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Auditing & Assurance Services A S Y S T E M A T I C A P P R O A C H

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William F. Messier, Jr. University of Nevada, Las Vegas

Department of Accounting and

Norwegian School of Economics Department of Accounting, Auditing and Law

Steven M. Glover Brigham Young University

Marriott School of Management School of Accountancy

Douglas F. Prawitt Brigham Young University

Marriott School of Management School of Accountancy

TENTH EDIT ION

Auditing & Assurance Services A S Y S T E M A T I C A P P R O A C H

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AUDITING & ASSURANCE SERVICES: A SYSTEMATIC APPROACH, TENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2012, and 2010. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6

ISBN 978-0-07-773250-9 MHID 0-07-773250-2

Senior Vice President, Products & Markets: Kurt L. Strand Vice President, General Manager, Products & Markets: Marty Lange Vice President, Content Design & Delivery: Kimberly Meriwether David Managing Director: Tim Vertovec Marketing Director: Brad Parkins Brand Manager: Nichole Pullen Director, Product Development: Rose Koos Director of Digital Content: Patricia Plumb Lead Product Developer: Ann Torbert Product Developer: Jonathan Thornton Marketing Manager: Michelle Nolte Market Development Manager: Erin Chomat Digital Product Analyst: Xin Lin Director, Content Design & Delivery: Linda Avenarius Program Manager: Daryl Horrocks Lead Content Project Managers: Pat Frederickson and Brian Nacik Buyer: Susan K. Culbertson Design: Debra Kubiak Content Licensing Specialists: Carrie Burger and Shannon Manderscheid Cover Image: © Danita Delimont/Getty Images Compositor: SPi Global Printer: R. R. Donnelley

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Messier, William F., author. Auditing & assurance services : a systematic approach / William F. Messier, Jr., Steven M. Glover, Douglas F. Prawitt.—Tenth edition. pages cm ISBN 978-0-07-773250-9 (alk. paper) 1. Auditing. I. Glover, Steven M., 1963- author. II. Prawitt, Douglas F. author. III. Title. IV. Title: Auditing and assurance services. HF5667.M46 2016 657’.45–dc23 2015028419

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

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William F. Messier, Jr. holds the Kenneth and Tracy Knauss Endowed Chair in Account- ing at the Department of Accounting, University of Nevada, Las Vegas. He is also an Adjunct Professor at the Department of Accounting, Auditing and Law at the Norwegian School of Economics. Professor Messier holds a B.B.A. from Siena College, an M.S. from Clarkson University, and an M.B.A. and D.B.A. from Indiana University. He is a CPA in Florida and has held faculty positions at the University of Florida (Price Waterhouse Professor) and Georgia State University (Deloitte & Touche Professor). Professor Messier was a visiting faculty member at SDA Bocconi in Milan and the Universities of Luxembourg and Michigan. Professor Messier served as the Academic Member of the AICPA’s Auditing Standards Board and as Chair of the AICPA’s International Auditing Standards Subcommittee. He is a past editor of Auditing: A Journal of Practice & Theory and formerly President of the Audit- ing Section of the American Accounting Association. Professor Messier was the recipient of the American Accounting Association’s Outstanding Accounting Educator Award (2015), AICPA’s Distinguished Achievement in Accounting Education Award (2012), AAA Audit- ing Section’s Outstanding Educator Award (2009) and the Distinguished Service in Auditing Award (2008). In 2011, Professor Messier was awarded an honorary doctorate from the Nor- wegian School of Economics and Business Administration. Professor Messier has also served as an expert witness in audit litigation cases.

Professor Steven M. Glover is the K. Fred Skousen Professor and Associate Dean of the Marriott School of Management, Brigham Young University. Professor Glover is a CPA in Utah and holds a PhD and BS from the University of Washington and an AA in Business from BYU – Idaho. He previously worked as an auditor for KPMG LLP and as a director in the national office of PwC LLP. Professor Glover is currently serving on the AICPA Auditing Standards Board and has served on the audit committee of a nonprofit organization. He has served on the board of advisors for technology companies and he actively consults with public companies and public accounting firms. He has also served as an expert witness. Professor Glover is a past President of the Auditing Section of the American Accounting Association and he has been on auditing-related task forces of the AICPA. Professor Glover is or has served on the editorial boards of Auditing: A Journal of Practice & Theory, The Accounting Review, Current Issues in Auditing, and the review board of the AAA/CAQ Access to Audit Personnel Program. He has authored or coauthored over 40 articles and books primarily focused in the areas of auditor decision making, audit education, and audit practice. Together with Professor Prawitt and KPMG, LLP, he co-authored an award-winning monograph designed to acceler- ate the professional judgment of auditors and auditing students, as well as a monograph on professional skepticism commissioned by the Standards Working Group of the GPPC, an international consortium of the six largest public accounting network firms.

Professor Douglas F. Prawitt is the Glen Ardis Professor of Accountancy at the Marriott School of Management, Brigham Young University. Professor Prawitt is a CPA in Utah. He holds a PhD from the University of Arizona, and BS and MAcc degrees from Brigham Young University. Professor Prawitt was awarded the Marriott School’s Teaching Excellence and Outstanding Researcher awards in 1998 and 2000. He received the Merrill J. Bateman Student Choice Teaching Award in 2002, BYU’s Wesley P. Lloyd Award for Distinction in Graduate Education in 2006, and the American Accounting Association’s Deloitte/Wildman Award in 2013.

About the Authors

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Dedications

The authors dedicate this book to the following individuals:

Teddie, Stacy, Brandon, Zachary, Mark, Lindsay, Olive, and Frederick —William F. Messier, Jr.

