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&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&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(www.gomery.ca)in 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 Moreon Auditing Financialdecisionmakersusuallyobtaintheiraccountinginformationfromcompanies wanting loans or selling stock. This is a potential conflict of interest, a condition that leads tosociety'sdemand forauditservices.Usersneedmore than just information;theyneed reliable,error-free information. Preparers and issuers (directors, managers,accountants, and 6PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities others employed in abusiness) might benefit from giving false,misleading, or overly opti-misticinformation.The potentialconflictisrealenoughtogenerateanaturalskepticism on the part of users. Thus, users depend on external professional auditors to serve as objec-tiveintermediariesandtolendsomecredibilitytofinancialinformation.This''lendingof credibility" is also known as providing assurance, and external auditing of financial state-mentsisdescribedasan assurance engagement. Auditingdoesnotincludefinancialreportproduction.Thatfunctionisperformedbya company'saccountantsunder thedirectionof management.Auditorsdeterminewhetherthe information in the financial statements is reliable, and they communicate this conclusion to the users by reporting that the company's presentation of financial position.results of operations, andcashflowsstatementareinaccordancewithGAAP,orsomeotherdisclosedbasisof accounting. Tiris is the assurance provided by the assurance function,as it relates to the tradi-tionalfinancialstatements. Assurancealways requiresthree-partyaccountability,asdiscussed previously.Thachieve three-partyaccountability,auditorsmust not beinvolved in production of the information audited.Such external auditors can provide a range of services in addition toaudits,causing them to be referred to frequentlyas public accounting (PA) firms. External auditors work for clients. Aclient is the person (company, board of directors, agency, or some other person or group) who retains the auditor and pays the fee.In finan-cial statement audits, the client and the auditee are usually the same economic entity. The auditee is the company or entity whose financial statements are being audited. Occasionally, the client and the auditee are different entities. For example, if Conglomerate Corporation hiresandpaystheauditorstoauditNewtekCompanyinconnectionwithaproposed acquisition,Conglomerate isthe client and Newtek is theauditee. As explained previously, reliable financial information helps make capital markets effi-cient and helpspeople understand the consequencesof awidevarietyof economicdeci-sions.Externalauditorspracticingtheassurancefunctionarenot,however,theonly auditorsatworkintheeconomy.Bankexaminers,CanadaRevenueAgencyauditors, provincialregulatoryagencyauditors(e.g.,auditorswithaprovince'sCommissionerof Insurance), internal auditors employed by a company, and the Office of the Auditor General of Canada (or aprovincialequivalent) all practise auditing in one formor another.There are manyacronymsassociatedwith various auditingassociations and auditors.The acro-nymsare part of the jargon of theprofession. Professionaljudgmentisawidelyusedconceptinaccountingandauditing.Itis definedinCAS200as"the application of relevanttraining,knowledge,andexperience, withinthecontextprovidedbyauditing,accounting,andethicalstandards,inmaking informed decisionsabout thecoursesof actionthatare appropriateinthecircumstances of the audit engagement." Professional judgment includes consideration of keyprinciples andconceptsofdisciplinesunderlyingtheprofessionalstandards,suchaseconomics, psychology, law,finance,statistics, philosophy, and other socialsciences. This integration of diverse areas helps explain why auniversity education is now required of external audi-tors.Specialized concepts and language integrate the disciplines in order to provide appro-priate justification forauditdecisions.Werefer tothebasicconceptsandprinciplesof justificationascritical thinking.Criticalthinkingconceptsarecoveredin someof the more difficult exercises throughout the book, and aspects of it are applied in cases analyzed at theend of most chapters. RE VIE W2What isauditing? What conditioncreatesdemand for auditsof financialreports? CHECK P 0I NT S3What is the differencebetween aclientand anauditee? What are the three partiesin three-partyaccountability? 4What isthe difference between auditingand accounting? 5Whatconditionscreatedemandforfinancialreports,andwhoproducesfinancial reports for external users? CHAPTER1Introduction to Auditing7 DEFINITIONSOFAUDITING Definitionsof Auditing In1971,theAmericanAccountingAssociation(AAA)CommitteeonBasicAuditing Concepts prepared acomprehensivedefinition of auditingasfollows: Auditing isasystematic processof objectively obtainingand evaluatingevidenceregarding assertionsabouteconomicactionsandeventstoascertainthedegreeof correspondence betweentheassertionsandestablished criteriaandcommunicatingtheresultstointerested users. Thisdefinitioncontainsseveral ideasimportantin awidevarietyof audit practices.The firstand most important concept is theperception of auditing asasystematic process that ispurposeful,logical,andbasedonthedisciplineof astructuredapproachtodecision making. Auditing is not haphazard,unplanned,or unstructured. Theauditprocess,accordingtothisdefinition,involvesobtainingandevaluatingevi-denceconsistingof alltheinfluencesthatultimatelyguideauditors'decisions,andit relates to assertions about economic actions and events. When beginning an audit engage-ment,an externalauditor receivesfinancialstatementsand otherdisclosuresby manage-mentthataremanagement'sassertionsabouteconomicactionsandevents(assets, liabilities,revenues,expenses).Evidence is then gathered toeithersubstantiate or contra-dict these management assertions. External auditors generally begin work with explicit representations from management-assertionsof financialstatementnumbersandinformationdisclosedinthenotestothe financial statements. When these assertions are made explicit in writing by the accountable party (the asserter), the resultingaudit engagement is referred to asan attest engagement. Financialstatementsareanexampleof writtenassertions,andthustheauditof financial statements isan attest engagement.Not allauditorsare provided with such explicit represen-tations.An internalauditor,forexample,may be assignedtoevaluatethe cost-effectiveness of the company'spolicytoleaseratherthan purchaseequipment.Agovernmentalauditor maybeassignedtodeterminewhetherthegoalof creatinganenvironmentalprotection agencyhas beenmet by theagency'sactivities.Often,theselatter typesof auditorsmust developthe explicit standardsof performance forthemselves.Thistypeof engagement is called direct reporting. Thepwposeof obtainingandevaluatingevidenceistodeterminethedegreeof cor-respondencebetweentheassertionsandtheestablishedcriteria.Thefindingswillulti-matelybecommunicatedtointerestedusers.Tocommunicateinanefficientand understandable manner, there must be a common basis, or established criteria, for measur-ing and describing financialinformation. Theseestablished criteria appear in avariety of sources.For external auditors, government auditors,and Canada Revenue Agency inspec-tors,thecriterialargelyconsistof theGAAP.CanadaRevenueAgencyinspectorsalso relyheavilyoncriteriaspecifiedinfederaltaxacts.Governmentauditorsmayrelyon criteria established in legislation or regulatory agency rules.Bank examinersand provin-cial insurance board auditors look to definitionsand rules of law.Internal and governmen-tal auditors rely extensively on financial and managerial models of efficiency and economy, aswellasonGAAP.Allauditorsrelytosomeextenton theelusivecriteriaof general truth and fairness. Exhibit1-2 (page 8) depictsan overviewof financialstatement auditing. Audit Objectiveand the Auditor'sReport The AAAdefinitionof accountingisbroadandgeneralenoughtoencompassexternal, internal,and governmental auditing.The Canadian Institute of Chartered Accountants (CICA) sets forththe main objectiveof afinancialauditasfollows: 8 EXHIBIT1-2 PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities OVERVIEWOFFINANCIAL STATEMENTAUDITING Objective outsider Assertions about economic adions and evenls Footnotes Balance sheet Oblainsand evaluates evidence Knowledge of clienYs business, observation of physical assels, enquiry Ascerlains degree of correspondence Of managers, confirmations from oulsiders, inspection/ of documents Generally accepted accountingprinciples The objective of the audit of financialstatements is to enable the auditor to express an opin-ion whether the financial statements are prepared, in all material respects, in accordancewith an applicable financialreportingframework.2 The CICA statement of objective restricts auditing interest to external auditors'audit of the traditionalfinancialstatementsandaccompanyingnotes.However,astheneedsofusers change, new audit objectives and reportsare created to meet them. Thus, the CICA Handbook alsooffersguidanceon suchdivergenttopicsasreportingon controlproceduresat service organizations,solvencyissues,and examiningafinancialforecastin aprospectus.Aset of evolving"assurancestandards''(presented in Chapter2)providesaframeworkgoverninga wide range of assurance services, including audit services. These expanding standards indicate a corresponding demand for new types of audits and an expanded social role for auditing. This isconsistent with an evolving audit society. Historically, the demand for an expanded role for auditinghas grown faster than standard setters'ability tomeet these public expectations. As a result,an expectations gap has developed between what the public expects of auditorsand what auditors can actually deliver.For example, historically,the public has expected auditors to take on more responsibility for ftaud detection than the standards required. The auditor'sopinion on financialstatements isexpressed in thelast paragraphof the audit report. Astandard report is shown in Exhibit 1-3. (Chapter 3 explains this and other audit reports in moredetail.) In this book, we refer to aCanadian Audit Standard as CAS. Unless otherwise indicated, theequivalentInternationalStandardonAuditing(ISA)isthesamenumberastheCAS number.For example,CAS700and ISA 700 refer tothesamestandard,except forsome minor variations explained later. We refer to each CAS by the number associated with it,and givethe equivalent,originalCICAHandbook Recommendation nwnber in parentheses.For example,CAS700 isthe equivalent of the original Recommendation 5400sowe present it asCAS 700 (5400). 