This Document Contains Chapters 1 to 6 Chapter 1 An Introduction to Assurance and Financial Statement Auditing Learning Objectives Review Questions Multiple- Choice Questions Problems Discussion Cases Internet Assignments/ EarthWear Mini-Cases (EWMC) LO 1-1: Understand why studying auditing can be valuable to you whether or not you plan to become an auditor, and why it is different from studying accounting. 1 29 30 LO 1-2: Understand the demand for auditing and be able to explain the desired characteristics of auditors and audit services through an analogy to a house inspector and a house inspection service. 2,3,4 13,14,20 24,25 29 LO 1-3: Understand the relationships among auditing, attestation, and assurance services. 5 15,16 LO 1-4: Know the basic definition of a financial statement audit. 5,6 13,14 25 LO 1-5: Understand three fundamental concepts that underlie financial statement auditing. 7 17,18 25 LO 1-6: Be able to understand why on most audit engagements an auditor tests only a sample of transactions that occurred. 8 LO 1-7: Be able to describe the basic financial statement auditing process and the phases in which an audit is carried out. 9, 10 17,19,20 26 EWMC LO 1-8: Know what an audit report is and understand the nature of an unqualified report. 11 21,22,23 27,28 LO 1-9: Understand that the way audits are done is changing in exciting ways due to the application of technology, and audit data analytics in particular. LO 1-10: Understand why auditing demands logic, reasoning, and resourcefulness. 12 30 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number Comparison Number This Document Contains Chapters 1 to 6 in 10th edition in 11th edition 1-1 Unchanged 1-1 1-2 Unchanged 1-2 1-3 Unchanged 1-3 1-4 Unchanged 1-4 1-5 Unchanged 1-5 1-6 Unchanged 1-6 1-7 Unchanged 1-7 1-8 Revised 1-11 1-9 Unchanged 1-8 1-10 Unchanged 1-9 1-11 Revised 1-10 1-12 Revised 1-12 1-13 Unchanged 1-13 1-14 Unchanged 1-14 1-15 Unchanged 1-15 1-16 Unchanged 1-16 1-17 Unchanged 1-17 1-18 Unchanged 1-18 1-19 Unchanged 1-19 1-20 Unchanged 1-20 1-21 Unchanged 1-21 1-22 Revised 1-22 1-23 Unchanged 1-23 1-24 Unchanged 1-24 1-25 Unchanged 1-25 1-26 Revised 1-26 1-27 Revised 1-27 1-28 Unchanged 1-28 1-29 Unchanged 1-29 1-30 Revised 1-30 When students enter the first introductory class, they seldom understand what assurance or auditing entails. Generally, they will not have read Chapter 1 before class, so it’s important to spend the time necessary during the first class to capture students’ attention and stimulate their interest in auditing. Introduction After going over the class expectations, we spend the first part of class discussing and illustrating the demand for auditing and the role of auditing in society. If students are to be interested and excited to dig in and learn this daunting new material, they need to be convinced that it is important and useful. Thus, we also emphasize that the concepts underlying auditing are useful in many contexts other than auditing, including consulting and management. Later in the class, we might ask the students how they would audit the automobile revenues (say $100 billion) of a large automobile manufacturer. We tell them that each car and truck has an invoice on the window and in the company's computer system, and that 8 million cars and trucks were sold. We then ask them how many invoices out of 8 million they want to examine in order to verify the $100 billion of revenues in the financial statements. Of course, you will get some outlandish answers (e.g., 400,000 invoices). We eventually tell them that you may not look at any invoices and that you may rely solely on the company’s internal controls in conjunction with a careful ratio analysis or other type of analytical procedure. This type of example quickly gets the students' attention that auditing involves a substantial amount of judgment and common sense. [LO 1-1] Tips for Learning Auditing We spend a few minutes on this section emphasizing the differences between the study of accounting (which they are very familiar with) and the study of auditing (which they are not). We try to make sure they understand what auditing focuses on and how it is much more conceptual than their other accounting courses. We introduce the idea of a “tool kit” and how it relates to what we will be covering during the course. [LO 1-2] The Demand for Auditing and Assurance We spend a reasonable amount of time during the first lecture discussing why there is a demand for auditing and assurance services. Many students think that the demand for auditing is driven by the requirements of the Securities laws. It is important that the students have some basic understanding of the agency relationship that leads to the demand for auditing. Figure 1-1 provides a good framework for this discussion. We then bring in how the CPA fits this need with the qualities of independence, integrity, and objectivity. Sometimes we do role-plays, asking students to come to the front of the room. One is selling a car, while the other is interested in buying it. We let them discuss their concerns, what information they want, what the incentives of the two parties are, what information asymmetries might exist, etc. We then tie this scenario, which most students are somewhat familiar with or at least can relate to, back to the idea of the demand for auditing. Use Figure 1-1 An Assurance Analogy: The Case of the House Inspector Sometimes it is difficult for students to grasp the theoretical perspective of the role accounting and auditing play in the principal-agent relationship, so we use a practical analogy to aid their understanding. We go over how a house inspection is similar to a financial statement audit including who the players are and how their roles relate to what we just discussed. We ask the students what is similar and different between the house inspection and the financial statement audit beginning with Table 1-1. Lastly, we ask the students for other examples of assurance services and again try to relate the specifics of each to the characteristics listed in Table 1-1. Use Table 1-1 We then introduce the concept of “management assertions” by asking the students what specific assertions the company is making about specific financial statement items (for example: cash or inventory). They usually can come up with the most obvious ones: existence, fairly and accurately recorded, and all items are included. They might need to be pushed for some of the others. They may also fail to distinguish between assertions in terms of account balances and assertions in terms of transactions. It is useful to help them understand the differences between assertions for transactions and balances but also how they are related. Then we ask them how, as an auditor, you might go about collecting evidence on the cash account, bringing in what assertions are most important and why. We like to emphasize the differences between assertions about the account balance at the end of the period and the transactions posted to the account during the period, relating these concepts to each other and to the idea of risk from an audit perspective. Use Table 1-2 Next, we talk about what else the prospective investor would want to know besides the quality of management’s assertions. Finally, we relate all of this back to Table 1-1. Problem 24 could be covered here. [LO 1-3, 1-4] Auditing, Attest, and Assurance Services Defined Here we introduce the definitions for auditing, attest, and assurance services. We show how the attributes of independence, integrity, and competence that led to the historical demand for financial statement audits have resulted in requests for auditors to provide additional services. We briefly provide examples of attest and assurance services. Figure 1-2 can be used to present a comparison of auditing, attestation, and assurance. Use Figure 1-2 In discussing the definitions for the various services, we focus on the general definition of “auditing” from A Statement of Basic Auditing Concepts (ASOBAC). We emphasize the following phrases in the definition: • Systematic process. • Objectively obtaining and evaluating evidence. • Assertions about economic actions and events. • Degree of correspondence between those assertions and established criteria. • Communicating the results to interested users. We then discuss how the definitions for attest and assurance services are broader in nature. In discussing assurance services, we focus on improving the quality of information. [LO 1-5] Fundamental Concepts in Conducting a Financial Statement Audit In this section, we discuss examples of the fundamental concepts in a financial statement audit: materiality, audit risk, and evidence. Our philosophy is that it is much better for students to grasp the fundamental principles and concepts of auditing early on, rather than immerse them in the details of reporting, ethics, or legal liability too soon. We use Figure 1-3 to present a simple overview of the audit process and then introduce the three fundamental concepts and the conceptual and procedural details that a financial statement audit is built on: materiality, audit risk, and evidence relating to management assertions. Use Figure 1-3 This is an extremely important section as much of the rest of the