Chapter IXExternal Auditors’ Roles and Responsibilities
Chapter Objectives:• Recognize the role independent auditors play in achieving effective corporategovernance and reliable financial reports.• Understand the history of auditing, the traditional roles of auditors, and regulationsrecently placed on them.• Address the expectation gap regarding what auditors can provide in the way ofreasonable assurance and the expectations of investors for a higher level ofassurance.• Identify the roles and responsibilities of the PCAOB, and discuss the auditingstandards 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 therationale on both sides of the issue. VIDEO ( VIDEO)
Key TermsThe Accountancy Investigation & Discipline Board (AIDB)Audit qualityAudit riskAudit strategyAuditor independenceControl riskDetection riskExpectation gapInherent riskIntegrated audit approachInternal Revenue Service (IRS)International Standards on Auditing (ISAs)PCAOB-USProfessional Ethics ExecutiveCommittee (PEEC)Standing Advisory Group (SAG)Statements on Auditing Standards
External Auditor ResponsibilityCurrent auditing standards require that independent auditorsprovide reasonable assurance 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 Competency1. 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. Auditor’s ability to choose appropriate evidence-gathering procedures (tests of controls, substantive tests) and execute auditing procedures4. Reporting competencies. Reporting competencies refer to the auditors’ ability and willingness to discover and report material misstatements.
Reports AccompanyingFinancial 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 financial reporting?
The Purpose of the Audit Report• Definition of auditing: “... communicating results to interested 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 ofAudit Reports• Standard unqualified (clean opinion)• Unqualified with explanatory paragraph or modified 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 InterpretationUnqualified Financial statements taken as a whole present fairlyOpinion 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, the financial 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 in conformity with GAAP.Disclaimer of Auditor does not express an opinion on the financialOpinion position, results of operations, or cash flows.
Standard Unqualified ReportThe five necessary conditions have been met: 1. All four required statements are included. 2. The three general standards have been followed in all respects on the engagement. 3. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables the conclusion that the three standards of field work 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.
Standard Unqualified Audit Report (Nonlisted Companies)Title Report of Independent AuditorAddress To the Board of Directors and stockholders of Anyto client companyAudit AuditWe have audited the accompanying balancenotice notice of Any company as of December 31, 1990 sheets and 1989, and the related statements of income,Identify Management retained earnings, and cash flows for the yearthe responsibility then ended. These financial statements are thefinancial responsibility of the company’s management. Ourstatement responsibility is to express an opinion on these Auditors financial statements based on our audits. responsibility continued
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 includesDescriptio examining, on a test basis, evidence supportingn of the the amounts and disclosures in the financialaudit statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statementNo special presentation. We believe that our audit provides a Opinion on In our opinion, the financial statementsmention of reasonableabove for our opinion. all material referred to basis present fairly, in financialadequate statement respects, the financial position of Any company asdisclosure s of December 31, 1990 and 1989, and the resultsor of its operations and its cash flows for the years Refer toconsistenc then ended in conformity with generally accepted GAAPy accounting principles.Signature ___________________________________, CPADate February 28, 1991
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 letters2. Shareholders’ rights to question auditors3. Publication of auditor resignation statements4. Lead audit partner’s signature on audit reports5. Active audit committee participation in evaluating the scope and results of the integrated audit of both ICFR and financial statements6. Mandatory rotation of the audit firm every seven to twelve years in the context of the quality of audit work performed by the firm and the audit efficacy7. Mandatory shareholder vote on the ratification of the independent auditor each year
Public Company Accounting Oversight BoardThe PCAOB created by SOX to regulate the auditingprofession.The PCAOB’s primary functions are to:1. Register public accounting firms that audit publiccompanies.2. Inspect the registered public accounting firms on a regularbasis.3. Establish auditing, attestation, ethics, quality control, andindependence standards.4. Conduct investigations and disciplinary proceedings.
