Auditing The Art and Science of Assurance Engagements, Fifteenth Canadian Edition, 15E Alvin Arens S by TBtutors

Type:

Solution Manual

Resource:

Auditing The Art and Science of Assurance Engagements

Edition:

15th Edition

Author(s):

Alvin A. Arens Randal J. Elder Mark S. Beasley Chris E. Hogan Joanne C. Jones

INSTRUCTOR’S RESOURCE MANUAL Bartosz Amerski York University Joanne Jones York University

Auditing The Art and Science of Assurance Engagements Fifteenth Canadian Edition Alvin A. Arens Former PricewaterhouseCoopers Emeritus Professor, Michigan State University Randal J. Elder Syracuse University Mark S. Beasley North Carolina State University, Deloitte Professor of Enterprise Risk Management Chris E. Hogan Michigan State University Joanne C. Jones York University

Introduction: An overview of the instructor’s resource manual

Contents

An Overview of the Instructor’s Resource Manual Chapters

The demand for audit and other assurance services

The public accounting profession and audit quality

Professional ethics and legal liability

Audit responsibilities and objectives

Audit evidence

Client acceptance, preliminary planning, and materiality

Risk assessment and inherent risk

Understanding the internal control system

Control risk assessment

Risk response: Audit strategy, overall approach, and audit program

Audit sampling concepts

Audit of the revenue cycle

Audit of the acquisition and payment cycle

Audit of the inventory and distribution cycle

Audit of the human resources and payroll cycle

Audit of cash and cash equivalents

Completing the audit

Audit reports on financial statements ..

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Other audits, assurance engagements, and related services

Audit of the capital acquisition and repayment cycle

An Overview of the Instructor’s Resource Manual The purpose of the Instructor’s Resource Manual is to help you teach auditing courses more efficiently and, perhaps more importantly, to encourage student engagement. Naturally, we do not want to interfere with your present approach or imply that our suggestions are the only good alternatives. This resource manual has several parts: 

An illustrative course outline for a traditional 12-week university introductory auditing course.



Some resources, from accounting education journals we have used for group and individual projects.



Some group and individual projects we and other instructors have used successfully.



Mapping the chapters to the CPA Competency Map’s Fundamental Assurance Concepts and Related Technical Competencies



Chapter-by-chapter suggestions for teaching the content in each chapter.

The suggestions for each chapter include the following:    

Ideas we find useful in teaching introductory auditing. Discussion and practice questions we have found to be effective in facilitating student learning and keeping the class interesting. Additional teaching resources and videos to reinforce and integrate the learning objectives. A matrix illustrating how learning objectives correlate with chapter problem material. The matrix for each chapter is designed to provide a one-page summary of this information to assist you in assigning problem material.

The chapters are designed so that their arrangement and selection provide maximum flexibility in course design.

Introduction: An overview of the instructor’s resource manual

Suggested Syllabi In this section, we provide a possible schedule for use in a one-semester universitylevel introductory-level audit course. We also provide suggested problem assignments that could easily be presented in your syllabus as well as the course evaluation scheme. Some of the questions we use for 4 individual graded assignments. You will note that we cover the three key cycles (revenue, acquisition and payment, and inventory and distribution) as well as cash. Some of you may wish to cover some of the other cycles as well. From chapters 18 and 19, which cover special reports and other assurance engagements, we only cover reviews and compilation engagements. The remaining material, we cover in our advanced auditing course. Following our suggested syllabi, we briefly overview other teaching materials that you might find helpful as you develop your plan for coverage of the course content.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Organization of the Course (assumes two 1 ½ hour classes or one three-hour class per week) Week

Topics

Chapters

Practice or Discussion Questions

Introduction, audit and other assurance services The public accounting profession and audit quality

1 and 2

1-19, 1-28, 1-30, 2-25, 2-27, 2-28

Professional ethics and legal liability Audit responsibilities and objectives

3 and 4

3-32, 3-35, 3-39, 4-29, 4-31, 4-32

Audit evidence Client acceptance, planning, and materiality

5 and 6

5-36, 5-38, 5-39, 5-42 6-42, 6-43, 6-46, 6-47

Assessing the risk of material misstatement

Internal controls, COSO framework Assessing control risk and test of controls

8 and 9

7-28, 7-29

8-28, 8-31, 8-35, 9-27, 9-33, 9-37

Midterm

Audit strategy and program Sampling concepts

10 and 11

10-25, 10-30, 10-28, 11-29, 11-39

Audit of revenue cycle

12-42, 12-43, 12-48, 12-49, 12-52

Audit of acquisition and payment and inventory and distribution cycles

13 and 14

13-27, 13-34, 13-36, 14-27, 14-28, 14-31

Audit of cash and completing the audit

16 and 17

16-23, 16-25, 16-26, 17-26, 17-33, 17-35

Audit reporting

18-28, 18-32, 18-33, 18-34

Group Presentations

Group Risk Assessment Due

Introduction: An overview of the instructor’s resource manual

Other assurance and non-assurance services Group Presentations

19-23, 19-25, 19-27, 19-28, 19-29

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Chapter Vignettes and Other Chapter Material ― Lessons from Practice Each chapter begins with a short vignette, with the majority of them based upon real-life events. In addition, each chapter contains several Auditing in Action vignettes, related to the chapter content, that highlight real-world issues. Some of these Auditing in Actions (and figures) provide a glimpse into the real world of auditing. Others highlight recent events in Canada and abroad, news articles, fraud cases, and/or thought papers and academic articles. These opening vignettes and Auditing in Action features provide instructors with some meaningful examples and can be helpful in generating some great class discussion. One of our colleagues has used them as a “Lesson for the Day” for students. Each opening vignette illustrates the point implied by its title and is followed by several questions that students should consider while reading the chapter. The questions can also be used as concept checks throughout the lecture or serve as an end of the lecture summary of what was covered. The vignettes and Auditing in Action can be assigned as pre-reading for discussion of a particular point or as short cases on a stand-alone basis. The suggested syllabus includes some end-of-chapter questions that are related to various chapter vignettes. From our experience, students enjoy “real life” cases and find them useful in helping them learn the course material. A brief discussion of each of the vignettes appears in each chapter’s material in this resource guide and many of the vignettes are related to end-of-chapter questions. Professional Judgment Problems and Cases Each chapter has several questions that require students to apply their professional judgment. In addition, most chapters include Cases that challenge students beyond what is required in other end of chapter problems. They are generally more complex than other homework problems. Thus, we sometimes assign these as individual or group assignments that can be worked outside of class (we often use them for our individual assignments in the syllabus). We also assign them as in-class assignments whereby students work together to develop a group solution to the case for subsequent class discussion. Research Activities Research activities that require students to search for information using a number of Internet-based resources are included in the end of chapter material for most of the 20 chapters. These assignments require students to use the Internet and the CPA Canada Handbook—Assurance to research relevant auditing issues and they expose students to real-world events, such as CPAB reports, OSC statement of allegations, as well as SEC enforcement actions related to fraud investigations, actual audit committee charters that outline the audit committee’s role in the oversight of the external auditor selection process. ..

Introduction: An overview of the instructor’s resource manual

We believe these assignments provide opportunities for students to engage in research activities outside traditional homework problems to learn about issues affecting the audit process and the profession. Some of these can be assigned as individual assignments while others could be assigned to groups for in-class presentation and discussion. Applying Professional Judgment to Real Life Events Some of the end-of-chapter problems and research activities provide instructors with an opportunity to examine the real-life events discussed in the chapter in more depth as well as aiding in students’ professional judgment. Below is a summary: Chapter

Vignette or Auditing in Action

Auditing in Action 1-3 - And the Oscar goes To…La, La, Opps! Wrong Envelope! Vignette - A focus on audit quality

Related Questions Question 1-28 Question 2-25

Auditing in Action 3-2 - The High Costs of Legal Liability Sino Forest

Question 3-36

Auditing in Action 4-2 - It’s a Matter of Professional Judgment—The Livent Audits Vignette - CEO Confesses to Falsifying Documents to Hide Fraud for Over 20 Years Vignette - The Right Skills and Auditing in Action 6-1 Professional Judgement and the Client Continuance Decision at Enron Auditing in Action 8-3Cyberattacks: a New Reality

Question 4-31

5 6

8 9 12 8

Question 5-34 Question 6-44

Question 8-32

Auditing in Action 9-3 Question 9-37 Controls in Crypto-asset Transactions Auditing in Action 12-4 – Question 12-50 Revenue Recognition at ..

Assurance Concepts Need for assurance engagements Professional judgment, quality control, ethical reasoning Evaluation of evidence, professional skepticism, professional standards Professional judgment Control deficiencies, confirmations Client acceptance, professional judgment Control deficiencies, COSO guidance Control testing, evidence Inherent risk revenue, audit

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Tesco: It’s a Matter of Timing

strategy

Introduction: An overview of the instructor’s resource manual

Auditing in Action 13-1 – Question 13-32 Incorrect Classifications Hide a Greater Loss

Auditing in Action 14-3 – Blackberrry’s Inventory Obsolescence Woes

Question 14-26

Substantive tests - expenses, professional judgment Evaluation of inventory obsolescence, inherent risk inventory

Hillsburg Hardware Hillsburg Hardware continues to be the fictional company used to illustrate many of the concepts – particularly in relation to documentation of key planning decisions, including: preliminary analytical review (Table 6-5 and Figure 6-4), preliminary decisions for overall materiality (Figure 6-8), internal control questionnaire (9-3), the audit strategy memo (Figure 10-2), Documentation of Understanding of the Entity (Figure 10-4), and Audit Team Planning Memo (Figure 10-5). As this is likely the first time that students are learning about auditing, they may encounter new concepts that at first they may find difficult to understand. To help students better understand these concepts, each chapter now includes a “Still Confused? Read This” section. Instructors may wish to direct students to these new sections, which include conversations involving various audit team members of an audit client — Hillsburg Hardware Limited. Each of these conversations includes an explanation (usually through an analogy that most students can relate to) of some key audit concepts, and illustrates how the concepts apply to an actual audit engagement and real life. The table below presents a summary of the topics/questions covered in the new “Still Confused? Read This” sections: Chapter 1 2 3 4 5

        

6 10

 

“Still Confused? Read This” Topic/Question Introduction of the audit team member. Audits vs. Revenue – What’s the Difference? Audit Opinions, Clean and Dirty? Can You Prepare Tax Returns for Audit Clients? Yes? No? It Depends Who is Supposed to Correct Errors—Management or Auditors? A Cycle Approach has Nothing to do with a Bicycle Persuasiveness of Evidence. What’s That? How to Form Expectations When Conducting Analytical Procedures? Data Analytics and Artificial Intelligence in Audit. What, How, and Why? What Is an Engagement Letter? What Is Client Acceptance? ..

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones



What Is Materiality?

Introduction: An overview of the instructor’s resource manual

8 9 10

    

11 12

 

13 14 15 16 17

       

18 19

What Are the Components of Audit Risk? What Are Inherent Risk Factors? What Are Internal Controls? What Are Tests of Controls? What’s the Difference Between a Combined and a Substantive Audit Approach? Why Sample if We Have Audit Data Analytics Tools? How Does the Audit Approach Impact the Timing of Substantive Tests? Telling the Complete Story about Accounts Payable Using Analytical Procedures to Assess Fraud Risk in Inventory What’s a Walk-through? Bank Confirmations, Are They a Waste of Time? What Is a Contingent Liability? What Is a Legal Confirmation? What’s a Key Audit Matter? What’s the Difference Between an Attestation and a Direct Engagement?

New questions have also been added at the end of each chapter, which provide an opportunity for students to apply their professional judgment to a hypothetical audit of Hillsburg Hardware Limited. Similar to “Still Confused? Read This,” these questions include conversations involving various audit team members and present scenarios that auditors may encounter in real life. Hillsburg Hardware Integrated Case For instructors who are interested in providing a more complex case that students can work across multiple chapters, the Appendix in the textbook includes an integrated case based on Hillsburg Hardware. This case can be worked individually or in small teams, or assigned as an individual or group project. Downloadable Instructor Resources The Pearson Canada eCatalogue and the Instructor’s Resources area of MyLab Accounting offers a number of downloadable resources prepared to accompany the 15 th Canadian edition of Auditing: The Art and Science of Assurance Engagements , including PowerPoints, Test Bank, and Instructor’s Solutions Manual. Other Resources That We Use

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

In addition to the many features included in this 15 th edition of Auditing: The Art and Science of Assurance Engagements, there are several other resources that you might find useful as complementary materials and assignments. These are briefly highlighted next. Use of Auditing Cases Auditing Cases: An Interactive Learning Approach, Sixth Edition (2015) by Beasley, Buckless, Glover, and Prawitt is an excellent supplement to the textbook. This collection of 48 auditing cases addresses most major activities performed during the conduct of an audit, from client acceptance to issuance of an audit report. (Since it is an American textbook, some of the questions may need to be adapted to refer to relevant CASs). Many of the cases are based on actual companies, some of which were engaged in financial reporting fraud. Several cases involve students working with realistic audit evidence and preparing and evaluating audit documentation. Auditing Cases: An Interactive Learning Approach provides instructors an easy opportunity to introduce short active learning exercises to promote in-class discussions of real-world audit issues throughout the introductory (or advanced) auditing course. Some cases we have used in the past are:     

Asher Farms Inc. (Understanding of Client’s Business Environment) Ocean Manufacturing Inc. (New Client Acceptance Decision) EyeMax Corporation (Evaluation of Audit Differences) Longeta Corporation (Auditing Revenue Contracts) Burlingham Bees (Using Analytical Procedures as Substantive Tests)

Use of Peer-Reviewed Published Cases Over the years, we have used several cases published in accounting education journals, below is a list of some that we have found to be effective: Phillips, F., & Martin, R. D. (1998). Instructional case: Northern Frontier Park. Issues in Accounting Education, 13(4), 1005. We find that this case serves as a great foundation to help students understand audit risk and risk assessment. We assign it as a pre-class reading when we cover the topics of client acceptance and materiality and risk, and discuss it in the weeks that we cover client acceptance, and materiality and risk. Sanchez, M. H., Brown, K. F., & Agoglia, C. P. (2007). Consideration of control environment and fraud risk: A set of instructional exercises. Journal of Accounting Education, 25(4), 207221.

