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1 The Role of the Auditor in the American Economy1

What Is the Attest Function？2

Financial Statement Audits4

What Creates the Demand for Audits？6

Major Auditing Developments of the 20th Century8

Types of Audits11

Types of Auditors12

The Public Accounting Profession13

American Institute of Certified Public Accountants13

The CPA Examination16

State Boards of Accountancy16

Financial Accounting Standards Board16

Governmental Accounting Standards Board17

Securities and Exchange Commission17

Other Types of Professional Services18

Organization of the Public Accounting Profession19

Industry Specialization—The Wave of the Future20

Responsibilities of the Professional Staff21

Professional Development for CPA Firm Personnel22

Seasonal Fluctuations in Public Accounting Work23

Relationship with Clients23

2 Professional Standards32

Generally Accepted Auditing Standards （GAAS）33

Application of Auditing Standards34

Training and Proficiency34

Independence34

Due Professional Care35

Standards of Field Work—Accumulating and Evaluating Evidence35

Adequate Planning and Supervision35

Sufficient Understanding of Internal Control35

Sufficient Competent Evidential Matter35

Standards of Reporting36

Statements on Auditing Standards（SASs）36

The Auditors’ Responsibility for Detecting Misstatements37

Errors and Fraud38

Illegal Acts by Clients38

The Auditors’ Report39

The Introductory Paragraph of the Auditors’ Report40

The Scope Paragraph of the Auditors’Report41

The Opinion Paragraph of the Auditors’ Report41

Generally Accepted Accounting Principles （GAAP）43

Other Types of Auditors’ Reports45

The Attestation Standards45

The Assurance Function47

Quality Control in CPA Firms47

Division for CPA Firms48

The Public Oversight Board49

Peer Reviews50

International Accounting and Auditing Standards50

3 Professional Ethics61

The Nature of Ethics62

What Are Ethical Dilemmas？62

A Framework for Ethical Decisions62

Making Ethical Decisions—A Professional Example63

The Need for Professional Ethics66

Professional Ethics in Public Accounting67

The AICPA Code of Professional Conduct68

Section Ⅰ—Principles69

Preamble69

Article Ⅰ—Responsibilities69

Article Ⅱ—The Public Interest69

Article Ⅲ—Integrity70

Article Ⅳ—Objectivity and Independence70

Article Ⅴ—Due Care70

Article Ⅵ—Scope and Nature of Services70

Section Ⅱ—Rules70

Applicability70

Rule 101—Independence70

Analysis of Independence72

Rule 102—Integrity and Objectivity77

Analysis of Integrity and Objectivity77

Rule 201—General Standards78

Analysis of General Standards78

Rule 202—Compliance with Standards78

Analysis of Compliance with Standards78

Rule 203 —Accounting Principles79

Analysis of Accounting Principles80

Rule 301—Confidential Client Information80

Analysis of Confidential Client Information80

Rule 302 —Contingent Fees81

Analysis of Contingent Fees82

Rule 501—Acts Discreditable82

Analysis of Acts Discreditable82

Rule 502 —Advertising and Other Forms of Solicitation83

Analysis of Advertising and Other Forms of Solicitation83

Rule 504—Commissions and Referral Fees83

Analysis of Commissions and Referral Fees84

Rule 505 —Form of Organization and Name84

Analysis of Form of Organization and Name84

The CPA as Tax Adviser—Ethical Problems85

Enforcement of Professional Ethics86

Ethics for Internal Auditors86

4 Legal Liability of Auditors97

Unique Vulnerability of Accountants to Lawsuits98

Definitions of Terms98

Litigation Placed in Perspective98

Auditors’ Liability to Their Clients under Common Law101

Auditors’ Common Law Liability to Third Parties103

Ultramares Approach103

Restatement of Torts Approach104

Rosenblum Approach104

Joint and Several Liability105

Liability to Third Parties under Statutory Law106

Securities Act of 1933106

Securities Exchange Act of 1934108

Comparison of the 1933 and 1934 Acts110

The Racketeer Influenced and Corrupt Organizations Act111

Auditors’ Criminal Liability under the Securities Acts112

The SEC’s Regulation of Accountants113

Accountants’ Liabityty for Accounting and Review Services113

The CPAs’ Posture in the Age of Litigation115

5 Audit Evidence128

