Corporate governance anc! audits gay Te ovritng poe of th took tol undone ire pls BIST oe sar et nets ots ant eaame conn Toa eo hae ue ae ‘will be able to: 1 Dab carmela genes aside he pres rund capes goverance 2 Desoto canals goerance resporablies and fakes of connie gowmence lxsrg 1 trourrentol he operat Law Coonan Flor Pogam Ack Reo an Corel CSc) (2004 CLEP Oe 2 ent key carpets of he Ct ausirg pes Destoe marageents ob meena and conmurkatg ne arta cetlforaon frien reapers of a3 connie, Desctbe eae conmroaions bebe he su i ern at crite. seals te core bavosn coma governed as dol be vero Spee of fonerok prourcenets ft ale! he aun plese and he Serdveloned whi ac te rena clogs, 8° Desa he smtis end erences beeen aug ar asarance sandal he AASB and eines, 10. Lette indanertl pres of Astaln ang Surcass ASA) devoed by he ALAS ard Intemational Standards on Auditing (SAs) developed by the AASB. 11> ind acerdastoed apre0d 0 at er ee open orale oe. 1P 9 Act of 2009 relevent to corporete management and the Ciena REVIEN ates ues PROC Profesional Legal Laitycharrer 2 ‘The public accounting profession has been widely ertcised for not doing encugh to protect investor Jnferesis. While much of the audit profession has always pesformed admirably, the failures during te POH past decade have been spectacular: HIH and Cne-Tel in Australia and Enron end WoridCom in the US, jaa not to mention the impact on corporate collapse of the recent global financial criss, The Australian Government reacred to these failures by enacting the most extensive legislation affecting the audit profession in living memory. The Corporate Lew Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (CLERP 9 Act) fundamentally changed the auditor-cient relationship and ‘raneforred the process of setting audit standards from the private sector to the public sector Inthe US the SnvhancsCetey °ho2, more stringent than the CLERP 9 Act, was passed In response to ‘corporate collepses there However, the fallures that occurred during the past decade were not solely atsiburable to fallures tn the audit profession, They also represanted fundamental failures at the very heart of ergenisations failures of the corporate govemance structure. For example, questions have been ralsed about management greed associated with share-bescd incentives and shout whether a baad of diectats has enough power, time and resources 0 provide proper oversight of management. In response, the landscape forthe auditing profession has changed to include increased responsibilities, expectations and reater regulatory oversight, This chapter describes those changes anc: also introduces the auciting standards and the audit process. In terms of the audit and review opinion formulation process, this Chapter focuses on the basic notions ofthe auelting profession, regulation and camporate governance in ‘general anc Phase I ofthe process, i, understanding the cient in temas of corporate governance, Cais iveea| 72009, the Australian Treasury pubished research onthe rolatonstip beivesen corporate governance atibutes and the patformance ofthe SEP ASK 90D. This study examined tne |) relatonsrip between a company’s adoption ofthe Autaian (Creat, oganisatons tat have commits to good jgovemance, as evidenced by highs: goverance scores, padomed better - not oriyin he shart an but ove a longer tem. In some ways, good! govenano9 is corelatod high ‘Socuiies Exchange (ASY) Corporate Governance Conci's Principles ol Good Corporate Governance anc Best ractoe Recorrmenratons (ASX Corporate Governance Principle) ‘and its franc postormance in the areas of shareholder performance, operating performance and cre-year selos growth forthe top G00 Austraen listed companies, The results sugges that compenies demonstrating greater complance wih the ASK. Corporate Governance Penciples oulperorm ess compliant companies in each ofthese thre ow, Rett lars, Tue. Tesnins Worry Pape 200220 Compa sean Gate. Mirch 92 © erect. Commer Abiking Soe wih organisations’ org farm gucoess and hebas overcome meragaren’s short-term focus cn meeting ‘araist's expectations’ CContas the research fnings from the Treasury above with a suvey of Big 4 audios views oftheir cians’ shortcomings Common probiem reas noted by autre about thi clnis sre sted below mary reais to weskresses in oxpor governance: dovemanse a Fiat Fevarnance 1 new sires cle By Four sien? hanes apps of Unie etPart 1 >> Uunerstanoius aubsvon ResponsrerLi nies ‘Oval complex corporate stustres, 2 Felura to keep the legal since inline with the ‘management siuctue. 3. LeckotimeNement ofthe board of crectars ‘commurication wih auctor. 4 Lackat serio management sponsorship ofthe impotence of auit— tone fom the top. 5 Delogaing the auc relaionship too far down the ccomeany 6 Noone atthe alent is realy responsible for an ecient snrwal auc Not achieving {Ul buy fom the france function exound the group to deer the company's side ofthe bargain [Cents] only focus cn iow fees end not the defverabies, 9 Btieving that an aust sa commocsy ‘20 Not enough research dono or documented around ihe soricantjudgerens that have been made in procucing (9100p franca stotoments 122. Improper documentation af he "hought processes in ‘erhing t cris estinates and judgements inherent in the Preparation of fhanci statements ‘Ae you read tis chapter, consider the resus rom the Treoeury esearch along with the complaints by aucers about ‘hele cents 2s you thnk about the folowing questions: 4A Whyis te corporate governance of an argerisation Impotant to both rectors and audions? 2 Why woud the quali of corporate govemance affect the ‘quay of an crgarisaton's fnencia perormance? Wet eve the risks to an aor the company does not have good corporate governance? 44 What letionshi do tne board of diecters and the aut ccornmittes have wih the aust funcion? 5. Whyisit important that ogenisa have dreclors and audi cormitless that ae ful independent of menagement? 8 Shaud an auctor aocept an aust lergagerrent witha cormpary that does not have goad governs? 77 How are aucing standers designed tobalp protec he auctor against poor ‘governance by clents? Corporate governanca is @ process by which the owners and creditors of an organisation exert ‘control and require aecauntability for the resources entrusted to the organisation, The owners (hareholders) elect a board of directors Uo provide oversight of the organisations activities and accountability to stakeholders. Many parties have a vested interest in the quality of an organisation's corporate governance, including the following © shareholders Doards of directors audit committees as subcommittees of boars ‘management (financial and operational) Internal auditors quasi-regulatory accounting organisations, such as the [CAA, CPAA, IPA. other self-regulatory organisations, such as the ASK regulatory agencies, such as the FRC, ASIC, APRA, etc. extemal auditors eee re Eich Sea Exhibit 2. provides a broad schematic of the averall govemance process. Governance starts with the sharcholdersiowners delegating responsibiltls through an elected board of direczors tochapter 2 > management snd, in turn, to operating units with oversight and, where present, assistance from ingernal auditors. In return for those responsibilities (and power), governance demands accountability back through the system to the shareholders. However, the accountability does not sop with the shareholders. Management anc the board have responsibilities to act within the laws ‘of society and to meet various requirements of creditors and employees. Tn some parts of the world, particularly in Europe, organisations are increasingly called upon ta issue tziple-bottom-line or sustainability reporting tab delineates the organisation's contributions to the broader goals of society and the organisation's employees, TN See) Audit Assurance Stakeholders t Pod Perl oo Crore peri ‘Recountabiinty on Management « Ro —— Cree ‘The alternative reporting complements a company’s financial reports, with an emphasis on the activities the company has taken to meet ils social obligations and to sustain the environment, For example, an extract from Chief Executive Officer's Review in the 2010 Sustainability Report of BHP Billiton states: ‘Throughout che worl, national and regional policymakers are considering @ variety of legislative and regulatory options to mitigate areenhouse gas emissions. In our view, assessing these options requires an understanding oftheir Hkoly effectiveness, scale and cost, as wells thelr implications for economie grow and quality of hie. Within BHP Billion, we analyse and compare the various plie options by evalusting the degzve to which they meet defined set of principles, oulined in the Buvzoruent section ofthis ReporParr 1 >> Unpensranoine aupiroR ResponszoiLirtes Pome (hk Ceeere rity A ET dl In addition to focus on reduclng enengy consumption and greenhouse gs emisions, ‘BPs envionmental improvement pragrams incorporate biodiversy and land maagement, ‘water reuse andl reegeling to reduce consumption of high-quaiy water, waste management ad rtigating he risk of environmental incents [Assurance is not provided on most corporate sustainability reports, but they contain a wealth of information about the company’s philosophy and corporate governance that could be of interest to the suitor, It is important to understand that a broad group of stakeholders have an interest in the quality of eorporate governance and its relationship with econornic performance. For example, itis Hkely that many employees have significant funds invested in superannuation funds. We use ‘society’ in [Exhibit 2.1 to indicate those broad invorests. In a similar fashion, employees and creditors have a vested interest in the crganisation and how itis governed. Regulators are a tesponse to society's wishes to ensure organisations, n their pursuit of returns for thelr owners, act responsibly and ‘operate in compliance with relevant laws and regulations. Shareholders/owners requive accountability as lo how well the resources that have been ‘entrusted to management and the board have been used. For example, the owners wart acon on sch thins a financial performance » financial transparency ~ financial reports that are clear with full disclosure and that reflect the underlying economic reality of the company 1 stewardship, including how well he company protects and manages the resources entrusted tolt quality of internal controls composition of the board of directors ane! the nature of its