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control over financial reporting as of the end of the fiscal period. If auditors conclude that the events reflect a material weakness that existed at year-end, they must give an adverse opinion on internal control over financial reporting. If they are unable to determine the effect of the subsequent event on the effectiveness of internal control, they must disclaim their opinion on internal control. Chapter 24 / COMPLETING THE AUDIT 765 Those That Do Not Have a Direct Effect on the Financial Statements but for Which Dis closure Is Required Subsequent events of this type provide evidence of conditions that did not exist at the date of the balance sheet being reported on but are so significant that they require disclosure even though they do not require account adjustment. Ordinarily, these events can be adequately disclosed by the use of footnotes, but occasionally, one may be so significant as to require disclosure in supplemental financial statementsthat include the effect of the event as if it had occurred on the balance sheet date. An example is an extremely material merger. Events or transactions occurring in the subsequent period that may require dis - closure rather than an adjustment in the financial statements include: • A decline in the market value of securities held for temporary investment or resale • The issuance of bonds or equity securities • A decline in the market value of inventory as a consequence of government action barring further sale of a product • The uninsured loss of inventories as a result of fire • A merger or an acquisition Auditors of accelerated filer public companies may also identify events related to internal control over financial reporting that arose subsequent to year-end. If the auditor determines that these subsequent events have a material effect on the company’s internal control over financial reporting, the auditor’s report must include an explanatory para - graph either describing the event and its effect or directing the reader to a disclosure in management’s report on internal control of the event and its effect. Audit Tests There are two categories of audit procedures for the subsequent events review: 1. Procedures normally integrated as a part of the verification of year-end account balances 2.APproacegduores pPerfDormFe d sEpencifihcaallyn focr teher purpose of discovering events or trans - actionsthat must be recognized as subsequent events The first category includes cutoff and valuation tests done as a part of the tests of details of balances. For example, auditors examine subsequent period sales and acquisition transactions to determine whether the cutoff is accurate. Auditors also test the collecti - bility of accounts receivable by reviewing subsequent period cash receipts to evaluate the valuation of the allowance for uncollectible accounts. Procedures for cutoff and valuation have been discussed sufficiently in preceding chapters and are not repeated here. The second category of tests are performed specifically to obtain information to incorporate into the current year’s account balances or footnotes as tests of the complete - ness presentation and disclosure objective. These tests include the following: Review Records Prepared Subsequent to the Balance Sheet Date Auditors should review journals and ledgers to determine the existence and nature of significant transactions related to the current year. If journals are not kept up-to-date, auditors should review documents that will be used to prepare the journals. Auditors of public companies that are accelerated filers must inquire about and examine statements issued during the subsequent events review period, such as relevant internal audit reports and regulatory agency reports on the company’s internal control over financial reporting. Review Internal Statements Prepared Subsequent to the Balance Sheet Date In the review, auditors should emphasize changes in the business compared to results for the same period in the year under audit and changes after year-end. They should pay

careful attention to major changes in the business or environment in which the client is operating. Auditors should discuss the interim statements with manage ment to determine whether they are prepared on the same basis as the current period statements, and also inquire about significant changes in the operating results. 766 Part 5 / COMPLETING THE AUDIT Examine Minutes Issued Subsequent to the Balance Sheet Date Auditors must examine the minutes of stockholders and directors meetings subsequent to the balance sheet date for subsequent events affecting the current period financial statements. Correspond with Attorneys As discussed earlier in the chapter, auditors correspond with attorneys as a part of the search for contingent liabilities. Auditors normally request the attorney to date and mail the letter as of the expected completion date of field work to fulfill the auditors’ responsibility for subsequent events. Inquire of Management Inquiries vary from client to client, but normally include significant changes in the assets or capital structure of the company after the balance sheet date, the current status of items that were not completely resolved at the balance sheet date, and unusual adjustments made subsequent to the balance sheet date. Public company auditors must also include inquiries of management about any changes in internal control over financial reporting made subsequent to the end of the fiscal period. Inquiries of management about subsequent events must be done with appropriate client personnel to obtain meaningful answers. For example, it is not useful for the auditor to discuss tax or union matters with an accounts receivable supervisor. Depending on the information desired, auditors usually make inquiries of the controller, vice presidents, and the president. Obtain a Letter of Representation The letter of representation written by the client’s management to the auditor formalizes statements made by management about different matters throughout the audit, including discussions about subsequent events. This letter is mandatory and includes other relevant matters. This letter is discussed in the following section. Occasionally, the auditor determines that a subsequent event that affects the current Dual Dating period financial statements occurred after the field work was completed but before the audit report was issued. The source of such information is typically management or the Apago PDF Enhancer media. For example, what if an audit client acquired another company after the auditor’s last day of field work? Using the dates in Figure 24-3 on page 765, assume the acquisi - tion occurred on March 23, when the last day of field work was March 11. In that situation, auditing standards require the auditor to extend audit tests for the newly discovered subsequent event to make sure that it is correctly disclosed. The auditor has two equally acceptable options for expanding subsequent events tests: 1. Expand all subsequent events tests to the new date 2. Restrict the subsequent events review to matters related to the new subsequent event For the first option, auditors simply change the audit report date to the new date. For the second option, the auditor issues a dual-dated audit report, meaning that the audit report includes two dates: the first date for the completion of field work, except for the specific exception, and the second date, which is always later, for the exception. In the example, assume the auditor returned to the client’s premises to perform audit tests pertaining only to the acquisition and completes those tests on March 31. The audit report will be dual- dated as follows: March 11, 2012, except for note 17, as to which the date is March 31, 2012. FINAL EVIDENCE ACCUMULATION In addition to the review for subsequent events, the auditor has several final evidence OBJECTIVE 24-5 accumulation responsibilities that apply to all cycles. Five types of final evidence Design and perform the accumulation are discussed in this section: perform final analytical procedures,

final steps in the evidence- evaluate the going-concern assumption, obtain a management representation letter, accumulation segment of consider information accompanying the basic financial statements, and read other the audit. information in the annual report. Each of these is done late in the audit. Chapter 24 / COMPLETING THE AUDIT 767 Perform Final Auditing standards require auditors to perform analytical procedures during the Analytical Procedures completion of the audit. They are useful as a final review for material misstatements or financial problems not noted during other testing and to help the auditor take a final objective look at the financial statements. It is common for a partner to do the analytical procedures during the final review of audit documentation and financial statements. Typically, a partner has a good understanding of the client and its business because of ongoing relationships. This knowledge combined with effective analytical procedures help the partner identify possible oversights in an audit. The opening story in the audit of Westside Industries illustrates this point. When performing analytical procedures during the final review stage, the partner generally reads the financial statements, including footnotes, and considers: 1. The adequacy of evidence gathered about unusual or unexpected account balances or relationships identified during planning or while conducting the audit. 2. Unusual or unexpected account balances or relationships that were not previously identified. Results from final analytical procedures may indicate that additional audit evi - dence is necessary. Evaluate Going- Auditing standards require the auditor to evaluate whether there is a substan tial doubt Concern Assumption about a client’s ability to continue as a going concern for at least one year beyond the balance sheet date. Auditors make that assessment initially as a part of planning but may revise it after obtaining new information. For example, an initial assessment of going concern may need revision if the auditor discovers during the audit that the company has defaulted on a loan, lost its primary customer, or decided to dispose of substantial assets to pay off loans. Auditors use analytical procedures, discussions with management about potential financial difficulties, and their knowledge of the client’s business gained through out the audit to assess the likelihood of financial failure within the next year. Apago PDF Enhancer A final assessment of the entity’s going concern status is desirable after all evidence has been accumulated and proposed audit adjustments have been incorporated into the financial statements. When auditors have reservations about the going-concern assump - tion, they must evaluate management’s plans to avoid bankruptcy and the feasibility of achieving these plans. Making the final decision whether to issue a report with a going- concern explanatory paragraph can be time-consuming and difficult. (For more discussion of going-concern explanatory paragraphs, see pages 52–53 in Chapter 3.) Obtain Management Auditing standards require the auditor to obtain a letter of representation documen - Representation Letter ting management’s most important oral representations made during the audit. The letter is prepared on the client’s letterhead, addressed to the CPA firm, and signed by high-level corporate officials, usually the president and chief financial officer. While the letter implies that it has originated with the client, it is common practice for the auditor to prepare the letter and request the client to type it on the company’s letterhead and sign it. Refusal by a client to prepare and sign the letter requires a qualified opinion or disclaimer of opinion. The letter should be dated no earlier than the date of the auditor’s report to make sure that there are adequate representations about subsequent events. The three purposes of the client letter of representation are: 1. To impress upon management its responsibility for the assertions in the financial

statements. It is easy for management to forget that they are responsible, not the auditor, for the fair presentation of financial statements, especially in smaller companies that lack personnel with expertise in accounting. 2. To remind management of potential misstatements or omissions in the financial statements. For example, if the letter of representation includes a reference to pledged assets and contingent liabilities, honest management may be reminded of its unintentional failure to disclose the information adequately, which helps satisfy the completeness presentation and disclosure objective. To fulfill this 768 Part 5 / COMPLETING THE AUDIT objective, the letter of representation should be sufficiently detailed to act as a reminder to management. 3. To document the responses from management to inquiries about various aspects of the audit.This provides written documentation of client representations in the event of disagreement or a lawsuit between the auditor and client. Because it is more formal than oral communication, a letter of representation also Phase IV— Completing the Audit helps reduce misunderstandings between management and the auditor. Auditing standards suggest four categories of specific matters that should be Perform additional tests for presenta- included. The four categories, with examples of each, are: tion anddisclosure 1. Financial statements •Management’s acknowledgment of its responsibility for the fair presentation Review for of the financial statements contingent liabilities •Management’s belief that the financial statements are fairly presented in con- formity with applicable accounting standards Review for subsequent events 2. Completeness of information •Availability of all financial records and related data Accumulate •Completeness and availability of all minutes of meetings of stockholders, final evidence directors, and committees of directors 3. Recognition, measurement, and disclosure Evaluate results •Management’s belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements Issue audit report •Information concerning fraud involving (a) management, (b) employees who have significant roles in internal control, or (c) others where the fraud could Communicate with audit committee have a material effect on the financial statements andmanagement •Information concerning related party transactions and amounts receivable from or payable to related parties •Unasserted claims or assessments that the entity’s lawyer has advised are proba- Apago PDF Enhancer ble of assertion and must be disclosed in accordance with accounting standards 4. Subsequent events •Bankruptcy of a major customer with an outstanding account receivable at the balance sheet date •A merger or acquisition after the balance sheet date PCAOB Standard 5 requires the auditor to obtain written representations from management about its responsibility for internal control over financial reporting and management’s conclusion about the effectiveness of internal control over financial reporting as of the end of the fiscal period. Auditors of public companies may obtain a combined representation letter for both the audit of the financial statements and the audit of internal control. A client representation letter is a written statement from a nonindependent source and therefore cannot be regarded as reliable evidence. However, the letter does provide documentation that management has been asked certain questions to make sure that management understands its responsibilities and to protect the auditor if management files claims against the auditor. In some audits, the auditor may find other evidence that contradicts statements in the letter of representation. In such cases, the auditor should investigate the circum - stances and consider whether representations in the letter are reliable. Clients often include additional information beyond the basic financial statements in Consider materials prepared for management or outside users. Auditing standards refer to this Supplementary

additional information as supplementary information in relation to the financial state - Information ments as a whole. Figure 24-4 (p. 770) illustrates the basic financial statements and in Relation to additional supplementary information. Financial Statements Auditing standards intentionally refrain from defining or restricting supplemen - as a Whole tary information to enable companies to individualize the information to meet the Chapter 24 / COMPLETING THE AUDIT 769 FIGURE 24-4 Supplementary Information Accompanying Basic Financial Statements Balance sheet Standard Basic financial Income statement auditor’s statements report Statement of cash flows Footnotes Detailed comparative Supplementary Explanatoryparagraph statements information or separate report— accompanying unqualified, qualified, basic financial Statistical data or disclaimer statements Schedule of insurance coverage needs of statement users. However, several types of information are commonly included in the additional information section, such as detailed comparative statements supporting the totals on the primary financial statements for accounts such as cost of goods sold and operating expenses. Auditors must clearly distinguish their audit and reporting responsibility for the primaAry pfinaangciaol s taPtemDeFnts anEdn fohr saupnplcemeenrtary information. Usually, the auditor has not performed a sufficiently detailed audit to justify an opinion on the additional information. In some instances, however, the auditor may be engaged by the client to report on the supplementary information accompanying the basic financial statements. To complete that engagement, the supplementary information must be derived from the accounting records used to generate the basic financial statements and involve the same time period as the basic financial statements. Additionally, the auditor cannot have issued an adverse opinion or disclaimer of opinion on the basic financial statements. When reporting on supplementary information, the auditor users the same materi - alityas that used in forming an opinion on the basic financial statements. As a result, the additional procedures required are less extensive than if the auditor were issuing an opinion on the information taken by itself. Auditor reporting on supplementary information can be either in an explanatory para graph following the opinion paragraph in the auditor’s report on the financial state - ments or in a separate report on the supplementary information. If the auditor’s report on the audited financial statements contains an adverse opinion or a disclaimer of opinion, the auditor is precluded from issuing an opinion on the supplementary information. The following is an example of an explanatory paragraph reporting on supple - mentary information in relation to the financial statements as a whole: Our audit was conducted for the purpose of forming an opinion on the financial statements as a whole. The accompanying information on pages x through y is presented for purposes of additional analysis and is not a required part of the financial statements. Such information is the responsibility of management and was derived from and relates directly to the underlying accounting and other records used to prepare the financial statements. The information has been subjected to the auditing procedures applied in the audit of the financial statements and certain additional procedures, including comparing and reconciling such information directly 770 Part 5 / COMPLETING THE AUDIT to the underlying accounting and other records used to prepare the financial state - ments or to the financial statements themselves, and other additional procedures in accordance with auditing standards generally accepted in the United States of America. In our opinion, the information is fairly stated in all material respects in relation to the financial statements as a whole. If the auditor concludes that the supplementary information is materially mis - stated in relation to the financial statements as a whole, the auditor should request

manage ment to revise the supplementary information. If management does not make the necessary modifications, the auditor should modify the auditor’s opinion on the supplementary information and describe the misstatement in the auditor’s report. If a separate report is being issued on the supplementary information, the auditor should withhold the auditor’s report on the supplementary information. Sometimes additional information is required by accounting standards, which auditing standards refer to as required supplementary information. Required supplemen- tary information is not part of the basic financial statements; however, a designated accounting standards setter considers the information to be an essential part of finan- cial reporting. When required supplementary information accompanies the basic financial statements, auditing standards require the auditor to perform certain additional procedures that are limited to inquiry of management about the methods of preparing the information and comparison of the information for consistency with management’s responses to the auditor’s inquiries, the basic financial statements, and to information the auditor obtains during the audit of the basic financial statements. Because these limited procedures do not provide sufficient evidence to provide any assurance about the required supplementary information, the auditor’s report on the basic financial statements includes an explanatory paragraph that contains a disclaimer of opinion about the required supplementary information. Auditing standards requires the audiAtopr toa rgeado o thPerD inFfor mEatnionh inaclnudcede inr annual Read Other reports pertaining directly to the financial statements. For example, assume that the Information in the president’s letter in the annual report refers to an increase in earnings per share from Annual Report $2.60 to $2.93. The auditor is required to compare that information with the financial statements to make sure it corresponds. Auditor responsibility to read other information included in annual reports pertains only to information that is not a part of the financial statements but is published with them. Examples are the president’s letter and explanations of company activities included in annual reports of nearly all publicly held companies. It usually takes auditors only a few minutes to make sure that the nonfinancial statement information is con - sistent with the statements. If auditors conclude that a material inconsistency exists, they should request the client to change the information. If the client refuses, which would be unusual, the auditor should include an explanatory paragraph in the audit report or withdraw from the engagement. EVALUATE RESULTS After performing all audit procedures in each audit area, including the review for OBJECTIVE 24-6 contingencies and subsequent events and accumulating final evidence, the auditor Integrate the audit evidence must integrate the results into one overall conclusion about the financial statements. gathered and evaluate the Ultimately, the auditor must decide whether sufficient appropriate audit evidence has overall audit results. been accumulated to warrant the conclusion that the financial statements are stated in accordance with accounting standards applied on a basis consistent with those of the preceding year. Similarly, when issuing a report on internal control, auditors must also arrive at an overall conclusion about the effectiveness of internal control over financial reporting. The five main aspects of evaluating the results are discussed next. Chapter 24 / COMPLETING THE AUDIT 771 FIGURE 24-5 Completing the Audit Checklist YES NO 1. Examination of prior year’s audit documentation a. Were last year’s audit files examinedfor areas of emphasis in the current year audit? b. Was the permanent file reviewedfor items that affect the current year? 2. Internal control a. Has internal control been adequately understood? b. Is the scope of the audit adequate in light of the assessed control risk? c. Have all significant deficiencies andmaterial weaknesses been reported in writing to those

charged with governance? 3. General documents a. Were all current year minutes and resolutions reviewed, abstracted, andfollowed up? b. Has the permanent file been updated? c. Have all major contracts and agreements been reviewed and abstracted, copied, or downloaded to ascertain that the client complies with all existing legal requirements? Sufficient To make a final evaluation as to whether sufficient appropriate evidence has been Appropriate Evidence accumulated, the auditor reviews the audit documentation for the entire audit to deter - mine whether all material classes of transactions, accounts and disclosures have been adequately tested, considering all circumstances of the audit. An important part the review is to make sure that all parts of the audit program have been accurately completed and documented, and that all audit objectives have been met. The auditor must decide whether the audit program is adequate, considering problem areas identified as the audit progressed. For example, if misstatements were discovered during tests of sales, the initial plans for tests of details of accounts receivable may have been insufficient. As an aid in deciding whether the audit evidence is adequate, auditors often use a Apago PDF Enhancer completing the audit checklistwhich is a reminder of items that may have been over - looked. Figure 24-5illustrates part of a completing the audit checklist. If auditors conclude that sufficient evidence has notbeen obtained to decide whether the financial statements are fairly presented, they have two choices: accumulate addi- tional evidence or issue either a qualified opinion or a disclaimer of opinion. Evidence Supports An essential part of evaluating whether the financial statements are fairly stated involves Auditor’s Opinion the auditor’s review of their summary of misstatements found in the audit. When any one misstatement is material, auditors should propose that the client correct the financial Phase IV— statements. It may be difficult to determine the appropriate amount of adjustment Completing the Audit because the exact amount of the misstatement may be unknown if it involves an estimate Perform additional or includes sampling error. Nevertheless, the auditor must decide on the required tests for presenta- adjustment. (In some audits there may be more than one material misstatement.) tion anddisclosure In addition to individually material misstatements, there are often several imma- terial misstatements that the client did not adjust. Auditors must combine individually Review for contingent liabilities immaterial misstatements to evaluate whether the combined amount is material. They can keep a record of these misstatements and combine them in different ways, Review for but many auditors use an unadjusted misstatement audit schedule or summary of subsequent events possible misstatements. An example of an unadjusted misstatement worksheet is given Accumulate in Figure 24-6. final evidence The schedule in Figure 24-6 includes both known misstatements that the client has decided not to adjust and projected misstatements, including sampling error, and total Evaluate results possible misstatements for several financial statement categories. The bottom left Issue audit report portion of the audit schedule, under the heading “Conclusions,” includes a comparison of possible overstatements and understatements to materiality. A summary of this audit Communicate with schedule is often included with management’s representation that the uncorrected audit committee misstatements are immaterial. andmanagement 772 Part 5 / COMPLETING THE AUDIT FIGURE 24-6 Unadjusted Misstatement Audit Schedule Hillsburg Hardware Co. Schedule A-3 Date Summary of Possible Misstatements Prepared by LF 3/15/12 12/31/11 Approved by JA 3/15/12 POSSIBLE MISSTATEMENT—OVERSTATEMENT (UNDERSTATEMENT) Audit File Type of Total Current Noncurrent Current Income Source Misstatement Amount Assets Assets Liabilities Before Tax B-4 Understated allowance for [EA] 95,000 95,000 95,000 uncollectible accounts

C-8 Accounts receivable/Sales cutoff [P] 60,000 (60,000) (60,000) misstatements D-2 Difference between physical [A] 120,000 (120,000) (120,000) inventory and book figures H-7/2 Unrecorded liabilities [P] 285,000 (100,000) (85,000) (285,000) 100,000 V-10 Repairs expense items that [A] 90,000 (90,000) (90,000) should have been cAapiptaliazedgo PDF Enhancer Totals (185,000) (175,000) (285,000) (75,000) [EA] Estimated based on analytical procedures. [A] Actual population misstatements. [P] Estimatedpopulation misstatements based on the sample, including sampling error. Conclusions The net effects of the above items are as follows: None of these aggregate effects or the individual items has a material effect on the financial statements in Materiality total or with respect to the components they pertain Current assets (185,000) 1,531,000 to. On this basis, adjustment of any or all of the items Total assets (360,000) 1,841,000 is passed. Leslie Franklin Income before taxes (75,000) 442,000 3/15/12 If auditors believe that there is sufficient evidence but they conclude that the financial statements are not fairly presented, they again have two choices: The statements must be revised to the auditor’s satisfaction or either a qualified or an adverse opinion must be issued. Notice that the options here are different from those in the case of insufficient evidence. Before completing the audit, auditors must make a final evaluation of whether the dis - Financial Statement closures in the financial statements satisfy all presentation and disclosure objectives. As Disclosures we discussed at the beginning of this chapter, auditors must design and perform audit procedures to obtain evidence that the four presentation and disclosure objectives are satisfied. As part of the final review for financial statement disclosures, many CPA firms require the completion of a financial statement disclosure checklist for every audit. These questionnaires are designed to remind the auditor of common disclosure problems in financial statements and to facilitate the final review of the entire audit by Chapter 24 / COMPLETING THE AUDIT 773 FIGURE 24-7 Financial Statement Disclosure Checklist: Property, Plant, andEquipment 1. Are the following disclosures included in the financial statements or notes: a. Balances ofmajor classes ofdepreciable assets (land, building, equipment, and so forth) at the balance sheet date? b. Allowances for depreciation, by class or in total, at the balance sheet date? c. General description ofdepreciation methodsfor major classes of PP&E? d. Total amount ofdepreciation charged to expense for each income statement presented? e. Basis of evaluation? 2. Are carrying amounts ofpropertymortgaged and encumbered by indebtedness disclosed? 3. Are details of sale and leaseback transactions during the perioddisclosed? 4. Is the carrying amount ofproperty not a part of operating plant—for example, idle or heldfor investment or sale—segregated? 5. Has consideration been given to disclosure offullydepreciated capital assets still in use and capital assets not presently in use? an independent partner. Figure 24-7 illustrates a partial financial statement disclosure checklist. Naturally, a checklist is not sufficient to replace the auditor’s knowledge of the proper application of accounting standards for the circumstances of the audit. Audit Documentation There are three reasons why an experienced member of the audit firm must thoroughly Review review audit documentation at the completion of the audit: 1. To evaluate the performance of inexperienced personnel.A considerable portion of most audits is performed by audit personnel with fewer than four or five years of experience. These people may have sufficient technical training to conduct an adequate audit, but their lack of experience affects their ability to make sound professional judgments in complex situations. Apago PDF Enhancer 2. To make sure that the audit meets the CPA firm’s standard of performance. Within any CPA firm, the quality of staff performance varies considerably, but

careful review by top-level personnel in the firm helps to maintain a uniform quality of auditing. 3. To counteract the bias that often enters into the auditor’s judgment. Auditors must attempt to remain objective throughout the audit, but they may lose proper perspective on a long audit when complex problems need to be solved. Except for a final independent review, which is discussed shortly, the review of audit documentation should be conducted by someone who is knowledgeable about the client and the circumstances in the audit. Therefore, the auditor’s immediate supervisor normally conducts the initial review of audit files prepared by another auditor. For example, the least experienced auditor’s work is ordinarily reviewed by the audit senior. The senior’s immediate superior, who is normally a supervisor or manager, reviews the senior’s work and also reviews, less thoroughly, the schedules of the inexperienced auditor. Finally, the partner assigned to the audit must ultimately review all audit documentation, but the partner reviews those prepared by the supervisor or manager more thoroughly than the others. While performing the review, each reviewer has discussions with the auditor responsible for preparing the audit documentation to learn how significant audit issues were resolved. Except for the final independent review, most audit documentation review is done as each segment of the audit is completed. Independent Review At the completion of larger audits, it is common to have the financial statements and the entire set of audit files reviewed by a completely independent reviewer who has not participated in the audit, but is a member of the audit firm doing the audit. An independent review, sometimes referred to as an engagement quality review, is 774 Part 5 / COMPLETING THE AUDIT UNRECORDED In March 2002, the SEC announced it had Andersen to write off the accumulated errors over completed its investigation of the accounting periods of up to 10 years. However, as time ADJUSTMENTS practices at Waste Management, Inc. and had filed progressed, management never complied with PROVE COSTLY suits against the company and several of its top the terms of their secret agreement. executives charging them with perpetrating a The SEC eventually settled charges with TO AUDIT FIRM massive financial statement fraud lasting more Andersen and four of its partners related to the than five years. The SEC alleged that management 1992 through 1996 audited financial statements. manipulated the company’s financial results using Andersen agreed to pay a penalty of $7 million, a multitude of improper accounting practices to the largest ever assessed against an accounting meet predetermined earnings targets. firm at the time. Commenting on the SEC’s As part of the investigation, the SEC noted that actions, Richard Walker, SEC Director of Waste Management’s auditors, Arthur Andersen, Enforcement, noted: had identified the company’s improper accounting “Arthur Andersen and its partners failed to practices and quantified much of the impact of stand up to company management and thereby those practices on the company’s financial betrayed their ultimate allegiance to Waste statements. According to SEC filings, Andersen Management’s shareholders and the investing annually presented company management with public. Given thepositions held by these partners “Proposed Adjusting Journal Entries (PAJEs)” to and the duration and gravity of the misconduct, the correct errors that understated expenses and firm itself must be held responsible for the false overstated earnings in thecompany’s financial and misleading audit reports.” statements. Managementconsistently refused to Source: Beasley, Buckless, Glover, and Prawitt, make the adjustments called for by the PAJEs, Auditing Cases: An Interactive Learning Approach, and, instead, entered into an agreement with 4th Edition, pp. 103-110, published by Prentice Hall. required for SEC engagements, including the review of interim financial information and the audit of internal controls. This reviewer often takes an adversarial position to

make sure the conduct of the audit was adequate. The audit team must be able to justify the evidence it has accumulated and the conclusions it reached on the basis of the circumstances of the audit. Apago PDF Enhancer Figure 24-8 summarizes evaluating whether there is sufficient appropriate evidence Summary of and whether the evidence supports the opinion on the financial statements. It Evidence Evaluation shows that the auditor evaluates the sufficiency and appropriateness of the evidence by first evaluating achieved audit risk, by account and by cycle, and then making Phase IV— the same evaluation for the overall financial statements. The auditor also evaluates Completing the Audit whether the evidence supports the audit opinion by first estimating misstatements in each account and then for the overall financial statements. In practice, the Perform additional evaluation of achieved audit risk and estimated misstatement are made at the same tests for presenta- tion anddisclosure time. On the basis of these evaluations, the audit report is issued for the financial statements. Review for contingent liabilities Review for FIGURE 24-8 Evaluating Results and Reaching Conclusions on the Basis subsequent events ofEvidence Accumulate Evaluating Results final evidence and Reaching Conclusions Evaluate results Actual audit evidence Evaluate results Evaluate overall (by cycle, account, (by account and cycle) financial statements and objective) Issue Issue audit report audit Audit procedures Estimatedmisstatement Estimatedmisstatement report Communicate with Sample size (by account) (overall statements) audit committee Items to select Achieved audit risk Achieved audit risk andmanagement Timing (by account and cycle) (overall statements) Chapter 24 / COMPLETING THE AUDIT 775 ISSUE THE AUDIT REPORT The auditor should wait to decide the appropriate audit report to issue until all evidence has been accumulated and evaluated, including all steps of completing the audit discussed so far. Because the audit report is the only thing that most users see in the audit process, and the consequences of issuing an inappropriate report can be severe, it is critical that the report be correct. In most audits, the auditor issues an unqualified report with standard wording. Firms usually have an electronic template of this report and need to change only the name of the client, title of the financial statements, and date. When a CPA firm decides that a standard unqualified report is inappropriate, there will almost certainly be extensive discussions among technical partners in the CPA firm and often with client personnel. Most CPA firms have comprehensive audit reporting manuals to assist them in selecting the appropriate wording of the report they decide to issue. COMMUNICATE WITH THE AUDIT COMMITTEE AND MANAGEMENT OBJECTIVE 24-7 After the audit is completed, several potential communications from the auditor may be sent to the audit committee or others charged with governance, including com - Communicate effectively munication of detected fraud and illegal acts, internal control deficiencies, other with the audit committee communications with the audit committee, and management letters. The first three of and management. these communications are required by auditing standards to make certain that those charged with governance, which is often the audit committee and senior management, are informed of audit findings and auditor recommendations. The fourth item, manage - Apago PDF Enhancer mentletters, is often communicated to operating manage ment. Communicate Fraud Auditing standards require the auditor to communicate all fraud and illegal acts to the and Illegal Acts audit committee or similarly designated group, regardless of materiality. The purpose is to assist the audit committee in performing its supervisory role for reliable financial statements. Communicate Internal As discussed in Chapter 10, the auditor must also communicate in writing significant Control Deficiencies internal control deficiencies and material weaknesses in the design or operation of

internal control to those charged with governance. In larger companies, this communi - cation is made to the audit committee and in smaller companies, it may be made to the owners or senior management. Other Auditing standards require the auditor to communicate certain additional infor mation Communications obtained during the audit to those charged with governance, which is generally the with Audit Committee audit committee. The purpose of this required communication is to keep the audit committee, or others charged with governance, informed about significant and relevant information for the oversight of the financial reporting process and to provide an opportunity for the audit committee to communicate important matters to the auditor. Thus, the auditing standard requirements are designed to encourage two-way communications between the auditor and those charged with governance. There are four principal purposes of this required com munication: 1. To communicate auditor responsibilities in the audit of financial statements. This communication includes discussion by the auditor that the audit of financial statements is designed to obtain reasonable, rather than absolute, assurance about material misstatements in the financial statements. For audits of financial statements that do not include an audit of internal control 776 Part 5 / COMPLETING THE AUDIT over financial reporting, the communication also indicates that the auditor is not providing an opinion on the effectiveness of internal control, in addition to other limitations of an audit of financial statements. 2. To provide an overview of the scope and timing of the audit.The purpose of this Phase IV— required communication is to provide a high-level overview, such as the Completing the Audit auditor’s approach to addressing significant risks and consideration of internal control, and timing of the audit. Details of the nature and timing of audit Perform additional tests for presenta- procedures is not appropriate to avoid compromising the effectiveness and tion anddisclosure predictability of the audit. 3. To provide those charged with governance with significant findings arising during Review for the audit. These communications might include discussion of material, contingent liabilities corrected misstatements detected during the audit, the auditor’s view of quali - tative aspects of significant accounting practices and estimates, and significant Review for subsequent events difficulties encountered during the audit, including disagree ments with management, among other matters. Accumulate 4. To obtain from those charged with governance information relevant to the audit. final evidence The audit committee or others charged with governance, such as the full board of directors, may share strategic decisions that may affect the nature and Evaluate results timing of the auditor’s procedures. Issue audit report Communications about significant findings arising during the audit are normally made in writing. Communications about other matters may be made orally or in Communicate with writing, with all oral communications documented in the audit files. Communications audit committee should be made timely to allow those charged with governance to take appropriate andmanagement actions. Generally, communications about the auditor’s responsi bilities and the audit scope and timing occur early in an audit, while communi cations about significant findings usually occur throughout the entire engagement period. The Sarbanes–Oxley Act of 2002 includes additional communication requirements Apago PDF Enhancer for auditors of public companies. For example, auditors must communicate all alternative treatments of financial information within requirements of accounting standards that have been discussed with management, ramifications of the alternative disclosures and treatments, and the treatment preferred by the auditor. As the audit is completed, the auditor should determine that the audit committee is informed about the initial selection of and changes in significant accounting policies or their application during the current

audit period, as well as the reasons for any changes. The auditor should also communi- cate information about methods used to account for any significant unusual transactions and the effect of significant accounting policies in controversial or emerging areas. Amanagement letteris intended to inform client personnel of the CPA’s recommen - Management Letters dations for improving any part of the client’s business. Most recommendations focus on suggestions for more efficient operations. The combination of the auditor’s experience in various businesses and a thorough understanding gained in conducting the audit places the auditor in a unique position to provide assistance to management. Many CPA firms write a management letter for every audit to demonstrate to management that the firm adds value to the business beyond the audit service pro - vided. Their intent is to encourage a better relationship with management and to suggest additional tax and permitted management services that the CPA firm can provide. A management letter differs from a letter reporting significant deficiencies in internal control, which was discussed in Chapter 10. The latter is required when there are sig nificant deficiencies or material weaknesses in internal control, and must follow a prescribed format and be sent in accordance with the requirements of auditing standards. A management letter is optional and is intended to help the client operate its business more effectively. Each management letter should be developed to meet the style and preferences of the CPA firm and the needs of the client. Some auditors combine the management Chapter 24 / COMPLETING THE AUDIT 777 letter with the letter about significant deficiencies and material weaknesses. On smaller audits, it is common for the auditor to communicate operational suggestions orally rather than by a management letter. SUBSEQUENT DISCOVERY OF FACTS OBJECTIVE 24-8 After the auditor issues the audit report and completes all communications with manage ment and the audit committee, the audit is finished. Usually, the next major Identify the auditor’s contact between the auditor and client occurs when the planning process of the next responsibilities when facts year’s audit begins. affecting the audit report are discovered after its Although it rarely happens, auditors sometimes learn after the audited financial issuance. statements have been issuedthat the financial statements are materially misstated. Examples are the inclusion of material nonexistent sales, the failure to write off obsolete inventory, or the omission of an essential footnote. When this subsequent discovery of facts occurs, the auditor has an obligation to make certain that users who are relying on the financial statements are informed about the misstatements. (If the auditor had known about the misstatements before the audit report was issued, the auditor would have insisted that management correct the misstatements or, alternatively, a different audit report would have been issued.) It does not matter whether the failure to discover the misstatement was the fault of the auditor or the client. In either case, the auditor’s responsibility remains the same. Although subsequent discovery of facts is not part of completing the audit, it is included in this chapter because it is easier to understand in this context. If the auditor discovers that the statements are misleading after they have been issued, the most desirable action is to request that the client issue an immediate revision of the financial statements that includes an explanation of the reasons for the revision. If a Apago PDF Enhancer subsequent period’s financial statements are completed before the revised statements would be issued, it is acceptable to disclose the misstatements in the subsequent period’s statements. When pertinent, the client should inform the SEC and other regulatory agencies of the misstated financial statements. The auditor is responsible to make certain that the client has taken the appropriate steps to inform users of the misstated statements.