2 Canadian Audit Standard(CASI200, General Objective of theIndependent Auditor. TheCanadian Audit Standards oftheCICAHandbookoretheauthoritativeCICApronouncemenbonauditingtheoryandpractice. EXHIBIT1-3 LEARNINGOBJECTIVE 0Explain the role of audit-ingininformationrisk reduction. CHAPTER1Introduction to Auditing9 INDEPENDENTAUDITOR'SREPORT Tothe Shareholdersof............. Report ontheFinancialStotements Wehaveauditedtheaccompanyingfinancialstatementsof ABCCompany,whichcomprisethebalance sheetasatDecember3 1,20X 1,andtheincomestatement,statementof changesinequityandcash Rowsstatementfortheyearthenended,andasummaryof significantaccountingpoliciesandother explanatorynotes. Management'sResponsibilityFortheFinancialStatements Management isresponsiblefor the preparation and fair presentation of thesefinancial statements inaccordance withCanadiangenerallyacceptedaccountingprinciples;thisincludesthedesign,implementation, andmaintenanceof internal controlrelevanttothepreparationandfairpresentationof financialstatements thatarefreefrommaterialmisstatement,whetherduetofraudor error. Auditor'sResponsibility Our responsibilityistoexpressanopiniononthesefinancialstatementsbased onour audit.Weconducted ourauditinaccordancewithCanadiangenerallyacceptedauditingstandards.Thosestandardsrequire thatwecomply withethicalrequirementsandplanandperformtheaudittoobtainreasonableassurance whetherthefinancialstatementsarefreefrommaterialmisstatement. Anauditinvolvesperformingprocedurestoobtainauditevidenceabouttheamountsanddisclosuresinthe financialstatements.TheproCeduresselecteddependontheauditor'siudgment,includingtheassessmentof therisksof materialmisstatement of thefinancialstatements,whether duetofraudor error.Inmakingthoserisk assessments,theauditorconsidersinternalcontrolrelevanttotheentity'spreparationandfairpresentationof thefinancialstatementsinordertodesignauditproceduresthatoreappropriateinthecircumstances,butnot forthepurposeof expressinganopinionontheeHectivenessoftheentity'sinternalcontrol.Anauditalso includesevaluatingtheappropriatenessof accountingpoliciesusedandthereasonablenessof accounting estimatesmadebymanagement,aswellasevaluatingtheoverallpresentationof financialstatements. We believethattheauditevidencewe haveobtainedissufficient and appropriatetoprovidea basisfor ourauditopinion. Opinion Inouropinion,thefinancialstatementspresentfairly,inallmaterialrespects,thefinancialpositionof ABC Companyasof December31,20X1,andof itsfinancialperformanceanditscoshflowsfortheyearthen endedinaccordancewithCanadiangenerallyacceptedaccountingprinciples. [Auditor'ssignature] [Dateofauditor'sreport] [Auditor'saddress] Soun:e:11:1 CAS700. ADefinition of Auditing Relating to"Risk Reduction" Although it issometimesdifficulttodistinguishbetweenadefinitionand atheory,most statementsof theory begin with adefinition.The theory that auditing isa"risk-reduction activity"isgaining popularity,and the followingdefinitionsupports thisview: Auditinginfinancialreportingisaprocessof reducing(toasociallyacceptablelevel)the information risk to usersof financialstatements. Economicactivitytakesplace in anatmosphereof businessrisk.Businessrisksresult from significant conditions, events, circumstances,or actions that might adversely affect the entity'sabilitytoachieve itsobjectivesand execute itsstrategies. Auditorsdonotdirectly influence acompany's business risk,but they are responsible for ensuring proper disclosure of these risks by the auditee in the financialstatements. As the business world becomes more complex, auditors are finding that they must increasingly focus on understanding the client's business risks in order to judge whether the financialstatementsreflect them properly.It is emphasized in auditingthat risk isan important part of economic substance that should be reflected in financialreporting. Agood illustration of the effects of business risks related to the economic crisis that began in 2008 is given in the box on page10. 10PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities ACCOUNTINGBLAMEDFORGLOBALCREDITCRISIS WallStreet executivesand lobbyistssaytheyknowwhathelpedpushthenation's largest financial institutions over the edge in recent months.The culprit, theysay, is accounting. Companies including American International Group Inc., the insurer that accepted $85billionin aU.S.takeover,have said the rule by theU.S.Financial Accounting Standards Board requires them to record losses they don't expect to incur.Financial servicecompanies have reported morethan$520billioninwrite-downsandcredit lossessince last year.Supportersof therulesaycompaniesseekingthe exemption arecitingfairvalueas away to cover theirpoor performance. Fair value"isanaccountingissuethat'stooimportant to be left just toaccoun-tants;formerSECChairmanHarveyPittsaidinaninterviewtoday.Economists, academics and regulators from outside FASB, in addition toaccountants,should be involved in consideringanew approach tofairvalue,he said. "Whatthebanksaretellingeveryoneisthattheaccountinghascausedthe problem,"formerSECchief accountantLynnTurnersaid."Theonlythingfair-value accountingdid is forceyou to tellinvestorsyou madeabunchof very bad loans." "...Thebankinglobbyisalsoconfusingtheroleof accounts.Theseshould simplybeatrueandfairrecordofmanagement'sstewardshipof thebusiness. How the owners, regulators,and tax authorities that read accounts choose to inter-pret them is their choice. Complaining about what the accountsshow, when we're talkingaboutasystemsupportedbysuchusersofaccountsasinvestorsand regulators,isakintoblamingatorchforshiningalightonthemessinyour cupboard." As an example of recent accounting challenges, analysts cite Merrill Lynch'ssale of $30.6 billion of collateralized debt obligations, or pools of mortgage-linked assets, to the investment company Lone Star Funds foronly 22 centson the dollar in July. JessicaOppenheim,aspokeswomanforMerrill,whichthismonthagreedtobe purchased by Bank of America,declined tocomment. Advocatesforleadingfinancialinstitutions,includingtheFinancialServices Roundtableand the American Bankers Association,have been raising the issue with governmentofficialsin WashingtonandNew Yorkformonths.ArizonaSen.John McCain, the GOP presidential candidate, mentioned fair-value accounting as a prob-lem in arecentstumpspeech. Lobbyists have been seeking temporary relief from the accounting measure, which theysayestablishesbargain-basementpricesforassetsthatwouldbevaluedfar higherduringmorenormal tradingconditions.Theeventsof last week raised fresh concernsamongindustryexecutiveswhofearthatinvestmentssoldtothegovern-mentaspart of the $700billion bailout plan willset abargain-basement precedent forthe rest of the market. Banksalsohave been fightingtheirauditors,someof whichhavereasoned that downmarket conditions have persisted for so long that assetsare no longer ''tempo-rarilyimpaired"but nowrequirewrite-downsand capitalinfusions.Bankingtrade association officials are scheduled to meet withSEC regulators this week to discuss theissue,which could prompt some bankstoattract new capital tomeet regulatory requirements. ''Theaccountingrulesandtheirimplicationshave madethiscrisismuch,much worse than it needed to be,"said Ed Ymgling,president of the bankers'association. "Instead of measuring the flame,they'repouringfuelon the fire!' SOUlCe:Excerpts fromWashingtonPost,Sept. 23, 2008:DOl(Cm:ie Johnson);Bloomberg.com, Ian Katz,Sept.23, 2008; and jennifer.hughes@ft.com,www.ft.com/accountancy, The FiMncial TunesLimited,2008. CHAPTER1Introduction to Auditing11 Infonnation risk refers tothe possible failureof financialstatements to appropriately refiect theeconomicsubstance of businessactivities, including risksand uncertainties.It thusincludesfailureto properly disclose businessrisk.For example,if acompany fails todisclosethatit planstofileforbankruptcy,the riskof bankruptcy isabusinessrisk, and failuretodisclose it isaninformationrisk.Notethat informationriskisinfluenced by theevidenceof