Hayes_ppr

30/01/2006

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Second
Edition

“Very accessible, especially for non-native English speaking students.”
Ron Crijns, Haagse Hogeschool, The Netherlands

The first text fully based upon International Standards on
Auditing (ISAs), this revised and updated new edition presents
a structured approach to auditing principles using ISAs as its
basis. More and more, the International Standards on
Auditing are regarded as the global benchmark for auditing
standards. This book describes the development and practical
use of all ISAs, as well as significant national standards in
different countries.
In addition to dealing with these new standards, the authors
explain important new developments from a regulatory point of
view. Emerging conceptual developments such as strategic
auditing and business risk are covered, as well as cutting-edge
audit techniques.
Features:
• The ONLY principles of auditing textbook fully based

www.pearson-books.com

Hayes Dassen
Schilder Wallage

• All audit concepts are illustrated with case study examples
from famous companies, such as Enron, Xerox, and
WorldCom, bringing the subject to life.

Principles of Auditing: An Introduction to International
Standards on Auditing is suitable for those studying
courses in auditing at undergraduate or postgraduate
levels. It will also be of interest to accounting
professionals looking for practical guidance on
International Standards on Auditing and recent
developments in the profession.

PRINCIPLES OF AUDITING

“The book is easy to navigate and easy to handle. I think the questions, exercises and cases are excellent.
The glossary is really excellent. This is the best glossary I have ever seen in an auditing textbook.”
Stellan Nilsson, Umeå School of Business and Economics, Sweden

An Introduction to International Standards on Auditing

“I found the book extremely easy to follow. In general I believe all the features of the book are very well
done. It seems to me there is a good balance in the difficulty of the student assignments: they range from
simple ‘repeat-the-book’ questions to more complex questions, requiring research and judgement. As an
all-purpose introduction to auditing with an international perspective, I believe the book is outstanding.”
Marcia Halvorsen, Göteborg University, Sweden


Companion Website resources
Visit the Companion Website at www.booksites.net/hayes
For lecturers
Complete, downloadable Instructor’s Manual
PowerPoint slides that can be downloaded and used as OHTs


Second Edition

PRINCIPLES OF AUDITING
An Introduction to International Standards on Auditing

Rick Hayes
California State University, Los Angeles

Roger Dassen
Deloitte Touche, Amsterdam
International Auditing and Assurance Standards Board (IAASB)
Free University of Amsterdam, University of Maastrict

Arnold Schilder
The Netherlands Central Bank
Basel Committee of Banking Supervisions Accounting Task Force
University of Amsterdam

Philip Wallage
KPMG, Amsterdam
University of Amsterdam


ISBN 0 273 68410 8
British Library Cataloging-in-Publication Data
A catalogue record for this book is available from the British Library.
Library of Congress Cataloging-in-Publication Data
A catalog record for this book is available from the Library of Congress.
10 9 8 7 6 5 4 3 2 1
08 07 06 05
Typeset in 10.5/12.5 pt Minion by 25.
Printed and bound in Great Britain by Ashford Colour Press Ltd. Gosport.
The publisher’s policy is to use paper manufactured from sustainable forests.


Contents
List of illustrations
Foreword by
Preface
Acknowledgements

1 International Auditing Overview
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11

Learning Objectives
Introduction
Theories on the Demand and Supply of Audit Services
Audit Regulation
Audit Firms
Audit Quality and Audit Fee Determination
Legal Liability
Some Developments in the Audit Market
Examples of Landmark Studies and Legislation that Influenced the
International Audit Market
2.10 Summary
2.11 Answers to Certification Exam Questions

xi
xv
xvii
xix

1
1
2
3
5
10
14
16
19
23
28
33

3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14

Learning Objectives
What Are Ethics?
The IFAC Code of Ethics for Professional Accountants
Ethics Guidelines Applicable to All Accountants (Part A)
Ethics Applicable to Professional Accountants in Public Practice (Part B)
Independence Requirements
Other Topics Applicable To Professional Accountants in Public Practice
Applicable To Employed Professional Accountants (Part C)
Enforcement of Ethical Requirements
Future Developments
Summary
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

4 An Auditor’s Services
4.1
4.2
4.3


vi

Learning Objectives
Client Acceptance: the First Step on the Journey to an Opinion
Evaluate the Client’s Background
Ability to Meet Ethical and Specific Competence Requirements
Use of Other Professionals in the Audit
Communicating With the Predecessor (Existing) Auditor
Acceptance by the Client – The Engagement Proposal
The Audit Engagement Letter

