2-1

Chapter Two
The Financial Statement Auditing
Environment

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2-2

Problems and Warning Signs

1990 2000

During the economic boom of the late
1990s and the early 2000s, accounting
firms aggressively sought opportunities
to market a variety of high-margin
nonaudit services to their audit clients.

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2-3

Problems and Warning Signs

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. All rights reserved. Inc. 2-4 An Explosion of Scandals WorldCom Enron Tyco Adelphia Xerox McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

2-5 Government Regulation In July 2002. All rights reserved. The Sarbanes-Oxley Act effectively ended the profession’s era of “self- regulation. Inc. . McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.” creating and transferring authority to set and enforce standards to the Public Company Accounting Oversight Board (PCAOB). Congress passed the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act.

2-6 A Model of Business Business organizations exist to create value for their stakeholders. through which managers are overseen and supervised. Board of Audit Directors Committee McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. Due to the way resources are invested and managed in the modern business world. a system of corporate governance is necessary. . All rights reserved.

2-7 A Model of Business Processes: Five Components Financing Purchasing Process Process Human Resource Management Process Inventory Revenue Management Process Process McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. All rights reserved. .

2-8 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved. Inc. .

. the inventory. 2-9 Management Assertions Financial statements issued by management contain explicit and implicit assertions. Transaction Account Presentation s Balances & Disclosure Management asserts Management asserts Management asserts that transactions that the entity owns that the financial related to inventory the inventory statements properly actually occurred. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved. represented in the classify and present inventory account. Inc.

2-10 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. . All rights reserved.

. All rights reserved. 2-11 Auditing Standards Auditing standards serve as guidelines for and measures of the quality of the auditor’s performance. Inc. Auditing PCAOB Standards Board Public Nonpublic Companies Companies McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

. All rights reserved. 2-12 The 10 Generally Accepted Auditing Standards (GAAS) GAAS General Field Work Reporting McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc.

2-13 General Standards Adequate Technical Training & Proficiency Due Professional Independence Care McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. All rights reserved. .

All rights reserved. Inc. . 2-14 Standards of Field Work Adequate Planning Obtain Sufficient & Supervised Understanding of Assistants Internal Controls Obtain Sufficient Competent Evidential Matter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

. Inc. 2-15 Standards of Reporting GAAP Consistency Disclosures Opinion McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved.

All rights reserved. 2-16 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. .

GAAS and SAS. PCAOB adopted. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved. . 2-17 Statements on Auditing Standards (SAS)—Interpretations of GAAS GAAS and SAS are considered to be minimum standards of performance for auditors. on an interim basis. Standards issued by PCAOB are called Auditing Standards (AS). Inc.

Second. SASby two No. The AUofnumber field work or evidence applies to the topical collection content inand evaluation.numbering 39. 2-18 Statements on Auditing Standards (SAS)—Interpretations of GAAS SAS For are classified example. and Third Standards of Reporting 500s The Fourth Standard of Reporting 600s Other Types of Reports 700s Special Topics 800s Compliance Auditing 900s Special Reports of the Committee on Auditing Procedures McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. The SAS number applies to the order found under AU 350 because the AU 300s relate in which the standards are issued and are thus to the standards chronological. Inc. the statement. . AU Section Topical Content 100s Introduction 200s The General Standards 300s The Standards of Field Work 400s The First. All rights reserved.” SAS is and AU numbers. “Auditcategories: Sampling.

or qualities that characterize or mark a profession or professional person. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved. 2-19 Ethics. Independence. and the Code of Professional Conduct Ethics refers to a system or code of conduct based on moral duties and obligations that indicates how we should behave. . All professions operate under some type of code of ethics or code of conduct. Inc. Professionalism refers to the conduct. aims.

and the Code of Professional Conduct Code of Professional Conduct Principles Rules of Conduct Interpretation s of the Rules McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. All rights reserved. . 2-20 Ethics. Independence.

but not misstatements. assurance that material caused by errors or fraud. All rights reserved. 2-21 The Auditor’s Responsibility for Errors. that misstatements are detected. the auditor is able to reasonable assurance that obtain reasonable. Inc. and Illegal Acts The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. are not material to the financial statements will be detected. whether caused by error or fraud. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. The auditor has no Because of the nature of audit responsibility to plan and evidence and the characteristics perform the audit to obtain of fraud. whether absolute. . Fraud.

All rights reserved. 2-22 Audit Reporting McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. . Inc.

2-23 The Auditor’s Standard Unqualified Audit Report The most common type of audit report issued is the “standard unqualified audit report” because management’s assertions about the entity’s financial statements are usually found to conform to GAAP. Introductory Scope Title Addressee Paragraph Paragraph Opinion Explanatory Auditor Report Date Paragraph Paragraph Name McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. . All rights reserved. Inc.

Inc. . All rights reserved. 2-24 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

All rights reserved. . 2-25 Reasons for Departures from an Unqualified Audit Report Scope Limitation GAAP Departure Lack of Auditor Independence McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc.

2-26 Other Types of Audit Reports Issued for either a material scope Qualified limitation or departure from GAAP. All rights reserved. Issued for lack of sufficient evidence Disclaimer to form an opinion or lack of auditor independence. Issued when the overall financial Adverse statements do not present fairly in conformity with GAAP. . McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc.

. All rights reserved. 2-27 Public Accounting Firms Public accounting firms range in size from a single proprietor to thousands of owners (or “partners”) and thousands of professional and administrative staff employees. Big 4 Public Accounting Firms Deloitte Ernst & Young Pricewaterhous KPMG e Coopers McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc.

All rights reserved. Inc. 2-28 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. .

All rights reserved. and Assurance Services Audit Services Internal Control Audits Compliance Audits Operational Audits Forensic Audits McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. . Inc. Attest. 2-29 Types of Audit.

Inc. 2-30 Types of Audit. . and Assurance Services Attest Services Financial Reporting on Forecasts and Internal Control Projections McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Attest. All rights reserved.

All rights reserved. . and Assurance Services Assurance Services Performance Risk Assessment Measurement Information System Reliability & E-Commerce McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. 2-31 Types of Audit. Attest.

2-32 Types of Audit. All rights reserved. and Assurance Services Other Nonaudit Services Management Tax Services Advisory Services Accounting and Review Services McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Attest. . Inc.

All rights reserved. Inc. 2-33 Types of Auditors External Auditors Internal Auditors Government Forensic Auditors Auditors McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. .

All rights reserved. Inc. . 2-34 Organizations That Affect the Public Accounting Profession American Institute of Securities and Certified Public Exchange Accountants (AICPA) Commission (SEC) Public Company Financial Accounting Accounting Oversight Standards Board Board (PCAOB) (FASB) McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

. 2-35 End of Chapter 2 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved. Inc.