Presentation Chapter 9.pptx

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External uditors’ Roles and

Responsibilities

Chapter IX



Chapter Objectives:• Recognize the role independent auditors play in achieving effective corporate

governance and reliable financial reports.

• Understand the history of auditing, the traditional roles of auditors, and regulations

recently placed on them.

• Address the expectation gap regarding what auditors can provide in the way of

reasonable assurance and the expectations of investors for a higher level of

assurance.

• Identify the roles and responsibilities of the PCAOB, and discuss the auditing

standards published by the PCAOB.

• Demonstrate the importance of auditor independence both in fact and in appearance.

• Discuss an integrated audit of both financial statements and ICFR.

• Address the issue of a liability cap for independent auditors, and understand the

rationale on both sides of the issue.

VIDEO ( VIDEO)

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Key TermsThe Accountancy Investigation Discipline Board (AIDB)

Audit quality

Audit riskAudit strategy

Auditor independence

Control risk

Detection risk

Expectation gap

Inherent risk

Integrated audit approach

Internal Revenue Service (IRS)

International Standards on Auditing (ISAs)

PCAOB-US

Professional Ethics ExecutiveCommittee (PEEC)

Standing Advisory Group (SAG)

Statements on Auditing Standards



External Auditing and Corporate

Governance



External Auditor Responsibility

Current auditing standards require that independent auditorsprovide re son ble ssur nce that the financial statementsare free from material misstatements, whether caused byerror or fraud, to render an unqualified opinion on the financialstatements.

External auditors are not and should not be expected toprovide absolute assurance regarding reliability of financialstatements, but the public expectations concerning externalauditors performance are high.

Users of audited financial statements generally expectexternal auditors to detect financial statement fraud andemployees’ illegal acts and fraud, which affects the integrityof financial reports. External auditors, however, are moreconcerned with material misstatements in the auditedfinancial statements.



Auditor Competency

1. Professional competencies. To audit public companies,

auditors should register with the PCAOB and meet all

registration and inspection requirements.

2. Technical competencies. Auditors should be knowledgeable

in professional standards, rules, laws and regulations, and

understand their clients’ industry and business, corporate

governance, financial reporting process, and internal

controls.

3. Process competencies. uditor’s ability to choose

appropriate evidence-gathering procedures (tests of

controls, substantive tests) and execute auditingprocedures

4. Reporting competencies. Reporting competencies refer to

the auditors’ ability and willingness to discover and report

material misstatements.



Reports Accompanying

Financial Statements

• Report on financial statements and related disclosures(prepared by auditor) Are financial statements and disclosures according to GAAP?

• Report on internal control over financial reporting(prepared by management) Has company maintained effective internal control over financial

reporting?

• Report on internal control over financial reporting

(prepared by auditor) Is management’s assessment of its internal control appropriate?

Has company maintained effective internal control over financialreporting?



The Purpose of the Audit Report

• Definition of auditing: “... communicating results tointerested users.”

• Indicate whether the FS are in accordance with GAAP Provide indication of what the FS would be like if GAAP were

followed

Provide any company-omitted disclosures

• Indicate any unusual aspects of the audit examination Scope limitations

Division of responsibility

• Indicate any unusual matters related to the company Going concern uncertainty

Consistency

Emphasize a matter



Four Categories of

Audit Reports• Standard unqualified (clean opinion)

• Unqualified with explanatory paragraph ormodified wording

• Qualified

• Adverse or disclaimer



Definitions: Webster’s New

Unabridged Dictionary

• Qualified:

Having met conditions or requirements set

Limited, modified

• Unqualified:

Not having the usual or requisite talents,

abilities, or accomplishments Not modified, limited, or restricted by conditions

or exceptions



Types of Audit ReportsType of Report Interpretation

Unqualified

Opinion

Financial statements taken as a whole present fairly

the financial position, results of operations, and cash

flows in conformity with generally accepted

accounting principles (GAAP).

Qualified Opinion ―Except for ‖ the effects of a particular matter, thefinancial statements present fairly the financial

position, results of operations, and cash flows in

conformity with GAAP.

Adverse Opinion Financial statements do not present fairly the financial

position, results of operations, and cash flows inconformity with GAAP.

Disclaimer of

Opinion

Auditor does not express an opinion on the financial

position, results of operations, or cash flows.



Unqualified Reports



Standard Unqualified Report

The five necessary conditions have been met:

1. All four required statements are included.

2. The three general standards have beenfollowed in all respects on the engagement.3. Sufficient evidence has been accumulated

and the auditor has conducted theengagement in a manner that enables theconclusion that the three standards of fieldwork have been met.