If the client refuses to disclose the misstated statements, the auditor must inform the board of directors. The auditor must also notify regulatory agencies having juris- diction over the client that the statements are no longer fairly stated and also, when practical, each person who relies on the financial statements. If the stock is publicly held, it is acceptable to request the SEC and the stock exchange to notify stockholders. The subsequent discovery of facts requiring the recall or reissuance of financial statements arises only from business events that existed before the date of the auditor’s report. For example, a revision of the financial statements is not requiredif an account receivable is believed to be collectible after an adequate review of the facts at the date of the audit report, but the customer subsequently files bankruptcy. If the customer had filed for bankruptcy before the audit report date, however, there is a subsequent discovery of facts. The auditor’s responsibility for subsequent events review ends on the date of the completion of the field work. Auditors have no responsibility to search for subsequent facts, but if they discover that issued financial statements are incorrectly stated, they must take action to correct them. In most cases, subsequent discovery of facts occurs when auditors discover a material misstatement in issued financial statements during the subsequent year’s audit, or when the client reports a misstatement to the auditor. Figure 24-9 illustrates the periods covered by the review for subsequent events, pro cessing the financial statements, and subsequent discovery of facts after the audit report date. As you review the figure, note that auditors have no responsibility to review subse quent events after the audit report date. If auditors discover subsequent 778 Part 5 / COMPLETING THE AUDIT FIGURE 24-9 Review for Subsequent Events and Subsequent Discovery of Facts Client’s ending Audit Date client balance sheet report issues financial date date statements 12-31-11 3-11-12 3-26-12 Period to which Periodfor Period in which review for subsequent processing subsequent discovery events applies the financial offacts is made statements facts after the audit report date (3-11-12), but before the financial statements are issued (3-26-12), they will require that the financial statements be revised before they are issued. Auditors will also follow one of the two options discussed in the “Dual Dating” section, page 767. SUMMARY The completion phase of the audit is critical to ensuring a quality audit. In this phase, auditors perform additional tests for presentation and disclosure, including reviewing for contingencies and subsequent events. Auditors also review the sufficiency of the audit evidence and the decisions reached to determine whether they support the audit opinion. Apago PDF Enhancer Auditors then communicate with the audit committee and management about important audit findings and other matters. ESSENTIAL TERMS Commitments—agreements that the entity of disclosure problems commonly en - will hold to a fixed set of conditions, such countered in audits and that facilitates as the purchase or sale of merchandise at a final review of the entire audit by an inde- stated price, at a future date, regardless of pendent partner what happens to profits or to the economy as a whole Independent review—a review of the financial statements and the entire set of Completing the audit checklist—a reminder audit files by a completely independent to the auditor of aspects of the audit that reviewer to whom the audit team must may have been overlooked justify the evidence accumulated and the Contingent liability—a potential future conclusions reached obligation to an outside party for an un - known amount resulting from activities Inquiry of the client’s attorneys—a letter that have already taken place from the client requesting that legal counsel inform the auditor of pending litigation Dual-dated audit report—the use of one or any other information involving legal

audit report date for normal subsequent counsel that is relevant to financial state- events and a later date for one or more ment disclosure subsequent events that come to the auditor’s attention after the field work has Letter of representation—a written com - been completed munication from the client to the auditor Financial statement disclosure checklist— formalizing statements that the client has a questionnaire that reminds the auditor made about matters pertinent to the audit Chapter 24 / COMPLETING THE AUDIT 779 Management letter—an optional letter Subsequent discovery of facts—auditor written by the auditor to a client’s manage - discovery that the financial statements are ment containing the auditor’s recommen- materially misstated after they have been dat ions for improving any aspect of the issued client’s business Subsequent events—transactions and Other information included in annual other pertinent events that occurred after reports—information that is not a part of the balance sheet date that affect the fair the financial statements but is pub - presentation or disclosure of the state - lished with them; auditors must read ments being audited this information for inconsistencies with the financial statements Unadjusted misstatement audit schedule— a summary of immaterial misstatements Review for subsequent events—the audit- not adjusted at the time they were found, ing procedures performed by auditors to used to help the auditor assess whether the identify and evaluate subse quent events; combined amount is material; also known also known as a post-balance-sheet review as a summary of possible misstate ments Review of audit documentation—a review of the completed audit files by another Unasserted claim—a potential legal claim member of the audit firm to ensure quality against a client where the condition for a and counteract bias claim exists but no claim has been filed REVIEW QUESTIONS 24-1 (Objective 24-1) Identify and describe the four presentation and disclosure audit objectives. 24-2 (Objective 24-1) Describe the purpose of a financial statement disclosure checklist and explain how it helps the auditor determine if there is sufficient appropriate evidence for eacAh opf taheg proes entPatiDonF an d Edisnclohsuaren obcjecetivres. 24-3 (Objective 24-2) Distinguish between a contingent liability and an actual liability and give three examples of each. 24-4 (Objective 24-2) In the audit of the James Mobley Company, you are concerned about the possibility of contingent liabilities resulting from income tax disputes. Discuss the procedures you could use for an extensive investigation in this area. 24-5 (Objective 24-2) Explain why an auditor is interested in a client’s future commitm ents to purchase raw materials at a fixed price. 24-6 (Objective 24-3) Explain why the analysis of legal expense is an essential part of every audit. 24-7 (Objectives 24-2, 24-3)During the audit of the Merrill Manufacturing Company, Ralph Pyson, CPA, has become aware of four lawsuits against the client through discussions with the client, reading corporate minutes, and reviewing correspondence files. How should Pyson determine the materiality of the lawsuits and the proper disclosure in the financial statements? 24-8 (Objective 24-3) Distinguish between an asserted and an unasserted claim. Explain why a client’s attorney may not reveal an unasserted claim. 24-9 (Objective 24-3) Describe the action that an auditor should take if an attorney refuses to provide information that is within the attorney’s jurisdiction and may directly affect the fair presentation of the financial statements. 24-10 (Objective 24-4) Distinguish between the two general types of subsequent events and explain how they differ. Give two examples of each type. 24-11 (Objectives 24-3, 24-4) In obtaining letters from attorneys, Bill Malano’s aim is to receive the letters as early as possible after the balance sheet date. This provides him with a signed letter from every attorney in time to properly investigate any exceptions. It also eliminates the problem of a lot of unresolved loose ends near the end of the audit. Evaluate

Malano’s approach. 780 Part 5 / COMPLETING THE AUDIT 24-12 (Objective 24-4)What major considerations should the auditor take into account in determining how extensive the review of subsequent events should be? 24-13 (Objective 24-4) Identify five audit procedures normally done as a part of the review for subsequent events. 24-14 (Objectives 24-4, 24-8) Distinguish between subsequent events occurring between the balance sheet date and the date of the auditor’s report, and subsequent discovery of facts existing at the date of the auditor’s report. Give two examples of each and explain the appropriate action by the auditor in each instance. 24-15 (Objective 24-5) Miles Lawson, CPA, believes that the final summarization is the easiest part of the audit if careful planning is followed throughout the audit. He makes sure that each segment of the audit is completed before he goes on to the next. When the last segment of the audit is completed, he is finished with the audit. He believes this may cause each part of the audit to take a little longer, but he makes up for it by not having to do the final summarization. Evaluate Lawson’s approach. 24-16 (Objectives 24-1, 24-5, 24-6) Compare and contrast the accumulation of audit evidence and the evaluation of the adequacy of the disclosures in the financial statements. Give two examples in which adequate disclosure could depend heavily on the accumulation of evidence and two others in which audit evidence does not normally significantly affect the adequacy of the disclosure. 24-17 (Objectives 24-5, 24-7) Distinguish between a client letter of representation and a management letter and state the primary purpose of each. List some items that might be included in each letter. 24-18 (Objective 24-5)Explain what is meant by information accompanying basic financial statements. Provide two examples of such information. What levels of assurance may the CPA offer for this information? 24-19 (Objective 24-5)What is meanAt pby aregadiong oPtheDr fFin ancEianl inhfoarmnatcione inr annual reports? Give an example of the type of information the auditor is examining. 24-20 (Objective 24-6) Distinguish between regular audit documentation review and independent review and state the purpose of each. Give two examples of potential findings in each of these two types of review. 24-21 (Objective 24-7) Describe matters that the auditor must communicate to audit committees of public companies. MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS 24-22 (Objective 24-2) The following questions deal with contingent liabilities. Choose the best response. a. The audit step most likely to reveal the existence of contingent liabilities is (1) a review of vouchers paid during the month following the year-end. (2) an inquiry directed to legal counsel. (3) accounts payable confirmations. (4) mortgage-note confirmation. b. Which of the following would be least likely to be included in a standard inquiry to the client’s attorney? (1) A list provided by the client of pending litigation or asserted or unasserted claims with which the attorney has had some involvement. (2) A request for the attorney to opine on the correct accounting treatment associated with an outstanding claim or pending lawsuit outcome. (3) A request that the attorney provide information about the status of pending litigation. (4) A request for the attorney to identify any pending litigation or threatened legal action not identified on a list provided by the client. Chapter 24 / COMPLETING THE AUDIT 781 c. When a contingency is resolved subsequent to the issuance of audited financial state - ments, which correctly contained disclosure of the contingency in the footnotes based on information available at the date of issuance, the auditor should (1) take no action regarding the event. (2) insist that the client issue revised financial statements. (3) inform the audit committee that the report cannot be relied on. (4) inform the appropriate authorities that the report cannot be relied on. 24-23 (Objectives24-5, 24-7)The following questions concern communications between

management, those charged with governance, and the auditor. Choose the best response. a. A principal purpose of a letter of representation from management is to (1) serve as an introduction to company personnel and an authorization to examine the records. (2) discharge the auditor from legal liability for the audit. (3) confirm in writing management’s approval of limitations on the scope of the audit. (4) remind management of its primary responsibility for financial statements. b. The date of the management representation letter should coincide with the (1) balance sheet date. (2) date of the auditor’s report. (3) date of the latest subsequent event referred to in the notes to the financial statements. (4) date of the engagement agreement. c. Which of the following is not a required item to be communicated by the auditor to the audit committee or others charged with governance? (1) Information about the auditor’s responsibility in an audit of financial statements. (2) Information about the overall scope and timing of the audit. (3) Recommendations for improving the client’s business. (4) Significant findings arising from the audit. d. A management letter (1A) pis atheg aoud itoPr’sD reFpo rtE onn shignaifnicacnte derficiencies and material weaknesses in internal control. (2) contains management’s representations to the auditor documenting statements made by management to the auditor during the audit about matters affecting the financial statements. (3) is mandatory in all audits and must be dated the same date as the audit report. (4) contains recommendations from the auditor designed to help the client improve the efficiency and effectiveness of its business. 24-24 (Objective 24-4) The following questions deal with review of subsequent events. Choose the best response. a. Subsequent events for reporting purposes are defined as events that occur subsequent to the (1) balance sheet date. (2) date of the auditor’s report. (3) balance sheet date but before the date of the auditor’s report. (4) date of the auditor’s report and concern contingencies that are not reflected in the financial statements. b. An example of an event occurring in the period of the auditor’s field work subsequent to the end of the year being audited that normally will not require disclosure in the financial statements or auditor’s report is (1) serious damage to the company’s plant from a widespread flood. (2) issuance of a widely advertised capital stock issue with restrictive covenants. (3) settlement of a large liability for considerably less than the amount recorded. (4) decreased sales volume resulting from a general business recession. c. Ruffin has audited the financial statements of Weaver Corporation for the year ended December 31, 2011. The auditor completed the audit work on February 22, 2012 and dated the audit report as of that date. The report was delivered to management for inclusion in its financial statements submitted by Weaver Corporation to its banker on February 27, 782 Part 5 / COMPLETING THE AUDIT 2012. Ruffin archived all its working papers for the audit on March 1, 2012. Under the circumstances, Ruffin is responsible for reviewing subsequent events occurring through (1) December 31, 2011. (3) February 27, 2012. (2) February 22, 2012. (4) March 1, 2012. 24-25 (Objective 24-5)The following questions concern information accompanying basic financial statements. Choose the best response. a. The Form 10-K filed by management of a public company includes a section on manage- ment’sdiscussion and analysis (MD&A) in addition to the annual financial statements. Which of the following best describes the auditor’s responsibility for the MD&A information? (1) The auditor must perform sufficient appropriate audit procedures to opine on the MD&A information. (2) The auditor has no responsibilities related to the MD&A disclosures. (3) The auditor must read the MD&A information to determine if there is any material inconsistency with the audited financial statements. (4) The auditor must provide a disclaimer of opinion related to the MD&A inform ation.

b. Ansman, CPA, has been requested by a client, Rainco Corp., to prepare information in addition to the basic financial statements for this year’s audit. Which of the following is the best reason for Rainco’s requesting the additional information? (1) To provide an opinion about the supplemental information when certain items are not in accordance with accounting standards. (2) To provide Rainco’s creditors a greater degree of assurance as to the financial soundness of the company. (3) To provide Rainco’s management with information to supplement and analyze the basic financial statements. (4) To provide the documentation required by the SEC in anticipation of a public offering of Rainco’s stock. c. Management of Thurman CorpoAraptioan gincolu dedP aDddFitio naEl snuphplaemnenctarey irnforma- tion in documents that include the audited financial statements for the year ended December 31, 2011. Management has asked its audit firm, Wally, CPAs, whether they can report on the supplementary information. Which of the following conditions would preclude Wally, CPAs from conducting this engagement? (1) The supplementary information is derived from the accounting records used to generate the basic financial statements. (2) The supplementary information covers the period January 1, 2011 through February 15, 2012. (3) Wally’s opinion of the basic financial statements was unqualified. (4) When evaluating supplementary information, Wally plans to use the same materiality threshold as that used in the audit of the basic financial statements. DISCUSSION QUESTIONS AND PROBLEMS 24-26 (Objective 24-1, 24-2) Elizabeth Johnson, CPA, has completed the audit of notes payable and other liabilities for Valley River Electrical Services and now plans to audit con - tingent liabilities and commitments. a. Distinguish between contingent liabilities and commitments and explain why both Required are important in an audit. b. Describe how Johnson’s testing in phases I-III of the audit of notes payable might help her obtain evidence about the four presentation and disclosure objectives. c. Identify three useful audit procedures for uncovering contingent liabilities that Johnson will likely perform in the normal conduct of the audit, even if she had no responsibility for uncovering contingencies. d. Identify three other procedures Johnson is likely to perform specifically for the pur- pose of identifying undisclosed contingencies. Chapter 24 / COMPLETING THE AUDIT 783 24-27 (Objective 24-2) In an audit of the Marco Corporation as of December 31, 2011, the following situations exist. No entries have been made in the accounting records in relation to these items. 1. During the year 2011, the Marco Corporation was named as a defendant in a suit for damages by the Dalton Company for breach of contract. An adverse decision to the Marco Corporation was rendered and the Dalton Company was awarded $4,000,000 damages. At the time of the audit, the case was under appeal to a higher court. 2. On December23, 2011, the Marco Corporation declared a common stock dividend of 1,000 shares with a par value of $1,000,000 of its common stock, payable February2, 2012, to the common stockholders of record December30, 2011. 3. The Marco Corporation has guaranteed the payment of interest on the 10-year, first mortgage bonds of the Newart Company, an affiliate. Outstanding bonds of the Newart Company amount to $5,500,000 with interest payable at 5% per annum, due June 1 and December 1 of each year. The bonds were issued by the Newart Company on December 1, 2009, and all interest payments have been met by that company with the exception of the payment due December 1, 2011. The Marco Corporation states that it will pay the defaulted interest to the bondholders on January 15, 2012. Required a. Define contingent liability. b. Describe the audit procedures you would use to learn about each of the situations listed. c. Describe the nature of the adjusting entries or disclosure, if any, you would make for each of these situations.* 24-28 (Objective 24-3)In analyzing legal expense for the Boastman Bottle Company, Mary

Little, CPA, observes that the company has paid legal fees to three different law firms during the current year. In accordance with her CPA firm’s normal operating practice, Little requests standard attorney letters as of the balance sheet date from each of the three law firms. On the last day of field work, Little notes that one of the attorney letters has not yet been received. The second letter contains a statement to the effect that the law firm deals exclusively in registering patents and refuses to comment on any lawsuits or other legal Apago PDF Enhancer affairs of the client. The third attorney’s letter states that there is an outstanding unpaid bill due from the client and recognizes the existence of a potentially material lawsuit against the client but refuses to comment further to protect the legal rights of the client. Required a. Evaluate Little’s approach to sending the attorney letters and her follow-up on the responses. b. What should Little do about each of the letters? 24-29 (Objective 24-4) The following unrelated events occurred after the balance sheet date but before the audit report was prepared: 1. The granting of a retroactive pay increase 2. Declaration of a stock dividend 3. Sale of a fixed asset at a substantial profit 4. Determination by the federal government of additional income tax due for a prior year 5. Filing of an antitrust suit by the federal government Required a. Explain how each of the items might have come to the auditor’s attention. b. Discuss the auditor’s responsibility to recognize each of these in connection with the report.* 24-30 (Objectives 24-4, 24-8)The field work for the June 30, 2011, audit of Tracy Brewing Company was finished August 19, 2011, and the completed financial statements, accom - panied by the signed audit reports, were mailed September 6, 2011. In each of the highly material independent events (a through i), state the appropriate action (1 through 4) for the situation and justify your response. The alternative actions are as follows: 1. Adjust the June 30, 2011, financial statements. 2. Disclose the information in a footnote in the June 30, 2011, financial statements. 3. Request the client to recall the June 30, 2011, statements for revision. 4. No action is required. *AICPA adapted. 784 Part 5 / COMPLETING THE AUDIT The events are as follows: a. On December 14, 2011, the auditor discovered that a debtor of Tracy Brewing went bankrupt on July 15, 2011, due to declining financial health. The sale had taken place January 15, 2011. b. On December 14, 2011, the auditor discovered that a debtor of Tracy Brewing went bankrupt on October 2, 2011. The sale had taken place April 15, 2011, but the amount appeared collectible at June 30, 2011, and August 19, 2011. c. On August 15, 2011, the auditor discovered that a debtor of Tracy Brewing went bankrupt on August 1, 2011. The most recent sale had taken place April 2, 2010, and no cash receipts had been received since that date. d. On August 6, 2011, the auditor discovered that a debtor of Tracy Brewing went bank - rupt on July 30, 2011. The cause of the bankruptcy was an unexpected loss of a major laws uit on July 15, 2011, resulting from a product deficiency suit by a different customer. e. On August 6, 2011, the auditor discovered that a debtor of Tracy Brewing went bank - rupt on July 30, 2011, for a sale that took place July 3, 2011. The cause of the bankruptcy was a major uninsured fire on July 20, 2011. f. On July 20, 2011, Tracy Brewing settled a lawsuit out of court that had originated in 2008 and is currently listed as a contingent liability. g. On September 14, 2011, Tracy Brewing lost a court case that had originated in 2010 for an amount equal to the lawsuit. The June 30, 2011, footnotes state that in the opinion of legal counsel there will be a favorable settlement. h. On July 20, 2011, a lawsuit was filed against Tracy Brewing for a patent infringement action that allegedly took place in early 2011. In the opinion of legal counsel, there is a danger of a significant loss to the client.

i. On May 31, 2011, the auditor discovered an uninsured lawsuit against Tracy Brewing that had originated on February 28, 2011. 24-31 (Objective 24-5) Leslie MorganA, CpPAa, hgaso pr epPareDd Fa l etteEr onf hreparensenctaetiorn for the president and controller to sign. It contains references to the following items: 1. Inventory is fairly stated at the lower of cost or market and includes no obsolete items. 2. All actual and contingent liabilities are properly included in the financial statements. 3. All subsequent events of relevance to the financial statements have been disclosed. a. Why is it desirable to have a letter of representation from the client concerning these Required matters when the evidence accumulated during the course of the audit is meant to verify the same information? b. To what extent is the letter of representation useful as audit evidence? Explain. c. List several other types of information commonly included in a letter of representation. 24-32 (Objective 24-5)As a part of the audit of Ren Gold Manufacturing Company, a non - public company, management requests basic financial statements and separately, the same basic financial statements accompanied by additional information. Management informs you that the intent is to use the basic financial statements for bankers, other creditors, and the two owners who are not involved in management. The basic financial statements accompanied by the additional information are to be used only by managem ent. Manage- ment requests the inclusion of specific information but asks that no audit work be done beyond what is needed for the basic financial statements. The following is requested: 1. A schedule of insurance in force. 2. The auditor’s feelings about the adequacy of the insurance coverage. 3. An aged trial balance of accounts receivable and evaluation of the adequacy of the allowance for uncollectible accounts. 4. A summary of fixed asset additions. 5. Material weaknesses in internal control and recommendations to improve internal control. 6. A 5-year summary of the most important company ratios, with the appropriate ratios to be determined at the auditor’s discretion. Chapter 24 / COMPLETING THE AUDIT 785 7. A schedule of notes payable accompanied by interest rates, collateral, and a payment schedule. Required a. What is the difference between basic financial statements and additional information? b. What are the purposes of additional information accompanying basic financial statem ents? c. For the previously listed items (1 through 7), state which ones could appropriately be included as additional information. Give reasons for your answer. d. Identify three other items that may appropriately be included as additional inform at ion. e. Assume that an unqualified opinion is proper for the basic financial statements report, that no testing was done beyond that required for the basic financial state ments report, and that only appropriate information is included in the additional informa - tion. Write the proper auditor’s report. 24-33 (Objective 24-6)The following items were discovered during the December 31, 2011 audit of the financial statements of Westmoreland Corporation: 1. The company’s financial statements did not include an accrual for bonuses earned by senior management in 2011 but payable in March 2012. The aggregate bonus amount was $125,000. 2. Equipment originally costing $725,000 that was fully depreciated with a remaining residual value of $60,000 was sold for $85,000 on December 29, 2011. The purchaser agreed to pay for the equipment by January 15, 2012. 3. Based on close examination of the client’s aged accounts receivable trial balance and correspondence files with customers, the auditor determined that management’s allowance for bad debts is overstated by $44,000. 4. Expenses totaling $52,000 associated with the maintenance of equipment were inappropriately debited to the equipment account. 5. Marketing expenses of $43,000 were incorrectly classified as cost of goods sold. 6. The company received new computer equipment on January 3, 2012 that was ordered

and shipped F.O.B. shipping point to Westmoreland on December 27, 2011. No Apago PDF Enhancer entry has been recorded for this purchase that was financed by a long-term note payable due in full June 30, 2013. Required a. Prepare an Unadjusted Misstatement Audit Schedule using the following format (see Figure 24-6 on page 773 as an example): Possible Misstatement – Overstatement (Understatement) Total Current Noncurrent Current Noncurrent Income Amount Assets Assets Liabilities Liabilities Before Tax b. Balance sheet and income statement materiality for the audit of Westmoreland financial statements is $75,000. What is your conclusion about the financial statements if the audit findings are not corrected by Westmoreland management before you issue the audit report? 24-34 (Objective 24-7) In a letter to the audit committee of the Cline Wholesale Company, Jerry Schwartz, CPA, informed them of material weaknesses in the control of inventory. In a separate letter to senior management, he elaborated on how the material weaknesses could result in a significant misstatement of inventory by the failure to recognize the existence of obsolete items. In addition, Schwartz made specific recomm endations in the management letter on how to improve internal control and save clerical time by installing a computer system for the company’s perpetual records. Management accepted the recommendations and installed the system under Schwartz’s direction. For several months, the system worked beautifully, but unforeseen problems developed when a master file was erased. The cost of reproducing and processing the inventory records to correct the error was significant, and management decided to scrap the entire project. The company sued Schwartz for failure to use adequate professional judgment in making the recommen dations. Required a. What is Schwartz’s legal and professional responsibility in the issuance of manage - ment letters? b. Discuss the major considerations that will determine whether he is liable in this situation. 786 Part 5 / COMPLETING THE AUDIT CASE 24-35 (Objective 24-6) In your audit of Aviary Industries for calendar year 2011, you found a number of matters that you believe represent possible adjustments to the company’s books. These matters are described below. Management’s attitude is that “once the books are closed, they’re closed,” and management does not want to make any adjustments. Planning materiality for the audit was $100,000, determined by computing 5% of expected income before taxes. Actual income before taxes on the financial statements prior to any adjustments is $1,652,867. Possible adjustments: 1. Several credit memos that were processed and recorded after year-end relate to sales and accounts receivable for 2011. These total $26,451. 2. Inventory cutoff tests indicate that $25,673 of inventory received on December 30, 2011, was recorded as purchases and accounts payable in 2012. These items were included in the inventory count at year-end and therefore were included in ending inventory. 3. Inventory cutoff tests also indicate several sales invoices recorded in 2011 for goods that were shipped in early 2012. The goods were included in inventory even though they were set aside in a separate shipping area. The total amount of these shipments was $41,814. 4. The company wrote several checks at the end of 2011 for accounts payable that were held and not mailed until January 15, 2012. These totaled $43,671. Recorded cash and accounts payable at December 31, 2011, are $2,356,553 and $2,666,290, respectively. 5. The company has not established a reserve for obsolescence of inventories. Your tests indicate that such a reserve is appropriate in an amount somewhere between $15,000 and $30,000. 6. Your review of the allowance for uncollectible accounts indicates that it may be understated by between $35,000 and $55,000. a. Determine the adjustments that yoAu bpeliaeveg mous t bPe mDadFe f or EAvniarhy’s afinnancciael stratements Required to be fairly presented. Include the amounts and accounts affected by each adjustment.

b. Why may Aviary Industries’ management resist making these adjustments? c. Explain what you consider the most positive way of approaching management personnel to convince them to make your proposed changes. d. Describe your responsibilities related to unadjusted misstatements that management has determined are immaterial individually and in the aggregate. e. Assuming Aviary Industries is an accelerated filer public company, describe how the noted adjustments might impact your audit report on internal control over financial reporting. INTERNET PROBLEM 24-1: AUDIT COMMITTEE RESPONSIBILITIES Audit committees of public companies have many responsibilities in today’s financial reporting environment. Visit the website of Microsoft Corporation (www.microsoft.com) and locate the Audit Committee’s Charter under the “Investor Relations” link to answer the following questions. a. What is the primary purpose of the Microsoft Audit Committee? Required b. What responsibility, if any, does the Audit Committee have in regards to the engage - ment of the external auditor? c. At a minimum, how often will the Audit Committee meet in a given year? d. Review the Audit Committee Responsibilities Calendar and briefly describe the nature of items included in the Audit Committee’s review with Finance management and the independent auditor upon completion of the audit. e. With whom does the Audit Committee meet in executive session? Describe your views about why these sessions are conducted. Chapter 24 / COMPLETING THE AUDIT 787 Apago PDF Enhancer T R A P C H A P T E R S 2 5 – 2 6 6 OTHER ASSURANCE AND NONASSURANCE SERVICES Chapter 1 introduced assurance and nonassurance services offered by CPA firms and other types of auditors. Assurance services other than audits have become increasingly important to both CPA firms and other auditors. The two chapters inPart 6expand on that discussion. • Chapter 25deals with assurance and nonassurance services, both traditional and emerging, that CPA firms offer. • Chapter 26covers services performed most often by governmental and internal auditors, including internal financial auditing, governmental financial auditing, and operational auditing. 25 C H A P T E R OTHER ASSURANCE SERVICES LEARNING OBJECTIVES After studying this chapter, Skepticism Applies To All Types Of Engagements you should be able to Barnhart Construction Company was a contractor specializing in apartment 25-1 Understand the level of assurance complexes in the Southwest. The owner of the construction company, David and evidence requirements for Barnhart, reached an agreement with a promoter named Alton Leonard to review and compilation services. serve as a contractor on three construction projects Leonard was currently 25-2 Describe special engage ments marketing. One problem with the agreement was that Barnhart would not to review interim financial information for public companies. receive final payment for the construction work until all the partnership units were sold. 25-3 Distinguish AICPA attestation standards from auditing The first partnership offering was completely sold and Barnhart was paid. standards and know the type of engage ments to which they Unfortunately, the next two partnerships were not completely sold. To solve apply. this problem, Barnhart loaned money to relatives and key employees who 25-4 Understand the nature of bought the necessary interests for the partnerships to close so that Barnhart WebTrustandSysTrustassurance would receive the final payment. services. 25-5 Describe engagements to report Renee Lathrup, CPA, a sole practitioner, was engaged to conduct a review of on internal controls at service Barnhart Construct ion’s financial statements. She noticed that the accounting organizations. records showed loans receivable froAmp aa nugmobe r oPf DemFpl oyEeens ahnda inndic - er 25-6 Understand special engagements viduals named Barnhart. She also observed that the loans were made just to attest to prospective financial before the second and third partnerships closed and that they were in statements.

multiples of $15,000, the cost of a partnership unit. Renee asked Barnhart to 25-7 Define agreed-upon procedures explain what happened. Barnhart told Renee, “When I received the money engagements. from the first partnership escrow, I wanted to do something nice for relatives 25-8 Describe other audit and limited and employees who had been loyal to me over the years.” He told Renee, assurance engagements related to historical financial statements. “This is just my way of sharing my good fortune with the ones I love. The equality of the amounts is just a coincidence.” When Renee considered the reasonableness of this scenario, she found it hard to believe. First, the timing was odd. Second, the amounts seemed to be an unusual coincidence. Third, if he really had wanted to do something special for these folks, why didn’t he give them something, rather than loan them money? Renee asked that the promoter, Leonard, send her detailed information on the subscriptions for each partnership. Leonard refused, stating that he was under legal obligation to keep all information confidential. When Renee pressed Barnhart, he also refused further cooperation, although he did say he would “represent” to Renee that the loans had nothing to do with closing the partnerships so that he could get his money. At this point, Renee withdrew from the engagement. Up to this chapter, the book has primarily focused on audits of historical financial statements prepared in accordance with applicable accounting standards. Now, other types of assurance services offered by CPAs involving historical financial statements are discussed, such as reviews of historical financial statements and limited assurance engagements involving historical financial statements to meet specific needs of financial statement users. The chapter also examines assurance services for several types of attestation engagements that do not involve historical financial statements, such as reports on service organizations, WebTrust and SysTrust engagements, and reports on forecasted financial statements. REVIEW AND COMPILATION SERVICES OBJECTIVE 25-1 Many nonpublic companies have their financial statements reviewed or compiled by a CPA, instead of having them audited. The opening story about Barnhart Construction Understand the level of Company is an example of a review service. A company’s management may believe that assurance and evidence an audit is unnecessary because no bank or regulatory agency requires one and manage- requirements for review and compilation services. ment sees no need for audited statements for internal use. Instead, the company may engage the CPA to assist in the preparation of financial statements, either for internal use or to provide to creditors or lenders under loan agreements. Depending on the size of the loan, a lender may require compiled or reviewed financial statements, rather than an audit. A review provides limited assurance on the financial statements, whereas a compilation provides no expressed assurance. The standards for compilations and reviews of financial statements, called State - ments on Standards for Accounting and Review Services (SSARS), are issued by the Accounting and Review Services Committee of the AICPA. This committee has authority equivalent to the Auditing Standards Board for services involving unaudited financial statements of nonpublic companies. Because they are not doing audits, SSARS refer to CPAs performing review and compilation services as accountants, not auditors. Apago PDF Enhancer Because the assurance provided by compilations and reviews is considerably below that of audits, less evidence is required for these services and they can be provided at a lower fee than an audit. Figure25-1 illustrates the difference in evidence accumulation and level of assurance for audits, reviews, and compilations. The amount of evidence and assurance needed for each engagement is not defined by the profession and there - fore depends on the accountant’s judgment. Because review and compilation services provide less assurance than audits, the

accountant should establish an understanding with the client about the services to be provided through a written engagement letter. The understanding should include a FIGURE 25-1 Relationship Between Evidence Accumulation and Assurance Attained High (Audit) Level of Limited Assurance (Review) Attained None (Compilation) Minimal Significant Extensive (Compilation) (Review) (Audit) Amount of Evidence Accumulated 790 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES description of the objectives of the engagement, management’s responsibilities, the accountant’s responsibilities, the type and limitations of the service to be provided, and a description of the compilation or review report expected to be issued. The require - ments for review and compilation services are now discussed in greater detail. Areview service (SSARS review)engagement allows the accountant to express limited Review Services assurance that the financial statements are in accordance with applicable accounting standards, including appro priate informative disclosures, or other comprehensive basis of accounting (OCBOA), such as the cash basis of accounting. CPAs must be independent of the client for review service engagements. Procedures Suggested for Reviews The evidence for a review engagement consists primarily of inquiries of management and analytical procedures, substantially fewer procedures than those required for an audit. For reviews, accountants do not obtain an understanding of internal control, test controls, assess fraud risk, or do substantive tests of transactions or tests of balances, such as confirmation of receivables or physical examination of inventory. SSARS require the accountant to obtain evidence that consists of the following for a review engagement: • Obtain knowledge of the accounting principles and practices of the client’s industry.The accountant can study AICPA industry guides or other sources to obtain industry knowledge. The level of knowledge for reviews can be somewhat less than for an audit. • Obtain knowledge of the client. The information should be about the nature of the client’s business transactions, its accounting records and employees, the accounting principles and practices used by the client, and the content of the financial statements. The level of knowledge can be less than for an audit. • Make inquiries of management.Inquiry is the most important review procedure. The objective is to determine whether the financial statements are fairly pre - sented, assuming that management does not intend to deceive the accountant. Apago PDF Enhancer Inquiries must be made of the appropriate client personnel and typically involve discussions, such as the following illustrative inquiries: 1. Describe your procedures for recording, classifying, and summarizing transactions and disclosing information in the statements. 2. What unusual or significant transactions occurred this year including impor - tantactions taken at meetings of stockholders and the board of directors? 3. Is each account on the financial statements prepared in conformity with accounting standards and consistently applied? 4. Do you have knowledge of an actual or suspected fraud? • Perform analytical procedures. Based on the accountant’s understanding of the industry and knowledge of the client, the accountant designs and performs analytical procedures. These identify relationships and individual items that appear to be unusual. The appropriate analytical procedures are no different from the ones already studied (in Chapters 7 and 8 and in chapters dealing with tests of details of balances). As unusual trends are noted, the accountant engages in further inquiries with client personnel to obtain explanations for any unexpected relationships. • Obtain letter of representation. The accountant is required to obtain a letter of repre sentation from members of management who are knowledgeable about financial matters. • Prepare documentation. The accountant should prepare documentation that is sufficient in detail to provide a clear understanding of the work performed, the

review evidence obtained and its source, and the conclusions reached. Docu - mentation should include the engagement letter, analytical procedures performed, significant matters covered in the inquiries with management, significant findings and issues, communications with management or others regarding possible fraud, and the representation letter. Chapter 25 / OTHER ASSURANCE SERVICES 791 FIGURE 25-2 Example of Review Report Based on these procedures, the accountant may become concerned that informa - tion is incorrect, incomplete, or otherwise unsatisfactory. If so, additional procedures should be performed before the accountant issues a standard review services report. Form of Report Figure 25-2 provides an example of the review report when the accountant has completed a review engagement and decides that no material changes to the financial statements are needed. In addition to the required report title, the standard review report includes four paragraphs that include the following: Apago PDF Enhancer 1. Similar to the audit report, the first paragraph explicitly notes that the accountant has conducted a review and identifies the entity and period of financial state - ments subject to the review. The first paragraph also includes a statement that a review primarily consists of analytical procedures and inquiries and is substantially less in scope than an audit. 2. The second paragraph specifies that management is responsible for the preparation and fairness of the financial statements and for designing, imple - menting, and maintaining internal controls relevant to financial reporting. 3. The third paragraph notes that the accountant’s responsibility is to conduct a review of management’s financial statements in accordance with SSARS and that those standards require the accountant to perform procedures to obtain limited assurance that there are no material modifications that should be made to the financial statements. 4. The fourth paragraph expresses limited assurance in the form of negative assurance that “we are not aware of any material modifications that should be made to the accompanying financial statements” in order for them to be in conformity with applicable accounting standards. The date of the review report should be the date on which the accountant has accumulated review evidence sufficient to provide a reasonable basis for the report conclusion.Each page of the financial statements reviewed should include the reference “See independent accountant’s review report.” Failure to Follow Applicable Accounting Framework If a client has failed to follow applicable accounting standards in a review engagement, the report must be modified. (Accounting standards are the same for all historical financial statements, including reviews.) The report should disclose the effects of the departure as determined by management or the accountant’s review procedures. Even if the effects have not 792 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES been determined, the disclosure must appear in the report in a separate paragraph. The following provides an example of suggested wording: As disclosed in note X to the financial statements, accounting principles generally accepted in the United States of America require that land be stated at cost. Management has informed us that the company has stated its land at appraised value and that, if generally accepted accounting principles generally accepted in the United States of America had been followed, the land account and stockholders’ equity would have been decreased by $500,000. A compilation service engagement is defined in SSARS as one in which accountants Compilation Services prepare financial statements and present them to a client or third party without providing any CPA assurance about those statements. Many CPA firms prepare monthly, quarterly, or annual financial statements for their clients. These statements are usually for internal use by management, although they may also be provided to external users. The CPA is not required to be independent to perform a compilation and the financial

statements can be issued without additional disclosures such as footnotes. When accountants submit financial statements and expect them to be used by a third party, they are required to, at least, issue a compilation report that accompanies the statements. It is not permissible for the accountant to prepare and present financial statements to a client that plans to provide them to external users without, at a minimum, having satisfied the requirements for a compilation engagement, including the issuance of a compilation report. When the accountant does not expect the financial statements to be used by a third party, the CPA does not have to issue a compilation report, as long as the CPA documents in the engagement letter with the client an understanding regarding the services to be performed and a restriction that the financial statements are for management’s use only. Requirements for Compilation Compilation does not absolve accountants of responsibility, as they are always responsible for exercising due care in performing all Apago PDF Enhancer duties. In a compilation engagement, an accountant must accomplish the following: • Establish an understanding with the client in a written engagement letter about the objectives of the engagement, type and limitations of the services to be provided including acknowledgement that the accountant does not obtain any assurance about the financial statements, and a description of the report, if a report is to be issued. • Possess knowledge about the accounting principles and practices of the client’s industry. • Know the client, including the nature of its business transactions, accounting principles and practices used by the client, and content of its financial statements (the knowledge can be less than that for a review). • Make inquiries to determine whether the client’s information is satisfactory. • Read the compiled financial statements and be alert for any obvious omissions or errors in arithmetic and in the application of accounting standards. • Prepare documentation in sufficient detail to provide a clear understanding of the work performed. Accountants do not have to make other inquiries or perform other procedures to verify information provided by client personnel. But if they become aware that the statements are not fairly presented, they should obtain additional information. If the client refuses to provide the information, the accountant should withdraw from the compilation engagement. Form of Report SSARS define three types of compilation reports. The use of each depends on whether management elects to include all the required disclosures with the financial statements and whether the accountant is independent. 1. Compilation with full disclosure.A compilation of this type requires disclosures in accordance with accounting standards, the same as for audited financial statements or reviews, as illustrated by Figure25-3 (p. 794). Chapter 25 / OTHER ASSURANCE SERVICES 793 FIGURE 25-3 Compilation Report with Full Disclosure Accountant’s Compilation Report We have compiled the accompanying balance sheet of Williams Company as of December 31, 2011, and the related statements of income, retained earnings, and cash flows for the year then ended. We have not audited or reviewed the accompanying financial statements and, accordingly,do not express an opinion or provide any assurance about whether the financial statements are in accordance with accounting principles generally accepted in the United States of America. Management is responsible for the preparation andfair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America and for designing, implementing, and maintaining internal control relevant to the preparation and fair presentation of the financial statements. Our responsibility is to conduct the compilation in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accoun- tants. The objective of a compilation is to assist management in presenting financial information