bankruptcygathered bytheauditorand bythe rules(i.e.,GAAP) for appropriately disclosingthis. Information risk from the auditor's perspective is the risk (probability) that the financial statements distributed by acompany will be materially false and misleading.Materiality, as used in auditing, means the same thing as it does in your accounting courses. Basically, amaterial misstatement isone that would affect user decision making. Financial analysts and investors depend on financialreports for stock purchase and sale decisions; creditors (suppliers, banks, and so on) use them to decide whether to give trade credit and bank loans; labour organizations use them to help determine acompany'sabil-ity to pay wages; and government agencies and Parliament use them in preparing analyses of the economy and making laws concerning taxes, subsidies, and the like. All these users cannot determine whether financial reports are reliable and, therefore, low on the informa-tionriskscale.Theydonot havetheexpertise,resources,or timetoenterthousandsof companiestosatisfythemselvesabout theveracityof financial reports.Auditorsassume thesocial roleof attesting to published financialinformation,offering usersthe valuable service of assurancethatthe information risk is low.This role of auditorshas been insti-tutionalized through laws and regulations. It isimportanttobe awarethat,fromtheauditor'sperspective,therearetwomajor categoriesof information risk.One istherisk of insufficient evidencebeinggathered on the factsconcerning the client's (auditee's) economic circumstances. This is referred toasauditrisk.Theothercategoryistheriskthaterrorsassociatedwithforecasts used in GAAP accounting estimates are not properlydisclosed. We refer to thissecond category of information riskasaccounting risk. Forecastsareadistinguishingfeature ofGAAPandarewhatseparateGAAPaccountingfromcashbasisaccounting. Accounting risk is primarily the responsibility of accountingstandards.However, while the term audit risk isakey part of auditingstandards,accounting risk isdealt with only indirectlyinaccountingstandards.Youlikelydidnotencountertheaccountingrisk concept inyourfinancialaccountingcoursesbecauseaccountingtheoryisnotasrisk oriented as auditing theory currently is. This makes controlling information risk in finan-cial reportingamajorchallengeforauditors.The accounting risk concept usedinthis book addressesthischallenge. The risk-reduction definitionmay appear verygeneral.As your studyof auditingcon-tinues,you will find that the primary objective of many auditing tasks is reducing the risk of givinganinappropriateopinion on financialstatements. Auditorsarecarefultowork fortrustworthyclients,togatherandanalyzeevidenceabout thedatain financialstate-ments, and totake steps to ensure audit personnel report properly on the statements when adverseinformationisknown.Subsequentchapterswillhavemoretosayaboutthese activities.We begin the processwith the Application Caseand Analysisdiscussion at the end of thischapter. RE VIE W6What would you say if asked byananthropologymajor,"What doauditors do?" CH E CK P 0I N T S7What is the essence of the risk-reductiondefinition of auditing? 12PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities THECURRENTENVIRONMENTOFAUDITING LEARNINGOBJECTIVE 0Describethecurrent audit environment, includ-ing regu1atmy oversight. The audit environment has undergone profound changes as a result of spectacular corporate failures,suchas Enronand WorldCom,startingin 2001.Thisprocessof rapidchange is continuing with the economic crisis of 2008/2009. The integrity of capital markets is being questioned all over theworld.WorldCom's failure in 2002 led tothepassage of themost drastic legislation affecting the accounting profession since 1933. This section briefly sum-marizesthese changes in the current audit environment.Later chapters explain the signifi-canceof thesechangesinmoredetail,and AppendixlBonthetext'sOnlineLearning Centre providesabrief overviewof the history of the profession leading up to them. TheSarbanes-Oxley Act OnJuly30,2002,PresidentBushsignedtheSarbanes-OxleyAct (SOX)intolaw.This legislation began its progress through Congressafter the fall of Enron, and the WorldCom failurecatalyzedthelegislativeprocessandguaranteedquickpassageandapprovalby Bush.Forauditorsof publiccompanies,SOXcreatedafive-memberPublicCompany AccountingOversight Board (PCAOB)with the authoritytotighten qualitycontrolof audit practices and report on the resultsof inspections of audit firm practices.Key features of SOX include the following: increased oversight of auditors, includingauditstandardsetting by PCAOB increased penaltiesfor corporate wrongdoers moretimelyand extensive financialdisclosures moretimelyand extensive disclosure on the waythe firm isgoverned new options of recourse for aggrieved shareholders, including increased legal liability forauditors Canadian companieslisted on the Americanstock exchanges,aswellastheir auditors, aresubject tothese SOX rules.SOX and the financialdisastersthat preceded it havehad a huge impact on corporate governanceand the regulation of accounting and auditingaround theworld.For example,inCanada,theCICAhelpedorganizethecreationof itsown Canadian Public AccountabilityBoard (CPAB) tooversee theauditorsof publiccom-panies. The CPAB also tightens quality control of audit practice and reports on inspections of audit firm practices.In addition,several of Canada's largest pension and mutual funds bandedtogether in 2002toformtheCanadianCoalitionforGoodGovernance.This organizationcontrols$400billioninassetsandmonitorsexecutives,auditcommittees, auditors,and boards of directorsin corporate Canada for compliance with what they con-sidergoodcorporategovernanceandfinancialreportingpractices.However,in Canada, for thetimebeingat least, theprofessioncontinuestobe self-regulating.ThroughSOX, in the United States,theprofession ismore constrained under the PCAOB. The PCAOB'scompositionwasfinalizedin April2003.Itsfirstactionsincludedthe following:(1)conductingan inspectionof theBig Four accounting firms,(2)creatinga registrysystemforPAfirms,(3)conductingareviewof existingauditstandards,and, mostimportantly,(4)takingonthetaskof settingfutureauditstandardsintheUnited States.Thelastactionisnoteworthyasit representsthefirsttimeAmericanauditing standards are not set by its professional institute, the American Institute of Certified Public Accountants (AICPA). The AICPA,however,stillsetsaudit standardsfor non-publiccom-panieswhose sharesare not traded on the stock markets. The corporate failures,thefallof Arthur Andersen,andthe resultingpassageof SOX dramaticallychanged thecorporateenvironment.Werefertothischangedworldasthe post-Enron world.The PCAOB'sactions reflect the dramatically increased regulation of the profession. The Canadian, American, and other accountability boards around the world will likely make this second-guessing of professional judgment afixtureof the post-Enron CHAPTER1Introduction to Auditing13 world. That world is now more complicated for auditors and the profession, and the impli-cations will become more clear asit unfolds.However,auditingwill likely become more importanttoaccountingfirmsandtosociety.Specificeffectsevident through2009are included in thistext. Until2002, the accounting profession was largely self-regulating.By self-regulation we mean the profession itself established the rulesgoverning audit practice and monitored com-pliance with them.This reliance on self-regulation changed with the perceived failureof the profession to detect the problems leading to the corporate scandals of 2002/2003. The crucial role of auditingin well-functioning capital marketsbecame clear as never before. But thisincreased attention came at aprice:the extensive impact on the marketsof the profession'sperceived failuresmeansit isnolonger acceptabletoleavemonitoringof the profession totheprofessionalsthemselves.Thestockmarkets hit multi-year lowsin 2002, coinciding with WorldCom's bankruptcy and resultant speedy passage of the SOX legislation with its increased external monitoring and control of the profession. The monitoring process now involvesgroups representing the broader public interest as well as the government, but theexactmixof monitorsdependsonthecountry.Sincemostof thecorporatefailures prompting the changestook place in the United States, America tends to lead in promoting new waysof providing oversight of auditors,and the instrument of the changesisSOX. SOX's impact can be seen throughout the world. but it also had consequences for broader areas of corporate activities.Following isaquick overview of its main impact on auditors: management certification of all its publiclyissued financialinformation evaluationof internal control in statements made by management closer regulation of the profession,including regular monitoring of its activities greater responsibilitiesassigned toclient auditcommittees increased importance of the role of the internalauditor Intemal control statements deal with the reliabilityof the system or processthat creates the financial statements.3 Audit committees monitor management's financial reporting respon-sibilities,includingmeetingwiththeexternalauditorsanddealingwithvariousauditand accounting matters that may arise duringan audit Wewill discuss audit committees and the evolving concept of