AUDIT & ASSURANCE AF 3100 – COURSEWORK 2015

ANH HO

120005724

APRIL 5, 2015

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INTRODUCTION

Auditor surely plays important role in assuring the reliability and credibility of financial

information and financial annual report, which contribute to the interests of (potential)

shareholders and bondholders. The purpose of this report is to evaluate different approach towards

audit quality control and measures so as to maintain such approach. The details are divided in 3

sections as follows:

Word count: 2,128

INDEX Page

1. Audit Quality Review (AQR) .......................................................................................... 02

1.1 AQR approach ............................................................................................................ 02

1.2 AQR main concerns in 2012/13/14............................................................................. 03

2. Audit quality control ........................................................................................................ 06

2.1 Firm audit level ........................................................................................................... 06

2.2 Individual audit level .................................................................................................. 08

3. European Directive 2014/56/EU ...................................................................................... 09

4. References ......................................................................................................................... 11

LIST OF FIGURES

1. Figure 1: Summary of area of concerns in 2011/12, 2012/13 and 2013/14 ..................... 03

2. Figure 2: Summary of prohibited NAS to PIE audit clients. ........................................... 10

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1.1 Audit Quality Review (AQR)

Audit Quality Review (AQR) is defined as a team under the Financial Reporting Council (FRC),

whose primary role is to inspect the quality of major audit firms in the UK independently. By

quality of the UK’s audit firms, AQR emphasized their role of reviewing how audit was performed

rather than examining the correctness of audited information.

1.1 AQR approach

Primarily, AQR makes assessment for each individual audit engagement based on audit fees

disclosed under the audit files, while taking into account explanation provided to them by the audit

teams on gathering the evidence of the audit files. AQR sets out different types of grades to define

the quality of the audit work that they inspected, and through grading profile (Section 2 and 3),

they are able to evaluate whether audit quality has been maintained or improved at good standard

from the overall grade. The four grades are:

(1) Grade 1: Good;

(2) Grade 2A: Limited improvements required;

(3) Grade 2B: Improvement required; and

(4) Grade 3: Significant improvements required. This grade is given when AQR has significant

concern in relation to quantity (sufficiency) and quality of audit evidence.

The grades have yet changed overtime but the grouping to different levels has. Initially, there are

3 threshold levels set out by the AQR: Good with limited improvement required (Grade 1 and

2A), Acceptable with improvement required (Grade 2B) and Significant improvement required

(Grade 3). Since 2013, AQR decided to report all four grades separately to increase the

transparency of their findings.

As for quality control, the audit inspection works is initially monitored at peer review staff level

and finally reviewed and approved by independent non-executives.

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1.2 AQR main concerns in 2012/13/14

Figure 1: Summary of area of concerns in 2011/12, 2012/13 and 2013/14

Source: AQR (2012, 2013 and 2014).

Area of concerns 2011/12

Audit qualityProfessional scepticism

Financial services

Impairment

Going concern

Group audit consideration

Revenue recognition

Materiality thresholdUse of experts

and specialists

External confirmations

Testing effectiveness

of internal control

Auditor independence

Reporting to audit

committees

Engagement quality control

review

Financial statement

review process

Perfomance evaluation

Area of concerns 2012/13

Audit quality

Professional scepticism

Financial services

Auditor independence & ethical issue

Group audit consideration

Auditor quality monitoring

Area of concerns 2013/14

Ehanced reporting by auditor

Letterbox comapny

audits

Banks and building societies

Auditor independence & ethical issue

Group audit consideration

Fair value measurements

and impairments

IT controls

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7 key areas that are consistent for 2 or 3 years from Figure 1:

(1) Auditor independence and ethical issue

AQR identify non-audit service as the problem that would impair the audit independence when

firm try to cross-sell non-audit services to audited entities. AQR also suspects problem associated

with ‘letterbox companies’, where there has been insufficient group company or auditor

involvement in control, supervision and review of audit work from other auditor.

As for ethical issue, across all firms, there has been cases for failure to consult to Ethics partner

on appropriateness of contingent fee and arrangement for tax service. Cases where key partners

involved is not being identified or subject to potential audit rotation and shareholdings in audited

entities were not disposed on timely basis are also identified as ethical problem. Most recently,

there has been cases when partners hold financial interests in their clients.

