Chapter 1: Auditing Integral to the Economy External Auditing: a special function

Introduction External Auditing

Financial Statement Audit
- systematic process of objectively obtaining and evaluating evidence
regarding assertions about economic actions and events to ascertain the
degree of correspondence between those assertions and established
criteria; and communicating the results to interested users.
Objective of External Audit
- to provide opinions on the reliability of the financial statements and, as
part of an integrated audit, provide opinions on internal control
effectiveness.
External Auditing to have Value
- the public needs to have confidence in the objectivity and accuracy of the
opinions provided by external auditors.
Free Market Economy
- can exist only if there is sharing of reliable information among parties that
have an interest in the financial performance of an organization.
Market is Strengthened
- information is:
1. Transparent
2. Unbiased - data is not presented in such a way that it favors one party
over another.
Organization’s Reported Information
- must reflect economics of its transactions and the current economic
conditions of both its assets and liabilities.
External Audit
- is intended to enhance the confidence that users can place on
management-prepared financial statements.
Unqualified Audit Report
- the auditor has no reservations about management’s financial statements
or internal controls.
Adverse Opinion
- issued when the auditor has reservations.
- is a “special function” as described by Chief Justice Warren Burger in a
1984 Supreme Court decision:
“By certifying the public reports that collectively depict a corporation’s
financial status, the independent auditor assumes a public responsibility
transcending any employment relationship with the client. The independent
public accountant performing this special function owes ultimate allegiance
to the corporation’s creditors and stockholders, as well as to the investing
public. This “public watchdog” function demands complete fidelity to the
public trust.”
- Auditors
- guardians of the capital markets.
- serve several parties, the most important:
o Public - investors, lenders, workers, and others who make decisions
based on financial information about an organization.
- Auditing
- requires the highest level of technical competence, freedom from bias,
and concern for the integrity of the financial reporting process.
- Public expects auditors to:
(a) find fraud
(b) require accounting principles that best portray the spirit of the
concepts adopted by accounting standard setters
(c) be independent of management
- In fact
- In appearance
- Audit Profession Pressures
o keeping fees down
o making careful decisions regarding independence
o conducting a quality audit
Need for Unbiased Reporting and Independent Assurance Overall Objectives in Conducting an Audit

Effective Capital Markets - to obtain reasonable assurance about whether the financial
- require quality financial reporting. statements are free from material misstatement
- to report on the financial statements based on the auditor’s
Organization’s Financial Statements findings.
- should reflect a true and fair view of the organization’s financial results
- should not favor one user over another. In completing these objectives, the auditor:

Need for Independent Assurance 1. Complies with relevant ethical requirements

arises from several factors: 2. Plans and performs an audit with professional skepticism
3. Exercises professional judgment
1. Potential bias - Management has incentives to bias financial 4. Obtains sufficient appropriate evidence on which to base the auditor’s
information to convey a better impression of the financial data than opinion
real circumstances might merit. 5. Conducts the audit in accordance with professional auditing standards
2. Remoteness - An organization and the users of its financial
information are often remote from each other, both in terms of
geographic distance and the extent of information available to both
parties.
3. Complexity - Transactions, information, and processing systems are
often very complex, so it can be difficult to determine their proper
presentation.
- provides an opportunity for management to deceive users.
4. Consequences - the consequences of, unreliable information can be
seen in the subprime mortgage crisis in the United States.
- information is not reliable, investors and other users lose a
significant source of information that they need to make decisions
that have important consequences

Factors suggest a role for external auditors who are independent.