course is built around these three concepts. It is imperative for the students to begin to understand that the auditor’s judgment of materiality and audit risk impact the auditor’s decision about the nature, timing, and extent of evidence to be gathered. [LO 1-6] Sampling: Inferences Based on Limited Observations Many students have the impression that auditors look at all or most of an entity’s transactions. This is a good time to introduce the idea behind sampling: auditors make inferences based on a limited (small) number of transactions. Additionally, be sure to highlight the idea that although emerging technologies like AI and big data will enable auditors to review entire populations in some situations, sampling will remain an important audit tool for the foreseeable future, for example in auditing physical inventory counts. [LO 1-7] The Audit Process We begin this section by asking the students how they might go about the audit process and listing steps on the board. Before we begin, we talk about how an auditor should plan and conduct an audit so that audit risk (the risk the auditor may unknowingly fail to appropriately modify his/her opinion on financial statements that are materially misstated) will be limited to an acceptable level. We think about the end result (an opinion) and what information is needed to develop and support that opinion. We try to get something down like this: • Obtain an understanding of the company, its business and industry. • Assess risks the company faces and how it deals with those risks. • Identify risks that may be likely to lead to material misstatement in the financials. • Design audit tests to address those risks. • Carry out audit tests and gather evidence. • Evaluate the evidence. • Issue a report. We then talk about how this process is carried out in seven phases, using Figure 1-4 to illustrate the process. This provides students with a basic framework for what occurs in an audit and what will be covered in the course. When discussing Figure 1-4, we refer the students to the chapters in the book that will cover each phase. Problem 26 could be covered here. Use Figure 1-4 [LO 1-8] Evaluate Results and Issue Audit Report We reiterate that the purpose of an audit is to issue the audit report and the importance of the evaluation process in choosing the appropriate report to issue. We use Exhibit 1-1 to introduce the “unqualified” opinion and review the components of the updated auditor’s report. We note that an unqualified opinion is sometimes referred to as a “clean” opinion. We discuss the standards surrounding “scope limitations” and “departures from GAAP” to introduce the other types of audit reports that may be issued (qualified and adverse). Note that the text does not discuss a disclaimer of opinion in this chapter, though it is covered later in the text. We also highlight the newly added section of the report relating to critical audit matters (CAMs) and the auditor’s response to CAMs. This addition represents the first major change to the auditor’s report in over 50 years! Again, our view is that it is best not to overwhelm students with large amounts of detail before they understand the basic concepts of auditing, so keep discussions of auditor reporting as basic as possible at this point. Use Exhibit 1-1 [LO 1-9] Audit Data Analytics Here we discuss data analytics and other emerging technologies and their impact on the audit. Often, students have heard all kinds of speculative rumors and may believe that AI and related advancements will one day cost them their jobs. Although this is a possibility, companies are currently hiring more finance and accounting professionals (including auditors) even as they adopt new technologies. Further, most knowledgeable observers believe the demand for well-trained auditors and financial professionals will continue to remain strong, though the nature of their jobs may change...mostly in positive ways! We like to highlight ways in which emerging technologies augment and redefine the auditor’s responsibility, instead of replacing them. By learning to skillfully interact with and interpret the data provided by these technologies, as well as make professional judgements using new systems, students will be well prepared for their careers and future technological advancements. It is important to emphasize that new technologies will make understanding fundamental accounting and auditing concepts, as well as sound professional judgment, even more important...not less! [LO 1-10] Conclusion We discuss the logic, reason, and resourcefulness (including imagination and innovation) needed by an auditor. We leave this chapter reminding the students not to memorize details but rather to try to gain an understanding of the basic underlying concepts: why financial statement audits are so important, what auditing is, and the basic process through which it is carried out. This is a great opportunity to get your students excited about and motivated to work hard studying auditing! Discussion Case We believe that using discussion cases help the students expand their understanding of the basic topics covered in the chapter. If you want your students to be able to articulate the value of an audit, we would use Discussion Case 1-29. Internet Assignment If you wish to familiarize your students with Internet sites that have accounting or auditing resources (e.g., the PCAOB’s website), you may want to assign Internet Assignment 1-30. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. Hands-On Cases EarthWear Mini-Cases The Chapter 1 mini-case can be assigned as a stand alone case and gives students the opportunity to familiarize themselves with the EarthWear Mini-Case website. This is especially useful if you plan to make use of EarthWear mini-cases in subsequent chapters! Students are asked to find several different pieces of information pertaining to EarthWear and its auditor, Willis & Adams, CPAs. Please visit Connect for the EarthWear Mini-Case assignment. IDEA and TABLEAU The Chapter 1 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 2 The Financial Statement Auditing Environment Learning Objectives Review Questions Multiple- Choice Questions Problems Discussion Cases Internet Assignments LO 2-1: Be familiar with the different types of auditors. 1 15 24 28 LO 2-2: Be familiar with the various types of audit, attest, and assurance services offered by accounting professionals. 2 16,17 24 26 28 LO 2-3: Understand the organization of public accounting firms and the composition of audit teams. LO 2-4: Understand the significant changes that have taken place in the auditing profession over the past two decades. 3,4 18 LO 2-5: Know that management is primarily responsible for the entity’s financial statements and understand the auditor’s responsibility for detecting errors, material fraud, and illegal acts. 5 19 LO 2-6: Recognize that an audit is shaped by the auditee’s business, industry, and economic environment and understand essential components and processes characteristic of most business entities. 6,7 20 LO 2-7: Be familiar with a model of business processes used to organize an audit. LO 2-8: Identify and be familiar with the major organizations that affect the public accounting profession’s environment. 8,9,10,11 21 28, 29,30 LO 2-9: Understand that auditing standards are established by both U.S. and international standard setters. 22 LO 2-10: Be familiar with the “principles underlying an audit conducted in accordance with generally accepted auditing standards.” 12,13 23 25,26 26, 27 LO 2-11: Understand the nature of auditing standards. LO 2-12: Understand that the auditing profession places a premium on ethical behavior and is governed by a Code of Professional Conduct. 14 26, 27 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 2-1 Unchanged 2-1 2-2 Unchanged 2-2 2-3 Unchanged 2-3 2-4 Unchanged 2-4 2-5 Unchanged 2-5 2-6 Revised 2-6 2-7 Unchanged 2-7 2-8 Unchanged 2-8 2-9 Unchanged 2-9 2-10 Unchanged 2-10 2-11 Unchanged 2-11 2-12 Revised 2-12 2-13 Revised 2-13 2-14 Unchanged 2-14 2-15 Unchanged 2-15 2-16 Unchanged 2-16 2-17 Revised 2-17 2-18 Unchanged 2-18 2-19 Unchanged 2-19 2-20 Unchanged 2-20 2-21 Unchanged 2-21 2-22 Unchanged 2-22 2-23 Revised 2-23 2-24 Unchanged 2-24 2-25 Revised 2-25 2-26 Removed 2-26 2-27 Revised 2-26 2-28 Unchanged 2-27 2-29 Unchanged 2-28 2-30 Unchanged 2-29 Chapter 2 covers the context, or environment, in which auditors function, starting with an overview of the recent changes in the public accounting profession. [LO 2-1, 2-2] Types of Auditors and Services We spend a few minutes discussing the different types of audits and services (e.g., internal control audits, compliance audits, operational audits, forensic audits, attest services, and assurance services) firms can provide and the different types of auditors (e.g., external auditors, internal auditors, government auditors, and forensic auditors). Chapter 21 discusses attestation services more thoroughly. Problem 24 could be covered here. [LO 2-3] Public Accounting Firms We briefly review the organization of firms (e.g., proprietorship, general or limited liability partnerships, or corporation), the categorization of the firms (e.g., Big 4, mid-tier firms, regional firms, and local firms), the types