AUDITING

An International Approach
FOURTH EDITION

Wally J. Smieliauskas, Ph.D., C.P.A., C.F.E.

Joseph L. Rotman School of Management
University of Toronto

Kathryn Bewley, Ph.D., C.A.

York University

Toronto Montréal Boston Burr Ridge, IL Dubuque, IA Madison, WI

New York San Francisco St. Louis Bangkok Bogotá Caracas
Kuala Lumpur Lisbon London Madrid Mexico City Milan
New Delhi Seoul Singapore Sydney Taipei
Auditing
An International Approach
Fourth Edition

Copyright © 2007, 2004, 2001, 1998 by McGraw-Hill Ryerson Limited, a Subsidiary of The McGraw-Hill
Companies. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any
means, or stored in a data base or retrieval system, without the prior written permission of McGraw-Hill Ryerson
Limited, or in the case of photocopying or other reprographic copying, a license from The Canadian Copyright
Licensing Agency (Access Copyright). For an Access Copyright licence, visit www.accesscopyright.ca or call toll
free to 1-800-893-5777.

ISBN-13: 978-0-07-095169-3
ISBN-10: 0-07-095169-1
1 2 3 4 5 6 7 8 9 10 TCP 0 9 8 7
Printed and bound in Canada
Care has been taken to trace ownership of copyright material contained in this text; however, the publisher will
welcome any information that enables them to rectify any reference or credit for subsequent editions.

EDITORIAL DIRECTOR: Joanna Cotton

SPONSORING EDITOR: Rhondda McNabb
DEVELOPMENTAL EDITORS: Hope Miller/Marcia Luke
MARKETING MANAGER: Joy Armitage Taylor
SENIOR EDITORIAL ASSOCIATE: Christine Lomas
COPY EDITOR: Shirley Corriveau
PRODUCTION COORDINATOR: Zonia Strynatka
COVER DESIGN: Dianna Little
COVER IMAGE CREDIT: © ImageState/Almay
PAGE LAYOUT: Bookman Typesetting
PRINTER: Transcontinental Printing Group

National Library of Canada Cataloguing in Publication

Smieliauskas, Wally
Auditing / Wally J. Smieliauskas, Kathryn Bewley. — 4th Canadian ed.
Includes index.
Second Canadian ed. written by Jack C. Robertson, Wally J. Smieliauskas
ISBN-13: 978-0-07-095169-3
ISBN-10: 0-07-095169-1
1. Auditing—Textbooks. I. Bewley, Kathryn, 1955- II. Title.
HF5667.S567 2006 657'.45 C2006-904928-9
W. J. Smieliauskas dedicates this book to
Fabrice and Adrian

Kathryn Bewley dedicates this book to

her husband
About the Authors
Wally J. Smieliauskas is a professor of accounting at the University of Toronto, where he
has been a member of the faculty since 1979. In 1987 he served as chair of the CAAA’s
Expectation Gap Task Force, which made a submission to the MacDonald Commission.
Also in 1987, he co-chaired the CAAA conference that had as invited speaker Nobel lau-
reate Herbert Simon.
Professor Smieliauskas is a certified public accountant and has worked in industry and
public accounting. He spent his 1986–87 sabbatical year with the firm of Deloitte & Touche.
Professor Smieliauskas is a member of the American Institute of Certified Public
Accountants, the Canadian Academic Accounting Association, and the Association of
Fraud Examiners.
Professor Smieliauskas’s research and writing interests include auditing and the role of
accounting in society. He has published numerous articles on educational and technical
topics in such journals as Accounting Review, Contemporary Accounting Research, Journal
of Accounting Research, Journal of Accounting Literature, and Auditing: A Journal of
Practice and Theory. In 1999, the Canadian Academic Accounting Association published
his research monograph entitled “A Framework for Assurance Evidence and Its Role in
Accounting.” This monograph has been extensively cited and quoted in the International
Federation of Accountants Issues Paper on the Foundations of Assurance Principles
published in April 2003.
At the University of Toronto, Professor Smieliauskas developed the first degree-credit
introductory auditing course (in 1981) and the first advanced auditing course (in 1990). In
1988 he was the first director of the MBA Co-op Program in Professional Accounting, a
position he held until 1993. The program is designed to facilitate the entry of undergradu-
ates from various fields into the profession, and to provide a broader management educa-
tion as well as specialized training in accounting, auditing, and tax topics. It has evolved
to become the Master of Management & Professional Accounting (MMPA) program now
offered through the University of Toronto’s Mississauga campus.