Introduction: An overview of the instructor’s resource manual

We have used this case as a group assignment several times and find it very effective in helping students perform an integrated analysis of control risk. It provides the students with a completed internal control environment questionnaire that they must evaluate and assess the risk of misappropriation of assets and/or financial reporting fraud. There are four different versions of the questionnaire and different case facts, which will change the students’ assessment (and enable instructors to use the assignment multiple times). Peaden, D. and Stephens, N. (2013) Old Main Manufacturing: The Case of Unrecorded Sales Discounts. Issues in Accounting Education. We have used this case as an individual assignment. It is fairly straightforward; however, it requires the students to refer to the relevant auditing standards (which they often have limited exposure to) regarding audit sampling. Note: Instructors will need to modify the case requirements to make reference to the relevant CASs. Student feedback has been overwhelmingly positive since they feel that they have had an opportunity to perform some “real” audit work - vouching, preparing a working paper, and evaluating and concluding on the results of their testing. Suggested Term Projects 1. Have students teams obtain the annual report of a public company through SEDAR and prepare an analysis of business risks that impact financial reporting risk, perform some preliminary planning activities and develop an audit strategy for the revenue cycle for the company selected. 2.

Have students go through the audit process for the acquisition and payment cycle of a small manufacturing company from flowcharting the system to designing the audit program.

Have students evaluate the sampling approach used by an auditor for sales and cash receipts for a small business. The case can be used with nonstatistical sampling, difference estimation, or monetary unit sampling. The requirements should be modified depending on the alternative you select.

Student guidelines for each project follow.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

SAMPLE TERM PROJECT Developing an Audit Strategy Based upon Analysis of Business Risks and Financial Reporting Risk The group term project is a hands-on exercise in planning a financial statement audit. The project will give you an opportunity to consider how the concepts and techniques discussed in the course apply in auditing an actual business. Your team will take on the role of the audit engagement team for a publicly-traded Canadian company. Assume that your audit firm has already conducted its client retention procedures (this is not the first year that you are auditors), independence analysis, and has determined that the members of your team are the best people for the job. Now that has been done, your team is required to develop the client risk profile and plan the audit of the “client company” (with a focus on the revenue cycle) for its upcoming year-end. Your team is expected to provide two deliverables – A Planning Memo (more details on each part are provided below) and Group Presentation: Description Allocation Planning Memo Part 1 - Assess Client Business Risk 25 Part 2 - Perform Preliminary Analytical 45 Review Determine Audit Risk, Materiality Part 3 - Audit Strategy for Revenue Cycle 30 100 Group Presentation 50 Total 150 You are expected to use the company’s most recent quarterly results, the most recent annual report, and other publicly-available information. State any assumptions you find it necessary to make. You should not contact the organization or interview people for this project. You should not contact the actual auditors as they will need to keep all the client information confidential. Please feel free to ask the instructor for further guidance if any of the requirements are not clear. Part 1 - Assess Client Business Risk (limit of 3-4 pages, including appendices) The aim of this part of your assignment is to prepare a detailed industry and business risk analysis for the company you have been assigned: In preparing the analysis, be sure to include the following:      

Business objectives and strategies (explain how the organization makes money) Industry and External Environment (include key competitors and industry trends) Key Business Operations and Processes Financial Resources and Availability Management and Governance Measurement and Performance (ensure to consider what are some of the key nonfinancial performance indicators for the industry) .. 15

Introduction: An overview of the instructor’s resource manual

In your analysis, you need to make a conclusion on the company’s risk and its implications for financial reporting risk. You are expected to perform a thorough search, using a variety of electronic sources such as:       

The company’s annual report (ensure you look at management’s discussion and analysis along with the financial statements) The company’s website Sources of industry data Stock broker or investment analyses Business press CPA Canada Handbook – Assurance and Accounting Standards CPA Canada Risk Alerts

* Note – You may find that the industry guides prepared by many of the Big Four Firms (PWC, Deloitte, KPMG, and E&Y) to be useful for your industry. Part 2 – Preliminary Analytical Review & Implications for the Audit (limit of 3-4 pages, not including appendices) Preliminary Analytical Review In this part of your assignment, you are expected to conduct an analytical analysis of your company that includes: (1) common-size financial statements for the past three years (you will need to decide what expectations you have regarding the interim statements for your company) and (2) financial ratios that are commonly used for that particular industry Your financial ratio analysis should include: (1) a three-year ratio comparison by year (for the company), relevant comparisons to (2) industry and (3) a relevant competitor. Categories (more details on the various categories have been posted to the course website in Assignments folder) for your ratios should be:      

Stock valuation Growth Financial Strength Profitability Management Effectiveness Efficiency

All of the above ratios should be presented in an appendix (2 page max). 16

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Your analysis should relate to your client business risk analysis and highlight which account balances warrant further concern/attention in terms of audit planning. You should not comment on all ratios and changes. Only comment on changes that warrant further attention. Please ensure you relate your concerns to management assertions for the particular accounts. Inherent Risk In this report, you need to include a discussion of what your conclusions in your business risk analysis and your analytical analysis mean for the conduct of the audit. In particular, you should discuss what accounts/cycles you feel are high inherent risk and which are at lower levels of risk. In making these decisions, you should consider factors such as unusual or unexpected fluctuations, audit complexity, and risk of material misstatement due to management bias. Refer to your textbook and Audit Standards for further guidance. As in Part 1, you are expected to perform a thorough search, using a variety of electronic sources. This is necessary to obtain explanations for fluctuations, deviations, etc. Acceptable Audit risk Now that you have familiarized yourself with your client, you should have enough information to set acceptable audit risk. Ensure that you consider the relevant factors that would heighten the risk of the engagement to the auditor (refer to your textbook, and audit standards regarding how to set acceptable audit risk). Materiality Another important decision is determination of overall and performance materiality. To determine overall and performance materiality, you should refer to the Audit Standards, the textbook, and any other relevant professional materials. Part 3– Audit Strategy of Revenue Cycle (limit 4 pages, including appendices) Using your previous analyses, your team is expected to prepare an audit strategy for the revenue cycle. In this section, you are expected to discuss:    

What are your company’s key revenue cycle accounts? What are the critical accounting policies and estimates for these accounts? What does your company say in its footnotes about its use of estimates related to the revenue cycle? How informative are these footnotes? What risk do the revenue estimates pose for your audit? Using your analytical analysis you conducted in Part 2, discuss the key findings that are relevant to the revenue cycle. ..

Introduction: An overview of the instructor’s resource manual



o Outline what inquiries and follow-up procedures might be performed to understand unusual fluctuations, trends, etc. Based upon your risk analysis conducted in Part 1, discuss those risks that are most relevant to the revenue cycle. o Outline what inquires and follow-up procedures you need to make in order to understand the risk. Assuming you have developed a good understanding of the components of internal control, you assessed control risk at medium, and your tests were consistent with your planned assessment, outline your audit strategy for the revenue cycle using the following format:

Balance – Related Assertions

Audit Objectives

Assessmen t of Inherent Risk

Assessmen t of Control Risk

Planned Substantive Testing (Timing, Nature, & Extent)

Medium Transaction– Audit Related Objectives Assertions

Assessmen t of Inherent Risk

Assessmen t of Control Risk

Planned Substantive Testing (Timing, Nature, & Extent)

Medium

Part 4– Group Presentation Video Your group will be expected to prepare a 5-minute video related to your client company:  

PART I: Overview of Client Business Risk PART II: Summary of Key Findings and Identification of High Risk Accounts, Audit Risk and Materiality

Question Period Class members will act as the audit committee and will ask your group questions on your video. All group members are expected to be at the presentation and to answer the questions. You will be assessed on the quality of your responses and understanding of the material.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

SAMPLE TERM PROJECT Internal Control and Audit Program Case You are provided with the following description of the accounting system and internal controls for materials purchases by the Johnson Machinery Company, a medium- sized firm that builds special machinery to order. Materials purchase requisitions are first approved by the plant foreman, who then sends them to the purchasing department. Purchasing department employees enter the purchase requisition information into the computer, which automatically generates a purchase order in sequential order. The system automatically generates a paper copy of the purchase order, which is sent by purchasing department employees to the vendor. The receiving department electronically accesses a copy of the purchase order, which is printed to serve as a receiving report. Delivered materials are immediately sent to the storeroom. The completed receiving report, which is a printed copy of the purchase order, is sent to the purchasing department. A copy of the receiving report is sent to the storeroom. Materials are issued to factory employees subsequent to the verbal request by one of the foremen. When the mailroom clerk receives vendors’ invoices, he or she forwards them to the purchasing department employee who placed the order. The invoice is compared with the electronic copy of the purchase order for price and terms by the employee. The invoice quantity is compared with the receiving department’s report. After checking footings, extensions, and discounts on the vendor invoice, the employee indicates approval for payment by initialing the invoice. The invoice is then forwarded to the accounting department (voucher section) where it is coded for account distribution, assigned a voucher number, and entered into the accounting system for recording in the voucher register. The system tracks invoices due by payment date due. The purchase order and receiving report are filed in the purchasing department. On payment dates, the system automatically generates a request for payment. The system automatically prepares cheques and a transaction list for preparation of a cash disbursements journal, updates the accounts payable master file, and indicates the payment date for the voucher register. Prenumbered cheques are sent to the cashier, who puts them through the cheque-signing machine. The cheques are then sent to the voucher section that makes sure that the cheques were correctly prepared. The cheques are placed in envelopes and sent to the mailroom. The vouchers are subsequently filed in numerical order. At the end of each month, a computer listing of voucher and cash disbursement transactions, and an outstanding accounts payable list is prepared.

Introduction: An overview of the instructor’s resource manual

Required: 1. 2. 3. 4. 5. 6. 7.

Prepare a flowchart for the acquisition and the payment cycle for Johnson Machinery Company (JMC). List the controls in existence for each of the six transaction-related audit objectives for acquisitions. For each control in part 2, list one test of control procedure for verifying its effectiveness. List the most important deficiencies in the acquisition and payment cycle. Identify the most likely error or fraud that could result from each of the deficiencies listed in part 4. Suggest a system alteration for JMC that would correct each of the deficiencies identified in part 4. Be sure to keep cost/benefit in mind. Design an audit program to test internal control. The program should include, but not be limited to, tests of controls from part 3 and procedures to compensate for the deficiencies in part 4.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

TERM PROJECT 3 Audit Sampling Case Hip E. Dude, CPA, is doing the audit of Go Fish Inc., a national wholesaler of fishing equipment and supplies. He is surprised at the results found so far in the testing of sales and sales returns. There are large numbers of misstatements in the sales tests, which were done using a nonstatistical sample. There are a variety of misstatements, including pricing, extensions, footings, failure to record, and duplicate recording in sales returns and postings to the accounts receivable master file. The confirmation of accounts receivable also indicates numerous misstatements. Upon analysis of the misstatements, he concludes that the problem is extremely sloppy accounting, rather than intentional misstatements. When Dude informs management of the problem, he is told that they are not too surprised. Customers have been complaining about their bills in recent months, and the company accountant has been having personal problems. He has now been discharged, and the company is in the process of hiring a new accountant. The owner states that she does not feel that the problem is serious from a financial statement point of view, because the misstatements mostly offset each other. Dude is not convinced that the problem of overall financial statement misstatements is as minor as the owner states. He decides that additional confirmation of accounts receivable is required under the circumstances. Further thought leads him to conclude that there are two problems: the positive confirmation response has been only approximately 25% to 30% in the past, and it is now 45 days after the balance sheet date. After considerable deliberation, Dude decides to select a combined sample of sales and sales returns and determine the effect of the misstatements on net sales and earnings. He has concluded that a misposting of a sale or return to the wrong customer is not a misstatement, because gross sales are correctly stated. The owner assures Dude that failure to bill a customer even for a period of several months is not likely to make the receivable uncollectible. Total recorded sales amount to $15,356,686 and recorded sales returns are $1,492,797. Dude concludes that a misstatement of $210,000 affecting net earnings would be material. He decides to use an ARIA of 10% and an ARIR of 25%. He has no basis for estimating the standard deviation or a point estimate. He decides to randomly select 100 items to calculate these two items. The sales invoices for the year started with 15424 and ended with 28841. They are recorded in the sales journal in the order of issue rather than sequentially. Sales returns and allowances, which are sequentially recorded in the sales returns and allowances journal, start with 1351 and end with 4301. ..

