Auditing Public Accounting Profession Integrity Financial Reporting

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A UDITING AND THE P UBLIC A CCOUNTING P ROFESSION I NTEGRITY OF F INANCIAL R EPORTING
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INTERNAL AUDITORS UNCOVER FINANCIAL FRAUD AT WORLDCOM
In June 2002, WorldCom announced that during the previous two years $3.8 billion in costs had been capitalized rather than expensed. This announcement shook a sagging investors condence that was already weakened by the restatement of nancial statements by companies like Enron, Waste Management, and Sunbeam and by allegations of dishonesty at the top of other U.S. companies. The size of WorldComs nancial fraud was so signicant that this event propelled Congress to pass the Sarbanes-Oxley Act of 2002 to further regulate the nancial reporting process. With hindsight we now see WorldCom as a company that, during price wars that reduced prots in its long-distance markets, relied on aggressive accounting practices to bolster earnings. How do we now know this? The public learned about WorldComs nancial fraud through the hard work of several auditing heroes led by Cynthia Cooper (age 38), WorldComs vice president for Internal Auditing. What did Cynthia Cooper and her staff of internal auditors do to uncover the nancial fraud? The internal audit team: Followed up on an e-mail with a local newspaper article about a former employee in WorldComs Texas ofce who had been red after he raised questions about a minor accounting matter involving capital expenditures. Recognized that $2 billion in capital expenditures had not been authorized as part of the capital budget process. Did not settle for glib answers from the director of nancial planning who described the $2 billion in capital expenditures as prepaid capacity but could not explain the nature of prepaid capacity. Uncovered over $500 million in capitalized computer costs that were not supported by vendors invoices. Demonstrated their independence by continuing to investigate the capitalization of line costs (fees paid to lease portions of other companies telephone networks) even when instructed by Scott Sullivan, the CFO, to delay this particular audit until the 3rd quarter. The issue came to a head when Cynthia Cooper and her audit team brought evidence of the improper capitalization of expense to the chairman of WorldComs audit committee. The audit committee instructed the internal auditors to work with WorldComs new external auditor, KPMG. Within a week the internal and external auditors compiled evidence of the nancial fraud for the audit committee and the external auditors concluded that the accounting treatment was not in accordance with generally accepted accounting
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THE AUDITING ENVIRONMENT
principles. Scott Sullivan, the CFO, was given the opportunity to make his case to the audit committee, but the committee members were not persuaded. The next day the audit committee and the board of directors made public the $3.8 billion restatement of earnings due to the fact that costs had been capitalized that should have been expensed. The audit committee and board of directors also red the then CFO, Scott Sullivan, who was subsequently indicted by the U.S. Justice Department.
Source: Susan Pulliam and Deborah Solomon, How Three Unlikely Sleuths Exposed Fraud at WorldCom, Wall Street Journal, October 30, 2002, p.1.
[PREVIEW OF CHAPTER 1]
As fraudulent nancial reporting and restatements of earnings have become more prevalent, auditing (external audits, internal audits, and governmental audits) has become more important. Financial statement audits provide an important level of assurance about the integrity of nancial statement information used by decision makers. Chapter 1 provides an introduction to contemporary auditing and assurance services, describes the organizations associated with the public accounting profession, and ends with a discussion of the regulatory framework that ensures high-quality audit and assurance services. The following diagram provides an overview of the chapter organization and content.
Introduction to Contemporary Auditing
Auditing and Assurance Services Defined Auditing Defined Types of Audits Types of Auditors Assurance Services Defined Value of Audit and Assurance Services
The Demand for Auditing The Roots of Auditing The Need for the Financial Statement Audit Economic Benefits of an Audit Limitations of an Audit
Organizations Associated with the Public Accounting Profession Public Sector Organizations Private Sector Organizations
Regulatory Framework for Ensuring High-Quality Services Standard Setting Firm Regulation Inspection and Peer Review Government Regulation
Chapter 1 addresses the following aspects of the auditors knowledge.
focus on auditor knowledge

After studying this chapter you should understand the following aspects of an auditors knowledge base: 1. Know the common attributes of activities dened as auditing. 2. Know the differences between the different types of audits and auditors. 3. Know the common attributes of assurance services.
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AUDITING AND THE PUBLIC ACCOUNTING PROFESSION
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Know the variety of services and levels of assurance in the universe of assurance services. Know the value of the audit and other assurance services. Know a historical perspective of the demand for auditing. Know the factors that inuence the need for nancial statement audits. Know the economic benets and inherent limitations associated with a nancial statement audit. Know the public sector and private sector organizations associated with auditing and assurance services. 10. Know the four components of the auditing professions multilevel regulatory framework. 11. Know the elements of a system of quality control for a CPA rms attest practice.
4. 5. 6. 7. 8. 9.
[ AUDITING AND ASSURANCE SERVICES DEFINED]

Auditing plays a vital role in business, government, and our economy. Evidence of the importance of auditing is provided by the following:
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Investors and nancial analysts value the work of auditors who audit the nancial statements of over 15,000 public companies annually, including all companies whose securities are traded on the New York Stock Exchange and NASDAQ. Many investors and nancial analysts rely on nancial statement audits to provide assurance about the credibility of critical information that they use when making investment decisions. Bankers, bonding agencies, and other creditors rely on nancial statement audits to ensure that they are using reliable information when extending credit to public and private companies. The Sarbanes-Oxley Act of 2002 requires auditors to provide assurance about the quality of internal control over nancial reporting in addition to assurance about fair presentation in nancial statements. The federal government values the work of auditors who audit state and local governments receiving $500,000 or more per year in nancial assistance from the federal government under the Single Audit Act. The board of directors and audit committees of many public companies value the work of internal auditors who evaluate information systems and report to the board about potential improvements in company operations. The federal government values the work of auditors working for the Internal Revenue Service who recommended an additional $4.3 billion in taxes based on corporate audits conducted in 2003.1
As a vocation, auditing offers the opportunity for challenging and rewarding careers in public accounting, industry, and government. Many auditors develop a client base with a concentration in one or more key industries. As a result of serving many clients in similar industries, few individuals understand the key competitiveness factors for a business better than the auditor.
Reported by the Transactional Records Access Clearing House at Syracuse University, http://trac.syr.edu/tracirs/trends/current/taxpen_corp.html
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Individuals choosing an auditing career in a public accounting rm have the opportunity to progress from a starting position of staff assistant to senior auditor, to manager, and then to partner. Becoming a partner ordinarily takes from 10 to 12 years. As auditors progress in their careers, they can expect to be faced with more challenging accounting and auditing issues. In the process of earning a partnership, CPAs develop a reputation for expertise in accounting, auditing, and giving unbiased professional views regarding nancial reporting, internal control, business risk, and performance measurement. Auditing career paths in industry and government vary considerably. Some state and local government chief auditor positions are elective ofces. Regardless of their career path, most auditors are recognized for their expertise in evaluating organizational performance. AUDITING DEFINED The term auditing is used to describe a broad range of activities in our society. The following broad denition of auditing identies a number of common attributes of most modern auditing activities as depicted in Figure 1-1. The Report of the Committee on Basic Auditing Concepts of the American Accounting Association (Accounting Review, vol. 47) denes auditing as
a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.
Auditor Knowledge 1
s Know the common
attributes of activities dened as auditing.
Several attributes of auditing contained in this denition merit special comment:

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A systematic process connotes a logical, structured, and organized series of steps or procedures. Objectively obtaining and evaluating evidence means examining the bases for the assertions and judiciously evaluating the results without bias or prejudice either for or against the individual (or entity) making the assertions.
Figure 1-1
Overview of the Audit Process The audit process is a systematic process designed to obtain and evaluate evidence about the degree of correspondence with established criteria.
Managements assertions about economic events Results are communicated through an independent Auditors Report
Interested Users can use the information with reasonable assurance that information is free of material misstatement.
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Assertions about economic actions and events are the representations made by the entity or individual. They comprise the subject matter of auditing. Assertions include information contained in nancial statements, internal operating reports, and tax returns. Degree of correspondence refers to the closeness with which the assertions can be identified with established criteria. The expression of correspondence may be quantied, such as the amount of a shortage in a petty cash fund, or it may be qualitative, such as the fairness of financial statements. Established criteria are the standards against which the assertions or representations are judged. Criteria may be specic rules prescribed by a legislative body, budgets and other measures of performance set by management, or generally accepted accounting principles (GAAP) established by the Financial Accounting Standards Board (FASB) and other authoritative bodies. Communicating the results is achieved through a written report that indicates the degree of correspondence between the assertions and established criteria. The communication of results either enhances or weakens the credibility of the representations made by another party. The goal of the audit process is to add credibility to managements representations so that interested users can use the information with reasonable assurance that it is free of material misstatement. Interested users are individuals who use (rely on) the auditors ndings. In a business environment, they include stockholders, management, creditors, governmental agencies, and the public.
These attributes provide a sound description of the auditors work. Many of these attributes are common to all types of audits. Figure 1-2 compares some of the signicant differences between various types of audits: nancial statement audits, compliance audits, audit reports on internal control, and operational audits.
Figure 1-2 Type of Audit
Comparative Summary of Types of Audits Financial Statement Audit Presentation of nancial position, results of operations, and cash ows Generally accepted accounting principles Opinion of independent CPA Compliance Audit Claims or data pertaining to adherence to policies, laws, regulations, etc. Managements policy or laws and regulations Summary of ndings or assurance regarding degree of compliance Management, board of directors, and others Audit Report on Internal Control Adequacy of system of internal control over nancial reporting COSO criteria for evaluating internal controls Opinion of independent CPA Operational Audit Operational or performance data
Assertion about economic actions and events Established criteria Communication of results
Objectives set by management Summary of ndings regarding efciency and effectiveness observed Management and board of directors
Interested users
Investors, creditors and others
Investors, creditors and others
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Auditor Knowledge 2
s Know the differ-
ences between the different types of audits and auditors.
TYPES OF AUDITS Three types of audits normally demonstrate the key characteristics included in the definition of auditing: financial statement audits, compliance audits, and operational audits. The audit report on internal control over financial reporting is a variation of a compliance audit. The nature of each type of audit is briefly described in the following pages. Financial Statement Audit A financial statement audit involves obtaining and evaluating evidence about an entitys presentation of its financial position, results of operations, and cash flows for the purpose of expressing an opinion on whether they are presented fairly in conformity with established criteriausually generally accepted accounting principles (GAAP). In most states only CPAs can perform financial statement audits, and the company whose statements are being audited usually hires the external audit firm. The results of financial statement audits are distributed to a wide spectrum of users such as stockholders, creditors, regulatory agencies, and the general public through the auditors report on financial statements. In addition, the external auditor also prepares a report to the audit committee of the board of directors about the companys accounting policies, internal controls, and other audit findings. Financial statement audits for major corporations are indispensable to the functioning of our national securities markets. Many lenders and creditors also rely on nancial statement audits to obtain assurance about the reliability of information used to support lending decisions. High-quality nancial audits signicantly reduce the risk that investors and creditors will use poor-quality information when making a variety of investment decisions. In addition, the audit logic developed for nancial statement audits is the cornerstone on which auditors have developed compliance audits, operational audits, and a wide array of attest and assurance services. As a result, this text gives extensive consideration to the logic underlying the audit of nancial statements. Compliance Audit A compliance audit involves obtaining and evaluating evidence to determine whether certain financial or operating activities of an entity conform to specified conditions, rules, or regulations. The established criteria in this type of audit may come from a variety of sources. The Sarbanes-Oxley Act of 2002 requires companies to have a dual-purpose audit that audits both the financial statements and managements assertion as to whether it has complied with criteria regarding an adequate system of internal control over financial reporting. Compliance audits may also be based on criteria established by creditors. For instance, a bond covenant may require the maintenance of a specified current ratio. Possibly the widest application of compliance audits relates to criteria based on government regulations. Corporations, for example, must comply with extensive income tax and other government regulations that are subject to audit. Defense contractors must comply with the terms and conditions of government contracts.
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audit engagements on compliance with internal controls A number of studies, beginning with the Trueblood Commission in the 1980s, have come to the conclusion that a sound system of internal control helps prevent fraud. Section 404 of the Sarbanes-Oxley Act of 2002 established a requirement that the management of a public company establish and maintain adequate internal controls over nancial reporting and report annually on (1) managements responsibility for internal controls over nancial reporting and (2) the effectiveness of such controls. Each annual report led with the SEC should include an internal control report:
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Stating that management is responsible for establishing and maintaining adequate internal controls and procedures over nancial reporting. Containing managements assessment, as of the end of the most recent scal year, of the effectiveness of the companys internal controls and procedures over nancial reporting.
In addition, the independent auditor must audit (provide reasonable assurance about) managements assertions regarding the system of internal control over nancial reporting. Under Sarbanes-Oxley, an independent auditor will audit both the nancial statement audits and managements assertions regarding compliance with criteria about the adequacy of internal control over nancial reporting.
Some reports of independent auditors come in the form of an audit report on the adequacy of internal control for general-purpose users. Other reports on compliance audits may be directed to the authority that established the criteria and may include either (1) a summary of ndings or (2) an expression of assurance as to the degree of compliance with those criteria. Operational Audit An operational audit involves obtaining and evaluating evidence about the efficiency and effectiveness of an entitys operating activities in relation to specified objectives. This type of audit is sometimes referred to as a performance audit or a management audit. In a business enterprise, the scope of the audit may encompass all the activities of (1) a department, branch, or division, or (2) a function that may cross business unit lines such as marketing or data processing. In the federal government, an operational audit might extend to all the activities of (1) an agency, such as the Federal Emergency Management Agency (FEMA) or (2) a particular program, such as the distribution of food stamps. The criteria or objectives against which efficiency and effectiveness are measured may be specified, for example, by management or enabling legislation. In other cases, the operational auditor may assist in specifying the criteria to be used. Reports on such audits typically include not only an assessment of efficiency and effectiveness, but also recommendations for improvement. When performed by CPA firms, such audits are likely to involve individuals from the consulting department, or individuals with extensive industry expertise, such as the audit staff.
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TYPES OF AUDITORS Individuals who are engaged to audit economic actions and events for individuals and legal entities are generally classied into three groups: (1) independent auditors, (2) internal auditors, and (3) government auditors. Independent Auditors Independent auditors are usually CPAs who are either individual practitioners or members of public accounting rms who render professional auditing services to clients. In general, licensing involves passing the uniform CPA examination and obtaining practical experience in auditing. By virtue of their education, training, and experience, independent auditors are qualied to perform each type of audit described previously. The clients of independent auditors may include protmaking business enterprises, not-for-prot organizations, and governmental agencies. Like members of the medical and legal professions, independent auditors work on a fee basis. There are similarities between the role of an independent auditor in a public accounting rm and an attorney who is a member of a law rm. However, there is also a major difference: The auditor is expected to be independent of the client in making an audit and in reporting the results, whereas the attorney is expected to be an advocate for the client in rendering legal services. Users rely on the auditors independence and derive value from the fact that the auditor is unbiased with respect to the client under audit. More attention will be given to independence in later chapters. Internal Auditors Internal auditors are employees of the organizations they audit. This type of auditor is involved in an independent evaluation of evidence, called internal auditing, within an organization as a service to the organization. The objective of internal auditing is to assist the management of the organization in the effective discharge of its responsibilities. The scope of the internal audit function extends to all phases of an organizations activities. Internal auditors are primarily involved with compliance and operational audits. However, as is explained later, the work of internal auditors may supplement the work of independent auditors in nancial statement audits. Many internal auditors hold the certied internal auditor (CIA) credential and some are also CPAs. The international association of internal auditors is the Institute of Internal Auditors (IIA), which prescribes certication criteria and administers the certied internal auditor examination. In addition, the IIA has established practice standards for internal auditing and a code of ethics. Government Auditors Government auditors are employed by various local, state, and federal governmental agencies. At the federal level, the three primary agencies are the General Accounting Ofce (GAO), the Internal Revenue Service (IRS), and the Defense Contract Audit Agency (DCAA). In performing the audit function for Congress, GAO auditors engage in a wide range of audit activities, including nancial statement audits, compliance audits,
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and operational audits. The results of these audits are reported to the U.S. Congress and the public. GAO auditors are also involved in fact-nding and evaluating alternatives for Congress. IRS auditors (or agents) audit the returns of taxpayers for compliance with applicable tax laws. Their ndings are generally restricted to the agency and the taxpayer. The Defense Contract Audit Agency, as its name suggests, conducts audits of defense contractors and their operations, and reports to the Department of Defense. The national organization for government accountants is the Association of Government Accountants (AGA). Today most government auditors hold CPA and/or CIA certicates. ASSURANCE SERVICES DEFINED Assurance services is a broader term that includes audits and a variety of other assurances about various representations of management. The AICPA Special Committee on Assurance Services2 developed the following denition.
Assurance services are independent professional services that improve the quality of information, or its context, for decision makers.
Auditor Knowledge 3
s Know the common
attributes of assurance services.
There are several important differences between the AAA denition of auditing and the AICPA denition of assurance service that relate to the qualities of the auditor, not just the audit process.
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The concept of independence is a key aspect of assurance services. Users rely on the CPAs independence and derive value from the fact that the CPA is unbiased and objective. The concept of professional services encompasses the application of professional judgment that is a unique attribute that the CPA brings to the engagement. CPAs bring their professional skepticism and objectivity to an engagement. Although advances in information technology can speed the accumulation or analysis of data, technology cannot replace the practitioners professional judgment. The purpose of assurance services is to improve the quality of information or its context. Quality, as discussed by the Special Committee on Assurance Services, encompasses the concepts of decision usefulness. Assurance services improve the quality of information by improving its reliability or relevance. The Special Committee denes reliability and relevance as follows:3 s Reliability includes representational faithfulness, neutrality, and consistency among periods. s Relevance includes understandability, comparability with other entities, usability, and completeness. The decision maker is featured prominently in the services denition. Assurance services are intended to provide a benet to the decision maker. Decision makers may be clients or outside third parties.
Additional information on assurance services can be found by visiting the Assurance Services web site, which can be accessed through the AICPA homepage at http://www.aicpa.org. 3 The denitions of reliability and relevance used by the Special Committee on Assurance Services differ somewhat from the description in Statement of Financial Accounting Concepts No. 2.
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what it means to be a professional John Careys book, The Rise of the Accounting Profession: From Technician to Professional, identied seven criteria that distinguish professions from other pursuits. Each of these is discussed here in the context of the requirements to be recognized as a Certied Public Accountant (CPA).
1. A Body of Specialized Knowledge. CPAs are recognized as experts in the areas of accounting,
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auditing, and taxation. This reputation is enhanced by the CPAs expertise in business and organizational success. A Formal Educational Process. In most states students must complete 150 semester hours of education including a minimum study in accounting, business, and other subjects in order to qualify to sit for the CPA exam. Standards Governing Admission. In order to become a CPA, candidates usually must complete education requirements including the study of accounting, pass the CPA exam, and complete an experience requirement (usually one year of experience). A Code of Ethics. The American Institute of CPAs has adopted a code of professional ethics that governs the behavior of CPAs. This code of ethics has been important in establishing a reputation for the CPA profession as one where its members are recognized as acting with integrity and objectivity. In addition, many states have written similar codes into their state accountancy laws. A Recognized Status Indicated by a License or Special Designation. Today 54 jurisdictions license CPAs, most of which give CPAs exclusive rights in the practice of accounting and auditing. In addition, CPAs do not have to register as enrolled agents when practicing taxation. A Public Interest in the Work that the Practitioners Perform. CPAs who practice as auditors perform an important role in providing assurance about the reliability of the nancial information included in audited nancial statements. A Recognition by Professionals of a Social Obligation. The auditing profession has recognized the importance of their obligation to the public through self-regulation in the form of peer reviews to ensure high standards in the quality of work. The investing public depends on auditors to provide reasonable assurance that audited nancial statements are free of material misstatement.
Auditor Knowledge 4
s Know the variety of
services and levels of assurance in the universe of assurance services.
The audit is only one type of an assurance service. The audit focuses primarily on the information contained in nancial statements. Assurance services deal with a wide array of information used by decision makers, not just nancial statement users. Example Assurance Services Figure 1-3 depicts the universe of assurance services. The following discussion provides examples of assurance and attest services provided by CPAs, along with an explanation of the levels of assurance that are often associated with the various services. Audit Engagements The purpose of an audit engagement is to provide reasonable assurance, not a guarantee, that the nancial information is free of material misstatement. This type of
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Figure 1-3
Universe of Assurance Services
Accounting & Compilation Assurance Services
Compiled financial statements
Attest Services Audit Engagements
Other Assurance Services such as: s CPA Risk Advisory s CPA Performance View
Financial Statement Audits Audits of Internal Control over Financial Reporting
Attest services such as: Attesting to management's assertions about internal control s Attesting to a forcast s Reviewing interim financial statements
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audit involves obtaining and evaluating evidence about an entitys historical nancial statements. Although the nancial statements of public companies are prepared in accordance with GAAP, nancial statements of private companies can be audited in accordance with a federal income tax basis of accounting or a cash basis of accounting. Auditors can also audit only an element of the nancial statements such as royalties payable. In addition, auditors of public companies audit the effectiveness of internal controls over nancial reporting. Attest Services An attest service is one in which the CPA rm issues a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party. In recent years, growing recognition of the skills and experience of CPAs has resulted in a demand from clients, regulating agencies, and others for a variety of attest services. The term examination is used to describe other services that culminate in the positive expression of an opinion as to whether or not another partys assertions conform to stated criteria. Examples include examinations of (1) prospective (rather than historical) nancial statements and (2) an entitys compliance with specied laws or regulations. In an examination, as in an audit, the CPA also issues a positive expression of opinion on whether managements assertions are presented fairly in conformity with established criteria. Again the goal is to provide reasonable assurance that managements assertion is free of material misstatement. Reviews of financial information also fall under the category of attest services because CPAs provide negative assurance about financial information. A review engagement consists primarily of inquiries of an entitys management
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and comparative analyses of financial information. The scope of this service is significantly less than that of an audit or examination. The purpose is to give negative assurance as opposed to the positive expression of opinion given in an audit. Thus, instead of stating that financial statements are presented fairly in conformity with GAAP, a review report states that the reviewer is not aware of any material modifications that should be made to the statements in order for them to be in conformity with GAAP. This service is sometimes performed on the interim statements of public companies and the annual statements of nonpublic companies. CPAs may also review managements representation about compliance with debt covenants. The auditor can also complete an agreed-upon procedures engagement. An agreed-upon procedures engagement is one in which the auditor performs specic procedures to attest to managements assertion (for example, the amount of royalties payable) for an outside third party (the entity receiving the royalties). The specic procedures to be performed are agreed upon by the party making the assertion, the party using the assertion, and the CPA. The level of assurance depends on the nature and extensiveness of the attest procedures agreed upon by all parties. Accounting and Compilation Services A CPA rm may be engaged by a client to perform a variety of accounting services, including doing manual or automated bookkeeping, journalizing, and posting adjusting entries. The CPA may also be engaged to perform a compilation service through which the CPA, who is an expert regarding GAAP, drafts and compiles nancial statements for the client. When the CPA compiles a set of nancial statements, the CPA provides no assurance about whether the nancial statements present fairly in accordance with GAAP, for the CPA has not obtained evidence supporting the nancial statements. Nevertheless, this is an important assurance service that improves the relevance of information for decision makers in nonpublic entities. Accounting services are a major activity for some sole practitioners and local CPA rms. Other Assurance Services Assurance services are generally focused on improving the relevance or reliability of information used by decision makers. Examples of other types of assurance services include:
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CPA Risk Advisory servicesservices in which the CPA can improve the quality of risk information for internal decision makers through independent assessments of the likelihood that an event or action will adversely affect an organizations ability to achieve its business objectives and execute its strategies successfully. CPA Performance Viewa service that focuses on providing assurance regarding an organizations use of both nancial and nonnancial measures to evaluate the effectiveness and efciency of its activities.
These services build upon the trust and reputation for integrity and objectivity earned by CPAs, but extend traditional services into totally new areas, as discussed in detail in Chapter 20.
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Levels of Assurance CPAs can provide several levels of assurance when performing assurance services. The common levels of assurance discussed above are as follows:
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Reasonable assurance. This is a very high level of assurance but not a guarantee. In audit and examination engagements the CPA needs to obtain sufcient, competent evidence to support a positive opinion that the assertion is presented fairly in all material respects. Negative assurance or review-level assurance. This is substantially less than an audit or examination. In a review engagement the CPA makes inquiries and performs analytical procedures so that the reviewer can state that he or she is not aware of any material modications that should be made to managements assertion. Agreed-upon procedures. In some cases the entity making an assertion and the entity using an assertion will agree on specic procedures to be performed by the CPA. The level of assurance that is obtained depends on the nature and extensiveness of the agreed-upon procedures performed by the CPA. Compilation without assurance. In some cases the CPA may compile information to provide decision makers with relevant information. In this case the CPA provides no assurance about the underlying reliability of the information.
Auditor Knowledge 5
s Know the value of
the audit and other assurance services.
VALUE OF AUDIT AND ASSURANCE SERVICES Figure 1-4 describes the accountants value chain. Accountants provide a wide array of services that assist decision makers. Understanding this value chain may help in understanding the value of audit and assurance services. The steps in the accountants value chain can be described as follows:
s
Capturing business events in the form of data. This is the job of the accounting information and communication system. In addition, many internal controls function at this level to ensure that accounting data are accurate. In the initial step, for example, data may be input regarding inventory transactions. Communicating the total picture with integrity and objectivity. This is the process of developing nancial statements and other information that might be reported to management, the board of directors, or outside creditors and investors. This second step might be exemplied by developing nancial statements that report inventory and other transactions. Transforming complex information into knowledge. This is the process of provide a context for information and making it usable. An example of the third step might be determining that a company turns inventory four times a year. This information is not very useful, however, without the context of the company, its industry, and its competitors. A retail grocer or a brewer would expect to turn its inventory much more frequently than four times a year. However, this would be an unrealistically high inventory turn for a winery. Jewelry stores and pharmaceutical companies also have slower inventory turns. Signicant value is added by establishing a knowledgeable setting for how information will be used. Anticipating and creating opportunities. If a company is turning its inventory four times a year, and that is slow for the industry, then the next question becomes one of determining how to increase inventory turns. This step might
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Figure 1-4
The Accountants Value Chain Transforming Vision into Reality Decisions
Anticipating and Creating Opportunities Knowledge
Transforming Complex Information Into Knowledge Information
Communicating the Total Picture with Integrity and Objectivity Data
Establishing the Information & Communication System Business Events
involve identifying slow-moving inventory and determining a strategy for selling off that inventory. Decision making. Ultimately, management decide on a course of action to improve inventory management. Management must make the sales and streamline the inventory management process to improve inventory turns.
The role of the nancial statement audit is to provide reasonable assurance that the information sets known as nancial statements prepared in accordance with GAAP are presented fairly in all material respects. Financial statements that contain material misstatements often lead to poor decisions. For example, many investors in WorldCom made investment decisions based on information that did not accurately reect the underlying protability of the company. When the information was corrected, share price declined and investors lost billions of dollars. Imagine the value to investors of having information that was materially correct in the rst place. This value is not limited to outside investors. Many directors rely on audited information to fulll their role in evaluating the performance of management and guiding the company. Management needs reliable information for day-to-day decision making. Without information that is fairly presented, the decisions made by these members of management are signicantly handicapped. Reliable information is the foundation for many decisions. The purpose of an audit is to provide assurance that information used in decision making is reliable. Without audits, outsiders who use information provided by management may not have an adequate foundation on which to make important decisions. The
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value of every step above information on the value chain is dependent upon the credibility of that information. In addition, internal auditors provide a variety of services in this value chain. For example, they might test internal controls and perform other procedures to provide assurance about the underlying accuracy of information used by management. In addition, they might perform operational audits that use the information coming from the accounting system combined with knowledge of the business and industry to recommend operational improvements. The operational audit assists management in identifying opportunities for improving protability or for reducing liquidity or solvency risks. Other assurance services are also aimed at providing valuable information to decision makers. Even though the compilation service provides no assurance about the credibility of underlying information, it usually provides information for decision makers that they would not otherwise have. The review service adds some credibility to underlying information (negative assurance vs. reasonable assurance), but this level of credibility benets decision makers at a reasonable cost. A service such as CPA Performance View is designed to provide decision makers with additional, relevant information that they otherwise might not have. A service such as CPA Risk Advisory assists the decision makers in understanding the risks associated with various business opportunities. Each of these services provides value to the decision maker by providing more relevant or more reliable information.
[LEARNING CHECK
1-1 Explain the seven attributes that describe the nature of the auditors work. 1-2 Distinguish among the three principal types of audits and describe the
nature of the auditors report for each.