in the form offinancial statements without undertaking to obtain or provide any assurance that there are no material modifications that should be made to the financial statements. 2. Compilation that omits substantially all disclosures.Figure25-4 shows the appro - priate wording that the accountant adds after the conclusion paragraph of the standard compilation report when the accountant compiles statements without disclosures. In this example, management has also elected not to present the statement of cash flows. This type of compilation is acceptable if the report indicates the lack of disclosuresand the absence of disclosures is not, to the CPA’s knowledge, undertaken with the intent to mislead users. Typically, this type of statement is used primarily for management purposes. 3. Compilation without independence.A CPA firm can issue a compilation report Awpitah gfulol o r oPmDittFed diEscnloshuraes nevcene if rit is not independent of the client, as defined by the Code of Professional Conduct. When the accountant lacks inde - pendence, an additional paragraph must be added as the last paragraph of the report that states: “We are not independent with respect to Williams Company.” For all three types of compilation reports, the following elements are also required: • A report title that says “Accountant’s Compilation Report.” • The date of the accountant’s report is the date of completion of the compilation. • Each page of the financial statements compiled by the accountant should state “See accountant’s compilation report.” • If the client fails to follow accounting standards, the auditor must include the same modifications in the compilation report that are used in a review report. FIGURE 25-4 Compilation That Omits Substantially All Disclosures We have compiled the accompanying balance sheet of Williams Company as of December 31, 2011, and the related statements of income and retained earnings for the year then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. A compilation is limited to presenting in the form offinancial statements information that is the representation ofmanagement. We have not audited or reviewed the accompanying financial statements and, accordingly,do not express an opinion or any other form of assurance on them. Management has elected to omit substantially all of the disclosures and the statement of cash flows required by accounting principles generally accepted in the United States of America. If the omitted disclosures were included in the financial statements, they might influence the users conclusions about the company’sfinancial position, results of operations, and cash flows. Accordingly, the financial statements are not designed for those who are not informed about such matters. 794 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES REVIEW OF INTERIM FINANCIAL INFORMATION FOR PUBLIC COMPANIES The SEC requires that quarterly financial statements be reviewed by the company’s OBJECTIVE 25-2 external auditor prior to the company’s filing of the Form 10-Q with the SEC. The Describe special engage - SEC also requires a footnote in the annual audited financial statements disclosing ments to review interim quarterly sales, gross profit, income, and earnings per share for the past two years. financial information for Typically, the footnote in the annual statements is labeled unaudited. At a minimum, public companies. the CPA firm must perform review procedures of the footnote information. Because the same CPA firm does both the annual audit and the public company interim financial statement review, they are referred to as auditors, not accountants for the interim review. Like reviews under SSARS, a public company interim reviewincludes five require - ments for review service engagements. The auditor must: (1) obtain knowledge of the accounting principles of the client’s industry, (2) obtain knowledge of the client, (3) make inquiries of management, (4) perform analytical procedures, and (5) obtain a letter of

representation. Also like SSARS reviews, reviews for public companies do not provide a basis for expressing positive opinion level assurance. Ordinarily, auditors perform no tests of the accounting records, independent confirmations, or physical examinations. However, the two types of reviews differ in several areas. Below are the key differences: • Because an annual audit is also performed for the public company client, the auditor must obtain sufficient information about the client’s internal control for both annual and interim financial information. • Similarly, because the client is audited annually, the auditor’s knowledge of the results of these audit procedures is used in considering the scope and results of the inquiries and analytical procedures for the review. • Under SSARS, the auditor maAkeps ianqguiorie s aPboDutF ac tioEnsn tahkean ant dcireectrors’ and stock holders’ meetings; for a public company, the auditor reads the minutes of those meetings. • The auditor must also obtain evidence that the interim financial information agrees or reconciles with the accounting records for a public company interim review. For example, the auditor might compare the interim financial informa tion to the general ledger. A public company interim review is performed following standards of the PCAOB and the review report makes no reference to SSARS. See Figure25-5 for an example of FIGURE 25-5 Example of a Report for Interim Financial Statements for a Public Company Report of Independent Registered Public Accounting Firm We have reviewed the consolidated balance sheet of Rainer Company and consolidated sub- sidiaries as of September 30, 2011, and the related statements of earnings, retained earnings, and cash flows for the three-month and nine-month periods then ended. These financial statements are the responsibility of the company’smanagement. We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interimfinancial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of anymaterial modifications that should be made to the accompanying interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. Chapter 25 / OTHER ASSURANCE SERVICES 795 such a report. Each page of the interim financial information which accompanies the report should be clearly marked as “unaudited.” If the auditor determines the interim statements violate accounting standards, the report should be modified. The language of the modification is similar to that used in a review under SSARS, except that the auditor should state the effect of the departure, if the amount can be determined. The quarterly data reviewed by the auditor and included as a footnote in the annual audited statements should be labeled “unaudited.” However, a separate review report for this information is not required. ATTESTATION ENGAGEMENTS OBJECTIVE 25-3 Chapter 1 described assurance services as independent professional services that improve the quality of information for decision makers. Individuals who are respon - Distinguish AICPA attestation sible for making business decisions seek assurance services to help improve the standards from auditing reliability and relevance of the information on which they base their decisions. One standards and know the type of engage ments to which category of assurance services provided by CPAs is attestation services. they apply. CPAs have increasingly been asked to perform a variety of audit-like services, known as attest services, for different purposes. In an attestation engagement, the CPA

reports on the reliability of information or an assertion made by another party. An example is when a bank requests a CPA to report in writing whether an audit client has adhered to all requirements of a loan agreement. Attestation Standards The AICPA has issued 11 attestation standards that parallel the 10 generally accepted auditing standards (GAAS), as shown in Table25-1. The attestation standards are stated in sufficiently general terms to enable CPAs to apply them to any attestation engagement, includAingp naewg tyope s oPf DenFgag emEenntsh thaatn mcaye arrise. The most notable differences in the attestation standards and the 10 GAAS are in general attestation standards 2 and 3. Standard 2 requires that the CPA have adequate knowledge of the subject matter over which there is attestation. For example, for CPAs to attest to a company’s compliance with environmental protection laws, they need a thorough knowledge of the laws and methods that companies use to assure compliance. Standard 3 requires that the CPA be able to evaluate the subject matter against criteria that are suitable and available to users. Again, using the example of environmental protection laws, measurement difficulties or the lack of specific criteria may make it difficult for the CPA to conclude whether there is compliance. To provide additional guidance for doing attestation engagements, the Auditing Standards Board of the AICPA issues Statements on Standards for Attestation Engagements (SSAE). These are normally called attestation standards. The Auditing Standards Board attempts to distinguish between issues that should be addressed by auditing standards and those that should be addressed by attestation standards, even though both are attestations. In general, auditing standards apply to attesta - tions that deal with providing assurance on historical financial statements, including one or more parts of those statements. These may include audits of financial statements prepared in accordance with accounting standards or some other comprehen sive basis of accounting, audits of only a balance sheet, and audits of individual accounts. All other forms of attestation are addressed in the attestation standards (an exception is reviews of historical financial statements of a nonpublic entity, which are addressed in SSARS and were discussed earlier in the chapter). Attestation standards are established by the Auditing Standards Board following the same process used for auditing standards. (Attestation standards are labeled as AT rather than AU.) Types of Attestation The Auditing Standards Board decided not to attempt to define the potential bound - Engagements aries of attestation engagements except in conceptual terms because new services are 796 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES TABLE 25-1 Comparison of Attestation Standards and Generally Accepted Auditing Standards Attestation Standards Generally Accepted Auditing Standards General Standards 1.The practitioner must have adequate technical training 1. The auditor must have adequate technical training and proficiency and proficiency to perform the attestation engagement. to perform the audit. 2.The practitioner must have adequate knowledge of the subject matter. 3.The practitioner must have reason to believe that the subject matter is capable of evaluation against criteria that are suitable and available to users. 4.The practitioner must maintain independence in mental 2. The auditor must maintain independence in mental attitude in all attitude in all matters relating to the engagement. matters relating to the audit. 5.Due professional care shall be exercised in the planning 3. The auditor must exercise due professional care in the performance and performance of the engagement and the preparation of the audit and the preparation of the report. of the report. Standards of Field Work 1.The practitioner must adequately plan the work and must 1. The auditor must adequately plan the work and must properly properly supervise any assistants. supervise any assistants.

2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control to assess the risk of material misstatement whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. 2.The practitioner must obtain sufficient evidence to provide 3. The auditor must obtain sufficient appropriate audit evidence by a reasonable basis for the conclusion that is expressed in performing audit procedures to afford a reasonable basis for an the report. opinion regarding the financial statements under audit. Standards of Reporting 1.The practitioner must identify the subject matter or assertion Apago PDF Enhancer being reported on and state the character of the engagement in the report. 2.The practitioner must state the practitioner’s conclusion about 1. The auditor must state in the auditor’s report whether the financial the subject matter or the assertion in relation to the criteria statements are presented in accordance with generally accepted against which the subject matter was evaluated in the report. accounting principles. 2. The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period. 3. When the auditor determines that informative disclosures are not reasonably adequate, the auditor must so state in the auditor’s report. 3.The practitioner must state all of the practitioner’s significant 4. The auditor must either express an opinion regarding the financial reservations about the engagement, the subject matter, and, statements, taken as a whole, or state that an opinion cannot be if applicable, the assertion related thereto in the report. expressed. When the auditor cannot express an overall opinion, the auditor must state the reasons therefor in the auditor’s report. In all cases where an auditor’s name is associated with financial statements, the auditor should clearly indicate the character of the auditor’s work, if any, and the degree of responsibility the auditor is taking in the auditor’s report. 4.The practitioner must state in the report that the report is intended solely for the information and use of the specified parties under the following circumstances: — When the criteria used to evaluate the subject matter are determined by the practitioner to be appropriate only for a limited number of parties who either participated in their establishment or can be presumed to have an adequate understanding of the criteria. — When the criteria used to evaluate the subject matter are available only to specified parties. — When reporting on subject matter and a written assertion has not been provided by the responsible party. — When the report is on an attestation engagement to apply agreed-upon procedures to the subject matter. Chapter 25 / OTHER ASSURANCE SERVICES 797 likely to arise. For example, PricewaterhouseCoopers has been attesting to the balloting for the Miss America contest for decades, but attesting to compliance with environ - mental protection laws started only in recent years. The AICPA and the Canadian Institute of Chartered Accountants (CICA) have jointly developed assurance services related to e-commerce and information technology. These groups of services, known as WebTrust and SysTrust, are performed under the attestation standards. In addition, the AICPA has developed specific attestation standards in the following areas: • Prospective financial statements • Reports on internal controls at service organizations • Pro forma financial information • Reports on internal control over financial reporting for private companies • Compliance with laws and regulations • Agreed-upon procedures engagements • Management’s discussion and analysis Standards are necessary for these types of engagements because CPAs already perform these services in sufficiently large numbers to need more specific guidance than the general attestation standards provide. However, the absence of specific standards for

a type of service does not imply that it is inappropriate to provide such a service. Levels of Service The attestation standards define three levels of engagements and related forms of conclusions: 1. Examinations 2. Reviews 3. Agreed-upon procedures In addition, compilation engagements are defined for prospective financial state ments. An examination results in a positive conclusion. In this type of report, the CPA Apago PDF Enhancer makes a direct statement about whether the presentation of the assertions, taken as a whole, conforms to the applicable criteria. Figure 25-6 shows an examination report written under the general guidance of the attestation standards. This is for an engage - ment to determine that the rate of return on a hypothetical portfolio, based on a brokerage firm’s buy–sell recommendations, is correct as represented in the firm’s promotional materials. A report on an examination is unrestricted as to distribution by the client after it is issued. This means that a client can distribute the information widely, including to prospective investors, and for sales and marketing purposes. FIGURE 25-6 Example of an Examination Report under the Attestation Standards To Management Akron Securities, Inc. We have examined the accompanying statement for investment performance statistics of the Akron Securities Model Portfolio for the year ended December 31, 2011. Akron Securities’ management is responsible for the statement of investment performance statistics. Our respon- sibility is to express an opinion based on our examination. Our examination was conducted in accordance with attestation standards established by the American Institute of Certified Public Accountants and, accordingly, included examining, on a test basis, evidence supporting Akron Securities Model Portfolio’s statement for investment performance statistics andperforming such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the schedule referred to above presents, in all material respects, the investment performance statistics of Akron Securities Model Portfolio for the year ended December 31, 2011, based on the actual results that would have been obtained if the buy-and-sell recommen- dations for the portfolio were followed as described in the buy–sell recommendations set forth in Note 1. 798 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES FIGURE 25-7 Types of Engagements and Related Reports Amount of Level of Form of Type of Engagement Evidence Assurance Conclusion Distribution Examination Extensive High Positive General Review Significant Moderate Negative General Agreed-upon procedures Varying Varying Findings Limited In a review, the CPA provides a negative assurance conclusion. For a negative assurance report, the CPA’s report states whether any information came to the CPA’s attention to indicate that the assertions are not presented in all material respects in con- formitywith the applicable criteria. A review report is also unrestricted in its distribution. Review engagements are prohibited for most services where specified attestation standards have been issued, such as prospective financial statements, because of the difficulty of setting standards for the limited assurance provided by reviews. In an agreed-upon procedures engagement, all procedures the CPA will perform are agreed upon by the CPA, the responsible party making the assertions, and the specific persons who are the intended users of the CPA’s report. The degree of assurance included in such a report varies with the specific procedures agreed to and performed. Accordingly, such reports are limited in their distribution to only the involved parties, who know the procedures the CPA will perform and the level of assurance resulting from them. The report should include a statement of what procedures management and the CPA agreed to and what the CPA found in performing the procedures. Figure 25-7 summarizes the reporting levels for attestation engagements. Next we

Apago PDF Enhancer discuss four common types of engagements for which detailed attestation standards have been issued: WebTrust and SysTrust services, reports on controls of service organizations, prospective financial statements, and agreed-upon procedures. WEBTRUST AND SYSTRUST SERVICES Most organizations rely heavily on the use of information technologies to conduct OBJECTIVE 25-4 business, including the use of the Internet to buy and sell goods and services. As more Understand the nature of reliance is placed on information systems, businesspeople often demand greater WebTrustandSysTrust assurances about their accuracy, availability, and security. WebTrust and SysTrust are assurance services. examples of attestation services developed to address these assurance needs. In a WebTrust attestation engagement, a client engages a CPA to provide reasonable WebTrust Services assurance that a company’s Web site complies with certain Trust Servicesprinciples and criteria for one or more aspects of e-commerce activities. A site that meets the Trust Servicesprinciples is eligible to display the WebTrustelectronic seal on its transaction or order page, which is intended to give users of the site assurance about the site’s credi- bility. At least once every 12 months, the CPA firm updates its testing of the e-commerce aspects to ensure that the client’s site continues to comply with the Trust Services principles and criteria. The CPA firm also updates its report. If the site does not comply, the seal can be revoked. TheWebTrustservice is a specific service developed under the broader Trust Services principles and criteria jointly issued by the AICPA and CICA. When performing WebTrust assurance services, the CPA firm assesses whether the company’s Web site complies with the five Trust Servicesprinciples, which are shown in Table25-2 (p. 800). These Trust Services principles represent broad statements of objectives. To provide Chapter 25 / OTHER ASSURANCE SERVICES 799 TABLE 25-2 Five Trust Services Principles Principle The entity discloses and maintains compliance with its Security security practices, ensuring that the system is protected against unauthorized access (both physical and logical). Availability availability practices, ensuring that the system is available for operation and use as committed or agreed. Processing Integrity processing integrity, ensuring that system processing is complete, accurate, timely, and authorized. Online Privacy online privacy practices, ensuring that personal information obtained as a result of e-commerce is collected, used, disclosed, and retained as committed or agreed. Confidentiality confidentiality practices, ensuring that information designated as confidential is protected as committed or agreed. more specific guidance, there are related Trust Services criteria for each of the five principles. A company must conform to these criteria to obtain and maintain its WebTrustseal. SysTrust Services As organizations become more dependent on information technology, the security, availability, and accuracy of computer systems are critical. An unreliable system can trigger a chain of business events that negatively affect the company, its customers, suppliers, and other business partners. The SysTrust service provides assurance to managAempeant,g thoe b oaPrdD oFf d ireEctnorsh, oar nthicrde parrties about the reliability of informa - tion systems used to generate real-time information. In a SysTrust engagement, the SysTrust licensed CPA evaluates a company’s com - puter system using Trust Services principles and criteria and determines whether controls over the system exist. The CPA then does tests to determine whether those controls were operating effectively during a specified period. If the system meets the requirements of the Trust Services principles and criteria, an examination-level unqualified attestation report is issued under AICPA attestation standards. The report may address a single Trust Services principle or any combination of Trust Services principles.

An organization may request a SysTrust engagement for a system that is in the preimplementation phase. For this type of engagement, the CPA reports on the suitability of the design of controls, and the report covers a point in time rather than a period of time. REPORTS ON CONTROLS AT SERVICE ORGANIZATIONS OBJECTIVE 25-5 Chapter 12 highlighted that many clients outsource some or all of their IT needs to an independent computer service organization rather than maintain an internal IT Describe engagements to function or data center. In those situations, the auditor faces difficulty when obtaining report on internal controls an understanding of the client’s internal control because many of the controls reside at at service organizations. the service organization, and the auditor cannot assume that the controls are adequate because they are provided by an independent IT provider. It has become increasingly common for the service center to engage a CPA firm to obtain an understanding and test internal controls of the service organization and issue a report for use by all customers and their independent auditors. 800 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES These engagements have historically been referred to as SAS 70 engagements because the guidance for service auditors was contained in that auditing standard. The Auditing Standards Board recently moved the guidance for service auditors from auditing standards to the attestation standards. Those standards provide guidance for service auditors who are engaged by a service organization to issue one of two types of reports: 1. Report on a description of a service organization’s system and the suitability of the design of controls (Type 1 report). 2. Report on a description of a service organization’s system and the suitability of the design and operating effectiveness of controls (Type 2 report). In a Type 1 report, the service auditor expresses an opinion about the fairness of the description of the service organization’s system and an opinion about the suitability of the design of controls in that system. The service auditor obtains and reads the system description prepared by the organization’s management and assesses whether the description is fairly presented. In making that assessment, the service auditor evaluates whether management used suitable criteria in preparing and presenting the service organization’s system description. For example, the service auditor would evaluate whether the organization’s description includes information about procedures by which transactions are initiated, authorized, recorded, processed, corrected, and reported for user entities and the related accounting records prepared to support those processes. In a Type 1 engagement, the service auditor also performs procedures to obtain sufficient available evidence to obtain reasonable assurance about the suitability of the design of controls. In making that determination, the service auditor evaluates whether controls have been designed to address risks threatening the achievement of control objectives and whether those controls, if operating as described, provide reasonable assurance that those risks would not prevent achievement of control objectives. Apago PDF Enhancer In a Type 2 engagement, the service auditor performs tests of the operating effectiveness of the controls at the service organization, in addition to procedures per- formed in the Type 1 engagement. When testing controls at the service organization, the service auditor performs tests of controls using procedures similar to those described in earlier chapters to obtain sufficient appropriate evidence about the operating effectiveness of those controls throughout the period under audit. The service auditor’s Type 2 report contains the two opinions about the description and suitability of the design of controls that are provided in a Type 1 report, plus an addi- tional opinion about the operating effectiveness of controls throughout the period. PROSPECTIVE FINANCIAL STATEMENTS As implied by the term, prospective financial statementsrefer to predicted or expected OBJECTIVE 25-6

financial statements in some future period (income statement) or at some future date Understand special engage - (balance sheet). An example is management’s predictions of the income statement and ments to attest to prospective balance sheet one year in the future. financial statements. Most CPAs believe there are significant opportunities and potential risks for auditors to provide credibility to prospective financial information. It is widely accepted that users want reliable prospective information to aid their decision making. If auditors can improve the reliability of the information, information risk may be reduced in the same way it is in audits of historical financial statements. The risks arise because the actual results obtained in the future may differ significantly from the results predicted in the prospective financial statements. Regulators, users, and others may criticize and even sue auditors, even if the prospective statements were fairly stated, given the information available when they were prepared. Chapter 25 / OTHER ASSURANCE SERVICES 801 Forecasts AICPA attestation standards define two general types of prospective financial statements: and Projections 1. Forecastsare prospective financial statements that present an entity’s expected financial position, results of operations, and cash flows, to the bestof the respon - sible party’s knowledge and belief. Banks commonly require this information as a part of loan applications. 2. Projectionsare prospective financial statements that present an entity’s financial position, results of operations, and cash flows, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions. For example, projected financial statements might assume the company is able to increase the price of its primary product by 10 percent with no reduction in units sold. There is considerable literature available to management to help them prepare both forecasts and projections. This literature, along with guidance for independent accountants, is presented in the AICPA Guide for Prospective Financial Statements, which includes criteria against which an attestation engagement can be compared. Use of Prospective Prospective financial statements are prepared for one of two audiences: Financial Statements 1. General use statements are prepared for use by any third party, such as the inclusion of a financial forecast in a prospectus for the sale of hospital bonds. 2. Limited use statements are prepared solely for third parties with whom the responsible party is dealing directly, such as the inclusion of a financial projection in a bank loan application document. Forecasts can be provided for both general and limited use. However, projections are restricted to the latter, because limited users are in a better position to understand the prospective statements and related assumptions than other parties. For example, a potential venture capital investor can ask the responsible party about hypothetical assumptions in a projection, whereas a removed user, such as a reader of a company prospectus, cannot. Because general users may have difficulty interpreting hypothetical assumptions without Apago PDF Enhancer obtaining additional information, the standards prohibit their general use. There is an excep - tion to this rule: a projection may be issued as a supplem ent to a forecast for general use. Types of Engagements AICPA attestation standards prohibit a CPA firm from performing a review of a forecast or projection, because a review service implies the CPA can be “moderately satisfied” about both the computational accuracy of the projections and the assumptions on which the projection is based. To avoid confusion among users, the AICPA created more specific attestation standards, prescribing the following types of engagements for prospective financial statements: • An examination engagement in which the CPA obtains satisfaction as to the completeness and reasonableness of all the assumptions. • A compilation engagement in which the CPA is primarily involved with the compu -

tational accuracy of the statements, and not the reasonableness of the assumptions. • An agreed-upon procedures engagement in which the CPA and all users of the statements agree on specific, limited attestation procedures. Only an examination of prospective statements is included in this chapter. POTENTIAL A partner in one of the Big Four CPA firms incurred to defend against lawsuitsinvolving stated that his firm has decided not to do these engagements. The firm discovered that LEGAL LIABILITY assurance engagements for prospective legal costs exceededrevenues. The partner IN PROSPECTIVE financial statements because of litigation said, “You don’t have to be a rocket scientist costs. He reported that his firm calculated toconclude that if legal costs exceed FINANCIAL their total revenues (not profits) from all revenues it’s a bad business. Users sue STATEMENTS prospective financial statement when actual profits are less favorable than engagements and also calculated all legal thoseprojected regardless of what the CPA costs, including partner and staff time firm’s report says.” 802 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES FIGURE 25-8 Example of a Report on a Forecast Independent Accountant’s Report We have examined the accompanying forecasted balance sheet, statements of income, retained earnings, and cash flows of Allstar, Inc., as of December 31, 2012, andfor the year then ending. Allstar’smanagement is responsible for the forecast. Our responsibility is to express an opinion on the forecast based on our examination. Our examination was conducted in accordance with attestation standards established by the American Institute of Certified Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate both the assumptions used by management and the preparation and presentation of the forecast. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the accompanying forecast is presented in conformity with guidelines for presentation of a forecast established by the American Institute of Certified Public Accountants, and the underlying assumptions provide a reasonable basis for management’s forecast. However, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this report. AICPA attestation standards clearly state that CPAs are not attesting to the accuracy of Examination the prospective financial statements. Instead, they examine the underlying assumptions of Prospective and the preparation and presentation of the forecast or projection. For examinations of Financial Statements forecasts and projections, there are four elements: 1. Evaluating the preparation of the prospective financial statements 2. Evaluating the support underlying the assumptions 3. Evaluating the presentation of the prospective financial statements for con - formity with AICPA presentation guidelines Apago PDF Enhancer 4. Issuing an examination report These elements are based on accumulating evidence about the completeness and reasonableness of the underlying assumptions, as disclosed in the prospective financial statements. To make the evaluation, the CPA needs to become familiar with the client’s business and industry, identify the significant matters on which the client’s future results are expected to depend (“key factors”), and determine that appropriate assumptions have been included with respect to these key factors. Figure 25-8 illustrates a report on an examination of a forecast with an unqualified opinion. As the figure shows, the CPA’s report on an examination of prospective financial statements is similar to the standard audit report for audited financial statem ents except for wording differences due to the unique labeling of the prospective financial statements and the inclusion of statements by the CPA about these three key distinctions:

1. A statement that the prospective results may not be achieved. 2. A statement that the CPA assumes no responsibility to update the report for events and circumstances occurring after the date of the report. 3. The date of the examination report (because the report is a forecast, the date of the forecasted balance sheet is after the report date). AGREED-UPON PROCEDURES ENGAGEMENTS When the auditor and management or a third-party user agree that the audit will be OBJECTIVE 25-7 limited to certain specific audit procedures, it is referred to as an agreed-upon procedures Define agreed-upon engagement. Many CPAs refer to these as procedures and findings engagements because procedures engagements. the resulting reports emphasize the specific audit procedures performed and the findings of those completed procedures. Chapter 25 / OTHER ASSURANCE SERVICES 803 Agreed-upon procedures engagements appeal to CPAs because management, or a third-party user, specifies the procedures they want done. Imagine the difficulty a CPA firm faces if it is asked to issue an opinion to a federal agency that a company complied with federal affirmative action laws for a 2-year period under compliance attestation standards. Now assume that the federal agency is willing to specify 10 audit procedures the CPA firm will do to satisfy the agency. Obviously, the latter engagement will be much easier to manage. Assuming the CPA firm and federal agency can agree on the procedures, many CPA firms are willing to perform the procedures and issue a report of the related findings. AU 622 in the auditing standards and AT 601 in the attestation standards are the primary professional standards addressing agreed-upon procedures engagements. They are called mirror standards, because of their similarities, but auditing standards deal with finan- cial statement items, while attestation standards deal with nonfinancial statement matters. In an agreed-upon procedures engagement under attestation standards, a CPA might calculate the internal rate of return, beta risk for measuring volatility, and other relevant information of interest to investors for a mutual fund. For engagements under auditing standards, CPAs might do agreed-upon procedures on the gross sales account for a lease agreement. For example, retail stores commonly contract for such engage- ments when the store leases from the building owner on the basis of a percent of gross sales. A report for such an engagement describes the procedures agreed upon and the findings resulting from the procedures. OTHER AUDITS OR LIMITED ASSURANCE ENGAGEMENTS OBJECTIVE 25-8 Now that we have discussed compilation and review services for nonpublic companies, as well as reviews of interim financial information for public companies, we will Describe other audit and examine other types of audit and attestation services that fall within the auditing limited assurance engage - Apago PDF Enhancer standards but are not audits of historical financial statements in accordance with ments related to historical financial statements. GAAP or IFRS. Some of these services include: audits of financial statements prepared on another comprehensive basis of accounting (OCBOA), audits of specified elements, accounts, or items; and debt compliance letters. Other Comprehensive Auditors often audit statements prepared on a basis other than GAAP or IFRS. Basis of Accounting Auditing stan dards apply to these audit engagements, but the reporting requirements differ some what from those described in Chapter 3. Bases other than GAAP or IFRS for which reports may be issued include: • Cash or modified cash basis.With cash basis accounting, only cash receipts and disbursements are recorded. Under the modified cash basis of accounting, the cash basis is followed except for certain items, such as fixed assets and depreciation. Physicians and attorneys often follow this accounting method. • Basis used to comply with the requirements of a regulatory agency. Common examples include the uniform system of accounts required of railroads, utilities,

and some insurance companies. • Income tax basis. The same measurement rules used for filing tax returns are often used for financial statement preparation, even though this is not in accordance with GAAP or IFRS. Many small businesses use this method. • A definite set of criteria having substantial support.An example is the price-level basis of accounting. The method of accounting must be applied to all material items in the financial statements. Auditors usually do these audits in the same way as when clients follow GAAP or IFRS.Naturally, the auditor must fully understand the accounting basis that the client is required to follow. For example, in auditing a railroad, complex accounting requirements require the auditor to have specialized accounting knowledge to conduct the audit. 804 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES FIGURE 25-9 Example of a Report on Income Tax Basis Independent Auditor’s Report We have audited the accompanying statements of assets, liabilities, and capital—income tax basis of Triangle Partnership as of December 31, 2011 and 2010, and the related statements of revenue and expenses—income tax basis and changes in partners’ capital accounts—income tax basis for the years then ended. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these financial state- ments based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note X, these financial statements were prepared on the basis of accounting the Partnership uses for income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities, and capital of Triangle Partnership as of December 31, 2011 and 2010, and its revenue and expenses and changes in partners’ capital accounts for the years then ended, on the basis of accounting described in Note X. When clients follow a comprehensive basis other than GAAP or IFRS, the auditor must make sure the statements clearly indicate that they are prepared using another basis of accounting. If the statements imply that GAAP is followed, the reporting requirements covered in Chapter 3 apply. Consequently, terms such as balance sheet and statement of operations must bAe pavaoigdeod b y PthDe cFlie ntE. Innshteaad,n a ctiteler such as “statement of assets and liabilities arising from cash transactions” is appropriate for a cash basis statement. Figure25-9 is an example of a report prepared on a partnership following the income tax basis of accounting. Auditors are often asked to audit and issue reports on specific aspects of financial state - Specified Elements, ments. A common example is a report on the audit of sales of a retail store in a shopping Accounts, or Items center to be used as a basis for rental payments. Other common examples include reports on royalties, profit participation, and provision for income taxes. The authority for auditing specified elements, accounts, or items is AU 623 (Special Reports). CPA firms typically do audits for specified elements, accounts, or items. This type of audit is much like an ordinary audit of financial statements except it is applied to less than the full financial statements. There are two main differences in audits of specified elements, accounts, or items and audits of complete financial statements:

1. Materiality is defined in terms of the elements, accounts, or items being audited rather than for the overall statements. The effect is to ordinarily require more evidence than if the item being verified is just one of many parts of the state - ments. For example, if the sales account is being reported on separately, a smaller misstatement will be considered material than it is when sales are one of many accounts in a full financial statement audit. 2. The first standard of reporting under GAAS does not apply because the presen - tationof elements, accounts, or items is not a financial statement prepared in accordance with applicable accounting standards. Auditors must extend their audit efforts to include other elements, accounts, or items that are interrelated with those that are being audited. For example, in expressing an opinion on sales, the auditor must also consider the effect of accounts receivable on sales. Chapter 25 / OTHER ASSURANCE SERVICES 805 FIGURE 25-10 Example of Debt Compliance Report Independent Auditor’s Report We have audited, in accordance with generally accepted auditing standards, the balance sheet of Bollert Company as of December 31, 2011, and the related statements of income, retained earnings, and cash flows for the year then ended, and have issued our report thereon dated February 16, 2012. In connection with our audit, nothing came to our attention that caused us to believe that the Companyfailed to comply with the terms, covenants, provisions, or conditions of sections I to IX, inclusive, of the Indenture dated July 21, 2009, with First Bank insofar as they relate to accounting matters. However, our audit was not directed primarily toward obtaining knowledge of such noncompliance. This report is intended solely for the information and use of the boards of directors and managements of Bollert Company and First Bank and should not be usedfor any other purpose. Debt Compliance Clients occasionally enter into loan agreements that require them to provide the lender Letters and with a report from a CPA about the existence or nonexistence of some condition. For Similar Reports example, a bank may require a company to maintain a certain dollar amount of working capital at a specified date and to obtain an audit report that states whether the company complied with the stated working capital requirements. Auditors may issue reports on debt compliance and similar engagements as separate reports or, by adding a paragraph after the opinion paragraph, as part of a report that expresses their opinion on the financial statements. In either case, the auditor must observe the following matters in such engagements: • Auditors must be qualified to evaluate whether the client has met the provisions in the engagement. In the audit of a debt compliance agreement, auditors are Anoprmaagllyo qu alPifiDedF to evEalnuahte awhnetcheer prrincipal and interest payments were made when due, whether the proper limitations were maintained on dividends, working capital, and debt ratios, and whether the accounting records were adequate for conducting an ordinary audit. However, auditors are not qualified to determine whether the client has properly restricted its business activities to the requirements of an agreement or if it has title to pledged property. These are legal questions and the Code of Professional Conductprohibits the auditor from practicing as an attorney in such circumstances. • The auditor should provide a debt compliance letter only for a client for whom the auditor has done an audit of the overall financial statements. A debt compliance letter on a matter such as the existence of a current ratio of 2.5 or better would be difficult to accomplish without having conducted a complete financial statement audit. • The auditor’s opinion is a negative assurance, stating that nothing came to the auditor’s attention that would lead the auditor to believe there was nonc ompliance. Figure 25-10 provides an example of a separate report on debt compliance. Note that the final paragraph restricts distribution of the report to the directly affected parties. SUMMARY

This chapter described many of the other services offered by CPAs. The types of services offered continue to grow and expand as society demands assurance on new and different types of information. Depending on the nature of the service, the guidance for performing the service may come from auditing standards, accounting and review services standards, or attestation standards. Table 25-3 provides a summary and examples of the primary categories of services discussed in this chapter. 806 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES TABLE 25-3 Primary Categories of Other Assurance Services Engagements Type of Engagement Example Source of Authoritative Support Audits of historical financial statements Audit of General Mills’ financial statements Auditing standards prepared in accordance with accounting standards Attestation engagements under the Attestation of General Mills’ e-commerce Attestation standards and Trust Services attestation standards system availability availability principles and criteria Reviews or compilations of historical Review of Ron’s Shoe Store’s quarterly Accounting and review services standards for financial statements prepared in financial statements nonpublic companies; auditing standards accordance with accounting standards for public companies Audits or limited assurance engagements Audit of Ron’s Shoe Store’s ending balance Auditing standards other than audits, reviews, or compilations in inventory of historical financial statements prepared in accordance with accounting standards ESSENTIAL TERMS Agreed-upon procedures engagement— Prospective financial statements—finan - an engagement in which the procedures cial statements that deal with expected to be performed are agreed upon by the future data rather than with historical data CPA, the responsible party making the Public company interim review—reviews assertions, and the intended users of the of interim, unaudited financial informa - CPA’s report; the CPA’s report is presented Apagotio n PpeDrfoFrm edE ton hhelpa pnubclice cormpanies in the form of a negative assurance meet their reporting responsibilities to Attestation engagement—a type of as - regulatory agencies surance service in which the CPA firm Review—an attestation engagement that issues a report about the reliability of results in a negative assurance as to the subject matter or of an assertion that is CPA’s awareness of any information indi - the responsibility of another party cating that the assertions are not pre sented Compilation service—a nonaudit engage- in conformity with the applicable criteria ment in which the accountant under takes to present, in the form of financial state - Review service (SSARS review)—a review ments, information that is the representation of unaudited financial statements de signed of management, without undertaking to to provide limited assurance that no material express any assurance on the statements modifications need be made to the state - ments in order for them to be in conformity Examination—an attest engagement that with accounting standards or, if appli - results in positive assurance as to whether cable, with another compre hensive basis or not the assertions under examination of accounting conform with the applicable criteria Forecasts—prospective financial state ments Statements on Standards for Accounting that present an entity’s expected financial and Review Services (SSARS)—standards position, results of operations, and cash issued by the AICPA Accounting and flows for future periods, to the best of the Review Services Committee that govern respon sible party’s knowledge and belief the CPA’s asso ciation with unaudited finan - cial statements of nonpublic companies Projections—prospective financial state - ments that present an entity’s financial Statements on Standards for Attestation position and results of operations and cash Engagements (SSAE)—statements issued flows for future periods, to the best of the by the AICPA to provide a conceptual responsible party’s knowledge and belief, frameworkfor various types of attesta tion

given one or more hypothetical assumptions services Chapter 25 / OTHER ASSURANCE SERVICES 807 —an attestation service designed —an attestation service designed to provide reasonable assurance that to provide reasonable assurance that a a company’s computer system complies company’s Web site complies with Trust with Trust Services principles and Services principles and criteria for busi - criteria ness-to-consumer electronic commerce REVIEW QUESTIONS 25-1 (Objective 25-1)What is meant by the term level of assurance? How does the level of assurance differ for an audit of historical financial statements, a review, and a compilation? 25-2 (Objective 25-1)What is negative assurance? Why is it used in a review engagement report? 25-3 (Objective 25-1)Distinguish between compilation and review of financial state ments. What is the level of assurance for each? 25-4 (Objective 25-1) Distinguish the three forms of compilation reports that a CPA can provide to clients. 25-5 (Objective 25-1) List five things that are required of an auditor by SSARS for a compilation. 25-6 (Objective 25-1)What steps should auditors take if during a compilation engage ment they become aware that the financial statements are misleading? 25-7 (Objective 25-1)What procedures should the auditor use to obtain the information necessary to give the level of assurance required of reviews of financial statements? 25-8 (Objective 25-1)What should auditors do if during a review of financial statements they discover that applicable accounting standards are not being followed? 25-9 (OAbpjeactigveso 2 5-1P, 2D5-F2) WEhant ahrea thne dciffeerrences between the review reports for a private company under SSARS and for the interim financial statements of a public company? 25-10 (Objective 25-2) Explain why a review of interim financial statements for a public company may provide a greater level of assurance than an SSARS review. 25-11 (Objective 25-3)Define what is meant by attestation standards. Distinguish between attestation standards and auditing standards. 25-12 (Objective 25-4) List the five Trust Services principles and explain whether a WebTrust licensed CPA can report on an entity’s compliance with those principles indi - vidually or in combination. 25-13 (Objective 25-4) Describe the purpose of a SysTrustassurance services engagement. 25-14 (Objective 25-5) An audit client has engaged a third party service organization to host its payroll software package on servers located at the service organization. What options do you have to obtain assurance about the controls embedded in the payroll application? 25-15 (Objective 25-6) Explain what is meant by prospective financial statements and distinguish between forecasts and projections. What four things are involved in an examination of prospective financial statements? 25-16 (Objective 25-8) State the reporting requirements for statements prepared on a basis other than GAAP. 25-17 (Objective 25-8) The Absco Corporation has requested that Herb Germany, CPA, provide a report to the Northern State Bank as to the existence or nonexistence of certain loan conditions. The conditions to be reported on are the working capital ratio, dividends paid on preferred stock, aging of accounts receivable, and competence of management. This is Herb’s first experience with Absco. Should Herb accept this engagement? Sub - stantiate your answer. 808 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS 25-18 (Objective 25-1)The following are miscellaneous questions about compilation and review services. Choose the best response. a. It is acceptable for a CPA to be associated with financial statements when not inde - pendent with respect to the client and still issue a substantially unmodified report for which of the following: (1) Audits of companies following GAAP. (2) Audits of companies on a comprehensive basis of accounting other than GAAP. (3) Review of financial statements following GAAP. (4) Compilation of financial statements following GAAP. b. A CPA is performing review services for a small, closely held manufacturing company.