69
71

74
74
75
76
76
82
83
94
101
104
105
106
107
108
110

5.12

Summary
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

6 Understanding the Entity, Risk Assessment and Materiality
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9

Learning Objectives
Planning – Phase II of the Audit Process Model
Understanding the Entity and its Environment
Based on the Evidence, Assess Risk; Types of Risk
Planning Materiality
Summary
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

7 Internal Control and Control Risk
7.1


8 Control Risk, Audit Planning and Test of Controls
8.1
8.2
8.3
8.4
8.5
8.6
8.7

Learning Objectives
Understanding, Assessing and Testing Internal Controls
Understanding of Internal Controls and Documentation
Assessing Control Risk
Overall Responses to Assessed Risk
Prepare Planning Memorandum and Audit Plan
Tests of Controls

186
187
188
190

193
193
194
197
208
215
220

vii


CONTENTS

8.8
8.9
8.10
8.11
8.12

Evaluate Sufficiency and Appropriateness of Audit Evidence
Summary
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

9 Analytical Procedures
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
9.10
9.11
9.12


viii

Learning Objectives
Introduction
The Basis of Evidence
Sufficient Appropriate Audit Evidence
Substantive Audit Procedures
Audit Procedures for Obtaining Audit Evidence
Summary
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

304
305
307
309
310

317
317
318
319
324
326
333
335
337
341

391
392
392
397
400
401

Preface
Introduction
Definitions
Audit Evidence
Selecting Items for Testing to Gather Audit Evidence
Statistical versus Non-Statistical Sampling Approaches


CONTENTS

10.A.7
10.A.8
10.A.9
10.A.10

Design of the Sample
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

11 Completing the Audit
11.1
11.2

418
419

421
421
423
424
430
441
445
448
455
457
458
460
461
463
466

Appendix to Chapter 11
Audit Documentation and Working Papers

473

11.A.1
11.A.2
11.A.3
11.A.4
11.A.5
11.A.6

12.6
12.7
12.8

Learning Objectives
Introduction
Basic Elements of the Auditor’s Report
Types of Reports Expressing Audit Opinions
Matters that Do Not Affect the Auditor’s Opinion (Modification of an
Auditor’s Report Containing an Unqualified Opinion)
Circumstances That May Result in Other Than an Unqualified Opinion
Uncertainties Leading to Qualification of Opinions
Communications with those Charged with Governance

490
490
491
493
499
505
511
516
520

ix


CONTENTS

12.9

The Audit Planning Memorandum – Plan Part
Audit Program (Audit Plan)
Completion Memorandum
Summary
Answers to Certification Exam Questions
Notes
Questions, Exercises and Cases

14 Corporate Governance
14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8
14.9
14.10
14.11
14.12

Learning Objectives
Introduction
The Nature of Corporate Governance
Causes of Current Corporate Governance Discussions
Corporate Governance Structures
Corporate Governance Committees and Reports
Best Practice from a Global Perspective
Corporate Governance and the Role of the Auditor

602
604
606
617
624
626
627
630

Appendix A to Chapter 14
The Combined Code (UK): An Example of Auditors’ Review of Corporate
632
Governance Best Practice
Appendix B to Chapter 14
Governance and Auditing in a Public Interest Context
Glossary
Index
x

636
644
683


List of Illustrations

1.1
1.2
1.3
1.4

3.4

Ethical Principles
Three-Part Framework of IFAC Ethics Code
Independence in the Sarbanes-Oxley Act of 2002
Application of Ethics to Specific Situations (Topic and Applicable Paragraph
in the Code of Ethics for Professional Accountants)
Identification of Potential Threats to Auditors Independence
Examples of Safeguards Within Audit Firms
Considerations of Fees Charged to Clients
Considerations Concerning Incompatible Activities and Advertising
Considerations for Handling Clients’ Monies
Considerations Concerning Relations with Other Professional Accountants
Procedures to Change Auditors

75
77
84

3.5
3.6
3.7
3.8
3.9
3.10
3.11
4.1
4.2
4.3
4.4

97
98
99
115
118
119
125
128
130

132
133
134

xi


LIST OF ILLUSTRATIONS

4.10

4.13
4.14
4.15
4.16

Report on Summarized Financial Statements When an Unqualified Opinion
Was Expressed on the Annual Audited Financial Statements
Prospective Financial Report Examples
Illustrative Report Expressing An Unqualified Opinion On Management’s