Introduction: An overview of the instructor’s resource manual

Based upon the sample size of 100 items, of which 26 were sales returns and allowances, the following misstatement information was noted. The value of the 67 items in the sample that have no misstatements is $77,280.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

RECORDED VALUE

AUDIT VALUE

Pricing

98.50 333.00 25.30 1,147.40 789.10 615.00 542.25 2,040.40 998.00 478.50 13.12 883.20 629.50 174.39

Extensions and footings

921.00 292.80 448.50 168.20 1,515.15 2,750.50 7,137.00 111.10 727.20 10.00

901.00 278.50 430.50 155.00 1,499.00 2,570.50 7,173.00 125.10 772.20 100.00

(510.00) (890.90) (152.00)

(810.00) (590.90) (1.52)

-0-0-0-0-0-0-

(725.00) (700.00) (515.00) (1,219.50) (353.00) (777.00)

TYPE OF MISSTATEMENT SALES:

95.50 310.00 25.10 1,117.04 758.90 605.00 539.25 2,000.00 948.00 432.50 131.20 890.20 653.40 194.39

SALES RETURNS: Posting to accounts receivable master file

Failure to record sales returns

xxiii

Introduction: An overview of the instructor’s resource manual

Required: 1. 2. 3. 4. 5. 6. 7. 8.

xxiv

Evaluate the reasonableness of the sampling approach Dude is taking. Explain how he should select the random numbers using computer generation of random numbers. Calculate the confidence limits for the population of sales and sales returns combined using difference estimation. Show all intermediate steps. Evaluate the sufficiency of the sample size Dude used in establishing the confidence limits. How large would the sample need to be to meet Dude’s confidence limit requirements? At what level of ARIR would Dude be able to accept the recorded value of “net sales” as being fairly stated within acceptable materiality? Show justification for your answer. What would the confidence limits be for the sales population alone? Why is the difference between your answers in 3 and 6 so large? Suggest a strategy for Dude to follow at this point. Be sure that the documentation of your answers is adequate for inclusion in the audit files.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

The Enabling and Technical Competencies of a Professional Auditor The overall objective of this book is to aid in the development of both the technical and practical knowledge necessary to be a competent professional auditor in today’s complex and ever-changing business and regulatory environment. While updating the book, we kept in mind the specific assurance concepts and competencies as articulated by the CPA Competency Map, as well as the following key enabling competencies: Professional and Ethical Behaviour  Uses an ethical reasoning process.  Adopts the profession’s values.  Maintains a stakeholder focus.  Adheres to laws, professional standards, and policies when exercising professional judgment. Problem-Solving and Decision-Making  Demonstrates a cohesive process for using professional judgment to solve problems and make decisions. Communication  Obtains accurate and relevant information through research.  Adapts communications to meet audience needs (Prepares professional memos and reports). Data Analytics and Information Systems (DAIS) To align with the changes to the 2019 and 2020 Chartered Professional Accountants Competency Maps, we added new discussions about how audit data analytics (ADA) are being incorporated into audit work. For example, in Chapter 11 (sampling), we highlight that by using ADA tools, it may be easier for the auditor to efficiently test the entire population rather than just a sample. In the cycle-specific chapters, we go into a little bit more depth and provide examples of how ADAs are applied to risk assessment procedures and testing for specific risks. For instance, in Chapter 15 (human resources and payroll cycle), we suggest that ADAs could be used to identify nonexistent employees or fraudulent labour hours. In Chapter 12 (revenue cycle), we discuss the application of ADAs as a risk assessment procedure, whereby ADAs can be used to break down revenue by customer demographic, by invoice, and in aggregate for the year. The following table summarizes how the chapters reflect the relevant concepts and technical competencies of CPA Canada’s technical assurance competencies.

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Summary of Fundamental Assurance Concepts and Related Technical Competencies Covered in 15 th Edition Fundamental Assurance Concepts

Relevant Technical Competencies

Relevant Chapters 1

a) Concept of assurance  Economic purposes of assurance engagement

4.2.1

Advises on an entity’s assurance needs

 The expectation gap (i.e., gaps between the outcomes delivered by the assurance engagement and the expectations of the users)

4.3.1

Assesses issues related to the undertaking of the engagement or project

3, 4

b) The audit concept

1, 19

 Social and economic purposes of auditing  Distinction between statutory and voluntary audits a) Auditing and assurance standard–setting process, including the following:  Formulation of auditing and assurance standards in Canada  Documents for comment/exposure drafts

4.2.1

Advises on an entity’s assurance needs

1, 19 2

4.2.2

Explains the implications of pending changes in assurance standards

2, 19 2, 18, 19 8, 9, 11

 Directions in assurance research b) Monitoring of the auditing profession;

2, 3

c) Regulatory process in Canada; i.e., issues for public companies

2, 3

d) Implications of regulatory reporting and assurance

2, 3 4.3.1

a) Client acceptance and continuation (CAS 210)

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Assesses issues related to the undertaking of the engagement or project

6, 7

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Fundamental Assurance Concepts 4.3.9 b) Association (5020)

Relevant Technical Competencies

Relevant Chapters

Documents the work performed and its results

3, 5, 11 3, 11

4.3.10 Draws conclusions and communicates results 4.3.1

Assesses issues related to the undertaking of the engagement or project

4.1.1

Assesses the entity’s risk assessment processes

4.1.2

Evaluates the information system, including the related processes

4.3.1

Assesses issues related to the undertaking of the engagement or project

 Responsibilities relating to fraud (CAS 240)

4.3.4

Assesses materiality for the assurance engagement or project

 Materiality (CAS 320)

4.3.5

Assesses the risks of the project, or, for audit engagements, assesses the risks of material misstatement at the financial statement level and at the assertion level for classes of transactions, account balances, and disclosures

d) Audit planning (CAS 300) e) Risk assessment process  Business risk  Going concern (CAS 570)  Risk of material misstatement (CAS 315)

 Internal control

5 - 10 6,7,8, 12-16 (specific cycles) 7, 8 7, 17, 18 7 4, 6, 12-16 (fraud risk for specific cycles) 4 (assertions), 7, 11 (performance materiality & tolerable misstatement) 12-16 (risk of material misstatement for specific cycles) 17 8

 Control environment (CAS 260, CAS 265)

 Control frameworks (e.g., COSO, COCO, ITGC, COBIT)

 Management of internal controls (CAS 402):

8 8, 12-16 (controls for specific cycles) 8, 12-16 (controls for

- Authorization of transactions/activities - Segregation of duties

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Introduction: An overview of the instructor’s resource manual

Fundamental Assurance Concepts

Relevant Technical Competencies

specific cycles) 8, 12-16 (controls for specific cycles) 8, 12-16 (controls for specific cycles) 8, 12-16 (controls for specific cycles) 8 8 8 8 8 8

- Design and use of documentation and records - Safeguards over access to and use of assets and records - Preventive, detective, and corrective measures  Objectives of internal controls: - Optimizing the use of resources - Preventing and detecting error and fraud - Safeguarding assets - Maintaining reliable control system  IT functions and controls - General computer controls versus application controls - Automated controls versus manual controls - Data entry and access controls - Processing controls (within the process) - End-user and business unit computing controls - Specific controls (e.g., identification, authorization, authentication, non-repudiation, encryption, and monitoring)

8 8 8 8 8 8 5, 10, 12-17 (for specific cycles and accounts)

f) Audit procedures  Nature, timing, and extent of procedures (CAS 510, 540, 550, 560, 600, 610, 620, 710)  Test of controls, substantive tests (CAS 330)

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Relevant Chapters

4.3.6

Develops appropriate procedures, including Audit Data Analytics (ADA), based on the identified risk of material misstatement

5, 10, 12-17 (specific cycles and accounts) 5, 8, 10, 11, 12- 17 (for specific cycles and

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Fundamental Assurance Concepts

Relevant Technical Competencies

Relevant Chapters

4.3.7

Performs the work plan

accounts) 5, 10, 12-16 (for specific cycles and accounts), 18 (completing the audit) 11 5, 12, 13, 16 8, 10,

4.3.8

Evaluates the evidence and results of analysis

 Sufficiency

5, 11, 12-17 (for specific cycles and accounts and completing the audit) Same as above

 Reliability

Same as above

 Appropriateness

Same as above

 Analytical procedures (CAS 520)  Sampling approach (CAS 530)  Confirmation (CAS 505)  Computer-assisted techniques g) Evidence (CAS 500, 501, 580)

h) Documentation (CAS 230)

4.3.9

Documents the work performed and its results

4 , 5, 8

i) Audit conclusions (CAS 450, 700, 705, 706)

4.3.10 Draws conclusions and communicates results

17, 18

a) Assurance engagements related to financial statements:  An audit of general-purpose financial statements (CAS 200, 220, 250, 720)

4.2.1

Advises on an entity’s assurance needs

1-19

4.3.1

Assesses issues related to the undertaking of the engagement or project

1-18

 An audit of special-purpose financial statements

4.3.2

Assesses which set of criteria to apply to the subject matter being evaluated

 An audit of financial statements prepared in accordance with special-purpose frameworks (CAS 800)

4.3.3

19 N/A

Assesses or develops which standards or guidelines

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Introduction: An overview of the instructor’s resource manual

Fundamental Assurance Concepts

Relevant Technical Competencies

4.3.4

Assesses materiality for the assurance engagement or project

4.3.5

 An audit of single financial statements and specific elements of a financial statement (CAS 805)  An engagement to report on summary financial statements (CAS 810) b) Other assurance engagements:  Reporting on controls at a service organization (CSAE 3416)  Assurance on other matters (i.e., not financial statements or financial information)

4.3.6

 An audit on compliance with agreements, statutes, and regulations

Develops appropriate procedures based on the identified risk of material misstatement

4.3.7

Performs the work plan

4.3.8

Evaluates the evidence and results of analysis

4.3.9

Documents the work performed and its results

 An audit on compliance with legislative and related authorities in the public sector  An audit of internal controls over financial reporting that is integrated with an audit of financial statements

Relevant Chapters

to apply based on the nature and expectations of the assurance engagement or project

1, 19 8, 19 1, 19 19 N/A – Chapter 1 Opening Vignette and p. 10 provides brief overview

4.3.10 Draws conclusions and communicates results 4.3.11 Prepares or interprets information and reports for stakeholders

8, 19

c) Review engagements:

 A review of general-purpose financial statements

 A review of special-purpose financial statements

 A review of financial information other than financial statements  A review of non-financial information

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Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Fundamental Assurance Concepts

Relevant Technical Competencies

Relevant Chapters

 A review of compliance with agreements and regulations

 Auditor review of interim financial statements

d) Other engagements:

 Compilation engagements

 Compilation of a financial forecast or projection

N/A

 Reports on the results of applying specified auditing procedures to financial information other than financial statements

 Agreed-upon procedures regarding internal control over financial reporting

 Reports on application of accounting principles

 Auditor’s involvement with offering documents

N/A

e) Comprehensive audit engagements:

4.4.1

Applies comprehensive auditing techniques

1, 19 1

 Operational audits  Continuous auditing engagements  Forensic audits

 Comprehensive auditing, including value-for-money (VFM) audits  Environmental audits

1 1, 19

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Introduction: An overview of the instructor’s resource manual

Fundamental Assurance Concepts

Relevant Technical Competencies

a) Rules of Professional Conduct Relates to all assurance competencies

b) Ethical Principles c) CPA Canada Handbook — Assurance:  Canadian Standards on Quality Control (CSQC 1)  Canadian Auditing Standards (all specifically referred to above)  Other Canadian standards

Relevant Chapters

4 Chapter 2 and 19 provide an overview of the Handbook 2 Throughout 19

 General assurance and auditing

1, 19

 Specialized areas

 Review engagements

 Related services

 Public sector

N/A – some examples of issues in public sector (Chapter 1 Opening Vignette Chapter 1 discussion of role of government auditor, AC 18-2, and Direct Reports (Chapter 19)

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Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Fundamental Assurance Concepts

Relevant Technical Competencies

Relevant Chapters 19

d) Assurance and related services guidelines

xxxiii

Chapter 1 The Demand for Audit and Other Assurance Services Overview Usually students will not have read Chapter 1 before the material in this chapter is covered. Most students are also not familiar with the concept of “audit” and we also need to keep in mind that the vocabulary used in this course is also new for most students. Accordingly we spend more time taking up this material and explaining the fundamental concept of audit, which usually requires the majority of the scheduled time of the first day of class (assuming 1 ½ hour class). In addition to reviewing the detailed course outline for the course, we attempt to cover the opening vignette and learning objectives.

Learning Objectives 1. 2. 3. 4. 5. 6.

Define an assurance engagement. Define auditing and its purpose. Explain why there is a demand for audit and other assurance services. Describe major types of assurance engagements and auditors. Distinguish between accounting and financial statement auditing. Describe assurance and nonassurance services provided by public accountants and distinguish the financial statement audit from other assurance services.

Chapter opening vignette: “Brown Goes Green” This vignette first discusses United Parcel Service’s (UPS) commitment to sustainability and how through optimization of delivery routes, in 2014, UPS reduced its annual carbon emission by 1.5 percent even though delivery volume increased by 3.9 percent. It then outlines how the UPS Corporate Sustainability Report is prepared and how the increase in sustainability reporting by companies such as UPS has resulted in increased interest in the accuracy of reported information. The vignette then goes on to describe the reports issued by a Big 4 public accounting firm that were included in the UPS Corporate Sustainability Report. Information from the opening vignette can be used during the lecture as an example to explain to students that assurance services are not only limited to financial information, but extend to all kinds of different information, including greenhouse gas emissions.