As a part of the follow-up of a significant decrease in the gross margin for the current year, the CPA discovers that there are no supporting documents for $40,000 of disburse - ments.The chief financial officer assures her that the disbursements are proper. What should the CPA do? (1) Include the unsupported disbursements without further work in the statements on the grounds that she is not doing an audit. (2) Modify the review opinion or withdraw from the engagement unless the unsup- ported disbursements are satisfactorily explained. (3) Exclude the unsupported disbursements from the statements. (4) Obtain a written representation from the chief financial officer that the disburse - ments are proper and should be included in the current financial statements. c. Which of the following best describes the responsibility of the CPA in performing compilation services for a company? (1) The CPA has to satisfy only himself or herself that the financial statements were prepared in conformity with accounting standards. Apago PDF Enhancer (2) The CPA must understand the client’s business and accounting methods and read the financial statements for reasonableness. (3) The CPA should obtain an understanding of internal control and perform tests of controls. (4) The CPA is relieved of any responsibility to third parties. 25-19 (Objectives 25-3, 25-6) The following questions concern attestation engagements. Choose the best response. a. Which of the following professional services is considered an attestation engagement? (1) A management consulting engagement to provide IT advice to a client. (2) An income tax engagement to prepare federal and state tax returns. (3) An engagement to report on compliance with statutory requirements. (4) A compilation of financial statements from a client’s accounting records. b. A Type 1 service auditor’s report on internal controls at a service organization (1) includes an opinion about the suitability of the design of controls at the service organization. (2) is based on the performance of tests of controls and substantive tests of trans - actions at the service organization. (3) contains an opinion about the operating effectiveness of internal controls at the service organization. (4) provides an opinion about the fair presentation of the service organization’s financial statements in accordance with accounting standards. c. Which of the following statements concerning prospective financial statements is correct? (1) Only a financial forecast is normally appropriate for limited use. (2) Any type of prospective financial statement is normally appropriate for limited use. (3) Only a financial projection is normally appropriate for general use. (4) Any type of prospective financial statement is normally appropriate for general use. Chapter 25 / OTHER ASSURANCE SERVICES 809 25-20 (Objective 25-8)The following questions concern reports issued by auditors, other than those on historical financial statements. Choose the best response. a. An auditor is reporting on cash basis financial statements. These statements are best referred to in the opinion of the auditor by which of the following descriptions? (1) Cash receipts and disbursements and the assets and liabilities arising from cash transactions. (2) Financial position and results of operations arising from cash transactions. (3) Balance sheet and income statements resulting from cash transactions. (4) Cash balance sheet and the source and application of funds. b. Which of the following statements with respect to an auditor’s report expressing an opinion on a specific item on a financial statement is correct? (1) Such a report can be expressed only if the auditor is also engaged to audit the entire set of financial statements. (2) Materiality must be related to the specific item rather than to the financial state- ments taken as a whole. (3) The attention devoted to the specified item is usually less than it would be if the financial statements taken as a whole were being audited. (4) The auditor who has issued an adverse opinion on the financial statements taken as a

whole can never express an opinion on a specified item in these financial statements. c. When asked to perform an audit to express an opinion on one or more specified elements, accounts, or items of a financial statement, the auditor (1) may not describe auditing procedures applied. (2) should advise the client that the opinion can be issued only if the financial state- ments have been audited and found to be fairly presented. (3) may assume that the first standard of reporting with respect to GAAP does not apply. (4) should comply with the request only if they constitute a major portion of the financial statements on which an auditor has disclaimed an opinion based on an audit. Apago PDF Enhancer DISCUSSION QUESTIONS AND PROBLEMS 25-21 (Objective 25-1) Evaluate the following comments about compiled financial state - ments: “When CPAs associate their name with compiled financial statements, their only responsibility is to the client and that is limited to the proper summarization and presen - tation on the financial statements of information provided by the client. The opinion clearly states that the auditor has not conducted an audit and does not express an opinion on this fair presentation. If users rely on compiled financial statements, they do so at their own risk and should never be able to hold the CPA responsible for inadequate performance. Users should interpret the financial statements as if they had been prepared by management.” 25-22 (Objective 25-1)You are doing a review services and related tax work engagement for Murphy Construction Company. You have made extensive inquiries of management about their financial statements and have concluded that management has an excellent understanding of its business and is honest, but lacking in knowledge of technical account- ing issues. In doing the review you determine the following: 1. Repairs and maintenance expense has increased significantly compared to the preceding year. The president states that this seems to have been a year with a lot of repairs, in part because their equipment is getting older. 2. Property tax expense is the same as last year even though Murphy purchased a new building, including the land. The president states that there are no real estate taxes on the new building and land until next year. 3. Based on your knowledge of the construction industry you know that the pipes Murphy uses in construction have had a decrease in selling price to construction companies near the end of the current year. The president states that even though they have a large pipe inventory it will all be used in the next year or two, so the current price doesn’t matter because they won’t need to buy any. 810 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES 4. Accounts receivable has increased almost 25% compared to the previous year, but the allowance for uncollectible accounts has stayed the same. The president states that even though receivables have increased, they still expect uncollectible accounts to be less than the stated allowance. 5. In discussions with the president you determine that there is a material uninsured lawsuit against the company from a former customer. The president believes it is a frivolous lawsuit and will not permit a footnote about it for fear that it will result in similar lawsuits from other customers. a. Beyond inquiries and analytical procedures, what are the accountant’s responsibilities Required in performing review service engagements? b. Describe what you should do in each of the preceding situations, assuming each one is material. 25-23 (Objective 25-1) SSARS contain several procedures that are required when engaged to perform a compilation or review engagement. Below are ten statements that may or may not be relevant to a compilation or review engagement. For each of the ten statements, indicate whether the procedure is to be performed in a compilation or review engagement. Required for a Compilation Review Description of Procedure Engagement? Engagement? 1. Obtain a written engagement letter.

2. Understand the client’s industry and the nature of the client’s business. 3. Read the financial statements. 4. Design and perform analytical procedures. 5. Make inquiries of client management. 6. Perform tests of controls. 7. Assess fraud risk. 8. Obtain a letter of representation fAromp maangageome nt.PDF Enhancer 9. Prepare documentation in sufficient detail to provide a clear understanding of the work performed. 10. Issue a report that contains limited assurance about whether the accountant is aware of the need for material modification to the financial statements. 25-24 (Objective 25-1) In an engagement to review the financial statements of a nonpublic company, SSARS require the accountant to obtain review evidence that is primarily based on inquiries and analytical procedures. The nature of the accountant’s inquiries is a matter of judgment. For example, the accountant may consider the nature and materiality of the items, likelihood of misstatement, how the items may be affected by management’s judgment, qualifications of client personnel, among other matters. Below are several inquiry procedures for the sales and collection cycle: Revenue 1. Are revenues from the sale of major products and services recognized in the appro - priate period? Receivables 1. Has an adequate allowance been made for doubtful accounts? 2. Have receivables considered uncollectible been written off? 3. If appropriate, has interest been reflected? 4. Has a proper cutoff of sales transactions been made? 5. Are there any receivables from employees and related parties? 6. Are any receivables pledged, discounted, or factored? 7. Have receivables been correctly classified between current and noncurrent? a. What other information about accounts receivable and revenue, besides the items Required listed, will the accountant have to obtain? Chapter 25 / OTHER ASSURANCE SERVICES 811 b. Compare the illustrative procedures for review services and those commonly per - formed for audits. What are the major differences? c. Of whom should the accountant make inquiries in a small, closely-held company? d. Under what circumstances will procedures beyond those illustrated likely be performed? Be specific. e. Compare the levels of achieved assurance for review services and audits. Is the achieved level much higher for audits, somewhat higher, or approximately the same? Give reasons for your answer. 25-25 (Objective 25-2) Lucia Johnson, of Johnson and Lecy, CPAs, has completed the first-year audit of Tidwell Publishing Co., a publicly held company, for the year ended December 31, 2011. She is now working on a review of interim financial statements for the quarter ended March 31, 2012. Johnson has never done an interim review of a public company, but her firm does exten - sive compilation and review work. She therefore has one of her most experienced assistants, Fred Blair, do the work. She instructs him to follow the firm’s standard review services pro - cedures for SSARS reviews and to do high-quality work because Tidwell is a high-risk client. Blair completes the review of Tidwell’s statements and Johnson carefully reviews Blair’s work. No exceptions are found. Each page of the client’s financial statements is marked “reviewed.” The following report is issued. SECURITIES AND EXCHANGE COMMISSION We have reviewed the accompanying balance sheet of Tidwell Publishing Co. as of March 31, 2012, and the related statements of income, retained earnings, and changes in financial position for the year then ended, in accordance with the standards of the Public Company Accounting Oversight Board (United States). All information included in these financial statements is the representation of the management of Tidwell Publishing Co. A review consists principally of inquiries of company personnel and analytical Apago PDF Enhancer procedures applied to financial data. It is substantially less in scope than an audit in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial

statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles. Johnson & Levy, CPAs March 31, 2012 Required a. Is it appropriate to do a review service for a publicly held company? Explain. b. Evaluate the approach taken by Johnson and Blair on the engagement. c. Evaluate the report. 25-26 (Objective 25-4) Each of the following represents different client requests for engagements related to WebTrustandSysTrustassurance services. a. Ware Hospital Systems, Inc. is in the process of developing a new patient records system. Management has approached a licensed SysTrust accountant to perform a SysTrust engagement on its new system. Specifically, management wants the CPA to examine the system’s processing integrity using the Trust Servicesprocessing integrity principle and criteria. The examination will be scheduled prior to the new system’s implementation. b. MoonBay.com’s management requested that their auditor perform a WebTrustassur - ance service on their assertion about MoonBay.com e-commerce policies’ compliance with the five Trust Services principles and criteria. Although the auditor is not a registered WebTrustprovider, the CPA firm is a member of the AICPA. c. The board of directors of Ferguson Hardware Company has requested that their auditor perform a SysTrust assurance services engagement on its information tech - nology system. The board has requested that the auditor, who is a licensed SysTrust 812 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES provider, report solely on the company’s IT availability policies and controls using the Trust Servicesavailability principle and criteria. d. Management of Greenshield Technology, Inc. requested that its auditors perform a WebTrust assurance services engagement on its e-commerce security policies. The CPA firm performed the WebTrustservices as of April 30, 2011, and has not updated its work. Management wants its WebTrustseal to stay posted on its Web site through May 31, 2012. Consider each request separately. Describe whether the requested assurance service can be Required performed. 25-27 (Objective 25-6) Carl Monson, the owner of Major Products Manufacturing Company, a small, successful, longtime audit client of your firm, has requested you to work with his company in preparing 3-year forecasted information for the year ending December 31, 2012, and two subsequent years. Monson informs you that he intends to use the forecasts, together with the audited financial statements, to seek additional financing to expand the business. Monson has had little experience in formal forecast preparation and counts on you to assist him in any way possible. He wants the most supportive opinion possible from your firm to add to the credibility of the forecast. He informs you that he is willing to do anything necessary to help you prepare the forecast. First, he wants projections of sales and revenues and earnings from the existing business, which he believes can continue to be financed from existing capital. Second, he intends to buy a company in a closely related business that is currently operating unsuccessfully. Monson states that he wants to sell some of the operating assets of the business and replace them with others. He believes that the company can then be made highly successful. He has made an offer on the new business, subject to obtaining proper financing. He also informs you that he has received an offer on the assets he intends to sell. a. Explain circumstances under which it is and is not acceptable to undertake the engage - Required ment. Apago PDF Enhancer b. Why is it important that Monson understand the nature of your reporting requirements before the engagement proceeds? c. What information will Monson have to provide to you before you can complete the forecasted statements? Be as specific as possible.

d. Discuss, in as specific terms as possible, the nature of the report you will issue with the forecasts, assuming that you are able to properly complete them. 25-28 (Objective 25-8) You have been requested by the management of J. L. Lockwood Co. to issue a debt compliance letter as a part of the audit of Taylor Fruit Farms, Inc. J. L. Lockwood Co. is a supplier of irrigation equipment. Much of the equipment, including that supplied to Taylor, is sold on a secured contract basis. Taylor Fruit Farms is an audit client of yours, but Lockwood is not. In addition to the present equipment, Lockwood informs you they are evaluating whether they should sell another $500,000 of equipment to Taylor Fruit Farms. You have been requested to send Lockwood a debt compliance letter concerning the following matters: 1. The current ratio has exceeded 2.0 in each quarter of the unaudited statements pre- pared by management and in the annual audited statements. 2. Total owners’ equity is more than $800,000. 3. The company has not violated any of the legal requirements of California fruit- growing regulations. 4. Management is competent and has made reasonable business decisions in the past 3 years. 5. Management owns an option to buy additional fruit land adjacent to the company’s present property. a. Define the purpose of a debt compliance letter. Required b. Why is it necessary to conduct an audit of a company before it is acceptable to issue a debt compliance letter? Chapter 25 / OTHER ASSURANCE SERVICES 813 c. For which of the five requested items is it acceptable for a CPA firm to issue a debt compliance letter? Give reasons for your answer. 25-29 (Objective 25-8) Bengston, CPA, is conducting the audit of Pollution Control Devices, Inc. In addition, a supplemental negative assurance report is required to a major mortgage holder. The supplemental report concerns indenture agreements to keep the client from defaulting on the mortgage. Total assets are $14 million and the mortgage is for $4 million. The major provisions of the indentures are as follows: 1. The current ratio must be maintained above 2.3 to 1. 2. The debt/equity ratio must be maintained below 3.0. 3. Net earnings after taxes must exceed dividends paid by at least $1 million. Required a. Write the appropriate supplemental report if all three indenture agreement provisions have been satisfied. b. How would the supplemental report change if net earnings after taxes were $1,010,000 and dividends paid were $60,000? c. Assume the same situation as in part b and also assume that the client refuses to modify the financial statements or disclose the violation of the indenture agreement provisions on the grounds that the amount is immaterial. What is the nature of the appropriate auditor’s report? d. What is the nature of the appropriate supplemental report if all the indenture agree- ment provisions have been satisfied but there is a lawsuit against the company that has resulted in disclosure of the lawsuit in a footnote to the financial statements? 25-30 (Objective 25-8) Jones, CPA, has completed the audit of Sarack Lumber Supply Co. and has issued a standard unqualified report. In addition to a report on the overall financial statements, the company needs a special audited report on three specific accounts: sales, net fixed assets, and inventory valued at FIFO. The report is to be issued to Sarack’s lessor, who bases annual rentals on these three accounts. Jones was not aware of the need for the report on the three specific accounts until after the overall audit was completed. Apago PDF Enhancer Required a. Explain why Jones is unlikely to be able to issue the audit report on the three specific accounts without additional audit tests. b. What additional tests are likely to be needed before the report on the three specific accounts can be issued? c. Assuming that Jones is able to satisfy all the requirements needed to issue the report on the three specific accounts, write the report. Make any necessary assumptions. INTERNET PROBLEM 25-1: ACCOUNTING AND REVIEW SERVICES COMMITTEE

The Accounting and Review Services Committee (ARSC) is responsible for issuing standards for compilations and reviews of financial statement issued by nonpublic companies.Visit the AICPA website (www.aicpa.org) and answer the following questions about the operations of this committee: Required a. How many individuals serve on the ARSC and how are they chosen to serve? b. What is the nature of the due process ARSC follows when developing and establishing new standards? c. How long must an exposure draft of a new standard (i.e., a new SSARS) be made available for public comment? d. How many affirmative votes are required before an exposure draft of a proposed or final SSARS can be issued? e. Are meetings of the ARSC open to the public? 814 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES 26 C H A P T E R INTERNAL AND GOVERNMENTAL LEARNING OBJECTIVES FINANCIAL AUDITING AND After studying this chapter, you should be able to OPERATIONAL AUDITING 26-1 Explain the role of internal auditors in financial auditing. 26-2 Describe the auditing and reporting requirements under Good Auditing Often Government Auditing Standards Results In Improved Cash Flows and the Single Audit Act. 26-3 Distinguish operational auditing Sandy Previtz is an experienced internal audit staff person with Erhardt from financial auditing. Freight Company (EFC), a long-haul trucking company. EFC has been growing 26-4 Provide an overview of rapidly, adding customers and shipping agents daily. Daily volume now operational audits. exceeds several thousand shipments per day. To address the growing 26-5 Plan and perform an operational volume of freight bills and related receivables, EFC implemented a new audit. state-of-the-art computerized information system. Previtz was assigned to test the accuracy of the aging of the accounts receivable system and the adequacy of the allowance for doubtful accounts. She took an initial sample of 300 freight bills selected at random from a popuAlatpiona ogf 2o0,0 00P oDutFsta ndEingn frheigahtn bicllse. Shre used the sample to project an aging and develop an estimate of the required allowance for doubtful accounts. Her tests indicated the allowance could be understated by as much as $1 million. Previtz informed Martha Harris, the head of internal audit, of the situation. Harris informed the chief financial officer that as long as the tests indicated there could be a material misstate ment, EFC must expand the sample until it was clear whether the allowance was materially misstated. Previtz’s second sample increased the total sample to 600 items, with essentially the same results. However, at Harris’s request, she analyzed the items from both a management standpoint and an accounting standpoint. When Harris and Previtz met with the CFO to discuss the updated information, Harris pointed out that the real problem was not the allowance but that receivables were out of control, and EFC faced a significant loss in cash flows if manage ment didn’t act quickly. The CFO quickly agreed and responded by hiring a team of temporary workers to analyze the aging of all 20,000 freight bills and to institute a large-scale collection effort. Not only did the analysis and collection efforts improve cash flows, it also showed that Previtz’s estimate was right on target. The last chapter discussed types of assurance services that external auditors provide. This chapter examines the activities of internal auditors and government auditors, who perform a significant amount of financial auditing similar to that done by external CPA firms. As Sandy Previtz of Erhardt Freight Company demonstrates in the introductory story, internal auditors can have a significant impact on a company’s operational efficiency and effectiveness, as well as on earnings and cash flow. The concepts and methodologies studied in the preceding 25 chapters of this book apply to internal and governmental audits. We begin this chapter by examining the role of internal auditors in financial auditing. INTERNAL FINANCIAL AUDITING OBJECTIVE 26-1 As discussed in Chapter 1, companies employ their own internal auditors to do both

financial and operational auditing. During the past two decades, the role of internal Explain the role of internal auditors has expanded dramatically, primarily because of the increased size and auditors in financial auditing. complexity of many corporations. Because internal auditors spend all of their time within one company, they have much greater knowledge about the company’s opera - tions and internal controls than external auditors. That kind of knowledge can be critical to effective corporate governance. The New York Stock Exchange requires its registrants to have an internal audit function, and many other public and private companies also have an internal audit function. The Institute of Internal Auditors professional practices framework provides the following definition of internal auditing: Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing asystematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. Apago PDF Enhancer This definition reflects the changing role of internal auditors. They are expected to provide value to the organization through improved operational effectiveness, while also performing traditional responsibilities, such as: • Reviewing the reliability and integrity of information • Ensuring compliance with policies and regulations • Safeguarding assets The objectives of internal auditors are considerably broader than the objectives of external auditors, providing flexibility for internal auditors to meet their company’s needs. At one company, internal auditors may focus exclusively on documenting and testing controls for Sarbanes–Oxley Act Section 404 requirements. At another company, internal auditors may serve primarily as consultants, focusing on recommendations that improve organizational performance. Not only may internal auditors focus on different areas, but the extent of internal auditing may vary from one company to another. Internal audit reports are not standardized because the reporting needs vary for each company and the reports are not relied on by external users. Institute of Professional guidance for internal auditors is provided by the Institute of Internal Internal Auditors Auditors (IIA), an organization similar to the AICPA that establishes ethical and practice standards, provides education, and encourages professionalism for its approximately 170,000 worldwide members. The IIA has played a major role in the increasing influence of internal auditing. For example, the IIA has established a highly regarded certification program resulting in the designation of Certified Internal Auditor (CIA) for those who meet specific testing and experience requirements. The IIA professional practice framework includes a code of ethics and IIA International Standards for the Professional Practice of Internal Auditing(known as the “Red Book”). All IIA members and Certified Internal Auditors agree to follow the 816 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES FIGURE 26-1 Institute of Internal Auditors Ethical Principles and Code of Ethics ETHICAL PRINCIPLES Integrity The integrity of internal auditors establishes trust and thus provides the basis for reliance on their judgment. Objectivity Internal auditors exhibit the highest level ofprofessional objectivity in gathering, evaluating, and communicating information about the activity or process being examined. Internal auditorsmake a balanced assessment of all the relevant circumstances and are not unduly influenced by their own interests or by others in forming judgments. Confidentiality Internal auditors respect the value and ownership of information they receive and do not disclose information without appropriate authority unless there is a legal or professional obligation to do so. Competency Internal auditors apply the knowledge, skills, and experience needed in the performance of internal auditing services.

RULES OF CONDUCT 1. Integrity Internal auditors: 1.1. Shallperform their work with honesty,diligence, and responsibility. 1.2. Shall observe the law andmakedisclosures expected by the law and the profession. 1.3. Shall not knowingly be a party to any illegal activity or engage in acts that are discreditable to the profession of internal auditing or to the organization. 1.4. Shall respect and contribute to the legitimate and ethical objectives of the organization. 2. Objectivity Internal auditors: 2.1. Shall not participate in any activity or relationship that may impair or be presumed to impair their unbiased assessment. This participation includes those activities or relationships that may be in conflict with the interests of the organization. 2.2. Shall not accept anything that may impair or be presumed to impair their professional judgment. 2.3. Shall disclose all material facts known to them that, if not disclosed, may distort the reporting of activities under review. 3. Confidentiality Internal auditors: 3.1. Shall be prudent in the use andprotection of information acquired in the course of their duties. 3.2. Shall not use information for any personal gain or in any manner that would be contrary to the law or detrimental to the legitimate and ethical objectives of the organization. Apago PDF Enhancer 4. Competency Internal auditors: 4.1. Shall engage only in those services for which they have the necessary knowledge, skills, and experience. 4.2. Shallperform internal auditing services in accordance with the International Standardsfor the Professional Practice of Internal Auditing. 4.3. Shall continually improve their proficiency and the effectiveness and quality of their services. Institute’s Code of Ethics, which requires compliance with the Standards. Figure 26-1 outlines the IIA Code of Ethics, which is based on the ethical principles of integrity, objectivity, confidentiality, and competency. As shown in Figure 26-2 (p. 818), the International Standards for the Professional Practice of Internal Auditing are divided into attribute standards for internal auditors and audit departments, and performance standards for the conduct and reporting of internal audit activities. The IIA created specific standards within each category. For example, Attribute Standard 1100 on Independence and Objectivity, includes individual standards to address organizational independence (1110), individual objectivity (1120), and impair- ments to independence and objectivity (1130). In addition, the IIA developed specific implementation standards for assurance and consulting engagements. For example, Implementation Standard 1110.A1 provides guid - ance for applying Attribute Standard 1110 on organizational indepen dence for assurance engagements, stating that the internal audit activity should be free from interference in deter mining the scope of internal auditing, performing work, and communicating results. You may want to compare these standards to the AICPA generally accepted auditing standards, as detailed in Table 2-3 on page 35, to note similarities and differ ences. Statements on Internal Auditing Standards (SIASs)are issued by the Internal Auditing Standards Board to provide authoritative interpretations of the standards. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 817 FIGURE 26-2 International Standards for the Professional Practice of Internal Auditing Source: From The International Standards for the Professional Practice of Auditing, Copyright © 2010 by The Institute of Internal Auditors, Inc. 247 Maitland Avenue, Altamonte Springs, FL 32701-4201. Reprinted with permission. Apago PDF Enhancer Relationship The responsibilities and conduct of audits by internal and external auditors differ in of Internal and one important way. Internal auditors are responsible to management and the board, External Auditors while external auditors are responsible to financial statement users who rely on the auditor to add credibility to financial statements. Nevertheless, internal and external

auditors share many similarities: • Both must be competent as auditors and remain objective in performing their work and reporting their results. • Both follow a similar methodology in performing their audits, including planning and performing tests of controls and substantive tests. • Both consider risk and materiality in deciding the extent of their tests and evalu - ating results. However, their decisions about materiality and risks may differ because external users may have different needs than management or the board. External auditors rely on internal auditors when using the audit risk model to assess control risk. If internal auditors are effective, the external auditors can significantly reduce control risk and thereby reduce substantive testing. As a result, external auditors may reduce their fees substantially when the client has a highly regarded internal audit function. External auditors typically consider internal auditors effective if they are: • Independent of the operating units being evaluated • Competent and well trained • Have performed relevant audit tests of the internal controls and financial statements Auditing standards permit the external auditor to use the internal auditor for direct assistance on the audit. By relying on the internal audit staff for performing some of the audit testing, external auditors may be able to complete the audit in less time and at a lower fee. When internal auditors provide direct assistance, the external auditor should assess their competence and objectivity and supervise and evaluate their work. 818 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES FRAUD The International Standards for the Professional The IIA announced plans to partner with Practice of Internal Auditing require internal the Center on Audit Quality (CAQ), the Financial GUIDANCE auditors to have sufficient knowledge to evaluate Executives International (FEI), and the National FOR INTERNAL the risk of fraud and how that risk is managed by Association of Corporate Directors (NACD) to the organization. The Institute of Internal Auditors collaborate on developing long-term efforts to AUDITORS has released two pieces of guidance to help prevent and deter fraudulent financial reporting. internal auditors address fraud risks. Collectively, these organizations plan to leverage Internal Auditing and Fraud provides guidance their experience and resources to advance the on addressing fraud risks during internal audit understanding of conditions that contribute to engagements, including fraud awareness, risk fraud, develop techniques to enhance the assessment, and fraud investigation. Fraud application of professional skepticism, moderate Prevention and Detection in an Automated World the risks of only focusing on short-term focuses on IT-related fraud risks and how results, and leverage the role of technology in technology can help internal auditors and others deterring and detecting fraudulent financial in the organization address fraud risks. “A down reporting. economy produces conditions ripe for fraud” states Institute of Internal Auditors Director of Sources: 1. “New Practice Guides Define Internal Technology Practices Lily Bi. “It’s important for Auditors’ Role in Combating Fraud,” (December 3, organizations to have a strong fraud program that 2009) (www.theiia.org); 2. Press Release, “CAQ includes awareness, prevention, and detect ion Releases Report on Deterring and Detecting programs, as well as a fraud risk assessment Financial Reporting Fraud, Center on Audit Quality process to identify risks within the organization.” (October 6, 2010) (www.thecaq.org). GOVERNMENTAL FINANCIAL AUDITING Federal and state governments employ their own auditing staffs to perform audits in OBJECTIVE 26-2 Apago PDF Enhancer much the same way as internal auditors. Chapter 1 briefly discussed the United States Describe the auditing and Government Accountability Office (GAO). All states have their own audit agencies, reporting requirements similar to but smaller than the GAO. In addition, CPA firms do considerable financial

under Government Auditing auditing of governmental units. For example, some states require that all city and Standards and the Single school district financial statements be audited by CPA firms. Audit Act. The primary source of authoritative literature for doing government audits is Government Auditing Standards, which is issued by the GAO. Because of the color of the cover, it is usually referred to as the “Yellow Book”rather than by its more formal name. The initial Yellow Book standards were similar to the GAAS standards but have been expanded in subsequent revisions to provide guidance standards for performance audits. These standards are often called generally accepted government auditing standards (GAGAS). Financial auditing under the Yellow Book includes several categories of informa- tion to audit, including financial statements of governmental units, government contracts and grants, internal control, fraud, and other noncompliance with laws and regulations. Because governmental units are as concerned with compliance with laws and regulations as they are with the reliability of financial statements, these categories of information are broader than audits under auditing standards and encompass the types of attestation work outlined in Table 25-1 on page 797. The financial auditing standards of the Yellow Book are consistent with the 10 generally Financial Audit accepted auditing standards of the AICPA, and also contain extensive additional guidance, and Reporting including the following additions and modifications: Requirements — • Materiality and significance. The Yellow Book recognizes that in government Yellow Book audits the thresholds of acceptable audit risk and materiality may be lower than in an audit of a commercial enterprise. This is because of the sensitivity of govern- mentactivities and their public accountability. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 819 • Quality control. CPA firms and other organizations that audit government entities in compliance with the Yellow Book must have an appropriate system of internal quality control and participate in an external quality control review program. The latter requirement exists for some CPAs, but only as a require - ment for membership in the AICPA, and for the audit of public companies. Auditors involved in planning, performing, or reporting on audits under GAGAS must complete 80 hours of continuing professional education in each two-year period. At least 24 of these 80 hours of training must be in subjects related to the government environment and government auditing. • Compliance auditing. The audit should be designed to provide reasonable assurance of detecting material misstatements resulting from noncompliance with provisions of contracts or grant agreements that have a material and direct effect on the financial statements. • Reporting. The audit report must state that the audit was made in accordance with generally accepted government auditing standards (GAGAS). In addition, the report on financial statements must describe the scope of the auditors’ tests of compliance with laws and regulations and internal controls and present the results of those tests or refer to a separate report that includes the information. Audit and Reporting TheSingle Audit Actof 1984 provides for a single coordinated audit to meet the audit Requirements — requirements of all federal agencies. Entities that receive more than $500,000 in federal Single Audit Act and funds are subject to a single audit even if more than one agency provided funds. The OMB Circular A-133 Single Audit Act applied only to audits of state and local governments, but it was ex- tended in 1990 to higher-education institutions and other not-for-profit organizations by the Office of Management and Budget (OMB) through the issuance of OMB Circular A-133, Audits of States, Local Governments, and Non-Profit Organizations. Audit Requirements The Single Audit Act as amended and OMB Circular A-133 Apago PDF Enhancer (hereafter referred to collectively as the Act) contain requirements for the scope of the

audit, including: • The audit should be in accordance with GAGAS. • The auditor must obtain an understanding of internal control over federal pro - grams sufficient to support a low assessed level of control risk for major programs. • The auditor should determine whether the client has complied with laws, regulat ions, and the provisions of contracts or grant agreements that may have a direct and material effect on each of its major programs. A-133 Compliance Supplement identifies 14 compliance requirements along with suggested audit procedures that should be considered in every audit. In addition, it lists CALIFORNIA CITY Residents of Bell City were shocked to learn in totaling $70 million after state auditors questioned July 2010 that city officials in the California city of how the bonds were used. Proceeds from the ROCKED BY 40,000 residents were receiving salaries that were bond sale were placed into the general fund PAY SCANDAL likely the largest in the nation. Robert Rizzo, the rather than in a separate account, and were city manager, received a salary of $787,637 and placed in a non-interest-bearing account, costing his total annual compensation with benefits the city significant amounts of interest income. exceeded $1.5 million. In contrast, the President of the United States receives an annual salary of Sources: Adapted from 1. Jeff Gottlieb and Ruben $400,000. Vives, “Bell City Manager Might Be Highest Paid in Rizzo, Mayor Oscar Hernandez, the assistant the Nation: $787,637 per year,” Los Angeles Times, city manager, and five city council members were July 14, 2010 (latimesblogs.latimes.com); 2. Jeff arrested in September 2010 and charged with Gottlieb and Ruben Vives, “SEC Investigating $70 misappropriation of public funds. The SEC also Million in Bonds Issued by Bell,” Los Angeles Times, launched a probe in the sale of three city bonds October 15, 2010 (articles.latimes.com). 820 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES specific requirements for individual federal programs. The following are examples of specific compliance objectives: • Whether the amounts reported as expenditures were for allowable services. • Whether the records show that those who received services or benefits were eligible to receive them. • Whether matching requirements (where the government unit matches federal funds), levels of effort, and earmarking limitations were met. Reporting Requirements The following reports are required under OMB Circular A-133: • An opinion on whether the financial statements are in accordance with GAAP. • An opinion as to whether the schedule of federal awards is presented fairly in all material respects in relation to the financial statements as a whole. • A report on internal control related to the financial statements and major programs. • A report on compliance with laws, regulations, and the provisions of contracts or grant agreements, where noncompliance could have a material effect on the finan- cial statements. This report can be combined with the report on internal control. • A schedule of findings and questioned costs. Auditors doing government auditing often find it complex. The auditor must be familiar AICPA Guidance with both GAAS and a series of government audit documents, laws, and regulations. for Auditors Thus, the first step in preparing for such an engagement is extensive professional development. Sources of AICPA guidance include: • The audit guide Government Auditing Standards and Circular A-133 Audits • AU 801, Compliance Auditing Considerations in Audits of Governmental Entities and Recipients of Governmental Financial Assistance Apago PDF Enhancer OPERATIONAL AUDITING Beyond financial auditing activities, internal auditors, government auditors, and CPAs also do operational auditing, which deals with efficiency and effectiveness of an organization. Other auditors use the terms management auditing or performance auditinginstead of operational auditingto refer to these activities, while others do not distinguish among the terms performance auditing, management auditing, and

operational auditingand use them interchangeably. We prefer to use operational auditingbroadly, as long as the purpose of the test is to determine the effectiveness or efficiency of any part of an organization. Testing the effectiveness of internal controls by an internal auditor may therefore be considered part of operational auditing—if the purpose is to help an organization operate its business more effectively or efficiently. Similarly, determining whether a company has adequately trained assembly line personnel may also be operational auditing, if the purpose is to determine whether the company is effectively and efficiently producing products. The three major differences between operational and financial auditing are the Differences Between purpose of the audit, distribution of the report, and inclusion of nonfinancial areas in Operational and operational auditing. Financial Auditing Purpose of the Audit This is the most important difference. Financial auditing OBJECTIVE 26-3 emphasizes whether historical information was correctly recorded, while operational auditing emphasizes effectiveness and efficiency. Financial auditing is oriented to the Distinguish operational past, while operational auditing focuses on improving future performance. An auditing from financial auditing. operational auditor, for example, may evaluate whether a type of new material is being purchased at the lowest cost to save money on future raw material purchases. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 821 Distribution of the Reports Financial auditing reports are typically distributed to external users of financial statements, such as stockholders and bankers, while operational audit reports are intended primarily for management. The widespread distribution of financial auditing reports requires a well-defined structure and wording, as shown in Figure 3-1 on page 47. The limited distribution of operational reports and the diverse nature of audits for efficiency and effectiveness allow opera - tional audit reports to vary considerably from audit to audit. Inclusion of Nonfinancial Areas Financial audits are limited to matters that directly affect the fairness of financial statement presentation, while operational audits cover any aspect of efficiency and effectiveness in an organization. For example, an opera - tional audit might address the effectiveness of an advertising program or efficiency of factory employees. Effectiveness Before an operational audit can be performed, auditors must define specific criteria for Versus Efficiency measuring effectiveness and efficiency. In general, effectiveness refers to meeting objectives, such as producing parts without defects. Efficiency refers to determining the resources used to achieve those objectives, such as determining whether parts are produced at minimum cost. OBJECTIVE 26-4 Effectiveness In an operational audit for effectiveness, an auditor, for example, might need to assess whether a governmental agency has met its assigned objective of Provide an overview of achieving elevator safety in a city. To determine the agency’s effectiveness, the auditor operational audits. must establish specific criteria for elevator safety. For example, is the agency’s objective to inspect all elevators in the city at least once a year? Is the objective to ensure that no fatalities occurred as a result of elevator breakdowns, or that no breakdowns occurred? Efficiency Like effectiveness, there must be defined criteria for what is meant by doing things more efficiently before operational auditing can be meaningful. It is often easier Ato pseta efgficoien cyP thDanF e ffeEctinvenhesas cnritcereia irf efficiencyis defined as reducing cost without reducing effectiveness. For example, if two different production processes manufacture a product of identical quality, the process with the lower cost is considered more efficient. Operational auditing commonly uncovers several types of typical inefficiencies, including: Types of Inefficiency Example

•Acquisition of goods and •Bids for purchases of materials are not services is excessively costly. required. •Raw materials are not available •An entire assembly line must be shut for production when needed. down because necessary materials were not ordered. •There is duplication of effort •Identical production records are kept by employees. by both the accounting and production departments because they are unaware of each other’s activities. •Work is done that serves no •Copies of vendors’ invoices and receiving purpose. reports are sent to the production department where they are filed without ever being used. •There are too many employees. •The office work could be done effectively with one less administrative assistant. Relationship Between Management establishes internal controls to help meet its goals. As we discussed in Operational Auditing Chapter 10, three concerns are vital to establishing good internal controls: and Internal Controls 1. Reliability of financial reporting 2. Efficiency and effectiveness of operations 3. Compliance with applicable laws and regulations 822 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES Obviously, the second of these three client concerns directly relates to operational auditing, but the other two also affect efficiency and effectiveness. For example, manage ment needs reliable cost accounting information to decide which products to continue producing and the billing price of products. Similarly, failure to comply with a law, such as the Sarbanes–Oxley Act, can result in a large fine to the company. Two things distinguish internal control evaluation and testing for financial and operational auditing: purpose and scope. Purpose The purpose of operational auditing of internal control is to evaluate effi - ciency and effectiveness and to make recommendations to management. In contrast, internal control evaluation for financial auditing has two primary purposes: to determine the extent of substantive audit testing required and, when applicable, to report on the effectiveness of internal control over financial reporting. For both financial and operational auditing, the auditors may evaluate the control procedures in the same way, but for different purposes. An operational auditor might test whether internal verification procedures for duplicate sales invoices are effective to ensure that the company does not offend customers, but also to collect all receivables. A financial auditor often does the same internal control tests, but the primary purpose is to reduce confirmation of accounts receivable or other substantive tests. (A secondary purpose of many financial audits is also to make operational recommendations to management.) Scope The scope of operational auditing concerns any control affecting efficiency or effectiveness, while the scope of internal control evaluation for financial audits is restricted to the effectiveness of internal control over financial reporting and its effect on the fair presentation of financial statements. For example, an operational audit can focus on policies and procedures established in the marketing department to deter - mine the effectiveness of catalogs in marketing products. Apago PDF Enhancer Operational audits fall into three broad categories: functional, organizational, and Types of special assignments. In each case, part of the audit is likely to concern evaluating Operational Audits internal controls for efficiency and effectiveness. Functional Audits Functions are a means of categorizing the activities of a business, such as the billing function or production function. Functions may be categorized and subdivided many different ways. For example, the accounting function may be sub - divided into cash disbursement, cash receipt, and payroll disbursement functions. The payroll function may be subdivided into hiring, timekeeping, and payroll disbursement functions. A functional audit deals with one or more functions in an organization, concerning, for example, the efficiency and effectiveness of the payroll function for a

division or for the company as a whole. A functional audit has the advantage of permitting specialization by auditors. Certain auditors within an internal audit staff can develop considerable expertise in an area, such as production engineering. They can be more efficient and effective by spending all their time auditing in that area. A disadvantage of functional auditing is the failure to evaluate interrelated functions. For example, the production engineering function interacts with manufacturing and other functions in an organization. Organizational Audits An operational audit of an organization deals with an entire organizational unit, such as a department, branch, or subsidiary. An organizational auditemphasizes how efficiently and effectively functions interact. The plan of organi - zation and the methods to coordinate activities are important in this type of audit. Special Assignments In operational auditing, special assignments arise at the request of management for a wide variety of audits, such as determining the cause of an ineffective IT system, investigating the possibility of fraud in a division, and making recommendations for reducing the cost of a manufactured product. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 823 Who Performs Operational audits are usually performed by one of three groups: internal auditors, Operational Audits government auditors, or CPA firms. Internal Auditors Internal auditors are in such a unique position to perform opera - tional audits that some people use the terms internal auditingandoperational auditing interchangeably. It is, however, inappropriate to conclude that all operational auditing is done by internal auditors or that internal auditors do only operational auditing. Many internal audit departments do both operational and financial auditing, often simultaneously. Because they spend all their time working for the company they are auditing, internal auditors have an advantage in doing operational audits. They can develop considerable knowledge about the company and its business, which is essential to effective operational auditing. To maximize their effectiveness for both financial and operational auditing, the internal audit department should report to the board of directors or president. Internal auditors should also have access to and ongoing communications with the audit com - mittee of the board of directors. This organizational structure helps internal auditors remain independent. If internal auditors report to the controller, it is difficult for them to do independent evaluations and make recommendations to senior manage ment about inefficiencies in the controller’s operations. Government Auditors Different federal and state government auditors perform operational auditing, often as a part of doing financial audits. As already discussed, the most widely recognized government auditor group is the GAO, but many state govern - ment auditors are also concerned with financial and operational audits. The Yellow Book defines and sets standards for performance audits, which are essentially the same as operational audits. Performance audits include the following: • Economy and efficiency audits.The purpose of an economy and efficiency audit is to determine: A1.paWhgetohe r thPe eDntFity isE acnquhirinag,n prcoteectring, and using its resources economically and efficiently 2. The causes of inefficiencies or uneconomical practices 3. Whether the entity has complied with laws and regulations concerning matters of economy and efficiency • Program audits.The purpose of a program auditis to determine: 1. The extent to which the desired results or benefits established by the legisla - ture or other authorizing body are being achieved 2. The effectiveness of organizations, programs, activities, or functions 3. Whether the entity has complied with laws and regulations applicable to the program The first two objectives of each of these types of performance audits are clearly opera - tional in nature, while the final objective concerns compliance.