activities, including information on how well management incentive systems are aligned with shareholders’ best interests Further, the owners want assurances that the representations made by management and the ‘board are accurate and objectively verifiable. For example, the board has a responsibility to report ‘on ils activities, including its oversight of manegement incentive systems. CORPORATE GOVERNANCE RESPONSIBILITIES AND FAILURES ‘The Australian financial failures of the past decade (e.g. HIH Ltd, Ansett Ltd, One:Tel Lid, Harris Scarfe Lid) cannot be attributed as primarily dhe fault of the public accounting profession. Rather, many of the failures represented fundamental breakdowns in the structure of corporate governance. Nor were the failures limited to any one country. Failures occurred in major ‘companies located in the US, Italy, Prance, India, Japan, the UK, as well as other parts of the ‘world. Greed simply overwhelmed many parts of the system, and arguably the selF-regulatory mechanisms (professional accounting bodies such as the ICAA, CPAA and TPA) failed in holdin ‘their members to the highest level of corporate accountability. The global francinl crisis triggered several collapses between 2008 and 2010, the most notable including Centro Properties Group, MFS Lid (renamed Octavisr), Opes Prime, Blderslie, ABC Learning Ltd, Storm Financial, Alleo Group, Babcock & Brown, Great Souther Lid and Timbercorp Ltd. Shareholder class actions anc other regulatory and private legal actions are pending against several ofthese entities’ auditors an no doubt there will be more corporate collapses and legal actions yet to emerge from the crisis. In response to the corporate failures early In this century, regulations such as the GLERP 9 ‘Act were ented, In part to address fundamental problems in corporate governance. To % sano sustincaity Roper UP Don,understand the nature of the changes in corporate ‘governance dictated by the CLERP 9 Act, itis necessary to understand the interrelationships ofthe primary parties ancl hhow each ean be alleged to have failed. A brief summary is presented in Exhibit 2.2, When reviewing Exhibit 22, keep ‘in mind that corporate governance failures were broad and ‘number of diferent parties contributed to those failures, ceunren 22> ConPoRATE GoveRnance ano auDiTs ‘otgansation efictvely provide accurate ancl timely countably to sarehckles and oder saveholdas ‘Specific activites include "Formulating strategy and sisk management * Inplementng lective internal conte * Developing france and omer rors to mec pub, ‘sakeholée. and regustory requirements Managing nd reviewing operations + Jmpimoning en docu etca envuonment Shareholders | Broad Role: Provide effective oversicht though election of | Focused on. short-term pies fal to por lng-tenn Doard members auctor eppotntmens, approval ofmajor | grown anny abdicated mos: responses to ‘ntives auch as beng taken over, anual reports on ‘management and analysts os lng es sate price increased ‘management compensation fom the boatd Board of Directors | Broad Role: The major wpresnrative fsareholdersto | + Inadequate oversight of management censure tat the erganisation is un acoeding othe + Approval of management compensation plans, ‘organization's constitution and thar there is ropes artical soc tons that provided perverse fsccounainity meentives,inclediog incentives to manage earings ‘Specific activities incuce + Drea eftenceminated ny management * Salecting management * Did not spend sulflient sme or have sufcient * Reviewing management peormance nd determing expertise to prion cities compensation * Contin epiced share options wien matt pice + Dedarng dividends ected + Appronng mejor changes, og merges * Approving comporete satay + Overseeing eccountsaity ectvties ‘Management | Broad Role: Operations and accomntaiity. Menage the | * Hamings management to meet analyst expectations Pascoe fine reprting Uullsing accnenting concans to achieve roping objeoaves * Greed an entronment of gresd, rater then one of igh etial conduct. ‘To efien actod as cat of he auahor ‘Ausitopinion shopping ‘Aualt Committee ofthe Board of Directors ‘Broad Role: Provide oversight of intemal end extemal audit funciona he process of propating the axonal aca xepor Specific activities inctuce * Nominating extemal audi fom * Sigrng off to board tet non-aut work psfonned by the ‘uct frm does nt compremise independence + Salecting andr eppronng the appointment ofthe Hes of Intel Audit poston * Reviewing and approving ie scope aed budget of the samara ai imction| + Discussing awit Ancings with intemal autor and extra auditor and advising the Load and menagarment) cc. specie aons tht shouldbe taken + Stler 16 board members — id not have expertise of ue to provide etecive oversight of aut functions * Commitee members were not viewed sfc by ‘utes an potential support| ‘SelfRegulatory | Broad Role: +» Peer revives that were not always wansparent Geeta | + Dearne nantes 1 Toma scot footy ong santas Cina Tenn ea | + tony on bat mento 1 Mans oul ret ne ore ctl 1 Toned Cau boone | Sect er eae « Ratin nnd ebdog a eto | on oe + Rietog marten net endacenmangeatenens | "tan enfin ts Ouertai | Bead Rte mre te tcecy fe inal atta | > oot tnt bee Aad ia aa asm pectic ees ee * Dealing isting veutements-mneludng governance requlomnts and recommendations Tdanties problems bus was not ented sulin Regulatory ‘Broad Role: Ene the accurcy, meine ad famess ot | Agencies: ASIC | publeroporing of fxancal and othe information for reaourees o cos] wit he suo | companies Specific activities include + eviowig flings with the ASK + Faelstaing Standard Busines Reporting (SBR) Ned fianetal pone Conducting quattyreriew inspections of au ras Matting corpora fade, vestigate emusesand | ‘suggest remediel actions {+ Momtonng wedmg acwetiog External Auditors | Broed Role Feform aus of company nancial opens to | + Helped companies use 2ocountng cones to ensure thot te saterents ae tee of material misstatements | achioveesmings objectives Ietuding miseatements tat may be ve 0 fae | + Became economically dependent en some cents Specific activities inciase | + Promoted personnel peed on aby to sul "nan-auck Aude and vows of Manca epots sata + ther service sich a axor comeing Replaced cect teste of acount lances with Inui, rk analysts ad analos Fale to uncover har rand hocae fundamental auc procedures were not performed TIntemal Auditors | Broad Role: Pecom audits of companies fo compance Tossed ellos on “operational audi! and assumed ‘uh company ples and Is, as to culuate tho ‘at nancial auditing was aresoed by the extemal ficiency o perations, and pevedicevsiuasen and ts of | audit function conto 1 Reported pamanly to manogetent wnt tle eportng Spediic activities include totheaudlt comminee + Reporting rests anc analyse to management Gralveing | * In ame instances die not have acess to the corporate ‘petationl management) and awit committees nancial accounting recos + Bvehatiag cama contols Investment analysts focused on ‘earnings expectations’ and contributed to the governance problem by relying on management guidance rather than performing their own fundamental analysis, The problems were further exacerbated by the prevalence of share options as a major part of executive remuneration. Finally, there was a loss in confidence in accounting numbers asanalysts reengnised that company management had the ability to make accounting judgements to manipulate reported earings through estimates or other accounting choices. In the US, SBC Charman Levit. ins speech that attracted international attention," cited numerous problems ‘vith the profession, inluding the use ofthe following “cookie jar reserves to manage earnings 2 improper revenue recognition «© croatve aceounting for mergers and acquistions that td not reflect economic reality 1 imoreased use of share-based remuneration that put inereased pressure on meeting earninss tara ‘There was concer that public aceountng fms did net have elther the aptitude or the desire to say no to client accounting that pushed the hounds of financial reporting reasonableness. What ‘wns needed was a change that would require auditors to make judgements on the economic ‘substance of transactions and certify reports of company activities that were fully transparent. Some ofthe rain concer were: = Analytical procedures were being used! inappropriately to replace direct tests of account balances. = Ault firms were not thoroushiy evaluating intemal control and applying substantive procedures to adcess weaknesses in conto * Audit documentation, especially related to the planning of the audit, was not up to professional standards + Aucltors were ignoring warning signal of trad and other problers. + Aucitors were not providing suicient warring to investors about companies that might not continue as ‘gong concerns: ‘The warning sigs were presen but company management ignored! them and the auditing profession did not recognise them. Its against this backcrop thatthe Government acted to develop the CLERP 9 legislation and ‘empowered the Financial Reporting Council (FRC) and the Australian Securities and Investments Commission (ASIC) to take more effective action in policing governance, financial reporting and auditing THE CLERP 9 ACT 2004 AND THE ASX CORPORATE GOVERNANCE GUIDELINES (2003) (SINCE REVISED) After the debacles of HIH and One-Tel in 2001 in Australia and the Bnron and WorldCom frauds ‘and eallapse of Andersen in the US, the Australian Government felt it necessary to act to protect the investing public. In these companies and in many others, significant operational failures were not detected by the public accounting firms. The press, Parliament and the general public continued to ask why such failures could have accurred when the public accounting profession had been given the sole licence to protect the public from financial fraud and misleading financial reports. In Australia an inquiry by a prominent academic into the independence of auditors was conducted ~ the Ramsay Report (2002) ~ and the Senate launched a public inquiry into the audit, * Antur Let "T Numb Gave Remar the NYU Cater a Lav a Buss Report, 28 epee 08, Harter 2 > ConPoRATE Govenuaucs AND AUaTTSPaar >> engrawine AUDITOR ResPONSURILITIES funetion (JCPAA 2002). Adaltionally, GPAA and the ICAA issued a revised code of conduct in relation to Independence (Professional Statement Fi 2002) and eventually (2006) established a more independent body to issue such