Kathryn Bewley has been a professor of accounting and auditing at York University since
1991. As well, she is a member of the Institute of Chartered Accountants of Ontario.
Professor Bewley began her career in auditing with Clarkson Gordon in Toronto.
Professor Bewley has her PhD from the University of Waterloo. Her main research focus
is on the impact of regulations, including auditing standards, on the information companies
report and how people use that information, with a particular interest in environmental
reporting. Her work has been published in several professional and academic journals.
Brief Contents
Preface xvii

PART I
INTRODUCTION TO AUDITING, PUBLIC PRACTICE, AND PROFESSIONAL RESPONSIBILITIES

Chapter 1 Professional Practice 1

Chapter 2 Audit, Assurance and Quality Control Standards 27
Chapter 3 Reports on Audited Financial Statements and Audited Internal Control Statements 59
Chapter 4 Professional Ethics and Auditor Responsibilities 87
Chapter 5 Legal Liability and Corporate Governance Issues 129

PART II
BASIC AUDITING CONCEPTS AND TECHNIQUES

Chapter 6 Understanding the Client’s Business and Risks 161

Chapter 7 Information Systems, Technology, and Internal Controls 210
Chapter 8 Audit Planning: Concepts and Tools 254
Chapter 9 Internal Control Evaluation and Testing 313
Chapter 10 Audit Sampling 370

PART III
AUDIT APPLICATIONS

Chapter 11 Revenues, Receivables, and Receipts Process 423

Chapter 12 Purchases, Payables, and Payments Process 469
Chapter 13 Production and Payroll Process 510
Chapter 14 Finance and Investment Process 552
Chapter 15 Completing the Audit 589

PART IV
OTHER PROFESSIONAL SERVICES

Chapter 16 Other Public Accounting Services and Reports 627

Chapter 17 Fraud Awareness Auditing 682
Chapter 18 Internal Auditing and Public Sector Auditing 737

Index
Contents
Preface xvii

PART I
INTRODUCTION TO AUDITING, PUBLIC PRACTICE, AND PROFESSIONAL RESPONSIBILITIES

Chapter 1 Professional Practice 1

Learning Objectives 1
Introduction: The Coming of Age of the Audit Society 2
User Demand for Reliable Information 5
Definitions of Auditing 6
The Current Environment of Auditing 10
Other Kinds of Audits and Auditors 12
Public Accounting 15
Regulation of Public Accounting 19
International Auditing 22
Summary 22
Multiple-choice Questions for Practice and Review 23
Exercises and Problems 24
Appendix 1A: How to Become A PA in Canada 26
Appendix 1B: Brief History of Auditing (Online)

Chapter 2 Audit, Assurance, and Quality Control Standards 27

Learning Objectives 27
Practice Standards 28
Generally Accepted Auditing Standards (GAAS) 28
GAAS Reporting Standards 34
Overview of the Audit Process 38
Professional Skepticism and Critical Thinking 43
Assurance Standards 44
Quality Control Standards 50
Summary 54
Multiple-choice Questions for Practice and Review 55
Exercise and Problems 56

Chapter 3 Reports on Audited Financial Statements and

Audited Internal Control Statements 59
Learning Objectives 59
Association with Financial Statements 60
Levels of Assurance 61
Standard Unqualified Report and Variations 62
 Contents vii

Audit Report Reservations 64

Unqualified Opinion with Explanation or Modification 71
Audit Reports on Internal Control Statements 76
Reporting on the Application of Accounting Principles 79
Summary 80
Multiple-choice Questions for Practice and Review 81
Exercises and Problems 82
Appendix 3A: Additional Audit Report Topics (Online)
Appendix 3B: ISA 700 86

Chapter 4 Professional Ethics and Auditor Responsibilities 87

Learning Objectives 87
Rules of Professional Conduct and Code of Ethics 94
Independence and Objectivity 99
Regulation and Quality Control 113
Consequences of Unethical/Illegal Acts 118
Summary 119
Multiple-choice Questions for Practice and Review 119
Exercises and Problems 121
Discussion Cases 124
Appendix 4A: Framework for Critical Thinking (Online)

Chapter 5 Legal Liability and Corporate Governance Issues 129

Learning Objectives 129

The Legal Environment 130
Liability Under Common Law 132
Auditor’s Liability Under Statutory Law 145
Other Issues 149
Summary 152
Multiple-choice Questions for Practice and Review 153
Exercises and Problems 154

PART II
BASIC AUDITING CONCEPTS AND TECHNIQUES

Chapter 6 Understanding the Client’s Business and Risks 161

Learning Objectives 161

An Overview of the Audit Engagement 162
Pre-engagement Arrangements 163
Understanding the Client’s Business, Its Environment and Risks 170
Business Risk Approach to Auditing 173
Effects of Information Technology and E-Commerce on Business Risk 177
viii Contents