The Relationship of Audit Risk to Evidence129

Financial Statement Asseerions129

Audit Risk at the Asseerion Level130

Audit Risk Illustrated131

Measuring Audit Risk131

Audit Evidence133

Types of Evidence134

Audit Procedures141

The Nature of Audit Procedures141

Timing of Audit Procedures141

Extent of Audit Procedures141

The Cost of Audit Procedures141

Analytical Procedures143

Developing an Expectation143

Timing of Analytical Procedures147

Extent of Analytical Procedures148

Evidence on Accounting Estimates148

Evidence on Related Party Transactions149

6 Planning the Audit； Designing Audit Programs162

Client Acceptance163

Communication with Predecessor Auditors164

Other Communications165

Other Considerations in Accepting an Audit Client165

Obtaining the Engagement165

Audit Committees166

Fee Arrangements166

Engagement Letters167

Audit Planning167

Obtaining an Understanding of the Client’s Business167

Developing an Overall Audit Strategy170

Audit Plans181

Time Budgets for Audit Engagements181

Planning a Recurring Engagement182

Designing Audit Programs183

The Audit Trail183

Organization of the Audit Program184

Objectives of Audit Programs187

General Objectives of Audit Programs for Asset Accounts188

Substantiation of Account Balances188

Existence of Assets188

Rights to the Assets189

Establishing Completeness189

Valuation of Assets190

Clerical Accuracy of Records190

Financial Statement Presentation and Disclosure191

An Illustration of Audit Program Design191

Audit Process191

Timing of Audit Work194

Appendix 6A：Selected Internet Addresses205

Appendix 6B：Illustrative Audit Case205

Part 1：Audit Planning205

7 Internal Control216

The Meaning of Internal Control217

The Foreign Corrupt Practices Act of 1977219

Means of Achieving Internal Control219

The Control Environment219

Integrity and Ethical Values220

Commitment to Competence220

Board of Directors or Audit Committee220

Management Philosophy and Operating Style220

Organizational Structure221

Assignment of Authority and Responsibityty223

Human Resource Policies and Procedures223

Risk Assessment224

The Accounting Information and Communication System225

Control Activities225

Performance Reviews226

Information Processing226

Physical Controls227

Segregation of Duties228

Monitoring229

The Internal Audit Function229

Limitations of Internal Control229

The Auditors’ Consideration of Internal Control230

Obtaining an Understanding of Internal Control to Plan the Audit230

Assess Control Risk239

Decision Aids for Audit Program Modification241

Consideration of the Work of Internal Auditors244

Communication of Control Related Matters245

Internal Control in the Small Company245

8 Consideration of Intern Control in a Computer Environment260

Nature of Computer Systems261

Characteristics of Various Types of Computer Systems262

Impact of Computers on the Audit Trail265

Internal Control in a Computer Environment266

Organizational Structure of the Information System Function266

Computer-Centered Fraud269

Internal Auditing in a Computer Environment271

Control Activities in a Computer System271

General Control Activities272

Application Control Activities275

User Control Activities276

Control in Microcomputer Systems277

The Auditors’ Consideration of Internal Control in a Computer Environment277

Obtaining an Understanding of Computerized Intern Control278

Documenting Computerized Internal Control278

Assessing Control Risk—Testing Computer System Controls280

Substantive Testing with Computers286

Using Audit Software：An Illustration287

Computer Service Centers and Outsourced Computer Processing287

9 Audit Sampling299

Comparison of Statistical and Nonstatistical Sampling300

Selecting a Random Sample301

Other Methods of Sample Selection304

Stratification304

Types of Statistical Sampling Plans305

Allowance for Sampling Risk（Precision）306

Sample Size307

Audit Sampling for Tests of Controls307

Sampling Risk for Tests of Controls307

Attributes Sampling308

Determine the Objective of the Test309

Define the Attributes and “Deviation” Conditions309

Define the Population310

Specify the Risk of Assessing Control Risk Too Low and the Tolerable Deviation Rate310