of services (e.g., audit, tax, management advisory services, and accounting and review services), and the internal organization (e.g., partner, manager, senior, and associate) that describes the public accounting firms. [LO 2-4] Two Decades of Challenge and Change for Financial Statement Auditors The time we spend with this topic depends on what was covered in the earlier class. We try to continue the discussion, emphasizing to the students issues facing the profession today or the overall environment the profession is operating in. We focus on • Events leading up to the current landscape. • The explosion of scandals that took place. • Government intervention (i.e., Sarbanes-Oxley Act 2002, Dodd-Frank Act 2010). • The profession’s response (a healthy move back to the basics). [LO 2-5] Society’s Expectations and the Auditor’s Responsibility Students generally find this topic very interesting. We focus on the auditor’s responsibility to detect errors, fraud, and illegal acts. Many students falsely believe that auditors have the responsibility to detect all errors, fraud, and illegal acts. Sometimes, we have a guest speaker come into this class to discuss the growing field of forensic accounting. [LO 2-6] The Context of Financial Statement Auditing We spend a few minutes emphasizing to the students the importance of an auditor knowing his/her auditees’ business and industry characteristics since that is the context or environment within which a particular business operates. We emphasize that it is difficult for an auditor to effectively audit something which he/she does not fully understand. We end this section with a short introduction to a high-level model of a business entity and then spend more time with the five cycles used to break the audit down into manageable pieces covered in LO 2-7. [LO 2-7] A Model of Business With the high-level model, we make sure everyone knows how a business operates at the highest level by including the roles of corporate governance, the board of directors, and the audit committee. Then we discuss briefly with the students how objectives are formed and what strategies might be designed to achieve those objectives by asking the students to come up with related examples of each and writing them on the board. Then we write down specific processes that might be set up so that the strategies are implemented. Last, we ask them for specific risks that might threaten the achievement of the objectives we came up with and write these down as well. We then spend more time with the process part of the above exercise. We ask the students to list the five cycles and relate them to what we discussed above using Figure 2-1. Next, we briefly discuss each of the five cycles individually as well as how they are interrelated: • The financing process. • The purchasing process. • The human resource management process. • The inventory management process. • The revenue process. Use Figure 2-1 Finally, we relate the process components to the “business model.” Management establishes processes in the five categories discussed above to implement the organization’s strategies and achieve its objectives, as well as integrating internal controls to mitigate enterprise risks. The financial statements report the financial results of those efforts to outside parties (the organization’s performance and its external reporting and accountability). [LO 2-8] Organizations that Affect the Public Accounting Profession We use Figure 2-2 as a framework for discussing the various organizations that affect financial statement audits. We tend to focus on the SEC, the PCAOB, the FASB, and the AICPA. Use Figure 2-2 [LO 2-9, LO 2-10] Auditing Standards Auditing standards provide a systematic approach to auditing and thus should be emphasized to the students. We begin the discussion with the current state of audit standard-setting: ASB and PCAOB. We discuss how the PCAOB issued AS1 to adopt all existing audit standards as of 2003, but we remind the students that standards for audits of private companies are beginning to diverge from those applicable to audits of public companies since both standard-setting bodies are still active. We also discuss the principles underlying a financial statement audit by referring back to the ASB’s auditing standards. Our intention by discussing the purpose and premise of the audit, responsibilities, performance, and reporting is to help students realize how a solid understanding of the framework of the audit can inform their approach regardless of which set of standards they find themselves using. Problems 25 and/or 26 could be covered here. Use Exhibit 2-2 [LO 2-11] Auditing Standards and the Codification of Standards Here, we discuss recent updates the PCAOB has made to update and improve the codification of their auditing standards, reorganizing them into topical categories and subcategories like the FASB’s GAAP codification. We also mention the similar coverage, although differing structure, of the ISA. [LO 2-12] Ethics, Independence, and the Code of Professional Conduct We try to demonstrate to the students why it is important for auditors to be independent and act ethically. The key point for the students to learn is that the value in the audit lies in the auditor’s reputation for integrity and objectivity, which of course involves independence from the auditee. Users of the financial statements will place little value on the auditor’s report if the auditor is not perceived to be honest and objective. We also might spend a little time discussing the issues of low-balling and opinion shopping. We use this section to alert the students to the existence of the Code of Professional Conduct and the importance of independence for auditors (Chapter 19 discusses this topic in greater detail). Discussion Cases Discussion Cases 27 and 28 present Merry-Go-Round, a real world company that sued its consultants over poor advice. The case covers Ernst & Young’s consulting work for the company and provides the instructor an opportunity to expand the discussion of audit versus consulting services. The case also provides an opportunity to talk about how work for one company may affect the objectivity and independence of work on another company. Internet Assignments The Internet assignments included in this chapter provide ample opportunity to have the students use the Internet to search for information. If you have access to the Internet in your classroom, show students the AICPA home page (http://www.aicpa.org). Internet Assignment 30 has the students go to this site as well as the SEC, PCAOB, IAASB, and IFRS websites. Internet Assignment 29 provides the students with the opportunity to examine the types of audits conducted by the GAO. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. Hands-On Cases IDEA and TABLEAU The Chapter 2 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 3 Audit Planning, Types of Audit Tests, and Materiality Learning Objectives Review Questions Multiple- Choice Questions Problems Discussion Cases Internet Assignments/ EarthWear Mini-Cases (EWMC) LO 3-1: Understand the auditor’s requirements for client acceptance and continuance. 1,2 16 26 34, EWMC LO 3-2: Understand the steps that are involved in the preliminary engagement activities. 27 LO 3-3: Know what is required to establish an understanding with the entity. 3 27, 28 LO 3-4: Know the types of information that are included in an engagement letter. 3 17 28 LO 3-5: Understand how the work of the internal auditors can assist in the performance of the audit. 4 18 35 LO 3-6: Know the responsibilities of the audit committee and how it relates to the external auditors. 5 20 29 LO 3-7: Know the steps that are performed in planning an audit engagement. 6,7,8 19,21,22 27 33 36 EWMC LO 3-8: Understand the importance of supervision to the planning and conduct of the audit. 9 23 LO 3-9: Know the types of audit tests. 10 33 LO 3-10: Understand the concept of materiality. 11,12,13, 14,15 24 EWMC LO 3-11: Know the steps to applying materiality in an audit. 11,12,13, 14,15 24, 25 30,31,32 LO 3-12: Apply the materiality steps to an example (EarthWear). 