compliments we have received regarding past editions. We are gratified by the enthusiastic response the text has received as we have done our best to create a clear, easy-reading, student-friendly auditing textbook. As always, we welcome your feedback and suggestions, and we hope you will be pleased with the updates we have made in this new edition. With warm regards, William F. Messier, Jr. Steven M. Glover Douglas F. Prawitt
Give your students an intuitive, hands-on learning experience! The 10th Edition includes the following important features and enhancements: ∙ A “professional judgment” module, designed to accelerate the development of the student’s profes- sional judgment and based on the AAA Deloitte/Wildman Award-winning KPMG Professional Judg- ment monograph, is now included in the print version of the book. Additional resources relating to this module are available through KPMG’s University Connection website. ∙ Increased use of “Stop and Think” questions throughout the book to encourage students to more fully internalize key concepts. ∙ User-focused, user-friendly improvements. ∙ Chapter 2 has been updated for recent changes in the audit environment, Chapter 3 presents the latest information available on major firms’ audit guidance relating to materiality, Chapter 6 reflects COSO’s new internal control framework, and Chapter 19 includes coverage of professional conduct consistent with the AICPA’s newly reorganized Code of Professional Conduct. ∙ Increased use of Practice Insights that provide a link from the textbook material to the real world. ∙ The introduction of IDEA audit software. IDEA is a powerful and user-friendly data analysis tool designed to help auditors perform data analysis, audit sampling, and other audit procedures efficiently and effectively. IDEA is illustrated in Chapters 8 and 9 and there are end-of-chapter IDEA assignments and problems for hands-on application throughout the book. ∙ Improved descriptions of the hands-on EarthWear Mini-Cases that provide students with opportunities to apply audit professional judgment and practice audit procedures. ∙ Clarified explanations of technical business and accounting jargon. ∙ Improved linkage between chapter content and end-of-chapter material. ∙ References to auditing standards reflect the new codification of AICPA ASB clarity standards. Here is a sampling of the improvements made in recent editions: Chapter 1, An Introduction to Assurance and Financial Statement Auditing ∙ Discussion of fundamental concepts of auditing streamlined and clarified Chapter 2, The Financial Statement Auditing Environment ∙ Updated to reflect changes in audit environment ∙ Includes AICPA’s “principles underlying an audit” in addition to PCAOB’s traditional set of “generally accepted auditing standards” Chapter 3, Audit Planning, Types of Audit Tests, and Materiality ∙ Revised engagement letter for an integrated audit ∙ Discussion of the current practices of the major auditing firms based on a recent article by Aasmund Eilifsen and Bill Messier Chapter 4, Risk Assessment ∙ Improved presentation of the risk assessment process ∙ Revised presentation of the fraud risk assessment process ∙ Addition of a new case based on the fraud at Koss Corporation ix
x Give your students an intuitive, hands-on learning experience! Chapter 5, Evidence and Documentation ∙ Revised Advanced Module on the use of substantive analytical procedures Chapter 6, Internal Control in a Financial Statement Audit ∙ New discussion case about the fraud in Dixon, Illinois ∙ An extension of the Koss Corporation fraud that considers the control deficiencies Chapter 7, Auditing Internal Control over Financial Reporting ∙ Easier to understand explanations of the important steps in the audit of internal control over financial reporting Chapter 8, Audit Sampling: An Overview and Application to Tests of Controls ∙ Introduction of industry leading IDEA auditing software to this edition of the book with illustrations of how to use IDEA for attribute sampling within the chapter. ∙ Updated for academic research examining audit sampling in practice Chapter 9, Audit Sampling: An Application to Substantive Tests of Account Balances ∙ Introduction of industry leading IDEA auditing software to this edition of the book with illustrations of how to use IDEA for monetary unit sampling within the chapter. ∙ Updated for academic research examining audit sampling in practice Chapters 10–16, Business Process Chapters ∙ Revised for enhanced clarity and brevity ∙ Clarified illustrations linking assertions to possible misstatements to example controls and tests of controls ∙ Updated exhibits and practice insights for recent events Chapter 17, Completing the Audit Engagement ∙ Improved examples to illustrate the possible self-fulfilling prophecy effects of going concern opinions, and to explain the role and impact of commitments in completing an audit ∙ Clarified discussion of auditor’s responsibility for subsequent events ∙ Enhanced discussion of evaluation of misstatements in light of qualitative materiality considerations ∙ New coverage of iron curtain versus roll-over