1-3 Distinguish among the three principal types of auditors and indicate the
types of audits each may perform. a. Provide two examples of examination engagements and explain the level of assurance provided by the CPA. b. Provide an example of a review engagement and explain the level of assurance provided by the CPA. 1-5 What assurance is provided by CPAs who perform accounting and compilation services for a client? Explain the benets received by a client who requests accounting and compilation services. 1-6 Identify two other assurance services provided by CPAs and explain how they improve the relevance or reliability of information used by decision makers. 1-7 a. Explain the value of the audit in the context of the accountants value chain. b. Explain the value of the compilation service and the review service in the context of the accountants value chain. c. Explain the value of the CPA Risk Advisory service in the context of the accountants value chain.
1-4
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PART 1
[KEY TERMS
Accounting services, p. 14 Agreed-upon procedures, p. 15 Agreed-upon procedures engagement, p. 14 Assurance services, p. 11 Attest service, p. 13 Audit engagement, p. 12 Auditing, p. 6 Compilation service, p. 14 Compilation without assurance, p. 15 Compliance audit, p. 8 Examination, p. 13 Financial statement audit, p. 8 Government auditors, p. 10 Independent auditors, p. 10 Internal auditors, p. 10 Negative assurance or review-level assurance, p. 15 Operational audit, p. 9 Reasonable assurance, p. 15 Review engagement, p. 13
[THE DEMAND FOR AUDITING]

