johnstone 9e auditing chapter1 pptfinal
TRANSCRIPT
A U D I T I N GA RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
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Chapter 1Auditing: Integral to the Economy
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Learning Objectives
1. Define the objective of external auditing and describe its role in meeting societyās demands for reliable financial and internal control information
2. Identify parties involved in preparing and auditing financial statements and briefly describe their roles
3. List the types of audit service providers and the skills and knowledge needed by professionals entering the external auditing profession
4. Identify organizations that affect the external auditing profession and the nature of their effects
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Learning Objectives
5. Define audit quality and identify drivers of audit quality as specified by the Financial Reporting Councilās Audit Quality Framework
6. Identify professional requirements that help to achieve audit quality and minimize auditor exposure to lawsuits
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PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Conducting a Quality Audit and Complying with Professional
Standards
ā¢ Penalties were imposed on Bentleys Brisbane Partnership and Robert Forbes by PCAOB because it concluded that they failed to: ā¢ Exercise due professional careā¢ Exercise professional skepticismā¢ Obtain sufficient evidence necessary to issue an audit
opinion on the financial statements of Alloy Steelās 2006 fiscal year end financial statements
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PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Conducting a Quality Audit and Complying with Professional
Standards
ā¢ What is the objective of auditing, and what process should auditors follow to accomplish this objective? (LO 1)ā¢ Why do companies obtain audited financial
statements? (LO 1)ā¢ Who are the users of audited financial statements?
(LO 1)ā¢ What skills and knowledge are needed to be a
competent audit professional? (LO 3)
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PROFESSIONAL JUDGMENT IN CONTEXT - Importance of Conducting a Quality Audit and Complying with Professional
Standards
ā¢ Why is it vital to perform an audit in a quality manner? (LO 5)ā¢ Why are low quality audits, like those performed in
this case, harmful? (LO 5)
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DEFINE THE OBJECTIVE OF EXTERNAL AUDITING AND DESCRIBE ITS ROLE IN MEETING SOCIETYāS DEMANDS FOR
RELIABLE FINANCIAL AND INTERNAL CONTROL INFORMATION
Learning Objective 1
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External Auditing Profession
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External Auditing Profession
ā¢ Objectives of external auditing is to provide opinions on:ā¢ Reliability of financial statementsā¢ Internal control effectiveness
ā¢ Integrated audit: Provided when an external auditor is engaged to perform an audit of the effectiveness of internal control over financial reporting that is integrated with an audit of financial statements
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External Auditing Profession
ā¢ External audit is intended to enhance confidence that users can place on management-prepared financial statements ā¢ Unqualified audit report: When the auditor issues
this type of report, it implies that the auditor has no reservations about managementās financial statements or internal controls
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External Auditing Profession
ā¢ When the auditor has reservations about the fair presentation of the financial statementsā¢ Audit report is modified to explain the nature of the
reservations ā¢ Adverse opinion is expressed when auditors believe
that:ā¢ Financial statements taken as a whole are not
presented fairly in conformity with GAAP and/orā¢ Clientās internal controls not effective
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External Auditing: A Special Function
ā¢ Described by Chief Justice Warren Burger - Captures the essence of the external auditing professionā¢ Most important party served by the auditors is the
publicā¢ Auditing requires:ā¢ Technical competenceā¢ Freedom from biasā¢ Concern for the integrity of the financial reporting process
ā¢ Auditors - Guardians of the capital markets
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External Auditing: A Special Function
ā¢ Public expects auditors to:ā¢ Find fraudā¢ Require that management use accounting principles that
best portray the spirit of the concepts adopted by accounting standard setters ā¢ Be independent of management
ā¢ Auditing profession faces many pressures ā¢ Keeping fees downā¢ Making careful decisions regarding independenceā¢ Conducting a quality audit
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Auditing in Practice - Why Is Owning Stock in an Audit Client Unacceptable?
