10e auditing, assurance services & ethics

Auditing, Assurance Services & Ethics in AustraliaAn Integrated Approach

Arens Best Shailer Fiedler Elder Beasley

10e

A01_AREN9138_10_LT_FM.indd 3 8/4/16 4:53 PM

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Authorised adaptation from the United States edition, entitled Auditing and Assurance Services with ACL software CD, 15th edition, ISBN: 0133125637 by Arens, Alvin A.; Elder, Randal J.; Beasley, Mark S., published by Pearson Education, Inc, Copyright © 2014 published by Pearson Education, Inc, publishing as Prentice Hall, Copyright 2014

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National Library of AustraliaCataloguing-in-Publication Data

Creator: Arens, Alvin A., author.

Title: Auditing assurance services and ethics in Australia: an integrated approach/Alvin Arens, Peter Best, Greg Shailer, Brenton Fielder, Randal Elder, Mark Beasley.

Edition: 10th edition.

ISBN: 9781488609138 (paperback)

Notes: Includes index.

Subjects: Auditing—Australia—Textbooks.

Other Creators/Contributors: Best, Peter J, author. Shailer, Greg, author. Fielder, Brenton, author. Elder, Randal, author. Beasley, Mark S, author.

Dewey Number: 657.450994

Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them.

Pearson Australia Group Pty Ltd ABN 40 004 245 943


Contents in full

Preface xiVisual preface xivAbout the authors xviii

PART 1 The AudiTing PRofession 1

Chapter 1 Demand for audit and assurance services 3

Assurance services 5Economic demand for auditing 10Causes of information risk 11Nature of auditing 12Distinction between auditing and accounting 14Types of audits 15Types of auditors 16Public accounting firms 19Professional accounting bodies 21Australian Auditing Standards 22International auditing standards 25Quality control 26Corporations Act 2001 28Impact of e-commerce on public accountants 28

Summary 30Questions and problems 30Online issue 38

Chapter 2 Auditors’ legal environment 39

Audit regulation 41Statutes and auditors’ liability 41Criminal liability 49Legal concepts affecting liability 50Liability to clients 51Liability to third parties under common law 56Fraud and error 62Managing individual legal liability 63

Summary 64Questions and problems 64Online issue 70Appendix: Chronological schedule of leading cases

affecting auditors’ legal liability in Australia 71

Chapter 3 Audit quality and ethics 73

Audit quality and corporate governance 75Expectations gap 77Auditor competence 78Ethics 79Ethical dilemmas 81Code of Ethics for Professional Accountants 83Independence 86Aids to maintaining independence and

integrity of the audit 97


Chapter 4 Audit responsibilities and objectives 108

Objective of conducting an audit of financial statements 110

Management’s responsibilities 110Auditor’s responsibilities 111Financial statement cycles 116Setting audit objectives 121Management assertions 122Transaction-related audit objectives 125Balance-related audit objectives 127Presentation and disclosure-related

audit objectives 130How audit objectives are met 130


Chapter 5 Audit evidence 142

Nature of evidence 143Audit evidence decisions 144Persuasiveness of evidence 146Types of audit evidence 149Analytical procedures 158Five types of analytical procedures 160Using statistical techniques and

computer software 165


Summary 165Questions and problems 166Online issue 177Appendix: Common fi nancial ratios 178

PART 2 The AudiT PRocess: decisions And PlAnning 181

Chapter 6 Audit planning and documentation 183

Planning 185Accepting audit engagement and performing

initial audit planning 186Understanding the client’s business and industry 191Assessing client business risk 196Performing preliminary analytical procedures 197Purposes of audit documentation 199Content and organisation of audit fi les 200Eff ect of technology on audit evidence and audit

documentation 206

Summary 208Questions and problems 209Online issue 217Case study: Integrated case application—

Pinnacle Manufacturing: Part I 217

Chapter 7 Materiality and risk 221

Materiality 223Materiality for fi nancial statements as a whole 224Determine performance materiality 227Estimate misstatement and compare with

preliminary judgment 230Audit risk 232Audit risk model for planning 232Assessing acceptable audit risk 236Assessing inherent risk 239Relationship of risks to evidence and factors

infl uencing risks 242Relationship of risk and materiality to

audit evidence 246


Pinnacle Manufacturing: Part II 262

Chapter 8 Internal control and control risk 264

Client and auditor concerns 265Eff ect of information technology on internal

control 268Components of internal control 269Procedures to obtain an understanding of

internal control 279Assessing control risk 284Tests of controls 290


Pinnacle Manufacturing: Part III 303

Chapter 9 Fraud auditing 306

Types of fraud 307Conditions for fraud 309Assessing the risk of fraud 312Corporate governance oversight to reduce fraud

risks 316Responding to the risk of fraud 321Specifi c fraud risk areas 323Responsibilities when fraud is suspected 329


Chapter 10 The impact of information technology on the audit process 339

How information technologies enhance internal control 341

Assessing the risks of information technology 341Internal controls specifi c to IT 343Impact of IT on the audit process 349Auditing with use of the computer 352Using a microcomputer as an audit tool 362Issues for diff erent IT environments 365

