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AUDITING
A P R AC T I C A L A P P R O AC H W I T H D ATA A N A LY T I C S
2ND EDITION

Cover Design: Wiley

Cover Image: © Lidiia Moor / Getty Images JOHNSON | WILEY
www.wiley.com MOR ONEY | CAMPBELL | HAMILTON

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Auditing
A Practical Approach with Data Analytics

Second Edition

RAYMOND N. JOHNSON PhD, CPA

Portland State University
Portland, Oregon

LAURA D. WILEY PhD, CPA

Louisiana State University
Baton Rouge, Louisiana

Adapted from Robyn Moroney, Fiona Campbell,

and Jane Hamilton, Auditing: A Practical Approach (Wiley)

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DEDICATION

This book would not be what it is today without the

unconditional support and thoughtful input and suggestions from
our spouses, Marilyn Johnson and Joe Wiley.

VICE PRESIDENT, EDITORIAL PRODUCT MANAGEMENT Michael McDonald

ASSOCIATE EDITORIAL DIRECTOR Zoe Craig
ACQUISITIONS EDITOR Veronica Schram
SENIOR MANAGER, COURSE DEVELOPMENT
AND PRODUCTION Ed Brislin
MARKETING MANAGER Christina Koop
EDITORIAL SUPERVISOR Terry Ann Tatro
EDITORIAL ASSISTANT Natalie Munoz
SENIOR COURSE PRODUCTION OPERATIONS SPECIALIST Nicole Repasky
SENIOR DESIGNER Wendy Lai
COVER IMAGE © Lidiia Moor/Getty
Images

This book was set in Source Sans Pro-Regular 9.5/12.5 by Lumina Datamatics.

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ISBN-13: 978-1-119-78608-5

The inside back cover will contain printing identification and country of origin if omitted from this
page. In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the
back cover is correct.

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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Brief Contents
1 Introduction and Overview of Audit and Assurance   1-1

2 Professionalism and Professional Responsibilities   2-1

3 Risk Assessment Part I: Audit Risk and Audit Strategy   3-1

4 Risk Assessment Part II: Understanding the Client   4-1

5 Audit Evidence   5-1

6 Gaining an Understanding of the Client’s System of Internal

Control  6-1

7 Risk Response: Performing Tests of Controls   7-1

8 Audit Data Analytics   8-1

9 Risk Response: Performing Substantive Procedures   9-1

10 Risk Response: Audit Sampling for Substantive Procedures   10-1

11 Auditing the Revenue Process   11-1

12 Auditing the Purchasing and Payroll Processes   12-1

13 Auditing Cash, Inventory, and Related Income Statement

Accounts  13-1

14 Auditing Investing and Financing Activities   14-1

15 Completing the Audit   15-1

16 Reporting on the Audit   16-1

APPE ND IX A Cloud 9 Inc. Audit A-1

AU D I T IN G A N D A SS URA N C E STA N DA RDS    AS-1

GLOSS A RY    G-1

I N D E X   I-1

iii

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From the Authors

Being an auditor is being a trusted professional. Auditing is about developing an inquisitive
mind and mastering decision-making. It is also about adapting to change and pivoting when
unexpected situations occur. With companies evolving more rapidly than ever, auditors must
think critically, act ethically, communicate clearly, and embrace new technologies.
To help you develop these skills, we have taken a very practical approach in this second
edition:

• Written the text in a conversational style and incorporated more

headings and bulleted/numbered lists to streamline the content.
Auditing is about developing an inquisitive
mind and mastering decision-making. With • Created a five-step audit decision-making framework to assist you
companies evolving more rapidly than ever, au- with developing your critical thinking skills.
ditors must think critically, act ethically, com- • Added information about biases in decision-making.
municate clearly, and embrace new technolo- • Included new infographics to increase your understanding of key
gies. To help you develop these skills, we have topics.
taken a very practical approach in this text.
• U
 pdated content for recent changes in auditing standards and new
CPA exam content to provide you with the most up-to-date content.

In the area of technology, auditors and their clients are incorporating more technology
than ever before. You should not be concerned about mastering any specific technology or
software at this time, but you should be knowledgeable about how auditors are incorporating
various technologies, and you should be technologically nimble and willing to experiment
with using technology to analyze client data. To help you do this, we have:

• I ncluded a separate chapter on audit data analytics (ADA) and integrated the use of ADA
into many chapters.
• O
 ffered IDEA-based cases, Tableau exercises, and Excel exercises in Wiley Course Re-
sources.
• A
 dded discussions about clients’ digital mindset, automated tools for performing audit
procedures, artificial intelligence and machine learning, and cybersecurity.

The accounting and auditing skills you build in this course will serve you for the rest of
your life as you develop independence of thought and action. If you keep asking questions,
continue to explore the application of new technologies, and stay true to the importance of
integrity and independent thought and actions that will earn the public trust, you should have
a rich and rewarding career.
We are excited and honored to lead you on this “auditing” journey. We hope you dive
into the material and explore the resources provided in this text and Wiley Course Resources.
Above all else, we wish you great success in your auditing course and your career!

Raymond N. Johnson, PhD, CPA

Laura D. Wiley, PhD, CPA

iv

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About the Authors

©The National Association of State Boards of

©Aaron Hogan, Eye Wander Photo

Accountancy
©The National Association of State ©Aaron Hogan, Eye Wander Photo
Boards of Accountancy

Raymond N. Johnson Laura D. Wiley

Raymond N. Johnson, PhD, CPA, has taught auditing con- Laura Wiley, PhD, CPA, is the Assistant Department Chair
cepts and practices, financial statement analysis, and a case and senior instructor in the Department of Accounting
course focused on developing students’ critical-thinking skills at the E. J. Ourso College of Business, Louisiana State
at Portland State University for 35 years. He was the first re- University (LSU). She came to LSU in 1996 and teaches
cipient of Harry C. Visse Excellence in Teaching Fellowship financial accounting and auditing courses. She also leads
and is currently a professor emeritus from Portland State a study-abroad excursion in the Master of Accountancy
University. He has also taught auditing and accounting at program, taking students on educational business trips to
Bond University, The University of Queensland, the Aus- Central and South American countries. Dr. Wiley is active
tralian National University, and Southampton University. in the Society of Louisiana CPAs (LCPA) and has served as
Dr. Johnson is a past Chair of the International Accounting the chair of the Accounting Education Issues committee
Education Standards Board’s Consultative Advisory Group. since 2014. She received the LSU Tiger Athletic Founda-
Previously, he served on the NASBA board of directors for tion Outstanding Instructor Award in 2019 and the LCPA’s
seven years, and he previously chaired NASBA’s Education Distinguished Achievement in Education award in 2015.
Committee and the NASBA Ethics Committee. He also served Dr. Wiley has consulted with large and small companies on
on an AACSB Task Force that was responsible for the most accounting-related matters and conducted onsite training
recent update to AACSB Accounting Accreditation rules. sessions for company employees. Over her career, she has
Dr. Johnson served a three-year term on the AICPA Profession- also been a presenter at numerous CPE events and published
al Ethics Executive Committee, which sets ethical standards for in the Journal of Accounting Education. Prior to coming to
CPAs in the United States. He is a former member of NASBA’s LSU, she was an auditor with PricewaterhouseCoopers in
Standard Setting Advisory Committee and served for seven Atlanta, Georgia. She earned her bachelor’s degree in ac-
years on the NASBA/AICPA International Qualifications counting from The University of Alabama, her master’s de-
Appraisal Board. Previously, Dr. Johnson served on the Oregon gree in accounting from LSU, and her doctorate in human
Board of Accountancy for seven years and was Chair of the resource education and workforce development from LSU.
Board for two years. Dr. Johnson is a past president of the Oregon Her research interests are accounting education and finan-
Society of CPAs. He has previously served as staff to the U.S. cial literacy. She is an active licensed CPA in the state of
Auditing Standards Board, has written numerous academic Louisiana.
and professional articles, and has made numerous presenta-
tions at professional meetings.

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New to This Edition:

Chapter-by-Chapter Changes
Chapter 1: Introduction and Overview of Audit and • UPDATED tables on financial ratios to include not only
Assurance the formulas but also a description of what they assess
• ADDED the 2020 ASB Audit Report Updates. and how they are interpreted.
• NEW discussion of review of interim financial state- • REDUCED text discussions where they repeated illustra-
ments. tion or table information.
• NEW section on the critical-thinking and data analytics • UPDATED discussions on (1) procedures performed to
skills required by auditors. gain an understanding of the client, (2) tools for per-
forming analytical procedures, (3) related parties, and
• NEW illustration on the audit decision-making frame-
(4) inherent risk considerations for IT, as well as a cli-
work.
ent’s digital mindset.
• NEW Audit Decision-Making Example at the end of the
text discussion. Chapter 5: Audit Evidence
• UPDATED discussion of management assertions from
Chapter 2: Professionalism and Professional
SAS 134.
Responsibilities
• NEW illustrations on (1) the four forms of information
• NEW section on applying the conceptual framework
that auditors can use as audit evidence, (2) attributes that
through use of an example.
auditors should consider when evaluating audit evidence,
• UPDATED Illustration 2.10 to reflect the most recent de- and (3) using ADA and automated tools to perform audit
piction of auditor liability under common law. procedures.
• UPDATED discussion of Ultramares Corp. v. Touche case • UPDATED discussion and examples of sufficient appro-
reflecting the latest appeal. priate audit evidence from SAS 142.
Chapter 3: Risk Assessment Part I: Audit Risk and • UPDATED discussion of ADA and automated tools for
Audit Strategy performing audit procedures.
• UPDATED Illustration 3.1 and following discussion for Chapter 6: Gaining an Understanding of the Client’s
clear connection and focus on the factors that influence System of Internal Control
client acceptance and retention.
• NEW illustrations on (1) common inherent limitations
• UPDATED Illustration 3.4 to include “Developing an Au- of internal control, (2) steps involved in assessing control
dit Strategy” as part of the risk assessment phase. risk, and (3) major benefits and risks of IT systems.
• UPDATED definition and discussion of materiality from • REDUCED text discussions that repeated information
SAS 138, including qualitative and quantitative factors. presented in tables.
• NEW discussion of unconscious and conscious biases • DELETED cash receipts example of transaction flows, as
that impact professional skepticism. sales process example is comprehensive.
• IMPROVED discussion of audit risk with more logical • NEW Professional Environment feature on cybersecurity.
flow of audit risk components.
• NEW discussion on the use of a service organization by
• NEW illustration on inherent and control risk compo- an audit client (SOC 1 Reports).
nents.
• MOVED section on management letters to Chapter 7.
• NEW discussion on role of data analytics in audit risk and
audit strategy. Chapter 7: Risk Response: Performing Tests of Controls
(previously Chapter 8)
• ENHANCED discussion of fraud risk.
• MOVED discussion of steps in assessing control risk into
Chapter 4: Risk Assessment Part II: Understanding the Chapter 6.
Client
• NEW discussion, illustrations, and EOC on evaluating an
• NEW illustrations: (1) comparing entity risks of a fast- SOC 1, Type 2 report.
food restaurant versus a high-end restaurant and (2) how
• ADDED section on management letters from Chapter 6.
KPIs vary by industry.

vi

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  NEW TO THIS EDITION: CHAPTER-BY-CHAPTER CHANGES vii

• NEW Professional Environment feature on AICPA evi- Chapter 12: Auditing the Purchasing and Payroll
dence from peer reviews on control testing. Processes
• HIGHLIGHTED AND EXPANDED example of New Mil- • NEW illustrations detailing the auditing steps for both
lennium Ecoproducts throughout. the purchasing and payroll processes.
Chapter 8: Audit Data Analytics (previously Chapter 7) • COMBINED some learning objectives for improved pre-
sentation of topics.
• NEW learning objective (and related EOC material) on
how artificial intelligence and machine learning may be Chapter 13: Auditing Cash, Inventory, and Related
used in an audit. Income Statement Accounts (previously
• NEW emphasis on how ADA fits into the five-step audit first half of Chapter 13)
decision-making framework with specific focus on use of • NEW discussions of understanding internal controls, de-
ADA as a risk assessment tool and as a substantive pro- veloping a preliminary audit strategy, and drawing a final
cedure. conclusion.
• NEW focus on how gathering data for ADA application • REVISED discussion of bank transfers for improved un-
involves two key steps: (1) accessing and preparing the derstanding.
data for ADA and (2) considering the relevance and reli- • NEW Professional Environment feature on bank confir-
ability of the data used. mations.
• NEW Professional Environment feature detailing a recent • NEW discussion on the three-step process of valuing in-
report on the use of technology in UK audit firms. ventory.
Chapter 9: Risk Response: Performing Substantive • NEW discussion of the use of ADA to count inventories.
Procedures
Chapter 14: Auditing Investing and Financing Activities
• NEW illustrations highlighting (1) dual-purpose tests, (previously second half of Chapter 13)
(2) using a substantive analytical procedure in the con-
• NEW discussions of how audit planning decisions affect
text of the audit decision-making framework, (3) an ex-
the assessment of inherent risk, understanding internal
ample of estimation uncertainty, (4) inherent risk factors,
controls, developing a preliminary audit strategy, and
and (5) an illustrative timeline of an event related to an
drawing a final conclusion.
estimate occurring before the date of the audit report.
• NEW section on auditing debt transactions.
• UPDATED discussion on auditing accounting estimates
from SAS 143, including a running case example to illus- • NEW Auditing Decision-Making Example on investing
trate application. and financing activities.

Chapter 10: Risk Response: Audit Sampling for Chapter 15: Completing the Audit (previously Chapter 14)
Substantive Procedures • ENHANCED discussions and explanations throughout.
• COMBINED discussions within Learning Objectives 1 • REVISED Professional Environment feature on forensic
with 2, and 4 with 5, for a more streamlined, focused ap- accounting.
proach.
Chapter 16: Reporting on the Audit (previously
• ADDED audit risk model depictions to illustrate example Chapter 15)
scenarios for improved understanding.
• UPDATED throughout to reflect 2020 ASB auditing
• NEW summary discussion of PPS sampling. standards.
Chapter 11: Auditing the Revenue Process • NEW audit reports from Amazon.com and Photronics,
• NEW section and assessment material on evaluating con- Inc.
trol activities in a paperless revenue system. • NEW discussion of preparation engagements.
• NEW discussions of the preliminary audit strategy as well
as drawing a final conclusion for revenues.
• NEW illustration on (1) the five-step process for auditing
revenues, (2) the lapping scheme, and (3) the ADA de-
cision tree for auditing allowance for doubtful accounts.

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Hallmark Features
Auditing provides a unique pedagogical framework that helps students master the content and
prepare them for a successful career in accounting.

CHAPTER 8 The Big Picture

Each chapter begins with a flowchart de-
Audit Data Analytics tailing exactly what section of the audit
process students are about to learn. The
Special thanks to Dr. Adrian Gepp of Bond University, Queensland, Australia, for his invaluable
assistance in co-authoring this chapter.

The Audit Process chart helps students see the big picture of
Overview of Audit and Assurance
(Chapter 1)
the audit process.
Professionalism and Professional Responsibilities
(Chapter 2)

Client Acceptance/Continuance and Risk Assessment

(Chapters 3 and 4)

Gaining an Identifying Significant

Setting Planning
Understanding of Accounts and
Materiality
the Client Transactions

Gaining an Understanding
Making Preliminary
of the System of Internal Control
Risk Assessments
(Chapter 6)

Developing Responses to Risk and an Audit Strategy

Audit Evidence

Audit Data Analytics

(Chapter 5)

(Chapter 8)

Performing Tests of Controls Performing Substantive Procedures

(Chapter 7) (Chapter 9)

Audit Sampling for

Substantive Procedures
(Chapter 10)

Auditing the Auditing the Purchasing Auditing Cash and Auditing Investing and
Revenue Process and Payroll Processes Inventory Financing Activities c03RiskAssessmentPartI.indd Page 3-2 24/01/19 9:35 PM F-0590 /208/WB02435/9781119401810/ch03/text_s
(Chapter 11) (Chapter 12) (Chapter 13) (Chapter 14)

Completing and Reporting on the Audit

(Chapters 15 and 16)
3-2
Learning Objectives
CH A PT E R 3 Risk Assessment Part I

c05AuditEvidence.indd Page 2 04/03/19 8:37 PM F-0590

Procedures Performed Near
the End of the Audit
Drawing Audit
Conclusions
/208/WB02435/9781119401810/ch05/text_s
Reporting LearningLearning
Objectives Objectives have been carefully craft-
ed to reflect the Bloom’s
LO 1 Evaluate client acceptance and continuance Taxonomy
LO 5 Explain framework,
how auditors determine their audit

LO 2 Identifyas well asofreinforce the practical auditing skills

decisions. strategy and how audit strategy affects audit decisions.
5-2 Chapt e r 5 audit evidence
the different phases an audit. LO 6 Explain the fraud risk assessment process and

that students will develop.

analyze fraud risk.
Learning Objectives LO 3 Explain and apply the concept of materiality.

