Chapter 2 The Audit Market

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Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014

Principles of Auditing: An Introduction to

International Standards on Auditing

US Classes – PCAOB Standards

Chapter 2 – The Audit Market

Rick Hayes, Hans Gortemaker

and Philip Wallage

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• Management controls the accounting

systems, the internal controls and the

financial reports to investors.

• Management is not independent or objective

because their success depends on positive

reports.

• The auditor increases the confidence of the

report users by giving an independent opinion

on the fairness of these reports.

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Demand for audit services explained by

several different theories

• The Policeman Theory

• The Lending Credibility Theory

• The Theory of Inspired Confidence

• Agency Theory

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Agency theory

• A company is viewed as the result of ‘contracts’, in which several groups make some kind of contribution to the company, given a certain ‘price’.

• Management is seen as the ‘agent’, trying to obtain contributions from ‘principals’ such as bankers, stockholders and employees.

• Management tries to do what is best for management and has a considerable advantage over the principals regarding information about the company (information asymmetry).

• Cost of an agency relationship are monitoring costs, bonding costs and residual loss.

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Audits required

• In most countries, audits are now legally required

for some types of companies

(statutory audits).

• For example, listed companies, companies

receiving government money, certain industries.

• Major bourses (including NYSE, NASDAQ,

London Stock Exchange, Tokyo NIKKEI and

Frankfurt DAX) have listing rules that require all

companies to have an audited annual report.

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Audit regulation

Although there is regulation around the world,

two that may be the most influential are:

• The Sarbanes–Oxley Act of 2002 required the

US Securities and Exchange Commission (SEC)

to create a Public Company Accounting

Oversight Board (PCAOB).

• European Union Eighth Council Directive

84/253/EEC and EU Directive 2006/43/EC.

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Independent oversight

• International Forum of Independent Audit

Regulators (IFIAR)

• In Australia – Financial Reporting Council

• In the UK – The Review Board

• In the Netherlands – Authority for the Financial

Markets (AFM)

• France – Autorité des marchés financiers (AMF)

• USA – Public Company Accounting Oversight

Board

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The International Forum of Independent

Audit Regulators (IFIAR) Core Principles

• Comprehensive and well defined accounting and auditing principles and standards

• Legal requirements for the preparation and publication of financial statements according to those principles and standards

• An enforcement system for preparers of financial statements to ensure compliance with accounting standards

• Corporate governance practices that support high‐quality corporate reporting and auditing practice

• Effective educational and training arrangements for accountants and auditors.

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Public Company Accounting Oversight Board

(PCAOB)

Created by the Sarbanes–Oxley Act of 2002

In the United States who supervises auditing rules

and auditing firms for Publicly listed companies?

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PCAOB’s audit standards

• PCAOB has passed 16 audit standards as of December 2010.

• They also enforce as ‘temporary standards’ the existing audit standards by the Audit Standards Board called Statements of Audit Standards (SAS).

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PCAOB’s audit standards – US classes

• AS No. 1: References in Auditors’ Reports to the Standards

of the Public Company Accounting Oversight Board

• AS No. 2: on internal control report replaced by AS No. 5.

• AS No. 3: Audit Documentation

• AS No. 4: Reporting on Whether a Previously Reported

Material Weakness Continues to Exist

• AS No. 5: An Audit of Internal Control Over Financial

Reporting That Is Integrated with An Audit of Financial

Statements

• AS No. 6: Evaluating Consistency of Financial Statements

• AS No. 7: Engagement Quality Review

• AS No. 8: Audit Risk

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PCAOB’s audit standards – US classes

(Continued)

• AS No. 9: Audit Planning

• AS No. 10: Supervision of the Audit Engagement

• AS No. 11: Consideration of Materiality in Planning and

Performing an Audit

• AS No. 12: Identifying and Assessing Risks of Material

Misstatement

• AS No. 13: The Auditor's Responses to the Risks of Material

Misstatement

• AS No. 14: Evaluating Audit Results

• AS No. 15: Audit Evidence

• AS No. 16: Communications with Audit Committees

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PCAOB audit standard # 1: References in auditors’ reports

to the standards of the Public Company Accounting Oversight

Board

• Adopted as interim standards, on an initial,

transitional basis, GAAP in AICPA’s Auditing

Standards Board’s Statement on Auditing

Standards No. 95.