LO 1 What Are Assurance Engagements? Three concepts to highlight: 1. Assertions

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

2. Quantifiable information 3. Established criteria We start by asking students to discuss in small groups what auditors do and why auditing is important. The feedback from the groups usually provides lots of material to generate class discussion. (A common response is that auditors are like policemen looking for fraud and for individuals that “cook the books”.) An easy means by which to help students understand the basic premise of auditing is to describe it as “checking” – students are usually able to grasp this simple term much easier. We can facilitate this discussion by asking students how they would audit or “check” if all students present in class are actually registered in the course. For instance, the following could be part of the discussion:   



How would you audit or “check” if all students that are currently sitting in the classroom are actually registered in the course? What evidence would you need to check this? o Each student can be asked to verbally confirm their registration in the course. o Each student may be required to show identification. Why would you need this evidence? – This part of the discussion can be used to show students the difference in evidence strength, in other words, persuasiveness. Verbal evidence (inquiry) – less persuasive versus documentation (such as students’ identification cards and the class list) – more persuasive evidence. How would you report the results of the checking that has been performed? This part of the discussion can be linked to the independent auditor’s report, which communicates the outcome of the auditor’s work.

Students tend to think of auditing as the auditing of financial statements by public accounting firms in accordance with GAAS. It is therefore helpful to use Figure 1-2 (“Audit of a Corporate Tax Return”) to discuss the definition and inform the students that an audit of financial statements is just one type of information that can be audited. Refer to the opening vignette to show another type of information that can also be audited that is not related to financial statements. As a part of this discussion, students are briefly introduced to Canada Revenue Agency (CRA) auditors. Be sure to identify this as a tax compliance audit (tax returned is checked against the Income Tax Act) rather than a financial statement audit. After you have gone over this information, refer students to the definition of auditing and ensure they comprehend that auditing is simply “checking” of information to make sure that it’s correct. Briefly talk about the importance of: 

Competence of auditor For example, auditors who audit financial statements must have a strong knowledge of financial accounting (they must be competent), otherwise how would they know what and how to “check” if transactions were accounted for

Chapter 1: The Demand for Audit and Other Assurance Services

 

correctly in accordance with an applicable financial accounting framework? Professional scepticism Competence is more than having a technical knowledge – the auditor must act with integrity and apply professional scepticism (a critical assessment of audit evidence and a willingness to challenge the auditee’s assertions) Independence of the auditor A key characteristic that the public values is the auditor’s independence and objectivity. This is closely related to professional scepticism (it would be hard to be sceptical if the auditor was biased). Teaching Tip: A good question to ask in relation to the opening vignette is what is causing an increased interest in the accuracy of reported greenhouse gas emissions and how could this be related to the CO2 cap and trade programs launched in some Canadian provinces and states in the USA? To further enhance the discussion, the instructor may access more information about Ontario’s cap and trade at: https://www.ontario.ca/page/cap-and-trade

Need to report on findings At this point we ask the student to identify those individuals or parties who rely on financial statements. It’s important for the student to understand who relies on the audited information and for what purposes (decision-making). It is also important that we tell students that information is not always “correct”, even on financial statements, and that’s why we need an auditor to check it. The following question can help with this discussion (this can be tied into the concept of information risk):  What would happen if investors made decisions based on financial statement information that is incorrect?  Why would someone want to present financial statement information that is not correct?

LO2 What Is Auditing? A short amount of time may be spent on the distinction between accounting and auditing, although it is at least desirable to point out the differences and relationship between the two. Ask the students to identify who is responsible for accounting as well as auditing (client versus the auditor.) It may be helpful to explain to the students that the process of accounting is to document events that have taken place (using a specific accounting framework), for instance, recording sale transactions. In comparison, auditing happens after the transactions have been recorded and is the process of checking documentation that supports the event (in this example, a sale transaction). The key concept that student should understand is that:  Accounting is the process of recording events that generates documents. Auditing does NOT generate any new documents but is simply the process of “checking” documents that were created by the accounting process. It is important to point out that auditing is more than checking documentation and requires considerable professional judgment.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Teaching Tip: Question 1-19 is a good question to use to highlight the three concepts in the definition of auditing as well as the attributes of the auditor.

LO3 Why Are Audits and Other Assurance Engagements Needed? Review the various factors that affect the demand for audits and allow the students an opportunity to discuss the various factors and gain a better understanding of why audits are conducted. The following questions can help facilitate this discussion.   

Why are people willing to pay for audits? (this can be connected to causes of information risk) Where is the value of an audit derived from? Why would you pay someone to “check” information?

Students might find it difficult to relate to the impact that material misstatements in the financial statements could have on investors (users of financial statements). To help them better relate to this, we present to them the following situation. We tell the students that their mid-term exam grades will be posted online on the course website. Each student will be able to view their mid-term exam grade prior to when the actual exams are returned back to them during class. Now we tell the students to imagine that when they check their mid-term grade on the course website, they find the letter “A” beside their student number/name. Just like an investor reading the financial statements and finding favourable results (growth in revenue or net income), the student reads the favourable exam grade and becomes excited. However, few days later when the instructor returns back the mid-term exams, instead of seeing the letter “A” on the front page of his/her exam, the student finds the letter “F”. Unfortunately, the instructor was marking the exams really late at night and accidentally, when posting the grades online, keyed in the wrong letter grade beside the student’s name. We explain to the students that similar to what they would feel in this scenario, users of financial statements feel the same way if it turns out that the information they believed to be true was in fact false, especially if as a result they suffered a financial loss. Thus, that is why there is a need for auditing, to minimize the risk of an “F” accidentally becoming an “A” or vice versa. It is good to spend a few minutes discussing the economic role of auditors in society and their impact on the economy by providing confidence in the financial information reported (and, reducing the cost of capital). Ask the students to identify the goal of an audit. The discussion should encompass the reliability of information to the users of the information and providing more confidence in the reported information. This is something that the mid-term exam scenario should help them better understand. Point out to the students that the auditor obtains “a high level of assurance” that there are “no material errors.” Most students will not be familiar and will not understand what is meant by the term “assurance” and “material error”. A few minutes should be spent on explaining these terms in simple language. Ask the students why the auditor can’t provide absolute or

Chapter 1: The Demand for Audit and Other Assurance Services

100% assurance that there are no material errors. In other words, why can’t the auditor be absolutely sure that everything that was checked is 100% correct? (Answer: test checking performed, judgement involved, evidence is pervasive but not conclusive). Ask the students why the auditor can’t provide assurance that the financial statements are correct to the nearest dollar. (Answer: cost effectiveness of an audit and timeliness of the results). Teaching Tip: For a further explanation of some of the key audit concepts, you may refer the students to “Still Confused? Read This.” New in this edition of the textbook, in each chapter we include conversations involving various audit team members of an audit client — Hillsburg Hardware Limited. Each of these conversations includes an explanation of some key audit concepts and illustrates how they apply to an actual audit engagement. In Chapter 1, we explain the difference between assurance and auditing. Highlight the key components of this objective: reasonable assurance, opinion, fairly presented, materiality, GAAP, IFRS or appropriate disclosed basis of accounting. A few minutes should be spent on explaining these terms as most students will not be familiar with them. Refer to Figure 1-1 to discuss the unique accountability relationship among the auditor, client, and external users to highlight the responsibilities with an assurance engagement, why the users want assurance, and how the audit report reduces information risk. We briefly go over the causes of information risk, providing examples that relate to remoteness of information, biases and motives of the provider of information, voluminous data, and complexity of transactions. Teaching Tip: Parts of question 1-20 are useful to demonstrate how users can reduce information risk and the important role that “assurers” can play in reducing information risk. (Students tend to relate to buying a car.) We refer here back to the mid-term exam example and expand the situation by asking the students how they would react to finding out online that their posted final exam grade is poor (final exams are usually not returned back to the students). Knowing about the entry error with the mid-term exam grades, we ask the students what, if any, action they would take to verify that their poor grade on the final exam is not a result of another entry error. (Students would want to make an appointment with their professor to review their actual final exam to check the grade that they received). Using this example, we highlight to students the concept of risk (because of the error with the mid-term exam grades (increased risk) the student wanted to check their final exam grade). The information risk was reduced directly by the student through an “audit” procedure: review and inspection of the grade indicated on the actual final exam. We can point out here to students that, in their daily lives, sometimes without realizing it, they perform many audit-type procedures to reduce information risk. (Reviewing their final exam, cell-phone bill, matching their purchase receipts to their credit card statement are few of the examples).

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

We point out here to the students that similar to how they rely on their grades (information) to make decisions (enroll into the next course or retake the course, switch into a different program or enroll into the CPA training program), external users (such as shareholders and lenders) rely on financial statements to make business decisions. Whereas it is feasible for a student to review their final exam to reduce the information risk, external financial statement users look to the independent auditor’s report as an indication that the information presented on the financial statements is overall reasonably complete, accurate, and unbiased.

LO 4 Common Types of Assurance Engagements Most students at colleges/universities know little of the types of auditors and the nature of public accounting. In a brief lecture, we tell the students:  

The nature of financial, compliance, and operational audits The primary difference between independent PAs, government auditors, Canada Revenue Agency auditors, internal auditors, forensic and fraud auditors Teaching Tip: Table 1-1 and Auditing in Action 1-1 and 1-2 provide useful examples for this discussion.

LO 5 Accounting vs. Auditing We spend a few minutes pointing out the differences between auditing and accounting, highlighting that “accounting” is the process of defining, recording, classifying, and summarizing of economic events in a logical manner for the purpose of providing financial information for decision making. Auditing is “checking” to make sure that the accounting was done correctly, with “correctly” meaning that it was done in accordance with applicable standards, such as IFRS and ASPE. Another key point to mention is that accounting is done by management and not auditors. Students sometimes get this confused.

LO 6 Assurance and Nonassurance Services Offered by Public Accountants We highlight to students that an engagement that fulfills the following criteria is an assurance engagement:

• Existence of a three-party relationship • Subject matter • Criteria • Gathering of sufficient appropriate evidence • Expression of opinion or conclusion Most students will not yet be familiar with these terms; therefore, we spend a few minutes explaining their meaning by relating to real-life examples.

Chapter 1: The Demand for Audit and Other Assurance Services

Students usually struggle to understand the difference between moderate vs. high assurance. To help them understand this difference, we can use the following scenario. We ask the students to imagine a situation where they suspect that a poultry farm where they purchase “organic” meat is adding antibiotics and growth hormones to the animal feed. The students decide to hire a farm inspector to visit and inspect the farm for one week and report back to them. We then tell the students that, assuming the inspector does not find any problems, the inspector can provide the students with one of two conclusions, and ask which one they would prefer. If the inspector provides moderate assurance, the conclusion will state that that during the week of the inspection, nothing has come to the farm inspector’s attention that would indicate antibiotics or growth hormones were added to the animal feed. Alternatively, a higher assurance conclusion would state that during the week of the inspection, no antibiotics or growth hormones were added to the animal feed. (Students should prefer the second conclusion as it offers more certainty). We then highlight to students that both conclusions provide assurance, with the first one providing moderate and the second one providing a higher level of assurance. We then explain that the level of assurance is tied to the amount and type of gathered evidence. Obtaining higher-level assurance usually requires more work (evidence); as a result, it takes more time and is more costly. Teaching Tips: Auditing in Action 1-3 provides a short summary of events surrounding the erroneous announcement of the 2017 Oscars for best picture and is a good way to start a class discussion related to this topic. We can then ask students to describe assurance services. The term will be unfamiliar to most students, but some may recognize the concept. We briefly provide an overview of the following services:   

Assurance services – Financial information (Attestation) Assurance services – Non-financial information (Attestation and direct reporting engagements) Non-assurance services – compilations, management advisory services, tax services, and accounting and bookkeeping Teaching Tips: You could show a webpage from any of the major accounting firms to demonstrate the variety of services provided. Question 1-28 is useful for reinforcing some concepts regarding how assurance services aid in adding credibility to information, and provides a different type of assurance engagement and discussion of the types of services provided by public accounting firms.

Although the financial audit is the main focus of the book, this brief overview provides some background on the different types of services offered by public accounting firms. This is a good opportunity to explain the difference between an attestation engagement versus a direct reporting engagement (students tend to have considerable difficulty in understanding the differences). The best example of the attestation engagement is the financial statement

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

audit (the auditor attests (by providing an opinion) to the reliability of the financial statement prepared by management). In contrast, for direct reporting engagements, which are common for internal auditors and auditors general, the criteria are embedded in the report itself. Teaching Tip: You may refer students to the “Still Confused? Read This” explanation on the difference between audits and reviews. In the discussion of non-financial assurance services, instructors may wish to highlight that assurance engagements that are not in connection with the financial statements do not require a public accountant, yet public accountants are often hired to perform these engagements. The same applies to the variety of non-assurance services. A good question is to ask why do many users prefer a public accountant over other service providers? (Answer: They are trained in assurance and are required to follow rules of professional conduct. For many of these engagements, the profession has developed standards.) Instructors may wish to show this video: https://www.youtube.com/watch?v=Nd-lQJt_T5E&feature=youtu.be It is part of the Center for Audit Quality video series “Focus on the Profession.” The CEO of Crowe Horwath LLP discusses the various services offered at the US public accounting firm and provides a discussion of the importance of independence, competence, integrity and professional skepticism for public accountants.

