Auditing Course Assignment

1-1

Introduction and Overview of Audit and Assurance

CHAPTER 1

Au di

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a An

al yt

ic s

(C ha

pt er

7 )

Au di

t E vi

de nc

e (C

ha pt

er 5

)

Client Acceptance/Continuance and Risk Assessment (Chapters 3 & 4)

Develop Responses to Risk and an Audit Strategy

Gaining an Understanding of

the Client

Identify Significant Accounts and Transactions

Set Planning Materiality

Make Preliminary Risk Assessments

Gaining an Understanding of Internal Controls

(Chapter 6)

Overview of Audit and Assurance

Audit Assurance (Chapter 1)

Concluding the Audit and Reporting (Chapters 14 & 15)

ReportingDrawing AuditConclusions Procedures Performed Near

the End of the Audit

Auditing the Balance Sheet and Related Income Accounts

(Chapter 13)

Auditing Purchases, Payables, and Payroll

(Chapter 12)

Auditing Sales and Receivables

(Chapter 11)

Reliance on Internal Controls (Chapter 8)

Substantive Strategy (Chapter 9)

Audit Sampling for Substantive Tests (Chapter 10)

Professionalism and Professional Responsibilities (Chapter 2)

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1-2 CHAPTER 1 Introduction and Overview of Audit and Assurance

Auditing and Assurance Standards

PCAOB Framework for Audits of Public Companies

AS 2201 An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements

AS 3101 The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion

AUDITING STANDARDS BOARD Framework for Audits of Private Companies

AU-C 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards

AU-C 700 Forming an Opinion and Reporting on Financial Statements

Learning Objectives

LO 1 Define and diff erentiate among assurance, attestation, and audit services.

LO 2 Diff erentiate among diff erent types of assurance services.

LO 3 Explain the demand for audit and assurance services.

LO 4 Distinguish the diff erent roles of the financial statement preparer and the auditor.

LO 5 Explain the roles of diff erent regulators and organizations that aff ect the audit profession.

LO 6 Explain the concepts of reasonable assurance, materiality, and the nature of an unqualified/ unmodified report on the audit of financial statements.

LO 7 Explain the concept of reasonable assurance and the nature of an unqualified report on internal controls over financial reporting.

LO 8 Discuss the audit expectation gap.

Cloud 9 - Continuing Case This book is designed to provide you with the opportunity to learn about auditing by using a practical, problem-based approach. Each chapter begins with some information about an example audit client—Cloud 9, Inc. (Cloud 9). The chapter then provides the underlying concepts and background information needed to deal with this client’s situation and the problems facing its auditor. As you work through the chapters, you will gradually build your knowledge of auditing by studying how the contents of each chap- ter are applied to Cloud 9. The end-of-chapter exercises and prob- lems also provide you with the opportunity to study other aspects of Cloud 9’s audit, in addition to applying the knowledge gained in the chapter to other practical examples.

Cloud 9 Inc., a listed company (publicly traded) in the United States (U.S.), is looking to expand. McLellan’s Shoes was seen as a potential target.

In 1985, Ron McLellan started a business in Seattle, manu- facturing and retailing customized basketball shoes. Ron calls his business McLellan’s Shoes. Ron borrowed from the bank to start

the business, using his house as security, and over the years he worked very hard to establish a profi table niche in the highly com- petitive sport shoe market. Ron repaid the bank in 1999, and he vows to never borrow again.

As the business grew, Ron’s wife and three adult children started to work with him, with responsibility for administration, marketing and sales, production, and distribution. By the early 2000s, Ron’s business employed 20 people full time, most of whom work in pro- duction. There are also several casual employees and part-time staff in the retail outlet in Seattle, particularly during busy periods.

In February 2020, Ron received a call from Chip Masters, the senior vice president of Cloud 9 Inc. Chip expressed an interest in buying McLellan’s Shoes. Ron wants to retire, and his children are starting to fi ght among themselves about who is going to take over their father’s business. Ron is looking for an exit strategy, but he does not want Chip to know that. He asks if Chip is ready to talk about the price. Chip says he is, but fi rst he needs to see the audited fi nancial statements for McLellan’s Shoes.

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Assurance, Attestation, and Audit Services 1-3

Chapter Preview: Audit Process in Focus The purpose of this chapter is to provide an overview of assurance, attestation, and audit services. While the focus of this book is the audit of fi nancial statements, in this chapter we defi ne assurance and attest engagements and diff erentiate among diff erent types of assur- ance engagements. The assurance engagements explained in this chapter include fi nancial statement audits, compliance audits, operational (performance) audits, and internal audits. We also discuss why there is a demand for audit and assurance services and then discuss the separate roles of the fi nancial statement preparer and the auditors.

Regulatory bodies and other organizations that impact the audit profession are intro- duced in this chapter. Also, the audit reports issued by auditors at the completion of the audit are discussed with the goal of explaining what is communicated in the auditor’s report. The audit expectation gap is explained in the last section of this chapter.

LEARNING OBJECTIVE 1 Define and diff erentiate among assurance, attestation, and audit services.

The terms assurance, attestation, and auditing are sometimes used interchangeably, but they actually represent diff erent types of services. They are similar in that they all represent a com- mon process of an independent accounting fi rm taking information prepared by someone else and comparing that information to an established set of criteria. At the end of the service, the independent accounting fi rm provides a written report about the results of the service per- formed. This process is important because it adds credibility, or integrity, to the information, which makes it more useful for decision making. An everyday example of this process would be needing a physical exam from a medical doctor before joining a sports team. The doctor would be the independent professional. The doctor would conduct the physical exam and compare your results to standards considered acceptable for someone of your age and height. At the completion of the physical exam, the doctor would provide you with written documen- tation stating that you were in good physical condition to play on the sports team. The service provided by the doctor improves the “integrity” of your claim that you are in good condition to participate on the team.

The relationship of assurance, attestation, and auditing services is shown in Illustration 1.1 and resembles overlapping umbrellas. We will refer to Illustration 1.1 as we discuss the three services in more detail.

Assurance, Attestation, and Audit Services

Cloud 9 - Continuing Case Chip Masters has asked Ron McLellan for audited fi nancial state- ments of McLellan’s Shoes. Ron has never had an audit and is not sure what it involves. He has heard about tax audits, safety audits, effi ciency audits, as well as fi nancial statement audits. Are they

all the same thing? Ernie explains to Ron that there are several services that people call “audits” that are diff erent from fi nancial statement audits. However, all these services, including fi nancial statement audits, can be defi ned as assurance services.

Ron asks for some time. He tells Chip that he needs to talk to his family and he will get back to him. When Ron puts the phone down he immediately calls his friend from the golf club, Ernie Black, who is a CPA. For years, Ernie has been suggesting to Ron that his business aff airs need attention. Ron is good at making deals

and working hard, but he has never bothered with sophisticated fi nancial arrangements. He is still running his business as a sole proprietor (not a corporation), and his wife does all the tax returns. Ron is in a panic—he wants to sell McLellan’s Shoes, but what is he going to do about Chip’s request for audited fi nancial statements?

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1-4 CHAPTER 1 Introduction and Overview of Audit and Assurance

Audit services are the most specifi c and narrow of the three services; therefore, it is the smallest umbrella in Illustration 1.1. Two primary types of audit services are an audit of fi nancial statements and an audit of internal controls over fi nancial reporting (ICFR). The purpose of an audit of fi nancial statements is to provide fi nancial statement users with an opinion by the auditor on whether the fi nancial statements are presented fairly in accor- dance with an applicable fi nancial reporting framework. The purpose of an audit of ICFR is to provide fi nancial statement users with an opinion by the auditor on the design and operating eff ectiveness of ICFR. These audit services enhance the degree of confi dence that intended users can place in the fi nancial statements (AU-C 200.04). Some key concepts in these descriptions require further explanation. The fi nancial statements refer to historical fi nancial statements of either a public or private company. The auditor refers to an indepen- dent Certifi ed Public Accountant, or CPA, who is qualifi ed to perform the auditing service. The only professional who can audit historical fi nancial statements and internal controls for a public or private company is a CPA. The applicable fi nancial reporting framework refers to the set of standards used in preparing the historical fi nancial statements, such as generally accepted accounting principles (GAAP) in the United States, international fi nancial report- ing standards (IFRS), or a federal income tax basis of accounting. The intended users refer to any group that will be using the fi nancial statements to make decisions, such as investors and creditors.

Companies produce fi nancial information that goes beyond historical fi nancial state- ments. Examples include fi nancial forecasts and reports on fi nancial reporting processes. When CPAs are hired to report on the integrity of this type of fi nancial information, it is called an attestation service. Attestation services are performed when an independent prac- titioner, or CPA, is engaged to issue a report on subject matter that is the responsibility of an- other party. As depicted in Illustration 1.1, audit services fall under the umbrella of attestation services, but so do other services that involve a CPA reporting on other fi nancial information. Note the use of the term practitioner in the defi nition of attestation services. The term practi- tioner is used rather than auditor because attestation services encompass more than just the audit of historical fi nancial statements and internal controls.

Another example of an attestation service is a review of historical fi nancial statements. Small private companies often do not want or need a service as extensive as an audit of the fi nancial statements in which the auditor has to express an opinion on the fair presentation of the fi nancial statements. In a review engagement, the practitioner expresses limited assur- ance that no material modifi cations need to be made to the fi nancial statements, so a review of historical fi nancial statements is a less extensive and, therefore, less expensive service that

audit services services by an independent CPA that provide fi nancial statement users with (1) an opinion on whether the fi nancial statements are presented fairly, in all material respects, in accordance with an applicable fi nancial reporting framework and/or (2) an opinion on the eff ectiveness of ICFR, which enhance the degree of confi dence that intended users can place in the fi nancial statements

attestation services services performed when an independent practitioner, or CPA, is engaged to issue a report on subject matter that is the responsibility of an- other party

Assurance Services

Attestation Services Review of historical financial statements

Audit Services Examination

of control processes

Historical financial

statements

Internal controls

Data integrityExamination

of financial forecast

Risk advisory services

Website security

Compliance with EPA standards

ILLUSTRATION 1.1 Relationship of assurance, attestation, and auditing services

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Assurance, Attestation, and Audit Services 1-5

can be very useful for smaller private companies. A more detailed discussion of a review is presented in Chapter 15.

The largest umbrella in Illustration 1.1 represents assurance services. Assurance ser- vices are independent professional services that improve the quality of information, or its context, for decision makers. Some key concepts are included in this defi nition. The term independent is common to audit, attestation, and assurance services. Independent implies that the service is performed by someone who was not involved with the creation of the information and who is objective in the evaluation of the information. (Chapter 2 covers the concept of independence in more depth.) The term quality refers to the relevance and reliability of the information. The term information refers to subject matter that can be fi - nancial or nonfi nancial, historical or prospective, standalone data or entire systems of data, internal or external to a company. Essentially, the concept of assurance services encompasses any service that a professional provides that involves improving the quality of information that was prepared by someone else. Both attestation and audit services fall under the broad term of assurance services, and therefore are depicted under the assurance umbrella in Illustration 1.1.

