Instructor Manual For Auditing & Assurance Services A Systematic Approach 12th Edition by William Me

Instructor Manual For Auditing & Assurance Services A Systematic Approach 12e Messier Chapter 1 An Introduction to Assurance and Financial Statement Auditing

Learning Objectives

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.

LO 1-2: Understand the demand for auditing and be able to explain the desired characteristics of auditors and audit services.

LO 1-3: Know the basic definition of a financial statement audit.

LO 1-4: Understand three fundamental concepts that underlie financial statement auditing.

LO 1-5: Understand why sampling is important in an audit.

LO 1-6: Be able to describe the basic financial statement auditing process and the phases in which an audit is carried out.

LO 1-7: Know what an audit report is and understand the nature of an unqualified report.

LO 1-8: Understand how technology and audit data analytics are changing audits in exciting ways.

LO 1-9: Understand why auditing demands logic, reasoning, and resourcefulness.

Review Questions

MultipleChoice Questions

Problems

1

2,3,4

13,14,20

24,25

5,6

13,14,15,16

25

7

17,18

25

9, 10

17,19,20

26

11

21,22,23

27,28

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC)

29

30

29

8

12

EWMC

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.

15-1 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th 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 Revised 1-6 1-7 Unchanged 1-7 1-8 Unchanged 1-8 1-9 Unchanged 1-9 1-10 Unchanged 1-10 1-11 Unchanged 1-11 1-12 Unchanged 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 Unchanged 1-22 1-23 Unchanged 1-23 1-24 Unchanged 1-24 1-25 Revised 1-25 1-26 Revised 1-26 1-27 Unchanged 1-27 1-28 Unchanged 1-28 1-29 Unchanged 1-29 1-30 Unchanged 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.

15-2 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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

15-3 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 1-4] 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 1-2 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 1-2 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 15-4 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

of materiality and audit risk impact the auditor‘s decision about the nature, timing, and extent of evidence to be gathered.

[LO 1-5] 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 1-6] 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 1-3 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 1-3 we refer the students to the chapters in the book that will cover each phase.

Use Figure 1-3 [LO 1-7] 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 15-5 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 1-8] 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 welltrained 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 1-9] 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 self15-6 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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.

15-7 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 2 The Financial Statement Auditing Environment Learning Objectives LO 2-1: Be familiar with the different types of auditors.

LO 2-2: Be familiar with the various types of audit, attest, and assurance services offered by accounting professionals.

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.

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.

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.

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.

LO 2-9: Understand there are auditing standards that are established by both U.S. and international standard setters.

LO 2-10: Be familiar with the ―principles underlying an audit conducted in accordance with generally accepted auditing standards.‖ LO 2-11: Understand the nature of auditing standards.

Review Questions

MultipleChoice Questions

Problems

1

15

24

2

16,17

24

3,4

18

5

19

6,7

20

8,9,10,11

21

Discussion Cases

Internet Assignments 28

26

28

28, 29,30

22

12,13

23

25,26

26, 27

15-8 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 Number Comparison in 10th edition in 11th edition 2-1 Unchanged 2-1 2-2 Unchanged 2-2 2-3 Unchanged 2-3 2-4 Revised 2-4 2-5 Unchanged 2-5 2-6 Unchanged 2-6 2-7 Unchanged 2-7 2-8 Unchanged 2-8 2-9 Unchanged 2-9 2-10 Revised 2-10 2-11 Unchanged 2-11 2-12 Unchanged 2-12 2-13 Unchanged 2-13 2-14 Unchanged 2-14 2-15 Unchanged 2-15 2-16 Unchanged 2-16 2-17 Unchanged 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 Unchanged 2-23 2-24 Revised 2-24 2-25 Revised 2-25 2-26 Unchanged 2-26 2-27 Unchanged 2-27 2-28 Unchanged 2-28 2-29 Revised 2-29

15-9 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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, fraud audits, attest services, and assurance services) firms can provide and the different types of auditors (e.g., external auditors, internal auditors, government auditors, and fraud 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.

15-10 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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.

15-11 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 26 and 27 present Merry-Go-Round, a real world company that sued its consultants over poor advice. The case covers EY‘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 29 has the students go to this site as well as the SEC, PCAOB, IAASB, and IFRS websites.

Internet Assignment 28 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 15-12 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

each chapter to highlight important and interesting real-world trends and practices. These selfcontained 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 LO 3-1: Understand the auditor‘s requirements for client acceptance and continuance.

LO 3-2: Understand the steps that are involved in the preliminary engagement activities.

LO 3-3: Know what is required to establish an understanding with the entity.

LO 3-4: Know the types of information that are included in an engagement letter.

LO 3-5: Understand how the work of the internal auditors can assist in the performance of the audit.

LO 3-6: Know the responsibilities of the audit committee and how it relates to the external auditors.

LO 3-7: Know the steps that are performed in planning an audit engagement.

LO 3-8: Understand the importance of supervision to the planning and conduct of the audit.

LO 3-9: Know the types of audit tests.

LO 3-10: Understand the concept of materiality.

LO 3-11: Know the steps to applying materiality in an audit.

Review Questions

MultipleChoice Questions

Problems

1,2

17

27

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC) 36, EWMC

28 3

28, 29

3

18

29

4

19

5

21

31

6,7,8

20,22,23

28,30

9

24

37

10 11,12,13, 14,15,16 11,12,13, 14,15,16

35

36 EWMC

35 25 25, 26

EWMC 32,33,34 15-13

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

LO 3-12: Apply the materiality steps to an example (EarthWear).

26

32,33,34

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.

15-14 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number in 11th edition 3-1 3-2 3-3 3-4 3-5 3-6 3-7 3-8 3-9 3-10 3-11 3-12 3-13 3-14 3-15 3-16 3-17 3-18 3-19 3-20 3-21 3-22 3-23 3-24 3-25 3-26 3-27 3-28 3-29 3-30 3-31 3-32 3-33 3-34 3-35 3-36

Comparison Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

Number in 12th edition 3-1 3-2 3-3 3-4 3-5 3-6 3-7 3-8 3-9 3-10 3-11 3-12 3-13 3-14 3-15 3-16 3-17 3-18 3-19 3-20 3-21 3-22 3-23 3-24 3-25 3-26 3-27 3-28 3-29 3-30 3-31 3-32 3-33 3-34 3-35 3-36 3-37 3-38

15-15 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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.

15-16 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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 Audit Function 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.

15-17 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 Procedures Present the three general types of audit tests:  

Risk assessment procedures.

Futher audit procedures, which include: o Tests of controls, when required by auditing standards or when the auditor has chosen to do so. o Substantive procedures, which include test 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: 15-18 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 3-36 provides a good exercise for the students to learn more about auditor changes.

15-19 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Internet assignment 3-37 provides a good exercise for the students to learn more about internal auditing and its governing body, the IIA. Internet assignment 3-38 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 selfcontained 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

LO 4-1: Understand the concept of audit risk.

LO 4-2: Learn the form and components of the audit risk model.

LO 4-3: Understand how to use the audit risk model.

LO 4-4: Understand the auditor‘s risk assessment process.

LO 4-5: Learn how the auditor assesses the risk of material misstatement.

LO 4-6: Understand the fraud risk assessment process.

LO 4-7: Learn how to respond to the results of the risk

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC)

28,29,30, 32

33

EWMC 34

17,18,20

28,29,30, 32

33

34

17,18,19, 20

31

Review Questions

MultipleChoice Questions

Problems

1,2

13,14

23,24,25, 26,27

2,3

15

23,24,25, 26,27

4

16

23,24,25, 26,27,28

5,6,7,8

16

5,6,7,8,9 10 11,12

32

34

15-20 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

assessments.

LO 4-8: Learn how to evaluate the results of the audit tests.

LO 4-9: Understand the documentation requirements for risk assessments and responses.

LO 4-10: Learn the auditor‘s communication requirements about fraud to management, the audit committee, and others.

32 31

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.

15-21 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison th in 11 edition in 12th edition 4-1 Unchanged 4-1 4-2 Unchanged 4-2 4-3 Unchanged 4-3 4-4 Unchanged 4-4 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 4-17 4-18 Unchanged 4-18 4-19 Unchanged 4-19 4-20 Unchanged 4-20 4-21 Unchanged 4-21 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 4-29 4-30 Unchanged 4-30 4-31 Unchanged 4-31 4-32 Unchanged 4-32 4-33 Unchanged 4-33 4-34 Unchanged 4-34

15-22 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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.

15-23 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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.

Selection and application of accounting principles.

Industry, regulatory, and other external factors (Table 4-1).

Entity objectives, strategies, and related business risks.

Entity performance measures.

System of internal control (Chapter 6).

Use Table 4-1

EarthWear serves as a good example for discussing the issues related to assessing business risks.

15-24 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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. We make sure the students can clearly distinguish between high-risk and low-risk assertions.

15-25 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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.

[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.

15-26 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 selfcontained 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

LO 5-1: Understand the relationship between audit evidence and the auditor‘s report.

LO 5-2: Know management assertions about classes of transactions, account balances, and related disclosures.

LO 5-3: Understand the basic concepts of audit evidence.

LO 5-4: Know the audit procedures used for obtaining audit evidence.

LO 5-5: Understand the reliability of evidence.

LO 5-6: Understand the audit testing hierarchy.

LO 5-7: Understand the purposes of audit documentation.

LO 5-8: Develop an understanding of the content, types, organization, and ownership of audit documentation.

LO 5-9: Understand the auditor‘s decision process for conducting analytical procedures.

LO 5-10: Learn the types of analytical procedures.

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC)

40,42

43 EWMC

32, 34,35,36

40,42

43

34,35,36

40,42

43

MultipleChoice Questions

Problems

3,4

17,18

30,31,33

5,6

19

Review Questions

1,2

7,8,9 8,9,10 11,12

17,18,19, 20,21,22, 23 20,21, 22,23 24

37

13

25,26,27

37

14,15

28

38,39

16

29

39

41

15-27 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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.

15-28 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART Number in 11th edition 5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15 5-16 5-17 5-18 5-19 5-20 5-21 5-22 5-23 5-24 5-25 5-26 5-27 5-28 5-29 5-30 5-31 5-32 5-33 5-34 5-35 5-36 5-37 5-38 5-39 5-40

Comparison Unchanged Unchanged Unchanged Unchanged Unchanged Revised Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Revised Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

Number in 12th edition 5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15 5-16 5-17 5-18 5-19 5-20 5-21 5-22 5-23 5-24 5-25 5-26 5-27 5-28 5-29 5-30 5-31 5-32 5-33 5-34 5-35 5-36 5-37 5-38 5-39 5-40

15-29 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

5-41 5-42 5-43

Unchanged Unchanged Unchanged

5-41 5-42 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 51 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

15-30 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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] Understanding Audit Evidence It is important to discuss the following concepts related to audit evidence:   

Information used as audit evidence.

The sufficiency and appropriateness of audit evidence.

The evaluation of audit evidence.

We first discuss information used as 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:     

Knowledgeable source independent of 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: 15-31 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

      

Inspection.

Observation.

Inquiry.

Confirmation.

Recalculation.

Reperformance.

Analytical procedures.

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 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] Purposes 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 15-32 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

standards stipulate that working papers have three purposes: 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 crossreferencing, 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] Auditor Decision Process-Analytical Procedures 15-33 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 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 Figure 5-7 [LO 5-10] Types of Analytical Procedures We introduce the three types of procedures: trend analysis, ratio analysis, and reasonableness analysis (using Table 5-10).

Use Table 5-10

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 15-34 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

(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 selfcontained 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 LO 6-1: Understand the importance of the system of internal control to management and auditors.

LO 6-2: Know the definition of internal control.

LO 6-3: Know what controls are relevant to the audit.

LO 6-4: Understand the effect of information technology on internal control.

LO 6-5: Be familiar with the components of internal control together with the principles associated with each component.

LO 6-6: Understand how to plan an audit strategy based on assessments and decisions about internal control.

LO 6-7: Know how to develop an understanding of an entity‘s internal control.

LO 6-8: Be familiar with the tools available for documenting the understanding of internal control.

Review Questions

MultipleChoice Questions

1

12,13

Problems

14

Discussion Cases

EarthWear Mini-Cases (EWMC)

25

2

27

3,4

15

25,26,29

32,33

5

16,17

25,26,27, 29

32,33

6

13

25, 27

EWMC

25,28

EWMC

7, 8

15-35 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

LO 6-9: Know how to assess the level of control risk.

LO 6-10: Know how auditors perform tests of controls.

LO 6-11: Understand audit strategies for the nature, timing, and extent of substantive procedures based on different levels of detection risk.

LO 6-12: Understand the considerations for the timing of audit procedures.

LO 6-13: Be familiar with how to assess control risk when an entity‘s accounting transactions are processed by a service organization.

LO 6-14: Understand the auditor‘s communication of internal control-related matters.

LO 6-15: Be familiar with general and application controls.

LO 6-16: Understand how to flowchart a business process.

18 9

29

17,19, 20

EWMC

30

10

30

21

11

22

31

23 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 Number Comparison in 11th edition in 12th 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 15-36 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

6-19 6-20 6-21 6-22 6-23 6-24 6-25 6-26 6-27 6-28 6-29 6-30 6-31 6-32 6-33

Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

6-19 6-20 6-21 6-22 6-24 6-23 6-25 6-26 6-27 6-28 6-29 6-30 6-31 6-32 6-33

15-37 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 6 provides detailed coverage of the auditor‘s assessment of the system 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 the system 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 the system of 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 the system 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

15-38 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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

15-39 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[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.

15-40

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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.

15-41 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 selfcontained 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.

Chapter 7 Auditing Internal Control over Financial Reporting Learning Objectives

Review Questions

MultipleChoice Questions

LO 7-1: Understand management‘s responsibilities for reporting on internal

1

19

Problems

Discussion Cases

Internet Assignments

15-42 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

control under Section 404 of the Sarbanes-Oxley Act. LO 7-2: Understand the auditor‘s responsibilities for reporting on internal control under Section 404 of the Sarbanes-Oxley Act. LO 7-3: Know the definition of internal control over financial reporting (ICFR).

LO 7-4: Be able to explain the differences between a control deficiency, a significant deficiency, and a material weakness.

LO 7-5: Understand management‘s process for assessing ICFR. LO 7-6: Know how auditors conduct an audit of ICFR. LO 7-7: Understand how the auditor plans the audit of ICFR. LO 7-8: Be able to describe the topdown, risk-based approach that auditors use to identify controls to test.

LO 7-9: Understand how to test the design and operating effectiveness of controls.

LO 7-10: Understand how to evaluate identified control deficiencies.

LO 7-11: Understand how remediation affects audit reporting.

LO 7-12: Know the written representations that the auditor must obtain from management.

LO 7-13: Be familiar with the auditor‘s documentation requirements.

LO 7-14: Understand auditor reporting for the audit of ICFR. LO 7-15: Know the auditor‘s communication responsibilities on an audit of ICFR. LO 7-16: Understand how to obtain assurance on controls at a service organization that processes transactions for the entity.

LO 7-17: Know management‘s and the auditor‘s responsibilities for controls that provide reasonable assurance for safeguarding entity assets.

LO 7-18: Be familiar with computerassisted audit techniques.

1

19

2

20,21

3,4,5 6

46, 47

24,37 22

34,35,36,37

7,8 4,8,9, 10

35,36,37, 38

34 22,23, 25

34

23, 25, 26 11

20,21,32

35,36,37, 38,39,40, 41,42,43

46

27,28,29

38,39,40, 41,42,43

46,47

12

13 14,15,16

30,31

17

18

32,33

44,45

15-43 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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 11th edition 7-1 7-2 7-3 7-4 7-5 7-6 7-7 7-8 7-9 7-10 7-11 7-12 7-13 7-14 7-15 7-16 7-17 7-18 7-19 7-20 7-21 7-22 7-23 7-24 7-25 7-26 7-27 7-28 7-29 7-30 7-31 7-32 7-33 7-34 7-35 7-36 7-37

Comparison Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

Number in 12th edition 7-1 7-2 7-3 7-4 7-5 7-6 7-7 7-8 7-9 7-10 7-11 7-12 7-13 7-14 7-15 7-16 7-17 7-18 7-19 7-20 7-21 7-22 7-23 7-24 7-25 7-26 7-27 7-28 7-29 7-30 7-31 7-32 7-33 7-34 7-35 7-36 7-37

15-44 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

7-38 7-39 7-40 7-41 7-42 7-43 7-44 7-45 7-46 7-47

Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

7-38 7-39 7-40 7-41 7-42 7-43 7-44 7-45 7-46 7-47

Chapter 7 covers the reporting requirements of management regarding the effectiveness of internal control and the steps required by the auditor in the testing of management‘s assertion regarding the effectiveness of internal control. The material covered in this chapter applies only to companies subject to the reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002.

[LO 7-1] Management Responsibilities under Section 404 We begin this chapter by asking the students what they have heard about ―Section 404.‖ We try to elicit from them management‘s responsibilities as well as the auditor‘s. For management, we get the following up on the board:    

Accept responsibility for the effectiveness of the entity‘s ICFR. Evaluate the effectiveness of the entity‘s ICFR using suitable criteria (at this point we mention COSO again).

Support the evaluation with sufficient evidence, including documentation.

Present a written assessment regarding the effectiveness of the entity‘s ICFR as of the end of the entity‘s most recent fiscal year.

We stress to the students that the second and third bullets are where management will spend most of its time and energy. We make sure the students understand the expectations of each bullet.

[LO 7-2] Auditor Responsibilities under Section 404 and AS 2201 In regard to the auditor‘s responsibilities, we stress to the students that the auditor will audit and report on the effectiveness of internal control. The auditor must integrate the audits of the financial statements and the internal control but realize the two have different objectives. In order for the audits to be integrated, both must be done by the same auditor.

15-45 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 7-3] Internal Control over Financial Reporting Defined We take a few minutes to go over the COSO definition of internal control that we covered in Chapter 6. We also review with the students the more specific definition described by PCAOB. [LO 7-4] Internal Control Deficiencies Defined We spend significant time making sure the students understand PCAOB‘s definitions of deficiency, significant deficiency, and material weakness, bringing into the discussion the concepts of likelihood and magnitude. We make sure students understand that the focus of AS 2201 is on material weaknesses, and that an audit of ICFR is not designed to identify significant deficiencies. Figure 7-1 shows how these concepts relate to each other in determining the materiality of a control deficiency and highlights the responsibility for communication of each of the different levels of control deficiency. We use Problem 7-36 to solidify their understanding after we have covered the chapter.

Use Figure 7-1 [LO 7-5] Management’s Assessment Process We spend time discussing management‘s assessment process because of its importance to the auditor‘s work. We start by making sure the students understand that the auditor cannot participate in the assessment process since the auditor must remain independent in his or her audit of ICFR. We then discuss the elements found in the process and review Table 7-1 that describes the entity-level controls and Table 7-2, which describes the controls that are typically included for testing.

Use Table 7-1 and Table 7-2 Management is required to base its assessment of the effectiveness of the entity‘s ICFR on a suitable, recognized control framework established by a body of experts that follows due-process procedures. In the U.S., most entities use the framework developed by COSO (COSO Internal Control–Integrated Framework). However, companies are not required by SOX to use the COSO framework.

We remind students that the COSO framework identifies three primary objectives for internal control. However, it is important for students to understand that the integrated audit focuses on only one of the objectives—reliable financial reporting.

We go over the importance of management documenting its understanding. Management should document the design of controls over all relevant assertions related to all significant accounts and disclosures in the financial statements, including controls in all five components of ICFR. We explain that documentation of ICFR may take many forms, such as paper, electronic files, or other media. It includes a variety of information, such as policy manuals, process 15-46 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

models, flowcharts, job descriptions, documents, and forms.

[LO 7-6] Performing an Audit of ICFR We start this section by reminding students that the overall goal is to obtain sufficient, appropriate evidence about the design and operating effectiveness of controls over all relevant financial statement assertions relating to significant accounts and disclosures in the financial statements. The auditor does this by planning and performing the audit of internal control to obtain reasonable assurance that deficiencies rising to the level of a material weakness are identified.

Figure 7-2 can be used to present to students the steps involved in this process. We spend considerable time here covering each step thoroughly. We try to show the integration of the financial statement audit to the internal control audit as we do so.

