A (soJ O IS 1-Ü AUDITING SERVICES SIXTEENTH EDITION

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A (soJ o IS" 1-ÜAUDITINGAND ASSURANCESERVICESAN INTEGRATED APPROACHSIXTEENTH EDITIONGLOBAL EDITION%ALVIN A. ARENS Former PricewaterhouseCoopers'Emeritus ProfessorMichigan State UniversityRANDAL j. ELDERSyracuse UniversityProfessorMARK S. BEASLEYNorth Carolina State UniversityDeloitte Professor of Enterprise Risk ManagementCHRIS E. HOGANMichigan State UniversityProfessorPEARSONBoston Columbus Indianapolis New York San Francisco AmsterdamCape Town Dubai London Madrid Milan Munich Paris Montreal TorontoDelhi Mexico City Säo Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

CONTENTSPREFACE17THE AUDITING PROFESSIONPART1THE DEMAND FOR AUDIT AND OTHERASSURANCE SERVICES1tEARNING OBJECTIVES 27Nature of Auditing 28Distinction Between Auditing and Accounting 30Economic Demand for Auditing 30Assurance Services 32Types of Audits 36Types of Auditors 38Certified Public Accountant 40Summary 41Essential Terms 41Review Questions 42Multiple Choice Questions from CPA Examinations 42Discussion Questions and Problems 44THE CPA PROFESSIONCHARTERLEARNING OBJECTIVES 48Certified Public Accounting Firms 49Structure of CPA Firms 51Sarbanes-Oxley Act and Public Company Accounting Oversight BoardSecurities and Exchange Commission 54American Institute of Certified Public Accountants (AICPA) 55International and U.S. Auditing Standards 56Organization of U.S. Auditing Standards 58Quality Control 62Summary 64Essential Terms 65535

//CHAPTER3CHARTER4Review Questions 65Multiple Choice Questions from CPA ExammationsDiscussion Questions and Problems 6866AUDIT REPORTSLEARNING OBJECTIVES 70Standard Unmodified Opinion Audit Report for Nonpublic Entities 71Conditions for Standard Unmodified Opinion Audit Report 74Standard Audit Report and Report on Internal Control Over FinancialReporting Under PCAOB Auditing Standards 74Unmodified Opinion Audit Report with Emphasis-of-Matter ExplanatoryParagraph or Nonstandard Report Wording 78Modifications to the Opinion in the Audit Report 82Materiality 84Discussion of Conditions Requiring a Modification of Opinion 87Auditor s Decision Process for Audit Reports 90International Accounting and Auditing Standards 92Summary 93Essential Terms 93Review Questions 94Multiple Choice Questions from CPA Examinations 95Discussion Questions and Problems 96PROFESSIONAL ETHICSLEARNING OBJECTIVES 101What Are Ethics? 103Ethical Dilemmas 104Special Need for Ethical Conduct in Professions 107Code of Professional Conduct 109Independence Rule 113Sarbanes-Oxley and Related Independence Requirements 117Other Rules of Conduct 120Enforcement 127Summary 129Essential Terms 129Review Questions 129Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 132Cases 135CONTENTS130

LEGAL LIABILITYLEARNING OBJECTIVESCH"TER138Changed Legal Environment 139Distinguishing Business Failure, Audit Failure, and Audit Risk 140Legal Concepts Affecting Liability 141Liability to Clients 143Liability to Third Parties Under Common Law 146Civil Liability Under the Federal Securities Laws 148Criminal Liability 154The Profession's Response to Legal Liability 155Summary 156Essential Terms 156Review Questions 157Multiple Choice Questions from CPA Examinations 158Discussion Questions and Problems 160Gase 164THE AUDIT PROCESS AUDIT RESPONSIBILITIES AND OBJECTIVEScARNING OBJECTIVESCHAPTER166Objective of Conducting an Audit of Financial Statements 167Managements Responsibilities 168Auditor's Responsibilities 169Professional Skepticism 172Professional Judgment 174Financial Statement Cycles 176Setting Audit Objectives 181Management Assertions 182Transaction-Related Audit Objectives 185ßalance-Related and Presentation and Disclosure Related AuditObjectives 186How Audit Objectives Are Met 190Summary 192Essential Terms 192Review Questions 193Multiple Choice Questions from CPA Examinations 194Discussion Questions and Problems 196CONTENTS7