While the audit of a company’s historical fi nancial statements and internal controls is the focus of much of this book, there are other types of audit and assurance services that warrant some discussion. The next section provides a description of these diff erent types of services.

assurance services indepen- dent professional services that improve the quality of informa- tion, or its context, for decision makers

Professional Environment Becoming a CPA

Certifi ed public accountants (CPA) are the only licensed accounting professionals in the United States. CPA licenses are not issued at the national level, but at the state level. To become a licensed CPA, an in- dividual must earn the three Es – Education, Exam, and Experience.1

The fi rst step is meeting the education requirements set by a state board of accountancy, which vary from state to state. Most states re- quire a Bachelor’s degree and completion of 150 hours of total col- lege credit. Within the 150 hours, some states require completion of courses in specifi c subject areas in accounting, business, or ethics. (See the discussion in this chapter on National Association of State Boards of Accountancy (NASBA) and State Boards of Accountancy.)

The second step is passing the Uniform CPA Examination, or CPA exam. The CPA exam is accepted for CPA licensure by all states, which is why it is called the “uniform” CPA exam. The CPA exam consists of four sections: Auditing and Attestation (AUD), Business Environment and Concepts (BEC), Financial Accounting and Reporting (FAR), and Regulation (REG). The testing time for

each section is four hours for a total test time of 16 hours. Each part of the exam consists of multiple-choice items and task-based simulations, and the BEC section also contains written communi- cation items. Exam candidates can take one part of the exam at a time and have 18 months to pass all four parts once the fi rst part has been successfully passed.

The fi nal step is work experience. Work experience require- ments also vary by state. In general, states require one to two years of work experience under the supervision of a licensed CPA. The work experience can be earned either before, during, or after sit- ting for the CPA exam, but some restrictions may apply for when the experience can be earned.

A state board of accountancy will only issue a license to prac- tice after all three Es have been earned. The purpose of the entire licensure process is to ensure that individuals possess the level of knowledge and the skills necessary to perform the duties of a CPA and to protect the public interest.

Before You Go On 1.1 Who are intended users of assurance services? 1.2 What does “independent” mean in the context of assurance services? 1.3 What is an example of an “applicable fi nancial reporting framework”?

1American Institute of Certifi ed Public Accountants. The Uniform CPA Examination: Purpose and Structure, 2018. www.aicpa.org/becomeacpa/cpaexam/examoverview

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1-6 CHAPTER 1 Introduction and Overview of Audit and Assurance

Public companies in the United States are also required to have an audit of ICFR. The objec- tive in an audit of ICFR is to express an opinion on the eff ectiveness of the company’s system of internal controls over fi nancial reporting (AS 2201.03). The reason for requiring an audit of internal controls is because eff ective internal control provides reasonable assurance regarding the reliability of fi nancial reporting and the preparation of fi nancial statements for external purposes (AS 2201.02). Therefore, public companies are required to have two audits every year, one on the fi nancial statements and one on the eff ectiveness of the company’s internal controls. For effi ciency purposes, these two audits are performed at the same time. This is referred to as an integrated audit. The objectives of the audits are not identical, however, and the auditor must plan and perform the work to achieve the objectives of each audit (AS 2201.06). Private companies are not required by the government to have an audit of ICFR. As mentioned above, other interested users, such as a lender, may require a private company to have an audit of ICFR along with an audit of the fi nancial statements as a condition for being approved for a loan.

Limitations of an Audit A fi nancial statement audit is conducted to enhance the reliability and credibility of the information included in the fi nancial statements. It is not a guarantee that the fi nancial

integrated audit an audit that combines the fi nancial statement audit with an audit of the eff ec- tiveness of ICFR

LEARNING OBJECTIVE 2 Diff erentiate among diff erent types of assurance services.

In this section we provide an overview of the most common types of assurance services that a practitioner can provide. We will discuss fi nancial statement audits, compliance audits, oper- ational (performance) audits, and internal audits.

Financial Statement Audits As stated earlier, the purpose of an audit of fi nancial statements is to provide fi nancial statement users with an opinion by the auditor on whether the fi nancial statements are presently fairly in accordance with an applicable fi nancial reporting framework, which enhances the degree of confi dence that intended users can place in the fi nancial statements (AU-C 200.04). Within a U.S. context, the applicable fi nancial reporting framework is typically GAAP. Public companies, or issuers, in the United States are required by the federal government to have an annual fi nan- cial statement audit. Private companies, or non-issuers, are not required by the U.S. government to have an annual fi nancial statement audit, but often other interested users request that a pri- vate company provide audited fi nancial statements. A good example would be a lender (bank or other fi nancial institution) requesting audited fi nancial statements from a private company when considering whether to lend money to the private company. Audited fi nancial statements add a degree of confi dence that helps the lender make an informed lending decision.

Diff erent Assurance Services

Cloud 9 - Continuing Case Ron is not running a corporation. He operates his customized basketball shoe business as a sole proprietor. He is aware that big corporations have to be audited, but because he is not a pub- licly traded company he does not believe that he has to have an audit. Ernie agrees that Ron does not have to follow the same

rules, but he also tells him that there are auditing standards in place that apply to a company like his. This means that although all the attention is usually on corporations, sole proprietors can, and may be required to, have their fi nancial statements audited, too.

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Diff erent Assurance Services 1-7

statements are free from error or fraud. The limitations of an audit are caused by (1) the nature of fi nancial reporting, (2) the nature of audit procedures, and (3) the need for the audit to be conducted within a reasonable period of time at a reasonable cost (AU-C 200.A49).

The nature of fi nancial reporting refers to the use of judgment when preparing fi nancial statements due to the subjectivity required when arriving at accounting estimates. Judgment is also required when selecting and applying accounting methods.

The nature of audit procedures refers to the reliance on evidence provided by the client and its management. For example, if auditors do not have access to all the infor- mation relevant to the audit, there is a limitation in the scope of their audit. If auditors are unaware of this situation, they may arrive at an inappropriate conclusion based on incomplete facts. Evidence may be withheld or modified by perpetrators of fraud. It can be difficult for an auditor to determine whether a fraud has occurred because documents altered by those committing a fraud generally hide evidence. Also, auditors use sam- pling techniques when testing some transactions and account balances. If a sample is not representative of all items available for testing, an auditor may arrive at an incorrect conclusion.

The nature of audit procedures also refers to the concept of materiality. The Financial Accounting Standards Board (FASB) defi nes materiality as follows:

Information is material if omitting it or misstating it could infl uence decisions that users make on the basis of the fi nancial information of a specifi c reporting entity. (SFAC No. 8, para QC11)

In other words, an error or misstatement in the fi nancial statements is considered material if it impacts, or changes, the decision-making process of those individuals or groups who are using the fi nancial statements. Therefore, when planning an audit, auditors select audit procedures that are designed to discover material misstatements. Because of time and cost constraints, it would be impractical for an audit to focus on fi nding all misstatements.

The timeliness and cost of a fi nancial statement audit refer to the pressures auditors face to complete their audit within a certain time frame at a reasonable cost. While it is important that auditors do not omit procedures in an eff ort to meet time and cost constraints, they may be under some pressure to do so. This pressure will come from clients wanting to issue their fi - nancial statements by a certain date, from clients refusing to pay additional fees for additional audit eff ort, and from within the accounting fi rm where there are pressures to complete all audits on a timely basis to avoid incurring costs that may not be recovered. By taking the time to plan the audit properly, auditors can ensure that adequate time is spent where the risks of a material error or fraud are greatest.

This text focuses primarily on audits of fi nancial statements and eff ectiveness of ICFR. The following section will briefl y discuss some other common types of assurance engagements.

Compliance Audits A compliance audit involves gathering evidence to determine whether the person or entity under review has followed the rules, policies, procedures, laws, and regulations with which they must conform. One of the best examples of a compliance audit is an income tax audit. The Internal Revenue Service (IRS) may conduct an audit of an individual or a company to determine if tax laws have been followed and the correct amount of tax paid.

Operational (Performance) Audits Operational, or performance, audits are concerned with the economy, effi ciency, and eff ectiveness of an organization’s activities. Economy refers to the cost of inputs, including wages and materials. Effi ciency refers to the relationship between inputs and outputs, or the use of the minimum amount of inputs to achieve a given output. Finally, eff ectiveness refers to the achievement of certain goals or the production of a certain level of outputs. From an

materiality the ability of infor- mation to infl uence decisions that users make on the basis of the fi nancial information of a specifi c reporting entity

compliance audit an audit to determine whether the entity has conformed with regulations, rules, or processes

operational (performance) audit an assessment of the economy, effi ciency and eff ectiveness of an organization’s operations

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1-8 CHAPTER 1 Introduction and Overview of Audit and Assurance

organization’s perspective it is important to perform well across all three dimensions and not allow one to dominate. For example, if buying cheap inputs results in an ineffi cient produc- tion process, effi ciency is sacrifi ced to achieve economic goals. Operational audits are gener- ally conducted by an organization’s internal auditors (discussed in the next section) or they may be outsourced to an external accounting fi rm.

Internal Audits Internal audits are conducted to provide assurance about various aspects of an organiza- tion’s activities. The internal audit function is typically conducted by employees of the orga- nization being audited, but can be outsourced to an external accounting fi rm. The function of an internal audit is determined by those charged with governance and management within the organization. While the functions of internal audits vary widely from one orga- nization to another, they are often concerned with evaluating and improving risk manage- ment, internal control procedures, and elements of the governance process. The internal auditors often conduct operational audits, compliance audits, internal control assessments, and reviews. Many internal auditors are members of the Institute of Internal Auditors (IIA). The IIA is an international organization with more than 120,000 members that provides guid- ance and standards to aid internal auditors in their work. When conducting the fi nancial statement audit, the external auditor may rely on the work done by internal auditors when evaluating the evidence needed to form an opinion on the fi nancial statements or on ICFR. A more detailed discussion of how internal auditors may assist with the audit is provided in Chapter 5.

internal audit a function within an entity which gener- ally evaluates and improves risk management, internal control procedures and elements of the governance process those charged with governance persons with responsibility for overseeing the strategic direction of the entity and the obligations related to the accountability of the entity

Cloud 9 - Continuing Case Ron is not concerned about internal audits—his business is too small for a separate internal audit function. He is also not wor- ried about compliance and operational audits. His priority at the

moment is to close the deal with Chip Masters, and he still does not know what he will do about the audit.

Before You Go On 2.1 What is the objective of a fi nancial statement audit? 2.2 Explain the inherent limitations of a fi nancial statement audit. 2.3 What are the three elements of an operational audit? 2.4 What are the most common functions of the internal auditors?

LEARNING OBJECTIVE 3 Explain the demand for audit and assurance services.

In this section we provide an overview of the primary fi nancial statement users followed by a description of why these users may demand an audit of the fi nancial statements.

Demand for Audit and Assurance Services

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Demand for Audit and Assurance Services 1-9

Financial Statement Users Financial statement users include current and potential investors, suppliers, customers, lend- ers, employees, governments, and the general public. Each of these groups will read the fi nan- cial statements for a slightly diff erent reason as described below.

Investors Investors generally read fi nancial statements to determine whether they should invest in the company. They are interested in the return on their investment and are concerned that the entity will remain a going concern (continue operating) into the foreseeable future. Investors may also be interested in the capacity of the company to pay a dividend. Prospective investors read fi nancial statements to determine whether they should buy shares in the entity.