• The auditor in their opinion must refer to ‘the

standards of the Public Company Accounting

Oversight Board (United States).’

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Report of independent Registered Public Accounting Firm

The Board of Directors and Shareholders of Wal-Mart Stores, Inc.

We have audited the accompanying consolidated balance sheets of Wal-Mart Stores, Inc.

as of January 31, 2010 and 2009, and the related consolidated statements of income,

shareholders’ equity and cash flows for each of the three years in the period ended

January 31, 2010. 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.

We conducted our audits in accordance with the standards of the

Public Company Accounting Oversight Board (United States).

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 as evaluating

the overall financial statement presentation. We believe that our audits provide a

reasonable basis for our opinion.

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In our opinion, the financial statements referred to above present fairly, in all

material respects, the consolidated financial position of Wal-Mart Stores, Inc. at

January 31, 2010 and 2009, and the consolidated results of its operations and its

cash flows for each of the three years in the period ended January 31, 2010, in

conformity with US generally accepted accounting principles.

As discussed in Note 8 to the consolidated financial statements, effective

February 1, 2007, the Company changed its method of accounting for uncertainty

in income taxes.

We also have audited, in accordance with the standards of the Public Company

Accounting Oversight Board (United States), Wal-Mart Stores, Inc.’s internal

control over financial reporting as of January 31, 2010, based on criteria

established in Internal Control – Integrated Framework issued by the Committee

of Sponsoring Organizations of the Treadway Commission and our report dated

March 30, 2010 expressed an unqualified opinion thereon.

Ernst & Young

Rogers, Arkansas

March 30, 2010

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PCAOB audit standard # 3: Audit documentation

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(#3) This standard establishes general requirements for documentation the auditor should prepare and retainin connection with engagements.

(#3) Audit documentation is the written record of the basis for the auditor’s conclusions that provides the support for the auditor’s representations, whether those representations are contained in the auditor’s report or otherwise.

(#3) The auditor must retain audit documentation for seven years from the date the auditor grants permission to use the auditor’s report in connection with the issuance of the company’s financial statements (report release date).

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PCAOB audit standard # 4: Reporting on whether a

previously reported material weakness continues to exist

Establishes requirements and provides direction that

apply when an auditor is engaged to report on whether

a previously reported material weakness in internal

control over financial reporting continues to exist as of a

date specified by management.

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Report of Independent Registered Public Accounting Firm

We have previously audited and reported on management’s annual assessment

of XYZ Company’s internal control over financial reporting as of December 31,

200X based on (Identify control criteria, for example, ‘criteria established in

Internal Control – Integrated Framework issued by the Committee of Sponsoring

Organizations of the Treadway Commission (COSO)’). Our report, dated (date of

report), identified the following material weakness in the Company’s internal

control over financial reporting:

(Describe material weakness)

We have audited management’s assertion, included in the accompanying (title

of management’s report), that the material weakness in internal control over

financial reporting identified above no longer exists as of (date of management’s

assertion) because the following control(s) addresses the material weakness:

(Describe control(s))

…

In our opinion, the material weakness described above no longer exists as of

(date of management’s assertion).

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PCAOB audit standard # 5: An audit of internal control over financial

reporting that is integrated with an audit of financial statements

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(#5) This standard establishes requirements when an auditor is

engaged to perform an audit of management’s assessment of

the effectiveness of internal control over financial reporting

(‘the audit of internal control over financial reporting’) that is

integrated with an audit of the financial statements.

(#5) If one or more material weaknesses exist, the company’s internal

control over financial reporting cannot be considered effective.