Standard Unqualified Report

4. The financial statements are presented in

accordance with GAAP (including adequate

disclosures.

5. There are no circumstances requiring the

addition of an explanatory paragraph or

modification of the report wording.



Auditnotice

Standard Unqualified Audit Report

(Nonlisted Companies)

Title Report of Independent Auditor

Address

to client

To the Board of Directors and stockholders of Any

company

Auditnotice

We have audited the accompanying balancesheets of Any company as of December 31, 1990

and 1989, and the related statements of income,

retained earnings, and cash flows for the year

then ended. These financial statements are the

responsibility of the company’s management. Our

responsibility is to express an opinion on these

financial statements based on our audits.

Identify

the

financial

statements

Management

responsibility

Auditor

responsibility

continued



Descriptio

n of the

audit

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 of

material 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 asevaluating the overall financial statement

presentation. We believe that our audit provides a

reasonable basis for our opinion.

No special

mention of

adequate

disclosure

or

consistenc

y

In our opinion, the financial statements

referred to above present fairly, in all material

respects, the financial position of Any company as

of December 31, 1990 and 1989, and the results

of its operations and its cash flows for the yearsthen ended in conformity with generally accepted

accounting principles.

Opinion on

financial

statement

s

Refer toGAAP

___________________________________,

CPAFebruary 28, 1991

Signature

Date



Audit Failures and Audit QualityFollowing is the list of the initiatives that have beensuggested to improve audit quality, as well as transparency.

1. Publication of audit engagement letters

2. Shareholders’ rights to question auditors3. Publication of auditor resignation statements

4. Lead audit partner’s signature on audit reports

5. Active audit committee participation in evaluating thescope and results of the integrated audit of both ICFR andfinancial statements

6. Mandatory rotation of the audit firm every seven to twelveyears in the context of the quality of audit work performedby the firm and the audit efficacy

7. Mandatory shareholder vote on the ratification of theindependent auditor each year



Public Company Accounting

Oversight Board The PCAOB created by SOX to regulate the auditing

profession.

The PC OB’s primary functions are to:

1. Register public accounting firms that audit public

companies.

2. Inspect the registered public accounting firms on a regular

basis.

3. Establish auditing, attestation, ethics, quality control, andindependence standards.

4. Conduct investigations and disciplinary proceedings.



PCAOB Auditing Standards

The PCAOB has issued five auditing standards as ofSeptember 2007:

1. PCAOB Auditing Standard No. 1 (audit is conducted inaccordance with auditing standards of PCAOBUS, the city and

state has to be disclosed)2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No.5 superseded AS No. 2 and requires the independent audit toopine only on the effectiveness of ICFR, not the managementprocesses and assessments concerning ICFR)

3. PCAOB Auditing Standard No. 3 (auditors are required to

maintain the audit documentation in a sufficient manner andkeep the records for at least seven years)

4. PCAOB Auditing Standard No. 4 (voluntary engagement forthe auditor’s report on thecompany’s elimination of previouslyreported material weaknesses in its ICFR)



20

Roles and Responsibilities—Internal Control over

Financial Reporting

• Management: Designs and implements the system ofinternal control over financial reporting; evaluates theeffectiveness of the company’s internal control over financialreporting and provides a public report on that assessment;

prepares the financial statements.• Audit Committee: Has responsibility for oversight of the

company’s financial reporting process.

• Independent Auditor : Performs an audit of internal controlover financial reporting and issues a report onmanagement’s assessment of internal control over financialreporting and on the effectiveness of internal control overfinancial reporting; also performs an audit of the company’sfinancial statements.



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What Management’s Report

Will Include

Under the SEC rules, management’s report on internal control overfinancial reporting should include the following information:

• Statement of management’s responsibility for establishing andmaintaining adequate internal control over financial reporting.

• Statement identifying the framework used by management to evaluate

the effectiveness of internal control over financial reporting.• Management’s assessment of the effectiveness of the company’s

internal control over financial reporting as of the end of the company’smost recent fiscal year, including an explicit statement as to whether thatcontrol is effective and disclosing any material weakness identified bymanagement in that control.

• Statement that the registered public accounting firm that audited thefinancial statements included in the annual report has issued anattestation report on management’s internal control assessment.



