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The Audit Market Principles of Auditing: An Introduction to International Standards on Auditing Ch'


Original purchasers have recourse against the auditor for up to the original ... the purchaser of securities (plaintiff) was caused by factors other than the ... – PowerPoint PPT presentation

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Title: The Audit Market Principles of Auditing: An Introduction to International Standards on Auditing Ch'

The Audit Market Principles of Auditing An
Introduction to International Standards on
Auditing - Ch. 2
  • Rick Stephan Hayes,
  • Roger Dassen, Arnold Schilder,
  • Philip Wallage

Demand for audit services explained by several
different theories
  • The Policeman Theory
  • The Lending Credibility Theory
  • The Theory of Inspired Confidence
  • Agency Theory

Agency Theory
  • a reputable auditor is appointed in the interest
    of third parties and of management.
  • a company is viewed as the result of 'contracts',
    in which several groups make some kind of
    contribution to the company, given a certain
  • agent 'management' has a considerable advantage
    over the principals regarding information about
    the company.

Audit Regulation
  • The Sarbanes-Oxley Act of 2002 required the U.S.
    Securities and Exchange Commission (SEC) to
    create a Public Company Accounting Oversight
    Board (PCAOB).
  • In Australia, the Corporate Law Economic Reform
    Program Act 1999 established a new body, the
    Financial Reporting Council (FRC)
  • The Review Board Limited in the UK whose work is
    being transferred to the UK Financial Reporting
  • Public Interest Oversight Board founders include
    Basel Committee, IOSCO, IAIS, World Bank,
    Financial Stability Forum (FSF) and EU.

Who supervises Auditing rules and Auditing Firms?
Public Company Accounting Oversight Board (PCAOB)
Created by the Sarbanes-Oxley Act of 2002
PCAOBs Audit Standards (Not in Text)
  • PCAOB Audit Standard No. 1 Reference in Audit
  • PCAOB Audit Standard No. 2 Internal Control
  • PCAOB Audit Standard No 3 Audit Documentation
  • PCAOB Audit Standard No 4 Reported Weakness

Key Provisions of Audit Standard No. 2 (Not in
  • Evaluating Management's Assessment
  • 2. Obtaining an Understanding of Internal
    Control Over Financial Reporting, Including
    Performing Walkthroughs
  • Identifying Significant Accounts and Relevant
  • Testing and Evaluating the Effectiveness of the
    Design of Controls
  • 5. Testing Operating Effectiveness
  • Timing of Testing
  • Using the Work
  • of Others

Key Provisions of Audit Standard No. 2
  • 8. Evaluating the Results of Testing
  • 9. Identifying Significant Deficiencies
  • 10. Forming an Opinion and Reporting
  • 11. No Disclosure of Significant Deficiencies
  • 12. Material Weaknesses Result in Adverse
    Opinion on Internal Control
  • 13. Testing Controls Intended to Prevent or
    Detect Fraud

Who used to make auditing rules in the U.S.?
the Auditing Standards Board
Big Four Firms Non-Big Four
  • Deloitte, Ernst Young, KPMG, PricewaterhouseCoop
  • Second Tier Grant Thornton BDO Seidman
    McGladrey Pullen Moss Adams Myer, Hoffman
    McCann Crowe Group, American Express, BKD

Technical and Functional Audit Quality
  • Technical audit quality is the degree to which an
    audit meets a consumer's expectations with regard
    to the detection and reporting of errors and
    irregularities - the quality of the outcome of
    the audit process.
  • Functional audit quality is the degree to which
    the process of carrying out the audit and
    communicating its results meets a consumer's
    expectations - the process itself.

Audit Fees
  • Important determinants of audit fees are
  • the size of the auditee and the geographical
  • the size of the audit firm (Big Four firms seem
    to demand a fee premium)
  • the quality of the auditee's internal control
  • the type of fee contract (fixed fee versus
    variable fee).

Legal liability of the auditor
  • varies from country to country, district to
  • based on one or more of the following
  • common law,
  • civil liability under statutory law,
  • criminal liability under statutory law, and
  • liability for members of professional accounting

Common Law Ultramares - Touche case (Ultramares
Corporation v 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.

Civil Liability Under Statutory Law
  • The Securities Act of 1933 established the first
    U.S. 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 all
    that the loss of the purchaser of securities
    (plaintiff) was caused by factors other than the
    misleading financial statements.

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 v. Natelli
    (1975) United States v. Weiner (1975) ESM
    Government Securities v. Alexander Grant Co.

Liabilities as Members of Professional
  • Nearly all national audit professions have some
    sort of disciplinary court.
  • The disciplinary court makes its judgment and
    determines the sanction. It may be
  • a fine
  • a reprimand (either oral or written)
  • a suspension for a limited period of time (e.g. 6
    months) or
  • a lifetime ban from the profession.

In order to hold the auditor successfully legally
liable in a civil suit, the following conditions
have to be met
  • 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 her losses and the alleged
    audit failure (causation issue)
  • The plaintiff must quantify her losses
    (quantum issue).

Suggested Solutions to Auditor Liability
  • 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.
  • Some countries (e.g. Germany) have put a legally
    determined cap on the liability of auditors (to
    the client in the case of Germany).
  • 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).

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
  • the company's internal control system
  • the occurrence of fraud and
  • the occurrence of illegal acts.

Company's Internal Control (not in Text)
  • Section 404 of the Sarbanes-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, and
  • (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
    authorization, safeguarding assets, and properly
    recording of transactions.
  • (4) An independent auditor attests to any
    difference between managements assertions under
    404 and the audit evidence on internal controls

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
  • 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

US Fraud Standard
  • 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 clients financial statements may
    be susceptible to fraud.
  • Gather information by inquiring of management and
    consider ing fraud risk factors

The Occurrence of Illegal Acts
  • Both ISA 250 and most national regulators state
    that the auditor's responsibility 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

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.

COSO Report
  • The COSO report was published by the Committee of
    Sponsoring Organizations of the Treadway
    Commission. The COSO report envisaged
  • 1 harmonizing 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 and
  • 4 creating a basis for the external reporting on
    the adequacy of the internal controls.

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.

The Sarbanes-Oxley Act of 2002 Restrictions on
  • 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
  • It is a felony with penalties of up to 10 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.

Thank You for Your Attention
  • Any Questions?