Principles of auditing

PRINCIPLES OF AUDITING

An Introduction to International

Standards on Auditing

Rick Hayes Roger Dassen Arnold Schilder Philip Wallage

The first text fully based upon International Standards on

Auditing (ISAs), this revised and updated new edition presents

a structured approach to auditing principles using ISAs as its

basis. More and more, the International Standards on

Auditing are regarded as the global benchmark for auditing

standards. This book describes the development and practical

use of all ISAs, as well as significant national standards in

different countries.

In addition to dealing with these new standards, the authors

explain important new developments from a regulatory point of

view. Emerging conceptual developments such as strategic

auditing and business risk are covered, as well as cutting-edge

audit techniques.

Features:

• The ONLY principles of auditing textbook fully based

on ISAs.

• Presents the latest auditing standards from a truly

international perspective.

• All audit concepts are illustrated with case study examples

from famous companies, such as Enron, Xerox, and

WorldCom, bringing the subject to life.

• The authors bring a broad and in-depth range of auditing

experience as: practising professionals in auditing, a

regulation setter, an auditing standards setter, as well as

considerable teaching experience as university professors.

This provides students with a real-world perspective as

close to current auditing practice and thinking as possible.

An imprint of www.pearson-books.com

“Very accessible, especially for non-native English speaking students.”

Ron Crijns, Haagse Hogeschool, The Netherlands

“I found the book extremely easy to follow. In general I believe all the features of the book are very well

done. It seems to me there is a good balance in the difficulty of the student assignments: they range from

simple ‘repeat-the-book’ questions to more complex questions, requiring research and judgement. As an

all-purpose introduction to auditing with an international perspective, I believe the book is outstanding.”

Marcia Halvorsen, Göteborg University, Sweden

“The book is easy to navigate and easy to handle. I think the questions, exercises and cases are excellent.

The glossary is really excellent. This is the best glossary I have ever seen in an auditing textbook.”

Stellan Nilsson, Umeå School of Business and Economics, Sweden

Principles of Auditing: An Introduction to International

Standards on Auditing is suitable for those studying

courses in auditing at undergraduate or postgraduate

levels. It will also be of interest to accounting

professionals looking for practical guidance on

International Standards on Auditing and recent

developments in the profession.

Dr Rick Hayes is Professor of Accounting at California

State University at Los Angeles, and is the author of

numerous books in accounting.

Dr Roger Dassen is a Partner at Deloitte & Touche,

Amsterdam and Professor of Auditing at the Free

University of Amsterdam and the University of

Maastricht. He serves as a member on the International

Auditing and Assurance Standards Board (IAASB).

Dr Arnold Schilder is an Executive Director of the

Netherlands Central Bank and Chairman of the Basel

Committee of Banking Supervision’s Accounting Task

Force, as well as Professor of Auditing at the University

of Amsterdam.

Dr Philip Wallage is a Partner at KPMG, Amsterdam

and Professor of Auditing at the University of

Amsterdam.

Schilder Wallage

Hayes Dassen

An Introduction to International Standards on Auditing

PRINCIPLES OF AUDITING

Second Edition

Second

Edition

Hayes_ppr 30/01/2006 12:04 PM Page 1

PRINCIPLES OF AUDITING

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Second Edition

PRINCIPLES OF AUDITING

An Introduction to International Standards on Auditing

Rick Hayes

California State University, Los Angeles

Roger Dassen

Deloitte Touche, Amsterdam

International Auditing and Assurance Standards Board (IAASB)

Free University of Amsterdam, University of Maastrict

Arnold Schilder

The Netherlands Central Bank

Basel Committee of Banking Supervisions Accounting Task Force

University of Amsterdam

Philip Wallage

KPMG, Amsterdam

University of Amsterdam

Pearson Education Limited

Edinburgh Gate

Harlow

Essex CM20 2JE

England

and Associated Companies throughout the world

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First published by McGraw-Hill Publishing Company 1999

Second edition published by Pearson Education Limited 2005

Copyright © 1999 by McGraw-Hill International (UK) Limited

© Pearson Education Limited 2005

The rights of Rick Hayes, Roger Dassen, Arnold Schilder and Philip Wallage to be identified

as authors of this work have been asserted by them in accordance with the Copyright,

Designs, and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval

system, or transmitted in any form or by any means, electronic, mechanical, photocopying,

recording, or otherwise without either the prior written permission of the Publishers or a

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ISBN 0 273 68410 8

British Library Cataloging-in-Publication Data

A catalogue record for this book is available from the British Library.