22

PCAOB Auditing Standard No. 2: An Audit of Internal Control over Financial Reporting Performed in Conjunction with

an Audit of Financial Statements

1. AS No. 2 required three integrated reports on:

a. Financial statements audited by registered public accounting

firms.b. Management’s assessment of the effectiveness of internal

control over financial reporting (Section 404).

c. The effectiveness of internal control over financial reporting

over financial reporting based on the auditor’s attestation of

internal control.2. AS No. 2 was effective beginning June 17, 2004.





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Report of Independent Registered Public

Accounting Firm

*The explanatory paragraph is required only when the auditor’s opinion is other than unqualified and may also be placed after the opinion paragraph

when the auditor issues two separate reports on the audit of financial statements and internal controls, thus making reference to opinion on the

financial statement audit in the report on the internal control audit.

1. Introductory

Paragraph

2. Scope

Paragraph

3. Definition

Paragraph

6. Inherent

LimitationsParagraph

5. Explanatory

Paragraph*

4. Opinion

Paragraph

7. Signature 8. City andState or

County

9. Date



25Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.









PCAOB Auditors Independence

The new rules restrict public accounting firms in

performing a variety of tax services to their audit clients.

The new rules are intended to prevent the selling of

abusive tax shelters.



Audit Committee Oversight of

External Auditors

The extended oversight responsibilities for the audit

committee are:

1. Appointment, compensation, and retention of registered

public accounting firms2. Preapproval of audit services and permissible nonaudit

services

3. Review of the independent auditor’s plan for an integrated

audit of both ICFR and annual financial statements

4. Review and discussion of financial statements audited orreviewed by the independent auditor

5. Monitoring the auditor’s independence

6. Auditor rotation requirement



Audit Committee Oversight of

External Auditors

The number of companies that change auditors, and the

number of auditors changed



Independent Auditors

Communications with the Audit

CommitteeCommunications from the committee to the

independent auditor:

Communications from the independent

auditor to the audit committee:

1. Appointment and retention approval of the

independent auditor

2. Formal approval of audit and permissible nonauditservices

3. Formal approval of fees for both audit and nonaudit

services with a keen focus on improving the quality of

audit and nonaudit services

4. Any concerns or risks threatening management’s

reputation and integrity, etc.

5. Allegations of financial statement fraud

1. Seeking committee preapproval of all audit and

nonaudit services in a timely manner

2. The critical accounting policies and practices used bymanagement in the preparation of financial statements

3. All alternative treatments of financial information within

GAAP

4. Any accounting disagreements between the

independent auditor and the company’s management

5. Any material, written communications between the

independent auditor and the company’s management

throughout the course of the audit

6. Significant deficiencies and material weaknesses ofICFR

7. The audit report on annual f inancial statements

8. The review report on quarterly financial statements

9. The audit report on management’s assessment of the

effectiveness of ICFR

10. The audit report on the effectiveness of ICFR

11. Financial risks associated with financial reports



Auditor Independence

Auditor Independence



Consolidation and Competition

in Public Accounting Firms SEC rules require public companies that change their public

accounting firms to file a Form 8-K, Item 4.01, to disclose

changes within four days, whereas auditors are required to

provide standard letters within ten days stating whether they

agree with the company’s disclosure without specifying anyreasons.



Integrated Audit Approach

Management assessment on

the effectiveness of ICFR

Effectiveness of both designand operation of ICFR based

on control criteria

Fair presentation of financialstatements in conformity withGAAP



Audit StrategyAudit Strategy:

1. No limited tests of controls

2. No use of cycle rotation in tests of controls

3. Dual testing of controls and substantive audit procedures

Auditors should focus on prevention, detection, and correction

of controls at both the company level and the transaction

level. Auditors should perform tests of controls as a basis for

forming an opinion on the effectiveness of ICFR. Auditorsshould also perform substantive tests as a basis for

expressing an opinion on the fair presentation of financial

statements, regardless of the identified significant

deficiencies and material weaknesses in internal controls.



The Audit

Video

http://www.youtube.com/watch?v=mkAfl2RmAZc&feature=fvw






Brief History Fraud Investigation• 1900s -- Fraud detection was a primary

objective of the audit

• 1940s -- Detection of fraud considered to bea ―responsibility not assumed‖

• 1960s -- Auditor acknowledged responsibilityfor detecting fraud that would normally beuncovered by an examination performed inaccordance with GAAS.

• 1980s -- Auditor had responsibility to searchfor fraud that may have a material affect onthe financial statements.