Suppliers Suppliers may read fi nancial statements to determine whether the company can pay for goods or services supplied. They are also interested in whether the company is likely to remain a going concern (is likely to continue to be a customer of the supplier) and continue to pay its debts when they come due.

Customers In many business-to-business transactions, customers may read fi nancial statements to deter- mine whether a company they rely on is likely to remain a going concern.

Lenders Lenders may read fi nancial statements to determine whether an entity is suffi ciently credit- worthy to qualify for a loan and whether it can pay the interest and principal as they come due.

Employees Employees may read fi nancial statements to determine whether the entity can pay their wages or salaries and other benefi ts (for example, pensions). They may also be interested in assessing the future stability and profi tability of the entity, as these aff ect job security.

Governments Governments may read fi nancial statements to determine whether the company is com- plying with regulations, to evaluate if the company is paying a fair amount of taxes given its reported earnings, and to gain a better understanding of the company’s activities. A company in receipt of government grants often must provide a copy of its audited fi nancial statements when applying for a grant and when reporting on how grant funds have been spent.

Cloud 9 - Continuing Case Ron believes that his business has good, reliable fi nancial records. Ron’s wife helps him keep tight control of the cash and other as- sets, and together they prepare some simple reports on a regular basis. Ron believes he knows exactly what is happening in the business and monitors the business’s cash fl ow and profi t very closely. However, he has not prepared fi nancial statements that

comply with U.S. generally accepted accounting standards. Is this a problem? Ernie explains to Ron that many businesses must apply the accounting standards, even if they are not corporations. It all depends on whether there are individuals or groups who are using the fi nancial statements for decision-making purposes. Ron is a bit worried now—how does he know if he has these users?

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1-10 CHAPTER 1 Introduction and Overview of Audit and Assurance

The General Public The general public may read fi nancial statements to determine whether they should associate with the company (for example, as a future employee, customer, or supplier), and to gain a better understanding of the company, what it does, and its plans for the future.

Sources of Demand for Audit and Assurance Services Financial statement users and their needs are many and varied. There are a number of rea- sons why some or all of these users would demand an audit of fi nancial statements. These include remoteness, complexity, competing incentives, and reliability. Each of these concepts is explained below.

Remoteness Most fi nancial statement users do not have access to the company under review. This makes it diffi cult to determine whether the information contained in the fi nancial statements is a fair presentation of the entity and its activities for the relevant period.

Complexity Financial statements are complex, the amounts are often aff ected by signifi cant estimates, and the disclosures often require signifi cant knowledge and experience to evaluate. Most fi nancial statement users do not have the accounting and legal knowledge to assess the reasonableness of complex accounting and disclosure choices being made by the company.

Competing Incentives Company managers have an incentive to disclose the information contained in the fi nancial statements in a way that presents their performance in the best possible light. Users may fi nd it diffi cult or impossible to identify when management is presenting biased information.

Reliability Financial statement users are concerned with the reliability of the information contained in the fi nancial statements. Since they use that information to make decisions that have real consequences, it is very important that users can rely on the information contained in the fi nancial statements.

An independent third-party review of the fi nancial statements by a team of auditors, who have the knowledge and expertise to assess the fairness of the information being presented by the preparers, helps users across all these issues. Auditors have access to company records, so they are not remote. Auditors are trained accountants and have detailed knowledge about the complex technical accounting and disclosure issues required to evaluate the choices made by the fi nancial statement preparers. Independent auditors, whose work is regularly reviewed by regulators, have little incentive to aid the company in presenting its results in the best possible light. Auditors are concerned with ensuring the information contained in the fi nancial state- ments is reliable and free from any material misstatements.

Cloud 9 - Continuing Case Ron tells Ernie that he has no remote users, such as sharehold- ers or lenders, and his business is not very complex. He is the owner and the manager of McLellan’s Shoes and therefore has no competing incentives. For all these reasons, he has never felt the

need to purchase an audit to assure users of the reliability of his business’s fi nancial information. Ernie agrees, but points out that there is now a user who is very interested in the reliability of the fi nancial information: Chip Masters.

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Preparers and Auditors 1-11

Before You Go On 3.1 Who are the main users of company fi nancial statements? 3.2 Why might fi nancial statement users demand an audit? 3.3 Explain why auditors, or CPAs, are the appropriate professionals to conduct an audit.

LEARNING OBJECTIVE 4 Distinguish the diff erent roles of the financial statement preparer and the auditor.

In this section we explain and contrast the diff erent responsibilities of fi nancial statement preparers and auditors. We provide details of the role that each group plays in ensuring the fi nancial statements are an accurate representation of the company in question. Following this discussion is an overview of the diff erent fi rms that provide assurance services.

Preparer Responsibility As you know from your fi nancial accounting courses, the fi nancial statements include the bal- ance sheet (statement of fi nancial position), income statement (statement of comprehensive income), statement of cash fl ows, statement of changes in equity, and accompanying notes. It is the responsibility of management, with oversight from those charged with governance (gen- erally the board of directors), to prepare the fi nancial statements. Specifi cally, management is responsible for the following:

1. Ensuring the information included in the fi nancial statements is presented fairly and complies with the applicable fi nancial reporting framework, which in the United States is most often GAAP.

2. Designing, implementing, and maintaining internal control relevant to the preparation and fair presentation of the fi nancial statements.

3. Providing the auditors with access to all records, documentation, and personnel relevant to the preparation and fair presentation of the fi nancial statements, and any additional information the auditors may consider relevant to complete the audit.

The preparation of fi nancial statements requires the use of knowledge and judgment on the part of management. Management is responsible for making estimates for some fi nancial statement items (e.g. allowance for doubtful accounts or a goodwill impairment) and selecting appropriate accounting policies within the applicable fi nancial reporting framework, usually GAAP (AU-C 200.A2–A3).

Auditor Responsibility The auditor’s responsibility is to provide an opinion on whether the fi nancial statements are presented fairly in accordance with the applicable fi nancial reporting framework. It is import- ant to emphasize the auditor is not responsible for preparing the fi nancial statements. Prepa- ration of fi nancial statements is management’s responsibility, as we discussed in the previous section. Auditors are responsible for the following:

1. Conducting the audit in accordance with the appropriate auditing standards. Audit stan- dards provide minimum requirements and guidance for the performance of an audit. Later in this chapter we discuss the audit standards that apply to fi nancial statement audits.

Preparers and Auditors

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1-12 CHAPTER 1 Introduction and Overview of Audit and Assurance

2. Planning and performing the audit with professional skepticism. Professional skepti- cism is an attitude adopted by auditors when conducting an audit. It means auditors re- main independent of the entity, its management, and its staff when completing the audit work. In a practical sense, it means auditors maintain a questioning mind and thoroughly investigate all evidence presented by their client. Auditors must seek independent evi- dence to corroborate, or confi rm, information provided by their client. Auditors must be suspicious when evidence contradicts documents held by their client or inquiries made of client personnel, including management and those charged with governance.

3. Planning and performing the audit with professional judgment. Professional judgment relates to the application of relevant training, knowledge, and experience that auditors use while making informed audit decisions in conducting an audit. Auditors must use their judgment throughout the entire audit. For example, auditors must use judgment when determining if an information source is reliable. They must also use judgment when deciding if enough audit evidence has been gathered to support the audit opinion.

The concepts of professional skepticism and professional judgment will be addressed through- out this textbook as we learn about the process used by auditors to arrive at their opinion. It is important to note that the auditor’s opinion on the fi nancial statements is not meant to be a predictor of the future success of the company. Also, the opinion is not a refl ection of how eff ectively management is performing its role of running the company. The auditor’s opinion is simply a report on whether the fi nancial statements are fairly presented in accordance with the applicable fi nancial reporting framework (AU-C 200.A1).

Assurance Providers Assurance services are provided by accounting and other consulting fi rms. The largest ac- counting fi rms in the United States are known collectively as the “Big 4” fi rms: Deloitte, Ernst & Young (EY), KPMG and Pricewaterhousecoopers (PwC). These four fi rms op- erate internationally through a network of affi liate companies, and dominate the assurance market throughout the world. These four fi rms dominate the audits of the largest companies in the United States.

The next tier of acco unting fi rms is known as the mid-tier. The fi rms that comprise the mid-tier have a signifi cant presence nationally and most have international affi liations. The mid-tier fi rms in the United States include, among others, Grant Thornton LLP, BDO USA LLP, RSM LLP, CBIZ/Mayer Hoff man McCann PC, and CroweHorwath LLC. These fi rms service medium-sized and smaller clients.

The next tier of accounting fi rms are regional and local accounting fi rms. These fi rms ser- vice clients in their local areas and range in size from single-partner fi rms to several-partner fi rms with professionally qualifi ed and trained staff .

Many of these accounting fi rms provide non-assurance (or non-audit) services as well as assurance services. These non-assurance services include management consulting, business valuation, mergers and acquisitions, insolvency, tax, and accounting. To ensure that auditors remain independent from their clients, there are some regulations regarding what types of non-audit services can be provided to audit clients. These regulations will be further discussed in Chapter 2.

Accounting fi rms are not the only providers of assurance services. A number of con- sulting fi rms provide assurance services in areas such as website security and environmental sustainability reporting. Consulting fi rms employ staff with a variety of expertise including, for example, engineers, accountants, IT professionals, scientists, and economists.

professional skepticism an attitude that includes a question- ing mind, being alert to condi- tions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence

professional judgment the application of relevant training, knowledge, and experience in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement

Cloud 9 - Continuing Case Ernie stresses to Ron that any fi nancial statements prepared for McLellan’s Shoes are Ron’s responsibility, even if they are au- dited. The auditor must be skeptical about the claims made by

Ron in the fi nancial statements. These claims include, for ex- ample, that the assets shown on the balance sheet exist and are valued correctly, and that the balance sheet contains a complete

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The Role of Regulators and Regulations 1-13

list of the business’s liabilities. In other words, the auditor is not just going to believe whatever Ron tells them. Auditors must gather evidence about the fi nancial statements before they can give an audit opinion. Ernie also explains to Ron that because his business is relatively small, he has a choice between large and small audit fi rms. Very large companies must choose a Big 4 auditor because often the other auditors are too small to do the

work and still maintain their independence. If a small audit fi rm audits a large company it is open to the criticism that it will not be suffi ciently skeptical because it does not want to lose the fees from that client. A large audit fi rm has many other clients, so the fees from any one client are a relatively small part of its revenue. Ron likes the idea that the smaller audit fi rms are generally less expensive.

Before You Go On 4.1 Describe management’s responsibilities in terms of the fi nancial statement audit. 4.2 What is professional skepticism? 4.3 What are non-audit services? Provide several examples of non-audit services provided by

CPA fi rms.

LEARNING OBJECTIVE 5 Explain the roles of diff erent regulators and organizations that aff ect the audit profession.

In this section we discuss the regulators and other organizations that impact the audit process and the profession.