ā¢ When auditors own stock in their audit clientsā¢ They are not independent of their clients because they
are part ownersā¢ Auditors may make judgments that favor the client
company rather than external users of the financial statementsā¢ External users may perceive an independence
conflict
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Exhibit 1.2 - Users of Audited Financial Statements and decisions they make based on the reports
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Need for Unbiased Reporting andIndependent Assurance - FACTORS
Why is there a risk that information provided by management may not always be reliable? ā¢Potential biasā¢ Management has incentives to bias financial information to
convey a better impression of financial data than real circumstances might merit
ā¢Remotenessā¢ Organization and users of its financial information are distant
from each other in terms of either geographic distance or the extent of information available to the both parties
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Need for Unbiased Reporting andIndependent Assurance - FACTORS
ā¢ Complexityā¢ Difficulty in determining a proper presentation of
complex transactions, information, and processing systems
ā¢ Consequencesā¢ With unreliable information, investors lose a significant
source of information needed to make important decisions
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Overall Objectives in Conducting an Audit
ā¢ Obtaining assurance about financial statements being free from material misstatementā¢ Reporting on financial statements based on auditorās
findings
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Overall Objectives in Conducting an Audit
ā¢ In completing these objectives, the auditor:ā¢ Complies with relevant ethical requirementsā¢ Plans and performs an audit with professional skepticismā¢ Exercises professional judgmentā¢ Obtains sufficient appropriate evidence on which to base
the auditorās opinionā¢ Conducts audit in accordance with professional auditing
standards
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Exhibit 1.3 - The Audit Opinion Formulation Process
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Identify Parties Involved in Preparing Audited Financial Statements and Briefly Describe Their
Roles
Learning Objective 2
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Exhibit 1.4 - Parties Involved in Preparing and Auditing Financial Statements
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List the Types of Audit Service Providers and the Skills and Knowledge Needed by Professionals
Entering the External Auditing Profession
Learning Objective 3
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Providers of External Auditing Services
ā¢ External auditing profession includes:ā¢ Sole-practitioner firmsā¢ Local and regional firmsā¢ Large multinational professional services firms
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Providers of External Auditing Services
ā¢ Organizational hierarchy of audit firms
Partners/Owners
Managers
ā¢ Responsible for overall conduct of each audit
ā¢ Responsible for many audit engagements being conducted simultaneously
ā¢ Review audit work of seniors and staff
ā¢ Responsible for fewer audit engagements being conducted simultaneously
Seniorsā¢ Responsible for overseeing day-to-
day activities on a specific auditā¢ Oversee performance of auditing
procedures
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Skills and Knowledge Needed for External Auditing Profession
ā¢ Technical knowledge and expertiseā¢ Auditors must:ā¢ Understand accounting and auditing authoritative
literatureā¢ Develop industry and client-specific knowledgeā¢ Develop and apply computer skillsā¢ Evaluate internal controlsā¢ Assess and respond to fraud risk
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Skills and Knowledge Needed for External Auditing Profession
ā¢ Leadership, teamwork, and professional skillsā¢ Auditors:ā¢ Make presentations to management and audit committee
membersā¢ Exercise logical reasoningā¢ Communicate decisions to usersā¢ Manage and supervise by providing meaningful feedbackā¢ Act with integrity and ethics and Interact in a team
environmentā¢ Collaborate and maintain a professional personal presence
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Auditing in Practice - Should I Work for a Large or a Small Audit Firm?
ā¢ Difference between large and small audit firms
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Identify Organizations that Affect the External Auditing Profession and the Nature of Their
Effects
Learning Objective 4
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Congress
ā¢ Due to various failures in auditing profession during early 2000s Congress passed the Sarbanes-Oxley Act of 2002ā¢ This legislation had an impact on audit firms through:ā¢ Increasing auditor independenceā¢ Enhancing the role and importance of audit committeeā¢ Requiring reporting on internal control over financial
reportingā¢ Providing new oversight of external auditing profession by
Public Company Accounting Oversight Board
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Public Company Accounting Oversight Board (PCAOB)
ā¢ Private sector, nonprofit organization ā¢ Oversees auditors of public companiesā¢ Goal of the PCAOBā¢ To protect the interests of investors and further the
public interest in the preparation of informative, fair, and independent audit reports
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Public Company Accounting Oversight Board (PCAOB)