pronouncements, the Accounting Profesional and Ethical Standards Board (APESB), Further, the HIM Royal Commission was setup in 2003 und reported in 2004, The ASK Listing Rules were amended to require the presence of an audit committee forthe s largest 600 companies by market capitalisation, It was a tumulluous time in accounting and Ce oudting eet ‘One outeome of the Ramsay Report (2002) was te taking up of a recommendation in 2008 that poten the then Australian Stock Exchange (now the Australian Securities Exchange) take responsibility for corporate governance recorunendations, ‘This resulted in the ASX Principles of Good Corporate Governance and Best Practice Recommendations (2003), with the latest version issued operative from 1 July 2011 being the amended second edition Corporate Governance are Principles and Recommendations with 2010 Amendments. It is impossible to understand the oT extent of reforms to auelit, corporate disclosure and cosporate governance in Australia without ees considering the impact of both the GLERP 9 Act (2004) and the ASX Corporate Governance c Principles and Recommendations (2008) and its ater revisions. ‘The CLERP 9 Act 2004 and the US Sarbanes-Oxley Act 2002 were both motivated by sirlar events. They have many snares, but also some important differences, with the US legislation being much more radical ak and far reaching than the Australian legislation. Because the US legislation affets auditors nd audited companies from other nations, some of the more significant provisions of | chat ge we soneciioantl a both Acts follow. Additionally, because some of the ASK : Corporate Governance Principles and Recommendations are relevant to a comparison of reforms inthe US, this source is inludedtin the analysisin Bibi 2.81. With the passage of GLERP 9, Parliament removed auctor selExegulatory privileges, n essence saying thatthe profession was not capable of setting its wm standards for : : the audits of entities subject to application of the Sante Corporations Act 2001. The previous auditing standard setting board (Ihe AUASB), which was funded entirely by the professional accounting bosles, was reconstituted with Af ‘members representing the public interest and brought under a the auspices of the Treasury through the FRC. Further, saying standards were provided the force of aw under the Corporations Act, as hod been the case for accounting standards for more than two decades, The regulate, ASIC, under delegation from the FRC, began inspections of audit fom and their audits with reports made publi aT eT 3 oe 5 a Auditor independence provisions 0 ain ‘The CLERP 9 Act provisions dealing with auditor i independence included requirements to: - = Include a general statement of principle requiring the a independence of auditors (S324CA)* * atrnce aetth Conmrtinns Ae 200 sce he CLERE 9A made edo A x wilt ASIC Ateuarrer 2 >> © require the auditor to make an annual declaration, addressed to the board of directors, that the ‘auditor has maintained its independence in accordance with the Act and the rules of the professional accounting bodies (S307C) strengthen restrictions on employment relationships between an auditor and audit elient. This includes a mandatory period of two years following resignation from an audit frm before a {former partner directly involved in the audit ofa client can become a director of the client or take a position with the client involving responsibilty for fundamental management decisions (sseacn impose new restrictions on financial relationships. This covers investments in audit clients and loans between an audit cient, and the auditor or their immediate family ($324CH) * require mandatory disclosure in the annual report of fees paid for not just non-audit services NAS) but, for the first time, the categories of NAS provided (S800(11Ba)) require a statement in the annual report of whether the board of directors is satisfied that the provision of NAS is compatible with auditor independence (S300(11Ba)). This disclosure Includes an explanation as to why the following non-audit services, if contracted, do not compromise audit independence: preparing accounting recotdls and financial statements of the audit client valuation services internal audit services IT systems services temporary staff assignments ligation support services legal services recruitment of senior management for the audit client i corporate finance and similar activities? = make audit lead engagement and review partner rotation compulsory after five years (S824AD); ‘with provision for ASIC ($842A) to grant relief where necessitated by circumstances = require accountants seeking registration as company auditors to meet agreed competency standards, to undertake to abide by an accepted code of professional ethics and to complete a specialist aueiting course prior to registration (S1280A), Corporate responsibilty for financial reporting Management has always had the primary responsibly forthe accuracy and completeness of an oxganisation’sfnancal report, Its management's responsibility to * choose which accounting principles best portray the economic substance of company transactions * implement a system of internal control that assures completeness and accuracy in financial reporting + ensure tha the financial statements contain accurate and complete disclosure In addition to these responsibilities, the CLERP 9 Act requires management (both the CEO and the OFO) to certify the accuracy of the financial report and provides for criminal penalties for materially misstated financial reports. Further, the OLERP 9 Act provides whistleblower protections exposing companies and their employees to criminal lability and penalties of fine of up to $2750 andor imprisonment for six months. These provisions are designed to encourage employees to report suspected breaches of the Corporations Act, In particular, there are provisions © See so ANS 01 Proseation a Powe Statens Rater APES 10 Cote cf Bhi for Profesional Accent 8Part 193 unersranoine avbi Ton nesroNsrarurries allowing a court to onder relnstatement of @ whistleblower at a comparable level where the cout is satisfied that the employer purported to terminate the employment of the whistleblower because of the disclosure made, There is also a new offence designed to protect the confidentiality of a Wwhistleblower's isclosure. If the auditor, director or any employee of the company leaks information disclosed by the whistleblower, the whistleblower's identity or snformation likely to identify the whistleblower, they wil commit a criminal offence unless the disclosure is to ASIC, ‘Australian Prudential Regulation Authority (APRA), the police or is made with the whistleblower’s ‘consent, Enhanced role of audit committees ‘The ASK issued its Corporate Governance Guidelines, prompted by the CLERP Discussion Paper (2002), which urged that if the ASX was unwilling to take responsibility for corporate governance, the regulator should, Based on the view that ‘one size does not fit all when st comes to corporate ‘governance mechanisms, the ASX Corporate Governance Guidelines are not mandatory, but ‘operate on an ‘if not why not’ basis where non-compliance should be explained in eorporate annual repotts. The mechanics for effective audit committees feature in these Guidelines, In Macch 2003, ‘The ASX Listing Rules were amended to require the presence of an audit ccommitize forthe largest 500 companies by market capitalisation, Many Australian companies had voluntarily established audit committees prior to this Rule, but even today, many smaller listed Companies do not have audit committees. Further, an initial requirement for audit committees of the top 500 to comply with best practices was relaxed in a 2007 review of the requirement to be applicable only to the top 300 companies. ‘The audit committee has broad oversight responsibilities over the internal aueit and financial reporting processes, See Exhibit 2.3 for an overview of audit committee responsibilities ‘The ASX Corporate Governance Guidelines state that the audit cormnittee should be composed of ‘outside directors, ic, directors who are not members of management and do not have other relationships with the fim (eq as vendor, consultant or lawyer). The audit committee has important oversight roles but does nat replace the CFO or divisional controllers ~ the responsibility {or all ofthese functions lies with management. The audit committee should = be apprised of all significant accounting choices made by management ® be apprised of all significant changes in accounting systems and controls built into those systems «have the authority to nominate the external auditor tothe annual general meeting fora vote of appointment and review aspects of the audit plan and audit results with the auditors have the authority to hire and fie the head of the internal aucit function, set the budget forthe internal audit activity, and review the internal audit plan and discuss all significant internal audit results 1 receive all the regulatory audit reports and periodically meet with the regulatory auditors (eg, from APRA) to discuss their findings and their concerns. ‘Auelt committees are inereasingly expanding their functions to include oversight over the tisk ‘management processes utilised by the organisation. In most organisations, the audit committee also reviews the annual report fled with ASIC or the ASX, including an analysis of the Directors” Report to determine that discussion therein is consistent with the committee's understanding of ‘operational performance.carter 2 > Auct Commitee Oversight Financial Aust porting Prepoting Functions Internal Contos ‘ver Financial Reporting, Fnancat Reporting Regulatory, ‘ustors (eg. APRA) ‘The audit conunittee is not intended to replace the important processes performed by the ‘auditors. But the audit committee must make Informed choices about the quality of work i recelves from te auditors. For example, the audit committee rust monitor and assess the independence and competence of all audit functions. It should review quality-control reports on both the external audit firm and any internal audit fanction, andl it should evaluate the quality of reports it receives from the auditors and the quality of fanelal reporting andl control discussions. ‘The audit. committee will receive feedback from both the internal and external auditors on the quality of internal controls over financial reporting. Finally, the audit committee should