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A catalog record for this book is available from the Library of Congress.

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Typeset in 10.5/12.5 pt Minion by 25.

Printed and bound in Great Britain by Ashford Colour Press Ltd. Gosport.

The publisher’s policy is to use paper manufactured from sustainable forests.

List of illustrations xi

Foreword by xv

Preface xvii

Acknowledgements xix

1.1 Learning Objectives 1

1.2 Auditing through World History 2

1.3 The Auditor, Corporations and Financial Information 3

1.4 International Accounting and Auditing Standards 5

1.5 An Audit Defined 10

1.6 Types of Audits 14

1.7 Types of Auditors 16

1.8 Setting Audit Objectives Based on Management Assertions 19

1.9 The Audit Process Model 23

1.10 International Public Accountancy Firms 28

1.11 Summary 33

1.12 Answers to Certification Exam Questions 35

1.13 Notes 35

1.14 Questions, Exercises and Cases 38

2.1 Learning Objectives 43

2.2 Introduction 44

2.3 Theories on the Demand and Supply of Audit Services 44

2.4 Audit Regulation 47

2.5 Audit Firms 50

2.6 Audit Quality and Audit Fee Determination 51

2.7 Legal Liability 52

2.8 Some Developments in the Audit Market 57

2.9 Examples of Landmark Studies and Legislation that Influenced the

International Audit Market 64

2.10 Summary 67

2.11 Answers to Certification Exam Questions 68

Contents

1 International Auditing Overview 1

2 The Audit Market 43

v

2.12 Notes 69

2.13 Questions, Exercises and Cases 71

3.1 Learning Objectives 74

3.2 What Are Ethics? 75

3.3 The IFAC Code of Ethics for Professional Accountants 76

3.4 Ethics Guidelines Applicable to All Accountants (Part A) 76

3.5 Ethics Applicable to Professional Accountants in Public Practice (Part B) 82

3.6 Independence Requirements 83

3.7 Other Topics Applicable To Professional Accountants in Public Practice 94

3.8 Applicable To Employed Professional Accountants (Part C) 101

3.9 Enforcement of Ethical Requirements 104

3.10 Future Developments 105

3.11 Summary 106

3.12 Answers to Certification Exam Questions 107

3.13 Notes 108

3.14 Questions, Exercises and Cases 110

4.1 Learning Objectives 113

4.2 International Framework for Auditor Services 114

4.3 Elements of an Assurance Engagement 117

4.4 General Considerations in An Assurance Engagement 124

4.5 Audits and Reviews of Historical Financial Information 126

4.6 Assurance Engagements Other than Historical Financial Information 136

4.7 Related Services 146

4.8 Summary 151

4.9 Answers to Certification Exam Questions 153

4.10 Notes 155

4.11 Questions, Exercises and Cases 160

5.1 Learning Objectives 164

5.2 Client Acceptance: the First Step on the Journey to an Opinion 165

5.3 Evaluate the Client’s Background 166

5.4 Ability to Meet Ethical and Specific Competence Requirements 171

5.5 Use of Other Professionals in the Audit 175

5.6 Communicating With the Predecessor (Existing) Auditor 178

5.7 Acceptance by the Client – The Engagement Proposal 179

5.8 The Audit Engagement Letter 183

CONTENTS

vi

3 Ethics for Professional Accountants 74

4 An Auditor’s Services 113

5 Client Acceptance 164

5.9 Summary 186

5.10 Answers to Certification Exam Questions 187

5.11 Notes 188

5.12 Questions, Exercises and Cases 190

6.1 Learning Objectives 193

6.2 Planning – Phase II of the Audit Process Model 194

6.3 Understanding the Entity and its Environment 197

6.4 Based on the Evidence, Assess Risk; Types of Risk 208

6.5 Planning Materiality 215

6.6 Summary 220

6.7 Answers to Certification Exam Questions 222