(#5) The audit of internal control over financial reporting should be

integrated with the audit of the financial statements.

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Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting The Board of Directors and Shareholders of Wal-Mart Stores, Inc.

We have audited Wal-Mart Stores, Inc.’s internal control over financial reporting as of January 31, 2010,

based on criteria established in Internal Control – Integrated Framework issued by the Committee of

Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wal-Mart Stores, Inc’s

management is responsible for maintaining effective internal control over financial reporting, and for its

assessment of the effectiveness of internal control over financial reporting included in the accompanying

‘Management’s Report to Our Shareholders’. Our responsibility is to express an opinion on the

Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight

Board (United States). Those standards require that we plan and perform the audit to obtain reasonable

assurance about whether effective internal control over financial reporting was maintained in all material

respects. Our audit included obtaining an understanding of internal control over financial reporting,

assessing the risk that a material weakness exists, testing and evaluating the design and operating

effectiveness of internal control based on the assessed risk, and performing such other procedures as

we considered necessary in the circumstances. We believe that our audit provides a reasonable basis

for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable

assurance regarding the reliability of financial reporting and the preparation of financial statements for

external purposes in accordance with generally accepted accounting principles. A company’s internal

control over financial reporting includes those policies and procedures that: (1) pertain to the

maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and

dispositions of the assets of the company.US classes

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(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorisations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion Wal-Mart Stores, Inc. maintained, in all material respects, effective internal control over financial reporting as of January 31, 2010, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Wal-Mart Stores, Inc. as of January 31, 2010 and 2009, and related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended January 31, 2010 and our report dated March 30, 2010 expressed an unqualified opinion thereon.

Ernst & Young

Rogers, Arkansas

March 30, 2010US classes

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PCAOB audit standard # 6: Evaluating consistency of

financial statements

(#6) This standard establishes requirements for the auditor’s evaluation of the consistency of the financial statements.

(#6) The auditor should recognise the following matters in an explanatory (emphasis of a matter) paragraph a relating to the consistency of the company’s financial statements in the auditor’s report if those matters have a material effect on the financial statements:

– A change in accounting principle

– An adjustment to correct a misstatement in previously issued financial statements.

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PCAOB audit standard # 7: Engagement quality review

(#7) An engagement quality review and concurring approval of issuance are required for each audit engagement and for each engagement to review interim financial information.

(#7) The objective of the engagement quality reviewer is to perform an evaluation of the significant judgments made by the engagement team and the related conclusions reached in forming the overall conclusion on the engagement in order to determine whether to provide concurring approval of issuance.

(#7) An engagement quality reviewer must have competence, independence, integrity and objectivity.

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PCAOB audit standard # 8: Audit risk

(#8) This standard discusses the auditor’s consideration of audit risk.

(#8) Risk of material misstatement at the assertion level consists of the following components: Inherent risk and Control risk.

(#8) The auditor uses the assessed risk of material misstatement to determine the appropriate level of Detection risk for a financial statement assertion.

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PCAOB audit standard # 9: Audit planning

(#9) Establishes requirements regarding planning an audit.

(#9) The engagement partner is responsible for planning the audit.

(#9) Planning the audit includes establishing the overall audit strategy for the engagement and developing an audit plan, which includes, in particular, planned risk assessment procedures and planned responses to the risks of material misstatement.

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PCAOB audit standard # 10: Supervision of the audit

engagement

(#10) This standard establishes requirements regarding supervision of the audit engagement, including supervising the work of engagement team members.

(#10) The engagement partner is responsible for the engagement and its performance including PCAOB standards and the work of engagement personnel, specialists, other auditors, internal auditors and others who are involved in testing controls.

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PCAOB audit standard # 11: Consideration of materiality

in planning and performing an audit

(#11) Establishes requirements regarding the auditor's

consideration of materiality in planning and

performing an audit.