Summary 370Questions and problems 370Online issue 382Appendix: Other computer-assisted audit

techniques 382

viiCONTENTS IN FULL


Chapter 11 Overall audit plan and audit program 384

Types of tests 386Selecting which types of tests to perform 391Impact of information technology on audit testing 395Evidence mix 395Design of the audit program 396Relationship of transaction-related audit

objectives with balance-related and presentation and disclosure-related audit objectives 404

Summary of the audit process 406


Chapter 12 Audit of the sales and collection cycle: Tests of controls and substantive tests of transactions 422

Accounts and classes of transactions in the sales and collection cycle 423

Business functions in the cycle and related documents and records 424

Methodology for designing tests of controls and substantive tests of transactions for sales 429

Sales returns and allowances 439Methodology for designing tests of controls and

substantive tests of transactions for cash receipts 439

Audit tests for the write-off of uncollectable accounts 443


PART 3 The AudiT PRocess: APPlicATion 457

Chapter 13 Completing the tests in the sales and collection cycle: Accounts receivable 459

Methodology for designing tests of details of balances 460

Designing tests of details of balances 466

Confi rmation of accounts receivable 472Developing the ‘tests of details’ audit program 478


Chapter 14 Audit sampling 493

The role of audit sampling 494Representative samples 495Statistical vs non-statistical sampling and

probabilistic vs non-probabilistic sample selection 496

Application of statistical and non-statistical sampling 497

Non-probabilistic sample selection methods 498Probabilistic sample selection methods 499Sampling for deviation rates and

misstatements 500Application of non-statistical audit sampling 501Application of non-statistical audit sampling

for tests of controls and substantive tests of transactions 502

Non-statistical sampling for tests of details of balances 513

Statistical audit sampling 519Application of attributes sampling 520Monetary unit sampling 524Variables sampling 533


Pinnacle Manufacturing: Part IV 548

Chapter 15 Audit of transaction cycles and fi nancial statement balances I 551

Accounts and classes of transactions in the acquisition and payment cycle 552

Business functions in the cycle and related documents and records 553

Methodology for designing tests of controls and substantive tests of transactions 556

Methodology for designing tests of details of balances for accounts payable 562

viii CONTENTS IN FULL


Design and perform analytical procedures (phase III) 564

Design and perform tests of details of the accounts payable balance (phase III) 564

Reliability of evidence 568Business functions in the cycle and related

documents and records 571Parts of the audit of inventory 573Audit of cost accounting 575Analytical procedures 578Physical observation of inventory 579Auditing of pricing and compilation 583Integration of the tests 586Accounts and transactions in the payroll and

personnel cycle 589Business functions in the cycle and related

documents and records 590Methodology for designing tests of controls and

substantive tests of transactions 592Methodology for designing tests of details

of balances 597Perform analytical procedures (phase III) 598Design and perform tests of details of balances

for liability and expense accounts (phase III) 599

Summary 601Questions and problems 602Online issues 619Case study: Integrated case application—

Pinnacle Manufacturing: Part V 620Case study: Integrated case application—

Pinnacle Manufacturing: Part VI 621

Chapter 16 Audit of transaction cycles and fi nancial statement balances II 626

Types of cash accounts 628Cash balances and transaction cycles 629Audit of the general cash account 631Fraud-oriented procedures 639Audit of property, plant and equipment 643Audit of manufacturing equipment and related

accounts 644Audit of prepaid expenses 650Audit of accrued liabilities 650Capital acquisition and repayment cycle 652

Internal controls 653Analytical procedures 654Tests of details of balances 654Internal controls 656Audit of issued and paid-up capital 657

Summary 660Questions and problems 660Online issues 672

PART 4 The AudiT PRocess: comPleTing The AudiT 673

Chapter 17 Completing the audit 675

Perform additional tests for presentation and disclosure 677

Review for contingent liabilities and commitments 678

Make inquiries regarding litigation and claims 681Review for subsequent events 683Final evidence accumulation 686Evaluate results 688Communicate with the audit committee

and management 694Subsequent discovery of facts 696


Chapter 18 Audit reporting 706

The audit report 708Standard unmodifi ed audit report 708Audit reporting requirements of

listed companies 712Conditions requiring a departure 719Audit reports other than unmodifi ed 719Materiality 720Examples of reports 723Other reporting issues 725Impact of e-commerce on audit reporting 727


ixCONTENTS IN FULL


PART 5 sPeciAl ToPics 737

Chapter 19 Other auditing and assurance engagements 739

Assurance engagements 742Audit reports on special purpose

fi nancial reports 744Assurance services pertaining to specifi c fi nancial

information 744Assurance reports on internal controls 745Review engagements 752Audits of prospective fi nancial information 754Diff erences between performance auditing and

fi nancial auditing 757Eff ectiveness versus effi ciency 758Relationship between performance auditing

and internal controls 759Types of performance audits 759Who undertakes performance audits? 760Independence and competence of performance

auditors 761Criteria for evaluating effi ciency and

eff ectiveness 762

Phases in performance auditing 763The role of internal auditors 765Relationship between internal and

external auditors 767Public sector audits in Australia 768Auditing of Australian Commonwealth

Government agencies 769Auditing standards 772Features peculiar to the public sector 773Australia’s Clean Energy Scheme 774Assurance issues 777External auditor expertise and qualifi cations 779Guidelines and standards for conducting

external assurance engagements and preparing reports 780

Questions and problems 782Online issue 792

Index 793Rouge Clothing Company Ltd case study

x CONTENTS IN FULL


ObjectivesThe tenth edition of Auditing, Assurance Services and Ethics in Australia: An Integrated Approach is based

on the fi fteenth US edition of Auditing and Assurance Services: An Integrated Approach. It contains

numerous changes and revisions, but the principal objectives and emphasis remain unchanged from the

previous edition. It represents a conscious effort to focus on the Australian auditing environment in

terms of the current practices and standards issued by the Auditing and Assurance Standards Board

(AUASB).