6.8 Notes 223

6.9 Questions, Exercises and Cases 225

7.1 Learning Objectives 229

7.2 Introduction 230

7.3 Internal Control Defined 230

7.4 The Importance of Internal Control 232

7.5 Components of Internal Control 235

7.6 Control Environment 236

7.7 Risk Assessment 245

7.8 Information Systems, Communication, and Related Business Processes 247

7.9 Control Activities (Control Procedures) 251

7.10 Monitoring of Controls 256

7.11 Design of Internal Controls 259

7.12 Summary 261

7.13 Answers to Certification Exam Questions 263

7.14 Notes 264

7.15 Questions, Exercises and Cases 267

8.1 Learning Objectives 272

8.2 Understanding, Assessing and Testing Internal Controls 274

8.3 Understanding of Internal Controls and Documentation 274

8.4 Assessing Control Risk 286

8.5 Overall Responses to Assessed Risk 290

8.6 Prepare Planning Memorandum and Audit Plan 293

8.7 Tests of Controls 296

vii

CONTENTS

6 Understanding the Entity, Risk Assessment and Materiality 193

7 Internal Control and Control Risk 229

8 Control Risk, Audit Planning and Test of Controls 272

8.8 Evaluate Sufficiency and Appropriateness of Audit Evidence 304

8.9 Summary 305

8.10 Answers to Certification Exam Questions 307

8.11 Notes 309

8.12 Questions, Exercises and Cases 310

9.1 Learning Objectives 317

9.2 Introduction 318

9.3 The Analytical Review Process 319

9.4 Formulating Expectations 324

9.5 General Analytical Procedures 326

9.6 Analytical Procedures During Different Phases In The Audit Process 333

9.7 Analytical Procedures As Substantive Tests 335

9.8 Computer Assisted Audit Techniques (CAATs) and

Generalized Audit Software (GAS) 337

9.9 Analytical Procedures Using Data Mining Techniques 341

9.10 Follow-Up In Case Of Unexpected Deviations 343

9.11 Summary 343

9.12 Answers to Certification Exam Questions 345

9.13 Notes 346

9.14 Questions, Exercises and Cases 348

10.1 Learning Objectives 352

10.2 Introduction 353

10.3 The Basis of Evidence 354

10.4 Sufficient Appropriate Audit Evidence 358

10.5 Substantive Audit Procedures 364

10.6 Audit Procedures for Obtaining Audit Evidence 368

10.7 Summary 380

10.8 Answers to Certification Exam Questions 382

10.9 Notes 384

10.10 Questions, Exercises and Cases 385

Appendix to Chapter 10

Audit Sampling and Other Selective Testing Procedures 391

10.A.1 Preface 391

10.A.2 Introduction 392

10.A.3 Definitions 392

10.A.4 Audit Evidence 397

10.A.5 Selecting Items for Testing to Gather Audit Evidence 400

10.A.6 Statistical versus Non-Statistical Sampling Approaches 401

CONTENTS

viii

9 Analytical Procedures 317

10 Substantive Testing and Evidence 352

10.A.7 Design of the Sample 402

10.A.8 Answers to Certification Exam Questions 417

10.A.9 Notes 418

10.A.10 Questions, Exercises and Cases 419

11.1 Learning Objectives 421

11.2 Introduction 423

11.3 Quality Control 424

11.4 Evaluate Governance Evidence 430

11.5 Review for Discovery of Subsequent Events 441

11.6 Review Financial Statements and Other Report Material 445

11.7 Wrap-Up Procedures 448

11.8 Going Concern Issues 455

11.9 Matters for Attention of Partners (MAPs) 457

11.10 Reports to The Board of Directors 458

11.11 Summary 460

11.12 Answers to Certification Exam Questions 461

11.13 Notes 463

11.14 Questions, Exercises and Cases 466

Appendix to Chapter 11

Audit Documentation and Working Papers 473

11.A.1 Introduction 473

11.A.2 Form and Content of the Working Papers 475

11.A.3 Document Retention 477

11.A.4 Permanent and Current Files 478

11.A.5 Preparation of Working Papers 483

11.A.6 Adjusting Entry 485