25 30,31,32 EWMC NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 3-1 Unchanged 3-1 3-2 Unchanged 3-2 3-3 Unchanged 3-3 3-4 Unchanged 3-4 3-5 Unchanged 3-5 3-6 Unchanged 3-6 3-7 Unchanged 3-7 3-8 Unchanged 3-8 3-9 Unchanged 3-9 3-10 Unchanged 3-10 3-11 Unchanged 3-11 3-12 Unchanged 3-12 3-13 Unchanged 3-13 3-14 Unchanged 3-14 3-15 Unchanged 3-15 3-16 Unchanged 3-16 3-17 Unchanged 3-17 3-18 Unchanged 3-18 3-19 Unchanged 3-19 3-20 Unchanged 3-20 3-21 Unchanged 3-21 3-22 Unchanged 3-22 3-23 Unchanged 3-23 3-24 Unchanged 3-24 3-25 Unchanged 3-25 3-26 Unchanged 3-26 3-27 Unchanged 3-27 3-28 Unchanged 3-28 3-29 Unchanged 3-29 3-30 Unchanged 3-30 3-31 Unchanged 3-31 3-32 Unchanged 3-32 3-33 Unchanged 3-33 3-34 Unchanged 3-34 3-35 Unchanged 3-35 3-36 Unchanged 3-36 The major focus of Chapter 3 is audit planning. It is critical to impress upon the students how good audit planning leads to an effective and efficient audit. The discussion covers the following phases of the audit that relate to audit planning (refer to Figure 3-1): • Client acceptance and continuance. • Preliminary engagement activities. • Plan the audit. Use Figure 3-1 The chapter also covers the types of audit tests and the concept of materiality. [LO 3-1] Client Acceptance and Continuance It is important for the students to have an understanding of the client acceptance and continuance process. We first talk about the issues the auditor should consider when going through the client acceptance and continuance process. Table 3-1 (revised) provides a list of procedures that the auditor can use to evaluate a prospective auditee. The key factor to emphasize with the students is the fact that the client acceptance and continuance process is a valuable source of information for identifying business risks. Use Table 3-1 We also discuss the types of inquiries that the successor auditor should make to the predecessor auditor. [LO 3-2] Preliminary Engagement Activities There are generally three preliminary engagement activities: (1) determining the audit engagement team requirements, (2) ensuring that the audit team and audit firm are in compliance with ethical and independence requirements, and (3) establishing an understanding with the entity. CPA firms must ensure that audits are staffed by individuals who possess an appropriate amount of technical training for the engagements. Factors that should be considered when staffing an engagement include: • Engagement size and complexity. • Level of risk. • Industry or other expertise required. • Personnel availability. • Timing of the work to be performed. The second issue that must be addressed as part of preliminary planning is independence of the audit team and firm. We mention family relationships may impair independence. Point out that this issue will be covered later. Third, establishing an understanding with the entity is part of LO3. [LO 3-3] Establish an Understanding with the Entity Finally, we discuss that the auditor should establish an understanding with the entity about the terms of the engagement including the engagement letter, using the work of internal auditors, and the role of the audit committee. [LO 3-4] The Engagement Letter The students should be told about the importance of the engagement letter. We emphasize to the students that the engagement letter is the contract between the auditor and the auditee. It spells out each party's responsibilities. We then have the students look at the engagement letter included in Exhibit 3-1 and then discuss the information contained in the letter. Use Exhibit 3-1 [LO 3-5] Using the Work of the Internal Auditors This is a good time to discuss the importance of the internal audit function to the financial statement audit. We focus on the factors included in Table 3-2 for assessing the reliability of the internal audit function. Use Table 3-2 [LO 3-6] The Role of the Audit Committee We spend a bit of time here discussing the different requirements for public companies regarding audit committees. We specifically go over the requirements from Sarbanes-Oxley regarding public companies. We also discuss the relationship between the audit committee and the external auditor. It is important to focus on how an active audit committee improves the auditor's independence. There are numerous sources of additional information about audit committees. You might consider inviting an audit committee member to speak with your class about his/her changing role in corporate governance. [LO 3-7] Planning the Audit This section presents the steps that are involved in developing an audit strategy, including: • Assess business risks. • Establish materiality. • Consider multilocations. • Assess the need for specialists. • Consider violations of laws and regulations. • Identify related parties. • Consider additional value-added services. • Document the overall audit strategy, audit plan, and prepare audit programs. We use Table 3-3 (revised) to discuss issues related to violations of laws and regulations. Use Table 3-3 [LO 3-8] Supervision of the Audit We spend some time here discussing the audit team structure and who has responsibility for planning and supervision of the audit. Specifically, we discuss the engagement partner's responsibilities and how they differ from the responsibilities of the remainder of the engagement team. [LO 3-9] Types of Audit Tests Present the three general types of audit tests: • Risk assessment procedures. • Tests of controls. • Substantive procedures (tests of details and substantive analytical procedures). Define each type of test and give examples. We find that most students have difficulty distinguishing between tests of controls and substantive procedures. We tell the students that while textbooks make such distinctions, in the real world, many of these tests serve both purposes (i.e., dual-purpose tests). [LO 3-10] Materiality We usually start the discussion of materiality by introducing the Supreme Court of the United States interpretation of the federal securities laws, which states that a fact is material if there is “a substantial likelihood that the…fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Further, the Supreme Court has stated that the determination of materiality requires “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him…” It is important to impress upon the students that the consideration of materiality involves professional judgment and that there is very little specific guidance in the auditing standards on how to establish materiality. [LO 3-11] Steps in Applying Materiality We use Figure 3-2 to present the three steps in applying materiality: 1. Determine overall materiality. 2. Determine tolerable misstatement. 3. Evaluate audit findings. Use Figure 3-2 When discussing how to establish overall materiality (Step 1), the common bases shown in Table 3-5 and the qualitative factors that should be considered (e.g. prior year misstatements, risk of fraud, loan covenant violations, analyst expectations, the auditee’s business environment). Use Table 3-5 In discussing the determination of tolerable misstatement or performance materiality (Step 2), note to the students that this process involves setting tolerable misstatement for each account. There is no required or optimal method for this process; rather it is based on judgment or some formal quantitative approach. In discussing Steps 1 and 3, make sure that the students realize that the preliminary and final judgments about materiality need to consider qualitative factors such as those listed above. When discussing Step 3, it is important to note that misstatements include factual misstatements found in the sample data, as well as projections based on sample data. We also discuss the actions the auditor should consider when the misstatements are greater than the preliminary judgment about materiality. If management will not adjust the financial statements, the auditor should issue a qualified or adverse opinion because the financial statements do not present fairly in conformity with GAAP. [LO 3-12] Apply Materiality: EarthWear Clothiers It is time well spent to walk the students through the three steps for applying materiality using the EarthWear example. We refer them to Exhibit 3-3 to show them an example working paper for estimating likely misstatements (Step 3). Use Exhibit 3-3 Discussion Case Discussion case 3-33 is also based on a real world situation. It is a good case for discussing a potential violation of laws and regulation and possible effects on the audit. In this case, the company was very concerned about its employees and intended to protect them even though it might lead to a violation of a consent decree. Internet Assignments Internet assignment 3-34 provides a good exercise for the students to learn more about auditor changes. Internet assignment 3-35 provides a good exercise for the students to learn more about internal auditing and its governing body, the IIA. Internet assignment 3-36 is part of the EarthWear running case. This problem requires the students to find information on the retail mail order industry. Practice Insights Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. EarthWear Mini-Cases The Chapter 3 mini-cases can be assigned as stand alone cases. The case entitled “Client Acceptance” asks students to evaluate the continuance decision for EarthWear as an auditee. The other cases give students the opportunity to complete the audit planning memo for the EarthWear engagement. Please visit Connect for the mini-case assignments. IDEA The Chapter 3 IDEA problems are an excellent hands-on supplement to the textbook material. Please visit Connect for IDEA exercises. Chapter 4 Risk Assessment Learning Objectives Review Questions Multiple- Choice Questions Problems Discussion Cases Internet Assignments/ EarthWear Mini-Cases (EWMC) LO 4-1: Understand the concept of audit risk. 1,2 13,14 23,24,25, 26,27 LO 4-2: Learn the form and components of the audit risk model. 2,3 15 23,24,25, 26,27 LO 4-3: Understand how to use the audit risk model. 4 16 23,24,25, 26,27,28 LO 4-4: Understand the auditor’s risk assessment process. 5,6,7,8 16 28,29,30, 32 33 EWMC 34 LO 4-5: Learn how the auditor assesses the risk of material misstatement. 5,6,7,8,9 17,18,20 28,29,30, 32 33 34 LO 4-6: Understand the fraud risk assessment process. 10 17,18,19, 20 31 LO 4-7: Learn how to respond to the results of the risk assessments. 