review all regulatory audit findings, where applicable, to determine if they provide important Feedback on the quality of controls, operational problems or financial issues ‘The aueit commities, where it exists, has become a key component of effective corporate governance; its members must have both sufficient time and expertise to ful its function; and the chair of the audit committee must be a strong individual who is willing to have frequent contacts with auditors and management, REQUIRED AUDIT FIRM COMMUNICATION TO THE AUDIT COMMITTEE 1c is important that auditors and audit committee members have clear expectations of the audit profession. The AUASB developed ASA 260 Communication with Those Charged with External Astor Internal Auster:Part 197 Uwoenstanoine auDs ten ReSroNS:BILIT2ES ( e. endthewal camino on corpo ent. cs Governance and ASA 285 Communicating Deficiencies in Internal Control to Those Charged. with Governance and Management to promote better communication between aucitors and audit committees by specifying certain things that must be communicated on every engagement. ‘The required communication, shown in Exhibit 2.2, forms the foundation upon which ll ‘communication takes place with the audit committee. The auditor must discuss all significant, accounting and audit issues, including any restrictions by management on the conduct of the audit ‘or any disagreements with management on how to account for something. In addition, the auditor is required to communicate all significant deficiencies in internal control to the audit committee. ‘The auelt committee must be assured that the aualtor is free of any restrictions and has not been influenced by management during the course of the audit. Thus, the auditor must also communicate whether major issues were discussed with management before the auditor was ‘engaged or whether management has consulted with other audit firms on accounting issues. Ibis important to note that under ASA 260 and ASA 265, the required communication Js not limited to listed companies, but is required for all entities that have an audit commitice. If an entity does not have an audit committee, the issues must be communcated ta the board asa whole, In addition, auditors have a responsibilty to exercise informed judgement beyond simply determining whether the financial statements reflect accounting standards. The auditor must have a discussion with the audit committee not only about the acceptance of a chosen accounting principle but about whether or not the auditor believes the accounting choices made by the organisation best portray the economic substance of the transactions and accurately represent its Current financial state, ‘The notion of professional scepticism and having a questioning mind is relevant here. ‘The required communleation between auditors and the audit committee gives the audit committee a pivotal role in corporate govemance, a role enhanced by the CLERP 9 requirement that auditing firms cannot provide non-auelt services without the explicit approval ofthe board of directors, which often then defers to the audit cammittee, Further, audit coramittees are motivated to make sure the aueitors do thelr jab, because poor performance on the part of the auditors will directly reflec on the performance of auelit committee members. IMPORTANCE OF GOOD GOVERNANCE TO THE AUDIT Good governance is important to the conduct of an auklt for ane very simple reason: Companies with good corporate governance are less risky to audit, These companies generally have the {allowing characteristics: ‘They are les likely vo engage in ‘inancial engineering. “They have a code of concduet that is reinforced by actions of top management, ‘They have independent board and audit committee members who take thelr roles seriously and have sufficient time and resources to perform their work. ‘They take the requirements of good internal control over financial reporting seriously. "They make a commitment to financial competencies needed.7 cmapreR 23> ConpoRaTe GOVERNANCE Aub AUDITS : na 4 ‘An axgersalon wihowt 2 commiment to good govemance retaining the ckant or fo) pecring mare aucit werk to beter represents higher ris to the auctor. The autor mearage the encial risk to the auto for having peviormedt adktosses this higher risk Brough ether (a) not accepting or the eu | Further, as noted in the Professional Judgement im Context feature at the beginning of the 4q chapter, recent empirical studies have shown that companies with good corporate governance have higher retum on equity than other companies. They also have lower costs of capital and - superior share price returns compared to companies with weaker corporate governance. Many audit firms are not willing to accept potential audit clients unless the clients demonstrate 1 strong commitment to good corporate governance. Stated simply, listed companies that do not ‘commit to good corporate governance are too much of a risk for an audit frm. Most audit: firms Jook at the govemnance issues when making a decision to become associated with, or to remain associated with, an audit client. f ‘With ethical requirements restricting some types of NAS that can be provided to auclt clients, as public accounting firms expand their non-audit services such as the internal audit work to non audit clients, the governance issues remain important in accepting these non-auetit clients, For + ‘example, assume that a Big 4 public accounting firm performed only internal audit work for a a company with a less than reputable corporate governance structure and that management was : ound to have enwaged in the payment of bribes. Outside users would ask why the internal audit funetion had not looked at the risk associated with bribery and corruption and brought it to the attention of the board and, further, seen to it that the board took proper action ‘Aucliting standards are set by various authorities with one common objective - to provide assurance to the public that auelits are conducted in a professional manner and that misstatements are prevented and the financial results are clearly communicated. But auditors do not audit financial information only. They may be ealled upon to provide assurance on various economic data, or even non-financial information, such as the quality of an organisation's internal controls, ‘Thus, there is a need to distinguish amonat four types of standards issued by the AUASE, FRAMEWORK PRONOUNCEMENTS q ‘The following are the categories of framework pronouncements adopted by the AUASB: | = Auditing standards (ASAs) that apply tothe autor’ task of developing and communicating : an aut epiion on financial reports. + Standazds on Review Engagements (ASREs} that apply to the auditor’ task of developing q and communicating an opinion on interim financial information. + Standards on Assurance Engagements (ASABs) tat apply to assurance services other then auctor reviews of historical nancial informationPart 1 >9 Upeasranpine auortoR meseoxsissLartes = Standards on Quality Control (ASQC) that relate to engagement quality control In addition there remain a small number of auditing standards from prior to the reconstitution of the AUASE under the CLBRP 9 Act. These standards (AUSs) are ‘gradually being replaced, Guidance statements are also part of the suite of pronouncements issued by the AUASB. A list of standards relevant to each framework category, together with guidance statements ‘current at the time of writing is provided in the online appendix to ts chapter. Fortunately, there is a great deal of commonality among the auditing standards. All of the standards start from fundamental principles on how an audit engagement should be planned and conducted and then how the results should be communicated. An overview of the nature of each suite of audit standards is shown in Exhibit 24. Understanding the US situation is important because of the need for many companies incorporated or listed outside of the US to comply with the requirements of the Sarbanes-Osley Act 2002, Additionally, several countries have adopted elements of the Sarbanes-Oxley Act. Further, the AUASB, under the strategie direction of the Financial Reporting Council, is required to pay regard to the developments in standard setting beyond International Auditing and Assurance Standards Board (IASB) developments even though Intemational Standards on Auditing (ISAs) are required to be the base on which ASAs are developed. Ards of non-pule US ens, Aus ofl pubic tod) US ‘ntamatona standards are Required companies ~ refered nas rgistored except govermental unt, for which Opinion ana Communication ‘Aust Evidence Nour of the Aut Report PCAOB stands parallel most othe. Require to fer an epinian on the spprepiateness of the acocunting fuarework used by he compeny. (Grtona ae presented to determine the | appropriateness of the amework Standards (eatuing Asta scooenting fms standards a stb the GAO™*. Objective of aud | Forman opinion ca whatherthe | Forman opiianon tienda) | Forman opinion on whether he Standards nancial statomente ase preparedin | statements whether hey area fancial tsterents ere prepare i al matecal aspects, in eafomaty with | acoadance with US GAAP ar IFRS. | secon win US GAAP. ‘ne apicabereporing amework. | and an pion onthe quay of | contots over nants parang, (Commonalities | Allao pinciplas based supplemented by more deals guidance Staneds te srl in key ares such as ‘Among the * Pranning the Av to Minimise Risk Standards + Audit Documentation De Profesional Coot Reasonable Cao Independence (US), Proessona Septicism (AAS) PA standards quedo form crrion on wheter ‘thomas aporepite accountng treatment was used apd ta convey that pinion to management and te board wen another acceptable accounting treatment was use GAAP is noooConPorAve savenuance ana au0l7s Key Dire: internal Control | Reporseaimemaleonvolaraécissed | Speoiioavattstandacten the austot | mama conttl auc re covernd ‘when equi by goveming unit tntemal contol over inanil reporting. | under separate attestation stands. | Convergence | Committed ointemational ‘Asa new eglsory body, the PCAOB | The AICPA is commited to convergence on auditing sendards, | does net havea mandate fa Intemational coavergence and works Intemational cnvexgence | wen sn 14888 in developing many standards. Assurance ‘Assurance standards ae builtin tie | Doce not eave assurance tances. a | The AICPA owes esas ond standards !ntemationsaucing standards lets noc part ote mandate ‘testator standards, but they re sced ‘amewonk byotherbodes withinte AICPA. | Independence and | More focus on professional scopiisn | Mjerfocuson independenceand | A very rle-besed approach to autor Professional with ewer speetieson ndepenence | implementation of prnepies on sndepenence Scepticism 09 promulcied 3y the SBC, Composition of | 1 members with 10 naminawzd by | Smembers of which ony 2eanbe | 19 members, indudng one academic. | IFAC members Qofwhichsre US},3 | CPAS(S, and the CPAcdonct | a sopceuntatwe om each ofthe Big 4 public embers. and § tom maior | necessary nave wo have audit firms, anda wide rpreseniaon fom fms, inciuding allot he Big pls | experience. All ace apeinted by tie | other awit fs (Grnt Thomo0 SEC since the PCAOB is quasi roulatory exanisaton “The AUASD empresa pe chanson ho Tess ond appoarasly ne other mens pone the Rance poring Cul este ar ao he i ap sooner pe ecu La, ial uh, hs Kg ton td Se ‘GPA Aenea Ineo Cae Pube Asean *"0R0 -Gevemnen: AecounatanyOfeo | Curent practoe n Austalais that he auc repat signature algo be provided, Naring he indkiguals ue auto's rept ‘snow the name of the fim and the name of he indica aut is ued to rerfrce to those auditors te impertance of partner sigirg the report. There has bean some debate ast _pecrming be auc cigar, whether 2 qually engagsment review parners name shuld FUNDAMENTAL PRINCIPLES OF IAASB (AND HENCE AUASB) AUDITING STANDARDS ‘The IAASB has taken a broad approach to standard setting that recognises the demand for both assurance and aust services. Its standard setting also recognises te fundamental differences in how accounting is conducted throughout the world and that the world has not fully converged fon IPRs as the appropriate set of financial accounting standards, Thus, the [AASB pronouncements, referred to as,Paar 1 >> of, mesons Standards on Anta AH, regake the aur to demmine whether the framework a elient uses for financial reporting is appropriate. An overview of the prineiples for the ‘conduct of an audit is shown in Exhibit 25. Although most international slandards are lauded as prineiples-based, the ISA general principles refer to more detailed standards that are designed to guide the auditor in making Judgements regarding the planning and conduct of the audit and communication of the audit results. The standards incorporate the following features: 1 Theres a reference to ethical standards, not just auditor independence. 11 Professional scepticism Is emphasised. 1 Reasonable assurance recognises inherent difficulties in conducting an audit, such as that the auditor cannot test every transaction, or management may have covered up frauds that are virtually impossible to detect. ‘The abjeonve ofan auc of franca statements to enable te audio to express an opinion whelhes the nani Matements are prepared in all msterel specs, n accordance with an apptoeble nancial reporting famawonk Bnica! Requirements ‘The auae shad comply with relevant eical requirements rating to the audit engagement, Those recpirementsinludefmdemantal panel regercing (3 ntegnty, 8 ebjciy, (2) profesional competence and due care, (confident a () professional behawout Conduct of an Audit of Financial Statements "Tae audio should conduct an austin aocrdance wit nternational Standards on Aung toi0) ‘Scope of an Audit of Financial Statements In determing the audi rceedures toe performed in conducting an aut in accordance with Interationat Standards on Auditing, the ator should comply wit esc ofthe Intemational Standards on Auding relevant to the st Professional Scepticism "The auctor stould plan ane patfonn an aude wea an ate of prefesionl scopic recognising that citounsances may exst hat caus the fnanca statemonts lobe materially missed Reasonable Assurance ‘Reaconaie assurance ea conoart relating to the accumulation of the aut evidence necesary fo the auto conch thet there ate no ratoil misstatements in he fnncil sateen akon zea wile, Reasonable sssurance relates to the who ae process ‘uit Rik and Matesility The auc sou plan and perform the aud reduce aud isk oan acceptably ow lve thai consistent ‘th the objective fen and. The aor x concemed with matenal misteiements, an isnot response fr to detection of misstatements that se not meter toe fanca statements, Acceptability ofthe Financial Reporting Framework ‘Tae acer ould determine whedter to nana epatiog framework adopted by management in preparing the finance statement is nonepadle a an a Seco a ea Fea Ants, 00canter 2 >> Conpoante covennance AnD avatys Audit risk should be minimised to an acceptable level ~ although tht level is not defined In the standard, © Materiality is a major concept that affects the design of the audit. © The auditor must determine the acceptability of the accounting framework used by the aualt client STANDARDS FOR OTHER AUDIT ENGAGEMENTS Financial report audits represent only a part of the demand for assurance services, As the demand for other assurance services has emerged, new assurance and attestation standards have been developed to ensure quality for a broader array of services beyond financial report audits, Other standards have been developed or are being developed for the practice of assurance provision on governmental information, sustainability information, greenhouse gas disclosures and water flows, among others. Assurance standards ‘The IAASB and hence the AUASB have taken a two-pronged approach to assurance standards. ‘These bodies identify two major types of assurance standards: 11 reasonable assurance engagements 2. limited assurance engagements. Assurance engagements are engagements in which an assurance practitioner expresses conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria ‘There are some key elements in this definition that are important = There is alvays a third party involved, and the assurance is provided to the third party, © There js measurement or evaluation against specific criteria, Those criteria may be part of a framework or might be related to criteria that have been agreed upon prlor to the assurance engegerent © The auditor or assurance provider is expected to communicate a definitive report, with reasonable or limited assurance provided, on the information being presented, ‘The IASB and hence the AUIASB identify the following elements of an assurance engagement: © a three-party relationship involving a practitioner, a responsible party and intended users © an appropriate subject matter suitable criteria = sullicient appropriate evidence + avwmitten assurance report in the form appropriate to a reasonable assurance engagement or a limited assurance engagement.” ‘A ‘reasonable assurance’ engagement is one where the assurance practitioner's objective is a reduction in assurance engagement risk t an acceptably low level in the cireumstances of the assurance engagement as the basis for a positive form of expression of the assurance practitioner's conclusion. A reasonable assurance engagement is commonly referred to as an aul and the the ASAs are the standards relevant to thege engagement, A Mimited assurance’ engagement is one in which the abjective is to provide more llted assurance by doing less work (thereby leading toa higher level of risk of being incorrect) that may ternational Promenorsor Assure Eagapermets New Yr, 28), 7Part 19> (©) desontes relevant oticl requirments (o) desorbes relevant ical rouiremsnts (f desenbes the pobees and procedures requitod foc the fim’s (e) sets ont engagement bbe appropriately understood by all three parties. Limited assurance engagements normally result it ‘negative assurance’ or a negative ‘ession; Le, auditors perform limited procedures (usually analysis of an issue but without significant testing) and check to see i anything comes t0 their attention idicating a problem. Limited assurance engagements related to financial statements are referred to as reviows and the ASRBSs are the standards relevant to these engagements. list of auditing standards is available online QUALITY CONTROL STANDARDS |ASQC 1 Quality Control for Pirms that Perform Audits and Reviews of Financial Reports and Other Financial Information, and Other Assurance Engagements sets out the public accounting firms responsbilties for its system of quality control for audits and reviews of financial reports and other financial information, and other assurance engagements. ASA 220 Quality Control for an, Audit of Financial Report and Other Historical Financial Information sets ‘out the auelitor’s respansibilties in respect of quality control procedures for an audit of a financial report and other historical financial information. It also addresses, where applicable, the responsibilities of the engagement quality control reviewer. Together, these standartis and compliance with the financial report audit and review standards establish the minimum requirements for the exercise af due care and skill expected of auditors by society and by courts of law. The elements included in the two quality control standards are described in Exhibit 2.6 SORTRETEITT (a establishes ta eadartp espansiaites ofthe engagement partner foc quaty on audits ( entabieheselmonts of syste: of intra contol and lesdersip| ox quay within the: 3 the proces ford sccepeance and continuance of ent tons and auc engages (a) cones the poices and proosduresrequed fo the acoepeance ‘one contmianee of cent eatonships and specie engagements [e) cet out the ples an proosduresconcoming the As (cts one aignzont of an engagement earn to he mut Allocation of aran resources io engagements engagemen: padonnance requirements including direction, fengogementperornance meting consultation, quality review | supervision reviews, consutations andl quay contol reviews reso, eston of any ferences of opinion wthn the fm ‘sonooming the eogsgemeat; and the menegement of and retetion of engagement cocumeniaton (@ requres mentoring processes over he fn/ssysemctquatty | @) explana tie mantoring proosss ox compance with he sytem conto inhuding desbng wth any deicioncles denied cr any | quaityconzl complains or alogetions made (sets out the poticies and procedures regarding anpronsiat a {@ establishes the documentation requtemens ltd to quality canto documentation that provides evdence of tvecperatim ofthe | forte aut engagement, nlucing thooe reine to the engagement system of qustity conta [___uaty como reneeewaeten 2 >> ConroRare GoveRuance aup auptts FUTURE OF AUDIT STANDARD SETTING Standard setting wil be divided among a number of parties in