internal controlin much greater detail throughout the restof this text. Perhaps the most important result of SOX for the auditor has been the increased moni-toringof theprofession,intheformof accountabilityboards.Theboardin Canadahas authority and responsibilities that are quite different from those of its American counterpart, as the legalsystemsand politicalinstitutionsof the two countries are quite different. In the United States,the PCAOBhas nationwide legislative backing for its monitoring and enforcement activities.PCAOBhasfinalauthority on auditing,ethical,and indepen-dence standards,aswell as on the quality control criteria that will be used to monitor the profession.Detailed monitoring reports identifying specific audit firmsare available to the publicat www. pcaob.orglinspection. In Canada,ontheother hand.theCPABdoesnot havelegislative backing.Thismeans that if an accounting firm claims the legal privilege of client confidentiality, the CPAB cannot reviewthoseclient documents.ThisconstrainstheCPAB 's monitoringactivities.Also,the CPABis directly funded by the audit firms,leading to questionsabout its independence from the profession itself. In contrast, the PCAOB is directly funded by the Securities and Exchange Commission (SEC).Finally,the CPABusesthe profession'sauditing,ethics,independence, andqualitycontrolstandardsinperformingitsmonitoring.However,like the PCAOB,the CPABissues reportson its monitoringthat are made public at www.cpab-ccrc.org. The firsttwo consequencesof SOX identified above relate to management'sincreased responsibilityforfinancialreportingandtherequirementofanexternalauditof management's internal control statement. Management's certification of financial reporting 3 We deviate fromofficialtenninology by always referring to reports as auditor-prepared andstalements as management-preparedcammunicatians_ 14 REVIEW CHECKPOINTS PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities meansthat it muststate in writing that it isnot aware of anyfactualerrorsor omissions of factsthatwouldmakethefinancialand internalcontrolstatementsmisleading.These areallbestsummarizedasattemptstostrengthenthesystemof corporategovernance. Corporate governance describes how well a company is run in the interests of sharehold-ersandotherstakeholders.Corporate governance principlesare covered in Appendix 7F. Audit committeesandinternalauditingare alsocovered in moredetail later. Canadianregulations,especiallythoseinOntario,havebeeninfluencedbytheSOX requirements. There is now greater emphasis on more timely disclosuresof material infor-mationandmoredisclosureofcorporategovernancepractices.Managementisnow required to disclose its conclusions about theeffectiveness of internal control in theman-agementdiscussionandanalysis(MD&A)sectionof theannualreport.InCanadait is not required that this disclosure on internal control be audited. In contrast, the SEC requires auditsof internalcontroldisclosuresbyregistrantcompanies.InOntario,theToronto Stock Exchange(TSX)companiesdo not needto followbest corporate governanceprac-tices, but failure to do so by the largest companies must be disclosed. The Ontario Securities Commission (OSC)specifiesthe dutiesandauthority of audit committees,including pro-vidinga definitionof independenceof its members. 8Whatismeantbyself-regulation?Howisself-regulationfortheprofessionbeing affected in thepost-Enron environment? 9What are thedifferences between Canadian and U.S.accountability boards? Compare thedifferencesin their monitoringreports.Which ones do you think arebetter? OTHERKINDSOFAUDITSANDAUDITORS LEARNINGOBJECTIVE 0Describetheotherma-jortypesof auditsand auditors. The AAA,theCICA,andtherisk-reductiondefinitionsapplytothefinancialstatement auditpracticeof independentexternalauditorswhopracticeinpublicaccountingfirms. The word audit,however,is usedin other contextstodescribebroader kindsof work.. Thevarietyofauditworkperformedbydifferentkindsof auditorscausesproblems withterminology.Hereafterinthistext,thetermsindependentauditor,externalauditor, chartered accountant (CA), certified general accountant (CGA), and public accountant (PA)refertopeopledoingaudit work withpublicaccountingfirms_In governmental and internal contexts,auditors are identified as governmental auditors, operational auditors, and internalauditors.Whilemanyofthesearecharteredaccountantsorcertifiedgeneral accountants,in this text the initialsPA,CA, and CGA will refer to auditors in public prac-tice_Wewill use the neutraltermPAasmuch aspossible. Internal and Operational Auditing TheInstitute of Internal Auditors(IIA)definesinternal auditinganditspurposeas follows: Internalauditingisan independent,objectiveassuranceand consultingactivitydesignedto addvalue and improvean organization'soperations.It helpsan organization accomplishits objectives by bringingasystematic,disciplined approach to evaluate and improve theeffec-tivenessof risk management, control,and governance processes.4 Internal auditing is practiced by auditorsemployed by organizations suchasbanks,hos-pitals,citygovernments,or industrial companies.Some internalauditingactivityisknown asoperational auditing.Operationalauditing(alsoknownasperformance auditing and management auditing) is the study of business operations in order to make recommendations 4 www.theiia.org. CHAPTER1Introduction to Auditing15 about the economic and efficient use of resources,effective achievement of businessobjec-tives,andcompliancewith companypolicies.Thegoalof operationalauditingistohelp managersdischarge their management responsibilitiesand improve profitability. Internalandoperationalauditorsalsoperformauditsof financialreportsforinternal use,much as external auditors audit financial statements distributed to outside users. Thus, some internalauditingwork issimilar totheauditingdescribed elsewhere in thistext.In addition,the expanded-scope services provided by internal auditors include (1) reviews of controlsystemsforensuringcompliancewithcompanypolicies,plans,procedures,and lawsandregulations;(2)appraisalsof theeconomyandefficiencyof operations;and (3)reviews of program resultsin comparison with their objectives and goals. Internalauditorsneed to be independent of the organization's line managers,much like theexternalauditorsneed to be independentof thecompanymanagement.Independence helps internal auditors be objective and achieve three-party accountability. Asnoted earlier, youasauser of auditedinformationexpect theauditortobe unbiasedandimpartial,as well ascompetent, in verifying the accuracy of the information you rely on in making your decision.Internalauditors can recommend correction of poor business decisionsand prac-tices,and they can praise good decisions and practices. If they were responsible for making the decisions or carrying out the practices themselves,they would hardly be credible in the eyes of upper-managementofficerstheyreportto.Consequently,theidealarrangement is to have internal auditors whose only responsibilities are to audit and report to a higher level in the organization, such as a financialvice-president and the audit committee of the board of directors.This arrangement offersan independence that enhances the appraisal function (internalaudit)withinacompany.Internalauditcanbeanimportantaspectofauditee internal controls astheymonitorauditeeoperationsyearround.When such internalinde-pendence exists, external auditors may also be able to rely quite a bit on internal audit work as a valuable source for evidence. In the SOX world, internal auditor reports to independent audit committeesare increasingly viewed asindispensable for good corporate governance. In addition,in theSOXworld, if an externalauditor performsinternalauditfunctionshe or she is deemed to be insufficiently independent andprohibited from auditing for external reporting. Again,thishelpspreserve external auditor independence. PublicSector(Governmental)Auditing The Office of the Auditor General of Canada (OAG)is an accounting, auditing, and inves-tigating agency of Parliament, headed by the Auditor General.In one sense, OAG auditors are the highest level of internal auditors for the federalgovernment.Many provinces have audit agencies similar to the OAG answering to provincial legislatures and performing the same typesof work aswe describe in thissection. In another sense, theOAG and equiv-alent provincialauditorsarereallyexternal auditorswithrespect togovernment agencies theyaudit because theyareorganizationally independent. Many government agencieshave their own internalauditorsand inspectors:for exam-ple,federalministriessuchastheDepartmentof NationalDefenceorCanadaRevenue Agencyandprovincialeducation,welfare,controlleragencies.Well-managed localgov-ernments(cities,regions,townships)alsohave internalauditstaff. Activitiesof all levels of government are frequentlyreferredtoasthepublic sector. Internal and public sector auditors have much in common. The OAG and internal auditors shareelementsof expanded-scopeservices.TheOAG,however,emphasizestheaccount-ability of public officials for the efficient,economical,and effective use of public fundsand other resources. The CICA setsaccounting and auditing standards for all public sector audit engagements, including those of the federal,provincial,and local levelsof government. In thepublicsector,youcanseetheauditfunctionappliedtofinancialreportsanda