Independence

- requires objectivity and freedom from bias

- referred to as the cornerstone of the auditing profession
- Without independence, audits would lack value.
 Parties Involved in Preparing and Auditing Financial Statements
Audit Opinion Formulation Process 1. Management
- has responsibilities for
I. Client Acceptance and Continuance
(a) preparing and presenting financial statements in accordance with the
- choose whether to perform each individual audit
applicable financial reporting framework
- procedures to help them ensure that they are not associated
(b) designing, implementing, and maintaining internal control over
with clients where management integrity is in question or
financial reporting
where a company might otherwise present the audit firm with
(c) providing the auditors with information relevant to the financial
unnecessarily high risk
statements and internal controls.
II. Perform Risk Assessment Procedures
- to understand the client’s, its industry, its competition, and its
2. Internal audit function
management and governance processes (including internal
- provides management and the audit committee with assurance on
controls)
internal controls and reports.
- to determine the likelihood that financial accounts might be in
3. Audit committee
error
- a subcommittee of the organization’s board of directors, oversees both
III. Obtain Evidence about Internal Control Operating
management and the internal auditors
Effectiveness
- hire the external auditor
- through testing those controls
4. External Auditor
IV. Obtaining of Substantive Evidence about accounts, disclosures,
- job is to obtain reasonable assurance about whether management’s
and assertions
statements are materially accurate and to provide a publicly available
-amount of testing is influenced by I, II, & III
report.
V. Complete the Audit and Making Reporting Decisions
- conduct their procedures and make judgments in accordance with
- type of audit is identified
professional standards
 Skills and Knowledge Needed to Enter the External Auditing Profession

Providers of External Auditing Services 1. Technical Knowledge and Expertise

- understand accounting and auditing authoritative literature, develop
External Auditing Profession includes sole-practitioner firms, local and
industry and client-specific knowledge, develop, and apply computer skills,
regional firms, and large multinational professional services firms.
evaluate internal controls, and assess and respond to fraud risk.
The Big 4 firms are
2. Leadership, Teamwork, and Professional skills
1. KPMG
- make presentations to management and audit committee members,
2. Deloitte Touche Tohmatsu (Deloitte in the United States)
exercise logical reasoning, communicate decisions to users, manage and
3. PricewaterhouseCoopers (pwc)
supervise others by providing meaningful feedback, act with integrity and
4. Ernst & Young.
ethics, interact in a team environment, collaborate with others, and
- the organizational structure of these firms is quite complex
maintain a professional personal presence.
Member Firms are organized as a partnership or limited liability corporation
within each country.

Smaller Firms also practice internationally through an affiliation with a

network of firms.

Public Accounting Firms have also organized their practices along industry
lines to better serve clients in those industries.