The book is an introduction to auditing for students who have not had signifi cant experience in the

fi eld and is intended for either a full-year or one-semester course at the undergraduate or graduate

level. The book is also appropriate for introductory professional development courses for public

accounting fi rms, internal auditors and government auditors.

The primary emphasis in this textbook is on the auditor’s decision-making process. We believe that

the most fundamental concepts in auditing relate to determining the nature and amount of evidence

the auditor should accumulate after considering the unique circumstances of each engagement. If

students of auditing understand the objectives to be accomplished in a given audit area, the

circumstances of the engagement and the decisions to be made, they should be able to determine the

appropriate evidence to gather and how to evaluate the evidence obtained.

Thus, as the title of the book refl ects, our purpose is to integrate the most important concepts of

auditing with certain practical aspects in a logical manner to assist students in understanding audit

decision making and evidence accumulation. For example, internal control is integrated into each of

the chapters dealing with a particular functional area and is related to tests of transactions. Tests

of transactions are, in turn, related to the tests of details of fi nancial statement balances of the

accounts for the area; and audit sampling is applied to the accumulation of audit evidence rather

than treated as a separate topic. Technology, e-commerce and fraud issues are also integrated

throughout the chapters.

Features of the tenth edition

Auditing regulationsThe tenth edition incorporates recently issued auditing standards (ASAs, ASREs and ASAEs),

Accounting Professional and Ethical Statements (APESs), the Framework for Assurance Engagements,

the Explanatory Guide to AUASB Standards Applicable to Review Engagements, and guidance

statements (AGSs and GSs). It includes up-to-date referencing of relevant legislation (including the

Corporations Act 2001) and common law.

Chapter 9 on fraud auditing and expanded fraud coverageThis chapter on fraud auditing examines the auditor’s responsibility for assessing the risk of fraud and

detecting material misstatements due to fraud. The chapter includes coverage of corporate governance

and other factors that reduce fraud risk. Specifi c fraud risk areas and procedures to detect fraud are

also discussed. Additional references to fraud risks have been integrated into other chapters. The results

from the KPMG A Survey of Fraud, Bribery and Corruption in Australia & New Zealand 2012 are

incorporated within the chapter.

Preface


xii PREFACE

Increased emphasis on audit qualityThere is an emphasis on audit quality, in the context of the role of auditing in corporate governance.

The major changes in relevant regulation, including the changes to the Corporations Act 2001, are

integrated into relevant chapters.

Running case—Rouge Clothing annual reportExtracts from the annual report for the running case of the fi ctitious Rouge Clothing Company are

included as a full-colour insert at the back of the textbook. Financial statements and other information

included in the annual report are used in examples throughout the book to illustrate chapter concepts.

When Rouge Clothing is referred to in the text, a shopping bag icon is shown in the margin.

Running case—Pinnacle Manufacturing integrated case studyThe Pinnacle Manufacturing integrated case represents a larger, multi-division company, and appears

in six parts in Chapters 6, 7, 8, 14 and 15. Each part of the case is included at the end of the chapter to

which the part relates. The parts of the case are connected so that students will gain a better

understanding of how the parts of the audit are interrelated and integrated by the audit process.

Online issuesEach chapter includes Internet-based cases that require students to research relevant auditing issues

online.

ACL Education edition student software supplementStudents are exposed to ACL audit software in the opening vignettes for Chapters 9 and 10. Chapter 10

illustrates the application of audit software using an ACL demonstration showing screenshots.

ACL provides a wide range of opportunities for incorporating computer-assisted audit techniques

(CAATs) in the auditing curriculum. Instructors may use this supplement in conjunction with Chapter

10, The Impact of Information Technology on the Audit Process, which introduces the study of CAATs.

The objectives of this supplement are twofold:

1 developing students’ understanding of CAATs—audit software exercises explore how CAATs can

assist the auditor in testing audit objectives

2 developing students’ profi ciency in global, market-leading audit software—the marketability of

accounting graduates seeking audit-related employment is significantly enhanced through

exposure to ACL.

ACL is generalised audit software used by auditors to extract and analyse data on client’s

computerised systems. Generalised audit software is discussed on pages 352–358 of the textbook.

ACL is a personal-computer implementation of the English-like Audit Command Language. It has

been designed primarily as a powerful auditing tool for easy access to and analysis of data. ACL has a

number of key features.

ACL is installed on the auditor’s personal computer and provides universal access to client data.

The client’s data tables are downloaded to the auditor’s computer and defi ned to the system so that

data analysis is feasible.

