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This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. NINTH EDITION A U D I T I N G A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT Karla M. Johnstone University ofWisconsin—Madison Audrey A. Gramling Bellarmine University Larry E. Rittenberg University ofWisconsin—Madison Australia(cid:129)Brazil(cid:129)Japan(cid:129)Korea(cid:129)Mexico(cid:129)Singapore(cid:129)Spain(cid:129)UnitedKingdom(cid:129)UnitedStates Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Auditing:ARisk-BasedApproachto ©2014,2012South-Western,CengageLearning ConductingaQualityAudit,NinthEdition ALLRIGHTSRESERVED.Nopartofthisworkcoveredbythecopyrightherein KarlaM.Johnstone,AudreyA.Gramling,and maybereproduced,transmitted,stored,orusedinanyformorbyanymeans LarryE.Rittenberg graphic,electronic,ormechanical,includingbutnotlimitedtophotocopying, SeniorVicePresident,LRS/Acquisitions& recording,scanning,digitizing,taping,webdistribution,informationnetworks, SolutionsPlanning:JackW.Calhoun orinformationstorageandretrievalsystems,exceptaspermittedunder Section107or108ofthe1976UnitedStatesCopyrightAct,withouttheprior EditorialDirector,Business&Economics: writtenpermissionofthepublisher. 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Foryourcourseandlearningsolutions,visitwww.cengage.com Purchaseanyofourproductsatyourlocalcollegestoreoratourpreferred onlinestorewww.cengagebrain.com PrintedintheUnitedStatesofAmerica 1 2 3 4 5 6 7 17 16 15 14 13 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Dedication We dedicate this book to our families who encourage and support us through many hours of development, to our students who inspire us to always improve, to our mentors who guide us, to our professional friends who continue to educate us, and to our colleagues who challenge us. KARLA M. JOHNSTONE AUDREY A. GRAMLING LARRY E. RITTENBERG Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. B R I E F C O N T E N T S Preface, xxiii About the Authors, xxxiii 1 CHAPTER Auditing: Integral to the Economy, 2 2 CHAPTER The Risk of Fraud and Mechanisms to Address Fraud: Regulation, Corporate Governance, and Audit Quality, 32 3 ’ CHAPTER Internal Control over Financial Reporting: Management s Responsibilities and Importance to the External Auditors, 72 4 CHAPTER Professional Liability and the Need for Quality Auditor Judgments and Ethical Decisions, 114 5 CHAPTER Professional Auditing Standards and the Audit Opinion Formulation Process, 156 6 CHAPTER A Framework for Audit Evidence, 212 7 CHAPTER Planning the Audit: Identifying and Responding to the Risks of Material Misstatement, 266 8 CHAPTER Specialized Audit Tools: Sampling and Generalized Audit Software, 316 9 CHAPTER Auditing the Revenue Cycle, 366 10 CHAPTER Auditing Cash and Marketable Securities, 438 11 CHAPTER Auditing Inventory, Goods and Services, and Accounts Payable: The Acquisition and Payment Cycle, 500 12 CHAPTER Auditing Long-Lived Assets: Acquisition, Use, Impairment, and Disposal, 560 13 ’ CHAPTER Auditing Debt Obligations and Stockholders Equity Transactions, 594 14 CHAPTER Activities Required in Completing a Quality Audit, 620 15 CHAPTER Audit Reports on Financial Statements, 684 v Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. vi Brief Contents 16 CHAPTER Advanced Topics Concerning Complex Auditing Judgments, 726 17 CHAPTER Other Services Provided by Audit Firms, 790 ACL Appendix, 841 Case Index, 857 Index, 859 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. C O N T E N T S PREFACE, xxiii ABOUT THE AUTHORS, xxxiii 1 CHAPTER Auditing: Integral to the Economy, 2 Overview of the External Auditing Profession, 3 Introduction to the External Auditing Profession, 3 External Auditing: A Special Function, 4 The Need for Unbiased Reporting and Independent Assurance, 6 Overall Objectives in Conducting an Audit, 7 Overview of the Audit Opinion Formulation Process, 8 Parties Involved in Preparing and Auditing Financial Statements, 9 Providers of External Auditing Services, 9 Skills and Knowledge Needed to Enter the External Auditing Profession, 10 Organizations Affecting the External Auditing Profession, 11 Audit Quality, 14 Audit Firm Culture, 15 Skills and Qualities of the Engagement Team, 15 Effectiveness of the Audit Process, 16 Reliability and Usefulness of Audit Reporting, 16 Factors Outside the Control of Auditors That Affect Audit Quality, 16 Achieving Audit Quality and Minimizing Lawsuits, 16 Auditor Independence Requirements, 17 Review Programs, 19 Engagement Letters, 20 vii Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. viii Contents Client Acceptance/Continuance Decisions, 20 Audit Firm Limitations, 21 Audit Documentation, 21 Summary and Next Steps, 21 Significant Terms, 21 True-False Questions, 23 Multiple-Choice Questions, 24 Review and Short Case Questions, 26 Contemporary and Historical Cases, 28 Application Activities, 30 Academic Research Case, 31 2 CHAPTER The Risk of Fraud and Mechanisms to Address Fraud: Regulation, Corporate Governance, and Audit Quality, 32 Fraud Defined, 34 Misstatements Arising From Misappropriation of Assets, 34 Misstatements Arising from Fraudulent Financial Reporting, 34 The Fraud Triangle, 35 Incentives or Pressures to Commit Fraud, 37 Opportunities to Commit Fraud, 37 Rationalizing the Fraud, 38 Recent History of Fraudulent Financial Reporting, 38 Examples of Recent Frauds and Implications for External Auditors, 38 The Third COSO Report, 41 The Enron Fraud: A Key Driver of Regulatory Change, 42 ’ An Overview of the Auditor s Fraud-Related ’ Responsibilities and Users Expectations, 44 – The Sarbanes Oxley Act of 2002 as a Regulatory Response to Fraud, 45 The Post Sarbanes-Oxley World: A Time of Improved Corporate Governance, 49 What Is Corporate Governance? 49 Principles of Effective Corporate Governance, 50 Responsibilities of Audit Committees, 53 Summary and Next Steps, 53 Significant Terms, 54 True-False Questions, 54 Multiple-Choice Questions, 55 Review and Short Case Questions, 58 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.