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Chapter 01 of the textbook "Auditing: An International Approach" 5th Edition. Email to buy full textbook (price is US $30).


<p>CHAPTER Introduction to Auditing Chapter1isanintroductiontoauditing,especiallyfinancialstatementauditing.Otheraccounting courseshelped youlearn the principles and methodsof accounting,but hereyouwill begintostudy thewaysandmeansof auditing-the verificationof accountingandotherinformation. LEARNINGOBJECTIVES After completing this chapter, you will be able to do the following: 0Explain the importance of auditing. 0Distinguish auditing from accounting. 0Explain the role of auditing in information risk reduction. 0Describe the current audit environment, includ-ing regulatory oversight. 0Describe the other major typesof auditsand auditors. 0Outlinehowpublicaccountants(PAs)are regulated. Q Provide an overview of international auditing and its impact on Canadian audit standards. 0Apply andintegrate 1hechaptertopics to analyze a practical auditing siUlation/case/scenari.o. G Researchwebsite&amp;ontheaccountingand auditingactivitiesofPAorganizations. (Appendix lA) ((:; Chronicle the historical development of audit-ingstandards,includingthecriticismsand responses of the profession. (Appendix lB) (lp Describealternativetheoriesof theroleof auditing in society. (Appendix lC) Thia is conaiderad advancedmalarial.Nota: Appendices1A, 18, and1Care locatadonthiatext'a OnlineLearningCenlre (OLq. 1 2PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities INTRODUCTION:THECONCEPTOFAUDITING LEARNINGOBJECTIVE 0Explaintheimportance of auditing. Auditingisafieldof studythathasreceived considerable mediaattentionlately.In the business press, audit-related issues are mentioned daily.Headlines such as "Auditors: The Leash Gets Shorter,""The Betrayed Investor,""Dirty Rotten Numbers:and ''Accounting in Crisis" indicate that the attention hasnot all been positive. This reality arisesfromthe fact that auditing is critical to the proper functioningof capital markets,and, if audits are perceived tofail,then capitalmarketscan do thesame. Without effective audits,modem capital markets cannot ful:fill their role as efficient economic systems leading to high living standards. An exampleof an effective auditor isshown in the box below. ANEFFECTIVEAUDITOR MolexIncorporatedisa$2.2billionelectronicsmanufacturerheadquarteredin Chicago.In late2004 Molex's auditor,Deloitte&amp;Touche,complained thatCEO J.Joseph Kingand hischief financialofficer had not disclosed that they allowed a bookkeepingerror worth1%of net income into the audited results.When the audi-tor demanded on Nov.13 that King be removed from office, the board initially stood behind the CEO with aunanimousvote. Then Deloitte did something unexpected:It quit.Two weeks later the firmwrote ablisteringand detailed account of the affair for public disclosure at the SEC. That virtuallyassured that no auditor wouldwork for Molexagainas longasKingwas in charge. Within 10 days the directors had eaten crow:They ousted King, promised to hire anewdirector with financial expertise for their audit committee,and agreed to taketrainingclassesin proper financialreporting. SOUICe:'The B0811on the Sidelinea," BusinessWeek, April25, 2005, p. 94. Theprecedingexampleillustratestheworkof effectiveauditorsinthenewbusiness environment of theearly twenty-first century.In modem business, the role of auditing is socriticalthatreferencescanbemadetoauditsocieties.Inauditsocieties,economic activities (and other politically important ones) are extensively monitored to ensure market efficiency.Inthesesocieties,auditorsalsomonitortheeffectivenessandefficiencyof government. For example, the political uproar surrounding Canada's Gomery commission inquiry( 2005wasthe resultof an audit of questionablesponsorship payments that yielded ''no value" for taxpayer moneyspent. As aresult of thisand simi-lar events,auditingisincreasingly recognized as part of abroader processof social con-trol.This expanding roleisat theheart of the audit societyconcept. 1 But whatisauditing,exactly?Simply put,auditing istheverificationof information by someoneother thantheone providingit.Since therearemanytypesof information, thereare many typesof audits.Most of thistext focuseson audits of financialstatement information,or financialstatement auditing for short.Before describing auditing in more detail,wewilltry tomakefinancialstatementauditingmoreintuitivethroughasimple illustration. A Simple Illustrationof the Importanceof Auditing Assumeyou havealwayswantedtorunyourown business,say,aThaifoodrestaurant. Aftersomesearching,youfindanownerwhowantstoretireandiswillingtosellhis 1 M.P.Power,TheAudit Society (NewYork:OxfordUniversilyPress,1997). CHAPTER1Introduction to Auditing3 busy restaurantin achoice locationof amajor metropolitanarea for$3million.One of thefirstthingsyouaskyourself iswhether thebusinessisworththe$3millionasking price.How can you answer that? Youcouldfindoutthepriceof similar