TENTH EDITION Auditing & Assurance Services ,

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TENTH CHWilliam F. Messier, Jr.University of Nevada, Las VegasDepartment ofAccountingandNorwegian School of EconomicsDepartment ofAccounting, Auditing and LawSteven M. GloverBrigham Young UniversityMarriott School of ManagementSchool of AccountancyDouglas F. PrawittBrigham Young UniversityMarriott School of ManagementSchool of AccountancyMcGrawHillEducation

PART 1Introduction to Assurance andFinancial Statement Auditing1Chapter 1An Introduction to Assurance and FinancialStatement Auditing 2Tips for Learning Auditing 4The Demand for Auditing and Assurance 5Principals and Agents 5The Role of Auditing 6An Assurance Analogy: The Case of the HouseInspector 8Seiler Assertions, Information Asymmetry, andInspector Characteristics 8Desired Characteristics of the House InspectionService 8Relating the House Inspection Analogy toFinancial Statement Auditing 9Management Assertions and FinancialStatements 10Auditing, Attest, and Assurance Services Defined 12Auditing 12Attestation 13Assurance 13Fundamental Concepts in Conducting a FinancialStatement Audit 14Materiality 14Audit Risk 15Audit Evidence Regarding Management Assertions 16Sampling: Inferences Based on LimitedObservations 16The Audit Process 17Overview of the Financial Statement AuditingProcess 17Major Phases ofthe Audit 18The Unqualified/Unmodified Audit Report 21Other Types of Audit Reports 22Conclusion 23Key Terms 24Review Questions 25Multiple-Choice QuestionsProblems 27Discussion Case 28Internet Assignment 29Hands-On Cases 2925Chapter 2The Financial Statement AuditingEnvironment 36Types of Auditors 38External Auditors 38Internal Auditors 38Government Auditors 39Forensic Auditors 40Types of Other Audit, Attest, and AssuranceServices 40Other Audit Services 40Attest Services 41Assurance Services 41Other Nonaudit Services 42Public Accounting Firms 42Organization and Composition 42A Decade of Challenge and Change for FinancialStatement Auditors 44Government Regulation 44Society's Expectations and the AuditoresResponsibilities 45The Context of Financial Statement Auditing 45The Business Entity as the Primary Context ofAuditing 45A Model of Business 46Corporate Governance 46Objectives, Strategies, Processes, Controls,Transactions, and Reports 48A Model of Business Processes: FiveComponents 48

Table of ContentsXXOrganization That Affect the Public AccountingProfession 49Securities and Exchange Commission (SEC) 51Public Company Accounting Oversight Board{PCAOB) 51American Institute of Certified Public Accountants(AICPA) 51International Auditing and Assurance StandardsBoard (IAASB) 52Financial Accounting Standards BoardInternational Accounting Standards Boardf/AM) J2Auditing Standards 52Three Sets of Auditing Standards: The Roles of theASB, PCAOB,7AASB 53The 10 Generally Accepted Auditing Standards 53Principles Underlying an Audil Conducted inAccordance with Generally Accepted AuditingStandards 55Statements on Auditing Standards and the AUCodification 55Ethics, Independence, and the Code of ProfessionalConduct 57Conclusion 58Key Terms 58Review Questions 59Multiple-Choice Questions 60Problems 62Discussion Cases 64Internet Assignments 65Hands-On Cases 66Assess Compliance with Ethical and IndependenceRequirements 72Establish an Understanding with the Entity 72Flanning the Audit 78Audit Strategy and Plan 78Assess Business Risks 78Establish Materiality 78Consider Multilocations or Business Units 79Assess the Needfor Specialists 79Consider Violations ofLaws andRegulations 79Identify Related Parties 80Consider Additional Value-Added Services 81Document the Overall Audit Strategy, Audit Plan,and Prepare Audit Programs 81Supervision of the Audit 83Types of Audit Tests 83Risk Assessment Procedures 83Tests of Controls 83Substantive Procedures 84Dual-Purpose Tests 84Materiality 85Steps in Applying Materiality 86An Example 88Key Terms 90Review Questions 90Multiple-Choice Questions 91Problems 92Discussion Case 95Internet Assignments 95Hands-On Cases 96Chapter 4Risk AssessmentPART 2Audit Flanning and Basic AuditingConcepts67Chapter 3Audit Flanning, Types of Audit Tests, andMateriality 68Client Acceptance and Continuance 70Prospective Client Acceptance 70Client Continuance 71Preliminary Engagement Activities 71Determine the Audit Engagement TeamRequirements 7198Audit Risk 100The Audit Risk Model 100Use of the Audit Risk Model 102The Auditor' s Risk Assessment Process 104Management''s Strategies, Objectives, and BusinessRisks 104Auditor's Risk Assessment Procedures 105Assessing Business Risks 106Evaluate the Entity's Risk AssessmentProcess 109Assessing the Risk of Material Misstatement 109Causes and Types of Misstatements 110The Fraud Risk Assessment Process III