methods of assessing materiality of misstatements Chapter 18, Reports on Audited Financial Statements ∙ Updated for recent developments including the new “clarified” form of the ASB audit report Chapter 19, Professional Conduct, Independence, and Quality Control ∙ Updated for changes in the newly reorganized AICPA Code of Professional Conduct ∙ Discussion of quality control and peer review/inspection updated for recent changes in relevant standards Chapter 20, Legal Liability ∙ Updated for important recent cases and statutory law Chapter 21, Assurance, Attestation, and Internal Auditing Services ∙ Updated standards relating to practitioner independence in compilation engagements ∙ Attestation reports updated for new AICPA standards ∙ Updated to reflect changes in IIA standards ∙ Updated to reflect changes to structure around Trust Services principles and practices
Give your students an intuitive, hands-on learning experience! xi Tenth Edition Supplements Connect instructor resources library offers: ∙ Solutions Manual, revised by William F. Messier, Jr., Steven M. Glover, and Douglas F. Prawitt ∙ Instructor’s Manual ∙ Test Bank with AACSB, AICPA, and Bloom’s Taxonomy tags ∙ Instructor PowerPoint Presentations ∙ EarthWear Mini-Case Solutions ∙ Solutions to IDEA Solutions Addtional resources include: Links to Professional Resources, Sample Syllabi, Text Updates, and Digital Image Library Connect student resources include: ∙ EarthWear Mini-Cases ∙ IDEA Assignments and Problems, by Messier, Glover, and Prawitt ∙ Student PowerPoint Presentations ∙ Relevant Accounting and Auditing Pronouncements by chapter ∙ Link to EarthWear Clothiers home page ∙ Link to Willis & Adams, CPAs home page Assurance of Learning Ready Many educational institutions today are focused on the notion of assurance of learning, an important ele- ment of some accreditation standards. The Messier, Glover, and Prawitt Auditing and Assurance Services: A Systematic Approach book is designed specifically to support your assurance of learning initiatives with a simple, yet powerful, solution. Each chapter in the book begins with a list of numbered learning objectives, which appear throughout the chapter as well as in the end-of-chapter assignments. Each test bank question for Auditing and Assurance Services: A Systematic Approach maps to a specific chapter learning outcome/objective listed in the text. Each test bank question also identifies topic area, level of difficulty, Bloom’s Taxonomy level, AACSB and AICPA skill areas. You can use Connect to easily query for learning outcomes/objectives that directly relate to the learning objectives for your course.
How does 10e prepare your students? The continuing rapid pace of change in auditing standards and practices, together with the recent crises in the financial markets, has had a significant effect on the auditing profession. In this ever-changing environment, it is crucial that stu- dents learn from the most up-to-date, student-friendly resources. As always, the author team of Auditing & Assurance Services: A Systematic Approach is dedicated to providing the most current professional content and real-world applica- tion, as well as helping students develop professional judgment and prepare for the CPA exam. In their 10th edition, authors Messier, Glover, and Prawitt continue to reinforce the fundamental values central to their past nine editions: Student Engagement. The authors believe students are best served by acquiring a strong understanding of the basic concepts that underlie the audit process and how to apply those concepts to various audit and assurance services. The primary purpose for an auditing text is not to serve as a reference manual but to facilitate student learning, and this text is written accordingly. The text is accessible to students through straightforward writing and the use of engaging, relevant real-world examples, illustrations, and analogies. The text explicitly encourages students to think through fundamental concepts and to avoid trying to learn auditing through rote memorization. Students are prompted by the text to “stop and think” at important points in the text, in order to help them apply the principles covered. Consistent with this aim, the text’s early chapters avoid immersing students in unnecessary detail such as the minutia relating to all the complexities of audit reporting, focusing instead on students’ intuition relating to the fundamental audit concepts of materiality, audit risk, and audit evidence relating to management assertions. The first chapter provides a high-level introduction to what an audit report looks like while avoiding immersion in unnecessary detail. It also lays out a clear explanation and illustration of the demand for assurance and provides an understandable overview of the auditing process from start to finish. A case involving EarthWear Clothiers, a mail-order retailer, is integrated throughout the book and additional student resources and includes free student access to several useful hands-on mini-cases, with full solutions available to the instructor. Finally, “practice insights” throughout