6.1
6.2
6.3
6.4

Audit Process Model
Overview of the Proposed ISAs
Global Systems Perspective on Client Business Risk
Industry, Regulatory And Other External Factors, Including The Applicable
Financial Reporting Framework Auditors Should Consider
Considerations When Obtaining An Understanding Of The Nature Of
The Entity
Entity Level Business Model
Examples of Legal documents and Records to Consider in the Context of
Understanding the Entity’s Nature
Considerations Concerning Entity Objectives, Strategies And Related
Business Risks
Measurement and Review of the Entity’s Financial Performance
Important Characteristics of Analytical Procedures at Three Audit Stages
Documentation Formats for Strategic Risk and Significant Classes of
Transactions
Components of Audit Risk
Interrelationship of the Components of Audit Risk
Relationship between Inherent, Control and Detection Risk
Inverse Relationship Between Materiality and Audit Risk

195
196
199

Factors on Which to Assess Internal Control Environment
Risk Assessment Blank Evaluation Tool
Typical Input, Subsystems and Output of an Information System
Overview of Segregation of Duties
Overall Internal Control Evaluation Tool

136
139

200
202
203
204
206
206
207
209
212
212
213
217
232
236
241
244
245
248
254
258



The Analytical Review Process
Five Types of Ratio Analysis
Standard Client and Industry Ratios
Indications that the Going Concern Assumption Might be Questioned
The Four-Phase Analytical Review Process Using GAS

322
327
328
330
340

10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.A.1
10.A.2
10.A.3
10.A.4

Legal Evidence and Audit Evidence
Financial Statement Assertions Grouped by Substantive Test Areas
The Quality of Audit Evidence
Sufficient Appropriate Audit Evidence
Reliability of Evidence

Responsibilities of the Engagement Partner
Legal Letter
Management Representation Letter
Circumstances That May Indicate Unidentified Related Parties
Procedures to Identify Related Parties Transactions
Procedures to Identify Events That May Require Adjustment of,
or Disclosure in, the Financial Statements
Financial Statement Disclosure Checklist: Inventory
Typical Wrap-up Procedures
Review Checklist
Independent Review Checklist
Indications that the Going Concern Assumption Might be Questioned
Summary of Audit Process Documents
Significant Findings or Issues Documented
Sample Work Papers – Permanent File Contents

422
423
428
432
436
440
441

8.3

11.9
11.10
11.11
11.12

11.A.3
11.A.4
11.A.5
11.A.6

Sample Work Papers – Current File
Sample Work Papers – Account Analysis Schedule
Sample Work Papers – Interest and Long-term Debt Work Paper
Example of Digit-Position Indexing

480
482
484
485

12.1
12.2
12.3

492
497

12.14

Certification of Schlumberger Financial Statements by Corporate Officers
Sample Wording – Auditor’s Unqualified Report
Sample US Unqualified Report and Management’s Report on Responsibility
for Financial Reporting for Wm. Wrigley Jr. Company
Sample Wording – Limitation on Scope Qualified Opinion
Sample Wording – Inadequate Disclosure Adverse Opinion

Contents of Audit Planning Memorandum – Strategy Part
Contents of Audit Planning Memorandum – Plan Part
Audit Program
Contents of Completion Memorandum
Outline of Management Letter to Local
Summary of Unadjusted Audit Differences Found in the Audit

543
545
546
549
553
557
575
577
579

14.1
14.2
14.3
14.4
14.5

Causes of Current Discussions
Corporate Governance Structures
Corporate Governance Committees and Reports
Current and Future Business Reporting Models
Next Steps Enhanced Business Reporting

598



Foreword

In the last few years the auditing environment has changed dramatically. The failure of
Enron was perhaps the biggest single catalyst for change, but other corporate scandals, in
the US and in Europe, also led to serious concern about the quality of financial reporting
and corporate behavior. Inadequate audits, poor corporate governance, lax standards and
insufficient regulatory oversight were, to varying degrees, blamed for the problems. In
particular, the regulation of accounting firms and their auditing practices came under
intense scrutiny throughout the world, even in those jurisdictions that had not suffered
from a serious scandal.
The changes may have been swiftest and most radical in the United States of America,
where the Sarbanes-Oxley Act created a new regulatory regime for public company
auditing, but in other countries there have also been changes. In Europe, for example, the
proposed revisions to the EC’s 8th Directive on statutory audit have undoubtedly been
influenced by these recent events. Further restrictions have been placed on the ability of
auditors to provide non-audit services to their audit clients, standard setting in some
jurisdictions has been moved wholly or partly out of the hands of the auditing profession
and standard-setters have been looking closely at what can be done to improve the ability
of auditors to meet public expectations.
The International Auditing and Assurance Standards Board (IAASB), the independent
standards-setter that operates under the auspices of the International Federation of
Accountants (IFAC), has sought to respond effectively to the new environment. At the
time of the Enron scandal, IAASB was working on revising its core standards for the basis
of the audit process (the ‘audit risk model’ standards dealing with the identification of the
risks of error in financial statements and effective audit responses to those risks). The
finalization of those standards reflected the lessons learned from the recent scandals. The
standard on the auditor’s approach to the risk of fraudulent misstatement of financial
statements has also been recently revised and strengthened. Included in our current work