Use Figure 7-2 In discussing the audit of ICFR, we emphasize the requirement that this and the financial statement audit are to be integrated. We usually discuss how the control testing from the audit of ICFR can be used in the financial statement audit; and how the results of the financial statement audit may impact the opinion on internal control.

We remind the students that when an entity has effective ICFR, the auditor should be able to perform sufficient testing of controls to assess control risk for all relevant assertions at a low level. If, however, the auditor assesses control risk as other than low for certain assertions or significant accounts for purposes of the financial statement audit, the auditor should document the reasons for that conclusion.

[LO 7-7] Plan the Audit of ICFR We tell the students that planning this audit is very similar to planning the financial statement audit. In planning the engagement, the auditor considers the following activities:   

The role of risk assessment and the risk of fraud.

Scaling the audit.

Using the work of others.

Table 7-3 may be used to show factors that may impact the planning of an ICFR audit.

Table 7-3 A major consideration for the external auditor is how much the work performed by others (internal audit function or others working for management) can be relied on in adjusting the nature, timing, or extent of the auditor‘s work. In determining the extent to which the auditor may use the work of others, the auditor should consider the risk; that is, as the risk associated with the control increases, the auditor should perform more of the work.

15-47 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

15-48 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 7-8] Identify Controls to Test The auditor should complete the following steps when using a top-down, risk-based approach (see Figure 7-3):    

Identify entity-level controls.

Identify significant accounts and disclosures and their relevant assertions.

Understand likely sources of misstatements.

Select controls to test.

We cover each of these steps in detail and refer to Table 7-4 for factors to consider in identifying controls to test.

Figure 7-3 Table 7-4 [LO 7-9] Evaluate the Design and Test the Operating Effectiveness of Controls This part of the chapter provides a detailed discussion of how the auditor evaluates the design and tests the operating effectiveness of the controls. We discuss the nature, timing, and extent of tests of controls, and the factors in Table 7-5 and how they affect the risks related to the controls.

Table 7-5 [LO 7-10] Evaluating Identified Control Deficiencies One of the most important aspects of the audit of ICFR is the evaluation of control deficiencies. We spend considerable time discussing the two concepts that affect the classification of identified deficiencies: likelihood and magnitude. We discuss the factors and indicators presented in Tables 7-6 and 7-7.

Use Tables 7-6 and 7-7 We use Exhibit 7-3 to present a detailed example of how an auditor might evaluate the design and test the operating effectiveness for a daily IT application control and a daily IT-dependent manual control.

Use Exhibit 7-3 [LO 7-11] Remediation of a Material Weakness We discuss the process of remediation that is necessary to correct any material weakness. If a material weakness cannot be remediated and/or properly tested by the balance sheet date, then an adverse opinion on ICFR will be issued.

15-49 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 7-12] Written Representations Table 7-8 lists the typical management representations made to the auditor in relation to the audit of internal control. Failure by management to provide written representations constitutes a scope limitation that would preclude an unqualified opinion.

Use Table 7-8 [LO 7-13] Auditor Documentation Requirements AS5 requires that the auditor appropriately document the processes, procedures, judgments, and results relating to the audit of internal control consistent with the PCAOB‘s documentation standards. The auditor‘s documentation must include the auditor‘s understanding and evaluation of the design of each of the components of the entity‘s ICFR, documentation of the process used to determine the points at which misstatements could occur within significant accounts and disclosures, the extent to which he or she relied upon work performed by others, and the scope of testing. Finally, the auditor must describe the evaluation of any deficiencies discovered, as well as any other findings that could result in a modification to the auditor‘s report.

[LO 7-14] Auditor Reporting on ICFR After auditing the effectiveness of an entity‘s internal control, an auditor issues an unqualified opinion if the entity‘s internal control is designed and operating effectively in all material respects. We use Figure 7-4 to review the types of audit reports that the auditor may issue relating to the effectiveness of ICFR. The auditor may choose an unqualified report, an adverse report for a material weakness, or a disclaimer of opinion for a scope limitation.

Use Figure 7-4 The auditor‘s report on the effectiveness of internal control has a number of required elements. The auditor may choose to issue separate reports on the entity‘s financial statement and ICFR or may issue a combined report. Under either approach, the date of the two reports should be the same.

The auditor‘s report on the effectiveness of internal control has a number of required elements. First, the report must include the title ―Report of Independent Registered Public Accounting Firm‖ and be addressed to the shareholders and the board of directors of the entity.

Second, the auditor provides an opinion on whether the entity maintained, in all material respects, effective ICFR as of the specified date, based on the control criteria. Third, the report must contain the auditor‘s basis for the opinion. Fourth, the report defines ICFR and its limitations. Finally, it contains the signature of the auditor, office location, and date.

[LO 7-15] Additional Required Communications in an Audit of ICFR

15-50 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

The auditor has numerous communication responsibilities under Section 404:    

Communicate in writing to management and the audit committee all significant deficiencies and material weaknesses identified during the audit.

Communicate to management, in writing, all control deficiencies (lesser magnitude than significant deficiencies) identified during the audit and inform the audit committee when such a communication has been made.

If the auditor has been made aware that fraud is taking place, it must be brought to the attention of the appropriate level of management or the audit committee (if the fraud involves senior management).

If the auditor has discovered possible illegal acts, the auditor must assure him or herself that the audit committee is adequately informed unless the matter is clearly inconsequential.

The auditor‘s written communications about control deficiencies state that the communication is intended solely for the information and use of the board of directors, audit committee, management, and others within the organization. When governmental authorities require the entity to furnish such a report, a specific reference to such regulatory agencies may be made in the report.

Advanced Module 1: Special Considerations for an Audit of Internal Control Depending on time and your interests, you can cover the following:  

Service organizations.

Safeguarding assets.

[LO 7-16] Use of Service Organizations We explain to students that many companies use service organizations to process transactions. If the service organization‘s services make up part of an entity‘s information system, then they are considered part of the information and communication component of the entity‘s ICFR. Thus, both management and the auditor must consider the activities of the service organization. We will then explain the importance of a Type 2 report. Management and the auditor should perform the following procedures with respect to the activities performed by the service organization: 

obtain an understanding of the nature and significance of the services provided by the service organization and their effect on the user entity‘s internal control relevant to the audit, and sufficient to identify and assess the risks of material misstatement; and



design and perform audit procedures responsive to those risks.

[LO 7-17] Safeguarding of Assets 15-51 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Safeguarding of assets is defined in AS5 as policies and procedures that ―provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the entity‘s assets that could have a material effect on the financial statements.‖ We point out that the above definition is consistent with the definition in the COSO framework.

[LO 7-18] Advanced Module 2: Using Technology in the Audit of ICFR We review each of the following technologies, using the tables and figures provided in the text:   

Generalized audit software (including IDEA packaged with the text).

Custom Audit Software.

Test Data.

Table 7-9 can be used to present functions performed by generalized audit software.

Use Table 7-9 We like to walk the students through an example of how generalized audit software can be used. Problem 7-45 could be used here as an example.

Internet Assignments Internet assignments 7-46 and 7-47 prompt the students to search for audit reports for audits of ICFR. 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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

IDEA and Tableau The Chapter 7 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls Learning Objectives

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

EarthWear Mini-Cases (EWMC)

15-52 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

LO 8-1: Learn the definition of audit sampling and why auditors use sampling to gather evidence.

LO 8-2: Understand basic sampling terminology.

LO 8-3: Learn the types of audit procedures that do and do not involve sampling.

LO 8-4: Learn the types of audit sampling.

LO 8-5: Learn the sampling requirements in auditing standards.

LO 8-6: Learn how to apply attribute sampling to tests of controls.

LO 8-7: Work through an example of attribute sampling.

LO 8-8: Learn how to apply nonstatistical sampling to tests of controls.

1 2

21 17,19,20

21,22

3

22,23 11,12

5,6,8,9 5,6,8,9 6,8,9,10

32

12,13,14, 15,16,17, 18,19,20 13,14,15, 16

22,23

24,25, 26,27,28,3 0 24

32

EWMC

32

EWMC EWMC

29, 31

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.

15-53 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 8-1 Unchanged 8-1 8-2 Unchanged 8-2 8-3 Unchanged 8-3 8-4 Unchanged 8-4 8-5 Unchanged 8-5 8-6 Unchanged 8-6 8-7 Unchanged 8-7 8-8 Unchanged 8-8 8-9 Unchanged 8-9 8-10 Unchanged 8-10 8-11 Unchanged 8-11 8-12 Unchanged 8-12 8-13 Unchanged 8-13 8-14 Unchanged 8-14 8-15 Unchanged 8-15 8-16 Unchanged 8-16 8-17 Unchanged 8-17 8-18 Unchanged 8-18 8-19 Unchanged 8-19 8-20 Unchanged 8-20 8-21 Unchanged 8-21 8-22 Unchanged 8-22 8-23 Unchanged 8-23 8-24 Unchanged 8-24 8-25 Unchanged 8-25 8-26 Unchanged 8-26 8-27 Unchanged 8-27 8-28 Unchanged 8-28 8-29 Unchanged 8-29 8-30 Unchanged 8-30 8-31 Unchanged 8-31 8-32 Unchanged 8-32

15-54 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 8 has two objectives: (1) to provide an overview of audit sampling and (2) to apply sampling techniques to tests of controls. Although most students will have had a statistics course prior to taking auditing, we find that it is necessary to review basic statistical concepts. This helps to refresh the students' memories and to introduce the terms used in auditing to describe basic statistical concepts.

Introduction We begin by asking the students why there is a need for sampling. Then we give the students an overview of the similarities and differences between statistical and nonstatistical sampling, without getting technical at this point, and explain that nonstatistical sampling is now most common. We then spend a few minutes discussing how computer assisted audit techniques and audit data analytics has impacted the need for sampling.

[LO 8-1] Definitions and Key Concepts – Audit Sampling We start by defining audit sampling and then point out that when sampling is used, the auditor must be concerned about both sampling and nonsampling risk as discussed in Chapter 3.

Audit sampling is defined as: The selection and evaluation of less than 100 percent of the items in a population of audit relevance selected in such a way that the auditor expects the sample to be representative of the population and thus likely to provide a reasonable basis for conclusions about the population.

[LO 8-2] Sampling Risk This leads us into a discussion on sampling risk: the risk that the sample drawn is not representative of the population and that, as a result, the auditor will reach an incorrect conclusion about an account balance or class of transactions based on the sample. Next we cover Type I and Type II errors: the decision errors that an auditor can make when deciding whether the sample evidence supports or does not support a test of controls or a substantive test.

For tests of controls, we have the following relationships:  

Type I = Risk of assessing control risk too high.

Type II = Risk of assessing control risk too low.

For substantive tests, we have the following relationships:  

Type I = Risk of incorrect rejection.

Type II = Risk of incorrect acceptance.

We then ask the students what the result of a Type I error might be (conducting more work than necessary) and what the result of a Type II error might be (the auditor failing to detect a 15-55 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

material misstatement in the financial statements that could lead to litigation) and we discuss the ramifications of each.

We then spend a few minutes discussing how the auditor decides sample size defining the following inputs: confidence level, tolerable error, and expected error. Students are generally familiar with confidence levels from earlier classes but we spend extra time on tolerable and expected errors, as it is important for them to understand the concept of how large the difference is between the defect rate that is expected and the defect rate that can be tolerated.

In statistics classes the term precision is a measure of the closeness between a sample estimate and the population characteristic being estimated given a specified sampling risk.

Comparable terms in audit sampling are: 

Precision at the planning stage is the difference between the expected and the tolerable deviation rate or misstatement.



Auditing standards use the term allowance for sampling risk to reflect the concept of precision.

[LO 8-3] Audit Evidence Choices that Do and Do Not Involve Sampling Point out to the students that some audit tests do not involve sampling. List evidence types and ask the students for input to get something like Table 8-1 up on the board.

Use Table 8-1 Point out that there are certain situations where all items with a particular characteristic are tested or when only one or a few items are tested. Try to elicit from the students examples of each.

[LO 8-4] Types of Audit Sampling This is a good place to provide an overview of the sampling techniques that will be covered in Chapters 8 and 9. First, review the comparison of nonstatistical sampling with statistical sampling. Second, briefly present the three categories of statistical sampling techniques covered in the text: attribute sampling, monetary-unit sampling, and classical variables sampling.

[LO 8-5, 8-6, 8-7] Attribute Sampling Applied to Tests of Controls In this section, we define attribute sampling and walk the students through the steps in an attribute-sampling application. Table 8-2 can be used to present the steps for a sampling application. Spend considerable time going through each step. At this point, we mainly focus on the concepts that underlie the decisions that the auditor makes at each step. This is time well spent since the underlying concepts apply to the sampling techniques introduced in Chapter 9 as well. Following are the key points that we make when discussing each step: Use Table 8-2 15-56 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Planning 1. Determine the test objective(s). The objective is: (1) to evaluate the operating effectiveness of the internal control(s) for the purpose of a public company internal control audit or (2) to determine the degree of reliance that can be placed on controls for a financial statement audit.

2. Define the population characteristics: a. Define the sampling population. Three issues are important: (1) all or a subset of the items that constitute the class of transactions which make up the sampling population, (2) the auditor must determine that the population from which the sample is selected is appropriate for the audit assertion being tested, and (3) the auditor must determine that the physical representation of the population (or frame) is complete. b. Define the sampling unit. Point out to the students that a sampling unit for attribute sampling is normally a document, an entry, or a line item. c. Define the control deviation conditions. Point out that it is important to have good definitions of what is a control deviation.

3. Determine the sample size, using the following inputs: a. The desired confidence level or risk of incorrect acceptance. The risk that the sample results will support a conclusion that the control is functioning effectively, when in truth it is not, can result in assessing control risk too low. This risk impacts the effectiveness of the audit. When the auditor intends to rely on controls, the confidence level is set at 90 or 95 percent, meaning the auditor is willing to accept a 10 to 5 percent risk of accepting the control as effective, when in fact it is not. The students should remember that there is an inverse relationship between the risk of assessing control risk too low and the size of the sample. b. The tolerable deviation rate. The tolerable deviation rate is the maximum deviation rate the auditor is willing to accept and still rely on control procedures.

Table 8-3 provides suggested tolerable deviation rates for the assessed importance of controls. Again, sample size is inversely related to tolerable deviation rate.

Use Table 8-3 c. The expected population deviation rate. This is the rate that the auditor expects to exist in the population. The auditor can develop this estimate based on prior years‘ results or on a pilot test. There is a direct relationship between expected population deviation rate and sample size.

15-57 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Note: Later in the chapter it is discussed why the population size has little or no effect on the sample size unless the population is relatively small (less than 1,000). Normally, auditors sample from large populations, so population size is commonly ignored in determining sample size. For more information on what to do when the population is small, see the Advanced Module 1 in this chapter.

Tables 8-5 and 8-6 illustrate sample size tables for attribute sampling at the 95 and 90 percent desired confidence levels. It is helpful to walk students through how to use the tables, why an incremental increase in the Expected Population Deviation Rate doesn‘t always results in a larger sample size (see the footnote in the tables, there are no such things as ―partial deviations‖ so the sample sizes are rather ―lumpy‖ in that they increase only when the integer value of the tolerable number of deviations changes), and the meaning of the asterisks in the table (see explanation provided in the tables).

Use Tables 8-5 and 8-6 Refer the students to Table 8-7 for a summary of how each factor affects sample size.

Use Table 8-7 Performance 4. Select sample items. The key point here is that when a statistical sampling application is used, the sample selection process must allow selection of a sample that is representative of the population. Briefly discuss random versus systematic selection.

5. Perform the auditing procedures. The students should be reminded of the possibility of committing nonsampling errors. Also discuss how the following four items can affect a sampling application for tests of controls:    

Voided documents.

Unused or inapplicable documents.

Inability to examine a sample item.

Stopping the test before completion.

Understand and analyze deviations observed: the auditor should consider the cause and consequence of the deviation and how the deviations may impact the other phases of the audit.

Evaluation 6. Calculate the sample deviation and the computed upper deviation rates. Point out that these calculations can be done using a computer program or attribute-sampling tables.

Also make it clear why attribute-sampling tests are usually one-sided; the auditor is only interested in the maximum deviation rate in the population. Tables 8-8 and 8-9 illustrate sample evaluation tables for 95 and 90 percent desired confidence levels. It is helpful to walk students through how to use the tables and how to handle sample sizes between the 15-58 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

round numbers provided (i.e., either round down in sample size or extrapolate).

Use Tables 8-8 and 8-9 7. Draw final conclusions. First present the decision rules for the auditor‘s decision about whether the sample evidence supports or does not support the test. Then use Table 8-10 to explain the auditor‘s risks when making such decisions.

Use Table 8-10 An extended example of an attribute-sampling plan is provided in the text. This example uses a hypothetical test of three controls that exist in the revenue process of Calabro Wireless Services. We walk the students through this example as a way of applying the concepts covered in the prior section. While the calculations are completed using the attribute-sampling tables, we show the students the output from the IDEA software. Use Problems 25 and 26 or 27 and 28 here to help the students with their understanding.

[LO 8-8] Nonstatistical Sampling for Tests of Controls Discuss the differences between nonstatistical and statistical sampling in each of the following steps in a sampling application:   

Determining the sample size.

Selecting the sample items.

Calculating the computed upper deviation rate.

It is particularly important to discuss with the students how the auditor reaches a conclusion about the reliability of the tested control when nonstatistical sampling is used. Problems 29 and/or 31 could be used here.

Advanced Module 1: Considering the Effect on Sample Size of a Small Population At this point, make sure the students understand that population size generally has little or no effect on the sample size and if the population contains more than 1,000 units, the effect on the sample size is negligible.

Also, briefly discuss how auditors determine sample sizes when testing controls that operate infrequently, as shown in Advanced Module 1 in the chapter. Emphasize that the Small Population Sample Size Table in the text is used frequently in practice as some controls operate only on an infrequent basis. Remind the students, however, that just because a control operates infrequently (e.g., monthly or quarterly) does not mean that they automatically should use this table. For example, if a monthly reconciliation occurs for 50 bank accounts, the population is 600 (50 accounts/month times 12 months/year), not 50 and thus the table would not be used.

Advanced Module 2: Comparing Terminology for Attribute Sampling between IDEA and Sampling Tables 15-59 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

This table highlights terminology specific to IDEA and the relationship to the terms introduced in the text.

Discussion Case Discussion case 8-32 is a good case for reinforcing the concepts that underlie attribute sampling.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

EarthWear Mini-Cases The Chapter 8 mini-cases can be assigned as stand-alone cases. Please go to Connect for the mini-case assignments.

IDEA The Chapter 8 IDEA problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 9 Audit Sampling: An Application to Substantive Tests of Account Balances Learning Objectives LO 9-1: Understand the similarities and differences between audit sampling for tests of controls and substantive tests of details of account balances.

LO 9-2: Learn to apply monetary-unit sampling.

LO 9-3: Work through an extended example of monetary-unit sampling.

LO 9-4: Learn to apply nonstatistical sampling techniques and work through an example.

LO 9-5: Learn to apply classical variables

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

7

11,12,13,14, 18,19

21

27,28

1,2,3,4,5,6

12,13,14,15,16, 17,18,20

21,22,23

27

5,6

15,16

22,23

7,8

13

24

28

2,9,10

11,13,17,18, 19,20

21,25,26

27

Internet Assignments

15-60 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

sampling.

LO 9-6: Work through an example of classical variables difference estimation.

10

25,26

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.

15-61 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART Number in 11th edition 9-1 9-2 9-3 9-4 9-5 9-6 9-7 9-8 9-9 9-10 9-11 9-12 9-13 9-14 9-15 9-16 9-17 9-18 9-19 9-20 9-21 9-22 9-23 9-24 9-25 9-26 9-27 9-28

Comparison

Number in 12th edition

Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

9-1 9-2 9-3 9-4 9-5 9-6 9-7 9-8 9-9 9-10 9-11 9-12 9-13 9-14 9-15 9-16 9-17 9-18 9-19 9-20 9-21 9-22 9-23 9-24 9-25 9-26 9-27 9-28

15-62 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 9 focuses on sampling for substantive tests of account balances. It covers two statistical sampling techniques, monetary-unit and classical variables sampling (covered in the Advanced Module) and nonstatistical sampling.