the future even though there is a movement to harmonise existing domestic and international standards. The IAASB is firmly established as the developer of broad standards around the world and there wall continue to be convergence between the [AASB standards and US Standards. The II's Intemal Audit Standazcis ‘Doddid has attained recognition as the premier standard setter for the professional practice of Internal auditing on a worldwide basis, ‘An overview of the relevant standards, thelr source and similaities is shown in Exhibit 2383, Audits and reviews of financial reports are an important part of the governance process of organisations and help fulfl the accountability function. The auditing standards (ASAs) provide the framework forthe audit opinion formulation process. ‘The assurance on reviow engagements standards (ASREs) provide the framework for the review conclusion formulation process. After deciding to accept a new client or retain an existing client (Phase D, the auditor works to gain a orough understanding ofthe elient (Phase I. PHASE Il: UNDERSTANDING THE CLIENT Im terms ofthe audit and review opinion formulation process, this chapter so far has focused on the basic notions of the auditing profession, regulation and corporate governance in general. It nov proceeds to discuss Phase Il of the process, Lc. understanding the client in terms of corporate ‘overnance, beginning with audit planning Planning meeting Audit planning saris with a meeting withthe audit client ~ the directors and management of the company being audited and members ofthe audit comniltee where a committe exists, on behalf ofthe shareholders who are the actual cent under the Corporations Act 2001. These are te Key people involved in the governance process. The purpose of the planning meeting isto develop an Understanding of: * the scope of aut services tobe performed management's preparedness Key accounting isues and assumptions that affect the preparation ofthe fnancil statements = materiality "auait committee and management's assessment ofrsks associated with internal control end reliable financial reporting eeePart 1 >> changes in the competitive and economic environment affecting the client and its potential effect on the financial report = potential ordination of work with the intemal auditor © audit fees and expectations of each party ‘The meeting ensures that the key governance parties, particularly the audit committee, are aware of the audit approach and the responsibilities of each party. Although the overall audit approach is shared with management, the details of the plan, including the determination of ‘materiality, is not, The audit committee, where one exists, o ottierwise Ue board of directors has the ultimate responsibility for oversight of the auc Developing an understanding of materiality ‘The audit must be planned to provide reasonable assurance that material misstatements will be detected, The concept of materiality is pervasive and guldes the nature and extent of auditing the financial report. AASB 1031 Mater‘atiy provides the following definition of materia ‘Omissions or mistatements of items are mater f they could, individually or collectively, influence the eeonomde decisions of users taken on the basis of the Anancial report Materalty depends on the sie and nature ofthe emission or misstatement judged in the | sutrounding eiteumstanees. The sie or nature of the item, oF @eombinalin of bolt, could i be the detennning flor? Materiaity 18 not simply a Runetion of specie dollar amounts in the organisation’ financial stalements oF notes thereto. The auctor should have meaningful diseusion with those charged ‘ith governance about qaltatve, as wel as quantitative, dimensions of materiality as basis for designing the aucit process to address material misstatements, Althougt many audit, rms have {developed guidelines for materiality decisions, ttf important to note that any guideline is just | sarling poi that is adjusted for ther relevant information. For example, if the cient has a loan | with a restrictive covenant that requis a current ratio of 2:1, any dollar amount that would bring j that rato under 2:1 would be materia | Materialty guidelines usually involve applying percentages to some base, such as total assets, total reverue or pre-tax income, A simple quielie fr small business audits could be, for example, to set overall maternity at 1% of total assets or revenue, whichever is higher. The percentage may be smaller for large cents, Other public accounting fms have more complicated guidance that may be based on Ue nature of the industry or a Composite of materiality decisions made by i experts inthe frm, | ‘Ther has been eritiism of the accounting profession for not suficientty examining qualitative i \ actors in making materiality decisions. In particular, the profession has been criticised for: = Netting (ofeuting) material misstatemenis and not making adjustments because the net effect may not be material to net income, = Not applying the materiatity concept to ‘swings! é accounting estimates, for example, an accounting estimate could be misstaled by just under a material amount in one direction one reat and just under @ material amount in the opposite direction the next year. = Consistently ‘passing’ or waiving on éndividual adjustments that may not be considered material, but may be indicative of larger problems. * vsrain ecneting Send sn, AASB 108 atria, OM) Api Deed Temcunprer 29> Corporate covennance and aupiTs 3 Developing a preliminary audit program = Dotailed planning leads to the development of a detailed audit program designed to discover ratevial misstatements. Planning is the foundation for the audit program and includes the q folowing: 3 Developing an understanding of the client's business andl the industry within which it erates. = Developing an understanding of risks the company’ faces and determining how those risks ‘ight affect the presentation of company’s fianlal resus Ff ——__& Developing an understanding of plans for remuneration of Key’ managerial personnel and how : those plans may motivate management actions. q + Developing a prelininary understanding of the quality of the client's intemal controls over | financial reporting + Building a detailed audit program on aucit sk, internal contvol quality if there isan intention es to rely on internal controls, aecounting assertions ancl materiality. : + Developing an understanding ofthe client's accounting polices and procedures 7 Anticipating financial report items ely to require adjustment, as well as those that are : subjective in nature + * Identifying factors that may require the extension or modification of audit tests, such as t potential related-party transactions or the possibility of materia misstatements + Determining the type of financial reports to be issued, such as consolidated statements or single-company statements, special reports, or other reporis to be fled with ASIO or other regulatory agencies, ‘Subsequent chapters cleal with each of these topies in detail. PHASES Ill AND IV: OBTAINING EVIDENCE, Testing assertions ‘The third and fourth phases of the audit and review opinion formulation process involve obtaining : understanding of controls, determining their impaet on the financial report aul, and obtaining : substantive evidence about specfe account assertions. Me auditing standards require te auditor to gather ‘sulficient, appropriate aut evidence in order to reach « conclson on the faimess (or truth and faimess for audits under the Corporations Act 2001) of the organisations financial | presentations. Te reviw standards require aut evidence primarily in the form of inquiries of ‘management and analytical procedures (generalty rato ana). As noted in Chapter 1, the aucit ’ and review processes are designed around assertions that are inherent in the accounting a ‘communication, For example, ia company represents tha it has property, plant aid equipment net of depreciatian of $42 milion, the company i representing tha © Thowns the equipment and has title to the equipment. 4 = "The equipment is actively used in the conduct of the organisation's business, | ‘© The equipment is properly valued at cast and the cost amounts add up to the balance show in | the financial report, ; Depreciation accurately reflects the economic usage of the equipment. = All disposals of assets ave fully recorded,Parr 1 >> «All nonproductive assets, assots that are intended to be sold ot assets that have sulfered a \ permanent impairment in value, are accounted for at their net realisable value (current market value) ss The amounts reflected in the financial report accurately portray the amounts that are in the general leduer. Example: Testing aciditions to property, plant and equipment ‘Throughout this text, we will develop audit programs for various audit areas. The following demonstrates the overall structure of an audit program based on financial report assertions. The faa procedures, constituting the individual elements of an audit prograrm, address Fundamental avertions in each account balance. Consider an audit of property, plant and equipment (PPE) and the valuation assertion implied in a company’s finanelal report: “The equipment shown on the | mancial statements is properly valued at cost (nat to exceed its recoverable value) with applicable allowances for depreciation” i “This assertion ean be broken dowm into four major components: the valuation of assets thet were acquired in previous years the vatuation of new assets added this yenr 4 the proper recording of depreciation potential impairment of the existing assets due to changed economle conditions oF rhanagement plans regarding the manufacture of some of is products. ii For ustration purposes, we assume that the previous year's financial report had been audited Ee and that the aueitor had verified cost and accumulated depreciation for the previous years, Thus, the aualtor is concerned that the current year’s additions to equipment are properly valued. An audit procedure that would address the assertion is: | T uditeng citditions lo PPB ~ Take a statistical sample of ell additions to property, plant and | ‘equipment and verily the cast through reference to vendor invoices to dotermine that cost 's aecurately recorded and that ttle has passed tothe company. i = Additional audit procedure for company that is considered to be ‘righ risk’~ For the items Selected, verify that Uhe asset has been put in production by