The interest of [businessmen] is

always in some respects different

from, and even opposite to, that of the
public ... The proposal of any new law
or regulation of commerce which
comes from this order ... ought never
to be adopted, till after having been
long and carefully examined ... with
the most suspicious attention. It
comes from an order of men ... who
have generally an interest to deceive
and even oppress the public
Adam Smith

The Financial
Statement
Auditing Environment

Chapter 2

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

LO# 1

Types of Auditors
External Auditors

Government
Auditors

Internal Auditors

Forensic Auditors

2-2

Types of Audits and Auditors

Financial (External Auditors/CPAs)

Ensure that financial statements are reliable

Operational (Internal and Governmental

Auditors/CIAs)
Improve operational economy
Improve operational efficiency

Compliance (Internal and Governmental Auditors)

Ensure compliance with company and/or governmental
rules and regulations

Forensic (Fraud Auditors/CFEs)

Designed to investigate a crime and will often involve
gathering evidence designed to convict a fraudster

1-3

External vs. Internal Auditing

External auditing is often called independent
auditing because it is done by certified
public accountants who are independent of
the organization being audited.
External auditors represent the interests of
third-party stakeholders in the organization,
such as stockholders, creditors, and
government agencies.
Because the focus of external audit is on
financial statements, this type of audit is
called financial audit

Financial, Internal Control,

Compliance, Operational, Forensic
a. Evaluate the policies and procedures of the Food and
Drug Administration in terms of bringing new drugs to
market.
Operational- Government Auditor
b. Determine the fair presentation of Ajax Chemicals
balance sheet, income statement, and statement of
cash flows.
Financial- External
c. Review the payment procedures of the accounts
payable department for a large manufacturer.
Operational or I/C or Compliance- Internal
or External

Financial, Internal Control,

Compliance, Operational, Forensic
d. Examine the financial records of a division of a
corporation to determine if any accounting irregularities
have occurred.
Forensic- Internal, External, or Forensic
e. Evaluate the feasibility of forecasted rental income for
a planned low income public housing project.
Operational- Government, External, or
Internal
f. Evaluate a companys computer services department
in terms of the efficient and effective use of corporate
resources.
Operational- Internal or External

Financial, Internal Control,

Compliance, Operational, Forensic
g. Audit the partnership tax return of a real
estate development company.
Compliance- Government
h. Investigate the possibility of payroll fraud
in a labor union pension fund.
Forensic- External or Forensic

Problem 2-24

External vs. Internal Auditing

Institute

of Internal Auditors defines

internal auditing as an
independent appraisal function
established within an organization to
examine and evaluate its activities

External vs. Internal Auditing

Internal

auditors perform a wide range of

activities on behalf of the organization,
including conducting financial audits,
examining an operations compliance
with organizational policies, reviewing
the organizations compliance with legal
obligations, evaluating operational
efficiency, detecting and pursuing fraud
within the firm, and conducting IT audits.

External vs. Internal Auditing

While external auditors represent outsiders,
internal auditors represent the interests of the
organization.
Internal auditors often cooperate with and
assist external auditors in performing financial
audits.
This is done to achieve audit efficiency and
reduce audit fees. For example, a team of
internal auditors can perform tests of computer
controls under the supervision of a single
external auditor.

10

Context of Financial Statement

Auditing

LO# 6

The primary context with which an auditor is concerned is the industry or

business of his or her auditee. In other words, the context provided by the entitys
business impacts the auditor and the audit, and is thus a primary component of the
environment in which financial statement auditing is conducted.

Thought Question:
How would your concerns about the
inventory account differ for a Computer
Hardware Manufacturer versus a Jewelry
Store?
2-11

LO# 7

A Model of Business
Business organizations exist to create value for their
stakeholders. Due to the way resources are invested and
managed in the modern business world, a system of
corporate governance is necessary, through which
managers are overseen and supervised.