John Kellas
Chairman, International Auditing and Assurance Standards Board

xvi


Preface
This audit text in all editions is created and written from the point of view of the international student – the world’s future audit and accounting professional.
So much has changed in the audit profession since our first edition that this second
edition had to be no less than a major revision. The basic audit concepts remain as timeless as ever, but many of the rules have changed.
Oversight and governance issues have moved to the top of an auditor’s agenda. The US
Public Companies Accounting Standards Board (PCAOB), created by the Sarbanes–Oxley
Act of 2002, has become a powerful force in the US and the rest of the world. PCAOB has
declared existing US audit standards temporary and now set their own standards.
Corporate Governance has also become a high-priority concern for world governments
(e.g. EU revised 8th Directive, UK Combined Code).
Audit services have undergone extensive change. Ethics standards have been reconceptualized. What was once considered legitimate services for audit clients are now
forbidden. The International Auditing and Assurance Standards Board (IAASB) have
revised their International Standards on Auditing (ISAs) extensively, re-categorizing and
renumbering standards on review, prospective financial information, compilations and
agreed-upon services. The newly revised standards focus on the concept of risk.
There are whole new sets of international standards: International Standards on
Quality Control (ISQCs), International Standards on Review Engagements (ISREs),
International Standards on Assurance Engagements (ISAEs), and International Standards
on Related Services (ISRSs). Auditors are using other standards for their assurance
services such as sustainability reporting under Global Reporting Initiative (GRI).
Even before we co-authors began to write the first edition of this book over 10 years
ago, we all agreed that our only concern was to produce a high quality audit text for
the international student. This meant that it had to be fully up to date, use outstanding
material, have a sound balance of audit theory and real practice, and be based on international auditing standards. We were determined that this would be written from a truly

Rick Hayes, Roger Dassen,
Arnold Schilder, and Philip Wallage
July 29, 2004

xviii


Acknowledgements

This book was not the work of the co-authors alone, but also of the many professionals
and students who helped us shape our ideas and give depth to the knowledge contained
here.
First we would like to acknowledge the professional accountants who helped us: Lucas
Hoogduin, John Kellas, Wendy Kotterer, Herman Brons, and Elvira Könst.
We would like to thank these publishers and professional organizations: American
Accounting Association, American Institute of Certified Public Accountants, Canadian
Institute of Chartered Accountants, The Chartered Association of Certified Accountants
(ACCA), Chartered Institute Of Management Accountants, Institute of Chartered
Accountants of England and Wales, International Accounting and Assurance Standards
Board, International Federation of Accountants (IFAC), Royal NIvRA, Prentice Hall
Publishing Co.
In the writing of the book several individuals helped with the questions: Rong Hu,
Dizhou (Daisy) Chen, Stephanie Panzariello, and Ahava Goldman. We would like to also
thank the students in Hayes' auditing class at California State University at Los Angeles as
well as students at the University of Amsterdam and the University of Maastricht who
gave us very helpful comments.
And, of course, who can do any massive undertaking without the support of their families. We thank the Hayeses, Dassens, Schilders, and Wallages.

Publisher’s Acknowledgements
We would also like to express our gratitude to the following academics who provided