Auditor Knowledge 6
s Know a historical
perspective of the demand for auditing.
THE ROOTS OF AUDITING The beginning of the company audit can be linked to British legislation during the industrial revolution in the mid-1800s. Advances in transportation and industrial technology resulted in new economies of scale, larger companies, the advent of professional managers, and the growth of diverse absentee ownership of companies. The development of professional managers who were separate from investors and creditors created a demand for someone to add credibility to managements nancial representations. Initially, company audits had to be performed by one or more stockholders, who were not company ofcers and who were designated by the other stockholders as their representatives. The auditing profession quickly emerged to meet marketplace needs, and legislation was soon revised to permit persons other than stockholders to perform the audits, giving rise to the formation of auditing rms. Some of these early British rms, such as Deloitte & Co., Peat, Marwick, & Mitchell, and Price Waterhouse & Co., can be traced to rms that today practice on an international scale. The British inuence migrated to the United States in the late 1800s as English and Scottish investors sent their own auditors to check on managements statements about the condition of American companies in which they had heavily invested. The focus of these early audits was on nding errors in the balance sheet accounts and stemming the growth of fraud associated with the increasing phenomenon of professional managers and absentee owners. During the early 1900s, the demand for audits expanded greatly owing to rapid growth in the public ownership of corporate securities. Following the stock market crash of 1929, signicant deciencies were recognized in nancial reporting, and the profession was challenged to provide stronger leadership in the further development of accounting and auditing. By then, the income statement had gained status, and attention had to be paid to measures of operating performance and concepts of income as well as nancial condition. In order to enhance the credibility of information prepared for investors, the New York Stock Exchange, in 1932, adopted a requirement that all
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listed corporations obtain an audit certicate from an independent CPA. Passage of the Securities Act of 1933 and the Securities Exchange Act of 1934 further added to the demand for audit services for publicly owned companies. In response to these demands and growth in the size and complexity of businesses, by the 1940s three important changes in audit practice had evolved: (1) a shift from detailed verication of accounts to sampling or testing as the basis for rendering an opinion on the fairness of nancial statements, (2) development of the practice of linking the testing to be done to the auditors evaluation of a companys internal controls, and (3) deemphasis of the detection of fraud as an audit objective. The auditors responsibility to nd fraud is the subject of controversy to this day and is explained further both in the next chapter and in Chapter 9. In the 1980s the auditing profession came under scrutiny by Congress following discovery of nancial frauds at several public companies such as Equity Funding and National Student Marketing. At this time the public accounting profession took another step in ensuring high-quality audit services. Various states adopted requirements that CPAs engage in annual, continuing professional education in order to maintain their licenses. The public accounting profession also took a voluntary step by instituting a program of peer review. Under this program, a CPA rm would submit its accounting and auditing practice to a review by independent peers every three years. During the 1980s the accounting profession slowly addressed the issue of its responsibility for nding nancial fraud. The National Commission of Fraudulent Financial Reporting made recommendations for improvements in internal controls, and the Auditing Standards Board issued a series of 10 new auditing standards in 1988 to narrow a perceived expectations gap in order to bring auditor responsibilities more in line with investors expectations. The profession also developed new attestation standards as CPAs were asked to render their independent professional judgment about assertions other than nancial statement assertions. CPAs were routinely hired to provide review-level assurance to lenders about a companys compliance with debt covenants or to apply agreedupon procedures to royalty agreements. As information technology advanced and companies subcontracted accounting work to outside organizations, CPAs were asked to attest to the internal controls of the outside service provider. From 1990 to 2000 CPA rms became professional service rms, hiring a wide variety of business professionals that sold consulting services to their clients. By 2000 consulting revenues exceeded auditing revenues at all the national CPA rms, and in some cases consulting fees to an audit client exceeded the size of the audit fee. The SEC and the investing public began to question how CPAs could be independent on audit issues when the rms were so dependent on consulting revenues. The quality of audits was further questioned when a series of restatements of earnings from public companies such as Sunbeam, Waste Management, Xerox, Adelphia, Enron, and WorldCom brought about a crisis of condence in the work of auditors. Even though these events were relatively rare out of the approximately 15,000 annual public company audits, the consequences for shareholders amounted to losses in the billions of dollars. Over the years the demand for auditing has been inuenced by professional managers who misled investors by materially misstating the nancial performance in their companys nancial statements. Investors expect auditors to intervene and nd nancial statement misstatements. During the 20th century auditors were self-regulated, and the profession set its own standards. The Auditing
[ 20 ]
PART 1
Standards Board struggled to nd a balance of setting standards to expect auditors to nd most nancial statement misstatements, but to not set the standard so high that auditors appeared to be self-serving. Corporate management protested standards that would cause signicant increases in audit fees. By 2002 the collapse of Enron and WorldCom led Congress to pass the Sarbanes-Oxley Act of 2002. This Act created the Public Companies Accounting Oversight Board (PCAOB) and gave it responsibility for setting auditing, ethics, independence, and quality control standards for audits of public companies. Congress believed that self-regulation of auditors had not worked and that the SEC was better positioned to protect the investors interest. The Sarbanes-Oxley Act of 2002 also extended the auditors work beyond the nancial statement audit. A number of important commissions have recognized the importance of good internal controls in preventing nancial statement misstatements. Section 404 of the SarbanesOxley Act of 2002 also requires auditors to audit managements assertion about the adequacy of internal controls over nancial reporting. NEED FOR FINANCIAL STATEMENT AUDITS The FASB, in Statement of Financial Accounting Concepts No. 2, states that relevance and reliability are two primary qualities that make accounting information useful for decision makers. Users of nancial statements look to the independent auditors report for assurance about the reliability of information and its conformance to generally accepted accounting principles (a measure of relevance of nancial information). The need for independent audits of nancial statements can further be attributed to four conditions as follows:
s
Auditor Knowledge 7
s Know the factors
that inuence the need for nancial statement audits.
Conict of Interest. Many users of nancial statements are concerned about an actual or potential conict of interest between themselves and the management of the reporting entity. The apprehension extends to a fear that the nancial statements prepared by management may be signicantly biased in managements favor. A 1998 Business Week survey found that 67 percent of CFOs had been asked to misrepresent results and that 12 percent did so.4 In the same year CFO Magazine did a survey that found that 45 percent of CFOs had been asked to misrepresent nancial results and that 38 percent of the group did so.5 Users seek assurance from outside independent auditors that nancial statements are free of management bias to combat these pressures. Consequence. Published nancial statements represent an important and, in some cases, the only source of information used in making signicant lending, investment, and other decisions. Thus, users want the nancial statement to contain as much relevant and reliable information as possible. This need is recognized by the extensive disclosure requirements imposed by the SEC on the companies under its jurisdiction. It is also recognized by the relevance of GAAP disclosures to many lenders. Financial statement users look to the independent
S. Shuster, The Seventh Annual Business Week Forum of Chief Finanicial Ofcers, Business Week, July 13, 1998. 5 S. Barr, Misreporting Results, CFO: The Magazine for Senior Financial Executives, December 1998, pp. 3638.
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auditor for assurance that the nancial statements have been prepared in conformity with GAAP, including all the appropriate disclosures. Complexity. Both the subject matter of accounting and the process of preparing nancial statements have become increasingly complex. Accounting for the impairment of xed assets or goodwill, and accounting for leases, pensions, and income taxes are examples of this complexity. As the level of complexity increases, so does the risk of misinterpretations and of intentional or unintentional misstatements. Finding it impossible to evaluate the quality of the nancial statements themselves, users rely on the independent auditors to assess the quality of the information contained in the statements. Remoteness. Distance, time, and cost make it impractical for users of nancial statements to seek direct access to the underlying accounting records to perform their own verications of the nancial statement assertions. Rather than accept the quality of the nancial data on faith, once again users rely on the independent auditors report to meet their needs.
These four conditions collectively contribute to information risk, which is the risk that the nancial statements may be incorrect, incomplete, or biased. Thus, it can be said that nancial statement audits enhance the credibility of nancial statement by reducing information risk. This information risk was exhibited in cases such as material misstatement of earnings at WorldCom.
Auditor Knowledge 8
s Know the economic
benets and inherent limitations associated with a nancial statement audit.
ECONOMIC BENEFITS OF AN AUDIT The annual audit fee for Microsoft, a Fortune 500 company, was disclosed as $15.9 million for the year ended June 30, 2004. Clearly, economic benets must accrue from audits to justify such costs. Among the economic benets of nancial statement audits are the following:
s
Access to Capital Markets. As noted previously, public companies must satisfy statutory audit requirements under the federal securities acts in order to register securities and have them traded on securities markets. In addition, stock markets may impose their own requirements for listing securities. Without audits, companies would be denied access to these capital markets and many private companies would be denied access to loans. Lower Cost of Capital. Small companies often have nancial statement audits to obtain bank loans on more favorable borrowing terms. Because of the reduced information risk associated with audited nancial statements, creditors may offer loans with lower interest rates. Deterrent to Inefficiency and Fraud. Research has demonstrated that when employees know that an independent audit is to be made, they take care to make fewer errors in performing accounting functions and are less likely to misappropriate company assets. Thus, the data in company records will be more reliable, and losses from embezzlements and the like will be reduced. In addition, the fact that financial statement assertions are to be verified reduces the likelihood that management will engage in fraudulent financial reporting. Control and Operational Improvements. Based on observations made during a nancial statement audit, the independent auditor often makes suggestions to improve internal control, to evaluate managements assessments of business
[ 22 ]
PART 1
risks, to recommend improved performance measures, and to make recommendations to achieve greater operational efciencies within the clients organization. These benets are especially valuable to small and medium-sized companies. A companys management, including its board of directors, and shareholders nd that the signicant benets discussed above make the nancial statement audit valuable. LIMITATIONS OF AN AUDIT A nancial statement audit is subject to a number of inherent limitations. One constraint is that the auditor works within fairly restrictive economic limits. Following are two important economic limitations.
s
Reasonable Cost. A limitation on the cost of an audit results in selective testing, or sampling, of the accounting records and supporting data. In addition, the auditor may choose to test internal controls and may obtain assurance from a well-functioning system of internal controls. Reasonable Length of Time. The auditors report on many public companies is usually issued three to ve weeks after the balance sheet date. This time constraint may affect the amount of evidence that can be obtained concerning events and transactions after the balance sheet date that may have an effect on the nancial statements. Moreover, there is a relatively short time period available for resolving uncertainties existing at the statement date.
Another signicant limitation is the established accounting framework for preparing nancial statements. Following are two important limitations associated with the established accounting framework.
s
Alternative Accounting Principles. Alternative accounting principles are permitted under GAAP. Financial statement users must be knowledgeable about a companys accounting choices and their effect on nancial statements. Accounting Estimates. Estimates are an inherent part of the accounting process, and no one, including auditors, can foresee the outcome of uncertainties. Estimates range from the allowance for doubtful accounts and an inventory obsolescence reserve to impairment tests for xed assets and goodwill. An audit cannot add exactness and certainty to nancial statements when these factors do not exist.
Despite these limitations, a nancial statement audit adds credibility to the nancial statements.
[LEARNING CHECK
Explain the historical development of the demand for nancial statement audits. 1-9 Cite four factors that contribute to the need for a nancial statement audit. 1-10 Explain four economic benets of a nancial statement audit. 1-11 Describe four the inherent limitations of a nancial statement audit.
1-8
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[ 23 ]
[KEY TERMS
Access to capital markets, p. 21 Accounting estimates, p. 22 Alternative accounting principles, p. 22 Complexity, p. 21 Conict of interest, p. 20 Consequence, p. 20 Control and operational improvements, p. 21 Deterrent to inefciency and fraud, p. 21 Information risk, p. 21 Lower cost of capital, p. 21 Reasonable cost, p. 22 Reasonable length of time, p. 22 Remoteness, p. 21
[ORGANIZATIONS ASSOCIATED WITH ] THE PUBLIC ACCOUNTING PROFESSION

