Maire LoughranCertified Public Accountant

Learn to:• Understand the concepts and theories of

auditing

• Conduct internal and external audits

• Ensure accurate and correct records

• Avoid fraudulent practices

AuditingMaking Everything Easier!™

Open the book and find:

• A day in the life of an auditor

• Who gets audited and why

• Professional standards and ethics

• How to assess audit risk

• Tips on collecting and document-ing audit evidence

• The best way to get to know your client

• Auditing practices for every business angle (revenue, purchases, personnel, and more)

• What you’ll need to complete the audit

Maire Loughran is a self-employed certified public accountant (CPA)

who has prepared compilation, review, and audit reports for fifteen

years. Additionally, she is a university professor of undergraduate- and

graduate-level accounting classes.

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The easy way to master the art of auditingWant to be an auditor and need to hone your investigating skills? Look no further. This friendly guide gives you an easy-to-understand explanation of auditing — from gathering financial statements and accounting information to analyzing a client’s financial position. Packed with examples, it gives you everything you need to ace an auditing course and begin a career today.

• Auditing 101 — get a crash course in the world of auditing and a description of the types of tasks you’ll be expected to perform during a typical day on the job

• It’s risky business — find out about audit risk and arm yourself with the know-how to collect the right type of evidence to support your decisions

• Auditing in the real world — dig into tons of sample business records to perform your first audit

• Focus on finances — learn how both ends of the financial equation — balance sheet and income statement — need to be presented on your client’s financial statements

• Seal the deal — get the lowdown on how to wrap up your audit and write your opinion

• After the audit — see the types of additional services that may be asked of you after you’ve issued your professional opinion

Auditing

Loughran

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by Maire Loughran, CPA

AuditingFOR

DUMmIES‰

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Auditing For Dummies®

Published byWiley Publishing, Inc.111 River St.Hoboken, NJ 07030-5774www.wiley.com

Copyright © 2010 by Wiley Publishing, Inc., Indianapolis, Indiana

Published by Wiley Publishing, Inc., Indianapolis, Indiana

Published simultaneously in Canada

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About the AuthorMaire Loughran is a certifi ed public accountant and a member of the American Institute of Certifi ed Public Accountants. Her professional experience includes four years of internal auditing for a publicly traded company in the aerospace industry, two years as an auditor in the not-for-profi t sector, and even some experience as a U.S. federal agent! Her public accounting experience includes fi nancial reporting and analysis, audits of private corporations, accounting for e-commerce, and forensic accounting.

Maire is a full adjunct professor who teaches graduate and undergraduate auditing, accounting, and taxation classes. Interested in many different business-related fi elds, she has written a training manual for a Microsoft product and a guide to starting a home-based business, as well as the Arts and Crafts Business Guide for About.com, a part of The New York Times Company.

DedicationTo my much-loved son Joey, who serves his country aboard the USS Harry S. Truman: I am prouder of you than mere words can ever describe. And to my late husband Jeff, so long gone from our lives but never absent from our hearts.

Author’s AcknowledgmentsTo the Ursuline nuns and Jesuit priests who provided me with a stellar education, and to my parents, who selfl essly footed the bill.

To my agent, Barb Doyen, for all her hard work and support.

And to Joan Friedman, Chad Sievers, and Todd Lothery for their months of editing, follow-through, and advice.

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Contents at a GlanceIntroduction ................................................................ 1

Part I: Getting an Auditing Initiation ............................ 7Chapter 1: Taking Auditing into Account ....................................................................... 9Chapter 2: The Role of Auditing in Public Accounting................................................ 21Chapter 3: Understanding Professional Standards and Ethics .................................. 33

Part II: Performing the Initial Auditing Steps .............. 45Chapter 4: Getting Engaged: Preparing to Conduct an Audit..................................... 47Chapter 5: Assessing Audit Risk .................................................................................... 67Chapter 6: Collecting and Documenting Audit Evidence ............................................ 91Chapter 7: Auditing a Client’s Internal Controls ........................................................ 111Chapter 8: Sampling the Records ................................................................................ 133