Tina, Jessica, Andrew, Jennifer, Anna, Wayne, and Penny —Steven M. Glover

Meryll, Nathan, Matthew, Natalie, Emily, AnnaLisa, Leah, George, and Diana —Douglas F. Prawitt

He consults actively with international, regional, and local public accounting firms. He worked extensively over a five-year period with the Committee of Sponsoring Organiza- tions (COSO) on the COSO Enterprise Risk Management Framework and Internal Control over Financial Reporting—Guidance for Smaller Public Companies projects, and served a three-year appointment as a voting member of the AICPA Auditing Standards Board, from 2005–2008. In the fall of 2011, he was appointed to serve a three-year term as a member of the COSO Board and was appointed to serve a second three-year term beginning in 2014. Profes- sor Prawitt also has served in several capacities with the American Accounting Association, including as a member of the editorial boards of Auditing: A Journal of Practice & Theory, Behavioral Research in Accounting, and as associate editor of Accounting Horizons. He has authored or co-authored over 40 articles and books, primarily in the areas of auditor judgment and decision making, and audit practice. Most recently, together with Professor Steve Glover and KPMG, LLP, he co-authored an award-winning monograph designed to accelerate the professional judgment of auditors and auditing students, as well as a monograph on profes- sional skepticism commissioned by the Standards Working Group of the GPPC, an interna- tional consortium of the six largest public accounting firm networks.

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Why a New Edition?

Dear Colleagues and Friends, The pace of change in the financial statement auditing environment continues to accelerate, even as the need for relia- bile, high-quality assurance over financial reporting continues to intensify. The auditing environment is far more com- plex and dynamic today than it was even 10 years ago. Today, for example, financial statement auditors practice in a regulated environment and must deal with three sets of auditing standards: the standards of the PCAOB for audits of U.S. public companies, the standards of the AICPA’s Auditing Standards Board for audits of essentially all other U.S. entities (e.g., private companies, government entities, universities), and the standards of the IFAC’s International Audit- ing and Assurance Standards Board for audits of entities based outside of the United States. And those standards have undergone change at an unprecedented pace, with few signs of slowing. It is difficult enough for us as professors to stay abreast of the unprecedented change and complexity in the auditing environment; it is simply unrealistic to expect our students to be able to grasp all of this while they are working diligently just to learn the fundamentals of financial state- ment auditing.

That is why we have focused our efforts in this new edition to present the fundamentals of auditing in a crisp, clear, and understandable way, helping students navigate the inherent complexity while gaining a deep, intuitive grasp of fundamental auditing concepts. We do this by using simple yet compelling illustrations, examples, and analogies, such as relating the demand for an audit to the desire of a prospective home buyer to hire a house inspector. Our hope is that students will not only understand the important standards and concepts underlying auditing but that they will gain an intuitive grasp of why it is important and how the underlying logic can inform their judgments not only as auditors but as business people. In terms of the three sets of extant auditing standards, we simplify the complexities involved by adopting an approach similar to that taken by all of the major international accounting firms: we start with a base set of standards (in our case, the AICPA’s new body of “clarity” standards, which are at this point very similar to the IAASB standards) and we build on that base by addressing any requirements in the PCAOB standards that require more from the auditor. The AICPA’s clarity standards are newly converged with international auditing standards, which means that by studying this book your students will learn the auditing concepts that underlie an audit performed under any of the three extant sets of standards. All of the major firms have adopted a similar approach because it allows their pro- fessionals to practice effectively in any environment, domestic or international, using a single, merged set of auditing standards, rather than having to learn the specifics of three different sets. Your students will have that same advantage in learning auditing from this book.

Although the auditing environment has become even more complex and demanding, at the same time it is increasingly important that students gain a deep understanding and working knowledge of fundamental auditing concepts and how they are applied. From the beginning we have worked hard to make this book the most up-to-date, “student-friendly” introductory auditing book on the market, and this new edition continues that effort. Some of the ways this book encourages your students (and ours) to think more clearly and deeply about what they are studying are by

1. Expanding the use of “stop and think” phrases at key places throughout the chapters to encourage students to more fully internalize key concepts and facilitate deep learning by your students.

2. Clarifying explanations and adding easy-to-understand examples throughout the book.

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3. Making several chapters more concise and enhancing the focus on key concepts by deleting noncentral detail.

4. Improving end-of-chapter and supplementary materials throughout the book and on the website.

5. Adding a “Professional Judgment” module to the print copy of the book to accelerate the development of pro- fessional judgment abilities in your students. This module is based on the 2013 AAA Wildman Award winning KPMG Professional Judgment monograph, authored by Steve Glover and Doug Prawitt, in collaboration with KPMG leaders and partners.

6. New discussion cases added to Chapters 3 and 6 relating to the misappropriations of assets at Koss Corporation and Dixon, Illinois.

This new edition also contains several important updates including the introduction of industry leader IDEA® software by CaseWare Analytics. IDEA is a powerful and user-friendly data analysis tool designed to help auditors perform data analysis, audit sampling, and other audit procedures efficiently and effectively. Students are introduced to IDEA in the text and through hands-on tutorials, exercises, and problems. This edition also has been updated to reflect changes in auditing standards, such as the PCAOB’s Risk Assessment standards and the AICPA’s newly revised body of “clar- ity” standards, including the “principles underlying an audit conducted in accordance with generally accepted auditing standards.” The book also reflects new developments in how auditors assess materiality, based on research into major firms’ materiality policies by Aasmund Eilifsen and Bill Messier, and includes insights into audit sampling in practice based on research co-authored by Steve Glover. This edition also includes coverage of the newly revised COSO Internal Control-Integrated Framework. Because of their increasing complexity and importance to the audit process, this edi- tion also includes discussions of auditing the tax liability and auditing fair value measurements. The book also includes coverage of professionalism and ethics consistent with the AICPA’s newly reorganized Code of Professional Conduct. Finally, the authors took a hands-on role in improving this edition’s test bank, online quizzes, instructor PowerPoint slides, and the instructor’s manual.