To illustrate specific operational activities of a state governmental audit, the following three examples are taken from an article in the publication Internal Auditor: • A separate hospital with its own administrative staff occupied three buildings on the grounds of another state hospital. Our audit showed that the limited workload of the administrative activities of this separate hospital and its proximity to the offices of the main hospital would permit consolidation of the administrative functions of the two hospitals at a savings of $145,000 a year. • A local school district exercised control over 29 individual facilities. Our audit showed that the unused classroom facilities amounted to about 28 percent or the equivalent of eight schools and that enrollment was continuing to decline. We recommended consolidating and closing of individual facilities to the extent possible. Such action would not only reduce costs but also provide greater flexi - bility in class sizes and course offerings. 824 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES • The outstanding accounts receivable at a teaching hospital increased from $7 million to $11 million during a two-year period. An audit showed that this serious situation was caused, in part, by a lack of aggressive follow-up action, insufficient supervision, and insufficient staff to keep up with an increasing workload.1 CPA Firms When a CPA firm does an audit of historical financial statements, part of the audit often consists of identifying operational problems and making recommen - dations that may benefit the audit client. The recommendations can be made orally, but they are typically included in a management letter. (For coverage of management letters, see pages 777–778 in Chapter 24.) The background knowledge about a client’s business, which an external auditor must obtain while doing an audit, often provides useful information for giving operational recommendations. For example, suppose that the auditor determined that inventory turnover for a client slowed considerably during the current year. The auditor should determine the cause of the slower turnover to evaluate the possibility of obsolete inventory that would misstate the financial statements. In determining the cause of the reduced inventory turnover, the auditor may identify operational causes, such as ineffective inventory acquisition policies, that can be brought to the attention of management. An auditor who has a broad business background and experience with similar businesses is more likely to be effective at providing clients with relevant operational recommendations than a person who lacks those qualities. Clients commonly engage a CPA firm to do operational auditing for one or more specific parts of its business. For example, a company can ask the CPA firm to evaluate the efficiency and effectiveness of its computer systems. Usually, management engages the CPA firm for these audits only when the company does not have an internal audit staff or if the internal audit staff lacks expertise in a certain area. In some cases, manage- ment or the board of directors outsources the entire internal audit function to a CPA firm or co-sources select internal audit activities, such as IT operational auditing Apago PDF Enhancer activities, to be done jointly by a CPA firm and certain members of the company’s internal audit staff. In most cases, the CPA firm’s management consulting staff per - forms these services. Note that CPA firms cannot provide these services to their public company audit clients. The two most important qualities for an operational auditor are independence and Independence and competence. The auditor should report to the appropriate level of management to Competence of ensure that investigation and recommendations are made without bias. Indepen - Operational Auditors dence is seldom a problem for CPA firm auditors because they are not employed by the company being audited. The independence of internal auditors is enhanced by having the internal audit department report to the board of directors or president.

Similarly, government auditors should report to a level above the operating depart- ments. The GAO, for example, reports directly to Congress as a means of enhancing inde pendence. The responsibilities of operational auditors can also affect their independence. The auditor should not be responsible for operating functions in a company or for correcting deficiencies when ineffective or inefficient operations are found. For example, it would negatively affect auditors’ independence when they audit an IT system for acquisitions if they designed the system or are responsible for correcting deficiencies they found during the audit. While it is acceptable for auditors to recommend changes in operations, operating personnel must have the authority to accept or reject those recommendations. If auditors had the authority to require implementation of their recommendations, their independence would be reduced. 1From Round Table, © 1982 by The Institute of Internal Auditors, Inc., 249 Maitland Avenue, Altamonte Springs, Fla. 32701. Reprinted with permission. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 825 Competence is, of course, necessary to determine the cause of operational problems and to make appropriate recommendations. When operational auditing deals with wide-ranging operating problems, however, competence can be a major obstacle. For example, imagine the difficulties of finding qualified internal auditors who can evaluate both the effectiveness of an advertising program and the efficiency of a production assembly process. The internal audit staff doing that type of operational auditing will presumably have to include some personnel with backgrounds in marketing and others in production. Criteria for A major challenge of operational auditing is in selecting specific criteria for evaluating Evaluating Efficiency whether efficiency and effectiveness have occurred. In auditing historical financial and Effectiveness statements, accounting standards provide the broad criteria for evaluating fair presentation, and audit objectives facilitate more specific criteria in deciding whether OBJECTIVE 26-5 those standards have been followed. In operational auditing, there are no well-defined criteria. Plan and perform an To establish criteria for operational auditing, auditors could define the objectives operational audit. as determining whether some aspect of the entity could be made more effective or efficient, and recommending improvements. This approach may be adequate for experienced and well-trained auditors, but it provides little guidance for most auditors. Specific Criteria More specific criteria are usually desirable before starting an operational audit. For example, suppose that you are doing an operational audit of the equipment layout in plants for a company. Here are some specific criteria, stated as questions, that might be used to evaluate plant layouts: • Were all plant layouts approved by home office engineering at the time of original design? • Has home office engineering done a reevaluation study of plant layout in the past 5 years? Apago PDF Enhancer • Is each piece of equipment operating at 60 percent of capacity or more for at least 3 months each year? • Does layout facilitate the movement of new materials to the production floor? • Does layout facilitate the production of finished goods? • Does layout facilitate the movement of finished goods to distribution centers? • Does the plant layout effectively use existing equipment? • Is the safety of employees endangered by the plant layout? Sources of Criteria To develop specific evaluation criteria, the operational auditor can use several sources, including: • Historical performance.Criteria can be based on actual results from prior periods. By using these criteria, auditors can determine whether things have become “better” or “worse” in comparison. The advantage of this approach is that the criteria are easy to derive. However, they may not provide much insight into how well or poor the results are compared to what they could be.

• Benchmarking. Entities within or outside the client’s organization may be sufficiently similar to the client’s organization to use their operating results as criteria. Auditors should use care in selecting organizations to use as benchmarks. It makes little sense to benchmark with dissimilar organizations or those that perform at a substandard level. For internal comparable entities, the data are often readily available to use as criteria. Outside organizations are often willing to make their operating information available. Also, benchmarking data are often available through industry groups and governmental regulatory agencies. • Engineered standards.It may be possible in some engagements to develop criteria based on engineered standards. For example, auditors can use time and motion studies to determine efficient production output rates. These criteria are often time-consuming and costly to develop because they require considerable expertise, 826 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES but in some cases it may be worth the cost. Standards can be developed by industry groups for use by all their members, thereby spreading the cost. • Discussion and agreement.Sometimes objective criteria are difficult or costly to obtain, and are best developed through discussion and agreement. The parties involved should include management of the entity to be audited, the opera - tional auditor, and the entity or persons to whom the findings will be reported. The three phases in an operational audit are planning, evidence accumulation and Phases in evaluation, and reporting and follow-up. Operational Auditing Planning Planning for operational audits is similar to planning for audits of his - torical financial statements that we’ve discussed in earlier chapters. Like auditors of financial statements, the operational auditor must determine the scope of the engage- ment and communicate it to the organizational unit. It is also necessary to: • Staff the engagement properly • Obtain background information about the organizational unit • Understand internal control • Decide on the appropriate evidence to accumulate The major difference between planning an operational audit and a financial audit is the diversity created by the breadth of operational audits, which often makes it difficult to decide on specific objectives. Auditors select objectives based on the criteria developed for the engagement, depending on the specific circumstances at hand. For example, the objectives for an operational audit of the effectiveness of internal controls over payroll will be dramatically different from those of an operational audit of the efficiency of a research and development department. Yet, these diverse objectives might be part of a single operational audit. The breadth of operational audits often makes staffing more complicated than in a financial audit. Not only are the areAasp diavergseo, s uchP aDs pFro duEctnionh caonntrcol eanrd adver- tising, but the objectives within those areas often require special technical skills. For example, the auditor may need an engineering background to evaluate performance on a major construction project. Finally, unlike financial audits, operational audits require auditors to spend more time with the interested parties agreeing on the terms of the engagement and the criteria for evaluation. Regardless of the source of the criteria for evaluation, it is essential that representatives of the entity to be audited, the operational auditor, and the entity or persons to whom the findings will be reported are clear and in agreement on the objectives and criteria involved. Evidence Accumulation and Evaluation The eight types of evidence introduced in Chapter 7 and discussed throughout this book are equally applicable to operational auditing. Because internal controls and operating procedures are a critical part of operational auditing, it is common to use documentation, client inquiry, analytical procedures, and observation extensively. Confirmation, reperformance, and recalcula -

tion are used less extensively for most operational audits than for financial audits because the existence and accuracy objectives are not relevant for most operational audits. To illustrate evidence accumulation in operational auditing, reconsider the example of the agency evaluating the safety of elevators in a city. Assume the parties agree that the objective is to determine whether a competent inspector makes an annual inspec - tion of each elevator in the city. To satisfy the completeness objective, auditors might examine blueprints of city buildings and elevator locations and trace them to the agency’s list to ensure that all elevators are included in the population. Additional tests on newly constructed buildings will be appropriate to assess the timeliness with which the central listing is updated. Assuming auditors determine that the agency’s list is complete, they can select a sample of elevator locations and collect evidence as to the timing and frequency of Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 827 inspections. The auditor may want to consider inherent risk by doing greater sampling of older elevators or elevators with previous safety defects. The auditor may also want to examine evidence of the elevator inspectors’ competence by reviewing resumes, training programs, competency examinations, and performance reports. It is also likely that the auditor will want to reperform the inspection procedures for a sample of elevators to obtain evidence of inconsistencies in reported and actual conditions. Just like financial auditors, operational auditors must accumulate sufficient appro - priate evidence to provide a basis for a conclusion about the objectives being tested. For an audit of elevator safety, the auditor must accumulate sufficient evidence about elevator safety inspections. After the evidence is accumulated, the auditor must decide whether it is reasonable to conclude that an inspection is made annually of each elevator in the city by a competent inspector. Reporting and Follow-Up Two major differences in operational and financial auditing reports affect operational auditing reports: 1. In operational audits, the report is usually sent only to management, with a copy to the unit being audited. The lack of third-party users reduces the need for standardized wording in operational auditing reports. 2. The diversity of operational audits requires a tailoring of each report to address the scope of the audit, findings, and recommendations. Operational auditors often take a significant amount of time to clearly communi - cate audit findings and recommendations. On performance audits, when reports are being prepared following Yellow Book requirements, specified content must be included, but considerable freedom is permitted in the form of the report. Follow-up is common in operational auditing when auditors make recommendations to manage - ment to determine whether the recommended changes were made, and if not, why not. Examples of Each issue of the Internal Auditor, a bimonthly publication of the IIA, includes several Apago PDF Enhancer Operational internal operational audit findings submitted by practicing internal auditors. Most of the Audit Findings findings deal with efficiency rather than effectiveness. Readers of the journal are more likely to find efficiency findings more interesting than those related to effec tiveness. An operational audit resulting in savings of $68,000 will probably engage readers more than a report on improved accuracy of financial reporting. The following examples from the Internal Auditorinclude examples related to effectiveness and to efficiency: Outside Janitorial Firm Saves $160,000 • An internal auditor reviewed the efficiency and effectiveness of the janitorial services furnished by state employees for the buildings in the state capitol complex. The audit disclosed the costs of the janitorial services were excessive when compared with similar services performed by outside janitorial firms. In

addition, the auditors found many janitorial tasks were not completed as required, resulting in unacceptable quality. A study of alternative janitorial services indicated equal or better service could be provided by an outside janitorial firm and at a savings of $137,000 a year. The auditor recommended the state seek competitive bids and contract with the janitorial firm submitting the lowest bid that meets the specifications. The resultant contract actually saved more than $160,000, and the quality of the cleaning improved noticeably. Use the Right Tool • A company leased 25 heavy-duty trucks for use by service employees who installed and repaired about 20,000 vending machines in a large metropolitan area. All of the trucks were equipped with hydraulic lift-gates for loading and unloading vending machines. The internal auditor found that only a few of the trucks were actually delivering and picking up vending machines. Most of the trucks were used for service calls, which consisted of on-the-scene repair of the machines or other simple 828 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES adjustments not requiring the hydraulic lift-gates. The auditor recommended most of the heavy-duty trucks be phased out and replaced by conventional light vans. Management agreed and the savings in lease rates and operating expenses were estimated at $25,000 a year. Computer Programs Save Manual Labor • The federal Employee Retirement Income Security Act (ERISA) requires an annual audit of profit-sharing plans. Internal auditors tested the profit sharing plans as required by ERISA, but also performed an operational review, which provided a number of valuable recommendations to management. The IT auditors on the audit team developed several computer-assisted audit programs to test control over enrollment in and termination from the company’s profit-sharing plan. The computer assistance saved manual labor and detected several employees who were not eligible for the plan, such as employees with less than the required one year of service and terminated employees still on the plan. The computer portion of the audit program also detected conflicting data between the payroll and profit-sharing plan master files. When shown the results of the audit, management corrected all of the problems and instituted additional controls to prevent the problems in the future. And the additional controls were … well, guess. Yep, they wanted the IT auditors to leave their computer programs in the machine. The profit-sharing plan manager uses the programs periodically as a control to detect enrollment errors.2 SUMMARY This chapter discussed the financial auditing activities of internal auditors and the effect of internal auditors on external audits. We also discussed government auditors and the auditing and reporting requirements Aunpdear ggovoern mPenDt aFud itiEngn sthanadarndsc. Inecrreasingly, internal auditors and government auditors, as well as CPA firms, are also asked to perform operational audits of the efficiency or effectiveness of a company or government unit. In these engagements, the appropriate criteria for evaluating effi ciency or effectiveness is essential. ESSENTIAL TERMS Economy and efficiency audit—a govern- (GAGAS)— ment audit to determine whether an entity see Yellow Book is acquiring, protecting, and using its Government audits—financial or opera - resources economically and efficiently; the tional audits of government agencies or causes of any inefficiencies or uneconomi - government-funded institutions cal practices; and whether the entity has International Standards for the Profes- complied with laws and regulations con - sional Practice of Internal Auditing— cerning matters of economy and efficiency guidelines issued by the Institute of Effectiveness—the degree to which the Internal Auditors covering the attributes organization’s objectives are accomplished and performance of internal auditors Efficiency—the degree to which costs are Institute of Internal Auditors (IIA)— reduced without reducing effectiveness organization for internal auditors that

Functional audit—an operational audit establishes ethical and practice standards, that deals with one or more specific provides education, and encourages pro - functions within an organization, such as fessionalism for its members the payroll function or the production Operational auditing—the review of engineering function an organization for efficiency and 2Ibid. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 829 effectiven ess. The terms management satisfy the audit requirements of all federal auditing,performance auditing, and opera - funding agencies tional auditingare often synonymous terms Special assignments—management requests Organizational audit—an operational for an operational audit for a specific pur- audit that deals with an entire organiza - pose, such as investigating the possib ility tional unit, such as a department, branch, of fraud in a division or making recom- or subsidiary, to determine how effi ciently mend at ions for reducing the cost of a and effectively functions interact manufactured product Program audit—a government audit to Statements on Internal Auditing Standards determine the extent to which the desired (SIASs)—statements issued by the Internal results or benefits established by the legis- Auditing Standards Board of the IIA to latureor other authorizing body are being provide authoritative interpretations of achieved; the effectiveness of organizations, the IIA Practice Standards programs, activities, or functions; and Yellow Book—a publication of the GAO whether the entity has complied with laws that is widely used as a reference by and regulations applic able to the program government auditors and CPAs who do Single Audit Act—federal legislation that governmental audit work; the official title provides for a single coordinated audit to isGovernment Auditing Standards REVIEW QUESTIONS 26-1 (Objective 26-1)Explain the role of internal auditors for financial auditing. How is it similar to and different from the role of external auditors? 26-2 (Objective 26-1) What is the nature of the two categories of standards in the IIA International Standards for the Professional Practice of Auditing? 26-3 (AObpjeactigveo 26 -1P) DExFpla inE thne hdiaffenrenccee bretween the independence of internal auditors and external auditors in the audit of historical financial statements. How can internal auditors best achieve independence? 26-4 (Objective 26-2) Explain how governmental financial auditing is similar to and different from audits of commercial companies. Who does governmental auditing? 26-5 (Objective 26-2) Explain what is meant by the Single Audit Act. What is its purpose? 26-6 (Objective 26-2) In what ways is the Yellow Book consistent with generally accepted auditing standards, and what are some additions and modifications? 26-7 (Objective 26-2) Identify the primary specific objectives that must be incorporated into the design of audit tests under the Single Audit Act. 26-8 (Objective 26-2)Identify the key required reports of the Single Audit Act and OMB Circular A-133. 26-9 (Objective 26-3)Describe what is meant by an operational audit. 26-10 (Objective 26-3) Identify the three major differences between financial and opera- tional auditing. 26-11 (Objective 26-4) Distinguish between efficiency and effectiveness in operational audits. State one example of an operational audit explaining efficiency and another explaining effectiveness. 26-12 (Objective 26-4) Distinguish among the following types of operational audits: functional, organizational, and special assignment. State an example of each for a not-for- profit hospital. 26-13 (Objective 26-4) Explain why many people think of internal auditors as the primary group responsible for conducting operational audits. 26-14 (Objective 26-4) Explain the role of government auditors in operational auditing. How is this similar to and different from the role of internal auditors? 830 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES 26-15 (Objective 26-4) Under what circumstances are external auditors likely to be

involved in operational auditing? Give one example of operational auditing by a CPA firm. 26-16 (Objective 26-5)Explain what is meant by the criteria for evaluating efficiency and effectiveness. Provide five possible specific criteria for evaluating effectiveness of an IT system for payroll. 26-17 (Objective 26-5) Identify the three phases of an operational audit. 26-18 (Objective 26-5) Explain how planning for operational auditing is similar to and different from financial auditing. 26-19 (Objective 26-5)What are the major differences between reporting for operational and financial auditing? MULTIPLE CHOICE QUESTIONS FROM CPA, CIA, AND CMA EXAMINATIONS 26-20 (Objectives 26-1, 26-4)The following questions deal with independence of auditors. Choose the best response. a. The operational auditor’s independence is most likely to be compromised when the internal audit department is responsible directly to the (1) vice president of finance. (4) executive vice president. (2) president. (5) audit committee of the board of directors. (3) controller. b. The independence of the internal audit department will most likely be assured if it reports to the (1) president. (4) audit committee of the board of directors. (2) controller. (5) vice president of finance. Apago PDF Enhancer (3) treasurer. c. You have been asked to assess the organizational independence of an internal audit activity. You should consider all of the following factors except (1) functional reporting to the board and administrative reporting to the chief executive officer. (2) the criteria of education and experience considered necessary when filling vacant positions on the internal audit staff. (3) the degree to which internal auditors assume operational responsibilities. (4) a limitation on the scope of objectives for the engagements included in the review. 26-21 (Objective 26-2)The following questions deal with governmental auditing. Choose the best response. a. A governmental audit may extend beyond an examination leading to the expression of an opinion on the fairness of financial statement presentation to include Program Economy Results Compliance and Efficiency (1) Yes Yes No (2) Yes Yes Yes (3) No Yes Yes (4) Yes No Yes b. When engaged to audit a governmental entity in accordance with Government Auditing Standards, an auditor prepares a written report on internal control (1) on all audits, regardless of circumstances. (2) only when the auditor has noted material weaknesses. (3) only when requested by the governmental entity being audited. (4) only when requested by the federal government funding agency. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 831 c. Ward is auditing an entity’s compliance with requirements governing a major federal financial assistance program in accordance with the Single Audit Act. Ward detected noncompliance with requirements that have a material effect on the program. Ward’s report on compliance should express (1) no assurance on the compliance tests. (2) reasonable assurance on the compliance tests. (3) a qualified or adverse opinion. (4) an adverse opinion or a disclaimer of opinion. 26-22 (Objectives 26-3, 26-4, 26-5)The following questions deal with operational auditing. Choose the best response. a. Which of the following best describes the operational audit? (1) It requires constant review by internal auditors of the administrative controls as they relate to the operations of the company. (2) It concentrates on implementing financial and accounting controls in a newly organized company. (3) It attempts and is designed to verify the fair presentation of a company’s results of operations. (4) It concentrates on seeking aspects of operations in which waste would be reduced by the introduction of controls. b. The evaluation of audit field work of an operating unit should answer the following questions: 1. What are the reasons for the results? 2. How can performance be improved? 3. What results are being achieved? What is the chronological order in which these questions should be answered? (1) 3—1—2 (2) 1—3—2

Apago PDF Enhancer (3) 3—2—1 (4) 1—2—3 (5) 2—3—1 c. The purpose of governmental effectiveness or program auditing is to determine if the desired results of a program are being achieved. The first step in conducting such an audit is to (1) evaluate the system used to measure results. (2) determine the time frame to be audited. (3) collect quantifiable data on the program’s success or failure. (4) identify the legislative intent of the program being audited. 26-23 (Objectives 26-1, 26-4, 26-5) The following questions deal with internal auditing. Choose the best response. a. Which of the following is generally considered to be a major reason for establishing an internal auditing function? (1) To relieve overburdened management of the responsibility for establishing effec- tive systems of internal control. (2) To ensure that operating activities comply with the policies, plans, and procedures established by management. (3) To ensure the accuracy, reliability, and timeliness of financial and operating data used in management’s decision making. (4) To evaluate and improve the effectiveness of control processes. b. The scope of an internal auditing engagement is initially defined by the (1) engagement objectives. (2) scheduling and time estimates. (3) preliminary survey. (4) engagement work program. 832 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES c. With regard to corrective action on audit results, which of the following is not the internal auditor’s responsibility? (1) Soliciting auditees’ suggestions for corrective actions. (2) Recommending possible alternative corrective actions. (3) Directing the corrective actions. (4) Determining that the corrective actions are responsive to the audit results. (5) Evaluating new policy statements to determine whether they address the unsatis - factory conditions disclosed in the audit results. CASES 26-24 (Objectives 26-1, 26-4) Lajod Company has an internal audit department consisting of a manager and three staff auditors. The manager of internal audits, in turn, reports to the corporate controller. Copies of audit reports are routinely sent to the audit committee of the board of directors as well as to the corporate controller and the individual respon- sible for the area or activity being audited. The manager of internal audits is aware that the external auditors have relied on the internal audit function to a substantial degree in the past. However, in recent months, the external auditors have suggested there may be a problem related to the objectivity of the internal audit function. This objectivity problem may result in more extensive testing and analysis by the external auditors. The external auditors are concerned about the amount of nonaudit work performed by the internal audit department. The percentage of nonaudit work performed by the internal auditors in recent years has increased to about 25% of their total hours worked. A sample of five recent nonaudit activities are as follows: 1. One of the internal auditors assisted in the preparation of policy statements on internal control. These statements included such things as policies regarding Apago PDF Enhancer sensitive payments and standards of control for internal controls. 2. The bank statements of the corporation are reconciled each month as a regular assignment for one of the internal auditors. The corporate controller believes this strengthens internal controls because the internal auditor is not involved in the receipt and disbursement of cash. 3. The internal auditors are asked to review the budget data in every area each year for relevance and reasonableness before the budget is approved. In addition, an internal auditor examines the variances each month, along with the associated explanations. These variance analyses are prepared by the corporate controller’s staff after consul - tation with the individuals involved. 4. One of the internal auditors has recently been involved in the design, installation, and initial operation of a new computer system. The auditor was primarily con-

cerned with the design and implementation of internal accounting controls and the computer application controls for the new system. The auditor also conducted the testing of the controls during the test runs. 5. The internal auditors are often asked to make accounting entries for complex trans - actions before the transactions are recorded. The employees in the accounting department are not adequately trained to handle such transactions. In addition, this serves as a means of maintaining internal control over complex transactions. The manager of internal audits has always made an effort to remain independent of the corporate controller’s office and believes that the internal auditors are objective and independent in their audit and nonaudit activities. a. Define objectivityas it relates to the internal audit function. Required b. For each of the five situations outlined, explain whether the objectivity of Lajod Company’s internal audit department has been materially impaired. Consider each situation independently. c. The manager of audits reports to the corporate controller. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 833 (1) Does this reporting relationship result in a problem of objectivity? Explain your answer. (2) Would your answer to any of the five situations in requirement b have changed if the manager of internal audits reported to the audit committee of the board of directors? Explain your answer.* 26-25 (Objectives 26-1, 26-4, 26-5)Weston Corporation has an internal audit department operating out of the corporate headquarters. Various types of audit assignments are performed by the department for the eight divisions of the company. The following findings resulted from recent audits of Weston Corporation’s White Division: 1. One of the departments in the division appeared to have an excessive turnover rate. Upon investigation, the personnel department seemed to be unable to find enough workers with the specified skills for this department. Some workers are trained on the job. The departmental supervisor is held accountable for labor efficiency variances but does not have qualified staff or sufficient time to train the workers properly. The supervisor holds individual workers responsible for meeting pre- determined standards from the day they report to work. This has resulted in a rapid turnover of workers who are trainable but not yet able to meet standards. 2. The internal audit department recently participated in a computer feasibility study for this division. It advised and concurred on the purchase and installation of a specific computer system. Although the system is up and operating, the results are less than desirable. The software and hardware meet the specifications of the feasi- bility study, but there are several functions unique to this division that the system has been unable to accomplish. Linking of files has been a problem. For example, several vendors have been paid for materials not meeting company specifications. A revision of the existing software is probably not possible, and a permanent solution probably requires replacing the existing computer system with a new one. 3. One of the products manufactured by this division was recently redesigned to Aelimpianatge ao p otePntDialF saf etyE dnefehct.a Thnisc deefecrt was discovered after several users were injured. At present, there are no pending lawsuits because none of the injured parties has identified a defect in the product as a cause of the injury. There is insufficient information to determine whether the defect was a contributing factor. The director of internal auditing and assistant controller is in charge of the internal audit department and reports to the controller in corporate headquarters. Copies of inter- nal audit reports are sent routinely to Weston’s board of directors. Required a. Explain the additional steps in terms of field work, preparation of recommenda- tions, and operating management review that ordinarily should be taken by Weston Corporation’s internal auditors as a consequence of the audit findings in the first

situation (excessive turnover). b. Discuss whether there are any objectivity problems with Weston Corporation’s internal audit department as revealed by the audit findings. Include in your discussion any recommendations to eliminate or reduce an objectivity problem, if one exists. c. The internal audit department is part of the corporate controllership function, and copies of the internal audit reports are sent to the board of directors. (1) Evaluate the appropriateness of the location of the internal audit department within Weston’s organizational structure. (2) Discuss who within Weston should receive the reports of the internal audit depart ment.* 26-26 (Objectives 26-4, 26-5) Haskin Company was founded 40 years ago and now has several manufacturing plants in the Northeast and Midwest. The evaluation of proposed capital expenditures became increasingly difficult for management as the company became geographically dispersed and diversified its product line. Thus, the Capital Budgeting Group was organized in 2010 to review all capital expenditure proposals in excess of $100,000. *CMA adapted. 834 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES The Capital Budgeting Group conducts its annual planning and budget meeting each September for the upcoming calendar year. The group establishes a minimum return for investments (hurdle rate) and estimates a target level of capital expenditures for the next year based on the expected available funds. The group then reviews the capital expenditure proposals that have been submitted by the various operating segments. Proposals that meet either the return on investment criterion or a critical need criterion are approved to the extent of available funds. The Capital Budgeting Group also meets monthly, as necessary, to consider any projects of a critical nature that were not expected or requested in the annual budget review. These monthly meetings allow the Capital Budgeting Group to make adjustments during the year as new developments occur. Haskin’s profits have been decreasing slightly for the past 2 years despite a small but steady sales growth, a sales growth that is expected to continue through 2012. As a result of the profit stagnation, top management is emphasizing cost control and all aspects of Haskin’s operations are being reviewed for cost reduction opportunities. Haskin’s internal audit department has become involved in the companywide cost reduction effort. The department has already identified several areas where cost reductions could be realized and has made recommendations to implement the necessary procedures to effect the cost savings. Tom Watson, internal audit director, is now focusing on the activities of the Capital Budgeting Group in an attempt to determine the efficiency and effectiveness of the capital budgeting process. In an attempt to gain a better understanding of the capital budgeting process, Watson decided to examine the history of one capital project in detail. A capital expenditure proposal of Haskin’s Burlington Plant that was approved by the Capital Budgeting Group in 2011 was selected randomly from a population of all proposals approved by the group at its 2010 and 2011 annual planning and budget meetings. The Burlington proposal consisted of a request for five new machines to replace equip - ment that was 20 years old and for which preventive maintenance had become expensive. Four of the machines were for replaceAmepnta pugrpoos es,P anDd tFhe fifEthn wahs faorn plcanenedr growth in demand. Each of the four replacement machines was expected to result in annual maintenance cost savings of $20,000. The fifth machine was exactly like the other four and was expected to generate an annual contribution of $30,000 through increased output. Each machine had a cost of $110,000 and an estimated useful life of 8 years. a. Identify and discuss the issues that Haskin Company’s internal audit department must Required address in its examination and evaluation of Burlington Plant’s 2011 capital expendi- ture project. b. Recommend procedures to be used by Haskin’s internal audit department in the audit

review of Burlington Plant’s 2011 capital expenditure project.* 26-27 (Objectives 26-4, 26-5) Lecimore Company has a centralized purchasing depart ment that is managed by Joan Jones. Jones has established policies and procedures to guide the clerical staff and purchasing agents in the day-to-day operation of the department. She is satisfied that these policies and procedures are in conformity with company objectives and believes there are no major problems in the regular operations of the purchasing department. Lecimore’s internal audit department was assigned to perform an operational audit of the purchasing function. Their first task was to review the specific policies and procedures established by Jones. The policies and procedures are as follows: •All significant purchases are made on a competitive bid basis. The probability of timely delivery, reliability of vendor, and so forth, are taken into consideration on a subjective basis. •Detailed specifications of the minimum acceptable quality for all goods purchased are provided to vendors. •Vendors’ adherence to the quality specifications is the responsibility of the materials manager of the inventory control department and not the purchasing department. The *CMA adapted. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 835 materials manager inspects the goods as they arrive to be sure that the quality meets the minimum standards and then sees that the goods are transferred from the receiving dock to the storeroom. •All purchase requests are prepared by the materials manager based on the production schedule for a 4-month period. The internal audit staff then observed the operations of the purchasing function and gathered the following findings: •One vendor provides 90% of a critical raw material. This vendor has a good delivery record and is reliable. Furthermore, this vendor has been the low bidder over the past few years. •As production plans change, rush and expedite orders are made by production directly to the purchasing department. Materials ordered for cancelled production runs are stored for future use. The costs of these special requests are borne by the purchasing department. Jones considers the additional costs associated with these special requests as “costs of being a good member of the corporate team.” •Materials to accomplish engineering changes are ordered by the purchasing depart - ment as soon as the changes are made by the engineering department. Jones is proud of the quick response by the purchasing staff to product changes. Materials on hand are not reviewed before any orders are placed. •Partial shipments and advance shipments (that is, those received before the requested date of delivery) are accepted by the materials manager, who notifies the purchasing department of the receipt. The purchasing department is responsible for follow-up on partial shipments. No action is taken to discourage advance shipments. Required Based on the purchasing department’s policies and procedures and the findings of Lecimore’s internal audit staff, a. Identify deficiencies and/or inefficiencies in Lecimore Company’s purchasing function. b. Make recommendations for those deficiencies/inefficiencies that you identify.* Apago PDF Enhancer Use the following format in preparing your response: Deficiencies/Inefficiencies Recommendations 1. 1. 26-28 (Objectives 26-4, 26-5)Superior Co. manufactures automobile parts for sale to the major U.S. automakers. Superior’s internal audit staff is to review the internal controls over machinery and equipment and make recommendations for improvements when appro- priate. The internal auditors obtained the following information during the assignment: •Requests for purchase of machinery and equipment are normally initiated by the supervisor in need of the asset. The supervisor discusses the proposed acquisition with the plant manager. A purchase requisition is submitted to the purchasing department when the plant manager is satisfied that the request is reasonable and that there is a