[LO 9-1] Sampling for Substantive Tests of Details of Account Balances Introduce this chapter by reminding the students of the three important determinants of sample size for testing account balances: desired confidence level, tolerable misstatement, and estimated misstatement. It is a good idea to mention that a fourth factor, population size, will also influence of the sampling techniques used for substantive tests of details. We then review the idea that misstatements discovered in the audit sample must be projected to the population and there must be an allowance for sampling risk. We then bridge these concepts to audit sampling to test account balances. Lastly, we briefly discuss why monetary-unit sampling is used for testing account balances in audit software (including IDEA) versus classical variables sampling and the fact that monetary-unit sampling is not the best approach to use for all substantive tests of details of account balances.

[LO 9-2] Monetary-Unit Sampling In introducing monetary-unit sampling, we make the following points:   

The conclusion will be in monetary terms rather than a rate of occurrence.

This sampling technique has many important applications in public accounting.

It is primarily designed to test for overstatement errors.

We then present the advantages and disadvantages of monetary-unit sampling. We go through the sampling plan (that we covered in Chapter 8 for attribute sampling) highlighting the differences between the two. We use Table 9-1 to summarize the steps and focus on the special features that apply to the application of monetary-unit sampling: Planning 1. Determine the test objectives.

2. Define the population characteristics:  Define the population.  Defining the sampling unit. The major point here is that the sampling unit is an individual dollar (or other currency). The account or transaction that contains the selected dollar being audited is referred to as the logical unit.  Define a misstatement.

15-63 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

3. Determining the sample size. A monetary-unit sample size can be determined by using the attribute sampling tables shown in Chapter 8 using the inputs of the desired confidence level, the tolerable misstatement, and the expected population misstatement.

When using IDEA to compute a monetary-unit sample size, the population size is also a required input to determine sample size.

Performance 4. Selecting the sample items. Probability-proportional-to-size sample selection gives each individual dollar in the population an equal chance of being selected because the first selection or ―seed‖ is randomly determined. However, because the individual dollars are selected in a systematic manner (that is, every nth dollar), large accounts or transactions have a higher probability of being selected for testing. Figure 9-1 provides an example of how probability-proportional-to-size is applied. An important point to make is that because the first item in a systematic selection plan is selected randomly, all items do, at least initially, have an equal chance of being selected, similar to pure random selection.

5. Perform the auditing procedures. Understand and analyze any misstatements observed.

Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. With monetary-unit sampling, the auditor calculates the upper limit on misstatement. We go through the extended example to demonstrate the computation and evaluation of projected and upper misstatement limit of a monetary-unit sampling. Then we go over with the students computing the upper projected misstatement using IDEA. Exhibit 9-2 shows the evaluation of the sample results using IDEA. We make sure the students understand why sample size is not used in evaluating MUS results and the effect of understatement misstatements.

7. Drawing final conclusions. We use Table 9-4 to discuss the auditor‘s risks when evaluating an account based on sample evidence. Problems 21 and/or 23 could be used here.

Use Tables 9-1 to 9-4 Use Figure 9-1 Use Exhibit 9-2 [LO 9-3] An Extended Example: Monetary-Unit Sampling An extended example is provided to demonstrate the computation and evaluation of projected and upper misstatement limit (UML) of a monetary-unit sampling application for the entity‘s accounts receivable.

[LO 9-4] Nonstatistical Sampling for Tests of Account Balances The approach that is shown in the text for nonstatistical sampling is based on the Audit Guide, Audit Sampling. Again, we focus on the differences between a nonstatistical sampling 15-64 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

application and a statistical sampling application. The following need further explanation:    

Identifying individually significant items.

Determining the sample size.

Selecting sample items.

Calculating the sample results.

We then introduce the sample size formula included in LO 9-4 using the example under the heading ―An Example of Nonstatistical Sampling‖ and discuss its components. Lastly, we discuss how a nonstatistical sampling result should be evaluated and the importance of auditor judgment when reaching a final decision. Auditor judgment is particularly important when considering the adequacy of the allowance for sampling risk.

The example in the text involves the auditor's test of the fair presentation of the account receivable balance for Calabro Wireless Services. The students should find the example easy to follow. Problem 24 could be used here.

[LO 9-5] Advanced Module 1: Classical Variables Sampling We cover classical variables sampling in the same manner as monetary-unit sampling.  List the advantages and disadvantages.  Discuss how to apply classical variables sampling.  Work through an example (LO 9-6).

[LO 9-6] Applying Classical Variables Sampling An extended example is provided to demonstrate the special features that apply to classical variables sampling.

Discussion Cases Discussion cases 9-27 and 9-28 reinforce the concepts covered in this chapter.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

IDEA The Chapter 9 IDEA problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 10 15-65 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Auditing the Revenue Process Learning Objectives

LO 1: Understand why knowledge of an entity‘s revenue recognition policies is important to the audit.

LO 2: Understand the revenue process.

LO 3: Know the types of transactions in the revenue process and the financial statement accounts affected.

LO 4: Be familiar with the types of documents and records used in the revenue process.

LO 5: Understand the functions in the revenue process.

LO 6: Know the appropriate segregation of duties for the revenue process.

LO 7: Understand the inherent risks relevant to the revenue process and related accounts.

LO 8: Know how to assess control risk for a revenue process.

LO 9: Know the key internal controls and develop relevant tests of controls for revenue, cash receipts, and sales returns transactions.

LO 10: Relate the assessment of control risk to substantive testing.

LO 11: Know the substantive analytical procedures used to audit revenue-related accounts.

LO 12: Know the substantive tests of transactions and the tests of details used to audit revenue-related accounts.

LO 13: Understand the confirmation process for accounts receivable.

LO 14: Understand how to audit other types of receivables.

LO 15: Understand how to evaluate the audit findings and reach a final conclusion on revenue-related accounts.

Review Questions

MultipleChoice Questions

1

Problems

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC)

24

31

34

25

33 33 33

2,3 3

25 12,14

25

IDEA

4 5

13

6

13,14,15, 16

7

17,18

8

19,23

26,27,28, 29,30

EWMC

9,10

20,21,22

27,28,29

EWMC

25

11

32 23

28, 30

32

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.

15-66 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison th in 11 edition in 12th edition 10-1 Unchanged 10-1 10-2 Unchanged 10-2 10-3 Unchanged 10-3 10-4 Unchanged 10-4 10-5 Unchanged 10-5 10-6 Unchanged 10-6 10-7 Unchanged 10-7 10-8 Unchanged 10-8 10-9 Unchanged 10-9 10-10 Unchanged 10-10 10-11 Unchanged 10-11 10-12 Unchanged 10-12 10-13 Unchanged 10-13 10-14 Unchanged 10-14 10-15 Unchanged 10-15 10-16 Unchanged 10-16 10-17 Unchanged 10-17 10-18 Unchanged 10-18 10-19 Unchanged 10-19 10-20 Unchanged 10-20 10-21 Unchanged 10-21 10-22 Unchanged 10-22 10-23 Unchanged 10-23 10-24 Unchanged 10-24 10-25 Unchanged 10-25 10-26 Unchanged 10-26 10-27 Unchanged 10-27 10-28 Unchanged 10-28 10-29 Unchanged 10-29 10-30 Unchanged 10-30 10-31 Unchanged 10-31 10-32 Unchanged 10-32 10-33 Unchanged 10-33 10-34 Unchanged 10-34

15-67 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 10 re-introduces the concept of viewing businesses from a process perspective or through transaction cycles. This is important to auditors as auditing divides the financial statement components into business processes or cycles in order to better manage the audit. The revenue process is generally the first process we cover in the introductory auditing class because most students have some understanding of how entities sell products or deliver services. The chapter begins by reviewing the five-step approach required by the new revenue recognition accounting standard and then gives an overview of the revenue process. Then the audit risk model is followed as specific factors that impact inherent and control risk are introduced. This chapter also discusses the substantive audit procedures conducted by the auditor to reach the appropriate level of detection risk for accounts affected by the revenue process.

An Overview of Business We begin by using Figure 10-1 to make sure all of the students are familiar with the business processes; it also helps them in our future discussions.

Use Figure 10-1 [LO 10-1] Revenue Recognition We then go into revenue recognition and have found that it is useful to review the revenue recognition process that students learned in their financial accounting classes. We discuss the five-step approach required by FASB ASC 606. We indicate to the students that in many industries (e.g., software and construction) the recognition of revenue is not always easy to determine. We warn the students that the recognition of revenue can become an area of controversy between the auditee and the auditor (refer the students to the related inherent risk factors below). We refer the students to Exhibit 10-1 for an example of inappropriate revenue recognition and its impact on business decisions.

Use Exhibit 10-1 [LO 10-2 through 10-6] Overview of the Revenue Process This is an important section for the students since most of them have little experience with accounting systems. We approach this material by walking the students through the flowchart shown in Figure 10-2. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections using the previously reviewed flowchart as a benchmark:    

Types of transactions and financial statement accounts affected (LO 10-3).

Types of documents and records (LO 10-4).

The major functions (LO 10-5).

Key segregation of duties (LO 10-6).

15-68 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

In covering these subsections, we refer the students to Tables 10-1 through 10-4.

Use Figure 10-2 Use Tables 10-1 through 10-4 An alternative approach is to cover the material in reverse. You can review the subsections first and then walk the students through the flowchart.

[LO 10-7] Inherent Risk Assessment This is a good place to reinforce the concepts concerning inherent risk assessment that were covered in Chapter 4. We discuss each of the following inherent risk factors and how they may affect the revenue process and related accounts:    

Industry-related factors.

The complexity and contentiousness of revenue recognition issues.

The difficulty of auditing transactions and account balances.

Misstatements detected in prior audits.

[LO 10-8] Assessment of Control Risk The control risk assessment offers an excellent opportunity for the students to apply the internal control concepts learned in Chapters 6 and 7 to a business process. We use Figure 10-3 to refresh the students' memory of the major steps in assessing control risk and then discuss each of the steps as they apply to the revenue process.

Use Figure 10-3 [LO 10-9] Control Activities and Tests of Controls Revenue Transactions This section provides the details on the assertions, possible misstatements, internal control procedures, and selected tests of controls for revenue transactions. We use Table 10-5 to review the assertions about classes of transactions and events. Then we use Table 10-6 to cover this material in detail, though it is important to emphasize to the students that this table includes only a few examples and should not be construed as an exhaustive list. We generally go over each assertion, point out the possible misstatement, and the normal internal control procedures that an entity should have in its systems to minimize the possibility of such misstatements. It is a good idea to relate the control procedures back to the flowchart in Figure 10-2. Our experiences indicate that the students develop a better understanding of the revenue process and the auditor's control risk assessment if we work back and forth between Figure 10-2 and Table 10-6. The last thing we cover is the tests of controls that the auditor can conduct to test whether the controls are operating effectively.

15-69 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Use Tables 10-5 and 10-6 Cash Receipts Transactions We cover the material in Table 10-7 (a few examples only, not an exhaustive list) for cash receipts transactions in the same manner as we described for revenue transactions, except that we do not go into the same level of detail. Discussing the occurrence, completeness, and authorization assertions is usually sufficient.

Use Table 10-7 Sales Returns and Allowances Transactions Two important issues should be covered. First, we tell the students that credit memoranda, which are used to process sales returns and allowances, can also be used to cover unauthorized shipments of goods or conceal misappropriations of cash. Second, we discuss the two controls that should be present for the proper processing of credit memoranda: (1) each credit memorandum should be approved by someone other than the individual who initiated it and (2) each credit for returned goods should be supported by a receiving document indicating that the goods have been returned. We usually point out that on most engagements, the auditor can use substantive analytical procedures to verify sales returns and allowances.

If you want to cover this topic in more detail, we suggest that you use discussion Case 5-42.

It provides a situation where book returns are material and difficult to estimate. Problem 10-24 could be used here as well.

[LO 10-10] Relating the Assessed Level of Control Risk to Substantive Procedures This is a good place to reinforce the students' understanding of how the auditor's assessment of control risk in the revenue process impacts detection risk for revenue-related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. On the other hand, if the results of tests of controls do not support the planned level of control risk, detection risk will have to be set lower. This will normally lead to an increase in substantive tests.

Auditing Accounts Receivable and Related Accounts This is the first opportunity for the students to apply the audit tests learned in Chapters 4 and 5 to a financial statement account. We use Table 10-8 to present the management assertions about account balances and related disclosures for revenue-related accounts at the period end and remind the students that there are two categories of substantive procedures: substantive analytical procedures and tests of details of classes of transactions, account balances, and disclosures.

Use Table 10-8

15-70 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 10-11] Substantive Analytical Procedures Analytical procedures can be very effective and efficient tests for accounts receivable and related accounts. We discuss the analytical procedures shown in Table 10-9 and show how they might suggest to the auditor that an account contains a possible misstatement. Table 10-9 includes analytical procedures suggested by the AICPA‘s Audit Guide, Auditing Revenue in Certain Industries.

Use Table 10-9 [LO 10-12] Tests of Details of Classes of Transactions, Account Balances, and Disclosures We cover Table 10-10 completely. It provides assertions about classes of transactions and account balances along with examples of substantive tests of transactions, tests of details of account balances, and tests of details of disclosure. The students should be reminded that substantive tests of details of classes of transactions are conducted to detect monetary misstatements in the individual transactions processed through the revenue process. We also remind them that, in many cases, it is difficult to distinguish a substantive test of transactions from a test of controls. When going over the tests of details of account balances we begin with completeness using Exhibit 10-4 to show the students an example of an aged trial balance for accounts receivable. We discuss existence next and mention that confirmations are one of the primary sources of evidence for this assertion. After those two assertions, we focus on valuation.

Then we cover test of details of disclosure using Table 10-11. We have found that disclosure issues do not receive sufficient emphasis in financial accounting. This is a good place to impress on the students the importance of proper financial statement disclosure. However, allay the students' fears about disclosure by telling them that most firms use a financial statement disclosure checklist. Problem 10-26 could be used here to aid in the students‘ understanding of the relationship between assertions and audit procedures.

Use Tables 10-10 and 10-11 Use Exhibit 10-4 [LO 10-13] The Confirmation Process–Accounts Receivable We define the confirmation process and indicate that confirmation of accounts receivable is considered a generally accepted auditing procedure. You should then present the following three circumstances where auditing standards allow the auditor to omit confirmation of accounts receivable:   

The accounts receivable balance is immaterial.

External confirmations would be ineffective.

The auditor's assessed level of risk of material misstatement at the relevant assertion level is low, and the other planned substantive procedures address the assessed risk.

15-71 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

We next discuss the reliability of accounts receivable and indicate that the auditor should consider each of the following factors when using confirmations to test accounts receivable:   

The type of the confirmation request.

Prior experience with the client or similar engagements.

The intended respondent.

You might consider having the students read the articles by Paul Caster (referenced in the footnote) on the reliability of accounts receivable confirmations. At a minimum, the students should be aware of the possible limitations of accounts receivable confirmations.

The two types of confirmation, negative and positive, should be discussed. We mention the differences between each and when each type might be more appropriate than the other. We have the students look at Exhibits 10-7 and 10-8 for examples of positive and negative confirmations.

Use Exhibits 10-7 and 10-8 We walk the students through the confirmation procedures since many of them will perform these procedures during their first year in public accounting. It is important for them to understand that the auditor must maintain control over the confirmations. Students should also understand the types and causes of exceptions that may be reported by the customer. Table 10-12 provides examples of exceptions to confirmation requests.

Use Table 10-12 The last items we cover under the confirmation process are the alternative procedures followed by the auditor when confirmation requests are not returned or there are confirmation exceptions. These include examination of:   

Specific subsequent cash receipts.

Shipping documentation.

Other client documentation.

[LO 10-14] Auditing Other Types of Receivables Most entities have other types of receivables that must be audited. These include:   

Receivables from officers and employees.

Receivables from related parties.

Notes receivable.

We point out that the auditor's concerns with these types of receivables are the same as trade accounts receivable. Normally, such receivables are confirmed and assessed for collectibility.

15-72 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 10-15] Evaluating the Audit Findings In this section, we discuss how the auditor completes the third step in applying materiality―comparing the likely misstatements to the tolerable misstatement assigned to the account. We use EarthWear‘s accounts receivable balance to discuss the two possible outcomes; aggregate misstatement is either less than or more than tolerable misstatement. We discuss the auditor's options when likely misstatement is greater than tolerable misstatement.

Discussion Cases Discussion Case 10-31 gives the students an opportunity to identify and discuss the types of evidence an auditor needs to examine when faced with bill and hold transactions.

If you want to discuss problems with other types of receivables, the Friendly Furniture, Inc., Discussion case 10-32 covers the accounting for expected insurance proceeds and the types of audit evidence needed to verify the amount of the receivable to be recorded.

Internet Assignments There are two Internet assignments in Chapter 10. Internet assignment 10-33 has the students identify how another catalog retailer processes sales transactions, recognizes revenue, and reserves for returns. Internet assignment 10-34 requires the students to search the SEC‘s website for a company that has been recently cited for revenue recognition problems.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

EarthWear Mini-Cases The Chapter 10 mini-cases can be assigned as stand alone cases. Please go to Connect for the mini-case assignments.

IDEA and TABLEAU The Chapter 10 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 11 Auditing the Purchasing Process Learning Objectives

Review

Multiple-

Problems

Discussion

Internet

15-73 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Questions LO 11-1: Understand why knowledge of an entity‘s expense and liability recognition policies is important to the audit.

LO 11-2: Understand the purchasing process.

LO 11-3: Know the types of transactions in the purchasing process and the financial statement accounts affected.

LO 11-4: Be familiar with the types of documents and records used in the purchasing process.

LO 11-5: Understand the functions in the purchasing process.

LO 11-6: Know the appropriate segregation of duties for the purchasing process.

LO 11-7: Understand the inherent risks relevant to the purchasing process and related accounts.

LO 11-8: Know how to assess control risk for the purchasing process.

LO 11-9: Know the key internal controls and develop relevant tests of controls for purchasing, cash disbursements, and purchase return transactions.

LO 11-10: Relate the assessment of control risk to substantive testing.

LO 11-11: Know the substantive analytical procedures used to audit accounts payable and accrued expenses.

LO 11-12: Know the substantive tests of transactions and tests of details of account balances and disclosures used to audit accounts payable and accrued expenses.

LO 11-13: Understand the confirmation process for accounts payable.

LO 11-14: Understand how to evaluate the audit findings and reach a final conclusion on accounts payable and accrued expenses.

LO 11-15: Understand how to audit the tax provision and related balance sheet accounts.

Choice Questions

Cases

Assignments

1 2

13,14,15

25,26

3

13,14,15, 19

25,26

4

16,17,18

25,26

4

16,17,18

25,26

13,14,15, 16,17,18, 19,20,21

25,26

2

5

6,7

8

24,27,28

9,10

19,20,21, 22

27,28,29, 30

31

11

23

28,29

31

12

32,33

15-74 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 11-1 Unchanged 11-1 11-2 Unchanged 11-2 11-3 Unchanged 11-3 11-4 Unchanged 11-4 11-5 Unchanged 11-5 11-6 Unchanged 11-6 11-7 Unchanged 11-7 11-8 Unchanged 11-8 11-9 Unchanged 11-9 11-10 Unchanged 11-10 11-11 Unchanged 11-11 11-12 Unchanged 11-12 11-13 Unchanged 11-13 11-14 Unchanged 11-14 11-15 Unchanged 11-15 11-16 Unchanged 11-16 11-17 Unchanged 11-17 11-18 Unchanged 11-18 11-19 Unchanged 11-19 11-20 Unchanged 11-20 11-21 Unchanged 11-21 11-22 Unchanged 11-22 11-23 Unchanged 11-23 11-24 Unchanged 11-24 11-25 Unchanged 11-25 11-26 Unchanged 11-26 11-27 Unchanged 11-27 11-28 Unchanged 11-28 11-29 Unchanged 11-29 11-30 Unchanged 11-30 11-31 Unchanged 11-31 11-32 Unchanged 11-32 11-33 Unchanged 11-33

15-75 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 11 covers the purchasing process and related accounts. It focuses on the purchase of and payment for goods and services from outside vendors. It provides another opportunity for the students to apply the concepts learned in the earlier chapters. The chapter begins by reviewing expense and liability recognition concepts. The remainder of the chapter follows the audit risk model to present the audit of the purchasing process and related accounts.