complianceauditfunctionappliedwithrespecttolawsandregulations.Allgovernment organizations,programs,activities,and functionswerecreated bylawand aresurrounded by regulations governing the things they can and cannot do. For example, in some provinces thereareseriousproblemsof healthcardfraudbyineligiblepersons.Ahospitalcannot simplyprovide freeservices to anyone asthereare regulationsabout eligibility of tourists 16PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities andvisitorsfromother countries. Acomplianceauditof servicesinvolvesastudyof the hospital's proceduresand performance in determining eligibility and treatment of patients. Nationwide,such programs involve millions of peopleand billions of taxpayers'dollars. Also,inthepublicsectoryouseevalue-for-money(VFM)audits,acategorythat includeseconomy,efficiency,andeffectivenessaudits.Government isalwaysconcerned about accountability for taxpayers'resources,and VFM auditsare ameansof improving accountabilityfortheefficientandeconomicaluseof resourcesandtheachievementof program goals.VFM audits,like internalauditors'operationalaudits,involvestudiesof themanagementof governmentorganizations,programs,activities,andfunctions.The followingbox indicatestherange of activitiesthat VFM audits can cover. SOMEEXAMPLESOFRECOMMENDATIONSBASEDON VALUE-FOR-MONEYAUDITSCONDUCTEDBY THEONTARIOOFFICEOFTHEPROVINCIALAUDITOR Healthcare.Stronger efforts are needed in usingavailabledata toidentify pharma-ciesoverchargingtheOntarioDrugBenefitPlan.Ontarioisunpreparedforaflu pandemic despite 44 deathsfrom2003SARScrisis. Archives. Hundreds of historically significant items, including a valuable Group of Seven painting, havegone missing.Inventory control practices need to be strengthened. Education.Ontario university buildings are in need of $1.6 billion in repairs. Capital asset management systemsneed to be enforced. Environment.Monitoringof hazardouswasteshipmenthasbeenlax.Hundredsof tonnesof hazardouswastehavegonemissing.The Ministry'sown standardsneed to be better enforced. Transportation.New driversare more likely to be involved in collisions if theytake theprovince'sbeginningdriver education course than if theydonot.Inappropriate handlingofdrivereducationcertificatesbyunscrupulousdrivingschoolsissus-pected.Systemsandproceduresforassuringthepublic'smoneyisproperlyspent areinadequate. Criminallaw.Severalhundrednamesaremissingfromthesexoffenderregistry. Amendments to legislationareneeded. SOUlCe:'1007annual report by theOfficeof the Provincial Auditor of Ontarioassummarized by the authms. Comprehensivegovernmentalauditinginvolvesfinancialstatementauditing, compliance auditing,and VFM auditing.It goes beyond an audit of financialreportsand compliancewithlawsandregulationstoincludeeconomy,efficiency,andeffectiveness audits.The public sector standard on the elements of comprehensive auditing issimilar to theinternalauditors'view.Publicsectorstandardsdonotrequireallengagementsto includeall typesof audits.Thescopeof thework issupposed to be determinedby the needsof thosewhouse the audit results. Regulatory Auditors For the sake of clarity, other kinds of auditors deserve separate mention. You probably are awareof taxauditorsemployed by the Canada Revenue Agency.Theseauditorstake the "economicassertions" of taxable income madeby taxpayers in their tax returns and audit thesereturnstodeterminetheircorrespondencewith thestandardsfoundintheIncome TaxAct.Theyalsoaudit forfraudandtaxevasion.Their reportscaneitherclearatax-payer's return or claim that additionaltaxesare due. CHAPTER1Introduction to Auditing17 Federal and provincial bank examiners audit banks, trust companies, and other financial institutionsfor evidence of solvency and compliance with bankingand other related laws and regulations.In 1985 these examiners as wellas externalauditors made newswith the failuresof two Alberta banks-the firstCanadian bank failuresin over 60 years. Fraud Auditing andForensic Accounting Fraud is an attempt by one party (the fraudster) to deceive someone (the victim)for gain. FraudfallsundertheCriminalCodeandincludesdeceptionbasedonmanipulationof accountingrecordsandfinancialstatements.Recently,auditorresponsibilitiestodetect fraudhavesignificantlyincreased.Financialstatementauditorsarenowresponsiblefor detecting material financial reporting fraud. They can no longer presume that management is honest. The PA needs to look for fraud risk factors.Some firmsare beginning to screen clients before any wrongdoing is even suspected. The screening is done by specialist audi-torswhomaydosensitive interviewsor reviewunusualtransactionsandsuspiciouscir-cumstances. In anormalaudit theproceduresarediagnostic,notinvestigative.Thisisa distinctionwe will make moreclear later in the text. Fraud auditingisaseparateengagementthatmightbedoneonbehalfof theaudit committee-aspecialin-depthinvestigationof suspectedfraudbythosewithspecialized training, and often involving aspecialist auditor.It is a proactive approach to detecting finan-cial statement deceptionusingaccountingrecordsand information,analyticalrelations,and awareness of fraudperpetration and concealment in developinginvestigative procedures. Fraud auditing and forensic accountingare huge growth areas for PA firms in the post-Enronworld.Themainreasonforthisisthatwhite-collarcrimeisoneof thefastest-growing areasof crime,and policeand regulatorsneed the expertiseof auditorstocarry out these investigations. But there are other factors,and these relate to the broader category of forensicaccounting.Forensic accounting includes fraudauditingandusesaccounting and/orauditingskillsininvestigationsinvolvinglegalissues.Thelegalissuesmightbe criminal (e.g., fraud)or civil (e.g.,commercial disputes).Common examples of civil legal disputes are insurance claims for business losses of various types and valuation of spousal business assetsin adivorce proceeding. Twospecialistdesignationsareavailable for investigative engagements.One forCAsis referredtoasCA-IFAforinvestigativeandforensicaccounting.Seethewebsiteat www.rotman.utoronto.ca/difa for details.There is alsoan older associationof certified fraud examiners(CFEs)providingtrainingforan internationally recognizeddesignationthatdoes not require any other accounting designation.See itswebsite at www.cfenet.com for details. SomepeoplefeelallPAsshouldtakemoreresponsibilitytodetectfraud,especially financialstatement fraud,andthatthismaybethemainreasonfortheexistenceof the profession. The controversies generated by the economic crisis of 2008/2009 may strengthen thisperspective.Appendix1Con theOnline LearningCentrediscussesthisincreasingly influential viewin more detail. Chapter 17 also givesmore details on forensicaccounting and fraudauditing. REVIE W10Distinguish between forensicaccountingand fraudauditing. C H E CK P 0I N T S11What isfraud? 12What isoperational auditing? Howdoesthe CICA view operationalauditing? 13What arethe elementsof comprehensive auditing? 14What iscomplianceauditing? 15Name some other types of auditors in addition to external, internal,and governmental auditors. 16Are financialstatementauditsintended tofindfraud? 18PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities PUBLICACCOUNTING The Accounting Profession Thereare professionalaccountingassociationsat thenationalandinternational levels. Forexample,inCanada,therearetheCanadianInstituteof CharteredAccountants (CICA),theCertified General Accountants Association of Canada (CGA-Canada),and the Society of Management Accountants of Canada (SMAC). Internationally, there is the International Federation of Accountants (IFAC),and in the United States there isthe American Institute of Certified Public Accountants(AICPA),whose members arereferred toas CertifiedPublic Accountantsor CPAs. Within asingle country there may be anumber of professional designationsrepresent-ingauditors.Forexample,inCanadatherearetheprovincialInstituteof Chartered Accountants(knowninQuebecastheOrderof Chartered Accountantsof Quebec),the CertifiedGeneralAccountantsAssociations,theSocietiesof ManagementAccountants, and theInstitute of Internal Auditors.Eachof these organizations hasdeveloped itsown professionaldesignationasfollows:CharteredAccountants(CAs),CertifiedGeneral Accountants(CGAs),CertifiedManagementAccountants(CMAs),CertifiedInternal Auditors(CIAs),andCertified Fraud Examiners(CFEs).The requirementsforobtaining thesevariousdesignations varygreatly,soit isbest toconsulteach organization forthe details.Alistof websiteswitheducationandcertificationrequirementsisprovidedin AppendixlA on theOnlineLearning Centre. Each designation hasits distinguishing features:CAs are oriented to providing auditing and related publicaccountingservicesfor largecompanies,CMAs primarilyaim to pro-videprivate management and internalaccountingservices,CIAsprovide private internal auditservices to larger organizations,and CGAsaimtoprovidealltypesof services.In virtually all provinces, CGAs can be public accountants like CAs, but they tend to service smaller audit clients. There is considerable overlap among all these accounting profession-als.Theyallprovideaccounting,tax,andmanagementadvisorywork,withCAsand CGAs largely providing these services tothe public while CMAsand CIAs provide these services to their full-timeemployer companies. CGAsandCMAshavepublic practicerightsthroughoutCanada,thereforemakingit