Part III: Auditing How a Client Conducts Business ..... 153Chapter 9: The Revenue Process: Auditing How a Business Makes Money ........... 155Chapter 10: The Purchasing Process: Auditing How a Business Spends Money...181Chapter 11: The Human Resources Process: Auditing Personnel Practices .......... 201Chapter 12: Inventory Management: Auditing How a Business Manages

Its Products .................................................................................................................. 219

Part IV: Focusing on a Client’s Finances .................... 239Chapter 13: Auditing Fixed and Intangible Assets ..................................................... 241Chapter 14: Auditing Long-Term Liabilities and Stockholder Equity ...................... 261Chapter 15: Auditing Cash and Investments .............................................................. 283

Part V: Completing the Audit .................................... 297Chapter 16: Performing Final Due Diligence ............................................................... 299Chapter 17: Wrapping It Up: Issuing the Report ........................................................ 313Chapter 18: The Spectrum of Engagement Services.................................................. 325

Part VI: The Part of Tens .......................................... 339Chapter 19: Ten Procedures to Obtain Audit Evidence ............................................ 341Chapter 20: Ten Tips to Stay Educated in Audit Procedures ................................... 345

Index ...................................................................... 349

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Table of Contents

Introduction ................................................................. 1About This Book .............................................................................................. 1Conventions Used in This Book ..................................................................... 2What You’re Not to Read ................................................................................ 3Foolish Assumptions ....................................................................................... 3How This Book Is Organized .......................................................................... 4

Part I: Getting an Auditing Initiation .................................................... 4Part II: Performing the Initial Auditing Steps ...................................... 4Part III: Auditing How a Client Conducts Business ............................ 4Part IV: Focusing on a Client’s Finances ............................................. 5Part V: Completing the Audit................................................................ 5Part VI: The Part of Tens ....................................................................... 5

Icons Used in This Book ................................................................................. 6Where to Go from Here ................................................................................... 6

Part I: Getting an Auditing Initiation ............................. 7

Chapter 1: Taking Auditing into Account. . . . . . . . . . . . . . . . . . . . . . . . . .9

The Secret Lives of Auditors .......................................................................... 9Understanding the Increasing Demand for Auditing and Assurance ...... 10

Examining the changing nature of business ..................................... 11Expanding along with the world economy ....................................... 12

The Making of an Auditor ............................................................................. 12Getting educated .................................................................................. 12Taking the CPA exam ........................................................................... 13Working for a CPA fi rm ........................................................................ 15Identifying other career paths ........................................................... 17

Eyeing What an Auditor Has to Do .............................................................. 18Recognizing your customers .............................................................. 18Giving business owners what they need .......................................... 18Meeting the needs of management .................................................... 18Working with a client’s audit committee .......................................... 19

Getting to Know Major Auditing Concepts ................................................. 19Materiality: Not everything is important .......................................... 19Audit risk: Making the wrong decision.............................................. 19Evidence: Proving your case .............................................................. 20Sampling: Looking at a little bit of everything ................................. 20

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Auditing For Dummies viiiChapter 2: The Role of Auditing in Public Accounting . . . . . . . . . . . . .21

What Are You Looking for? Why Audits Are Done .................................... 21Starting with the fi nancial statements .............................................. 22Satisfying regulatory requirements ................................................... 23Safeguarding the public trust ............................................................. 24Resolving differences in confl icts of interest ................................... 26Evaluating contract compliance ........................................................ 27

Examining an Auditor’s Main Tasks ............................................................ 27Evaluating the relevance and reliability of the information ........... 28Testing management assertions on the fi nancial statements ........ 28Issuing an opinion ................................................................................ 29

Who Gets Audited — and Why .................................................................... 30Publicly run companies ...................................................................... 31Companies with state or federal contracts ...................................... 31Companies requiring bonding ............................................................ 31Governmental and tax-exempt entities ............................................. 32

Chapter 3: Understanding Professional Standards and Ethics . . . . . .33

Governing Audits of Private Companies ..................................................... 33Establishing the code of conduct: AICPA ......................................... 34Creating audit standards and procedures: ASB ............................... 39