Business Risk and the Risk of Material Misstatement 178

Business Information Sources and Methods 181
Management’s Financial Statements 184
Management Financial Statement Assertions and Audit Objectives 187
Strategic Systems Approaches to Business Analysis 191
Summary 193
Multiple-choice Questions for Practice and Review 194
Exercises and Problems 195
Discussion Cases 196
Appendix 6A: Frameworks for Strategic Analysis 205
Appendix 6B: Business Risk Factors 208

Chapter 7 Information Systems, Technology, and Internal Controls 210

Learning Objectives 210

Understanding Information Systems and Technology 211
Internal Control Components 216
Understanding Information Systems’ Internal Control and Risks 226
Simple Computer Systems: Characteristics and Control Considerations 234
Summary 250
Multiple-choice Questions for Practice and Review 250
Exercises and Problems 251

Chapter 8 Audit Planning: Concepts and Tools 254

Learning Objectives 254

Preliminary Analytical Procedures 255
Analysis of Management’s Draft Financial Statements 258
Preliminary Assessment of Planning Materiality 265
Audit Risk Assessment 273
Sufficient Appropriate Evidence in Auditing 283
Evidence-Gathering Audit Procedures 286
Planning Memorandum 295
Audit Programs 296
Audit Working Papers 298
Summary 304
Multiple-choice Questions for Practice and Review 305
Exercises and Problems 307
Discussion Cases 311
Appendix 8A: Selected Financial Ratios 312

Chapter 9 Internal Control Evaluation and Testing 313

Learning Objectives 313

Internal Control and the Audit Plan 314
Understanding the Role of Systems in Control Evaluation 314
 Contents ix

Reasons for Control Evaluation 317

Management Versus Auditor Responsibility for Control 323
Control Objectives and Procedures 325
Phases of a Control Evaluation 328
Phase 1: Understanding the Internal Control 330
Phase 2: Assessing the Control Risk 337
Phase 3: Testing Controls 344
Auditor’s Responsibility to Detect and Communicate Material Control Weaknesses
and Misstatements 345
Control Evaluation and Cost-Benefit 347
Evaluation Approaches for Information Systems 348
Information Systems and Controls in a Small Business 359
Summary 360
Multiple-choice Questions for Practice and Review 361
Exercises and Problems 362
Appendix 9A: The Effects of E-Commerce on IT Auditors (Online)

Chapter 10 Audit Sampling 370

Learning Objectives 370

Introduction to Audit Sampling 371
Test of Controls for Assessing Control Risk 379
Substantive Procedures for Auditing Account Balances 392
Sampling Steps for Account Balance Audit 394
Summary 407
Multiple-choice Questions for Practice and Review 407
Exercises and Problems 409
Discussion Cases 411
Appendix 10A: Statistical Sampling Tables 414
Appendix 10B: Statistical Sampling Concepts for Tests of Controls and
Tests of Balances (Online)
Prelude to Part III 416

PART III
AUDIT APPLICATIONS

Chapter 11 Revenues, Receivables, and Receipts Process 423

Learning Objectives 423

Risk Assessment for Revenues, Receivables and Receipts 424
Revenues, Receivables and Receipts Process: Typical Activities 425
Audit Evidence in Management Reports and Data Files 430
Control Risk Assessment 431
Casettes: Substantive Audit Procedures 436
x Contents

Special Note: The Existence Assertion 443

Special Note: Using Confirmations 445
Special Note: Audit of Bank Reconciliations with Attention to Lapping and Kiting 452
Summary 457
Multiple-choice Questions for Practice and Review 457
Exercises and Problems 459
Discussion Cases 462
Appendix 11A: Internal Control Questionnaires 465
Appendix 11B: Substantive Audit Programs 468

Chapter 12 Purchases, Payables, and Payments Process 469

Learning Objectives 469

Risk Assessment for Purchases, Payables and Payments 470
Purchases, Payments and Payables Process: Typical Activities 470
Audit Evidence in Management Reports 472
Control Risk Assessment 475
Casettes: Substantive Audit Procedures 481
Special Note: The Completeness Assertion 490
Special Note: Physical Inventory Observation 491
Summary 495
Multiple-choice Questions for Practice and Review 496
Exercises and Problems 497
Discussion Cases 501
Appendix 12A: Internal Control Questionnaires 507
Appendix 12B: Electronic Data Interchange (EDI) Systems and Accounts Payable
Audits (Online)