Teaching Tips: Auditing in Action 1-4 is a good example to end the class discussion related to this topic. Instructors may wish to show this video: https://www.youtube.com/watch?v=O1HZYjBAooc A lot has changed since the economic crisis and, today, boards and audit committees are asking for—and expecting—more from their audit. KPMG’s new report, “Future thought: the audit is changing,” discusses how audit delivery is being transformed by new technologies and techniques in order to provide business executives with insights they want and need. This video highlights the role of Data & Analytics and Lean in Audit™ methodologies and demonstrates how they are helping to meet the needs of today’s modern business. (5 min)

Chapter 1: The Demand for Audit and Other Assurance Services

Lecture Review This chapter defined auditing and distinguished auditing from accounting. Audits are valuable because they reduce information risk, which, in the case of a financial statement audit, lowers the cost of capital. The chapter outlined the common types of audits and different types of auditors. The final part of the chapter explained the general characteristics of an assurance engagement and described assurance and nonassurance services which public accountants can provide.

Suggested Homework Problems

Learning Objectives

Review Questions

Multiple Choice Questions

LO 1

2-1, 2-2, 2-3

2-17

LO 2

2-4, 2-5, 2-6, 27, 2-8, 2-9

2-17

LO 3

2-5, 2-10,

LO 4

2-10, 2-11, 2-12

LO 5

2-13

LO 6

2-14, 2-15, 2-16

2-18

2-19

Discussion Questions and Problems

Professional Judgment Problems and Cases

Hillsburg Hardware

2-23

2-20

2-23, 2-26

2-22

2-24, 2-25, 227 2-23, 2-24, 225, 2-27

2-22

2-28

Chapter 3 Professional Ethics and Legal Liability Overview In this lecture we discuss the ways in which the profession and society encourage public accountants to conduct themselves at a high level of ethics. The chapter incorporates ethical decision making into the framework and highlights its relevance and importance to the application of professional judgment. (Some tend to see these two activities as separate and discrete; however, we argue that there is considerable overlap between the two). We then provide a more focused discussion of auditor ethics and the auditor’s role, and highlight some biases and ethical blind spots. We then move on to a discussion of the independence standard and rules of professional conduct, and the role of both in ensuring auditors carry out high-quality audits that are in the public interest. The chapter concludes by describing society’s role and how, through the legal system, it holds auditors accountable for their professional conduct.

Learning Objectives 1. Explain the fundamental principles that guide public accountants’ professional ethics. 2. Recognize ethical dilemmas that public accountants typically encounter and recommend acceptable courses of action. 3. Explain the impact of ethical blind spots on auditors’ ethical reasoning. 4. Understand the rules of professional conduct and apply that knowledge to resolve ethical conflicts. 5. Identify and evaluate threats to independence and recommend appropriate safeguards to eliminate or reduce the threats to an acceptable level. 6. Describe the CPA (Chartered Professional Accountant) profession’s enforcement mechanisms for public accountants’ conduct. 7. Explain the expectations gap and explain how the profession can reduce the expectations gap. 8. Understand and analyze auditor legal liability, and explain how public accountants can reduce their litigation risk.

Chapter Opening Vignette: “Big 4 Partner Convicted of Insider Trading for Disclosing Confidential Information” This vignette highlights the fundamental ethical principle of the Canadian CPA Code of Professional Conduct. It highlights how the CPA cannot exploit confidential client information for their personal advantage or the advantage of a third party, and that trading in publicly traded companies on such inside information before it becomes public is often a violation of securities laws on insider trading. The vignette then describes an example of a senior partner in the Los Angeles office of KMPG who was sentenced to 14 months in prison for passing confidential client information to a friend who used it to make trades that resulted in profits over $1 million. (Note: You can ask students why ethics play an important role in the decision-making of a public accountant – the discussion can be tied to how the value of the audit report and the demand for audit services depends on public confidence in the independence and integrity of public accountants.)

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

LO 1 Professional Ethics and Public Accountants We begin the session by explaining to students the definition of ethics and professional ethics. We then highlight the definition of a “professional,” who is someone that: 1. Sees other members, including those employed elsewhere, as peers/colleagues. 2. Exercises judgment when performing specialized tasks and follows relevant professional standards. 3. Accepts the profession’s agreement to work in a morally permissible way (usually as set out in the profession’s code of ethics) as an obligation of his or her role. We point out to students that exercising judgment in the application of specialized knowledge is a key characteristic of a professional. However, that judgment is expected to be in keeping with professional standards, the profession’s code of ethics, and the public’s expectations of the professional’s role. We can then explain that professional judgment is mainly comprised of two parts – experience and personality of the professional making the judgment, and ethics, which are a set of moral principles or values that help shape the judgment to be socially acceptable. We also introduce some frameworks to aid students in evaluating the ethical dimension of issues that they may face in their auditing careers. Students are first introduced to the fundamental principles of the CPA Ontario Code of Professional Conduct in Table 3-1:     

Professional behaviour Integrity and due care Objectivity Professional competence Confidentiality

At this point, students will be somewhat familiar with integrity and due care, competence, and objectivity but less so with professional behaviour and confidentiality. The principles emphasize the shared values of the accounting profession (it applies to all accountants, not just public accountants). Instructor Note: Integrity is perhaps the best link between ethical reasoning and professional judgment. When rules are unclear or the auditor is facing conflicting decisions, integrity should be a guiding principle in determining the appropriate choice.

Teaching Tip: Question 3-35 is a good question regarding solving ethical dilemmas. CPA Canada has some tools to help instructors and students develop a methodological approach to solving ethical dilemmas. It is available at: https://www.cpacanada.ca/en/become-a-cpa/why-become-a-cpa/the-cpacertification-program/the-cpa-way

Chapter 3: Professional Ethics and Legal liability

LO 2 A Framework for Ethical Reasoning In addition to the ethical decision framework (which is similar to the professional judgment framework), the chapter provides an overview of Mary Gentile’s Giving Voice to Values Approach. This post-decisional tool assumes that the student is able to identify the issue and focuses on how the student can overcome various roadblocks and “speak up”. We use Figure 3-1 to provide an overview of a framework for ethical decision making. We then show how the framework is applied to a simulation of an ethical dilemma.

LO 3 Ethical Blind Spots Students often think they are only faced with an ethical dilemma when they are making a choice of doing something clearly “wrong” or where the harm is obvious. This part of the chapter introduces them to the notion that, often when analysing issues in the context of cost/benefit or other seemingly “neutral” criteria such as risk, the ethical dimension of the decision is missed. This is what is referred to as an ethical blind spot. In addition to ethical blind spots, a common issue that arises when someone is faced with an ethical choice is rationalizations such as denial of responsibility and denial of victim, which can lead to making unethical choices.

Teaching Tips: As with professional judgment, the best way to discuss this material is to provide various examples. Marianne Jennings has published numerous articles regarding accounting and auditor ethics that students and instructors can easily engage with. She has several in Corporate Finance Review. Her 2006 article: “In their own words: What we learn about ethical lapses and their prevention from hindsight of those who committed them” in Corporate Finance Review provides many examples of ethical blind spots and rationalizations.

Blind spots in Action: This video on inattentional blindness is a useful way of demonstrating ethical blind spots and framing a problem. http://invisiblegorilla.com/gorilla_experiment.html

LO 4 Professional Guidance on Ethical Conduct In this part of the lecture we discuss key professional guidance rules that are relevant to performing an audit engagement as well as consideration of the auditor’s responsibility as being a member of a professional body. Instructor Note: Some instructors may wish to frame the discussion around the pros and cons of rules versus principles.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Some key rules to highlight: Relevant to the Audit Quality Confidentiality – Confidentiality is closely related to independence (cannot use confidential information to one’s benefit). The discussion also highlights that working papers can only be provided with the client’s permission except in situations that involve court subpoenas and practice inspections. Instructor Note: Instructors may wish to highlight that confidentiality can be complicated if a PA firm represents two clients that do business with each other. Communication with Other Auditor – the RPC require that the auditor contact the predecessor auditor and that the incumbent respond. This is a key part of the client acceptance process. Association with False and Misleading Information – Auditors (and all members of the profession) cannot sign or associate with false and misleading information. This is an important part of the auditor’s responsibility to protect the public interest. Competence, Integrity, and Due Care – Instructors may stress that these are requirements of GAAS as well as RPC. Contingent Fees – Instructors can highlight how contingent fees have the potential to erode auditors’ independence. Instructor Note: Instructors may raise the question of offering contingent fees for related services (such as tax or advisory services). We also highlight that the preamble of the CPA Code of Professional Conduct emphasizes that the following fundamental principles should guide collegial relations: that client interests are placed ahead of the interest of the member or firm, and that professional courtesy and cooperation are expected at all times. General Aspects of Professionalism Professional behaviour – CPAs are expected to behave in the best interests of the profession and to be collegial towards each other. Instructor Note: Instructors may wish to raise the question of what is a public accountant’s responsibility when a client asks for a second opinion on an accounting transaction that the current auditor does not support. Advertising and solicitation – Although not obvious, the logic behind much of this is closely related to professional behaviour. Aspects of Enforcement of the Rules of Professional Conduct Duty to report breaches – Members have a duty to report breaches but also must advise the other member of their intention. Instructor Note: Instructors may wish to reverse the order of teaching the rules of professional conduct and independence.

Teaching Tip: Questions 3-15 and 3-16 are excellent to quickly test students’ understating of key concepts covered in this part of the lecture.

Chapter 3: Professional Ethics and Legal liability

LO 5 The Independence Standard for Assurance Engagements A key point to highlight is that independence is a defining feature of the auditor and it is closely related to competence. Instructor Note: Instructors may wish to probe the class regarding whether the independence standard focuses on independence in appearance or independence in fact? (Answer – Rules can only address independence in fact with the goal of ensuring independence in appearance as well.) Instructors may wish to walk students through the decision process in Figure 3-2. (The first two questions regarding prohibited services at the beginning of the process are added since if the services or circumstances fall in this category, then the logical conclusion is to decline or discontinue the assurance engagement. However, the emphasis of the discussion should be on the principles that guide the decision process rather than requiring memorization of particular prohibitions.) 1. Are the services or circumstances among general prohibitions? (If yes, decline or discontinue the assurance engagement) 2. Is the client a listed entity? (If yes, are there any particular prohibitions? If yes, then decline/discontinue) 3. Identify the threat to independence:  Self-interest, self-review, advocacy, familiarity, and intimidation 4. Evaluate and document the significance of the threat 5. Identify and Apply Safeguards (Do safeguards eliminate or reduce threats to an acceptable level? If no, then decline or discontinue the assurance engagement)  Could be regulatory, within the client entity, or within the public accounting firm Students tend to find discussion of independence threats quite interesting; however, they are often uncertain as to when some situations would be considered a threat. An important point to highlight is that when in doubt, use the guidelines of the standard – How would the situation be viewed from the outside by a “reasonable person”? A particularly challenging situation for many students is when the auditor does not agree with a client’s accounting treatment. For instance, does the recommendation of posting a particular journal entry constitute a self-review threat? Instructors can highlight that auditors must obtain client management approval for making journal entries, classifications, etc. For particular clients, this may be challenging if they are not that sophisticated in their accounting knowledge (as in the case of small businesses and not-for-profit organizations).

Teaching Tip: An effective way to discuss safeguards is to use the examples in Table 3-2 and ask students to provide safeguards that the public accounting firm could put in place to mitigate these threats. Question 3-20 asks students to explain the type of potential threat(s) to independence and is excellent to use to quickly review the key concepts covered in this part of the lecture.

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

LO 6 Enforcement of the Code of Professional Conduct The rules of conduct for CPAs are established and administered provincially. As described in Table 3-4, the various professional bodies have the power to impose penalties ranging from public censure in the body’s newsletter or requiring that courses be taken to upgrade skills, to levying fines or expulsion. In some cases, the fines can be quite substantial. Since the professional accounting bodies are self-regulating, there is a danger that the public will perceive the disciplinary process as not being as stringent as it should be. This issue is dealt with by including laypersons on disciplinary committees and being transparent regarding disciplinary committee proceedings. (All information pertaining to disciplinary proceedings are available to the public.)

Teaching Tip: Instructors may wish to show examples of actual decisions, orders in cases involving disciplinary proceedings against CPAs in Ontario. Students usually find these very interesting. The index of disciplinary proceedings by rule of Professional Conduct can be found here: https://ebusiness.cpaontario.ca/discipline/RulesIndex.cfm Question 3-27 consists of situations involving possible violation of the rules of conduct and is excellent to use to review students’ understating of key concepts covered in this part of the lecture.

LO 7 The Expectations Gap It is important that students understand the difference between business failure and audit failure. Ask students what they think is the responsibility of auditors and management when it comes to the financial statements, audit, and business failure. Table 3-5 can be later used to show the difference between Financial Users’ Expectations and Auditors’ Responsibilities. Point out to students that the expectation gap can be narrowed (e.g. by educating users or changing auditor professional responsibilities).

Teaching Tips: Provide examples of both a business failure and an audit failure and ask students to distinguish which example is representative of what type of failure.