(#11) The Supreme Court of the United States – a

fact is material if there is ‘a substantial likelihood

that the…fact would have been viewed by the

reasonable investor as having significantly

altered the “total mix” of information made

available’.

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(#11) To obtain reasonable assurance about whether

the financial statements are free of material

misstatement, the auditor should plan and

perform audit procedures to detect

misstatements that, individually or in

combination with other misstatements, would

result in material misstatement of the financial

statements.

PCAOB audit standard # 11: Consideration of materiality

in planning and performing an audit (Continued)

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PCAOB audit standard # 12: Identifying and assessing

risks of material misstatement

(#12) Establishes requirements regarding the process

of identifying and assessing risks of material

misstatement of the financial statements.

(#12) The auditor should perform risk assessment

procedures that are sufficient to provide a

reasonable basis for identifying and assessing

the risks of material misstatement, whether due

to error or fraud.

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• This standard discusses the following risk assessment procedures:

• Obtaining an understanding of the company and its environment

(paragraphs 7–17).

• Obtaining an understanding of internal control over financial reporting


• Considering information from the client acceptance and retention

evaluation, audit planning activities, past audits and other engagements

performed for the company (paragraphs 41–45).

• Performing analytical procedures (paragraphs 46–48).

• Conducting a discussion among engagement team members regarding

the risks of material misstatement (paragraphs 49–53).

• Inquiring of the audit committee, management, and others within the

company about the risks of material misstatement (paragraphs 54–58).

PCAOB audit standard # 12: Identifying and assessing

risks of material misstatement (Continued)

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PCAOB audit standard # 13: The auditor’s responses to

the risks of material misstatement

(#13) Establishes requirements regarding designing

and implementing appropriate responses to the

risks of material misstatement.

(#13) Responses that have an overall effect on how

the audit is conducted (‘overall responses’),

(paragraphs 5–7) – e.g. appropriate staff

assignment, supervision, unpredictable audit

procedures.

(#13) Responses involving the nature, timing and

extent of the audit procedures to be performed,


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PCAOB audit standard # 14: Evaluating audit results

Establishes requirements regarding the auditor’s evaluation of audit

results and determination of whether he or she has obtained sufficient

appropriate audit evidence which should include evaluation of the

following:

– The results of analytical procedures performed in the overall review of

the financial statements (‘overall review’)

– Misstatements accumulated during the audit, including, in particular,

uncorrected misstatements

– The qualitative aspects of the company’s accounting practices

– Conditions identified during the audit that relate to the assessment of the

risk of material misstatement due to fraud (‘fraud risk’)

– The presentation of the financial statements, including the disclosures

– The sufficiency and appropriateness of the audit evidence obtained.

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PCAOB audit standard # 15: Audit evidence

(#15) Explains what constitutes audit evidence and

establishes requirements regarding designing

and performing audit procedures to obtain

sufficient appropriate audit evidence.

(#15) Audit evidence is all the information, whether

obtained from audit procedures or other sources,

that is used by the auditor in arriving at the

conclusions on which the auditor’s opinion is

based.

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(#15) Sufficiency is the measure of the quantity of

audit evidence affected by the following:• Risk of material misstatement or the risk

associated with the control (risk increase

amount of evidence increases)

• Quality of the audit evidence obtained.

(#15) Appropriateness is the measure of the quality of

audit evidence, i.e. its relevance and reliability.

PCAOB audit standard # 15: Audit evidence (Continued)Sufficient Appropriate Audit Evidence

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PCAOB audit standard # 16: Communications with audit

committees

(#16) This standard requires the auditor to communicate

with the company’s audit committee regarding

certain matters related to the conduct of an audit

and to obtain certain information from the audit

committee relevant to the audit.

(#16) This standard also requires the auditor to establish

an understanding of the terms of the audit

engagement with the audit committee and to

record that understanding in an engagement

letter. (Included in the engagement letter)

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(#16) Significant accounting policies and practices

• Management choice of accounting policies and

effect on f/s and disclosures of controversial areas

and areas which lack authoritative guidance.