remaining balance in the plant’s share of the total corporate budget for capital acquisitions. •Upon receiving a purchase requisition for machinery or equipment, the purchasing department manager looks through the records for an appropriate supplier. A formal purchase order is then completed and mailed. When the machine or equipment is received, it is immediately sent to the user department for installation. This allows the economic benefits from the acquisition to be realized at the earliest possible date. •The property, plant, and equipment ledger control accounts are supported by computerized depreciation lapse schedules organized by year of acquisition. These lapse schedules are used to compute depreciation as a unit for all assets of a given type that are acquired in the same year. Standard rates, depreciation methods, and salvage values are used for each major type of fixed assets. These rates, methods, and salvage values were set 10 years ago during the company’s initial year of operation. •When machinery or equipment is retired, the plant manager notifies the accounting department so that the appropriate entries can be made in the accounting records. *CMA adapted. 836 Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES •There has been no reconciliation since the company began operations between the accounting records and the machinery and equipment on hand. Identify the internal control deficiencies and recommend improvements that the internal Required audit staff of Superior Co. should include in its report regarding the internal controls over fixed assets. Use the following format in preparing your answer:* Deficiencies Recommendations 1. 1. INTERNET PROBLEM 26-1: INSTITUTE OF INTERNAL AUDITORS The Institute of Internal Auditors (IIA) is an international professional association of more than 170,000 members with global headquarters in Altamonte Springs, Florida. Throughout the world, The IIA is recognized as the internal audit profession’s leader in certification, education, research, and technical guidance. Visit the IIA’s website (www.theiia.org) to answer questions about the IIA and certification of internal auditors. a. Why should an organization have an internal auditing department? (Hint: open Required “frequently asked questions” under the “About the Internal Audit Profession” link.) b. What are the six steps to receiving a certification in internal auditing? c. What certifications are available to internal auditors? d. What are the four parts of the CIA exam? How are the requirements for passing the CIA exam similar to and different from the CPA exam? Apago PDF Enhancer *CMA adapted. Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 837 APPENDIX ACL INSTALLATION AND INSTRUCTIONS INTRODUCTION ACL is generalized audit software used by auditors to extract and analyze data on client’s computerized systems. Generalized audit software is discussed on pages 385–386 of the text. The ACL Problems included in selected chapters (Chapters 7, 8, 11, 12, 14, 16 and 17) are intended to provide you with an introduction to ACL. An in-depth study of its use is beyond the scope of most first auditing courses. The guidance provided in this Appendix is intended only to help you solve the problems in the text. Software Installation The software should be installed on your personal computer. For any other installation, see your instructor. 1. Insert the CD in the CD holder on your computer. 2. On the opening screen, select “Install” and select the “ACL 9 Educational Edition.” Proceed through the prompts to completion. You may be prompted to install additional MSXML or other components if they are not already installed on yourcomputer. • You must accept the license agreement to complete the installation Apago PDF Enhancer • Select complete setup • Exit after the installation is complete Opening ACL An icon to open the ACL Education Edition should be on your desktop after installa - tion. If it does not appear, then go to Windows Start and select “Programs” to then

locate the ACL Desktop Education Edition link. Select the “ACL Desktop Education Edition” to launch the software. Finding Companies, The main screen Welcome to ACL should appear when you open ACL. Look at that Tables, and screen now. Using Commands On that screen, you will see a header “ACL Projects.” Click on the link for “Open an existing project.” You will then see a list of four projects. The ACL assignments in the text use only two of these projects: ACL_Demo and Sample_Project. Both of these projects have several files, which ACL calls tables. You will first click on a project to identify the tables, which will appear in the left side of your screen window once you click on the project folder. (Note: When you open ACL again, any projects you have accessed will appear under “Recent Projects” and can be accessed using those links.) Note: From now on, when you see italics it means you should use your computer to follow an instruction. The arrow sign (&) indicates an additional action to be taken. Click Sample_Project to open the tables under Sample_Project & Click the plus sign next to the yellow tables folder &Click the plus sign next to the yellow accounts payable subfolder. Observe that there are now two blue lined boxes under the accounts payable subfolder. Each of those represents a table. Double click AP_Trans and observe that a typical ACL table labeled AP_Trans for accounts payable transactions opens. On the bottom row of that screen, the 838 APPENDIX number of records in the table is listed (102). The table includes columns with titles and data in each column. That is the information that auditors verify using various commands. Click the top of the Invoice Amount column on the table (make sure the column is now all dark &Go to the Windows drop down options at the top of the screen and select “Analyze” (on the Menu bar) & Under “Analyze”, select “Total Fields” (on the drop down list). The amount shown on the screen should be 278,641.33. You just used an ACL command (Total Fields) to calculate the total of the invoice amounts in the table. That sure beats using an adding machine or reentering the data in Excel. (Note: Commands can be accessed through the Menu bar or using the icons at the top of the screen. In this text we use the Menu bar.) Click the small x below the large X at the top right hand side of your screen to close that window and return to the AP_Trans table. & Click the small x below the large X to close the AP_Trans table. This will return you to the “Welcome to ACL” screen; “Sample Project” will be open on the left side of the screen. & Click the large X to exit ACL. You will use the remainder of this material to help you answer the assigned questions in the text. The first three functions (Quick Sort, Filters, and Computed Fields) are not con- sidered ACL commands. The remaining functions included here are all ACL commands. You will use these commands in ACL homework problems that are included in selected chapters. The descriptions below provide a brief overview of the functions that will be used to complete those problems. Within each ACL homework problem in the text, you will see the commands needed to answer the problem listed within parentheses in that problem. Quick Sort Used to sort data in anAy fipelad, geitohe r frPomD lFow esEt tno hhigahenst ocr evicre versa. 1. Click on the column heading of the field you want to sort. 2. Right click using your mouse to find the & Quick Sort Ascending or Quick Sort Descending (you can right click Quick Sort Offto undo the sort). Filters Used to ask questions of data in a table without adding a new field. 1. Click the Edit View Filter button in an open table to enter the Edit view filter window. 2. Use the Expression box to build an expression. 3. The Expression box is where you build filters using the available fields in the current table, as well as the operators (=, < >, AND, etc.). There are three com ponents to a filter: (1) field, (2) operator and (3) a numeric value, character value, or date. 4. In the Available Fields portion of the window, double-click the name of the field

for which you are building a filter.Notice that the field name is inserted in the Expression box. 5. Use the operator buttons (=, +, <, >, etc.) and the numeric keypad on the key - board to build the filter.Note:If you are performing a recalculation to determine if the original calculation already in the data table is correct, use <> as the operator with no spaces between the less than and greater than signs. 6. Enter an appropriate string or value after the operator. Use the following guide lines: • Numeric values—enter as a number with no commas or dollar signs. For example, to enter $1,000, type 1000. • Character values—enclose with one or two quotations. For example, to enter department D10, type “D10” or ‘D10’. Use the same case as is used in the data field. • Dates—click on the Date button located just below the mathematical opera- tors to open the Date Selector box. Click the drop-down arrow to enter the monthly calendar box. Select the date, then click OK. APPENDIX 839 7. For more complex filters, use the AND, OR, or NOT operators and repeat the preceding process for each portion of the filter. After selecting an AND, OR or NOT, it is necessary to repeat all three components [(1) field, (2) operator and (3) a numeric value, character value, or date] of the filter. 8. An example of an expression to select all invoices from the AP _Trans table dated after October 1, 2000 greater than $1000 is as follows: Invoice_Date > ‘20001001’ AND Invoice_Amount > 1000 9. Click OK to complete the filter. 10. If you want to change the filter, click again to return to the Edit view filter window. Make changes in the filter and click OK. 11. You can also apply additional commands to a filtered table until you remove the filter. 12. Click the Remove Filter button after you have completed all additional tests on the filtered table to return to the unfiltered table. Computed Fields Used to ask questions of data in a table by adding a new field. The new field is derived from calculations using other fields in the table. 1. Click Edit &Table Layout to open the Layout Options window. 2. Select the “Edit Fields/Expressions” tab folder on the top row of the Layout window. 3. Click the Add a New Expression button , which is the third button down on the left side of the window under the “Edit Fields/Expressions” tab. (You may need to expand the window to see the .) 4. Add a name for the computed field in the Name box that describes the new column. Also add a column title in the Alternative Column Title box, which will appear in the Table after you complete the new field. 5. Click the Expression button , which is located to the right of the Name box to open the Expression box. Apago PDF Enhancer 6. Build an expression in the expression box in the same way as for filters. 7. After building the expression, click OK to return to the original tables window. 8. Click the Accept Entry button on the top left of the screen to save the new computed field. 9. The new field can be added to the table view by completing the following steps: • Close the Edit Fields/Expressions window if it is still open. • Return to the data table which contains all the data for the file you are examining. Place the cursor in the column heading to the right of where you want the new computed field to appear in the table view. • Right Click and then Click Add Columns from the drop-down menu. • Double-click on the name of the new computed field you just created. • Click OK.The new computed field now appears in the table view. Age Command Used to accumulate data in a table by age, usually for accounts receivable. 1. Click Analyze &Age to open the Age window. 2. Use the Age On drop-down arrow to select the date field you want to run the Age command on. 3. In the Subtotal Fields portion of the command dialog, click on the name of the numeric field you want to list for each aging interval. 4. Enter a date in the Cutoff Date box using the calendar. This date is used to cal - culate the aging. It is typically the client’s year-end date. 5. Click OK to run the Age command.

Classify Command Used to count and aggregate the number and percentage of records for each value of a character field and to subtotal the numeric fields for the field. 1. Click any cell in the column for the document number or any other character field you want summarized (Do not click the column heading). 840 APPENDIX 2. Click Analyze & Classify, then select the field you want to classify on. Next click on the quantity field in the Subtotal Field that you want summarized. 3. Click OK. Count Command Used to count records in a table that you have filtered. (For a table that has not been filtered, the record count is indicated at the bottom of the open table.) After a filter is applied to a table, observe that there is now a ?/ in the lower left corner that replaces the original count. 1. Click Analyze &Count Records. 2. Click OK.The new count replaces ?/ in the lower left corner. Duplicates Command Used to detect duplicates in the sequence of numbers in a table, usually document numbers. 1. Click on the column heading for the document numbers you want to test for duplicates. 2. Click Analyze &Look for Duplicates. 3. The result is a list of duplicates if any exist. When prompted click on OK and type any output file name such as “Duplicates”(you can change the radio button from “file” to “screen” under the output tab if you want to see the output on your screen and not save it to a file). Gaps Command Used to detect gaps in the sequence of numbers in a table, usually document numbers. 1. Click on the column heading for the document numbers you want to test for gaps. 2. Click Analyze &Look for Gaps. The result is a table of gaps if any exist. Statistics Command Used to identify characteristics in client data files to better understand the data being audited. 1. Click Analyze &Statistical &ApStaatisgticos t o oPpeDn tFhe StEatinstihcs wainndcowe. r 2. Select the numeric or date field(s) you want to generate statistics on by clicking on the line(s) containing the field name(s). Use the Shift or Control key to select more than one field. 3. Click OK to run the command. Stratify Command Used to accumulate stratification of numeric information in a field. 1. Select the field on which you intend to stratify. Use Quick Sort to identify large and small population items you want to exclude from the stratification. 2. Click Analyze &Stratify to open the Stratify window. 3. Use the Stratify On drop-down arrow to choose the name of the field you want to stratify. 4. Enter the minimum and maximum values in the minimum and maximum boxes with no dollars or commas. 5. Click OK to run the Stratify command. Summarize Command Used to count records and accumulate numeric amounts for a character or date field. 1. Click Analyze &Summarize to open the Summarize window. 2. In the Summarize On portion of the window, click on the field you want to summarize on. For example, in the AP-Trans table in Sample-Project, if you want the total amount of all invoices for each vendor, you would summarize on vendor number. Once you click on the desired field, click “OK”. 3. In the Subtotal Fields portion of the window, click on the name of the numeric field you want to accumulate for each summary category(for example, invoice amount). 4. When prompted, click OK and type any name for the file you are summarizing such as “Customers”. 5. Click OK for a new table. APPENDIX 841 Total Command Used to total one or more data fields for a table. 1. Click on the column heading for the column you want to total. 2. Click Analyze &Total Fields to obtain a total. Sampling Command Used to perform sampling for transactions or balances. To determine sample size: 1. Click Sampling &Select Sample Size from the menu bar. 2. Select the Monetary radio button to determine an MUS sample size; select the Record radio button to determine a sample size for records. 3. Input the sampling parameters and select Calculate. The sample size and sampling interval will appear below the calculate bar. To select a sample: 1. Click Sampling &Sample Records. 2. Select the Record radio button to sample records. Select the fixed interval or random

radio button. • For random selection, input the sample size and indicate the output file name (you can also indicate a random seed number, but it is not required). • For fixed interval selection, indicate the size of the sampling interval and output file name (you can also indicate a random seed number, but it is not required). 3. Select the MUS radio button to select an MUS sample. Also indicate the monetary amount field to be sample from. Select the fixed interval or random radio button. • For random selection, input the sample size and population size and indicate the output file name (you can also indicate a random seed number, but it is not required). • For fixed interval selection, indicate the size of the sampling interval and output Apafileg naom e (PyoDu cFan aElson inhdicaatne ac raendrom seed number, but it is not required). Note:The evaluation of sample errors is not illustrated. 842 APPENDIX INDEX NOTE: ESSENTIAL TERMS APPEAR IN BOLDFACE A Adjusting entries, 191–192 Attestation engagements,796–799 Adjustments to revenues, manipulation of, Attestation services,9–10 Absence of causal connection,121 352–353 Attorneys, clients’, inquiry of,762–764 Acceptable audit risk,211 Adverse opinion,56, 316 Attributes assessment of, 263–265 Advertising and solicitation (Rule 502), 100 and exception conditions, 487–488 Acceptable risk Agreed-upon procedures engagement,799, sampling,502–507, 612 of assessing control risk too low,491–492, 803–804 AU 161,36 561 Allocation AU 311,112 of incorrect acceptance,561–562, 577, 583 of expenditures, tests for, 648–649 AU 316,337 of incorrect rejection,583 of preliminary judgment about materiality, AU 326,156 specification of ARIA and ARIR, 584 254–256 AU 330,182, 741 Accounting Alternative procedures,536 AU 622,804 comprehensive basis of, 804–805 American Institute of Certified Public AU 623,805 by CPA firms, 26–27 Accountants (AICPA),31–32, 821 AU 801,821 defined, 6 Analysis of differences, 537 Audit distinguish between auditing and, 6 Analysis of exceptions, 498 (figure) in acquisition and payment cycle, 602–603, principles Analytical procedures 634 departure from, 53 for accounts payable, 614 of capital stock and paid-in capital, 720–722 shopping for, 89–90 for accounts receivable, 523–524 changing overall conduct of, 350 Accounting system, walkthroughs of, 307 as audit evidence, 183 communicate with audit committee and Accounts payable in audit plan development, 407–408 management, 776–778 fraud risks, 355–356 common financial ratios, 230–233 cycle approach to segmenting of, 148–151 master file,605 in design of audit program, 416 documentation.SeeDocumentation tests of details of balances, 612–620 five types of, 226–230 evaluate results, 771–775 Accounts receivable Apain gideontifi catPionD of Ffrau d rEisk,n 343h–3a44ncer evidence. SeeEvidence client business risks affecting, 417 for income and expense accounts, 647 (table) fee payment by management, 90 confirmation of, 532–538 for inventory and warehousing, 689 final evidence accumulation, 767–771 designing tests of details of balances for, for manufacturing equipment, 636 (table) of financial statements, 142 520–532 for notes payable, 714–715 of historical financial statements,9 fraud risks, 351–354 in payroll and personnel cycle, 669 in inventory and warehousing cycle, 686–689 lapping of,463 performed during engagement phases, review for master file, 446 223–226 contingent liabilities and commitments, tests of details of balances audit program for, in phase III of audit process, 425 759–764 421 (table) preliminary, 222–223 subsequent events, 766–767 trial balance, 446 relationship to substantive tests, 407–408 sampling. SeeSampling uncollectible, 447 signaling of revenue frauds by, 353 scope limitation, 55 Accrued interest, notes payable and, Application controls subsequent discovery of facts, 778–779 716–718 (figure) Automated controls,378 types of, 12–15 Accrued liabilities,audit of, 645 input controls,378–379 Audit assurance,262 Accrued payroll expenses,670–672 output controls,379–380 Audit committee,88–89

Accumulated depreciation, ending balance processing controls,379 communicate with, 497–498, 776–778 verification, 641 Application service providers (ASPs),388 communications and management letters, 312 Accuracy Appropriateness oversight, 349 accounts receivable, 527–528 of evidence,176–177 participation in control environment, as balance-related audit objective, 160 of types of evidence, 178–187 295–296 as transaction-related audit objective, 157 Assertions.SeeManagement Assertions Audit failure,115 Acquisition and payment cycle Assessment inquiry,357 Audit file contents and organization, accounts and classes of transactions in, 602–603 Asset account, ending balance verification, 641 190 (figure) audit of Asset custody, separation from other functions, 607 Auditing accrued liabilities, 644–645 Assets around the computer,382 income and expense accounts, 646–649 and costs, transfer of, 687–688 defined, 4 prepaid expenses, 641–644 fixed, and fraud risk, 356 distinguish between accounting and, 6 property, plant, and equipment, 634–641 misappropriation of, 145–146, 336–337 economic demand for, 6–8 business functions in, 603–606 and records, physical control over, 300 governmental financial, 819–821 misappropriations in, 356 Assurance engagements, limited, 804–806 internal financial, 816–819 other account types in, 634 Assurance services,8–12 in IT environments, 382–386 tests of controls and substantive tests of attestation services, 9–10 nature of, 4–6 transactions, 606–612 green initiatives, 11 operational, 821–829 tests of details of balances, 612–620 on IT, 10–11 profession, response to legal liability, 130 Acquisitions journal, 605 nonassurance services, 12 through the computer,383 843 C Audit objectives,142 standard unqualified,46–49 balance-related,158–160 unqualified Capital acquisition and repayment cycle meeting, 161–163 departures from, 55–56 accounts in, 712–713 presentation and disclosure-related,161 with explanatory paragraph or modified notes payable, 713–716 setting, 152–153 wording,51–54 owners’ equity, 716–723 transaction-related,156–158 Audit risk Capital stock Auditors acceptable,211 audit of, 720–722 decision process for audit reports, 62–65 assessing, 263–265 certificate record,719 defenses against audit failure vs., 115–116 Cash accounts client suits, 120–121 model,259, 405 (figure) fraud-oriented procedures,742–746 third-party suits, 123 for segments, 269–270 general,audit of, 735–742 direct knowledge of, 177 Audit sampling,478 imprest payroll, 746–747 discovery of material misstatements, Audit strategy,213–215 imprest petty cash fund,734, 747 144–147 Audit tests types of, 734–735 evaluation of management’s integrity, 265 analytical procedures. Cash disbursements external, 818 SeeAnalytical procedures processing and recording of, 605–606 independent,5 detailed, reduction of, 183 subsequent, 616 internal,16, 824 integration of, 697–699 Cash equivalents,735 legal liability, sources of, 118–130 IT effect on testing, 412–413 Cash flow, lack of statement of, 62 listening techniques, 358 objectives of, 486 Cash in the bank, and transaction cycles, 732–733 operational, 824–825 for petty cash, 747 Cash receipts opinion of, and supporting evidence, 772–773 of prepaid insurance, 641–644 cutoff, 529–530 reports involving other auditors, 53–54 procedures to obtain understanding of designing tests of controls and substantive responsibilities related to internal control, internal control, 303–305 tests of transactions for, 459–463 292–293 selection of which types to perform, processing and recording of, 446–447 restricted scope, 59–60 409–412 Certified Public Accountants.SeeCPAs types of, 15–16 for subsequent events review, 764–767 Chart of accounts,300 utilization of monetary unit sampling, substantive tests of transactions. See Civil liability under federal securities laws, 577–578 Substantive tests of transactions 123–127 Audit plan development tests of controls. SeeTests of controls Classification evidence mix,413–414 tests of details of balances. SeeTests of details acquisitions, 610

IT impact on audit testing, 412–413 of balances as balance-related audit objective, 159 selection of tests to perform, 409–412 for uncollectible accounts, 463–464 prepaid insurance-related expense, 644 types of tests, 404–409 Authorization of recorded sales, 456–457 Audit planning proper, 665 as transaction-related audit objective, 157 assess client business risk, 220–222 Apagof osale s, 4 P50 DF EnhancerClient business risk audit risk model for, 259 of transactions, 717–718 affecting initial,211 of purchases, 606–607 accounts payable, 612–613 key parts of, 224 (figure) of transactions and activities, 299 accounts receivable, 417, 521 perform preliminary analytical procedures, cash, 735–736 222–223 B payroll, 668 understand client’s business and industry, assessment of, 220–222 215–220 Backup and contingency planning, 377 management of, 296 Audit procedures Bad debt and nature of the business, 266 to address fraud risks, 350 expense, 531–532 Clients design and performance format, 458 provision for, 447 acceptance of, 211–212 evidence decisions and, 175 Balance-related audit objectives,153, 158–160, attorneys of, inquiry of,762–764 for finding contingencies, 760–761 416–417, 616 (table), 637 (table), and CPA firms, litigation between, 93 performance of, 493–494, 564 695 (table), 718 (table), 739 (table) data comparisons of, as analytical procedures, terms used in, 187 (table) accounts receivable,521 226–227 Audit process Bank confirmation inquiries of, 184 and financial statement cycles, 148–152 receipt, 737–740 liability to, 118–121 IT effect on, 380–386 standard form,738 personnel, inquiries of, 305 phases of,161–163 Bank reconciliation,738 (figure) rights to summary of, 424–428 tests of, 743 accounts receivable, 532 Audit program Batch input controls, 379 (table) all insurance policies, 643 defined, 176 Behavioral cues during inquiry, 358 Client’s business and industry, understanding of, design of, 414–423 Bills not paid after year-end, 616–617 183, 215–220 evidence decisions and, 174 Blank confirmation form,533 Client’s internal control tests of details development, 538–541 Block sample selection,481 effectiveness of, 177 Audit report Board of directors, participation in control understanding of, 35–36 auditor’s decision process for, 62–65 environment, 295–296 Code of Professional Conduct, 32, 84–87 combined report on financial statements Bonuses, accrued, 671 Collusion,291 and internal control,49–51 Bookkeeping services Combined report on financial statements and conditions requiring departure, 59–62 by CPA firms, 27 internal control over financial reporting, defined, 5 Rule 101 and, 94–95 49–51 issuance of, 163, 247 Branch bank account,734 Commissions materiality, 56–59 Budgets,228 accrued, 670–671 preparation of, 5–6 Business failure,115 Rule 503 and, 100–101 report on internal control over financial Business risk, client. SeeClient business risk Commitments,760 reporting, 302–307 Committee of Sponsoring Organizations of the 844 INDEX Treadway Commission. SeeCOSO of audit test types, 409–410 Direct financial interest,91 Comparability, explanatory paragraph for, of evidence types, 185–186 Direct projection estimate of misstatement,258 51–54 persuasiveness and, 179 Directed sample selection,480–481 Compensating control,310 Cost accounting Direct financial interest,91 Competence audit of, 686 Disclaimer of opinion,56, 316–317 commitment to, 295 controls,687 Discovery of facts, subsequent,778–779 of operational auditor, 825–826 records,685 Discreditable acts (Rule 501), 99 Compilation services,793–794 Cost systems, in inventory and warehousing Dividends, audit of, 722 Completeness cycle, 683 Documentary discrepancies, 354 as balance-related audit objective, 159 Covered members, Rule 101 and, 90–91 Documentation.See alsoEvidence; Information existing acquisitions and, 610 CPA firms, 15 adequate, 499–501 management assertions about, 154 activities of, 27–28 audit,188–196 as transaction-related audit objective, 156–157 and client, litigation between, 93 as audit evidence, 182–183, 188

Completing the audit checklist,772 ethical conduct by, 82–84 audit, review of, 774 Compliance audit,14 professional conduct in, 40 (figure) of fraud assessment, 345 Computed upper exception rate,484–485 quality control, 37–39 of understanding of internal control, 303–305 Computer-assisted audit programs, 829 size categories, 26–27 Documents and records Computer-generated random numbers, 482–483 structure of, 28–29 acquisition and payment cycle, 603–606 Confidence limits, calculation of, 586–587 (table) CPAs adequate, 299–300, 450 Confidential client information,96–98 assurance services provided by, 8–12 examination of, 305, 313 Confidentiality legal liability, 117–118 inventory and warehousing cycle, 682–684 of audit files, 189 professional conduct by, 84–87 payroll and personnel cycle, 660–663 Rule 301 and, 96–98 protection from, 130–131 sales and collection cycle, 443–447 Confirmation requirements to becoming, 17 Dual-dated audit report,767 of accounts receivable, 532–538 Credit Alliance v.Arthur Andersen & Co., 122 Dual dating, 767 as audit evidence, 180–182 Credit approval, 444 Due professional care, as GAAS, 35 bank, 737–741 Credit memo, 447 of code of conduct compliance, 347–348 Criminal liability,127–130 E Consistency, explanatory paragraph for, 51–52 for accountants,127–128 Consulting services, Rule 101 and, 94 Criteria Earnings management,336 Contingent fees (Rule 302), 98–99 established, information and, 4 Earnings, retained, 722–723 Contingent liabilities,review for, 759–764 for evaluating efficiency and effectiveness, E-commerce and IT systems issues, 388 Contract labor, 672 826–827 Economy and efficiency audit,824 Contributory negligence,120 Current files Effectiveness,822 Control activities adjusting and reclassification entries, 191–192 audit committee, 295–296 adequate documents and records, 299–300 supporting schedules, 192–194 criteria for evaluating, 826–827 Apago PDF Enhancer adequate separation of duties, 298–299 working trial balance, 191 vs.efficiency, 822 independent checks on performance, 300–301 Current year operating, of controls, 292 physical control over assets and records, 300 acquisitions and disposals, verifying, 638–639 of operations, 290 proper authorization of transactions, 299 balance, comparison with preceding year’s, 227 Efficiency,822 Control deficiency,308–310 Customer Embedded audit module approach,385–386 Control environment,295–297 billing, and recording of sales, 444–445 Emphasis of a matter, 53 control activities, 298–301 business risk for, 6 Employees, appropriate, hiring and promoting, 347 information and communication, 301 order processing, 444 Employment relationships, conflicts arising monitoring, 301–302 Cutoff from, 89 risk assessment, 297–298 for accounts receivable, 528–530 Encryption techniques,388 Control risk,262 bank statement,741 Enforcement of rules of conduct, 103 assessing too low, 491–492 tests,159, 617 Engagement letter,213–214 assessment of,307–312, 319, 320 (figure), 497, Cycle approach,148–151 Engagement risk,263 614, 669, 736–737 Engagement effect of D attestation, 796–799 general controls, 380–381 initialvs.repeat, 266 IT controls, 381 Database management systems,387–388 staff selection for, 215 matrix,308–310, 309 (figure), 460 (figure) Data comparisons, client, 226–227 Enron, 209 planned Debit memo,604 Enterprise resource planning (ERP) systems,387 acquisitions, 608–610 Debt compliance letters, 806 Enterprise risk management, 221 sales, 448–450 Decisions Equipment-related accounts, 635–656 for sales and collection cycle, 418, 522 audit evidence, 175–176, 186 Error,145 Corporate governance oversight, to reduce fraud auditors’ Errors vs.fraud, 145 risks, 345–349 in observation of inventory, 691–692 Estimated population exception rate,492 Corporate minutes,219 regarding audit reports, 62–65 Ethical conduct Corporations materiality, 56–59 elements of, 347 (table) general, of CPA firms, 29 Deficiencies in control need for, 82–84 professional, 29 identification of, 310–311 Ethical dilemmas,79–82 publicly heldandclosely held, 716–717 letter regarding, 318 (figure) Ethical rulings, 86

COSO Depreciation expense, verifying, 640–641 Ethical values, as subcomponent of control components of internal control, 294–302 Design format audit program,458 environment, 295 Internal Control-Integrated Framework,291 Detail tie-in, 159 Ethics Internal Control Over Financial Reporting Difference estimation,581, 584–585 code of, 219, 817 (figure) for Smaller Public Companies,304 Digital signatures,388 principles of, 78 (figure), 85 Cost Direct-effect illegal acts, 146 and reducing fraud risks, 346–348 INDEX 845 and unethical behavior, 78–79 standard unqualified audit report on, 46–49 H Evaluating audit results, 771–775 Finished goods, storage and shipping of, 683–684 Evidence.See alsoDocumentation; Information Firewall,388 Haphazard sample selection,481–482 accumulation Fixed asset master file,635 Hardware controls,378 and evaluation of, 4–5, 827–828 Flowchart Hierarchy of CPA firm, 29 final, 767–771 of internal control, 605 Hochfelder v.Ernst & Ernst, 126 appropriateness of,176–177 of sales and cash receipts, 449 (figure) Horizontal analysis, 344 decisions regarding, 175–176 Follow-up on nonresponses, 536–537 Human resource records, 661 differing, among cycles, 260 (table) Forecasts,802 Human resources, policies and practices, vs.legal and scientific evidence, 174 Foreign Corrupt Practices Act of 1977,127 296–297 persuasiveness of, 176–179 Forensic accounting, 14 from prior year’s audit, 314 Foreseeable users,122 I relationship to risk, 268–274 Foreseen users,122 reliability of, 618–619 Former practitioners, Rule 101 and, 91 Illegal acts,146 revising risk and, 273–274 Forms, S, K, and Q, 30 Imprest payroll account,663, 734, 746–747 sufficient appropriate, 772 Fraud Imprest petty cash fund,734 sufficient appropriate (as GAAS), 36 conditions for, 337–341 audit of, 747 terms related to, 423–424 error vs.,145 Income and expense accounts, audit of, types of, 179–187 and general cash account audit, 742–746 646–649 audit tests involving, 404–409 material, 145 Income smoothing,336 Evidence mix,413–414 occurrence rates for, 348 (figure) Independence Evidence-planning worksheet, 499 (figure) risk factors,337–339 in fact and in appearance,87 Examination,798 suspected, 356–360 in mental attitude (as GAAS), 35 Exception rate types of, 336–337 of operational auditor, 825–826 defined, 484 Fraud risk of provider, evidence and, 177 population, 576–577 assessment of, 341–345 rule of conduct (Rule 101), 90–95 estimated, 492 organizational factors contributing to, and Sarbanes–Oxley Act, 88–89 sampling for, 484–485 348 (figure) Independent auditors,5 tolerable, 489–490 reduction by corporate governance oversight, Independent checks,300–301, 665 Exchange transactions, complex, 7 345–349 Independent registrar,720 Existence responding to, 349–351 Independent review as balance-related audit objective, 158 specific areas of, 351–356 in completion of audit, 774–775 management assertions about, 153–156 Fraud triangle,337–338 of transactions, 607–608 occurrence as transaction-related audit Full disclosure, compilation with, 793–794 Indirect-effect illegal acts, 147 objective, 156 Functional audit,823 Indirect financial interest,91 Expected results, and client data comparisons, 230 Further audit procedures,404 Information.See alsoDocumentation; Evidence Apago PDF Enhancer Expense account about fraud risks, sources of, 342–344 analysis,648 G accompanying basic financial statements, tests of details of balances for, 671, 648 773–774 Explanatory paragraph, of unqualified audit General authorization,299 and communication,301 report, 51–54 General cash account confidential client,Rule 301 and, 96–98 External document,182 audit of, 735–742 and established criteria, 4 defined, 734 interim financial, review of, 795–796 F General controls Informational inquiry,357 administration of IT function, 374–375 Informational schedule, 194 Family members, Rule 101 and, 92 backup and contingency planning, 377 Information risk,6 Fees effect on control risk, 380–381 causes of, 7 audit, payment by management, 90 hardware controls,378 reduction of, 7–8

contingent (Rule 302), 98 physical and online security, 377 Information technology (IT) referral (Rule 503), 100–101 separation of IT duties, 375–377 effect on unpaid, 94 systems development, 377 audit process, 380–386 Fictitious revenues, 351–352 Generalized audit software,384–385, 386 (table) audit testing, 412–413 Final evidence accumulation, 767–771 Generally accepted accounting principles enhancement of internal control, 372 Financial interests, Rule 101 and, 90–91 (GAAP), 4 internal controls specific to, 374–380 Financial ratios, common, 230–233 comparison with attestation standards, risk assessment of, 372–374 Financial reporting 797 (table) separation from user departments, 298–299 fraudulent,336 lack of consistent application of, 51–52 Inherent limitations, 291 internal control over, 9–10 Generally accepted auditing standards (GAAS) Inherent risk,211, 261–262, 273 reliability of, 290, 292–293 defined, 34 for accounts receivable, 418 risk assessment for, 297–298 general standards, 34–35 assessing, 266–268, 613–614 Financial statement audit,14–15 standards of field work, 35–36 Initial audit planning,211–215 Financial statements Going concern Initial sample size,492–493, 563 auditable, 307 entity’s ability to continue as, 183 Input controls,378–379 audit of historical,9 substantial doubt about, 52–53 Inquiry cycles of, 148–152 Government accountability office auditor,15–16 of client, 184 disclosure checklist,773–774 Government Auditing Standards (GAGAS), of client’s attorneys,762–764 disclosures, 773–774 819–821. See alsoYellow Book interrogative, 357 historical, 9–10 Government auditors, 824–825 of management, regarding fraud, 342–343 information accompanying, 769–771 Government audits,819 Institute of Internal Auditors (IIA),816–818 preparation, GAAP departure, 55, 59–62 Governmental financial auditing, 819–821 Insurance, prepaid, 641–644 prospective,801–803 Guidelines, for materiality, 253 (figure) Insurance register,642 846 INDEX Integrity K levels of, 56–57, 63 (table) Rule 102 and, 95–96 preliminary judgment about,251–254, 568 as subcomponent of control environment, 295 Key controls,308, 452–453 (table), 461 (table), relationship to risk, 272–273 Interbank transfers, tests of, 744–746 609 (table), 666 (table) revised judgment about,252 Interest rate, risk-free, 6 Kiting,744–746 Rule 101 and, 91 Internal auditors,16, 818–819, 824 Material weakness,310–312, 316 (figure) Internal comparisons and relationships, 228 (table) L Mean-per-unit estimation,582 Internal control.See alsoTests of controls Measurement of audit risk model components, client’s. SeeClient’s internal control Lack of duty to perform,120 270–271 components of, 303 (table) Lawsuits, opposed by CPA firms, 130 Minutes of meetings,219 COSO components of, 294–302 Lead schedule,191 Misappropriation IT enhancement of, 372 Legal liability in acquisition and payment cycle, 356 management and auditor responsibilities for, business failure and, 115–116 of assets,145–146, 336–337 291–294 changed legal environment, 114–115 of receipts involving revenue, 354 for nonpublic companies, 317–319 of CPAs, 117–118 risk factors for, 339–341 objectives of, 290 protection from, 130–131 Misstatement bounds,570 over account balances, 464 lack of privileged communication, 117 Misstatements over financial reporting,9–10, 49–51 profession’s response to, 130 analysis of, 565 over petty cash, 747 prudent person concept, 116 comparison with preliminary judgment, owner’s equity, 717–720 sources of, 118–130 257–258 for prepaid insurance, 642 Lending procedures, Rule 101 and, 91 cutoff,528 procedures to obtain an understanding of,404 Letter of representation,768–769 define conditions of, 584 reevaluation of, 537–538 Level of disaggregation of planning activities, of information, 7 relationship to operational auditing, 822–823 419–420 known,257 Section 404 reporting on, 315–317 Liability likely,257 specific to IT, 374–380 accrued, audit of, 644–645 material,46–47, 57 understanding of civil, under federal securities laws, 123–127 discovery by auditors, 144–147

in acquisition and payment cycle, 606 to clients, 118–121 and monetary unit sampling, 568 obtaining and documenting, 302–307 contingent, review for, 759–764 in population, 584 in payroll and personnel cycle, 664–665 criminal, 127–130 estimation of, 584 summary of, 320 (figure) legal concepts affecting, 116–118 possible, 183 Internal control over financial reporting,9–10 out-of-period liability tests, 616 as result of fraud, 356–360 Internal document,182 payroll, tests of details of balances for, 671 in sales, 453–455 Internal financial auditing, 816–819 recognition of, 604–605 tolerable,254–256, 270, 521–522, Internal revenue agents,16 to third parties under common law, 121–123 613–614, 736 International Standards on Auditing (ISAs),32–34 Limited liability company (LLC), 29 Monetary unit sampling Apago PDF Enhancer Interrogative inquiry,357 Limited liability partnership (LLP), 29 acceptability of population using, 574–575 Inventory Liquidity activity ratios, 232 audit uses of, 577–578 compilation tests,685–686 Listening techniques, auditors’, 358 comparison with nonstatistical sampling, fraud risks, 354–355 Litigation 568–570 and fraudulent payroll considerations, 667–668 auditor, 129 generalizing master file, perpetual, 684 between CPA firm and client, 93 from sample to population, 570–571 price tests,693 Local area networks (LANs),386–387 when misstatements are found, 571–574 pricing and compilation of, 685–686 Long-term debt obligations, ability to meet, sample size determination using, 575–577 in transit, 618 232–233 Monitoring valuation of, 694–697 fraud risk prevention programs, 348–349 Inventory and warehousing cycle M of internal control performance, 301–302 analytical procedures, 689 Monthly statements, 450 audit of Management cost accounting, 686–689 communication with, 497–498, 776–778 N inventory, 684–686 and governance, 218–219 pricing and compilation, 693–697 information risk shared with, 7–8 Name and form of organization (Rule 505), 101 business functions in, 682–684 inquiries of, regarding fraud, 342–343 Narrative,describing internal controls, 304–305 integration of tests, 697–699 letter,312 Negative confirmation,533–535 physical observation of inventory, 689–693 override of controls, 350–351 Network environments, 382–386 Investigation of new client, 212 payment of audit fees, 90 Nonassurance services, 12 Invoice philosophy and operating style of, 296 Nonexistent payroll, tests for, 668 confirmation,533 representation letter, 768–769 Nonnegligent performance,120 vendor’s,604, 617 responsibilities, 143–144 Nonpublic companies, internal control for, related to internal control, 291 317–319 J Management assertions Nonresponses, follow-up on, 536–537 about account balances, 155 Nonroutine transactions, 267 Job cost system,683 about classes of transactions, 154–155 Nonsampling risk,478 Job time ticket, 662 about presentation and disclosure, 155 Nonstatistical sampling Joint investor relationship with client, 92 defined, 153 application of, 485–501 Journal or listing Management consulting services, 12, 27–28 comparison with acquisitions, 605 Manual controls,378 monetary unit sampling, 568–570 cash receipts, 447 Manufactured inventory, pricing of, 696–697 variables sampling, 578 payroll, 662 Materiality defined, 479 sales, 445–446 applying, steps in, 250–251 for tests of details of balances, 558–567 Judgment, professional, 507 decisions, 57–59 Nonverbal cues, during inquiry, 359 (table) INDEX 847 Notes payable Payment of payroll, 663 Professional conduct. Seealso Ethical conduct analytical procedures, 714–715 Payments, authorization of, 608 code of, 32, 84–87 internal controls, 713–714 Payroll and personnel cycle in CPA firms, 40 (figure) and related interest accounts, 714 (figure) accounts and transactions in, 660 by CPAs, 84 (figure) tests of controls and substantive tests of business functions in, 660–663 Professional skepticism,145, 341 transactions for, 714 tests of controls and substantive tests of Profitability ratios, 233 tests of details of balances for, 715–716 transactions, 664–668 Program audit,824

tests of details of balances, 668–672 Projections,802 O Payroll expenses, and fraud risk, 356 Proof of cash,743–744 Payroll master file,662 Proof of cash receipts,463 Objectivity Payroll tax forms, 665–667 Property, plant, and equipment, audit of, 634–641 degree of, 177 Peer review Property taxes, accrued, audit of, 644–645 Rule 102 and, 95 of CPA firms, 37–39 Proprietorship, 28 Obligations Rule 301 and, 97 Prospective financial statements,801–803 long-term debt, 232–233 Performance Prudent person concept,116 related to technical standards, 96 client, measurement system, 220 Public Company Accounting Oversight Board rights and, 160 independent checks on, 300–301 (PCAOB),30 Observation Performance format audit program,458 report on internal control, 49–51, 306 as audit evidence, 184 Permanent files,190–191 PCAOB Standard 5, 49–51, 296, 301–302, 314, physical, of inventory, 692–693 Perpetual inventory master file,684 349, 360, 769 Occurrence Personnel records,661 role of the PCAOB, 30 recorded acquisitions and, 610 Persuasiveness of evidence,176–179 Public company interim review,795–796 of recorded sales , 453–454 Petty cash, 734 Purchased inventory, pricing of, 695–696 as transaction-related audit objective, 156 audit of, 747 Purchase order,processing of, 603, 683 Occurrence and rights and obligations Physical controls Purchase requisition,603 (presentation and disclosure-related audit over records, 300, 665 Purchases, fraud risks for, 355–356 objective), 161 over computer equipment, 377 Occurrence rate. SeeException rate over raw materials, 687 Q Office of Management and Budget (OMB), Physical examination,as audit evidence, 180 Circular A-133, 820–821 Physical observation, of inventory, 692–693 Qualifications, of individuals providing Officers’ compensation, 671 Pilot testing,377 information, 177 Online security, 377 Planned detection risk,261, 315 Qualified opinion,55–56, 316–317 Operational audit,13 Planning and supervision, adequate, (as GAAS), 35 Quality control Operational auditing Planning phase of CPA firms, 37–39 criteria for evaluating efficiency and of audit process, 162–163 elements of, 37–38, 38 (table) effectiveness, 826–827 in operational auditing, 827 peer review, 37–39 Apago PDF Enhancer difference from financial auditing, 821–822 Point estimate,564–565 Questionnaire, internal control,305, 306 (figure) effectiveness vs.efficiency, 822 Population examples of findings, 828–829 acceptability of, 495–498, 564–565, 574–575, R independence and competence of auditor, 588 825–826 defining of, 488–489 Random sample,simple, 482 performance of audits, 824–825 generalize from sample to, 494–495, 570–571, Ratio estimation,581–582 phases in, 827–828 586–590 Raw materials relationship to internal controls, 822–823 misstatements in, 562, 584 physical controls over, 687 types of audits, 823 recorded dollar, 560 receipt and storage of, 685 Opinion paragraph rejected, subsequent action, 566–567 Realizable value of separate report, 50 (figure) Positive confirmation,533 of accounts receivable,530–532 of unqualified shared report, 54 (figure) Posting and summarization, as transaction-related as balance-related audit objective, 160 of standard unqualified audit report, 47–48 audit objective, 157 Reasonable assurance, 144–145, 291 Organizational audit,823 Preliminary judgment about materiality,251–254 Recalculation,184 Organizational structures Premature revenue recognition,352 Receipts involving revenue, misappropriation of, 354 and control environment, 296 Prenumbered documents, for sales, 450 Receiving report,603–604, 617 of CPA firms, 28–29 Prepaid expenses, audit of, 641–644 Reclassification entries, 191–192 Rule 505 and, 101 Presentation and disclosure-related audit Reconciliation Other information included in annual objectives,161 of amounts, 193 reports,771 for accounts receivable, 532 of imprest payroll bank account, 663 Out-of-period liability tests, 616 for capital stock, 721–722 Referral fees (Rule 503), 100–101 Output controls,379–380 and completing the audit, 427–428, 758–759 Related party,218