Commands are issued through selections from menus and submenus. Error messages notify the user

if the required data for a command have not been entered correctly. Context—sensitive help is available,

along with a full Windows-style help system. Commands can also be executed interactively through the

command log window. ACL permits both sequential and direct access to data tables. Sequential access

involves a complete pass through the consecutive records in a data table and suits most applications; for

example, locating all records meeting specifi ed criteria. Direct access permits the location of the fi rst

record meeting a criterion or containing a specifi ed key fi eld value (e.g. product number).


xiiiPREFACE

ACL possesses powerful expression evaluation capabilities, thereby allowing the creation of

computed fi elds—that is, those calculated from other fi elds, with formulae and functions. Commands

may be batched and executed on request. Groups of commands may be executed concurrently to permit

more effi cient processing. All commands and results are automatically saved in the command log. This

provides the auditor with the basis for review of work, a set of working papers and the potential

development of future batch applications. ACL can also extract data to create working audit tables for

further processing, and export data to other applications, such as MS Word. An in-depth study of its use

is beyond the scope of most fi rst auditing courses.

To access the educational ACL software go to https://accounts.aclgrc.com/promo and enter the

promotional code in the front of the book. Further information about the ACL software can be located

at http://www.acl.com/about-us.

Auditing and assurance implications of carbon tradingChapter 19 has been revised for the Australian developments pertaining to carbon emissions reporting

and assurance requirements.

AcknowledgmentsWe wish to thank the Auditing and Assurance Standards Board (AUASB) and the Australian

Accounting Standards Board (AASB) for permission to quote their standards, statements and other

pronouncements. Material from these Standards Boards is © Commonwealth of Australia. Every

attempt has been made to ensure that the material used is current.

The authors and publisher would also like to thank ACL Services Ltd for permission to package the

ACL student version with this textbook.

The dedicated contributions of many individuals helped make refi nements and improvements in this

edition. An impressive cast of reviewers provided many helpful suggestions and enthusiasm for the

organisation and content of the book. The authors and publisher are grateful to each one of them.

These include:

Mrs Prerana Agrawal, University of Western Australia

Dr Tehmina Khan, RMIT

Associate Professor Conor O’Leary, Griffi th University.

Dr Grace Hsu, The University of Queensland

P. J. Best

G. E. P. Shailer

B. A. Fiedler


Visual preface

For students

How do I use this book?

Learning objectivesThese are listed at the beginning of each chapter and explain the

key concepts that you should understand after studying the

chapter. They are then signposted throughout the chapter, which

steps you through each objective by listing the objective to which

each section corresponds.

Professional statements referred to in this chapterThese provide you with a list of relevant auditing and accounting

legislation that is explained throughout the chapter.

Chapter opening vignetteBoth real and fictitious companies and situations

introduce you to the concepts covered in the

chapter via a practical ‘real-life’ example.

Auditing FYISome chapters contain boxed features with

additional information, examples and/or

samples of audit documents to get you

thinking.

Auditing in the real worldExcerpts from real auditing cases, standards, news items and reports appear in

various chapters to show real-life examples of auditing in action.

CH

AP

TE

R

4LEARNING OBJECTIVESAfter studying this chapter you should be able to:

1 Explain the objective of conducting an audit of financial statements.

2 Distinguish management’s responsibilities for preparing financial statements from the auditor’s responsibilities for verifying those financial statements.

3 Explain the auditor’s responsibility for discovering material misstatements.

4 Classify transactions and account balances into financial statement cycles, and identify benefits of a cycle approach to segmenting the audit.

5 Describe why the auditor obtains a combination of assurance by auditing classes of transactions, ending balances in accounts, and presentation and disclosure.

6 Distinguish among the three categories of management assertions about financial information.

7 Link the six general transaction-related audit objectives to management assertions for classes of transactions.

8 Link the eight general balance-related audit objectives to management assertions for account balances.

9 Link the four presentation and disclosure-related audit objectives to management assertions for presentation and disclosure.

10 Explain the relationship between audit objectives and the accumulation of audit evidence.

AUDITING STANDARDSReferred to in this chapter

ASA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Australian Auditing Standards

ASA 300 Planning an Audit of a Financial Report

ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment

ASA 500 Audit Evidence

Audit responsibilities and objectives

M04_AREN9138_10_LT_C04.indd 108 12/29/15 6:43 PM

Who’s guarding the guards?

Quis custodiet ipsos custodes? Who is guarding the guards?

While the regulators are grasping at shadowy hedge funds and despicable rumour-mongers, the accountants remain as always unaccountable. What is the point of an

auditor if not to audit? Allco, ABC, Centro, MFS, City Pacific:

dogs’ breakfasts all. Billions of dollars blown, millions of

dollars clipped in audit and advisory fees for the big

accountancy practices: chiefly PWC and KPMG.

KPMG picked up $2.36 million in audit fees for Allco last

year from the parent alone. For ‘other’ work it banked

$2.96 million for a total chit of $6 million. PWC picked up

$1.3 million from the Allco head stock the year before. It was

the media and the market, however, which picked up on the $1.9 billion mistake in classifying short-term liabilities

as long-term liabilities. And when stock relisted from suspension a few weeks ago, and was slammed, another

$900 million in debt was exposed as subject to a market capitalisation clause. Not even a footnote in the accounts.

The first listed victim of the sub-prime debacle was of course RAMS—auditor PWC—but the icon of the times

soon became Centro whose inscrutable accounts were perhaps only understood by one external party, PWC.