8-1
LO 4 Explain professional skepticism and apply the
audit risk model.
LO 1 Define management assertions about classes of LO 4 evaluate when it is appropriate for auditors to use
transactions, account balances, and presentation and the work of others.
5-6 C h a pt er 5 audit evidence
disclosure. LO 5 Document the details of evidence gathered in
LO 2 Discuss the characteristics of audit evidence. working papers.
assets and liabilities may exist but not be owned by the entity. For example, inventory held on
Auditing and Assurance Standards
c08AuditDataAnalytics.indd 1 7/23/21 8:18 AM
LO 3 apply the procedures for gathering audit evidence, consignment in the client’s warehouse exists, but it is not owned by the client. This inventory
including the use of audit data analytics. should not be listed as an asset because it does not meet the rights and obligations assertion
P C AO B AUDIT ING STA NDARD S B OARD
since it is not owned by the client.
When considering (9) completeness, auditors search for assets, liabilities, andAS 1015items
equity Due Professional Care in the Performance of Work AU-C 200 Overall Objectives of the Independent
to ensure they have been recorded. This assertion is particularly important when auditors Auditor and the Conduct of an Audit in Accordance With
AS 1101 Audit Risk
believe there is a risk of understatement and the client has omitted some items from the bal- Generally Accepted Auditing Standards
Auditing and Assurance Standards
Auditing and Assurance
ance sheet. For example, a client may fail to record various accrued liabilities due AS to
1301 Communications with Audit Committees
an error AU-C 210 Terms of Engagement
or an attempt to improve reported financial ratios for the period. In addition, auditors
AS 2101 gather
Audit Planning
evidence that all related disclosures are included in the notes to the financial statements. AU-C 240 Consideration of Fraud in a Financial
PCAOB Au d i t i n g StA n dA r d SWhen
BOArdconsidering (10) accuracy, valuation and allocation, auditors search forAS 2105 that
evidence Consideration of Materiality in Planning and Statement Audit

Standards
AS 1105 audit evidence assets, liabilities, and equity items have been recorded at appropriate amounts and
Au-C 230 audit Documentation subsequent
Performing an Audit
allocation or valuation adjustments are appropriately recorded. Allocation refers to the alloca-
AU-C 300 Planning an Audit
AS 1205 part of the audit performed by Other Au-C 315 Understanding the entity and Its environment AS 2110 Identifying and Assessing Risk of Material
tion of historical cost over a period of time, such as depreciation of buildings and equipment. AU-C 315 Understanding the Entity and Its Environment
Independent auditors and assessing the risks of Material Misstatement Misstatement
Valuation refers to subsequent measurements that determine fair value or net realizable value. and Assessing the Risks of Material Misstatement
AS 1210 Using the Work of a Specialist Au-C 500 audit evidenceThis assertion is particularly important when auditors believe there is a risk of over- or under-
AS 2301 The Auditor’s Responses to the Risks of

Relevant AICPA and PCAOB Auditing and

valuation. Here are some examples: AU-C 320 Materiality in Planning and Performing an
Au-C 505 external Confirmations Material Misstatement
AS 1215 audit Documentation Audit
• An auditor verifies
Au-C 600 Special Considerations—audits that inventory has been appropriately recorded at the lower
of Group of cost
AS 2401 or
Consideration of Fraud in a Financial

Misstatement Assurance Standards

AS 2110 Identifying and assessing risks of Material
are listed
Financial Statements (Including
auditors)
at
net realizable
the Workvalue
the be-
(risk of overstatement).
of Component Statement Audit
• An auditor tests for the adequacy of the allowance for doubtful accounts (risk of under-
AU-C 330 Performing Audit Procedures in Response to
Assessed Risks and Evaluating Audit Evidence Obtained
AS 2610 Initial Audits—Communication Between
ginning of each Au-C
AS 2310 the Confirmation process
AS 2605 Consideration of the Internal audit Function
chapter and statement
highlighted
or overstatement
610 Using the Work of Internal auditors depending on the client’s motivation).
Predecessor and Successor Auditors
• An auditor verifies that equipment used in operations has been appropriately marked
Au-C 620 Using the Work of an auditor’s Specialist
QC10 A Firm’s System of Quality Control

throughout the discussion. For (11) classification, auditors gather evidence that assets, liabilities, and equity interests
down if it is impaired (risk of overstatement).

3-44 C h A pte R 3 Risk Assessment part I: Audit Risk and Audit Strategy
are recorded in the proper accounts. For example, a parking lot added to land should Cloud be clas-
9 - Continuing Case
sified in a separate account from land. A parking lot is considered a land improvement and is
subject to depreciation. Including the parking lot with the land account is improper classifica-

Continuing Case
Sharon and Josh have already discussed some specific client accep- and is part of professional ethics. Sharon also gives Josh the task
Cloud 9 - Continuing
CloudCase
9 Continuing Case tion because land is not depreciated. tance issues, such as independence threats and safeguards. Sharon of researching Cloud 9’s press coverage, with special focus on any-
explains they
When considering (12) presentation, auditors gather evidence that assets, liabilities, andalso must consider the overall integrity of the client thing that may indicate poor management integrity.
At the next planning meeting for Partners
the Cloud has
9 audit,
justSuzie the Januaryhandle
wonPickering the accounts receivable and inventory themselves.
uses the Second, (that is, management of Cloud 9). This means they need to perform Sharon emphasizes they must perform and document proce-
W&S 31, 2026, audit for equityW&Sinterests are
Partners appropriately aggregated
following or disaggregated
percentages as starting in the financial statements. For
presents the results of theCloud
analytical procedures
9. The audit teamperformed
assignedso
to far Sharon
this client is: is worried about how they for
points willthe
gather evidence
various regarding a
benchmarks: and document procedures that are likely to provide information dures to determine whether W&S Partners is competent to per-
example, liabilities are separated into current and long-term portions on the balance sheet. In
and a working draft of the audit program. The audit manager, subsidiary of Cloud 9 located in Vietnam. W&S Partners does not about the client’s integrity. Josh is a little skeptical. “Do you mean form the engagement and has the capabilities, time, and resources
have an office in Vietnam,addition, related disclosures foreffec-
long-term debt
Benchmark Threshold (%)should be relevant and understandable. In the

A Cloud 9 Continuing Case exercise

Sharon Gallagher, and the audit senior, Josh Thomas, are also in- so they must determine the most that we should ask them if they are honest?” Sharon suggests it is to do so. For example, they must make sure they have audit team
• Partner, Jo Wadley notes, Incomedescribes
a company before tax its long-term
5.0 debt and includes relevant details such as interest
volved in the planning, with special responsibility for the internal tive and efficient way to gather evidence regarding the subsidiary. probably more useful to ask others, and the key people to ask are members who understand the clothing and footwear business.
• Audit manager, Sharon Gallagher rates,the
payment Total revenue and maturity 0.5
schedule, dates.
control assessment. In the planning meeting, team considers the following the existing auditors. Josh is still skeptical. “The existing auditors They also must have enough staff to complete the audit on time.
Gross profit 2.0
The meeting’s agenda is •to Audit
discusssenior,
idence at Cloud 9 and specify•these
IT audit
the available
in the detailedMark
manager,
sources of ev-
Josh Thomas
audit Batten
The team members also must ensure they have enough evidence
program.
questions:
• What evidence is available?
Total assets
Equity
0.5
1.0
applies concepts introduced in each
are Ellis & Associates. Are they going to help us take one of their
clients from them?” Sharon says the client must give permission
first, and, if that is given, the existing auditor will usually state
In addition, Sharon and Josh must perform and document
procedures to show that W&S Partners can comply with all parts
of the code of professional conduct, not just those that focus on

chapter, concludes each chapter, and is

• Experienced
to conduct the audit. Two specific staff,members
issues worry Suzie Pickering
of the • What criteria will theThese team use to choose
starting pointsamong
can bealternative
increased or decreased by taking into whether or not there were any issues that the new auditor should independence threats and safeguards. Finally, they can draft the
• First-year
team. First, there are three very large assetstaff, Ian Harper
balances on Cloud 9’s sources of evidence? account qualitative client factors, which could be:
trial balance that have particular valuation issues. Josh suggests
Cloud 9 Continuing Case of using the work of specialists
• What are the implications
be aware of before accepting the work. This type of communica- engagement letter to cover the contractual relationship between

available as an assessment question.

• The nature of the client’s business and industry (for example, tion is covered by AS 2610 (AU-C 210 for private company clients) W&S Partners and Cloud 9.
that a specialist will be required forofthe
As a part thederivatives, but they
risk assessment phasecan for the new and other
audit, theauditors?
audit
Ian and Suzie have already talked in general rapidlyterms abouteither
changing, the through • No accounts
growth receivables or
or downsizing, were omitted when calculating the
team needs to gain an understanding of Cloud 9’s structure and its
errors that could occur in Cloud 9’s accounts an receivable. For exam-
unstable environment). total—completeness.
business environment, determineple, materiality, and assess the
basic mathematical risk and other clerical errors could
mistakes • Whether the client is a public•company Accounts(or subsidiary
receivables of) in the total do exist at year-end—
included
of material misstatement. This will assist
affect thethe team in developing
customer’s total in either direction. Suzie emphasizes
subject to regulations. existence.
an audit strategy and designing the thatnature,
Cloudextent, and timingasserts
9’s management of this error did not exist when
audit procedures. Chapter Preview—Audit Process in Focus
One task during the planning
• The knowledge of or high risk of
they prepared the financial statements—i.e., they assert that
phase is to consider
• fraud.
Accounts receivables belong to Cloud 9 and have not been
accounts receivable are the con-
valued Typically, income before tax is used; however,
correctly. sold or factored—rights
it cannot be usedand obligations.
cept of materiality as it3 applies to the client. Auditors will and
de- riskif assessment.
reporting a loss for the year
for or iffocused
profitability is not
In Chapters and 4, we considered
Auditors auditgather
must risk evidence about each Those
assertionchapters • Bad debts haveconsistent.
been provided for—accuracy, valuation and
sign procedures
on the to identify and
importance correct
of each errors or class,
risk transaction
identification irregularities
to account,
help ensure theWhen
and note calculating
auditor’s
in the desired
financial PM basedofonrisk
level
state- interim
is figures, it may be nec-
allocation.
that would have a material effect on the financial statements
ments. Now that Ian understands this essary
ideatobetter,
annualize theiden-
he can results. This allows the auditors to plan
and affect the decision-makingtify of the
the assertions
users of the • Sales from the next period are not included in the earlier period—
thatfinancial
relate to the the audit properly
potential errors in based
accounts on an approximate projected year-end
statements. Materiality is used inreceivable
determining cutoff. Ian is a bit confused about this because cutoff is an asser-
thataudit
they procedures
discussed earlier: balance. Then, at year-end, the figure is adjusted, if necessary, to
and sample selections, and evaluating differences from client tion for transactions, not account balances. Suzie agrees it is a
reflect the actual results.
records to audit results. Materiality•isNo themathematical
maximum amount mistakesof or other clerical errors exist that special sort of assertion that relates to transactions or events, but
misstatement, individually or in aggregate, could that
affectcan
thebetotal receivables Required
accepted in either direction—accuracy, also gives evidence about balance sheet accounts (e.g., an over-
in the financial statements. In selecting valuation and allocation.
the benchmark to be Answer the following questions basedstatement of revenue is also
on the information pre-an overstatement of receivables).
used to calculate materiality, the auditors should consider the sented for Cloud 9 in the appendix to this text and in the current
key drivers of the business. They should ask, “What are the end chapter and previous chapters.

viii users (that is, stockholders, banks, etc.) of the accounts going
to be looking at?” For example, will stockholders be interested
a. Using the October 31, 2025, trial balance (in the appendix
to this text), calculate planning materiality, and include the
in profit figures that can be used to pay dividends and increase
justification for the benchmark that you have used for your
share price?
calculation.
W&S Partners’ audit methodology dictates that one plan-
ning materiality (PM)c05AuditEvidence.indd
amount is to be6 used for the financial b. Discuss how the planning materiality would be used to deter-
7/26/21 12:26 PM
statements as a whole. The benchmark selected for determin- mine performance materiality.
ing materiality is the one determined to be the key driver of the c. If the planning materiality amount is increased or decreased
business. later in the audit, how would that impact the audit?

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Johnson_FM.indd 8 8/24/21 9:42 AM
 3-18 C h Apt e R 3 Risk Assessment part I: Audit Risk and Audit Strategy

• Significant subjectivity in measurement of financial information.

• Significant unusual transactions.

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As part of risk assessment, auditors will document the identified inherent risks for the client,
including documenting which risks are considered significant. Knowing where the risks are
greatest assists the auditor in planning the best procedures for the audit.

Control Risk After assessing IR, the second step is to gain an understanding of the cli-
ent’s system of internal controls. The client should have controls in place to minimize the
risk of material misstatement caused by inherent risks. The auditors gain an understand-
control risk (CR) the risk that
a client’s system of internal con-
ing of internal controls for the purpose of assessing control risk. Control risk (CR) is the H A LLMA RK FEATU RES ix
risk that a client’s internal controls will not prevent or detect a material misstatement on
trols will not prevent or detect a a timely basis.
material misstatement on a Illustration 3.7 shows inherent and control risks for a jewelry store. An inherent risk
timely basis
for jewelry inventory is that it is susceptible to theft from both customers and employees. If
2-8 Chapter 2 professionalism and professional responsibilities 5-32 Ch a pt e r 5 audit evidence
jewelry is stolen without the client knowing, the inventory account will be overstated because

Flowcharts and Graphs

stolen goods would remain recorded in the client’s records. The client knows that jewelry is
ILLUSTRATION 2.2 Threats Threats susceptible to theft; therefore, the client has put controls The trial balance is then referenced into the appropriate lead and supporting schedules where
in place to minimize the risk of theft.
Step 2 Step 3
Conceptual framework Step 1 identified Evaluate significant Identify The control risk for this client would be the risk of one or more of these controls failingaudit and work is documented for each account in the trial balance. At Bell & Bowerman, LLP,
flowchart Identify significance and apply jewelry stolen without client management knowing. the trial balance is referenced using the letter “A”; cash and cash equivalents in various banks
threats of threats safeguards are referenced into the C Lead; accounts receivable are referenced into the E Lead; inventory

Detailed flowcharts and graphs help students visualize important processes.

accounts are referenced into the F Lead; property, plant and equipment are referenced into
the K Lead; and so on.
c03RiskAssessmentPartI.indd Page 3-15 24/01/19 9:35 PM F-0590 /208/WB02435/9781119401810/ch03/text_s The first working paper example is the cash and cash equivalents lead schedule
Step 4
ILLUSTRATIONEvaluate
3.7 the
in Illustration 5.15. The purpose of this lead is to summarize all general ledger accounts that
Example of inherent and control risks
effectiveness are combined into the cash and cash equivalents account on the financial statements. The
lead schedule also has adjusting journal entries, if any, that are proposed by the auditor. In the

Conceptual Illustrations
of safeguards
No threats Threats not top-left corner of the lead schedule are the client name, period-end, and currency unit (in this
identified significant Professional Skepticism and Audit Risk 3-15 example, balances are rounded to the nearest thousand dollars). In the top center of the lead
schedule is section identification (C). In the top-right corner, details of the working paper pre-
Are threats Decline or parer and reviewers are documented. Next, details of the cash and cash equivalents balance
Professional Skepticism at an acceptable
No
terminate are listed. For each item listed in the lead schedule, the following are noted.

NEW situational art helps students

level? engagement
Auditors have a responsibility to plan and perform an audit with professional skepticism. • General ledger account number, per the client records.
Professional skepticism is an attitude adoptedYes
by auditors when conducting all phases of the • General ledger account name, per the client records.
audit. It means that auditors remain independent of the entity, its management, and its staff
when completing the audit work. In a practical
Proceed
sense,
Step 5 professional skepticism means au- professional skepticism an
the client’s trial balance (TB).
conceptualize auditing concepts.
• Preadjusted balance, any adjustments, and the audit-adjusted current-year balance per
ditors maintain a questioning mind and thoroughly
Documentinvestigate all evidence presented by the attitude that includes a question-
with
client (AS 1015.07). For example, AU-C 200.A22 states
threats and auditors should be skeptical if any of ing mind, being alert to condi- • The prior-year balance, per the prior-year audit file (PY).
engagement safeguards tions that may indicate possible
the following arise during the audit: • Variance and percentage change, the calculated difference between the prior-year and
applied misstatement due to fraud or
current-year balances.
• Audit evidence recently gathered that is contradictory to other evidence previously gathered. error, and a critical assessment of
Inherent Risk audit evidence Control Risk • The cross-reference to the working paper where supporting documentary evidence is
• New information that bringsJewelry
into question
inventorythe reliabilitytoof
is susceptible client
theft. documents
Inventory accountor responses Controls put in place include security cameras and a security guard. kept for each balance (e.g., C02).
to auditor inquiries. will be overstated if client is unaware of the theft. Risk of one or more of the controls failing and inventory
Step 1: Identify ThreatsthatCPAs being stolen without the client knowing.
• Conditions may interact
provide with clients
evidence of in a number
possible fraud.of circumstances. CPAs The final section of the lead working paper includes any relevant background information
need to be alert to a possible relationship or situation that might cause a threat to their com- about the account and comments based upon completed testing.
• Situations
pliance with ethical thatfollowing
rules. The indicate the
is aneed for additional
discussion of sevenaudit
commonprocedures
threatsbeyond what
that CPAs in is required

Real-World Illustrations
by generally
public practice should accepted
be alert auditingofstandards.
to, irrespective the services the CPA is engaged to perform. ILLUSTRATION 5.15 Working paper example: Cash lead schedule
Does maintaining
• Adverse interest threat. Anprofessional
adverse interest skepticismthreat mean auditors
is the threat should
that a CPAassumewillclient
not manage-
adverse interest threat the
ment is beingbecause
dishonest? Note that IR and CRis are dis-the client’s risks and Client:
exist separately fromEcoproducts
the audit of the
the The answer is no.areAuditors
opposedshould not assume management New Millennium Bell & Bowerman, LLP Prepared by: KM 1/21/2026
threat that a CPA will not act act with objectivity CPA’s interests to the client’s interests. For
honest, but at interest
the samethreat time,exists
auditors financial statements. In other words, the auditors have no control
Period-end: over a client’s inherent
12/31/2025
if a should notexpressed
assume management
an intention is to always
begin honest or C–LEAD Reviewed by: SO 1/22/2026
with objectivity because the example, an adverse client has Reference: C-Lead
correct. Using professional skepticism means and control risks. Inherentand Currency
risk is driven by industry, unit: $000and client factors that
economic, Reviewed by: MM 1/24/2026
of taxthat even if auditors believe management
Many illustrations, such as working
CPA’s interests are opposed to the litigation against the CPA regarding the quality work previously performed.
client’s interests those charged with governance are being honest, they should are gather outreliable
of the evidence
control of to the
sup-auditor. Control risk is impacted by the client’s design and
• Advocacyportthreat. An advocacy
management’s threat
responses toisauditor
the threat that a CPA
inquiries andwill promote a client’s inter-
implementation
to support amounts of internal
and disclosures
Lead schedule:
controls, which are also out of the auditor’s control. These two
advocacy threat the threat that
ests or in
position to the point that his orF-0590
her objectivity or independence is compromised. toFor
papers and confirmations, present
the
a CPA will promote a client’sc03RiskAssessmentPartI.indd Pagefinancial statements.
3-28 24/01/19 9:35 PMThroughout all phases of the audit,risks combine
auditors should form thethese
keep RMM. /208/WB02435/9781119401810/ch03/text_s Pre- Adjusted
example, an advocacy
questions in mind threat
whenexists if the CPA
gathering provides
audit evidence:expert witness
Is this services reliable?
information to a clientDoin we need to adjusted current-year Prior-year
interests or position to the point
that his or her objectivity or litigation or in a dispute with a customer regarding a licensing arrangement.
perform more audit procedures? When auditors exercise professional skepticism during the Once the CPA is Account balance balance balance %

documents that students will en-

advocating for a client, the CPA is no longer objective. An advocacy threat would also exist if no. Account name 12/31/2025 Adjustments 12/31/2025 12/31/2024 Variance Variance Ref
independence is compromised risk assessment phase, it helps to ensure they are using appropriate assumptions when devel-
a firm acts
opingas their
an investment adviser
audit strategy to an
that willofficer
be used or director of aresponse
in the risk client. phase. In the reporting phase, 10100 Cash in Bank: Wells Fargo $ 11,000 $0 $ 11,000 TB $ 10,500 PY $500 5% C01

counter in a real-world audit.