Outsourcing, of IT, 388–390 relationship to transaction-related audit Related party transaction,218 Owners’ equity, 716–723 objectives, 422–423 Relevance of evidence, 176 Ownership interests, 89 Pricing and compilation, audit of, 693–697 Relevant assertions,156 Ownership of audit files, 188–189 Private Company Practice Section (PCPS), 39 Reliability Private Securities Litigation Reform Act of of evidence,176–177, 618–619 P 1995,130 of financial reporting, 290, 292–293 Privileged communication, lack of, 117 Remittance advice, 446 Parallel simulation testing,384–385 Privileged information,97 Reperformance,184 Parallel testing,377 Probability proportional to size sample Reports on internal control over financial reporting Partner rotation, 89 selection,483–484 separate or combined report, 49–51 Partnerships Procedures to obtain an understanding,303–305 management assertions, 9–10 general, of CPA firms, 28 Process cost systems,683 review for subsequent event changes to limited liability (LLP), 29 Processing controls,375 (table) internal control, 764–767 848 INDEX Representative sample,478–479 probabilistic vs.nonprobabilistic, 480 Shipping contract Resolving ethical dilemmas, 80–82 probability proportional to size,568–569 FOB destination,618 Restatement of torts, 122 Sample size FOB origin,618 Retained earnings, 722–723 for accounts payable tests, 620 Shipping document, 444 Revenue fraud risks, 351–354 for attributes sampling, 504 (table) Short-term debt-paying ability, 232 Review,799 calculation with difference estimation, 584–585 Significant deficiency,310 Review of audit documentation,774 for confirming accounts receivable, 535 Significant risks,314 Review of historical financial statements,10 determination using monetary unit sampling, Simple random sample selection, 482 Review for subsequent events,764–767 577–578 Single Audit Act,820–821 Review service (SSARS review),791–793 evidence decisions and, 175 Six-step approach to resolving ethical dilemmas, Risk.See alsoClient business risk; Control risk initial, 492–493, 563 81–82 acceptable. SeeAcceptable audit risk in physical observation, 692–693 Skepticism, professional,145, 341–342 audit. SeeAudit risk Sampling Special assignments,in operational auditing, fraud. SeeFraud risk attributes, application of, 502–507 823 information,6–8 audit,478 Specific authorization,299 inherent. SeeInherent risk error,258 Specified elements, accounts, or items, 805 of material misstatement,262 for exception rates, 484–485 Staff selection, for engagement, 215 relationship to monetary unit, 567–578 Standard cost records,693 evidence, 268–274 nonstatistical,479, 485–501, 559–567 Standards materiality, 254–256 statistical,479, 501 accounting principles (Rule 203), 96 revising, 273–274 statisticalvs.nonstatistical, 479 attestation, 796 sampling variables,578–583 compliance with (Rule 202), 96 and nonsampling, 478–479 Sampling distribution,501–502 of conduct, 86 (figure) in variables sampling, 582–583 Sampling risk,478–479 ethical, 78 types of, 261–263 in variables sampling, 582–583 of field work, 35–36 Risk assessment Sampling unit, defining of, 489 general (Rule 201), 96 for financial reporting, 297–298 Sarbanes–Oxley Act,4, 49–51 International, on Auditing (ISAs), 32–33 of IT, 372–374 and audit documentation, 189 of reporting, 36 procedures,404 independence and, 88–89 set by AICPA, 31–32 updating of process of, 351 and PCAOB, 30 Standard unqualified audit report,46–49 Risk factors Section 404, 4, 9–10, 49–51, 291–294, 315–317 Statements on Auditing Standards (SASs), for fraudulent financial reporting, 337–339 SAS 25—Relationship of Generally Accepted 31, 36–37 for misappropriation of assets, 339–341 Auditing Standards to Quality Control Statements on Internal Auditing Standards Rules of conduct, 86 Standards, 36 (SIASs),817 advertising and solicitation (Rule 502), 100 SAS 32—Adequacy of Disclosures in Financial Statements on Standards for Accounting and applicability of, 87 Statements, 774 (Figure) Review Services (SSARS) review service, Apago PDF Enhancer

commissions and referral fees (Rule 503), SAS 70—Service Organizations, 801 791–793 100–101 SAS 99—Consideration of Fraud in a Financial Statements on Standards for Attestation confidentiality (Rule 301), 96–98 Statement Audit, 335, 337, 341–345, Engagements (SSAE),796 contingent fees (Rule 302), 98–99 350–351, 358–360, 455, 521 Statistical audit sampling, 501 discreditable acts (Rule 501), 99 SAS 120, 36 Statistical inferences,580–581 enforcement of, 103 Scienter, 126 Stock transfer agent,720 form of organization and name (Rule 505), 101 Scientific evidence, 174 Stratified sampling,560–561 independence (Rule 101), 90–95 Scope limitation Subpoenas, 97 integrity and objectivity (Rule 102), 95 of audit, 55 Subsequent discovery of facts, 778–779 summary of, 102 (table) materiality of, 59 Subsequent events technical standards (Rules 201–203), 96 Scope paragraph audit tests, 766–767 of separate report, 50 dual dating, 767 S of unqualified shared report, 54 (figure) types of, 765–766 of standard unqualified audit report, 46–47 Substantive tests,406 Salaries and wages, accrued, 670 Section 404 of the Sarbanes–Oxley Act of 2002 Substantive tests of transactions Sales auditor responsibilities, 291–294 in audit plan development, 406–407 cutoff, 528–529 combined report, 49–51 designing for designing tests of controls and substantive management responsibilities, 291–292 acquisition and payment cycle, 608–612 tests of transactions for, 451–457 types of audit opinions, 315–317 cash receipts, 459–463 recorded, existing, 455 Securities Act of 1933,124–125 payroll and personnel cycle, 666 returns and allowances, 458–459, 529 Securities and Exchange Commission (SEC), sales, 451–453 summary of methodology for, 457–458 30–31 in design of audit program, 414–416 Sales and collection cycle Advisory Committee on Smaller Public effect of results of, 464–465 accounts and classes of transactions in, 442–443 Companies, 305 IT controls effect on, 381 business functions for the,443 authority to sanction, 126–127 for notes payable, 714 classes of transactions in,442–443 Securities Exchange Act of 1934,125 in phase II of audit process, 163, 425 control risk for, 418, 522 Segregation of IT duties, 375–377 relationship to role of audit tests in audit of, 406 (figure) Separate report on internal control over analytical procedures, 411 Sample exception rate (SER),494–495 financial reporting,49–51 tests of controls, 404–406 Sample selection Separation of duties trade-off with tests of controls, 407–409 evidence decisions and, 175–176 adequate, 298–299, 449–450, 665 Sufficiency of evidence,178, 772 methods, 482–484 and proper record keeping, 719–720 Supporting schedules,192–194 nonprobabilistic,480 reduced, 374 Systematic sample selection,482–483 for nonstatistical sampling, 559–567 Service center,388–389 Systems development, 376 probabilistic,482–484 Shareholders’ capital stock master file,719–720 SysTrustservices, 10, 800 INDEX 849 T Transaction-related audit objectives,153, 307–308, 422–423, 452–453 (table), Tax return 461 (table), 609 (table), 666 (table) audit of, 5 (figure) Trial balance payroll, 663 accounts payable, 605 Tax services, by CPA firms, 27–28 accounts receivable, 446 Technical training, adequate (as GAAS), aged,526–527 34–35 or list, 193 Test data approach,383–384 working,191 Tests of controls Types of tests,404–409 in audit plan development, 404–406 designing for U acquisition and payment cycle, 606–612 cash receipts, 459–463 Ultramaresdoctrine,121 payroll and personnel cycle, 660–663 Unadjusted misstatement audit schedule,772 sales, 451 Unasserted claim,762–763 in design of audit program, 414–416 Uncollectible accounts effect of results of, 464–465 audit tests for, 463–464 extent of, 319 authorization form, 447 illustration of, 407 (table) Unethical behavior, 78–79 in phase II of audit process, 163, 426 Unit cost records, 688–689 procedures for, 313 United States v.Andersen, 128–129 purpose of, 312–313 Unqualified opinion, 315–316 relationship to Unusual fluctuations,183 procedures to obtain understanding, Unusual transactions, significant, 350–351 314–315

substantive tests, 406–407 V trade-off with substantive tests, 407–409 Tests of details of balances Vacation pay, accrued, 671 for accounts payable, 612–620 Valuation in audit plan development, 408 of inventory, 694–695 audit program, 538–541 inventory, payroll and, 667 of cash, 735–741 management assertions about, 155 designing for Variables sampling accounts receivable, 526–532 comparison with nonstatistical sampling, 578 in design of audit program, 416–417 Apadif gfere once es Ptim Datio Fn, 5 81 Enhancer evidence-planning worksheet, 271–272 mean-per-unit estimation, 582 expense account analysis,648 ratio estimation, 581–582 for notes payable, 715–716 sampling distributions, 578–580 payroll and personnel cycle, 668–672 sampling risks, 582–583 in phase III of audit process, 163, 426 statistical inference, 580–581 Tests of reasonableness, 193–194 stratified statistical methods, 582 Third parties Vendor’s invoice,604 legal liability to, 121–123 Vendor’s statement,605, 617 suits by, auditor defenses against, 123 Verbal cues, during inquiry, 358 (table) Those charged with governance,188, 295–296, Verification 312, 317, 343, 360, 497 in acquisition and payment cycle, 636–638 Tick marks,195 of information, by user, 7 Time record,662 internal procedures for, 450 Timeliness of audit evidence, 177 Vertical analysis, 344 Timing Viruses, computer, 382 of audit tests, 427 (table) Voucher,604 of confirmations, 535 Vouching,183 difference,530 evidence decisions and, 175 W as transaction-related audit objective, 157 Tolerable exception rate,489–490 Walkthrough,307 Tolerable misstatement,254–256, 270, 521–522, WebTrustassurance services, 10, 799–800 613–614, 669, 736 Wide area networks (WANs),387 Training, fraud awareness, 347 Working trial balance,191 Transaction classes Workplace environment, positive, 346 controls over, 293 in sales and collection cycle, 442–443 Y Transaction cycles, 148–152 cash in the bank and, 734–735 Yellow Book,819–820 Transaction file acquisitions, 604–605 cash receipts, 447 payroll, 662 sales, 445–446 850 INDEX 2011 Annual Report Apago PDF Enhancer Hillsburg Hardware Company 2011 Annual Report CONTENTS Letter to Shareholders 3 Company Description 4 Apago PDF Enhancer Report of Independent Registered Accounting Firm 8 Report of Management’s Responsibility for Financial Statements 9 Balance Sheets 10 Statements of Operations 11 Statements of Stockholders’ Equity 11 Statements of Cash Flows 12 Notes to Financial Statements 13 Management’s Discussion and Analysis 14 Five-Year Financial Summary 15 Rick Chulick, President and Chief Operating Officer DEAR SHAREHOLDERS March 29, 2012 We are proud to announce another year of noticeable improvement. In last year’s letter we stated, “We are committed to increasing the efficiency and effectiveness of operations through costA sapvinagsg anod p roPduDctivFity imEprnovehmaentns, cin leighrt of current economic conditions. In addition, we intend to maintain and further develop our customer base through recently implemented post-sale service programs.” The operating results in this report demonstrate that our objectives have been achieved, resulting in a net income increase of $740,000 from 2010 to 2011. This amounts to 15 cents per share, a 23.2% increase from last year. Our goal in the current year is to further improve the results of operations and create value for shareholders. In doing so, we will focus primarily on the following three strategic components of our business plan: 1. Post-sale service arrangements designed to further develop and maintain our customer base. 2. Aggressive advertising campaigns that allow us to penetrate markets dominated by national wholesale hardware store chains. 3. Implementation of new warehouse technology designed to increase productivity and reduce stocking and distribution costs. We will report our progress throughout the year. Christopher J. Kurran Rick Chulick Chief Executive Officer President and Chief Operating Officer 3 History the sales process, and also acts as a liaison between the cus- Hillsburg Stores Inc. began operations in 1982 in Gary, Indiana, tomer and post-sale service areas. For example, when customers

as a retail hardware store chain. On September 25, 1988, experience technical problems with recently purchased hardware, Hillsburg merged with Handy Hardware and Lumber Company, their salesperson has the responsibility to coordinate both which established the concept of selling high-quality hardware exchanges and warranty repairs with the manufacturer. This through wholesale distribution outlets, to form Handy-Hillsburg, process adds value for customers and makes post-sales service Inc., a Washington corporation. On June 5, 1992, after spinning more efficient and less problematic. Low turnover and extensive off all of its lumber-related assets to Handy Corporation, the training of our salespeople enhance this service. company changed its name to Hillsburg Hardware, Inc. To further encourage customer loyalty, each customer On October 22, 1994, the company reincorporated from is given access to our internal database system—ONHAND Washington to Delaware and changed its name to Hillsburg (Online Niche-Hardware Availability Notification Database). Hardware Company (hereafter referred to as “the Company”), The ONHAND system lets customers check the availability of which trades on the NASDAQ under the symbol “HLSB.” hard-to-find products instantly over the Internet. Moreover, the system includes data such as expected restock dates for items Overview that are currently sold out and expected availability dates for Hillsburg Hardware Company is a wholesale distributor of items that will soon be introduced to the market. hardware equipment to a variety of independent, high-quality Because of the two aforementioned processes, we have hardware stores in the midwestern part of the United States. managed to maintain a repeat-customer base. Nearly 75% of The primary products are power and hand tools, landscaping all first-time customers make at least one additional purchase equipment, electrical equipment, residential and commercial within one year of their first purchase. construction equipment, and a wide selection of paintproducts. Recently, there have been major consolidations in the whole- More than 90% of the Company’s products are purchased sale hardware industry. We believe this consolidation trend is from manufacturers and shipped either directly to customers or advantageous to our operations as a distributor of hard-to-find, to the main warehouse in Gary, IndianaA, whperae shgipmoen ts PareD F hEighn-quhalitay hnardcwaere erquipment. The recent consolidation of combined to minimize the costs of freight and handling. Builder’s Plus Hardware, Inc., one of the top ten largest national Hardware retailers, now more than ever, find it advantageous hardware store chains, is a case in point. One month after the to purchase from us rather than directly from manufacturers. We consolidation, Builder’s Plus decided not to carry high-end make it possible for smaller, independent retailers to purchase construction and landscaping equipment in order to focus on on an as-needed basis, rather than in bulk. Moreover, we offer what it called the “typical hardware customer.” our customers a range of high-quality products that cannot be found at most national chains. Products We also offer far more post-sale services to customers than To more effectively manage inventory, we carefully monitor the are offered by manufacturers and other national distributors. We composition of net sales by category of items sold. The follow- simplify the purchasing process by assigning each customer a ing chart indicates the percentage of net sales by class of permanent salesperson. Each salesperson becomes involved in merchandise sold during the years 2011, 2010, and 2009: SELAS TEN FO % 25% 2011 20% 2010 15% 2009 10% 5% 0% Power Hand Landscaping Electrical Residential Commercial Paint Tools Tools Equipment Equipment Construction Construction Products MERCHANDISE TYPE ssenisuB 4 Competitors There are other regional wholesale hardware distributors that compete with the Company, but national wholesale hardware store chains dominate the industry. Most of our competitors

are not only larger, but have greater financial resources than our company. Ten national chains exist in the geographic area in which Hillsburg Hardware Co. operates. Of the ten national chains, Hardware Bros., Tools & Paint, and Construction City account for a significant portion of the wholesale hardware market share and also carry the hard-to-find and high-quality items we provide. The success of our business depends on our ability to keep distribution costs to a minimum and our customers satisfied through superior customer service. The chart below is a breakdown of market share in the wholesale hardware market by competitor category, including the 2% market share held by the Company. The chart illustrates that we have considerable opportunity for sales growth. Marketing Program This year, the Company made a significant investment in a Employees new advertising campaign. Various Internet, radio, newspaper, Hillsburg Hardware currently employs 319 individuals. The magazine, and television advertisements were purchased at the majority of our employees are involved in day-to-day sales. local and regional levels using the Company’s new catchphrase, Because of our marketing and customer relations strategy, “Hardware for Hard Workers.” The new jingle has been partially we make significant investments in ongoing training and responsible for the fiscal 2011 increase in sales of 9%. professional development activities. Each year employees are required to attend 75 hours of professional training. Each Customers employee receives a performance evaluation at least four The majority of our customers are located in Illinois, Michigan, times per year, usually once each quarter. Our turnover is Wisconsin, Ohio, and Missouri. Our current customer base among the lowest in the industry because of our compen- consists of more than 400 independently owned hardware sation, training, and evaluation programs. We regard our stores. Approximately 25% of our customers make up more employees as our most valuable asset. Apago PDF Enhancer than 80% of total sales revenue. To promote long-standing relationships with customers, we offer an array of incentive Hillsburg Other Regional Wholesale and customer appreciation programs. Since these programs Hardware Co. HardwareDistributors were implemented in 2002, customer satisfaction ratings have 2% 5% improved steadily in each subsequent year. Tools & Paint Suppliers 17% We purchase hardware and other products from more than 300 manufacturers in the United States. No single vendor accounted for more than 5% of our purchases during fiscal 2011, but our 25 largest vendors accounted for nearly 35%. We currently have long-term supply agreements with two vendors: Mechanical Tools and Painter’s Paradise. These agreements are in effect until the end of fiscal year 2012. The combined dollar amount of each contract is not expected to exceed 5% of total purchases for the year. Construction City Other National 15% Wholesale Hardware Store Chains Hardware Bros. 39% 22% Business 5 Properties The Company owns and operates its main warehouse and an administrative office. The main warehouse and administrative office are in the same 475,000 square-foot building. We also rent a second warehouse for which rental fees are $312,000 annually. The building, located in Detroit, Michigan, serves as an off-site storage facility. Legal Proceedings On September 3, 2010, a suit was filed in the Circuit Court in Gary, Indiana, against the Company. The product liability suit, “Don Richards v. Hillsburg Hardware Co.” is related to injuries that resulted from an alleged defective design of a tractor manufactured by Silo-Tractor, a U.S. corporation. The suit is currently in pretrial proceedings. In the opinion of our legal counsel the suit is without merit. We intend to vigorously defend our position. The Company does not believe any other legal issues materially affect its finances. Executive Officers The following list provides names, ages, and present positions of the Company’s officers: Apago PDF Enhancer ssenisuB NAME AGE POSITION

John P. Higgins 55 Chairman of the Board Christopher J. Kurran 47 ChiefExecutive Officer (b) Rick Chulick 54 President and Chief OperatingOfficer (a) AvisA. Zomer 44 ChiefFinancialOfficer Brandon S. Mack 51 Vice President Sales and Marketing Mary R. Moses 36 Vice President Merchandising Vanessa M. Namie 53 Vice President Operations (c) JosephA.Akins 64 Vice President Quality Assurance (d) (a) Mr. Chulick has been President and Chief Operating Officer of the Company for ten years, since November 2001. Mr. Chulick was Chairman of the Board from 2004 to 2006. (b) Mr. Kurran has been Chief Executive Officer of the Company since September 2001. Prior to his role as CEO, Mr. Kurran was employed from 1992-2000 by Trini Enterprises, an industrial distributor. (c) Ms. Namie has been employed by the company since its inception in 1994. She has held her current position since 2000 and served as an operations manager from 1994- 2000. (d) Mr. Akins was Chief Operating Officer and President of Hardware Bros., one of the ten largest wholesale hardware chains in the nation, from 1998-2003. 6 Apago PDF Enhancer Business “We offer our customers a range of high-quality products that cannot be found at most national chains.” Controls and Procedures Information Regarding Common Equity Pursuant to Section 404 of the Sarbanes–Oxley Act of 2002 Hillsburg Hardware Company’s common stock currently trades and related Exchange Act Rules, we have carefully evaluated on the NASDAQ under the symbol “HLSB.” The following chart the design and operating effectiveness of our internal control shows the high and low prices of the Company’s common over financial reporting. After careful review of all key controls stock by quarter for the years 2011 and 2010: over financial reporting, our Chief Executive Officer and Chief Financial Officer implemented new controls over the internal 2011 2010 verification and timely recording of sales transactions. In com- HIGH LOW HIGH LOW pliance with Section 404 and related Exchange requirements, Quarter 1 22.50 19.05 23.30 20.00 management has issued its report that internal controls over financial reporting are operating effectively as of December Quarter 2 22.55 20.10 22.75 20.25 31, 2011 based on criteria established in the COSO Internal Quarter 3 22.30 20.99 24.10 19.75 Control-Integrated Framework. Quarter 4 22.40 17.95 21.50 18.20 On March 23, 2012, there were 1,250 shareholders of our com- mon stock. Dividend Policy Dividend payments on common stock are authorized annually by the Board of Directors. For 2011, dividend payments totaled $1.9 million, which is $.38 per share. 7 REPORT OF INDEPENDENT REGISTERED ACCOUNTING FIRM Board of Directors and Stockholders Hillsburg Hardware Company We have audited the accompanying balance sheets of Hillsburg Hardware Company as of December 31, 2011 and 2010, and the related statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three- year period ended December 31, 2011. We have also audited Hillsburg Hardware Company, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Hillsburg Hardware Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effective- ness of internal control over financial reporting, included in the accompanying report, Management’s Responsibility for the Financial Statements. Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial state- ments are free of material misstatement and whether effective internal control over financial reporting was maintained in all material

respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal cAonptroal bagsedo o n thPe aDsseFss ed Eriskn. Ohur aaudnitsc alseo inrcluded performing such other proce- dures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding the prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Hillsburg Hardware Company, Inc. as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Hillsburg Hardware Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Berger & Anthony, LLP Berger and Anthony, LLP March 21, 2012 8 Apago PDF Enhancer Financial Statements Management’s Responsibility for the Financial Statements To Our Shareholders: The accompanying financial statements of Hillsburg Hardware Company have been prepared by management, which is responsible for their integrity and objectivity. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include amounts based on management’s best estimates and judgments. Management has also prepared information elsewhere in this Annual Report that is consistent with data in the financial statements. The Company’s financial statements have been audited by Berger and Anthony, independent Certified Public Accountants. Our auditors were given unrestricted access to all financial records and related data, including minutes of the meetings of the Board of Directors. We believe all representations made to Berger and Anthony were legitimate and appropriate. The management of Hillsburg Hardware Company is responsible for establishing and maintaining adequate internal control over

financial reporting. Hillsburg Hardware Company’s internal control system was designed to provide reasonable assurance to the com- pany’s management and board of directors regarding the preparation and fair presentation of published financial statements. Hillsburg Hardware Company management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2011. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment we believe that, as of December 31, 2011, the company’s internal control over financial reporting is effective based on those criteria. Hillsburg Hardware Company’s independent auditors have issued an audit report on our financial statements and internal control over financial reporting. This report appears on the preceding page. John P. Higgins Christopher J. Kurran Avis A. Zomer Chairman of the Board Chief Executive Officer Chief Financial Officer 9 Apago PDF Enhancer teehS ecnalaB Hillsburg Hardware Company Balance Sheets (in thousands) December 31 ASSETS 2011 2010 Current assets Cash and cash equivalents $ 828 $ 743 Trade receivables (net of allowances of $1,240 and $1,311) 18,957 16,210 Other receivables 945 915 Merchandise inventory 29,865 31,600 Prepaid expenses 432 427 Total current assets 51,027 49,895 Property and equipment Land 3,456 3,456 Buildings 32,500 32,000 Equipment, furniture, and fixtures 6,304 8,660 Less: accumulated depreciation (31,920) (33,220) Total property and equipment (net) 10,340 10,896 Total assets $ 61,367 $ 60,791 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Trade accounts payable $ 4,720 $ 4,432 Notes payable 4,180 4,589 Accrued payroll 1,350 715 Accrued payroll tax 120 116 Accrued interest and dividends payable 2,050 1,975 Accrued income tax 796 523 Total current liabilities 13,216 12,350 Long-term notes payable 24,120 26,520 Deferred income taxes 738 722 Other long-term payables 830 770 STOCKHOLDERS’ EQUITY Capital stock ($1 par value; 5,000,000 shares issued) 5,000 5,000 Capital in excess of par value 3,500 3,500 Retained earnings 13,963 11,929 Total stockholders’ equity: 22,463 20,429 Total liabilities and stockholders’ equity $ 61,367 $ 60,791 See Notes to Financial Statements. 10 Apago PDF Enhancer Statement of Operations Hillsburg Hardware Company Statement of Operations (in thousands) Year Ended December 31 2011 2010 2009 Net sales $ 143,086 $131,226 $122,685 Cost of sales 103,241 94,876 88,724 Gross profit 39,845 36,350 33,961 Selling, general and administrative expenses 32,475 29,656 28,437 Operating income 7,370 6,694 5,524 Other income and expense Interest expense 2,409 2,035 2,173 Gain on sale of assets (720) — — Total other income/expense (net) 1,689 2,035 2,173 Earnings before income taxes 5,681 4,659 3,351 Provision for income taxes 1,747 1,465 1,072 Net income $ 3,934 $ 3,194 $ 2,279 Earnings per share $ 0.79 $ 0.64 $ 0.46 See Notes to Financial Statements. ytiuqE ’sredlohkcotS Hillsburg Hardware Company Statement of Stockholders’ Equity (in thousands) Common Stock Paid-in Retained Total Shares Par value Capital Earnings Stockholders’ Equity Balance as of December 31, 2008 5,000 $5,000 $ 3,500 $ 10,256 $ 18,756 Net income 2,279 2,279 Dividends paid (1,900) (1,900) Balance as of December 31, 2009 5,000 $5,000 $ 3,500 $ 10,635 $ 19,135 Net income 3,194 3,194 Dividends paid (1,900) (1,900) Balance as of December 31, 2010 5,000 $5,000 $ 3,500 $ 11,929 $ 20,429 Net income 3,934 3,934 Dividends paid (1,900) (1,900) Balance as of December 31, 2011 5,000 $5,000 $ 3,500 $ 13,963 $ 22,463 See Notes to Financial Statements. 11 Apago PDF Enhancer swolF hsaC Hillsburg Hardware Company Statement of Cash Flows (in thousands) Year Ended December 31 OPERATINGACTIVITIES 2011 2010 2009 Net income $ 3,934 $ 3,194 $ 2,279 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 1,452 1,443 1,505 (Gain) or Loss on sale of assets (720) — —

Deferred income taxes increase (decrease) 16 (8) 43 Changes in assets and liabilities: Trade and other receivables (2,777) (393) (918) Merchandise inventory 1,735 (295) (430) Prepaid expenses (5) (27) (55) Accounts payable 288 132 76 Accrued liabilities 714 77 142 Income taxes payable 273 23 13 Net cash provided by operating activities 4,910 4,146 2,655 INVESTINGACTIVITIES Capital expenditures (10,500) (1,800) (2,292) Sale of equipment 10,324 — — Net cash used in investing activities (176) (1,800) (2,292) FINANCINGACTIVITIES Dividend payment (1,900) (1,900) (1,900) Proceeds (repayments) from borrowings (net) (2,749) (423) 1,602 Net cash used in financing activities (4,649) (2,323) (298) Net increase in cash and cash equivalents 85 23 65 Cash and cash equivalents at beginning of year 743 720 655 Cash and cash equivalents at end of year $ 828 $ 743 $ 720 See Notes to Financial Statements. 12 Apago PDF Enhancer Notes to Financial Statements 1. Description of Significant Accounting account consists largely of temporary differences related to (1) Policies and Business the valuation of inventory, (2) depreciation, and (3) other accruals. We are a wholesale distributor of high-quality power tools, hand tools, electrical equipment, landscaping equipment, residential 2. Other Receivables and commercial construction equipment, and paint products. The other receivables balance consists largely of vendor allow- The majority of our customers are smaller, independent hard- ances and vendor rebates. When vendor allowances and vendor ware stores located in Illinois, Michigan, Wisconsin, Ohio, and rebates are recognized (all activities required by the supplier Missouri. are completed, the amount is determinable, and collectibility is reasonably certain), they are recorded as reductions of costs of Allowance for Doubtful Accounts: Our allowance for goods sold. doubtful accounts is maintained to account for expected credit losses. Estimates of bad debts are based on individual customer 3. Notes Payable risks and historical collection trends. Allowances are evaluated Notes payable for the year ended December 31, 2011, consists and updated when conditions occur that give rise to collection of three notes payable to the bank. Each note carries a fixed issues. interest rate of 8.5%. One note for $4,180,000 matures in June Merchandise Inventory: Merchandise inventory is presented 2012 and the other two mature on December 31, 2014. During at the lower of average cost or market. To present accurately 2011, there was an additional note outstanding in the amount of the estimated net realizable value of the accounts, we adjust $4,400,000, which was paid off during October 2011. inventory balances when current and expected future market conditions, as well as recent and historical turnover trends, 4. Commitments indicate adjustments are necessary. The Company is currently committed to an operating lease that expires in 2015. Rental payments for the remainder of the con- Property, Plant and Equipment: Land, buildings, comput- tract are set at $312,000 per annum. ers and other equipment, and furniture and fixtures are stated at historical cost. Depreciation is calculated on a straight-line 5. Segment Reporting basis over estimated useful lives of the assets. Estimated The Company operates in one segment. The breakdown of useful lives are 20 to 35 years for buildings and 2 to 10 years revenues (in thousands) from different products is listed in the for equipment and furniture and fixtures. chart below: Revenue Recognition: Revenues are recognized when goods are shipped, title has passed, the sales price is fixed, and col- SEGMENT REPORTING lectibility is reasonably assured. A sales returns and allowance 2011 2010 2009 account is maintained to reflect estimated future returns and Power Tools $ 31,479 $ 27,557 $ 26,991 allowances. Adjustments to the sales returns and allowance Hand Tools 21,463 19,684 18,403 account are made in the same period as the related sales are recorded and are based on historical trends, as well as analyses Landscaping Equipment 14,309 15,645 13,494

of other relevant factors. Sales are recorded net of returns and ElectricalGoods 17,170 15,849 11,042 allowances in the statements referred to in this report. Residential Income Taxes: The deferred income tax account includes Construction Equipment 21,463 18,372 15,949 temporary differences between book (financial accounting) Commercial income and taxable income (for IRS reporting purposes). The Construction Equipment 11,447 10,498 9,815 Paint Products 25,755 23,621 26,991 $143,086 $131,226 $122,685 6. Earnings Per Share Earnings per share calculations for 2011, 2010, and 2009 were computed as follows: Numerators (net income in thousands): $3,934, $3,194, and $2,279 Denominators (shares of common stock): 5,000,000 (unchanged for all years) Diluted earnings per share was the same as basic earnings per share for all years. 13 Apago PDF Enhancer noissucsiD s’tnemeganaM Management’s Discussion and due to our new advertising campaign and increased expendi- Analysis of Financial Condition and tures on sales meetings and training. General and administrative expenses increased by Results of Operations $908,000 or 5.4% from 2010 to 2011 and by $414,000 or 2.5% from 2009 to 2010. As a percentage of net sales, general and The following discussion and analysis of the results of our administrative expenses decreased by 0.42% since 2010 and operations and our financial condition are based on the finan- decreased by 0.55% from 2009 to 2010. The overall increase cial statements and related notes included in this report. When from 2010 to 2011 was caused mostly by unexpected repairs preparing the financial statements, we are frequently required needed to reattach and replace damaged shelving units in our to use our best estimates and judgments. These estimates and main warehouse building. judgments affect certain asset, liability, revenue, and expense account balances. Therefore, estimates are evaluated constantly Interest Expense: In 2011, interest expense increased by based on our analyses of historical trends and our understand- $374,000, or approximately 18.4%, compared to 2010. The ing of the general business environment in which we operate. increase was due to an overall interest rate increase and There are times, however, when different circumstances and the restructuring of debt covenants that are less restrictive assumptions cause actual results to differ from those expected but demand higher interest rates. In 2010 interest expense when judgments were originally made. The accounting policies decreased by $138,000 or 6.4% compared to 2009. The referred to in Note 1 to the financial statements, in our opinion, 2010 decrease was mainly due to the Company’s decision to influence the judgments and estimates we use to prepare our decrease the level of long-term debt. The average interest rates financial statements. on short- and long-term debt during 2011 were approximately 10.5% and 8.5% respectively. Results of Operations For the year ended December 31, 2011, gross profit increased Liquidity by 9.6% or $3,495,000 from 2010. This increase in gross profit During 2011, our working capital requirements were primarily more than offsets the increase in operating expenses from 2010 financed through our line of credit, under which we are to 2011 of $2,819,000 or 9.5%. The increase in gross margin permitted to borrow up to the lesser of $7,000,000 or 75% of largely explains the operating income increase of $676,000. accounts receivable outstanding less than 30 days. The aver- For the year ended December 31, 2010, gross profit age interest rate on these short-term borrowings in 2011 was increased by $2,389,000 or 7% from 2009. Total operating approximately 10.5% expenses increased by $1,219,000 or approximately 4.3% from Cash provided by operating activities for 2011 and 2010 was 2009. The increase in gross profit offset the total operating $4,910,000 and $4,146,000 respectively. The change from 2010 expense increase, and the net result was a $1,170,000 increase to 2011 is primarily due to the increase in net income. Increases

