Chapter 1
Auditing: Integral to the Economy
Copyright © 2012 South-Western/Cengage Learning
Audit Opinion Formulation Process
The Auditing Profession
The capital markets depend on accurate, reliable, and objective (neutral) data that portray the economic nature of an entity’s business
Accounting transactions are becoming increasingly complicated as companies engage in more elaborate structures as well as in transactions that are difficult to measure
The economy is becoming global ad accounting is moving towards global harmonization
The Auditing Profession
As a profession, we are in a period of change in which auditors and accountants are called upon to make professional judgments
Audit firms need professionals who make consistent judgments across a wide variety of companies, countries, and types of transactions
LO 1: Objective and Role of Auditing
A financial statement audit has been defined as a:
“A 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”
Objective and Role of Auditing
A financial statement audit has been defined as a:
“A 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”
Auditing: A Special Function
“Auditing is a unique function that is licensed by the government to promote the effective functioning of the capital markets. But that unique license comes with a price—accountability and responsibility to the public”
Challenges of the Profession
Detect material fraud and assure that users of financial statements are free from fraud
Complex accounting transactions and organizational structures
Computer systems are complex
Many companies are global
Time pressure to get audit done
Need to generate sufficient audit fees
Need for Unbiased Reporting
and Independent Assurance
Potential bias in providing information
Remoteness between a user and the organization or trading partner
Complexity of the transactions, information, or processing systems
Investors need to manage their risk and thereby minimize financial surprises
Consequences to investors, and others, of relying on inaccurate information can be quite significant
Users of Audited Financial Statements
LO 2: Providers of Public Accounting Services
The public accounting profession includes:
Sole-practitioner firms
local and regional firms
large multinational professional services firms such as the Big 4
The organizational structure of accounting firms varies dramatically
Typical Organizational Hierarchy of CPA Firms
The organizational hierarchy of CPA firms has most often taken a pyramidal structure:
Partners (or owners) form the top of the pyramid and are responsible for the overall conduct of each audit
Managers, who review the audit work performed by staff personnel (the base of the pyramid)
Seniors are responsible for overseeing the day-to-day activities on a specific
Staff personnel typically spend two to four years at a staff level, after which they assume increasing supervisory responsibilities
Knowledge and Expertise Needed
Accounting and Auditing
Knowledge of the Client’s Industry, Business, and Risks
Computer Skills and Accounting Systems
Internal Control Expertise
Fraud—auditors need to be aware of the incentives for employees (including upper-level management) to commit fraud, the opportunities that weak internal controls may create that will allow a fraud to be perpetrated or concealed, and the rationalizations that employees may use to justify their actions and to continue or escalate the fraud over time
LO 3: Organizations Affecting the Public Accounting Profession
Congress:
Sarbanes-Oxley Act of 2002
Auditor Independence and the Role of the Audit Committee
Required Reporting on Internal Control over Financial Reporting
Oversight of the Accounting Profession
Public Company Accounting Oversight Board (PCAOB)
The Securities and Exchange Commission (SEC)
American Institute of Certified Public Accountants (AICPA)
International Auditing and Assurance Standards Board (IAASB)
Organizations Affecting the Public Accounting Profession
Committee of Sponsoring Organizations (COSO)
Accounting Standard Setters:
Generally accepted accounting principles (GAAP) set by Financial Accounting Standards Board (FASB), with approval by the Securities and Exchange Commission (SEC)
International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB)
State Boards of Accountancy
The Court System
LO 4: Audit Standard Setting in the
Public Accounting Profession
Auditors in the United States follow auditing guidance issued by the AICPA, PCAOB, and IAASB
Auditing standards set by these various authorities have a common objective—to provide assurance to the public that audits are conducted in a professional manner
Overall Audit Guidance Issued by the AICPA and the IAASB
The guidance, which is almost identical, recognizes that the objective of an audit is to obtain reasonable assurance about whether the financial statements are free from material misstatement and to report on the financial statements based on the auditor’s findings
Overall Audit Guidance Issued by the AICPA and the IAASB
In completing these objectives, the auditor:
Complies with relevant ethical requirements
Plans and performs an audit with professional skepticism
Exercises professional judgment
Obtains sufficient appropriate evidence on which to base the auditor’s opinion
Conducts the audit in accordance with professional auditing standards
This overall guidance is supplemented with specific auditing standards (SASs issued by the AICPA and ISAs issued by the IAASB)