questions. Adapted and reprinted with permission from AICPA. Copyright © 2000 &
1985 by American Institute of Certified Public Accountants; AICPA are not responsible
for the suggested answers to the questions. Full responsibility for these is accepted by the
authors; and the Canadian Institute of Chartered Accountants, Toronto for CICA questions. Adapted with permission. Copyright © Canadian Institute of Chartered
Accountants. Any changes to the original material are the sole responsibility of the author
(and/or publisher) and have not been reviewed or endorsed by the CICA.
Illustration 4.1: based on International Auditing and Assurance Standards Board
(IAASB), 2003, Interim Terms of Reference and Preface to the International Standards on
Quality Control, Auditing, Assurance and Related Services, “Appendix”, International
Federation of Accountants, New York. Copyright © International Federation of
Accountants; Illustration 6.2: based on International Auditing and Assurance Standards
Board, 2002, Exposure Draft Audit Risk Proposed International Auditing, Assurance, and
Ethics Pronouncements, Appendix 2: Overview of the proposed ISA, International
Federation of Accountants, New York, October. Copyright © International Federation of
Accountants; Illustrations 6.3 and 6.6: from Bell, T., et al., 1997, Auditing Organizations
Through a Strategic-Systems Lens: The KPMG Business Measurement Process, KPMG, p.27
and p.31; Illustration 6.12: from AICPA, 1985, ‘Auditing Procedures Study’ in Audits of
Small Business, New York, p. 44; Illustration 7.1: from Committee of Sponsoring
Organizations of the Treadway Commission (COSO), 2002, Internal Control – Integrated
Framework, American Institute of Certified Public Accountants (AICPA), New Jersey.
In some instances we have been unable to trace the owners of copyright material and we
would appreciate any information that would enable us to do so.

xx


Chapter 1

INTERNATIONAL AUDITING OVERVIEW


■ Scribes of Ancient Times
Auditors existed in ancient China and Egypt. They were supervisors of the accounts of the
Chinese Emperor and the Egyptian Pharaoh. The government accounting system of the
Zhao dynasty in China included an elaborate budgetary process and audits of all government departments. From the dawn of the dynastic era in Egypt (3000 BC) the scribes
(accountants) were among the most esteemed in society and the scribal occupation was
one of the most prestigious occupations.
Egyptian Pharaohs were very severe with their auditors. Each royal storehouse used
two auditors. One counted the goods when they came in the door and the second counted
the goods after they were stored. The supervisor looked at both accounts. If there was a
difference, the auditors were both killed.
Bookkeeping as a support mechanism for the determination of profit or wealth, or as a
decision support system for achieving profit maximization, was basically unknown in
ancient cultures like the Mesopotamian, Egyptian, Greek or Roman. Auditing in Englishspeaking countries dates to 1130 AD. Then, although they had highly developed
economic systems, registration of economic facts or events was limited to the recording of
single transactions whose sole purpose was to support the short-term memory of the
trading partner.
Rational maximization of wealth or profit did not fit into the systems of these cultures.
Wealth was not a function of keen entrepreneurship or of smart cost–benefit trade-offs.
It was merely a reward for one’s loyalty to the government or for living in accordance with
religious and moral principles and rules.

■ Profit Maximization and Double Entry
The attitude of profit maximization emerged at the end of the Middle Ages, with the
emergence of large merchant houses in Italy. Trading was no longer the domain of the
individual commercial traveler; it was now coordinated centrally at the luxurious desks of
the large merchant houses in Venice, Florence or Pisa. As a result, communication
became vital. Not unexpectedly, therefore, the system of double entry bookkeeping was
first described in Italy, in Luca Pacioli’s Summa de Arithmetica dated 20 November 1494.
The practice of modern auditing dates back to the beginning of the modern corporation at the dawn of the Industrial Revolution. In 1853, the Society of Accountants was
founded in Edinburgh. Several other institutes emerged in Great Britain, merging in 1880

statements. To give them confidence in the financial statements, an auditor 2 provides an
independent and expert opinion on the fairness of the reports, called an audit opinion.

1.3 The Auditor, Corporations and Financial Information
■ The Importance of Auditing
It can be said that the function of auditing is to lend credibility to the financial statements.
The financial statements are the responsibility of management and the auditor’s responsibility is to lend them credibility. By the audit process, the auditor enhances the usefulness
and the value of the financial statements, but he also increases the credibility of other
non-audited information released by management. 3

■ The Expectations of Auditors
The importance of the company as a potential generator of wealth is increasingly
understood, and so is the impact that a company’s activities have on society and the
3


CHAPTER 1

INTERNATIONAL AUDITING OVERVIEW

environment. This has led to the expectation by investors that more information than just
financial statements should be provided about a company. Public expectations go further
and include questions such as:
■
■
■
■
■
■
■

With the explosion in the use of information technology the auditor needs sufficient
expertise, coupled with the knowledge of his client’s affairs, to enable him to obtain and
interpret all the evidence needed to provide reasonable assurance that the financial statements are fairly presented. The new auditing environment will demand new skills of
auditors if they are to be reporters and assessors of governance and measurements. They
must have a questioning mind and be able to analyze and critically assess evidence.

Certification Exam Question 1.15
An attitude that includes a questioning mind and a critical assessment of audit
evidence is referred to as:
(A)
(B)
(C)
(D)

4

Due professional care.
Professional skepticism.
Reasonable assurance.
Supervision.