Securities and Exchange Commission (SEC) The SEC is a federal government agency whose mission is to protect investors, maintain fair and effi cient markets, and facilitate capital formation (www.sec.gov). A primary task of the SEC is to enforce and interpret securities laws. Some of the key laws that impact the audit profession are the Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes-Oxley (SOX) Act of 2002. The Securities Act of 1933 regulates the disclosure of fi nancial information in a company’s initial public off ering of stock and requires that the fi nancial information be audited. The Securities Exchange Act of 1934 regulates the ongoing trading of securities after the initial public off ering and requires the annual audit of a public company’s fi nancial statements. The SOX Act of 2002 was passed to help restore investor confi dence after a series of corporate accounting scandals were revealed in the late 1990s and early 2000s. The SOX Act enhanced fi nancial disclosures for public companies and placed more emphasis on corporate responsibility. It also created the Public Company Accounting Oversight Board, or PCAOB, which oversees the audits of public companies.

Public Company Accounting Oversight Board (PCAOB) The PCAOB is a non-profi t corporation established through the SOX legislation in 2002. Its mission is to oversee the audits of public companies to protect the interests of investors

The Role of Regulators and Regulations

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1-14 CHAPTER 1 Introduction and Overview of Audit and Assurance

(www.pcaobus.org). Prior to the creation of the PCAOB, the audit profession was self-regulated. This means that audit professionals, through their own professional organization, created the audit standards to be followed in the conduct of an audit. The audit profession also created a system of peer review for inspecting audit work to ensure auditors were following the stan- dards, and would take enforcement action for auditors who did not perform audits accord- ing to the standards. The audit profession is still self-regulated with respect to the audits of private companies, but when the PCAOB was created, it took over the regulation and stan- dard setting for the audits of public companies. Standards issued by the PCAOB are called Auditing Standards (AS), which provide minimum requirements and guidance for auditing services. When the PCAOB was created, it adopted the audit profession’s standards in 2003 as its interim standards, providing a starting point for the audits of public companies. Since then the PCAOB has issued its own standards that supersede, or replace, some of the interim standards. In 2015, the PCAOB reorganized its auditing standards using a topical structure and a single, integrated numbering system. The current topical organization of the PCAOB standards is listed in Illustration 1.2. Throughout the text you will be learning some of the specifi c PCAOB auditing standards in the diff erent topical categories. The beginning of each chapter will list which PCAOB standards will be discussed in that particular chapter. You will also see references to the PCAOB standards within each chapter. The reference will begin with “AS” followed by the standard number, such as “AS 2201.”

Source: www.pcaobus.org/standards/auditing

General Auditing Standards (1000)

1000 General Principles and Standard

1100 General Concepts

1200 General Activities

1300 Auditor Communications

Audit Procedures (2000)

2100 Audit Planning and Risk Assessment

2200 Auditing Internal Control Over Financial Reporting

2300 Audit Procedures in Response to Risks – Nature, Timing, and Extent

2400 Audit Procedures for Specifi c Aspects of the Audit

2500 Audit Procedures for Certain Accounts or Disclosures

2600 Special Topics

2700 Auditor’s Responsibilities Regarding Supplemental and Other Information

2800 Concluding Audit Procedures

2900 Post-Audit Matters

Auditor Reporting (3000)

3100 Reporting on Audits of Financial Statements

3300 Other Reporting Topics

Matters Relating to Filings Under Federal Securities Laws (4000)

Other Matters Associated with Audits (6000)

ILLUSTRATION 1.2 PCAOB auditing standards topical organization

Accounting fi rms that want to audit public companies must register with the PCAOB. Registration involves paying fees to the board, complying with the PCAOB Auditing Stan- dards, and having their audit work inspected by the board. The PCAOB has disciplinary authority over registered fi rms and can impose punishment on accounting fi rms that do not adhere to standards. Punishments can include revoking a fi rm’s registration, imposing mone- tary fi nes, and banning an individual from auditing public companies.

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The Role of Regulators and Regulations 1-15

American Institute of Certified Public Accountants (AICPA) The AICPA is a private professional membership organization of CPAs representing the ac- counting profession. There are over 400,000 members in 145 countries (www.aicpa.org). Some key activities of the AICPA include representing the profession before rule-making bodies, acting as an advocate for the profession before legislative bodies, providing educational ma- terials to its members, and setting ethical standards for the profession. The AICPA is also responsible for creating and grading the Uniform CPA Exam.

The AICPA accomplishes many of its activities through its system of committees. One of the standing committees is the Auditing Standards Board, or ASB. Prior to the creation of the PCAOB, the ASB was responsible for issuing audit standards that were used for the audits of public and private companies. Since 2003, the task of the ASB has been to issue audit standards for the audits of private companies and not-for-profi t organizations only. Audit standards is- sued by the ASB are called Statements on Auditing Standards (SAS). In an eff ort to improve the clarity of auditing standards, the ASB approved new clarity standards that were eff ective for audit periods ending after December 15, 2012. The new clarity standards include a more comprehensive set of principles underlying an audit conducted in accordance with generally accepted auditing standards (GAAS), which are presented in Illustration 1.3. These princi- ples explicitly address the concepts of materiality and professional skepticism. The principles describe the responsibilities of management, and those charged with governance of an entity, for the fi nancial statements. The auditor responsibilities also address the important concepts of compliance with ethical requirements (including independence requirements) and the fact

Purpose of an Audit The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. An auditor’s opinion enhances the degree of confi- dence that intended users can place in the financial statements.

Premise Upon which an Audit is Conducted An audit in accordance with generally accepted auditing standards is conducted on the premise that management, and where appropriate, those charged with governance, have responsibility:

a. for the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatements, whether due to fraud or error.

b. to provide the auditor with: i. all information, such as records, documentation, and other matters that are relevant to

the preparation and fair presentation of the financial statements; ii. any additional information that the auditor may request from management, and where

appropriate, those charged with governance; and iii. unrestricted access to those within the entity from whom the auditor determines it

necessary to obtain audit evidence.

Responsibilities of the Auditor Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical requirements; and maintaining professional skepticism and exer- cising professional judgment, throughout the planning and performance of the audit.

Performing the Audit To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free of material misstatement, whether due to fraud or error.

To obtain reasonable assurance, which is a high, but not absolute, level of assurance, the auditor:

• plans the work and properly supervised any assistants.

• determine and applies appropriate materiality level or levels throughout the audit

ILLUSTRATION 1.3 Principles underlying an audit conducted in accordance with generally accepted auditing standards

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1-16 CHAPTER 1 Introduction and Overview of Audit and Assurance

that an auditor must use professional judgment. Take a few minutes to read the principles in Illustration 1.3.

The SASs are interpretations of the principles underlying an audit conducted in accor- dance with GAAS. The SASs explain the nature and extent of an auditor’s responsibility and off er guidance to an auditor in performing the audit of a private company. Compliance with the SASs is mandatory for AICPA members, who must justify any departures from the stan- dards. The SASs are numbered in the order in which they are issued by the ASB. Then the standards are organized by topical content using the AU numbering system. (Note: The “AU” stands for Auditing Standards, but these are not to be confused with the Auditing Standards (AS) from the PCAOB.) The AU-C topical order (the “C” denotes the clarifi ed standards) is listed in Illustration 1.4. Throughout the text we will be learning some of the specifi c ASB auditing standards in the diff erent topical categories. The beginning of each chapter will list which ASB standards will be discussed in that respective chapter. You will also see references to the ASB standards within the text. The reference will begin with “AU-C” followed by the standard number, such as “AU-C 200.”

The ASB also issues Statements on Standards for Attestation Engagements (SSAE) and Statements on Quality Control Standards (SQCS) for AICPA member fi rms. Another standing committee of the AICPA is the Accounting and Review Services Committee. This committee is tasked with issuing Statements on Standards for Accounting and Review Services (SSARS). The SSARS provide guidance for services provided on historical fi nancial statements that are less extensive than an audit. An example that we discussed earlier is a review of historical

• identifies and assesses risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control.

• obtains suff icient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate responses to the assessed risks.

The auditor is unable to obtain absolute assurance that the financial statements are free of mate- rial misstatement because of inherent limitations, which arise from:

• the nature of financial reporting;

• the nature of audit procedures; and

• the need for the audit to be conducted within a reasonable period of time and so as to achieve a balance between benefit and cost.

Reporting the Results of an Audit Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in accordance with the auditor’s findings, or states that an opinion can- not be expressed. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with applicable financial reporting framework.

Source: AU-C Preface

ILLUSTRATION 1.3 (continued)

ILLUSTRATION 1.4 Auditing Standards Board AU-C topical content

Source: AICPA

AU-C Section General Topic

AU-C 200–299 General Principles and Responsibilities

AU-C 300–499 Risk Assessment and Response to Assessed Risks

AU-C 500–599 Audit Evidence

AU-C 600–699 Using the Work of Others

AU-C 700–799 Audit Conclusions and Reporting

AU-C 800–899 Special Considerations

AU-C 900–999 Special Considerations in the United States

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The Role of Regulators and Regulations 1-17

fi nancial statements. A more detailed discussion of accounting and review services is pro- vided in Chapter 15.

To help summarize the audit standard-setting environment in the United States, Illustration 1.5 provides a diagram of the current audit standard setting-structure for the audits of public and private companies.

Financial Accounting Standards Board (FASB) The FASB is a privately funded organization whose mission is to establish fi nancial accounting and reporting standards for nongovernmental entities with the goal of providing information

Professional Environment International Auditing and Assurance Standards Board (IAASB)

In 1977, 63 accountancy bodies (including the AICPA) represent- ing 51 countries signed an agreement creating the International Federation of Accountants (IFAC). The mission of IFAC is to serve the public interest and strengthen the accountancy pro- fession by supporting the development and implementation of high-quality international standards.2 Toward this end, IFAC has established, as a standing subcommittee, the International Au- diting and Assurance Standards Board (IAASB) with the respon- sibility and authority to issue International Standards on Audit- ing (ISA). The mission of the IAASB is to establish high-quality auditing, assurance, quality control, and related services stan- dards and to improve the uniformity of practice by professional accountants throughout the world, thereby strengthening public

confi dence in the global auditing profession and serving the pub- lic interest.3

Today auditing has become a global profession. Many coun- tries adopt IAASB standards as their own. Other countries have auditing standards that closely resemble the IAASB standards (for example, the SAS in the United States). Where diff erences exist between the international standards and local standards, the local member body, such as the AICPA’s ASB, is expected to give prompt consideration to such diff erences with a view to achieving harmo- nization. In recent years, the U.S. ASB and the IAASB have worked jointly in creating auditing standards that have global acceptance. Most of the auditing principles and practices discussed in this text are consistent with IAASB standards.