(2) Audit quality

One of the main concern AQR points out in 2011/12 and 2012/13 is that the related parties seek

action to reduce the audit fees and thus exerts pressure and forces the practitioners to achieve

efficiency by reducing audit hours. For example, AQR (2013) finds sample that are not

representative and fails to cover the entire period or total population.

(3) Auditor quality monitoring

Through inspecting regular identified issues such as timeliness of completion and extent of

coverage, it is evident that overall findings from auditor quality monitoring internal audit quality

monitoring shows more positive results than inspection findings. Thus, AQR questions the

robustness of audit quality monitoring process and the standard or expectation set by audit firms.

(4) Fair value measurements and impairments

There have been deficiencies in the audit of fair value measurements and impairment suspected,

where 5 out of 20 audits need significant improvement (Grade 3). In particular, there is

inadequate challenge in relation to the appropriateness of key assumption and other judgments in

tangible and intangible assets, potential impairment and feasibility of business plan.

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(5) Financial services (Banks and building societies)

Auditing quality of financial services remains an issue as the overall grading for Banks and

Building societies continued to be below other types of entity, where no audit was graded at good

and more than half requires improvement.

AQR has discovered there was not enough challenge to the key assumption, adjustment and inputs

in models used to define both specific and collective provision, in which loan loss provisioning

and testing IT control continues to be the main concerns. For instance, AQR suspects insufficient

verification of management’s explanation and supporting calculation on credit risk for loan loss

provisioning and insufficient testing on automated application controls in relation to IT control.

This concern raises problem of completeness of information in respect of forbearance

arrangements in a number of audits and deficiencies in testing of general IT controls.

(6) Group audit consideration

There has been concern relating to group auditor’s involvement in planning stage of the audit,

however, AQR (2014) analyses the problem is no longer significant and in fact, contribute to Good

grade to audit firms.

(7) Professional scepticism

Professional scepticism continues to be one of the main concerns as audit firms fail to provide

sufficient challenge as analysed above.

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2. Audit quality control

PCAOB (2013) defines audit quality as the ability for audit firm to meet fundamental roles of the

audit work, in which, investor demands independence, reliability and robustness of audit, including

communication with audit committee for any related subject matters. In order to increase quality

control ICAEW (2014:102) separates in to small categories (red coloured section), while ISQC 1

provides the details requirement for quality control system (blue and green coloured section). The

procedures implemented by audit firms are taken (F: firm- & i: individual-audit level), as follows:

2.1 Firm audit level

Audit quality as firm level provides fundamental infrastructure with a set of policies, guiding

partners and staff towards the audit objectives. Thus, it is vital to regard audit quality as culture of

the firm. Quality- the foundation of profession as a key stone no matter what environment (PwC,

2014:4).

2.1.1 Leadership responsibilities for audit quality

This infrastructure should ensure there is sufficiency and efficiency in allocating resources to the

development of quality control policies and procedures.

While giving staff incentive to incorporate quality work to through strong and robustness

remuneration and promotion policy, it is important to isolate commercial consideration from the

quality of work perform. Audit staffs received appropriate bonus, salary and promotion are less

tempted to go against the rules and standards of the company and be more competence to be

recognised. Share-based payment scheme as to align staff with the objective of company, since

profit from the employees stocks relies upon the audit firm’s performance.

Only suitable clients are taken & retained

Professional competence (both partner & staff)

Ethics & Professional scepticism guidance

Communication skills

Briefing & supervising skills

Monitoring

Leadership responsibilities for audit quality

Ethical requirement

Acceptance of engagement

Human Resources

Engagement of performance

Monitoring

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2.1.2 Ethical requirement & Acceptance of engagement

At firm level, there must be sufficient policies and procedures to assure the extent whether ethical

requirements are maintained and whether only suitable clients are accepted and/or retained.

For example, at PwC, there are various technology-based tools to support the company’s auditor

in maintaining their independence along with independence consultations with in-house expert,

dedicated experienced partners and staff (PwC, 2014:6). There is a policy at PwC that requires

auditor to disclose all their possible interests in clients, including holding a personal bank account

at client’s entity as a safeguard to prevent self-interest and possibly, familiarity threat. In addition

to lower litigation threat, there is rotation of partners for non-public companies audit engagements

every five years.

