karen l. hooks - gbv · karen l. hooks florida atlantic university ... appendix d: audit committees...

KAREN L. HOOKS

Florida Atlantic University

WILEYJohn Wiley & Sons, Inc.

PARTIINTRODUCTION

1 An Introduction to Auditing ' 2INTRODUCTION 3

FINANCIAL STATEMENTS, INTERNAL CONTROL, AND INTEGRATED AUDITS 3

DEFINITION OF AN AUDIT 7

AUDITING INTERNAL CONTROL OVER FINANCIAL REPORTING 9

PURPOSE AND VALUE OF AN AUDIT 11

Misstated Financial Statements 12

Different Benefits to Different Parties 13

Remote Owners and Complex Transactions 14

Internal Operations and Management 15

SERVICES PROVIDED BY AUDITORS 15

STANDARDS SETTERS AND GOVERNING AUTHORITIES 16Federal-Level Authority 18

PCAOB Authority 18

INTERNAL AUDITORS 19

OTHER AUDIT SERVICES 19

ACCOUNTANTS WHO ARE NOT AUDITORS 20

CONCLUSION 21

Key Terms 21

Multiple Choice 23

Discussion Questions 25

Problems 25

Activity Assignments 28

APPENDIX A: WORKING IN A CPA FIRM 29Services Provided by CPA Firms 29Common Firm Structures 30Firm Size 31Hierarchy within the Firm 31Activity Assignments 32

VI CONTENTS

Overview of an Integrated Audit 34INTRODUCTION 35

INTEGRATED AUDITS 35

PRELIMINARY REQUIREMENTS FOR AN AUDIT 37

OVERVIEW OF AN INTEGRATED AUDIT 38

Preliminary.Engagement Procedures 38

Planning and Risk Assessment 38Tests of ICFR Operating Effectiveness and Substantive Procedures 40

Wrap-Up, Completion, and Reporting 40

FUNDAMENTAL CONCEPTS 41

Management Assertions 42Audit Evidence 43Auditors' Use of Management Assertions 43

More Audit Concepts and Their Relationships 44

PRELIMINARY ENGAGEMENT PROCEDURES 49

AUDIT PLANNING AND RISK ASSESSMENT 51

Preliminary Audit Strategy 51Understanding the Company 51Assessing Risk 52

Audit Planning 53

TESTS OF ICFR OPERATING EFFECTIVENESS 54

SUBSTANTIVE PROCEDURES ON ACCOUNTS AND DISCLOSURES 54

WRAP-UP, COMPLETION, AND REPORTING 57

NONPUBLIC COMPANY AUDITS 58

AUDITING STANDARDS 61

General Standards 63Training and Proficiency 63Independence 63Due Professional Care 64

Standards of Field Work 64Planning and Supervision 64Understanding 64Evidence 64

Reporting Standards 64

CONCLUSION 65

Key Terms 65

Multiple Choice 67


Problems 70


APPENDIX A: AICPA GENERALLY ACCEPTED AUDITING STANDARDS(AU 150.02) 74

General Standards 74Standards of Field Work 74Standards of Reporting 75

CONTENTS vii

PART IITHE AUDIT ENVIRONMENT 77

3 The Auditor's Role in Society 78INTRODUCTION 79

SOCIETY'S RELIANCE ON AUDITORS 79

Auditors' Clients and Other Constituents 80

INFLUENCES ON BEHAVIOR 81

What Is Right? 81Moral Development 84

Ethical Orientation 85

AUDITING AS A PROFESSION 86 '

Community of Peers 86Entry and Membership 86External Regulation 87Individual Characteristics 87