Chapter 13 Production and Payroll Process 510

Learning Objectives 510

Risk Assessment for the Production and Payroll Process 511
Part I: Production Process: Typical Activities 512
Audit Evidence in Management Reports and Files 515
Control Risk Assessment 517
Casettes: Substantive Audit Procedures 522
Part II: Payroll Process: Typical Activities 526
Audit Evidence in Management Reports and Files 529
Control Risk Assessment 532
Casettes: Substantive Audit Procedures 537
Summary 540
Multiple-choice Questions for Practice and Review 540
Exercises and Problems 542
Discussion Cases 544
Appendix 13A: Internal Control Questionnaires 550
 Contents xi

Chapter 14 Finance and Investment Process 552

Learning Objectives 552

Risk Assessment for Finance and Investment Process 553
Finance and Investment Process: Typical Activities 553
Control Risk Assessment 559
Assertions, Substantive Procedures and Casettes for Finance and Investment
Accounts 564
Casettes 569
Other Aspects of Clever Accounting and Fraud 574
Summary 578
Multiple-choice Questions for Practice and Review 578
Exercises and Problems 579
Discussions Cases 582
Appendix 14A: Substantive Audit Programs 587
Appendix 14B: Derivative Securities—An Example of Risks that Management and
Auditors Face (Online)

Chapter 15 Completing the Audit 589

Learning Objectives 589

Introduction 590
Audit of Revenues and Expenses 590
A Sequence of Audit Events 595
Events Subsequent to the Balance Sheet Date 605
Responsibilities After the Audit Report Has Been Issued 608
Final Wrap-Up 611
Overall Evaluation of Audit Tests 614
Summary 617
Multiple-choice Questions for Practice and Review 617
Exercises and Problems 618
Appendix 15A: Sample Audit Working Papers 625

PART IV
OTHER PROFESSIONAL SERVICES

Chapter 16 Other Public Accounting Services and Reports 627

Learning Objectives 627

Introduction 628
Unaudited Financial Statements 628
Other Review and Compilation Topics 633
Interim Financial Information 635
Special Reports and AADBA 638
Reporting on Internal Control 646
xii Contents

Forecasts and Projections 660

Financial Statements for Use in Other Countries 666
The Assurance Framework 667
The Association Framework 672
Summary 674
Multiple-choice Questions for Practice and Review 676
Exercises and Problems 678
Discussion Cases 681
Appendix 16A: Assurance Engagements for E-Business (Online)

Chapter 17 Fraud Awareness Auditing 682

Learning Objectives 682

Introduction 683
Definitions Related to Fraud 683
Auditors’ and Investigators’ Responsibilities 687
Conditions That Make Fraud Possible, Even Easy 695
Fraud Prevention 698
Fraud Detection 702
Bribery and Corruption: A New Global Social Concern 705
Schemes and Detection Procedures 710
Some Newer Approaches to Fraud Detection 712
Documents, Sources and “Extended Procedures” 718
After Discovering a Fraud 725
Fraud Audits as Assurance Engagements 729
Summary 731
Multiple-choice Questions for Practice and Review 731
Exercises and Problems 733
Discussion Cases 736

Chapter 18 Internal Auditing and Public Sector Auditing 737

Learning Objectives 737

Internal, Public Sector and External Audits 738
Definitions and Objectives 743
Internal Auditing Standards 746
Economy, Efficiency and Effectiveness Audits 747
Summary 750
Multiple-choice Questions for Practice and Review 751
Exercises and Problems 752
Discussion Cases 754
Appendix 18A: The Changing Role of Internal Auditors in Corporate Governance
(Online)

Index
Preface to the Fourth Edition

This is the first edition co-authored with Kate Bewley and we are sure that readers will
notice the substantial improvements that have ensued. Although Kate has been involved in
earlier editions, the dynamics this time have totally changed. Kate has replaced retired co-
author Jack Robertson, Professor Emeritus, University of Texas at Austin. Jack has left us
with a strong foundation on which to build an auditing text for the 21st century. Kate has
greatly facilitated the evolution of what started as a Canadian adaptation of an American
audit text into a uniquely Canadian text with an international orientation. We are confident
that our approach is well suited to meeting the needs of professional accountants in an age
of international convergence of audit standards. Welcome aboard, Kate!
In this our fourth edition, we have updated the myriad of professional developments that
have taken place in the post-Enron environment. These include the creation of the public
accountability boards and their monitoring activities, and increasing emphasis on corporate
governance, internal controls, risk-based auditing, independence, and quality controls. In
this edition, we summarize these developments through mid-2006, offering our perspective
on their significance. We refer to this dramatically altered corporate landscape as the “post-
Enron audit environment.” In this new environment, we see not only radical changes in audit
standards and the regulatory environment, but also significantly revised expectations of the
auditor’s role in corporate governance and capital markets. This environment is character-
ized by more risks for auditors and their clients than ever before, as well as more restric-
tions on non-audit services for audit clients.
Fraud, corporate governance, independence risk, the role of audit committees, global
convergence of audit and accounting standards and information technology have all become
more prominent since the third edition; consequently, all these issues have been updated for
the fourth edition. As in past editions, we continue to provide thorough coverage of audit-
ing at the conceptual and procedural levels. Overall, we hope that students come away with
a well-rounded and forward-looking learning experience in the field of auditing.