11.A.7 Summary 486

11.A.8 Notes 487

11.A.9 Questions, Exercises and Cases 489

12.1 Learning Objectives 490

12.2 Introduction 491

12.3 Basic Elements of the Auditor’s Report 493

12.4 Types of Reports Expressing Audit Opinions 499

12.5 Matters that Do Not Affect the Auditor’s Opinion (Modification of an

Auditor’s Report Containing an Unqualified Opinion) 505

12.6 Circumstances That May Result in Other Than an Unqualified Opinion 511

12.7 Uncertainties Leading to Qualification of Opinions 516

12.8 Communications with those Charged with Governance 520

ix

CONTENTS

11 Completing the Audit 421

12 Audit Reports and Communication 490

12.9 Long-Form Audit Report 523

12.10 XBRL and Continuous Reporting 525

12.11 Summary 528

12.12 Answers to Certification Exam Questions 530

12.13 Notes 531

12.14 Questions, Exercises and Cases 534

13.1 Learning Objectives 541

13.2 Introduction 542

13.3 You are the Audit Manager 542

13.4 The Audit Planning Memorandum – Strategy Part 548

13.5 The Audit Planning Memorandum – Plan Part 554

13.6 Audit Program (Audit Plan) 557

13.7 Completion Memorandum 575

13.8 Summary 580

13.9 Answers to Certification Exam Questions 581

13.10 Notes 583

13.11 Questions, Exercises and Cases 584

14.1 Learning Objectives 592

14.2 Introduction 593

14.3 The Nature of Corporate Governance 593

14.4 Causes of Current Corporate Governance Discussions 597

14.5 Corporate Governance Structures 602

14.6 Corporate Governance Committees and Reports 604

14.7 Best Practice from a Global Perspective 606

14.8 Corporate Governance and the Role of the Auditor 617

14.9 Summary 624

14.10 Answers to Certification Exam Questions 626

14.11 Notes 627

14.12 Questions, Exercises and Cases 630

Appendix A to Chapter 14

The Combined Code (UK): An Example of Auditors’ Review of Corporate

Governance Best Practice 632

Appendix B to Chapter 14

Governance and Auditing in a Public Interest Context 636

Glossary 644

Index 683

CONTENTS

x

13 Overview of a Group Audit 541

14 Corporate Governance 592

1.1 List of International Standards on Auditing 8

1.2 Types of Audit 15

1.3 Auditor Certification Designations Around the World 18

1.4 Financial Statement Assertions, Definitions and Procedures for Auditing

Receivables 21

1.5 Audit Process Model 24

1.6 Developing and Audit Program 26

1.7 The Organizational Hierarchy of a Typical International Auditing Firm 28

2.1 An Illustration of Four Theories of Auditing 45

2.2 Objectives of the COSO Report 65

3.1 Ethical Principles 75

3.2 Three-Part Framework of IFAC Ethics Code 77

3.3 Independence in the Sarbanes-Oxley Act of 2002 84

3.4 Application of Ethics to Specific Situations (Topic and Applicable Paragraph

in the Code of Ethics for Professional Accountants) 86

3.5 Identification of Potential Threats to Auditors Independence 87

3.6 Examples of Safeguards Within Audit Firms 92

3.7 Considerations of Fees Charged to Clients 95

3.8 Considerations Concerning Incompatible Activities and Advertising 96

3.9 Considerations for Handling Clients’ Monies 97

3.10 Considerations Concerning Relations with Other Professional Accountants 98

3.11 Procedures to Change Auditors 99

4.1 Assurance Engagements and Related Services 115

4.2 Context Data Flow Diagram of Assurance Engagement Elements 118

4.3 Data Flow Diagram Assurance Engagement Elements and Engagement

Sub-Processes 119

4.4 Assurance Report Basic Elements 125

4.5 Form of Unqualified Review Report 128

4.6 Reports on Special Purpose Audit Engagements 130

4.7 Form of Examples of Reports on Financial Statements Prepared in