Social Contracts 87

ETHICAL DECISION MAKING 88

MORAL DILEMMAS 90

EXTERNAL REGULATION 92

AICPA CODE OF PROFESSIONAL CONDUCT 93

Principles of Professional Conduct 98

Rules of Conduct 99

PCAOB RULES OF THE BOARD 104

AUDITOR INDEPENDENCE 107

INDEPENDENCE REQUIREMENTS OF SOX AND THE SEC 112

SERVICES THAT IMPAIR FIRM INDEPENDENCE 113

PUBLIC ACCOUNTING FIRMS AND QUALITY CONTROL 116

PCAOB OVERSIGHT OF FIRMS 117 ,

CONCLUSION 118

Key Terms 119

Multiple Choice 120


Problems 123


4 Legal Environment Affecting Audits 130INTRODUCTION 131

AUDITORS AND RISK 131

WHO CAN SUE THE AUDITOR? 132

Privity 132Near Privity 133Foreseen Third Parties 134Foreseeable Third Parties 135

vii i CONTENTS

EVENTS INVOLVED IN A LEGAL ACTION 136Arbitration, Negotiations, and Settlements 137Step 1: The Complaint 138Step 2: The Answer 138Step 3: Discovery 138Step 4: Court Proceedings 139Step 5: After the Proceedings 139

CAUSES OF ACTION, DEFENSES, AND POTENTIAL DAMAGES 1 3 9Negligence and Gross Negligence 140

Cause of Action 140Defenses 141

Other Defenses' 141Damages 142

Relevant Cases 143Fraud 143

Cause of Action 143Defenses 144Damages 144Relevant Cases 144

Breach of Contract 145

Cause of Action 145Defenses 146

Damages 146

Relevant Case 146

STATUTORY CIVIL LAW 1 4 7

Cause of Action, Securities Act of 1933 147

Defenses 148

Relevant Cases 148

Cause of Action, Securities Exchange Act of 1934 149

Defenses 149

Damages 149

Relevant Cases 150

GOVERNMENT CIVIL ACTIONS 1 5 1

SEC Rules of Practice 151

Racketeer Influenced and Corrupt Organization Act (RICO) 152

Foreign Corrupt Practices Act of 1977 152

Sarbanes-Oxley Act of 2002, the Civil Statutes 153

CRIMINAL ACTIONS 1 5 3

Securities Act of 1933 and Securities Exchange Act of 1934, Fraud 154

Relevant Cases 155

Title 18 § U.S.C. 1512, Obstruction of Justice 156

Sarbanes-Oxley Act of 2002 157

JURISDICTION 1 5 7

CONCLUSION 157

Key Terms 159

CONTENTS IX

Multiple Choice 160Discussion Questions 163Problems 163Activity Assignments 168

APPENDIX A: UNITED STATES COURT SYSTEMS 169Stare Decisis 170Subject Matter Jurisdiction 170Private Securities Litigation Reform Act of 1995 and the Securities Litigation UniformStandards Act of 1998 171

PART IIIEXECUTING AN INTEGRATED AUDIT 173

5 Client Acceptance and Continuance and Preliminary EngagementProcedures 174INTRODUCTION 175

CLIENT ACCEPTANCE AND CONTINUANCE 177

GUIDANCE IN THE PROFESSIONAL LITERATURE AND STANDARDS 177

OPPORTUNITY FOR A NEW CLIENT 178

Independence 179

INVESTIGATING THE POTENTIAL CLIENT 1 8 0Published Financial Information 181Performance Information 181Accounting Practices and Disclosures 182Management and Board of Directors Integrity 184Company Leadership 185Audit Committee and Board of Directors Involvement and Qualifications 186Potential Client Business Activities 188Financial Statement Restatements 189Public Information Releases by Management 189Organizational Structure 190 s

Financial Difficulty and Going Concern 190Multiple Business Locations 191Client Accounting Function 191

Management's Use of Information 191

SOURCES OF INFORMATION 1 9 2Publicly Available Information 192Interviewing the Potential Client 192Communication with the Predecessor Auditor 193Business Resources 194