The modern profession of public accounting is inuenced by a number of professional and regulatory organizations that either function within the profession itself or directly inuence the profession through their standard-setting and regulatory activities. These organizations, representing both the private and public sectors, are identied in Figure 1-5.
Auditor Knowledge 9
s Know the public
PUBLIC SECTOR ORGANIZATIONS Securities and Exchange Commission The Securities and Exchange Commission (SEC) is a federal government agency that was created under the 1934 Securities Exchange Act to regulate the distribution of securities offered for public sale and subsequent trading of securities on stock exchanges and over-the-counter markets. Under the provisions of this Act, the SEC has the authority to establish GAAP for companies under its jurisdiction. Throughout its history, the SEC has, with few exceptions, delegated this authority to the private sector, and it currently recognizes the pronouncements of the FASB
sector and private sector organizations associated with auditing and assurance services.
Figure 1-5
Organizations Associated with the Public Accounting Profession Private Sector Organizations Public Companies Accounting Oversight Board American Institute of Certied Public Accountants State societies of certied public accountants Practice units (CPA rms) Accounting standards setting bodies: FASB and GASB
Public Sector Organizations Securities and Exchange Commission State boards of accountancy U.S. General Accounting Ofce Internal Revenue Service State and federal courts U.S. Congress
[ 24 ]
PART 1
as constituting GAAP in the ling of nancial statements with the agency. In some instances, however, the SECs disclosure requirements exceed GAAP. The SEC also exerts considerable inuence over auditing and the public accounting profession. The Sarbanes-Oxley Act of 2002 established a private sector Public Companies Accounting Oversight Board (see p. 25) to oversee the audit of public companies that are subject to securities laws. The PCAOBs rulemaking process results in proposals that do not take effect until the SEC approves them. Over the years, the SEC has not been reluctant to use this authority. Further consideration is given in Chapter 4 to the independent auditors responsibilities in lings with the SEC. State Boards of Accountancy There are 54 boards of accountancy (one in each state, one in the District of Columbia, and one in each U.S. territory). The primary functions of the state boards of accountancy are issuing licenses to practice as a CPA, renewing licenses, and suspending or revoking licenses to practice. State boards usually consist of ve to seven CPAs and at least one public member, who are generally appointed by the governor. A full-time administrator and a small (ve to ten) administrative staff are common. Each board administers its state accountancy laws, which set forth the conditions for licensing of CPAs, codes of professional ethics, and, in most cases, mandatory continuing professional education requirements. State boards are also becoming more active in positive enforcement programs aimed at maintaining high quality in audit practice. U.S. General Accounting Ofce The General Accounting Ofce (GAO) is the nonpartisan, federal audit agency of the U.S. Congress. Headed by the Comptroller General of the United States, the GAO has the authority to issue standards pertaining to the audit of governmental organizations, programs, activities, and functions. Its standards have been published in a booklet called Government Auditing Standards, also known as the yellow book after the color of its cover. These standards apply not only to government auditors, but to CPAs who perform audits of federal agencies and other entities that receive federal nancial assistance, including state and local governments, institutions of higher education, and certain nonprot organizations and contractors. Internal Revenue Service The Internal Revenue Service (IRS) is the division of the U.S. Treasury Department responsible for administration and enforcement of the federal tax laws. A publication that has a major inuence on CPAs who perform tax services is the IRSs Circular 230, Rules Governing the Practice of Attorneys and Agents Before the Internal Revenue Service. CPAs who depart from these rules are subject to nes and other penalties that can be imposed by the IRS. State and Federal Courts Occasionally, CPA rms are sued for alleged substandard work in performing audits or other services. In reaching a judgment in a particular case, generally the courts have looked to the standards of performance established by the profession
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itself. But occasionally, the courts have ruled that the professions standards were not adequate for the protection of the public. Following trends of such court decisions, the profession has responded by raising existing practice standards. Examples include mandating the use of particular auditing procedures pertaining to accounts receivable, inventories, related-party transactions, and the discovery of subsequent events. U.S. Congress Following a number of widely publicized audit failures, congressional committees have undertaken several investigations of the accounting profession over the past two decades. The investigations have focused on such matters as the independence of CPA rms, their effectiveness in auditing publicly held companies, and their responsibilities for detecting and reporting fraud and illegal client acts (whistleblowing). The nancial frauds at Enron and WorldCom prompted an inquiry into whether the professions regulatory system is adequate to protect the public. In response, Congress passed the Sarbanes-Oxley Act of 2002 that created the PCAOB which sets independence, auditing, quality control, and ethics standards for auditors of public companies. PRIVATE SECTOR ORGANIZATIONS Public Companies Accounting Oversight Board The Public Companies Accounting Oversight Board (PCAOB) describes itself as a private sector, nonprot corporation, created by the Sarbanes-Oxley Act of 2002, to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports. The PCAOB was given authority in ve major areas:
1. Registering public accounting rms that audit the nancial statements of pub-
lic companies.
2. Setting quality control standards for peer review of auditors of public compa-
nies and conducting inspections of registered public accounting rms.

3. Setting auditing standards for audits of public companies. 4. Setting independence and ethics rules for auditors of public companies. 5. Performing other duties or functions to promote high professional standards
for public company audits, and enforce compliance with the Sarbanes-Oxley Act of 2002. The PCAOB has enforcement authority and can prohibit CPA, or accounting rms, from auditing public companies. The PCAOBs rulemaking process results in the adoption of rules that are then submitted to the SEC for approval. PCAOB rules do not take effect unless approved by the SEC. American Institute of Certied Public Accountants The public accounting professions national professional organization is the American Institute of Certied Public Accountants (AICPA). As stated in its annual report, the mission of the AICPA is to act on behalf of its members and provide necessary support to assure that CPAs serve the public interest in performing quality
[ 26 ]
PART 1
professional services. Membership in the AICPA is voluntary. Currently, there are over 300,000 members of whom 45 percent are in public accounting, 40 percent in business and industry, and the remainder in education, government, or retired. The AICPA provides a broad range of services to its members. In addition, the AICPA develops and distributes continuing professional education (CPE) materials and courses, provides technical accounting and auditing assistance through a technical information hotline and an extensive library of technical references, and publishes a variety of books, studies, and surveys, as well as three periodicals the Journal of Accountancy, The Tax Advisor, and The CPA Letter. Through its senior technical committees, members participate in establishing a variety of professional standards for CPAs who provide services to private companies. Three AICPA divisions or teams have a direct impact on auditing.
1. The AICPA Practice Monitoring Program is responsible for quality control
standards and peer reviews of rms that provide assurance services to private companies. 2. The Auditing and Attest Standards Team sets auditing and attest standards for audit, accounting, and review services provided to private companies. 3. The Professional Ethics Division is responsible for setting and enforcing the AICPA Code of Professional Conduct. State Societies of Certied Public Accountants CPAs within each state have formed a state society (or association) of CPAs. As in the AICPA, membership in a state society is voluntary and many CPAs are members of both the AICPA and a state society. State societies function through small full-time staffs and committees composed of their members. Although state societies are autonomous, they usually cooperate with each other and the AICPA in areas of mutual interest, such as continuing professional education, quality control, and ethics. Practice Units (CPA Firms) A CPA may practice as a sole practitioner or as a member of a rm. A CPA rm may be organized as a proprietorship, limited liability partnership, professional corporation, or any other form of organization permitted by state law or regulation. There are approximately 45,000 practice units in the United States. These rms are often classied into four groupsthe Big Four, second-tier, regional, and local rms. The four largest firms in the United States are referred to as the Big Four. Together, their clients include over 95 percent of the Fortune 500 companies and thousands of smaller clients. The combined U.S. revenues of the Big Four exceeded $20 billion in 2003, or about one-quarter of the total revenues of the U.S. profession. Each of these firms had worldwide affiliations with partnerships in many countries. With offices in the principal cities of the United States as well as major cities throughout the world, these are truly international firms. The competitive environment is changing as some of the largest accounting firms are not CPA firms. Names like H&R Block, Century Business Services, and
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American Express are on the list. Selected additional data for these and several other practice units are presented in Figure 1-6. In 1999 each of the Big Four firms earned less than 50 percent of its revenues from accounting and auditing services. These firms have now sold off significant portions of their consulting practices, and the pendulum has swung back to a point where the majority of these firms earn over 60 percent of their revenues from accounting and auditing services. As the figure shows, distinct gaps in the size of revenues separate the secondtier firms from both the Big Four and smaller firms. Although the international reach of these firms is significantly less than that of the Big Four, the domestic practice of each is national in scope. Thus, these firms provide competition for the Big Four in serving large, publicly held companies as well as other clients of all sizes. Figure 1-6 also includes three examples of regional firms. The offices of these firms tend to be concentrated in a more limited geographical area such as the East, Midwest, or West. Although these firms serve some publicly owned companies, their clients tend to be smaller than those of the Big Four and secondtier firms. Local rms may have one or several ofces within a state. The local rm is by far the most common form of practice unit. Although some local rms serve public companies, their clients are primarily smaller businesses and individuals. Some of the smallest local rms decline to perform audit services because of the high cost of maintaining competence and the increased exposure to legal liability. To remain competitive, many smaller and midsized rms join an association of CPA rms. There are more than two dozen associations in the United States with as few as 6 and as many as 60 practice unit members. Associations vary widely in the services provided to members, but most offer staff training programs, a directory of experts in member rms available for consultation with other member rms about their areas of expertise, assistance in recruiting personnel, and client referral services. Accounting Standard-Setting Bodies The Financial Accounting Standards Board (FASB) and Governmental Accounting Standards Board (GASB) are independent private sector standard-setting bodies whose primary functions are the development of generally accepted accounting principles for business and not-for-profit entities, and state and local governmental entities, respectively. The statements and interpretations issued by both boards have been officially recognized by the AICPA as constituting GAAP. The FASB consists of seven full-time members who are assisted by a research staff and an advisory council. Before its Statements of Financial Accounting Standards (SFASs) are issued, a due process is followed including issuing exposure drafts for public comment and, in some cases, holding public hearings. The GASB follows a similar process in issuing its Statements of Governmental Accounting Standards (SGASs).
[ 28 ]
PART 1 s
Figure 1-6
Select Accounting Firm Data No. of U.S. Revenue ($Mil) Revenues Sources (%) Actg/ MCS/ Audit Tax Other
Rank by Revenue Big Four 1 2 3 4
Firm
U.S. Ofces
Partners
Prof. Staff
Deloitte & Touche Ernst & Young PricewaterhouseCoopers KPMG
6,511.0 5,260.0 4,850.0 3,793.0 20,414.0
91 86 125 94
2,613 2,000 2,000 1,622
20,487 14,400 21,000 11,529
39% 62% 62% 67%
25% 35% 33% 33%
27% 3% 5% 0%
Second Tier 5 6 7 8 9 10 11 Regional 12 13 14 Local 23 25 Eisner Berdon 71.9 64.0 3 2 65 39 234 245 53% 38% 27% 36% 20% 26% Crowe Group LLP BKD Moss Adams 247.3 215.7 181.0 16 27 23 153 194 185 925 952 825 24% 42% 36% 19% 36% 38% 57% 22% 26% H&R Block RSM McGladrey Grant Thornton Jackson Hewitt Tax Inc. American Express Tax and Business Services 3,694.7 595.9 484.8 397.3 367.5 10,000 91 48 4,225 50 146 36 n.a. 498 328 n.a. 330 n.a. 281 n.a. 2,701 2,217 129 1,650 1,475 1,243 0% 39% 52% 0% 36% 40% 46% 58% 42% 33% 100% 32% 40% 37% 42% 19% 15% 0% 32% 20% 17%
Century Business Services Inc. 354.0 BDO Seidman 350.0
Source: Accounting Today Special Report: Top 100 Firms Study 2000, March 2004.
[LEARNING CHECK
Identify six public sector organizations and ve private sector organizations associated with the auditing profession. 1-13 Explain the authority of the SEC and state boards of accountancy with respect to auditors and the auditing profession. 1-14 a. Explain the authority given to the PCAOB. b. Identify three important AICPA divisions or teams that have a direct impact on auditors.
1-12
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[ 29 ]
1-15
a. In what form of business may a CPA rm be organized? b. In what four groups are CPA rms often classied?
[KEY TERMS
American Institute of Certied Public Accountants (AICPA), p. 25 General Accounting Ofce, p. 24 Public Companies Accounting Oversight Board (PCAOB), p. 25 Securities and Exchange Commission (SEC), p. 23 State boards of accountancy, p. 24
[REGULATORY FRAMEWORK FOR ] ENSURING HIGH-QUALITY SERVICES