2International Federation of Accountants website. Accessed June 5, 2018. www.ifac.org 3International Auditing and Assurance Standards Board website. Accessed June 5, 2018. www.iaasb.org

ILLUSTRATION 1.5 Auditing standard setting in the United States

Public company (issuer)

Private company (non-issuer)

Statements on standards for

attestation engagements (SSAE)

Staff audit practice alerts from the PCAOB to provide guidance to

CPAs and auditors

Statements on auditing standards

(SAS)

Interpretive publications from the ASB to provide guidance to CPAs and auditors

Statements on quality control

standards (SQCS)

Auditing standards (AS)

AICPA’S auditing standards board

(ASB)

Public company accounting oversight board

(PCAOB)

Audit standard setting

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1-18 CHAPTER 1 Introduction and Overview of Audit and Assurance

that is useful for decision making (www.fasb.org). You are probably familiar with the FASB from your fi nancial accounting courses. The FASB maintains the Accounting Standards Codi- fi cation (ASC), which represents the authoritative standards of fi nancial reporting recognized by the SEC, the PCAOB, and the AICPA. We commonly refer to the authoritative standards as GAAP. There are seven full-time members of the FASB who have diverse backgrounds in accounting, fi nance, business, and research. Members of the FASB work closely with the AICPA, SEC, and the PCAOB when researching and drafting fi nancial accounting and report- ing standards.

Committee on Sponsoring Organizations of the Treadway Commission (COSO) COSO is an independent private-sector group that focuses on providing guidance to man- agement and expertise in the areas of internal control, enterprise risk management, and fraud deterrence (www.coso.org). COSO was organized in 1985 and is sponsored by the fol- lowing organizations: the American Accounting Association (AAA), the AICPA, Financial Executives International (FEI), the Institute of Internal Auditors (IIA), and the National Association of Accountants, which is now the Institute of Management Accountants (IMA). The fi rst chairman of the commission was James C. Treadway, Jr., a former commissioner of the SEC. The group is often referred to as the “Treadway Commission.” In 1992, COSO is- sued a landmark report titled Internal Control—Integrated Framework. This report provided a comprehensive defi nition of internal controls and a framework that companies could use to design their own internal control systems. In 2013, the framework went through a com- prehensive update and was reissued. This updated framework will be covered in depth in Chapter 6.

National Association of State Boards of Accountancy (NASBA) and State Boards of Accountancy CPAs are professionals who are licensed by state governments. Each state legislature has established a state board of accountancy to license and regulate CPAs to protect the public interest. Some of the functions of a state board of accountancy include:

• issuing CPA licenses to individuals who meet all the requirements • adopting and enforcing rules of professional conduct for CPAs • adopting and enforcing rules regarding continuing professional education requirements • investigating complaints, conducting hearings, and taking appropriate disciplinary ac-

tions, such as suspension or revocation of the CPA license

NASBA is a professional organization whose mission is to enhance the eff ectiveness and advance the common interests of its members, which are the state boards of accountancy (www.nasba.org). There are actually 55 jurisdictions with boards of accountancy. They in- clude the 50 states, the District of Columbia, the Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico, and the Virgin Islands. NASBA acts as a collective voice for the boards of accountancy and works to promote the interests of the state boards with legislative and regulatory bodies. NASBA also provides education and development opportunities for its members, provides technology support, and promotes ethical behavior in the profession. One of the services NASBA provides to state boards is that it serves as the application center for individuals applying to sit for the CPA exam. When you are ready to apply to take the CPA exam, you may be asked to apply through NASBA’s website. Note that NASBA does not create the CPA exam or score it; it simply serves in an administrative capacity with the application process.

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Audit Report on Financial Statements 1-19

Cloud 9 - Continuing Case Ernie explains that, in general, the regulators and regulations that apply to publicly traded corporations are not relevant to McLellan’s Shoes. However, any auditor Ron engages would apply the auditing and accounting standards that are relevant to an audit

engagement when auditing a small business. Since McLellan’s Shoes is a private company, the auditors would follow the audit standards of the ASB when conducting the audit.

Before You Go On 5.1 What is the SEC and what is its role? 5.2 Which organization sets the standards for the audits of public companies? For the audits of

private companies? 5.3 What are the main functions of a state board of accountancy?

LEARNING OBJECTIVE 6 Explain the concepts of reasonable assurance, materiality, and the nature of an unqualified/unmodified report on the audit of financial statements.

In this section we introduce you to the independent auditor’s report, which is the “end prod- uct” of the fi nancial statement audit. The independent auditor’s report is used to communi- cate the audit fi rm’s opinion about a company’s fi nancial statements to interested users. We will revisit the independent auditor’s report in more depth in Chapter 15, but it is helpful to understand this report from the perspective of a fi nancial statement reader as you begin to learn the audit process.

Reasonable Assurance and the Financial Statements We have explained how the responsibility of the auditor is to provide an opinion on whether the fi nancial statements are presented fairly in accordance with the applicable fi nancial reporting framework. An opinion is defi ned as a judgment about matters that are subjective. The prepa- ration of fi nancial statements is considered somewhat subjective because management must make some estimates and choose between diff erent accounting methods. Therefore, the audi- tor is only required to obtain reasonable assurance about whether the fi nancial statements as a whole are free from material misstatement, whether due to fraud or error. Reasonable assurance is a high, but not absolute, level of assurance (AU-C 200.06). In other words, the au- ditor does not “guarantee” or “certify” that the fi nancial statements are 100% accurate because that is considered absolute assurance, which is not possible with content that is subjective.

In addition, an audit could not be completed in a reasonable amount of time if auditors had to provide absolute assurance. For some accounts and transactions, auditors use sampling techniques when gathering audit evidence and therefore do not examine 100% of a company’s transactions for the period under audit. So, how do auditors know when they have gathered enough evidence? Ultimately, that is a matter of professional judgment. Since judgment is

reasonable assurance a high, but not absolute, level of assurance

Audit Report on Financial Statements

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1-20 CHAPTER 1 Introduction and Overview of Audit and Assurance

involved, there will always be a risk the auditors will give the wrong opinion. This is called audit risk. Audit risk is aff ected by client characteristics as well as actions of the auditor. For example, when a client implements a new accounting standard, audit risk increases because there is increased risk for error when implementing a new process. The internal control sys- tem of the client also impacts audit risk. If the client has strong internal controls, it is more likely the internal controls will prevent, or detect and correct, material misstatements, which decreases audit risk. Auditors impact audit risk by the decisions made in how to conduct the audit. For example, using a larger sample size versus a smaller sample size, in general, will decrease audit risk. The concept of audit risk is covered in depth in Chapter 3. We will devote considerable attention throughout the text to the concept of audit risk and determining how auditors make important professional judgments about collecting suffi cient, appropriate evi- dence to achieve reasonable assurance and support the audit opinion.

Materiality and the Financial Statements Although fi nancial statements contain approximations, they must refl ect a reasonable degree of precision. However, accounting is not precise, or accurate, the way we might think of Newtonian physics as being precise. If a potential misstatement of the fi nancial statements is signifi cant enough to infl uence or make a diff erence in the judgment or consequential activi- ties of a fi nancial statement user, it is considered material.

Materiality is a relative concept, and it diff ers from company to company and from year to year for a given company. For example, a $25,000 misstatement of revenues may be material to a company with $200,000 of net income, while a $25,000 misstatement for a company with $5,000,000 in net income may be immaterial. In addition, qualitative characteristics infl uence materiality. For example, an error in the fi nancial statements may be a small percentage of an account balance. This small error, however, may be considered material because it could cause an entity to breach a loan covenant, which could result in a misclassifi cation of current and noncurrent debt.

Auditors design an audit to provide reasonable assurance that the fi nancial statements are free of material misstatement. However, auditors do not design an audit to look for imma- terial misstatements because they would not infl uence a fi nancial statement user. A deeper discussion of how auditors make materiality decisions can be found in Chapter 3.

audit risk the risk that an au- ditor expresses an inappropriate audit opinion when the fi nan- cial statements are materially misstated

Professional Environment Materiality

In the audit of a very large company, the amount of misstatement that would be considered immaterial might be quite large. Con- sider the audit of The Boeing Company for the year ended De- cember 31, 2017 when Boeing had total revenues of $93.392 bil- lion, earnings before income taxes of $10.047 billion, net income of $8.197 billion, and total assets of $92.333 billion at December 31, 2017. Boeing rounds its fi nancial statement amounts to the nearest $1 million. For the year ended December 31, 2017, Boeing had a return on assets of 8.99%.

As an investor, would you consider a return on assets of 8.99% or 9.00% to be substantially the same? It would take approx- imately a $10 million–dollar misstatement to change return on as- sets by only 1/100 of 1% for Boeing for the year ended December 31, 2017. Alternatively, as an investor would you consider a return on assets of 8.99% or 8.89% to be substantially the same? It would take approximately a $100 million–dollar misstatement to change return on assets by only 1/10 of 1% for Boeing for the year ended December 31, 2017.

The Auditorʼs Report on Financial Statements When the audit fi rm has determined that it has gathered suffi cient, appropriate evidence to form an opinion, then it is ready to issue the audit report. Audit standards require a standard format of the audit report be used for all audits. In other words, all accounting fi rms use the same standard format and standard wording for reporting their audit opinions. Using a standard format makes it easier for fi nancial statement users to navigate the audit report. There is a standard report for

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Audit Report on Financial Statements 1-21

the audit of public company fi nancial statements and a standard report for the audit of private company fi nancial statements. The actual process of auditing the fi nancial statements of public and private companies is similar, but there are also some diff erences, which will be discussed throughout the text. One of the key diff erences is the format of the audit reports.

Illustration 1.6 provides an example of an unmodifi ed audit report on the fi nancial statements of McLellan’s Shoes, a private company. If auditors have determined the fi nancial statements are presented fairly in accordance with the applicable fi nancial reporting frame- work, they issue the standard unmodifi ed report. Take a moment to read over the report. You will see some of the key concepts we have already discussed in this chapter. Sections of the report are numbered so we can further explain each component. Explanations of each num- bered component follow Illustration 1.6.

[1] Independent Auditor’s Report

[2] To the owners of McLellan’s Shoes:

[3] Report on the Financial Statements We have audited the accompanying financial statements of McLellan’s Shoes, which comprise the balance sheets as of December 31, 2022 and 2021, and the related statements of income, changes in equity, and cash flows for the years then ended, and the related notes to the financial statements.

[4] Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the prepa- ration and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.

[5] Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reason- able assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and dis- closures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the pur- pose of expressing an opinion on the eff ectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.

We believe that the audit evidence we have obtained is suff icient and appropriate to provide a basis for our audit opinion.

[6] Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of McLellan’s Shoes as of December 31, 2022 and 2021, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.

[7] Bell & Bowerman LLP Seattle, Washington

[8] February 15, 2023

ILLUSTRATION 1.6 Example of an unmodifi ed audit report on the fi nancial statements of McLellan’s Shoes, a private company

Source: AU-C 700.A63 Exhibit Illustration 2

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1-22 CHAPTER 1 Introduction and Overview of Audit and Assurance

1. Title—The term independent is in the title of the report to emphasize the auditors are external to the company and therefore can provide an objective opinion.

2. Address—The report is addressed to the owners or shareholders of the company and to the board of directors, if applicable.

3. Introductory paragraph—This paragraph explains that an audit was conducted and iden- tifi es the fi nancial statements and the date of the fi nancial statements.

4. Management’s responsibility paragraph—This paragraph explains that management is responsible for the preparation and fair presentation of the fi nancial statements and for the design, implementation, and maintenance of ICFR.