(#16) Critical accounting policies and practices

• Those that are both most important to the

portrayal of the company’s financial condition and

results, and require management’s most difficult,

subjective or complex judgements.

PCAOB audit standard # 16: Communications with

audit committees (Continued)The auditor should communicate to the audit committee the

following matters:

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(#16) Critical accounting estimates

• Management’s process in developing the

estimates including significant assumptions

used, and any significant changes management

made in the process.

(#16) Significant unusual transactions

• Significant transactions outside the normal

course of business or that appear unusual in

timing, size or nature.


audit committees (Continued)The auditor must also communicate to the audit committee

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• Overall audit strategy, timing of the audit and significant

risks

• Auditor’s evaluation of the quality of the company’s

financial reporting

• Other information in documents containing audited

financial statements

• Difficult or contentious matters for which the auditor

consulted

• Auditors going concern evaluation.


audit committeesThe auditor must also communicate to the audit committee

(Continued)

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• Uncorrected and corrected misstatements

• Other material written communications between the

auditor and management

• Departure from the auditor’s standard report

• Disagreements with management

• Difficulties encountered in performing the audit.


audit committeesThe auditor must also communicate to the audit committee

(Continued)

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Current standard-setting and related

rulemaking activities

• Proposed auditing standard on related parties and related

amendments to PCAOB auditing standards

• Concept release on auditor independence and audit firm

rotation

• Proposed auditing standard on auditing supplemental

information accompanying audited financial statements

and related amendments to PCAOB standards

• Concept release on possible revisions to PCAOB

standards related to reports on audited financial

statements and related amendments to PCAOB

standards.

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List of PCAOB temporary standards

• AU Section 100 – Statements on Auditing Standards – Introduction

• AU Section 200 – The General Standards

• AU Section 300 – The Standards of Field Work

• AU Section 400 – The First, Second and Third Standards of Reporting

• AU Section 500 – The Fourth Standard of Reporting

• AU Section 600 – Other Types of Reports

• AU Section 700 – Special Topics AU Section 800 –Compliance Auditing

• AU Section 900 – Special Reports of the Committee on Auditing Procedures

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Big Four firms and non-Big Four

• Deloitte, Ernst & Young, KPMG and

PricewaterhouseCoopers

• Second Tier – Grant Thornton; BDO Seidman;

McGladrey & Pullen; Moss Adams; Myer,

Hoffman & McCann; Crowe Group; American

Express; and BKD.

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Legal liability of the auditor

• Varies from country to country, district to district.

• Based on one or more of the following:

• common law;

• civil liability under statutory law;

• criminal liability under statutory law;

• liability for members of professional accounting

organisations.

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Common Law Ultramares – Touche case

(Ultramares Corporation vs. Touche et al.)

• The accountants were negligent for not finding

that a material amount of accounts receivable

had been falsified when careful investigation

would have shown it to be fraudulent

• Not liable to a third party bank because the

creditors were not a primary beneficiary, or

known party

• Called the Ultramares doctrine, that ordinary

negligence is not sufficient for a liability to a third

party because of lack of privity of contract

between the third party and the auditor.

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Caparo Industries, PLC vs. Dickman

• The question in Caparo was the scope of the assumption

of responsibility of the auditor if a clean opinion was

given for negligent accounts, and what the limits of

liability ought to be.

• The House of Lords of the UK, following the Court of

Appeal, set out a ‘three-fold test’ for an obligation (duty

of care) to arise from negligence

• harm must be reasonably foreseeable;

• the parties must be in a relationship of proximity;

• it must be fair, just and reasonable to impose liability.

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Civil liability under statutory law

• The Securities Act of 1933 established the first US

statutory civil recovery rules for third parties against

auditors.

• Original purchasers have recourse against the

auditor for up to the original purchase price if the

financial statements are false or misleading.