While we are very much aware of the extra investment required when a book rolls to a new edition, we believe that we owe it to our colleagues and students to provide the most up-to-date materials possible so their hard work and energy in teaching and studying represents an investment in the latest, most current concepts, delivered in the most understand- able way possible. We are confident that the changes made in this edition will make it easier for you to teach effectively and for your students to learn more efficiently and more deeply.

Thank you for your support of this text and the many compliments we have received regarding past editions. We are gratified by the enthusiastic response the text has received as we have done our best to create a clear, easy-reading, student-friendly auditing textbook. As always, we welcome your feedback and suggestions, and we hope you will be pleased with the updates we have made in this new edition.

With warm regards,

William F. Messier, Jr. Steven M. Glover Douglas F. Prawitt

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The 10th Edition includes the following important features and enhancements:

∙ A “professional judgment” module, designed to accelerate the development of the student’s profes- sional judgment and based on the AAA Deloitte/Wildman Award-winning KPMG Professional Judg- ment monograph, is now included in the print version of the book. Additional resources relating to this module are available through KPMG’s University Connection website.

∙ Increased use of “Stop and Think” questions throughout the book to encourage students to more fully internalize key concepts.

∙ User-focused, user-friendly improvements. ∙ Chapter 2 has been updated for recent changes in the audit environment, Chapter 3 presents the latest

information available on major firms’ audit guidance relating to materiality, Chapter 6 reflects COSO’s new internal control framework, and Chapter 19 includes coverage of professional conduct consistent with the AICPA’s newly reorganized Code of Professional Conduct.

∙ Increased use of Practice Insights that provide a link from the textbook material to the real world. ∙ The introduction of IDEA audit software. IDEA is a powerful and user-friendly data analysis tool

designed to help auditors perform data analysis, audit sampling, and other audit procedures efficiently and effectively. IDEA is illustrated in Chapters 8 and 9 and there are end-of-chapter IDEA assignments and problems for hands-on application throughout the book.

∙ Improved descriptions of the hands-on EarthWear Mini-Cases that provide students with opportunities to apply audit professional judgment and practice audit procedures.

∙ Clarified explanations of technical business and accounting jargon. ∙ Improved linkage between chapter content and end-of-chapter material. ∙ References to auditing standards reflect the new codification of AICPA ASB clarity standards.

Here is a sampling of the improvements made in recent editions:

Chapter 1, An Introduction to Assurance and Financial Statement Auditing ∙ Discussion of fundamental concepts of auditing streamlined and clarified

Chapter 2, The Financial Statement Auditing Environment ∙ Updated to reflect changes in audit environment ∙ Includes AICPA’s “principles underlying an audit” in addition to PCAOB’s traditional set of “generally

accepted auditing standards”

Chapter 3, Audit Planning, Types of Audit Tests, and Materiality ∙ Revised engagement letter for an integrated audit ∙ Discussion of the current practices of the major auditing firms based on a recent article by Aasmund

Eilifsen and Bill Messier

Chapter 4, Risk Assessment ∙ Improved presentation of the risk assessment process ∙ Revised presentation of the fraud risk assessment process ∙ Addition of a new case based on the fraud at Koss Corporation

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Chapter 5, Evidence and Documentation ∙ Revised Advanced Module on the use of substantive analytical procedures

Chapter 6, Internal Control in a Financial Statement Audit ∙ New discussion case about the fraud in Dixon, Illinois ∙ An extension of the Koss Corporation fraud that considers the control deficiencies

Chapter 7, Auditing Internal Control over Financial Reporting ∙ Easier to understand explanations of the important steps in the audit of internal control over

financial reporting

Chapter 8, Audit Sampling: An Overview and Application to Tests of Controls ∙ Introduction of industry leading IDEA auditing software to this edition of the book with illustrations of

how to use IDEA for attribute sampling within the chapter. ∙ Updated for academic research examining audit sampling in practice

Chapter 9, Audit Sampling: An Application to Substantive Tests of Account Balances ∙ Introduction of industry leading IDEA auditing software to this edition of the book with illustrations of

how to use IDEA for monetary unit sampling within the chapter. ∙ Updated for academic research examining audit sampling in practice

Chapters 10–16, Business Process Chapters ∙ Revised for enhanced clarity and brevity ∙ Clarified illustrations linking assertions to possible misstatements to example controls and tests

of controls ∙ Updated exhibits and practice insights for recent events

Chapter 17, Completing the Audit Engagement ∙ Improved examples to illustrate the possible self-fulfilling prophecy effects of going concern opinions,

and to explain the role and impact of commitments in completing an audit ∙ Clarified discussion of auditor’s responsibility for subsequent events ∙ Enhanced discussion of evaluation of misstatements in light of qualitative materiality considerations ∙ New coverage of iron curtain versus roll-over methods of assessing materiality of misstatements

Chapter 18, Reports on Audited Financial Statements ∙ Updated for recent developments including the new “clarified” form of the ASB audit report

Chapter 19, Professional Conduct, Independence, and Quality Control ∙ Updated for changes in the newly reorganized AICPA Code of Professional Conduct ∙ Discussion of quality control and peer review/inspection updated for recent changes in

relevant standards

Chapter 20, Legal Liability ∙ Updated for important recent cases and statutory law

Chapter 21, Assurance, Attestation, and Internal Auditing Services ∙ Updated standards relating to practitioner independence in compilation engagements ∙ Attestation reports updated for new AICPA standards ∙ Updated to reflect changes in IIA standards ∙ Updated to reflect changes to structure around Trust Services principles and practices

