Chapter 2 The Financial Statement Auditing Environment McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-2 Problems and Warning Signs 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 audit clients. LO# 1

2-3 Problems and Warning Signs LO# 1

2-4 An Explosion of Scandals Enron WorldCom Tyco Xerox Adelphia LO# 1

2-5 Government Regulation In July 2002, Congress passed the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act. The Sarbanes-Oxley Act effectively ended the profession’s era of “self- regulation,” creating and transferring authority to set and enforce standards to the Public Company Accounting Oversight Board (PCAOB). LO# 1

2-6 The Act  Mandated Broad reform in Corporate Governance Practices  Impacted  Public Companies  Financial Analysts  External Auditors  Securities Exchange Markets

2-7 Context of Financial Statement Auditing The primary context with which an auditor is concerned is the industry or business of his or her audit client. For example, if you are auditing a computer hardware manufacturer, one of your concerns will be whether your client has inventories that are not selling quickly and are becoming obsolete due to industry innovation. Such inventory might not be properly valued on the client’s financial records. If you are auditing a jeweler you will probably not be as worried about obsolescence, but you will be interested in whether the diamonds and other gems in inventory are valued properly. You may need to hire a qualified gemologist to help you assess the valuation assertion, and you would want to keep up on the dynamics of the international diamond and gem marketsand the audit,. In other words, the context provided by the client’s business impacts the auditor and the audit, and is thus a primary component of the environment in which financial statement auditing is conducted. LO# 2

2-8 A Model of Business Board of Directors Audit Committee 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. LO# 3

2-9 Corporate Governance  Consists of all of the people, processes, and activities in place to help ensure proper stewardship over an entity’s assets

2-10 A Model of Business Processes: Five Components Financing Process Purchasing Process Human Resource Management Process Inventory Management Process Revenue Process LO# 4

2-11 LO# 4 An Overview of Business

2-12 Management Assertions Financial statements issued by management contain explicit and implicit assertions. Transactions Management asserts that transactions related to inventory actually occurred. Account Balances Management asserts that the entity owns the inventory represented in the inventory account. Presentation & Disclosure Management asserts that the financial statements properly classify and present the inventory. LO# 5

2-13 LO# 5 Management Assertions

2-14 Auditing Standards Auditing standards serve as guidelines for and measures of the quality of the auditor’s performance. Public Companies PCAOB Nonpublic Companies Auditing Standards Board LO# 6, 7 AI C PA SECSEC

2-15 The 10 Generally Accepted Auditing Standards (GAAS) GAAS GeneralFieldworkReporting LO# 6, 7

2-16 General Standards Adequate Technical Training & Proficiency Independence Due Professional Care LO# 6, 7 Qualifications & Quality of Audit

2-17 Standards of Fieldwork Adequate Planning & Supervised Assistants Obtain Sufficient Appropriate Evidential Matter Obtain Sufficient Understanding of Client & Environment, including Internal Controls LO# 6, 7 Actual conduct of a audit

2-18 Standards of Reporting GAAPConsistency DisclosuresOpinion LO# 6, 7

2-19 GAAS LO# 6, 7

2-20 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. Standards issued by PCAOB are called Auditing Standards (AS). LO# 8, 9

2-21 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. LO# 8, 9 Statements on Auditing Standards (SAS)—Interpretations of GAAS

2-22 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. LO# 8, 9 Statements on Auditing Standards (SAS)—Interpretations of GAAS

2-23 Ethics, Independence, and the Code of Professional Conduct Ethics refers to a system or code of conduct based on moral duties and obligations that indicates how we should behave. Professionalism refers to the conduct, aims, or qualities that characterize or mark a profession or professional person. All professions operate under some type of code of ethics or code of conduct. LO# 10

2-24 Ethics, Independence, and the Code of Professional Conduct Code of Professional Conduct Principles Rules of Conduct Interpretations of the Rules LO# 10

2-25 The Auditor’s Responsibility for Errors, Fraud, and Illegal Acts 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. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements will be detected. LO# 11

2-26 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. DeloitteErnst & Young KPMG Pricewaterhouse Coopers Big 4 Public Accounting Firms LO# 12

2-27 LO# 12 Audit Teams

2-28 Types of Audit, Attest, and Assurance Services Internal Control AuditsCompliance Audits Operational AuditsForensic Audits Audit Services LO# 13

2-29 Types of Audit, Attest, and Assurance Services Reporting on Internal Control Financial Forecasts and Projections Attest Services LO# 13

2-30 Types of Audit, Attest, and Assurance Services Risk Assessment Performance Measurement Assurance Services Information System Reliability & E-Commerce LO# 13

2-31 Types of Audit, Attest, and Assurance Services Tax Services Management Advisory Services Non-assurance Services Accounting and Review Services LO# 13

2-32 Types of Auditors External AuditorsInternal Auditors Government Auditors Forensic Auditors LO# 14

2-33 Organizations That Affect the Public Accounting Profession American Institute of Certified Public Accountants (AICPA) Securities and Exchange Commission (SEC) Public Company Accounting Oversight Board (PCAOB) Financial Accounting Standards Board (FASB) LO# 15

2-34 End of Chapter 2