2.1.3 Human resources

All audit firms should ensure a strict hiring and recruitment procedure, such as professional

education is required for trainees, continuing professional development for every one and work

experience and coaching for a more experienced senior position.

At all time, audit staffs are required to have relevant experience (practical or understanding),

appropriate technical, industry knowledge, professional scepticism and understanding of firm’s

quality control procedures and policies. This would be maintained through creating policy and

procedure to evaluate performance, capabilities and competence amongst staff members, which

can be under self-appraisal or peer-appraisal.

There should be policy and procedure to disclose and identify the identity, role and responsibilities

of the engagement partner, in which his capabilities, competence, authority and timeliness are

specified.

At PwC, there is annual assessments which evaluate the performance of non-partner professionals

while non-partner are entitled to bonus plan performance based to align with the achievement of

quality targets (PwC. 2014:5).

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2.2 Individual audit level

At individual audit level, audit quality are maintained under four main steps:

2.2.1 Directing & Supervising

At individual audit level, engagement partners remain the key in directing their staff towards the

approach of audit engagement; albeit, the duty is delegated to the most senior team member on

site at the engagement. Before the engagement, partners are required to provide team members

guidance on the work they are supposed to do, matter in relation to the nature, risk or any problems

that might possibly arise during engagement of business entity and details of the approach.

During the engagement, staff must be strictly supervised through progress tracking, while,

competence, capabilities and independence of each audit team member are consistently

considered. Additionally, ISA 220 requires audit team to disclose and address any significant

matter and the extent whether specialists should be appointed.

2.2.2 Reviewing (‘Hot’ review) & Monitoring (‘Cold’ review)

The effectiveness of these two stages relies on second partner, who is not involved in the

engagement of the audit team either directly or indirectly through third party OR a suitably

qualified consultant for a ‘cold’ review.

A ‘hot’ review is defined as a file review carried out by the defined second partner BEFORE the

date audit report is signed so as to assure audit work complies with relevant rules, professional and

legal standards and regulation and finally, the extent audit work meets audit strategy. Other matters

include any significant suspects, revision of nature and timeliness, and the adequacy and

appropriateness of audit report in gathering audit evidence.

The final stage is monitoring, which is also known as a ‘cold’ review by second partner or external

consultant AFTER the audit report is signed in order to determine key weaknesses in quality

control procedure and the measures to mitigate overall shortcomings, which increases efficiency

and effectiveness of later audit work.

Directing Supervising Reviewing Monitoring

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3. European Directive 2014/56/EU

EU Directive 2014/5/6EU reform issued to resolve current affairs in audit market to enhance

public confidence, which takes 2 years for EU members to adopt the new rules (16 June 2016).

Changes are as follows:

3.1 Audit report:

Audit reports are required to be more detailed and informative. In particular, details assessing risk

of material misstatements and explanation on the capability statutory audit in suspecting

irregularities, such as fraud, are required; thus, increase the transparency and supervision of audit

report.

3.2 Audit rotation:

Audit rotation as a safeguard to prevent threats of litigation which impair the independence of the

auditors. The requirement is as follows:

Audit contract Allowable years before switching new auditor

More than 20 years old 6

11-20 years old 9

Less than 10 years Re-tender contract required in year 10

However, empirical evidence (Jackson et al., 2008; Jenkins et al., 2013) argue audit tenure

increases audit quality while audit rotation impair the quality.

3.3 Audit committees:

There is requirement for audit committee to have at least one member who has competence in

accounting and/or auditing and members as whole to have competence in the sector the entity

operates. Further roles are granted to audit committee in relation to audit tender.

Empirical evidence finds audit committees with member having financial experience (Abbott et

al., 2003; Ho Yong et al., 2007; Zaman et al., 2011) and industry knowledge (Cohen et al., 2014)

increase audit quality.

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3.4 Audit and non-audit services:

There is a restriction on the term ‘Big Four only’ requirement by third parties so as to increase the

diversity of audit firms, increasing competition in audit statutory market. Additionally, there is a

cap of 70% of average fees paid by client in the previous three years to reduce the reliance of audit

firms on clients and impairment of the independence of auditor.