Board of Directors
Audit
Committee

2-12

LO# 7

A Model of Business
Strategies

Objectives

Processes
(5 broad
categories)

Transactions

Controls

Reports

2-13

LO# 8

A Model of Business Processes:

Five Components
Financing
Process

Purchasing
Process
Human
Resource
Management
Process

Inventory
Management
Process

Revenue
Process

2-14

Skills and Knowledge Needed

for External Auditing Profession

Technical

knowledge and expertise

Auditors must:
Understand

accounting and auditing

authoritative literature
Develop industry and client-specific
knowledge
Develop and apply computer skills
Evaluate internal controls
Assess and respond to fraud risk

Skills and Knowledge Needed

for External Auditing Profession

Leadership,

skills

teamwork, and professional

Auditors:
Make

presentations to management and audit committee

members
Exercise logical reasoning
Communicate decisions to users
Manage and supervise by providing meaningful feedback
Act with integrity and ethics and Interact in a team
environment
Collaborate and maintain a professional personal
presence

The Public Accounting

Profession

Assurance services

Financial Statement Audit

engagements
Assurance engagements
Attestation engagements
Compilations
Reviews

Tax services
Consulting and Advisory services

1-17

LO# 3

Public Accounting Firms

Public accounting firms range in size from a single proprietor
to thousands of owners (or partners) and thousands of
professional and administrative staff employees.

Big 4

Mid-Tier

PwC

Grant Thornton

EY

BDO Seidman

Deloitte

Regional

Local

RSM McGladrey

KPMG
2-18

Organization of the Profession

Big Four Accounting Firms

Deloitte, E&Y, KPMG, PwC

National
Grant Thornton, BDO Seidman

Local/Regional (KY)
Blue and Co.
Mountjoy, Chilton, and Medley
Dean Dorton Allen Ford

Sole Proprietor

1-19

Revenues for the Big Four CPA

Firms

1-20

Public Accounting Firm Organization

1-21

Audit Teams

LO# 3

2-22

Organizational hierarchy of
audit
firms
Responsible for overall conduct of

Partners/
Owners

Managers

Seniors

each audit
Responsible for many audit
engagements being conducted
simultaneously
Review audit work of seniors and staf
Responsible for fewer audit engagements
being conducted simultaneously

Responsible for overseeing day-today activities on a specific audit

Oversee performance of auditing
procedures

LO# 4

A Time of Challenge and Change

1990

2000

During the economic boom of the late

1990s and the early 2000s, accounting
firms aggressively sought opportunities
to market a variety of high-margin
nonaudit services to their auditees.
2-24

LO# 4

An Explosion of Scandals
Brokerage
Firms

Corporate
Giants

Stock
Exchanges
Mutual Fund
Managers

Public
Accounting
Firms

http://www.accounting-degree.org/scandals/

2-25

LO# 5

Societys Expectations and the

Auditors Responsibilities
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.
Because of the nature of audit evidence and the
characteristics of fraud, the auditor is able to obtain
reasonable, but not absolute, assurance that material
misstatements are detected.
2-26

LO# 4

Government Regulation
In 2002, Congress passed the
Sarbanes-Oxley Public Company
Accounting Reform and Investor
Protection Act.

In 2010, Congress passed the DoddFrank Wall Street Reform and

Consumer Protection Act.

2-27

Prohibited Professional Services

In summary, Sarbanes-Oxley prohibits professional service firms

from performing any client services for audit clients in which the
auditors may find themselves making management decisions or
auditing their own firms work.
Specifically, Sarbanes-Oxley prohibits professional service firms
from providing any of the following services to an audit client:
1)
bookkeeping and related services
2)
design or implementation of financial information
systems
3)
appraisal or valuation services
4)
actuarial services
5)
internal audit outsourcing
6)
management or human resources services
7)
investment or broker/dealer services
8)
legal and expert services (unrelated to the audit)
Professional service firms may provide client tax services (with
some restrictions) and other non-prohibited services to audit
clients if the companys audit committee has approved them in
advance.