WHAT’S NEW IN THE FOURTH EDITION

This fourth edition has a number of compelling features designed with students in mind.
Each concept has been carefully developed/revised to facilitate the ease and enjoyment of
your auditing learning experience. The following is a list of these integral features:
• extensive CICA Handbook changes through mid-2006 that incorporate a risk-based
approach to auditing
• updated referencing to International Standards on Auditing (ISAs) and their conver-
gence with Canadian auditing standards
These include:
• understanding the audit client’s business, its operating environment, and risks
• assessing the risk of material misstatement in the financial statements on an asser-
tion-by-assertion basis
• developing auditing objectives and gathering evidence with auditing procedures
• making judgements about the fair presentation of financial statement assertions
• a significant reorganization of topics, placing professional ethical and legal respon-
sibilities at the beginning of the text, and integrating strategic systems auditing (SSA)
and information technology (IT) throughout
xiv Preface

• an innovative introduction of critical-thinking concepts integrating ethical, accounting,

as well as auditing theory to help structure professional audit decision making and
analysis in financial reporting
• a pioneering chapter on fraud awareness, of which fraud detection procedures are inte-
grated in the rest of the text
• strategic systems auditing, seen in previous editions, is now used throughout the text
to help explain business risk and risk-based auditing
• information systems and information technology topics integrated with the coverage of
internal control and control evaluation in audit planning
• comprehensive coverage of the assurance engagement concept as it applies now to
internal auditing, audits of internal control, as well as to external and public sector
auditing
• website appendices on the more technical aspects of statistical sampling in auditing,
corporate governance, critical thinking, integrating auditing, accounting, and ethical
reasoning
• various updated anecdotes, asides, and “casettes” (short cases) that all enrich the text
material
• several new critical-thinking and Internet assignment questions complement the
preceding changes

KEY FEATURES

International Auditing
This edition continues the incorporation of international auditing standards. Since the last
edition, the rigour and acceptability of International Standards on Auditing (ISAs) as issued
by the International Federation of Accountants (IFAC) continues to grow. At the time of
writing, Canadian auditing standards are in the process of harmonizing coverage with the
ISAs, and thus are becoming very similar. This edition provides CICA Handbook Assurance
section references and the corresponding ISA references whenever these exist. References
to U.S. auditing standards, issued by the PCAOB for public companies and the AICPA for
non-public companies, are included when these are important in the Canadian environment.
This brings students to the leading edge of auditing and responds to the increasing focus on
international auditing and accounting standards in the real world of business management.

CICA Handbook Assurance Recommendation Updates:

Risk-based Auditing
The major change in CICA Handbook Assurance Recommendations since the last edition
is the introduction of CICA Handbook, sections 5141 and 5143, requiring a risk-based
approach to auditing. Related changes to other CICA Assurance Recommendations have
also been incorporated. All these changes bring the CICA Assurance Recommendations
closer to international auditing standards. This edition includes these newly issued stan-
dards as enacted to mid-2006, taking the view that they incorporate best practices formally
into the professional standards. In particular, the new risk-based approach builds on the
idea of the strategic systems approach to auditing, developed in the 1990s, that the audi-
tor needs to understand the client’s business as management runs it in order to conduct an
effective audit. By formally placing these business risk assessment requirements into
the standards, the CICA has linked these requirements more clearly to the generally
accepted auditing standards (GAAS), which outline the required procedures and judge-
ments supporting the auditor’s opinion on whether the financial statements are materially
misstated.
xv Preface

Fraud Auditing
This text was the first to contain full-chapter coverage of fraud awareness auditing, a crucial
topic in the new millennium. With the rapid global growth in white-collar crime, especially
that of fraudulent financial reporting, auditors have had to take more responsibility for fraud
detection, particularly in the area of premature revenue recognition. The basic purpose of the
fraud chapter (Chapter 17) is to create awareness of, and sensitivity to, the signs of potential
errors, irregularities, frauds, and corruption. The chapter contains some unique insights on
extended auditing and investigation procedures. In addition, fraud coverage is integrated
throughout the text, consistent with the increased need for auditors to detect fraud.