3-28 • CHAPT
familiarity threat the threat Familiarity
ER 3 threat.
auditors Risk A familiarity
use Assessment
professional I threatwhen
skepticism
Part is the evaluating
threat that,the dueevidence
to a longgathered
or close and
rela-forming an 10200 Cash in Bank: U.S. Bank 134 0 134 TB 134 PY 0 0% C02
that, due to a long or close tionship with athat
opinion client,
the afinancial
CPA willstatements
become too aresympathetic to the client’s interests or too
presented fairly.
relationship with a client, a CPA 10300 Cash in Bank: Barclays 126 0 126 TB 126 PY 0 0% C03
accepting of the client’s work or product. For example, a familiarity threat would exist if
will become too sympathetic • Ongoing losses.
a CPA’s immediate family member were employed by the client in a key position (such 10400 Cash in Bank: Citigroup 56 0 56 TB 50 PY 6 12% C04
to the client’s interests or too • Rapid growth.
c03RiskAssessmentPartI.indd 18 8/19/21 1:41 PM

Real-World Examples
as the CFO). A familiarity threat would also exist if a former partner or professional 10500 Short -Term Deposits 5,796 0 5,796 TB 5,600 PY 196 4% C05
accepting of the client’s work or
employeeAuditof an audit Reasoning
firm joined • Example
Poor cash flas
the client ows combined
CFO and with
itsProfessional high earnings.
had Skepticism
knowledge of the firm’s
product Total Cash and Cash $17,112 $0 $17,112 $16,410 $702 4%
policies and practices for the audit engagement.
• Pressure to meet market expectations and profit targets. Equivalents
management participation • Management An auditorparticipation
was auditing•threat.
aPlanning A management
recreational vehicle
to list on a(RV)
stock participation
dealership.
exchange. threat
The auditor had is the some
obtained Key to audit tick marks (TM):
threat the threat that a CPA threat thatinitial
a CPA will take
financial on the role
information fromofthe
client management
client or otherwise
showing unaudited assume
results for the endman-
of the third TB Agrees to client’s trial balance.
• Planning to raise debt or renegotiate a loan.

Audit Reasoning Examples apply chapter

will take on the role of client quarter. Sales were
agement responsibilities. Forupexample,
and profit amargins
CPA may were up, making
have a small itbusiness
the best year
client,so and
far for
the the client. PY Agrees to prior-year audit file.
management or otherwise assume owner asks Interim recordsfirm
the CPA’s showed •that
to do The client
inventory
various being
was also
bookkeeping about to enter
up, and intothe
the client’s
services for ainventory
signifi
client.cant newshowed
records
Providing contract.
over
management responsibilities 300 RVs
bookkeeping on hand
services mayatcause
the •end
A of
the the third
signifi
CPA cant quarter. Theofaudit
proportion
to make various senior went
remuneration
management to talk
tied towhich
the audit
to earnings
decisions, man-
(that is, bonuses or stock options). Background: No significant changes in banks or bank accounts from the prior period. Note: Analytical review on movements in the cash flows has

concepts in brief real-world scenarios that

ager about the good news and the client’s performance. The audit manager asked the senior a key been performed on the cash flow schedule — see A1.1.
is a threat to the firm’s objectivity and independence. This may also put an accounting
self-interest threat the threat question. “You did the inventory observation last year. How many RVs did the client have then?”
firm in a position of auditing its own work. Comments: Cash and cash equivalents: In line with budget and change consistent with level of activity for the period (see also our review of the
that a CPA could benefit, financially “I think it was about 210,” the senior replied. Then the audit manager asked, “How full was the lot

students might encounter in a professional

statement of cash flows referenced in A1.1). Short-term deposits: Although the balance is very consistent with previous period, inclusion of
or otherwise, from an interest in, • Self-interest threat.
last year?” The A self-interest
senior threat
replied that it is theoverfl
was “almost threat thatthe
owing” a CPA couldThe
year before. benefit,
manager then short-term deposits within cash and cash equivalents is acceptable (refer to C5).
or a relationship with, a client or financiallysaid,
or otherwise,
“Let’s look from
at thisan interest
Audit
more skeptically. Example
in, or relationship
ReasoningI don’t think with,have
they a client or persons
storage
Fraudcapacity asso-
for another
at Toshiba: 90 I
Part
persons associated with the client ciated with theeven
RVs client. For sales
though example, a There
are up. self-interest
could bethreat exists
an error when
in the a CPArecords.
inventory has a financial
This information
makes me believe that the existence of inventory is a very high inherent risk.”
You may be familiar with Toshiba Corporation, a publicly traded Japanese company headquar-
tered in Tokyo that makes consumer electronics, household electronics, office equipment, and
environment. They also provide real-world
c02ProfessionalismAndProfessionalResponsibilities.indd 8
more. In July 2015, the CEO of Toshiba announced he was resigning amid an accounting scandal
in which profits had been overstated for the past seven years by approximately $1.9 billion (224.8
7/23/21 8:43 AM c05AuditEvidence.indd 32
company examples of chapter concepts. 7/23/21 8:20 AM

Audit Risk billion yen). What incentives and pressures were involved that led to the fraud? The technology
industry is extremely competitive and Toshiba’s upper management set aggressive profit targets.
The home electronics and appliances division was showing losses and the memory chip division
Audit risk is the risk that an auditor expresses an inappropriate audit opinion when financial
was feeling pressure because of decreasing demand from Chinese electronics companies.6 As an
statements are materially misstated (AU-C 200 Overall Objectives of the Independent Auditor
example, in September 2012, the head of the digital products and service division was told by the c05AuditEvidence.indd Page 5-20 1/15/19 9:44 PM f-1241 /208/WB02435/9781119401810/ch05/text_s
and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards and
CEO to improve a 24.8 billion yen loss into a 12 billion yen profit in just three days!7 Think about
AS 1101 Audit Risk). Thishow meansthe the audit
external reportwould
auditor stateslearn
the about
financial statements
the incentives aretopresented
given lower-level management. How
fairly, in all material respects,
might when in actuality
an internal the fiabout
auditor learn nancial
thesestatements
incentives?contain a material
error or fraud. While it is impossible to eliminate audit risk, auditors aim to reduce it to an
5-20 CH A PT E R 5 Audit Evidence

The Professional
Opportunities to Environment
Perpetrate a Fraud
After identifying one or more incentives or pressures to commit a fraud, auditors assess
Professional Environment Working with IT Auditors
Specialist IT auditors are often used in audits of clients with com- Finally, Brazel argues that the research findings demon-
whether a client’s employees have an opportunity to perpetrate a fraud. Auditors utilize their plex information technology (IT) environments because the effec- strated that auditors need to consider the implications of finding

Professional Environment features provide in-depth discussions

knowledge of how other frauds have been perpetrated to assess whether the same opportuni-
ties exist at the client. While the examples below of opportunities to commit a fraud suggest
tive audit of the IT systems contributes to overall audit quality.
Large audit firms usually have such specialists within the firm, but
a balance between greater software-assisted audit techniques
training for financial statement auditors and greater use of IT
a fraud may have been committed, their existence does not mean a fraud has definitely oc- smaller audit firms could engage external IT consultants for this specialists for overall audit efficiency and effectiveness.

of how concepts in a chapter are applied in the business world.

curred. Auditors must use professional judgment to assess each opportunity in the context of
other risk indicators and consider available evidence thoroughly.
Audit Decision-Making example 3-35
part of the financial statement audit. In general, reliance on an
IT specialist is appropriate when the financial statement auditor
The role of IT audit specialists could grow to become even
more than a support function for auditors. Some researchers
Examples of opportunities that increase the risk that a fraud may have been perpetrated complies with the conditions of AU-C 620. suggest that in e-businesses, the external financial statement
If the IT expert and the financial statement auditor do not auditor’s authority will be challenged by IT audit specialists be-
include:
work well together, audit quality can be impaired. For this rea- cause of technological change and its impact on auditing.13 In
Audit Decision-Making Example son, researchers have investigated the factors that affect the way e-businesses, economic transactions are captured, measured,
• Accounts that rely on estimates and judgment (discussed further in Chapter 9).
that financial statement auditors work with specialist IT auditors. and reported on a real-time basis without either internal human
• A high volume of transactions close to year-end. Brazel12 reviewed this research evidence and drew the following intervention or paper documentation.14 Auditing is likely to be-
Obtain Company Background Information
• Signifi and Data
cant adjusting entries and reversals after year-end. conclusions. First, responses from financial statement auditors in come more real-time and continuous to reflect the pattern of the
the United States who were surveyed about their experiences with transactions. If traditional auditors are unwilling or unable to
You have been assigned to the audit of• inventory
Significant
forrelated-party
a private companytransactions
that owns(discussed further
and operates in Chapter 4).
a chain
IT auditors indicated that they believe IT auditors’ competence adapt to the new environment, their role could be taken over by
of retail jewelers. The company’s sales revenue has grown by 300% in the last two years, primarily
• Poor corporate governance mechanisms. levels vary in practice. Financial statement auditors also said that IT specialists.
by acquisitions. Seventy-eight percent of the value of the company’s inventory is in wedding rings,
• Poor system of internal control (discussed further in Chapters 6 and 8). IT auditors appear to be overconfident in their abilities in some Other developments such as reporting using XBRL (eXten-
diamonds, gold necklaces, and high-end watches. Because the company has grown through acqui-
settings, and questioned the value provided by IT auditors to the sible Business Reporting Language) provide challenges for au-
sition, the company has not yet brought two acquired
• A high turnovercompanies (representing
of staff with accounting35% of sales) control
or internal under responsibilities.
financial statement audit. ditors as they have to adapt their techniques and approaches to
the company’s inventory system. As a result, the company is currently operating with three different
Second, Brazel suggests the research shows that both finan- audit financial information that is disaggregated and tagged. Us-
inventory-control systems. The core inventory system being used by the retail stores represents 65%
cial statement auditors’ IT ability and experience and the IT audi- ers can extract and analyze XBRL data directly without re-entry
of sales. Sixty percent of inventory was tested in the prior year and controls over the existence of
tor’s competence affect how these two professions interact on an and the tag provides additional information about the calculation
inventory were effective. 6
E. Pfanner and M. Fujikawa, M. “Toshiba Slashes Earnings for Past Seven Years,” The Wall Street Journal, audit engagement. This indicates that audit firms need to ensure and source of the data. This means auditors have to recognize that
The CFO’s top priority is to put all retail7,operations
September under this one inventory-control system by the
2015. https://www.wsj.com/articles/toshiba-slashes-earnings-for-past-7-years-1441589473 that staff training and scheduling produce appropriate combi- their clients are reporting financial data with different levels of
end of the fiscal year (January 31). He
7
K. is particularly
Nagata. concerned
“Pressure to show about
a profitlower-than-expected gross margins
led to Toshiba’s accounting scandal,” The Japan Times, September 18, nations of financial statement auditors and IT auditors on an information and users might have greater expectations of the data.
at some of the acquired stores, and 2015.
he expects that better inventory control will improve this situation. In
http://www.japantimes.co.jp/news/2015/09/18/business/corporate-business/pressure-to-show-a-profi t- engagement. Learn more about XBRL at www.xbrl.org.
addition, gold prices have risen 15%led-to-toshibas-accounting-scandal/#.WNJjNmQrLjA
in the last 12 months, and the company is making sure it is not selling
“conflict diamonds” illegally traded to fund conflict in war-torn areas of Africa. Your responsibility is to
develop an audit strategy for testing the existence of inventory.

? What Is the Audit Problem You Are Trying to Solve?

The focus of attention in this instance is to develop an audit strategy for testing the existence of inventory. Cloud 9 - Continuing Case
The auditor may develop a different audit strategy for testing the valuation of that inventory.
Josh will take responsibility for obtaining a specialist’s opinion on has some experience of using a derivatives specialist on prior audits,
Gather Information and Evidence the derivatives. He knows that W&S Partners has other staff (who and he also plans to ask Jo Wadley (the partner) to recommend a
Important information includes: are not part of the audit team) who can provide additional expertise. suitable specialist.

Audit Decision-Making
However, because he believes the accounts are so material to the Josh plans to investigate any possible connections between
• A significant portion of the inventory is high in value, small in size, and susceptible to theft. audit and derivatives have become such a big issue in audits in recent the specialist and Cloud 9 that could adversely impact the special-
• Although internal controls may be strong overall, there is risk they may not be operating effectively years, he deems an external specialist’s opinion is also required. He ist’s objectivity before engaging him for this audit.
and uniformly in some locations.
• The weak gross margins in some stores may be evidence of inventory shrinkage or theft.
• Fraud risk may be high in some locations due to the opportunity offered by weak internal
controls.
Framework Using the Work of Internal Auditors
• The auditor needs to determine how internal controls affect audit strategy and whether the auditor
wants one audit strategy for part of the inventory and another audit strategy for another part of the internal auditors employees The role of the internal audit function was introduced in Chapter 1. Internal auditors are
inventory.
Each chapter concludes with an Audit
of the client who perform assur-
ance and consulting activities
employees of the client who perform assurance and consulting activities designed to evaluate
and improve the effectiveness of the entity’s governance, risk management, and internal con-
Perform the Analysis and Evaluate the Results designed to evaluate and improve

Decision-Making Example that takes stu-

trol processes. Not every client will have an internal audit function. For example, small and
the effectiveness of the entity’s medium-sized companies, especially private companies, may not have the resources to staff
Analysis of risk:
governance, risk management,
• Inherent risk factors include valuable inventory that is subject to theft and misappropriation.
an internal audit function. But if the client does have an internal audit function, what role,

dents through specific steps of the audit

and internal control processes
if any, do the internal auditors play in the financial statement audit? According to AU-C 610
• Internal controls are not uniform. Based on the prior year’s evidence and a preliminary understand-
ing of the system in the current year, strong internal controls appear to operate over only 60% of
the inventory.
• It may be more efficient to physically inspect inventory as of one date and use one audit strategy for
process while offering solutions to issues 12
J. F. Brazel. “How do financial statement auditors and IT auditors work together?” The CPA Journal,
November, 2008, pages 38–41.

presented throughout the example.

all inventory testing. 13
A. Kotb, C. Roberts, & S. Sian. “E-business Audit: Advisory Jurisdiction or Occupational Invasion?” Critical
• Fraud risk is considered to be high at locations where inventory controls are not strong. Perspectives on Accounting 23, no. 6 (2012), pages 468–82.
14
Kotb et al., 2012.
! Draw an Audit Conclusion
• Inherent risk is set at the maximum because inventory is high in value and susceptible to theft and
misappropriation.
• Control risk is set at high, as 40% of inventory may not have sufficient internal controls.
• Fraud risk is considered high due to the opportunity offered by weak internal controls.
• These risk settings result in setting detection risk at low.
• Low detection risk impacts the nature, timing, and extent of substantive procedures. For exam-
ple, the auditor will plan testing of the physical existence of inventory at year-end, select a larger
number of locations to visit, and vary the extent of inventory testing at each location depending on
internal controls over the counting of inventory at each location.

c03RiskAssessmentPartI.indd 35 7/23/21 8:20 AM

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Engaging Students
The Auditing online homework system features a suite of teaching and learning resources
that were developed under close review of the authors. In the homework system, students can
access review content and practice assessment that will help them better understand course
material.

Student Practice
Each chapter includes practice questions
for each learning objective that students
can review to assess their understanding
of chapter topics.

Data Visualization
Assignments—Tableau
and PowerBI
Tableau and NEW PowerBI visual-
izations accompanied by assessments
are available with most chapters.

IDEA Cases
Select chapters include IDEA cases and case video
resources that allow students to use IDEA software
to analyze data. An IDEA casebook and accompany-
ing data sets, provided by Audimation Data Analytic
Software and Services, is also available.

Alteryx
NEW Alteryx cases and supporting video
resources are available with some chapters.

Gradable Excel
Select chapters include gradable Excel questions that
assess students’ understanding of Excel formulas.

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ENGAGING STUDENTS xi

Relevant Accounting
Articles
Up-to-date accounting articles and videos
are posted to the Wiley accounting update
site, www.wileyaccountingupdates.com.
Many of these updates address auditing-
related topics.