appropriatetorefer to public accountantsasPAsrather than CAsin atext about external auditing.AlthoughweusethemoregenerictermPAthroughoutthetext,manyof our illustrationsare based on standardsset by the CICA, as these standards have legalstand-ing in the courts through the various federaland provincial Corporation Acts,and through regulatory policy statements. In addition, when CGAs and CMAs practise public account-ing,their guidesrefer totheCICAHandbookstandards. Public Accounting Firms Manypeoplethinkof publicaccountingintermsof the''big"accountingfirms.Asof 2009,therearefoursuchfirms,oftenreferredtoasthe"BigFour'':Ernst&Young, Deloitte&Touche,KPMG,andPricewaterhouseCoopers.Notwithstandingthispercep-tion,publicaccounting is carriedout in hundredsof practice unitsrangingin size from sole proprietorships (individuals who "hang out ashingle") to international firmsemploy-ingthousandsof professionals.Manystudents look upon publicaccountingas theplace tobeginacareer;theygainintimateknowledgeof many different businessenterprises for the firstthree to ten years,andthen theyselectan industrysegment to pursuetheir interests in. Public accounting experience is an excellent background toalmost any busi-nesscareer. Publicaccountants do business in acompetitive environment.They perform auditser-vices in the public interest, but theyalsoneed to make aliving at it,so theyhave aprofit motivejustlikeotherprofessionals.Thisduality-profitmotiveandprofessional EXHIBIT1-4 CHAPTER1Introduction to Auditing19 responsibility-----createstensionsin theirwork.Asaresultof increasedlitigationagainst them in the1990s,theprofession lobbied forlegislation makingit harder tosueprofes-sionalaccountingfirms.In1995,intheUnitedStates,legislationwaspassedallowing public accounting firmsto take on thelimited liability partnership (LLP) form of orga-nization. The LLP structure,which will be covered in Chapter 5,is nowcommonplace in Canada andaround the world. TheUnitedStatesandCanadawentthroughaneconomicboom in thesecondhalf of the1990s.Thiswasalsoatimeof unprecedentedgrowthinnon-auditservicesfor the public accounting firms.However, by the late1990s, this growth had led to concerns about the independence of audit services provided by accounting firmsthat also engaged in extensive,possibly conflicting, non-auditservices for the same client.Many cite this lackof independenceastheprimarycauseof theprofession'sproblemsinthepost-Boron world. Publicaccounting services involve many PAsemployed in assurance, tax, and consult-ing work.Although structureswill differ,Exhibit1-4 shows theorganization of a typical larger PA firm. Some firms include additional departments, such assmall-business advisory or compensation consulting departments, while others might have different names for their staff and management positions. In Exhibit1-4 yousee thevariousstaffing levels withina PA firm.A recent gradu-atewillmost likelystartworkasastaff accountant.Thistypicalentry-levelposition involvesworkingunderthesupervisionof moreseniorpeople.Asauditorsneedto verifyvirtuallyeverythingtheauditeeclaimsin hisfinancialreporting,thereismuch mundanework to be doneverifying the math and theextensionsof financialdataand reconcilingthephysicalamountswithrecordedamounts.Howdoesauserknowthe balance sheet balances? Someone needs to verify the seemingly obvious, and that some-one is theauditor.One shouldlook upon thisexperienceasaformof apprenticeship. Inmostfirmsyourresponsibilitieswillincreasequicklyonceyoudemonstrateyour reliability. Dependingonthefirm,theremaybeseverallevelsof staff accountants.Individuals who have just passed the professional exams are usually themost senior staff accountants and are ready to be promoted to manager once they've had a fewyears of experience and demonstratedleadershippotential.Leadershipmeanshavingpeoplemanagementskills thataresuccessfulwithbothclientsandstaffaccountants.Technicalskillsaloneare TYPICALORGANIZATIONOFAPAFIRM Taxation Department Accountingand Assurance Department Business Advisory Department ~ ~ ~ ~I ~ i g e lI ~ ~ ~ ~ Senior (in-charge) Accountonls Staff Accountonls ~ ~ ~ ~I ~ ~ ~ e lI ~ ~ ~ ~ Senior (in-charge) Accountants Stoff Accountants 2DPARTIIntroduction to Auditing, Public Practice. and Professional Responsibilities usuallynotsufficientforamanager.Theabilityto expand the firm'spracticebecomes increasingly important Getting along comfortably with client personnel is ahigh priority, as otherwise it is difficult to get the information an auditor needs. These personal dynam-ics become more important at the higher levels in aPA firm.Keepthis context in mind as you read descriptions of the various procedures in subsequent chapters. Managers super-vise most of the detailsof the audit engagement as explained throughout this text.They are the backbone of the audit at the technical level. Partners,workingcloselywithmanagers,takeoverallresponsibilityfor theauditand lead meetings with auditee's management and its audit committee. Partners usually have at least ten years'experienceandare theonlypermanent employeesinaPAfinn.About 5 percent of those with a PA designation become partners,while the rest go into industry or other PAfirms.For more information on these positions, career opportunities,and the latest salary trends for PAs in North America, see the websites at www.mcintyre-smith.com and www.roberthalffinance.com. Assurance Services Audits of traditional financial statements are the most frequent type of assurance services forpubliccompaniesandformostlargeand mediumnonpubliccompanies.Auditing amountsto 20-60 percent of the business of larger PA finns.Most of thistext isabout the audit of traditional financial statements. Accounting and review servicesare the''nonaudit"or other servicesperformed fre-quently for medium andsmall businessesand not-for-profit organizations. Agreat deal of nonaudit work is done by small public accounting practice units.PAs can be associ-ated with clients' financial statements without giving the standard audit report They can perform compilations,which consist of writing up the financialstatementsfromacli-ent'sbooksandrecords,withoutperforminganyevidence-gatheringwork.Theycan performreviews,whicharelesserinscopethanauditsbutincludesomeevidence-gatheringwork.(Compilationandreviewstandardsareexplainedinmoredetailin Chapter 16.) Assurance services are also performed on information in presentationsother than tra-ditional financialstatements. Since assurance is the lending of credibility by an indepen-dent party(assurer,auditor)torepresentationsmadeby onepersonor organizationto another, demand for agreater variety of PAengagements has grown. Public accountants provideassuranceto vote counts(e.g.,for the Academy Awards),todollaramountsof prizes claimed to have been given in lotteryadvertisements,to investmentperformance statistics, and to claims made about the capabilities of computer software programs. These nontraditional services are governed by professional standards. In this text we reference threesets of professionalstandards-Canadian, interna-tional,and, to alesser extent, American-which all influence each other. For exam-ple,theCICA'sAssuranceand AuditingStandardsBoardinfluencesinternational standardsby providingcommentaryonexposuredraftsof newinternationalstan-dards.Onceanewinternationalstandardisadopted,theCICAissuesan exposure draftanyunique-to-Canadamodificationsthatmustbemadebeforetheycanbe incorporatedintotheCICAstandards.Othercountriesfollowsimilarprocesses. Increasingly,thetrend isconvergencetoacommonsetof standards.Forexample, the CICA is to adopt international standards with minor modifications by 2010. These Canadian Auditing Standards (CAS)are the main professionalstandardswe refer to in this text. Convergence is adefiningcharacteristicof thepost-Enronworldand makesit more important to be aware of the similarities, as well as the differences,among the standards. InternationalstandardsreferenceIFAC's International Standards on Auditing(ISAs); American PCAOBstandardsare referenced to its Auditing Standards (AS.s). CHAPTER1Introduction to Auditing21 TaxationServices Local,provincial,national,and internationaltaxlawsareoftencalled"full-employment acts"foraccountantsandlawyers;theyare complex,andPAsperformtaxplanningand tax return preparation services in theareasof income,sales, property,and other taxation. Alargeproportionof smallaccountingfirmworkistaxpractice.Taxlawschangefre-quently,and tax practitioners have to spend considerable time in continuing education and self-study to keep current. Consultingor Management Advisory Services(MAS) All accounting firmshandle agreat deal of consultingand management advisoryservices (somefirmsrefertotheseasmanagementancillaryservices).Thesearethe great "open end"of publicaccountingpracticethatputsaccountantsindirect competitionwiththe non-PA consulting firms.The field is virtually limitless,and no list of consulting activities could possibly include allof them. Indeed, accounting firmshave created consulting units with professionals from other fields-lawyers,actuaries,engineers,and advertising exec-utives, to name a few.Until Enron, many of the large accounting firms had tried to become "one-stopshoppingcentres"forclients'auditing,taxation,andbusinessadviceneeds. However, through the chilling effect of the SOX, these activities have been greatly restricted whenever the engagement includesassuranceservices. Nevertheless, consulting work for nonaudit clients may continue to expand to newnon-conflictingareas,such as eldercare where PAsprovide apackage of servicesranging from assurance to consulting, bill paying, and financial planning for the elderly. In large PA firms, theconsultingdepartmentisquiteoftenindependentfromtheauditingandaccounting departments, performing engagements that do not directly interact with the audits. PA firms aregreatly restricted in the types of consulting or business advisory services they can pro-vide to audit clients,but thereare no such restrictionsfornonaudit clients. REGULATIONOFPUBLICACCOUNTING LEARNINGOBJECTIVE 0Outlinehowpublic accountants(PAs)are regulated. Regulation of publicaccounting in Canada, as with most professionalgroups,isaprovin-cial matter. Most provinces have laws-public accountancy acts-that specify who is allowed to practise public accounting in the province. For example, for many years Ontario'sPublic Accounting Act licensed only CAs to performassuranceengagements.However,aspart of the post-Enron reform process,thislegislation wasamended in 2004 to allowanyaccount-ingorganizationmeetingthe Public AccountantsCouncil(PAC)of Ontario'seducational and experience standards to perform what they describe as public accounting functionsthat meetthepublicinterest.