1-28

LO# 9

Organizations That Affect the

Public Accounting Profession
Securities and Exchange
Commission (SEC)

Public Company
Accounting Oversight
Board (PCAOB)

Financial Accounting
Standards Board (FASB)

American Institute of
Certified Public
Accountants (AICPA)

International Auditing and

Assurance Standards
Board (IAASB)

International Accounting
Standards Board (IASB)

2-29

LO# 10,11

Auditing Standards
Auditing standards serve as
guidelines for and measures of
the quality of the auditors
performance.
PCAOB

Auditing
Standards
Board

IAASB

Public
Companies

Nonpublic
Companies

> 100
Countries
2-30

Congress
Due to various failures in auditing profession
during early 2000s Congress passed the
Sarbanes-Oxley Act of 2002
This legislation had an impact on audit firms
through:

Increasing auditor independence

Enhancing the role and importance of audit committee
Requiring reporting on internal control over financial
reporting
Providing new oversight of external auditing profession
by Public Company Accounting Oversight Board

Public Company Accounting

Oversight Board (PCAOB)

Private

sector, nonprofit organization

Oversees auditors of public
companies
Goal of the PCAOB
To protect the interests of investors and
further the public interest in the
preparation of informative, fair, and
independent audit reports

Formation of the PCAOB

The PCAOB was formed to ensure that audit

quality is not compromised and that auditor
performance
continues
to
meet
public
expectations.
The membership of the board consists of five
SEC-appointed
public
members
(business
executives, investment analysts) and is supported
by fees paid by publicly traded companies.
The Boards tasks include
registering and monitoring accounting firms that prepare
audit reports for public companies.
establishing rules to govern auditing, quality control,
ethics, and independence.

Public Company Accounting

Oversight Board (PCAOB)

Primary

auditors

responsibilities related to

Registration of audit firms that audit public

companies
Periodic inspections of registered audit firms
Establishment of auditing and related
standards for registered audit firms
Investigation and discipline of registered
audit firms for violations of relevant laws or
professional standards

PCAOB: Standard Setting Role

Congress has taken the responsibility for creating

standards for the audits of publicly traded
companies from the Auditing Standards Board
(ASB) of the AICPA and turned that responsibility
over to the newly created Public Company
Accounting Oversight Board (PCAOB).
Rather than starting from scratch, the PCAOB has
declared that, for the time being, the previously
created practice standards (e.g., ASBs SASs) will
function as the PCAOBs Interim Professional
Auditing
Standards
for
audits
of
public
companies.

PCAOB: Monitoring Role

The Boards goal is to ensure that audit quality is

not compromised and that auditor performance
continues to meet public expectations.
Soon after it began operations in early 2003, the
PCAOB began registering professional services firms
providing auditing services to public entities. Firms
not registered are not allowed to conduct audits of
public companies.
Other
Board
monitoring
activities
include
inspections of registered auditing firms (similar to
peer
reviews),
special
investigations,
and
disciplinary proceedings.

Securities and Exchange

Commission (SEC)

Governmental

body established by
Congress in 1934
Regulates the capital market system
Has authority to establish GAAP for
companies whose stock is publicly
traded
Responsible to prosecute public
companies and their auditors for
violating SEC laws

American Institute of Certified

Public Accountants (AICPA)

Primary governing organization of the

public accounting profession
Develops standards for audits of nonpublic
companies
Responsible for a peer review program
Provides continuing education programs
Prepares and administers the Uniform CPA
Examination - through its Board of
Examiners

International Auditing and Assurance

Standards Board (IAASB)
Part

of the International Federation

of Accountants (IFAC)
A global organization for the accounting
profession

Sets

International Standards on
Auditing (ISAs)
Facilitates convergence of national
and international auditing standards

Committee of Sponsoring Organizations of

the Treadway Commission (COSO)
Provider

of thought leadership and

guidance on:
Internal control
Enterprise risk management
Fraudulent deterrence

Provides

the internal control

framework
Serves as benchmark for auditors

Committee of Sponsoring Organizations of

the Treadway Commission (COSO)
Sponsored

by the following
organizations:
Financial Executives International
The American Institute of Certified
Public Accountants
The American Accounting Association
The Institute of Internal Auditors
The Association of Accountants and
Financial Professionals in Business (IMA)

Accounting Standard Setters

Generally

accepted accounting
principles (GAAP)
Has general acceptance and provides
criteria by which to assess the fairness
of a financial statement presentation
GAAP traditionally been set by FASB,
with approval by the SEC in the United
States

Accounting Standard Setters

International

accounting standards
(IFRS -International Financial Reporting
Standards)
Set by the IFRS Foundation of IASB
Their goal is to develop a single set of
international financial reporting standards
that is:
Understandable
Enforceable
Globally

accepted

Types of Practice Standards

Client

Public
Companies

Private
Companies

Governmental
Entities

Foreign
Companies

Rulemaking
body

Public Company
Accounting
Oversight
Board
(PCAOB)