Media and Data Searches; Other Investigations 194

FIRM RESOURCES AND EXPERTISE 1 9 5

ECONOMIC CONSIDERATIONS 1 9 5

PROPOSING ON THE ENGAGEMENT 1 9 5

CONTENTS

AFTER THE SELECTION 196Terms of the Engagement and Engagement Letter 197

Confirming Independence 202

CONCLUSION 203

Key Terms 203

Multiple Choice 204


Problems 207


APPENDIX A: INDUSTRY DESCRIPTIONS 212Manufacturing 216Retailing 217HealthCare 219Banking 220Service 222Real Estate Development and Construction 222Hospitality 224Conclusion 225Problem 225

APPENDIX D: AUDIT COMMITTEES AND CORPORATE GOVERNANCE 226The Value of Audit Committees 226Composition of Audit Committees 227Audit Committee Charter 228Responsibilities of Audit Committees 228Reports to Audit Committees 230Conclusion 231Problem 231

6 Audit Planning and Risk Assessment 232INTRODUCTION 233

OVERVIEW OF THE PLANNING AND RISK ASSESSMENT PROCESS 233

ESTABLISHING THE OVERALL AUDIT STRATEGY 235Scope of the Engagement 235

Accounting Presentation 235

Entity Structure 237

Information Technology 237

Client Outsourcing 237

Work of Others 238

First-Year and Continuing Audits 238

Timing 238

Materiality and Risk 239

Fraud Risk 243

Recent Significant Developments 244

Sources of Information 250

Planning Meeting and Planning Memorandum 250

PLANNING THE AUDIT RESOURCES 2 5 4

Assignments of the Audit Team 254

CONTENTS xi

Timing of Audit Work 255Interim and Year End 255Roll Forward 256

High-Risk Areas 256

Engagement Budget 258

AUDIT PLAN 260Nature, Timing, and Extent 260Top Down Approach 262Different Types of Audit Procedures 262

COMMUNICATION ON PLANNING 264

CONCLUSION 265

Key Terms 265 ' •

Multiple Choice 267


Problems 270


APPENDIX A: USING THE WORK OF OTHERS 275Internal Auditors and Others 275Responsibility Shared between Independent Auditors 276Deciding to Rely on the Work of Others 277Competence and Objectivity 277Effect on the Independent Auditor's Work 278

Nature of Controls 278Risk 278Judgment Required in the Audit Work 279Estimates and Judgment Affecting the Account 279

Evaluating and Testing the Effectiveness of Other's Work 280Direct Assistance to the Auditor 280Conclusion 281Key Terms 281Multiple Choice 282Discussion Question 282

Understanding Internal Control over Financial Reporting andAuditing Design Effectiveness 283INTRODUCTION 284

INTERNAL CONTROL AND RELIABLE FINANCIAL REPORTING 284

What is ICFR? 285

MANAGEMENT'S MOTIVATION FOR GOOD INTERNAL CONTROL 286

THE FINANCIAL STATEMENT AUDIT AND INTERNAL CONTROL OVER FINANCIALREPORTING 287

DEFINITIONS OF INTERNAL CONTROL 287

COMPONENTS OF INTERNAL CONTROL 288

Control Environment 289Integrity and Ethical Values 289Commitment to Competence 289

Xli CONTENTS

Board of Directors or Audit Committee Participation 290Management's Philosophy and Operating Style 290Organizational Structure 290Assignment of Authority and Responsibility 290

Human Resources Policies 291Risk Assessment 291Control Activities 292Information and Communication 295Monitoring 296