PCAOB Auditing StandardsThe 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 andstate 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 tomaintain 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 the company’s elimination of previouslyreported material weaknesses in its ICFR)
Roles and Responsibilities—Internal Control overFinancial Reporting• Management: Designs and implements the system of internal control over financial reporting; evaluates the effectiveness of the company’s internal control over financial reporting 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 control over financial reporting and issues a report on management’s assessment of internal control over financial reporting and on the effectiveness of internal control over financial reporting; also performs an audit of the company’s financial statements. 20
What Management’s ReportWill IncludeUnder the SEC rules, management’s report on internal control over financial reporting should include the following information:• Statement of management’s responsibility for establishing and maintaining 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’s most recent fiscal year, including an explicit statement as to whether that control is effective and disclosing any material weakness identified by management in that control.• Statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management’s internal control assessment. 21
PCAOB Auditing Standard No. 2:An Audit of Internal Control over Financial Reporting Performed in Conjunction withan 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. 22
The Independent Auditor’s OpinionThe content of the auditor’s report is prescribed by the PCAOB standard. The most common opinions on the effectiveness of internal control over financial reporting will be:• Unqualified Opinion. An opinion that internal control over financial reporting is effective: no material weaknesses in internal control over financial reporting exist as of the fiscal year-end assessment date.• Adverse Opinion. An opinion that internal control over financial reporting is not effective: one or more material weaknesses exist as of the fiscal year-end assessment date.• Disclaimer of Opinion. A report stating that restrictions on the scope of the auditor’s work prevent the auditor from expressing an opinion on the company’s internal control over financial reporting. 23
Report of Independent Registered Public Accounting Firm 1. Introductory 2. Scope 3. Definition Paragraph Paragraph Paragraph 6. Inherent 5. Explanatory 4. Opinion Limitations Paragraph* Paragraph Paragraph 7. Signature 8. City and 9. Date State or County*The explanatory paragraph is required only when the auditor’s opinion is other than unqualified and may also be placed after the opinion paragraphwhen the auditor issues two separate reports on the audit of financial statements and internal controls, thus making reference to opinion on thefinancial statement audit in the report on the internal control audit. 24
25Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.
Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org. 26
Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org. 27
PCAOB Auditors IndependenceThe new rules restrict public accounting firms inperforming a variety of tax services to their audit clients.The new rules are intended to prevent the selling ofabusive tax shelters.
Audit Committee Oversight of External AuditorsThe extended oversight responsibilities for the auditcommittee are:1. Appointment, compensation, and retention of registeredpublic accounting firms2. Preapproval of audit services and permissible nonauditservices3. Review of the independent auditor’s plan for an integratedaudit of both ICFR and annual financial statements4. Review and discussion of financial statements audited orreviewed by the independent auditor5. Monitoring the auditor’s independence6. Auditor rotation requirement
Audit Committee Oversight of External AuditorsThe number of companies that change auditors, and the number of auditors changed
Independent AuditorsCommunications with the Audit CommitteeCommunications from the committee to the Communications from the independentindependent auditor: auditor to the audit committee:1. Appointment and retention approval of the 1. Seeking committee preapproval of all audit and independent auditor nonaudit services in a timely manner2. Formal approval of audit and permissible nonaudit 2. The critical accounting policies and practices used byservices management in the preparation of financial statements3. Formal approval of fees for both audit and nonaudit 3. All alternative treatments of financial information withinservices with a keen focus on improving the quality of GAAPaudit and nonaudit services 4. Any accounting disagreements between the4. Any concerns or risks threatening management’s independent auditor and the company’s managementreputation and integrity, etc. 5. Any material, written communications between the5. Allegations of financial statement fraud independent auditor and the company’s management throughout the course of the audit 6. Significant deficiencies and material weaknesses of ICFR 7. The audit report on annual financial 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
Consolidation and Competition in Public Accounting FirmsSEC rules require public companies that change their publicaccounting firms to file a Form 8-K, Item 4.01, to disclosechanges within four days, whereas auditors are required toprovide standard letters within ten days stating whether theyagree with the company’s disclosure without specifying anyreasons.
Integrated Audit Approach Management assessment on the effectiveness of ICFR Effectiveness of both design and operation of ICFR based on control criteria Fair presentation of financial statements in conformity with GAAP
Audit StrategyAudit Strategy:1. No limited tests of controls2. No use of cycle rotation in tests of controls3. Dual testing of controls and substantive audit proceduresAuditors should focus on prevention, detection, and correctionof controls at both the company level and the transactionlevel. Auditors should perform tests of controls as a basis forforming an opinion on the effectiveness of ICFR. Auditorsshould also perform substantive tests as a basis forexpressing an opinion on the fair presentation of financialstatements, regardless of the identified significantdeficiencies and material weaknesses in internal controls.