AICPA Auditing
Standards
Board (ASB)

U.S. Government
Accountabili
ty Office
(GAO)

IFAC International
Auditing and
Assurance
Standards
Board (IAASB)

Standards

Auditing Standards
(ASs)

Statements on
Auditing
Standards
(SASs)

Government
Auditing
Standards
(The Yellow
Book)

International
Standards on
Auditing (ISAs)

Web site

www.pcaobus.org

www.aicpa.org

www.gao.gov

www.ifac.org

State Boards of Accountancy

Certified

Public Accountants (CPAs)

Licensed by state boards of accountancy

which are charged with regulating the
profession at the state level
Required by all state boards for passage
of Uniform CPA Examination as one
criterion for licensure

Become Certified!
Education
Examination
Experience
State

Certificate and License

KY State Board of Accountancy

Skills

sets and your education

1-46

The CPA Exam

Four parts:
Auditing and Attestation (AUD)- the entire audit
process, other services including compilations,
reviews and attestation engagements, and the
AICPA Code of Professional Conduct
Financial Accounting and Reporting (FAR)- financial
accounting, differences btwn GAAP and IFRS, fund
accounting
Regulation (REG)- federal taxation and business
law
Business Environment and Concepts (BEC)operations and strategic management, economics,
financial management and information technology

1-47

CPA Exam
Multiple Choice Questions and Task-Based
Simulations
AICPA released Exposure Draft

Changes Proposed for 2017

Other important information:

Parts expire after 18 months

Expensive
Review course necessary
Testing windows

The CPA Exam

Cost

AUD- 4.5 Hours

$192.03
BEC- 2.5 Hours
$172.51
FAR- 4 Hours
$192.03
REG- 3 Hours
$172.51
KY State Board Fees $150.00
$879.08
Review

Course

$1,200-$3,400

The Court System

Acts

as a quality-control mechanism
for the auditing profession
Third parties may sue CPAs under
federal securities laws, various state
statutes, and common law for
substandard audit work

LO# 10,11

The 10 Generally Accepted

Auditing Standards (PCAOB)
GAAS

General

Field Work

Reporting

2-51

Engagement Overview and GAAS

GAAS

is used to measure the quality of the auditors

performance. They are the same from audit to audit.

Audit

procedures are the particular and specialized

actions that auditors take to obtain evidence in a specific
audit engagement.
OBTAIN
(OR RETAIN)
CLIENT

ENGAGEMENT
PLANNING

INTERNAL
CONTROL
EVALUATION

EVIDENCE
GATHERING

REPORTING

General Standards
Standards of Fieldwork
Reporting
Standards

LO# 10,11

General Standards
Adequate Technical
Training &
Proficiency

Independence

Due Professional
Care

2-53

General Standards
The General Standards affect all phases of
the audit, including client acceptance or
retention.
1.

2.

3.

The audit must be performed by a person or

persons having adequate technical training and
proficiency as an auditor.
In all matters relating to the assignment, an
independence in mental attitude is to be
maintained by the auditor or auditors.
Due professional care is to be exercised in the
performance of the audit and the preparation of
the report.

LO# 10,11

Standards of Field Work

Adequate Planning
& Supervised
Assistants

Obtain Sufficient
Understanding of
Internal Controls

Obtain Sufficient
Appropriate
Evidential Matter

2-55

Standards of Fieldwork
The Fieldwork Standards guide the planning, internal
control evaluation, and the evidence gathering
phases of the engagement.
1.
2.

3.

The auditor must adequately plan the work and must

properly supervise any assistants.
The auditor must obtain a sufficient understanding of the
entity and its environment, including its internal control,
to assess the risk of material misstatement of the financial
statements whether due to error or fraud, and to design
the nature, timing, and extent of further audit procedures.
The auditor must obtain sufficient appropriate audit
evidence through audit procedures performed to afford a
reasonable basis for an opinion regarding the financial
statements under audit.