MANAGEMENT'S RESPONSIBILITIES FOR ICFR 2 9 8

Foreign Corrupt Practices Act 298

SOX 298

SEC Interpretive Guidance 300

BACKGROUND TO AN AUDIT OF ICFR 3 0 2

MANAGEMENT ASSERTIONS AND AUDIT PROCEDURES 3 0 2

Management Assertions 303

Existence or Occurrence 304

Completeness 305

Accuracy 305

Cutoff 305

Classification 306

Ownership, Rights, Obligations 306

Valuation, Allocation 307

ICFR Tests and Time Period Covered 307

AUDITOR'S UNDERSTANDING AND ASSESSMENT OF DESIGN EFFECTIVENESSOF ICFR 308

Evidence Related to ICFR 308

Audit Documentation 310

Documentation of the Company's ICFR 312

ENTITY-LEVEL CONTROLS 3 1 4

Audit Committee and Those in Governance 315

Fraud Risk Assessment 316Information Technology 318

Period-End Financial Reporting Process 319

IDENTIFYING SIGNIFICANT ACCOUNTS, DISCLOSURES, AND RELEVANTASSERTIONS 320

Analyzing the Relevance of Assertions 320

Classes of Transactions 321Likely Sources of Misstatements 322

IT Related to Likely Sources of Misstatement 323

ASSESSING DESIGN EFFECTIVENESS AND CHOOSING THE CONTROLS TO TEST 324CONCLUSION 325Key Terms 325Multiple Choice 327Discussion Questions 329

CONTENTS Xlll

Problems 330


APPENDIX A: SPECIFICS OF IT GENERAL CONTROLS 336Introduction 336Approaches to UnderstandingTJGC 337IT Control Environment 338

Policies 338Licensing Agreements 339Passwords 339Use of Company Resources, Internet, and E-mail 339Physical Control over Portable Resources 339Social Engineering 339Control Breakdowns 339Third-party Service Providers 340 .Segregation of Duties 340Monitoring 340

Software Acquisition 340Hardware and Network Technology Acquisition 341Program Development 341Program Changes 341Computer Operations 342

Policies and Procedures 342Batch Processing and End User Computing 342Backup Management 342Data Center Controls 342Capacity Planning and Performance Issue Management 342Recovery 343

Access to Programs and Data 343Software and Interface Controls 343Contingency Controls 344

Backup Procedures 344Service Interruption, Disaster, and Recovery 344

Human Resources 345Hiring Policies 345Training 345Termination Policies and Controls 345 ,

Physical Facilities and Controls 345ITGC and the Integrated Audit 346Key Terms 346Multiple Choice 347Discussions Questions 348Problem 348Activity Assignment 349

APPENDIX B: ENTERPRISE RISK MANAGEMENT, INTEGRATED FRAMEWORK 3 4 9Introduction 349Objectives 349Components 350Internal Environment 351Objective Setting 351Event Identification 352Risk Assessment 353Risk Response 354

XIV CONTENTS

Control Activities 355Information and Communication 355Monitoring 356Roles and Responsibilities 356Limitations of Enterprise Risk Management 357

APPENDIX C: INTERNAL CONTROL OVER FINANCIAL REPORTING IN SMALLER PUBLICCOMPANIES 357

SEC Interpretive Release 358PCAOB Guidance 360Entity-Level Controls 361Risk of Management Override 362Segregation of Duties 362IT Controls 362Financial Reporting'Competencies 363Documentation 363

8 Planning and Testing Operating Effectiveness of Internal Controlover Financial Reporting 365INTRODUCTION 366

SELECTING THE CONTROLS TO TEST 366

TESTING METHODS 367

CAATs 368

PLANNING THE TESTS 370Define the Error and Identify Evidence Related to the Error 370

Plan the Timing and Extent of Testing 371

TIMING OF TESTS 3 7 2Benchmarking 373Document Availability 374

Updating Interim Audit Work 374

EXTENT OF TESTS 3 7 5

Period-End Reporting Process 376

FRAUD 379

ILLEGAL ACTS 379

RELATED PARTY TRANSACTIONS 381

SAMPLING 382Sampling Risk 382Planning the Sample 383Approaches to Sampling 384Nonsampling Risk 384

Sampling and ICFR Testing 385

AUDIT RISK MODEL 3 8 7

Other Risks 387Audit Risk Model 387Inherent Risk 388Control Risk 389IT Considerations 389Using the Audit Risk Model for Planning 389

CONTENTS XV

AUDIT DOCUMENTATION 391

Permanent Files 391Current Files 391Organization, Indexing, and Cross Referencing 392