Bearing in mind the $1.5 billion in short-term liabilities that bobbed out of the blue and sank the Centro stock price,

PWC booked $1.27 million in audit fees last year alone, complemented by a cool $2.15 million in ‘assurance’ fees

and $1.15 million in tax advice. That’s $4.57 million. But there’s more.

Centro Retail, whose destiny is also uncertain and which boasts a replica board to the mothership, man-for-

man, also used PWC. Audit $406 000, ‘assurance’ $616 000 and tax $71 268.

‘True and fair view of the company’s financial position’ was the way PWC saw things. It qualified the accounts

after the blow-up by saying ‘material uncertainty regarding continuation as a going concern’. It’s always ‘true and

fair’. The qualifications however rarely precede the blow-up. In Centro’s case, everything remained true and fair on

the audit front while shares that were trading at $7 suddenly became $1.

To balance the equation in favour of the big audit firms, they reckon you can’t appreciate the work that gets

done behind the scenes. Was it worth these millions in fees? In the least it ought to be pro bono this year.

Auditors have a responsibility to members, not to the managers of capital who give the big firms audit gigs along

with all the ‘other’ work. Clearly the regulators have failed at prevention and are now trying their hand at a cure by

blaming hedge funds. Cure is far more costly than prevention and if there is to be fundamental reform then

governance and professional services should be the focus rather than a bunch of funds finding trading opportunities

because the system and its safeguards have failed.

Source: Michael West, ‘Who’s Guarding the Guards?’, Sydney Morning Herald, 12 March 2008, www.smh.com.au. This work has been licensed by Copyright Agency Limited (CAL). Except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or CAL.

© Jeffrey Blackler/Alamy Stock Photo

M04_AREN9138_10_LT_C04.indd 109 12/29/15 6:43 PM

113CHAPTER 4 Audit responsibilities and objectives

Auditor’s responsibilities for detecting material fraudAuditing standards make no distinction between the auditor’s responsibilities for searching for errors

and for fraud, whether from fraudulent financial reporting or misappropriation of assets. For both

errors and fraud, the auditor must obtain reasonable assurance about whether the statements are free

of material misstatements.

The standards also recognise that it is often more difficult to detect fraud than errors because

management, or the employees perpetrating the fraud, attempt to conceal the fraud. The difficulty of

detection doesn’t change the auditor’s responsibility to plan and perform the audit properly.

An important part of planning every audit is to assess the risk of errors and fraud. In making a risk

assessment for fraud, it is useful to keep in mind that fraud typically includes two characteristics. The

auditor’s risk assessment for fraud focuses on both of these characteristics, which are as follows:

1 Pressure or incentive to commit the fraud. Often, this pressure is a desire for direct financial gain in the

case of misappropriation of assets, or an indirect gain in the case of fraudulent financial reporting.

The gain in the second case may be, for example, an increase in the market value of company

shares held by management.

Auditing in the real w

orld

Lack of professional scepticism in the HIH auditAuditors play a vital role in the financial reporting process. This is particularly so with companies such as HIH because their true financial position and performance is a matter of national economic significance. A properly conducted audit should allow users of the company’s financial report—including regulators, shareholders, policyholders, lenders and other creditors—to rely on the accounts with a degree of confidence. The audit process should be designed to provide the company and users of its accounts with early notice of potential risks affecting the company’s short- or long-term viability.

It is sometimes suggested that whenever a company fails its auditor must have been at fault. I do not subscribe to that theory. It is correct neither in principle nor practice. The work performed by the auditor must be carefully analysed, having regard to all the circumstances of the audit process. In the case of Andersen, those circumstances include the fact that on some occasions and in relation to material matters they were misled.

During the course of the inquiry, a select number of specific accounting matters dealt with by Andersen in the course of the 1999 and 2000 audits were examined in detail. In relation to some of them I found that Andersen did not obtain sufficient audit evidence to support its conclusions. In many instances I found that adjustments ought to have been made to the accounts in relation to matters that were the subject of inquiry.

. . .One area of concern was the manner in which Andersen relied on the valuations of HIH’s consulting

actuary, David Slee, in the conduct of its audit. As noted, the largest single item on the balance sheet of a general insurer is the provision it sets aside for payment of future claims. That item is based on actuarial valuations. Andersen did not have any actuarial expertise, and nor did it retain such expertise to assist it as part of the audit process. It therefore relied heavily on Slee’s work to confirm the credibility of the provision for outstanding claims.

In these circumstances it was incumbent on Andersen to take steps to satisfy itself as to Slee’s competence, integrity and objectivity. It also needed to obtain an understanding of the assumptions and methods Slee used and to consider whether they were reasonable, based on Andersen’s knowledge of the business and the results of other procedures performed. This is not to suggest that Slee’s work was questionable; it is to say that Andersen was required to satisfy itself that Slee’s work was beyond reproach before relying on it so heavily.

Source: The Hon Justice Owen, The HIH Royal Commission, The Failure of HIH Insurance: A Corporate Collapse and its Lessons, 4 April 2003. © Commonwealth of Australia 2015.

M04_AREN9138_10_LT_C04.indd 113 12/29/15 6:43 PM

46 PART 1 The auditing profession

Audits of either yearly or half-yearly financial reports must accord with the standards (s. 307A).