Post-Enron Environment
As previously mentioned, a most compelling change to this new edition is the incorporation
of a post-Enron perspective throughout the text. This perspective includes the changes to the
auditing standards, the regulatory environment, and society’s expectations, as well as an
analysis of the significance of these changes. Specific post-Enron topics include: increased
monitoring of the profession by accountability boards such as CPAB, increased emphasis
on good corporate governance, the increased importance of audit committees, independence
guidance, fraud risk assessments, the risk-based audit approach, and increased liability due
to statutory law.

Critical Thinking
The pioneering coverage of logical argumentation in auditing has been expanded to the
broader concept of critical thinking. Such an expanded approach to a more formalized scep-
ticism incorporates assessments of the character of individuals with whom the auditor deals,
the language used in the reasoning, as well as the logic of the reasoning. Such an approach
to scepticism and ethical reasoning is increasingly important in detecting fraudulent finan-
cial reporting. Critical thinking provides an improved framework for tackling issues that
require integration of ethical, accounting, as well as audit reasoning. Critical-thinking con-
cepts are first introduced in Chapter 2, and then are found integrated throughout the text
where appropriate, as well as in new critical-thinking discussion questions.

Learning Aids
Each chapter and section in Auditing: An International Approach contains a number of ped-
agogical features that both enhance and support the learning experience. They include the
following:
• Learning Objectives. Each chapter opens with a new presentation of pertinent learn-
ing objectives for the following chapter material. These are repeated as marginal notes
throughout the chapters. In addition, all Exercises and Problems, and Discussion Cases
are cross-referenced to their corresponding Learning Objectives to assist student
learning.
• Professional Standards References. Each chapter references the relevant professional
standards for the chapter topics.
• Anecdotes and Asides. Illustrative anecdotes and asides are found throughout the text
and have been updated considerably with this new edition. Some are located within the
chapter text, while others stand alone (in boxes) to add realism and interest for students.
The result is a real-world flavour to the treatment of auditing.
• Exhibits. To assist in the learning process, we have included several more exhibits in
this edition to visually illustrate teaching concepts.
• Icons for Critical Thinking, Fraud/Ethics, International Standards, and Internet
Assignments. For quick and easy identification purposes, we have included these icons
to flag the text material dealing with these major issues.
xvi Preface

Casettes
The “casettes” are a feature, unique to this text, which are presented as short stories struc-
tured to reveal error, irregularity, or fraud in an account. An audit approach follows, which
describes an audit objective, desirable controls, and tests of control procedures and audit of
balance procedures that can result in discovering the situation. The casettes occur in the
“applications” chapters (Chapters 11-14), and also in Chapter 17.
The purpose of the casettes is to enliven the study of auditing. They replace the typical
lengthy exposition of auditing fundamentals with illustrative situations based on real events.
There are 23 casettes with auditing approaches in the applications chapters. Another 20
casettes are in the end-of-chapter discussion case sections. The case stories are told in these
and the students’ assignment is to write the audit approach sections.

Key Terms
Throughout the text, key terms are highlighted in boldface print. An alphabetical key terms
reference list with definitions is in the back of the text.

Kingston Case
The Kingston Company case is a practice case, which appears on the Online Learning
Centre for this text (www.mcgrawhill.ca/college/smieliauskas), and accompanies this
fourth edition. The company description starts in Chapter 6 and continues through to
Chapter 15. Assignments related to the Kingston case connect many of the technical topics
in a logical sequence of auditing engagement activities. However, there are numerous exer-
cises, problems, and discussion cases at the end of each chapter that are unrelated to the
Kingston Company. To enhance clarity, the case material is integrated throughout the text.

ORGANIZATION

Part I—Introduction to Auditing and Public Practice

Part I consists of five chapters covering the basic orientation to auditing as a profession.
Chapter 1 introduces the concept of auditing and the role of the public accounting profes-
sion. Chapter 2 introduces generally accepted auditing standards, assurance standards, and
quality control standards, providing an overview of the audit process. Chapter 3 covers audit
reports, including audits of internal control over financial reporting. Chapter 4 discusses pro-
fessional ethics including a technical appendix on critical thinking. Chapter 5 covers pro-
fessional legal responsibilities, including technical appendices on the effects of recent
legislation and an introduction to basic corporate governance concepts as it affects the
auditor.