Tick Marks 392

EVALUATING THE RESULTS 394Severity of the Deficiency 395

AS 5 Definitions of Significant Deficiency, Material Weakness 395

Evaluating Deficiencies 396

ADDITIONAL DOCUMENTATION CONSIDERATIONS 397

"BIG PICTURE" TOPICS AND OPERATING EFFECTIVENESS 398

Entity-Level Controls 398Soft Controls and Personnel Qualifications 398Preventive and Detective Controls 399

Materiality 399

IMPACT OF MULTIPLE LOCATIONS AND BUSINESS UNITS 399

IMPACT OF OUTSOURCING 400

ICFR EFFECTIVENESS AND THE FINANCIAL STATEMENT AUDIT 402

CONCLUSION 403

Key Terms 403

Multiple Choice 405


Problems 409


APPENDIX A: TESTING IT APPLICATION CONTROLS AND COMPUTER-ASSISTED AUDITSOFTWARE 416

Testing IT Controls 416Test Data Approach 416Parallel Simulation 417Integrated Test Facility 417

Using Computer-Assisted Audit Software to Facilitate Testing 418Key Terms 420Multiple Choice 420Activity Assignments 421

APPENDIX B: STATISTICAL TECHNIQUES AND TESTS OF CONTROLS 421

Substantive Procedures and the Financial Statement Audit 427INTRODUCTION 428

TRANSACTION CYCLES AND ACCOUNT BALANCES 429

Organizing the Audit Tasks 429

Management Assertions, Audit Objectives, and Evidence 430

MATERIALITY AND REASONABLE ASSURANCE 4 3 0

Impacts of Sampling 431

Sampling Error 431

Analytical Procedures 432

Audit Risk Model 434

XVI CONTENTS

PERFORMING SUBSTANTIVE TESTS AND PROCEDURES 435

Conclusions as a Result of Substantive Tests and Procedures: Evaluating Results 438Substantive Analytical Procedures 442Tolerable Misstatement and Unadjusted Differences 442

Misstatements from Fraud or Error 444

AUDIT DOCUMENTATION 4 4 6

Working Trial Balance, Lead Schedules, and Detailed Work Papers 446

IMPORTANT CONSIDERATIONS IN A FINANCIAL STATEMENT AUDIT 4 4 8Estimates 448Fair Value Measurements and Disclosures 448Illegal Acts 449Related Party Transactions 451Going Concern 451

Cutoff Issues and Substantive Procedures at Interim Dates 452

AREAS ADDRESSED IN A FINANCIAL STATEMENT AUDIT 4 5 4Cash 454Receivables 455Inventory 456Investments, Emphasis on Marketable Securities 458Prepaid Assets 460Long-Term Productive Assets 460Current Payables 460Long-Term Debt 460Owners'Equity 461Revenue and Expenses 462

SUMMARY OF SUBSTANTIVE TESTS AND PROCEDURES 463

CONCLUSION 464

Key Terms 465

Multiple Choice 465


Problems 469


APPENDIX A: STATISTICAL TECHNIQUES AND TESTS OF DETAILS OF BALANCES 475Classical Variables Sampling 476

Sampling Without Replacement 480An Example Using Classical Variables Sampling 481Monetary Unit Sampling 483

MUS with Anticipated Misstatements 485An Example Using Monetary Unit Sampling 486Key Terms 489Multiple Choice 490

10 Auditing Revenue Processes: Sales, Billing, and Collection inthe Health-Care Provider and Retailing Industries 491INTRODUCTION 492

OVERVIEW 492

CONTENTS xvii

HEALTH-CARE PROVIDERS 493

RETAILING ' 496

BUSINESS PROCESSES, DOCUMENTS, AND INTERNAL CONTROLS 499

Revenue Recognition 500Sales 503Managing Bad Debts 504Documents and Processes 504