5. Auditor’s responsibility paragraphs—These paragraphs explain the auditors are responsi- ble for expressing an opinion on the fi nancial statements, for following audit standards, for assessing the risk of material misstatement, and for obtaining reasonable assurance about the fair presentation of the fi nancial statements. The appropriate audit standards would be those issued by the ASB since the company is a private company. In a private company audit, auditors state they do not evaluate internal control for the purpose of expressing an opinion on internal control. The audit fi rm concludes with a statement that it believes it has obtained suffi cient and appropriate evidence to provide a basis for its audit opinion.

6. Opinion paragraph—This paragraph clearly states the auditor’s opinion that the fi nancial statements are fairly presented, in all material respects, in accordance with the applicable fi nancial reporting framework, which in this example is GAAP.

7. Signature—The fi rm name and location are used as the signature. 8. Date—The date represents the end of fi eldwork, which is the conclusion of gathering and

evaluating evidence, and drawing all conclusions for the audit.

Illustration 1.7 provides an example of an unqualifi ed audit report on the fi nancial state- ments of The Boeing Company, a public company. If auditors have determined the fi nancial statements are presented fairly in accordance with the applicable fi nancial reporting frame- work, they issue the standard unqualifi ed report. The PCAOB standards use the term unqual- ifi ed report. The term unqualifi ed is equivalent to the term unmodifi ed used for the private company audit report. The terms are sometimes used interchangeably.

Take a moment to look over the report in Illustration 1.7 and note some of the sim- ilarities and diff erences with the private company audit report. Again, you will see some of the key concepts discussed in this chapter. Sections of the report are numbered so we can further explain each component. Explanations of each numbered component follow Illustration 1.7.

ILLUSTRATION 1.7 Example of an unqualifi ed audit report on the fi nancial statements of The Boeing Company, a public compan y

[1] REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

[2] To the shareholders and the Board of Directors of The Boeing Company

Opinion on the Financial Statements [3] We have audited the accompanying consolidated statements of financial position of The Boeing Company and subsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consol- idated statements of operations, comprehensive income, equity, and cash flows, for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.

[4] We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 12, 2018, expressed an unqualified opinion on the Company’s internal control over financial reporting.

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Audit Report on Financial Statements 1-23

Basis for Opinion [5] These financial statements are the responsibility of the Company’s management. Our responsi- bility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

[6] We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial state- ments, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

[7] /s/ Deloitte & Touche LLP Chicago, Illinois [8] February 12, 2018

[9] We have served as the Company’s auditor since at least 1934; however, an earlier year cannot be reliably determined.

1. Title—The term independent is also in the title of this report to emphasize the auditors are external to the company and therefore can provide an objective opinion. In addition, the term registered is included to emphasize the fi rm is registered with the PCAOB.

2. Address—The report is addressed to the shareholders and board of directors of the company.

3. Opinion paragraph—The fi rst sentence explains that an audit was conducted and iden- tifi es the fi nancial statements and the dates of the fi nancial statements. The second sen- tence states the auditor’s opinion. Note the opinion sentence is virtually identical to the opinion paragraph for the private company audit report.

4. Paragraph referencing the audit of internal control—This paragraph is unique to the public company audit report. Public companies are required to have an audit of ICFR and auditors issue a separate opinion for that audit, which is discussed in the next section.

5. Basis for opinion paragraph—This paragraph states the diff ering responsibilities of man- agement and auditors. It is similar to the responsibility paragraphs of the report for pri- vate company audits, but the private company report goes into more detail regarding the responsibilities of management and auditors. One key diff erence is that this paragraph references registration with the PCAOB and independence requirements of the SEC and other federal securities laws.

6. Scope paragraph—This paragraph explains, in brief terms, the process of conducting an audit. It mentions the concept of reasonable assurance about whether the fi nancial state- ments are free of material misstatement. It includes an explicit statement that PCAOB audit standards were followed since it is a public company. The scope paragraph also includes a brief discussion of the professional judgments made during the audit. Finally, it concludes with a statement that the audit fi rm believes that its audit provides a reason- able basis for its opinion.

7. Signature—The fi rm name and location is used as the signature. 8. Date—The date represents the end of fi eldwork, which is the conclusion of gathering and

evaluating evidence, and drawing all conclusions for the audit. 9. Auditor tenure—The fi nal component of the report is a sentence that states the year in

which the fi rm began serving consecutively as the company’s auditor.

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1-24 CHAPTER 1 Introduction and Overview of Audit and Assurance

After reviewing the standard audit reports, you may be wondering what happens if au- ditors conclude the fi nancial statements are not presented fairly in accordance with the ap- plicable fi nancial reporting framework? Or what happens if auditors cannot gather enough evidence to form an opinion? When situations such as these occur, auditors may have to mod- ify their opinion. Audit standards have established three types of modifi ed audit opinions: a qualifi ed opinion, an adverse opinion, and a disclaimer of opinion. Illustration 1.8 provides a brief summary of situations that could cause auditors to issue a modifi ed opinion. It is im- portant to note that only material situations would cause auditors to modify the opinion. The discovery of immaterial errors would not prevent the issuance of an unmodifi ed/unqualifi ed opinion. The diff erent types of modifi ed reports will be covered in depth in Chapter 15, so consider Illustration 1.8 a basic introduction to the modifi ed reports.

Before You Go On 6.1 Why do auditors provide reasonable assurance and not absolute assurance? 6.2 Explain the concept of materiality. How does the concept of materiality relate to reasonable

assurance? 6.3 How are the audit reports for private and public companies similar? 6.4 How are the audit reports for private and public companies diff erent?

Professional Environment PCAOB Releases New Audit Report

Prior to 2017, the standard unqualifi ed auditor’s report had re- mained substantially unchanged since the 1940s. Over the years, there had been much debate about the relevance of continuing to use the same standard report, particularly in the modern in- formation age in which investors and other users demand better and faster information. Since 2011, the PCAOB has encouraged open discussion, comments, and feedback on various proposals for making the auditor’s report more relevant to the public. Finally, on June 1, 2017, the PCAOB adopted a new auditor reporting standard, AS 3101 The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualifi ed Opinion. The standard was approved by the SEC on October 23, 2017. The

standard includes two signifi cant changes to the existing auditor’s report.

The fi rst signifi cant change is the communication of critical audit matters, or CAM, in the audit report. A CAM is any audit matter that was communicated to or required to be communicated to the audit committee. The rationale is that if a matter is being communicated to the audit committee, it must be important and should be made available to users of the fi nancial statements. The standard states that a CAM “relates to accounts or disclosures that are material to the fi nancial statements and involves especially chal- lenging, subjective, or complex auditor judgement.” (AS 3101.11) For each CAM that is included in the auditor’s report, the auditor

ILLUSTRATION 1.8 Situations that cause a modifi ed opinion

Situation Type of modified opinion

Material departure(s) from the applicable fi nan- cial reporting framework and the client refuses to make corrections

• Qualified – financial statements are presented fairly, except for the uncorrected departure(s)

• Adverse – financial statements are not presented fairly and should not be relied upon (pervasively material departures)

Material limitation on the auditor’s ability to gather suffi cient appropriate evidence, referred to as a scope limitation

• Qualified – financial statements are presented fairly, except for the auditor’s inability to gather evidence for a material item

• Disclaimer of opinion – auditor was not able to gather sufficient appropriate evidence and cannot express an opinion on the financial statements (pervasively material scope limitations)

Auditor is not independent • Disclaimer of opinion – auditor is not independent and cannot express an opinion

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Audit Report on Internal Controls over Financial Reporting 1-25

must identify the CAM, describe why the auditor considered the item a CAM and how it was addressed during the audit, and refer to the relevant accounts or disclosures that relate to the CAM.

The second signifi cant change is the inclusion of auditor ten- ure in the auditor’s report. After the signature of the fi rm at the conclusion of the report, there is a statement that says, “We have served as the Company’s auditor since [year]” (AS 3101 Appendix B). The fi rm includes the year in which it began serving consecu- tively as the company’s auditor.

The PCAOB recognizes that including CAM in the au- ditor’s report is a significant change. Therefore, the require- ment to include CAM will go into effect for fiscal years ending on or after June 30, 2019. The other changes to the auditor’s report, including the disclosure of auditor tenure, went into effect for fiscal years ending on or after December 15, 2017.4

The audit report for The Boeing Company in Illustration 1.7 reflects the new audit report and includes the statement about auditor tenure.

4PCAOB Release No. 2017-001, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualifi ed Opinion.

Audit Report on Internal Controls over Financial Reporting

LEARNING OBJECTIVE 7 Explain the concept of reasonable assurance and the nature of an unqualified report on internal controls over financial reporting.

Next we will discuss the audit report for the audit of ICFR. Recall from earlier in the chapter that only public companies are required to have an audit on the eff ectiveness of ICFR.

Reasonable Assurance and Internal Controls Section 404 of the SOX legislation requires that management accept responsibility for the design and maintenance of internal controls. It also requires that management issue a report each year asserting whether internal controls over fi nancial reporting were eff ective. Further, management’s claims about the eff ectiveness of ICFR must be audited by the independent external auditor. The reason for requiring an audit of internal controls is because eff ec- tive ICFR provides reasonable assurance regarding the reliability of fi nancial reporting and the preparation of fi nancial statements for external purposes (AS 2201.02). Here again we see the phrase reasonable assurance. If internal controls are eff ective, then it is more likely that the fi nancial statements will be free of material misstatements and errors. Even though internal controls may be considered eff ective, it does not mean they will prevent all misstatements or errors from aff ecting the fi nancial statements. There is still some risk that a material error could occur on the fi nancial statements. Even an eff ective system of internal controls over fi nancial reporting will only provide reasonable assurance, not absolute assurance, that fi nan- cial statements are free from material misstatement.

PCAOB Auditing Standard 2201 An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements states that auditors must conduct an integrated audit for public companies. This means auditors must plan and perform their work to achieve the objectives of both the fi nancial statement audit and the audit of the eff ective- ness of ICFR simultaneously. For effi ciency purposes, auditors will select audit procedures that allow them to gather evidence that is useful to both of the audits. Auditors are only re- quired to obtain reasonable assurance about whether the company maintained eff ective ICFR for the period under audit. Auditors cannot provide absolute assurance about the eff ective- ness of internal controls for the same reasons they cannot provide absolute assurance on the fair presentation of the fi nancial statements. The design and implementation of controls is

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1-26 CHAPTER 1 Introduction and Overview of Audit and Assurance

somewhat subjective and there is not enough time for auditors to test the eff ectiveness of all of the entity’s internal controls. Using professional judgment, auditors select the most critical internal controls over fi nancial reporting and test the eff ectiveness of those controls. This will be discussed further in Chapters 6 and 8.

The Auditor’s Report on Internal Control Over Financial Reporting When auditors have determined they have gathered suffi cient, appropriate evidence to form an opinion on the eff ectiveness of ICFR, then they are ready to issue the audit report. Similarly to the fi nancial statement audit report, AS 2201 requires a standard format of the audit report be used for all audits of eff ectiveness of ICFR. Illustration 1.9 provides an example of an audit report on the eff ectiveness of ICFR for a public company. If auditors have determined the company has maintained eff ective ICFR for the period under audit, then they issue the standard unqualifi ed report. Take a moment to read over the report and you will see some similarities to the fi nancial statement audit report for a public company.