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Tenth Edition Supplements

Connect instructor resources library offers:

∙ Solutions Manual, revised by William F. Messier, Jr., Steven M. Glover, and Douglas F. Prawitt ∙ Instructor’s Manual ∙ Test Bank with AACSB, AICPA, and Bloom’s Taxonomy tags ∙ Instructor PowerPoint Presentations ∙ EarthWear Mini-Case Solutions ∙ Solutions to IDEA Solutions

Addtional resources include: Links to Professional Resources, Sample Syllabi, Text Updates, and Digital Image Library

Connect student resources include: ∙ EarthWear Mini-Cases ∙ IDEA Assignments and Problems, by Messier, Glover, and Prawitt ∙ Student PowerPoint Presentations ∙ Relevant Accounting and Auditing Pronouncements by chapter ∙ Link to EarthWear Clothiers home page ∙ Link to Willis & Adams, CPAs home page

Assurance of Learning Ready Many educational institutions today are focused on the notion of assurance of learning, an important ele- ment of some accreditation standards. The Messier, Glover, and Prawitt Auditing and Assurance Services: A Systematic Approach book is designed specifically to support your assurance of learning initiatives with a simple, yet powerful, solution.

Each chapter in the book begins with a list of numbered learning objectives, which appear throughout the chapter as well as in the end-of-chapter assignments. Each test bank question for Auditing and Assurance Services: A Systematic Approach maps to a specific chapter learning outcome/objective listed in the text. Each test bank question also identifies topic area, level of difficulty, Bloom’s Taxonomy level, AACSB and AICPA skill areas. You can use Connect to easily query for learning outcomes/objectives that directly relate to the learning objectives for your course.

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The continuing rapid pace of change in auditing standards and practices, together with the recent crises in the financial markets, has had a significant effect on the auditing profession. In this ever-changing environment, it is crucial that stu- dents learn from the most up-to-date, student-friendly resources. As always, the author team of Auditing & Assurance Services: A Systematic Approach is dedicated to providing the most current professional content and real-world applica- tion, as well as helping students develop professional judgment and prepare for the CPA exam.

In their 10th edition, authors Messier, Glover, and Prawitt continue to reinforce the fundamental values central to their past nine editions:

Student Engagement. The authors believe students are best served by acquiring a strong understanding of the basic concepts that underlie the audit process and how to apply those concepts to various audit and assurance services. The primary purpose for an auditing text is not to serve as a reference manual but to facilitate student learning, and this text is written accordingly. The text is accessible to students through straightforward writing and the use of engaging, relevant real-world examples, illustrations, and analogies. The text explicitly encourages students to think through fundamental concepts and to avoid trying to learn auditing through rote memorization. Students are prompted by the text to “stop and think” at important points in the text, in order to help them apply the principles covered. Consistent with this aim, the text’s early chapters avoid immersing students in unnecessary detail such as the minutia relating to all the complexities of audit reporting, focusing instead on students’ intuition relating to the fundamental audit concepts of materiality, audit risk, and audit evidence relating to management assertions. The first chapter provides a high-level introduction to what an audit report looks like while avoiding immersion in unnecessary detail. It also lays out a clear explanation and illustration of the demand for assurance and provides an understandable overview of the auditing process from start to finish. A case involving EarthWear Clothiers, a mail-order retailer, is integrated throughout the book and additional student resources and includes free student access to several useful hands-on mini-cases, with full solutions available to the instructor. Finally, “practice insights” throughout the book engage students and help them see the application of concepts in a practical setting.

A Systematic Approach. The text continues to take a systematic approach to the audit process by first introducing the three underlying concepts: audit risk, materiality, and evidence. This is followed by a discussion of audit planning, the assessment of control risk, and a discussion of the nature, timing, and extent of evidence necessary to reach the appropriate level of detection risk. These concepts are then applied to each major business process and related account balances using a risk-based approach. The text has been revised to include the risk assessment process included in the standards adopted by the Auditing Standards Board and the International Auditing and Assurance Standards Board, as well as the PCAOB’s newly adopted Risk Assessment Standards.

Decision Making. In covering these important concepts and their applications, the book focuses on critical judg- ments and decision-making processes followed by auditors. Much of auditing practice involves the application of auditor judgment. If a student understands these basic concepts and how to apply them to an audit engagement, he or she will be more effective in today’s dynamic audit environment. Two of the authors of this textbook recently worked with KPMG to develop a monograph designed to accelerate the development of professional judgment in students. We are very excited to include in this edition a “professional judgment” module as part of the printed material in the text. This module is based on the KPMG Professional Judgment monograph, which was awarded the 2013 AAA Deloitte/Wildman award for the work published within the most recent five-year period that has had the most significant impact on the practice of professional accountancy. Access to additional directly related resources, including videos, mini-cases, and problems, are available on KPMG’s University Connection website for integration into the auditing course, as instructors see fit.

How does 10e prepare your students?

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Free IDEA software

The educational version of IDEA software is avail- able for free with each new book. IDEA is new to this edition and the authors wrote chapter-specific IDEA assignments and problems, all of which are found inside Connect. Exposing students to IDEA allows them the opportunity to work with real professional audit software.

Real-World Integration and Hands-On Mini-Cases.

Mini EarthWear cases “Hands-on” mini-cases are integrated throughout the text. Enhanced case descriptions and a new mini-case on the search for unrecorded liabilities were added this edition. The mini-cases are also available in Connect, giving your students the opportunity to actually do some common audit- ing procedures.

Practical applications for the modern student

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know, if the securities acts had not been passed by Congress in the 1930s, no one would be interested in having an audit performed.”

Required: Draft a memo that highlights your thoughts about Lee’s statement that audits only

take place because they are required by law.