[LO 11-1] Expense and Liability Recognition Again, we find that it is useful to briefly review the expense and liability recognition concepts that students learn in their financial accounting classes. We present the SFAC No. 6 definitions for expenses and liabilities. We also use SFAC No. 5 to present the three categories of expenses: (1) product costs, (2) period costs, and (3) allocable costs. Examples of each of these costs should be presented to the students.

[LO 11-2 through 11-6] Overview of the Purchasing Process The students probably have little experience with the way information is processed in the purchasing process. We follow the same approach outlined in Chapter 10. We walk the students through the flowchart shown in Figure 11-1. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections, using the flowchart in Figure 11-1 as a benchmark:    

Types of transactions and financial statement accounts affected (LO 11-3).

Types of documents and records (LO 11-4).

The major functions (LO 11-5).

The key segregation of duties (LO 11-6).

In covering these subsections, we refer the students to Tables 11-1 through 11-4.

Use Figure 11-1 Use Tables 11-1 through 11-4 [LO 11-7] Inherent Risk Assessment We discuss each of the following inherent risk factors and how they may affect the purchasing process and related accounts:  

Industry-related factors.

Misstatements detected in prior audits.

15-76 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 11-8] Control Risk Assessment Figure 11-2 summarizes the major steps in assessing control risk for the purchasing process.

This offers an opportunity for the students to apply the internal control concepts learned in Chapters 6 and 7 to another accounting process. If the students have a good grasp of the material based on the coverage of Chapter 10, this material can be briefly reviewed.

Use Figure 11-2 In order to set control risk for the purchasing process, the auditor must understand the five components of internal control. They include:     

Control Environment.

The Entity‘s Risk Assessment Process.

Control Activities.

Information Systems and Communication.

Monitoring of Controls.

The auditor systematically analyzes the purchasing process in order to identify controls that ensure that material misstatements are either prevented, or detected and corrected. These controls can be relied upon by the auditor to reduce control risk. When the auditor relies on the controls, tests of controls are necessary to verify that the controls are operating effectively.

After the controls are tested, the auditor documents the achieved level of control risk. When tests of controls support the planned level of control risk, no modifications are normally necessary to the planned level of detection risk, and the auditor may proceed with the planned substantive procedures. When the tests of controls do not support the planned level of control risk, the auditor must set a higher level of control risk. This results in a lower level of detection risk and leads to more substantive procedures than originally planned.

The auditor should establish and document the achieved level of control risk. Documentation of the control risk for the purchasing process might include a flowchart, the results of tests of controls, and a memorandum indicating the auditor‘s overall conclusion about the control risk.

[LO 11-9] Control Activities and Tests of Controls Purchase Transactions This section provides the details on the assertions, possible misstatements, control procedures, and selected tests of controls for purchasing transactions. We use Tables 11-5 and 11-6 to cover this material. We generally go over each assertion and point out the possible misstatements and the normal control procedures that an entity should have in its system to minimize the possibility of these misstatements occurring. It is a good idea to relate the control procedures back to the flowchart in Figure 11-1. The students develop a better understanding of the purchasing process and the auditor's control risk assessment if we work back and forth between Figure 11-1 and Table 11-6.

15-77 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

The last thing we cover is the tests of controls that the auditor can conduct to test whether the controls are operating effectively.

Use Tables 11-5 and 11-6 Figure 11-1 Cash Disbursements Transactions We cover the material in Table 11-7 for cash disbursements transactions in the same manner as we described for purchase transactions except that we do not go into the same level of detail.

We usually focus on the occurrence and authorization assertions. If Chapter 10 has been covered in depth, the students should have developed a sound understanding of how to work through the material in Table 11-7.

Use Table 11-7 Purchase Return Transactions Generally, the number and magnitude of purchase return transactions are not material for most entities. However, the auditor should understand how such transactions are handled.

Usually, a debit memo is processed through the purchasing process. Point out those analytical procedures can often be used to test the reasonableness of purchase returns (i.e., purchase returns as a percentage of revenue to prior years' and industry data).

[LO 11-10] Relating the Assessed Level of Control Risk to Substantive Procedures In this section, we reiterate how the auditor's assessment of control risk in the purchasing process impacts detection risks for accounts payable and related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. On the other hand, if the results of tests of controls indicate that controls are not effective at reducing the risk of material misstatement and thus do not support the planned level of control risk, detection risk will have to be set lower. This will normally lead to an increase in substantive procedures.

Auditing Accounts Payable and Accrued Expenses We use Table 11-8 to present the management assertions about account balances, and related disclosures, at the period end for accounts payable and accrued expenses. We then cover the two categories of substantive procedures: substantive analytical procedures and tests of details of account balances and disclosures.

Use Table 11-8

15-78 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 11-11] Substantive Analytical Procedures We discuss the analytical procedures shown in Table 11-9 and the possible misstatements they may detect.

Use Table 11-9 [LO 11-12] Tests of Details of Classes of Transactions, Account Balances, and Disclosures We review Table 11-10, which provides a substantive test of transactions for each assertion for purchase transactions. We cover the assertions about classes of transactions first, focusing on completeness, accuracy, and cutoff. Exhibit 11-2 provides an example of an accounts payable listing working paper, while Exhibit 11-3 shows an account analysis for accrued real estate taxes.

Then we go over the account balance assertions focusing on existence, mentioning that confirmations are one source of evidence for this assertion, and the completeness assertion where we cover the steps involved in the search for unrecorded liabilities. The remaining assertions are straightforward, and the students should be able to review them on their own. Problem 11-29 could be used here.

Use Table 11-10 Use Exhibits 11-2 and 11-3 [LO 11-13] Accounts Payable Confirmations We point out to the students that accounts payable confirmations are used less frequently by auditors than accounts receivable confirmations because the auditor can examine reliable external documents (e.g., vendor invoices and monthly vendor statements). It is also important to note that accounts payable confirmations mainly provide evidence on completeness and, as a result, auditors generally use a blank or zero-balance confirmation (see Exhibit 11-5).

Use Exhibit 11-5 [LO 11-14] Evaluating the Audit Findings We review how the auditor completes the third step in applying materiality―comparing the aggregate misstatement to the tolerable misstatement assigned to the account.

[LO 11-15] Advanced Module: Auditing the Tax Provision and Related Balance Sheet Accounts We introduce this topic first by reviewing the financial statement impact of accounting for income taxes. We discuss temporary and permanent differences, giving examples of each. We then briefly discuss accounting for uncertain tax positions as well as unique issues that must be considered with multinational corporations. We discuss the need for the auditor to be familiar with both GAAP and tax accounting in order to properly audit the tax provision and related balance sheet accounts. A tax specialist should be involved if the auditor is working with a very large entity. Indicators that suggest the use of a specialist are: 15-79 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

    

Multiple locations with significant foreign operations and related foreign tax credits/deductions Business combinations and/or subsidiary dispositions Material uncertain income tax positions with a governmental authority Significant changes in ownership, business operations, or tax status Significant deferred tax assets for which the future realization of the recorded value is in question

We then discuss some of the typical procedures that might be applied to the audit of the tax provision and related balance sheet accounts.

Discussion Case Discussion case 11-31 provides a good case for discussing accounts payable confirmations.

Internet Assignments Internet assignments 11-32 and 11-33 parallel the assignments used in Chapter 10.

Internet assignment 11-32 requires the students to determine how another catalog retailer processes purchase transactions and recognizes expenses. Internet assignment 11-33 requires a search of the SEC‘s website for a case involving financial reporting problems related to the recognition of expenses.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

IDEA and TABLEAU The Chapter 11 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 12 Auditing the Human Resource Management Process Learning Objectives LO 12-1: Develop an understanding of the human resource management process.

LO 12-2: Be familiar with the types of transactions in the human

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

Internet Assignments

1 2 15-80

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

resource management process and the financial statement accounts affected.

LO 12-3: Know and describe the types of documents and records used in the payroll process.

LO 12-4: Understand the functions in the human resource management process.

LO 12-5: Know the appropriate segregation of duties for the human resource management process.

LO 12-6: Know and evaluate inherent risks relevant to the human resource management process.

LO 12-7: Assess control risk for a human resource management process.

LO 12-8: Know key internal controls and develop relevant tests of controls for payroll transactions.

LO 12-9: Understand how to relate the assessment of control risk to substantive procedures.

LO 12-10: Be familiar with substantive analytical procedures used to audit payroll expense and payroll-related accrued expenses.

LO 12-11: Be familiar with substantive tests of transactions and tests of details of account balances and disclosures used to audit payroll expense and payrollrelated accrued expenses.

LO 12-12: Understand how to evaluate the audit findings and reach a final conclusion on payroll expense and payroll-related accrued expenses.

3

14,15

4

16

24,25

5

15,16,17, 18

24,25

6

29

7 7,8,9,10

14,15,16, 19, 22

25

28

25

28

23

11

23

26,27

29

10,12,13

21,23

26,27

29

15-81 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 12-1 Unchanged 12-1 12-2 Unchanged 12-2 12-3 Unchanged 12-3 12-4 Unchanged 12-4 13-5 Unchanged 12-5 12-6 Unchanged 12-7 12-7 Unchanged 12-8 12-8 Unchanged 12-9 12-9 Unchanged 12-6 12-10 Unchanged 12-10 12-11 Unchanged 12-11 12-12 Unchanged 12-12 12-13 Unchanged 12-13 12-14 Unchanged 12-14 12-15 Unchanged 12-15 12-16 Unchanged 12-16 12-17 Unchanged 12-17 12-18 Unchanged 12-18 12-19 Revised 12-19 12-20 Unchanged 12-20 12-21 Unchanged 12-21 12-22 Unchanged 12-22 12-23 Unchanged 12-23 12-24 Unchanged 12-24 12-25 Unchanged 12-25 12-26 Unchanged 12-26 12-27 Unchanged 12-27 12-28 Unchanged 12-28 12-29 Unchanged 12-29

15-82 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 12 covers the human resource management process and related financial statement accounts. The material in the chapter follows the same framework as Chapters 10 and 11. If we have covered the revenue or purchasing processes and their related accounts in depth, we can usually go through this material quickly on the assumption that the students can properly apply the concepts to any business process.

[LO 12-1 through 12-5] Overview of the Human Resource Management Process We walk the students through the flowchart shown in Figure 12-1. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections, using the Figure 12-1 flowchart as a benchmark:    

Types of transactions and financial statement accounts affected (LO 12-2).

Types of documents and records (LO 12-3).

The major functions (LO 12-4).

The key segregation of duties (LO 12-5).

In covering these subsections, we refer the students to Tables 12-1 through 12-4.

Use Figure 12-1 Use Tables 12-1 through 12-4 [LO 12-6] Inherent Risk Assessment We point out that there are generally few inherent risk factors that affect the human resource management process and related financial statement accounts and that inherent risk is usually assessed as low. We do mention the following factors as potential problems:    

The supply of skilled workers and employee turnover.

The presence of labor contracts.

Legislation such as the Occupational Safety and Health Act. Executive compensation (see Exhibit 12-1) Use Exhibit 12-1

[L0 12-7] Control Risk Assessment Figure 12-2 summarizes the major steps in assessing control risk for the human resource management process. We briefly review this material since the students should understand this process.

Use Figure 12-2

15-83 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 12-8] Control Activities and Tests of Controls—Payroll Transactions We use Table 12-5 to cover the details on the assertions, possible misstatements, control procedures, and selected tests of controls for payroll transactions. We generally go over each assertion (Note: in the 11th edition, the assertions have been updated to be consistent with international and AICPA auditing standards) and point out the possible misstatements and the normal control procedures that an entity should have in its system to minimize the possibility of these misstatements occurring. It is a good idea to relate the control procedures back to the flowchart in Figure 12-1. The last thing we cover is the tests of controls that the auditor can conduct to test whether the controls are operating effectively. Problem 12-25 can be used here.

Use Table 12-5 [LO 12-9] Relating the Assessed Level of Control Risk to Substantive Procedures In this section, we reiterate how the auditor's assessment of control risk impacts detection risk for payroll-related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. If the results of tests of controls do not support the planned level of control risk, detection risk will have to be set lower. This will normally lead to modified substantive testing to obtain more persuasive audit evidence.

Auditing Payroll-Related Accounts We use Table 12-6 to present the assertions for testing payroll expense and payroll-related liabilities. We then cover the two categories of substantive tests: substantive analytical procedures and tests of details of account balances, and disclosures.

Use Table 12-6 [LO 12-10] Substantive Analytical Procedures Table 12-7 presents the analytical procedures for payroll expense and payroll-related accrual accounts and the possible misstatements they may detect. We discuss these analytical procedures since such tests are used extensively on payroll-related accounts.

Use Table 12-7 [LO 12-11] Tests of Details of Classes of Transactions, Account Balances, and Disclosures Table 12-8 presents examples of substantive tests of transactions, account balances, and disclosures for assertions related to payroll. We quickly go over the substantive tests of transactions. Then we cover tests of details of account balances and tests of details of disclosures, focusing on the assertions of existence, completeness, valuation and allocation and disclosure. We show Exhibit 12-3 as an example of an account analysis for accrued payroll taxes. Table 12-9 provides some disclosure items for the human resource management process and related accounts. Problems 12-26 and/or 12-27 can be used here.

15-84 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Use Tables 12-8 and 12-9 Use Exhibit 12-3 [LO 12-12] Evaluating the Audit Findings We review how the auditor completes the third step in applying materiality—comparing the likely misstatements to the tolerable misstatement assigned to the account.

Discussion Cases Discussion case 12-28 provides a good case for discussing the types of application controls an auditor would expect in a computerized payroll system.

Internet Assignment Internet assignment 12-29 deals with the issue of executive compensation and audit tests that can best be used to detect executive compensation abuse or fraud.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving. This edition adds several new Practice Insights regarding the overlap between audit data analytics and the HR Cycle.

IDEA AND TABLEAU The Chapter 12 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 13 Auditing the Inventory Management Process Learning Objectives LO 13-1: Develop an understanding of the inventory management process.

LO 13-2: Be able to identify and describe the types of documents and records used in the inventory management process.

LO 13-3: Understand the functions in the inventory management process.

Review Questions

MultipleChoice Questions

Problems

1,2

14

27,28

3

4

Discussion Case

Internet Assignments

27

14

27

15-85 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

LO 13-4: Know the appropriate segregation of duties for the inventory management process.

LO 13-5: Be able to identify and evaluate inherent risks relevant to the inventory management process.

LO 13-6: Know how to assess control risk for the inventory system.

LO 13-7: Know key internal controls and develop relevant tests of controls for inventory transactions.

LO 13-8: Understand how to relate the assessment of control risk to substantive procedures.

LO 13-9: Be familiar with substantive analytical procedures used to audit inventory and related accounts.

LO 13-10: Know how to audit standard costs.

LO 13-11: Know how to observe physical inventory.

LO 13-12: Be familiar with tests of transactions and tests of details used to audit inventory and related accounts.

LO 13-13: Understand how to evaluate the audit findings and reach a conclusion on inventory and related accounts.

5

15,16,17

6

28

7

27,28

8

15,16,17, 18,19

27

20

28

9

34

28

33

34

10 11

20,21,22, 23,24

28,29, 30,31

33

12,13

20,22,23, 24,25,26

28,30, 31,32

33

33

34

34

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.

15-86 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 13-1 Unchanged 13-1 13-2 Unchanged 13-2 13-3 Unchanged 13-3 13-4 Unchanged 13-4 13-5 Unchanged 13-5 13-6 Unchanged 13-6 13-7 Unchanged 13-7 13-8 Unchanged 13-8 13-9 Unchanged 13-9 13-10 Unchanged 13-10 13-11 Unchanged 13-11 13-12 Unchanged 13-12 13-13 Unchanged 13-13 13-14 Revised 13-14 13-15 Unchanged 13-15 13-16 Unchanged 13-16 13-17 Unchanged 13-17 13-18 Unchanged 13-18 13-19 Unchanged 13-19 13-20 Unchanged 13-20 13-21 Unchanged 13-21 13-22 Unchanged 13-22 13-23 Unchanged 13-23 13-24 Unchanged 13-24 13-25 Unchanged 13-25 13-26 Unchanged 13-26 13-27 Unchanged 13-27 13-28 Unchanged 13-28 13-29 Unchanged 13-29 13-30 Unchanged 13-30 13-31 Unchanged 13-31 13-32 Unchanged 13-32 13-33 Unchanged 13-33 13-34 Unchanged 13-34

15-87 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 13 covers the inventory management process and related accounts, and it follows the same framework as earlier business process chapters. This is a topic that is usually not covered in the first auditing class but can be included in a second or graduate auditing class. The material can be covered quickly on the assumption that the students can properly apply the concepts learned in the first course to any business process. The chapter material can be supplemented in a graduate class with a written assignment that requires the students to research some legal cases (e.g., MiniScribe) that involved inventory fraud. This type of material impresses upon the students the importance of the audit of inventory.

[LO 13-1 through 13-4] Overview of Inventory Management Process We use Figure 13-1 to show the students how the inventory management process is related to other business processes. We then walk the students through the flowchart of the inventory management process shown in Figure 13-2, which is based on EarthWear Clothiers. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections, using the Figure 13-2 flowchart as a benchmark:   

Types of documents and records (LO 13-2).

The major functions (LO 13-3).

The key segregation of duties (LO 13-4).

In covering these subsections, we refer the students to Tables 13-1 through 13-4.

Use Figures 13-1 and 13-2 Use Tables 13-1 through 13-4 [LO 13-5] Inherent Risk Assessment Inherent risk factors that affect the inventory management process include many of the fraud risk factors discussed in Chapter 3 and include:  

Industry-related factors, such as competition and rapid technological changes (see Exhibit 13-2).

Engagement and operating characteristics, including: o Susceptibility of the product to theft (e.g., computer memory chips). o Valuation issues may lead to disagreements with the entity. o Possible related-party transactions for acquisition of raw material and sales of finished product.

Use Exhibit 13-2

15-88 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

[LO 13-6] Control Risk Assessment Figure 13-3 summarizes the major steps in assessing control risk for the inventory management process. We briefly review this material since the students should already understand this process.

Use Figure 13-3 [LO 13-7] Control Activities and Tests of Controls—Inventory Transactions We use Table 13-5 to cover the details on the assertions and how they relate to possible misstatements, control procedures, and selected tests of controls for inventory transactions (Note: in the 11th edition, the assertions have been updated to be consistent with international and AICPA auditing standards). We generally limit the discussion to the most important assertions.

We point out the possible misstatements and the normal internal control procedures that an entity should have in its system to minimize the possibility of these misstatements occurring. We relate the internal control procedures back to the flowchart in Figure 13-2. Lastly, we cover the tests of controls that the auditor can conduct to test whether the controls are operating effectively.

Problem 13-27 can be used here.

Use Table 13-5 [LO 13-8] Relating the Assessed Level of Control Risk to Substantive Procedures In this section, we reiterate how the auditor‘s assessment of control risk in the inventory process impacts detection risks for inventory and related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. On the other hand, if the results of tests of controls do not support the planned level of control risk, detection of risk will have to be set lower. This will normally lead to an increase in substantive procedures.

Auditing Inventory We use Table 13-6 to present the assertions for classes of transactions, account balances, and disclosures for inventory. We go over Table 13-6 to make sure the students understand each of the important assertions.

Use Table 13-6 [LO 13-9] Substantive Analytical Procedures Then we use Table 13-7 to present examples of analytical procedures used for inventory and related accounts and the possible misstatements they may detect. We discuss these analytical procedures since such tests are used extensively to audit inventory. We generally focus on the gross profit percentage and inventory turnover ratio. The students should be reminded of the importance of industry averages for comparison purposes.

15-89 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Use Table 13-7 [LO 13-10] Auditing Standard Costs Since many manufacturing companies use some type of standard cost system to value inventory, it is important to discuss how an auditor would verify the entity's standard costs. We approach this material by using the manufacture of wireless devices by Calabro Wireless Services as an example (we have also used the manufacture of lawnmowers and woolen cloth as examples). The students know from their cost accounting class that standard costs are developed by three components (materials, labor, and overhead). We get the class to think about how they would verify each of those types of costs for a wireless device. For example, the students eventually realize that they will have to look at some type of engineering specifications for a particular wireless device. These specifications can be used to determine what materials or parts are used in the device.

