Auditing: Integralto the Economy

Auditing

Investors

Creditors

Society and

others

Regulators

Learning Objectives

Discuss the nature/scope of services offered by public accounting firms

Define assurance services, attestation services, and auditing

Explain various types of audit and auditor Identify non-attest services Identify the factors that generate a demand

for auditing Describe how the accounting profession has

changed and the influences for those changes

Learning Objectives

Understand the demand for reporting on internal control over financial reporting and the reporting requirements for public companies

Describe the organizations that have influenced auditing practice

Give an overview of the audit opinion formulation process (i.e., audit activities)

Describe audit quality and its drivers Define process for client acceptance and

continuance Identify the types of audit service providers

and the skills/knowledge needed by entering professionals

The Nature/Scope of Services Offered by Public Accounting Firms

Two Party Contracts: client and CPA

Services that improve quality of information or its context

Services that recommend uses for information

Attestation

Consulting

Three Party Contracts: client, responsible party, and CPA

Assurance

Audit

Assurance Services

Independent professional services that improve the quality of information or its context for decision makers

Assurance services emphasize relevance not reliability.

Assurance services involve four components: Information or process on which assurance is

provided Provider or responsible party Users who derive value from the assurance

(client) An assurance service provider (assurer)

Not a new concept, e.g., Consumers Union

Attestation Services

Assurance services that express conclusion about the reliability of an assertion (normally written) that is the responsibility of another party

Attestation services are driven by 11 Attestation Standards.

Common attestation services (other than audit):1. Agree-upon procedures2. Review engagements

Auditing Defined

A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic activities and events to determine the degree of correspondence between those assertions and established criteria and communicating the results to interested users (the attest function)

Types of Audit

Financial statement audit – correspondence with GAAP (or an applicable financial reporting framework, AFRF)

Compliance audit – correspondence or compliance with established criteria

Operational audit concerned with effectiveness concerned with efficiency of operations

Types of Auditor

External (independent) auditorsInternal auditors Governmental auditors

IRS auditors perform compliance audit on tax returns

GAO

Distinction Between Accountingand Auditing

Accounting Process of identifying,

recording & summarizing economic events

primary purpose is to provide information for decision making

AuditingProcess of obtaining and evaluating evidenceto test assertions

Primary purpose is to provide assurance on those assertions

Quick Case: An Attestation or Assurance Service?

VAN Technologies, a value-added network service provider, links subscribing electronic data integration (EDI) networks, receives network transmissions from trading partners, translates transmissions into an ANSI X12 format, and functions as an electronic post office by transmitting and acknowledging orders electronically. Owing to widespread reports of data security problems in EDI networks, several subscribers have approached management, questioning VAN’s controls over hacker attacks, transmission failures, identification authentication, and infiltration of confidential data files. In response, management asks an engagement partner in Settles & Weick LLP to propose on offering assurances that would quiet subscribers’ fears.

Quick Case: An Attestation or Assurance Service?

Questions:1. Would the engagement partner more likely

prefer to cast the engagement as an attestation service or as an assurance service? Why or why not?

2. Use your imagination: What are the key components driving the design and implementation of the engagement VAN proposes?

Non-Attest Services Offered by Public Accounting Firms

Tax services Information system design and processing Financial forecasts and projections Business valuation Litigation support Fraud investigation Accounting services – compilation Financial planning Sustainability services

Financial Statement Audit Defined

An audit is an attestation service where the auditor gathers evidence to determine whether the financial statements are fairly presented in accordance with GAAP (or an AFRF), and issues an opinion to be used by third-party, the Board of Directors, and the management.

Auditing is All About Evidence

The auditor gathers evidence to determine if the client's financial statements as a whole are fairly presented

Implied in this is that: the process of auditing is to gather and

evaluate evidence to test management’s assertions

the process is systematic the auditor is independent of the entity audited

and the process followed in gathering evidence is unbiased

Management & GAAP

When management prepares financial statements, they assert that those statements are fairly presented in accordance with GAAP

GAAP is the criteria by which "fairness" of financial statement presentation is judged

Communication

Communication of audit results to third party, the Board of Directors, and the management completes the audit process.

To minimize misunderstandings, this communication follows a prescribed format.

Unqualified Audit Report

Almost all audits result in reports that do not contain reservations about the fair presentation of the financial statements.