• 1997 -- SAS No. 82; 2002 – SAS No. 99

37



Types of Fraud

FRAUD

Management

Fraud

Employee

Fraud

Financial Statement Fraud

Misrepresentation of materialfacts

Misappropriation of assets

Concealment of material

facts

Illegal Acts

Bribery

Conflict of Interest

Embezzlement of money or

property

Breach of fiduciary duty

Theft of trade secrets of

intellectual property

Illegal acts



Why People Commit Fraud

Studies show that employees are likely to

commit fraud when four conditions exist:

– PRESSING FINANCIAL NEED – OPPORTUNITY

– REASONABLE JUSTIFICATION

– LACK OF MORAL PRINCIPLES

39



Embezzlement Formula

40

MOTIVE +

OPPORTUNITY +

RATIONALIZATION =

CRIME [FRAUD]



Profile of Fraud Perpetrators

41

The fraud perpetrator is more likely to be an ordinary member of thecommunity: intelligent, respected, never suspected of dishonesty,NOT YOUR TYPICAL CRIMINAL TYPE.

MORE LIKELY TO BE:

• A woman• Married

• Church member

• Older

• Heavier

• Have children• Have a higher education

• Never been arrested

• Have high self-esteem

• High achiever

LESS LIKELY TO BE:

• Divorced• Alcoholic

• Tattooed



Financial Statement Fraud

• Definition – Deliberate misstatements or omissionsof amounts or disclosures of financial statements todeceive financial statement users, particularlyinvestors and creditors

• Financial statement fraud has become a daily thing.Press reports challenge the corporate responsibilityand integrity of major companies such as Lucent,Xerox, Rite-Aid, Waste Management,Microstrategy, KnowledgeWare, Sunbeam,Cendent, and ZZZ Best, Enron, WorldCom, Qwest,Madoff, Satyam, Stanford Financial, and Parmalat.

42

Hi h P fil Fi i l t t t



High-Profile Financial statement

FraudBasis of the Fraud Older Example Year Recent Example Year

Fictitious revenue,

documentation forgery and

theft of corporate assets

ZZZZ Best

1987

Enron2001

Personal use of assets, falsedocumentation and financial

statement fraud

Phar-Mor 1992 Adelphia 2002

Capitalizing expenses, among

other issues

Waste

Management

1997 WorldCom 2002

Abuse of accounting

standards

Savings and Loan

Crisis

1982 Stock Options

Backdating 2006

S t f Fi i l



Symptoms of Financial

Statement Fraud

• Continuous Deterioration of Quality and

Quantity of Earnings

• Inadequacy of Cash Flow

• Overstatement of Inventories

• Overly Aggressive Accounting

• Management ―Short-termism‖ • Improper Revenue Recognition

• Overstatement of Assets



Elements of Fraud

• A false representation of a material nature

• Knowledge that the representation is false orreckless disregard for the truth (Scienter)

• Reliance on the false representation by thevictim

• Financial damages are incurred (to the

benefit of the perpetrator).• The act was intentional.



Auditor and Investigator

Responsibilities

• External Auditors (CPAs) SAS 99: Consideration of Fraud in a Financial Statement Audit

– Design audit to provide reasonable assurance of detecting fraud that could havea material effect on the financial statements.

– Perform fraud-related procedures

SAS 54: Illegal Acts

– Focused primarily is on direct-effect illegal acts SAS 61: Communication with Audit Committees

• Internal Auditors (CIAs) SIAS 3: Deterrence, Detection, Investigation, and Reporting of Fraud

• Governmental Auditors Focus on laws and regulations (compliance), design audit to detect abuse

and illegal acts, report to the appropriate authority• Certified Fraud Examiners (CFEs)

Assignments begin with predication (probable cause)

46



Auditor’s Responsibility for

Detecting Fraud

• GAAS makes NO DISTINCTION

between the auditor’s responsibilities for

searching for errors or for fraud

• Per SAS No. 99, auditors must

specifically assess the risk of material

misstatement due to fraud

47



Assessing the Risk of Fraud• Pressure or incentive to commit the fraud

Direct financial gain, such as misappropriationof assets or retaining job

Indirect financial gain, such as increase instock price

• Perceived opportunity to commit the fraud

Can fraud be perpetrated without detection?