Organizational Hierarchy of Audit Firms

- Partners (owners) at top level, responsible for overall conduct of audit.
- Managers, next of the hierarchy, who review the audit work performed by
seniors and staff personnel.
*Both are responsible for many audit engagements that are being
conducted simultaneously.
- Seniors are responsible for overseeing the day-to-day activities on a
specific audit, and they oversee entry-level personnel who perform many of
the basic auditing procedures.
*Seniors and Staff are usually assigned to fewer audits at one time.
Organizations Affecting the External Auditing Profession
External auditing is a profession with many organizations shaping and
regulating the services provided by those in the profession.
Congress
During the early 2000s, various shocks affected the future of the auditing
profession:
(a) the failure of one of the largest audit firms in the world
(Arthur Andersen & Co.)
(b) four of the largest bankruptcies in history, and each of the bankruptcies
occurred because of fraud had taken place
(c) auditors were not independent of management
(d) a question as to whether the auditing profession could sufficiently
govern itself to ensure that it would always act in the public interest.
Congress passed the Sarbanes-Oxley Act of 2002
This legislation has had a significant impact on audit firms through:
1. Increasing auditor independence
2. Enhancing the role and importance of the audit committee
3. Requiring reporting on internal control over financial reporting
4. Providing new oversight of the external auditing profession by the Public
Company Accounting Oversight Board (PCAOB)
Public Company Accounting Oversight Board
The PCAOB is a private sector, nonprofit organization that oversees auditors
of public companies.
Overall Goal:
“protect the interests of investors and further the public interest in the
preparation of informative, fair, and independent audit reports.”
Four Primary Responsibilities related to auditors of public companies:
1) registration of audit firms that audit public companies;
2) periodic inspections of registered audit firms;
3) establish auditing and related standards for registered audit firms;
(4) investigation and discipline of registered audit firms for violations of
relevant laws or professional standards.
Professional Qualifications of Five board members (PCAOB)
- not all are external auditors
- no more than two board members may be Certified Public Accountants
to ensure that the Board was not unduly dominated by members of the
external audit profession
to assure users of financial statements that this important regulator is
representing the broad interests of users
Securities and Exchange Commission
- was established by Congress in 1934 to regulate the capital market system.
- has oversight responsibilities for the PCAOB and for all public companies
that are traded on U.S. stock exchanges.
- has the authority to establish GAAP for companies whose stock is publicly
traded
- although it has generally delegated this authority to the
Financial Accounting Standards Board (FASB).
- has a responsibility to prosecute public companies and their auditors for
violating SEC laws, including fraudulent accounting.
American Institute of Certified Public Accountants
- has long served as the primary governing organization of the public
accounting profession.
- role has changed with the establishment of the PCAOB as the body for
setting auditing standards for the audits of public companies
- continues to develop standards for audits of nonpublic companies
- is responsible for a peer review program in which registered firms are
subject to periodic peer review of their nonpublic audits
- provides continuing education programs, and through its Board of
Examiners, prepares and administers the Uniform CPA Examination.
The Center for Audit Quality
- is dedicated to enhancing investor confidence and trust in the financial
markets
- is a thought leader in fostering high audit quality, collaborating with
auditors and financial statement users about emerging issues and
advocating for accounting and auditing standards that promote auditors’
effectiveness
International Auditing and Assurance Standards Board
- is a part of the International Federation of Accountants (IFAC), a global
organization for the accounting profession
- sets International Standards on Auditing (ISAs) and facilitates the
convergence of national and international auditing standard
Committee of Sponsoring Organizations
- part of the Treadway Commission
- is a recognized provider of guidance on internal control, enterprise risk
management, and fraudulent deterrence
- is sponsored by five organizations:
1. Financial Executives International
2. American Institute of Certified Public Accountants
3. American Accounting Association
4. Institute of Internal Auditors
5. Association of Accountants and Financial Professionals in Business (IMA).
- provides the internal control framework that serves as the benchmark
for auditors who assess the effectiveness of their client’s internal controls.
Accounting Standard Setters
Generally accepted accounting principles (GAAP) in the United States
have traditionally been set by the Financial Accounting Standards Board
FASB, with approval by the Securities and Exchange Commission (SEC).
International accounting standards (IFRS-International Financial Reporting
Standards) are set by the IFRS Foundation of International Accounting
Standards Board (IASB)