Adaptive Assignments
Adaptive Assignments ignite students’ con-
fidence to persist so that they can succeed in
their courses and beyond. By continuously
adapting to each student’s needs and providing
achievable goals with just-in-time instruction,
Adaptive Assignments close knowledge gaps
to accelerate learning.

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Preparing for the CPA Exam

For each chapter in the Auditing course, students can access CPAexcel videos, CPA Exam
Practice Questions in the PrometricTM Testing Interface, and Task-Based Simulations (TBSs),
which are the primary form of assessment used by the American Institute of Certified Public
Accountants (AICPA). These resources:

1. Reinforce understanding of course topics.

2. Demonstrate relevance to show students how the auditing content they are learning will be
assessed on the CPA exam.
3. Build student confidence with early exposure to CPA exam questions.

CPA Exam Practice Questions in

the Prometric™ Testing Interface
Wiley partners with CPAexcel to provide CPA exam
practice questions for each chapter that recreate the
environment students will encounter on the CPA
exam.

Task-Based Simulation in the

Prometric™ Testing Interface
CPA simulations recreate the environment stu-
dents will see on the CPA exam.

CPA Exam Video Lessons

Each chapter includes CPA exam text discus-
sions and videos that provide students with
insight into auditing topics commonly ad-
dressed on the CPA exams.

CPA Exam Assignment

Each chapter includes one CPA exam assign-
ment that allows instructors to assign CPA
multiple-choice questions. Student perfor-
mance is tied to the gradebook.

xii

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Student Assessment
Each chapter of Auditing has over 300 assessment questions that can help keep your students
engaged and on track.

End-of-Chapter Assessment
Questions and Problems
Each Auditing text chapter concludes with over 40 assessment questions and problems you can
use to gauge students’ understanding and ability to apply auditing concepts, as follows:

• Multiple-Choice Questions—Available to quickly and effectively test students’ under-

standing of the chapter material.
• S
 hort Answer Questions—Open-ended questions that require students to begin
thinking critically about the auditing process.
• Analysis Problems—Based on scenarios students might encounter as auditors in the
business world, analysis problems assess how well students understand specific topics in
a chapter.

Cases
Because no two audits are alike, Auditing uses a practical, case-based approach to help stu-
dents develop professional judgment, think critically about the auditing process, and develop
the decision-making skills necessary to perform a real-world audit. The best way for a student
to learn auditing is to actually do auditing. To help provide real-world application, we have
developed the following cases:

• A
 udit Decision Cases—Three cases run through most of the text chapters and provide
a broad review of the audit process (King Companies, Inc., Mobile Security, Inc., and
Brookwood Pines Hospital). In addition, chapter-specific cases help you assess students’
understanding of topics that are the focus of a particular chapter.
• C
 loud 9 Continuing Case—Requires students to apply chapter concepts to the ongoing
Cloud 9 case that is highlighted in the chapter.

To help you more easily identify what questions you want to assign, questions are tagged
with learning objectives, professional AICPA and AACSB outcome standards, Bloom’s
Taxonomy level, level of difficulty, and a recommended time of completion. You can track
student performance in the gradebook found in the Wiley online homework system.

Test Bank
Over 150 NEW, more challenging application and analysis questions were added to this edi-
tion’s test bank. Each chapter of the test bank has between 130 and 200 questions that you
can assign to students in an exam or as graded practice. Question types include true/false,
multiple-choice (NEW multiple-select), fill-in-the-blank, and short answer questions. To help
you more easily identify what questions you want to assign, questions are tagged with learning
objectives, professional AICPA and AACSB outcome standards, Bloom’s Taxonomy level, level
of difficulty, and a recommended time of completion. You can track student performance in
the gradebook.

xiii

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Acknowledgments
Auditing has benefited tremendously from the input of students who have used this text’s ma-
terial in class. We are also very appreciative of the comments and suggestions we received from
instructors who reviewed and used the first edition of this textbook, as well as the instructors
who participated in development and authoring activities for this new edition. A special thank
you to Kathleen Bakarich. We greatly appreciate her contributions to our Alteryx resources.

Sanaz Aghazadeh Dale Flesher Joe Looney

Louisiana State University University of Mississippi Hofstra University
Anne Albrecht Paul Franklin Jason MacGregor
Texas Christian University Purdue Global Baylor University
Matthew Anderson Scott Fulkerson Roger Martin
Michigan State University University of California—Santa Barbara University of Virginia
LuAnn Bean Lori Fuller Susanna Matson
Florida Institute of Technology West Chester University Siena College of Taytay, Philippines
Marie Blouin Amber Gray Linda McCann
Ithaca College Adrian College Metropolitan State University
A. Faye Borthick Abo-El-Yazeed Habib Karen McDougal
Georgia State University Minnesota State University—Manka Pennsylvania State University—Brandywine
Joe Brazel James Hansen Linda McKeag
North Carolina State University Weber State University University of Dubuque
Billy Brewster Frederick Harmon Mary Mindak
Texas State University University of Bridgeport DePaul University
Rich Brody Julia Higgs Ashley Minnich
The University of New Mexico Florida Atlantic University Park University
Melodi Bunting CPA, CMA, CGMA Karen Hooks Paula Mooney
Wegner CPAs Florida Atlantic University Savannah State University
Jeffrey R. Cohen Carol Jessup Anita Morgan
Boston College University of Illinois—Springfield Indiana University
Emily Cokeley Eric Johnson Grace Mubako
Rochester Institute of Technology University of Wyoming California Stata University—Sacramento
Sheila Coomes Joe Johnston Christine Noel
Kansas State University Illinois State University Metropolitan State University of Denver
Laurence DeGaetano Bill Joyce Christopher A. Nogot
Montclair State University Bemidji State University Siena College of Taytay, Philippines
Kristina Demek Brett Kawada Connie O’Brien
University of Central Florida San Diego State University Minnesota State University—Mankato
Lisa Derouin Walied Keshk Aimee Pernsteiner
Wisconsin Lutheran College California State University—Fullerton University of Wisconsin—Eau Claire
Raymond Elson Katherine Kinkela Rossen Petkov
Valdosta State University Iona College Lehman College
Steven Ernest Milton Krivokuca Byron Pike
Baton Rouge Community College California State University—Dominguez Hills Minnesota State University—Mankato
Reza Espahbodi Ellen L. Landgraf Lincoln Pinto
Washburn University of Topeka Loyola University—Chicago Concordia University Chicago
Kel-Ann Eyler Betsy Lin Marshall Pitman
Georgia College and State University Montclair State University University of Texas—San Antonio
Magdy Farag Cathy Liu Dwayne Powell
California Polytechnic University—Pomona University of Houston—Downtown Arkansas State University

xiv

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  AC K NOWLED GMENTS xv

Sridhar Ramamoorti Margaret B. Shackell-Dowell Lisa Victoravich

University of Dayton—Ohio Ithaca College University of Denver
Matthew Reidenbach Philip Slater Jim Vogt
Pace University—New York Forsyth Technical Community College University of Colorado—Denver
Maria Sanchez Vicki Stewart Rick Warne
Rider University Texas A&M University—Commerce University of Cincinnati
Matthew J. Sargent Jaclyn Strauss Amanda Warren
University of Texas at Arlington Purdue Global University of Tennessee—Knoxville
Gary Schneider Floran Syler Barrett Wheeler
California State University—Monterey Bay Azusa Pacific University Tulane University
Dan Schrag Paula Thomas Angela Woodland
Baldwin Wallace University Middle Tennessee State University Montana State University
Edward B. Seibert Andrea Tietjen Gail E. Wright
Wesley College Caldwell College Fengyun Wu
Tim Seidel Patricia Timm Manhattan College
Brigham Young University Northwood University—Michigan Aleksandra Zimmerman
Jamie L. Seitz Madeline Trimble Florida State University
University of Southern Indiana Illinois State University Ally Zimmerman
Suzanne Seymoure Richard Turpen Northern Illinois University
Saint Leo University, University Campus University of North Carolina—Asheville

We also want to thank several individuals for their help in We appreciate suggestions and comments from users—
moving this text from concept to publication. This work would instructors and students alike. Please send us your thoughts
not have come to fruition without the extensive support and and ideas about the text.
guidance of Emily Marcoux, Veronica Schram, Joel Hollen-
beck, Ed Brislin, Nicole Repasky, Natalie Munoz, Terry Ann Raymond Johnson Laura Wiley
Tatro, and Vimal Shanmugavelu. Sunriver, Oregon Baton Rouge, Louisiana

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Table of Contents
1 Introduction and Overview of Audit 2.2 The Structure of the AICPA Code of Professional
Conduct 2-5
and Assurance 1-1 Purpose of the Code 2-5
Organization of the Code 2-6
1.1 Assurance, Attestation, and Audit Services 1-3 2.3 Conceptual Framework for Members
Audit Services 1-4 in Public Practice 2-7
Attestation Services 1-4 Steps in the Conceptual Framework 2-7
Assurance Services 1-5 Applying the Conceptual Framework: An Example 2-10
1.2 Different Assurance Services 1-6 2.4 Integrity and Objectivity 2-11
Financial Statement Audits 1-6 Conflicts of Interest 2-11
Compliance Audits 1-8 Subordination of Judgment 2-12
Operational (Performance) Audits 1-8 2.5 Independence 2-12
Internal Audits 1-8 Key Individuals and Independence Requirements 2-14
1.3 Demand for Audit and Assurance Services 1-9 Employment or Association with an Attest Client 2-18
Financial Statement Users 1-9 Nonattest Services 2-19
Demand for Audit and Assurance Services 1-10 SEC and PCAOB Independence Rules 2-22
1.4 Preparers and Auditors 1-11 2.6 General Standards 2-25
Preparer Responsibility 1-11 2.7 Other Rules of Conduct for Members in
Auditor Responsibility 1-12 Public Practice 2-26
Auditor Skills 1-12 Accounting Principles Rule 2-26
Assurance Providers 1-13 Fees and Other Types of Remuneration 2-27
1.5 The Role of Regulators and Regulations 1-14 Confidential Information 2-27
Securities and Exchange Commission (SEC) 1-14 2.8 Auditor Liability Under Common Law 2-28
Public Company Accounting Oversight Board (PCAOB) 1-15 Liability to Clients 2-29
American Institute of Certified Public Accountants Liability to Third Parties 2-31
(AICPA) 1-16 Burden of Proof and Common Law Defenses 2-34
Financial Accounting Standards Board (FASB) 1-19 2.9 Auditor Liability Under Statutory Law 2-35
Committee on Sponsoring Organizations of the Treadway The Securities Act of 1933 2-36
Commission (COSO) 1-19 The Securities Act of 1934 2-37
National Association of State Boards of Accountancy The Foreign Corrupt Practices Act of 1977 2-38
(NASBA) and State Boards of Accountancy 1-19 The Private Securities Litigation Reform Acts of 1995 and
1.6 Audit Report on Financial Statements 1-20 1998 2-38
Reasonable Assurance and the Financial Statements 1-20 The Sarbanes-Oxley Act of 2002 2-39
Materiality and the Financial Statements 1-21 Criminal Liability 2-41
The Auditorʼs Report on Financial Statements 1-21 Audit Decision-Making Example 2-45
1.7 Audit Report on Internal Controls over
Financial Reporting 1-27
Reasonable Assurance and Internal Controls 1-27 3 Risk Assessment Part I: Audit Risk
The Auditor’s Report on Internal Control over Financial
Reporting 1-28
and Audit Strategy 3-1
1.8 The Audit Expectation Gap 1-30
3.1 Client Acceptance and Continuance
Audit Decision-Making Example 1-33
Decisions 3-3
3.2 Phases of an Audit 3-8
2 Professionalism and Professional Risk Assessment Phase 3-9
Responsibilities 2-1 Risk Response Phase 3-10
Reporting Phase 3-10
2.1 Professionalism and Accounting 2-3 3.3 Materiality 3-11
Level of Expertise 2-3 Qualitative and Quantitative Factors 3-11
Concern for the Public Interest 2-4 Setting Materiality 3-12
xvi

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  TAB LE OF CONTENTS xvii

3.4 Professional Skepticism and Audit Risk 3-15

Professional Skepticism 3-15
5 Audit Evidence 5-1

Audit Risk 3-16 5.1 Management Assertions 5-3

3.5 Audit Strategy 3-23 Assertions in the ASB Auditing Standard 5-3
Reliance on Controls Approach 3-24 Assertions in the PCAOB Standard 5-7
Substantive Approach 3-26 Relevant Assertions 5-7
Where Does Data Analytics Fit In? 3-26 5.2 Characteristics of Audit Evidence 5-8
3.6 Fraud Risk 3-28 Sufficient Audit Evidence 5-8
Incentives and Pressures to Commit a Fraud 3-30 Appropriate Audit Evidence 5-9
Opportunities to Perpetrate a Fraud 3-31 Persuasive Audit Evidence 5-12
Attitudes and Rationalization to Justify a Fraud 3-32 5.3 Procedures for Gathering Audit Evidence 5-13
Fraud Risk Assessment Process 3-32 Inspection of Documents and Assets 5-14
Audit Decision-Making Example 3-35 Observation 5-15
Inquiry 5-15
Confirmation 5-16
Recalculation 5-19
Reperformance 5-19
4 Risk Assessment Part II: Analytical Procedures 5-20
Understanding the Client 4-1 Scanning 5-20
Audit Data Analytics and Automated Tools 5-20
4.1 Understand the Entity and the Industry 4-3 5.4 Using the Work of Others 5-22
Gain an Understanding of the Entity 4-4 Using the Work of an Auditor’s Specialist 5-23
Gain an Understanding of the Industry and Business Using the Work of Internal Auditors 5-25
Environment 4-6 Using the Work of Another Auditor 5-27
Procedures Performed to Gain an Understanding of 5.5 Documentation—Audit Working Papers 5-29
the Client 4-8 Permanent File 5-29
Compliance with Laws and Regulations 4-8 Current File 5-30
4.2 Client Approaches to Measuring Performance 4-11 Examples of Working Papers 5-31
Profitability 4-11 Audit Decision-Making Example 5-36
Liquidity, Solvency, and Cash Flow 4-12
4.3 Analytical Procedures 4-13
Comparisons 4-14
6 Gaining an Understanding of
Trend Analysis 4-14 the Client’s System of Internal
Common-Size Analysis 4-15 Control 6-1
Ratio Analysis 4-16
Software Tools for Performing Analytical 6.1 Internal Control Defined 6-3
Procedures 4-19 The COSO Framework 6-4
Factors to Consider When Conducting Inherent Limitations 6-6
Analytical Procedures 4-19 Steps for Understanding and Assessing Control Risk 6-6
Audit Data Analytics During Risk Assessment 4-20 6.2 Entity-Level Internal Controls 6-8
4.4 Related Parties 4-21 The Control Environment 6-9
Risk Associated with Related Parties 4-21 Risk Assessment 6-11
Audit Procedures 4-22 Control Activities 6-13
4.5 Corporate Governance 4-23 Information and Communication 6-16
Audit Committee 4-24 Monitoring Activities 6-17
Public Company Requirements 4-24 Internal Control in Small Entities 6-19
4.6 Internal Control, Information Technology, and 6.3 Transaction-Level Internal Controls 6-20
the Client’s Digital Mindset 4-26 Example Transaction Flows—Sales Process 6-21
System of Internal Controls 4-26 6.4 Information Technology (IT) Controls 6-23
Information Technology 4-26 Benefits and Risks of IT Systems 6-23
Client’s Digital Mindset 4-27 IT General Controls 6-25
4.7 Closing Procedures 4-28 IT Application Controls 6-26
Audit Decision-Making Example 4-31 IT-Dependent Manual Controls 6-28

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xviii TAB LE OF CON TEN TS

6.5 Documenting Internal Controls 6-30 Step 2: What Is the Audit Problem You Are Trying to
6.6 Identifying Strengths and Weaknesses in a Solve? 8-5
System of Internal Controls 6-33 Step 3: Gather Information and Evidence 8-6
Internal Controls and Audit Strategy 6-33 Step 4: Perform the Analysis and Evaluate
Evaluating Internal Control Weaknesses 6-33 the Results 8-7
6.7 Use of a Service Organization by an Audit Client 6-34 Step 5: Draw an Audit Conclusion 8-8
Significant User Entity Controls over the Service Audit Documentation 8-9
Organization 6-35 8.2 Steps Associated with Accessing and Preparing
User Auditor Obtains a Systems Organization and Data for Audit Data Analytics 8-11
Controls (SOC) 1 Report 6-36 Are the Data Complete? 8-11
What Is a Soc 2 Report and How Does It Differ from a Do the Data Need to Be Cleaned? 8-12
SOC 1 Report? 6-38 Key Questions to Be Addressed in Evaluating
Audit Decision-Making Example 6-40 the Relevance and Reliability of Data Used in
Audit Data Analytics 8-12
7 Risk Response: Performing Tests 8.3 Using Audit Data Analytics as a Risk
Assessment Procedure 8-13
of Controls 7-1
Understanding the Risk Analysis Decision Tree 8-14
What Do We Mean by Notable Items? 8-15
7.1 Identify Relevant Transaction-Level Controls and
Tools for Searching for Notable Items 8-15
Determine Preliminary Audit Strategy 7-3
What to Do When ADA Identifies a Large Number of
Preventive and Detective Controls 7-4
Items for Further Consideration 8-16
Manual and Automated Controls 7-7
8.4 Applying Audit Data Analytics as a Risk Assessment
Determine Preliminary Audit Strategy 7-8
Procedure 8-18
7.2 Procedures for Testing Controls 7-10
Cluster Analysis 8-18
Inquiry 7-10
Matching Information in Key Data Fields 8-26
Observation 7-10
Regression Analysis 8-31
Inspection of Physical Evidence 7-10
Visualization 8-35
Reperformance 7-11
8.5 Using Audit Data Analytics as a Substantive
Tests of Software Controls 7-11
Procedure 8-38
7.3 Selecting and Designing Tests of Controls 7-12
8.6 Applying Audit Data Analytics as a Substantive
Selecting the Controls for Testing 7-13
Procedure 8-39
Selecting Audit Procedures 7-15
Validating Sales Revenue and Accounts Receivable with
The Extent of Tests of Controls 7-16
Subsequent Cash Receipts 8-39
Timing of Tests of Controls 7-20
8.7 Artificial Intelligence and Machine Learning 8-44
Benchmarking 7-21
Examples from Audit Practice 8-45
Selecting and Designing Tests of Controls—A Summary 7-22
The Role of Professional Judgment in the AI
7.4 Results of the Auditor’s Testing 7-25
Environment 8-46
Tests of Controls and Audit Strategy 7-27
Audit Decision-Making Example 8-48
Classifying Control Exceptions 7-27
7.5 Using a Soc 1, Type 2 Report 7-29
Section 1: Independent Service Auditor’s Report 7-31 9 Risk Response: Performing
Section 2: Management’s Assertion 7-34 Substantive Procedures 9-1
Section 3: Management’s Description of the System 7-36
Section 4: Control Descriptions, Related Controls, 9.1 Audit Risk and Substantive Procedures 9-3
and Tests of Operating Effectiveness 7-38 9.2 Risk Response at the Financial Statement Level 9-5
7.6 Documenting Conclusions 7-41 Auditor’s Understanding of the Entity’s Control
7.7 Management Letters 7-43 Environment 9-6
Audit Decision-Making Example 7-46 Risk of Material Misstatement Due to Fraud 9-6
9.3 Nature of Substantive Procedures 9-7
8 Audit Data Analytics 8-1 Determining the Purpose of an Audit Procedure 9-7
Determining the Type of Substantive Procedure 9-8
8.1 Applying the Audit Decision-Making Initial Procedures 9-9
Framework to Audit Data Analytics 8-3 Substantive Analytical Procedures 9-10
Step 1: Obtain Company Background Information Tests of Details 9-14
and Data 8-4 ADA and Substantive Procedures 9-15