The content of an audit report is also determined by standards under ss. 308–309.

Reporting obligationsIn addition to the auditor’s reporting obligation to the members of the audited company, auditors are

obliged to: (1) report particular matters to ASIC (this can also extend to other authorities, as noted

earlier in our comment on criminal codes), and (2) provide an audit transparency report (if they meet

the threshold conditions).

Reporting to ASICSection 311 of the Corporations Act imposes mandatory reporting responsibilities for auditors to notify

ASIC of: (1) breaches of the Corporations Act or circumstances that give the auditor reasonable grounds

to suspect there has been a contravention, and (2) circumstances that amount to an attempt to unduly

influence, coerce, manipulate or mislead a person involved in the conduct of the audit.

Section 1308 makes it an offence for an auditor to knowingly lodge a statement with ASIC that is

false or misleading (including omissions). Failing to take reasonable steps to ensure that a statement is

Auditing FYI

Specific auditing standards functions of the FRCThe FRC functions include:

(a) appointing the members of the AUASB (other than the Chair)

(b) approving and monitoring the AUASB’s:

(i) priorities

(ii) business plans

(iii) budgets

(iv) staffing arrangements (including level, structure and composition of staffing)

(c) determining the AUASB’s broad strategic direction

(d) giving the AUASB directions, advice or feedback on matters of general policy and on the AUASB’s

procedures

(e) monitoring the development of international auditing standards and the auditing standards that

apply in major international financial centres

(f) furthering the development of a single set of auditing standards for worldwide use with appropriate

regard to international developments

(g) promoting the continued adoption of international best practice auditing standards in the Australian

auditing standard-setting processes if doing so would be in the best interests of both the private and

public sectors in the Australian economy

(h) monitoring:

(i) the operation of auditing standards to assess their continued relevance and their effectiveness

in achieving their objectives in respect of both the private and public sectors of the Australian

economy

(ii) the effectiveness of the consultative arrangements used by the AUASB

(i) seeking contributions towards the costs of the Australian auditing standard-setting processes

(j) monitoring and periodically reviewing the level of funding, and the funding arrangements, for the

AUASB

Source: ASIC Act 2001, s. 225(2a). © Commonwealth of australia. this legislative material is reproduced by permission, but is not the official or authorised version. It is subject to Commonwealth of australia copyright.

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xvVISUAL PREFACE

Running glossary in the marginBolded key terminology and concepts are explained as they occur in the text.

Integrated case study— Pinnacle Manufacturing This running case appears in Chapters 6, 7, 8, 14

and 15. When all parts of the case are completed

you will have a very sound understanding of

each stage of the audit and how it relates to the

whole process.

Chapter summaryAll the material covered in each chapter is

encapsulated in a few paragraphs; a great

revision tool.

End-of-chapter questions and problemsReview questions, multiple choice questions, discussion questions and problems, case

studies and Internet problems help reinforce your understanding of chapter content.

All questions are keyed to the learning objective to which they correspond so you can

pick and choose the areas you want to work on.

AppendicesWhere appropriate, some chapters will have an appendix to

extend and explicate chapter content.

Extra features• Rouge Clothing—Extracts from the annual

report for the running case of the fictitious

Rouge Clothing Company are included as a

four-colour insert at the end of the book.

This case illustrates chapter concepts in a

‘real-world’ business context. When Rouge

Clothing is referred to in the text, a shopping

bag icon is shown in the margin.

• ACL software will help develop your proficiency in a global, market-leading audit

software, and give you more marketability as an accounting graduate seeking

audit-related employment.

122 PART 1 The auditing profession

Similarly, there are several audit objectives that must be met for each account balance. They are called

balance-related audit objectives. For example, there are specific accounts receivable balance-related

audit objectives and specific accounts payable balance-related audit objectives. It will be shown later that

the transaction-related and balance-related audit objectives are somewhat different but closely related.

The third category of audit objectives relates to the presentation and disclosure of information in the

financial statements. These are called presentation and disclosure-related audit objectives. For

example, there are specific presentation and disclosure-related audit objectives for accounts receivable

and notes payable.

Throughout the remainder of this book, the term ‘audit objectives’ refers to transaction-related,

balance-related, and presentation and disclosure-related audit objectives.

Before examining audit objectives in more detail, it is necessary to understand management

assertions. These are studied next.

Management assertionsManagement assertions are implied or expressed representations by management about classes of

transactions and the related accounts and disclosures in the financial statements. As an illustration, the

management of Rouge Clothing Company Ltd asserts that cash of $827 568 (see Figure 4.4) was

present in the company’s bank accounts or on the premises as of the balance sheet date. Unless otherwise

disclosed in the financial statements, management also asserts that the cash was unrestricted and

available for normal use. Management asserts, too, that all required disclosures related to cash are

accurate and understandable. Similar assertions exist for each asset, liability, owners’ equity, revenue

and expense item in the financial statements. These assertions apply to classes of transactions, account

balances, and presentations and disclosures.

Management assertions are directly related to accounting standards. These assertions are part of

the criteria that management uses to record and disclose accounting information in financial statements.

Return to the definition of auditing in Chapter 1. It states, in part, that auditing is a comparison of

information (financial statements) with established criteria (assertions established according to

accounting standards). Auditors must therefore understand the assertions to do adequate audits.