PART II—Basic Auditing Concepts and Techniques

Part II is organized to present financial statement auditing from the business risk perspec-
tive. Chapter 6 starts this off with a discussion of how auditors obtain an understanding of
the client’s business, its environment, and its risks, and how this knowledge is used to
assess the risk that the financial statements are materially misstated. It explains the link
from the business strategy to its business processes and the related accounting cycles that
create the financial statements, and describes management’s assertions contained in the
financial statements. Chapter 7 expands on the business understanding by giving an
overview of information systems and information technology used in business to capture
and report financial information, and the controls used by management to reduce risks of
 Preface xvii

materially misstating this information. Chapter 8 presents the fundamental concepts and
tools that are used in planning the audit fieldwork, including materiality, audit risk, evi-
dence-gathering procedures, audit programs, and working paper documentation. Chapter
9 elaborates on internal control consideration in an audit engagement, describing control
risk assessment and control testing.
The topics presented in Chapters 6 to 9 provide a basis for developing an appropriate
overall strategy for the audit, the detailed audit plan, and specific programs used to perform
the audit. Chapter 10 covers the pervasive concept of audit testing, how testing is affected
by the audit risk model, and how representative testing can be implemented using the most
simple formulas and tables from statistical sampling. An extensive appendix to Chapter 10
provides more details on the technical aspects of statistical sampling, and is located in the
Online Learning Centre.

Part III—Audit Applications

Part III contains four chapters that address performing the work set out in a detailed audit
plan for the main business processes that will need to be managed in every organization, and
a fifth chapter that wraps it all up with audit completion considerations. The processes cov-
ered are as follows: the Revenues, Receivables and Receipts Process (Chapter 11); the
Purchases, Payables and Payments Process (Chapter 12); the Production and Payroll
Processes (Chapter 13); and the Finance and Investment Process (Chapter 14). Each of
these chapters provides an overview of the transactions, balances, and risks of misstatement
in the business process, the relevant controls, and auditing procedures. Short casettes are
used to illustrate the application of concepts and techniques in practice, and examples of
audit programs are provided to demonstrate the kinds of audit procedures that can be used.
Each of these chapters also provides an overview of the balance sheet approach as a basis
for the overall analysis of the financial statements. Chapter 15 presents various activities
involved in completing the audit work such as the audit of the revenue and expense accounts,
overall analytical review, lawyer’s letters, management representation letters, subsequent
events, and adjustments to the financial statements.

Part IV—Other Professional Services and Responsibilities

The three chapters in Part IV (Chapters 16 to 18) can stand alone or be integrated with the
preceding chapters. Chapter 16 deals with other assurance and some non-assurance services
offered by public accounting firms. Chapter 17 covers fraud awareness auditing in more
detail. It gives students a better understanding of the mindset and specialized procedures
needed to more effectively detect frauds. This chapter has benefited from our association
with the Association of Certified Fraud Examiners. Chapter 18 introduces students to the
standards, methodology, and reports of internal auditors and public sector auditors. Note that
Part IV and the advanced material of earlier chapters (often located on the Online Learning
Centre) can be used to develop the core topics for advanced auditing courses, if preferred.

PROFESSIONAL STANDARDS

This text contains numerous references to authoritative statements on auditing standards and
to standards governing other areas of practice. Even so, the text tries to avoid the mere rep-
etition of passages from the standards, concentrating instead on explaining their substance
and operational meaning in the context of making auditing decisions. Instructors and stu-
dents may wish to supplement the text with current editions of pronouncements published
by the International Federation of Accountants (IFAC), the Canadian Institute of Chartered
Accountants (CICA), the Certified General Accountants Association of Canada (CGA-
Canada), and the Institute of Internal Auditors (IIA).
xviii Preface

SUPPLEMENTS

Several additional resources for introductory auditing courses are available for instructors
and students:
CaseWare IDEA Software—Student Version: If practical, hands-on exposure to
CaseWare IDEA is important to your course objectives, there is now the option to package
a student version of CaseWare IDEA. Integrating the use of this software with the 4th edi-
tion of the text, student exercises requiring the use of CaseWare IDEA have been developed.
These are integrated with the text’s Kingston Company case and are available on the Online
Learning Centre.

Instructors’ Resource CD: The instructor support materials available on the Instructors’
Resource CD include:
• Instructors’ Resource Guide—The Instructor’s Resource Guide includes a description
of the Kingston Company case and a set of syllabi for organizing topical coverage.
Each chapter contains suggested answers for all the review checkpoints, multiple-
choice questions, Kingston Case assignments, exercises and problems, and discussion
cases. Blank forms for some homework assignments can be removed and copied for the
students. (Note: Also available as a downloadable from the Instructors area of the
Online Learning Centre)
• Computerized Test Bank—The Computerized Test Bank contains numerous multiple
choice, short-answer, and essay questions.
• Microsoft® PowerPoint® Slides—The PowerPoint® Slides offer a summary of chap-
ter concepts for lecture purposes. (Note: Also available as a downloadable from the
Instructors’ area of the Online Learning Centre)
Online Learning Centre—(www.mcgrawhill.ca/college/smieliauskas): The Online
Learning Centre serves as an extension of the text, providing supplements, additional con-
tent, and regularly updated material for students and instructors. The Information Centre
includes such material as the text Preface, Table of Contents, and a sample chapter. The
Student Edition contains an interactive student component with additional chapter ques-
tions, true/false questions, Internet exercises, and the Kingston case material and questions.
New to the fourth edition are also exercises, integrated with the Kingston case, which require
the use of CaseWare IDEA.

