Chapter 2Chapter 2

The Financial StatementAuditing

Environment

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-2

Problems and Warning Signs

1990 2000

During the economic boom of the late 1990s and the early 2000s, accounting firms aggressively sought opportunities

to market a variety of high-margin nonaudit services to their audit clients.

LO# 1

2-3

Problems and Warning Signs

LO# 1

2-4

An Explosion of Scandals

Enron

WorldCom

Tyco

Xerox Adelphia

LO# 1

2-5

Government Regulation

In July 2002, Congress passed the Sarbanes-Oxley Public Company Accounting Reform and Investor

Protection Act.

The Sarbanes-Oxley Act effectively ended the profession’s era of “self-

regulation,” creating and transferring authority to set and enforce standards to the Public Company Accounting

Oversight Board (PCAOB).

LO# 1

2-6

The Act

Mandated Broad reform in Corporate Governance Practices

Impacted Public Companies Financial Analysts External Auditors Securities Exchange Markets

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Context of Financial Statement Auditing

The primary context with which an auditor is concerned is the industry or business of his or her audit client. For example, if you are auditing a computer hardware manufacturer, one of your concerns will be whether your client has

inventories that are not selling quickly and are becoming obsolete due to industry innovation. Such inventory might not be properly valued on the client’s

financial records. If you are auditing a jeweler you will probably not be as worried about obsolescence, but you will be interested in whether the diamonds

and other gems in inventory are valued properly. You may need to hire a qualified gemologist to help you assess the valuation assertion, and you would

want to keep up on the dynamics of the international diamond and gem marketsand the audit, . In other words, the context provided by the client’s business impacts the auditor and the audit, and is thus a primary component

of the environment in which financial statement auditing is conducted.

LO# 2

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A Model of Business

Board of Directors

Audit Committee

Business organizations exist to create value for their stakeholders. Due to the way resources are invested and managed in the modern business

world, a system of corporate governance is necessary, through which managers are overseen and

supervised.

LO# 3

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Corporate Governance

Consists of all of the people, processes, and activities in place to help ensure proper stewardship over an entity’s assets

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A Model of Business Processes: Five Components

Financing Process

Purchasing Process

Human Resource

Management Process

Inventory Management

Process

Revenue Process

LO# 4

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LO# 4

An Overview of Business

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Management AssertionsFinancial statements issued by management contain

explicit and implicit assertions.

Transactions

Management asserts that transactions

related to inventory actually occurred.

Account Balances

Management asserts that the entity owns

the inventory represented in the inventory account.

Presentation & Disclosure

Management asserts that the financial

statements properly classify and present

the inventory.

LO# 5

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LO# 5

Management Assertions

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Auditing Standards Auditing standards serve as

guidelines for and measures of the quality of the auditor’s

performance.

Public Companies

PCAOB

Nonpublic Companies

Auditing Standards

Board

LO# 6, 7

AICPA

SEC

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The 10 Generally Accepted Auditing Standards (GAAS)

GAAS

General Fieldwork Reporting

LO# 6, 7

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General Standards

Adequate Technical Training

& Proficiency

IndependenceDue Professional

Care

LO# 6, 7

Qualifications & Quality of Audit

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Standards of Fieldwork

Adequate Planning & Supervised

Assistants

Obtain Sufficient Appropriate

Evidential Matter

Obtain Sufficient Understanding of Client &

Environment, including Internal Controls

LO# 6, 7

Actual conduct of a audit

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Standards of Reporting

GAAP Consistency

Disclosures Opinion

LO# 6, 7

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GAASLO# 6, 7

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Statements on Auditing Standards (SAS)—

Interpretations of GAAS

GAAS and SAS are considered to be minimum standards of performance for

auditors.

PCAOB adopted, on an interim basis, GAAS and SAS. Standards issued

by PCAOB are called Auditing Standards (AS).

LO# 8, 9

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SAS are classified by two numbering categories: SAS and AU numbers. The SAS number applies to the order in which the standards are issued and are thus chronological. The AU codification organizes

the SAS according to topical content.

LO# 8, 9

Statements on Auditing Standards (SAS)—

Interpretations of GAAS

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For example, SAS No. 39, “Audit Sampling,” is found under AU 350 because the AU 300s relate

to the standards of fieldwork on evidence collection and evaluation.

AU Section Topical Content100s Introduction200s The General Standards300s The Standards of Field Work400s The First, Second, and Third Standards of Reporting500s The Fourth Standard of Reporting600s Other Types of Reports700s Special Topics800s Compliance Auditing900s Special Reports of the Committee on Auditing Procedures

LO# 8, 9

Statements on Auditing Standards (SAS)—

Interpretations of GAAS

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Ethics, Independence, and the Code of Professional

ConductEthics refers to a system or code of conduct based on moral duties and obligations that

indicates how we should behave.

Professionalism refers to the conduct, aims, or qualities that characterize or mark a profession or

professional person. All professions operate under some type of code of ethics or code of

conduct.

LO# 10

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Ethics, Independence, and the Code of Professional

ConductCode of

Professional Conduct

Principles

Rules of Conduct

Interpretations of the Rules

LO# 10

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The Auditor’s Responsibility for Errors, Fraud, and Illegal

Acts The auditor has a responsibility to plan and perform

the audit to obtain reasonable assurance about whether the financial statements are free of material

misstatement, whether caused by error or fraud.

Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain

reasonable, but not absolute, assurance that material

misstatements are detected.

The auditor has no responsibility to plan and

perform the audit to obtain reasonable assurance that

misstatements, whether caused by errors or fraud, that are not material to the financial

statements will be detected.

LO# 11

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Public Accounting Firms

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

staff employees.

Deloitte Ernst & Young

KPMGPricewaterhouse

Coopers

Big 4 Public Accounting Firms

LO# 12

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LO# 12

Audit Teams

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Types of Audit, Attest, and Assurance Services

Internal Control Audits Compliance Audits

Operational Audits Forensic Audits

Audit Services

LO# 13

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Types of Audit, Attest, and Assurance Services

Reporting on Internal Control

Financial Forecasts and Projections

Attest Services

LO# 13

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Types of Audit, Attest, and Assurance Services

Risk Assessment Performance

Measurement

Assurance Services

Information System Reliability & E-Commerce

LO# 13

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Types of Audit, Attest, and Assurance Services

Tax Services Management

Advisory Services

Non-assurance Services

Accounting and Review Services

LO# 13

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Types of Auditors

External Auditors Internal Auditors

Government Auditors

Forensic Auditors

LO# 14

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Organizations That Affect the Public Accounting

ProfessionAmerican Institute of

Certified Public Accountants (AICPA)

Securities and Exchange

Commission (SEC)

Public Company Accounting Oversight

Board (PCAOB)

Financial Accounting Standards Board

(FASB)

LO# 15

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End of Chapter 2