Accordance with a Comprehensive Basis of Accounting other than

International Accounting Standards or National Standards 132

4.8 Report on Components of Financial Statements –

Schedule of Accounts Receivable 133

4.9 Report on Compliance 134

List of Illustrations

xi

4.10 Report on Summarized Financial Statements When an Unqualified Opinion

Was Expressed on the Annual Audited Financial Statements 136

4.11 Prospective Financial Report Examples 139

4.12 Illustrative Report Expressing An Unqualified Opinion On Management’s

Assessment Of The Effectiveness Of Internal Control Over Financial Reporting

(Separate Report) 141

4.13 “Year at a Glance” from The Shell Report 143

4.14 Auditor’s assurance on the Shell’s Sustainability Report 145

4.15 Example of a Report of Factual Findings in Connection with Accounts Payable 148

4.16 Examples of Compilation Reports 150

5.1 Standard Audit Process Model – Phase I Client Acceptance 165

5.2 Sources of Information for Client Evaluation 167

5.3 Three Major Influences on the Continuance of the Relationship 169

5.4 Sample Table of Contents of New Client Proposal 181

5.5 Sample Audit Engagement Letter 185

6.1 Audit Process Model 195

6.2 Overview of the Proposed ISAs 196

6.3 Global Systems Perspective on Client Business Risk 199

6.4 Industry, Regulatory And Other External Factors, Including The Applicable

Financial Reporting Framework Auditors Should Consider 200

6.5 Considerations When Obtaining An Understanding Of The Nature Of

The Entity 202

6.6 Entity Level Business Model 203

6.7 Examples of Legal documents and Records to Consider in the Context of

Understanding the Entity’s Nature 204

6.8 Considerations Concerning Entity Objectives, Strategies And Related

Business Risks 206

6.9 Measurement and Review of the Entity’s Financial Performance 206

6.10 Important Characteristics of Analytical Procedures at Three Audit Stages 207

6.11 Documentation Formats for Strategic Risk and Significant Classes of

Transactions 209

6.12 Components of Audit Risk 212

6.13 Interrelationship of the Components of Audit Risk 212

6.14 Relationship between Inherent, Control and Detection Risk 213

6.15 Inverse Relationship Between Materiality and Audit Risk 217

7.1 Components of Internal Control – COSO Report 232

7.2 Components of Internal Control Structure 236

7.3 Organizational Chart Segregation Of Duties And Assignment Of Authority

And Responsibility 241

7.4 Factors on Which to Assess Internal Control Environment 244

7.5 Risk Assessment Blank Evaluation Tool 245

7.6 Typical Input, Subsystems and Output of an Information System 248

7.7 Overview of Segregation of Duties 254

7.8 Overall Internal Control Evaluation Tool 258

LIST OF ILLUSTRATIONS

xii

8.1 The Process of Auditing Based on Internal Controls 273

8.2 Examples of Factors That Affect the Nature and Extent of Procedures for

an Understanding Sufficient to Plan the Audit 276

8.3 Effect of Account Characteristics on the Auditor’s Understanding of the

Internal Control System 277

8.4 Narrative Description of the Control Environment 281

8.5 Internal Control Narrative (Table) Documentation 282

8.6 Internal Control Questionnaire Documentation 283

8.7 Checklist Documentation 284

8.8 Internal Control Flow Chart Revenue Cycle 285

8.9 Sample Audit Plan (Audit Program) – Accounts Receivable 295

9.1 The Analytical Review Process 322

9.2 Five Types of Ratio Analysis 327

9.3 Standard Client and Industry Ratios 328

9.4 Indications that the Going Concern Assumption Might be Questioned 330

9.5 The Four-Phase Analytical Review Process Using GAS 340