Monitoring Public Company Audits: PCAOB ............................................. 40Introducing Generally Accepted Accounting Principles (GAAP) ............ 41Following the Ten Generally Accepted Auditing Standards .................... 42

General standards ................................................................................ 43Standards of fi eldwork ........................................................................ 43Standards of reporting ........................................................................ 44

Part II: Performing the Initial Auditing Steps ............... 45

Chapter 4: Getting Engaged: Preparing to Conduct an Audit . . . . . . . .47

Learning about Your Client .......................................................................... 48Assessing repeat clients...................................................................... 49Researching new clients ..................................................................... 49

Establishing Independence and Objectivity .............................................. 52Looking at independence and objectivity with your client ............ 52Considering third parties .................................................................... 53

Integrity and Competence: Considering a Client’s Reliability ................. 57Judging a client’s integrity .................................................................. 57Evaluating a client’s competence ...................................................... 58

Assessing What Services Are Required ...................................................... 58Finding out what your client needs ................................................... 58Tailoring audit procedures to each job ............................................ 59Following the standards for the type of engagement ...................... 60

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ix Table of Contents

Preparing the Engagement Letter and Entering into the Contract ......... 61Part of the Team: Knowing What to Expect from the Audit ..................... 63

Finding out your place in the food chain .......................................... 63Preparing workpapers and other audit documents ........................ 64

Chapter 5: Assessing Audit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .67

Using the Audit Risk Model .......................................................................... 67Inherent risk: Recognizing the nature of a client’s business .......... 69Control risk: Assessing a client’s ability to detect and

correct problems ............................................................................. 72Detection risk: Figuring out your chances of overlooking

inaccuracies ...................................................................................... 73Following Risk Assessment Procedures ..................................................... 74

Recognizing the nature of the company ........................................... 75Examining the quality of company management ............................. 76Asking employees for information ..................................................... 77Analyzing processes and paperwork ................................................ 78Observing the client at work .............................................................. 79

Figuring Out What’s Material and What Isn’t ............................................. 80Distinguishing errors from fraud ....................................................... 81Explaining the triangle of fraud .......................................................... 83

Evaluating Your Audit Risk Results ............................................................. 87Tailoring the audit to a low-risk situation ........................................ 87Responding to a high-risk assessment .............................................. 88Documenting audit risk results .......................................................... 89

Chapter 6: Collecting and Documenting Audit Evidence . . . . . . . . . . .91

Management Assertions: Assessing the Information a Client Gives You .................................................................................................... 92

Defi ning fi nancial statement presentation and disclosure ............. 92Monitoring classes of transactions ................................................... 93Analyzing account balances ............................................................... 95

Eyeing the Four Concepts of Audit Evidence ............................................. 96The nature of the audit evidence ....................................................... 96The competence of the audit evidence ............................................. 97The suffi ciency of the audit evidence ............................................... 99The evaluation of the audit evidence .............................................. 100

Applying Professional Judgment ............................................................... 101Exercising skepticism ........................................................................ 101Brainstorming with audit team members ....................................... 102

Using Your Audit Program to Request the Right Evidence .................... 104Documenting the Audit Evidence .............................................................. 105

Types of documentation ................................................................... 106Ownership and retention of the audit documentation ................. 108

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Auditing For Dummies xChapter 7: Auditing a Client’s Internal Controls . . . . . . . . . . . . . . . . . .111

Defi ning Internal Controls .......................................................................... 112Identifying the Five Components of Internal Controls ............................ 113Determining When You Need to Audit Internal Controls ....................... 114

Defi ning substantive strategy and control testing strategy ......... 115Figuring out which strategy is best ................................................. 116

Testing a Client’s Reliability: Assessing Internal Control Procedures ................................................................................................ 117

Considering external factors ............................................................ 117Evaluating how management assesses its controls ...................... 117Using questionnaires to evaluate internal controls ...................... 119Designing your tests of controls ...................................................... 121Using sampling to test internal controls ......................................... 122Knowing when internal controls are sound or weak..................... 125Documenting your conclusion ......................................................... 127