physically verifying its existence and operation Nove the major elements in the audit procedures that are extensions of the pr = Statisically select c sample of items 1o test. The auditor needs to take a representative ‘sample because itis often too costly to examine all additions to PPE. = Review documentary evidence of cost and title. The auditor examines outside, objective fevidence of the ammount paid, the nature of the equipment purchased and the conveyance of tile to the company. Verify existonce ofthe asset. in situations where the auditor has doubts about management's invarity or there are other factors that point to the potential existence of fraud, the auditor should visually inspect the asset to determine its presence and operation. # Assossing the potential imapairment of the assets, Review continued operation of plant with ‘management and future budgets to determine if the plant should be written down to an impaired valle. Gather current economic information and independent evidence as to the ‘current market price of the assets vious audit testscarter 2 >> ConpaRare GoveRNANCE AND AUDESS Other audit procedures, eg estimating the life of the asset and the proper application of dopreciation, would also be performed in the audit of PPE. The important poin to understand here fs that audit programs are based on the folowing fundamentals: «Audit procedures reflect a thorough understanding of the underlying assertions, "Audit procedures are adjusted for the risk of potential misstatement in the account balance. = There are many factors that influence the risk of misstatement. The auditor must understand these risk. PHASE V: WRAPPING UP THE AUDIT AND MAKING REPORTING DECISIONS Summarising audit evidence and reaching an auciit conclusion ‘The fifth phase in the audit and review opinion formulation process involves summarising the audit evidence related to the assertions tested and reaching a conclusion about the faimess of the client's financial presentation. If the evidence supports that an account balance is faitly represented (Irue and fair), the auditor will continue with the auelit of other account balances. If the evidence does not support a fair presentation, the auditer will gather additional evidence though detailed testing. The additional information gathered will lead the auditor to one of three conclusions: © The account balance is misstated and the client agrees to adjust the Snancial statements to climinate the misstatement. © The account balance is misstated, but the client disagrees. The auditor wil issue an avait report indicating that the financial report, in his or her opinion, is not fairly presented. ® Sufficient evidence has not been gathered to reach a conclusion on whether there Is a misstatement in the accounts. For example, the client's controls may be so poor that documentary evidence does not exist. The auditor would issue a report that he or she cannot render an opinion on the faimess of the financial report. The procectres described herein, whie sinple, wouidhave were new capi ems fpxooety, plant and ecuicmen), Tests of dlscovered, I propel perormed, the sigriicant auc that took asset axons, as desarioed hte tx, would Pave uncewared pace at WorlcCom. The feud ocoured when the company the fra, ineted income by caplaising line ental expenditures asi they For most audit engagements, the auditor will reach a conclusion that the financial report is fairly sated ois true and fair in the case of an audit under the Corporations Act 2001. In these situations, the auditor will issue an ‘unqualified audit report'similar to the unqualified report shown in Chapter 1pant Summary ‘The business fullures of the past decade have been closely associated with corporate governance failures. The governance failures involved a number of parties: management, boards of directors, aucitors, aut committees ard some investor sgroups, The CLERP 9 Act 2004 was more than a new work requivement; i addressed many of the causes of corporate ‘povernance failures. Among other provisions, the Act also established a new, independent, quasi-governmental board to set audit standards and it gave the backing of law to auditing standards ‘Audit standard setting has evolved with convergence projects between the [AASB and US standard setters, the source of the main impedient to a global set of aulting standards, Auditors will need to understand the context of particular ‘andit engagement in order to reference the appropriate standards for the conduct of the aucit, Fortunately, there is & ‘great dea! of consistency among all the standards, SELECTED REFERENCES 10 RELEVANT PROFESSTOUAL PRONOUNCENENTS RUD GUIDANCE Reference International Equivalent" Description asa tw001 Cnty Coir or Fs tht Par As and eins of Facial Repos end (ine Frendl ferratn, and Ofer Assurance Engagements asnzao ‘saz ‘uty Conte fran Au oa Franca Report and Other Moral Fanci ‘lemon asa 158200 ‘Comicon vith Thee Cnarge wih Governance asa 265 1sA265 Ccommurcating Det Intra Cote Tse Charged wh Goverarce sand Morogeent AAS 203 Moeraty ASE 2400 Fevew ct Fens Recon Partarred by a Assurance Pracionar Who Not ‘ie Alor ofthe Ey SFE 2005 evi ol stoi! rans etaration Other than a havc Repor asne2a10 Isr 2010 Fes of nest en Over France! Rapots Proradby he néepenent ‘urs ot Ey sre 2615 vio ot Facial Rept ~Company Lied by Gueranie AUASB and Asaf nti of ‘sl Commiees A Gude 0 Good Practice ‘Company Clete (CO ana tne betes Ar 04) neta Sta on liter ca ect ASN, ee ete Acs eno Psi Perce ad tc MSS — ein cig Sts Bo, ACD ~ vn mt Ong reso PES oan Psp aE Sars Bat APA = Asn Scan aps ory. ASK oe Sendo a. 8 Asn Seas we sae Com ASK nf ein Echany, ASKS Ree gre, LASS ~ cn Asting ‘Su fssc Svns Be, SD- Geis asp Oita FAS Fr Accu Sree owe i FH0 Frss enr fonce A Fema ey rs Aso Sais Bo SD oman san Ss, AS Toa osx Sta Csmi, FA ~ tala ose {treat MS ra Fron PpsigSans, A nr’ Sana a SE fhe Sn n Ren nano, PAOS Pale Cary ney Desh a 08, SCS | ‘ ss ste Como 5.HAPTER 2 > Review questions Note: More questions including multiple choice question, are avallable oni. 1 (LON) Define ‘corporate governance’ and identify the key parties involved in effective corporate governanee (102) Identify the parties that, atleast to some degree, falled to meet thelr corporate governance objectives in the past decade (102) In what ways were the boards of directors responsible for corporate governance failures in the past decade? (10.2) In what ways was the auditing profession partially vesponsible for corporate governance failures in the past decade? 5 (LO2) Arthur Levit criticises companies for using ‘cookie jar reserves! to help manage earnings. What are ‘cookie Jar reserves’ and low might they be used to manage corporate earnings? 2-6 (LO 1, 2) What should users reasonably expect from the audit profession? 2-7 (103) What was the CLERP 9 Act designed to accomplish? What were the major factors that led Parliament to develop the Act? (10.8) What is the AUASB and what is its authority? What isthe role of ASIC regarding registered company auditors and inspections of firms that perform audils? (108) The CLERP 9 Act contains certification requirements of management. What are these requirements and what are the penalties for false eertifeations? 2-10 (LO 8) The CLERP 9 Act included a ‘whistle-blowing’ provision, What is whistle-blowing’ and why ist an Important element of corporate governance? 2-11 (LO 8) What requirements of the CLERP 9 Act are intended to strengthen the independence of the external auditor? £08) Compare and contrast the CLERP 9 Act requirements with those of the Sarbanes-Oxley Act £04) To whom does a company’s financial report belong: management, the audit committee or the auditor? Explain and discuss why the ownership issue is important, (£0 5) What is an aut committee? What critical role does the audit commitize play in corporate governance? (LO 5) An audit committee should be composed of outsite directors. Define ‘outside directors’ within the context of an audit committee. How does the existence of an auelt committee affect the auditor's independence? Explain. 2-16 (LO 5) What oversight responsibilities does an audit committee have? Explain the difference between an ‘oversight responsibilty’ and a ‘primary responsibiliy’. (10 5) Explain the difference between the audit committee's responsibilities regarding the external auditor and the audit commitzee’s relationship to the internal aucit and regulatory audit functions. (LO 5) Are nondisted companies, such as a small business, required to have audit committees that represent outside stakeholders such as banks or other lending institutions? 2-19 (LO 6) Identify the specific tems that must be communicated by the external auditer to those charged with governance on every engagement. 2-20 (LO 6) What responsibilty does the board of directors have regarding the provision of non-audit services to a company and its management? Explain, 2-21 (LO 7) Why is the governance structure of an organisation important to the external auelitor? What are the Implications for the auditor if company has not made a comitment to good governance practices?Parr t > 2:22 (LOT) How would an auditor go about assessing the quality of an organisation's corporate governance? In formulating your answer, consider the possiblity that-a company may have a good governance structure on paper but its actuol implementation may be significantly less than what is on paper 2:23 (LO) Whatis the relationship between good corporate governance and (a) entity performance and (b) aucit risk? In what ways does poor corporate governance affect audit isk? 2-24 (LO 10) What authority do the AUASB standards have? 2-25 (LO 10) Explain the concept of ‘due professional care and ski’ and how it might be used in a court case resarcing tie conduet of an audit, How does an independent third party evaluate whether or not an aueltor met the standard of due professional care and skill? 2-26 (LO) In what ways are the standards issued by the IAASB different from the standards issued by the AUSAB? 2:27 (LO9) In what ways are the standards issued by the IASB consistent with the standards issued by the AUASB? 2-28 (LOG) Whatis the difference, ifany, between an assurance engagement as defined by the AUASB and an audit engagement? 2-29 (LO) What is the diference between a reasonable assurance engagement and a limited assurance engagement? 