Potential Misstatements and Controls 510

MANAGEMENT ASSERTIONS IN AN INTEGRATED AUDIT 515

Design Effectiveness 515Operating Effectiveness 515

Financial Statement Assertions 515

AUDIT TESTS AND PROCEDURES 516

TESTS OF CONTROLS 517

Tests of Controls for Sales 519Tests of Controls for Sales Returns and Allowances 522Tests of Controls for Cash Receipts 523

SUBSTANTIVE PROCEDURES: DUAL PURPOSE TESTS, ANALYTICAL PROCEDURES,

AND TESTS OF DETAILS OF BALANCES 525

Dual Purpose Tests 526

Substantive Analytical Procedures 530

TESTS OF DETAILS OF BALANCES 533

External Confirmations 533

Accounts Receivable Confirmations 536

Confirmations of Other Financial Statement Accounts 538

Bank Confirmations 539

Aging of Accounts Receivable 539

Cash 542

AUDITING SALES, BILLING, AND COLLECTIONS IN THE HEALTH-CARE PROVIDER

INDUSTRY 544 '

AUDITING SALES, BILLING, AND COLLECTIONS IN THE RETAIL INDUSTRY 544

CONCLUSION 546

Key Terms 546

Multiple Choice 547


Problems 552


11 Completing the Integrated Audit and Reporting 559INTRODUCTION 560

FINAL AUDIT PROCEDURES 561

Unusual Year-End Transactions 562Contingent Liabilities and Commitments 563Inquiry of a Client's Lawyer 564Management's Written Representations 567

xviii CONTENTS

Subsequent Events Review 571New Information after the Date of the Audit Report 573Going Concern 575Other Published Information 578Other Financial Statements and Financial Statement Disclosures 579Communications 583Final Review 584

Review of Audit Documentation 587

Engagement Quality Review 588

REPORTING 589

Dating the Report 590Dating the Report with New Information after the Audit Report Date 590New Information after the Financial Statements Are Released 591Integrated Audit Opinion Dates 592

Reissuing an Audit Report 593

REPORTING ON THE AUDIT OF THE FINANCIAL STATEMENTS 594

Introductory Paragraph 595Scope Paragraph 595Opinion Paragraph 596

FINANCIAL STATEMENT AUDIT REPORTS THAT DIFFER FROM UNQUALIFIED, STANDARDREPORTS 597

Explanatory Language 597Opinion Based in Part on the Report of Another Auditor 598

Substantial Doubt about an Entity's Ability to Continue as a Going Concern 599

Changes Affecting Consistency within or between Periods 599

Consistency: Change in Accounting Principle 600Consistency: Changes in the Method of Applying an Accounting Principle 600Consistency: Accounting Changes Expected to Have a Material Future Effect 601Consistency: Correction of a Material Misstatement in Previously Issued FinancialStatements 602Emphasis of a Matter 602Departure from a Promulgated Accounting Principle 603Qualified, Adverse, and Disclaimer Financial Statement Audit Reports 603Qualified Opinion for a Departure from Generally Accepted AccountingPrinciples 604Qualified Financial Statement Audit Opinion Because of a Scope Limitation 605Adverse Opinion 606Disclaimer of Opinion 607

REPORTING ON AN AUDIT OF INTERNAL CONTROL OVER FINANCIAL REPORTING 608

Audit Reports on ICFR that are not Unqualified 610

CONCLUSION 612

Key Terms 613

Multiple Choice 614


Problems 616


CONTENTS XIX

PART IVJ ^ ^ 625

12 Auditing Acquisition and Payments Processes: Purchases,Cash Disbursements, arid Related Activities in the AutomotiveIndustry 626INTRODUCTION 627