• The auditor has the burden of demonstrating that

reasonable investigation was conducted or that all

the loss of the purchaser of securities (plaintiff) was

caused by factors other than the misleading

financial statements.

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Sarbanes–Oxley Act of 2002 civil penalties for

CEOs and CFOs

• If there is a material restatement of a company’s reported financial results due to the material non-compliance of the company, as a result of misconduct, the CEO and CFO shall reimburse the company for any bonus or incentive or equity-based compensation received within the 12 months following the filing with the financial statements subsequently required to be restated (Section 304).

• Financial statements filed with the SEC by any public company must be certified by CEOs and CFOs. If all financials do not fairly present the true condition of the company CEOs and CFOs may receive fines of up to $1 million. If certifications are made knowing the statements are incorrect, the fine can be up to $5 million.

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Criminal liability under statutory law

• The Securities Exchange Act of 1934 in the United

States sets out (Rule 10b-5) criminal liability for the

auditor to employ any device, scheme or artifice to

defraud or intentionally or recklessly misrepresent

information for third party use.

• Not In Text Cases: In United States vs. Natelli

(1975), United States vs. Weiner (1975), ESM

Government Securities vs. Alexander Grant & Co.

(1986).

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• To knowingly destroy, create, manipulate documents

and/or impede or obstruct federal investigations is

considered felony, and violators will be subject to fines

or up to 20 years imprisonment, or both.

• All audit reports or related workpapers must be kept by

the auditor for 7 years. Failure to do this may result in

10 years imprisonment.

• CFOs and CEOs who falsely certify financial statements

or internal controls are subject to 10 years imprisonment.

Willful false certification may result in a maximum of

20 years imprisonment.

Sarbanes–Oxley Act of 2002 criminal penalties

for CEOs, CFOs and auditors

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Liabilities as members of professional

organisations

Nearly all national audit professions have some sort of

disciplinary court.

The disciplinary court makes its judgment and

determines the sanction. It may be:

1. a fine;

2. a reprimand (either oral or written);

3. a suspension for a limited period of time (e.g. 6

months); or

4. a lifetime ban from the profession.

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Under common law in order to hold the auditor

successfully legally liable in a civil suit, the

following conditions have to be met: US classes

• An audit failure/neglect has to be proven (negligence issue).

• The auditor should owe a duty of care to the plaintiff (due professional care).

• The plaintiff has to prove a causal relationship between his losses and the alleged audit failure (causation issue).

• The plaintiff must quantify his losses (quantum issue).

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Financial risks resulting from litigation for

audit firms

European Union Commissioner

Charlie McCreevy has said:

‘We have concluded that unlimited liability combined

with insufficient insurance cover is no longer tenable. It

is a potentially huge problem for our capital markets

and for auditors working on an international scale. The

current conditions are not only preventing the entry of

new players in the international audit market, but are

also threatening existing firms.’

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Suggested solutions to auditor liability

• Some countries (e.g. Germany) have put a

legally determined cap on the liability of auditors

(to the client in the case of Germany).

• A system of proportionate liability – an audit firm

is not liable for the entire loss incurred by

plaintiffs but only to the extent to which the loss

is attributable to the auditor.

• In order to protect the personal wealth of audit

partners, some audit firms are structured as a

limited liability partnership (e.g. in the UK).

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Suggested solutions to auditor liability

(Continued)

• To make insurance of all liability risks compulsory

using new legislation was one of the

recommendations of a EU commission.

• Exclude certain activities with a higher risk profile

from the auditors’ liability. A mechanism to

achieve this outcome would be to introduce so-

called safe harbour provisions by legislation.

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Audit expectations with regard to the following

duties of auditors: giving an opinion on

• the fairness of financial statements;

• the company’s ability to continue as a going concern;

• the company’s internal control system;

• the occurrence of fraud;

• the occurrence of illegal acts.

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The fairness of financial statements: The

company’s ability to continue as a going concern

A large part of the financial community (users of audit

services) expects that financial statements with an

unmodified (unqualified) audit opinion are completely

free from error. The inherent limitations of auditing not

accepted.

