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The Audit Market Principles of Auditing: An Introduction to International Standards on Auditing - Ch. 2


Principles of Auditing: An Introduction to International Standards on Auditing - Ch. 2 Rick Stephan Hayes, Roger Dassen, Arnold Schilder, Philip Wallage – PowerPoint PPT presentation

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Title: The Audit Market Principles of Auditing: An Introduction to International Standards on Auditing - Ch. 2

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

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
  • PCAOB has passed 15 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)

PCAOBs Audit Standards
  • AS No. 1 References in Auditors Reports to the
    Standards of the Public Company Accounting
    Oversight Board
  • 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
  • AS No. 7 Engagement Quality Review

PCAOBs Audit Standards
  • AS No. 8 Audit Risk
  • 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

PCAOB Audit Standard 3 Audit Documentation
  • This standard establishes general requirements
    for documentation the auditor should prepare and
    retain in connection with engagements
  • 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
  • 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 ),

PCAOB Audit Standard 5 An Audit of Internal
Control Over Financial Reporting That Is
Integrated with An Audit of Financial Statements
  • 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.
  • If one or more material weaknesses exist, the
    company's internal control over financial
    reporting cannot be considered effective.
  • The audit of internal control over financial
    reporting should be integrated with the audit of
    the financial statements.

PCAOB Audit Standard 6 Evaluating Consistency
of Financial Statements
  • This standard establishes requirements for the
    auditor's evaluation of the consistency of the
    financial statements.
  • The auditor should recognize the following
    matters 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.

Auditing Standard No. 7  Engagement Quality Review
  • An engagement quality review and concurring
    approval of issuance are required for each audit
    engagement and for each engagement to review
    interim financial information
  • 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
  • An engagement quality reviewer must have
    competence, independence, integrity, and

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

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 that
    all the loss of the purchaser of securities
    (plaintiff) was caused by factors other than the
    misleading financial statements.

Sarbanes Oxley Act of 2002 Civil Penalties for
CEOs and CFOs
  • If there is a material restatement of a companys
    reported financial results due to the material
    noncompliance 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.

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.

Sarbanes Oxley Act of 2002 Criminal Penalties for
CEOs, CFOs and Auditors
  • 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

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
  • 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 tauditor is not responsible for
    preventing non-compliance and cannot be expected
    to detect noncompliance with all laws and
    regulations. In conducting an audit of financial
    statements, the auditor takes into account the
    applicable legal and regulatory framework when
    planning the audit.
  •  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?