Estimate the Expected Population Deviation Rate311

Determine the Sample Size311

Select the Sample313

Test the Sample Items313

Evaluate the Sample Results313

Document the Sampling Procedure315

Detailed Illustration of Attributes Sampling315

Other Statistical Attributes Sampling Approaches317

Nonstatistical Attributes Sampling319

Audit Sampling for Substantive Tests320

Sampling Risk for Substantive Tests320

Classical Variables Sampling321

Mean-per-Unit Estimation321

Controlling Sampling Risk321

Determination of Sample Size322

Evaluation of Sample Results324

Illustration of Mean-per-Unit Estimation324

Ratio and Difference Estimation328

Illustration of Ratio and Difference Estimation329

Nonstatistical Sampling for Substantive Tests330

Illustration of Nonstatistical Sampling331

Appendix 9A：Probability-Proportional-to-Size （PPS） Sampling343

Determination of Sample Size343

Controlling Sampling Risk344

Method of Sample Selection344

Evaluation of Sample Results345

Illustration of PPS Sampling346

Considerations in Using PPS Sampling348

Appendix 9B：Audit Risk349

10 Audit Working Papers； Examination of the General Records355

What Are Audit Working Papers？356

Functions of Working Papers356

Confidential Nature of Working Papers358

Ownership of Audit Working Papers358

Working Papers and Auditors’ Liability358

Types of Working Papers360

Organization of the Working Papers362

Guidelines for Preparation of WorkingPapers363

Computer-Generated Working Papers365

The Review of Audit Working Papers365

Examination of the General Records368

Articles of Incorporation and Bylaws369

Partnership Contract369

Corporate Minutes Book369

Contracts Held or Issued by Client371

Laws and Regulations372

Correspondence Files374

Income Tax Returns of Prior Years374

Financial Statements and Annual Reports of Prior Years374

Reports to the SEC375

Review and Testing of the Accounting Records375

The General Ledger376

The General Journal377

Audit Working Papers for the Examination of Accounting Records379

11 Cash and Marketable Securities391

Cash392

Sources and Nature of Cash392

The Auditors’ Objectives in the Audit of Cash392

How Much Audit Time for Cash？394

Internal Control over Cash Transactions394

Internal Control over Cash Receipts395

Internal Control over Cash Disbursements397

Internal Control and the Computer403

Audit Working Papers for Cash403

Audit Program for Cash403

Interim Audit Work on Cash417

Marketable Securities417

The Auditors’ Objectives in Examination of Marketable Securities417

Internal Control over Marketable Securities418

Internal Control Questionnaire419

Audit Program for Securities420

Substantive Tests for Investments in Securities420

12 Accounts Receivable，Notes Receivable，and Sales Transactions436

Receivables437

Sources and Nature of Accounts Receivable437

Sources and Nature of Notes Receivable437

The Auditors’ Objectives in Auditing Receivables and Sales437

Internal Control of Sales Transactions and Accounts Receivable438

Internal Control over Notes Receivable444

Internal Control and the Computer444

Audit Working Papers for Receivables and Sales445

Audit Program for Receivables and Sales Transactions445

Interim Audit Work on Receivables and Sales468

Appendix 12A Illustrative Audit Case：Key-stone Computers ＆ Networks，Inc480

Part Ⅱ：Consideration of Internal Control480

Obtaining and Documenting an Understanding of the Sales and Collections Cycle481

Testing Controls and Assessing Control Risk481

Appendix 12B Illustrative Audit Case：Keystone Computers ＆ Networks，Inc.495

Part Ⅲ：Substantive Tests—Accounts Receivable and Sales495

13 Inventories and Cost of Goods Sold499

Sources and Nature of Inventories and Cost of Goods Sold500

The Auditors’ Approach to Auditing Inventories and Cost of Goods Sold500

Internal Control over Inventories and Cost of Goods Sold502

Internal Control and the Computer507

Audit Working Papers for Inventories and Cost of Goods Sold507

Audit Program for Inventories and Cost of Goods Sold508

Problems Associated with Inventory of First Year Audit Clients528

14 Property，Plant，and Equipment：Depreciation and Depletion540

The Auditors’ Approach to Auditing Property，Plant，and Equipment541

Contrast with Audit of Current Assets541

Internal Control over Plant and Equipment542

Audit Working Papers543

Initial Audits and Repeat Engagements545

Audit Program for Property，Plant，and Equipment545

Depreciation554

The Auditors’ Perspective Toward Depreciation554

The Auditors’ Objectives in Auditing Depreciation555

Audit Program—Depreciation Expense and Accumulated Depreciation555

Testing the Client’s Provision for Depreciation556

Examination of Natural Resources556

Examination of Intangible Assets557

Examination of Plant and Equipment in Advance of the Balance Sheet Date558

15 Accounts Payable and Other Liabilities567