1. Introductory paragraph – identifies the financial statements audited, management's responsibility and auditor's responsibility

2. Scope paragraph – states the audit is performed in accordance with standards and limitations of the audit

3. Opinion paragraph – assures statements are presented fairly, in all material respects, in conformity with GAAP

Quick Case: Is There Value to an Audit?

The LTV Corporation entered into a contract with Cap Gemini to outsource LTV's information processing to Cap Gemini. The multi-year, $350 million contract included the cost of IBM computer equipment and Microsoft Windows software tailored by Cap Gemini to LTV’s end user information needs. Cap Gemini has received an ISO 9000 quality-control report from the McKinsey Group.

Question: LTV’s board asks, “What value do you, the auditor, add?”

Why is There a Need for Audits?

The information risk (errors & fraud) complexity of transactions and processing

systems separation of decision makers from the

organization’s operations and records conflict of interest among managers, owners,

and other usersThe audit reduces the information risk.

Challenges of the Profession

An audit must be designed to detect material errors and fraud. This involves challenges: Accounting transactions and organizational

structures are complex Computer systems are complex Many companies are global Data is big There is time pressure to get the audit done

quickly There is a need to generate sufficient audit

fees

Loss of Public Confidence

The public lost confidence in the ability of the profession to serve the public interest due to many cases of major fraud, leading to four of the largest bankruptcies ever In most cases, companies had poor internal

controls over financial reporting Boards of Directors failed to oversee

management and effectively utilize the audit function

Perception was that auditors were not independent from management

Trends in Accounting and Auditing

The nature of accounting standards and the demand for accounting information have changed in five significant ways:1. Global harmonization2. Expanded accountability3. Setting audit standards4. More current reporting5. Increased risk reporting

Implication: be prepared to audit in this broader environment

Organizations That Have Influenced Auditing Practice

AICPA – sets auditing standards (since 2003 for non-public companies), upholds Code of Conducts, provides continuing education, prepares and grades the uniform CPA exams

IIA – sets auditing standards for internal auditing

GAO – sets standards for governmental audits

AAA – encourages/supports research in auditing

SEC – sets rules to ensure full and fair disclosure of financial information

COSO – Committee of the Sponsoring Organizations

Organizations That Have Influenced Auditing Practice

POB – monitored performance of public company auditors

PCAOB – the current body with authority to establish or adopt auditing standards for public company audits

Center for Audit Quality (CAQ) – affiliated with AICPA and works closely with PCAOB

IAASB – facilitates convergence of international and national auditing standards

The Role of Controversy in Audit Standard Setting – An Example

Arthur Levitt, former SEC Chair: NYU Law School, 9/28/98

“Hocus Pocus” Accounting:

1. Big Bath Restructuring Reserves (Sunbeam, 97)2. In-Process R&D3. Cookie Jar Reserves (WR Grace, 91-95)4. Materiality5. Revenue Recognition (Priceline.com, 00)

Blue Ribbon Committee on Improving the Effectiveness of Audit Committees, Recommendations, 2/99

SAS No. 90, “Audit Committee Communications “

Discuss with the auditor the quality … ... not just the acceptability of accounting

principles.

What Are Audit CommitteesMissing?

What Can AuditCommittees Do?

Arthur Levitt, former SEC Chair: NYU Law School, 9/28/98

“Hocus Pocus” Accounting:

1. Big Bath Restructuring Reserves (Sunbeam, 97)2. In-Process R&D3. Cookie Jar Reserves (WR Grace, 91-95)4. Materiality5. Revenue Recognition (Priceline.com, 00)

Blue Ribbon Committee on Improving the Effectiveness of Audit Committees, Recommendations, 2/99

SAS No. 90, “Audit Committee Communications “

Discuss with the auditor the quality … ... not just the acceptability of accounting

principles.