the book engage students and help them see the application of concepts in a practical setting. A Systematic Approach. The text continues to take a systematic approach to the audit process by first introducing the three underlying concepts: audit risk, materiality, and evidence. This is followed by a discussion of audit planning, the assessment of control risk, and a discussion of the nature, timing, and extent of evidence necessary to reach the appropriate level of detection risk. These concepts are then applied to each major business process and related account balances using a risk-based approach. The text has been revised to include the risk assessment process included in the standards adopted by the Auditing Standards Board and the International Auditing and Assurance Standards Board, as well as the PCAOB’s newly adopted Risk Assessment Standards. Decision Making. In covering these important concepts and their applications, the book focuses on critical judg- ments and decision-making processes followed by auditors. Much of auditing practice involves the application of auditor judgment. If a student understands these basic concepts and how to apply them to an audit engagement, he or she will be more effective in today’s dynamic audit environment. Two of the authors of this textbook recently worked with KPMG to develop a monograph designed to accelerate the development of professional judgment in students. We are very excited to include in this edition a “professional judgment” module as part of the printed material in the text. This module is based on the KPMG Professional Judgment monograph, which was awarded the 2013 AAA Deloitte/Wildman award for the work published within the most recent five-year period that has had the most significant impact on the practice of professional accountancy. Access to additional directly related resources, including videos, mini-cases, and problems, are available on KPMG’s University Connection website for integration into the auditing course, as instructors see fit. xii
Rev. Confirming Pages Chapter 1 An Introduction to Assurance and Financial Statement Auditing 7 Practical applications for theF I G U R E 1 – 1 Chapter 1 Overview of the Principal–Agent Relationship Leading to the Demandfor AuditingAn Introduction to Assurance and Financial Statement Auditing 29 know, if the securities acts had not been passed by Congress in the 1930s, no one modern student would be interested in having an audit performed.”Principal provides capital and hires agent to manage resources. Required: Draft a memo that highlights your thoughts about Lee’s statement that audits only take place because they are required by law.Information asymmetry Principal and conflicts of interest Agent (Absentee Owner) lead to information risk (Manager) for the principal. INTERNET ASSIGNMENT Real-World Integration and Hands-On Mini-Cases.LO 1-1, 1-9 1-30 Using an Internet browser, identify five Internet sites that contain accounting or auditing resources. For each site identified, prepare a brief summary of theAgent is accountable to principal; Auditor gathers types of information that are available. For example, the PCAOB’s home pageprovides financial reports. Agent hires auditor evidence to evaluate(www.pcaobus.org) contains extensive information on the organization’s activitiesto report on theRev. Confirming Pages fairness of agent’s fairness of agent’s financial reports. Auditor(you may use the PCAOB site as one of the five). Your five summaries should notfinancial reports. Mini EarthWear cases issues audit opinion toexceed a total of one typed page. Agent pays auditor accompany agent’s financial Auditor to reduce principal’s reports, adding credibility to information risk. “Hands-on” mini-cases are integrated throughout HANDS-ON CASESthe reports and reducing 29 Chapter 1 An Introduction to Assurance and Financial Statement Auditing principal’s information risk. the text. Enhanced case descriptions and a new EarthWear Introductionknow, if the securities acts had not been passed by Congress in the 1930s, no one In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis andadds credibility to the report and reduceswould be interested in having an audit performed.”information risk, or the risk that information cir- mini-case on the search for unrecorded liabilities EarthWear Online Adams. This introductory activity also provides an opportunity to become familiar with the structure andculated by a company’s management will be false or misleading. Reducing information risk format of the EarthWear Online cases.potentially benefits both the owner and the manager. Figure 1–1 provides an overview of thisRequired: were added this edition. The mini-cases are also agency relationship.Draft a memo that highlights your thoughts about Lee’s statement that audits onlytake place because they are required by law. Visit Connect’s additional student resources to find a detailed description of the case and to downloadWhile the setting we’ve outlined is very simple, understanding the basics of the owner– available in Connect, giving your students the required materials.manager