ā¢ Primary responsibilities related to auditorsā¢ Registration of audit firms that audit public companiesā¢ Periodic inspections of registered audit firmsā¢ Establishment of auditing and related standards for
registered audit firmsā¢ Investigation and discipline of registered audit firms for
violations of relevant laws or professional standards
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Securities and Exchange Commission (SEC)
ā¢ Governmental body established by Congress in 1934ā¢ Regulates the capital market systemā¢ Has authority to establish GAAP for companies
whose stock is publicly tradedā¢ Responsible to prosecute public companies and their
auditors for violating SEC laws
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Auditing in Practice - Locating Enforcement Actions on the SEC Web Site
ā¢ SEC issues enforcement actions:ā¢ To penalize individuals and firms for wrongdoings in
auditing professionsā¢ To have a deterrence effect
ā¢ Steps to see what enforcement releases have been made recently:ā¢ Go to www.sec.gov.ā¢ Go to the āDivisions and Officesā section and click
āEnforcementā
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Auditing in Practice - Locating Enforcement Actions on the SEC Web Site
ā¢ Click āAccounting and Auditing Enforcement Releasesāā¢ Click the appropriate yearā¢ Click the enforcement release that you wish to read
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American Institute of Certified Public Accountants (AICPA)
ā¢ Primary governing organization of the public accounting professionā¢ Develops standards for audits of nonpublic
companiesā¢ Responsible for a peer review program ā¢ Provides continuing education programsā¢ Prepares and administers the Uniform CPA
Examination - through its Board of Examiners
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Center for Audit Quality (CAQ)
ā¢ Organization affiliated with AICPAā¢ Dedicated to enhance investor confidence and trust
in financial marketsā¢ A thought leader in:ā¢ Fostering audit qualityā¢ Collaborating with auditors and financial statement
users about emerging issuesā¢ Advocating for accounting and auditing standards that
promote auditorsā effectiveness
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International Auditing and Assurance Standards Board (IAASB)
ā¢ Part of the International Federation of Accountants (IFAC)ā¢ A global organization for the accounting profession
ā¢ Sets International Standards on Auditing (ISAs)ā¢ Facilitates convergence of national and international
auditing standards
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Committee of Sponsoring Organizations of the Treadway Commission (COSO)
ā¢ Provider of thought leadership and guidance on:ā¢ Internal controlā¢ Enterprise risk managementā¢ Fraudulent deterrence
ā¢ Provides the internal control frameworkā¢ Serves as benchmark for auditors
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Committee of Sponsoring Organizations of the Treadway Commission (COSO)
ā¢ Sponsored by the following organizations:ā¢ Financial Executives Internationalā¢ The American Institute of Certified Public Accountantsā¢ The American Accounting Association ā¢ The Institute of Internal Auditorsā¢ The Association of Accountants and Financial
Professionals in Business (IMA)
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Accounting Standard Setters
ā¢ Generally accepted accounting principles (GAAP)ā¢ Has general acceptance and provides criteria by which
to assess the fairness of a financial statement presentationā¢ GAAP traditionally been set by FASB, with approval by
the SEC in the United States
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Accounting Standard Setters
ā¢ International accounting standards (IFRS -International Financial Reporting Standards)ā¢ Set by the IFRS Foundation of IASBā¢ Their goal is to develop a single set of international
financial reporting standards that is:ā¢ Understandableā¢ Enforceableā¢ Globally accepted
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State Boards of Accountancy
ā¢ Certified Public Accountants (CPAs)ā¢ Licensed by state boards of accountancy which are
charged with regulating the profession at the state levelā¢ Required by all state boards for passage of Uniform
CPA Examination as one criterion for licensure
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The Court System
ā¢ Acts as a quality-control mechanism for the auditing professionā¢ Third parties may sue CPAs under federal securities
laws, various state statutes, and common law for substandard audit work
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DEFINE AUDIT QUALITY AND IDENTIFY DRIVERS OF AUDIT QUALITY AS SPECIFIED BY THE FINANCIAL REPORTING
COUNCILāS AUDIT QUALITY FRAMEWORK
Learning Objective 5
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Audit Quality
ā¢ Performing an audit in accordance with accepted auditing standards (GAAS)ā¢ Providing assurance that audited financial statements
and disclosures are presented in accordance with GAAPā¢ Providing assurance that those financial statements
are not materially misstated whether due to errors or fraud
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Exhibit 1.5 - Drivers of Audit Quality
ā¢ Primary drivers of audit quality included in Audit Quality Framework developed by Financial Reporting Council (FRC)
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Drivers of Audit Quality
ā¢ Audit firm culture contributes to audit quality when leadership:ā¢ Creates work culture where audit quality is valued and
rewardedā¢ Emphasizes that ādoing the right thingā is appropriate
from a public interest perspectiveā¢ Ensures that employees have time and resources to
address difficult issuesā¢ Ensures that monetary considerations do not adversely