[1] REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

[2] To the Shareholders and Board of Directors of The Boeing Company

[3] Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of The Boeing Company and subsid- iaries (the “Company”) as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Tread- way Commission (COSO). In our opinion, the Company maintained, in all material respects, eff ec- tive internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by COSO.

[4] We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended December 31, 2017, of the Company and our report dated February 12, 2018, expressed an unqualified opinion on those financial statements.

[5] Basis for Opinion The Company’s management is responsible for maintaining eff ective internal control over financial reporting and for its assessment of the eff ectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Finan- cial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. fed- eral securities laws and the applicable rules and regulations of the Securities and Exchange Com- mission and the PCAOB.

[6] We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether eff ec- tive internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating eff ective- ness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

[7] Definition and Limitations of Internal Control over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reason- able assurance regarding the reliability of financial reporting and the preparation of financial

ILLUSTRATION 1.9 Example of an unqualifi ed audit report on the eff ective- ness of ICFR for The Boeing Company, a public company

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Audit Report on Internal Controls over Financial Reporting 1-27

statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions and recorded as necessary to permit preparation of financial statements in ac- cordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a mate- rial eff ect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of eff ectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

[8] /s/Deloitte & Touche LLP

Chicago, Illinois [9] February 12, 2018

The key components of the unqualifi ed report in Illustration 1.9 are as follows:

1. Title—The term independent is also in the title of this report to emphasize the audi- tors are external to the company and therefore can provide an objective opinion. In addition, the term registered is required to indicate that the fi rm is registered with the PCAOB.

2. Address—The report is addressed to the shareholders and board of directors of the company.

3. Opinion paragraph—The fi rst sentence explains that an audit of ICFR was conducted and references the COSO Internal Control—Integrated Framework as the criteria used as the basis for determining if ICFR are eff ective. The second sentence states the auditor’s opinion.

4. Paragraph referencing the fi nancial statement audit—This paragraph is a reference to the fi nancial statement audit report and states the type of opinion that was given on the fi nancial statements.

5. Basis for opinion paragraph—This paragraph states the diff erent responsibilities of man- agement and auditors. Like the audit report on the fi nancial statements, this paragraph references registration with the PCAOB and independence requirements of the SEC and other federal securities laws.

6. Scope paragraph—This paragraph explains that auditors conducted their audit in accor- dance with the standards of the PCAOB. In brief terms, it explains the process of con- ducting an audit of the eff ectiveness of ICFR. It mentions that auditors are only required to obtain reasonable assurance about whether the company maintained, in all material respects, eff ective ICFR. It concludes with a statement that the audit fi rm believes its audit provides a reasonable basis for its opinion.

7. Definition and inherent limitations paragraph—This paragraph provides a defini- tion of ICFR that is taken directly from AS 2201. This is helpful for users of the financial statements in case they are not familiar with the concept of internal con- trols. Also note the use of reasonable assurance in the definition to clarify that an internal control system does not eliminate all risk associated with the preparation of financial statements. The final sentence cautions not to use the current-year opinion to assume that future internal controls will be effective. Circumstances may change in the future that could render controls ineffective if the controls are not modified appropriately.

8. Signature—The audit fi rm’s name and location are used as the signature.

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1-28 CHAPTER 1 Introduction and Overview of Audit and Assurance

9. Date—The date represents the end of fi eldwork, which is the conclusion of gathering and evaluating evidence for the audit. Since the audits are integrated, the date on both the fi nancial statement audit report and the audit report on the eff ectiveness of ICFR will be the same.

What happens if auditors conclude the company did not maintain eff ective ICFR over the period under audit? That would mean the auditors discovered a material weakness in the client’s ICFR. The PCAOB defi nes a material weakness as follows:

A defi ciency, or combination of defi ciencies, in ICFR, such that there is a reasonable possibility that a material misstatement of the fi nancial statements will not be prevented or detected on a timely basis. (AS 2201.A7)

If one or more material weaknesses are discovered during the audit, then auditors issue an ad- verse opinion on the eff ectiveness of ICFR that explicitly states the company did not maintain eff ective ICFR during the period under audit. AS 2201 dictates how auditors would modify the audit report to express an adverse opinion. If auditors encounter a material limitation in the scope of their work, they may consider disclaiming an opinion. We will cover these modifi ca- tions in greater detail in Chapter 15.

Before You Go On 7.1 Explain the concept of reasonable assurance as it applies to a system of internal controls and

to the audit of the eff ectiveness of internal controls. 7.2 What is management’s responsibility for internal controls as stated in the audit report on the

eff ectiveness of internal controls? 7.3 What date is used on the audit report on the eff ectiveness of internal controls, and what does

the date represent?

material weakness a defi ciency, or combination of defi ciencies, in ICFR, such that there is a reasonable possibility that a material misstatement of the fi nancial statements will not be prevented or detected on a timely basis

The Audit Expectation Gap

LEARNING OBJECTIVE 8 Explain the audit expectation gap.

The audit expectation gap occurs when there is a diff erence between the expectations of auditors and fi nancial statement users. The gap occurs when user beliefs do not align with what an au- ditor has actually done. In particular, the gap is caused by unrealistic user expectations such as:

• The auditor is providing absolute assurance. • The auditor is guaranteeing the future viability of the entity. • An unmodifi ed audit opinion is an indicator of complete accuracy of the fi nancial

statements. • The auditor will defi nitely fi nd any and all fraud. • The auditor has checked all transactions.

The reality is that:

• An auditor provides reasonable assurance. • The audit does not guarantee the future viability of the entity.

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The Audit Expectation Gap 1-29

• An unmodifi ed opinion indicates the auditor believes there are no material misstate- ments in the fi nancial statements.

• The auditor will assess the risk of fraud and conduct tests to try to uncover any fraud, but there is no guarantee the auditor will fi nd all material fraud, should one have occurred.

• The auditor tests a sample of transactions.

The audit expectation gap is represented graphically in Illustration 1.10.

Cloud 9 - Continuing Case Ron believes that Chip Masters would know what an audit can provide, and what it cannot, because Chip is an experienced vice president of a large international company. He deals with auditors on a regular basis.

Ron thanks Ernie for his time. Ernie has helped him to un- derstand that preparing more detailed fi nancial statements and

engaging an auditor to perform a fi nancial statement audit would not be as bad as he fi rst thought. Ron now understands why Ernie thinks audits are valuable, and not just another business expense. If Chip Masters thinks that Ron’s fi nancial statements are more credible with an audit, then it is likely he will be prepared to pay a higher price for Ron’s business.

Before You Go On 8.1 Defi ne the audit expectation gap. 8.2 What has caused the audit expectation gap? 8.3 What can be done to reduce the audit expectation gap?

Auditor Performance Expectation Gap

Financial Statement User’s Expectations

Auditor performance impacted by: • Audit standards • Ethical standards • Regulations • Legislation • Firm policy and procedures

Financial statement user’s expectations impacted by:

• Audit firm reputation • Audit firm independence • Reader’s knowledge of auditing • Economic conditions

ILLUSTRATION 1.10 Audit expectation gap

The audit expectation gap can be reduced by:

• auditors performing their duties appropriately, complying with auditing standards and meeting the minimum standards of performance that should be expected of all auditors

• inspections of audits ensuring that auditing standards have been applied correctly • auditing standards being reviewed and updated on a regular basis to enhance the work

being done by auditors • fi nancial statement users being educated as to the responsibilities of preparers and audi-

tors of fi nancial statements • assurance providers reporting accurately the level of assurance being provided

As described in this chapter, fi nancial statement users rely on audited fi nancial state- ments to make a variety of decisions. Financial statement users demand access to reliable information to help ensure the stability of fi nancial markets. The audit profession is dedicated to providing reliable assurance services in the interest of protecting the public trust.

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1-30 CHAPTER 1 Introduction and Overview of Audit and Assurance

Learning Objectives Review

5 Explain the roles of the diff erent regulators and orga- nizations that aff ect the audit profession.

Regulators and organizations that impact the audit profession include the Securities and Exchange Commission (SEC), the Public Company Accounting Oversight Board (PCAOB), the American Institute of Cer- tifi ed Public Accountants (AICPA), the Financial Accounting Stan- dards Board (FASB), the Committee on Sponsoring Organizations of the Treadway Commission (COSO), and the National Association of State Boards of Accountancy (NASBA). Auditors must follow the PCAOB’s Auditing Standards (AS) when auditing public companies and follow the Auditing Standards Board’s Statements on Auditing Standards (SAS) when auditing private companies.

6 Explain the concepts of reasonable assurance, mate- riality, and the nature of an unqualified/unmodified re- port on the audit of financial statements.

Auditors are only required to provide reasonable assurance about whether the fi nan cial statements as a whole are free from material misstatement, whether due to error or fraud. In a private company au- dit, if auditors determine the fi nancial statements are presented fairly in accordance with the applicable fi nancial reporting framework, then auditors issue the standard unmodifi ed audit report. In a pub- lic company audit, if auditors determine the fi nancial statements are presented fairly in accordance with the applicable fi nancial reporting framework, then they issue the standard unqualifi ed audit report.

7 Explain the concept of reasonable assurance and the nature of an unqualified report on internal controls over financial reporting.

An eff ective system of ICFR provides reasonable assurance the fi nancial statements will be free of material misstatements. Only public companies are required to have an audit of the eff ectiveness of ICFR. In the audit of the eff ectiveness of ICFR, auditors provide reasonable assurance regard- ing whether or not there is a material weakness in ICFR for the period un- der audit. If auditors have determined the company has maintained eff ec- tive ICFR, then they issue the standard unqualifi ed audit report on ICFR.

8 Explain the audit expectation gap.

The audit expectation gap occurs when there is a diff erence between the expectations of assurance providers and fi nancial statement users. The gap occurs when user beliefs do not align with what an auditor has actually done.

1 Define and diff erentiate among assurance, attesta- tion, and auditing services.

An assurance engagement involves an assurance provider arriv- ing at an opinion about some information being provided by their client to a third party. Attestation and auditing services are types of assurance services. A financial statement audit involves an audit firm obtaining evidence to support an opinion about the fair presentation of the financial statements, in all material re- spects, in accordance with an applicable financial reporting framework.

2 Diff erentiate among diff erent types of assurance services.

Assurance services include financial statement audits, audits of effectiveness over internal control of financial reporting, compliance audits, operational/performance audits, and internal audits.

3 Explain the demand for audit and assurance services.

Financial statement users include investors (shareholders), sup- pliers, customers, lenders, employees, governments, and the general public. These groups of users demand audited financial statements due to their remoteness from the entity, accounting complexity, competing incentives between them and the entity’s managers, and their need for reliable information on which to base decisions.

4 Distinguish the diff erent roles of the financial state- ment preparer and the auditor.

It is the responsibility of the company’s management to prepare the fi nancial statements in accordance with the applicable fi nan- cial reporting framework. Management is also responsible for the design, implementation, and maintenance of internal control over fi nancial reporting and for providing the auditors with access to all documentation needed to complete the audit. It is the responsibility of the auditor to form an opinion on the fair presentation of the fi nancial statements. In doing so the auditor must utilize profes- sional skepticism and professional judgment in the planning and performance of the audit and must adhere to the appropriate audit standards.