Evidence Considerations
The auditor must "obtain
sufficient, appropriate audit
evidence to support
opinion.
Sufficient Evidence
Enough

to support opinion
Persuasive enough to convince
another person (judge, jury?)
Essentially a matter of professional
judgment

Appropriate Evidence
Competent,

valid, relevant, reliable

Characteristics of Appropriate Evidence

Relevance
Testing what you want to test (e.g.,
direction of testing)
Evidence Source
Generally an externally generated piece
of evidence more reliable than an
internal (client-generated) piece of
evidence
Evidence Hierarchy
Direct personal knowledge
External evidence
External-internal evidence
Internal Evidence
Verbal and written
Objective v. Subjective Evidence

LO# 10,11

Standards of Reporting

GAAP

Consistency

Disclosures

Opinion

2-59

Reporting Standards
The Reporting Standards guide the reporting phase of the audit
engagement.
1.
The report shall state whether the financial statements are
presented in accordance with GAAP.
2.
The report shall identify those circumstances in which such
principles have not been consistently observed in the
current period in relation to the preceding period.
3.
Informative disclosures in the financial statements are to
be regarded as reasonably adequate unless otherwise
stated in the report.
4.
The report shall either contain an expression of opinion
regarding the financial statements, taken as a whole, or an
assertion to the effect that an opinion cannot be
expressed. When an overall opinion cannot be expressed,
the reasons therefore should be stated. In all cases where
an auditor's name is associated with financial statements,
the report should contain a clear-cut indication of the
character of the auditor's work, if any, and the degree of
responsibility the auditor is taking.

LO# 10,11

Principles Underlying an Audit ASB

Purpose:

To express an opinion on the financial statements prepared by management,

whose responsibility is to prepare the financial statements and to provide the
auditor with information necessary to conduct the audit.

Responsibilities:

Have competence and capability; comply with ethical requirements; maintain

professional skepticism; exercise professional judgment.

Performance:

Sufficient appropriate audit evidence supporting reasonable (not absolute)

assurance that the financial statements are free of material misstatement.

Reporting:
Express an opinion, in the form of a written report, based on an evaluation of the
audit evidence obtained; or state that an opinion cannot be expressed.
2-61

LO# 12

Statements on Auditing Standards

(SAS)Interpretations of GAAS
GAAS and SAS are considered to be
minimum standards of performance for
auditors.
PCAOB adopted, on an
interim basis, GAAS and
SAS existing in 2003.
Standards issued by
PCAOB are called
Auditing Standards (AS).

2-62

LO# 12

Statements on Auditing Standards

(SAS)Interpretations of GAAS
SAS are classified by two numbering categories:
SAS and AU numbers. The SAS number applies to
the order in which the standards are issued and are
thus chronological. The AU codification organizes
the SAS according to topical content.

2-63

LO# 12

Statements on Auditing Standards

(SAS)Interpretations of GAAS
For example, SAS No. 39, Audit Sampling, is
found under AU 350 because the AU 300s relate
to the standards of fieldwork on evidence
collection and evaluation.
AU Section
AU 200
AU 300-499
AU 500
AU 600
AU 700
AU 800-999

Topical Content
General Principles and Responsibilities
Risk Assessment and Response to Assessed Risks
Audit Evidence
Using the Work of Others
Audit Conclusions and Reporting
Special Considerations

2-64

LO# 13

Ethics, Independence, and the

Code of Professional Conduct
Ethics refers to a system or code of conduct
based on moral duties and obligations that
indicate how we should behave.
Professionalism refers to the conduct, aims, or
qualities that characterize a profession or
professional person. All professions operate
under some type of code of ethics or code of
conduct.
2-65

Independence
Auditors are required to
independent in fact as well as in
appearance.

LO# 13

Ethics, Independence, and the

Code of Professional Conduct
Code of Professional
Conduct

Principles

Rules of Conduct
Interpretations
of the Rules
2-67

End of Chapter 2

2-68

Discussion Assignment
Articles:

Fraud
Future of Auditing
New Hire Skills
Videos:

Observation and Problem Solving

70

minutes to read/watch all

Written Component
Class Discussion

What to Think About

Articles:

Authors Purpose
Tone
Evidence
Your Reaction
Videos:

How pertains to auditing

How pertains to career
aspirations/life/school