Assertions provide a foundation for the design of audit objectives. They can be classified into three

categories by ASA 315:

1 assertions about classes of transactions and events for the period under audit

2 assertions about account balances at period end

3 assertions about presentation and disclosure.

The specific assertions in each category are included in Table 4.2. The assertions are grouped so

that assertions related across categories of assertions are included on the same table row.

Assertions about classes of transactions and eventsManagement makes several assertions about transactions. These assertions also apply to other

events that are reflected in the accounting records, such as recording depreciation and allowing for

doubtful debts.

OccurrenceThe occurrence assertion concerns whether recorded transactions included in the financial statements

actually occurred during the accounting period. For example, management asserts that recorded sales

transactions represent exchanges of goods or services that actually took place.

balance-related audit objectiveseight audit objectives that must be met before the auditor can conclude that any given account balance is fairly stated; the general balance-related audit objectives are existence, completeness, accuracy, classification, cutoff, detail tie-in, realisable value, and rights and obligations

presentation and disclosure-related audit objectivesfour objectives that must be met before the auditor can conclude that presentation and disclosures are fairly stated; the presentation and disclosure-related audit objectives are occurrence and rights and obligations; completeness; classification and understandability; and accuracy and valuation

OBJECTIVE 6

Distinguish among the three categories of management assertions about financial information.

ASA 500

ASA 315

management assertionsimplied or expressed representations by management about classes of transactions and related accounts in the financial statements

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217CHAPTER 6 Audit planning and documentation

REQUIREDa Evaluate and discuss whether Henson, Davis & Partners complied with Australian Auditing Standards

in their acceptance of McMullan Resources as a new client. What can they do at this point in the

engagement to resolve deficiencies if these exist?

b Evaluate and discuss whether sufficient audit work was done with regard to McMullan’s Singapore

contract. If not, what more should be done?

c Evaluate and discuss whether Black and Beale conducted themselves in accordance with Australian

Auditing Standards.

Online issuePlanning is one of the most demanding and important aspects of an audit. Auditors prepare planning

documents that summarise client and industry background information and discuss important accounting

and auditing issues related to the client’s financial statements. Your assignment is to find and document

information for inclusion in an audit planning memorandum. Obtain the necessary information by

downloading a public company’s most recent annual report from its website (the company will be selected

by you or your instructor) or other sources of information. You should address the following matters in four

brief bulleted responses:

❯❯ Brief company history

❯❯ Description of the company’s business (for example, related companies, competitors)

❯❯ Key accounting issues identified from a review of the company’s most recent annual report (In addition

to the basic financial statements you should refer to management reports as well as the footnotes.)

❯❯ Necessary experience levels (for example, industry experience) required of the auditors to be involved

in the audit.

Case study INTEGrATED CASE APPlICATIoNPinnacle Manufacturing: Part I

Introduction

This case study is presented in six parts. Each part deals largely with the material in the chapter to which that

part relates. However, the parts are connected in such a way that in completing all six, you will gain a better

understanding of how the parts of the audit are interrelated and integrated by the audit process. The parts of

the case appear in the following textbook chapters:

❯❯ Part I—Perform analytical procedures for different phases of the audit, Chapter 6.

❯❯ Part II—Understand factors influencing risks and the relationship of risks to audit evidence, Chapter 7.

❯❯ Part III—Understand internal control and assess control risk for the acquisition and payment cycle,

Chapter 8.

❯❯ Part IV—Determine sample sizes using audit sampling, and evaluate results, Chapter 14.

❯❯ Part V—Design tests of controls and substantive tests of transactions, Chapter 15.

❯❯ Part VI—Design, perform and evaluate results for tests of details of balances, Chapter 15.

OBJECTIVE 3

OBJECTIVES 3, 4, 5

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133CHAPTER 4 Audit responsibilities and objectives

Questions and problemsREvIEW QuEstIons4.1 State the objective of the ordinary audit of financial statements. In general terms, how do auditors

meet that objective?

4.2 Distinguish between management’s and the auditor’s responsibility for the financial statements

being audited.

4.3 Distinguish between the terms ‘error’ and ‘fraud’. What is the auditor’s responsibility for finding each?

4.4 Distinguish between fraudulent financial reporting and misappropriation of assets. Discuss the

probable difference between these two types of fraud on the fair presentation of financial statements.

4.5 It is well accepted in auditing that throughout the conduct of the ordinary audit, it is essential to obtain large

amounts of information from management and to rely heavily on management’s judgments. After all, the

financial statements are management representations, and the primary responsibility for their fair

presentation rests with management, not the auditor. For example, it is extremely difficult, if not impossible,

for the auditor to evaluate the obsolescence of inventory in a highly complex business as well as management

can. Similarly, the collectability of accounts receivable and the continued usefulness of machinery and

equipment is heavily dependent on management’s willingness to provide truthful responses to questions.

Reconcile the auditor’s responsibility for discovering material misrepresentations by management

with these comments.

4.6 List two main characteristics that are useful in predicting the likelihood of fraudulent financial

reporting in an audit. For each of the characteristics, state two things the auditor can do to evaluate its

significance in the engagement.

4.7 Describe what is meant by the ‘cycle approach’ to auditing. What are the advantages of dividing the

audit into different cycles?