properties-comparisonshop.But,ultimately, you must decide on the valueof thisparticular business. Accounting information is useful in answering these types of questions: What is the business's net worth (Assets- Liabilities)? What isits profitability? The owner of the restaurant mayclaimannualprofitsof $600,000.First,you want to reachanagreementonhowthatprofitiscalculated:onacashbasis?beforetax?after tax? under generally accepted accounting principles? Those are the criteria you might use in measuring the profitability(earnings) of the business. Having decidedon thecriteria for measurement,you need to use adecisionrule with yourmeasurement.Businessesarefrequentlyvaluedonsomemultipleof earnings.For example, if you are willing to pay five times current earnings (calculated using your agreed criteria)and the current owner reports$600,000 in earnings annually,you would be pay-ing fivetimes$600,000 or $3millionfor the business. Youneed accountinginformation toestablish that $600,000 is thecurrent earningsnumber. But the owner prepares theaccountingrecords.How do you knowtheyareaccurate? There may be errors or, worse, the owner might inflate earnings to get ahigher price than the business isworth.For example, if theowner isoverstatingthe earningsand theyare only $500,000, the most the businessis worth to you is fivetimes$500,000, or $2.5 mil-lion rather than $3million.In other words,youare concernedabout the risk of overpay-ing for your investment. What can you do to minimize this risk and give yourself assurance? Hire an auditor!The auditor can helpyou byverifyingthat the $600,000figurereported by thecurrentowner is accurate. The earnings can be on whatever basis you agree to, usually generally accepted accounting principles (GAAP). The auditor can independentlyand competently verify the earningssothat youwillhave moreconfidence(assurance)in thenumbersyou base your decisionon.Theauditorincreasesthereliability,or reducestherisk,of usinginaccurate information in your decision making. For example, if the auditor finds that earnings are really $400,000,you wouldbe unwillingtopay more than fivetimes $400,000 or $2 million for the restaurant.The differencebetween the originalaskingprice($3million)and what you shouldactuallypay($2million)isthevalueof theaudit-inthiscase $1million.If the audit feeis under $1million you would, therefore,be better off havingan audit. This simplified example illustrates the value of auditing in investment decision making. But it also shows how auditingcan provide other,more general,social services.For exam-ple, the restaurant owner can retirewith afair price for his business,and you can achieve your dreams of owningarestaurant and being your own boss. These are accomplished by using afairexchange price based on reliable(accurate,trustworthy)information. Thetransactionentriesthat youlearninyouraccountingcoursesarepart of the raw data auditors deal with. The summarization of all the transactions over a period is achieved throughthefinancialstatements.When auditorsverifythereliabilityof thisinforma-tion,theyreduce theinformation risk associatedwiththefinancialstatements.Now, imagine this illustration extended toall investorscontemplating even partial ownership of abusiness-for example,investors in thestock market-and you will have some idea of howauditingcan facilitateefficient economic activitiesby reducing financialinforma-tionrisk.Andwhenauditorsfailtodoaproper jobof verification(i.e.,failtoreduce information risk),the typeof headlinesnoted at the beginningof thissection can result. Whenyoumakeaninvestment,youagreetoenterintoacontracttopurchasefrom another party. The auditor can be called the first party and the seller the second party. Notice, however,that thereisathirdparty-you the investor.Theauditorisan independent party hired to verifyinformation provided by thesecond party.Theauditor is hired because you, the third party, do not trust the information provided by the second party. You feel the infor-mation risk is too high;therefore,the first party will provide you with independent verifica-tion. We refer tothis relationship throughout the text as three-party accountability. 4 EXHIBIT1-1 PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities Inanauditsociety,three-partyaccountabilityissoinstitutionalizedthatregulators requirecertain second parties to pay forthe audit.In particular, companieswhoseshares aretradedonregulatedstockexchanges(publiccompanies)arerequiredtohirean independentauditortoverifytheannualfinancialstatements.Theaccountabilityisstill threeparty,because theaudit'spurpose is to reduce informationrisk forthethirdparty, but the public company second party pays the audit fee.It is important tonote that three-party accountability isnot determined by who pays the fee. Exhibit1-1indicateshowthree-partyaccountabilityappliestotheMolexandThai restaurant examples. In the Exhibit,accountability is represented asa triangle with the audi-torof thefinancialinformation,themanagementpreparingthefinancialinformation,and the usersof the