Accounts Payable568

Sources and Nature of Accounts Payable568

The Auditors’ Approach to Auditing Accounts Payable568

Internal Control over Accounts Payable569

Internal Control and the Computer571

Audit Working Papers for Accounts Payable571

Audit Program571

Other Liabilities585

Amounts Withheld from Employees’Pay585

Sales Tax Payable586

Unclaimed Wages586

Customers’ Deposits586

Accrued Liabilities587

Balance Sheet Presentation590

Time of Examination591

Appendix 15A Illustrative Audit Case：Keystone Computers ＆ Networks，Inc.599

Part Ⅳ：Consideration of Internal Control599

16 Debt and Equity Capital603

Interest-Bearing Debt604

Sources and Nature of Interest-Bearing Debt604

The Auditors’ Approach to Auditing Interest-Bearing Debt604

Internal Control over Interest-Bearing Debt605

Audit Working Papers606

Audit Program for Interest-Bearing Debt606

Time of Examination—Interest-Bearing Debt613

Equity Capital614

Sources and Nature of Owners’ Equity614

The Auditors’ Approach to Auditing Owners’ Equity614

Internal Control over Owners’ Equity614

Control of Capital Stock Transactions by the Board of Directors615

Independent Registrar and Stock Transfer Agent615

The Stock Certificate Book and Stockholders Ledger616

Internal Control over Dividends616

Audit Working Papers for Owners’Equity617

Audit Program—Capital Stock617

Retained Earnings and Dividends620

Time of Examination—Stockholders’Equity621

Financial Statement Presentation of Stockholders’ Equity622

Audit of Sole Proprietorships and Partnerships622

17 Auditing Operations and Completing the Audit633

Auditing Operations634

The Auditors’ Approach to Examining Operations634

Revenue635

Relationship of Revenue to Balance Sheet Accounts635

Miscellaneous Revenue635

Expenses636

Relationship of Expenses to Balance Sheet Accounts636

Substantive Tests for Selling，General，and Administrative Expenses636

The Audit of Payroll638

Internal Control over Payroll641

Description of Internal Control for Payroll643

Audit Program for Payrolls643

Audit of the Statement of Cash Flows645

Completing the Audit645

Search for Unrecorded Liabilities646

Review the Minutes of Meetings646

Perform Final Analytical Procedures646

Perform Procedures to Identify Loss Contingencies646

Perform the Review for Subsequent Events651

Obtain Representation Letter655

Evaluating Audit Findings655

Reviewing the Engagement656

Responsibilities for Other Information in the Financial Report658

Opinion Formulation and Report Issuance659

Communicating with the Audit Committee660

Post-Audit Responsibilities660

The Auditors’ Subsequent Discovery of Facts Existing at the Date of Their Report660

Subsequent Discovery of Omitted Audit Procedures661

18 Auditors’ Reports674

Financial Statements675

Financial Statement Disclosures676

Comparative Financial Statements676

The Auditors’ Standard Report677

Expression of an Opinion678

The Unqualified Opinion679

Explanatory Language Added to the Auditors’ Report678

Qualified Opinions684

Adverse Opinions687

Disclaimer of Opinion688

Summary of Auditors’ Reports690

Two or More Report Modifications690

Different Opinions on DifferentStatements693

Reporting on Comparative Financial Statements693

Reports to the SEC694

19 Other Attestation and Accounting Services710

The Attestation Function712

Attestation Engagements—Historical Financial Information713

Special Reports713

Financial Statements Prepared for Use in Other Countries718

Audits of Personal Financial Statements718

Reviews of the Interim Information of Public Companies719

Review Services for Nonpublic Companies722

Accountants’ Reports on Comparative Statements725

Letters for Underwriters726

Condensed Financial Statements726

Attestation Engagements—Other Information727

Prospective Financial Statements727

Reporting on a Company’s Internal Control729

Other Agreed-Upon Procedures Engagements732

Accounting Services732

Compilation Engagements for Financial Statements of Nonpublic Companies732

Other “Association” with the Financial Statements of Public Companies735

Compilations of Prospective Financial Statements736

Summary of Reporting736

20 Internal，Operational，and Compliance Auditing749

Internal Auditing750

What Is the Purpose of Internal Auditing？750

Evolution of Internal Auditing750

Professional Standards of Internal Auditing752

Certification of Internal Auditors755

Operational Auditing756

Objective of Operational Audits756

General Approach to Operational Audits757

Compliance Auditing759

Attesting to Compliance with Laws and Regulations760

Compliance Auditing of Federal Financial Assistance Programs764

Audits in Accordance with Generally Accepted Auditing Standards764

Audits in Accordance with Government Auditing Standards765

Audits in Accordance with the Single Audit Act767

Compliance Auditing—A Summary771

Index781