2-30 (LO8) What are the four types of standards that affect the auditing and assurance profession? Define each, 2-31 (LO, 10) Why fs it important that users perceive anaitors to be indepenclent? What is the relationship between. auditor independence and professional scepticism? 2-32 (LO 10) Identify the roles of each of the following parties in audit standard setting: 8. AUASB: b. IAASB c, Internal Auditing Standards Board (IASB) 2-33 (LO 11) To what extent do auditing standards and the principles of goo corporate governance directly affect the design of sult prograrns? Please describe. 2:34 (LO 11) What are the major planning steps that should be performed in developing an audit program for a client? 2-35 (LO 11) Define the term materiality and describe how an auctor would go about determining materiality to be used in the planning of an audit af an organisation's financial report. 2-36 (LO 11) What procedures should an auditor use to determine that al items debited to a long-lived asset account in the current year represent purchases of property that is now owned by the company and is properly valued? Discussion and research questions -37 (Comporate Governance, LO 1) One component of good corporate governance is a company code of ethics. REQUIRED ____ = ‘a What evidence would an auditor gather ta determine whether a corporate code of ethics is actually being adhered to? . Can an auditor make meaningful decisions about areas such as corporate governance where considerable judgement must be apalied in making the decision? Are auaitors equipped to make subjective judgements? ‘e. How would an auditor go about assessing the financial competence of an auclit committee? What are the implications for accepting an audit engagement if the auditor doesnot believe the audit committee has sufficient expertise? 4. In what ways is an effective internal audit department a part of good corporate governance? Bxplin.2-88 (Corporate Governance, LO 1) One of the ctticisms of corporations in the last decacle was that there was a failure E in corporate governance. 7} _—- REQUIRED. ce : 4 Define the term corporade governance and identify the major parties involved in corporate governance as well as thar ros b. Identify the failures in conporate governance that taok place in the past decade, Inehude the fires af each major party in the process. S Briefly explain why there isa relationship between corporate governance andl sk to the auditor. 39 (Corporate Governance Characteristics, LO 1) "The following describes a potential audit client: ‘The company isin the financial services sector and has a large number of consumer loans, including mortgages, outstanding b, ‘The chief executive officer (CEO) and ehiet financial officer's (CFO) compensation Is based on three ceomponents (a) base salary, (b) bonus based on growth in assets and profits, and (e) significant share-basel options. «c. The audit committee meets semi-annually, It is chaired by a retired CFO who knows the company well because she had served as the CFO ofa division ofthe frm. ‘The ther two members are local coramunity members — cone is the president ofthe Chamber of Comamerce and the other @ retired executive from a successful local ‘manufacturing fi. . Tp the equipment held by the company fairly old or new? Explain, ‘c. Develop an aucit procedure to determine that al leased equipment that should have been capitalised during the year was actually capitalised (as opposed to being treated as a lease expense) 44. The constzuction equipment account shows thatthe company purchased approximately $400 000 of new ‘equipment chis year. Identify an audit procedure that wil determine whether the equipment account was properly accounted for curing the year. Assuming the auditor determines the debits to construction equipment were proper during the year, what other information does the auditor need to know in order to ensure that the construction equipment ~net of depreciation — is properly reflected an the balance sheet? £. How can an auditor determine thatthe client has assigned an appropriate useful life to the equipment andl has depreciated it accurately? 2:56 (CLERP9 Act, LO 3, 4) The research report by Houghton, Jubb, Kend and Ng entited “The Puture of Ault ‘Keeping Capital Markets Efficient’ documents the reactions of auditors and other parties tothe introduction of the CLERP 9 reforms, especialy to the force of law auditing standards. t finds many auditors perceive auditing to have taken on more ofa ‘checklist’ approach subsequent tothe reforms. REQUIRED. - ‘a. Access the Future of Auelit report (hp./faneaorecanu eduau/FAReportacp) and summarise the views of the various parties interviewed with respect to:cuarten 2 e @ legal backing for auditing standards - G) ASIC inspections 87 (Practical Researcte: Comorate Governance, LO 1, 8) Selecta sted or unlisted company that is near your university and perform a preliminary review of its corporate governance. Identify all the sourees of evidence for 2 your conelusion regarding corporate governance. Identify the strengths und weaknesses ofthe governance ad 4 ‘desribe the implications ofthe gavernanee structure forthe auditor (Practical Research: Andit Committees, LO 1, §) Audit committees have taken on much more responsibilty i the pas few years, However, it must also be remembered that mudi committee service i nota fulltime appointment g REQUIRED Search annual reports using a database housed by a university library or by looking up the home page of : selecied companies. Selective companies (oreferably in diferent industries) and prepare a report that dlevcribes the fallowing i @ Ananalysis of the audit coumittee charters that identifies the commonalities in all the charters as well as any differences “The characterises of audit committee members, eg. whether a CPAICA, other experienc, te (Gp The inavidua() who could be identified as ‘nancial experts" (fo) The mimber of times the audit committee met during the year () Whether the char ofthe cami was als the char ofthe boar {+ Whether ua omnes members ected remuneration est tele members PS b. (Group Discusion), Discuss in your groups an eprtoihe ene cles youraners tothe LGR). folowing ae 1 (0 How do the companies ier in crms of aut committee characteris? Od ‘What do you think are the underlying causes ofthe differences? 4 Gi) What are the professional backgrounds of individuals who could be designated as “Bnancial experts? How do those differ across the various organisations? | (Gi) What are the implications of variations in the amount of time that the audit comuritee met during the year? 1 Cases 2-69 (Audit Committees) 4 $6 bition privately held consumer products compary has approached you to help them Implement an audit committee charter and to identify the elements needed to develop an effective aualt committee, 4 REQUIRED, a, Identify the major stakeholders, in addition to the shareholders (usually a family, who would be likely ‘candidates to serve on the company’s audit committee b. Identify the key attributes that should be used in choosing auelt conunittee members ‘e. Review the annual report ofa listed company arid locate its audit eommitige charter. What are the key features of the charter? What are its strengths? What are its weakmesses?Introduction snd comorate governance Go tote textbook website fr the AEC and ABT materi Within subseavent chacters ofthis textbook, we highight chep\e-reievant material using two Austain isted comeeries, Advenced Engine Comporents Lid and Advanced Braking Technology Lid es practical ‘examples, We pose questions tal wll equite you io apply the concepts niroduoed in hal cheer to the fects o! these or one companies where these are more sitio fo lysate and apply the chapter content, We have seocted these companies because (1) thay are manlaclers of procs thet wll b> ‘amir to you, (2) thay operate fh dymamis incustes thal presert serous rks and chalangss, especially ater the global nancial cris and (3) they are publicly traded on the ASX ‘On the textocok webse, we Inlud a lage gel of moras for hess comoaries, These materials incude annual reports, Chapta-end matarals conceming hese companies contain quests refeconced to spectc pages within these sources. These rateraswilnrocuo8 you to he companies, provide you wth insight int their respectve Mcustes, deta france results and describe relevant corporate ‘governance sues, In subsequent chapters, we present adcitiona materia fom these source the topes of those chapters. For Chepter 2, you should answer the folowing questions. ‘alred to (Corporate Webs Isp nee atvanordengine com? itp wun advorcadbreng com ABC, 2010 ann epent genera. ‘ABT, 2010 nual rope 1c Compaio the nate of Advanced Bngine Component’s | aes tory, sings actos andl reportable sagen to tose of ‘Advance Braking Technology Datdnalsis | Comore Govemance Qstons nation to fnnea your ended in 2010 ‘Corpse Wabatos (eee cena Capote Govemance Guidelines 207 asincependent? Is | pea iteiatoteceoere se geo yess dee aes ‘A80, 2010 nnua por, po. 17-25.9.49 | 2, Ya tho ropotion of each bert that independent? 2e. Why cose det idependece mazar to sachs? 2a. What charac tthe compares eling wen orsign to servo thebeats? 2, How ate board members compare? Cock he rane of aha compensation potanay afl the ect" incepandenee? Exon ceumon business, cperang sectors and reportable sginens ctors acting Advanced Engire Components actors afectng the auzomctve oesty ib Intp dire sevancecengine com(Coorate Webstes bupthreactrancedongine com! bup/ ww advancodakng cod ARG, 2010 annual epot, Pp. ABT, 2010 ans ropa. pp. 10-18 [thice Related Questions canrren 2 > ‘a, Deer each company’s aut comutieo and is dts, Sb. Who could be designated as francial expe) co the aud commites? o, Whavwas the auendance record ofdectesand awa | committee member ins? ‘34. What were the ae fes for each company or 7010 an 20057 Did tbr company purchase non-aud srices NAS} fom te autor fo, what categoxe of NAS wore purchased” Why arocther es paid tothe aut fm important? Wy i important that thos teste cecosed? ‘3, What ae the cut fes asa ercertage of toa evene snd (tia assets? at With wih athe ASK Comrate Governance Recommendations does each company ot comply? What are the dsnavantages to shareholders a such non-camilance? ‘Wat, any, are to dierenen in corporate governance mechanisms doped by each company? ogee board of doctors What are the msn components cetes? Prowie a ertique othe campanonts and vec, message contained in the codes. 4h, What any. itetnes does management provide ae to how ewatons tom each company's code of ethics wail be hanaled?