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  TA B LE OF CONTENTS xix

9.4 Timing of Substantive Procedures 9-17 10.7 Applying Nonstatistical Sampling for
During an Interim Period 9-17 Substantive Procedures 10-27
During Year-End 9-18 Step 5: Choose the Audit Sampling
9.5 Extent of Substantive Procedures 9-19 Technique 10-27
Auditing an Entire Population 9-20 Step 6: Determine Sample Size Using
Auditing Select Items from a Population 9-21 Professional Judgment 10-27
9.6 Auditing Accounting Estimates 9-22 Step 7: Judgmentally Select Representative
Inherent Risk Factors 9-22 Sample 10-28
Possible Management Bias 9-23 Step 8: Apply Audit Procedures 10-28
Risk Assessment Procedures for Step 9: Evaluate Results Judgmentally 10-29
Accounting Estimates 9-24 Step 10: Document Conclusions 10-31
Identifying and Assessing the Risks of Material Appendix 10A: Applying Classical Variables
Misstatement 9-26 Sampling for Substantive Procedures 10-32
Risk Response Procedures for Accounting Estimates 9-26 Step 5: Apply Classical Variables Sampling 10-32
Overall Evaluation and Documentation 9-28 Step 6: Determine the Sample Size 10-33
9.7 Documenting Results of Substantive Step 7: Select a Random Sample 10-37
Procedures 9-30 Step 8: Apply Audit Procedures 10-37
Audit Decision-Making Example 9-33 Step 9: Evaluate the Sample Results 10-37
Step 10: Document Results 10-39
10 Risk Response: Audit Sampling for Audit Decision-Making Example 10-42
Substantive Procedures 10-1
11 Auditing the Revenue Process 11-1
10.1 Audit Sampling versus Audit Data Analytics 10-3
10.2 Sampling Risk and Nonsampling Risk 10-4 11.1 Understanding the Revenue Process 11-3
Risk of Incorrect Acceptance 10-5 Understand the Nature of the Revenue Process 11-4
Risk of Incorrect Rejection 10-5 Revenue Transactions 11-4
Nonsampling Risk 10-5 11.2 How Audit Planning Decisions Affect the
10.3 Statistical versus Nonstatistical Sampling 10-7 Assessment of Inherent Risk 11-5
Population and Sampling Unit 10-7 Understanding the Entity and Its
Sampling Methods 10-8 Environment 11-6
10.4 Factors That Influence the Sample Determining Inherent Risk in the Revenue
Size—Substantive Procedures 10-10 Process 11-10
Tolerable Misstatement 10-10 11.3 Control Activities for Credit Sales 11-14
Desired Level of Assurance 10-11 Example Transaction Flows—Credit Sales 11-15
Expected Misstatement in the Population 10-11 Evaluate What Can Go Wrong (WCGW) and Identify
Stratification of the Population 10-12 Key Controls—Credit Sales and Accounts
10.5 A Basic Framework for Audit Sampling 10-12 Receivable 11-17
Step 1: Determine the Objectives of the Substantive 11.4 Control Activities for Cash Receipts 11-20
Procedure 10-14 Example Transaction Flows—Cash Receipts 11-20
Step 2: Determine the Substantive Procedures to Evaluate WCGW and Identify Key Controls—Cash
Perform 10-14 Receipts 11-22
Step 3: Determine Whether to Audit a Sample 11.5 Control Activities in a “Paperless” Revenue
or the Entire Population 10-14 System 11-24
Step 4: Define the Population and Sampling Unit 10-15 Initiating an ERS Transaction 11-25
10.6 Applying Probability-Proportionate-to-Size Shipping Goods 11-25
Sampling for Substantive Procedures 10-15 Recording Sales and Receivables 11-25
Step 5: Choose the Audit Sampling Technique 10-15 Electronic Cash Receipt 11-25
Step 6: Determine Sample Size 10-16 Internal Controls in an ERS System 11-26
Step 7: Randomly Select Representative Sample 10-18 11.6 Control Activities for Sales Adjustments
Step 8: Apply Audit Procedures 10-20 and Revenue Process Disclosures 11-27
Step 9: Evaluate Results Statistically and Granting Sales Returns and Allowances 11-27
Judgmentally 10-20 Determining Uncollectible Accounts 11-28
Step 10: Document Conclusions 10-25 Other Controls in the Revenue Process 11-28
Summary of PPS Sampling 10-26 Preliminary Audit Strategy 11-29

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xx TAB LE OF CON TEN TS

11.7 Tests of Controls in the Revenue Process and 12.8 Substantive Procedures for the Purchasing
Audit Strategy 11-30 Process 12-29
Tests of Controls in the Revenue Process 11-30 Initial Procedures 12-30
Fraud Risk Assessment 11-31 Substantive Analytical Procedures 12-31
Audit Data Analytics as a Risk Assessment Procedure 11-32 Audit Data Analytics as a Substantive Procedure 12-31
The Risk of Material Misstatement and Audit Strategy 11-32 Tests of Details of Transactions 12-31
11.8 Substantive Procedures for the Revenue Tests of Details of Balances 12-33
Process 11-33 Tests of Details of Presentation 12-33
Initial Procedures 11-36 Draw a Final Conclusion 12-34
Substantive Analytical Procedures 11-36 Appendix 12A: Auditing Payroll 12-35
Audit Data Analytics as a Substantive Procedure 11-36 12.9 Explain the Nature of Payroll Transactions and
Tests of Details of Transactions 11-37 Balances 12-36
Tests of Details of Balances 11-38 Understand the Nature of the Payroll Process 12-36
Tests of Details of Presentation 11-43 Payroll Transactions 12-36
Draw a Final Conclusion 11-44 12.10 How Audit Planning Decisions Affect
Audit Decision-Making Example 11-46 the Assessment of Inherent Risk 12-37
Understanding the Entity and Its Environment 12-37

12 Auditing the Purchasing and Determining Inherent Risk in the Payroll Process 12-39
12.11 Control Activities for Payroll 12-40
Payroll Processes 12-1 Example Transactions Flows—Payroll Transactions 12-40
Evaluate What Can Go Wrong (WCGW) and Identify Key
12.1 Auditing Purchase Transactions and Balances 12-2 Controls—Payroll 12-42
Overview of Auditing Purchases 12-2 Preliminary Audit Strategy 12-44
Understand the Nature of the Purchasing Process 12-3 12.12 Tests of Controls in the Payroll Process and Audit
Purchase Transactions 12-4 Strategy 12-45
12.2 How Audit Planning Decisions Affect the Tests of Controls for Payroll 12-45
Assessment of Inherent Risk 12-5 Fraud Risk Assessment 12-46
Understanding the Entity and Its Environment 12-5 Audit Data Analytics Used in Fraud Risk Assessment 12-46
Determining Inherent Risks in the Purchasing Process 12-9 The Risk of Material Misstatement and Audit Strategy 12-46
12.3 Control Activities for Purchases 12-12 12.13 Substantive Procedures for the Payroll
Example Transaction Flows—Credit Purchases 12-12 Process 12-47
Evaluate What Can Go Wrong (WCGW) and Identify Key Initial Procedures 12-48
Controls—Purchases and Accounts Payable 12-15 Substantive Analytical Procedures 12-49
12.4 Control Activities for Cash Disbursements 12-18 Audit Data Analytics as a Substantive Procedure 12-49
Example Transaction Flows—Cash Disbursements 12-18 Tests of Details of Transactions 12-49
Evaluate What Can Go Wrong (WCGW) and Tests of Details of Balances 12-50
Identify Key Controls—Cash Disbursements 12-20 Tests of Details of Presentation 12-50
12.5 Evaluated Receipt Settlement (ERS) 12-21 Draw a Final Conclusion 12-51
Initiating an ERS Transaction 12-22 Audit Decision-Making Example 12-53
Receiving Goods 12-22
Recording Payables 12-22
Electronic Payment 12-22
13 Auditing Cash, Inventory, and
Internal Controls in an ERS System 12-23 Related Income Statement
12.6 Control Activities for Purchase Adjustments and Accounts 13-1
Purchasing Process Disclosures 12-24
Purchase Returns and Allowances 12-24 13.1 Auditing Cash and Cash Equivalents 13-3
Other Controls in the Purchasing Process 12-25 How Audit Planning Decisions Affect the Assessment of
Preliminary Audit Strategy 12-25 Inherent Risk 13-3
12.7 Tests of Controls in the Purchasing Process and Understanding Internal Controls and Developing a
Audit Strategy 12-26 Preliminary Audit Strategy 13-4
Tests of Controls in the Purchasing Process 12-26 Assessing Control Risk, Fraud Risk, and RMM and
Fraud Risk Assessment 12-27 Determining a Final Audit Strategy 13-5
Audit Data Analytics as a Risk Assessment Procedure 12-28 Substantive Procedures for Cash and Cash
The Risk of Material Misstatement and Audit Equivalents 13-6
Strategy 12-28 Draw a Final Conclusion 13-13

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  TA B LE OF CONTENTS xxi

13.2 Auditing Inventory 13-13 15.5 Management Representation and Communication

How Audit Planning Decisions Affect the Assessment of with Those Charged with Governance 15-23
Inherent Risk 13-14 Management Representation Letter 15-23
Understanding Internal Controls and Developing a Communication with Those Charged with Governance 15-26
Preliminary Audit Strategy 13-17 Audit Decision-Making Example 15-30
Assessing Control Risk, Fraud Risk, and RMM and
Determining a Final Audit Strategy 13-19
Substantive Procedures for Inventory 13-21 16 Reporting on the Audit 16-1
Audit Decision-Making Example 13-31
16.1 Standard Unmodified/Unqualified Audit
Report 16-3
14 Auditing Investing and Financing 16.2 Additional Wording for the Standard Unmodified
Activites Report 16-9
14-1
Going Concern Section 16-9
14.1 Auditing Property, Plant, and Equipment 14-2 Emphasis Added at Discretion of the Auditor 16-10
How Audit Planning Decisions Affect the Assessment of Consistency of Financial Statements 16-11
Inherent Risk 14-3 16.3 Opinion Based in Part on the Report of Another
Understanding Internal Controls and Developing a Auditor 16-13
Preliminary Audit Strategy 14-5 16.4 Modifying the Audit Opinion 16-15
Assessing Control Risk and Fraud Risk, and Determining a Departure from Applicable Financial Reporting
Final Audit Strategy 14-7 Framework 16-16
Substantive Procedures for Property, Plant, and Scope Limitation 16-18
Equipment 14-7 16.5 Subsequently Discovered Facts 16-24
Draw a Final Conclusion 14-12 Subsequently Discovered Facts That Become Known
14.2 Auditing Financing Activities 14-13 Before the Report Release Date 16-24
How Audit Planning Decisions Affect the Assessment of Subsequently Discovered Facts That Become Known After
Inherent Risk 14-13 the Report Release Date 16-26
Understanding Internal Controls and Developing a 16.6 Reports on the Audit of ICFR 16-28
Preliminary Audit Strategy 14-16 Standard Unqualified Opinion on ICFR 16-28
Assessing Control Risk and Fraud Risk, and Determining a Modified Opinion on ICFR 16-30
Final Audit Strategy 14-17 Integrated Audits for Private Companies 16-32
Substantive Procedures for Long-Term Debt 14-18 16.7 Preparation, Compilation, and Review
Substantive Procedures for Stockholders’ Equity 14-21 Engagements 16-32
Audit Decision-Making Example 14-25 Preparation of Financial Statements 16-33
Compilation of Financial Statements 16-33
Review of Financial Statements 16-35
15 Completing the Audit 15-1 Audit Decision-Making Example 16-39

15.1 Audit Procedures for Loss Contingencies 15-3 Cloud 9 Inc. Audit A-1
APPENDIX A  
Accounting for Loss Contingencies 15-3 Cloud 9 Inc. Company Background A-1
Auditing Loss Contingencies 15-4 Personnel A-2
Legal Letter 15-4 Financial Information A-2
15.2 Subsequent Events 15-7 Transcript of Meeting with David Collier A-4
Accounting for Subsequent Events 15-8
AUDITING AND ASSURANCE STANDARDS AS-1
Auditing Subsequent Events 15-9
15.3 Engagement Wrap-Up 15-11 GLOSSARY G-1
Final Analytical Procedures 15-11 INDEX I-1
Final Evaluation of Audit Findings 15-12
Completion of Working Paper Review 15-17
Engagement Quality Review 15-18
Completion of Documentation 15-19
15.4 Going Concern 15-20
Management Responsibility 15-20
Auditor Responsibility 15-21
Audit Procedures to Evaluate Going Concern 15-21

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CHAPTER 1
Introduction and Overview of
Audit and Assurance
The Audit Process

Overview of Audit and Assurance

(Chapter 1)

Professionalism and Professional Responsibilities

(Chapter 2)

Client Acceptance/Continuance and Risk Assessment

(Chapters 3 and 4)

Gaining an Identifying Significant

Setting Planning
Understanding of Accounts and
Materiality
the Client Transactions

Gaining an Understanding
Making Preliminary
of the System of Internal Control
Risk Assessments
(Chapter 6)

Developing Responses to Risk and an Audit Strategy

Audit Data Analytics

Audit Evidence
(Chapter 5)

(Chapter 8)
Performing Tests of Controls Performing Substantive Procedures
(Chapter 7) (Chapter 9)

Audit Sampling for Substantive Procedures

(Chapter 10)

Auditing the Auditing the Purchasing Auditing Cash and Auditing Investing and
Revenue Process and Payroll Processes Inventory Financing Activities
(Chapter 11) (Chapter 12) (Chapter 13) (Chapter 14)

Completing and Reporting on the Audit

(Chapters 15 and 16)

Procedures Performed Near Drawing Audit

Reporting
the End of the Audit Conclusions

1-1

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1-2 C h a pt er 1 Introduction and Overview of Audit and Assurance

Learning Objectives

LO 1 Differentiate among assurance, attestation, and LO 6 Explain the concepts of reasonable assurance and
audit services. materiality, and the nature of an unqualified/
unmodified report on the audit of financial statements.
LO 2 Describe the different types of assurance
services. LO 7 Explain the concept of reasonable assurance and
the nature of an unqualified report on internal controls
LO 3 Explain the demand for audit and assurance
over financial reporting.
services.
LO 8 Discuss the audit expectation gap.
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.

Auditing and Assurance Standards

PCAOB AUDITING STANDARDS BOARD (ASB)

Framework for Audits of Public Companies Framework for Audits of Private Companies
AS 2201 An Audit of Internal Control Over Financial AU-C 200 Overall Objectives of the Independent Auditor
Reporting That Is Integrated with An Audit of Financial and the Conduct of an Audit in Accordance with Generally
Statements Accepted Auditing Standards
AS 3101 The Auditor’s Report on an Audit of Financial AU-C 700 Forming an Opinion and Reporting on
Statements When the Auditor Expresses an Unqualified Financial Statements
Opinion

This text is designed to provide you with the opportunity to learn about auditing by using a practical, problem-based approach.
Each chapter begins with some information about an example audit client—Cloud 9 Inc. (Cloud 9). The chapter then provides the
underlying concepts and background information needed to deal with this client’s situation and the problems facing its auditor. As
you work through the chapters, you will gradually build your knowledge of auditing by studying how the contents of each chapter are
applied to Cloud 9. The end-of-chapter exercises and problems also provide you with the opportunity to study other aspects of Cloud
9’s audit, in addition to applying the knowledge gained in the chapter to other practical examples.