[LO 13-11] Observing Physical Inventory The students should be told that the auditor's observation of inventory is a generally accepted auditing procedure and that the primary reason for observing inventory is to establish the existence of the inventory. They should also learn that the observation of the physical inventory could provide evidence on the rights and obligations and valuation assertions.

The audit procedures performed by the auditor during the physical inventory count should be covered in some depth. We find that it is helpful for the students if the instructor covers each of the procedures listed in the discussion entitled ―Observing Physical Inventory.‖ This is normally a good place to tell some ―war stories‖ about inventory observation and remind the students that they will likely be involved in inventory counts as an intern or first-year staff.

[LO 13-12] Tests of Details of Classes of Transactions, Account Balances, and Disclosures We use Table 13-8 to cover assertions about classes of transactions, account balances, and disclosures as well as substantive tests of transactions, tests of details of account balances, and tests of details of disclosure. Generally, the substantive tests of transactions that affect inventory are conducted as part of testing the revenue, purchasing, and human resource management process. Transactions that affect the receipt of raw materials, shipment of goods, or assignment of labor costs are tested as part of those processes. We discuss how the more important assertions are tested. We use Table 13-9 to provide examples of disclosures for inventory. Problem 13-31 can be used here.

Use Tables 13-8 and 13-9 [LO 13-13] Evaluating the Audit Findings We review how the auditor completes the third step in applying materiality—comparing the likely misstatements to the tolerable misstatement assigned to the account for the purpose of determining whether the inventory account is fairly stated.

15-90 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Discussion Case Discussion case 13-33 provides a good case for reviewing issues related to inventory observation.

Additional Case Assignment When we cover this material in the second auditing course, we have the students complete the following assignment in teams before the lecture on inventory.

In the past, there have been a number of lawsuits (e.g., possible audit failures) that have involved some type of inventory manipulation. Five such cases are: (1) Comptronix, (2) Leslie Fay, (3) MiniScribe, (4) Phar-Mor, and (5) Woolworth.

Instructions: Each group has been assigned one of these cases for analysis. Your group is to prepare a summary of the case with particular emphasis on the issues related to inventory. We suggest that you have two sections in your summary: (1) a general overview of the case and issues and (2) a section devoted specifically to the inventory problems. Your summary of the case should be no longer, than three typed double-spaced pages, plus at least three sources for your information.

Internet Assignments Internet assignment 13-34 requests the students to research a recent SEC case that involves inventory. This is a good current events type project.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving. This edition includes a new practice insight that discusses how audit data analytics and technology are being used in the inventory cycle.

IDEA AND TABLEAU The Chapter 13 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment Learning Objectives

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

Internet Assignments

15-91 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

LO 14-1: Know the various types of prepaid expenses and deferred charges.

LO 14-2: Understand the auditor‘s approach to auditing prepaid insurance.

LO 14-3: Know the various types of intangible assets.

LO 14-4: Understand the auditor‘s approach to auditing intangible assets.

LO 14-5: Develop an understanding of the property management process.

LO 14-6: Know the types of transactions in the property management process.

LO 14-7: Be familiar with the inherent risks for property, plant, and equipment.

LO 14-8: Assess control risk for property, plant, and equipment.

LO 14-9: Know the appropriate segregation of duties for property, plant, and equipment.

LO 14-10: Know the substantive analytical procedures used to audit property, plant, and equipment.

LO 14-11: Know the tests of details of account balances and disclosures used to audit property, plant, and equipment.

LO 14-12: Understand how to evaluate the audit findings and reach a final conclusion on property, plant, and equipment.

1,2,3

23

1,3,4, 5

12

23

2,6,7

18

24 24

3

13,14,15, 16,17,19

6

30,31 26

30,31

7 3,8

13,14, 15,16, 17,19,20

25,26

9

16,17

25

10

20

27,28

11

19,20, 21,22

26,27, 28

29

30

26

29

31

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.

15-92 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison th in 11 edition in 12th edition 14-1 Unchanged 14-1 14-2 Unchanged 14-2 14-3 Unchanged 14-3 14-4 Unchanged 14-4 14-5 Unchanged 14-5 14-6 Unchanged 14-6 14-7 Unchanged 14-7 14-8 Unchanged 14-8 14-9 Unchanged 14-9 14-10 Unchanged 14-10 14-11 Unchanged 14-11 14-12 Unchanged 14-12 14-13 Unchanged 14-13 14-14 Unchanged 14-14 14-15 Unchanged 14-15 14-16 Unchanged 14-16 14-17 Unchanged 14-17 14-18 Unchanged 14-18 14-19 Unchanged 14-19 14-20 Unchanged 14-20 14-21 Unchanged 14-21 14-22 Unchanged 14-22 14-23 Unchanged 14-23 14-24 Unchanged 14-24 14-25 Unchanged 14-25 14-26 Unchanged 14-26 14-27 Unchanged 14-27 14-28 Unchanged 14-28 14-29 Revised 14-29 14-30 Unchanged 14-30 14-31 Unchanged 14-31

15-93 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 14 covers the audit of selected asset accounts associated in the financing/investing cycle: prepaid expenses, intangible assets, and property, plant, and equipment.

[LO 14-1] Auditing Prepaid Expenses We normally point out that prepaid expenses are common ―other assets‖ that have an economic life of less than a year. Assets providing economic benefit for more than one year are referred to as ―deferred charges‖ or ―intangible assets.‖ It is helpful to provide examples of items that fall into each category. We note that for many companies these asset accounts are not material and that analytical procedures can be used to verify the account balances. The text uses prepaid insurance as an example since most students have a good understanding of this account from their financial accounting class.

Inherent Risk Assessment—Prepaid Expenses We tell the students that prepaid expenses do not involve any significant inherent risk and that it can usually be assessed as being low. Deferred charges and intangible assets, on the other hand, may represent serious inherent risk considerations because of valuation issues.

Control Risk Assessment—Prepaid Expenses The students should note that prepaid expenses, deferred charges, and intangible asset transactions are typically processed through the purchasing process. For example, the control procedures in the purchasing process should ensure that new insurance policies are properly authorized and recorded. We mention that larger entities should have an insurance register to keep track of insurance policies and that an independent person should verify the adequacy of the entity's coverage. Lastly, there should be controls over the systematic allocation of prepaid insurance to insurance expense.

[LO 14-2] Substantive Procedures—Prepaid Insurance We point out to the students that, on many engagements, analytical procedures can be used to verify prepaid insurance and insurance expense. Such analytical procedures include:   

Comparing the current-year balance in prepaid insurance and insurance expense with the prior year's balances after considering any changes in operations.

Computing the ratio of insurance expense to assets or sales and comparing it with the prior year's ratio.

Computing an estimate of the ending prepaid account balance(s) using the current premium and the amount of time remaining on the policy at the end of the period.

15-94 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Tests of the prepaid insurance and insurance expense may be necessary when the auditor suspects misstatements based on prior audits or when analytical procedures indicate that the account balance may be misstated. We use Exhibit 14-1 to demonstrate to the students the steps that would be followed to audit prepaid insurance and insurance expense.

Use Exhibit 14-1

[LO 14-3] Auditing Intangible Assets Intangible assets are assets that provide economic benefit for longer than a year, but lack physical substance. The following list includes examples of six general categories of intangible assets: 1.

2.

3.

4.

5.

6.

Marketing–trademark, brand name, and internet domain names.

Customer–customer lists, order backlogs, and customer relationships.

Artistic–items protected by copyright.

Contract–licenses, franchises, and broadcast rights.

Technology–patented and unpatented technology.

Goodwill—the difference between the acquisition price for a company and the fair values of the identified assets.

[LO 14-4] Substantive Procedures—Intangible Assets The principal substantive evidence regarding intangible evidence is obtained via tests of details. Tests of details associated with valuation and impairment of intangible assets are often necessary because the complexity and degree of judgment increase the risk of material misstatement.

[LO 14-5] Auditing the Property Management Process For most entities, property, plant, and equipment represent a material balance on the financial statements. However, the students should note that with an ongoing engagement, the auditor is often able to focus on current-year activity only, making the audit of this account straightforward.

[LO 14-6] Types of Transaction—Property Management Process We briefly discuss the four types of property, plant, and equipment transactions:    

Acquisition of capital assets for cash or nonmonetary considerations.

Disposition of capital assets through sale, exchange, retirement, or abandonment.

Depreciation of capital assets over their useful economic life.

Leasing of assets.

15-95 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

The students should be told that for most small entities, there might not be any formal control system over property, plant, and equipment. Larger entities, on the other hand, may have an accounting system similar to the computerized system shown in Figure 14-1. We walk the students through the system shown in Figure 14-1. When discussing leases, consider highlighting the revised leasing standards and how those changes affect the audit.

Use Figure 14-1 [LO 14-7] Inherent Risk Assessment—Property Management Process There are three inherent risk factors that should be discussed:   

Complex accounting issues.

Difficult-to-audit transactions.

Misstatements detected in prior audits.

We use lease accounting, self-constructed assets, and capitalized interest as examples of property, plant, and equipment transactions that can be complex and difficult to audit.

[LO 14-8] Control Risk Assessment—Property Management Process Most control procedures for property, plant, and equipment are contained in the purchasing process. We limit our comments to controls over occurrence, authorization, and completeness.

[LO 14-9] Segregation of Duties—Property Management Process We discuss the key segregation of duties for the property management process and examples of possible errors or fraud that can result from conflicts in duties. Problem 14-25 can be used here.

Use Table 14-1 Substantive Procedures—Property, Plant, and Equipment Our presentation on substantive procedures for property, plant, and equipment covers substantive analytical procedures and tests of details of transactions and account balances and disclosures.

[LO 14-10] Substantive Analytical Procedures—Property, Plant, and Equipment The following analytical procedures should be discussed: 

Compare prior-period balances in property, plant, and equipment and depreciation expense with current-year balances, taking into account any changes in conditions or asset composition.

15-96 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

   

Compute the ratio of depreciation expense to the related property, plant, and equipment accounts and compare to prior years' ratios.

Compute the ratio of repairs and maintenance expense to the related property, plant, and equipment accounts and compare to prior years' ratios.

Compute the ratio of insurance expense to the related property, plant, and equipment account and compare to prior years' ratios.

Review capital budgets and compare the amounts spent with amounts budgeted.

[LO 14-11] Tests of Details of Transactions and Account Balances and Disclosures— Property, Plant, and Equipment We usually review the substantive tests for the property, plant, and equipment accounts for each assertion relating to transactions and balances as shown in Table 14-2 (Note: in the 11th edition, the assertions have been updated to be consistent with international and AICPA auditing standards). We then focus our discussions on Exhibit 14-3 and show how the auditor verifies the various amounts on the lead schedule. We mention two other items. First, we point out that the auditor should obtain a list of major additions (all items over some dollar limit) and vouch the purchases to vendor invoices. Second, we note that the auditor may vouch items in the repairs and maintenance expense account, looking for items that should be capitalized.

Use Table 14-2 Use Exhibit 14-3 We also discuss some of the disclosure items that are required for property, plant, and equipment (see Table 14-3 and Exhibit 14-4). Problem 14-27 can be used here.

Use Table 14-3 Use Exhibit 14-4 [LO 14-12] Evaluating the Audit Findings – Property, Plant, and Equipment We review how the auditor completes the third step in applying materiality—comparing the aggregated misstatements to the tolerable misstatement assigned to the account.

Discussion Case The Discussion case 14-29 is complex and is best used in a second or graduate auditing course.

15-97 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Internet Assignments Internet assignment 14-30 can be used as part of the EarthWear case relating different depreciation methods to substantive analytical procedures. Internet assignment 14-31 requests the students to research the SEC website for companies that have been cited for problems related to property, plant, and equipment or lease accounting.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving. The 11th edition includes a new practice insight regarding how audit data analytics and IT help audit leases and contracts.

IDEA and TABLEAU The Chapter 14 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 15 Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders' Equity, and Income Statement Accounts Learning Objectives LO 15-1: Understand the types and features of long-term debt.

LO 15-2: Be familiar with assessing control risk for long-term debt.

LO 15-3: Be familiar with key control activities for long-term debt.

LO 15-4: Know how to conduct substantive audit procedures for long-term debt.

LO 15-5: Understand the types of stockholders‘ equity transactions.

LO 15-6: Be familiar with assessing control risk for stockholders‘ equity.

LO 15-7: Be familiar with key control activities for stockholders‘ equity.

LO 15-8: Know the appropriate segregation of duties for stockholders‘ equity.

LO 15-9: Know how to conduct substantive audit procedures for

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

1

Internet Assignments 26

2 2

11

1,3,4

12,13,14

1,5

16

21,22,23

25

26

15,16,17 6

15,16

1,7

15, 18

24 15-98

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

capital stock.

LO 15-10: Know how to conduct substantive audit procedures for dividends.

LO 15-11: Know how to conduct substantive audit procedures for retained earnings.

LO 15-12: Know how to assess control risk and conduct substantive audit procedures for income statement accounts.

8 8

9,10

19,20

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.

15-99 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 15-1 Unchanged 15-1 15-2 Unchanged 15-2 15-3 Unchanged 15-3 15-4 Unchanged 15-4 15-5 Unchanged 15-5 15-6 Unchanged 15-6 15-7 Unchanged 15-7 15-8 Unchanged 15-8 15-9 Unchanged 15-9 15-10 Unchanged 15-10 15-11 Unchanged 15-11 15-12 Unchanged 15-12 15-13 Unchanged 15-13 15-14 Unchanged 15-14 15-15 Unchanged 15-15 15-16 Unchanged 15-16 15-17 Unchanged 15-17 15-18 Unchanged 15-18 15-19 Unchanged 15-19 15-20 Unchanged 15-20 15-21 Unchanged 15-21 15-22 Unchanged 15-22 15-23 Unchanged 15-23 15-24 Unchanged 15-24 15-25 Unchanged 15-25 15-26 Unchanged 15-26

15-100 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 15 presents the audit of long-term liabilities, stockholders' equity, and the income statement. A substantive strategy is normally followed when these accounts are audited because, although the number of transactions is few, each transaction is usually material.

[LO 15-1] Auditing Long-Term Debt We point out to the students that long-term debt is no longer just composed of notes and bonds but includes sophisticated types of debt financing, such as collateralized mortgage obligations and derivatives (see Exhibit 15-1). These sophisticated instruments are beyond the scope of the text.

Use Exhibit 15-1 We have found it worthwhile to discuss some of the features of long-term debt and some terminology related to long-term debt such as (1) convertible, (2) callable, (3) secured, and (4) sinking fund.

[LO 15-2] Control Risk Assessment—Long-Term Debt For most entities, the auditor follows a substantive strategy. However, the auditor must have a sufficient understanding of the entity's internal control system to be able to anticipate the types of misstatements that may occur in order to plan the substantive tests. Thus, we focus our comments to the students on the general types of control procedures that should be present to minimize material misstatements.

[LO 15-3] Assertions and Related Control Activities—Long-Term Debt Our discussions focus on five assertions: occurrence, authorization, completeness, valuation, and classification (Note: In the 11th edition, the assertions have been revised to be consistent with international auditing standards and the standards of the AICPA). For example, we point out that authorized individuals should properly initiate any long-term borrowings. We mention that there should be adequate documentation to verify that a note or bond was properly authorized. For major debt financing, it is usually the board of directors who authorize the transaction and the board of directors' minutes are the source of evidence to verify the authorization.

[LO 15-4] Substantive Procedures—Long-Term Debt Under substantive tests, we first discuss how analytical procedures are useful in auditing interest expense and show the students a simple calculation for such a test. The auditor can multiply the twelve monthly balances for long-term debt by the average interest rate to arrive at an estimate for interest expense. This amount can be compared to the interest expense recorded on the general ledger.

We use Table 15-1 and Exhibit 15-2 to explain to the students how long-term debt and accrued interest payable are audited. For example, we mention how the debt is normally confirmed with debt holders and that payments may be traced to the cash disbursements journal.

15-101 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

It is also important to mention that the auditor must ensure that the entity is in compliance with any restrictive covenants included in the debt agreement. If material, such restrictions must be disclosed (see Exhibit 15-3).

Problems 21 or 23 could be used here.

Use Table 15-1 Use Exhibits 15-2 and 15-3 [LO 15-5] Auditing Stockholders' Equity We point out that for most entities, stockholders' equity is composed of common stock, preferred stock, paid-in capital, and retained earnings. We usually mention to the students that, in recent years, companies have issued financial instruments that have characteristics of both debt and equity.

The three types of transactions that can occur in stockholders' equity are:   

Issuance of stock.

Repurchase of stock.

Payment of dividends.

[LO 15-6] Control Risk Assessment—Stockholders' Equity Again, we note that a substantive strategy is followed when auditing stockholders' equity.

However, the auditor must have an understanding of the types of control procedures that are in place to prevent misstatements.

We tell the students that most large entities use an independent registrar, transfer agent, and dividend-disbursing agent. The students should know what activities each of these agents perform. When the company uses such agents, the auditor may be able to obtain sufficient evidence by confirming the relevant information with those parties.

When an entity has its own employees perform the stock transfer and dividend disbursement functions, the auditor will need to perform more detailed testing of stock-related records. We then cover the (1) assertions and related control procedures and (2) segregation of duties.

[LO 15-7] Assertions and Related Control Activities—Stockholders' Equity Following are the major assertions for stockholders‘ equity:   

Occurrence—verify that stock and dividend transactions are valid and comply with the corporate charter.

Accuracy—verify that all stock and dividend transactions have been properly posted and summarized in the accounting records.

Authorization—verify that stock and dividend transactions have been properly 15-102

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.



approved.

Valuation—verify that stock and dividend transactions have been properly valued.

[LO 15-8] Segregation of Duties—Stockholders’ Equity If the entity has enough personnel, the following segregation of duties should be maintained;    

The individuals responsible for issuing, transferring, and canceling stock certificates should not have any accounting responsibilities.

The individual responsible for maintaining the detailed stockholders‘ records should be independent of the maintenance of the general ledger control accounts.

The individual responsible for maintaining the detailed stockholders‘ records should not also process cash receipts or disbursements.

Appropriate segregation of duties should be established among the preparation, recording, signing, and distributing dividend payments.

[LO 15-9] Auditing Capital—Stock Accounts The auditor begins the audit of the stockholders' equity accounts by obtaining a schedule of all activity in the accounts for the current period. We tell the students that the auditor is concerned with four assertions: occurrence, completeness, valuation, and completeness of disclosure. We usually explain to them the various audit steps the auditor performs to verify the current-year activity in the stockholders' equity accounts. Table 15-2 provides sample disclosures for stockholders' equity. Problem 24 can be used here.

Use Table 15-2 [LO 15-10] Auditing Dividends When the company uses a dividend-disbursing agent, the amount of dividends can be confirmed. This amount should also be agreed to the amount authorized by the board of directors. If a dividend-disbursing agent is not used, the auditor can compute the amount authorized by the board of directors and agree it to the general ledger.

[LO 15-11] Auditing Retained Earnings We point out to the students the items that can affect retained earnings:  Net income or loss.  Dividends.  Prior-period adjustments, correction or errors, stock retirements, and changes in appropriations of retained earnings.

The first few items are easy to verify. The auditor must be certain that prior-period adjustments and correction of errors satisfy the requirements of relevant accounting standards.

15-103 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Changes in appropriations can usually be traced to the board of directors' minutes.

[LO 15-12] Auditing Income Statement Accounts For many companies, revenue is one of the largest accounts in the financial statements and is typically deemed to be a significant account that must be specifically considered. We point out to the students that auditing the income statement accounts is affected by the level of work conducted on the entity's business processes and balance sheet accounts. For example, if the auditor obtains good results from testing the purchasing process, he or she has evidence that the expense accounts are not likely to contain material misstatement. The students should know that the auditor normally performs the following substantive procedures on selected income statement accounts:    

The results of testing controls for the various business processes.

The results of the detailed tests of balance sheet accounts and the related income statement accounts.