Auditing Standards Issued by the AICPA
Ten standards that fall within three categories:
General standards—applicable to the auditor and audit firm
Fieldwork standards—applicable to the conduct of the audit
Reporting standards—applicable to communicating the auditor’s opinion
The ten standards were developed by the ASB of the AICPA and have been adopted by the PCAOB
The AICPA is working on converging its standards with those of the IAASB. As part of that convergence, the ten standards will be replaced by principles
General Standards
The audit be performed by individuals having adequate technical training and proficiency as an auditor
Auditors be independent in their mental attitude in conducting the audit (independence in fact) and be perceived by users as independent of the client (independence in appearance)
The audit be conducted with due professional care which is a standard of care that would be expected of a reasonably prudent auditor
Fieldwork Standards
An audit be properly planned and supervised
Auditors develop an understanding of the client’s controls as an important prerequisite to developing specific audit tests
Auditors obtain sufficient appropriate audit evidence by performing audit procedures to provide a reasonable basis for the audit opinion being provided
Reporting Standards
The auditor to state explicitly whether the financial statements are fairly presented
The auditor, to identify, in the auditor’s report, those circumstances in which accounting principles have not been consistently observed in the current period in comparison to the preceding period
The auditor to review disclosures for adequacy
The auditor to express an opinion on the financial statements as a whole or state that an opinion can not be expressed
Principles Governing an Audit Conducted in Accordance GAAS
In place of the ten standards, the AICPA has now developed fundamental principles in four categories
Purpose of an Audit and Premise Upon Which an Audit Is Conducted
Responsibilities
Performance
Reporting
Purpose of an Audit and Premise Upon Which an Audit Is Conducted
The purpose of an audit is to enhance the degree of confidence that users can place in the financial statement
This purpose is achieved when an auditor expresses an opinion on the financial statements
An audit is based on the premise that management has responsibility to prepare the financial statements, maintain internal control over financial reporting, and provide the auditor with relevant information and access to personnel
Responsibilities
Auditors are responsible for having the appropriate competence and capabilities to perform the audit, should comply with ethical requirements, and maintain professional skepticism throughout the audit
Performance
The auditor needs to obtain reasonable assurance as to whether the financial statements are free from material misstatement
Obtaining reasonable assurance requires the auditor to plan and supervise the work, determine materiality levels, identify risks of material misstatement, and design and implement appropriate audit responses to the assessed risks
An audit has inherent limitations such that the auditor is not able to obtain absolute assurance about whether the financial statements are free from misstatement
Reporting
The auditor expresses an opinion as to whether the financial statements are free of material misstatement or states that an opinion can not be expressed
Auditing Standards Issued by the IAASB
As of 2010, the IAASB auditing standards comprise thirty-six International Standards on Auditing (ISAs)
Over 100 countries have national auditing standards that are based on the ISA
It is expected that the standards of the AICPA and IAASB will converge
Auditing Standards Issued by the PCAOB
The PCAOB, which came into existence in 2002, issues auditing standards that apply to auditors of . public companies
As of 2010, the PCAOB has issued fifteen Auditing Standards (ASs)
Further, the PCAOB adopted the AICPA standards that were in place on April 16, 2003 (referred to as interim standards)
Public company auditors must follow these standards of the AICPA unless they have been superseded by a PCAOB standard
LO 5: The Audit Opinion
Formulation Process
Phases I and II: Making Client Decisions and Gaining an Understanding of the Client
Phases III and IV: Obtaining Evidence
Management Assertions
Audit Procedures to Test Assertions
Phase V: Wrapping Up the Audit and Making Reporting Decisions
LO 6: Other Assurance and Attestation Services
Assurance vs. Attestation vs. Audit
Sometimes the terms assurance, attestation, and audit are used interchangeably, However, they differ on two fundamental dimensions:
Existence of an outside third party that relies on the auditor’s opinion
Nature of services provided
Assurance Services
The broadest service
The AICPA’s Special Committee on Assurance Services defines assurance services as “independent professional services that improve the quality of information, or its context, for decision makers”
The items on which assurance is provided can range from financial statements to computer system integrity to quality of products and services being sold to compliance with regulatory requirements
Assurance Services
The assurance can be on information or processes
Examples of assurance services that have been performed by auditing firms include:
The adequacy of the process for capturing and reporting medical data