Cloud 9 Continuing Case

Cloud 9 Inc., a listed company (publicly traded) in the United 2000s, Ron’s business employed 20 people full-time, most of whom
States, is looking to expand. Stotez Shoes was seen as a potential work in production. There are also several seasonal employees and
target. part-time staff in the retail outlet in Seattle, particularly during
In 1985, Ron Stotez started Stotez Shoes in Seattle, Washington, busy periods.
manufacturing and retailing customized basketball shoes. Ron In February 2023, Ron received a call from Chip Masters, the
borrowed from the bank to start the company, using his house as senior vice president of Cloud 9. Chip expressed an interest in buy-
security. Over the years, he worked very hard to establish a profit- ing Stotez Shoes. Ron wants to retire, and his children are starting
able niche in the highly competitive sport shoe market. Ron repaid to fight among themselves about who is going to take over their
the bank in 1999, and he vows to never borrow again. father’s business. Ron is looking for an exit strategy, but he does not
As the business grew, Ron’s wife and three adult children want Chip to know that. He asks if Chip is ready to talk about the
started to work with him, with responsibility for administration, price. Chip says he is, but first he needs to see the audited financial
marketing and sales, production, and distribution. By the early statements for Stotez Shoes.

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  1.1 Assurance, Attestation, and Audit Services 1-3

Ron asks for some time. He tells Chip that he first needs to talk has never bothered with sophisticated financial arrangements. He
to his family and will then get back to him. When Ron puts the phone is still running his business as a sole proprietor (not a corporation),
down, he immediately calls his friend Ernie Black, who is a CPA. For and his wife does all the tax returns. Ron is in a panic—he wants to
years, Ernie has been suggesting to Ron that his business affairs need sell Stotez Shoes, but what is he going to do about Chip’s request for
attention. Ron is good at making deals and working hard, but he audited financial statements?

Chapter Preview: Audit Process in Focus

The purpose of this chapter is to provide an overview of assurance, attestation, and audit
services. While the focus of this text is the audit of financial statements, in this chapter we
define assurance and attest engagements, and differentiate among the types of assurance en-
gagements. We also discuss why there is a demand for audit and assurance services, and then
identify the separate roles of the financial statement preparer and the auditors.
In addition, we introduce regulatory bodies and other organizations that impact the audit
profession. We also explain what is communicated in the auditor’s report as well as discuss
the audit expectation gap.

Cloud 9 Continuing Case

Chip Masters has asked Ron Stotez for audited financial state- Ernie explains to Ron that there are several services that peo-
ments of Stotez Shoes. Ron has never had an audit and is not sure ple call “audits” that are different from financial statement audits.
what it involves. He has heard about tax audits, safety audits, ef- However, all these services, including financial statement audits,
ficiency audits, as well as financial statement audits. Are they all can be defined as assurance services.
the same thing?

1.1 Assurance, Attestation, and Audit Services

LEARNING OBJECTIVE 1
Differentiate among assurance, attestation, and audit services.

The terms assurance, attestation, and auditing are sometimes used interchangeably, but they
actually represent different types of services. The services have the following characteristics
in common.

• A
 n independent accounting firm is taking information prepared by someone else and
then comparing it to an established set of criteria.
• T
 he independent accounting firm provides a written report about the results of the ser-
vice performed.
• T
 he services add credibility, or integrity, to the information, which makes it more useful
for decision making.

An everyday example of this process would be needing a physical exam from a medical doctor
before joining a sports team. The doctor would be the independent professional. The doctor
would conduct the physical exam and compare your results to standards considered accept-
able for someone of your age and height. At the completion of the physical exam, the doctor
would provide you with written documentation stating that you were in good physical condi-
tion to play on the sports team. The service provided by the doctor improves the “integrity” of
your claim that you are in good condition to participate on the team.
The relationship of assurance, attestation, and auditing services is shown in Illustra-
tion 1.1 and resembles overlapping umbrellas. We will refer to Illustration 1.1 as we discuss
the three services in more detail.

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ILLUSTRATION 1.1
Relationship of assurance, Assurance Services
attestation, and auditing Website security
services

Attestation Services
Review of historical financial statements
System and Organization Controls (SOC) Report
Risk advisory Data
services Examination Audit Services integrity
Historical Internal
of financial Agreed-upon
financial controls
forecast procedures
statements

AU-C 200 Overall Objectives of Audit Services

the Independent Auditor and the
Conduct of an Audit in Accor- Audit services are the most specific and narrow of the three services; therefore, it is the smallest um-
dance with Generally Accepted brella in Illustration 1.1. Two primary types of audit services are an audit of financial statements
Auditing Standards and an audit of internal controls over financial reporting (ICFR). The purpose of an audit of finan-
cial statements is to provide financial statement users with an opinion by the auditor on whether
audit services services by an the financial statements are presented fairly in accordance with an applicable financial reporting
independent CPA that provide framework. The purpose of an audit of ICFR is to provide financial statement users with an opinion
financial statement users with by the auditor on the design and operating effectiveness of ICFR. These audit services enhance the
(1) an opinion on whether the degree of confidence that intended users can place in the financial statements (AU-C 200.04).
financial statements are presented Some key concepts in these descriptions require further explanation.
fairly, in all material respects, in
• The financial statements refer to historical financial statements of either a public or pri-
accordance with an applicable
financial reporting framework vate company.
and, in some cases, (2) an opinion • T
 he auditor refers to an independent certified public accountant, or CPA, who is qualified
on the effectiveness of internal to perform the audit service. The only professional who can sign an audit report on histor-
controls over financial reporting ical financial statements and internal controls for a public or private company is a CPA.
(ICFR), which enhance the de-
• The applicable financial reporting framework refers to the set of standards used in prepar-
gree of confidence that intended
users can place in the financial ing the historical financial statements, such as generally accepted accounting principles
statements (GAAP) in the United States, International Financial Reporting Standards (IFRS), or gov-
ernmental accounting standards for governmental entities.
• The intended users refer to any group that will be using the financial statements to make
decisions, such as investors and creditors.

Attestation Services
Companies produce financial information that goes beyond historical financial statements.
Examples include financial forecasts and detailed schedules for specific accounts. When CPAs
are hired to report on the integrity of this type of financial information, it is called an attesta-
attestation services services tion service. Attestation services are performed when an independent practitioner, or CPA,
performed when an independent is engaged to issue a report on subject matter that is the responsibility of another party.
practitioner, or CPA, is engaged As depicted in Illustration 1.1, audit services fall under the umbrella of attestation ser-
to issue a report on subject matter vices, but so do other services that involve a CPA reporting on other financial information.
that is the responsibility of an- Note the use of the term practitioner in the definition of attestation services. The term practitioner
other party
is used rather than auditor because attestation services encompass more than just the audit of
historical financial statements and internal controls.

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  1.1 Assurance, Attestation, and Audit Services 1-5

Another example of an attestation service is a review of historical financial statements. Small

private companies often do not want or need a service as extensive as an audit. In a review en-
gagement, the practitioner expresses limited assurance that no material modifications need to
be made to the financial statements. So a review is a less extensive and, therefore, less expensive
service that can be very useful for smaller private companies. A more detailed discussion of a
review is presented in Chapter 16.
One final example is a System and Organization Controls Report, referred to as a SOC 1
Report. Many clients outsource key accounting functions, such as payroll, to an outside service
organization. An independent CPA can evaluate and report on the controls at the service orga-
nization. This SOC reporting helps to build trust and confidence in the services provided by the
service organization. SOC reporting is discussed further in Chapters 6 and 7.

Assurance Services
The largest umbrella in Illustration 1.1 represents assurance services. Assurance services are assurance services indepen-
independent professional services that improve the quality of information, or its context, for dent professional services that
decision makers. Let’s discuss some key concepts in this definition: improve the quality of informa-
tion, or its context, for decision
• Independent. This term is common to audit, attestation, and assurance services. It im- makers
plies that the service is performed by someone who was not involved with the creation
of the information and who is objective in the evaluation of the information. (Chapter 2
covers independence in more depth.)
• Quality. This refers to the relevance and reliability of the information.
• Information. This refers to subject matter that can be financial or nonfinancial, histori-
cal or prospective, standalone or entire systems of data, internal or external to a company.
Essentially, the concept of assurance services encompasses any service that a professional pro-
vides that involves improving the quality of information that was prepared by someone else.
Both attestation and audit services fall under the broad term of assurance services, and there-
fore are depicted under the assurance umbrella in Illustration 1.1.
While the audit of a company’s historical financial statements and internal controls is
the focus of this text, there are other types of audit and assurance services that warrant some
discussion. The next section provides a description of these different types of services.

Professional Environment Becoming a CPA

Certified public accountants (CPAs) are the only licensed accounting the exam at a time and have 18 months to pass all four parts once
professionals in the United States. CPA licenses are not issued at the the first part has been successfully passed.
national level but at the state level. To become a licensed CPA, an in- In January 2024, a new model for the CPA exam is expected to
dividual must earn the three Es—Education, Exam, and Experience.1 launch. It will continue to be a four-section exam. Three sections
The first step is meeting the education requirements set by a state will cover the core topics of accounting, audit, tax, and technology.
board of accountancy, which vary from state to state. All states require a The fourth section will be a specialty area chosen by the exam can-
bachelor’s degree and completion of 150 hours of total college credit to didate. The specialty areas are business reporting and analysis, in-
be a licensed CPA. Within the 150 hours, some states require comple- formation systems and controls, and tax compliance and planning.
tion of courses in specific subject areas in accounting, business, or eth- To keep up to date with these future changes to the CPA exam, visit
ics. (See the discussion in this chapter on National Association of State the CPA Evolution initiative website.
Boards of Accountancy (NASBA) and State Boards of Accountancy.) The final step is work experience. Work experience require-
The second step is passing the Uniform CPA Examination, ments also vary by state. In general, states require one to two years
or CPA exam. The CPA exam is accepted for CPA licensure by all of work experience under the supervision of a licensed CPA. The
states, which is why it is called the “uniform” CPA exam. Currently, work experience can be earned either before, during, or after sit-
the CPA exam consists of four sections: Auditing and Attestation ting for the CPA exam, but some restrictions may apply for when
(AUD), Business Environment and Concepts (BEC), Financial the experience can be earned.
Accounting and Reporting (FAR), and Regulation (REG). The A state board of accountancy will only issue a license to prac-
testing time for each section is four hours, for a total test time tice after all three Es have been earned. The purpose of the entire
of 16 hours. Each part of the exam consists of multiple-choice licensure process is to ensure that individuals possess the level of
questions and task-based simulations, and the BEC section also knowledge and the skills necessary to perform the duties of a CPA
requires written responses. CPA candidates can take one part of and to protect the public interest.

1
American Institute of Certified Public Accountants, The Uniform CPA Examination: Purpose and Structure (2018).

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1-6 C h a pt er 1 Introduction and Overview of Audit and Assurance

Before You Go On
1.1 Who are intended users of assurance services?
1.2 What does “independent” mean in the context of assurance services?
1.3 What is an example of an “applicable financial reporting framework”?

1.2 Different Assurance Services

LEARNING OBJECTIVE 2
Describe the different types of assurance services.

In this section, we provide an overview of the most common types of assurance services that
a practitioner can provide. We will discuss financial statement audits, compliance audits, op-
erational (performance) audits, and internal audits.

Financial Statement Audits

As stated earlier, the purpose of an audit of financial statements 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 confidence that intended users can place in the financial state-
ments (AU-C 200.04). Within a U.S. context, the applicable financial reporting framework
is typically GAAP.
Public companies, or issuers, in the United States are required by the federal government
to have an annual financial statement audit. Private companies, or non-issuers, are not required
by the U.S. government to have an annual financial statement audit, but often other interested
users request that a private company provide audited financial statements. A good example
would be a lender (bank or other financial institution) requesting audited financial statements
when considering whether to lend money to the private company. Audited financial statements
add a degree of confidence that helps the lender make an informed lending decision.
Public companies are also required to prepare quarterly financial information, referred to
as interim financial statements. Although these interim financial statements are not required
to be audited, they are required to be reviewed by the company’s external auditors. Recall that
a review is less extensive than an audit. In a review, the auditor does not provide an opinion
on whether the interim financial statements are presented fairly. Instead, the auditor will only
state if there are any material modifications that should be made for the interim financial
statements to be in conformity with the appliable financial reporting framework.
In the course of your accounting studies, you have probably seen an annual report issued
by a public company. These annual reports can be found on a company’s website and i­ nclude
other information besides the company’s financial statements, such as a management discus-
sion and analysis section. Are the auditors required to audit this other information included
in the annual report? The answer is no. The auditors are only required to audit the financial
statements and related notes. However, the auditors have a responsibility to read the other
information included in the annual report to ensure it is not inconsistent with or contradictory
to information included in the financial statements.

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  1.2 Different Assurance Services 1-7

Cloud 9 Continuing Case

Ron is not running a corporation. He operates his customized Ernie agrees that Ron does not have to follow the same rules,
basketball shoe business as a sole proprietor. He is aware that but he also tells him that there are auditing standards in place that
big corporations have to be audited. However, because his busi- apply to a company like his. This means that although all the at-
ness is not a publicly traded company, Ron does not believe that tention is usually on corporations, sole proprietors can, and may
he has to have an audit. be required to, have their financial statements audited, too.

Integrated Audit
Certain public companies in the United States are also required to have an audit of internal AS 2201 An Audit of Internal
control over financial reporting (ICFR). The objective in an audit of ICFR is to express an opin- Control Over Financial Reporting
ion on the effectiveness of the company’s system of internal controls over financial reporting That Is Integrated with An Audit
(AS 2201.03). The reason for requiring an audit of ICFR is because effective internal control of Financial Statements
provides reasonable assurance regarding the reliability of financial reporting and the prepara-
tion of financial statements for external purposes (AS 2201.02). Therefore, public companies
are required to have two audits every year, one on the financial statements and one on the
effectiveness of the company’s internal controls.
For efficiency purposes, these two audits are performed at the same time. This is called
an integrated audit. The objectives of the audits are not identical, however, and the auditor integrated audit an audit that
must plan and perform the work to achieve the objectives of each audit (AS 2201.06). Private combines the financial statement
companies are not required by the government to have an audit of ICFR. As mentioned above, audit with an audit of the effec-
other interested users, such as a lender, may require a private company to have an audit of ICFR tiveness of ICFR
along with an audit of the financial statements as a condition for being approved for a loan.

Limitations of an Audit
A financial statement audit is conducted to enhance the reliability and credibility of the
information included in the financial statements. It is not a guarantee that the financial
statements are free from error or fraud. The limitations of an audit are caused by (1) the nature
of financial reporting, (2) the nature of audit procedures, and (3) the need for the audit to be
conducted within a reasonable period of time at a reasonable cost (AU-C 200.A49).
Nature of Financial Reporting The nature of financial reporting refers to the use of
j­ udgment when preparing financial statements. Since you have taken financial accounting cours-
es, think about the estimates that are included in preparing a set of financial statements. Can
you list a few? And think about the judgment required when selecting and applying accounting
methods. For example, depreciating a piece of equipment is an estimate that requires judgment
in selecting a depreciation method and determining a useful life and salvage value. While an
estimate may not be precise, the auditor must evaluate whether the estimate is fairly presented.
Nature of Audit Procedures The nature of audit procedures refers to the reliance on
evidence provided by the client and its management. For example, what if client management
withholds or hides important documents from the auditors? If auditors are unaware of this
situation, they may arrive at an inappropriate conclusion based on incomplete facts. Evidence
may be withheld or modified by perpetrators of fraud. It can be difficult for an auditor to
determine whether a fraud has occurred because documents altered by those committing the
fraud generally hide evidence. Also, auditors often use sampling techniques when gathering
audit evidence. If a sample is not representative of all items available for testing, an auditor
may arrive at an incorrect conclusion.
The nature of audit procedures also refers to the concept of materiality. The Financial materiality the ability of in-
Accounting Standards Board (FASB) defines materiality as follows. formation to influence decisions
that reasonable users make on the
Materiality is entity specific. The omission or misstatement of an item in a financial basis of the financial information
report is material if, in light of surrounding circumstances, the magnitude of the item of a specific reporting entity
is such that it is probable that the judgment of a reasonable person relying upon the
report would have been changed or influenced by the inclusion or correction of the item.
(SFAC No. 8, para QC11)

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1-8 C h a pt er 1 Introduction and Overview of Audit and Assurance

In other words, an error or misstatement in the financial statements is considered material

if it impacts, or changes, the decision-making process of those individuals or groups who are
using the financial statements. Therefore, when planning an audit, auditors select procedures
that are designed to discover material misstatements. Because of time and cost constraints, it
would be impractical for an audit to focus on finding all misstatements.

Need for a Timely Audit The timeliness and cost of an audit refer to the pressures au-
ditors face to complete their audit within a certain time frame at a reasonable cost. While it is
important that auditors do not omit procedures in an effort to meet time and cost constraints,
they may be under some pressure to do so. This pressure will come from clients wanting to is-
sue their financial statements by a certain date, from clients refusing to pay additional fees for
additional audit effort, and from within the accounting firm because of pressures to complete
all audits on a timely basis to avoid incurring costs that may not be recovered. By taking the
time to plan the audit properly, auditors can ensure that adequate time is spent where the risks
of a material error or fraud are greatest.

Compliance Audits
compliance audit an audit A compliance audit involves gathering evidence to determine whether the person or entity
to determine whether the entity under review has followed the rules, policies, procedures, laws, and regulations with which
has conformed with regulations, they must conform. One of the best examples of a compliance audit is an income tax audit.
rules, or processes The Internal Revenue Service (IRS) may conduct an audit of an individual or a company to
determine if tax laws have been followed and the correct amount of tax paid.

Operational (Performance) Audits

operational (performance) Operational (performance) audits are concerned with the economy, efficiency, and effec-
audit an assessment of tiveness of an organization’s activities.
the economy, efficiency and
effectiveness of an organization’s • Economy refers to the cost of inputs, including wages and materials.
operations • E
 fficiency refers to the relationship between inputs and outputs, or the use of the mini-
mum amount of inputs to achieve a given output.
• E
 ffectiveness refers to the achievement of certain goals or the production of a certain
level of outputs.