11,12 32 34 LO 4-8: Learn how to evaluate the results of the audit tests. 32 LO 4-9: Understand the documentation requirements for risk assessments and responses. 31 LO 4-10: Learn the auditor’s communication requirements about fraud to management, the audit committee, and others. 21,22 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 4-1 Unchanged 4-1 4-2 Unchanged 4-2 4-3 Unchanged 4-4 4-4 Unchanged 4-3 4-5 Unchanged 4-5 4-6 Unchanged 4-6 4-7 Unchanged 4-7 4-8 Unchanged 4-8 4-9 Unchanged 4-9 4-10 Unchanged 4-10 4-11 Unchanged 4-11 4-12 Unchanged 4-12 4-13 Unchanged 4-13 4-14 Unchanged 4-14 4-15 Unchanged 4-15 4-16 Unchanged 4-16 4-17 Unchanged 4-21 4-18 Unchanged 4-17 4-19 Unchanged 4-18 4-20 Unchanged 4-19 4-21 Unchanged 4-20 4-22 Unchanged 4-22 4-23 Unchanged 4-23 4-24 Unchanged 4-24 4-25 Unchanged 4-25 4-26 Unchanged 4-26 4-27 Unchanged 4-27 4-28 Unchanged 4-28 4-29 Unchanged 4-31 4-30 Unchanged 4-29 4-31 Unchanged 4-30 4-32 Unchanged 4-32 4-33 Unchanged 4-33 4-34 Unchanged 4-34 Chapter 4 introduces the basic auditing concept of audit risk. It is helpful to the students' understanding of this concept if the instructor relates them back to the wording used in the auditor’s report. Audit risk relates to “reasonable assurance.” It is also important to discuss how audit risk impacts the auditor’s decisions regarding evidence. This includes planning the nature, timing, and extent of audit procedures. [LO 4-1] Audit Risk Risk is the first fundamental concept that underlies the audit process. We begin by distinguishing between audit risk and engagement risk (discussed in LO 4-2). It helps the students to think about how each of the risks can be controlled. Audit risk can be controlled by a well- planned and well-conducted audit and engagement risk can be indirectly controlled by good client acceptance and continuance procedures. It may be a good idea to emphasize the definition of audit risk: Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. We also discuss the assessment of audit risk at the account or disclosure level and the assertion level, not just at the overall financial statement level. [LO 4-2] Audit Risk Model Proper coverage of the audit risk model is imperative. While it may be difficult to apply this model in the real world, the model provides an excellent framework for understanding the risks that the auditor must assess or control. Each of the process chapters (e.g., revenue) is organized around the components of the audit risk model. AR = IR × CR × DR We start by discussing the definition of each term in the model and tell the students that the factors that are important for assessing IR and CR are discussed under the auditor’s risk assessment process and the risk of material misstatements. We also tell the students that we will spend considerable time in Chapter 6 on the assessment of control risk. Detection Risk We point out to the students that detection risk is composed of two risks: sampling risk and nonsampling risk. We then define each type of risk. It is important to tell the students that nonsampling risk occurs because of the auditor’s use of an inappropriate audit procedure, improper or incomplete use of an appropriate audit procedure, or misinterpretation of results from an audit procedure. Mention that nonsampling risk can be minimized through adequate planning, proper assignment of audit staff to the engagement team, the application of professional skepticism, supervision and review of the audit work performed, and supervision and conduct of a firm’s audit practice in accordance with appropriate quality control standards. [LO 4-3] Use of the Audit Risk Model We normally work through the three steps involved in using the audit risk model: 1. Setting a planned level of audit risk. 2. Assessing the risk of material misstatement (IR × CR). 3. Solving the audit risk equation for the appropriate level of detection risk. We emphasize that when assessing IR and CR (Step 2), the auditor should identify and evaluate the factors that impact the entity’s business risks and the risk of material misstatement. Figure 4-1 can be used to show the relationship of the entity’s business risks and the risk of material misstatement to the IR and CR components of the audit risk model. Use Figure 4-1 You may also want to cover Problems 4-24 and 4-25 as examples of using the audit risk model to determine DR. We ask the students to think of any limitations of the audit risk model. We are primarily looking for the idea that the actual level of audit risk may be greater than (or less than) the risk indicated by the formula as well as the idea that inherent risk and control risk are assessed by the auditor as well and may differ from the actual risks that exist. [LO 4-4] The Auditor’s Risk Assessment Process The revised audit approach requires that the auditor obtain and support an understanding of the entity and its environment and identify business risks that may result in material misstatements (see Figure 4-2). Business risks are threats to the entity’s ability to achieve its objectives and execute its strategies. Use Figure 4-2 The auditor’s understanding of the entity and its environment includes knowledge about the following categories: • Nature of the entity. • Industry, regulatory, and other external factors (Table 4-1). • Objectives, strategies, and related business risks. • Entity performance measures. • Internal control (Chapter 6). Use Table 4-1 EarthWear serves as a good example for discussing the issues related to assessing business risks. [LO 4-5] Assessing the Risk of Material Misstatement In this section, we focus on the risk of material misstatement due to fraud. The students tend to find this very interesting. Auditing standards state that the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Normally, we start this discussion with the definitions of error and fraud, and examples of each. We also discuss the difference between “factual,” “judgmental,” and “projected” misstatements. We point out that fraud can be classified into two types: (1) fraudulent financial reporting and (2) misappropriation of assets. [LO 4-6] The Fraud Risk Assessment Process It is important to impress on the students that material misstatement due to fraud is a function of: Fraud = f(incentive/pressure, opportunity, attitude/rationalization) We think that it is a good idea to walk the students through the various categories of risk factors related to fraud. Risk factors for fraudulent financial reporting are shown for each category: • Incentives/pressures (Table 4-2). • Opportunities (Table 4-3). • Attitudes/rationalizations (Table 4-4). Risk factors that relate to misappropriation of assets for each category are also presented (see Table 4-5). Exhibits 4-1 (new example) and 4-2 illustrate current events regarding fraud. Alternatively, we sometimes show a short video (for instance on the ZZZZ Best scandal) or cover an outside case at this point. Problem 4-31 could be covered here. Use Tables 4-2 to 4-5 Use Exhibits 4-1 and 4-2 [LO 4-7] The Auditor’s Response to the Results of the Risk Assessments We like to spend a few minutes discussing with the students what responses the auditor should take given the risk assessment. Figure 4-3 shows the relationship between the assessment of risk of material misstatement to the design and performance of auditing procedures. We make sure the students can clearly distinguish between high-risk and low-risk assertions. Use Figure 4-3 [LO 4-8] Evaluation of Audit Test Results Again we spend a few minutes discussing with the students the implications of what we have discussed in this chapter. We point out to them that the auditor should consider whether the accumulated results of audit procedures affect the assessments of the entity’s business risks and the risk of material misstatement. We specifically point out that there are steps that the auditor should follow if the auditor has determined that a misstatement is or could be the result of fraud and the auditor thinks or knows that the misstatement is or could be material. We also mention to the students that if the audit indicates a significant risk of fraud, the auditor may consider withdrawing from the engagement. We use Figure 4-4 to recap all of the concepts in the chapter to this point. Use Figure 4-4 [LO 4-9] Documentation of the Auditor’s Risk Assessment and Response We use Exhibit 4-3 to illustrate a questionnaire to document the auditor’s understanding of the entity and its environment. Then we point out to the students other areas that require documentation similar to that shown in Exhibit 4-3. Use Exhibit 4-3 [LO 4-10] Communications about Fraud to Management, the Audit Committee, and Others We point out to the students that whenever the auditor has found evidence that a fraud may exist, these matters should be brought to the attention of an appropriate level of management or, in the case of fraud involving senior management and fraud that causes a material misstatement of the financial statements, directly to the attention of the audit committee of the board of directors. It is interesting to bring up the topic of confidentiality here and note that the disclosure of fraud to parties other than the entity’s management and its audit committee is ordinarily not part of the auditor’s responsibility. Discussion Cases There is one discussion case included in this chapter that is based on a real world situation: Koss Corporation (4-33). This case provides a way to supplement the discussion in the auditing standards with real fact situations. Internet Assignments Internet assignment 4-34 allows the instructor to have the students complete the questionnaire included in the chapter (Exhibit 4-3) for a real world company. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. EarthWear Mini-Cases The Chapter 4 mini-case can be assigned as a stand-alone case. Please go to Connect for the mini-case assignments. IDEA and TABLEAU The Chapter 4 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 5 Evidence and Documentation Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases Internet Assignmen ts/ EarthWea r Mini- Cases (EWMC) LO 5-1: Understand the relationship between audit evidence and the auditor’s report. 1,2 LO 5-2: Know management assertions about classes of transactions, account balances, and related disclosures. 3,4 17,18 30,31,33 LO 5-3: Learn the basic concepts of audit evidence. 5,6 19 40,42 43 EWMC LO 5-4: Know the audit procedures used for obtaining audit evidence. 7,8,9 17,18,19 , 20,21,22 , 23 32, 34,35,36 40,42 43 LO 5-5: Understand the reliability of the types of evidence. 8,9,10 20,21, 22,23 34,35,36 40,42 43 LO 5-6: Understand the audit testing hierarchy. 11,12 24 LO 5-7: Understand the functions of audit documentation. 37 LO 5-8: Develop an understanding of the content, types, organization, and ownership of audit documentation. 13 25,26,27 37 LO 5-9: Learn the purposes and types of analytical procedures. 14,15 28 38,39 41 LO 5-10: Be familiar with financial ratios that 16 29 39 are useful as analytical procedures. NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 5-1 Unchanged 5-1 5-2 Unchanged 5-2 5-3 Unchanged 5-3 5-4 Unchanged 5-4 5-5 Unchanged 5-5 5-6 Unchanged 5-6 5-7 Unchanged 5-7 5-8 Unchanged 5-8 5-9 Unchanged 5-9 5-10 Unchanged 5-10 5-11 Unchanged 5-11 5-12 Unchanged 5-12 5-13 Unchanged 5-13 5-14 Unchanged 5-14 5-15 Unchanged 5-15 5-16 Unchanged 5-16 5-17 Unchanged 5-17 5-18 Unchanged 5-18 5-19 Unchanged 5-19 5-20 Unchanged 5-20 5-21 Unchanged 5-21 5-22 Unchanged 5-22 5-23 Unchanged 5-23 5-24 Unchanged 5-24 5-25 Unchanged 5-28 5-26 Unchanged 5-29 5-27 Unchanged 5-25 5-28 Unchanged 5-26 5-29 Unchanged 5-27 5-30 Revised 5-30 5-31 Revised 5-31 5-32 Unchanged 5-32 5-33 Unchanged 5-33 5-34 Unchanged 5-34 5-35 Unchanged 5-35 5-36 Unchanged 5-36 5-37 Unchanged 5-37 5-38 Unchanged 5-38 5-39 Unchanged 5-39 5-40 Unchanged 5-40 5-41 Unchanged 5-41 5-42 Unchanged 5-42 5-43 Unchanged 5-43 Chapter 5 covers the third important concept underlying the audit process: audit evidence. We usually start this topic by reintroducing the third standard of fieldwork and the definition of evidential matter. We point out to the students that most of the work on a typical audit involves obtaining and evaluating evidence. [LO 5-1] The Relationship of Audit Evidence to the Audit Report Figure 5-1 can be used to provide an overview of how the auditor gathers evidence to support the audit report on the financial statements. We tell the students that the financial statements contain management's assertions about financial statement components (give them an example). We then tell them that the auditor develops audit procedures based on those assertions to gather evidence to test the assertions. Based on the evidence, the auditor decides which audit report to issue. Use Figure 5-1 This is also a good time to explain to the students that there are a number of different methods used by public accounting firms to identify components of the financial statements for testing purposes. We tell them that some firms use a balance sheet approach that identifies components by account, while other firms use a business process or cycle approach that focuses on the flow of the transactions by functional cycle and the related accounts. This text focuses on business processes and their related transactions and financial statement accounts. Note: The ASB and IAASB have revised the categories of assertions from three to two categories. Table 5-1 provides the revised categories and definitions. After we have presented this overview, we spend considerable time covering the details of management assertions and audit procedures. We have found that if the students develop a good understanding of these concepts, then it is easier to learn how to apply them to the various business processes. [LO 5-2] Management Assertions We usually present a summary of the management assertions by category similar to Tables 5- 1 and 5-2. We discuss each assertion and provide (or elicit from the students) at least one example for each. Use Tables 5-1 and 5-2 We use Table 5-3 to introduce the idea of audit procedures to the students using examples of audit procedures for accounts receivable. Students are usually able to understand how each of the audit procedures provides evidence on each management assertion for accounts receivable. Use Table 5-3 [LO 5-3] The Concepts of Audit Evidence It is important to discuss the following concepts related to audit evidence: • The nature of audit evidence. • The sufficiency and appropriateness of audit evidence. • The evaluation of audit evidence. We first discuss the nature of audit evidence by describing what makes up corroborating audit evidence. It is important to point out to the students that much of the evidence that auditors encounter today is in electronic form. In covering the sufficiency or quantity of evidence, it is important to point out that evidence is usually persuasive rather than convincing in forming an opinion on the financial statements for two reasons. First, the auditor usually reaches a conclusion on a component of the financial statements based on a subset of the available evidence, a sample. Second, the auditor usually relies on evidence that is not perfectly reliable. We also reinforce the idea that the amount and type of evidence is determined by the auditor's professional judgment. In discussing the appropriateness or quality of evidence, we focus on the relevance and reliability of audit evidence. In particular, we discuss the following factors that affect the reliability or validity of evidence: • Independent source outside the entity. • Effectiveness of internal control. • Auditor's direct personal knowledge. • Documentary evidence. • Original documents. Lastly, we indicate that the evaluation of evidence is an important skill that the auditor must develop. Auditors must understand the types of evidence and their reliability. The auditor must also be thorough in searching for evidence and be unbiased in its evaluation. [LO 5-4] Audit Procedures for Obtaining Audit Evidence We first remind the students of the three categories of audit procedures. These are risk assessment procedures, tests of controls, and substantive procedures. We point out to the students that the auditor examines the following types of audit evidence when conducting audit procedures: • Inspection of records or documents. • Inspection of tangible assets. • Observation. • Inquiry. • Confirmation. • Recalculation. • Reperformance. • Analytical procedures. • Scanning. We believe that it is important to go over each type of evidence. Problem 5-32 is good for testing the student’s knowledge of the types of evidence and Problem 5-35 relates these audit procedures to the categories of assertions and the primary assertion being tested. We tend to focus on the reliability of the types of evidence and present the hierarchy shown in Table 5-6 [see LO 5- 5 and 5-6 below]. Problem 5-34 allows students to evaluate the reliability of various types of evidence. Use Table 5-6 [LO 5-5] Reliability of the Types of Evidence Table 5-6 presents a hierarchy of the reliability of the types of evidence. The general guidelines include a continuum for levels of reliability from higher to lower reliability for each of the types of audit evidence. For example, inspection of tangible assets probably would be viewed as a high level of audit evidence. We point out that the reliability of the types of evidence may vary considerably across entities. Use Table 5-6 [LO 5-6] The Audit Testing Hierarchy We begin the topic by asking the students (and listing on the board) what decisions they believe are involved for testing significant balances. We try to get something up on the board similar to Figure 5-3. We then talk about why the hierarchy is important: it is more effective and more efficient. We make sure to point out that assurance cannot be obtained solely from testing controls; an auditor must also perform some type of substantive procedure (it may be analytical procedures or tests of details or both). Sometimes it is difficult for students to understand and visualize how the auditor decides on the proper evidence mix. We use Figures 5-4 and 5-5 (the assurance buckets) to aid their understanding. We point out that ultimately it is the auditor that will decide by using her professional judgment. Use Figures 5-3, 5-4, and 5-5 [LO 5-7] Functions of Audit Documentation Audit documentation is the auditor’s record of the work performed and the conclusions reached