Standard Setter Oversight Body Auditing Standard

Public Company Accounting Oversight Board

PCAOB Securities and Exchange Commission

SEC Auditing Standards

AS

Auditing Standards Board

ASB American Institute of Certified Public Accountants

AICPA Statements on Auditing Standards

SAS

International Auditing and Assurance Standards Board

IAASB Public Interest Oversight Board

PIOB International Standards on Auditing

ISA

Organizations Involved with Establishing Auditing Standards

Applicable Auditing Standards

The standards that are applicable to a given audit depend on: 1.The nature of the organization that is

being audited, and2.The home country and ownership

Overall Objectives of a Public Company Audit

Obtaining reasonable assurance about financial statements being free from material misstatement

Reporting on financial statements based on findingsIn completing these objectives, the auditor:• Complies with relevant ethical requirements• Plans and performs an audit with

professional skepticism• Exercises professional judgment• Obtains sufficient appropriate evidence• Conducts audit in accordance with

professional auditing standards

The Audit Opinion Formulation Process (Audit Activities)

I. Making client acceptance and continuance decision

Chapter 14

II. Performing risk assessment

Chapters 3, 7 and 9-13

III. Obtaining evidence about internal control operating effectivenessChapters 8-13 and 16

IV. Obtaining substantive evidence about accounts, disclosures and assertionsChapters 8-13 and 16

V. Completing the audit and making reporting decisions

Chapters 14 and 15

The auditing profession, regulation, corporate governance, and audit quality

Chapters 1 and 2

Professional liability and the need for quality auditor judgments and ethical decisions

Chapter 4

A framework for obtaining audit evidence

Chapter 5 and 6

Overview of the Audit Process

Phase I – Making Client Acceptance and Continuance DecisionsAuditors exercise care when

accepting clients or deciding to continue existing clients.

Statement on Quality Control Standards No. 1 also suggests that auditors establish policies to accept and continue clients.

Overview of the Audit Process

Phase II – Performing risk assessment Planning the audit

Planning meetingDeveloping an understanding of

materialityDeveloping a preliminary audit

program. It requires:• an understanding of client business,

industry, strategies, and governance process• an understanding of risks client faces and

how they might affect the company's financial statements

Overview of the Audit Process

• an understanding of management compensation plans and how those plans may motivate management actions• an understanding of client's accounting

policies and procedures• anticipating financial statement items likely

to require adjustment• identifying factors that might require

modification of audit tests

Overview of the Audit Process

Phase III and IV – Obtaining evidence about controls and obtaining substantive evidence Professional standards require the auditor to

gather "sufficient, appropriate” evidence in order to reach a conclusion about the fair presentation of the financial statements (and effectiveness of internal control over financial reporting)

Audit process is designed to examine assertions (and the effectiveness of internal control)

Overview of the Audit Process

Phase V – Completing the audit and making reporting decisions The auditor summarizes the audit evidence and

reaches an audit conclusion If the evidence supports fair presentation

(effective IC), the auditor will issue an unqualified opinion

If the evidence does not support fair presentation (effective IC), the auditor will seek client’s agreement to modify the financial statements (N/A to IC). If unsuccessful, the auditor modifies the audit opinion.

Audit Quality Defined

Performing an audit in accordance with professional auditing standardsProviding reasonable assurance that

audited financial statements and disclosures are presented in accordance with GAAP

Providing reasonable assurance that those financial statements are not materially misstated whether due to errors or fraud

Drivers of Audit Quality

Achieving Audit Quality

Audit quality can be achieved through: Maintaining auditor independenceExercising professional judgment &

skepticismParticipating in review programsIssuing engagement lettersMaking appropriate client acceptanceEvaluating the audit firm’s limitationsMaintaining quality audit documentation

Certification of Public Accountants

Board of Accountancy in each state has the authority to grant CPA certificates and to suspend or revoke them.

To become a CPA in a state, a candidate must meet the requirements of the state. Education Experience Examination Continuing education

Providers of External Auditing Services

Big-four firms – the largest acctg firms in the U.S., all of which operate internationally (D&T, EY, KPMG, PwC)

National firms – acctg firms with offices in most major cities and some foreign countries (BDO Seidman, Grant Thornton, McGladrey & Pullen, Crowe)

Regional firms – acctg firms with offices in several cities within a region

Local firms – acctg firms with one or more offices within a small area

Can take the form of sole proprietorship, partnership, professional corporation, limited liability companies, or limited liability partnership

Public Accounting Firms’ Organizational Structure

Staff – juniors perform more routine tasks Seniors – seniors plan and conduct the audit,

and supervise the work of staff Managers – provide guidance, help seniors plan

their audit program, and review seniors’ work Partner – Partners have the overall and final

responsibility for the audit; they review the work and resolve problems with the clients

Many firms have added additional levels to this structure.