LO 8 Audit Failure and Audit Liability Refer to Table 3-6 to discuss the major sources of auditors’ legal liability: common law liability to client and third parties, liability under provincial securities acts, and criminal liability. Point out to students how auditor liability was established in Canada by going over some of the key cases listed in the chapter. Information found in the vignette and Auditing in Action 3-2 and 3-3 can be used to

Chapter 3: Professional Ethics and Legal liability

demonstrate the legal environment faced by auditors. The Prudent Person Concept should be explained to students, emphasizing the fact that the auditor is not expected to be perfect, mistakes will occur but if he/she follows GAAS, IFRS, and their quality control system, they will be found to have acted like others in their profession and not negligently. Ask the students how they think the Prudent Person Concept is implemented in practice given that a definition of a “reasonable person concept” is vague. It is also useful to show students the liability of other professionals such as physicians, lawyers, and automobile manufacturers (they are substantially different). Teaching Tip: It might be helpful to show a recent article from a newspaper or business journal about a large monetary judgment or settlement in some other field. The following is a link to a CBC article about a $900 million US settlement made by General Motors regarding a faulty ignition switch: http://www.cbc.ca/news/business/gm-agrees-to-pay-900m-us-to-settle-ignitionswitch-probe-1.3231785 http://www.cbc.ca/news/business/gm-agrees-to-pay900m-us-to-settle-ignition-switch-probe-1.3231785 We can also discuss with students their opinions about the costs and benefits to society of extensive liability of public accountants. The following questions may help facilitate this discussion:    

Should there be no liability? Should public accountants be guarantors and ensurers of the accuracy of financial statements? Is there now too much or too little liability? What effect do students think litigation against a public accountant has on other public accountants and on society as a whole?

Key things to point out during the discussion are:    

The need for public accountants to be responsible for their actions, The cost and benefit to society of extensive liability, The need to attract competent people with integrity to the profession, and The difference of opinions held by different people depending on their values. Instructors may wish to show these videos: https://www.youtube.com/watch?v=s6pI1LPTk14 Carson Block, founder of Muddy Waters Research, discusses his firm's short position in Sino-Forest Corp and why he thinks Sino-Forest is a fraud. https://www.youtube.com/watch?v=apjGBEtA9Uc Discussion with Allen Chan, former Chairman & CEO Sino-Forest Corporation

Instructor's Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

regarding recent allegations by short-seller Muddy Waters (CEO Carson Block) against Sino-Forest.

Teaching Tip: For a further explanation of some of the key audit concepts, you may refer the students to “Still Confused? Read This.” New in this edition of the textbook, in each chapter we include conversations involving various audit team members of an audit client — Hillsburg Hardware Limited. Each of these conversations includes an explanation of some key audit concepts and illustrates how they apply to an actual audit engagement. In Chapter 3, we discuss the question “Can you prepare tax returns for audit clients? Yes? No? It depends.”

Lecture Review The demand for audit and other assurance services provided by public accountants depends upon public confidence in the profession. This chapter discussed the unique ethical responsibilities of PAs and the CPA Code of Professional Conduct, which is enforced by the provincial accounting bodies, in providing guidance on what is morally permissible. Foremost of all ethical responsibilities for all PAs is the need for independence. The independence standard provides a framework to help guide PAs in identifying threats to independence and recommending appropriate safeguards. Other rules of conduct are designed to maintain public confidence in the profession. The chapter also highlighted the role of the legal system in holding PAs accountable for their professional conduct. It provided insight into the legal environment in which PAs operate and the significant costs associated with litigation. No reasonable PA wants to eliminate the profession’s legal responsibility for fraudulent or incompetent performance. It is certainly in the profession’s best interest to maintain public trust in the competent performance of the auditing profession, while avoiding liability for cases involving strictly business failure and not audit failure. Aside from the profession and individual auditors taking steps to reduce litigation risk, the profession and society need to narrow the expectations gap. This involves a reasonable trade-off between the degree of responsibility the auditor should take for the financial statements and the audit cost to society.

Chapter 3: Professional Ethics and Legal liability

Suggested Homework Problems Learning Objectives

Review Questions

LO 1

3-1, 3-2

LO 2

3-1

Multiple Choice Questions

LO 3 LO 4

Professional Judgment Problems and Cases

Hillsburg Hardware

3-22

3-35

3-39

3-22

LO 5

3-3, 3-5, 3-6, 3-7, 3-8 3-2, 3-4

LO 6

3-6

LO 7

3-9, 3-11, 312 3-10, 3-12, 3-13, 3-14

LO 8

Discussion Questions and Problems

3-15, 3-16, 3-17 3-15, 3-18, 3-19, 3-20, 3-21

3-21, 3-23, 324, 3-26, 3-27, 3-29 , 3-25, 3-28

3-19

3-32, 3-33, 3-34

3-31, 3-33, 3-34

3-35 3-30

3-36, 3-37, 3-38

3-39

Chapter 4 Audit Responsibilities and Objectives Overview This chapter covers a number of important areas including materiality and management assertions. It is important that we spend sufficient time and ensure students understand some of the key concepts covered in this chapter as they form the foundation for the remainder of the course. We usually start the lecture by showing a short film on Barry Minko and the ZZZZ Best Company (link provided below). Because of the large amount of material covered in this chapter, some instructors may consider covering this chapter over two lectures.

Learning Objectives 1. Explain management’s responsibility for the financial statements and internal controls. 2. Explain the responsibilities of those in charge of governance for financial statements and internal controls. 3. Explain the overall objectives of the auditor and auditor’s responsibilities in the conduct of the financial statement audit. 4. Explain and apply the key elements of an effective professional judgment process. 5. Describe the need to maintain professional skepticism when conducting the audit. 6. Understand the logic of the cycle approach to segmenting the audit. 7. Define management assertions about classes of transactions and ending account balances. 8. Explain how the audit process ensures that the auditor obtains sufficient and appropriate audit evidence.

Chapter Opening Vignette: “Riding the Tiger: Indian Computer Company Engages in Billion Dollar Fraud” This vignette illustrates a situation where auditors failed to achieve the objectives of the audit of the company’s financial statements. During the period 2003 to 2008, Satyam Computer Services Limited, an information technology services based in India, engaged in massive fraud: 50.4 billion rupees ($1.04 billion) of their 53.6 billion rupees listed as assets did not exist. In order to make it appear that the assets did exist, the company created fictitious invoices and bank statements. The vignette notes that while Satyam’s auditors sent confirmations to verify the existence of the bank balances, they did not maintain control over the confirmations as required by auditing standards. They instead relied on Satyam’s management to mail out the confirmations and return the responses to the engagement team. (Note: Consider asking students what is professional skepticism and how does it ensure audit quality?)

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

LO 1 Management’s Responsibilities We explain that management is responsible for identifying, defining, and recording on the financial statements events that impact the business. Therefore, in simple terms, financial statements can be thought of as a “story book” with information about events. For instance, by reviewing the amount of revenue recorded, the user of the financial statements can determine how much product was sold. Reviewing legal liabilities value tells the reader how much the company being sued for by injured workers. We can point out here to students that this is similar to them reviewing their posted exam grades (instead of seeing a revenue number, the students see their grade) to find out how the instructor “valued” their written responses. To further enhance class discussion, we can then ask students the following questions:  

How does management know what events should be recorded on financial statements? What guidance does management use to determine how events should be identified, interpreted, defined, and recorded on the financial statements?



What would happen if it was left up to each individual manager to decide what and how business events should be defined and recorded on the financial statements? In other words, are the same events described by two different people ever told exactly the same way?

During this discussion, we should explain to students the purpose of different accounting frameworks, which in simple terms can be thought of as “rules/guidance/instructions” for what and how management should identify, interpret, define, and record on the financial statement events that affected the business. We can also point out that simply stated, the purpose of conducting an audit of financial statements is to “check” and issue a written opinion whether the “story book” correctly describes the events that took place during a specific time period and if management correctly followed an acceptable accounting framework when it created the financial statements. In other words, are events that took place and affected the business correctly (or truthfully) described in the story book? We initially use the words “correct/truthfully” as students usually struggle with the concept of “fair presentation” and “materiality,” which are explained later during this and other lectures. In this chapter students for the first time come across the term “internal controls.” We usually demonstrate what this term means through a simple class exercise. We ask one student to go around the class and count all of the chairs and tables and record the count results down on paper. We then instruct a second student to enter the count results into an Excel spreadsheet; however, before the numbers are keyed, we ask the student to purposely make a keying entry error. We then demonstrate a simple internal control by asking a third student to review and compare the keyed numbers against the count sheet (the control process allows the reviewer to identify the erroneous entry). This simple example allows us to demonstrate to students how errors can occur during information processing and how control activities, like a review, can help identify such errors.

Chapter 4: Audit Responsibilities and Objectives

We can then point out that without the internal control (review), the error would not have been identified and the table or chair inventory would have been incorrectly presented on the financial statements. We can refer back to the mid-term exam example, and ask the students to describe the internal control process that they would like the instructor to perform before publishing the exam grades online. (Review to make sure the posted grades are accurate.) After students understand the meaning of internal controls and the purpose of financial accounting frameworks, we then explain that the responsibility for adopting sound and appropriate financial reporting framework and corresponding accounting policies, maintaining adequate internal control, and making fair representations in the financial statements rests with management rather than with the auditor. Management is responsible for ensuring that information presented on the financial statements is captured, processed, and presented correctly. In other words, management is responsible for writing the “story book.” We can once again remind students that auditors are only responsible for “checking” the “correctness/truthfulness” of information in the “story book.” We still use here the words “correctness/truthfulness” until we introduce to students the concept of management assertions.

Instructors may wish to show the following videos: https://www.youtube.com/watch?v=pkKO9ZNyOIc KPMG video describing “what is Audit?” https://www.youtube.com/watch?v=M4KODhNVoo4 A video prepared by the Institute of Chartered Accountants of Australia describing “The Audit Process.”

LO 2 Responsibilities of Those Charged with Governance We can explain that corporate governance is a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (shareholders) elect a board of directors to provide oversight of the organization’s activities and to ensure accountability. A number of students are confused by the concept of corporate governance and get the impression that every business must have a board of directors and an audit committee. It is important to clarify and mention that the levels of corporate governance will very much depend on the size of the company, and that most small private companies may not have a board of directors or an audit committee.

LO 3 Auditor’s Responsibilities The overall objectives of the audit of financial statements form the foundation for the subsequent chapters. Students who at this point fail to understand these objectives usually

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

struggle in the course as they are unable to understand the purpose behind the work performed by auditors. It is recommended that we spend a few extra minutes to explain to students the meaning behind some of the terminology used in this part of the textbook. The following questions can help:      

What is reasonable assurance? Why can’t the auditors provide absolute assurance about the information presented on the financial statements? What does it mean for information contained within the financial statements to be free from material misstatement? What is the difference between fraud and error, and why is that important? Why does an auditor express an opinion? Why is this necessary? What is professional skepticism? Teaching Tip: Auditing in Action 4-1 is great to use as an example in the discussion of fraud and the auditor’s responsibilities when it comes to detecting financial statement fraud.

The following is an example of how we can explain the concept of materiality. Start the discussion by asking students: What is materiality? Most students will simply recite the definition from the book, without understanding what it means. To demonstrate how a material error in information can change or influence the decisions of an individual, we can ask students if they would respond to an advertisement for an entry level accounting position that offered an annual salary of $50,000. Most students would most likely be enticed by the salary information on the job ad and apply for the position. We then inform students that the information presented on the job ad actually contained a misprint error and in fact the position only offers an annual salary of $500. We then again ask the students how many would have applied for the position knowing that the actual salary is only $500. (The number of students should be lower). We can then point out that the error was material for the students that change their original decision and would no longer be interested in applying for the job. This same example can be continued and used to demonstrate an error that most students would consider not material. We inform students that the actual wage is $45,000 and therefore the misprint error was only $5000. Again, we ask the students if they would apply for the position. (It is assumed that most would still be interested in a job that paid $45,000.) It is important that we highlight how information impacts decision making and leads its users to undertake actions. The same concept applies to information presented on the financial statements, or an exam grade posted online. We point out that similar to a job ad, financial statements are also a medium to communicate information. Just like the students used information on the job ad to decide and apply for the job, others read information on the financial

Chapter 4: Audit Responsibilities and Objectives

statements to make business decisions or investments. What is important to highlight is that materiality is a measure that is difficult to quantify and requires professional judgment. It is useful to once again point out that just like with the job ad example, there is a risk that information presented on the financial statements may contain errors and that’s why the purpose of auditing is to “check” this information. In other words, information influences people’s decisions and actions. Information that’s incorrect can lead people to make bad decisions or wrong actions. An auditors’ job is to check information so that people don’t make decisions or act upon incorrect information. Teaching Tip: For a further explanation of some of the key audit concepts, you may refer the students to “Still Confused? Read This.” New in this edition of the textbook, in each chapter we include conversations involving various audit team members of an audit client — Hillsburg Hardware Limited. Each of these conversations includes an explanation of some key audit concepts and illustrates how they apply to an actual audit engagement. In Chapter 4, we explain who is supposed to correct errors found in the financial statements – management or auditors.