- goal is to develop a single set of understandable, enforceable, and globally
accepted international financial reporting standards.
State Boards of Accountancy
- CPAs are licensed by state boards of accountancy, which are charged with
regulating the profession at the state level
- require passage of the Uniform CPA Examination as one criterion for
licensure
- education and experience requirements vary by state
Education: most states require 150 college semester hours for CPA licensure
(120 for some)
- Some states require candidates to have external auditing experience
before issuing them a license to practice
- other states give credit for audit experience related to private or
governmental accounting.
- work experience requirement can also vary with the level of education.
The Court System
- acts as a quality-control mechanism for the auditing profession
- Third parties may sue CPAs under federal securities laws, various
state statutes, and common law for substandard audit work.
- help ensure that the profession meets its responsibilities to third parties
Audit Quality
Quality audit is one performed “in accordance with generally accepted
auditing standards (GAAS) to provide reasonable assurance that the audited
financial statements and related disclosures are presented in accordance
with generally accepted accounting principles GAAP and are not materially
misstated whether due to errors or fraud.”
- GAO (2003)
Financial Reporting Council (FRC)
- developed “The Audit Quality Framework” to provide guidance on specific
drivers of audit quality.
- is the United Kingdom’s independent regulator responsible for promoting
investment in securities through good corporate governance and financial
reporting.
The FRC’s Audit Quality Framework
- states that there are five primary drivers of audit quality
(1) audit firm culture,
(2) the skills and personal qualities of audit partners and staff, (3) the
effectiveness of the audit process,
(4) the reliability and usefulness of audit reporting,
(5) factors outside the control of auditors that affect audit quality
- effective audit processes, by themselves, are not sufficient to achieve audit
quality.
- it is a package of factors that includes a culture that influences auditors
who in turn influence audit procedures.
- Other factors, outside of the control of the audit firm
1. the robustness of the accounting framework
2. regulatory and legal environment.
Audit Firm Culture
Leadership
1. Creating a work culture where audit quality is valued and rewarded
2. Emphasizing that ‘doing the right thing’ is appropriate from a public
interest perspective, and that ‘doing the right thing’ helps to develop and
maintain both individual and audit firm reputation
3. Ensuring that audit firm employees have enough time and resources to
address difficult issues that may arise
4. Ensuring that monetary considerations do not adversely affect audit
quality
5. Promoting the benefits of having audit partners seek guidance on
difficult issues and supporting their professional judgment
6. Ensuring that the audit firm has quality systems in place for making
client acceptance and continuation decisions
7. Fostering evaluation and compensation practices that promote personal
characteristics important to quality auditing
8. Ensuring that audit quality is monitored within the audit firm and that
appropriate consequences are taken when audit quality is found to be
lacking
Skills and Qualities of the Engagement Team
Audit firm Employees
1. Understanding the clients’ business and adhering to auditing and ethical
standards
2. Exhibiting professional skepticism and addressing issues identified
during the audit
3. Ensuring that staff performing audit work have appropriate levels of
experience and that they are properly supervised by their superiors
4. Ensuring that partners and managers provide lower level staff with
mentoring and “on the job” training opportunities
5. Attending to and learning during training intended to aid in
understanding audit, accounting, and industry specialist issues
Effectiveness of the Audit Process
Audit Process
1. The audit methodology is well structured and:
a) Encourages partners and managers to be work diligently in planning
the audit
b) Provides a framework and procedures to obtain sufficient
appropriate audit evidence in an effective and efficient manner
c) Requires appropriate audit documentation
d) Provides for complying with auditing standards, but does not inhibit
professional judgment
e) Ensuring that audit work is effectively reviewed
f) Audit quality control procedures are effective, understood, and
applied.
2. Quality technical support is available when auditors encounter unfamiliar
situations in which they require assistance or guidance.
3. Ethical standards are communicated and achieved, thereby aiding
auditors’ integrity, objectivity, and independence.
4. Auditors’ evidence collection is not constrained by financial pressures.
Reliability and Usefulness of Audit Reporting
Audit Report Attributes:
1. written in a way that clearly and unambiguously convey the auditor’s
opinion on the financial statements and addresses the needs of users of
financial statements.
2. Auditors appropriately conclude as to the truth and fairness of the
financial statements
3. The auditor communicates with the audit committee about the
following:
a) Audit scope
b) Threats to auditor objectivity
c) Important risks identified and judgments that were made in
reaching the audit opinion