affect audit quality
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Drivers of Audit Quality
ā¢ Promotes benefits of audit partners seeking guidance on difficult issuesā¢ Ensures that audit firm has quality systems in placeā¢ Fosters evaluation and compensation practicesā¢ Ensures that audit quality is monitored within audit
firm with appropriate consequences in case of loopholes
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Drivers of Audit Quality
ā¢ Skills and qualities required of engagement teamā¢ Understanding clientsā business and adhering to auditing
and ethical standardsā¢ Exhibiting professional skepticism and addressing issues
identified during auditā¢ Ensuring that staff has appropriate experience and is
properly supervisedā¢ Ensuring that lower level staff is provided with mentoring
and on the job training opportunitiesā¢ Attending to and learning during training
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Drivers of Audit Quality
ā¢ There is effectiveness of the audit process when:ā¢ Audit methodology is well structured and:ā¢ Encourages partners and managers to work diligently in
planning the audit ā¢ Provides a framework and procedures to obtain sufficient
appropriate audit evidence in an effective and efficient mannerā¢ Requires appropriate audit documentationā¢ Provides for complying with auditing standards, but does
not inhibit professional judgment
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Drivers of Audit Quality
ā¢ Ensuring that audit work is effectively reviewedā¢ Audit quality control procedures are effective,
understood, and appliedā¢ Quality technical support is available when auditors
encounter unfamiliar situationsā¢ Ethical standards are communicated and achievedā¢ Auditorsā evidence collection not constrained by
financial pressures
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Drivers of Audit Quality
ā¢ Reliability and usefulness of audit reporting include:ā¢ Audit reports ā¢ Auditors appropriately concluding as to the truth and
fairness of financial statements
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Drivers of Audit Quality
ā¢ Auditors communicating with audit committee about the following:ā¢ Audit scopeā¢ Threats to auditor objectivityā¢ Important risks identified and judgments made in
reaching audit opinionā¢ Qualitative aspects of clientās accounting and possible
ways of improving financial reporting
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Factors Outside the Control of Auditors
ā¢ Client corporate governanceā¢ Regulatory environment
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Identify Professional Requirements that Help to Achieve Audit Quality and Minimize Auditor
Exposure to Lawsuits
Learning Objective 6
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Achieving Audit Quality and Minimizing Lawsuits
ā¢ Professional requirements that help to achieve audit quality ā¢ Maintaining auditor independenceā¢ Participating in review programsā¢ Issuing engagement lettersā¢ Making appropriate client acceptanceā¢ Evaluating the audit firmās limitationsā¢ Maintaining quality audit documentation
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PCAOB independence requirements
ā¢ Applicable to auditors of public companiesā¢ Designed to address requirements in Sarbanes-Oxley
Act of 2002
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SEC independence requirements
ā¢ Taking principles-based approachā¢ Applicable to auditors of public companies ā¢ Principles dictate that auditor independence is impaired
when:ā¢ Mutual or conflicting interest between accountant and
audit clientā¢ Accountant auditing own workā¢ Accountant acting as management or employee of audit
clientā¢ Accountant being an advocate for audit client
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AICPA independence requirements
ā¢ Threats to independenceā¢ Self-review threat ā¢ Advocacy threat ā¢ Adverse interest threat ā¢ Familiarity threatā¢ Undue influence threat ā¢ Financial self-interest threat ā¢ Management participation threat
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AICPA independence requirements
ā¢ Safeguards to avoid independence problems include:ā¢ Safeguards created by profession or regulationā¢ Safeguards created by audit clientā¢ Safeguards created by audit firm
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Review Programs
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Engagement letter
ā¢ States scope of work to be done on auditā¢ There should be no doubt in the mind of client,
external auditor, or court system - regarding expectations agreed to by external auditor and clientā¢ Includes:ā¢ Audit feeā¢ Timing description of external auditorās workā¢ Documentation that client is expected to provide to
external auditor
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Client Acceptance/Continuance Decisions
ā¢ Guidelines established to screen out:ā¢ Clients in financial and/or organizational difficultyā¢ Clients constituting a disproportionate percentage of
firmās total practiceā¢ Disreputable clientsā¢ Clients offering an unreasonably low fee for auditorās
services
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Audit firm limitations
ā¢ An external audit firm should not undertake engagement that it is not qualified to handleā¢ Important for smaller and growing firms
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Audit documentation
ā¢ Document everything done on auditā¢ Documentation should clearly show evidence of
supervisory review ā¢ Documentation should indicate:ā¢ What tests were performedā¢ Who performed themā¢ Any significant judgments made