External Auditors’ Roles and Responsibilities

Chapter IX

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

governance and reliable financial reports.

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

recently placed on them.

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

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

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

standards published by the PCAOB.

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

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

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

rationale on both sides of the issue.

VIDEO ( VIDEO)

Key Terms The 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 Auditing and Corporate Governance

External Auditor Responsibility

Current auditing standards require that independent auditors provide reasonable assurance that the financial statements are free from material misstatements, whether caused by error or fraud, to render an unqualified opinion on the financial statements.

External auditors are not and should not be expected to provide absolute assurance regarding reliability of financial statements, but the public expectations concerning external auditors performance are high.

Users of audited financial statements generally expect external auditors to detect financial statement fraud and employees’ illegal acts and fraud, which affects the integrity of financial reports. External auditors, however, are more concerned with material misstatements in the audited financial statements.

Auditor Competency 1. Professional competencies. To audit public companies,

auditors should register with the PCAOB and meet all registration and inspection requirements.

2. Technical competencies. Auditors should be knowledgeable in professional standards, rules, laws and regulations, and understand their clients’ industry and business, corporate governance, financial reporting process, and internal controls.

3. Process competencies. Auditor’s ability to choose appropriate evidence-gathering procedures (tests of controls, substantive tests) and execute auditing procedures

4. Reporting competencies. Reporting competencies refer to the auditors’ ability and willingness to discover and report material misstatements.

Reports Accompanying Financial Statements

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

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

reporting?• Report on internal control over financial reporting

(prepared by auditor) Is management’s assessment of its internal control appropriate? Has company maintained effective internal control over 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 of Audit 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 Interpretation

Unqualified Opinion

Financial statements taken as a whole present fairly the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles (GAAP).

Qualified Opinion “Except for” the effects of a particular matter, 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 Opinion

Auditor does not express an opinion on the financial position, results of operations, or cash flows.

Unqualified Reports

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.

Audit notice

Standard Unqualified Audit Report(Nonlisted Companies)

Title Report of Independent Auditor

Address to client

To the Board of Directors and stockholders of Any company

Audit notice

We have audited the accompanying balance sheets of Any company as of December 31, 1990 and 1989, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

Identify the financial statements

Management responsibility

Auditor responsibility

continued

Description of the audit

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

No special mention of adequate disclosure or consistency

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Any company as of December 31, 1990 and 1989, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.

Opinion on financial statements

Refer to GAAP

___________________________________, CPA

February 28, 1991

Signature

Date

Audit Failures and Audit QualityFollowing is the list of the initiatives that have been suggested 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 statements

6. 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 efficacy

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

Public Company Accounting Oversight Board

The PCAOB created by SOX to regulate the auditing profession.

The PCAOB’s primary functions are to:

1. Register public accounting firms that audit public companies.2. Inspect the registered public accounting firms on a regular basis.3. Establish auditing, attestation, ethics, quality control, and independence standards.4. Conduct investigations and disciplinary proceedings.

PCAOB Auditing Standards The PCAOB has issued five auditing standards as of September 2007:

1. PCAOB Auditing Standard No. 1 (audit is conducted in accordance with auditing standards of PCAOBUS, the city and state has to be disclosed) 2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR) 3. PCAOB Auditing Standard No. 3 (auditors are required to maintain the audit documentation in a sufficient manner and keep the records for at least seven years)4. PCAOB Auditing Standard No. 4 (voluntary engagement for the auditor’s report on the company’s elimination of previously reported material weaknesses in its ICFR)

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Roles and Responsibilities—Internal Control over Financial 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.

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What Management’s Report Will Include

Under 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.

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

1. AS No. 2 required three integrated reports on:a. Financial statements audited by registered public accounting

firms.

b. Management’s assessment of the effectiveness of internal control over financial reporting (Section 404).

c. The effectiveness of internal control over financial reporting over financial reporting based on the auditor’s attestation of internal control.

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

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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.

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Report of Independent Registered Public Accounting Firm

*The explanatory paragraph is required only when the auditor’s opinion is other than unqualified and may also be placed after the opinion paragraph when the auditor issues two separate reports on the audit of financial statements and internal controls, thus making reference to opinion on the financial statement audit in the report on the internal control audit.