financialinformationat theapexes.The triangle reflectsan accountability relationship because management isaccountableto the users.However,the userscannot rely on the financialstatements as they do not trust management sufficiently; they demand thatthefinancialstatementsbe verifiedbyacompetent,independentauditor.Thus,the auditor isalsoaccountabletotheuser.Three-party accountability isanimportantdistin-guishingfeatureof auditing. Note that the concept of three-partyaccountability meansthat the auditor is expected to act in the interests of the user of the financial statements. If the owner of the Thai restaurant gives you an audited set of financialstatements, you are entitled toassume that the auditor hasnot misled you.This is an important point, because, if youcould not assume the audi-tor istrustworthy,therelevanceof theauditwould largely disappear,leavinglittleif any role for the audit in society.Thus, it is extremely important to the audit profession that the auditor be perceived asacting in the interest of the financialstatement users,alsoreferred toasacting in the public interest. Later in this text, you will see how the public interest is reflected in the objectives of the audit engagement, in auditors'legal liability,and in the professionalrulesof conduct that determine the auditor'sprofessional role. Three-party accountability is also important because it distinguishes the type of services that only licensed practitioners can provide (in some parts of Canada) from other services, such astax work and business advisory services that anyonecan provide.Auditsare part of abroaderclassof servicescalledassuranceengagementsthatarelicensed toprofes-sionals(insomepartsof Canada).Three-partyaccountabilityappliestoallassurance engagements.Wewillclarifytheseimportantconceptsthroughouttherestof thetext, especially inChapters2and16.For now,think of three-partyaccountability as reducing theriskoninformationcreatedbythesecondparty,theprepareroftheinformation. THREEPARTIESINVOLVEDINAN AUDITINGENGAGEMENT (THREE-PARTYACCOUNTABILITY) Conclusion Auditor User{s)(e.g., you, as buyer of ThaiRestcurant, shareholders of Molex) SUBJECT MATTER Accountability Accountable party (management of Molex, seller of ThaiRestcurant) CHAPTER1Introduction to Auditing5 Reducinginformation risk is synonymouswith improving the credibility of, or providing assuranceon, information produced by thesecond party. We hope you havefound the preceding illustrations useful.Next,we further clarify the rolesof accountingand auditing in the financialreporting environment. USERDEMANDFORRELIABLEINFORMATION LEARNINGOBJECTIVE 0Distinguish auditing from accounting. Accounting The followingthreeunderlying conditionsaffect users'demand foraccounting information: 1.Complexity.Acompany'stransactionscanbe numerousand complicated.Users of financialinformation are not trained to collect and compile it themselves. They need the servicesof professionalaccountants. 2.Remoteness.Users of financial information are usually separated fromacompany's accounting records by distance and time, as well as by lack of expertise. They need toemployfull-timeprofessionalaccountantstodotheworktheycannotdofor themselves. 3.Consequences.Financial decisions are important to the state of investors'and other users'wealth.Decisionscan involve large dollaramountsand massive efforts.The consequences are so important that good information, obtained through the financial reportsprepared by accountants,isan absolute necessity. Accountingistheprocessof recording,classifying,andsummarizingintofinancial statementsacompany's transactions that createassets,liabilities,equities,revenues,and expenses.It is the means of satisfying users'demandsforfinancialinformation that arise from theforcesof complexity,remoteness,and consequences.The functionof financial reportingistoprovidestatementsoffinancialposition(balancesheets),statementsof resultsof operations(incomestatements),cashflowsstatements,andaccompanyingdis-closurenotes(footnotes)tooutsidedecisionmakers.Acompany'saccountantsarethe producersof suchfinancialreports.Inshort,accountingtriestorecordandsummarize economic realityforthe benefitof economicdecisionmakers(the users). Because of advancesin information technology(IT),theforminwhichaccounting recordsarestoredhaschangeddramaticallyoverthepastfewdecades.Althoughthese changeshaveaffectedtheformof audit evidence,thebasic roleof verificationfor users and their decision-makingneeds hasnot changed. The goal of generally accepted accounting principles (GAAP), which you study in your financialaccounting courses, is to yield financialstatements that represent as faithfullyas possible the economicconditions and performance of acompany. This is whyGAAP are themost commoncriteria usedin preparingfinancialstatements.However,asillustrated in the introduction, auditors are independent financialreporting experts who are frequently askedto verify that these goalsare met. REVIEW1Explain howthe auditor can help you in your investment decisionmaking. CHECKPOINTS More...</p>