3.5 Public interest entities (PIEs):

Due to significant increase in size and complexity of public interest entities, EU directive insists

on corroborating the credibility of audited financial statement.

Firstly there will be mandatory rotation of auditor rule applies to PIEs, which is similar to other

entities. Secondly, shareholder with at least 5% voting rights of audited entity are allowed to

bring claim before national court in the event of dismissal of auditor. Thirdly, there will be

restrictions and cap on fees on certain non-audit services (see Figure 2) to PIEs audit clients

either directly or indirectly. A prohibition of non-audit services to ensure PIEs perform ‘societal’

role (not for profit).

Figure 2: Summary of prohibited NAS to PIE audit clients.

Source: KPMG (2014).

Overall, after weighting all the possible pros and cons, European Directive 2014/56/EU is

expected to increase audit quality and effectiveness in audit quality control.

Prohibited NAS to PIE audit

clients

Tax services

Management or Decision

making

Bookkeeping & Preparing

finanical statements

Payroll

Internal audit, internal

control & risk management

Valuation, Legal service, financing & HR advice

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4. References

1) Abbott, L., Parker, S., Peters, G. and Raghunandan, K. (2003). The Association between Audit Committee

Characteristics and Audit Fees. Auditing: A Journal of Practice & Theory, 22(2), pp. 17-32.

2) Cohen, J., Hoitash, U., Krishnamoorthy, G. and Wright, A. (2014). The Effect of Audit Committee Industry

Expertise on Monitoring the Financial Reporting Process. The Accounting Review, 89(1), pp. 243-273.

3) Financial Reporting Council, (2012). Audit Quality Inspections: Annual report 2011/12. [Online] Available at:

https://www.frc.org.uk/Our-Work/Publications/AIU/Audit-Quality-Inspections-Annual-Report-2011-12.pdf

[Accessed 3 Apr. 2015].

4) Financial Reporting Council, (2013). Audit Quality Inspections: Annual report 2012/13. [Online] Available at:

https://frc.org.uk/Our-Work/Publications/Audit-Quality-Review/Audit-Quality-Inspections-Annual-Report-

2012-13.pdf [Accessed 3 Apr. 2015].

5) Financial Reporting Council, (2014). Audit Quality Inspections: Annual report 2013/14. [Online] Available at:

https://www.frc.org.uk/Our-Work/Publications/Audit-Quality-Review/Audit-Quality-Inspections-Annual-

Report-2013-14.pdf [Accessed 3 Apr. 2015].

6) Ho Young, L. and Mande, V. (2005). The Relationship of Audit Committee Characteristics with Endogenously

Determined Audit and Non-Audit Fees. Quarterly Journal of Business & Economics, 44(3/4), pp. 93-112.

7) ICAEW, (2014). Quality control. Audit and Assurance: Study manual, pp. 94-110.

8) Jackson, A., Moldrich, M. and Roebuck, P. (2008). Mandatory audit firm rotation and audit quality. Managerial

Auditing Journal, 23(5), pp.420-437.

9) Jenkins, D. and Vermeer, T. (2013). Audit firm rotation and audit quality: evidence from academic research.

Accounting Research Journal, 26(1), pp.75-84.

10) KPMG, (2014). Fact sheet: Restriction on certain non-audit services to public interest entity audit clients.

[Online] Available at: http://www.kpmg.com/BE/en/IssuesAndInsights/ArticlesPublications/Documents/EU-

Audit-Refrom-Fact-Sheet-NAS.pdf [Accessed 12 Apr. 2015].

11) Public Company Accounting Oversight Board (PCAOB), (2013). Standing advisory group meeting –

discussion – audit quality indicators. [Online] Available at:

http://pcaobus.org/news/events/documents/05152013_sagmeeting/audit_quality_indicators.pdf [Accessed 12

Apr. 2015].

12) PwC, (2014). Our focus on audit quality: 2014. [Online] Available at: http://www.pwc.com/en_US/us/audit-

assurance-services/publications/assets/2014-audit-quality-report.pdf [Accessed 13 Apr. 2015].

13) Zaman, M., Hudaib, M. and Haniffa, R. (2011). Corporate Governance Quality, Audit Fees and Non-Audit

Services Fees. Journal of Business Finance & Accounting, 38(1-2), pp. 165-197.