on the audit. You can think of audit documentation as the “story” of the audit. Audit documentation is also referred to as working papers or the audit file. Auditing standards stipulate that working papers have three functions: 1. To provide principal support for the representation in the auditor’s report that the audit was conducted in accordance with GAAS; 2. To aid in the planning, performance, and supervision of the audit; and 3. To provide the basis for the review of the quality of the work by providing a written documentation of the evidence supporting the auditor’s significant conclusions. We emphasize that the specific form and content of the working papers are a function of the circumstances of each specific engagement. [LO 5-8] Content of Audit Documentation Audit documentation should include a written audit program (or set of audit programs) for the engagement. Most public accounting firms maintain audit documentation in two types of files: permanent and current. Permanent files contain historical data about the company under audit that are of continuing relevance to the audit. Current files include information and data related specifically to the current year’s engagement (Table 5-9 contains examples of types of information in each type of file). It is important to cover the following topics when discussing working papers: • Examples of audit documentation (audit plan and programs, working trial balance, account analysis and listing, audit memoranda, adjusting and reclassification entries). • Format of Audit Documentation (heading, indexing and cross- referencing, tick marks). • The organization of audit documentation (Figure 5-6 presents an example of how audit documents could be organized to support the cash account). • The ownership of audit documentation (property of the auditor). • Audit Document Archiving and Retention (PCAOB standards require that audit documentation be retained for seven years from the date of completion of the engagement for public companies). Tables 5-7, 5-8, and 5-9, Exhibits 5-1, 5-2, and 5-3, and Figure 5-6 can be used to supplement the discussion of these topics including current changes. Use Tables 5-7, 5-8, and 5-9 Use Exhibits 5-1, 5-2, and 5-3 Use Figure 5-6 [LO 5-9] Advanced Module 1: Analytical Procedures Given the growing importance of analytical procedures, we spend considerable time with this topic. We also briefly discuss the use of audit data analytics. In particular, we focus on: • The definition of analytical procedures. • The purposes of analytical procedures. • The decision process. We spend considerable time discussing the decision process after we go over the definition and purposes of analytical procedures. We introduce the three types of procedures: trend analysis, ratio analysis, and reasonableness analysis (using Table 5-10). We go over Figure 5-7, which provides an overview of the auditor's decision process for substantive analytical procedures to collect audit evidence. We focus on the first step: developing an expectation for the amount or account balance. We make sure the students understand the idea of the quality or precision of an expectation and the four factors that affect it. It is important to "walk" the students through this exhibit, focusing on the important steps in the process. The text uses EarthWear Clothiers to illustrate the process, which we cover as well in class. We also use the Advanced Module to show the students the different types of ratios that can be used as analytical procedures. This is a good time to assign Problem 5-38 on estimating EarthWear’s “reserve for returns.” Use Table 5-10 Use Figure 5-7 [LO 5-10] Advanced Module 2: Selected Financial Ratios Useful as Analytical Procedures We review the following financial ratios used by auditors as analytical procedures: • Short-term liquidity ratios • Current ratio • Quick ratio • Operating cash flow ratio • Activity ratios • Receivables turnover and days outstanding in accounts receivable • Inventory turnover and days of inventory on hand • Profitability ratios • Gross profit percentage • Profit margin • Return on assets • Return on equity • Coverage ratios • Debt to equity • Times interest earned We remind students that auditors may compare the auditee’s ratios with industry averages, but we stress that because industry ratios are averages that they may not capture operating or geographical factors that may be specific to the entity. Also we discuss the use of ratios in trend analysis to observe changes in the financial health of the company over time. Discussion Cases Discussion case 5-40 is based on the Lernout & Hauspie fraud situation. It contains a number of interesting questions about management assertions and the types of information that could have been gathered by the auditors. Sources are also provided for background information for the students. Discussion case 5-42 is a case developed based on a real world scenario. We tell the students that this is a real case and that industry policy allows for the return of unsold books to the publisher (your own campus bookstore will have such a policy). The requirements of the case may be somewhat difficult for the students at this stage of their audit knowledge, but you can use the case to pique their interest in the importance of evidence and the difficulties that may arise in the real world in verifying estimates. Internet Assignment Internet assignment 5-43 requires the students to search the Internet for information about EDI and image-processing systems. We usually have them start at the AICPA’s home page (www.aicpa.org). Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. EarthWear Mini-Cases The Chapter 5 mini-case can be assigned as a stand alone case. Please go to Connect for the mini-case assignments. IDEA and TABLEAU The Chapter 5 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 6 Internal Control in a Financial Statement Audit Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases EarthWea r Mini- Cases (EWMC) LO 6-1: Understand the importance of internal control to management and auditors. 1 12,13 LO 6-2: Know the definition of internal control. 14 25 LO 6-3: Know what controls are relevant to the audit. 14, LO 6-4: Understand the effect of information technology on internal control. 2 27 LO 6-5: Be familiar with the components of internal control together with the principles associated with each component. 3,4 15 25,26,29 32,33 LO 6-6: Understand how to plan an audit strategy based on assessments and decisions about internal control. 5 16,17 25,26,27, 29 32,33 LO 6-7: Know how to develop an understanding of an entity’s internal control. 6,7 13 EWMC LO 6-8: Be familiar with the tools available for documenting the understanding of internal control. 8,9 25,28 EWMC LO 6-9: Know how to assess the level of control risk. 9 18 29 LO 6-10: Know how auditors perform tests of 17,19, 20 EWMC controls. LO 6-11: Understand audit strategies for the nature, timing, and extent of substantive procedures based on different levels of detection risk. 10 30 LO 6-12: Understand the considerations for the timing of audit procedures. 10 30 LO 6-13: Be familiar with how to assess control risk when an entity’s accounting transactions are processed by a service organization. 21 LO 6-14: Understand the auditor’s communication of internal control-related matters. 11 22 31 LO 6-15: Be familiar with general and application controls. 23 LO 6-16: Understand how to flowchart a business process. 24 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 6-1 Unchanged 6-1 6-2 Unchanged 6-2 6-3 Unchanged 6-3 6-4 Unchanged 6-4 6-5 Unchanged 6-5 6-6 Unchanged 6-6 6-7 Unchanged 6-7 6-8 Unchanged 6-8 6-9 Unchanged 6-9 6-10 Unchanged 6-10 6-11 Unchanged 6-11 6-12 Unchanged 6-12 6-13 Unchanged 6-13 6-14 Unchanged 6-14 6-15 Unchanged 6-15 6-16 Unchanged 6-16 6-17 Unchanged 6-17 6-18 Unchanged 6-18 6-19 Unchanged 6-19 6-20 Unchanged 6-20 6-21 Unchanged 6-21 6-22 Unchanged 6-22 6-23 Unchanged 6-24 6-24 Unchanged 6-23 6-25 Unchanged 6-25 6-26 Revised 6-26 6-27 Unchanged 6-27 6-28 Unchanged 6-28 6-29 Unchanged 6-29 6-30 Unchanged 6-30 6-31 Unchanged 6-31 6-32 Unchanged 6-32 6-33 Unchanged 6-33 Chapter 6 provides detailed coverage of the auditor’s assessment of internal control. We normally spend a substantial amount of time with the material contained in this chapter focusing on the basic concepts that apply to the audit of internal control and how the auditor’s consideration of internal control impacts the audit. Additionally, the students need to have a good grasp of the COSO framework covered in this chapter. [LO 6-1] Introduction We begin our discussion of internal control by pointing out why internal control is important to both management and the auditors. In discussing management's perspective, we focus on the fact that management needs reliable information systems in order to make sound business decisions and to meet its stewardship responsibilities of safeguarding assets. Then we discuss how internal controls are relevant to preventing, or detecting and correcting, material misstatements, and to the fact that the auditor needs assurances that data generated by the accounting system are reliable. We point out that this information is important because the auditor’s understanding of