INTERNET ASSIGNMENT

LO 1-1, 1-9 1-30 Using an Internet browser, identify five Internet sites that contain accounting or auditing resources. For each site identified, prepare a brief summary of the types of information that are available. For example, the PCAOB’s home page (www.pcaobus.org) contains extensive information on the organization’s activities (you may use the PCAOB site as one of the five). Your five summaries should not exceed a total of one typed page.

HANDS-ON CASES

EarthWear Online

EarthWear Introduction In this activity you will become further acquainted with EarthWear Clothiers and their auditors Willis and Adams. This introductory activity also provides an opportunity to become familiar with the structure and format of the EarthWear Online cases.

Visit Connect’s additional student resources to find a detailed description of the case and to download required materials.

Additional Student Resources

Visit Connect for author-created problem material to be completed using IDEA software.

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adds credibility to the report and reduces information risk, or the risk that information cir- culated by a company’s management will be false or misleading. Reducing information risk potentially benefits both the owner and the manager. Figure 1–1 provides an overview of this agency relationship.

While the setting we’ve outlined is very simple, understanding the basics of the owner– manager relationship is helpful in understanding the demand for auditing. The principal– agent model is a powerful conceptual tool that can be extrapolated to much more complex employment and other contractual arrangements. For example, how can a lender prevent management from taking the borrowed funds and using them inappropriately? One way is to place restrictive covenants in the debt agreement with which the entity and its management must comply. Again, this arrangement gives rise to a demand for the auditing of information reported by management to the lender.

Overview of the Principal–Agent Relationship Leading to the Demand for Auditing

F I G U R E 1 – 1

Auditor gathers evidence to evaluate fairness of agent’s financial reports. Auditor issues audit opinion to accompany agent’s financial reports, adding credibility to the reports and reducing principal’s information risk.

Principal provides capital and hires agent to manage resources.

Information asymmetry and conflicts of interest lead to information risk

for the principal.

Agent is accountable to principal; provides financial reports. Agent hires auditor

to report on the fairness of agent’s

financial reports. Agent pays auditor

to reduce principal’s information risk.

Auditor

Agent (Manager)

Principal (Absentee Owner)

Practice I N S I G H T

At the heart of a capital-market economy is the flow of reliable information, which investors, credi- tors, and regulators use to make informed decisions. Chief Justice Warren Burger gave his view of the significance of the audit function in a 1984 Supreme Court decision:

By certifying the public reports that collectively depict a corporation’s financial status, the indepen- dent auditor assumes a public responsibility transcending any employment relationship with the cli- ent. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.

More than 30 years later, the message is the same—users of financial statements rely on the external auditor to act with honor and integrity in protecting the public interest.

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know, if the securities acts had not been passed by Congress in the 1930s, no one would be interested in having an audit performed.”

Required: Draft a memo that highlights your thoughts about Lee’s statement that audits only

take place because they are required by law.

INTERNET ASSIGNMENT

HANDS-ON CASES

EarthWear Online

Visit Connect’s additional student resources to find a detailed description of the case and to download required materials.

Additional Student Resources

Visit Connect for author-created problem material to be completed using IDEA software.

Practice Insights Practice Insights in each chapter highlight important and interesting real-world trends and practices.

AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Auditing and Assurance Services 10e recognizes the curricula guidelines detailed in the AACSB stan- dards for business accreditation by connecting selected questions in the text and test bank to the six general knowledge and skill guidelines in the AACSB standards. The statements contained in Auditing and Assurance Services 10e are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Auditing and Assurance Services 10e and the teaching package make no claim of any specific AACSB qualification or evaluation, we have within Auditing and Assurance Services 10e labeled selected questions according to the six general knowledge and as a helpful starting point.

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McGraw-Hill Connect® Learn Without Limits Connect is a teaching and learning platform that is proven to deliver better results for students and instructors.

Connect empowers students by continually adapting to deliver precisely what they need, when they need it, and how they need it, so your class time is more engaging and effective.

Mobile

Connect Insight® Connect Insight is Connect’s new one-of-a-kind visual analytics dashboard—now available for both instructors and students—that provides at-a-glance information regarding student performance, which is immediately actionable. By presenting assignment, assessment, and topical performance results together with a time metric that is easily visible for aggregate or individual results, Connect Insight gives the user the ability to take a just-in- time approach to teaching and learning, which was never before available. Connect Insight presents data that empowers students and helps instructors improve class performance in a way that is efficient and effective.

88% of instructors who use Connect require it; instructor satisfaction increases

by 38% when Connect is required.

Students can view their results for any

Connect course.

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First and foremost, we thank our families for their continuous and unfailing support. We would like to acknowledge the American Institute of Certified Public Accountants for permission to quote from auditing standards, the Code of Professional Conduct, the Uniform CPA Examination, and the Journal of Accountancy. We would like to thank CaseWare IDEA for granting permission to distribute the educational version of IDEA software with our textbook. We would also like to thank Cassy Budd of Brigham Young University for her help with updating the Test Bank, Instructor’s Manual, Quizzes, and PowerPoints; and Jonathan Liljegren for revision of the EarthWear Mini-Cases. Finally, we would like to extend our gratitude to Christina Brenchley, Scott Jackson, and Andrew Glover for their research assistance.