relationship is helpful in understanding the demand for auditing. The principal– agent model is a powerful conceptual tool that can be extrapolated to much more complex opportunity to actually do some common audit- INTERNET ASSIGNMENTemployment and other contractual arrangements. For example, how can a lender prevent management from taking the borrowed funds and using them inappropriately? One way is to ing procedures. LO 1-1, 1-9 place restrictive covenants in the debt agreement with which the entity and its management1-30 Using an Internet browser, identify five Internet sites that contain accounting must comply. Again, this arrangement gives rise to a demand for the auditing of informationor auditing resources. For each site identified, prepare a brief summary of the reported by management to the lender.types of information that are available. For example, the PCAOB’s home page Additional Student (www.pcaobus.org) contains extensive information on the organization’s activities Visit Connect for author-created problem material to be completed using IDEA software.(you may use the PCAOB site as one of the five). Your five summaries should not Practice Insights Resources Practice At the heart of a capital-market economy is the flow of reliable information, which investors, credi- I N S I G H T tors, and regulators use to make informed decisions. Chief Justice Warren Burger gave his view ofexceed a total of one typed page. the significance of the audit function in a 1984 Supreme Court decision: Practice Insights in each chapter highlight HANDS-ON CASESBy certifying the public reports that collectively depict a corporation’s financial status, the indepen- dent auditor assumes a public responsibility transcending any employment relationship with the cli- important and interesting real-world trends and EarthWear Introductionent. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis and practices. EarthWear Online More than 30 years later, the message is the same—users of financial statements rely on the externalAdams. This introductory activity also provides an opportunity to become familiar with the structure and auditor to act with honor and integrity in protecting the public interest.format of the EarthWear Online cases. Visit Connect’s additional student resources to find a detailed description of the case and to download required materials. Free IDEA software Additional Student mes32502_ch01_001-034.indd 7 Visit Connect for author-created problem material to be completed using IDEA software. 09/30/15 02:33 PM The educational version of IDEA software is avail- Resources able for free with each new book. IDEA is new to this edition and the authors wrote chapter-specific IDEA assignments and problems, all of which are found inside Connect. Exposing students to IDEA allows them the opportunity to work with real professional audit software. AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Auditing and Assurance Servicesmes32502_ch01_001-034.indd10e recognizes the curricula guidelines detailed in the AACSB stan29 09/30/15 02:33 PM- dards for business accreditation by connecting selected questions in the text and test bank to the six general knowledge and skill guidelines in the AACSB standards. The statements contained in Auditing and Assurance Services 10e are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Auditing and Assurance Servicesmes32502_ch01_001-034.indd 29 10e and the teaching package make no claim of09/30/15 02:33 PM any specific AACSB qualification or evaluation, we have within Auditing and Assurance Services 10e labeled selected questions according to the six general knowledge and as a helpful starting point. xiii
Required=Results McGraw-Hill Connect® Learn Without Limits Connect is a teaching and learning platform that is proven to deliver better results for students and instructors. Connect empowers students by continually adapting to deliver precisely what they need, when they need it, and how they need it, so your class time is more engaging and effective. Using Connect improves passing rates 88% of instructors who use Connect by 10.8% and retention by 16.4%. require it; instructor satisfaction increases by 38% when Connect is required. Analytics Connect Insight® Connect Insight is Connect’s new one-of-a-kind visual analytics dashboard—now available for both instructors and students—that provides at-a-glance information regarding student performance, which is immediately actionable. By presenting assignment, assessment, and topical performance results together with a time metric that is easily visible for aggregate or individual Students can view results, Connect Insight gives the user the ability to take a just-in- their results for any time approach to teaching and learning, which was never before available. Connect Insight presents data that empowers students Connect course. and helps instructors improve class performance in a way that is efficient and effective. Mobile Connect’s new, intuitive mobile interface gives students and instructors flexible and convenient, anytime–anywhere access to all components of the Connect platform.