d) Qualitative aspects of the client’s accounting and reporting and
possible ways of improving financial reporting
Factors Outside the Control of Auditors That Affect Audit Quality
1. Client corporate governance
2. Regulatory environment
Professional Requirements
1. maintaining Auditor Independence
2. participating in Review Programs
3. issuing Engagement Letters
4. making appropriate Client Acceptance/Continuance Decisions
5. evaluating the Audit Firm’s Limitations
6. maintaining Quality Audit Documentation
Auditor Independence Requirements
SEC and PCAOB Independence Requirements
- applicable to auditors of public companies
- complementary independence requirements
PCAOB’s independence requirements are designed to address specific
requirements in the Sarbanes-Oxley Act of 2002
SEC’s commitment to independence:
Public Policy Goals:
1. to foster high quality audits by minimizing the possibility that any external
factors will influence an auditor’s judgments: Professional Skepticism
2. promote investor confidence in the financial statements of public
companies: Investor Confidence is the cornerstone of our securities
Market
Four Basic Principles that define when an auditor is in a position that impairs
independence:
● Creates a mutual or conflicting interest between the accountant and the
audit client
● Places the accountant in the position of auditing his or her own work
● Results in the accountant acting as management or an employee of the
audit client
● Places the accountant in a position of being an advocate for the audit
client
AICPA Requirements: A Conceptual Framework on Independence
Seven Categories of Threats to Independence;
-in fact
-in appearance
1. Self-review threat—when the audit firm also provides non-audit work for
the client, such as preparing source documents used to generate the client’s
financial statements. Independence is threatened because it may appear
that the auditor is reviewing his or her own work.
2. Advocacy threat—when the auditor acts to promote the client’s
interests, such as representing the client in tax court. Independence is
threatened because it may appear that the auditor cares more about the
client than external users of the financial statements.
3. Adverse interest threat—when the auditor and the client are in
opposition to one another, such as when either party has initiated litigation
against the other. Independence is threatened because the auditor may
take actions that are intended to weaken the client’s chances in the
litigation and may appear to care more about the audit firm and its interests
rather than those of the company or external users of the financial
statements.
4. Familiarity threat—when the auditor has some longstanding relationship
with an important person associated with the client.
Examples include:
● The audit partner’s close relative is employed in a key position at the
client.
● The audit partner has been assigned to the client for a long period of
time and has developed very close personal relationships with top
management.
● A member of the audit team has a close personal friend who is
employed in a key position at the client.
● A member of the audit team was recently a director or officer at the
client.
Independence is threatened because the auditor may act in a way that
favors the client or individual employed at the client rather than external
users of the financial statements.
5. Undue influence threat—when client management attempts to coerce or
provide excessive influence over the auditor.
Examples include:
● Top management threatens to replace the auditor or the audit firm
because of a disagreement over an accounting issue.
● Top management pressures the auditor to reduce the amount of
work they do on the audit in order to achieve lower audit fees.
● An employee of the client gives the auditor a gift that is clearly significant
or economically important to the auditor.
Independence is threatened because the auditor may act in a way that
favors the client or individual employed at the client rather than external
users of the financial statements.
6. Financial self-interest threat—when the auditor has a direct financial
relationship with the client, such as owning stock in the client company,
owing money to the client company, or when the audit client makes up
most of the audit firm’s total revenue.
Independence is threatened because the auditor’s judgment may be unduly
influenced by their own financial interests rather than acting in the best
interests of external users of the financial statements.
7. Management participation threat—when the auditor takes on the role
of management or completes functions that management should
reasonably complete, such as establishing internal controls or hiring/firing
client employees. Independence is threatened because the auditor is acting
as management, and so be reviewing his or her own work.
The AICPA Safeguards to avoid the independence problems associated with
these threats. These safeguards include:
1. Safeguards created by the profession or regulation.
2. Safeguards created by the audit client.
3. Safeguards created by the audit firm.
Review Programs
Three types of review programs exist:
● external inspections/peer reviews
● engagement quality reviews
● interoffice reviews
External Inspections/Peer Reviews
The PCAOB performs inspections of registered audit firms every year for
audit firms that have over 100 public company audits and every three years
for the other registered audit firms.