(Seetheirwebsiteatwww.pacont.orgformoredetailsontheir activitiesand requirements.)For PAC,thepublic interest iseffectivelyrepresentedbythe third-partyusersof thefinancialstatements.These reformswerelinked tothe creation of the new Accountability Board (CPAB), which provides oversight for all PAs in the province. Similar regulatoryreformsare evolvingin other provinces. In recent years,the trend in provincial public accountancy legislation has been to open public accounting to CGAs and CMAs, as well as CAs. The goal is to increase accessibil-itytoreasonablypricedpublicaccountingserviceswhilemaintainingstandards.Public interests,particularly those of vulnerable third parties, must be protected.Quality control standardsandCPABmonitoringimplementedinrecentyearstoensurethisarefurther explained in Chapter 2. In additiontothesystemof regulation outlined previously,other factorsgreatlyinflu-ence the profession.These include thelegalsystem the profession operates in (discussed in Chapter 5)and theimpactof regulatorson practisingauditors.Regulatorsinclude,at the federal level, the Superintendent of FinancialInstitutions,whose prime responsibility is regulating the financialservices industry under the jurisdiction of the Federal Bank Act. 22PARTIIntroductionto Auditing,Public Practice, and Professional RespODliibilities At theprovincial level,therearethe securitiescommissionswith responsibilityforinvestor protectionandensuringthe fairnessand efficiencyof the province'scapitalmarkets.There aresecuritiescommissionsin everyprovinceandterritory,but,becauseof thedivisionof powers between the provinces and the federal government, there is no national-level securities commission in Canada comparable to the SEC in the United States. However, since 1999 the Joint Forum of Financial Market Regulators, consisting of provincial securities commission-ersand variousnationalregulators,hascoordinatedandstreamlined the regulationand ser-vicesin Canadian financialmarkets through voluntary agreement between participants. The OntarioSecuritiesCommission(OSC)hasresponsibilityforthebiggestandmost developed capital markets in Canada. We will use it here to illustrate the impact aregulator canhaveonpublicaccounting.Threeprincipalactivitiesof theOSCensuretheorderly functioningof capital markets within its jurisdiction,such as the TorontoStock Exchange: 1.registering issuers, dealers, and advisers trading in securities and commodity futures contracts 2.monitoring the full extent of reporting requirements,including those related to pro-spectuses,takeovers,and continuousdisclosure of material information 3.enforcingthe provisionsof the Securities Act and the CommodityFutures Act Prospectuses are the information, usually including financial information, about afirm thataccompaniesanynewissuanceof sharesinaregulatedsecuritiesmarket.Thestaff of the OSC includes the chief accountant and achief forensic accountant who work under the director of enforcement.The Office of the Chief Accountant is responsible for formu-lating financial reporting policy and for monitoring the application of accounting principles andauditingstandardsbyreportissuersandtheirauditors.Financialstatementsare reviewed on aselective basis, and up toone-quarter of companies reviewed receive com-ment letters relating to inadequacies in their financial reports. The companies'auditors are alsoinformedof problems.If thefinancialreportingproblemsaresevereenough,the EnforcementBranchisnotified.In2001,theOSCfoundrevenuerecognitiontobea significant problem area forhigh-techfirms. An example of an Enforcement Branch action affecting an auditor is given in the follow-ing box. This OSC action followedan investigation of Nortel's accounting launched in April 2004 by the SEC and OSC. Nortel,thenoneof Canada's premiere high-tech companiesin the telecommunications industry, had to restate its financial results for quarterly periods going back through 2003,2002, and 2001. The restated 2003 results reduced earnings by 41 percent. By January 2005, Nortel's stock price had gone down to the $4 range from a July 2000 high of $124.Theearlier2003earningshad triggeredmillionsof dollarsof bonus paymentsto management. 1\velve senior executivesagreed to return$10.4 million of these bonuses,but Nortel isstillseeking repayment of 2003bonuses from managers firedin April2004. OSCCOMMISSIONERSCONTINUEMANAGEMENTCEASE-TRADEORDERAGAINSTNoRTELINSIDERS,MAv31,2004 TORONTO-Following a hearing held today, a panel of Ontario Securities Commission (OSC) Commissioners has made afinalorder under paragraph 2of subsection 127(1) of theSecuritiesActthatalltradingbycertaindirectors,officers,andinsidersof NortelNetworksCorporationandNortelNetworksLimitedinsecuritiesof Nortel Networks Corporation and Nortel Networks Limited cease until two full business days following the receipt by the Commission of all filings,including financialstatements, thecorporationsarerequired to make pursuant toOntariosecuritieslaw.Thisorder continuesthe temporaryorder made by the Director on May17,2004. Source:www.osc.gov.on.ca/About/NewsRelease/2004/nr_20040528_osc-nortel-cont-cease-II1lde.jsp. CHAPTER1Introduction to Auditing23 An independent review by Nortel's audit committee concluded that the corporate culture encouragedfinancialmanipulationthroughweakinternalcontrols.In January2005,the board of directorswent throughamajor reorganization,withhalf of theboard members leaving.Inaddition,ahigh-profileethicswatchdogandcomplianceofficerwashired to helpchangethecorporateculture.Theongoingsagaof lawsuitsandinvestigationsat Nortel that continued is covered in subsequent chapters. This example illustrates why good corporate governance principles need to be followed.(Corporate governance principles are explored in more detailin Appendix 7F.) The OSCalso monitors auditing and accountingstandardssetting of the CICA, and it providesinputonemergingissuesaswellascommentaryonproposedstandards.In addition, since 1989 the OSC has issued Staff Accounting Communiques (SACs) intended toexplaintheOSCstaff'sviewsonspecificreportingissues.AlthoughtheSACshave no officialOSCapproval,OSC staff arelikelytochallengeanytreatment that is incon-sistent with anSAC.By publishing the results of its monitoring program, by filingcom-plaintstoprovincialdisciplinarycommittees,andthroughitsrepresentationonCICA standard-setting boards,in recent years the OSChas made asignificant, ongoing impact on theprofession. There are other regulators affecting the profession. For example, the Canadian Investor ProtectionFund,whichissponsored by the Torontoand theMontrealstock exchanges, theCanadianVentureExchange,theTorontoFuturesExchange,andtheInvestment Dealers Association of Canada, is atrust established toprotect customers from the finan-cialfailureofamemberfirm(anymemberofasponsoringorganization,andsome AmericanbonddealersthattradeinCanada).In recentyears,Fund staff havetakena more active supervisory role by overseeing regular monthly,quarterly,and annual report-ing,payingsurprise visits to offices of member firms,and conductingat least one finan-cial questionnaireayear.The Fund can fineor set sanctionsagainst amemberfirmthat violatescapital,reporting,orotherrequirements.It developspolicystatementsthat addressstandardsforinternalcontrolwithinmemberfirms.Auditorsmust be awareof thesestandardswhenauditingmemberfirms.Internalcontrolreportsarediscussedin more detail in Chapter16. Another regulator, the Securities and Exchange Commission (SEC), affects Canadian auditorswhoseclientfirmshavedealingswithU.S.securitiesmarkets.In recentyears, many Canadian companies have gone to American and other international markets to raise cashthrough initial public offerings (IPOs).Becausetheyneed to fileregulatory docu-ments in each province, which increases the cost of financing,many Canadian companies arefindingitcheapertoraisemoneythroughpublicmarketsinothercountries.The Canadian Department of Finance has for anumber of years explored the idea of creating anationalsecuritiesregulator (like theSEC in theU.S.),or some national coordinator of provincial securities commissions, to improve the quality and competitiveness of Canadian securitiesmarkets. 