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Acknowledgments First and foremost, we thank our families for their continuous and unfailing support. We would like to acknowledge the American Institute of Certified Public Accountants for permission to quote from auditing standards, the Code of Professional Conduct, the Uniform CPA Examination, and the Journal of Accountancy. We would like to thank CaseWare IDEA for granting permission to distribute the educational version of IDEA software with our textbook. We would also like to thank Cassy Budd of Brigham Young University for her help with updating the Test Bank, Instructor’s Manual, Quizzes, and PowerPoints; and Jonathan Liljegren for revision of the EarthWear Mini-Cases. Finally, we would like to extend our gratitude to Christina Brenchley, Scott Jackson, and Andrew Glover for their research assistance. xvi
Brief Contents PART 1 Chapter 7 Introduction to Assurance and Auditing Internal Control over Financial Financial Statement Auditing 1 Reporting 220 Chapter 1 PART 4 An Introduction to Assurance and Financial Statistical and Nonstatistical Sampling Statement Auditing 2 Tools for Auditing 261 Chapter 2 Chapter 8 The Financial Statement Auditing Audit Sampling: An Overview and Environment 36 Application to Tests of Controls 262 PART 2 Chapter 9 Audit Planning and Basic Auditing Audit Sampling: An Application to Concepts 67 Substantive Tests of Account Balances 300 Chapter 3 PART 5 Audit Planning, Types of Audit Tests, and Auditing Business Processes 337 Materiality 68 Chapter 10 Chapter 4 Auditing the Revenue Process 338 Risk Assessment 98 Chapter 11 Chapter 5 Auditing the Purchasing Process 386 Evidence and Documentation 128 Chapter 12 PART 3 Auditing the Human Resource Management Understanding and Auditing Internal Process 422 Control 177 Chapter 13 Chapter 6 Auditing the Inventory Management Internal Control in a Financial Process 450 Statement Audit 178 xvii
xviii Brief Contents Chapter 14 Chapter 20 Auditing the Financing/Investing Process: Legal Liability 672 Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment 480 PART 8 Chapter 15 Assurance, Attestation, and Internal Auditing the Financing/Investing Process: Auditing Services 707 Long-Term Liabilities, Stockholders’ Equity, and Income Statement Accounts 506 Chapter 21 Assurance, Attestation, and Internal Auditing Chapter 16 Services 708 Auditing the Financing/Investing Process: Cash and Investments 528 Advanced Module: Professonal Judgment Framework—Understanding and Developing Professional PART 6 Judgment in Auditing 748 Completing the Audit and Reporting (Also visit KPMG’s University Connection Responsibilities 561 website for relevant resources, including videos, mini-cases, instructor notes, and problems, that Chapter 17 were created to accompany the AAA Deloitte/ Completing the Audit Engagement 562 Wildman award-winning KPMG Professional Judgment Framework monograph, on which this Chapter 18 module is based.) Reports on Audited Financial Index 757 Statements 596 PART 7 Professional Responsibilities 627 Chapter 19 Professional Conduct, Independence, and Quality Control 628
Table of Contents PART 1 Conclusion 23 Introduction to Assurance and Key Terms 24 Review Questions 25 Financial Statement Auditing 1 Multiple-Choice Questions 25 Chapter 1 Problems 27 Discussion Case 28 An Introduction to Assurance and Financial Internet Assignment 29 Statement Auditing 2 Hands-On Cases 29 Tips for Learning Auditing 4 Chapter 2 The Demand for Auditing and Assurance 5 Principals and Agents 5 The Financial Statement Auditing The Role of Auditing 6 Environment 36 An Assurance Analogy: The Case of the House Types of Auditors 38 Inspector 8 External Auditors 38 Seller Assertions, Information Asymmetry, and Internal Auditors 38 Inspector Characteristics 8 Government Auditors 39 Desired Characteristics of the House Inspection Forensic Auditors 40 Service 8 Types of Other Audit, Attest, and Assurance Relating the House Inspection Analogy to Services 40 Financial Statement Auditing 9 Other Audit Services 40 Management Assertions and Financial Attest Services 41 Statements 10 Assurance Services 41 Auditing, Attest, and Assurance Services Defined 12 Other Nonaudit Services 42 Auditing 12 Public Accounting Firms 42 Attestation 13 Organization and Composition 42 Assurance 13 A Decade of Challenge and Change for Financial Fundamental Concepts in Conducting a Financial Statement Auditors 44 Statement Audit 14 Government Regulation 44 Materiality 14 Society’s Expectations and the Auditor’s Audit Risk 15 Responsibilities 45 Audit Evidence Regarding Management Assertions 16 The Context of Financial Statement Auditing 45 Sampling: Inferences Based on Limited The Business Entity as the Primary Context of Observations 16 Auditing 45 The Audit Process 17 A Model of Business 46 Overview of the Financial Statement Auditing Corporate Governance 46 Process 17 Objectives, Strategies, Processes, Controls, Major Phases of the Audit 18 Transactions, and Reports 48 The Unqualified/Unmodified Audit Report 21 A Model of Business Processes: Five Other Types of Audit Reports 22 Components 48 xix
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