Instructors may wish to show this video https://www.youtube.com/watch?v=7AIELv-KMDc&t=16s It’s an excerpt from CBS 60 Minutes. The video profiles Barry Minkow who fooled auditors, investment bankers etc. to create and list on the New York Stock Exchange a fraudulent company called ZZZZ Best.

We use the example in the Teaching Tip below to discuss with students the auditor’s responsibility for identifying fraud and error and responsibility to consider client’s noncompliance with laws and regulations. Teaching Tip: The following is a link to a news article in the Financial Post related to the Volkswagen emission scandal: http://business.financialpost.com/news/transportation/epa-wants-volkswagen-fixthat-doesnt-hurt-vehicle-owners-were-not-there-yet We also highlight the limitations of EPA’s testing, which only tested passenger vehicles’ emissions in a lab setting and not in real-world driving situations. Due to this limitation, EPA’s test could only detect errors and not fraud, as only testing the vehicles in real-world driving conditions would allow for the detection of fraud committed by Volkswagen. We also discuss the possibility that Volkswagen’s management was aware of the fact that EPA only tested passenger vehicles in a lab setting. This knowledge allowed Volkswagen to circumvent the limited test feeling confident that the

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

vehicles would not be tested in real-world driving situations. We can link this discussion to financial statement audits and point out the risks associated with auditors sharing the details about their audit procedures with management.

LO 4 Framework for Professional Judgment In this part of the lecture we discuss professional judgment and highlight that it is a rigorous process (analytical, systematic, and prudent) based upon ethical principles (integrity, truthfulness) that ensures that auditors fulfil their professional responsibilities (protect the public interest). In simple words, we can also explain that professional judgment “happens/occurs” in the auditor’s mind and is strongly influenced by the auditor’s past experiences and, to some extent, personality. We then provide an overview of the professional judgment framework:



Identify and define the issue – Students are likely familiar with this concept from other courses but they often think of it as a mechanical exercise in that the issue is easily identifiable. However, instructors can point out in “real” life auditors are rarely faced with well-structured problems as in textbooks. (If indeed the issue is easily identified, then using a professional judgment framework is perhaps not necessary.) Framing the problem sets up what we think is important or unimportant, relevant or irrelevant. For new auditors who will often be given pre-assigned tasks, it is important to step back and ask what is the purpose of the audit procedures – this is a key way to get at the big picture.

Teaching Tip: Instructors can ask students how do frames affect the audit process and professional skepticism? Potential questions could include – How would your approach to evaluating audit evidence differ if the client is untrustworthy versus trustworthy (you can relate this discussion to Audit in Action 4-2, which explains how Deloitte auditors did not properly exercise professional judgment on the Livent audit) or if you are told to expect no errors versus numerous errors? Students should be able to see the connection with professional scepticism and the importance of being aware of one’s frame.

This video, available on YouTube, is an entertaining and highly effective way of illustrating the importance of framing the problem. https://www.youtube.com/watch?v=WDoEO6kSVEk

Gather facts and information – This is a key part of the audit process and instructors can relate to any parts of the audit process – such as: understanding the clients’ business, assessing risks, gathering and evaluating audit evidence. An important point to raise here is that the planning of the audit plays a crucial role in setting the parameters for sufficient and appropriate evidence.

Chapter 4: Audit Responsibilities and Objectives

Perform analysis and evaluate alternatives – Auditors should avoid selecting the first available alternative (this applies to students as well) and should consider and evaluate all alternatives. This is often a difficult task for auditors to perform since the client has already prepared an analysis and the auditor in his/her “checking” can be influenced by the client’s analysis (this is referred to as anchoring). For students, this stage can be overwhelming if there is a large volume of information. It is important to stress that they will need to narrow the possible outcomes and focus on those that require more careful consideration. (In case analysis, we stress - try to confine your analysis to case facts). Reach and document conclusions - This is what is referred to as the “stand back” point of view, when the auditor considers how the evidence is related to other key facts and the big picture. Instructor Note: Instructors may wish to refer to Table 4-1 to highlight the role of documentation and how by asking these questions, one can improve their judgment process.

LO 5 Professional Skepticism We begin this part of the lecture by asking students: What are the qualities of professional scepticism? Table 4-1 can help with this discussion. In our experience when using these concepts in class, students tend to be highly engaged. There are lots of activities available to demonstrate these various judgment tendencies and by using some simple tasks, often students become much more aware of these traps. (See additional resources listed below). This part of the chapter highlights some common biases or judgment traps that can impede the quality of auditors’ judgment.  Confirmation bias (this is an easy one to relate to students)  Overconfidence – The example provided in the textbook is relying upon an expert’s opinion unquestioningly. Students can easily relate this to their own experiences – overconfident in their ability to perform in exams or in the reliability of some information they are using to make a decision.  Anchoring – The two examples in the textbook, anchoring around the client’s calculations (say in developing a provision for doubtful accounts) and relying upon last year’s audit approach (which auditors often refer to as SALY – Same As Last Year). Instructors may wish to ask students what kind of strategies can overcome this bias? Answer - Discussing with colleagues, documenting the decision process and rationale.  Availability – The textbook discusses this in the context of the rare occurrence of fraud and because many auditors have not had direct experience with fraud, it is difficult to consider this as a possibility when assessing fraud risk.  Various other traps – Self-serving bias and motivated reasoning, and rush to solve are other relevant judgment traps. Instructor Note: An important point to highlight is that many characteristics of the audit environment (tight deadlines, overwhelming level of information, becoming familiar with the client) can all contribute to judgment traps. A key point to highlight is that when auditors are faced with a cognitive minefield, awareness and consultation with colleagues can help auditors and students avoid judgment traps.

Teaching Tip: The best way to teach this material is to provide lots of examples of judgment traps – either with everyday or audit-related examples. The purpose of the framework and judgment traps is not for students to memorize, but rather to expose them to these concepts to help them increase

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

their confidence in their decision-making and to enhance their thoroughness or rigour in their analyses. An Example to use: Availability and Confirmation – Ask students to imagine that they are responsible for reviewing inventory and they notice a sharp increase in the ending balance. They follow up and the inventory manager explains that is a result of a favourable deal on raw materials. Is it OK to accept this explanation (availability) and find information that supports the explanation (confirmation)? This can help impress upon students the need for professional skepticism and that the auditor should consider other potential explanations (ie: other sources of evidence). Framing and Anchoring – Ask students to consider how a checklist or audit program can frame the problem for them (perhaps focus on the goal of completing the checklist rather than critically examining the evidence. It may also inhibit their consideration of alternative forms of evidence).

Additional Resources for Teaching Professional Judgment: CPA Canada has developed a series of videos available on YouTube, illustrating the CPA Way (A methodological framework for solving professional problems). Instructors may find these useful for illustrating the decision process. Fay, R. and Montague, N. (2015) Witnessing your own cognitive bias: A compendium of classroom exercises. Issues in Accounting Education. 30(1): 1334, is a useful teaching resource for instructors to demonstrate five common judgment biases (it requires approximately 50 minutes). The examples that they use are not audit-specific but are effective in vividly highlighting the concepts to students. KPMG and Ernst & Young have developed professional judgment material, which includes slides, instructional videos, and cases that they make available to university instructors. Each firm’s material takes a slightly different approach to professional judgment. Both provide templates to help students organize their analysis. Instructors may sign up and have access to the various teaching modules.

LO 6 Financial Statement Cycles The key concept here is to explain to students that audits are performed by dividing financial statements into smaller segments or components. A common way to divide an audit is to keep closely related types (or classes) of transactions and account balances in the same segment.

Chapter 4: Audit Responsibilities and Objectives

This is called the cycle approach. For example, sales, sales returns, cash receipts, and chargeoffs of uncollectable accounts are four classes of transactions that cause accounts receivable to increase and decrease. We then highlight to students that the cycle approach makes the audit more manageable and aids in the assignment of tasks to different members of the audit team. Teaching Tip: For a further explanation of some of the key audit concepts, you may refer the students to “Still Confused? Read This.” New in this edition of the textbook, in each chapter we include conversations involving various audit team members of an audit client — Hillsburg Hardware Limited. Each of these conversations includes an explanation of some key audit concepts and illustrates how they apply to an actual audit engagement. In Chapter 4, we explain that “a cycle approach has nothing to do with a bicycle” but rather it is used to help with organizing, dividing, and assigning audit work.

We can refer to Figure 4-3 and Figure 4-4 to explain to students how transactions flow into journals and financial statements and the relationship between transaction cycles. As part of this discussion, it is important that we ensure students understand all the terms used in Figure 4-3, as some students may not be familiar with the term “journal” or “subsidiary records.” We can then refer to Table 4-3 and point out to students some of the key accounts that are included in the cycles applied to Hillsburg Hardware Limited. Teaching Tip: Question 4-26 is great to use to reinforce how accounts in the trial balance are linked to transaction cycles.

LO 7 Management Assertions We find that students usually have a difficult time in understanding audit objectives and management assertions without linking it to something they are familiar with. That’s why to help students with the remaining learning objectives in this chapter, we also refer to figures found in Chapter 12, Figure 12-8 (Substantive Tests of Detail for Revenue) and Chapter 14, Figure 145 (Assertions and Relevant Substantive Tests for the Inventory Cycle). These Figures are based on simple examples and are great to introduce students and explain what are management assertions, audit objectives and procedures. As we cover Figures 12-8 and 14-5, we can relate these two figures with Figure 4-5 to highlight why the most efficient way to conduct audits is to obtain some combination of assurance for each class of transactions and for the ending balance in the related account. Teaching Tip: For a further explanation of some of the key audit concepts, you may refer the students to “Still Confused? Read This.” On page 113 we provide an easy-to-understand explanation of assertions that students should find helpful.

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Using Figures 12-8, 14-5 and Table 4-4, Figure 4-6 and Figure 4-7, we explain to students what management assertions are. We highlight that up to this point, to keep things simple and easily understandable, we said that the objective of an audit is to “check” if information on the financial statements is “correct/truthful.” We then ask students:  

How would you check if information is correct/truthful? What does it mean for information to be “correct/truthful”?

We then point out that in place of the word “correct/truthful” we introduce the concept of management assertions. It is important to highlight that assertions do not only relate to information presented on financial statements, but in fact they relate to all different types of information presented through different information channels. We can refer to the example in the Teaching Tip below to highlight this point.

Teaching Tip: The following is a link to a report issued by the Office of the Auditor General of Ontario on a newly implemented Social Assistance Management System (“SAMS”): http://www.auditor.on.ca/en/reports_en/en15/3.12en15.pdf SAMS is used by the government of Ontario to distribute annually about $7 billion in social assistance payments to approximately 900,000 Ontarians. In the report on page 477 we can find the following excerpt: “The Executive Committee (which was responsible and made the decision to launch SAMS) was not aware of the full extent of SAMS’ pre-launch issues…. its decision to launch SAMS was not based on complete information because the project team did not tell the Committee about the following with respect to SAMS’ readiness:    

that the actual number of serious defects SAMS contained was in fact higher; that less user acceptance tests were actually conducted and their results were lower; that some of the interfaces were not tested; that converted data was not fully tested.

This example is a good illustration how information influences decision making. In this case the Executive Committee used an incomplete set of information and made a wrong decision to launch a computer system that was not ready for use. We can highlight to students that the project team purposely did not tell the Committee about problems with the system, which violated the assertion of completeness.

Chapter 4: Audit Responsibilities and Objectives

Time permitting, the instructor may wish to discuss the consequences of The Committee making a decision on a set of incomplete information: “As of October 2015, the consequences of launching a defective system so far included a total of about $140 million in benefit calculation errors....., the issuance of many letters and tax information slips with incorrect information, some of which may never be resolved. In addition, staff spent much of their time performing “workarounds” to deal with complex errors that SAMS was generating, and so spent less time serving clients. SAMS still cannot generate reports with accurate information, which affects the ability of the Ministry and municipalities to administer social assistance programs.”

Students usually struggle with understanding the difference between the assertions of completeness vs. existence. To help them understand the difference, we can do the following simple class exercise: Without any of the students noticing, place a $10 dollar bill into your pocket. On a large piece of paper write the following “I have $9 in my pocket” on the other side of the page write “I have $15 in my pocket”. Show the $15 dollar sign to students and ask them the following question: Based on what’s written, how much money do I have in my pocket? (Students should answer $15 dollars, because that’s what the sign says). Pull out the $10 bill from your pocket and tell the students that’s all the money in the pocket. Ask them what is wrong with the information presented on the page? Explain to students that information on the page made them believe and think that there was an extra five dollars, where in fact this $5 dollars did not exist. Therefore, the assertion of existence was violated. Now repeat the same steps but show the other side of the page. Does $9 completely represent all the money that’s in the pocket? The answer is no. Therefore, the information is incomplete as $1 exists but is not accounted for. The assertion of completeness was violated. We highlight to students that this example applies directly to the cash balance on the financial statements and that the concepts represented by this simple example actually applies to all other account balances and the information presented on financial statements. We can remind students again that financial statements are nothing more than an information medium and that information may overstate what actually happened (existence) or may not capture everything that has happened (completeness). To even better help the students understand and relate to the concept of assertions in simple terms, we can explain that there are three ways to lie or misinform. 1. Exaggerate the truth/overstate facts or what has occurred (violates the assertions of existence or occurrence)

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

2. Not tell the whole truth/understate/hide facts or what has occurred (violates the assertion of completeness) 3. Assert that something belongs to me (it exists), where in fact it doesn’t belong to me or vice versa (the concept of title, obligation) (violates the assertion of rights and obligations). We can then explain that the assertions of classification and cut-off relate to how events/transactions are defined (asset vs. expense) or categorized in terms of time (current vs. long-term, 2021 vs 2022). For example, when a business spends money, whatever it receives back in return can be defined (classified) as either an asset or an expense. If the transaction is incorrectly defined (it is recorded as an asset (capitalized) instead of an expense), this violates the assertion of classification. However, as a result, assets are overstated (existence violated) and expenses are understated (completeness violated). Similarly, if the event or transaction is recorded in the wrong time period, for example in 2021 instead of 2022, it affects cut-off; however, the end result is an overstatement (existence violated) in 2021 and an understatement of what has happened (completeness violated) in 2022. In simple terms, we can again remind the students that as part of the financial statement audit, the auditor “checks” if management has correctly/truthfully (assertions) defined, classified, and recorded events and transactions that have happened during a specified time period. We can also remind the students that:  Instructions on how to define, classify, and record events and transactions can be found in the accounting standards (IFRS/ASPE).  Instructions on how to behave as a CPA can be found in the CPA Ontario Code of Professional Conduct.  Instructions on how to “check” can be found in the Canadian Auditing Standards. Teaching Tip: Question 4-28 is great to use to reinforce how accounts in the trial balance are linked to transaction cycles.