Acknowledgments

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Brief Contents

PART 1 Introduction to Assurance and Financial Statement Auditing 1

Chapter 1 An Introduction to Assurance and Financial Statement Auditing 2

Chapter 2 The Financial Statement Auditing Environment 36

PART 2 Audit Planning and Basic Auditing Concepts 67

Chapter 3 Audit Planning, Types of Audit Tests, and Materiality 68

Chapter 4 Risk Assessment 98

Chapter 5 Evidence and Documentation 128

PART 3 Understanding and Auditing Internal Control 177

Chapter 6 Internal Control in a Financial Statement Audit 178

Chapter 7 Auditing Internal Control over Financial Reporting 220

PART 4 Statistical and Nonstatistical Sampling Tools for Auditing 261

Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls 262

Chapter 9 Audit Sampling: An Application to Substantive Tests of Account Balances 300

PART 5 Auditing Business Processes 337

Chapter 10 Auditing the Revenue Process 338

Chapter 11 Auditing the Purchasing Process 386

Chapter 12 Auditing the Human Resource Management Process 422

Chapter 13 Auditing the Inventory Management Process 450

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Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment 480

Chapter 15 Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income Statement Accounts 506

Chapter 16 Auditing the Financing/Investing Process: Cash and Investments 528

PART 6 Completing the Audit and Reporting Responsibilities 561

Chapter 17 Completing the Audit Engagement 562

Chapter 18 Reports on Audited Financial Statements 596

PART 7 Professional Responsibilities 627

Chapter 19 Professional Conduct, Independence, and Quality Control 628

Chapter 20 Legal Liability 672

PART 8 Assurance, Attestation, and Internal Auditing Services 707

Chapter 21 Assurance, Attestation, and Internal Auditing Services 708

Advanced Module: Professonal Judgment Framework—Understanding and Developing Professional Judgment in Auditing 748 (Also visit KPMG’s University Connection website for relevant resources, including videos, mini-cases, instructor notes, and problems, that were created to accompany the AAA Deloitte/ Wildman award-winning KPMG Professional Judgment Framework monograph, on which this module is based.)

Index 757

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Table of Contents

PART 1 Introduction to Assurance and Financial Statement Auditing 1

Chapter 1 An Introduction to Assurance and Financial Statement Auditing 2

Tips for Learning Auditing 4 The Demand for Auditing and Assurance 5

Principals and Agents 5

The Role of Auditing 6

An Assurance Analogy: The Case of the House Inspector 8

Seller Assertions, Information Asymmetry, and

Inspector Characteristics 8

Desired Characteristics of the House Inspection

Service 8

Relating the House Inspection Analogy to

Financial Statement Auditing 9

Management Assertions and Financial

Statements 10

Auditing, Attest, and Assurance Services Defined 12 Auditing 12

Attestation 13

Assurance 13

Fundamental Concepts in Conducting a Financial Statement Audit 14

Materiality 14

Audit Risk 15

Audit Evidence Regarding Management Assertions 16

Sampling: Inferences Based on Limited Observations 16

The Audit Process 17 Overview of the Financial Statement Auditing

Process 17

Major Phases of the Audit 18

The Unqualified/Unmodified Audit Report 21

Other Types of Audit Reports 22

Conclusion 23 Key Terms 24 Review Questions 25 Multiple-Choice Questions 25 Problems 27 Discussion Case 28 Internet Assignment 29 Hands-On Cases 29

Chapter 2 The Financial Statement Auditing Environment 36

Types of Auditors 38 External Auditors 38

Internal Auditors 38

Government Auditors 39

Forensic Auditors 40

Types of Other Audit, Attest, and Assurance Services 40

Other Audit Services 40

Attest Services 41

Assurance Services 41

Other Nonaudit Services 42

Public Accounting Firms 42 Organization and Composition 42

A Decade of Challenge and Change for Financial Statement Auditors 44

Government Regulation 44

Society’s Expectations and the Auditor’s Responsibilities 45

The Context of Financial Statement Auditing 45 The Business Entity as the Primary Context of

Auditing 45

A Model of Business 46 Corporate Governance 46

Objectives, Strategies, Processes, Controls,

Transactions, and Reports 48

A Model of Business Processes: Five

Components 48

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Organizations That Affect the Public Accounting Profession 49

Securities and Exchange Commission (SEC) 51

Public Company Accounting Oversight Board

(PCAOB) 51

American Institute of Certified Public Accountants

(AICPA) 51

International Auditing and Assurance Standards

Board (IAASB) 52

Financial Accounting Standards Board

(FASB) 52

International Accounting Standards Board

(IASB) 52

Auditing Standards 52 Three Sets of Auditing Standards: The Roles of the

ASB, PCAOB, and IAASB 53

The 10 Generally Accepted Auditing Standards 53

Principles Underlying an Audit Conducted in

Accordance with Generally Accepted Auditing

Standards 55

Statements on Auditing Standards and the AU

Codification 55

Ethics, Independence, and the Code of Professional Conduct 57

Conclusion 58 Key Terms 58 Review Questions 59 Multiple-Choice Questions 60 Problems 62 Discussion Cases 64 Internet Assignments 65 Hands-On Cases 66

PART 2 Audit Planning and Basic Auditing Concepts 67

Chapter 3 Audit Planning, Types of Audit Tests, and Materiality 68

Client Acceptance and Continuance 70 Prospective Client Acceptance 70

Client Continuance 71

Preliminary Engagement Activities 71 Determine the Audit Engagement Team

Requirements 71

Assess Compliance with Ethical and Independence

Requirements 72

Establish an Understanding with the Entity 72

Planning the Audit 78 Audit Strategy and Plan 78

Assess Business Risks 78

Establish Materiality 78

Consider Multilocations or Business Units 79

Assess the Need for Specialists 79

Consider Violations of Laws and

Regulations 79

Identify Related Parties 80

Consider Additional Value-Added Services 81

Document the Overall Audit Strategy, Audit Plan,

and Prepare Audit Programs 81

Supervision of the Audit 83 Types of Audit Tests 83

Risk Assessment Procedures 83

Tests of Controls 83

Substantive Procedures 84

Dual-Purpose Tests 84

Materiality 85 Steps in Applying Materiality 86

An Example 88

Key Terms 90 Review Questions 90 Multiple-Choice Questions 91 Problems 92 Discussion Case 95 Internet Assignments 95 Hands-On Cases 96