5 Theimpactof theSEConauditorsisdiscussedinmoredetailin AppendixlB. An important development in the regulation of the Canadian accounting profession was the creation of theCanadian Public Accountability Board (CPAB)on July17,2002.The Board represents the public interest through being dominated by non-CA members (seven of the eleven Board membersare to be non-CAs).The Board monitorsaudit practiceand conductsannual inspections of accounting firmstoassesstheir ability to protect the pub-lic interest. It has the power to sanction any auditor that failsto protect the public interest, and is viewed asthe first in a series of major structural reforms to protect the integrity of Canada's financialaccounting systems.Other stepsinclude the CICA'sevolvingstandard for auditor independence and the creation of provincial boards to oversee the professional conduct and peer-review systems. Finally,thereareregulators,suchasprovincialministriesof theenvironmentand naturalresources,thatindirectlyimpacttheprofessionbyplacingrestrictionson 5 A.FreemanandK.HawleH,MKeepIPO'satHome:Martin:TheGlobeandMail,Moren8,1996,81. REVIEW CHECKPOINTS PARTIIntroduction to Auditing, Public Practice. and Professional Responsibilities activitiesthat the clients themselves may need to disclose as part of the client's busi-ness risk. It should be clear from thisbrief reviewthat the profession is facingan increasingly complex regulatoryenvironment and that auditorsmust be sensitized to regulatorycon-cerns in order to do aproper audit. Auditorsalso need to be concerned with meeting the demandsof regulators in different countries.One part of the solution is using worldwide standardswhenever feasible. 17Identify several types of professional accountants and their organizations. 18What are some examples of assurance services rendered on representations other than traditional financialstatements7 19What are the three major areas of public accountingservices7 20Locate Nortel's audit committee report on the Internet. Is the OSC or the SEC website more user-friendly for investors? INTERNATIONAL AUDITING LEARNINGOBJECTIVE 0Providean overviewof internationalauditing and its impact on Cana-dian auditing standards. . f . , . ~ ~ - ~ ai. ...?: :1.::';/ - .. Many of the large public accounting firmsare worldwide organizations that grew rapidly in the last few decades, in parallel with the increased economic integration of their global clientele. Developments such as the North American Free Trade Agreement (NAFrA), the evolution of the European Economic Union and other free trade zones,and the pervasive effectsof technological change areall contributing to increased global harmonization of auditingandaccountingstandards.ForthesereasonstheInternationalFederation of Accountants(D'AC),createdin1977,mirrorsat an internationallevelwhatnational instituteshavebeendoing.In particular,IFACpublishes itsown handbookonauditing standards that recommends International Standards on Auditing(ISAs).ISAs cover basic principles of auditing, auditor's reports, professional independence, reliance on other audi-tors abroad,and professional qualifications. The issue iswhen ISAswillachieveworldwide acceptance.On April1,2002, the International Auditing and Assurance Standards Board was created with resources commensurate with its responsibilities. This Board now has probably the largest group of technical audit standard-setting support staff in the world, making future ISAs more rigorous.ISAsareincreasinglybecomingthedominantstandardsworldwide.The CICA's policyis toadopt ISAsasis,unlessCanadian conditionsrequireadifferent standard. The sources of auditing standards in Canada are the CICA Handbook,whose standardsweretraditionallyreferredtoasthe HandbookRecommendations,andthe Audit Guidelines (AuGs), which provide additional guidance on implementing the stan-dards.TheCICA adopted the revised and redrafted ISAsaswellas the International Standard onQualityControl on December15,2009,effective forfiscalperiodsafter December14,2010.It willdecideatafuturedatewhat,if any,otherinternational standards it will adopt. We provide more details in later chapters. The goal of conver-gence,or internationalharmonizationasit isfrequentlycalled,isakeyfocusof Canadian standard setters in the post-Enron world. Astheworld becomesmore interdependent,manyconceptsand termsused in other countrieswillbecomeincreasinglyacceptedin Canadianpractice.Indeed,manylarge finns already use manuals and training materials re:ftecting international practice. This text makesuseof thosetermsand concepts and doesnot restrictitself to thoseused in the CICAHandbook or CASs. CHAPTER1Introduction to Auditing25 REy1 EW21Find the IFACHandbook on the IFAC websire and review its table of contents. CHECKPOINTS LEARNINGOBJECTIVE 0Apply and integrate the chaptertopicstoana-lyze a practical auditing situation/case/scenario. APPUCATIONCASEANDANALYSIS MEANINGOFTHEWORDS"PRESENTfAIRLY" INTHEAUDITOR'SREPORT Discuuian Ccue Yourclient,MargoN.,haspreparedfinancialstatements thatshefeelsareinconformitywithCanadian GAAP,but shenotesthatinyourreport youuse!he words'"present fairly,inallmaterialrespects... in accordancewithCanadianGAAP.,.Sheasksyoutoexplainwhetthesewordsmeansot+totshecon fulfillherresponsibilitiestoprepore thefinonc:iolstatementsopprcpriotely. Analytis "Pre5ent fairly"isoneof thosewidelyusedaccountingtermsthatisneverdefinedinany standard.As auditor,youmustprovide anintuitive,reasonable,if not authoritative,explanation of itsmeaning. A good startingpointistellingMargothatfairpresentationmeansnottomislead,buttotellthetruthabout economicreality,includingappropriatedisclosure of businessrisks.Failureto discloseappropriatelybusi-nessrisksandeconomicrealityleadstoinformationriskinfinancialreporting.Definingfairnessofpre-entationinfinancialreporting10thatitincludNariskorientationwillleadtoacc:eptablelevelsof informationri1k. Butwhatis"economicreality"'Obviously,thereahouldbenodeliberateerrorsconcerningthe economic:factsofMargo'sreportingentity.ThisisimplicitinbothGAAPandyourstudiesoffinancial accounting,anditisworthrememberingas anauditor.Byverifyingthosefacts,asan auditor,youwill determinewhichonesare correct andwhichare misleading.Hence,fairpresentationincludesan under-standingthat anauditor willbe abletoverifythefactsthrough!herecordskeptby Margo'saccounting orinformationsystemby gatheringindependentevidenceof theinformation.Thiswaythe riskoferrorsinthatinformationwillbereducedtoalevelyouasauditorfindoc:ceptableforfinancial reporting.Thisisthelowaudit riskcomponent of informationrisk that audito" aimtoochieve.However, auditorsalsoneedtokeeptrackoftherisksaSIOciotedwit+!forecastinginGAAPestimates. Forecasts are based onassumptions, and if those assumptions are unrealistic: or unrea10nable, theingrisksassociatedwitntheaccountingestimatesincrease.Andincreasedaccountingrisks,intum,lead toincreasedinformationrisksinfinancialreporting.Thus,fairnessof presentational10includesappropri-ately disclosingbusiness risks throughaccounting entries and perhaps !+trough appropriate note disclosures as well. A speciRcexampleof thiscouldbe theproper accountingforaccountsreceivablethat youstudiedin your financialcourse.Todeterminetheappropriateness of thepresentationof accounts receiv-ableinthebalancesheet,itmustbe verifiedthat thereceivablesexist,thattheyare owedtoMargo's company,andthat theyhavebeenproperlyrecordedandclassified,per GAAP,as of thebalancesheet date.Allofthisisfactualinformationliasedonpost eventsthat canbe verifiedby variousauditproce-dures that youwillbe studyinginthisbook.Verificationis,therefore,the rrocess of assuring yourself and othersthatthesefactsareaccuratelyrecorded.Asanauditor,youwilgatner evidencefromMargo's accountingsystemthat thefactsregardingreceivablesare accurate. However,auditorsinfactrarelv findit an economicalUH of their time to exhaustively gather evidence onaccountsreceivable.Sotheydolessthanthat,andinsteadacc:eptthat theless-tnan-perfect evidence createsarisk of undetectedmaterialfactualerrorsregardingreceivables.Itisimportant toremember that audit risk forreceivables is the risk of l'ailingtodetect material factualerrors intherecords forreceivables. Auditriskis,therefore,anevidencegatheringrisk. Theother component of informationriskisaccountingrisk.Thisriskconsiders thequNtionof whether allthereceivableswillbecollectedat theirfaceamountl,regardleuofhowaccuratelytheamounts wererecorded.Thisuncertaintyisunavoidablebecauseitrelatestothefutureandthereislittlethatis certainabout the future.Neither youthe auditor nor Margo can predict withcertainty,as of thebalance sheetdate,whichreceivableswillbecollectedat facevalue.Youmightrecallfromyouraccounting course that there are techniquesforcalculatingbad debt expense that don't seem toinvolveforecosting. However,suchtechniquesarebasedonassumptionsfrompastexperience.Iftheseassumptionsare wrong,theresultingestimatewillbewrongaswell.Somecommonassumptionsarethotpercentage collection inthepastwillcontinuetoapply,thatinterestroteswon'tchange,or thatother economic:foc:torswillremainthesame.Only thepassageoftimeand actualcollectionofpaymentson thereceivableseliminate the uncertainty ar