LO 8 An Overview of the Audit Process We use Figure 4-7 to provide an overview of the audit process, pointing out that an audit has a beginning and an end. Just like any other process, we explain that the audit it is made up of “steps” or “stages” organized in a logical order. Auditors must complete each step or stage before moving on to the next one. This helps to ensure that sufficient and appropriate evidence is gathered by auditors to arrive at an appropriate conclusion about the information presented in financial statements. In other words, adhering and following the audit process helps to ensure that the audit is done correctly. We then provide a high-level overview of each stage of the audit and time permitting explain the timing and duration of a typical audit. Many students lack auditing experience and are unfamiliar with the timing of audits. Using a timeline, we explain that financial statement audits are usually conducted during February, March, and April, and that their duration depends on auditees’ size and complexity and typically last a few weeks.

Chapter 4: Audit Responsibilities and Objectives

Lecture Review This chapter described the responsibility of both management and those charged with governance for the financial statements and internal control, and the auditor’s responsibility to audit the financial statements. This chapter emphasized the critical importance of maintaining an attitude of professional skepticism and highlighted a professional judgment process to help auditor decision making. The chapter also discussed the cycle approach and management assertions and the way the auditor subdivides the audit to assess significant risks and develop an appropriate risk response. The auditor’s risk response addresses the risk of misstatement at the overall financial statement level and at the account and assertion level.

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

Suggested Homework Problems Learning Objectives

Review Questions

LO 1

4-2, 4-11

LO 2

4-2

LO 3

4-1, 4-2, 4-3, 4-4, 4-5

LO 4

4-6, 4-7, 4-8

Multiple Choice Questions

Discussion Questions and Problems

Hillsburg Hardware

4-22

4-18, 4-19

4-21, 4-22, 4-23

4-29, 4-30, 4-31

4-25

4-31

LO 5

4-31

LO 6

4-9, 4-10

LO 7

4-11, 4-12, 4-13, 414, 4-15, 4-16 4-17

LO 8

Professional Judgment Problems and Cases

4-26 4-20

4-27, 4-28 4-24

4-32 4-29, 4-30

Chapter 5 Audit Evidence Overview In this lecture, we discuss the types of evidence decisions auditors make, the evidence available to auditors, and the use of that evidence in performing audits and documenting the results. We also talk about the knowledge and skills used by auditors to accumulate sufficient appropriate evidence so that on every audit, standards of the profession are met. We conclude the lecture by highlighting that new technologies can improve the quality of audit evidence, but can also create new opportunities for evidence to be compromised.

Learning Objectives 1. Understand the purpose and types of audit evidence used throughout the audit process. 2. Explain the three audit evidence decisions to determine what evidence to gather and how much to accumulate. 3. Use professional judgment to determine the degree of persuasiveness of audit evidence. 4. Describe the types of audit procedures for gathering audit evidence. 5. Design analytical procedures for the various phases of the audit process. 6. Identify how auditors incorporate audit data analytics and other advanced technologies in the audit. 7. Understand the purposes of audit documentation and prepare organized audit documentation. 8. Understand and apply professional skepticism to evidence and documentation decisions.

Chapter Opening Vignette: “CEO Confesses to Falsifying Documents to Hide Fraud for Over 20 Years” The vignette describes how Russell Wasendorf, chief executive officer of Peregrine Financial Group (PFG), who was found unconscious in his car with a tube running from the exhaust pipe into the vehicle, was able to commit fraud worth about $215 million. Using a computer, scanner, and Photoshop, Russell was able to make “very convincing forgeries” of bank statements and official correspondence from the bank that fooled the auditors. Eventually a decision by the National Futures Association to switch from hard copies to electronic statements for regulatory filings contributed to the discovery of the fraud. (Note: Instructors may wish to discuss with students the following questions: What is sufficient appropriate audit evidence to verify the cash balance? What else could the auditors have done to verify PFG’s cash balance?)

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

LO 1 Nature of Audit Evidence We start the lecture by explaining to students that most of the auditor’s work in forming an audit opinion consists of obtaining and evaluating audit evidence. We explain that audit evidence is information used by the auditor in arriving at conclusions upon which the audit opinion is based. In simple terms we explain that the auditor gathers evidence to “check” if what is being reported by management in the financial statements “really” happened and that everything (all events and transactions) are being included and reported correctly. We continue to use this simple terminology to help the students more easily relate to and understand some of the key concepts of auditing. We then spend a few minutes providing examples of the different types of records/information generated by different events and transactions. For instance, we can ask the students if anyone prior to class purchased a cup of coffee. Assuming that someone has, we then ask the students to think of the ways and the evidence that could be used to check if the coffee purchase really happened. (Some examples include: directly confirm with the student who purchased the coffee, ask for a receipt, look at the credit card statement (if purchase made on credit), inspect the coffee cup (if available)). We can then ask the students if it is easier to check if an event or a transaction really happened (occurrence) or if all transactions and events that actually took place are included in the financial statements, in other words, if nothing is missing (completeness). During the discussion, we highlight to students that the starting point to check if something has really happened are the financial records, whereas the starting point to check if nothing is missing from the financial statements are the documents/information created by the event or transaction. We can point out that it is usually more difficult to check for completeness. We then use Figure 5-1 to provide an overview of evidence that auditors gather throughout the audit process.

LO 2 Audit Evidence Decisions Students usually struggle with formulating proper procedures; that’s why it is important to highlight that each procedure should consist of two components: first, “why” the procedure is being performed and second, a detailed description of “how” the assertion and account balance will be verified. For instance, To verify the existence of cash, confirm stated balances directly with client’s financial institution by sending bank confirmations Why How We point out to students that one of the reasons why audit procedures need to be so detailed is so that anyone on the audit team can understand what work needs to be done. In other words, audit procedures are written instructions that audit team members should be able to understand

Chapter 5: Audit Evidence

and follow to “check” a specific account and an assertion. A poorly written audit procedure is equivalent to missing pages in an Ikea furniture assembly instruction booklet. Without the pages, just like with poorly written procedures, it is difficult, sometimes impossible, to complete the required task.

To help students understand the evidence decisions auditors must make, we use Figure 12-8 found in Chapter 12 and Figure 14-5 found in Chapter 14. We use the figures as a basis for discussing the following questions:  

Which risks could result in a risk of material misstatement at the assertion level? Which audit procedures should be used (their “nature”)?

For instance, in Figure 14-5 we can highlight specific risks associated with verifying the valuation of diamonds. Instructors may also wish to discuss other examples of inventory where there is a higher risk of misstatement in measurement of quantity (existence and completeness), for instance, cement or scrap metal. Instructors may wish to ask students to think of ways to measure the quantity of cement or scrap metal.

Using real-life examples, we also discuss how risk factors into the following audit evidence decisions:   

What sample size to select for a given procedure (the “extent” of a test)? Which particular items to select from the population? When to perform the procedures (the “timing”)?

It is important to highlight that “risk,” or the level of uncertainty that financial statement information may be incorrect, is what primarily influences the auditor’s decisions as to what type of evidence needs to be gathered and how much evidence needs to be obtained. In simple terms, we explain that risk is the main factor influencing the auditor’s decision as to what to check, how much to check, and when to check it. Students sometimes presume that all the information presented on financial statements is a hard number like the cash balance. We remind them that a significant portion of financial statement information is in fact based on assumptions and estimates.

LO 3 Persuasiveness of Evidence We use a class exercise to demonstrate how persuasiveness of evidence factors into auditor’s decision making. Instructors may wish to use the following sample exercise. Ask students the following questions: Assume that you have a strong and trusting relationship with your parents. What evidence would they gather to verify that you have gone to see a movie on Saturday night and have not instead gone to a bar? (Your parents don’t like when you go out to a bar.)

Instructor’s Resource Manual for Auditing, 15Ce, by Arens/Elder/Beasley/Hogan/Jones

We then ask how many students feel that verbal evidence alone (them telling their parents the title of the movie, start time, and the location of the movie theater) would be sufficient evidence. Reminding the students that they have a strong and trusting relationship with their parents, we ask how many students’ parents would find verbal evidence insufficient and would request evidence of higher quality, for example for the student to provide a ticket stub? We now ask the students what evidence their parents likely would like to see if the relationship lacks trust. If the parents have a strong suspicion that the student has gone to the bar instead of the movie theater, would the previously obtained evidence no longer be sufficient? (In this situation, students should say that their parents would require higher quality evidence.) We then point out that evidence of higher quality in this situation could include:  

Review of online bank transactions (on their student’s Smartphone) to verify the purchase of the movie ticket. Review of security video at the movie theater, confirming the time when the student entered and exited the movie theater (if access was permitted).

The point of this exercise is to highlight the relationship between risk and evidence appropriateness. Evidence that may in one situation be appropriate, in another situation due to an increased level of risk (example, lack of trust) may not be. Another important point to highlight is the relationship between evidence quality and cost. For instance, reviewing video surveillance may be the most reliable type of evidence but it would probably also be the most time-consuming and costly evidence to obtain. We then use other real-life scenarios to demonstrate how timeliness and relevance impacts evidence appropriateness. Teaching Tip: Statements made by the Ontario Securities Commission in the matter of Ernst & Young’s failed Sino Forest audit provide an excellent real-life example when the auditor fails to gather sufficient audit evidence and fails to exercise professional skepticism. The following are key excerpts that can be used to facilitate a great class discussion: Ernst & Young were the auditors of Sino-Forest between August 2007 and April 2012. Ernst & Young did not obtain sufficient appropriate audit evidence with respect to the ownership and existence of the Timber Assets. Some of these limitations were acknowledged by Ernst & Young staff. For example, in an e-mail exchange between the members of Ernst & Young’s audit team, one auditor posed the question “[h]ow do we know that the trees that Poyry is inspecting (where we attend) are actually trees owned by the company? E.g. could they show us trees anywhere and we would not know the difference?” Another auditor answered “I believe they could show us trees anywhere and we would not know the difference…”.

Chapter 5: Audit Evidence

Ernst & Young also used a confirmation procedure to address the risk of fictitious distributors and suppliers in the IPO Audit. To carry out this procedure, Ernst & Young obtained addresses for selected distributors and suppliers. During the IPO Audit, Ernst & Young sent a total of 159 letters (referred to as “confirmations”) from Zungui’s premises to the addresses provided in order to confirm the distributors’ account receivable balances and the suppliers’ account payable balances as at current and prior period-end dates. Despite the fact that multiple confirmations were sent to addresses that were incomplete and that CBI had not been able to verify, 158 confirmations were returned. These confirmations confirmed the exact transaction balances, with no reconciling items noted. Moreover, nearly all of the confirmations were signed within seven days of their mailing. For the 2010 Audit, Ernst & Young sent 42 confirmations. All of the confirmations were returned and they confirmed the exact transaction balances, with no reconciling items noted. Moreover, nearly all of the confirmations were signed within seven days of their mailing. As a result of substantially all confirmations being returned in an unusually short timeframe without reconciling items, Ernst & Young ought to have considered the quality of the audit evidence obtained from the accounts receivable and accounts payable confirmations and to reconsider whether this procedure could be relied upon to address the risk of fictitious distributors and suppliers. Failure to Properly Structure the Audit Team The failures outlined above were facilitated by Ernst & Young’s failure to properly structure its Sino-Forest engagement team. Many Sino-Forest source documents were produced only in Chinese. Ernst & Young, however, failed to have these and other key documents translated into English. Ernst & Young’s audit team comprised both Chinese speaking and non-Chinese speaking staff. Several of the senior partners involved in the audits of the Material Financial Statements, however, were unable to read or speak Chinese. Ernst & Young’s non-Chinese speaking staff relied on its Chinese speaking staff to provide informal translations of important source documents. As a result, the nonChinese speaking staff were often not aware that important information was missing from some of Sino-Forest’s key documents. Links to OSC documents: http://www.osc.gov.on.ca/en/Proceedings_soa_20121203_ernst-young.htm http://www.osc.gov.on.ca/en/Proceedings_set_20140923_ernst-young-llp.htm