internal control is a major factor in determining the overall audit strategy. [LO 6-2] Definition of Internal Control We start this section by introducing the definition of internal control. You may want to present some historical perspectives on internal control. This can help the students develop an understanding for why internal control is approached as it currently is in practice. Internal control is designed by an entity’s board of directors, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives: (1) reliability, timeliness, and transparency of internal and external financial and nonfinancial reporting, (2) effectiveness and efficiency of operations, including safeguarding of assets, and (3) compliance with applicable laws and regulations. [LO 6-3] Controls Relevant to the Audit Generally, internal controls pertaining to the preparation of financial statements for external purposes are relevant to an audit. Some controls relating to operations and compliance objectives may be relevant when they relate to data the auditor uses to apply auditing procedures. The controls relevant to the audit are those that are likely to prevent, or detect and correct, material misstatements in the financial statements. [LO 6-4] The Effect of Information Technology on Internal Control It is critical to impress upon students the importance of understanding how IT affects internal control. Table 6-1 can be used to discuss the benefits and risks to an entity’s internal control from IT. Use Table 6-1 [LO 6-5] Components of Internal Control It is important to provide the students with comprehensive coverage of the components of internal control (Table 6-2 can be used): • Control environment. • Entity’s risk assessment process. • Control activities. • Information and communication. • Monitoring of controls. The new COSO Framework (revised in 2013) includes principles that represent fundamental concepts underlying the effectiveness of each of the five components of internal control. We spend a substantial amount of time covering the five components of internal control and the 17 principles from the COSO Framework using Tables 6-2 and 6-3. Figure 6-1 shows how each component relates to the objectives of internal control. Use Tables 6-2 and 6-3 Use Figure 6-1 [LO 6-6] Planning an Audit Strategy We usually start our discussion of this section by reviewing the audit risk model and then thoroughly covering Figure 6-2, which describes the auditor's decision process when considering internal control. We walk the students through the decision chart and then cover each part of the process in detail. The presentation in the text distinguishes between a substantive strategy and a reliance strategy. We stress to the students that there is no audit strategy for the entire audit; rather the auditor establishes a separate strategy for individual processes or by specific assertion within a process. This is a good time to reintroduce the assertions about classes of transactions and events and related disclosures using Table 6-4. Table 6-4 also shows basic control procedures that can be used by the entity to achieve each assertion. Use Figure 6-2 Use Table 6-4 [LO 6-7] Obtain an Understanding of Internal Control We spend considerable time covering how the auditor obtains an understanding of each of the five components of internal control. Exhibit 6-1 provides an example using EarthWear of how to understand (and document) the understanding of the control environment. Use Exhibit 6-1 [LO 6-8] Documenting the Understanding of Internal Control The various types of tools that are available to the auditor for documenting internal control should be discussed. These include: • Procedures manuals and organizational charts. • Internal control questionnaires (refer to Exhibit 6-1). • Flowcharts (Figure 6-3). • Narrative description Problem 6-28 could be covered here. It is also important to cover the remaining topics in this section: • The effect of entity size on internal control. • The limitations of an entity’s internal control (management override of internal control, human errors or mistakes, and collusion). Use Exhibit 6-1 Use Figure 6-3 [LO 6-9] Assessing Control Risk We point out that when the auditor follows a substantive strategy, control risk is set at high. However, when the auditor decides to assess and set control risk at a lower level, three steps are followed: 1. Identify specific controls that will be relied upon. 2. Perform tests of the identified controls. 3. Conclude on the achieved level of control risk given the results of testing. The first step in assessing control risk for a reliance strategy is identifying the controls that are present in the entity’s accounting system that will be relied upon. These controls would be identified as part of the auditor’s understanding of internal control. [LO 6-10] Performing Tests of Controls The second step in assessing control risk for a reliance strategy involves performing tests of controls. We then present the procedures that are used as tests of controls: • Inquiry of appropriate entity personnel. • Inspection of documents, reports, or electronic files indicating the performance of the control. • Observation of the application of the control. • Reperformance of the application of the control by the auditor. The last step in assessing control risk for a reliance strategy involves reaching a conclusion on the achieved level of control risk. This assessment is based on the accumulated evidence obtained by the auditor. Auditing standards state that the auditor should document the basis for his or her conclusions about the achieved level of control risk. Table 6-5 presents how account balances that differ in terms of their nature, size, and complexity result in different levels of understanding internal control and different control risk assessments. Use Table 6-5 [LO 6-11] Substantive Procedures The last step in the auditor's decision process (Figure 6-2) is performing substantive tests. We point out to the students that the assessed level of inherent risk and achieved level of control risk lead to the level of detection risk for substantive tests. We use this discussion to reinforce their understanding of the audit risk model. Table 6-6 provides two examples of how the nature, timing, and extent of substantive tests are affected by levels of detection risk. Use Table 6-6 Use Figure 6-2 [LO 6-12] Timing of Audit Procedures The timeline in Figure 6-5 for EarthWear Clothiers shows the students when the various types of audit tests might be performed. We cover the factors the auditor should consider when tests of controls and substantive tests are conducted at an interim date. Problem 6-30 could be covered here. Use Figure 6-5 [LO 6-13] Auditing Accounting Applications Processed by Service Organizations We point out to the students that many organizations today use service organizations to process transactions such as payroll. The services provided are part of the entity’s information system if they affect any of the items listed in the discussion of this learning objective. We discuss when and why the auditor needs to be concerned with the controls of the service organization. [LO 6-14] Communication of Internal Control-Related Matters Here we point out to the students that the standards for reporting internal control deficiencies are different for public versus private companies. For public companies, management must prepare an assertion on the effectiveness of internal control. Details on these requirements are covered in Chapter 7. For private companies, reportable conditions must be communicated to the audit committee. We use Table 6-7 to present examples of possible reportable conditions. Use Table 6-7 [LO 6-15] Advanced Module 1: Types of Controls in an IT Environment We first begin by explaining the difference between general and application controls. Then we talk about specific general controls. We spend the most time on access security controls trying to elicit from the students examples of such controls and what would have happened if the control were not in place. Then we briefly cover the specific application controls. In some programs, students would have had an Accounting Information Systems course previous to, or concurrent with, the Auditing course. In such cases, we wouldn’t spend much time on this topic. [LO 6-16] Advanced Module 2: Flowcharting Techniques We usually do not spend much time covering flowcharting techniques. Students either have had this material in a systems course or find it easy to learn on their own. If this is not the case, spend a bit of time here because of the important role flowcharting plays in documenting internal control. Discussion Case The Koss Corporation Discussion case (6-32) continues from Chapter 4 and is a good activity for reinforcing the students' understanding of the control environment. Practice Insights Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. EarthWear Mini-Cases The Chapter 6 mini-cases can be assigned as stand alone cases. Please go to Connect for the mini-case assignments. IDEA The Chapter 6 IDEA problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Instructor Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312
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