Brief History Fraud Investigation • 1900s -- Fraud detection was a primary objective of the audit • 1940s -- Detection of fraud considered to be a ―responsibility not assumed‖ • 1960s -- Auditor acknowledged responsibility for detecting fraud that would normally be uncovered by an examination performed in accordance with GAAS. • 1980s -- Auditor had responsibility to search for fraud that may have a material affect on the financial statements. • 1997 -- SAS No. 82; 2002 – SAS No. 99 37
Types of Fraud Financial Statement Fraud Misrepresentation of material facts Misappropriation of assets Concealment of material facts Management Fraud Illegal Acts Bribery Conflict of Interest Embezzlement of money or FRAUD property Breach of fiduciary duty Theft of trade secrets of Employee intellectual property Fraud Illegal acts
Why People Commit FraudStudies show that employees are likely to commit fraud when four conditions exist: – PRESSING FINANCIAL NEED – OPPORTUNITY – REASONABLE JUSTIFICATION – LACK OF MORAL PRINCIPLES 39
Profile of Fraud PerpetratorsThe 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: LESS LIKELY TO BE:• A woman • Divorced• Married • Alcoholic• Church member • Tattooed• Older• Heavier• Have children• Have a higher education• Never been arrested• Have high self-esteem• High achiever 41
Financial Statement Fraud• Definition – Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors• Financial statement fraud has become a daily thing. Press reports challenge the corporate responsibility and 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
High-Profile Financial statement FraudBasis of the Fraud Older Example Year Recent Example YearFictitious revenue, ZZZZ Best Enrondocumentation forgery and 1987 2001theft of corporate assetsPersonal use of assets, false Phar-Mor 1992 Adelphia 2002documentation and financialstatement fraudCapitalizing expenses, among Waste 1997 WorldCom 2002other issues ManagementAbuse of accounting Savings and Loan 1982 Stock Optionsstandards Crisis Backdating 2006
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 or reckless disregard for the truth (Scienter)• Reliance on the false representation by the victim• 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 have a 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 misappropriation of assets or retaining job Indirect financial gain, such as increase in stock 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 internal control 49
Red Flags• Personal financial pressure• Vices (drugs, alcohol or gambling)• Extravagant lifestyles• Real or imagined grievances against company• Related parties• Increased stress• Internal pressures 50
How Frauds Occurred• Poor internal controls• Management override of internal controls• Collusion between employees and third parties• 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 The Fraud Triangle RationalizationIncentives/ OpportunitiesPressures 53
The Fraud Triangle• Incentives/Pressures 95 percent of all fraud cases involve either: – Financial pressures – Vice-related pressures, including drug or alcohol addiction – Expensive romantic relationships – Need to maintain a particular lifestyle – Medical problems 54
The Fraud Triangle• Rationalization is the reconciliation of what we are doing with what our conscience tells us we should do.• "I was only borrowing it; I planned to return it after things improved." 55
The Fraud Triangle• Opportunity Easiest to control of the three components Most frequently achieved with internal controls – Segregation of duties – Authorizations – Independent checks – Physical safeguards – Adequate documents and records 56
Evaluate Control Environment Tests of Controls Audit Inherent Risk X Control Risk X = Detection Risk Risk Errors Errors Errors Analytical Procedures Misappropriation Misappropriation Misappropriation Tests of of Assets of Assets of Assets Details Financial Financial Statement Statement Financial Fraud Fraud Forensic Statement Fraud Procedures Evaluate Management Evaluate Top Controls Over Integrity Management Assets Controls R R 1 2 Incentive/ Opportunity Pressure Incentive/ Attitude/ OpportunityPressure Fraud Rationalization Fraud Risk Risk Factors Fraud Risk Factors Factors 58
Audit of Defined Benefit PensionsEmployer-defined benefit pension reforms, as proposed by theadministration and introduced by both the House and theSenate, would require plan sponsors to make minimum fundingcontributions 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 andrequired funding method.
Auditors’ Liability Limitation AgreementIn February 2006, the Federal Financial Regulatory Agenciesissued an interagency advisory that raised concerns regardingthe negative impacts on the quality and reliabilityof audits when financial institutions agree to limit theirindependent auditors’ liability.The advisory, while observing an increase in the types andextent of provisions in financial institutions’ external auditengagement letters that limit auditor liability, informsfinancial institutions that they should not enter into an auditengagement that includes unsafe and unsound limitation ofliability provisions relevant to an integrated audit of theirfinancial statements and ICFR.
Conclusion• The audit function should be regarded as an external corporategovernance mechanism that serves to protect investors fromreceiving incomplete, inaccurate, or misleading financial informationand thus adds value to the effectiveness of corporate governance.• SOX drastically changed the characteristics of the accountingprofession by connecting the audit function to the corporategovernance structure by requiring that the audit committee be directlyresponsible for not only hiring, compensating, and firing externalauditors, but also overseeing their work, monitoring theirindependence, and avoiding potential conflicts of interest.• In the auditing profession, the so-called expectation gap is referredto as the difference between (1) what the investing public and otherusers of audited financial statements believe the responsibilities ofauditors 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 theindependent audit to opine only on the effectiveness of ICFR, not themanagement processes and assessments concerning ICFR.
Conclusion• Sections 201 and 202 of SOX require that all audit and permissiblenonaudit services to be performed by the company’s independentauditor 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’sopinion.• Auditor independence is derived and guided by these threeprinciples: (1) independent auditors may not audit their own work, (2)independent auditors may not function in the role of their client’smanagement, and (3) independent auditors may not serve in anadvocacy role for their audit clients.• Tests of controls must be broadened to include understanding ofICFR and provide reasonable assurance about the effectiveness ofboth the design and operation of internal controls.• Any contractual provisions that limit the external auditor’s liability orrequire waiving the right to a jury trial may have detrimental effectson auditor impartiality, objectivity, and quality.