xxiTable of ContentsThe Auditor' s Response to the Results of the RiskAssessments 115Evaluation of Audit Test Results 117Documentation of the Auditor's Risk Assessment andResponse 118Communications about Fraud to Management, theAudit Committee, and Others 118Key Terms 120Review Questions 121Multiple-Choice Questions 121Problems 123Discussion Case 125Internet Assignment 126Hands-On Cases 127CHAPTER 5Evidence and Documentation128The Relationship of Audit Evidence to the AuditReport 130Management Assertions 131Assertions about Classes of Transactions andEvents during the Period 131Assertions about Account Balances at the PeriodEnd 133Assertions about Presentation andDisclosure 134The Concepts of Audit Evidence 135The Nature of Audit Evidence 135The Sufficiency and Appropriateness of AuditEvidence 135The Evaluation of Audit Evidence 137Audit Procedures for Obtaining Audit Evidence 138Inspection of Records or Documents 138Inspection of Tangible Assets 139Observation 140lnquiry 140Confirmation 141Recalculation 141Reperformance 142Analytical Procedures 142Scanning 142Reliability of the Types of Evidence 142The Audit Testing Hierarchy 143An "Assurance Bücket" Analogy 145Audit Documentation 146Functions of Audit Documentation 146Content of Audit Documentation 147Examples of Audit Documentation 148Formal of Audit Documentation 150Organization of Audit Documentation 151Ownership of Audit Documentation 151Audit Document Archiving andRetention 151Substantive Analytical Procedures 154Final Analytical Procedures 162Short-Term Liquidity Ratios 163Activity Ratios 163Profitability Ratios 164Coverage Ratios 165Key Terms 165Review Questions 166Multiple-Choice Questions 167Problems 169Discussion Cases 172Internet Assignment 174Hands-On Cases 174PART 3Understanding and Auditing InternalControl177Chapter 6Internal Control in a Financial StatementAudit 178Introduction 180Internal Control—an Overview 180Definition of Internal Control 180Controls Relevant to the Audit 180The Effect of Information Technology on InternalControl 181The COSO Framework 181Components of Internal Control 181Control Environment 182The Entity 's Risk Assessment Process 185Control Activities 186Information and Communication 188Monitoring of Controls 189Planning an Audit Strategy 189Substantive Strategy 191Reliance Strategy 192Obtain an Understanding of Internal Control 193Overview 193Understanding the Control Environment 193