Key Terms Review Assurance services Attestation services Audit risk Audit services Compliance audit

Integrated audit Internal audit Material weakness Materiality Operational (performance) audit

Professional judgment Professional skepticism Reasonable assurance Those charged with governance

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Multiple-Choice Questions 1-31

1. (LO 1) Which of the following is not a characteristic of an assur- ance service?

a. The engagement is conducted by an independent pro- fessional.

b. The service lends credibility to information. c. The subject matter is limited to fi nancial information. d. The service is useful for decision makers.

2. (LO 2) An assurance service that determines whether the entity has conformed with regulations, rules or processes is a (an):

a. compliance audit. b. fi nancial statement audit. c. internal audit. d. operational audit.

3. (LO 2) Operational (performance) audits are useful because they a. include a comprehensive audit. b. are concerned with the economy, effi ciency, and eff ectiveness

of an organization’s activities. c. involve gathering evidence to determine whether the

entity under review has followed the rules, policies, procedures, laws, or regulations with which they must conform.

d. ensure companies pay appropriate taxes.

4. (LO 2) The function of internal audit is determined by: a. the external auditor. b. the IIA. c. those charged with governance and management. d. the government.

5. (LO 3) All of the following are reasons why users would demand an audit of fi nancial statements except:

a. complexity. b. remoteness. c. cost. d. reliability.

6. (LO 4) Management is responsible for which of the following? a. preparing fi nancial statements in accordance with the appro-

priate auditing standards. b. designing, implementing, and maintaining internal control

relevant to the preparation of the fi nancial statements. c. using professional skepticism in the preparation of the fi nan-

cial statements. d. issuing an opinion on whether the fi nancial statements are

presented fairly in accordance with the appropriate fi nancial reporting framework.

7. (LO 5) Which of the following organizations issues auditing stan- dards for the audits of public companies?

a. PCAOB b. SEC c. ASB d. COSO

8. (LO 5) The role of COSO is to: a. establish fi nancial accounting and reporting standards. b. establish auditing standards for private companies. c. prepare and grade the CPA exam. d. provide guidance in the area of internal control and risk man-

agement.

9. (LO 6) Auditors can only provide reasonable assurance that the fi nancial statements are presently fairly because:

a. sampling techniques are used to gather evidence. b. some items in the fi nancial statements are subjective. c. an audit must be completed in a reasonable amount of

time. d. all of these answer choices are correct.

10. (LO 6) What is the appropriate date for an audit report? a. the date the auditors were hired. b. the date of the balance sheet. c. the conclusion of the gathering of evidence for the audit. d. the date required by regulators.

11. (LO 7) Auditors of publicly traded companies are required to per- form a(an) ________ for their clients.

a. compliance audit b. integrated audit c. internal audit d. operational audit

12. (LO 8) The audit expectation gap occurs when: a. auditors perform their duties appropriately and satisfy users’

demands. b. user beliefs do not align with what an auditor has actually

done. c. inspections of audits ensure that auditing standards have

been applied correctly and the standards are at the level that satisfy users’ demands.

d. the public is well educated about auditing.

Multiple-Choice Questions

CPAexcel CPAexcel questions and other resources are available in WileyPLUS.

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1-32 CHAPTER 1 Introduction and Overview of Audit and Assurance

R1.1 (LO 1) What does assurance mean in the fi nancial report- ing context? Who are the three parties relevant to an assurance engagement?

R1.2 (LO 1) An assurance engagement involves evaluation or measurement of subject matter against criteria. What criteria are used in a fi nancial statement audit?

R1.3 (LO 2) Discuss some limitations of a fi nancial statement audit.

R1.4 (LO 2) Who would request an operational (performance) audit? Why?

R1.5 (LO 3) Why would investors in a company demand an audit of fi nancial statements?

R1.6 (LO 4) Compare and contrast the responsibilities of preparers and auditors regarding a fi nancial statement audit.

R1.7 (LO 5) Describe the relationship between the SEC and the PCAOB.

R1.8 (LO 5) Compare and contrast the functions of a state board of accountancy and of NASBA.

R1.9 (LO 5) Briefl y describe the principles underlying an audit con- ducted in accordance with GAAS that are issued by the ASB.

R1.10 (LO 6) Discuss the similarities and diff erences in the audi- tor’s reports for a public company client and a private company client.

R1.11 (LO 7) List and briefl y describe the components of the audi- tor’s report on internal controls over fi nancial reporting for a public company.

R1.12 (LO 8) Debate the audit expectation gap. Why do you think auditors do not give users what they want?

AP1.1 (LO 1, 2) Basic Research Types of assurance engagements A friend knows that you are studying auditing and asks you what the diff erence is between internal and external auditing. Using what you learned in this chapter and from information from the AICPA website (www.aicpa.org) and the IIA web- site (www.theiia.org), compare and contrast the duties and characteristics of internal and external auditors.

AP1.2 (LO 3) Challenging Demand for assurance In 2002, the audit fi rm Arthur Andersen col- lapsed following charges brought against it in the United States relating to the failure of its client, Enron. Some other clients announced they would be dismissing Arthur Andersen as their auditor even before it was clear that Arthur Andersen would not survive.

Required

Using the discussion in this chapter on the demand for audits, explain some reasons why these clients took this action.

AP1.3 (LO 3, 4) Basic Big 4 vs non-Big 4 assurance providers Most audit fi rms maintain a web- site that explains the services off ered by the fi rm and provides resources to their clients and other inter- ested parties. The services off ered by most fi rms include both audit and non-audit services.

Required

Find the websites for: a. a Big 4 audit fi rm b. a mid-tier audit fi rm

Compare them on the following: i. the range of services provided ii. geographic coverage (i.e. where their offi ces are located) iii. staff numbers and special skills off ered iv. industries in which they claim specialization v. publications and other materials provided to their clients or the general public vi. marketing message

AP1.4 (LO 3, 4) Moderate Big 4 vs non-Big 4 assurance providers In times of economic recession, would you expect the demand for audits to increase or decrease? Would you expect clients to shift from large (Big 4) auditors to mid-tier auditors, or from mid-tier auditors to Big 4 auditors? Why or why not?

Review Questions

Analysis Problems

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Analysis Problems 1-33

AP1.5 (LO 5) Basic Research Requirements to become a CPA Each state has the power to determine the education and experience requirements to be a licensed CPA in that state. The power is delegated to the state board of accountancy in each state.

Required

Visit the state board of accountancy website for the state in which you are attending college. What are the education and experience requirements? If you intend to begin your career in another state, also re- search the education and experience requirements for that state. What are the similarities and diff erences between the two states?

AP1.6 (LO 5) Basic Research Accounting fi rm registration Since the creation of the PCAOB in 2003, accounting fi rms that wish to audit public companies must be registered with the PCAOB. Visit the PCAOB’s website (www.pcaobus.org) and browse the information.

Required

Explain what is required for an accounting fi rm to be registered with the PCAOB.

AP1.7 (LO 6, 7) Basic Audit reports Auditor’s reports for The Boeing Company are provided in Illustrations 1.7 and 1.9 in this chapter. Both reports are signed by Deloitte & Touche LLP. Deloitte & Touche also audits Starbucks Corporation. Visit the Starbucks investor relations website (www. investor.starbucks.com) to access the most recent annual report and 10-K. Find the auditor’s reports on the fi nancial statements and the eff ectiveness of ICFR.

Required

a. Compare the audit reports of The Boeing Company and Starbucks. What type of opinion did Star- bucks receive on its fi nancial statements and on the eff ectiveness of ICFR?

b. What are the advantages of having a standard report format for all clients?

AP1.8 (LO 4, 6, 8) Moderate Being an auditor You have recently graduated from your university and start work with an accounting fi rm. You meet an old school friend, Kim, for dinner—you haven’t seen each other for several years. Kim is surprised that you are now working as an auditor because your childhood dream was to be a ballet dancer. Unfortunately, your knees were damaged in a fall and you can no longer dance. The conversation turns to your work and Kim wants to know how you do your job. Kim cannot understand why an audit is not a guarantee the company will succeed. Kim also thinks that company managers will lie to you to protect themselves, and as an auditor you would have to assume that you cannot believe anything a company manager says to you.

Required

Compose a letter to Kim explaining the concept of reasonable assurance, and how reasonable assurance is determined. Explain why an auditor cannot off er absolute assurance. Describe the concept of pro- fessional skepticism and how it is not the same as assuming that managers are always trying to deceive auditors. Explain to Kim why her perceptions are a perfect example of the expectations gap.

AP1.9 (LO 2, 4, 6, 7, 8) Challenging Limitations of an audit You are an intern at a Big 4 account- ing fi rm and have just fi nished your internship training. You feel a little overwhelmed with all of the information from the training session, and you are wondering if you are qualifi ed to perform work that is of high-enough quality to meet the fi rm’s, and the profession’s, standards. What if you miss something or forget to do something? What if it takes you too long to complete your tasks? What if you spend time on something that is trivial and miss something that is important? You decide to review your notes from the training session and from your undergraduate audit course.

Required

a. Discuss the limitations of an audit. b. Refer to the audit reports in Illustrations 1.6, 1.7, and 1.9. What are some key terms and phrases

included in the reports that address these limitations?

AP1.10 (LO 6) Challenging Research Audit reports On an international level, other countries have also discussed and implemented expanding the audit report to include more detail from auditors about critical audit matters (CAM). The United Kingdom (U.K.) has already moved to using an expanded

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1-34 CHAPTER 1 Introduction and Overview of Audit and Assurance

audit report. An example of the new audit report format can be found in the annual report of GlaxoSmith- Kline plc (GSK). Visit GSK’s investor website and download the most recent annual report (www.gsk. com/en-gb/investors). Find the auditor’s report in the Financial Statements section of the annual report.

Required

a. Who are the auditors for GSK? b. What are some diff erences in the U.K. auditor’s report model compared with the current U.S. audi-

tor’s report model for public companies? c. Which report model do you prefer and why? Would your answer change based on the type of user

you are (lender, customer, investor)? Would your answer change if you were the preparer or auditor of the fi nancial statements?

Cloud 9 - Continuing Case Ron McLellan established his business, McLellan’s Shoes, in 1985. Since then he has run his business as a sole proprietor. Ron keeps records and his wife helps him prepare basic accounting records. As McLellan’s Shoes has no outside owners, Ron has never seen the need to have his accounts audited.

When Chip Masters from Cloud 9 Inc. expressed an interest in buying McLellan’s Shoes in 2020, Ron was asked to provide audited fi nancial statements. Ron discussed his concerns about having an audit with his friend Ernie Black. Ernie is concerned that Ron may forget their conversations and has asked you to pre- pare a summary of the issues listed below for Ron.

Required a. What are the main diff erences between a fi nancial statement

audit, a compliance audit, and an operational audit? b. What is the diff erence between reasonable assurance and

absolute assurance? c. Why would Chip ask that Ron have the fi nancial statements

for McLellan’s Shoes audited rather than reviewed? d. What factors should Ron consider when selecting an ac-

counting fi rm to complete the McLellan’s Shoes audit?

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