Chapter 4 Risk Assessment 98

Audit Risk 100 The Audit Risk Model 100

Use of the Audit Risk Model 102

The Auditor’s Risk Assessment Process 104 Management’s Strategies, Objectives, and Business

Risks 104

Auditor’s Risk Assessment Procedures 105

Assessing Business Risks 106

Evaluate the Entity’s Risk Assessment

Process 109

Assessing the Risk of Material Misstatement 109 Causes and Types of Misstatements 110

The Fraud Risk Assessment Process 111

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Examples of Audit Documentation 148

Format of Audit Documentation 150

Organization of Audit Documentation 151

Ownership of Audit Documentation 151

Audit Document Archiving and

Retention 151

Substantive Analytical Procedures 154

Final Analytical Procedures 162

Short-Term Liquidity Ratios 163

Activity Ratios 163

Profitability Ratios 164

Coverage Ratios 165

Key Terms 165 Review Questions 166 Multiple-Choice Questions 167 Problems 169 Discussion Cases 172 Internet Assignment 174 Hands-On Cases 174

PART 3 Understanding and Auditing Internal Control 177

Chapter 6 Internal Control in a Financial Statement Audit 178

Introduction 180 Internal Control—an Overview 180

Definition of Internal Control 180

Controls Relevant to the Audit 180

The Effect of Information Technology on Internal

Control 181

The COSO Framework 181 Components of Internal Control 181

Control Environment 182

The Entity’s Risk Assessment Process 185

Control Activities 186

Information and Communication 188

Monitoring of Controls 189

Planning an Audit Strategy 189 Substantive Strategy 191

Reliance Strategy 192

Obtain an Understanding of Internal Control 193 Overview 193

Understanding the Control Environment 193

The Auditor’s Response to the Results of the Risk Assessments 115

Evaluation of Audit Test Results 117 Documentation of the Auditor’s Risk Assessment and

Response 118 Communications about Fraud to Management, the

Audit Committee, and Others 118 Key Terms 120 Review Questions 121 Multiple-Choice Questions 121 Problems 123 Discussion Case 125 Internet Assignment 126 Hands-On Cases 127

CHAPTER 5 Evidence and Documentation 128

The Relationship of Audit Evidence to the Audit Report 130

Management Assertions 131 Assertions about Classes of Transactions and

Events during the Period 131

Assertions about Account Balances at the Period

End 133

Assertions about Presentation and

Disclosure 134

The Concepts of Audit Evidence 135 The Nature of Audit Evidence 135

The Sufficiency and Appropriateness of Audit

Evidence 135

The Evaluation of Audit Evidence 137

Audit Procedures for Obtaining Audit Evidence 138 Inspection of Records or Documents 138

Inspection of Tangible Assets 139

Observation 140

Inquiry 140

Confirmation 141

Recalculation 141

Reperformance 142

Analytical Procedures 142

Scanning 142

Reliability of the Types of Evidence 142 The Audit Testing Hierarchy 143

An “Assurance Bucket” Analogy 145

Audit Documentation 146 Functions of Audit Documentation 146

Content of Audit Documentation 147

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Control Deficiency 223

Material Weakness 223

Significant Deficiency 223

Likelihood and Magnitude 223

Management’s Assessment Process 225 Identify Financial Reporting Risks and Related

Controls 225

Consider Which Locations to Include in the

Evaluation 226

Evaluate Evidence about the Operating

Effectiveness of ICFR 226

Reporting Considerations 226

Management’s Documentation 227

Performing an Audit of ICFR 228 Plan the Audit of ICFR 229

The Role of Risk Assessment and the Risk of

Fraud 229

Scaling the Audit 230

Using the Work of Others 230

Identify Controls to Test 231 Identify Entity-Level Controls 231

Identifying Significant Accounts and Disclosures

and Their Relevant Assertions 232

Understanding Likely Sources of

Misstatements 232

Select Controls to Test 233

Evaluate the Design and Test the Operating Effectiveness of Controls 234

Evaluating Design Effectiveness of Controls 234

Testing and Evaluating Operating Effectiveness of

Controls 234

Evaluating Identified Control Deficiencies 236 Examples of Control Deficiency Evaluation 237

Remediation of a Material Weakness 239 Written Representations 239 Auditor Documentation Requirements 240 Auditor Reporting on ICFR 240

Elements of the Auditor’s Report 241

Unqualified Report 241

Adverse Report for a Material Weakness 241

Disclaimer for Scope Limitation 242

Other Reporting Issues 244 Management’s Report Incomplete or Improperly

Presented 244

The Auditor Decides to Refer to the Report of

Other Auditors 244

Subsequent Events 245

Understanding the Entity’s Risk Assessment

Process 194

Understanding the Information System and

Communications 195

Understanding Control Activities 195

Understanding Monitoring of Controls 195

Documenting the Understanding of Internal

Control 196

The Effect of Entity Size on Internal Control 196

The Limitations of an Entity’s Internal

Control 197

Assessing Control Risk 199 Identifying Specific Controls That Will Be Relied

Upon 199

Performing Tests of Controls 199

Concluding on the Achieved Level of Control

Risk 200

Documenting the Achieved Level of Control

Risk 200

An Example 200

Substantive Procedures 201 Timing of Audit Procedures 202

Interim Tests of Controls 202

Interim Substantive Procedures 203

Auditing Accounting Applications Processed by Service Organizations 203

Communication of Internal Control–Related Matters 204

General Controls 206

Application Controls 207

Symbols 209

Organization and Flow 210

Key Terms 211 Review Questions 211 Multiple-Choice Questions 212 Problems 214 Discussion Cases 216 Hands-On Cases 218