Performance of substantive analytical procedures on income statement accounts.

Detailed tests on selected income statement accounts.

We generally discuss each of the audit steps. We start by showing the students Table 15-3 for examples of income statement accounts that are verified when the relevant balance sheet accounts are audited. We talk about the types of analytical procedures that can be applied to the revenue and expense accounts. We discuss how recent regulatory changes have decreased the extent to which auditors use analytical procedures to audit revenue, instead using more detail testing of transactions. However, audit data analytics are also being used to provide high-level assurance over revenue and identify risky areas. We mention the use of examination of absolute changes in the accounts and changes in their ratios as a percentage of revenue. Lastly, we discuss some specific accounts where the auditor obtains an account analysis and vouches the transactions. The account analysis of legal expense in Exhibit 15-4 can be used as an example.

Use Table 15-3 Use Exhibit 15-4 Discussion Case Discussion case 15-25 provides a good example for discussing audit procedures that an auditor uses when there is a possibility that the entity was in violation of its debt covenants.

15-104 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Internet Assignment Internet assignment 15-26 requests the students to consider the implications of the changes in the lease accounting standards and the decision to move operating leases to the balance sheet and how the new liabilities are being treated for purposes of computing debt covenants.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

IDEA and TABLEAU The Chapter 15 IDEA and TABLEAU problem is an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

15-105 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

Chapter 16 Auditing the Financing/Investing Process: Cash and Investments

Learning Objectives

LO 16-1: Understand the relationship of the various business processes to cash.

LO 16-2: Know the different types of bank accounts.

LO 16-3: Know tests of details of transactions used to audit cash.

LO 16-4: Be able to explain tests of details of account balances used to audit cash.

LO 16-5: Know how to audit a bank reconciliation.

LO 16-6: Understand fraud-related audit procedures for cash.

LO 16-7: Understand why entities invest in securities of other entities.

LO 16-8: Be able to explain key controls for investments.

LO 16-9: Know the appropriate segregation of duties for investments.

LO 16-10: Know tests of details of account balances used to audit investments.

LO 16-11: Understand how to audit fair value measurements.

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC)

1 2 3

EWMC

4,5

12,13

25

4,5

12,13,14,1 5,16

25,26

6,7

12,13,17

25 24,27

8,9,10

18

24,27

8

18

24

9,10

19,20, 21,22

27,28,29

11

23

30

EWMC

31

31

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.

17-1 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement END OF CHAPTER MATERIALS COMPARISION CHART

Number Number Comparison in 11th edition in 12th edition 16-1 Unchanged 16-1 16-2 Unchanged 16-2 16-3 Unchanged 16-3 16-4 Unchanged 16-4 16-5 Unchanged 16-5 16-6 Unchanged 16-6 16-7 Unchanged 16-7 16-8 Unchanged 16-8 16-9 Unchanged 16-9 16-10 Unchanged 16-10 16-11 Unchanged 16-11 16-12 Unchanged 16-12 16-13 Unchanged 16-13 16-14 Unchanged 16-14 16-15 Unchanged 16-15 16-16 Unchanged 16-16 16-17 Unchanged 16-17 16-18 Unchanged 16-18 16-19 Unchanged 16-19 16-20 Unchanged 16-20 16-21 Unchanged 16-21 16-22 Unchanged 16-22 16-23 Unchanged 16-23 16-24 Unchanged 16-24 16-25 Unchanged 16-25 16-26 Unchanged 16-26 16-27 Unchanged 16-27 16-28 Unchanged 16-28 16-29 Unchanged 16-29 16-30 Unchanged 16-30 16-31 Unchanged 16-31

17-2 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement The focus of Chapter 16 is cash and investments. We usually cover these topics after the business processes because cash interacts with each of the other business processes.

[LO 16-1] Auditing Cash We use Figure 16-1 to show how each business process affects the cash account. In particular, we point out that the control procedures for cash receipts and cash disbursements significantly affect the controls over cash and were discussed in Chapters 10 and 11, respectively. You may want to refer the students back to Tables 10-7 and 11-7, which summarize assertions, possible misstatements, internal control procedures, and tests of control for cash receipts and cash disbursements transactions.

Use Figure 16-1 [LO 16-2] Types of Bank Accounts We briefly describe each of the following types of bank accounts:   

General cash account.

Imprest cash accounts.

Branch accounts.

[LO 16-3, 16-4] Substantive Procedures—Cash Because of its residual nature, cash does not have a predictable relationship with other financial statement accounts. Thus, the use of substantive analytical procedures is limited to comparisons with prior years‘ cash balances and to budgeted amounts.

Substantive Tests of Details of Transactions and Balances We use Table 16-1 to provide examples of tests of transactions. We point out that most of these tests were included in Chapters 10 and 11 and that they serve as dual-purpose tests that are normally conducted as part of the audit of the revenue and purchasing cycles.

Use Table 16-1 We use Table 16-2 to summarize for students the assertions and tests of details of account balances for cash accounts (Note: in the 11th edition, the assertions have been updated to be consistent with international and AICPA auditing standards). We then cover two major topics:  

Auditing the general cash account. [LO 16-5] Fraud-related audit procedures. [LO 16-6] Use Table 16-2

17-3 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement [LO 16-5] Auditing the General Cash Account We first mention to the students that the auditor needs the following documents to audit the general cash account:   

A copy of the bank reconciliation.

A standard bank confirmation.

A cutoff bank statement.

We then use Exhibit 16-1 to demonstrate how the bank reconciliation is audited. We focus on the information contained in the bank confirmation and the cutoff bank statement. Problem 1626 can be used here.

Use Exhibit 16-1 [LO 16-6] Fraud-Related Procedures We point out to the students that these procedures are normally only used when the entity does not have adequate control procedures or the auditor suspects some type of fraud or theft involving cash. We discuss three audit procedures:   

Extended bank reconciliation procedures.

Proof of cash.

Tests for kiting.

We use Exhibit 16-5 to demonstrate to the students how a proof of cash is performed and Exhibit 16-6 to show how an interbank transfer schedule can be used to identify transactions used to cover cash shortages. A new practice insight also discusses how audit data analytics can be used to perform a quasi-proof of cash.

Use Exhibits 16-5 and 16-6 We do not cover auditing a payroll or branch account, or petty cash. The students should be able to read and understand this material on their own.

[LO 16-7] Auditing Investments We briefly mention that FASB ASC Topics 320, ―Investments – Debt Securities‖ and 321 ―Investments – Equity Securities‖ provide detailed guidance on the accounting for investments in certain debt and equity securities. Again, the auditor's approach to the audit of investments depends on the size of the investment account and the amount of activity in the account.

[LO 16-8] Control Risk Assessment—Investments We focus on the main assertions for investments (occurrence and authorization, completeness, and accuracy and classification) and the related internal control procedures.

17-4 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement [LO 16-9] Segregation of Duties—Investments Only entities that engage in a significant number of investment activities are likely to have adequate segregation of duties. We use Table 16-4 to present the key segregation of duties for investments.

Use Table 16-4 [LO 16-10] Substantive Procedures—Investments The following analytical procedures can be used to test the overall reasonableness of investments:   

Comparison of the balances in the current year's investment accounts with prior years' balances after consideration of the effects of current-year operating and financing activities on cash and investments.

Comparison of current-year interest and dividend income with reported income for prior years and with the expected return on investments.

Recompute current-year interest income using the face amount of securities held, interest rate, and time period held.

We reference the students to Table 16-5 for a summary of the tests of the investment account for balance and presentation related disclosure assertions. We then cover existence, valuation and allocation, and classification and understandability. We particularly comment on the classification of securities among equity carried at fair value, and debt classified as held-tomaturity, trading, or available-for-sale. Problem 16-27 is good for covering the audit issues related to the classification of investments. Problems 16-28 and/or 16-29 could be used for covering assertions and audit procedures.

Use Table 16-5 [LO 16-11] Auditing Fair Value Measurements In this Advanced Module, we discuss how auditors approach the audit of fair value measurements. We briefly review the FASB ASC Topic 820 levels used to classify the inputs for valuation and then help the students understand how to obtain sufficient appropriate evidence that assets and liabilities are stated at their fair value. Problem 30 could be used to help students understand the big picture of auditing fair value.

Internet Assignment Internet assignment 16-31 provides the students an opportunity to evaluate two companies, Intel and Microsoft, who have large amounts of investments on their financial statements.

17-5 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement 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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

EarthWear Mini-Cases The Chapter 16 mini-case can be assigned as a stand-alone case and provides students with a hands-on experience of many of the aspects involved in auditing a cash account and includes documents such as bank confirmation, bank reconciliation, bank cutoff statement, proof of cash, and cash receipts and disbursements journals. Please go to Connect for the mini-case assignments.

IDEA and TABLEAU The Chapter 16 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 17 Completing the Audit Engagement Learning Objectives LO 17-1: Be able to explain the audit issues related to contingent liabilities.

LO 17-2: Know the audit procedures used to identify contingent liabilities.

LO 17-3: Understand the audit issues related to a letter of audit inquiry.

LO 17-4: Be able to explain why the auditor must be concerned with entity commitments.

LO 17-5: Know the types of subsequent events.

LO 17-6: Understand the effect of subsequent events on the dating of the audit report.

LO 17-7: Know the audit procedures used to identify subsequent events.

LO 17-8: Know the audit steps included in the auditor‘s final evaluation of audit evidence.

LO 17-9: Be able to explain how auditors identify and assess going

Problems

Discussion Cases

Internet Assignments/ ACL Problems

13

22

29

32

13

22,28

29

13,14

22,23,28

29

Review Questions

MultipleChoice Questions

1

2

ACL

3 4,5 5

24,25 15

25

16

24,25,28

6,7,8

17

26,27,28

9,10

18

33

30, 31

17-6 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement concern issues.

LO 17-10: Understand the auditor‘s communication with management and those charged with governance and the matters that should be addressed.

LO 17-11: Know the auditor‘s responsibilities when relevant facts that existed at the date of the auditor‘s report are discovered after the audit report has been issued.

11

19, 20

12

21

28

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.

17-7 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 17-1 Unchanged 17-1 17-2 Revised 17-2 17-3 Unchanged 17-3 17-4 Revised 17-4 17-5 Unchanged 17-5 17-6 Unchanged 17-6 17-7 Revised 17-7 17-8 Unchanged 17-8 17-9 Unchanged 17-9 17-10 Unchanged 17-10 17-11 Revised 17-11 17-12 Unchanged 17-12 17-13 Unchanged 17-13 17-14 Unchanged 17-14 17-15 Unchanged 17-15 17-16 Unchanged 17-16 17-17 Unchanged 17-17 17-18 Unchanged 17-18 17-19 Unchanged 17-19 17-20 Unchanged 17-20 17-21 Unchanged 17-21 17-22 Unchanged 17-22 17-23 Unchanged 17-23 17-24 Unchanged 17-24 17-25 Unchanged 17-25 17-26 Unchanged 17-26 17-27 Unchanged 17-27 17-28 Unchanged 17-28 17-29 Unchanged 17-29 17-30 Unchanged 17-30 17-31 Revised 17-31 17-32 Unchanged 17-32 17-33 Unchanged 17-33

17-8 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement Chapter 17 contains a number of important topics that are related to the completion of the engagement. These include:      

Review for contingent liabilities.

Review for commitments.

Review for subsequent events.

Final evidential evaluation processes.

Communications with the audit committee and management.

Subsequent discovery of facts existing at the date of the auditor's report.

We cover each of these topics in detail.

[LO 17-1] Review for Contingent Liabilities When discussing contingent liabilities, we cover the following items: 

FASB ASC Topic 450, ―Contingencies,‖ categories for accounting for contingencies (probable, reasonably possible, and remote).



Examples of contingent liabilities and disclosure include: o Pending or threatened litigation. o Actual or possible claims, fines, or assessments stemming from regulatory or other disciplinary action. o Income tax disputes. o Product warranties or defects. o Guarantees of obligations to others. o Agreements to repurchase receivables that have been sold.

[LO 17-2] Audit Procedures for Identifying Contingent Liabilities We cover examples of common procedures that may help the auditor identify contingent liabilities including: 1. Read the minutes of meetings of the board of directors, committees of the board, and stockholders.

2. Review contracts, loan agreements, leases, and correspondence from government agencies.

3. Review tax returns, IRS reports, and schedules supporting the entity‘s income tax liability.

4. Confirm or otherwise documenting guarantees and letters of credit obtained from financial institutions or other lending agencies.

17-9 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement 5. Inspect other documents for possible guarantees or other similar arrangements.

Exhibit 17-1 includes an example disclosure for a contingency.

Use Exhibit 17-1 [LO 17-3] Letters of Audit Inquiry The students should know and understand the importance of a legal letter and which attorneys should receive one. We use Table 17-1 to discuss the types of litigation that an auditor might encounter and show the students the example legal letter shown in Exhibit 17-2. In going over the legal letter in Exhibit 17-2, we focus on (1) the materiality limits established in the first paragraph and (2) the discussion of unasserted claims in the third paragraph.

Use Table 17-1 and Exhibit 17-2 [LO 17-4] Commitments The students should be aware that some types of commitments (sales or purchases) entered into by the entity must be disclosed in a footnote. Under some circumstances, the entity may have to recognize a loss even though the contract has not been executed.

[LO 17-5] Review for Subsequent Events for Audit of Financial Statements We start this topic by informing the students that transactions that occur after the balance sheet date but prior to the issuance of the financial statements and auditor's report may have a material effect on the financial statements. We discuss the two types of subsequent events that require consideration by management and evaluation by the auditor and present examples of each type of event.

[LO 17-6] Dual Dating We present the requirements for dual dating by showing the timeline shown in Figure 17-1 and discuss the example of EarthWear as discussed in the text. Problem 17-25 could be used here.

Use Figure 17-1 [LO 17-7] Audit Procedures for Subsequent Events Some audit procedures for business processes and their related financial statement accounts are conducted before year-end, while others may be conducted during the subsequent-events period. We review the examples of audit procedures outlined in the text.

17-10 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement We take a few minutes to make sure the students understand the requirements for auditors of public companies in regards to reporting any changes in internal control that might affect the financial reporting between the end of the reporting period and the date of the auditor‘s report.

Auditors of public companies are required to inquire of management whether there were any changes in internal control that might affect financial reporting between the end of the reporting period and the date of the auditor‘s report, and should obtain written representation regarding such changes. The auditor should also inquire about and examine, for this subsequent period, the following: 

Relevant internal audit reports issued during the subsequent period.



Independent auditor reports of deficiencies in internal control.



Regulatory agency reports on the entity‘s internal control over financial reporting.



Information about the effectiveness of the entity‘s internal control over financial reporting obtained through other engagements.

[LO 17-8] Final Evidential Evaluation We point out that the auditor conducts a number of important audit steps prior to deciding on the appropriate audit report for the entity. We then cover each of the following steps:       

Perform final analytical procedures.

Obtain a management representation letter.

Review audit work papers.

Perform the final evaluation of audit results.

Evaluate financial statement presentation and disclosure.

Obtain an independent review of the engagement.

Evaluate the entity‘s ability to continue as a going concern.

In covering the representation letter, we show Exhibit 17-3 to the students. Two points are important: (1) at a minimum, the chief executive officer and chief financial officer should sign the letter and (2) failure to receive a representation letter is a scope limitation. When we discuss the final evaluation of audit results, we refer the students to Exhibit 17-4. Covering this working paper again at this point in the course reinforces the students' understanding of the third step in applying materiality.

Use Exhibits 17-3 and 17-4 In covering archiving and retention, we point out to the students that this comes directly from the Sarbanes-Oxley Act and PCAOB‘s documentation standard. We make sure the students understand the requirements of the standard.

17-11 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement [LO 17-9] Going Concern Considerations In discussing the evaluation of going concern, we suggest the following approach: 

Point out the recent change in accounting standards under ASU 2014-15 which requires an entity‘s management to first evaluate the entity‘s ability to continue as a going concern, and auditors then make an independent assessment in order to evaluate the adequacy of management‘s going concern disclosures. Highlight the terms ―substantial doubt,‖ ―probable,‖ and ―reasonable period of time.‖



Describe the auditor's responsibility to evaluate management‘s assertions about the entity‘s ability to continue as a going concern.



Present the four steps in the going concern evaluation.



Cover the conditions and events that are indicative of going concern problems and audit procedures that may identify those conditions and events (refer the students to Tables 17-3 and 17-4).



Review the plans management can undertake to overcome the adverse effects of the conditions or events and explore the idea that management may use alternative accounting practices or creative means to secure financing.

Use Tables 17-3 and 17-4

[LO 17-10] Communications with Those Charged with Governance and Management Auditing standards require that the auditor communicate to the audit committee or similar body certain matters related to the conduct of the audit. We usually go over the matters that should be covered in the communication using Table 17-5.

We also cover all of the communication responsibilities with respect to the audit of internal control over financial reporting.

We also point out that it is normal practice for auditors to prepare a management letter for the entity. The general intent of the management letter is to make recommendations based on observations made during the audit. Many times the letter deals with organizational structure and efficiency issues. Problem 17-28 could be used here to cover many of the chapter topics.

Use Table 17-5 [LO 17-11] Subsequent Discovery of Facts Existing at the Date of the Auditor's Report When we cover this topic, we refer the students back to Figure 17-1 so they know what 17-12 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement period of time is relevant. We point out that this usually involves situations where the previously issued financial statements contain material misstatements due to either intentional or unintentional actions by management. Exhibit 17-5 provides a good real-world example. Lastly, we go over the actions the auditor should take in such situations, including withdrawing the audit report.

Use Exhibit 17-5 Discussion Cases Environmental liability issues are the subject of Discussion Case 17-29. This case can be very challenging but is one that students should experience at the end of an introductory course.

Discussion Cases 17-30 and 17-31 deal with issues related to the auditor's final evaluation of evidence.

Internet Assignments Internet Assignment 17-32 requires the students to identify and learn about companies that have reported contingent liabilities or pending lawsuits in their financial statements. We suggest that students start with the Edgar home page.

Internet Assignment 17-33 follows up on the discussion of subsequent discovery of facts existing at the date of the auditor‘s report. It requires the students to search for companies where the auditor has withdrawn the audit report.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

Hands-On Cases IDEA and TABLEAU The Chapter 17 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

17-13 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

Chapter 18 Reports on Audited Financial Statements Learning Objectives LO 18-1: Understand the various components of the standard unqualified financial statement audit report.

LO 18-2: Know the situations that result in the addition of explanatory language to the standard unqualified audit report.

LO 18-3: Be able to explain the conditions that lead to a departure from the standard unqualified audit report.

LO 18-4: Know the types of financial statement audit reports other than unqualified.

LO 18-5: Be able to explain the effect of materiality on the auditor‘s choice of audit reports.

LO 18-6: Understand the situations that may require different types of reports on comparative financial statements.

LO 18-7: Know the auditor‘s responsibility for other information in documents containing audited financial statements.

LO 18-8: Understand the auditor‘s reporting responsibility when financial statements are prepared on a basis other than GAAP. LO 18-9: Understand the auditor‘s responsibility for reporting on specified elements, accounts, or items of a financial statement.

LO 18-10: Understand the auditor‘s reporting responsibility when compliance with contractual agreements or regulatory requirements related to financial statements.

LO 18-11: Understand that the recent changes to the auditor reporting model are significant–the first major changes in over seventy years!

Review Questions

MultipleChoice Questions

Problems

1 (INTRO)

10,11,12

22,23,26, 27

2

10,11,12, 13

22,23,24, 25

3

14,15,16

22,23,25, 26

14,15,16

22,23,25, 26

3,4

15,16

5

17,18

6,7

19

8,9

20

8

21

Discussion Cases

28

25,26

22,23, 27

8

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.