In most national regulations, auditors need to determine

whether the audited entity is able to continue as a going

concern.

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Opinion on the company’s internal control

system

• The objective of the auditor is to identify and

assess the risks of material misstatement …

through understanding the entity and its

environment, including the entity’s internal

control.

• The United States Sarbanes–Oxley Act of 2002

requires that company officers certify that internal

controls are effective and requires that an

independent auditor verify management’s

analysis.

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Company’s internal control

Section 404 of the Sarbane–Oxley Act requires each annual report

of a company to contain an ‘internal control report’ which should:

1.State the responsibility of management for establishing and

maintaining an adequate internal control structure and procedures

for financial reporting.

2.Contain an assessment, as of the end of the fiscal year, of the

effectiveness of the internal control structure and procedures for

financial reporting.

3.Companies must select suitable criteria (COSO-based) against

which it may evaluate the effectiveness of internal controls for

authorisation, safeguarding assets, and properly recording of

transactions.

4.An independent auditor attests to any difference between

management’s assertions under 404 and the audit evidence on

internal controls.US classes

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Opinion on the occurrence of fraud

• Both governments and the financial community

expect the auditor to find existing fraud cases

and report them.

• Audit history has gone from the fraud detection

as the objective of an audit to not taking any

responsibility for fraud, to the current position

that the auditor is responsible for obtaining

reasonable assurance the financial statements

are free from material statement, whether

caused by fraud or error.

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The occurrence of fraud

• ISA 240 – the responsibility for the prevention and detection of fraud and error rests with both those charged with the governance and the management.

• ISA 210 states that when planning and performing audit procedures and in evaluating and reporting the results, auditors should consider the risk of misstatements in financial statements resulting in fraud.

• In planning the audit, the auditor must assess the risk that material fraud or error has occurred.

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US fraud standard – US classes

• Auditing Standard Number 99 (SAS 99).

• The standard requires that as part of the planning process the audit team must consider how and where the client’s financial statements may be susceptible to fraud.

• Gather information by inquiring of management and considering fraud risk factors.

US classes

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The occurrence of illegal acts

• Both ISA 250 and most national regulators state that

the auditor’s responsibility in this area is restricted to

designing and executing the audit in such a way that

there is a reasonable expectation of detecting

material illegal acts which have a direct impact on

the form and content of the financial statements.

• The professional regulations in some countries

require the auditor to inform members of the audit

committee or board of directors.

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Responses to accounting controversies

In response to the controversies there have been

in two landmark studies (the COSO Report and the

Cadbury Report which lead to the Combined Code

and the Turnbull Report) and most recently have

been legislated into the US accounting profession

by the Sarbanes–Oxley Act of 2002.

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COSO report

The COSO report was published by the Committee of Sponsoring Organizations of the Treadway Commission. The COSO report envisaged:

1.harmonising the definitions regarding internal control and its components;

2.helping management in assessing the quality of internal control;

3.creating internal control benchmarks, enabling management to compare the internal control in their own company to the state-of-the-art;

4.creating a basis for the external reporting on the adequacy of the internal controls.

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Combined Code UK

• In 1998 London Stock Exchange published a new

Listing Rule together with related Principles of

Good Governance and Code of Best Practice

(called ‘the Combined Code’).

• The combined code combines the

recommendations of the so-called Cadbury,

Greenbury, and Hampel committees on corporate

governance.

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The Sarbanes–Oxley Act of 2002

Restrictions on auditors

• Auditors must report to the audit committee.

• The lead audit partner and audit review partner must be rotated every five years.

• A second partner must review and approve audit reports.

• It is a felony with penalties of up to 20 years in jail to willfully fail to maintain ‘all audit or review work papers’ for seven years.

• Auditors are prohibited from offering certain information system and accounting services.

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Thank you for your attention

Any Questions?

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Chapter 2 The Audit Market

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