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Advanced Financial Statement Auditing Topics

Outline for Seminar #2
By the end of this seminar students should be able to explain:

How auditor independence can be affected by opinion shopping?

What are the requirements of AU 315?

What are the auditor independence rules for public and private companies?

1. Class questions and student presentation (see this Seminar outline).***
2. Audit quality and executive officers affiliations with CPA firms, C. Lennox, Journal
of Accounting and Economics, 2005, Vol. 39, No. 2: 201-231. This article is
helpful for answering Q2 below.***
3. Tax account misstatements and the PCAOBs restrictions on auditors tax
services. C. Lennox, Working paper, 2015, University of Southern California. This
article is helpful for answering Q3 below.***
4. AU 220: Independence.**
5. Chapter 4, Auditing and Assurance Services, Arens, Elder and Beasley.**
6. AICPA Code of Professional Conduct.*
7. AU Section 315. Communications between predecessor and successor auditors.
related to the student presentation.
8. Do companies successfully engage in opinion-shopping? The UK experience, C.
Lennox, Journal of Accounting and Economics, 2000, Vol. 29, No. 1: 321-337. This
article is related to the student presentation.

9. Management influence on auditor selection and subsequent impairments of

auditor independence during the post-SOX period, D. Dhaliwal, P. Lamoreaux, C.

Lennox, and L. Mauler), Contemporary Accounting Research, 2015, Vol. 32, 575607. This article is related to the student presentation.
***: Required reading
**: Recommended reading
*: Optional reading
: Recommended reading for the presenters and optional for everyone else

Questions to be discussed during the seminar

Q1. Lakeview Ltd has borrowed a substantial portion of its funds from a bank to pay
for land developments. The terms of the loan require the company to produce
unaudited quarterly financial statements. The financial statements prepared by the
book-keeper are inadequate and so the company has approached your audit firm to
prepare the financial statements. Because of limited funds your fee would be paid in
Lakeview shares rather than in cash. You would not receive enough shares to be a
major shareholder.

In light of the AICPA Code of Professional Conduct can you accept the
companys request to prepare the quarterly statements?
Assume you accept and the bank later requires annual audited financial
statements. The company realizes you might be unwilling to accept the
engagement if you are paid in shares so it is willing to pay your audit fee in
cash. Should you accept the engagement?

Q2. Sometimes a member of the audit team accepts an offer of employment at an

audit client.
What are the potential threats to audit quality when a member of the audit
team accepts an employment position at an audit client?
Do the potential threats to audit quality occur before or after acceptance of
the employment position?
Q3. In 2005-2006, the PCAOB introduced restrictions on the provision of tax services
to audit clients.
Given the AICPAs prohibition on contingent fees, why did the PCAOB feel it
was necessary to introduce Rule 3521?
Why did the PCAOB bar audit firms from selling aggressive tax services to
audit clients in Rule 3522?
Why did the PCAOB bar audit firms from selling tax services to executives in a
financial reporting role in Rule 3523?

Multiple choice questions

In which of the following situations might an audit firms independence be perceived
as being compromised?
A fee is based upon whether the audit report leads to approval of the clients
application for bank financing
A fee is to be established at a later date by the Bankruptcy Court
A fee is based upon the nature of the engagement rather than upon the
actual time spent on the engagement
A fee is based on the fee charged by the clients former auditors
As auditor you become aware a few days after the start of the audit that you lack
the independence required for this particular engagement. You should:
issue an opinion disclaimer
issue an adverse opinion
suggest that the client engage a different audit firm
rely on the independence of the internal audit department

Presentation Auditor changes and opinion shopping

Number of presenters: 1 student
Expected duration: 15 minutes

Is Shopping for an Audit Opinion? December 29, 2009 (NASDAQ: OSTK) just hired KPMG as its auditors to replace Grant
Thornton who was recently fired by the company, despite previous assurances by
CEO Patrick M. Byrne and company President Jonathan E. Johnson that they would
not hire new auditors until after the Securities and Exchange Commission Division of
Corporation Finance completed its review of certain financial reporting irregularities.
Both the SEC Enforcement Division and Division of Corporation Finance started
investigating after I alerted them that the company violated
Generally Accepted Accounting Principles (GAAP) by improperly establishing what is
known as "cookie jar" reserves to inflate its financial performance starting in Q4
2008. Afterwards, fired Grant Thornton as the company's auditors
and publicly vilified them when they recommended another restatement of the
company's financial reports, just as I previously called for in my blog. The company
filed an "unreviewed" Q3 2009 10-Q and CEO Patrick Byrne and CFO Steve Chesnut
did not sign required Sarbanes-Oxley certifications. NASDAQ sent a
letter warning the company of a possible de-listing. NASDAQ recently granted an extension to comply with its listing requirements.