1-1 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

1-2 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 18-1 Unchanged 18-1 18-2 Unchanged 18-2 18-3 Unchanged 18-3 18-4 Unchanged 18-4 18-5 Unchanged 18-5 18-6 Unchanged 18-6 18-7 Unchanged 18-7 18-8 Unchanged 18-8 18-9 Unchanged 18-9 18-10 Unchanged 18-10 18-11 Unchanged 18-11 18-12 Unchanged 18-12 18-13 Unchanged 18-13 18-14 Unchanged 18-14 18-15 Unchanged 18-15 18-16 Unchanged 18-16 18-17 Unchanged 18-17 18-18 Unchanged 18-18 18-19 Unchanged 18-19 18-20 Unchanged 18-20 18-21 Unchanged 18-21 18-22 Unchanged 18-22 18-23 Unchanged 18-23 18-24 Unchanged 18-24 18-25 Unchanged 18-25 18-26 Removed 18-27 Unchanged 18-26 18-28 Unchanged 18-27 18-29 Unchanged 18-28

1-3 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement Chapter 18 covers the reporting standards for audited financial statements. For a first auditing course, we cover Learning Objectives 1-5, which relate to basic audit reporting. We usually cover the remaining topics on special reporting issues in a second audit class.

[LO 18-1] Reporting on the Financial Unqualified/Unmodified Audit Report

Statement

Audit:

The

Standard

We start by referring the students to Exhibit 18-1 and by briefly reviewing the eight elements of the standard unqualified audit report (PCAOB). We then discuss the similarity and differences of the standard unmodified report (ASB). We remind them that this material was first introduced in Chapter 2. You may wish to emphasize new portions of the audit report, including ―Basis for Opinion,‖ ―Critical Audit Matters‖ and how long the auditor has served as the entity‘s auditor (referred to as ―auditor tenure‖). Discussing why these changes were made may prove enlightening for students.

Use Exhibit 18-1 [LO 18-2] Explanatory Language Added to the Standard Unqualified/Unmodified Audit Report The students should know that there are a number of situations where the auditor will modify the wording or add an explanatory paragraph to the standard unqualified/unmodified audit report.

Six situations are covered in the text:      

Reference to the report on the audit of internal control for public companies.

Modified wording for opinion based in part on the report of another auditor.

Substantial doubt about an entity‘s ability to continue as a going concern.

Lack of comparability of the financial statements between periods.

Management is required to report on internal controls, but the auditor is not required and has not been engaged to audit the report.

Circumstances in which the auditor wishes to emphasize a matter.

We point out to the students that the first situation results in an additional paragraph in the Opinion Section as shown in Exhibit 18-1. The other five situations are discussed below.

1. Opinion based in part on the report of another auditor. We discuss the need for the principal auditor to assess the professional reputation and independence of the other auditors and clearly indicate the division of responsibility between portions of the financial statements covered by the principal and other auditors in adherence to PCAOB standards. Then we present Exhibit 18-2 as an example of how the wording of the audit report is modified.

Use Exhibit 18-2 2. Going concern. We show the students the explanatory paragraph with an appropriate title in Exhibit 18-3.

1-4 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

Use Exhibit 18-3 3. Lack of Comparability of Financial Statements Between Periods. We tell the students that FASB ASC Topic 250, "Accounting Changes and Error Corrections," governs the accounting for changes in accounting principles. Note that this standard requires "retrospective application" for accounting changes and corrections of errors; thus, it not only affects financial reporting, but it may also affect the auditor's report. We then point out that, from an auditor's perspective, lack of comparability of financial statements can be placed in three categories: 

Changes in accounting principle or method of application - We cover the auditor‘s responsibility to offer an opinion on the appropriateness of the change.

Use Exhibit 18-4



Correction of a material misstatement in previously issued financial statements – We cover situations in which misstatements must be corrected because of: 1. Inappropriate application of accounting principles.

2. Changes from an incorrect classification of transactions or balances.

3. The correction of a material error.

Use Exhibit 18-5



Other changes that affect comparability – We cover changes in accounting estimates and reclassification from an acceptable classification to another.

4. Management Reports on ICFR but Audit of ICFR Not Required. We ensure students understand when auditors are required to add an explanatory paragraph for non-accelerated filers indicating the entity was not required to have an audit of ICFR performed, that the auditor obtained an understanding of controls to assist in the audit of financial statements, and the auditor nevertheless expresses no opinion on the effectiveness of ICFR.

5. Circumstances in which the Auditor Wishes to Emphasize a Matter. We inform students of conditions where an auditor may wish to emphasize an item in the way the financial statements are presented. We discuss the examples in the text if students have difficulty understanding. We also cover the difference between PCAOB reporting standards and those of the ASB and the ASB‘s emphasis-ofmatter and other-matter paragraphs as well as their appropriate use.

1-5 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement Departures from an Unqualified/Unmodified Financial Statement Audit Report We find that Figure 18-1 is a good tool for covering the material in this section. We use it as a framework for discussing the conditions for departure, the types of audit reports, and the effect of materiality.

Use Figure 18-1 [LO 18-3] Conditions for Departure We first cover the three basic reasons for a departure from a standard unqualified/unmodified audit report when circumstances indicate a need: (1) scope limitation; (2) departure from GAAP; and (3) lack of independence of the auditor.

[LO 18-4] Types of Financial Statement Audit Reports Other than Unqualified/Unmodified We then cover the other types of reports: Qualified, Adverse, and Disclaimer.

[LO 18-5] The Effect of Materiality on Financial Statement Reporting We review the effect of materiality and its pervasiveness on the auditor's choice of reports.

We point out that if the situation is immaterial, a standard unqualified/unmodified audit report can be issued. However, as the materiality of the situation increases, the auditor must judge the effect of the item on the overall financial statements.

Discussion of Conditions Requiring Other Types of Financial Statement Audit Reports We find that the material in this section can be approached in two ways. It can be integrated with the material presented in the prior section or it can be covered separately. The material in this section covers the types of reports and conditions for departure in more detail and, most importantly, provides examples of each type of report. It is helpful to the students' understanding if they see examples of the other types of reports.

Use Exhibits 18-6 to 18-9 Special Reporting Issues We usually start this section by referring back to the EarthWear Clothiers in Exhibit 18-1, which is an unqualified report that covers the balance sheet for two years and statements of income, stockholders‘ equity, and cash flows for three years.

[LO 18-6] Reports on Comparative Financial Statements We cover the three common situations discussed in the text: 

Different reports on comparative financial statements.

1-6

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement  

A change in report on the prior-period financial statements.

Report by a predecessor auditor.

Each of these situations is discussed and the example reports contained in Exhibits 18-10 and 1811 are presented.

Use Exhibits 18-10 and 18-11 [LO 18-7] Other Information in Documents Containing Audited Financial Statements We point out that an entity may publish documents such as annual reports and registration statements that contain other information in addition to the audited financial statements. Auditing standards require that the auditor read the other information and consider whether such information is consistent with the information contained in the audited financial statements. We usually provide an example and discuss the auditor's actions when the information is not consistent.

Special Reports Relating to the Financial Statements We start by discussing the fact that auditors are sometimes engaged to report on financial statements that are not prepared on a basis of GAAP or to report on an entity‘s compliance with contractual agreements. Three situations are covered:   

Financial statements prepared according to other comprehensive bases of accounting.

Specified elements, accounts, or items of a financial statement.

Compliance with aspects of contractual agreements or regulatory requirements related to audited financial statements.

[LO 18-8] Financial Statements Prepared According to Other Comprehensive Bases of Accounting We point out that auditing standards define special purpose financial statements as including those prepared under (1) a regulatory basis, (2) a tax basis, (3) cash (or modified cash) basis, and (4) a contractual basis.

[LO 18-9] Specified Elements, Accounts, or Items of a Financial Statement We tell the students that there are situations where the auditor may be engaged to audit only part (specified elements, accounts, or items) of the financial statements. We then introduce the fact that the auditor may not conduct a complete audit but only apply agreed-upon procedures.

These types of engagements are becoming more common. We point out that auditing standards require that the responsible party take responsibility for the sufficiency of the agreed-upon procedures.

[LO 18-10] Compliance Reports Related to Audited Financial Statements 1-7 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

We inform the students that many loan agreements require that the entity provide an audit report that the company is in compliance with the covenants of the loan agreement. We show Exhibit 18-11 to the students and point out that the report only provides negative assurance.

Use Exhibit 18-12 Problems 18-22 and/or 18-23 could be used here. Problem 18-28 requires the students to find deficiencies in an auditor‘s report.

[LO 18-11] The First Significant Change to the Auditor’s Report in More Than 70 Years We complete our discussion of audit reporting by discussing the recent changes to PCAOB reporting standards. Key enhancements to the report include: 1. The Opinion section of the report is now presented first, followed by a Basis for Opinion section, which explains the rationale for the opinion.

2. The respective responsibilities of management and the auditor are more clearly described.

3. The requirement that the auditor be independent of the entity is explicitly stated.

4. The key features of an audit are more clearly laid out, including the fact that amounts and disclosures, are examined “on a test basis,” and “the accounting principles used and significant estimates made by management” are evaluated by the auditor.

5. Critical audit matters that involve especially challenging, subjective, or complex auditor judgment are explicitly disclosed and described in a separate section of the report.

We also discuss ways in which the new reporting standards are anticipated to improve the relevance and transparency of the auditor‘s report by providing additional information to stakeholders and increasing communication between investors, auditors, and management.

Discussion Case Discussion Case 18-28 can be used to cover going concern issues.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

Hands-On Cases

1-8 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement IDEA The Chapter 18 IDEA problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 19 Professional Conduct, Independence, and Quality Control Learning Objectives

LO 19-1: Know the definitions and general importance of ethics and professionalism.

LO 19-2: Be able to explain three basic theories of ethical behavior and understand how to deal with ethical challenges.

LO 19-3: Know the entities involved in developing professional ethics standards for auditors and how those standards have developed over time.

LO 19-4: Understand the framework for the AICPA Code of Professional Conduct, including principles, rules, and interpretations.

LO 19-5: Acquire a working knowledge of the rules of conduct regarding independence, integrity, and objectivity, as well as the Code‘s ―threats and safeguards‖ conceptual framework for evaluating and responding to potential ethical concerns.

LO 19-6: Know the basic differences between the SEC‘s independence rules for public company auditors and the AICPA standards for audits of nonpublic entities.

LO 19-7: Know the rules of conduct regarding general standards and accounting principles, confidential information, fees and other types of remuneration, acts discreditable, advertising and other forms of solicitation, and form of organization and name.

LO 19-8: Be able to define and explain the components of a system of quality management for an accounting firm.

LO 19-9: Be familiar with the PCAOB inspection program for accounting firms that audit public companies.

Review Questions

MultipleChoice Questions

Problems

Discussion Cases

Internet Assignments/ EarthWear Mini-Cases (EWMC)

32,35,36

EWMC

14

1,2

14,22,23

3,5,6

14,17,21

30

33,35,36

4,7

15,18,19, 20,21

28,29,30, 31

32,34

37

8

16,21

27,28,30, 31

32,34

37

9,10,11

21,24

30

33

37

12,13

25

13

26

1-9 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

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 11th edition 19-1 19-2 19-3 19-4 19-5 19-6 19-7 19-8 19-9 19-10 19-11 19-12 19-13 19-14 19-15 19-16 19-17 19-18 19-19 19-20 19-21 19-22 19-23 19-24 19-25 19-26 19-27 19-28 19-29 19-30 19-31 19-32 19-33

Comparison Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged

Number in 12th edition 19-1 19-2 19-3 19-4 19-5 19-6 19-7 19-8 19-9 19-10 19-11 19-12 19-13 19-14 19-15 19-16 19-17 19-18 19-19 19-20 19-21 19-22 19-23 19-24 19-25 19-26 19-27 19-28 19-29 19-30 19-31 19-32 19-33

1-10 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement 19-34 19-35 19-36 19-37

Revised Unchanged Unchanged Revised

19-34 19-35 19-36 19-37

The focus of Chapter 19 is professional conduct, independence, and quality control. We point out to the students that any professional organization must indicate to its members what acceptable behavior is and must also demonstrate to the public that it is willing to monitor the actions of its members. The students should understand that the Code of Professional Conduct deals mainly with behavior and actions of individuals, while the Quality Control Standards are concerned with a firm's monitoring of its own practice.

[LO 19-1] Ethics and Professional Conduct We begin the discussion of this chapter with why there is a strong need for ethics in our society. Then we talk about professionalism and why it is valued. We go back to the house inspector example used at the beginning of the course, and we ask the students what it means to be a professional house inspector. Then we bridge the discussion to auditors and what professionalism means to them.

[LO 19-2] Theories of Ethical Behavior This leads us to begin to get a theoretical understanding of ethics. The text presents elements of the following three theories of ethical behavior:   

Utilitarian approach.

Rights-based approach.

Justice-based approach.

We start by describing each theory and then applying those theories to the ethical dilemma posed by the Sun City Savings and Loan Company example. We try to impress upon the students that auditors regularly face such dilemmas and that ethical auditors find a way to do the right thing.

[LO 19-3] Standards for Auditor Professionalism We spend some time clarifying for the students the principles, rules, and regulations governing ethics and professionalism in public accounting. Figure 19-1 does a good job summarizing the differences between public and private company audits, and we cover it thoroughly.

Use Figure 19-1 [LO 19-4] The AICPA Code of Professional Conduct: A Comprehensive Framework for Auditors The newly reorganized AICPA Code of Professional Conduct is one of the foundations of 1-11 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement defining ideal principles and minimum acceptable behavior for auditors. We begin coverage with the new organization of the Code of Professional Conduct: Principles of Professional Conduct, Rules of Conduct, and Interpretations of the Rules of Conduct (see Figure 19-2).

Use Figure 19-2 We find that it's a good idea to present each of the Principles to the students. We use Table 19-1 to provide the definition of each principle.

Use Table 19-1 We use Table 19-2 to provide an overview of Part 1 of the Rules of Conduct. We point out to the students how the rules are organized in terms of sections.

Use Table 19-2 While we make reference to the rules in our presentation, we prefer to discuss the underlying concepts. For example, in order to be independent, an auditor should not have any financial or managerial interests in an auditee. The remaining presentation in the text follows the sections of the Rules of Conduct.

[LO 19-5] Integrity, Objectivity, and Independence We first present Part 1 of the AICPA Code of Professional Conduct, Section 1.100 on Integrity and Objectivity. We then discuss Section 1.200 on Independence. We discuss each of the following issues:     

Financial Relationships (refer students to Table 19-3 and Exhibit 19-1).

Business Relationships (use Table 19-4).

Effect of Family Relationships.

Effect of Actual or Threatened Litigation.

Provision of Nonattest Services.

When discussing the above items, we bring into the conversation the SEC independence requirements for audits of public companies and how they are the same or differ from the AICPA requirements.

Use Exhibit 19-1 Use Tables 19-3 and 19-4 [LO 19-6] SEC and PCAOB Independence Requirements for Audits of Public Companies In this section, we discuss the primary areas in which the SEC and PCAOB independence rules differ from those of the AICPA Code of Professional Conduct. Until the past few years, the SEC‘s independence rules for auditors of public companies closely followed those of the AICPA. However, the SEC implemented more stringent rules in November 2000, which were further revised in January 2003, after Title II of the Sarbanes-Oxley Act (2002) required 1-12 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement additional independence restrictions. We review the recent differences which include:   

Provision of other professional services.

Human resource and compensation-related issues.

Required communications.

[LO 19-7] Other Rules in the Code of Professional Conduct General Standards and Accounting Principles The rules that fall under this section are fairly straightforward. The General Standards Rule captures much of what is contained in the ten GAAS, and the Compliance with Standards Rule merely states that an auditor must follow standards promulgated by bodies designated by the AICPA Council. The Accounting Principles Rule deals with compliance with accounting principles.

Confidential Client Information The Confidential Client Information Rule stipulates that a member in public practice shall not disclose any confidential client information except in five specific situations:     

To meet disclosure and performance requirements for GAAP and GAAS. To comply with a valid subpoena or summons.

To allow a review of a member‘s professional practice under the authority of the AICPA, a state CPA society, or a state board of accountancy.

To comply with an investigative or disciplinary proceeding.

To allow a review of a CPA‘s professional practice in conjunction with the purchase, sale, or merger of the practice.

Contingent Fees We remind students that contingent fees are not allowed for attest services. If contingent fees were allowed for attestation-related services, users of those services might question the CPA‘s independence.

Acts discreditable The students should know that an auditor should not commit acts discreditable to the profession, including:      

Discrimination and harassment in employment practices.

Solicitation or disclosure of CPA Examination questions and answers.

Failure to file a tax return or pay a tax liability.

Negligence in the preparation of financial statements or records.

Failure to follow requirements of governmental bodies, commissions, or other regulatory agencies.

Inappropriate sharing of confidential information obtained from 1-13

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

  

employment or volunteer activities.

False, misleading, or deceptive acts in promoting or marketing professional services.

Improper use of the CPA credential.

Failure to comply with records requests.

Advertising and other forms of solicitation The Advertising and Other Forms of Solicitation Rule allows advertising and solicitation unless they are false, misleading, or deceptive. Examples of such activities include:   



Creating false or unjustifiable expectations of favorable results.

Implying an ability to influence any court, tribunal, regulatory agency, or similar body or official.

Claiming that specific professional services in current or future periods will be performed for a stated fee, estimated fee, or fee range when it is likely at the time of representation that such fees will be substantially increased and the prospective auditee is not advised of that likelihood.

Making any other representations that would be likely to cause a reasonable person to misunderstand or be deceived.

Commissions and referral fees Commissions and Referral Fees Rule generally does not allow commissions or referral fees when the member or member's firm provides attestation-related services.

Form of organization and name Form of Organization and Name Rule requires that the form of a CPA's public accounting practice conform to state law or regulations whose characteristics conform to AICPA resolutions.

This allows most forms of organizations, including limited liability partnerships. The students should also know that this rule prohibits firms from operating under names that may mislead the public.

Disciplinary Actions It is useful to review with the students the ways that the AICPA can discipline members for violations of the Code of Professional Conduct.

Before leaving this discussion, we point out to the students that professional conduct and auditor independence are complicated subjects with much technical detail. We urge them to master the technical issues but to also keep in mind the primary purpose of it all: independence in fact and in appearance is critical to the CPA‘s reputation and the value he or she provides to society. To conclude the discussion of professional ethics, we recommend coming back to the principles that underlie the rules. In our experience, students are inspired by the fact that the 1-14 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement profession they are entering has, at its base, principles that center on integrity and honor.

[LO 19-8] Quality Management Standards We clarify for the students the roles of the ASB, PCAOB, and IAASB in quality management. In December 2020, the IAASB issued a new standard introducing a risk-based approach to quality management. The ASB and PCAOB announced their intent to follow the IAASB approach shortly after. The new quality management standards require accounting firms to design, implement, and operate a system of quality management that provides the firm reasonable assurance that:  The firm and its personnel fulfill their responsibilities and conduct engagements in accordance with professional standards and other legal and regulatory requirements  The firm issues engagement reports that are appropriate in the circumstances The standard describes the following eight components that make up an effective system of quality management:  .

1. The firm‘s risk assessment process 2. Governance and leadership 3. Relevant ethical requirements 4. Acceptance and continuance of client relationships and specific engagements 5. Engagement performance 6. Resources 7. Information and communication 8. The monitoring and remediation process Use Table 19-5 [LO 19-9] PCAOB Inspections of Registered Public Accounting Firms We then discuss the PCAOB‘s inspections of public accounting firms that are registered with the board.

Discussion Cases Discussion Case 19-32 extends the Sun City Savings and Loan case. This case introduces two independent situations that require the students to explore issues beyond those discussed in the text. Discussion Case 19-33 allows the students to discuss ethical issues that should be considered when an individual is considering a career move from public accounting to industry.

Discussion Case 19-34 allows students to explore SEC independence-related rules. Discussion Cases 19-35 and 19-36 give students an opportunity to work through ethical dilemmas using the framework given in the text.

1-15 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement Internet Assignment Internet Assignment 19-37 provides students with the opportunity to visit the AICPA‘s website to investigate Part 1 of the Code of Professional Conduct.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

Hands-On Cases EarthWear Mini-Cases The Chapter 19 mini-case can be assigned as a stand-alone case and asks students to read about a staff auditor who is confronted with an ethical challenge and then evaluate what he should do. Please go to Connect for the mini-case assignments.

Chapter 20 Legal Liability Learning Objectives LO 20-1: Understand the four general stages in an audit-related legal dispute.

LO 20-2: Know the definitions of key legal terms.

LO 20-3: Know the auditor‘s liability to clients under common law.