in operating income. in receivables were largely offset by decreases in inventories and increases in payables and other current liabilities. The increase in Net Sales: From 2010 to 2011 net sales increased by cash provided from operating activities of $1,491,000 from 2009 $11,860,000 or 9%. The increase in net sales can be explained to 2010 is largely the result of the increase in net income and largely by an aggressive advertising campaign that the smaller increases in receivables and merchandise inventory in Company organized during the second half of 2011. Net sales 2010 compared to 2009. We believe that cash flow from opera- for 2010 increased by $8,541,000 or 7.0% from 2009, which tions and the available short-term line of credit will continue to is consistent with industrywide average revenue growth of 7% allow us to finance operations throughout the current year. from 2009 to 2010. Gross Profit: Gross profit as a percentage of net sales stayed Statement of Condition relatively stable at 27.68% and 27.70% in 2009 and 2010, Merchandise inventory and trade accounts receivable together respectively, but increased to 27.85% in 2011. The 2011 accounted for over 95% of current assets in both 2011 and increase is mostly due to improved vendor incentive programs, 2010. Merchandise inventory turned over approximately 3.4 our focus on cost containment, and increases in the resale times in 2011 and 3.0 times in 2010. Average days to sell inven- values of certain commodities such as PVC piping material and tory were 108.6 and 120.9 in 2011 and 2010 respectively. Net certain types of metal wiring. While gross profit percentages in trade receivables turned over approximately 7.6 times in 2011 the industry have declined somewhat, our position as a niche and in 2010. Days to collect accounts receivable computations provider in the overall hardware market allows us to charge pre- were 48.1 and 48.0 in 2011 and 2010 respectively. Both inven- mium prices without losing customers. tory and accounts receivable turnover are lower than industry Selling, General and Administrative Expenses: Selling, averages. We plan for this difference to satisfy the market in General and Administrative Expenses: Selling expenses which we operate. Our market consists of smaller, independent increased by $1,911,000 or 14.8% from 2010 to 2011 and by hardware stores that need more favorable receivable collection $805,000 or 6.7% from 2009 to 2010. As a percentage of net terms and immediate delivery of inventory. Because we hold sales, selling expenses increased by 0.52% since 2010 and large amounts of inventory, we are able to fill orders quicker decreased by 0.03% from 2009 to 2010. The increase in selling than most of our competitors even during the busiest times of expenses as a percentage of net sales from 2010 to 2011 is the year. 14 Apago PDF Enhancer Management’s Discussion Outlook Information Concerning Forward-Looking During 2011 we experienced another year of noticeable Statements improvement, despite the economic downturn. The Company’s This report contains certain forward-looking statements (ref- financial performance can largely be attributed to (1) a continued erenced by such terms as “expects” or “believes”) that are focus on cost containment, (2) productivity improvements, (3) subject to the effects of various factors including (1) changes aggressive advertising, and (4) the implementation of programs in wholesale hardware prices, (2) changes in the general busi- designed to enhance customer satisfaction. ness environment, (3) the intensity of the competitive arena, During 2012, we will continue to apply the same strategic (4) new national wholesale hardware chain openings, and (5) efforts that improved 2011 performance. We are also imple- certain other matters influencing the Company’s ability to react menting a new warehouse information system designed to to changing market conditions. Therefore, management wishes increase productivity and reduce stocking and distribution to make readers aware that the aforementioned factors could

costs. Management believes that earnings growth will be pri- cause the actual results of our operations to differ consider- marily driven by (1) continued focus on customer satisfaction, ably from those indicated by any forward-looking statements (2) penetration into markets currently dominated by national included in this report. wholesale hardware store chains, and (3) the use of technol- ogy to attract additional customers and promote more efficient operations. Hillsburg Hardware Company Statement of Cash Flows (in thousands) BALANCESHEETDATA: 2011 2010 2009 2008 2007 Current assets $ 51,027 $ 49,895 $ 49,157 $ 47,689 $ 46,504 Total assets 61,367 60,791 59,696 57,441 51,580 Current liabilities 13,216 12,350 12,173 12,166 9,628 Long-term notes payable 24,120 26,520 26,938 25,432 25,223 Total stockholders’ equity 22,463 20,429 19,135 18,756 15,764 INCOMESTATEMENTDATA: Net sales $143,086 $131,226 $122,685 $ 120,221 $117,115 Cost of sales 103,241 94,876 88,724 88,112 85,663 Gross profit 39,845 36,350 33,961 32,109 31,452 Earnings before income taxes 5,681 4,659 3,351 3,124 1,450 Net income 3,934 3,194 2,279 2,142 994 Cash provided by operating activities 4,910 4,146 2,655 1,811 1,232 Per common share data: Net income $ 0.79 $ 0.64 $ 0.46 $ 0.43 $ 0.22 Cash dividends per share $ 0.38 $ 0.38 $ 0.38 $ — $ — Common shares outstanding 5,000 5,000 5,000 5,000 4,500 KEYOPERATINGRESULTSANDFINANCIALPOSITIONRATIOS: Gross profit (%) 27.85% 27.70% 27.68% 26.71% 26.86% Return on assets (%) 9.30% 7.73% 5.72% 5.73% 2.86% Return on common equity (%) 26.49% 23.55% 17.69% 18.10% 9.50% 15 Apago PDF Enhancer ACL Software License Agreement ACL Education Edition THIS ACL SOFTWARE LICENSE AGREEMENT (“AGREEMENT”) IS A LEGAL AGREEMENT BETWEEN YOU (EITHER A SINGLE ENTITY OR AN INDIVIDUAL, REFERRED TO AS “YOU” OR “YOUR”) AND ACL SERVICES LTD. OF 1550 ALBERNI STREET, VANCOUVER, BRITISH COLUMBIA, CANADA, V6G 1A5 (“ACL”). CAREFULLY READ THE TERMS OF THIS AGREEMENT BEFORE YOU INSTALL OR USE THE ACL EDUCATION EDITION SOFTWARE AND ACCOMPANYING DOCUMENTATION (“SOFTWARE”). BY INSTALLING OR USING THE SOFTWARE, YOU AGREE TO BE BOUND BY THE TERMS OF THIS AGREEMENT. You will not be able to install the Software unless you click on the button that indicates your acceptance of the terms of this Agreement. If you do not agree to all of the terms of this Agreement, then do not install or use the Software. If there is any conflict or ambiguity between the English language version and any other language version of this Agreement, the English language version will prevail and it will be the authentic text for the purposes of interpretation. Grant of License.ACL rants you the personal, non-assignable, non-transferable and non-exclusive license to install and use the Software for educational purposes only. Any commercial use of the Software is expressly forbidden and is a breach of the terms of this Agreement. If you are supplied the Desktop Edition of the Software, a specific individual (a “Named User”) is permitted to install and use the Software on a computer assigned to the Named User. If you are supplied the Network Edition of the Software, you are permitted to install and use the Software on a single computer network for a designated number of concurrent users at any particular time. Ownership.The grant of license is not a sale of the Software to you. No title to or ownership of the Software is transferred to you. All title, ownership rights and intellectual property rights in and to the Software, including any adaptations or copies of the Software, belong to ACL and its licensors. The Software is protected by copyright laws and international copyright treaties and ACL may incorporate certain measures in the Software to prevent unauthorized use of the Software. You further agree to indemnify ACL for any copyright infringement that is caused, contributed to or encouraged by your failure to abide by this Agreement. License Restrictions.ACL reserves all rights not expressly granted to you. Without limiting the generality of the foregoing, you acknowledge that

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Financial Accounting and Accounting Standards 1 Identify the major financial statements and 6 Explain the meaning of generally accepted other means of financial reporting. accounting principles (GAAP) and the role of the Codification for GAAP. 2 Explain how accounting assists in the efficient use of scarce resources. 7 Describe the impact of user groups on the rule-making process. 3 Identify the objective of financial reporting. 8 Describe some of the challenges facing 4 Explain the need for accounting standards. financial reporting. 5 Identify the major policy-setting bodies and 9 Understand issues related to ethics and their role in the standard-setting process. financial accounting. We Can Do Better A recent report says it best: “Accounting information is central to the functioning of international capital markets and to managing small businesses, conducting effective government, understanding business processes, and . . . how economic decisions are made. . . . Across the globe, a common characteristic of economies that flourish is the presence of reliable accounting information.” Many in the United States take pride in our system of financial reporting as being the most robust and transparent in the world. But most would also comment that we can do better, particularly in light of the many accounting scandals that have occurred at companies like AIG, WorldCom, and Lehman Brothers, and the financial crisis of 2008. To better understand where we are today, the Center for Audit Quality conducts a yearly survey that measures investor confidence in such categories as U.S. capital markets, audited financial information, and U.S. publicly traded companies. Here are the results: The results indicate that the 2008 financial crisis took a bite out of investor confidence. While investor confi- dence in U.S. markets, auditors, and public companies has stabilized, the question is how can we improve? Here are some possibilities on how we can enhance the existing system of financial reporting. 1. Today, equity securities are broadly held, with approximately half of American households invest- ing in stocks. This presents a challenge—investors have expressed concerns that one-size-fits-all financial reports do not meet the needs of the spectrum of investors who rely on those reports. While many individual investors are more inter- ested in summarized, plain-English reports, mar- ket analysts and other investment professionals may desire information at a far more detailed level than is currently provided. Technology may help customize the information that the different types of investors desire. 2. Companies also express concerns with the complexity of the financial reporting system. Companies assert that when preparing financial reports, it is difficult to ensure compliance with the voluminous and complex requirements contained in U.S. GAAP and SEC reporting rules. This is a particularly heavy burden on smaller, non-public com- panies, which may have fewer resources to comply with the wide range of rules. 3. We also need to consider the broader array of information that investors need to make informed decisions. As some have noted, the percentage of a company’s market value that can be attributed to accounting book value has declined significantly from the days of a bricks-and-mortar economy. Thus, we may want to consider a more comprehensive business reporting model, including both financial and nonfinancial key performance indicators. RETPAHC 1 LEARNING OBJECTIVES After studying this chapter, you should be able to: 90% 80% 70% 60% 50% 40% 0% 2007 2010 2012 Confidence in capital Confidence in audited Confidence in public markets financial statements company investments CONCEPTUAL FOCUS > See the Underlying Concepts on 4. Finally, we must also consider how to deliver all of this pages 6 and 7. information in a timelier manner. In a world where mes- sages can be sent across the world in a blink of an eye, it is > Read the Evolving Issue on page 17 for a ironic that the analysis of financial information is still subject discussion of the use of fair value accounting.

to many manual processes, resulting in delays, increased costs, and errors. INTERNATIONAL FOCUS Thus, improving financial reporting involves more than simply trimming or reworking the existing accounting literature. In some > See the International Perspectives cases, major change is already underway. For example: on pages 8, 9, 10, 17, and 20. • The FASB and IASB are working on a convergence project, > Read the IFRS Insights on which will contribute to less-complex, more-understand- pages 31–39 for a discussion of: able standards in the important areas of revenue recogni- —International standard-setting organizations tion, leasing, and financial instruments. —Hierarchy of IFRS • Standard-setters are exploring expanded reporting of key —International accounting convergence performance indicators, including reports on sustainability and a disclosure framework project to improve the effective- ness of disclosures to clearly communicate the information that is most important to users of financial statements. This project, combined with the introduction of a private-company reporting framework, could go a long way to address one-size-fits-all challenges. • The SEC now requires the delivery of financial reports using eXtensible Business Reporting Language (XBRL). Reporting through XBRL allows timelier reporting via the Internet and allows statement users to transform accounting reports to meet their specific needs. Each of these projects will hopefully support improvements in the quality of financial reporting and increase confidence in U.S. capital markets. Sources: Adapted from The Pathways Commission, “Charting a National Strategy for the Next Generation of Accountants” (AAA, AICPA, July 2012); Conrad W. Hewitt, “Opening Remarks Before the Initial Meeting of the SEC Advisory Committee on Improvements to Financial Reporting,” U.S. Securities and Exchange Commission, Washington, D.C. (August 2, 2007); and Center for Audit Quality, Main Street Investor Survey (September 2012). See www.fasb.org for updates on FASB/IASB convergence, disclosure, and private company decision-making projects. As our opening story indicates, the U.S. system of financial reporting PREVIEW OF CHAPTER 1 has long been the most robust and transparent in the world. However, to ensure that it continues to provide the most relevant and reliable financial information to users, a number of financial reporting issues must be resolved. These issues include such matters as adopting global standards, increasing fair value reporting, and meeting multiple user needs. This chapter explains the environment of financial reporting and the many factors affecting it, as follows. Financial Accounting and Accounting Standards Financial Statements and Parties Involved in Generally Accepted Issues in Financial Financial Reporting Standard-Setting Accounting Principles Reporting • Accounting and capital • Securities and Exchange • FASB Codification • Political environment allocation Commission • Expectations gap • Objective • American Institute of CPAs • Financial reporting • Need to develop standards • Financial Accounting challenges Standards Board • International accounting standards • Ethics 3 4 Chapter 1 Financial Accounting and Accounting Standards FINANCIAL STATEMENTS AND FINANCIAL REPORTING The essential characteristics of accounting are (1) the identification, measurement, LEARNING OBJECTIVE 1 and communication of financial information about (2) economic entities to (3) in- Identify the major financial statements terested parties. Financial accounting is the process that culminates in the prepa- and other means of financial reporting. ration of financial reports on the enterprise for use by both internal and external parties. Users of these financial reports include investors, creditors, managers, unions, and government agencies. In contrast, managerial accounting is the process of identifying, measuring, analyzing, and communicating financial information needed by manage- ment to plan, control, and evaluate a company’s operations.

Financial statements are the principal means through which a company communi- cates its financial information to those outside it. These statements provide a company’s history quantified in money terms. The financial statements most frequently provided are (1) the balance sheet, (2) the income statement, (3) the statement of cash flows, and (4) the statement of owners’ or stockholders’ equity. Note disclosures are an integral part of each financial statement. Some financial information is better provided, or can be provided only, by means of financial reporting other than formal financial statements. Examples include the presi- dent’s letter or supplementary schedules in the corporate annual report, prospectuses, reports filed with government agencies, news releases, management’s forecasts, and social or environmental impact statements. Companies may need to provide such infor- mation because of authoritative pronouncement, regulatory rule, or custom. Or they may supply it because management wishes to disclose it voluntarily. In this textbook, we focus on the development of two types of financial information: (1) the basic financial statements and (2) related disclosures. Accounting and Capital Allocation Resources are limited. As a result, people try to conserve them and ensure that they LEARNING OBJECTIVE 2 are used effectively. Efficient use of resources often determines whether a business Explain how accounting assists in the thrives. This fact places a substantial burden on the accounting profession. efficient use of scarce resources. Accountants must measure performance accurately and fairly on a timely basis, so that the right managers and companies are able to attract investment capital. For example, relevant and reliable financial information allows investors and creditors to compare the income and assets employed by such companies as IBM, McDonald’s, Microsoft, and Ford. Because these users can assess the relative return and risks associated with investment opportunities, they channel resources more effectively. Illustration 1-1 shows how this process of capital allocation works. ILLUSTRATION 1-1 Capital Allocation Financial Reporting Users Capital Allocation Process (present and potential) The financial information Investors and creditors The process of a company provides to use financial reports to determining how and at help users with capital make their capital what cost money is allocation decisions about allocation decisions. allocated among the company. competing interests. An effective process of capital allocation is critical to a healthy economy. It promotes productivity, encourages innovation, and provides an efficient and liquid market for Financial Statements and Financial Reporting 5 buying and selling securities and obtaining and granting credit. Unreliable and irrele- vant information leads to poor capital allocation, which adversely affects the securities markets. What do the numbers mean? IT’S THE ACCOUNTING “It’s the accounting.” That’s what many investors seem to be • Bank of America admits hiding debt. saying these days. Even the slightest hint of any accounting • Facebook, Zynga, Groupon: IPO drops due to account- irregularity at a company leads to a subsequent pounding of ing, not valuation. the company’s stock price. For example, the Wall Street Journal It now has become clear that investors must trust the ac- has run the following headlines related to accounting and its counting numbers, or they will abandon the market and put effects on the economy. their resources elsewhere. With investor uncertainty, the cost • Stocks take a beating as accounting woes spread beyond of capital increases for companies who need additional re- Enron. sources. In short, relevant and reliable fi nancial information • Quarterly reports from IBM and Goldman Sachs sent is necessary for markets to be effi cient. stocks tumbling. • VeriFone fi nds accounting issues; stock price cut in half. Objective of Financial Reporting What is the objective (or purpose) of financial reporting? The objective of

3 LEARNING OBJECTIVE general-purpose financial reporting is to provide financial information about the Identify the objective of financial reporting entity that is useful to present and potential equity investors, lenders, reporting. and other creditors in decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and provid- ing or settling loans and other forms of credit. Information that is decision-useful to capital providers (investors) may also be helpful to other users of financial reporting who are not investors. Let’s examine each of the elements of this objective.1 General-Purpose Financial Statements General-purpose financial statements provide financial reporting information to a wide variety of users. For example, when The Hershey Company issues its financial statements, these statements help shareholders, creditors, suppliers, employees, and regulators to better understand its financial position and related performance. Hershey’s users need this type of information to make effective decisions. To be cost- effective in providing this information, general-purpose financial statements are most appropriate. In other words, general-purpose financial statements provide at the least cost the most useful information possible. Equity Investors and Creditors The objective of financial reporting identifies investors and creditors as the primary users for general-purpose financial statements. Identifying investors and creditors as the primary users provides an important focus of general-purpose financial reporting. For example, when Hershey issues its financial statements, its primary focus is on inves- tors and creditors because they have the most critical and immediate need for informa- tion in financial reports. Investors and creditors need this financial information to assess 1Chapter 1, “The Objective of General Purpose Financial Reporting,” and Chapter 3, “Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), par. OB2. 6 Chapter 1 Financial Accounting and Accounting Standards Hershey’s ability to generate net cash inflow and to understand management’s Underlying Concepts ability to protect and enhance the assets of the company, which will be used to While the objective of fi nancial generate future net cash inflows. As a result, the primary user groups are not reporting is focused on investors management, regulators, or some other non-investor group. and creditors, fi nancial statements may still meet the Entity Perspective needs of others. As part of the objective of general-purpose financial reporting, an entity perspective is adopted. Companies are viewed as separate and distinct from their owners (present shareholders) using this perspective. The assets of Hershey are viewed as assets of the company and not of a specific creditor or shareholder. Rather, these investors have claims on Hershey’s assets in the form of liability or equity claims. The entity perspective is consistent with the present business environment where most companies engaged in financial reporting have substance distinct from their investors (both shareholders and creditors). Thus, a perspective that financial reporting should be focused only on the needs of shareholders—often referred to as the proprietary perspective—is not considered appropriate. What do the numbers mean? DON’T FORGET STEWARDSHIP In addition to providing decision-useful information about and technological and social changes. Because Hershey’s future cash fl ows, management also is accountable to inves- performance in discharging its responsibilities (referred to tors for the custody and safekeeping of the company’s eco- as its stewardship responsibilities) usually affects its ability nomic resources and for their effi cient and profi table use. For to generate net cash infl ows, fi nancial reporting may also example, the management of The Hershey Company has the provide decision-useful information to assess management

responsibility for protecting its economic resources from performance in this role. unfavorable effects of economic factors, such as price changes, Source: Chapter 1, “The Objective of General Purpose Financial Reporting,” and Chapter 3, “Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), paras. OB4–OB10. Decision-Usefulness Investors are interested in financial reporting because it provides information that is useful for making decisions (referred to as the decision-usefulness approach). As indi- cated earlier, when making these decisions, investors are interested in assessing (1) the company’s ability to generate net cash inflows and (2) management’s ability to protect and enhance the capital providers’ investments. Financial reporting should therefore help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. In order for investors to make these assessments, the economic re- sources of an enterprise, the claims to those resources, and the changes in them must be understood. Financial statements and related explanations should be a primary source for determining this information. The emphasis on “assessing cash flow prospects” does not mean that the cash basis is preferred over the accrual basis of accounting. Information based on accrual account- ing better indicates a company’s present and continuing ability to generate favorable cash flows than does information limited to the financial effects of cash receipts and payments. Recall from your first accounting course the objective of accrual-basis accounting: It ensures that a company records events that change its financial statements in the periods in which the events occur, rather than only in the periods in which it receives or Parties Involved in Standard-Setting 7 pays cash. Using the accrual basis to determine net income means that a company rec- ognizes revenues when it provides the goods or services rather than when it receives cash. Similarly, it recognizes expenses when it incurs them rather than when it pays them. Under accrual accounting, a company generally recognizes revenues when it makes sales. The company can then relate the revenues to the economic environment of the period in which they occurred. Over the long run, trends in revenues and expenses are generally more meaningful than trends in cash receipts and disbursements.2 The Need to Develop Standards The main controversy in setting accounting standards is, “Whose rules should we 4 LEARNING OBJECTIVE play by, and what should they be?” The answer is not immediately clear. Users of Explain the need for accounting financial accounting statements have both coinciding and conflicting needs for standards. information of various types. To meet these needs, and to satisfy the stewardship reporting responsibility of management, companies prepare a single set of general- purpose financial statements. Users expect these statements to present fairly, clearly, and completely the company’s financial operations. The accounting profession has attempted to develop a set of standards that Underlying Concepts are generally accepted and universally practiced. Otherwise, each company Preparing fi nancial statements would have to develop its own standards. Further, readers of financial state- prepared according to accepted ments would have to familiarize themselves with every company’s peculiar ac- accounting standards counting and reporting practices. It would be almost impossible to prepare contributes to the comparability statements that could be compared. of accounting information. This common set of standards and procedures is called generally accepted accounting principles (GAAP). The term “generally accepted” means either that an authoritative accounting rule-making body has established a principle of reporting in a given area or that over time a given practice has been accepted as appropriate because

of its universal application.3 Although principles and practices continue to provoke both debate and criticism, most members of the financial community recognize them as the standards that over time have proven to be most useful. We present a more extensive discussion of what constitutes GAAP later in this chapter. PARTIES INVOLVED IN STANDARD-SETTING Three organizations are instrumental in the development of financial accounting 5 LEARNING OBJECTIVE standards (GAAP) in the United States: Identify the major policy-setting bodies and their role in the standard-setting 1. Securities and Exchange Commission (SEC) process. 2. American Institute of Certifi ed Public Accountants (AICPA) 3. Financial Accounting Standards Board (FASB) Securities and Exchange Commission (SEC) External financial reporting and auditing developed in tandem with the growth of the industrial economy and its capital markets. However, when the stock market crashed in 2As used here, cash flow means “cash generated and used in operations.” The term cash flows also frequently means cash obtained by borrowing and used to repay borrowing, cash used for investments in resources and obtained from the disposal of investments, and cash contributed by or distributed to owners. 3The terms principles and standards are used interchangeably in practice and throughout this textbook. 8 Chapter 1 Financial Accounting and Accounting Standards International 1929 and the nation’s economy plunged into the Great Depression, there were Perspective calls for increased government regulation of business, especially financial institutions and the stock market. The International Organization of As a result of these events, the federal government established the Securities Commissions (IOSCO), Securities and Exchange Commission (SEC) to help develop and standardize established in 1987, consists of financial information presented to stockholders. The SEC is a federal agency. It more than 100 securities regu- latory agencies or securities ex- administers the Securities Exchange Act of 1934 and several other acts. Most changes from all over the world. companies that issue securities to the public or are listed on a stock exchange are Collectively, its members repre- required to file audited financial statements with the SEC. In addition, the SEC sent a substantial proportion of has broad powers to prescribe, in whatever detail it desires, the accounting the world’s capital markets. The practices and standards to be employed by companies that fall within its SEC is a member of IOSCO. jurisdiction. The SEC currently exercises oversight over 12,000 companies that are listed on the major exchanges (e.g., the New York Stock Exchange and the Nasdaq). Public/Private Partnership At the time the SEC was created, no group—public or private—issued accounting stan- dards. The SEC encouraged the creation of a private standard-setting body because it believed that the private sector had the appropriate resources and talent to achieve this daunting task. As a result, accounting standards have developed in the private sector either through the American Institute of Certified Public Accountants (AICPA) or the Financial Accounting Standards Board (FASB). The SEC has affirmed its support for the FASB by indicating that financial state- ments conforming to standards set by the FASB are presumed to have substantial authoritative support. In short, the SEC requires registrants to adhere to GAAP. In addition, the SEC indicated in its reports to Congress that “it continues to believe that the initiative for establishing and improving accounting standards should remain in the private sector, subject to Commission oversight.” SEC Oversight The SEC’s partnership with the private sector works well. The SEC acts with remarkable restraint in the area of developing accounting standards. Generally, the SEC relies on the FASB to develop accounting standards. The SEC’s involvement in the development of accounting standards varies. In some cases, the SEC rejects a standard proposed by the private sector. In other cases, the SEC

prods the private sector into taking quicker action on certain reporting problems, such as accounting for investments in debt and equity securities and the reporting of deriva- tive instruments. In still other situations, the SEC communicates problems to the FASB, responds to FASB exposure drafts, and provides the FASB with counsel and advice upon request. The SEC’s mandate is to establish accounting principles. The private sector, therefore, must listen carefully to the views of the SEC. In some sense, the private sector is the for- mulator and the implementor of the standards.4 However, when the private sector fails to address accounting problems as quickly as the SEC would like, the partnership between the SEC and the private sector can be strained. This occurred in the deliberations on the 4One writer described the relationship of the FASB and SEC and the development of financial reporting standards using the analogy of a pearl. The pearl (a financial reporting standard) “is formed by the reaction of certain oysters (FASB) to an irritant (the SEC)—usually a grain of sand—that becomes embedded inside the shell. The oyster coats this grain with layers of nacre, and ultimately a pearl is formed. The pearl is a joint result of the irritant (SEC) and oyster (FASB); without both, it cannot be created.” John C. Burton, “Government Regulation of Accounting and Information,” Journal of Accountancy (June 1982). Parties Involved in Standard-Setting 9 accounting for business combinations and intangible assets. It is also high- International lighted by concerns over the accounting for off-balance-sheet special-purpose Perspective entities, highlighted in the failure of Enron and, more recently, the subprime The U.S. legal system is based crises that led to the failure of IndyMac Bank. on English common law, whereby the government generally allows Enforcement professionals to make the rules. As we indicated earlier, companies listed on a stock exchange must submit their The private sector, therefore, financial statements to the SEC. If the SEC believes that an accounting or disclo- develops these rules (standards). sure irregularity exists regarding the form or content of the financial statements, Conversely, some countries have it sends a deficiency letter to the company. Companies usually resolve these followed codifi ed law, which deficiency letters quickly. If disagreement continues, the SEC may issue a “stop leads to government-run order,” which prevents the registrant from issuing or trading securities on the accounting systems. exchanges. The Department of Justice may also file criminal charges for viola- tions of certain laws. The SEC process, private sector initiatives, and civil and criminal litigation help to ensure the integrity of financial reporting for public companies. American Institute of Certifi ed Public Accountants (AICPA) The American Institute of Certified Public Accountants (AICPA), which is the na- tional professional organization of practicing Certified Public Accountants (CPAs), has been an important contributor to the development of GAAP. Various committees and boards established since the founding of the AICPA have contributed to this effort. Committee on Accounting Procedure At the urging of the SEC, the AICPA appointed the Committee on Accounting Proce- dure in 1939. The Committee on Accounting Procedure (CAP) composed of practicing CPAs, issued 51 Accounting Research Bulletins during the years 1939 to 1959. These bulletins dealt with a variety of accounting problems. But this problem-by-problem approach failed to provide the needed structured body of accounting principles. In response, in 1959 the AICPA created the Accounting Principles Board. Accounting Principles Board The major purposes of the Accounting Principles Board (APB) were to (1) advance the written expression of accounting principles, (2) determine appropriate practices, and (3) narrow the areas of difference and inconsistency in practice. To achieve these objectives, the APB’s mission was twofold: to develop an overall conceptual framework to assist in

the resolution of problems as they become evident and to substantively research indi- vidual issues before the AICPA issued pronouncements. The Board’s 18 to 21 members, selected primarily from public accounting, also included representatives from industry and academia. The Board’s official pronouncements, called APB Opinions, were in- tended to be based mainly on research studies and be supported by reason and analysis. Between its inception in 1959 and its dissolution in 1973, the APB issued 31 opinions. Unfortunately, the APB came under fire early, charged with lack of productivity and failing to act promptly to correct alleged accounting abuses. Later, the APB tackled numer- ous thorny accounting issues, only to meet a buzz saw of opposition from industry and CPA firms. It also ran into occasional governmental interference. In 1971, the accounting profession’s leaders, anxious to avoid governmental rule-making, appointed a Study Group on Establishment of Accounting Principles. Commonly known as the Wheat Committee for its chair Francis Wheat, this group examined the organization and operation of the APB and determined the necessary changes to attain better results. The Study Group submitted its recommendations to the AICPA Council in the spring of 1972, which led to the replacement of the APB with the Financial Accounting Standards Board (FASB) in 1973. 10 Chapter 1 Financial Accounting and Accounting Standards Changing Role of the AICPA When the FASB replaced the Accounting Principles Board, the AICPA established the Accounting Standards Executive Committee (AcSEC) as the committee authorized to speak for the AICPA in the area of financial accounting and reporting. It does so through various written communications: Audit and Accounting Guides summarize the accounting practices of specific indus- tries and provide specific guidance on matters not addressed by the FASB. Exam- ples are accounting for casinos, airlines, colleges and universities, banks, insurance companies, and many others. Statements of Position (SOPs) provide guidance on financial reporting topics until the FASB sets standards on the issue in question. SOPs may update, revise, International Perspective and clarify audit and accounting guides or provide free-standing guidance. Practice Bulletins indicate the AcSEC’s views on narrow financial reporting The CPA exam is administered issues not considered by the FASB. internationally at testing sites in Bahrain, Kuwait, Japan, The role of the AICPA in standard-setting has diminished. The FASB and Lebanon, United Arab Emirates the AICPA agree that the AICPA and AcSEC no longer will issue authoritative (UAE), and Brazil. The CPA exam accounting guidance for public companies. Furthermore, while the AICPA has now has some coverage of been the leader in developing auditing standards through its Auditing IFRS knowledge as part of the Standards Board, the Sarbanes-Oxley Act of 2002 requires the Public Company fi nancial reporting section of Accounting Oversight Board to oversee the development of auditing standards. the exam (see www.aicpa.org/ The AICPA continues to develop and grade the CPA examination, which is cpa-exam). administered in all 50 states. Financial Accounting Standards Board (FASB) The Wheat Committee’s recommendations resulted in the creation of a new standard- setting structure composed of three organizations—the Financial Accounting Foundation (FAF), the Financial Accounting Standards Board (FASB), and the Financial Accounting Standards Advisory Council (FASAC). The Financial Accounting Foundation selects the members of the FASB and the Advisory Council, funds their activities, and generally oversees the FASB’s activities. The major operating organization in this three-part structure is the Financial Accounting Standards Board (FASB). Its mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of financial information. The expectations of success and support for the new FASB relied on several significant differences between

it and its predecessor, the APB: 1. Smaller membership. The FASB consists of seven members, replacing the relatively large 18-member APB. 2. Full-time, remunerated membership. FASB members are well-paid, full-time mem- bers appointed for renewable 5-year terms. The APB members volunteered their part-time work. 3. Greater autonomy. The APB was a senior committee of the AICPA. The FASB is not part of any single professional organization. It is appointed by and answerable only to the Financial Accounting Foundation. 4. Increased independence. APB members retained their private positions with fi rms, companies, or institutions. FASB members must sever all such ties. 5. Broader representation. All APB members were required to be CPAs and members of the AICPA. Currently, it is not necessary to be a CPA to be a member of the FASB. Parties Involved in Standard-Setting 11 In addition to research help from its own staff, the FASB relies on the expertise of various task force groups formed for various projects and on the Financial Accounting Standards Advisory Council (FASAC). The FASAC consults with the FASB on major policy and technical issues and also helps select task force members. Illustration 1-2 shows the current organizational structure for the development of financial reporting standards.5 ILLUSTRATION 1-2 Financial Accounting Foundation Organizational Structure (FAF) for Setting Accounting Standards Purpose To select members of the FASB and GASB and their Advisory Councils, fund their activities, and exercise general oversight. Financial Accounting Standards Board Staff and Task (FASB) Forces Purpose Purpose To establish and improve standards of To assist Board on financial accounting and reporting for the reporting issues by guidance and education of the public, performing research, including issuers, auditors, and users of analysis, and writing financial information. functions. Financial Accounting Standards Advisory Council (FASAC) Purpose To consult on major policy issues, technical issues, project priorities, and selection and organization of task forces. Due Process In establishing financial accounting standards, the FASB relies on two basic premises. (1) The FASB should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession. (2) It should operate in full view of the public through a “due process” system that gives interested persons ample opportu- nity to make their views known. To ensure the achievement of these goals, the FASB follows specific steps to develop a typical FASB pronouncement, as Illustration 1-3 (page 12) shows. The passage of new FASB guidance in the form of an Accounting Standards Update requires the support of four of the seven Board members. FASB pronouncements are con- sidered GAAP and thereby binding in practice. All ARBs and APB Opinions implemented by 1973 (when the FASB formed) continue to be effective until amended or superseded by FASB pronouncements. In recognition of possible misconceptions of the term “principles,” the FASB uses the term financial accounting standards in its pronouncements. 5Other advisory groups, such as the Investors Technical Advisory Committee (ITAC), the Not- for-Profit Advisor Committee (NAC), the Valuation Resource Group (VRG), and the recently established Private Company Financial Reporting Committee (PCFRC), share their views and experience with the Board on matters related to projects on the Board’s agenda, from the perspective of various constituencies and/or in areas of specific expertise. 12 Chapter 1 Financial Accounting and Accounting Standards ILLUSTRATION 1-3 The Due Process System What do you think? of the FASB Topic B Topic A Pros Cons Topic C xxxxxxxxxxx xxxxxxx xxxxxxx xxxxxxx xxxxxxx xxxxxxx xxxxxxxxxxxxxx xxxxxxxxxxxxxxxxxx xxxxxxxxxxxxxx xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Preliminary Views Topics identified and placed Research and analysis conducted and Public hearing on proposed standard.

on Board's agenda. preliminary views of pros and cons issued. "Any more comments? Accounting Standards Update This will be your final .... . . . ...... chance." " GH Ae Are P ."is Accounting Standards Update Exposure Draft Board evaluates research and Board evaluates responses and public response and issues changes exposure draft, if necessary. exposure draft. Final standard issued. Types of Pronouncements The FASB issues two major types of pronouncements: 1. Accounting Standards Updates. 2. Financial Accounting Concepts. Accounting Standards Updates. The FASB issues accounting pronouncements through Accounting Standards Updates (Updates). These Updates amend the Accounting Stan- dards Codification, which represents the source of authoritative accounting standards, other than standards issued by the SEC. Each Update explains how the Codification has been amended and also includes information to help the reader understand the changes and when those changes will be effective. Common forms of amendments are accounting standards issued that address a broad area of accounting practice (such as the accounting for leases) or interpretations that modify or extend existing standards. Prior standard- setters such as the APB also issued interpretations of APB Opinions. A second type of Update is a consensus of the Emerging Issues Task Force (EITF), created in 1984 by the FASB. The EITF is comprised of representatives from CPA firms and financial statement preparers. Observers from the SEC and AICPA also attend EITF meetings. The purpose of the task force is to reach a consensus on how to account for new and unusual financial transactions that may potentially create differing financial reporting practices. Examples include accounting for pension plan terminations, reve- nue from barter transactions by Internet companies, and excessive amounts paid to takeover specialists. The EITF also provided timely guidance for the accounting for loans and investments in the wake of the credit crisis. The EITF helps the FASB in many ways. The EITF identifies controversial accounting problems as they arise. The EITF determines whether it can quickly resolve them or whether to involve the FASB in solving them. In essence, it becomes a “problem filter” for Generally Accepted Accounting Principles 13 the FASB. Thus, the FASB will hopefully work on more pervasive long-term problems, while the EITF deals with short-term emerging issues. We cannot overestimate the importance of the EITF. In one year, for example, the task force examined 61 emerging financial reporting issues and arrived at a consensus on approximately 75 percent of them. The FASB reviews and approves all EITF consen- suses. And the SEC indicated that it will view consensus solutions as preferred account- ing. Further, it requires persuasive justification for departing from them. Financial Accounting Concepts. As part of a long-range effort to move away from the APO 145 I12903NVDUS Financial problem-by-problem approach, the FASB in November 1978 issued the first in a series Accounting Series of Statements of Financial Accounting Concepts as part of its conceptual framework Statement of project. (The Concepts Statement can be accessed at http://www.fasb.org/.) The series sets Financial Accounting forth fundamental objectives and concepts that the Board uses in developing future Concepts No. 6 standards of financial accounting and reporting. The Board intends to form a cohesive Elements of Financial Statements a replacement of FASB Concepts Statement No. 3 set of interrelated concepts—a conceptual framework—that will serve as tools for solving FA(i Snc Bo Crp oo nr ca eti pn tg s a Sn ta a tm emen end tm Ne on .t 2of ) existing and emerging problems in a consistent manner. Unlike a Statement of Financial Accounting Standards, a Statement of Financial Accounting Concepts does not estab- lish GAAP. Concepts statements, however, pass through the same due process system (preliminary views, public hearing, exposure draft, etc.) as do standards statements. GENERALLY ACCEPTED