From an organization’s perspective, it is important to perform well across all three d

­ imensions
and not allow one to dominate. For example, if buying cheap inputs results in an inefficient
production process, efficiency is sacrificed to achieve economic goals. Operational audits are
generally conducted by an organization’s internal auditors (discussed in the next section), or
they may be outsourced to an external accounting firm.

Internal Audits
internal audit a unit within an Internal audits are conducted to provide assurance about various aspects of an organi-
entity which generally evaluates zation’s activities. The internal audit function is typically conducted by employees of the
and improves risk management, ­organization being audited but can be outsourced to an accounting firm. The purpose of an
internal control procedures, internal audit is determined by those charged with governance and management within
and elements of the governance the organization. While the purposes of internal audits vary widely from one organization to
process
another, they are often concerned with evaluating and improving risk management, internal
those charged with control procedures, and elements of the governance process.
governance persons with The internal a­ uditors often conduct operational audits, compliance audits, internal con-
responsibility for overseeing the
trol assessments, and r­ eviews. Many internal auditors are members of the Institute of Internal
strategic direction of the entity
Auditors (IIA). The IIA is an international organization with more than 120,000 members that
and the obligations related to the
accountability of the entity provides guidance and standards to aid internal auditors in their work. When conducting the
financial statement audit, the external auditor may rely on the work done by internal auditors
when evaluating the evidence needed to form an opinion on the financial statements or on
ICFR. A more detailed discussion of how internal auditors may assist with the external audit
is provided in Chapter 5.

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  1.3 Demand for Audit and Assurance Services 1-9

Cloud 9 Continuing Case

Ron is not concerned about internal audits—his business is too ­ oment is to close the deal with Chip Masters, and he still does
m
small for a separate internal audit function. He is also not wor- not know what he will do about the financial statement audit.
ried about compliance and operational audits. His priority at the

Before You Go On
2.1 What is the objective of a financial statement audit?
2.2 Explain the inherent limitations of a financial statement audit.
2.3 What are the three elements of an operational audit?
2.4 What are the most common functions of the internal auditors?

1.3 Demand for Audit and Assurance Services

LEARNING OBJECTIVE 3
Explain the demand for audit and assurance services.

In this section, we provide an overview of the primary financial statement users followed by a
description of why these users may demand an audit of the financial statements.

Cloud 9 Continuing Case

Ron believes that his business has good, reliable financial records. Ernie explains to Ron that many businesses must apply the
Ron’s wife helps him keep tight control of the cash and other as- accounting standards, even if they are not corporations. It all
sets, and together they prepare some simple reports on a regular depends on whether there are individuals or groups who are using
basis. Ron believes he knows exactly what is happening in the the financial statements for decision-making purposes. Ron is a bit
business and monitors the business’s cash flow and profit very worried now—how does he know if he has these users?
closely. However, he has not prepared financial statements that
comply with GAAP. Is this a problem?

Financial Statement Users

Financial statement users include current and potential investors, suppliers, customers, lend-
ers, employees, governments, and the general public. Each of these groups will read the finan-
cial statements for a slightly different reason, as described below.

Investors
Investors generally read financial statements to determine whether they should invest in
the company. They are interested in the return on their investment and are concerned that
the entity will remain a going concern (continue operating) into the foreseeable future.
­Investors may also be interested in the capacity of the company to pay a dividend. Pro-
spective investors read financial statements to determine whether they should buy shares
in the entity.

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1-10 C h a pte r 1 Introduction and Overview of Audit and Assurance

Suppliers
Suppliers may read financial statements to determine whether the company can pay for goods
or services supplied. They are also interested in whether the company is likely to remain a
going concern (is likely to continue to be a customer of the supplier) and continue to pay its
debts when they come due.

Customers
In many business-to-business transactions, customers may read financial statements to d
­ etermine
whether a company they rely on is likely to remain a going concern and meet their needs.

Lenders
Lenders may read financial statements to determine whether an entity is sufficiently credit-
worthy to qualify for a loan and whether it can pay the interest and principal as they come due.

Employees
Employees may read financial statements to determine whether the entity can pay their wages
or salaries and other benefits (for example, pensions). They may also be interested in assessing
the future stability and profitability of the entity, as these affect job security.

Governments
Governments may read financial statements to determine whether the company is comply-
ing with regulations, to evaluate if the company is paying a fair amount of taxes given its
reported earnings, and to gain a better understanding of the company’s activities. A company
in ­receipt of government grants often must provide a copy of its audited financial statements
when ­applying for a grant and when reporting on how grant funds have been spent.

The General Public

The general public may read financial statements to determine whether they should associate
with the company (for example, as a future employee, customer, or supplier) and to gain a
better understanding of the company, what it does, and its plans for the future.

Demand for Audit and Assurance Services

Financial statement users and their needs are many and varied. There are a number of reasons
why some or all of these users would demand an audit of financial statements:

• R  emoteness. Most financial statement users do not have access to the company under
­review. This makes it difficult to determine whether the information contained in the
­financial statements is a fair presentation of the entity and its activities for the relevant
period.
• Complexity. Financial statements are complex, the amounts are often affected by signifi-
cant estimates, and the disclosures often require significant knowledge and experience to
evaluate. Most financial statement users do not have the accounting and legal knowledge
to assess the reasonableness of complex accounting and disclosure choices being made
by the company.
• Competing incentives. Company managers have an incentive to disclose the informa-
tion contained in the financial statements in a way that presents their performance in the
best possible light. Users may find it difficult or impossible to identify when management
is presenting biased information.
• Reliability. Financial statement users are concerned with the reliability of the infor-
mation contained in the financial statements. Since they use that information to make
decisions that have real consequences, it is very important that users can rely on the
information contained in the financial statements.

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  1.4 Preparers and Auditors 1-11

An independent third-party review of the financial statements by a team of auditors, who

have the knowledge and expertise to assess the fairness of the information being presented by
the preparers, helps users address all these issues.
Auditors have access to company records, so they are not remote. Auditors are trained
accountants and have detailed knowledge about the complex technical accounting and dis-
closure issues required to evaluate the choices made by the financial statement preparers.
Independent auditors, whose work is regularly reviewed by regulators, have little incentive
to aid the company in presenting its results in the best possible light. Auditors are concerned
with verifying the information contained in the financial statements is reliable and free from
any material misstatements.
The audit service plays a vital role in maintaining the stability of the U.S. capital markets
and instilling investor confidence. Investors in public companies consider audited informa-
tion reliable, which facilitates the trading of stocks and other financial instruments.

Cloud 9 Continuing Case

Ron tells Ernie that he has no remote users, such as shareholders chase an audit to assure users of the reliability of his business’s
or lenders, and his business is not very complex. He is the owner financial information.
and the manager of Stotez Shoes and therefore has no competing Ernie agrees but points out that there is now a user who is very
incentives. For all these reasons, he has never felt the need to pur- interested in the reliability of the financial information: Chip Masters.

Before You Go On
3.1 Who are the main users of company financial statements?
3.2 Why might financial statement users demand an audit?
3.3 Explain why auditors, or CPAs, are the appropriate professionals to conduct an audit.

1.4 Preparers and Auditors

LEARNING OBJECTIVE 4
Discuss the different roles of the financial statement preparer and the auditor.

In this section, we explain and contrast the different responsibilities of financial statement
preparers and auditors. We provide details of the role that each group plays in ensuring the
financial statements are an accurate representation of the company. Following this discussion
is an overview of the different firms that provide assurance services.

Preparer Responsibility
As you know from your financial accounting courses, the financial statements include the
balance sheet (statement of financial position), income statement (statement of earnings),
statement of cash flows, statement of changes in equity, and accompanying notes. It is the
responsibility of management, with oversight from those charged with governance, to prepare
the financial statements. Specifically, management is responsible for the following.
1. Ensuring the information included in the financial statements is presented fairly and
complies with the applicable financial reporting framework, which in the United States
is most often GAAP.

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1-12 C h a pte r 1 Introduction and Overview of Audit and Assurance

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, and personnel relevant
to the preparation and fair presentation of the financial statements, and any additional
information the auditors may consider relevant to complete the audit.
The preparation of financial statements requires the use of knowledge and judgment on the
part of management. Management is responsible for making estimates for some financial
statement items (e.g., allowance for doubtful accounts or a goodwill impairment) and select-
ing appropriate accounting policies within the applicable financial reporting framework, usu-
ally GAAP (AU-C 200.A2–A3).

Auditor Responsibility
The auditor’s responsibility is to provide an opinion on whether the financial statements
are presented fairly in accordance with the applicable financial reporting framework. It is
­important to emphasize the auditor is not responsible for preparing the financial statements.
Preparation of financial statements is management’s responsibility. Auditors are responsible
for the following.
1. Conducting the audit in accordance with the appropriate auditing standards.
­Auditing standards provide minimum requirements and guidance for the performance of
an audit. Later in this chapter, we discuss the auditing standards that apply to financial
statement audits.
professional skepticism an 2. P
 lanning and performing the audit with professional skepticism. Professional
attitude that includes a question- skepticism is an attitude adopted by auditors when conducting an audit. It means
ing mind, being alert to condi- ­auditors remain independent of the entity, its management, and its staff when com-
tions that may indicate possible pleting the audit work. In a practical sense, it means auditors maintain a question-
misstatement due to fraud or ing mind and thoroughly investigate all evidence presented by their client. Auditors
error, and a critical assessment of
must seek independent evidence to corroborate, or confirm, information provided by
audit evidence
their client. Auditors must be suspicious when evidence contradicts documents held
by their client or inquiries made of client personnel, including management and those
charged with governance.
professional judgment the 3. P
 lanning and performing the audit with professional judgment. Professional
application of relevant training, judgment relates to the application of relevant training, knowledge, and experience that
knowledge, and experience in auditors use while making informed audit decisions in conducting an audit. Auditors must
making informed decisions about use their judgment throughout the entire audit. For example, auditors must use judgment
the courses of action that are when determining if an information source is reliable. They must also use judgment when
appropriate in the circumstances
deciding if enough audit evidence has been gathered to support the audit opinion.
of the audit engagement
The concepts of professional skepticism and professional judgment will be addressed through-
out this text as we learn about the process used by auditors to arrive at their opinion.
It is important to note that the auditor’s opinion on the financial statements is not meant
to be a predictor of the future success of the company. Also, the opinion is not a reflection of
how effectively management is performing its role of running the company. The auditor’s
opinion is simply a report on whether the financial statements are fairly presented in accor-
dance with the applicable financial reporting framework (AU-C 200.A1).

Auditor Skills
Being an auditor requires a broad skill set. Most importantly, an auditor must have exten-
sive knowledge of accounting and auditing standards. When you finish college, you will have
a good foundation of accounting and auditing standards, but your knowledge will become
deeper and more extensive with work experience.
As an auditor, most of your time is spent analyzing client data and making decisions based
on that data. Because accounting firms want to hire individuals who have good ­analytical

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  1.4 Preparers and Auditors 1-13

and critical-thinking skills, one of our goals in this text is to assist in developing these skills.
Illustration 1.2 outlines a framework for audit decision making.

Throughout the text, we will use this framework to critically analyze audit problems. At the end of
every chapter, you will find an Audit Decision-Making Example that uses the framework to walk you
through an audit issue.

ILLUSTRATION 1.2 Audit decision-making framework

Audit Decision-Making Process

? !
Step 1: Step 2: Step 3: Step 4: Step 5:
Obtain company What is the audit Gather Perform the analysis Draw an audit
background information problem you are information and and evaluate the conclusion.
and data. trying to solve? evidence. results.

Employers also want new hires to possess technology skills, especially in the area of data
analytics. You may be familiar with software like Excel, Tableau, or Power BI that is used to
manipulate data and create visualizations. These types of technologies are being used more
frequently in auditing, along with audit software such as Idea and ACL.
It is important to understand that data analytics skills are a subset of critical-thinking skills.
For example, referring to the framework in Illustration 1.2, auditors must first understand what
data are available to assist in solving an audit problem and then determine the best way to an-
alyze and evaluate the data. In some situations, auditors may analyze data without the use of
specialized software. In other instances, it may be best to use data analytics or audit software.
Throughout the text, we discuss situations when auditors may use data analytics or audit
software as a tool to help solve an audit problem. Chapter 8 will dive more deeply into the
concept of audit data analytics after you understand the key audit topics of audit risk, audit
evidence, and the reliability of data.

Assurance Providers
Assurance services are provided by accounting and other consulting firms. The largest
­accounting firms in the United States are known collectively as the “Big 4” firms: Deloitte,
Ernst & Young (EY), KPMG, and PricewaterhouseCoopers (PwC). These four firms
­operate internationally through a network of affiliate companies, and dominate the assurance
market throughout the world.
The next tier of accounting firms is known as the mid-tier. The firms that comprise the
mid-tier have a significant presence nationally, and most have international affiliations. The
mid-tier firms in the United States include, among others, Grant Thornton, BDO USA,
RSM, CBIZ/MHM, and Crowe. These firms service medium-sized and smaller clients.
The next tier of accounting firms are regional and local accounting firms. Regional
firms have a significant presence across multiple states in a geographical region. For exam-
ple, a ­regional firm might have offices located in the southeastern states of Georgia, Flor-
ida, ­Alabama, and Mississippi. The regional offices could be as large as some of the national
firms, with just as many partners and professional staff. Like the national firms, the regional
firms service m ­ edium-sized and smaller clients. Local accounting firms service clients in their
­local areas and range in size from a single-partner firm to several-partner firms. Local firms
­primarily service small-company clients and individuals.
Many of these accounting firms provide non-assurance (or non-audit) services as well as
assurance services. Independence is not required to provide non-assurance services. These
non-assurance services include management consulting, business valuation, mergers and
­acquisitions, tax, and accounting. In Chapter 2, we will discuss rules regarding what types of
non-assurance services, if any, can be provided to audit clients.

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1-14 C h a pte r 1 Introduction and Overview of Audit and Assurance

Finally, note that accounting firms are not the only providers of assurance services. A num-
ber of consulting firms provide assurance services in areas such as website security and envi-
ronmental sustainability reporting. Consulting firms employ staff with a variety of expertise
including, for example, engineers, accountants, IT professionals, scientists, and economists.

Cloud 9 Continuing Case

Ernie stresses to Ron that any financial statements prepared for Ernie also explains to Ron that because his business is rela-
Stotez Shoes are Ron’s responsibility, even if they are audited. tively small, he has a choice between large and small audit firms.
The auditor must be skeptical about the claims made by Ron in Very large companies must choose a Big 4 auditor because often
the financial statements. These claims include, for example, that the other auditors are too small to do the work and still maintain
the assets shown on the balance sheet exist and are valued cor- their independence. If a small audit firm audits a large company,
rectly, and that the balance sheet contains a complete list of the it is open to the criticism that it will not be sufficiently skeptical
business’s liabilities. In other words, the auditor is not just going because it does not want to lose the fees from that client. A large
to believe whatever Ron tells him or her. Auditors must gather audit firm has many other clients, so the fees from any one client
evidence about the financial statements before they can give an are a relatively small part of its revenue. Ron likes the idea that the
audit opinion. smaller audit firms are generally less expensive.

Before You Go On
4.1 Describe management’s responsibilities in terms of the financial statement audit.
4.2 What is professional skepticism?
4.3 What are non-audit services? Provide several examples of non-audit services provided by
accounting firms.

1.5 The Role of Regulators and Regulations

LEARNING OBJECTIVE 5
Identify the roles of different regulators and organizations that affect the audit
profession.

In this section, we discuss the regulators and other organizations that impact the audit process
and the profession.

Securities and Exchange Commission (SEC)

The SEC is a federal government agency whose mission is to protect investors, maintain fair
and efficient markets, and facilitate capital formation (www.sec.gov). A primary task of the
SEC is to enforce and interpret securities laws. Some of the key laws that impact the audit
profession are as follows.

• T
 he Securities Act of 1933 regulates the disclosure of financial information in a compa-
ny’s initial public offering of stock and requires that the financial information be audited.
• T
 he Securities Exchange Act of 1934 regulates the ongoing trading of securities after the
initial public offering and requires the annual audit of a public company’s financial state-
ments and the quarterly review of interim financial information.
• T
 he Sarbanes-Oxley Act of 2002 (SOX) was passed to help restore investor confidence after
a series of corporate accounting scandals were revealed in the late 1990s and early 2000s.

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  1.5 The Role of Regulators and Regulations 1-15

The SOX Act enhanced financial disclosures for public companies and placed more empha-
sis on corporate responsibility. It also created the Public Company Accounting Oversight
Board, or PCAOB, which oversees the audits of public companies.

Public Company Accounting Oversight

Board (PCAOB)
The PCAOB is a nonprofit corporation established through the SOX legislation in 2002. Its
mission is to oversee the audits of public companies to protect the interests of investors
(www.pcaobus.org). Prior to the creation of the PCAOB, the audit profession was self-
regulated. This means that audit professionals, through their own professional organization,
created the auditing standards to be followed in the conduct of an audit. The audit profession
also created a system of peer review for inspecting audit work to ensure auditors were fol-
lowing the standards, and would take enforcement action for auditors who did not perform
audits according to the standards. The audit profession is still self-regulated with respect to
the audits of private companies, but when the PCAOB was created, it took over the regulation
and standard setting for the audits of public companies.
Standards issued by the PCAOB are called Auditing Standards (AS), which provide min-
imum requirements and guidance for auditing services. When the PCAOB was created, it ad-
opted the audit profession’s standards in 2003 as its interim standards, providing a starting
point for the audits of public companies. Since then, the PCAOB has issued its own standards
that supersede, or replace, some of the interim standards.
The topical organization of the PCAOB standards is listed in Illustration 1.3. Through-
out the text, you will be learning some of the specific PCAOB standards in the different topical
categories. The beginning of each chapter will list which PCAOB ­standards will be discussed

General Auditing Standards (1000) ILLUSTRATION 1.3

PCAOB Auditing Standards
1000 General Principles and Responsibilities topical organization
1100 General Concepts
1200 General Activities
1300 Auditor Communications
Audit Procedures (2000)
2100 Audit Planning and Risk Assessment
2200 Auditing Internal Control Over Financial Reporting
2300 Audit Procedures in Response to Risks—Nature, Timing, and Extent
2400 Audit Procedures for Specific Aspects of the Audit
2500 Audit Procedures for Certain Accounts or Disclosures
2600 Special Topics
2700 Auditor’s Responsibilities Regarding Supplemental and Other Information
2800 Concluding Audit Procedures
2900 Post-Audit Matters
Auditor Reporting (3000)
3100 Reporting on Audits of Financial Statements
3300 Other Reporting Topics
Matters Relating to Filings Under Federal Securities Laws (4000)
Other Matters Associated with Audits (6000)

Source: www.pcaobus.org/standards/auditing.