7LEARNING OBJECTIYES 219Nature of Evidence 220AuditEvidenceDecisions 221Persuasiveness of Evidence 222Types of Audit Evidence 225Analytical Procedures 232Common Financial Ratlos 236Audit Documentation 239Summary 247Essential Terms 247Review Questions 248Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 251Case 258ACL Problem 259249AUDIT FLANNING AND MATERIALITYßLEARNING OBJECTIYES 260Flanning 261Accept Client and Perform Initial Audit Flanning 262Understand the Client s Business and Industry 266Perform Preliminary Analytical Procedures 271Materiality 274Materiality for Financial Statements asa Whole 275Determine Performance Materiality 278Estimate Misstatement and Compare with Preliminary JudgmentSummary 283Essential Terms 283Review Questions 285Multiple Choice Questions from CPA Examinations 287Discussion Questions and Problems 289Case 296Integrated Case Application—Pinnacle Manufacturing: Part IACL Problem 300CHARTER9ASSESSING THE RISK OF MATERIALMISSTATEMENTLEARNING OBJECTIYES 301Audit Risk 302Risk Assessment ProceduresCONTENTS303297281

Considering Fraud Risk 307Identification of Significant Risks 308Audit Risk Model 309Assessing Acceptable Audit Risk 313Assessing Inherent Risk 316Relationship of Risks to Evidence and Factors Influencing RisksRelationship of Risk and Materiality to Audit Evidence 323Summary 324Essential Terms 324Review Questions 324Multiple Choice Questions from CPA Examinations 326Discussion Questions and Problems 328Cases 332Integrated Gase Application—Pinnacle Manufacturing: Part II 334318ASSESSING AND RESPONDINGTO FRAUD RISKSBRNING OBJECTIVES 337Types of Fraud 338Conditions for Fraud 339Assessing the Risk of Fraud 343Corporate Governance Oversight to Reduce Fraud Risks 347Responding to the Risk of Fraud 351Specific Fraud Risk Areas 353Eesponsibilities When Fraud Is Suspected 359Documenting the Fraud Assessment 363Summary 363Essential Terms 364Review Questions 364Multiple Choice Questions from CPA Examinations 365Discussion Questions and Problems 367Case 372Integrated Case Application—Pinnacle Manufacturing: Part III 373ACE Problem 374INTERNAL CONTROL AND C0S0 FRAMEWORKLEARNING OBJECTIVES 375Internal Control Objectives 376Management and Auditor Responsibilities for Internal ControlCOSO Components of Internal Control 379Internal Controls Specific to Information Technology 389377

Impact of IT Infrastructure on Internal Control395Summary 397Essential Terms 397Review Questions 399Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 401Case 405400«um«ASSESSING CONTROL RISK AND REPORTINGJ2ON INTERNAL CONTROLSLEARNING OBJECTIVES 407Obtain and Document Understanding of Internal Control 408Assess Control Risk 411Tests of Controls 417Decide Planned Detection Risk and Design Substantive Tests 421Auditor Reporting on Internal Control 422Evaluating, Reporting, and Testing Internal Control for Nonpublicand Smaller Public Companies 425Impact of IT Environment on Control Risk Assessment and Testing 426Summary 430Essential Terms 430Review Questions 432Multiple Choice Questions from CPA Examinations 433Discussion Questions and Problems 435Case 443ACE Problem 445Integrated Case Application—Pinnacle Manufacturing: Part IV 445CHARTER13OVERALL AUDIT STRATEGY AND AUDITPROGRAMLEARNING OBJECTIVES 448Types of Tests 449Selecting Which Types of Tests to Perform 454EvidenceMix 458Design of the Audit Program 459Summary of Key Evidence-Related Terms 467Summary of the Audit Process 469Summary 473CONTENTS