Limiting Audit Procedures When Controls Are Good ............................. 127Tailoring Tests to Internal Control Weaknesses ..................................... 128Timing a Client’s Control Procedures ....................................................... 129

Setting a timeline for the client ........................................................ 130Conducting interim versus year-end audits ................................... 130

Chapter 8: Sampling the Records . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133

Knowing What a Sample Looks Like .......................................................... 133How large should the sample be? .................................................... 134Why is the right sample so important? ........................................... 135

Identifying Types of Evidence That Are Normally Sampled .................. 135Naming Types of Evidence That Aren’t Normally Sampled ................... 136Choosing an Audit Sampling Method ........................................................ 137

Statistical sampling ............................................................................ 137Nonstatistical sampling ..................................................................... 142

Assessing Sampling Risk ............................................................................. 143Dealing with Sampling Risk ........................................................................ 144

The risk of incorrect rejection ......................................................... 144The risk of incorrect acceptance ..................................................... 145Acceptable sampling risk .................................................................. 145Confi dence level ................................................................................. 146

Using Tolerable and Expected Error to Set Sample Size ........................ 146Following fi rm policy or last year’s audit ....................................... 147Using tables or software to set sample size ................................... 147Adjusting sample size based on your analysis .............................. 148

Using Sampling to Test Account Balances ............................................... 148Putting Sampling to the Test ...................................................................... 149

Step 1: Determining the test objectives .......................................... 150Step 2: Defi ning your population characteristics .......................... 150Step 3: Determining the sample size ............................................... 151Step 4: Selecting sample items ......................................................... 151Step 5: Performing audit procedures .............................................. 151Step 6: Drawing conclusions............................................................. 152

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xi Table of Contents

Part III: Auditing How a Client Conducts Business ...... 153

Chapter 9: The Revenue Process: Auditing How a Business Makes Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155

Realizing What You’re Looking For ........................................................... 155Recording Revenue: Accrual Method ....................................................... 156

Contracts: Identifying goods or services provided for a fee ........ 157Contra-accounts: Factoring in customer returns and

discounts for early payment ......................................................... 158Defi ning earned and realizable revenue.......................................... 159

Getting to Know Your Client ...................................................................... 159General client information ................................................................ 160Control environment ......................................................................... 160Accounting system ............................................................................ 161The fl ow of money in and out of the business ............................... 162Internal control procedures ............................................................. 162

Following the Flow of Revenue .................................................................. 163Receiving sales orders ...................................................................... 163Fulfi lling orders and billing ............................................................... 165

Looking at Risks and Controls ................................................................... 166Assessing the inherent risk of selling goods and services ........... 167Calculating the risks of cash transactions ...................................... 168Assessing control risk ....................................................................... 168

Testing Revenue Transactions .................................................................. 170Occurrence ......................................................................................... 170Completeness ..................................................................................... 172Authorization...................................................................................... 173Accuracy ............................................................................................. 175Cutting off transactions at year-end ................................................ 176

Confi rming Accounts Receivable ............................................................... 178Checking customer details ............................................................... 179Examining uncollectible accounts ................................................... 179

Chapter 10: The Purchasing Process: Auditing How a Business Spends Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .181

Understanding Expenses and Payables .................................................... 182Classifying expenses .......................................................................... 182Purchasing goods for cash or credit ............................................... 183Returning goods to vendors for cash or credit.............................. 186

Following the Purchasing Process ............................................................ 186Getting to know your client’s purchase patterns .......................... 186Submitting a purchase requisition .................................................. 187Selecting a vendor ............................................................................. 189Documenting transactions with purchase orders ......................... 190Receiving the goods .......................................................................... 191Moving to accounts payable ............................................................ 192Paying the vendor .............................................................................. 193

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Auditing For Dummies xiiExamining Purchase Risks and Controls .................................................. 194

Considering industry-related factors .............................................. 195Checking for prior misstatements ................................................... 195Assessing control risk ....................................................................... 196