OVERVIEW 627

ACQUISITION AND PAYMENT ASPECTS OF RETAILING 628

ACQUISITION AND PAYMENT ASPECTS OF MANUFACTURING 629

ACQUISITION AND PAYMENT CONSIDERATIONS OF OTHER ENVIRONMENTS 630

THE AUTOMOTIVE INDUSTRY: AN OVERVIEW 630

Business Risks Associated with Purchasing Activities 633

Reliance on Vendors 633

Managing Acquisition-Related Costs 635

Types of Acquisitions and Payments 635

BUSINESS PROCESSES, DOCUMENTS, AND INTERNAL CONTROL 637

Documents and Processes 638


Segregation of Duties 644

Safeguarding Assets 645

Accounting Processes 645

Cutoff 646

Cash Disbursement Procedures 646


TESTS OF CONTROLS FOR PURCHASES AND EXPENDITURE TRANSACTIONS 647

TESTS OF CONTROLS FOR PURCHASE RETURNS AND DISCOUNTS 652

TESTS OF CONTROLS FOR CASH DISBURSEMENTS 652

DUAL PURPOSE TESTS 656

SUBSTANTIVE ANALYTICAL PROCEDURES 660


Accounts Payable Confirmations 661

Search for Unrecorded Liabilities 663

Tests of Details of Balances for Accounts Payable 664

AUDIT OF PREPAID EXPENSES AND ACCRUED LIABILITIES 665

AUDIT OF EXPENSES 667

Account Analysis 667

Allocation Analysis 668

AUDIT OF PROPERTY, PLANT AND EQUIPMENT 669

Additions and Disposals 669

Impaired Value 670

Depreciation 671

AUDIT OF INTANGIBLE ASSETS 673

XX CONTENTS

AUDITING ACQUISITIONS AND PAYMENTS IN THE AUTOMOTIVE INDUSTRY 674

ICFR 674

Inventory Costing and Period Expenses 674

Estimated Accounts 674

Long-Term Assets 675

Accounts Payable and Accrued Liabilities 675

Disclosures 676

CONCLUSION 676

Key Terms 677

Multiple Choice 678


Problems 681


13 Auditing Human Resources Processes: Personnel and Payroll inthe Services Industries 688INTRODUCTION 689

OVERVIEW 689

HUMAN RESOURCES ASPECTS OF PUBLIC ACCOUNTING 692


Balance Sheet and Income Statement Effects 698

Government Required Records and Reports 698

Integration with Cost Accounting Records 699


Use of an Imprest Payroll Account 703


USING AN OUTSIDE SERVICE PROVIDER FOR PAYROLL: OVERVIEW 707

User Company Functions 708

Inputs to the Outside Service Provider 708

Processing by the Service Provider 709

Outputs of the Service Provider 710 s

User Company Controls 712

REPORTS ON THE PROCESSING OF TRANSACTIONS BY A SERVICE ORGANIZATION 713


TESTS OF CONTROLS FOR HUMAN RESOURCES TRANSACTIONS 716

TESTS OF CONTROLS FOR PAYROLL CASH DISBURSEMENTS 722

DUAL PURPOSE TESTS 723

SUBSTANTIVE ANALYTICAL PROCEDURES 726


HUMAN RESOURCES RELATED DISCLOSURES 729

AUDIT OF SHARE-BASED COMPENSATION 730

AUDITING HUMAN RESOURCES IN THE SERVICES INDUSTRIES 730

CONCLUSION 731

Key Terms 732

CONTENTS XXI

Multiple Choice 732


Problems 736


APPENDIX A: AN ENGAGEMENT TO ISSUE A REPORT ON THE PROCESSING OFTRANSACTIONS BY A SERVICE ORGANIZATION FOR USE BY OTHER AUDITORS 742

Types of Engagements 742Responsibilities of the Service Auditor 743Performing the Engagement 744

Service Organization's Report 744Service Auditor Activities for a Report on Controls in Place 744Service Auditor Activities for a Report on Controls Placed in Operation and Testsof Operating Effectiveness 746

Service Auditor Reports 747Type I Report 747Type II Report 748

Conclusion 750

14 Auditing Inventory Processes: Tracking and Costing Products inthe Land Development and Home Building Industry 751INTRODUCTION 752

OVERVIEW 752

LAND DEVELOPMENT AND HOME BUILDING INDUSTRY 753

Costing Inventory 754Allocation of Common Costs 754Inventory Valuation 755Variable Interest Entities 756 x,