Essential Terms 473Review Questions 474Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 476Cases 482475APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLEOAUDIT OF THE SALES AND COLLECTION CYCLE:TESTS OF CONTROLS AND SUBSTANTIVECHARTER14TESTS OF TRANSACTIONSLEARNING OBJECTIVES 486Accounts and Classes of Transactions in the Sales and Collection Cycle 487Business Functions in the Cycle and Related Documents and Records 488Methodology for Designing Tests of Controls and SubstantiveTests of Transactions for Sales 492Sales Returns and Allowances 503Methodology for Designing Tests of Controls and SubstantiveTests of Transactions for Cash Receipts 504Audit Tests for Uncollectible Accounts 508Effect of Results of Tests of Controls and SubstantiveTests of Transactions 508Summary 509E ssential Terms 510Review Questions 510Multiple Choice Questions from CPA Examinations 512Discussion Questions and Problems 514Case 519Integrated Case Application—Pinnacle Manufacturing: Part V 520ACE Problem 521AUDIT SAMPLING FOR TESTS OF CONTROLS ANDSUBSTANTIVE TESTS 0F TRANSACTIONSLEARNING OBJECTIVES522Representative Samples 523Statistical Versus Nonstatistical Sampling and Probabilistic VersusNonprobabilistic Sample Selection 524\5

Sample Selection Methods 525Sampling for Exception Rates 528Application of Nonstatistical Audit Sampling 529Statistical Audit Sampling 543Application of Attributes Sampling 546Summary 552Essential Terms 552Review Questions 553Multiple Choice Questions from CPA Examinations 554Discussion Questions and Problems 556Gase 561Integrated Gase Application—Pinnacle Manufacturing: Part VIACE Problem 563561COMPLETING THE TESTS IN THE SALES ANDCOLLECTION CYCLE: ACCOUNTS RECEIVABLELEARNING OBJECTIVES 564Methodology for Designing Tests of Details of Balances 565Designing Tests of Details of Balances 571Gonfirmation of Accounts Receivable 577Developing Tests of Details Audit Program 583Summary 587Essential Terms 587Review Questions 587Multiple Choice Questions from CPA Examinations 589Discussion Questions and Problems 590Gase 597Integrated Gase Application—Pinnacle Manufacturing: Part VII 598ACE Problem 603CHARTER17AUDIT SAMPLING FOR TESTS OF DETAILSOF BALANCESLEARNING OBJECTIVES 604Comparisons of Audit Sampling for Tests of Details of Balancesand for Tests of Controls and Substantive Tests of TransactionsNonstatistical Sampling 606Monetary Unit Sampling 615Variables Sampling 623Illustration Using Difference Estimation 628CONTENTSV605

Summary 631Essential Terms 632Review Questions 632Multiple Choice Questions from CPA and CIA ExaminationsDiscussion Questions and Problems 635Cases 640ACE Problem 642633APPLICATION OF THE AUDIT PROCESSTO OTHER CYCLESAUDIT OF THE ACQUISITION ANDPAYMENT CYCLE: TESTS OF CONTROLS,4CHARTER%ßSUBSTANTIVE TESTS OF TRANSACTIONS,AND ACCOUNTS PAYABLEÜEÄRNING OBJECTIVES 644Accounts and Classes of Transactions in the Acquisitionand Payment Cycle 645Business Functions in the Cycle and Related Documents and Records 646Methodology for Designing Tests of Controls and Substantive Tests ofTransactions 649Methodology for Designing Tests of Details of Balances for AccountsPayable 656Summary 664Essential Terms 664Review Questions 665Multiple Choice Questions from CPA Examinations 666Discussion Questions and Problems 668Gase 674COMPLETING THE TESTS IN THE ACQUISITIONCHARTERAND PAYMENT CYCLE: VERIFICATION OFSELECTED ACCOUNTSLEARNING OBJECTIVES 676Types of Other Accounts in the Acquisition and Payment CycleAudit of Property, Plant, and Equipment 677Audit of Prepaid Expenses 685677CONTFNTS11