Patrick Byrne and Jonathan Johnson went back on their promise that they would not
shop for an audit opinion. Both Byrne and Johnson previously told investors that would wait until after the SEC Division of Corporation Finance
completed its review of the company's financial disclosures. See quotes from
transcript below:

Willis Taylor - Gagnon Securities - Analyst

Since you've dismissed your auditor for a very specific accounting choice,
when you go to select a new auditor, how do you prevent yourself from being
accused of opinion shopping?
Jonathan Johnson - - President
That's a great question, Louis, and that's part of the reason that we've
decided not to select a new auditor until this -- until we resolve this issue with
the SEC.
We do not want to be accused of opinion shopping. We'd like the SEC to help
us figure out -- we'd like them to say we've done it the right way or we've
done it the wrong way. Once they say one of those two, we don't need to
opinion shop.
Patrick Byrne - - Chairman and CEO
But, so, I would even say to the point that when people have contacted us,
we have discouraged any communication on the grounds that we got -- for
just that reason -- well, I have the -- no matter who we talk to now, then
whoever we ultimately pick, people are going to say, well, you did this
because you opinion shop.
So we're really not having discussions with anybody. It's nice to get phone
calls, but we're not talking to anybody until we get through this just to
prevent -- just as a prophylactic measure.

KPMG is taking a client with no management integrity as is well advised to study

SAS No. 99 about "Consideration of Fraud in a Financial Statement Audit" regarding
the unethical "tone at the top" set by's unprincipled management
Every single initial financial report for every reporting period issued by has failed to comply with GAAP and other SEC disclosure rules since
the company's inception. has restated its financial reports two times
in the last three years and now is trying to avoid a third restatement of financial
reports resulting from its improper use of "cookie jar" reserves to inflate its financial
performance from Q4 2008 to Q3 2009.
In Going Concern, Caleb Newquist wrote:
Sorry, dear reader but apparently the high profile cat fight between the company
and Grant Thornton wasnt enough to scare KPMG off. Not even the very public
revelation of Patsys creepy-ass stalking of Overstock critics in the financial media
and blogosphere caused the KPMG partners in SLC to turn this client down. Oh, and
not to mention a management team who thought that filing unreviewed 10-Q was
the best course of action.

While Adrienne Gonzalez, another widely read accounting blogger, was even
more blunt in her criticism of KPMG:

F..cking KPMG. Come on, you can do better than this.

She added: KPMG just sold its ass up the river.

Scepticism sits low on FDs' audit priorities, Kevin Reed; 27 February 2013; Accountancy
SCEPTICISM SITS low down the list of finance directors' priorities when assessing the quality
of their auditors. A survey of 188 finance directors by Accountancy Age's sister title Financial
Director found that auditor scepticism ranked nine of 11 key traits when assessing their
importance in gauging audit quality, scoring an average of 2.5 out of four. Degree of challenge'
was ranked seven of the 11. Top of the pile was efficiency of audit process, scoring 3.7 out of 4.
Other key traits included the reliability of the audit report; sector and business knowledge;
communication skills; and the ability to spot misstatements.
The future structure of the audit market, and the services provided by its participants, is very
much up for debate. The Competition Commission said last week that auditors were focused on
the interests of management above shareholders. The European Commission is also set to report
on its findings into the audit market. Financial Director's survey included 92 interviews with FDs
of companies audited by the top six UK accountancy firms. FDs of 17 listed companies were
interviewed, alongside 171 non-listed FDs. Kevin Reed, editor of Accountancy Age and
Financial Director, said: "While FDs of non-listed companies are more likely to use auditors as
close-at-hand business advisers than for public interest entities, it is still worrying that auditors'
scepticism and challenge rank below process efficiency when they assess audit quality.
"Investors in large listed businesses need to play a more active role in their companies' audit
process. I hope that investors, or owners, of non-listed businesses are getting the most out of
their auditors."
Suggested questions
1. The Sarbanes-Oxley Act (2002) requires audit committees to take
responsibility for appointing and changing audit firms. Why was this
requirement introduced? Do you think management still have
opportunities to engage in opinion-shopping even after SOX?
2. What information must a company disclose in its 8-K filing when it
changes auditor? What is the likely impact of this disclosure requirement
on opinion-shopping?