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AuditinAudrey A. GramlingKennesaw State UniversityLarry E. RittenbergUniversity of Wisconsin—MadisonKarla M. JohnstoneUniversity of Wisconsin—Madison/ % SOUTH-WESTERN*%CENGAGE Learning-Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States

ContentsCHAPTER 1CHAPTER SAuditing: Integral to theEconomy, 2Corporate Governance and Audits, 36Importance of Audit Judgment, 2Increased Globalization of Accountingand Auditing, 5INTRODUCTION Auditing Defined, 6Auditing: A Special Function, 9Failures Within the Profession, 10The Need for Unbiased Reporting, 11Need for Assurance, 12CHANGES IN THE PROFESSION:INCREASED DEMAND FOR ACCOUNTABILITY, 13Demand for Improved Corporate Governance, 13Required Reporting on Internal Controls, 14Audit Standard Setting and AuditorIndependence, 15Public Expectations of Auditors, 15SCOPE OF SERVICES: OTHER ASSURANCE SERVICES, 15What Is Assurance?, 15REQUIREMENTS TO ENTER THE PUBLICACCOUNTING PROFESSION, 18Accounting and Auditing Expertise, 18Internal Control Expertise, 18Knowledge of Business and Its Risks, 19'Understanding Accounting System Complexity, 19THE PROVIDERS OF ASSURANCE SERVICES, 19The Public Accounting Profession, 19The Internal Audit Profession, 20The Governmental Auditing Profession, 21PROFESSIONAL AND REGULATORYORGANIZATIONS, 22The Public Company AccountingOversight Board, 22The Securities and Exchange Commission, 22The American Institute of Certified PublicAccountants, 23International Auditing and Assurance StandardsBoard, 23Committee of Sponsoring Organizations, 23Accounting Standard Setters, 24State Boards of Accountancy, 24The Institute of Internal Auditors, 24The U.S. Government Accountability Office, 24The Court System, 25All chapters contain the following end-of-chapter elements:SummarySignificant TermsSelected References to Relevant Professional GuidanceReview QuestionsMultiple-Choice QuestionsDiscussion and Research QuestionsCasesXIICORPORATE GOVERNANCEAND AUDITING, 38Corporate Governance Responsibilities and Failures, 39The Sarbanes-Oxley Act of 2002, 43Required Audit Firm Communication to theAudit Committee, 46Importance of Good Governance to the Audit, 47AUDIT STANDARD SETTING, 48Generally Accepted Auditing Standards and IAASBPrinciples, 51Fundamental Principles of IAASB AuditingStandards, 54Standards for Other Audit Engagements, 55Future of Audit Standard Setting, 56OVERVIEW OF THE AUDIT PROCESS:A STANDARDS-BASED APPROACH, 57Phase II: Understanding the Client, 58Phases III and IV: Obtaining Evidence, 60Phase V: Wrapping up the Audit and MakingReporting Decisions, 61FORD AND TOYOTA CASE 76CHAPTER 3Judgmental and EthicalDecision-Making Frameworksand Associated ProfessionalStandards, 78INTRODUCTION, 79Decision-Making, Ethics, and Organizational Performance, 79A GENERAL DECISION-MAKING FRAMEWORK, 80A Framework for Professional Decision-Making, 80AN ETHICAL DECISION-MAKINGFRAMEWORK, 82Accepting a Public Trust, 82Ethical Theories, 83An Ethical Framework, 84THE SARBANES-OXLEY ACT OF 2002 AS A REACTIONTO ETHICAL LAPSES, 86APPROACHES TO PROFESSIONALCODES OF ETHICS, 90International Ethics Standards Board for Accountants, 90AICPA Code of Professional Conduct, 90Independence Rules of the SEC and the PCAOB, 97FURTHER CONSIDERATIONS REGARDINGAUDITOR INDEPENDENCE, 98Major Threats to Independence, 99Managing Threats to Independence, 101Important Role of Audit Committees, 103FORD AND TOYOTA CASE 118