xxiiTable of ContentsUnderstanding the Entity's Risk AssessmentProcess 194Understanding the Information System andCommunications 195Understanding Control Activities 195Understanding Monitoring of Controls 195Documenting the Understanding of InternalControl 196The Effect of Entity Size on Internal Control 196The Limitations of an Entity's InternalControl 197Assessing Control Risk 199Identifying Specific Controls That Will Be ReliedUpon 199Performing Tests of Controls 199Concluding on the Achieved Level of ControlRisk 200Documenting the Achieved Level of ControlRisk 200An Example 200Substantive Procedures 201Timing of Audit Procedures 202Interim Tests of Controls 202Interim Substantive Procedures 203Auditing Accounting Applications Processed byService Organization 203Communication of Internal Control-RelatedMatters 204General Controls 206Application Controls 207Symbols 209Organization and Flow 210Key Terms 211Review Questions 211Multiple-Choice Questions 212Problems 214Discussion Cases 216Hands-On Cases 218Chapter 7Auditing Internal Control over FinancialReporting 220Management Responsibilities under Section 404 222Auditor Responsibilities under Section 404 and AS5 222Internal Control over Financial ReportingDefined 222Internal Control Deficiencies Defined 223Control Deficiency 223Material Weakness 223Significant Deficiency 223Likelihood and Magnitude 223Managements Assessment Process 225Identify Financial Reporting Risks and RelatedControls 225Consider Which Locations to Include in theEvaluation 226Evaluate Evidence about the OperatingEffectiveness oflCFR 226Reporting Considerations 226Managements Documentation 227Performing an Audit of ICFR 228Plan the Audit of ICFR 229The Role ofRisk Assessment and the Risk ofFraud 229Scaling the Audit 230Using the Work of Others 230Identify Controls to Test 231Identify Entity-Level Controls 231Identifying Significant Accounts and Disclosuresand Their Relevant Assertions 232Understanding Likely Sources ofMisstatements 232Select Controls to Test 233Evaluate the Design and Test the OperatingEffectiveness of Controls 234Evaluating Design Effectiveness of Controls 234Testing and Evaluating Operating Effectiveness ofControls 234Evaluating Identified Control Deficiencies 236Examples of Control Deficiency Evaluation 237Remediation of a Material Weakness 239Written Representations 239Auditor Documentation Requirements 240Auditor Reporting on ICFR 240Elements of the Auditor''s Report 241Unqualified Report 241Adverse Report for a Material Weakness 241Disclaimer for Scope Limitation 242Other Reporting Issues 244Management 's Report Incomplete or ImproperlyPresented 244The Auditor Decides to Refer to the Report ofOther Auditors 244Subsequent Events 245

xxiiiTable of ContentsManagement's Report Contains AdditionalInformation 245Reporting on a Remediated Material Weakness atan Interim Date 245Additional Required Communications in an Audit ofICFR 245Use of Service Organizations 246Safeguarding ofAssets 247Generalized Audit Software 247Custom Audit Software 248Test Data 249Key Terms 249Review Questions 250Multiple-Choice Questions 251Problems 253Internet Assignments 259Hands-On Cases 259PART 4Statistical and Nonstatistical SamplingTools for Auditing261Chapter 8Audit Sampling: An Overview andApplication to Tests of Controls 262Overview of Audit Sampling 264Definitions and Key Concepts 265Audit Sampling 265Sampling Risk 265Confidence Level 267Tolerable and Expected Error 267Audit Evidence Choices That Do and Do NotInvolve Sampling 268Types of Audit Sampling 269Nonstatistical versus Statistical Sampling 269Types of Statistical Sampling Techniques 270Attribute Sampling Applied to Tests of Controls 271Planning 271Performance 279Evaluation 283Nonstatistical Sampling for Tests of Controls 287Determining the Sample Size 287Selecting the Sample Items 288Calculating the Computed Upper DeviationRate 288Conclusion 289Key Terms 290Review Questions 291Multiple-Choice Questions 292Problems 294Discussion Case 297Hands-On Cases 298Chapter 9Audit Sampling: An Application toSubstantive Tests of Account Balances300Sampling for Substantive Tests of Details of AccountBalances 302Monetary-Unit Sampling 303Advantages 304Disadvantages 304Applying Monetary-Unit Sampling 304Planning 304Performance 308Evaluation 310Nonstatistical Sampling for Tests of AccountBalances 318Identifying Individually Significant Items 318Determining the Sample Size 318Selecting Sample Items 319Calculating the Sample Results 319An Example of Nonstatistical Sampling 320Advantages 324Disadvantages 324Applying Classical Variables Sampling 324Key Terms 328Review Questions 329Multiple-Choice Questions 330Problems 331Discussion Cases 335Hands-On Cases 336PART 5Auditing Business Processes337Chapter 10Auditing the Revenue Process338Revenue Recognition 341Overview of the Revenue Process 342Types of Transactions and Financial StatementAccounts Affected 343Types of Documents and Records 345