Auditor Knowledge 10
s Know the four com-
ponents of the auditing professions multilevel regulatory framework.
Every profession is concerned about the quality of its services, and the public accounting profession is no exception. Quality services are essential to ensure that the profession meets its responsibilities to the general public, clients, and regulators. To help assure quality in the performance of audits and other professional services, the profession has developed a multilevel regulatory framework. This framework encompasses many activities of the private and public sector organizations associated with the profession that were described in previous sections of this chapter. For purposes of describing the multilevel framework, these activities may be organized into four components as follows:
s
Standard setting. The private and public sectors establish standards for accounting, professional services, ethics, and quality control to govern the conduct of CPAs and CPA rms. Firm regulation. Each CPA rm adopts policies and procedures to assure that practicing accountants adhere to professional standards. Inspection and peer review. The PCAOB and the AICPA have implemented a comprehensive program of inspection of audits by PCAOB staff and peers in other accounting rms. Government regulation. Only qualied professionals are licensed to practice, and auditor conduct is monitored and regulated by the PCAOB, state boards of accountancy, and the courts.
Each component is discussed further in the following sections. STANDARD SETTING When performing auditing and assurance services CPAs must follow a variety of professional standards. Those standards are set differently for services performed for public companies and for private companies. Figure 1-7 outlines the various professional organizations that set relevant professional standards. The focus of this discussion relates to the standards that inuence the performance of high-quality audits. This book addresses standard setting that inuences
[ 30 ]
PART 1 s
Figure 1-7
Standard-Setting Organizations in the United States Public Companies Private Companies
Accounting: Generally accepted standards followed when preparing nancial statements. Auditing: Generally accepted standards for performing audits and reporting on nancial statements. Quality Control: Standards for quality of practice that provide the basis for inspection and peer review. Ethics and Professional Conduct: Standards for ethical conduct. Other Attest and Assurance Services: Standards for performing other attest engagements or other assurance services.
FASB/GASB/SEC PCAOB PCAOB PCAOB
FASB/GASB AICPA AICPA AICPA
AICPA
AICPA
the performance of high-quality audits and other assurance servicesfor example, professional standards associated with auditing standards, quality control standards, ethical standards, and standards for other attest and assurance services. In April 2003 the PCAOB adopted existing auditing and quality control standards that had previously been developed by the AICPA. The auditing standards that are common to the audits of both public and private companies are discussed throughout this book, along with discussion of additional standards that pertain to the audits of public companies. Quality control standards are examined below. When this book went to press, the quality control standards were the same for public and private companies. Standards for ethical conduct are discussed in Chapter 3. Once again, ethical standards that are common for auditors of public and private companies are discussed, along with how independence standards differ for auditors of public and private companies. Other attest and assurance services are discussed in Part 5 of this book. Quality Control Standards Statement on Quality Control Standards (SQCS) No. 1, System of Quality Control for a CPA Firm, mandates that a CPA rm shall have a system of quality control. SQCS No. 2 identies ve quality control elements that should be considered by a rm in adopting quality control policies and procedures to provide reasonable assurance of conforming with professional standards in performing auditing and accounting and review services. Their application to other services such as tax and consulting is voluntary. The ve elements and their purposes are shown in Figure 1-8. Quality control standards are important because they provide the basis for conducting peer reviews and inspections of the quality of work performed by CPA rms. The ve elements of quality control can be summarized as follows:
Independence, Integrity, and Objectivity
Auditor Knowledge 11
s Know the elements
of a system of quality control for a CPA rms attest practice.
Independence, integrity, and objectivity address whether a firm has no appearance of a vested interest in the client for whom it is performing attest services, and whether the firm performs professional services without subordi-
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Figure 1-8 Element
Quality Control Elements (SQCS No. 2) Purpose A rm should establish policies and procedures to assure that personnel: s Are independent of clients when performing attest services. s Perform all professional responsibilities with integrity and maintain objectivity while performing those responsibilities. The rms policies and procedures related to personnel management should provide it with reasonable assurance that: s Personnel hired have the characteristics needed to perform competently. s Work is assigned to personnel who have the technical training and prociency required for the assignment. s Personnel selected for advancement have the qualications needed to perform the responsibilities they will be called on to assume. s Personnel participate in general and industry-specic continuing professional education and other professional development activities that enable them to fulll their assigned responsibilities and the requirements of the AICPA and regulatory agencies. In general, a rm should establish policies and procedures that minimize the likelihood of being associated with a client whose management lacks integrity. In addition, the rm must establish policies and procedures that: s Provide reasonable assurance that it will accept only engagements it can complete with due professional competence. s Facilitate an understanding with the client about the nature, scope, and limitations of the services to be performed. A rm should establish policies and procedures for: s Planning, performing, supervising, reviewing, documenting, and communicating the results of each engagement. s Assuring that personnel consult with other professionals and seek assistance from persons having appropriate expertise, judgment, and authority, when appropriate, and on a timely basis. Monitoring is an ongoing process of evaluating the rms system of quality control. Inspection is a measure of the system of quality control at a point in time. A rm must establish policies and procedures that provide an ongoing consideration and evaluation of: s Relevance and adequacy of its policies and procedures. s Appropriateness of its guidance materials and any practice aids. s Effectiveness of professional development activities. s Compliance with its policies and procedures.
Independence, Integrity, and Objectivity
Personnel Management
Acceptance and Continuance of Clients and Engagements
Engagement Performance
Monitoring
nating judgment and in a way that is free of conflicts of interest. For example, an international firm may have professional staff report their investments on a regular basis so that they make sure that professionals are independent of the clients in cases where they might influence the outcome of an audit. In addition, the tone communicated from the highest levels of a CPA firm should encourage CPAs to act with integrity and objectivity. These concepts are discussed in more depth in Chapter 3.
[ 32 ]
PART 1
Personnel Management
Personnel management addresses a variety of procedures within a CPA firm for hiring, promoting, and firing accounting professionals. An important aspect of performing an audit involves making sure that auditors have adequate training, experience, and supervision to perform assigned tasks. Audit firms need to have procedures in place so that they hire employees with sufficient technical competence, they give individuals the training to allow for their advancement, and they ensure that work assignments and promotions are consistent with an individuals technical training and proficiency. Many firms evaluate work performance after work is completed for each client as a basis for effective personnel management.
Acceptance and Continuance of Clients and Engagements
Auditors have several concerns about acceptance and continuance of clients and engagements. First, the audit process relies on managements cooperation, and the process can break down if the client lacks honesty and integrity. CPA rms want to take steps to minimize the likelihood of being associated with a client that lacks integrity. Second, auditors also need to ensure that they can reasonably expect to complete an engagement with professional competence. It is common for some smaller audit rms to decline the audit of public companies or to decline engagements of clients in industries where they do not have sufcient expertise.
Engagement Performance
Engagement performance is about the policies and practices that ensure an audit is carried out appropriately with due professional care. For example, many key audit decisions require signicant professional judgment. Many rms will therefore have several professionals review the work of others to ensure that professionals concur on key issues and that the working papers document compliance with professional standards.
Monitoring
Monitoring is an ongoing process whereby a rm evaluates the effectiveness of the other four elements of quality control. Most rms perform internal inspections in which a team from other ofces actually inspects audit working papers, evidence of compliance with independence policies, personnel management decisions, and client acceptance and continuance decisions. In this way the rm monitors compliance with its own policies. As a rm considers how it will administer a system of quality control, it should consider three key issues. First, responsibility should be assigned within the rm to appropriate individuals for the design and maintenance of its quality control policies. Second, it should communicate its quality control policies and procedures to its personnel on a timely basis in a manner that provides reasonable assurance that they are understood and complied with. Finally, it should document compliance with its quality control policies and procedures. The form and content of the documentation is a matter of professional judgment and depends on such factors as rm size, number of ofces, degree of authority allowed personnel and ofces, the nature and complexity of the accounting and attest practice, rm organization, and cost-benet considerations.
CHAPTER 1
[ 33 ]
FIRM REGULATION Firm regulation occurs within a CPA rm. A prime example is implementing a system of quality control as mandated by the quality control standards discussed in the preceding section. This means that the rms day-to-day actions will comply with the policies and procedures pertaining to the quality control elements. For example, to assist staff in meeting professional standards, rms provide onthe-job training and require their professionals to participate in continuing professional education courses. Personnel who adhere to standards for professional services and show growth and progression in their skills often receive pay raises and promotions. Personnel whose work is identied as substandard may be terminated if rapid improvement is not forthcoming. A CPA rm is motivated by numerous incentives to do good work, including pride, professionalism, and a desire to be competitive with other rms. Additional motivation results from the desire to avoid the expense and damage to the rms reputation that accompanies litigation and other actions brought against it for alleged noncompliance with professional standards. INSPECTION AND PEER REVIEW Quality control standards provide the basis for rm regulation and the performance of high-quality audit and attest services. Inspection and peer review provide an external review of whether a rm is in fact meeting quality control standards. The following discussion outlines both the PCAOBs inspection program of accounting rms that audit public companies and the AICPAs practice monitoring (peer review) program of accounting rms that perform audit and attest services for private companies. PCAOB Inspection Program The Sarbanes-Oxley Act of 2002 instructs the PCAOB to conduct a continuing program of inspections to assess the degree of compliance of each accounting rm registered to audit public companies with the rules of the PCAOB, the SEC, and other professional standards in connection with its performance of audits, issuance of audit reports, and related matters. In conducting inspections, the Sarbanes-Oxley Act of 2002 states that the PCAOB should:
s s
Inspect and review selected audit and review engagements of the rm. Evaluate the sufciency of the rms quality control systems and the rms documentation and communication of that system. Perform such other testing of the audit, supervisory, and quality control procedures of the rm as are necessary or appropriate in light of the purpose of the inspection and the responsibilities of the board.
The PCAOB conducts annual inspections of rms that regularly provide audit reports for over 100 public companies. The PCAOB inspects the quality control activities of rms that provide audit reports for 100 or fewer public companies every three years. Finally, the Sarbanes-Oxley Act of 2002 states that a written report of the Boards ndings for each inspection shall be transmitted to the SEC and to each appropriate state regulatory authority, accompanied by any letter of response
[ 34 ]
PART 1
from the registered public accounting rm, and shall be made available in appropriate detail to the public. AICPA Practice Monitoring (Peer Review) Program Since the early 1980s the AICPA has sponsored a practice monitoring program through which a CPA rm would submit its accounting and auditing practice to a review by independent peers every three years. Participation is required for all members of the AICPA, and many state boards of accountancy require that auditors of private companies undergo a form of peer review equivalent to the AICPA program. Recall that auditors of public companies are inspected by the PCAOB. The purpose of a peer review is to determine whether:
s
The reviewed rms system of quality control for its accounting and auditing practice has been designed in accordance with quality control standards established by the AICPA. The reviewed rms quality control policies and procedures were being complied with to provide the rm with reasonable assurance of conforming with professional standards. The reviewed rm has demonstrated the knowledge, skills, and abilities necessary to perform accounting, auditing, and attestation engagements in accordance with professional standards, in all material respects.
At the end of the peer review, the independent peer review team will issue a report on the rms compliance with quality control standards and, if applicable, a letter of comment with recommendations for improvement. The rm may then le the report with the state board of accountancy, and clients can ask to see the results of a rms peer review. GOVERNMENT REGULATION Government regulates the auditing profession primarily through the activities of state boards of accountancy (which have the authority to issue and revoke CPA licenses), the SEC, and state and federal courts as discussed in previous sections. Recently, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 with regulatory legislation to be administered by the SEC and the PCAOB. The SEC plays an important role in linking private sector and public sector regulation; it does so through its authority over the PCAOB, a private sector organization. It is the SEC that puts signicant teeth in the standard-setting, inspection, and enforcement authority of the PCAOB. State boards of accountancy regularly ask rms to submit their peer review letters as part of obtaining a license for the rm to perform audit and attest services. Although peer reviews are performed as part of the self-regulation of the CPAs performing services for private companies, it is the state board of accountancy that has the authority to grant or revoke a CPAs, or CPA rms, license to practice.
[LEARNING CHECK
a. What is the purpose of the professions multilevel regulatory framework? b. Describe the four components of the multilevel regulatory framework. 1-17 State the ve elements of a system of quality control for a CPA rm.
1-16
CHAPTER 1
[ 35 ]
1-18
a. Describe the key elements of the PCAOB inspection program. b. Describe the purpose of the AICPA practice monitoring (peer review) program.
[KEY TERMS
Acceptance and continuance of clients and engagements, p. 32 Engagement performance, p. 32 Firm regulation, p. 29, 33 Government regulation, p. 29, 34 Independence, integrity, and objectivity, p. 30 Inspection and peer review, p. 29, 33 Monitoring, p. 32 Personnel management, p. 32 Standard setting, p.29
[FOCUS ON AUDITOR KNOWLEDGE]