4.8 Identify the cycle to which each of the following general ledger accounts would ordinarily be assigned:

sales, accounts payable, retained profits, accounts receivable, inventory, and repairs and maintenance.

4.9 Why are sales, sales returns and allowances, bad debts, cash discounts, accounts receivable and

allowance for doubtful debts all included in the same cycle?

4.10 Define what is meant by a ‘management assertion’ about financial statements. Identify the categories

of management assertions.

4.11 Distinguish between the general audit objectives and management assertions. Why are the general

audit objectives more useful to auditors?

OBJECTIVE 1

OBJECTIVES 2, 3

OBJECTIVE 3

OBJECTIVE 3

OBJECTIVE 3

OBJECTIVE 3

OBJECTIVE 4

OBJECTIVE 4

OBJECTIVES 4, 5

OBJECTIVE 6

OBJECTIVES 6, 7

This chapter discusses the objectives of the audit and the way the auditor subdivides an audit to result in specif ic audit objectives. The auditor then accumulates evidence to obtain assurance that each audit objective has been satisfied. The illustration on meeting the accuracy objectives for sales transactions and accounts receivable shows that the auditor can obtain

assurance by accumulating evidence using tests of controls, substantive tests of transactions, analytical procedures, and tests of details of balances. In some audits, there is more emphasis on certain of these tests, such as analytical procedures and tests of controls, whereas in others there is emphasis on substantive tests of transactions and tests of details of balances.

Summary

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RougeClothing Company

20X4 annual Report

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71CHAPTER 2 Auditors’ legal environment

Chronological schedule of leading cases affecting auditors’ legal liability in Australia

A wealth of case material pertains to developments regarding auditors’ legal liability in

Australia. The cases presented here represent only those that held significant precedent for

the Australian environment. Mere reaffirmations of an established principle are not included.

Where those cases listed have been addressed in greater detail in the chapter, the appropriate

reference has been provided.

1895 Re London and General Bank Ltd (No. 2) [1895] 2 Ch 673

United Kingdom Auditors have a duty to report directly to shareholders as their clients, not the directors. They don’t,

however, ensure the accuracy of the accounts (see the ‘Auditing in the real world’ box on page 52).

1896 Re Kingston Cotton Mill Co. (No. 2) [1896] 2 Ch 279

United Kingdom It is an auditor’s duty to bring to bear on his or her work that skill, care and caution which a

reasonably competent, careful and cautious auditor would use. However, while recognising

that a duty of care existed, what constituted reasonable competence and caution were not

identified.

1951 Candler v. Crane, Christmas & Co. [1951] 2 KB 164

United Kingdom The majority opinion here insisted that the auditor didn’t owe a duty of care in the absence

of a contractual or fiduciary relationship, regardless of the foreseeability of loss. The greater

significance of this case probably lies in Lord Denning’s dissenting judgment which was to

receive later affirmation in Hedley Byrne.

1963/64 Hedley Byrne & Co. Ltd v. Heller and Partners Ltd [1964] AC 465; [1963] 2 All ER 575

United Kingdom While this case didn’t directly involve auditors, it did embody a new legal principle from

which auditors were not excluded. The key element of the case lies in its identification of a

special relationship, between the expert giving professional advice and the known recipient,

which gives rise to a duty of care (see the ‘Auditing in the real world’ box on page 57).

1967 Re Thomas Gerrard & Son Ltd [1968] Ch 455; [1967] 2 All ER 525

United Kingdom Similar to the Kingston Cotton Mill case. Once auditors’ suspicions have been aroused as to

the possibility of fraud or error, auditors are not justified in relying on management

representations and should extend their investigations. This was to be affirmed and detailed

in the Australian context in Pacific Acceptance.

1968/70 Mutual Life and Citizens Assurance Co. Ltd v. Evatt (1968) 42 ALJR 316; (1970) 44 ALJR 478

Australia Basically an Australian interpretation and affirmation of the Hedley Byrne (UK) principle.

While the High Court originally found for Evatt, the Privy Council overturned its decision on

the basis that Evatt had failed to prove the existence of the ‘special relationship’. Therefore, it

wasn’t sufficient that the provider of the information knew that the recipient might rely on it,

but also that the provider had to be seen justifiably as appropriately expert (see the ‘Auditing

in the real world’ box on page 57).

Appendix

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xvi VISUAL PREFACE

What else can I use with this book?

For instructorsThe following is available for download from the Pearson catalogue site. Contact your sales

representative for passwords to access this material.

Solutions manualThe solutions manual provides educators with detailed, accuracy-verifi ed solutions to all of the end-of-

chapter problems in the book.

PowerPoint slidesA comprehensive set of PowerPoint slides can be used by educators for class presentations or by students

for lecture preview or review. They include key fi gures and tables, as well as a summary of key concepts

and examples from the text.

Test bankThe test bank provides a wealth of accuracy-verifi ed testing material. Updated for the new edition,

each chapter offers a wide variety of true/false, short-answer and multiple-choice questions, arranged

by learning objective and tagged by AACSB standards.

ACL softwareEducators may use this software in conjunction with Chapter 10 ‘The impact of information technology

on the audit process’, which introduces the study of CAATs.


10e auditing, assurance services & ethics

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