1. IntroductoryParagraph

2. ScopeParagraph

3. DefinitionParagraph

6. InherentLimitationsParagraph

5. ExplanatoryParagraph*

4. OpinionParagraph

7. Signature 8. City andState orCounty

9. Date

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

26Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.

27Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.

PCAOB Auditors Independence

The new rules restrict public accounting firms in performing a variety of tax services to their audit clients. The new rules are intended to prevent the selling of abusive tax shelters.

Audit Committee Oversight of External Auditors

The extended oversight responsibilities for the audit committee are:

1. Appointment, compensation, and retention of registered public accounting firms2. Preapproval of audit services and permissible nonaudit services3. Review of the independent auditor’s plan for an integrated audit of both ICFR and annual financial statements4. Review and discussion of financial statements audited or reviewed by the independent auditor5. Monitoring the auditor’s independence6. Auditor rotation requirement

Audit Committee Oversight of External Auditors

The number of companies that change auditors, and the number of auditors changed

Independent Auditors Communications with the

Audit Committee Communications from the committee to the independent auditor:

Communications from the independent auditor to the audit committee:

1. Appointment and retention approval of the independent auditor

2. Formal approval of audit and permissible nonaudit services3. Formal approval of fees for both audit and nonaudit services with a keen focus on improving the quality of audit and nonaudit services4. Any concerns or risks threatening management’s reputation and integrity, etc. 5. Allegations of financial statement fraud

1. Seeking committee preapproval of all audit and nonaudit services in a timely manner2. The critical accounting policies and practices used by management in the preparation of financial statements3. All alternative treatments of financial information within GAAP4. Any accounting disagreements between the independent auditor and the company’s management5. Any material, written communications between the independent auditor and the company’s management throughout the course of the audit6. Significant deficiencies and material weaknesses of ICFR7. The audit report on annual financial statements8. The review report on quarterly financial statements9. The audit report on management’s assessment of the effectiveness of ICFR10. The audit report on the effectiveness of ICFR11. Financial risks associated with financial reports

Auditor Independence

Auditor Independence

Consolidation and Competition in Public Accounting Firms

SEC rules require public companies that change their public accounting firms to file a Form 8-K, Item 4.01, to disclose changes within four days, whereas auditors are required to provide standard letters within ten days stating whether they agree with the company’s disclosure without specifying any reasons.

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 Strategy Audit Strategy:

1. No limited tests of controls2. No use of cycle rotation in tests of controls3. Dual testing of controls and substantive audit procedures

Auditors should focus on prevention, detection, and correction of controls at both the company level and the transaction level. Auditors should perform tests of controls as a basis for forming an opinion on the effectiveness of ICFR. Auditors should also perform substantive tests as a basis for expressing an opinion on the fair presentation of financial statements, regardless of the identified significant deficiencies and material weaknesses in internal controls.

The Audit

Video

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. 9937

Types of Fraud

FRAUD

Management Fraud

Employee Fraud

Financial Statement Fraud

Misrepresentation of material factsMisappropriation of assets

Concealment of material facts

Illegal Acts

Bribery

Conflict of Interest

Embezzlement of money or propertyBreach of fiduciary duty

Theft of trade secrets of intellectual property

Illegal acts

Why People Commit Fraud

Studies show that employees are likely to commit fraud when four conditions exist:

– PRESSING FINANCIAL NEED– OPPORTUNITY– REASONABLE JUSTIFICATION– LACK OF MORAL PRINCIPLES

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Embezzlement Formula

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MOTIVE +

OPPORTUNITY +

RATIONALIZATION =

CRIME [FRAUD]

Profile of Fraud Perpetrators

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

MORE LIKELY TO BE:• A woman• Married• Church member• Older• Heavier• Have children• Have a higher education• Never been arrested• Have high self-esteem• High achiever

LESS LIKELY TO BE:• Divorced• Alcoholic• Tattooed

Financial Statement Fraud• Definition – Deliberate misstatements or 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.

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High-Profile Financial statement Fraud

Basis of the Fraud Older Example Year Recent Example Year

Fictitious revenue, documentation forgery and theft of corporate assets

ZZZZ Best1987

Enron2001

Personal use of assets, false documentation and financial statement fraud

Phar-Mor 1992 Adelphia 2002

Capitalizing expenses, among other issues

Waste Management

1997 WorldCom 2002

Abuse of accounting standards

Savings and Loan Crisis

1982 Stock Options Backdating 2006

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)

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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

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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?