iLearning Sales Specialist

Your Integrated Learning Sales Specialist is a McGraw-Hill Ryerson representative who has
the experience, product knowledge, training, and support to help you assess and integrate
any of the following products, technology, and services into your course for optimum teach-
ing and learning performance. Whether it’s helping your students improve their grades, or
putting your entire course online, your iLearning Sales Specialist is there to help you do it.
Contact your local iLearning Sales Specialist today to learn how to maximize all of
McGraw-Hill Ryerson’s resources!

iLearning Services Program

McGraw-Hill Ryerson offers a unique iLearning Services package designed for Canadian
faculty. Our mission is to equip providers of higher education with superior tools
and resources required for excellence in teaching. For additional information visit
http://www.mcgrawhill.ca/highereducation/iservices.
ACKNOWLEDGEMENTS

The International Federation of Accountants (IFAC), the Certified General Accountants

Association of Canada (CGA-Canada), and the Canadian Institute of Chartered Accountants
(CICA) have generously given permission for liberal quotations from official pronounce-
ments and other publications, all of which lend authoritative sources to the text. In addition,
several publishing houses, professional associations and accounting firms have granted per-
mission to quote and extract from their copyrighted material. Their co-operation is much
appreciated because a great amount of significant auditing thought exists in this wide vari-
ety of sources.
We are also very grateful to the staff at McGraw-Hill Ryerson who provided their sup-
port, management skills, and ideas—especially our developmental editor, Hope Miller,
whose hard work and attention to detail kept us on track and transformed what we wrote into
a book.
A special acknowledgement is due Joseph T. Wells, former chairman of the Association
of Certified Fraud Examiners. He created the Certified Fraud Examiner (CFE) designation.
Mr. Wells is a well-known authority in the field of fraud examination education and his
entrepreneurial spirit has captured the interest of fraud examination professionals through-
out North America.
Special acknowledgement is also due to Steven E. Salterio of Queen’s University. Steven
contributed greatly to the strategic systems approach to auditing used in this text.
This text could not have been completed without the co-operation and input of our many
auditing students over the years. Special thanks go to Enola Stoyle for material that was
adapted in various forms in this text.
We are grateful to many people involved in the auditing profession in various roles who
generously shared their time and ideas with us over the years as the new materials for the
book took shape in our minds and on paper, including Jean Bédard, Janne Chung, Susan
McCracken, Steve Fortin, Genviève Turcotte, John Carchrae, James Sylph Alan Willis,
Robert Langford, Andre de Haan, Joy Keenan, Sylvia Smith, Dianne Hillier, Jan Munro,
Greg Shields, and Karen Duggan.
We would like to acknowledge our appreciation for the great academics and practition-
ers, who influenced us in various ways as we developed this text, including Ron Gage, Al
Rosen, Randy Keller, Don Cockburn, Dagmar Rinne, Morley Lemon, Ingrid Splettstoesser-
Hogeterp, Don Leslie, Larry Yarmolinsky, and Bill Scott, Efrim Boritz, Joel Amernic, Donna
Losell, Ulrich Menzefricke, Russell Craig, Kevin Lam, Yoshihide Toba, Takatoshi Hayashi,
Ping Zhang, Hung Chan, Len Brooks, Manfred Schneider, and Irene Wiecek. Also, we have
been inspired often by Rod Anderson’s 1984 text, The External Audit, which set out a log-
ical conceptual framework for auditing still stands the test of time.
And lastly, our sincere thanks go out to all the reviewers for their careful review and many
detailed and candid comments that were extremely useful in revising this new edition:
Christopher Batch of Wilfrid Laurier University, Ralph Cecere of McGill University, Peggy
Coady of Memorial University, Vincent Durant of St. Lawrence College, Brian and Laura
Friedrich of CGA-Canada, Concetta Gillard of Athabasca University, W. E. Gough of
Centennial College, Tom Kozloski of Wilfrid Laurier University, Shirley Lamarre of CGA-
Canada, Donna Losell of University of Toronto, Brad MacDonald of the Saskatchewan
Institute of Applied Science and Technology, Christine Maher of Conestoga College, Stuart
Munro of Sheridan College, Jagdish Pathak of University of Windsor, Louis W. Petro of
University of Windsor, Rand Rowlands of George Brown College, Stephen Spector of
Simon Fraser University, and Joan Wallwork of Kwantlen University College.
Wally Smieliauskas and Kate Bewley
June 2006