xxivTable of ContentsThe Major Functions 349Key Segregation ofDuties 350Inherent Risk Assessment 351Industry-Related Factors 351The Complexity and Contentiousness of RevenueRecognition Issues 352The Difficulty of Auditing Transactions andAccount Balances 352Misstatements Detected in Prior Audits 352Control Risk Assessment 353Understand and Document Internal Control 353Plan and Perform Tests of Controls 354Set and Document Control Risk 354Control Activities and Tests of Controls—RevenueTransactions 355Occurrence of Revenue Transactions 355Completeness of Revenue Transactions 357Authorization of Revenue Transactions 357Accuracy of Revenue Transactions 357Cutoff of Revenue Transactions 358Classification of Revenue Transactions 358Control Activities and Tests of Controls—CashReceipts Transactions 358Occurrence of Cash Receipts Transactions 358Completeness of Cash Receipts Transactions 359Authorization of Cash Discounts 360Accuracy of Cash Receipts Transactions 361Cutoff of Cash Receipts Transactions 361Classification of Cash Receipts 361Control Activities and Tests of Controls—SalesReturns and Allowances Transactions 361Relating the Assessed Level of Control Risk toSubstantive Procedures 362Auditing Revenue-Related Accounts 362Substantive Analytical Procedures 363Tests of Details of Classes of Transactions, AccountBalances, and Disclosures 364Completeness 364Cutoff 366Existence 367Rights and Obligations 367Valuation and Allocation 368Classification 369Other Presentation and DisclosureAssertions 369The Confirmation Process—Accounts Receivable 370Types of Confirmations 371Timing 372Confirmation Procedures 373Alternative Procedures 374Auditing Other Receivables 374Evaluating the Audit Findings—Revenue-RelatedAccounts 375Key Terms 375Review Questions 376Multiple-Choice Questions 377Problems 379Discussion Cases 382Internet Assignments 383Hands-On Cases 383Chapter 11Auditing the Purchasing Process386Expense and Liability Recognition 388Overview of the Purchasing Process 388Types of Transactions and Financial StatementAccounts Affected 389Types ofDocuments and Records 390The Major Functions 393The Key Segregation ofDuties 395Inherent Risk Assessment 396Industry-Related Factors 396Misstatements Detected in Prior Audits 396Control Risk Assessment 396Understand and Document Internal Control 396Plan and Perform Tests of Controls 398Set and Document Control Risk 398Control Activities and Tests of Controls—PurchaseTransactions 398Occurrence of Purchase Transactions 399Completeness of Purchase Transactions 399Authorization of Purchase Transactions 400Accuracy of Purchase Transactions 401Cutoff of Purchase Transactions 401Classification of Purchase Transactions 401Control Activities and Tests of Controls—CashDisbursement Transactions 402Occurrence of Cash DisbursementTransactions 402Completeness of Cash DisbursementTransactions 402Authorization of Cash Disbursement Transactions 402Accuracy of Cash Disbursement Transactions 402Cutoff of Cash Disbursement Transactions 403