Testing Cash Disbursement Transactions ............................................... 197Occurrence ......................................................................................... 197Completeness ..................................................................................... 198Authorization...................................................................................... 198Accuracy ............................................................................................. 199Cutting off transactions at year-end ................................................ 199

Confi rming Accounts Payable .................................................................... 200

Chapter 11: The Human Resources Process: Auditing Personnel Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201

Figuring Out How the Human Resources Process Works ...................... 202Keeping personnel records .............................................................. 202Maintaining W-4 and other deduction forms.................................. 203

Eyeing How the Payroll Process Works .................................................... 204Initiating employee hiring and fi ring ............................................... 206Preparing payroll ............................................................................... 207Recording and paying payroll taxes ................................................ 209

Examining HR Risks and Controls ............................................................. 210Considering the supply and demand of competent employees .. 210Evaluating labor contracts ............................................................... 211Confi rming Occupational Safety and Health Act (OSHA)

compliance ...................................................................................... 211Assessing payroll control risk .......................................................... 211

Testing Payroll Expense Transactions ..................................................... 214Occurrence ......................................................................................... 214Completeness ..................................................................................... 215Authorization...................................................................................... 215Accuracy ............................................................................................. 216Cutting off transactions at year-end ................................................ 216

Testing Accrued Payroll Liabilities ........................................................... 216

Chapter 12: Inventory Management: Auditing How a Business Manages Its Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219

Getting Familiar with the Inventory Process ........................................... 220Uncovering what goes into inventory ............................................. 220Distinguishing inventory systems ................................................... 221Accounting for manufacturing inventory ....................................... 223Valuing ending inventory .................................................................. 225

Taking the Physical Inventory ................................................................... 227Doing investigative work in advance of the count ........................ 228Putting the chore on management (while you observe) .............. 229Knowing what to do with obsolete or damaged items.................. 229

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xiii Table of Contents

Examining Inherent Inventory Management Risks .................................. 230Susceptibility to theft ........................................................................ 230Complexity of the year-end inventory procedure ......................... 231Prior-period misstatements .............................................................. 232

Assessing Inventory Management Control Risk ...................................... 232Making sure all recorded inventory exists ..................................... 233Safeguarding inventory ..................................................................... 234

Testing Inventory Transactions and Disclosure Issues .......................... 235Occurrence ......................................................................................... 235Completeness ..................................................................................... 235Authorization...................................................................................... 236Accuracy ............................................................................................. 236Cutting off transactions at year-end ................................................ 237Required disclosures ......................................................................... 237

Part IV: Focusing on a Client’s Finances ..................... 239

Chapter 13: Auditing Fixed and Intangible Assets . . . . . . . . . . . . . . . .241

Tackling Transactions That Affect Fixed (Tangible) Assets .................. 242Looking at types of property, plant, and equipment .................... 242Accounting for fi xed-asset purchases ............................................. 243Checking depreciation calculations ................................................ 244Figuring gain or loss on the disposal of a fi xed asset.................... 247Looking at how leases affect the balance sheet ............................. 248Handling assets that were made in-house, received as

donations, or traded for ................................................................ 248Dealing with Intangible Assets and Amortization ................................... 250

Looking at types of intangible assets .............................................. 250Amortization: Calculating use of intangible assets ....................... 251

Checking Out Other Assets: Prepaid Expenses and Deferred Charges...................................................................................................... 252

Prepaid expenses ............................................................................... 253Deferred charges ................................................................................ 253

Examining Inherent Risks of Fixed Assets ................................................ 254Recording the correct cost basis ..................................................... 254Recognizing the complexity of book value calculations ............... 254

Assessing Fixed-Asset Control Risk ........................................................... 255Automatically assigning high risk .................................................... 256Performing tests of controls ............................................................. 256

Testing Details of Transactions ................................................................. 257Occurrence ......................................................................................... 258Ownership........................................................................................... 258Completeness ..................................................................................... 258Authorization...................................................................................... 259Accuracy ............................................................................................. 259Cutoffs ................................................................................................. 260

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