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Misappropriation of Assets Risk Factors

• Susceptibility of assets to misappropriation

• Employee relationships or pressures

• Deficiencies in internal control

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Red Flags

• Personal financial pressure• Vices (drugs, alcohol or gambling)• Extravagant lifestyles• Real or imagined grievances against

company• Related parties• Increased stress• Internal pressures

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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

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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

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SAS No. 99

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Rationalization

Incentives/ Pressures

Opportunities

The Fraud Triangle

The Fraud Triangle• Incentives/Pressures

95 percent of all fraud cases involve either:– Financial pressures– Vice-related pressures, including drug or alcohol

addiction– Expensive romantic relationships– Need to maintain a particular lifestyle– Medical problems

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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."

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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

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3Cs of Financial statement Fraud

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Errors

Misappropriation of Assets

Financial Statement

Fraud

Audit Risk

Errors

Misappropriation of Assets

Financial Statement

Fraud

Errors

Misappropriation of Assets

Financial Statement

Fraud

Tests of Controls

Evaluate Control Environment

Analytical Procedure

s

Tests of Details

=

Incentive/ Pressure

Management Integrity

Opportunity

R1

R2

Incentive/ Pressure

Fraud Risk Factors

Attitude/ Rationalization

Fraud Risk Factors

Opportunity Fraud Risk

Factors

Forensic Procedure

s

Inherent Risk Control Risk Detection Risk

Evaluate Controls

Over Assets

X X

Evaluate Top

Management Controls

Audit of Defined Benefit Pensions

Employer-defined benefit pension reforms, as proposed by the administration and introduced by both the House and the Senate, would require plan sponsors to make minimum funding contributions equal to the greater of: (1)the contributions required under the plan’s funding

standard account estimated based on the plan’s actuarial accrued liability,

(2)deficient reduction contributions calculated under current liability rules.

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

system with a single measure of assets and liabilities andrequired funding method.

Auditors’ Liability Limitation Agreement

In February 2006, the Federal Financial Regulatory Agencies issued an interagency advisory that raised concerns regarding the negative impacts on the quality and reliabilityof audits when financial institutions agree to limit their independent auditors’ liability.

The advisory, while observing an increase in the types and extent of provisions in financial institutions’ external audit engagement letters that limit auditor liability, informs financial institutions that they should not enter into an audit engagement that includes unsafe and unsound limitation of liability provisions relevant to an integrated audit of their financial statements and ICFR.

Auditors Liability Limitation Agreement

Conclusion • The audit function should be regarded as an external corporate governance mechanism that serves to protect investors from receiving incomplete, inaccurate, or misleading financial informationand thus adds value to the effectiveness of corporate governance.• SOX drastically changed the characteristics of the accounting profession by connecting the audit function to the corporate governance structure by requiring that the audit committee be directly responsible for not only hiring, compensating, and firing external auditors, but also overseeing their work, monitoring their independence, and avoiding potential conflicts of interest.• In the auditing profession, the so-called expectation gap is referred to as the difference between (1) what the investing public and other users of audited financial statements believe the responsibilities of auditors are, and (2) what auditors are willing to assume as responsibilities according to their professional standards.• New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR.

Conclusion • Sections 201 and 202 of SOX require that all audit and permissible nonaudit services to be performed by the company’s independent auditor be approved by the audit committee.• Auditor independence is the backbone of the auditing profession, affecting the auditor’s planning, evidence-gathering procedures, findings, judgment, and credibility, and public trust in the auditor’s opinion.• Auditor independence is derived and guided by these three principles: (1) independent auditors may not audit their own work, (2) independent auditors may not function in the role of their client’s management, and (3) independent auditors may not serve in an advocacy role for their audit clients.• Tests of controls must be broadened to include understanding of ICFR and provide reasonable assurance about the effectiveness of both the design and operation of internal controls.• Any contractual provisions that limit the external auditor’s liability or require waiving the right to a jury trial may have detrimental effects on auditor impartiality, objectivity, and quality.