Table of ContentsClassification ofCash DisbursementTransactions 404Control Activities and Tests of Controls—PurchaseReturn Transactions 404Relating the Assessed Level of Control Risk toSubstantive Procedures 404Auditing Accounts Payable and AccruedExpenses 405Substantive Analytical Procedures 405Tests of Details of Classes of Transactions, AccountBalances, and Disclosures 406Completeness 406Existence 409CwK# 409Rights and Obligations 409Valuation 409Classification and Understandability 410Other Presentation Disclosure Assertions 410Accounts Payable Confirmations 411Evaluating the Audit Findings—Accounts Payable andRelated 412Key Terms 414Review Questions 415Multiple-Choice Questions 416Problems 417Discussion Case 421Internet Assignments 421Hands-On Cases 421Chapter 12Auditing the Human Resource ManagementProcess 422Overview of the Human Resource ManagementProcess 424Types of Transactions and Financial StatementAccounts Affected 425Types ofDocuments and Records 425The Major Functions 426The Key Segregation ofDuties 428Inherent Risk Assessment 429Control Risk Assessment 430Understand and Document Internal Control 430Plan and Perform Tests of Controls 431Set and Document the Control Risk 431Control Activities and Tests of Controls—PayrollTransactions 431Occurrence of Payroll Transactions 433XXVAuthorization of Payroll Transactions 433Accuracy of Payroll Transactions 433Classification of Payroll Transactions 434Relating the Assessed Level of Control Risk toSubstantive Procedures 434Auditing Payroll-Related Accounts 434Substantive Analytical Procedures 434Tests of Details of Classes of Transactions, AccountBalances, and Disclosures 435Payroll Expense Accounts 436Accrued Payroll Liabilities 437Evaluating the Audit Findings— Payroll-RelatedAccounts 439Key Terms 441Review Questions 442Multiple-Choice Questions 442Problems 444Discussion Cases 446Internet Assignment 448Hands-On Cases 448Chapter 13Auditing the Inventory ManagementProcess 450Overview of the Inventory Management Process 452Types of Documents and Records 453The Major Functions 455The Key Segregation ofDuties 456Inherent Risk Assessment 456Industry-Related Factors 457Engagement and Operating Characteristics 457Control Risk Assessment 457Understand and Document Internal Control 459Plan and Perform Tests of Controls 459Set and Document the Control Risk 459Control Activities and Tests of Controls— InventoryTransactions 459Occurrence of Inventory Transactions 460Completeness of Inventory Transactions 461Authorization of Inventory Transactions 461Accuracy of Inventory Transactions 461Cutoff of Inventory Transactions 462Classification of Inventory Transactions 462Relating the Assessed Level of Control Risk toSubstantive Procedures 462Auditing Inventory 463Substantive Analytical Procedures 464

xxviTable of ContentsAuditing Standard Costs 465Materials 465Labor 465Overhead 465Observing Physical Inventory 466Tests of Details of Classes of Transactions, AccountBalances, and Disclosures 467Accuracy 468Cutoff 469Existence 469Completeness 469Rights and Obligations 469Valuation and Allocation 469Classification and Understandability 470Other Presentation and DisclosureAssertions 470Evaluating the Audit Findings—Inventory 471Key Terms 471Review Questions 472Multiple-Choice Questions 472Problems 474Discussion Case 478Internet Assignment 479Hands-On Cases 479Chapter 14Auditing the Financing/Investing Process:Prepaid Expenses, Intangible Assets, andProperty, Plant, and Equipment 480Auditing Prepaid Expenses 482Inherent Risk Assessment—Prepaid Expenses 482Control Risk Assessment—Prepaid Expenses 482Substantive Procedures—Prepaid Insurance 483Substantive Analytical Procedures for PrepaidInsurance 483Tests of Details of the Prepaid Insurance 484Existence and Completeness 484Rights and Obligations 484Valuation 484Classification 484Auditing Intangible Assets 484Inherent Risk Assessment—Intangible Assets 485Control Risk Assessment—Intangible Assets 486Substantive Procedures—Intangible Assets 486Substantive Analytical Procedures for IntangibleAssets 486Tests of Details of Intangible Assets 487Auditing the Property Management Process 488Types of Transactions 488Overview of the Property ManagementProcess 489Inherent Risk Assessment—Property ManagementProcess 490Complex Accounting Issues 490Difficult-to-Audit Transactions 490Misstatements Detected in Prior Audits 490Control Risk Assessment—Property ManagementProcess 491Occurrence and Authorization 491Completeness 492Segregation of Duties 492Substantive Procedures—Property, Plant, andEquipment 493Substantive Analytical Procedures—Property,Plant, and Equipment 493Tests of Details of Transactions, Account Balances,and Disclosures—Property, Plant, andEquipment 494Evaluating the Audit Findings—Property, Plant,and Equipment 497Key Terms 498Review Questions 498Multiple-Choice Questions 499Problems 501Discussion Case 503I

Introduction to Assurance and Financial Statement Auditing 1 Chapter 1 An Introduction to Assurance and Financial Statement Auditing 2 Tips for Learning Auditing 4 The Demand for Auditing and Assurance 5 Principals and Agents 5 The Role of Auditing 6 An Assurance Analogy: The Case of

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