LO 20-4: Understand the auditor‘s liability to third parties under common law.

LO 20-5: Understand the auditor‘s legal liability under the Securities Act of 1933.

LO 20-6: Understand the auditor‘s legal liability under the Securities Exchange Act of 1934.

LO 20-7: Be able to explain how the Private Securities Litigation Reform Act of 1995, the Securities Litigation Uniform Standards Act of 1998, and the Class Action Fairness Act of 2005 relieve potential legal liability from auditors.

LO 20-8: Understand the auditor‘s

MultipleChoice Questions

Problems

14

26

3,4

14,15,16

26,27

2,5

14,17

26,27,28,2 9

30

6

18,19, 20,21

27,28,29

30

6,7,11

22

27,28,29

30

2,8

23

9

24

Review Questions

Discussion Cases

1

31 1-16

Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement legal liability under the SarbanesOxley Act of 2002.

LO 20-9: Know how the SEC and PCAOB can sanction an auditor or audit firm.

LO 20-10: Understand how the Foreign Corrupt Practices Act can result in legal liability for auditors.

LO 20-11: Understand how the Racketeer Influenced and Corrupt Organizations Act can affect the auditor‘s legal liability.

LO 20-12: Be able to explain how an auditor can be held criminally liable under various federal and state laws.

LO 20-13: Understand what academic research has learned about audit-related litigation and its effect on auditors.

10,11

24

12

25

9

24

13

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.

1-17 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement END OF CHAPTER MATERIALS COMPARISON CHART

Number Number Comparison in 11th edition in 12th edition 20-1 Unchanged 20-1 20-2 Unchanged 20-2 20-3 Unchanged 20-3 20-4 Unchanged 20-4 20-5 Unchanged 20-5 20-6 Unchanged 20-6 20-7 Unchanged 20-7 20-8 Unchanged 20-8 20-9 Unchanged 20-9 20-10 Unchanged 20-10 20-11 Unchanged 20-11 20-12 Unchanged 20-12 20-13 Revised 20-13 20-14 Unchanged 20-14 20-15 Unchanged 20-15 20-16 Unchanged 20-16 20-17 Unchanged 20-17 20-18 Unchanged 20-18 20-19 Unchanged 20-19 20-20 Unchanged 20-20 20-21 Unchanged 20-21 20-22 Unchanged 20-22 20-23 Unchanged 20-23 20-24 Unchanged 20-24 20-25 Unchanged 20-25 20-26 Unchanged 20-26 20-27 Unchanged 20-27 20-28 Unchanged 20-28 20-29 Unchanged 20-29 20-30 Unchanged 20-30 20-31 Unchanged 20-31

1-18 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement Chapter 20 presents a discussion of legal liability. We usually start our discussion of this topic by referring back to the agency or stewardship notions included in earlier chapters. It is easy to show the students how parties to the contract (principals and agents) can have recourse against the auditor if an inappropriate audit report is issued.

[LO 20-1] Overview of Auditor Legal Liability We start coverage here with a description of the four general stages in the initiation and disposition of audit-related disputes. We then cover the definitions of key legal terms in Table 20-1. It is important for the students to understand these terms. Next, we discuss the types of liability and actions that can result in liability for auditors (refer the students to Table 20-2). We point out that the remaining discussion will cover each of these types of liability.

Use Tables 20-1 and 20-2 [LO 20-2] Key Definitions of Key Terms Auditors can be sued by clients, investors, creditors, and the government for failure to perform professional services with due professional care. Auditors can be held liable under two broad categories of law: 

Common law. Case law developed over time by judges who issue legal opinions when deciding a case (the legal principles announced in these cases become precedent for judges deciding similar cases in the future).



Statutory law. Written law enacted by the legislative branch of federal and state governments.

It is important for students to understand the differences between these two legal categories.

Table 20-1 defines key legal terms, and Table 20-2 summarizes the auditor‘s liability by category of law and actions resulting in liability.

Use Tables 20-1 and 20-2 [LO 20-3] Common Law—Clients The students should realize that an auditor does not guarantee his or her work product.

However, the auditor is required to perform professional services with due care. When the auditor fails to carry out contractual arrangements with the client, he or she can be held liable for: (1) breach of contract, (2) negligence, or (3) fraud.

We point out that the auditor's liability for breach of contract arises from the obligations included in the engagement letter. For example, if the auditor agreed to provide audited financial statements by a certain date and the auditor misses the deadline because of inadequate performance, the client can sue for damages.

1-19 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement When discussing the auditor's liability under common law for negligence, we cover the following items:   



The definition of a tort.

What is meant by a ―reasonable person‖ (we use the quote from Cooley's Tort).

The elements for establishing auditor liability for negligence include: o duty to conform to a required standard of care; o failure to act in accordance with that duty; o causal connection between the auditor's negligence and the client's damage; o actual loss or damage to the client as a result.

A brief discussion of the Cenco, Inc. v. Seidman & Seidman (Exhibit 20-2) and 1136 Tenants v. Max Rothenberg (Exhibit 20-3) cases.

Use Exhibits 20-2 and 20-3

[LO 20-4] Common Law—Third Parties It is important for the students to know that auditor liability to third parties for negligence is very complex and that court rulings are not always consistent across federal and state jurisdictions.

We first cover the elements that a third party must prove in order to prevail in a suit alleging negligence:    

The auditor had a duty to the plaintiff to exercise due care.

The auditor breached that duty by not following professional standards.

The auditor's breach of due care was the proximate cause of the third party's injury.

The third party suffered an actual loss as a result.

We then cover the four standards that have evolved for defining the extent of the auditor's liability to third parties for ordinary negligence: 

Privity. We point out that privity is the traditional view that states that the auditor has no liability to any party who did not have a privity relationship with the auditor. It is a good idea to reference the students to the landmark case, Ultramares v. Touche (Exhibit 20-4). It is also important to comment on the more recent cases that led to the near privity doctrine discussed next.

1-20 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement Use Exhibit 20-4 

Near Privity. We point out that more recently, there have been cases that have applied the concept of near privity which include third parties whose relationship with the accountant approaches privity. We reference the Credit Alliance v.

Arthur Andersen and Barret v. Freifeld cases. As we cover this section, we continually remind students that these legal doctrines relate to ordinary negligence and that in any jurisdiction any third party damaged by the auditor may successfully sue the auditors for gross negligence or fraud.



Foreseen Third Party or Restatement Standard. We point out to the students that this standard is now the majority view and that it is based on Section 522 of Restatement (Second) of the Law of Torts. We refer the students to the 1968 Rusch Factors v. Levin case (Exhibit 20-5), which was the first case to apply this standard. This standard narrows the auditor's liability to a small group of persons or classes who are or should be foreseen by the auditor as relying on the financial information. We find it helpful to the students if we review the three examples included in the text.

Use Exhibit 20-5



Reasonably Foreseeable Third Parties. This is the most expansive view of auditor's liability to third parties. We briefly discuss the first case in this area, Rosenblum v. Adler (Exhibit 20-6) and mention the Citizens State Bank v. Timm, Schmidt & Co. case. Part of the logic behind the reasonably foreseeable third parties standard is that auditors are able to spread their risk through insurance.

However, in the current legal environment, such insurance may be unavailable or prohibitively expensive.

Use Exhibit 20-6

In discussing the auditor's liability to third parties for fraud, we note that the auditor must have acted with knowledge of the misrepresentation or with reckless disregard for the truth. We also review the five items that the plaintiff must prove to win a lawsuit for fraud.

[LO 20-5] Statutory Liability We point out to the students that there are various statutes at both the federal and state levels that are intended to protect the public from malfeasance in the marketplace and that

1-21 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement the discussion focuses on the following federal statutes:       

Securities Act of 1933 (LO 20-5).

Securities Exchange Act of 1934 (LO 20-6).

Private Securities Litigation Reform Act of 1995, the Securities Litigation Uniform Standards Act of 1998, and the Class Action Fairness Act of 2005 (LO 20-7).

Sarbanes-Oxley Act of 2002 (LO 20-8).

SEC and PCAOB Sanctions (LO 20-9).

Foreign Corrupt Practices Act (LO 20-10).

Racketeer Influenced and Corrupt Organizations Act (LO 20-11).

Securities Act of 1933 The students should be told that this act regulates the disclosure of material facts in a registration statement for a new public offering of securities and that Section 11 imposes a liability on auditors for losses suffered by third parties when false or misleading information is included in a registration statement.

We point out to the students that, unlike common law, the plaintiff does not have to prove negligence or fraud, reliance on the auditor‘s opinion, a causal relationship, or a contractual relationship. The plaintiff only has to prove that a loss was suffered and that the audited financial statements contained a material omission or misstatement.

We find it useful to cover some of the major cases such as Escott v. BarChris Construction (on the book‘s website) or Bernstein v. Crazy Eddie (Exhibit 20-7).

Use Exhibit 20-7 [LO 20-6] Securities Exchange Act of 1934 This statute is concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange or meet certain other statutory requirements. Two sections of this statute are important for auditors: Section 18 and Section 10(b), including Rule 10b-5.

We normally cover the four elements that a plaintiff has to establish in order to sue under Rule 10b-5: (1) a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as a result of reliance on the financial statements, and (4) scienter. We then talk about a major case in this area, Ernst & Ernst v. Hochfelder. The Phar-Mor case, provided on the book‘s web site, can also be covered here as a case that fell under the Securities Exchange Act of 1934. Also, Continental Vending and Mini-Scribe can be used from the book‘s website.

1-22 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement [LO 20-7] Private Securities Litigation Reform Act of 1995, the Securities Litigation Uniform Standards Act of 1998, and the Class Action Fairness Act of 2005 This is a good place to compare joint and several liability with proportionate liability. We usually discuss that public accounting firms are ―deep pockets‖ for plaintiffs‘ lawyers and that these two statues provide some protection for auditors by forcing cases to federal courts and increasing the standard of information and evidence the plaintiff must present with the initial claim rather than conducting ―fishing expeditions‖ in auditor‘s workpapers and files to identify possible claims.

[LO 20-8] Sarbanes-Oxley Act of 2002 Once again, we discuss the sweeping reforms of Sarbanes-Oxley. We try to discuss with the students items that we may have missed in earlier classes. We do remind them that most of the legal liability legislation of Sarbanes-Oxley represented enhancements or revisions to existing laws. We use Problems 27 and/or 28 here to review many of the concepts included in the chapter to this point.

[LO 20-9] SEC and PCAOB Sanctions We point out that under Rule 102e of the Rules of Practice, the SEC can suspend an individual's or a firm's privilege of practicing before the SEC. Typically, if a firm is faced with suspension, it will agree to sanctions such as not accepting any new SEC clients for a specified period of time. The SEC can also impose fines such as the $7 million one imposed on Arthur Andersen in connection with Waste Management. We also discuss with the students the PCAOB‘s authority to impose sanctions.

[LO 20-10] Foreign Corrupt Practices Act (FCPA) We usually discuss why the FCPA was passed and that it was codified as an amendment in 1988 to the Securities Exchange Act of 1934. The students should understand what a corporation's responsibilities are under the FCPA. [LO 20-11] Racketeer Influenced and Corrupt Organizations Act (RICO) We point out that while RICO was passed to combat organized crime, it has been used against auditors. The most common acts alleged by auditors are mail fraud and wire fraud. One of the major reasons for plaintiffs' suing auditors under RICO is that the act provides for treble damages. We also discuss the Reves v. Ernst & Young case (see book‘s website), which established an operations and management test for auditors that requires the plaintiff to prove that the accounting firm participated in the operation or management of the client's business.

1-23 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement [LO 20-8, 20-12] Statutory Law—Criminal Liability Under federal and state laws, auditors can be held criminally liable if some type of criminal intent was present. We usually discuss one of the cases in this area from the book‘s website as well as the Enron case (see Exhibit 20-8) and the impact of Sarbanes-Oxley, which included numerous criminal provisions.

Use Exhibit 20-8 [LO 20-13] Academic Research Regarding Audit-Related Litigation Many academic studies have explored the link between litigation risk and public company audits. The primary findings indicate auditors increase efforts and charge higher fees in response to litigation risk. The findings also indicate triggering events (e.g. restatements, bankruptcies, and regulatory enforcement actions) increase the likelihood that an auditor is included in litigation, but most litigation involving auditors end in settlement.

Discussion Cases Discussion case 20-30 provides a good example for discussing auditors' civil liability to shareholders and creditors. Discussion case 20-31 discusses some pros-and-cons to SarbanesOxley.

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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving. The 11th edition has several new practice insights, as well as updated versions of previous insights, that provide recent examples of auditor-related lawsuits.

IDEA The Chapter 20 IDEA problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

Chapter 21 Assurance, Attestation, and Internal Auditing Services Learning Objectives

Review Questions

MultipleChoice Questions

LO 21-1: Know the definition of assurance services.

1

15

Problems

Discussion Cases

Internet Assignments

1-24 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement LO 21-2: Be familiar with the types of assurance services offered

by CPAs. LO 21-3: Know the definition of an attestation engagement.

LO 21-4: Know the types of attestation engagements.

LO 21-5: Understand the type of attestation engagement that involves reporting on an entity‘s financial forecasts and projections.

LO 21-6: Be familiar with accounting and review services.

LO 21-7: Understand the standards pertaining to and the services provided by internal auditors.

LO 21-8: Be familiar with Trust Services - a type of assurance service offered by CPAs

11

15

2,3

16

34

2,3,4,5

16

34

6

17,18

31,32

7,8

19,20,21, 22

30

9,10

23,24,25

12,13,14

26,27,28, 29

35 33,35

36,37

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.

1-25 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement END OF CHAPTER MATERIALS COMPARISON CHART Number in 11th edition

Comparison

Number in 12th edition 21-1 21-2 21-3 21-4 21-5 21-6 21-7 21-8 21-9 21-10 21-11 21-12 21-13 21-14 21-15 21-16 21-17 21-18 21-19 21-20 21-21 21-22 21-23 21-24 21-25 21-26 21-27 21-28 21-29 21-30 21-31 21-32

21-1 Unchanged 21-2 Unchanged 21-3 Unchanged 21-4 Revised 21-5 Revised 21-6 Unchanged 21-7 Unchanged 21-8 Unchanged 21-9 Unchanged 21-10 Unchanged 21-11 Unchanged 21-12 Unchanged 21-13 Unchanged 21-14 Unchanged 21-15 Unchanged 21-16 Unchanged 21-17 Revised 21-18 Unchanged 21-19 Unchanged 21-20 Unchanged 21-21 Unchanged 21-22 Unchanged 21-23 Unchanged 21-24 Unchanged 21-25 Unchanged 21-26 Unchanged 21-27 Unchanged 21-28 Unchanged 21-29 Unchanged 21-30 Unchanged 21-31 Unchanged 21-32 Unchanged 21-33 Removed 21-34 Removed 21-35 Unchanged 21-33 21-36 Revised 21-34 21-37 Revised 21-35 21-38 Unchanged 21-36 21-39 Unchanged 21-37 Chapter 21 presents assurance and attest services as well as other types of accounting services 1-26 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement offered by CPAs. The chapter also discusses the several services and standards relating to internal auditing. We find that it is helpful if we start out coverage of this material by pointing out that auditors are often asked to provide a variety of services beyond the audit of historical financial statements.

[LO 21-1] Assurance Services We start our discussion of assurance services by presenting the history behind the AICPA Special Committee on Assurance Services (the Elliott Committee). We then go over the definition of assurance services and show them Figure 21-1. We then discuss the types of assurance services. Usually, we only cover a couple of the services included in the chapter.

Use Figures 21-1 [LO 21-2] Types of Assurance Services The AICPA, through its Assurance Services Executive Committee, identified and developed six categories of assurance services. They are:      

Risk assessment.

Business performance measurement.

Information system reliability.

Electronic commerce.

Health care performance measurement.

PrimePlus.

[LO 21-3] Attestation Engagements Here we define an attestation engagement and the types of attestation services an auditor might be involved in, and then use Figure 21-2 to discuss the relationship between the three parties to an attestation engagement.

Use Figure 21-2 [LO 21-4] Types of Attest Engagements We then describe the types of engagements that can be conducted under attestation standards and that specific standards may prohibit certain types of engagements (assertion-based examination, direct examination, review, and agreed-upon procedures). We use Table 21-1 to provide an overview of attestation engagements.

Use Table 21-1 [LO 21-5] Financial Forecasts and Projections We generally cover this topic quickly. We focus on the following issues: 1-27 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement

   

Types of prospective statements (financial forecasts and financial projections).

Minimum presentation guidelines (see Table 21-2).

Examination of prospective financial statements engagements, including example reports, using Exhibit 21-1 and Exhibit 21-2.

Agreed-upon procedures engagements, including the example report presented in Exhibit 21-3.

Use Table 21-2 Use Exhibits 21-1 to 21-3

[LO 21-6] Accounting and Review Services We introduce this topic by discussing nonpublic companies‘ need for services that are less comprehensive and less expensive than an audit. We also discuss some of the history leading up to the issuance of the SSARS. We briefly introduce the three forms of services (preparation, compilation and review) and compare them to an audit, using Figure 21-3.

Use Figure 21-3 We first cover a preparation of financial statements and draw attention to the idea that the accountant does not provide assurance but must provide a legend and disclose any departures from the financial reporting framework. We then cover a compilation of financial statements by focusing on the knowledge the accountant must have about the entity and on how the accountant is only required to read the compiled financial statements. We mention that compiled financial statements may contain prospective, pro forma, or historical financial information and show the students Exhibit 21-4.

Use Exhibit 21-4 We then cover a review of financial statements by again focusing on the knowledge required of the accountant and the steps that must be performed (mainly inquiries of the entity's personnel and analytical procedures). Afterward, we present a standard review report (Exhibit 21-6) and an example of a modified review report (Exhibit 21-6). We use Problems 33 and/or 34 here.

Use Exhibits 21-5 and 21-6 [LO 21-7] Internal Auditing We begin this section by relating to the students the increased emphasis being placed on the role of internal auditing in today‘s corporations. We go over the definition of internal auditing with the students and explain why this might be a viable career option for them. This is a good time to invite a guest into the class to speak about internal auditing.

If we do not have a guest speaker, we cover the material by first discussing the IIA, the 1-28 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement certifications it offers, and the IIA International Professional Practices Framework, which is broken down into mandatory guidance (which consists of the definition of internal auditing, code of ethics, and standards) and recommended guidance (which consists of position papers, practice advisories, and practice guides). If we want to cover the material in detail, we use Tables 21-4, 21-5, and 21-6 in our discussion.

Use Tables 21-4, 21-5, and 21-6 We then talk about the role of the internal audit function and how internal audit functions differ widely in how they are managed and staffed. We talk about the advantages/disadvantages of ―in-house‖ versus ―co-sourced‖ and the two roles played by the internal audit function: assurance and consulting. We once again emphasize the increasing contribution the internal audit function is making to corporate governance within an organization.

We then spend a few minutes discussing the more specific tasks of the internal audit function: evaluating risks, evaluating compliance, financial auditing, and operational auditing. The students should be familiar with most of the terms. We close out this section by examining the relationship between the internal and external auditors.

[LO 21-8] Advanced Module: An Example of An Assurance Service—Trust Services Trust Services and SOC 2®, SOC 3®, and SOC for Cybersecurity® Reports We begin by going over the five criteria that Trust Services are built on as listed in Table 217: security, availability, processing integrity, privacy, and confidentiality. We then review SOC 1 reports and cover SOC 2, SOC 3, and SOC for Cybersecurity reports.

Use Table 21-7 We also use Exhibit 21-8 to introduce an example of a SOC 2 report on EarthWear‘s online customer ordering and fulfillment system.

Use Exhibit 21-8 We use Problem 33 here.

Discussion Case Discussion Case 21-34 addresses compliance auditing. This topic is not covered in the text.

The case deals with environmental issues and compliance auditing.

Internet Assignments Internet Assignments 21-35 through 21-37 can be used to demonstrate and reinforce various issues related to assurance services.

1-29 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

Chapter 17 - Completing the Audit Engagement 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 selfcontained insights or scenarios focus on current events, student decision-making, and professional problem solving.

IDEA The chapter 21 IDEA problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments.

1-30 Copyright © 2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.