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1-16 C h a pte r 1 Introduction and Overview of Audit and Assurance

in that particular chapter. You will also see references to the PCAOB standards within each
chapter. The reference will begin with “AS” followed by the standard number, a decimal, and
then a paragraph number, such as “AS 2201.06.”
Accounting firms that want to audit public companies must register with the PCAOB.
Registration involves paying fees to the board, complying with the Auditing Standards, and
having their audit work inspected by the board. The PCAOB has disciplinary authority over
registered firms and can impose punishment on accounting firms that do not adhere to stan-
dards. Punishments can include revoking a firm’s registration, imposing monetary fines, and
banning an individual within a firm from auditing public companies.

American Institute of Certified Public

Accountants (AICPA)
The AICPA is a private professional membership organization of CPAs representing the
­accounting profession. There are over 400,000 members in 145 countries (www.aicpa.org).
Some key activities of the AICPA include representing the profession before rule-making bod-
ies, acting as an advocate for the profession before legislative bodies, providing educational
materials to its members, and setting ethical standards for the profession. The AICPA is also
responsible for creating and grading the Uniform CPA Exam.
The AICPA accomplishes many of its activities through its system of committees. One of
the standing committees is the Auditing Standards Board, or ASB. Prior to the creation of the
PCAOB, the ASB was responsible for issuing auditing standards used for the audits of public
and private companies. Since 2003, the task of the ASB has been to issue audit standards
for the audits of private companies and not-for-profit organizations only. Auditing standards
­issued by the ASB are called Statements on Auditing Standards (SAS).
The auditing standards include a comprehensive set of principles underlying an audit
conducted in accordance with generally accepted auditing standards (GAAS), which are pre-
sented in Illustration 1.4. These principles explicitly address the concepts of materiality

ILLUSTRATION 1.4
Principles underlying an audit Purpose of an Audit
conducted in accordance with The purpose of an audit is to provide financial statement users with an opinion by the auditor on
generally accepted auditing whether the financial statements are presented fairly, in all material respects, in accordance with
standards (GAAS) the applicable financial reporting framework. An auditor’s opinion enhances the degree of confi-
dence that intended users can place in the financial statements.

Premise Upon Which an Audit Is Conducted

An audit in accordance with generally accepted auditing standards is conducted on the premise
that management, and where appropriate, those charged with governance, have responsibility:

a. for the preparation and fair presentation of the financial statements in accordance with the
applicable financial reporting framework; this includes the design, implementation, and
maintenance of internal control relevant to the preparation and fair presentation of financial
statements that are free from material misstatements, whether due to fraud or error.
b. to provide the auditor with:
i. all information, such as records, documentation, and other matters that are relevant to
the preparation and fair presentation of the financial statements;
ii. any additional information that the auditor may request from management, and where
appropriate, those charged with governance; and
iii. unrestricted access to those within the entity from whom the auditor determines it
necessary to obtain audit evidence.

Responsibilities of the Auditor

Auditors are responsible for having appropriate competence and capabilities to perform the audit;
complying with relevant ethical requirements; and maintaining professional skepticism and exer-
cising professional judgment, throughout the planning and performance of the audit.

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  1.5 The Role of Regulators and Regulations 1-17

Performing the Audit ILLUSTRATION 1.4

To express an opinion, the auditor obtains reasonable assurance about whether the financial state- (continued)
ments as a whole are free of material misstatement, whether due to fraud or error.

To obtain reasonable assurance, which is a high, but not absolute, level of assurance, the auditor:

• plans the work and properly supervises any assistants.

• determines and applies appropriate materiality level or levels throughout the audit.
• identifies and assesses risks of material misstatement, whether due to fraud or error, based
on an understanding of the entity and its environment, including the entity’s internal control.
• o
 btains sufficient appropriate audit evidence about whether material misstatements exist,
through designing and implementing appropriate responses to the assessed risks.

The auditor is unable to obtain absolute assurance that the financial statements are free of
material misstatement because of inherent limitations, which arise from:

• the nature of financial reporting;

• the nature of audit procedures; and
• t he need for the audit to be conducted within a reasonable period of time and so as to achieve
a balance between benefit and cost.

Reporting the Results of an Audit

Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a
written report, an opinion in accordance with the auditor’s findings, or states that an opinion can-
not be expressed. The opinion states whether the financial statements are presented fairly, in all
material respects, in accordance with applicable financial reporting framework.

Source: AU-C Preface.

and professional skepticism. The principles describe the responsibilities of management, and
those charged with governance of an entity, for the financial statements. The auditor responsi-
bilities also address the important concepts of compliance with ethical requirements (includ-
ing independence requirements) and the use of professional judgment. Take a few minutes to
read the principles in Illustration 1.4.
The SASs are interpretations of the principles underlying an audit conducted in accor-
dance with GAAS. The SASs explain the nature and extent of an auditor’s responsibility and
offer guidance to an auditor in performing the audit of a private company. Compliance with
the SASs is mandatory for AICPA members, who must justify any departures from the stan-
dards. The SASs are numbered in the order in which they are issued by the ASB. Then the
standards are organized by topical content using the AU numbering system. (Note that the
“AU” stands for auditing standards, but these are not to be confused with the Auditing Stan-
dards (AS) from the PCAOB.) The AU-C topical order (the “C” denotes the clarified standards)
is listed in Illustration 1.5.

ILLUSTRATION 1.5
AU-C Section General Topic Auditing Standards Board
AU-C 200–299 General Principles and Responsibilities AU-C topical content

AU-C 300–499 Risk Assessment and Response to Assessed Risks

AU-C 500–599 Audit Evidence
AU-C 600–699 Using the Work of Others
AU-C 700–799 Audit Conclusions and Reporting
AU-C 800–899 Special Considerations
AU-C 900–999 Special Considerations in the United States

Source: AICPA.

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1-18 C h a pte r 1 Introduction and Overview of Audit and Assurance

Throughout the text, we will be learning some of the specific ASB auditing standards in
the different topical categories. The beginning of each chapter will list which ASB standards
will be discussed in that chapter. You will also see references to the ASB standards within the
text. The reference will begin with “AU-C” followed by the standard number, a decimal, and
then a paragraph number, such as “AU-C 200.05.”
The ASB also issues Statements on Standards for Attestation Engagements (SSAE) and State-
ments on Quality Control Standards (SQCS) for AICPA member firms. Another standing commit-
tee of the AICPA is the Accounting and Review Services Committee. This committee is tasked with
issuing Statements on Standards for Accounting and Review Services (SSARS). The SSARS provide
guidance for services provided on historical financial statements that are less extensive than an
audit. An example that we discussed earlier is a review of historical financial statements. A more
detailed discussion of accounting and review services is provided in Chapter 16.
To help summarize the audit standard-setting environment in the United States, Illus-
tration 1.6 provides a diagram of the current audit standard setting-structure for the audits of
public and private companies.

ILLUSTRATION 1.6 Audit Standard Setting

Audit standard setting in the
United States

Private company Public company

(non-issuer) (issuer)

AICPA’S Auditing Public Company Accounting

Standards Board Oversight Board
(ASB) (PCAOB)

Statements on
Statements on Statements on
Standards for Auditing Standards
Auditing Standards Quality Control
Attestation (AS)
(SAS) Standards (SQCS)
Engagements (SSAE)

Staff audit practice

Interpretive publications from the ASB to provide guidance to alerts from the PCAOB
CPAs and auditors to provide guidance to
CPAs and auditors

Professional Environment International Auditing and Assurance Standards Board (IAASB)

In 1977, 63 accountancy bodies (including the AICPA) repre- public confidence in the global auditing profession and serving the
senting 51 countries signed an agreement creating the Interna- public interest.3
tional Federation of Accountants (IFAC). The mission of IFAC Today, auditing has become a global profession. Many countries
is to serve the public interest and strengthen the accountancy adopt IAASB standards as their own. Other countries have auditing
profession by supporting the development and implementation standards that closely resemble the IAASB standards (for example,
of high-quality international standards.2 the SAS in the United States). Where differences exist between the
Toward this end, IFAC has established, as a standing subcom- international standards and local standards, the local member body,
mittee, the International ­Auditing and Assurance Standards Board such as the AICPA’s ASB, is expected to give prompt consideration to
(IAASB) with the responsibility and authority to issue International such differences with a view to achieving harmonization.
Standards on Auditing (ISA). The mission of the IAASB is to estab- In recent years, the U.S. ASB and the IAASB have worked
lish high-quality auditing, assurance, quality control, and related jointly in creating auditing standards that have global acceptance.
services standards and to improve the uniformity of practice by pro- Most of the auditing principles and practices discussed in this text
fessional accountants throughout the world, thereby strengthening are consistent with IAASB standards.

2
International Federation of Accountants website (accessed June 5, 2020), www.ifac.org.
3
International Auditing and Assurance Standards Board website (accessed June 5, 2020), www.iaasb.org.

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  1.5 The Role of Regulators and Regulations 1-19

Financial Accounting Standards Board (FASB)

The FASB is a privately funded organization whose mission is to establish financial account-
ing and reporting standards for nongovernmental entities with the goal of providing informa-
tion that is useful for decision making (www.fasb.org). You are probably familiar with the
FASB from your financial accounting courses.
The FASB maintains the Accounting Standards Codification (ASC), which represents the
authoritative standards of financial reporting recognized by the SEC, the PCAOB, and the
AICPA. We commonly refer to the authoritative standards as GAAP. There are seven full-time
members of the FASB who have diverse backgrounds in accounting, finance, business, and
research. Members of the FASB work closely with the AICPA, SEC, and the PCAOB when
researching and drafting financial accounting and reporting standards.

Committee on Sponsoring Organizations of the

Treadway Commission (COSO)
COSO is an independent private-sector group that focuses on providing guidance to man-
agement and expertise in the areas of internal control, enterprise risk management, and
fraud deterrence (www.coso.org). COSO was organized in 1985 and is sponsored by the fol-
lowing organizations: the American Accounting Association (AAA), the AICPA, Financial
Executives International (FEI), the Institute of Internal Auditors (IIA), and the ­Institute of
Management Accountants (IMA). Because the first chairman of the commission was James
C. Treadway, Jr., a former commissioner of the SEC, the group is often referred to as the
“Treadway Commission.”
In 1992, COSO issued a landmark report titled Internal Control—Integrated Framework.
This report provided a comprehensive definition of internal controls and a framework that
companies could use to design their own internal control systems. In 2013, the framework
went through a comprehensive update and was reissued. This updated framework will be
covered in depth in Chapter 6.

National Association of State Boards of

Accountancy (NASBA) and State Boards of
Accountancy
CPAs are professionals who are licensed by state governments. Each state legislature has
established a state board of accountancy to license and regulate CPAs to protect the public
interest. Some of the functions of a state board of accountancy include:

• Issuing CPA licenses to individuals who meet all the requirements.

• Adopting and enforcing rules of professional conduct for CPAs.
• Adopting and enforcing rules regarding continuing professional education requirements.
• Investigating complaints, conducting hearings, and taking appropriate disciplinary ac-
tions, such as suspension or revocation of the CPA license.

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
(www.nasba.org). There are actually 55 jurisdictions with boards of accountancy. They in-
clude the 50 states, the District of Columbia, the Commonwealth of the Northern Mariana
Islands, Guam, Puerto Rico, and the Virgin Islands.
NASBA acts as a collective voice for the boards of accountancy and works to promote the in-
terests of the state boards with legislative and regulatory bodies. NASBA also provides education
and development opportunities for its members, provides technology support, and promotes
ethical behavior in the profession. One of the services NASBA provides to state boards is that it
serves as the application center for individuals applying to sit for the CPA exam. When you are
ready to apply to take the CPA exam, you may be asked to apply through NASBA’s website.

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1-20 C h a pte r 1 Introduction and Overview of Audit and Assurance

Cloud 9 Continuing Case

Ernie explains that, in general, the regulators and regulations engagement when auditing a small business. Since Stotez Shoes
that apply to publicly traded corporations are not relevant to is a private company, the auditors would follow the auditing stan-
Stotez Shoes. However, any auditor Ron engages would apply the dards of the ASB when conducting the audit.
auditing and accounting standards that are relevant to an audit

Before You Go On
5.1 What is the SEC and what is its role?
5.2 Which organization sets the standards for the audits of public companies? For the audits of
private companies?
5.3 What are the main functions of a state board of accountancy?

1.6 Audit Report on Financial Statements

LEARNING OBJECTIVE 6
Explain the concepts of reasonable assurance and materiality, and the nature of an
unqualified/unmodified report on the audit of financial statements.

In this section, we introduce you to the independent auditor’s report, which is the “end product”
of the financial statement audit. The independent auditor’s report is used to communicate the
auditor’s opinion about a company’s financial statements to interested users. We will revisit the
independent auditor’s report in more depth in Chapter 16, but it is helpful to understand this
report from the perspective of a financial statement reader as you begin to learn the audit process.

Reasonable Assurance and the Financial

Statements
We have explained how the responsibility of the auditor is to provide an opinion on whether the
financial statements are presented fairly in accordance with the applicable financial reporting
framework. An opinion is defined as a judgment about matters that are subjective. The prepa-
ration of financial statements is considered somewhat subjective because management must
make some estimates and choose between different accounting methods. Therefore, the audi-
reasonable assurance a high, tor is only required to obtain reasonable assurance about whether the financial statements
but not absolute, level of assurance 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 (AU-C 200.06).
• I n other words, the a­ uditor 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.

In addition, an audit could not be completed in a reasonable amount of time if auditors had
to provide absolute assurance. For some accounts and transactions, auditors use sampling
techniques when gathering audit evidence and therefore do not examine 100% of a company’s
transactions for the period under audit. So, how do auditors know when they have gathered
enough evidence? Ultimately, that is a matter of professional judgment. Since judgment is

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  1.6 Audit Report on Financial Statements 1-21

involved, there will always be a risk the auditors will give the wrong opinion. This is called audit risk the risk that an au-
audit risk. ditor expresses an inappropriate
Audit risk is affected by client characteristics as well as actions of the auditor. For exam- audit opinion when the finan-
ple, when a client implements a new accounting standard, audit risk increases because there cial statements are materially
misstated
is increased risk for error when implementing a new process. The internal control system of
the client also impacts audit risk. If the client has strong internal controls, it is more likely the
internal controls will prevent, or detect and correct, material misstatements, which decreases
audit risk. Auditors impact audit risk by the decisions made in how to conduct the audit. The
concept of audit risk is covered in depth in Chapter 3.
We will devote considerable attention throughout the text to the concept of audit risk and
determining how auditors make important professional judgments about collecting sufficient,
appropriate evidence to achieve reasonable assurance and support the auditor’s opinion.

Materiality and the Financial Statements

Although financial statements contain approximations, they must reflect a reasonable degree
of precision. However, accounting is not precise, or accurate, the way we might think of
Newtonian physics as being precise. If a potential misstatement of the financial statements is
significant enough to influence or make a difference in the judgment of a financial 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. For example, a $25,000 misstatement of revenues may be material to a com-
pany with $200,000 of net income, while a $25,000 misstatement for a company with $5,000,000
in net income may be immaterial. In addition, qualitative characteristics influence materiality. For
example, an error in the financial statements may be a small percentage of an account balance.
This small error, however, may be considered material because it could cause an entity to breach a
loan covenant, which could result in a misclassification of current and noncurrent debt.
Auditors design an audit to provide reasonable assurance that the financial statements
are free of material misstatement. However, auditors do not design an audit to look for imma-
terial misstatements because they would not influence a financial statement user. A deeper
discussion of how auditors make materiality decisions can be found in Chapter 3.

Professional Environment Materiality

In the audit of a very large company, the amount of misstatement As an investor, would you consider a return on assets of
that would be considered immaterial might be quite large. Consider 38.19% or 38.18% to be substantially the same? It would take ap-
the audit of Starbucks for the year ended September 27, 2020, proximately a $6 million misstatement to change return on assets
when Starbucks had total revenues of $23.518 billion, earnings by only 1/100 of 1% for Starbucks for the year ended September 27,
before income taxes of $1.164 billion, net income of $928 million, 2020. Alternatively, as an investor, would you consider a return on
and total assets of $29.374 billion at September 27, 2020. Starbucks assets of 38.19% or 38.09% to be substantially the same? It would
rounds its financial statement amounts to the nearest $1 million. take approximately a $60 million misstatement to change r­ eturn
For the year ended September 27, 2020, Starbucks had a return on on assets by only 1/10 of 1% for Starbucks for the year ended
assets of 38.19%. September 27, 2020.

The Auditorʼs Report on Financial Statements

When the audit firm has determined that it has gathered sufficient, appropriate evidence to
form an opinion, then it is ready to issue the audit report. Auditing standards require a standard
format of the audit report be used for all audits. In other words, all accounting firms use the
same standard format and standard wording for reporting their audit opinions. Using a standard
format makes it easier for financial statement users to navigate the audit report.
There is a standard report for the audit of public company financial statements and a
standard report for the audit of private company financial statements. The actual process of
auditing the financial statements of public and private companies is similar, but there are also
some differences, which will be discussed throughout the text. One of the key differences is
the format of the audit reports.

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