Audit ofAccrued Liabilities 688Audit of Income and Expense Accounts689Summary 693Essential Terms 693Review Questions 693Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 696Cases 699694AUDIT OF THE PAYROLL AND PERSONNEL CYCLELEARNING OBJECTIVES 702Accounts and Transactions in the Payroll and Personnel Cyde 703Business Functions in the Cyde and Related Documents and RecordsMethodology for Designing Tests of Controls and SubstantiveTests ofTransactions 706Methodology for Designing Substantive Analytical Procedures andTests of Details of Balances 712Summary 716Essential Terms 716Review Questions 716Multiple Choice Questions from CPA Examinations 717Discussion Questions and Problems 719Case 723703AUDIT OF THE INVENTORY ANDWAREHOUSING CYCLELEARNING OBJECTIVES 725Business Functions in the Cycle and Related Documents and RecordsParts of the Audit of Inventory 729Audit of Cost Accounting 731Substantive Analytical Procedures 734Physical Observation of Inventory 735Audit of Pricing and Compilation 737Integration of the Tests 741Summary 743Essential Terms 743Review Questions 744Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 746Case 753745726

AUDIT OF THE CAPITAL ACQUISITION ANDREPAYMENT CYCLEC""TE"22LEARNING OBJECTIVES 755Accounts in the Cycle 756Notes Payable 757Owners' Equity 761Summary 767Essential Terms 767Review Questions 768Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 770768AUDIT OF CASH AND FINANCIAL INSTRUMENTSXÄRNING OBJECTIVES 776Types of Cash and Financial Instruments Accounts 777Cash in the Bank and Transaction Cycles 779Audit of the General Cash Account 780Fraud-Oriented Procedures 788Audit of Financial Instruments Accounts 793Summary 796Essential Terms 796Review Questions 797Multiple Choice Questions from CPA Examinations 798Discussion Questions and Problems 799COMPLETING THE AUDITCHAPTER23%5COMPLETING THE AUDITLEARNING OBJECTIVES 806Perform Additional Tests for Presentation and Disclosure 807Review for Contingent Liabilities and Commitments 808Review for Subsequent Events 813Final Evidence Accumulation 817Evaluate Results 821Issue the Audit Report 825Communicate with the Audit Committee and Management 825Subsequent Discovery of Facts 827Summary 829CHAPTER24CONTFNTS

Essential Terms 829Review Questions 830Multiple Choice Questions from CPA ExaminationsDiscussion Questions and Problems 833Gase 837831""OTHER ASSURANCE AND NONASSURANCE6SERVICESOTHER ASSURANCE SERVICESLEARNING OBJECTIVES 839Review, Compilation, and Preparation Services 840Review of Interim Financial Information for Public Companies 846Attestation Engagements 847Reports on Controls at Service Organization (SOG Reports) 851Prospective Financial Statements 853Agreed-Upon Procedures Engagements 854Other Audits or Limited Assurance Engagements 855Summary 857Essential Terms 858Review Questions 859Multiple Choice Questions from CPA Examinations 860Discussion Questions and Problems 861CHARTER26INTERNAL AND GOVERNMENTAL FINANCIALAUDITING AND OPERATIONAL AUDITINGLEARNING OBJECTIVES 866Internal Financial Auditing 867Governmental Financial Auditing 870Operational Auditing 873Summary 880Essential Terms 880Review Questions 881Multiple Choice Questions front CPA, CIA, and CMA ExaminationsDiscussion Questions and Problems 884INDEX888CREDITS 896CONTENTS881

ASSESSING AND RESPONDING TO FRAUD RISKS BRNING OBJECTIVES 337 Types of Fraud 338 Conditions for Fraud 339 Assessing the Risk of Fraud 343 Corporate Governance Oversight to Reduce Fraud Risks 347 Responding to the Risk of Fraud

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