The AICPA has a peer review program that reviews and evaluates those
portions of an audit firm’s accounting and auditing practice that are not
inspected by the PCAOB; therefore, the focus of the peer reviews would be
on the nonpublic clients of the audit firm. The reviews are conducted by
auditors from another external audit firm and provide an objective
assessment of the appropriateness of the firm’s quality-control policies and
procedures as well as of the degree of compliance with them.
Engagement Quality Reviews
-an audit partner not otherwise involved in the audit performs an
engagement quality review (also referred to as concurring partner review)
near the end of each audit to make sure that documented evidence
supports the audit opinion. Such reviews are required for audits of public
companies
- it is desirable for firms to conduct these reviews on all audits.
The concurring partner should be familiar with the nature of the business
being audited.
Single-partner audit firms arrange with other small firms to perform
concurring reviews for each other before issuing audit reports.
AICPA
- has no formal requirement for engagement quality/concurring
partner review on individual audit engagements.
- require that firms establish specific criteria by which they decide on a
systematic basis the clients that should have such a review
- requires the firms to undergo a quality review process at the overall audit
firm level on a periodic basis and:
(a) the absence of specific criteria for engagement quality reviews, or
(b) absence of adherence to those criteria
- considered a deficiency when overall audit firm reviews are performed.
Criteria to decide that an engagement quality review is needed include:
1. riskiness of client,
2. size of client
3. extent of outside distribution of audit report
PCAOB
- requires an engagement quality review
- the engagement quality reviewer must evaluate all significant judgments
made by the engagement team and to consider their evaluation of the
client’s risks.
- requires that all phases of the review be carefully documented.
Engagement quality reviewer
- must have competence, independence, integrity, and objectivity
IAASB
- requires that the engagement quality reviewer evaluate:
a. significant risks and the engagement team’s responses to those
risks,
b. judgments made (particularly relating to addressing risks and
materiality),
c. the disposition of misstatements identified during the engagement
(whether corrected or not),
d. matters communicated to management
e. others charged with governance over the organization.
Interoffice Reviews
- is a review of one office of the audit firm by professionals from another
office of the same firm to assure that the policies and procedures
established by the firm are being followed.
- include selecting and reviewing a sample of audits to help assure that
quality work was performed.
Engagement Letters Audit Firm Limitations
- states the scope of the work to be done on the audit so that there should An external audit firm should not undertake an engagement that it is not
be no doubt in the mind of the client, external auditor, or the court system qualified to handle.
as to the expectations agreed to by the external auditor and the client. Firms covered by an AICPA professional liability insurance plan that are
- includes: most susceptible to litigation are those with staffs of 11 to twenty-25
auditors.
a. audit fee - become overzealous, leading to low audit quality and exposure to
b. description of the timing of the external auditor’s work subsequent litigation.
c. description of documentation that the client is expected to provide
to the external auditor Audit Documentation
The audit team should document everything done on the audit.
If the client wants its auditors to go beyond the requirements of the - difficult to persuade a jury or a regulator such as the PCAOB that
auditing standards, the auditors should have their attorneys review the something was done that is not documented.
wording to make sure that it says not only what is intended but also what is - should clearly show evidence of supervisory review, particularly in those
possible. areas with the greatest potential for improprieties: inventories, revenue
Client Acceptance/Continuance Decisions recognition, and accounting estimates.
- should involve more than just a consideration of management’s integrity. - should indicate what tests were performed, who performed them, and any
Strict client acceptance/continuance guidelines should be established to significant judgments made (along with the rationale for those judgments).
screen out the following:
● Clients that are in financial and/or organizational difficulty—For
example, clients that could go bankrupt or clients with poor internal
accounting controls and sloppy records.
● Clients that constitute a disproportionate percentage of the firm’s total
practice—Clients may attempt to influence the auditor into allowing
unacceptable accounting practices or issuing inappropriate opinions.
● Disreputable clients—External audit firms cannot afford to have their
good reputation tarnished by serving a disreputable client or by associating
with a client that has disreputable management.
● Clients that offer an unreasonably low fee for the auditor’s services—In
response, the auditor may attempt to cut corners imprudently or lose
money on the engagement. Conversely, auditors may bid for audits at
unreasonably low prices.