10.1 Legal Evidence and Audit Evidence 355

10.2 Financial Statement Assertions Grouped by Substantive Test Areas 356

10.3 The Quality of Audit Evidence 359

10.4 Sufficient Appropriate Audit Evidence 360

10.5 Reliability of Evidence 361

10.6 Audit Procedures (Evidence Gathering Techniques) 369

10.7 Confirmation 375

10.A.1 Minimum sample size to detect 5 percent error 408

10.A.2 IDEA Audit Software Screen to Determine Sample Size 409

10.A.3 Error Projection 414

10.A.4 IDEA Evaluation of Sample Results 416

11.1 Audit Process Model – Phase Flow Diagram 422

11.2 Audit Process Model – Phase IV Evaluation and Reporting 423

11.3 Responsibilities of the Engagement Partner 428

11.4 Legal Letter 432

11.5 Management Representation Letter 436

11.6 Circumstances That May Indicate Unidentified Related Parties 440

11.7 Procedures to Identify Related Parties Transactions 441

11.8 Procedures to Identify Events That May Require Adjustment of,

or Disclosure in, the Financial Statements 444

11.9 Financial Statement Disclosure Checklist: Inventory 446

11.10 Typical Wrap-up Procedures 449

11.11 Review Checklist 450

11.12 Independent Review Checklist 452

11.13 Indications that the Going Concern Assumption Might be Questioned 456

11.14 Summary of Audit Process Documents 459

11.A.1 Significant Findings or Issues Documented 474

11.A.2 Sample Work Papers – Permanent File Contents 479

xiii

LIST OF ILLUSTRATIONS

11.A.3 Sample Work Papers – Current File 480

11.A.4 Sample Work Papers – Account Analysis Schedule 482

11.A.5 Sample Work Papers – Interest and Long-term Debt Work Paper 484

11.A.6 Example of Digit-Position Indexing 485

12.1 Certification of Schlumberger Financial Statements by Corporate Officers 492

12.2 Sample Wording – Auditor’s Unqualified Report 497

12.3 Sample US Unqualified Report and Management’s Report on Responsibility

for Financial Reporting for Wm. Wrigley Jr. Company 498

12.4 Sample Wording – Limitation on Scope Qualified Opinion 503

12.5 Sample Wording – Inadequate Disclosure Adverse Opinion 504

12.6 Sample Wording – Limitation of Scope Disclaimer of Opinion 505

12.7 Sample Wording – Auditor’s Unqualified Report with Legal Uncertainty

Emphasis of Matter Paragraph 506

12.8 Sample Wording – Auditor’s Unqualified Report with Going Concern

Emphasis of Matter Paragraph 507

12.9 Intel’s 2002 Unqualified Audit (Report with Change in Accounting Methods

Emphasis of Matter Paragraph 508

12.10 Dell’s 2002 Unqualified Audit Report with Change in Revenue Recognition

Emphasis of Matter Paragraph 509

12.11 Sample Wording – Auditor’s Qualified Report for Non-Disclosure of Going

Concern Problem 510

12.12 Disagreement on Accounting Policies – Inappropriate Accounting Method

Qualified Opinion 514

12.13 Disagreement on Accounting Policies – Inadequate Disclosure Qualified

Opinion 515

12.14 Example of XBRL-Coded Data 526

13.1 Contents of Group Audit Instructions 543

13.2 Subsidiaries Important to the Audit 545

13.3 HOT and Subsidiaries 546

13.4 Contents of Audit Planning Memorandum – Strategy Part 549

13.5 Contents of Audit Planning Memorandum – Plan Part 553

13.6 Audit Program 557

13.7 Contents of Completion Memorandum 575

13.8 Outline of Management Letter to Local 577

13.9 Summary of Unadjusted Audit Differences Found in the Audit 579

14.1 Causes of Current Discussions 598

14.2 Corporate Governance Structures 603

14.3 Corporate Governance Committees and Reports 604

14.4 Current and Future Business Reporting Models 616

14.5 Next Steps Enhanced Business Reporting 617

LIST OF ILLUSTRATIONS

xiv