1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-1 Chapter Two The Financial Statement Auditing Environment Chapter Two The Financial Statement Auditing Environment

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-2 Problems and Warning Signs 19902000 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.

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-3 Problems and Warning Signs

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-4 An Explosion of Scandals Enron WorldCom Tyco Xerox Adelphia

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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).

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-6 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.

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-7 A Model of Business Processes: Five Components Financing Process Purchasing Process Human Resource Management Process Inventory Management Process Revenue Process

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-8

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-9 Management Assertions Financial statements issued by management contain explicit and implicit assertions. Transaction s 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.

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-10

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-11 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

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-12 The 10 Generally Accepted Auditing Standards (GAAS) GAAS GeneralField WorkReporting

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-13 General Standards Adequate Technical Training & Proficiency Independence Due Professional Care

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-14 Standards of Field Work Adequate Planning & Supervised Assistants Obtain Sufficient Competent Evidential Matter Obtain Sufficient Understanding of Internal Controls

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-15 Standards of Reporting GAAPConsistency DisclosuresOpinion

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-16

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-17 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).

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-18 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 number applies to the topical content in the statement. For example, SAS No. 39, “Audit Sampling,” is found under AU 350 because the AU 300s relate to the standards of field work or evidence collection and evaluation.

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-19 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.

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-20 Ethics, Independence, and the Code of Professional Conduct Code of Professional Conduct Principles Rules of Conduct Interpretation s of the Rules

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-21 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.

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-22 Audit Reporting

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-23 The Auditor’s Standard Unqualified Audit Report The most common type of audit report issued is the “standard unqualified audit report” because management’s assertions about the entity’s financial statements are usually found to conform to GAAP. TitleAddressee Introductory Paragraph Scope Paragraph Opinion Paragraph Explanatory Paragraph Auditor Name Report Date

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-24

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-25 Reasons for Departures from an Unqualified Audit Report Scope Limitation GAAP Departure Lack of Auditor Independence

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-26 Other Types of Audit Reports Qualified Issued for either a material scope limitation or departure from GAAP. Disclaimer Issued for lack of sufficient evidence to form an opinion or lack of auditor independence. Adverse Issued when the overall financial statements do not present fairly in conformity with GAAP.

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-27 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 Pricewaterhous e Coopers Big 4 Public Accounting Firms

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-28

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-29 Types of Audit, Attest, and Assurance Services Internal Control AuditsCompliance Audits Operational AuditsForensic Audits Audit Services

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-30 Types of Audit, Attest, and Assurance Services Reporting on Internal Control Financial Forecasts and Projections Attest Services

31. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-31 Types of Audit, Attest, and Assurance Services Risk Assessment Performance Measurement Assurance Services Information System Reliability & E-Commerce

32. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-32 Types of Audit, Attest, and Assurance Services Tax Services Management Advisory Services Other Nonaudit Services Accounting and Review Services

33. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-33 Types of Auditors External AuditorsInternal Auditors Government Auditors Forensic Auditors

34. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-34 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)

35. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 2-35 End of Chapter 2