ContentsCHAPTER 4Audit Risk, Business Risk, andAudit Planning, 120NATURE OF RISK, 121MANAGING ENGAGEMENT RISK THROUGH CLIENTACCEPTANCE AND RETENTION DECISIONS, 124Management Integrity, 124Independence and Competence of the Audit Committee andBoard, 126Quality of Management's Risk Management Process and Controls, 126Regulatory and Reporting Requirements, 127Participation of Key Stakeholders, 127Existence of Related-Parry Transactions, 127The Financial Health of the Organization, 127Summary: High-Risk Audit Clients, 128The Purpose of an Engagement Letter, 129MANAGING AUDIT RISK, 130Materiality, 130Understanding the Audit Risk Model, 131PLANNING THE AUDIT USING THE AUDITRISK MODEL, 135Lessons Learned: The Lincoln Savings and Loan Case, 135Developing an Understanding of theBusiness and Risks, 137Understanding Management's Risk Management and ControlProcesses, 141Risk Analysis and the Conduct of the Audit, 142PRELIMINARY FINANCIAL STATEMENT REVIEW:USING ANALYTICAL TECHNIQUES TO IDENTIFYAREAS OF HEIGHTENED RISK, 144Assumptions Underlying Analytical Techniques, 144A Process for Performing Analytical Procedures, 145Types of Analytical Procedures, 146FORD AND TOYOTA CASEBILTRITE PRACTICE CASExiiiMake a Plan to Test the Controls and Execute That Plan, 219Consider the Results of Control Testing, 221DOCUMENTING THE AUDITOR'S UNDERSTANDINGAND ASSESSMENT OF AN ORGANIZATION'SINTERNAL CONTROLS, 222MANAGEMENT REPORTS ON INTERNAL CONTROLOVER FINANCIAL REPORTING, 223FORD AND TOYOTA CASE 249CHAPTER 6Performing an IntegratedAudit, 250EVOLUTION IN STANDARDS ON CONDUCTINGINTEGRATED AUDITS, 252AUDIT REPORTS ON INTERNAL CONTROL OVERFINANCIAL REPORTING, 253Unqualified Opinion on Internal Control over FinancialReporting, 253Adverse Audit Opinion on Internal Control over FinancialReporting, 253STEPS IN AN INTEGRATED AUDIT, 256Framework for Audit Evidence in an IntegratedAudit, 256Implementing the Integrated Audit Within the Audit OpinionFormulation Process, 257INTEGRATED AUDIT EXAMPLE: JUDGING THESEVERITY OF CONTROL DEFICIENCIES ANDIMPLICATIONS FOR THE FINANCIAL STATEMENTAUDIT, 270Management's Assessment of Controls, 271Auditor Assessment of Controls, 2727 701 73FORD AND TOYOTA CASE 290BILTRITE PRACTICE CASE 291CHAPTER SInternal Control overFinancial Reporting, 190IMPORTANCE OF INTERNAL CONTROL TO FINANCIALSTATEMENT AUDITS, 191COSO: A FRAMEWORK FOR INTERNAL CONTROL, 192Components of Internal Control, 193Risk Assessment, 195Control Environment, 197Control Activities, 200Information and Communication, 203Monitoring, 204Examples of Common Internal Control Activities, 204Common Control Activities, 205IT Controls Integrated intoInternal Control Evaluations, 206MANAGEMENT EVALUATION OF INTERNALCONTROLS, 212AUDITOR EVALUATION OF INTERNAL CONTROLS, 213Understand the Client's Internal Controls, 213Identify Controls to Test, 219CHAPTER 7Audit Evidence: A Framework, 304OVERVIEW OF THE AUDIT MODEL, 305ASSERTION MODEL FOR FINANCIAL STATEMENTAUDITS, 307GATHERING SUFFICIENT, APPROPRIATEEVIDENCE, 308Sufficiency, 310Reliability of Audit Evidence, 311Nature of Audit Testing, 314Audit Procedures, 315AUDIT PROGRAMS AND DOCUMENTING AUDITEVIDENCE, 321Audit Program Development, 321Documenting Audit Evidence, 322AUDITING ACCOUNT BALANCES AFFECTED BYMANAGEMENT'S ESTIMATES, 328Evidence Used in Auditing Management's Estimates, 329FORD AND TOYOTA CASE 347