Chapter 7 Auditing Internal Control over Financial Reporting 220

Management Responsibilities under Section 404 222 Auditor Responsibilities under Section 404 and AS5 222 Internal Control over Financial Reporting

Defined 222 Internal Control Deficiencies Defined 223

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Key Terms 290 Review Questions 291 Multiple-Choice Questions 292 Problems 294 Discussion Case 297 Hands-On Cases 298

Chapter 9 Audit Sampling: An Application to Substantive Tests of Account Balances 300

Sampling for Substantive Tests of Details of Account Balances 302

Monetary-Unit Sampling 303 Advantages 304

Disadvantages 304

Applying Monetary-Unit Sampling 304

Planning 304

Performance 308

Evaluation 310

Nonstatistical Sampling for Tests of Account Balances 318

Identifying Individually Significant Items 318

Determining the Sample Size 318

Selecting Sample Items 319

Calculating the Sample Results 319

An Example of Nonstatistical Sampling 320

Advantages 324

Disadvantages 324

Applying Classical Variables Sampling 324

Key Terms 328 Review Questions 329 Multiple-Choice Questions 330 Problems 331 Discussion Cases 335 Hands-On Cases 336

PART 5 Auditing Business Processes 337

Chapter 10 Auditing the Revenue Process 338

Revenue Recognition 341 Overview of the Revenue Process 342

Types of Transactions and Financial Statement

Accounts Affected 343

Types of Documents and Records 345

Management’s Report Contains Additional

Information 245

Reporting on a Remediated Material Weakness at

an Interim Date 245

Additional Required Communications in an Audit of ICFR 245

Use of Service Organizations 246

Safeguarding of Assets 247

Generalized Audit Software 247

Custom Audit Software 248

Test Data 249

Key Terms 249 Review Questions 250 Multiple-Choice Questions 251 Problems 253 Internet Assignments 259 Hands-On Cases 259

PART 4 Statistical and Nonstatistical Sampling Tools for Auditing 261

Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls 262

Overview of Audit Sampling 264 Definitions and Key Concepts 265

Audit Sampling 265

Sampling Risk 265

Confidence Level 267

Tolerable and Expected Error 267

Audit Evidence Choices That Do and Do Not

Involve Sampling 268

Types of Audit Sampling 269 Nonstatistical versus Statistical Sampling 269

Types of Statistical Sampling Techniques 270

Attribute Sampling Applied to Tests of Controls 271 Planning 271

Performance 279

Evaluation 283

Nonstatistical Sampling for Tests of Controls 287 Determining the Sample Size 287

Selecting the Sample Items 288

Calculating the Computed Upper Deviation

Rate 288

Conclusion 289

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Timing 372

Confirmation Procedures 373

Alternative Procedures 374

Auditing Other Receivables 374 Evaluating the Audit Findings—Revenue-Related

Accounts 375 Key Terms 375 Review Questions 376 Multiple-Choice Questions 377 Problems 379 Discussion Cases 382 Internet Assignments 383 Hands-On Cases 383

Chapter 11 Auditing the Purchasing Process 386

Expense and Liability Recognition 388 Overview of the Purchasing Process 388

Types of Transactions and Financial Statement

Accounts Affected 389

Types of Documents and Records 390

The Major Functions 393

The Key Segregation of Duties 395

Inherent Risk Assessment 396 Industry-Related Factors 396

Misstatements Detected in Prior Audits 396

Control Risk Assessment 396 Understand and Document Internal Control 396

Plan and Perform Tests of Controls 398

Set and Document Control Risk 398

Control Activities and Tests of Controls—Purchase Transactions 398

Occurrence of Purchase Transactions 399

Completeness of Purchase Transactions 399

Authorization of Purchase Transactions 400

Accuracy of Purchase Transactions 401

Cutoff of Purchase Transactions 401

Classification of Purchase Transactions 401

Control Activities and Tests of Controls—Cash Disbursement Transactions 402

Occurrence of Cash Disbursement

Transactions 402

Completeness of Cash Disbursement

Transactions 402

Authorization of Cash Disbursement Transactions 402

Accuracy of Cash Disbursement Transactions 402

Cutoff of Cash Disbursement Transactions 403

The Major Functions 349

Key Segregation of Duties 350

Inherent Risk Assessment 351 Industry-Related Factors 351

The Complexity and Contentiousness of Revenue

Recognition Issues 352

The Difficulty of Auditing Transactions and

Account Balances 352

Misstatements Detected in Prior Audits 352

Control Risk Assessment 353 Understand and Document Internal Control 353

Plan and Perform Tests of Controls 354

Set and Document Control Risk 354

Control Activities and Tests of Controls—Revenue Transactions 355

Occurrence of Revenue Transactions 355

Completeness of Revenue Transactions 357

Authorization of Revenue Transactions 357

Accuracy of Revenue Transactions 357

Cutoff of Revenue Transactions 358

Classification of Revenue Transactions 358

Control Activities and Tests of Controls—Cash Receipts Transactions 358

Occurrence of Cash Receipts Transactions 358

Completeness of Cash Receipts Transactions 359

Authorization of Cash Discounts 360

Accuracy of Cash Receipts Transactions 361

Cutoff of Cash Receipts Transactions 361

Classification of Cash Receipts 361

Control Activities and Tests of Controls—Sales Returns and Allowances Transactions 361

Relating the Assessed Level of Control Risk to Substantive Procedures 362

Auditing Revenue-Related Accounts 362 Substantive Analytical Procedures 363 Tests of Details of Classes of Transactions, Account

Balances, and Disclosures 364 Completeness 364

Cutoff 366

Existence 367

Rights and Obligations 367

Valuation and Allocation 368

Classification 369

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