This chapter introduces some basic knowledge about auditing and assurance services, presents the organizations associated with the public accounting profession, and provides an overview of the regulatory framework associated with ensuring high-quality audit and attest services. Figure 1-9 summarizes the key components of auditor knowledge discussed in this chapter and provides page references to where these decisions are discussed in more detail.
Figure 1-9
Summary of Auditor Knowledge Discussed in Chapter 1 Summary The Report of the Committee on Basic Auditing Concepts of the American Accounting Association denes auditing as a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. The common attributes auditing activities are identied in the preceding italics. This chapter distinguishes between nancial statement audits, compliance audits, and operational audits. Figure 1-2 provides a useful summary of the difference between these types of audits. The chapter also discusses the differences between independent auditors, internal auditors, and government auditors. The AICPA Special Committee on Assurance Services denes assurance services as independent professional services that improve the quality of information, or its context, for decision makers. The common attributes of assurance services are identied in the preceding italics. Chapter References pp. 67
Auditor Knowledge K1. Know the common attributes of activities dened as auditing.
K2. Know the differences between the different types of audits and auditors.
pp. 811
K3. Know the common attributes of assurance services.
pp. 1112
(table continues)
[ 36 ]
PART 1 s
Figure 1-9
(Continued) Summary Figure 1-3 describes the universe of assurance services, which includes audit engagements, attest engagements, accounting and compilation engagements, and other assurance engagements. CPAs can provide a variety of levels of assurance when performing these engagements including reasonable assurance, negative assurance, assurance that varies with the nature of agreed-upon procedures, and engagements with no assurance. Decision makers need credible and reliable information to support their decisions. The purpose of the audit is to provide reasonable assurance that information used by investors, creditors, and others is, in fact, reliable. Figure 1-4 demonstrates that the information captured about business events is the foundation for many business decisions. If this foundation is weak, every step that builds on that foundation is also weak. The value of the audit can be seen in the losses suffered by investors in WorldCom who made investment decisions based on unreliable information about the companys protability and liquidity and solvency risks. The chapter provides a historical prospective that looks back on the last 120 years and the events that have inuenced the demand for auditing. In general, the demand for auditing has been signicantly inuenced by professional managers who misled investors by materially misstating their companys nancial performance in nancial statements prepared for owners and other investors. Auditors add credibility to managements assertions by reducing information risk for nancial statement users. The need for nancial statement audits has been inuenced by an inherent conict of interest between management and owners, by the consequence and importance of nancial statement information to investors, by the complexity inherent in the preparation of nancial statements, and by the remoteness of investors from management of the rms they invest in. The economic benets of an audit to a company and its owners include (1) access to capital markets, (2) lower cost of capital, (3) the audit as a deterrent to inefciency and fraud, and (4) control and operational improvements that are often suggested by auditors. The inherent limitations of an audit include the fact that audits must be performed (1) at a reasonable cost and (2) in a reasonable length of time. There are also two important inherent limitations associated with our established accounting framework: (1) alternative accounting principles are often accepted and (2) the accounting process involves making signicant accounting estimates. Chapter References pp. 1215
Auditor Knowledge K4. Know the variety of services and levels of assurance in the universe of assurance services.
K5. Know the value of the audit and other assurance services.
pp. 1517
K6. Know a historical perspective of the demand for auditing.
pp. 1820
K7. Know the factors that inuence the need for nancial statement audits.
pp. 2021
K8. Know the economic benets and inherent limitations associated with a nancial statement audit.
pp. 2122
(table continues)
CHAPTER 1
[ 37 ]
Figure 1-9
(Continued) Summary Figure 1-5 summarizes a number of public sector and private sector organizations that are associated with the public accounting profession. The chapter explains their role in accounting and auditing. The four components of the auditing professions multilevel regulatory framework are (1) standard setting (see Figure 1-7), (2) rm regulation, (3) inspection and peer review, and (4) government regulation. The ve elements of quality control are (1) independence, integrity, and objectivity, (2) personnel management, (3) acceptance and continuance of clients and engagements, (4) engagement performance, and (5) monitoring. Each of these elements is explained further in Figure 1-8. The system of quality control provides the standards by which the profession evaluates an audit rms quality of practice when performing peer reviews. Chapter References pp. 2328
Auditor Knowledge K9. Know the public sector and private sector organizations associated with auditing and assurance services. K10. Know the four components of the auditing professions multilevel regulatory framework. K11. Know the elements of a system of quality control for a CPA rms attest practice.
pp. 2930
pp. 3034
objective questions
Objective questions are available for the students at www.wiley.com/college/boynton
comprehensive questions
1-19 (Types of audits and auditors) J. Cowan, an engineer, is the president of Arco Engineering. At a meeting of the board of directors, Cowan was asked to explain why audits of the company are made by (1) internal auditors, (2) independent auditors, and (3) government auditors. One board member suggested that the companys total audit expense might be lower if all auditing was done by internal auditors. J. Cowan was unable to distinguish between the three types of auditors or to satisfactorily respond to the board members suggestion. Required a. Explain the different kinds of audits made by each type of auditor. b. Identify the sources of practice standards applicable to each type of auditor. c. Comment on the board members suggestion to have all auditing done by internal auditors. 1-20 (Types of audits and auditors) After performing an audit, the auditor determines that 1. The nancial statements of a corporation are presented fairly. 2. A companys receiving department is inefcient.
[ 38 ]
PART 1
3. A companys tax return does not conform with IRS regulations. 4. A government supply depot is not meeting planned program objectives. 5. The nancial statements of a physician are properly prepared on a cash basis. 6. A foreman is not carrying out his assigned responsibilities. 7. The IRS is in violation of an established government employment practice. 8. A company is meeting the terms of a government contract. 9. A municipalitys nancial statements correctly show actual cash receipts and disbursements. 10. The postal service in midtown is inefcient. 11. A company is meeting the terms of a bond contract. 12. A department is not meeting the companys prescribed policies concerning overtime work. Required a. Indicate the type of audit that is involved: (1) nancial, (2) compliance, or (3) operational. b. Identify the type of auditor that is involved: (1) independent, (2) internal, (3) governmentGAO, or (4) governmentIRS. c. Identify the primary recipient(s) of the audit report: stockholders, management, Congress, and so on. Use the following format for your answers:
TYPE
OF
AUDIT
TYPE
OF
AUDITOR(S)
PRIMARY RECIPIENT(S)
1-21
(Accountant value chain and the value of the audit) You have just completed an audit for a small business client. In the process of performing the audit you found that the client turns its receivables, on average, every 58 days (this is after the client increased its provision for doubtful accounts based on your audit). You also discover that the median collection period for the industry is 45 days and the upper quartile is 59 days. Answer the following questions using this information. Required a. Explain each step of the accounts value chain in the context of this information and knowledge. b. Explain the value of the audit in the context of whether the nancial statements are compiled versus being audited.
1-22
(Benets and limitations of an audit) A fellow business student questions the benets of an audit as follows. Why should a company hire auditors? As far as I can tell auditors of public companies charge millions of dollars in audit fees, and it is not clear to me that management receives any benet for this expenditure. It is just money down the drain. It is also not clear to me that auditors accomplish anything. We have seen a number of material
CHAPTER 1
[ 39 ]
restatements of nancial statements. Why should a company pay for audits that are ineffective? I think auditors are just a drain on society. Required a. Explain the economic benets provided by a nancial statement audit. b. Explain the inherent limitations that might prevent auditors from nding every potential material misstatement in nancial statements. 1-23 (Organizations associated with the public accounting profession) Several private and public sector organizations are associated with the profession. Listed below are activities pertaining to these organizations. 1. License individuals to practice as CPAs. 2. Promulgate GAAP. 3. Issue Statements on Auditing Standards. 4. Regulate the distribution and trading of securities offered for public sale. 5. Establish its own code of professional ethics. 6. Issue Statements of Financial Accounting Standards. 7. Impose mandatory continuing education as a requirement for renewal of license to practice as a CPA. 8. Issue disclosure requirements for companies under its jurisdiction that may exceed GAAP. 9. Issue auditing interpretations. 10. Cooperate with the AICPA in areas of mutual interest such as continuing professional education and ethics enforcement. 11. Take punitive action against an independent auditor. 12. Establish accounting principles for state and local governmental entities. 13. Establish GAAS. 14. Suspend or revoke a CPAs license to practice. 15. Establish quality control standards. 16. Operate as proprietorships, partnerships, or professional corporations. 17. Issue government auditing standards. 18. Administer federal tax laws. Required Indicate the organization or organizations associated with each activity. 1-24 (Regulatory framework) The accounting professions commitment to achieving high quality in rendering professional services is demonstrated by the breadth and effectiveness of its multilevel regulatory framework. Required a. One component of this framework is standard setting which occurs primarily in the private sector. Identify four types of standards included in this component and the private sector bodies that establish them. b. Identify and briey describe the other three components of the regulatory framework.
[ 40 ]
PART 1
1-25
(Quality control elements) The AICPA has established ve elements of quality control. Listed below are specic policies and procedures adopted by the CPA rm of Baily, Brown & Co.: 1. Periodic evaluations are made of personnel. 2. Ongoing supervision is given to less experienced personnel. 3. An experienced CPA is designated as a public utility industry expert. 4. Rules on independence are communicated to the professional staff. 5. The scope and content of the rms inspection program are dened. 6. All new employees must be college graduates. 7. Copies of Statements on Auditing Standards are provided for all professional staff. 8. A partner assigns personnel to engagements. 9. All new clients must be solvent at the time the engagement is accepted. Required a. Identify the quality control element that applies to each of the foregoing items. b. For each element of quality control identied in (a) state the purpose of the element. c. Indicate another policy or procedure that applies to the element. Use the following format for your answers:
POLICY/ PROCEDURE NUMBER (A) QUALITY CONTROL ELEMENT (B) PURPOSE OF POLICY/PROCEDURE (C) ADDITIONAL PROCEDURE
1-26
(Regulating audit quality) The Public Companies Accounting Oversight Board and the AICPAs Practice Monitoring (Peer Review) Program play important roles in the professions regulation of the quality of audit and assurance services. Required a. The activities of these two organizations are directed toward CPA rms. How, if at all, do these divisions have a direct impact on individual members? b. Why do we have two organizations involved in peer review? Discuss the similarities in the objectives of the peer reviews and practice monitoring programs of the PCAOB and the AICPA. c. Identify the similarities in the peer review objectives of the two organizations and the common responsibilities and functions of the peer review teams used by each. d. What are the primary activities of the AICPA Practice Monitoring (Peer Review) Program?
CHAPTER 1
[ 41 ]
professional simulation
Situation Research Communication
Tom Meyers has a successful tax practice as a sole practitioner. Tom is a sole owner and he has 3 professional staff to assist him in tax research and tax return preparation. He has a number of clients that have small, and growing businesses. He has compiled nancial statements for these businesses with no assurance. As a result, he has had minimal requirements for peer review. Now he has several clients who have grown to the point where they need audited nancial statements for lenders. In order to better serve these clients, Tom is considering taking in Kenny Vaughn, an audit manager with a national CPA rm, as a partner to manage a new audit and assurance practice. Research Situation Communication
Tom and Kenny want to better understand what will be required in terms of how the combined practice will need to follow quality control standards. In particular, they are concerned about professional requirements for monitoring compliance with quality control standards. Research the professional standards and identify the quality control standards that: 1. Explain the monitoring procedures that should be performed by the rm. 2. Explain the factors that should be considered by small rms with a limited number of management individuals. Do this by indicating in the box below the appropriate QC section paragraphs that responds to these questions. 1. QC Section ______ 2. QC Section ______ Communication Situation Research
Draft a report with your recommendations for specic monitoring procedures that should be performed by Meyers and Vaughn. Remember: Your response will be graded for both technical relevance and writing skills. For writing skills you should demonstrate an ability to develop your ideas, organize them, and express them clearly. To: Re: From: Tom Meyers and Kenny Vaughn Monitoring Procedures CPA Candidate