xivContentsCHAPTER BTools to Gather Audit Evidence, 348OVERVIEW OF APPROACHES TO GATHERING ANDEVALUATING AUDIT EVIDENCE, 350Sampling: One Approach, 350Other Approaches, 351Overview of Audit Sampling, 352TESTING CONTROL EFFECTIVENESSA N D COMPLIANCE, 355Attribute Estimation Sampling, 356Nonstatistical Sampling, 365SAMPLING TO TEST FOR ACCOUNTBALANCE MISSTATEMENTS, 366Substantive Sampling Considerations, 366Nonstatistical Sampling, 369Monetary Unit Sampling (MUS), 370USING GENERALIZED AUDIT SOFTWARE T O PERFORMSUBSTANTIVE TESTS, 379Generalized Audit Software, 379ANALYTICAL PROCEDURES AS A SUBSTANTIVETEST, 383Assumptions Underlying Analytical Techniques, 383The Effectiveness of Substantive AnalyticalProcedures, 384Application of Analytical Procedures to SubstantiveTesting, 385Analytical Procedures Are Not Client Estimates, 385FORD AND TOYOTA CASE 404CHAPTER 9Auditing for Fraud, 408FRAUD A N D AUDITOR RESPONSIBILITIES:A HISTORICAL EVOLUTION, 409Magnitude of Fraud, 410Fraud Defined, 411Evolution of Fraud and Auditor Responsibility, 414Financial Reporting Frauds—The Second COSO Report, 417General Characteristics of Financial Reporting Frauds, 418AUDITING STANDARDS—MORE RESPONSIBILITY, 419A Proactive Approach to Fraud Detection, 420Conducting the Financial Statement Audit—FraudAwareness, 420FORENSIC ACCOUNTING, 443EXAMPLE: A N INTEGRATED AUDIT OF SALES A N DRECEIVABLES, 474Consider the Risk of Misstatement in the Revenue Cycle(Steps 1 and 2), 474Perform Preliminary Analytical Procedures (Step 3), 477Develop an Understanding ofInternal Controls (Step 4), 477Identify Important Controls (Step 5), 478Design and Perform Tests of Internal Controls and Analyze theResults of the Tests of Controls (Steps 6 and 7), 478Perform Substantive Tests (Step 8), 479PERFORMING THE INTEGRATED AUDIT OF THEREVENUE CYCLE, 479Consider the Risks Related to Revenue Recognition(Steps 1 and 2), 479Perform Preliminary Analytical Procedures (Step 3), 484Linking Internal Controls and Financial Statement Assertions forthe Revenue Account (Steps 4 and 5), 486Design and Perform Tests of Internal Controls and Analyze theResults of the Tests of Controls (Steps 6 and 7), 489Perform Substantive Tests in the Revenue Cycle (Step 8), 493FORD AND TOYOTA CASE 541BILTRITE PRACTICE CASE 542CHAPTER 11Audit of Acquisition and PaymentCycle and Inventory, 546INTRODUCTION, 547Significant Accounts and Relevant Assertions in the Acquisitionand Payment Cycle, 548PERFORMING THE INTEGRATED AUDIT OF THEACQUISITION A N D PAYMENT CYCLE, 549Consider the Risks Related to the Acquisition and PaymentCycle (Steps 1 and 2), 551Perform Preliminary Analytical Procedures for PossibleMisstatements (Step 3), 552Linking Internal Controls and Financial Statement Assertionsfor Accounts in the Payment and Acquisition Cycle (Steps 4. and 5), 552Design and Perform Tests of Controls and Analyze Results ofTests of Controls (Steps 6 and 7), 557Perform Substantive Testing of the Accounts in the Acquisitionand Payment Cycle (Step 8), 558COMPLEXITIES RELATED TO INVENTORY A N D COSTOF GOODS SOLD, 563Risks and Controls Related to Inventory and Cost of GoodsSold, 564Substantive Tests of Inventory and Cost of Goods Sold, 567FORD AND TOYOTA CASE 465FORD AND TOYOTA CASECHAPTER 1O-Auditing Revenue and RelatedAccounts, 466INTRODUCTION, 468The Cycle Approach, 468Overview of the Revenue Cycle, 469AUDITING INTERNAL CONTROLS A N DACCOUNT BALANCES—THE INTEGRATEDAUDIT OF REVENUE, 473Audit Stepsforan Integrated Audit, 473BILTRITE PRACTICE CASE598599CHAPTER 12Audit of Cash and Other LiquidAssets, 600INTRODUCTION, 601Overview of Cash Accounts, 601Overview of Financial Instruments and Marketable SecurityAccounts, 602Relevant Financial Statement Assertions, 603