The adequacy and reasonableness of the economic plans to build a new convention center in a major . city
Assurance Services
All types of assurance services involve three critical components:
Information or a process on which the assurance service is provided
A user or a group of users who derive value from the assurance services provided
An assurance service provider
Providers of Assurance Services
Many regional and local CPA firms provide a variety of assurance services to both audit and nonaudit clients
The large public accounting firms may provide consulting services—but they are not allowed to provide such services for their publicly traded audit clients
Smaller accounting firms that do not have public clients follow standards developed by the AICPA regarding services that they may perform for an audit client
Many smaller public accounting firms provide information systems consulting, financial planning, tax planning, and internal audit services to both audit clients and nonaudit clients
Levels of Assurance Provided
The IAASB has taken a two-pronged approach to the level of assurance provided that ultimately parallels the approach developed in the United States
The IAASB identifies two levels of assurance that can be provided:
Reasonable assurance
Limited assurance
Levels of Assurance Provided
The IAASB has taken a two-pronged approach to the level of assurance provided that ultimately parallels the approach developed in the United States
The IAASB identifies two levels of assurance that can be provided:
Reasonable assurance
Limited assurance
Levels of Assurance Provided
The IAASB has taken a two-pronged approach to the level of assurance provided that ultimately parallels the approach developed in the United States
The IAASB identifies two levels of assurance that can be provided:
Reasonable assurance
Limited assurance
Levels of Assurance Provided
Reasonable assurance engagements are “engagements in which a practitioner expresses a 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”
A “limited assurance” engagement is one in which the objective is to provide less assurance by doing less work that may be appropriately understood by all involved parties
In the United States, a limited assurance engagement related to financial statements is referred to as a review
Attestation Services
Attestation services are a subset of assurance services and always involve a report that goes to external users
For example, the auditor might provide a report to third parties about the quality of a company’s internal controls over compliance with regulation
The narrowest attestation service is the audit of a company’s financial statements
Attestation Services
An audit is a subset of the other services that an auditor can provide
Professional Standards for Non-Audit Assurance Engagements
Attestation standards
Compilation and review standards
The IAASB has also issued standards that can be used by auditors who are performing assertion based assurance services (what the AICPA would refer to as attestation standards)
LO 7: Other Auditing Professions
The Internal Audit Profession
The Governmental Auditing Profession
The Internal Audit Profession
Internal auditing is defined as:
“An independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.”
Services Provided by Internal Auditors
Internal auditors may provide both assurance and consulting services
Specific assurance services that internal auditors perform for an organization include:
Effectiveness of a company’s process for identifying and managing risk
Quality of an organization’s governance processes
Effectiveness and efficiency of an organization’s control processes
Effectiveness and efficiency of operations, with suggestions for operational improvements
Compliance of company operations with company policies and/or regulatory policies
Services Provided by Internal Auditors
One type of internal audit activity involves the analysis of company operations, often referred to as an operational audit
Operational audits are designed to evaluate the effectiveness, economy, and efficiency with which resources are employed and can be applied to virtually every facet of an organization’s operations
Institute of Internal Auditors
The Institute of Internal Auditors (IIA) is a voluntary organization dedicated to enhancing the professionalism and status of the internal auditing profession
With more than 170,000 members located in over 100 countries, the IIA is responsible for issuing standards for the profession
The IIA administers the Certified Internal Auditor (CIA) program and has established a peer review process to help ensure that the practice of internal auditing around the globe is consistent with the professional standards
The Governmental Auditing Profession
Governmental auditors are employed by various federal, state, and local agencies and perform all the types of audits that internal auditors perform
The . Government Accountability Office places an emphasis on performance audits. These audits determine:
Whether the entity is acquiring, protecting, and using its resources economically and efficiently
The causes of inefficiencies or uneconomical practices; (3) whether the entity has complied with laws and regulations
The extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved
The effectiveness of organizations, programs, activities, or functions
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