48



Misappropriation of Assets

Risk Factors

• Susceptibility of assets

to misappropriation

• Employee relationships

or pressures

• Deficiencies in internalcontrol

49



Red Flags

• Personal financial pressure

• Vices (drugs, alcohol or gambling)

• Extravagant lifestyles

• Real or imagined grievances againstcompany

• Related parties

• Increased stress

• Internal pressures

50



How Frauds Occurred

• Poor internal controls

• Management override of internal controls

• Collusion between employees and thirdparties

• Collusion between employees or

management• Lack of control over management

• Poor or nonexistent corporate ethics policy

51



Reasons Auditors Fail to Detect Fraud

• Over reliance on client representations

• Lack of awareness or failure to recognize

that an observed condition may indicate a

material fraud

• Lack of experience

• Personal relationships with clients

52



SAS No. 99

53

Rationalization

Incentives/Pressures

Opportunities

The Fraud Triangle



The Fraud Triangle

• Incentives/Pressures

95 percent of all fraud cases involve either:

– Financial pressures

– Vice-related pressures, including drug or alcoholaddiction

– Expensive romantic relationships

– Need to maintain a particular lifestyle

– Medical problems

54





The Fraud Triangle

• Opportunity

Easiest to control of the three components

Most frequently achieved with internalcontrols

– Segregation of duties

– Authorizations

– Independent checks

– Physical safeguards

– Adequate documents and records

56



3Cs of Financial statement Fraud



58

Errors

Misappropriationof Assets

FinancialStatement

Fraud

AuditRisk

Errors


FinancialStatement

Fraud

Errors


FinancialStatement

Fraud

Tests of Controls

Evaluate ControlEnvironment

AnalyticalProcedures

Tests ofDetails

=

Incentive/

Pressure

ManagementIntegrity

Opportunity

R 1

R 2

Incentive/Pressure Fraud

Risk Factors

Attitude/Rationalization

Fraud RiskFactors

OpportunityFraud Risk

Factors

ForensicProcedures

Inherent Risk Control Risk Detection Risk

EvaluateControls Over

Assets

X X

Evaluate TopManagement

Controls



Audit of Defined Benefit

PensionsEmployer-defined benefit pension reforms, as proposed by the

administration and introduced by both the House and the

Senate, would require plan sponsors to make minimum funding

contributions equal to the greater of:(1)the contributions required under the plan’s funding standard

account estimated based on the plan’s actuarial accrued

liability,

(2)deficient reduction contributions calculated under current

liability rules.

These reforms would replace the current law’s “double-barrel”

system with a single measure of assets and liabilities and

required funding method.



uditors’ Liability Limitation

Agreement

In February 2006, the Federal Financial Regulatory Agencies

issued an interagency advisory that raised concerns regarding

the negative impacts on the quality and reliability

of audits when financial institutions agree to limit their

independent auditors’ liability.

The advisory, while observing an increase in the types and

extent of provisions in financial institutions’ external audit

engagement letters that limit auditor liability, informs

financial institutions that they should not enter into an audit

engagement that includes unsafe and unsound limitation ofliability provisions relevant to an integrated audit of their

financial statements and ICFR.

Auditors Liability Limitation



Agreement



Conclusion • The audit function should be regarded as an external corporate

governance mechanism that serves to protect investors from

receiving incomplete, inaccurate, or misleading financial information

and thus adds value to the effectiveness of corporate governance.

• SOX drastically changed the characteristics of the accounting

profession by connecting the audit function to the corporate

governance structure by requiring that the audit committee be directly

responsible for not only hiring, compensating, and firing external

auditors, but also overseeing their work, monitoring their

independence, and avoiding potential conflicts of interest.

• In the auditing profession, the so-called expectation gap is referred

to as the difference between (1) what the investing public and other

users of audited financial statements believe the responsibilities of

auditors are, and (2) what auditors are willing to assume asresponsibilities according to their professional standards.

• New PCAOB AS No. 5 superseded AS No. 2 and requires the

independent audit to opine only on the effectiveness of ICFR, not the

management processes and assessments concerning ICFR.



Conclusion • Sections 201 and 202 of SOX require that all audit and permissible

nonaudit services to be performed by the company’s independent

auditor be approved by the audit committee.

• Auditor independence is the backbone of the auditing profession,

affecting the auditor’s planning, evidence-gathering procedures,

findings, judgment, and credibility, and public trust in the auditor’s

opinion.

• Auditor independence is derived and guided by these three

principles: (1) independent auditors may not audit their own work, (2)

independent auditors may not function in the role of their client’s

management, and (3) independent auditors may not serve in an

advocacy role for their audit clients.

• Tests of controls must be broadened to include understanding of

ICFR and provide reasonable assurance about the effectiveness ofboth the design and operation of internal controls.

• Any contractual provisions that limit the externalauditor’s liability or

require waiving the right to a jury trial may have detrimental effects

on auditor impartiality, objectivity, and quality.

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Presentation Chapter 9.pptx