Revenue Recognition 757

INVENTORY IN THE MANUFACTURING ENVIRONMENT: OVERVIEW 757


ACCOUNTING FOR INVENTORY 761Valuing Inventory 762



AUDIT TESTS AND PROCEDURES 7 6 5Tests of Controls 765

Dual Purpose Tests 770


TESTS OF DETAILS OF BALANCES 7 7 2

Inventory Observation 772Auditing Estimates 775Tests of Account Balances 777Auditing Inventory Disclosures 779

AUDITING INVENTORY IN THE LAND DEVELOPMENT AND HOME BUILDINGINDUSTRY 780

Specific Identification of Costs of Inventory 780

Estimates and Allocations 781

XX11 CONTENTS

Valuation 782

Risks of Construction Defects and Long-Term Product Problems 782

CONCLUSION 784

Key Terms 784

Multiple Choice 785


Problems 788


15 Auditing Assets, Liabilities, and Equity Related to the FinancingCycle 795INTRODUCTION 796 '

OVERVIEW 796

ASSETS AND THE FINANCING CYCLE 797

Cash and Near Cash 797What is a Cash Equivalent? 797

Auditing Cash and Near Cash 798Disclosure 799Investments 800

Investment Transactions 802Accounting for Investments 803Valuing Investments 804Tests of Controls and Dual Purpose Tests 806


Tests of Details of Balances 809

Auditing Other Comprehensive Income 811 .Auditing the Consolidation Process 811

Auditing Disclosures 812

LIABILITIES AND THE FINANCING CYCLE 813

Long-Term Debt 813Other Long-Term Accounts 814Tests of Controls and Dual Purpose Tests 815Substantive Analytical Procedures 817Tests of Details of Balances 817Debt Covenants 820Auditing Pensions and Postretirement Benefits Accounts 820Using the Work of a Specialist 822Auditing Taxes 822


EQUITY AND THE FINANCING CYCLE 823

Equity Transactions and Activities 824Tests of Controls and Dual Purpose Tests 824Substantive Analytical Procedures 825Tests of Details of Balances 825Auditing Mergers and Acquisitions 826

CONTENTS xxiii

Auditing Retained Earnings 826


AUDITING RELATED PARTY TRANSACTIONS 828

CONCLUSION 832

Key Terms 832

Multiple Choice 833


Problems 836


16 Topics Beyond the Integrated Audit 842INTRODUCTION 843

FORENSIC ACCOUNTING 843

Differences between Audit and Forensic Accounting 844Fraud Triangle 845Evidence 846

Career Paths 846

INTERNAL AUDITING 847

Code of Ethics 847Professional Standards 848SOX Compliance 848

Internal Audit Careers 850

STATE AND LOCAL GOVERNMENT AUDITS 851

Single Audit Act 852

GOVERNMENT AUDITING STANDARDS AND THE YELLOW BOOK 853

GOVERNMENT ACCOUNTABILITY OFFICE (GAO) ACTIVITIES 853

GAO Careers 854

COMPILATION AND REVIEW ENGAGEMENTS 855

Compilations 856

Reviews 860

ATTEST ENGAGEMENTS 863

SEC-RELATED ENGAGEMENTS 867

Letters for Underwriters 867

Interim Financial Information 868

Activities Related to Registration Statements 870

CONCLUSION 871

Key Terms 871

Multiple Choice 872


Problems 876


APPENDIX A: INSTITUTE OF INTERNAL AUDITORS, CODE OF ETHICS 882

APPENDIX B: INSTITUTE OF INTERNAL AUDITORS, INTERNATIONAL STANDARDS FOR

THE PROFESSIONAL PRACTICE OF INTERNAL AUDITING 883

XXIV CONTENTS

APPENDIX C: YELLOW BOOK ETHICAL PRINCIPLES 896

APPENDIX D: ILLUSTRATIVE INQUIRIES FOR A SSARS REVIEW ENGAGEMENT 898

INDEX 905

CREDITS 923 T