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A UDITING AND THE P UBLIC A CCOUNTING P ROFESSION I NTEGRITY OF F INANCIAL R EPORTING

THE AUDITING ENVIRONMENT

Introduction to Contemporary Auditing

Chapter 1 addresses the following aspects of the auditors knowledge.

focus on auditor knowledge

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

[ AUDITING AND ASSURANCE SERVICES DEFINED]

THE AUDITING ENVIRONMENT

attributes of activities dened as auditing.

Several attributes of auditing contained in this denition merit special comment:

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

Figure 1-2 Type of Audit

Investors, creditors and others

Investors, creditors and others

THE AUDITING ENVIRONMENT

ences between the different types of audits and auditors.

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

THE AUDITING ENVIRONMENT

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

attributes of assurance services.

THE AUDITING ENVIRONMENT

services and levels of assurance in the universe of assurance services.

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

Universe of Assurance Services

Accounting & Compilation Assurance Services

Compiled financial statements

Attest Services Audit Engagements

Financial Statement Audits Audits of Internal Control over Financial Reporting

THE AUDITING ENVIRONMENT

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

the audit and other assurance services.

THE AUDITING ENVIRONMENT

The Accountants Value Chain Transforming Vision into Reality Decisions

Anticipating and Creating Opportunities Knowledge

Transforming Complex Information Into Knowledge Information

Communicating the Total Picture with Integrity and Objectivity Data

Establishing the Information & Communication System Business Events

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

nature of the auditors report for each.

THE AUDITING ENVIRONMENT

[THE DEMAND FOR AUDITING]

perspective of the demand for auditing.

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

THE AUDITING ENVIRONMENT

that inuence the need for nancial statement audits.

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

benets and inherent limitations associated with a nancial statement audit.

THE AUDITING ENVIRONMENT

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

[ORGANIZATIONS ASSOCIATED WITH ] THE PUBLIC ACCOUNTING PROFESSION

THE AUDITING ENVIRONMENT

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

nies and conducting inspections of registered public accounting rms.

THE AUDITING ENVIRONMENT

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION

THE AUDITING ENVIRONMENT

Rank by Revenue Big Four 1 2 3 4

Deloitte & Touche Ernst & Young PricewaterhouseCoopers KPMG

6,511.0 5,260.0 4,850.0 3,793.0 20,414.0

2,613 2,000 2,000 1,622

20,487 14,400 21,000 11,529

39% 62% 62% 67%