ACCT 4240: Auditing

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ACCT 4240 Auditing

• Professional Standards

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Practice Standards

• Generally Accepted Auditing Standards
• Measures of the quality of the AUDITOR'S
  PERFORMANCE
• Same from audit to audit
• STANDARDS vs. PROCEDURES
• Standards for Attestation and Assurance Services
• Quality Control Standards
• Others (not discussed in this chapter)
• International Standards on Auditing (ISAs)
• Generally Accepted Governmental Auditing
  Standards (GAGASs)
• Statements of Internal Audit Standards (SIASs)
• Video (VIDEO)

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Management Assertions

• For each account in the financial statements,
  management makes five assertions that the auditor
  tests
• Existence or occurrence
• Completeness
• Rights and obligations
• Valuation or allocation
• Presentation and disclosure

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Existence or Occurrence Assertion

• Assets, liabilities, and equity actually existed
  at the balance sheet date.
• Revenue and expense transactions actually
  occurred during the period covered by the
  financial statements.
• Audit tests include counting cash and inventory,
  confirming receivables with customers primarily
  testing for overstatement.

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Completeness Assertion

• All transactions and balances that should be
  presented in the financial statements are
  included.
• Primarily a test of understatement.
• Audit tests include verifying that all unsold
  inventory is included, all notes payable are
  included, and all expenses are recognized.

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Rights and Obligations Assertion

• Assets are owned by the entity.
• All liabilities shown are obligations of the
  entity.
• Audit tests include verifying ownership of title
  to items shown as assets, and confirming that
  liabilities are not obligations of a different
  entity.

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Valuation or Allocation

• Valuation is often the most difficult to test.
• Valuation often involves complex estimates such
  as allowance for doubtful accounts.
• Valuation also includes allocation of costs over
  time, such as depreciation and amortization.
• Audit tests include determining lower of cost or
  market and evaluating collectibility.

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Presentation and Disclosure Assertion

• GAAP properly selected and applied.
• Disclosures are adequate both in financial
  statements and footnotes.
• Transactions and balances are properly classified.

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Generally Accepted Auditing Standards (GAAS)

• General Standards
• Have adequate technical training and proficiency.
• Maintain independence in mental attitude.
• Exercise due professional care.

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Generally Accepted Auditing Standards (GAAS)

• Standards of Field Work
• Adequately plan and supervise the audit.
• Have sufficient understanding of the internal
  control structure.
• Gather sufficient competent evidential matter.

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Generally Accepted Auditing Standards (GAAS)

• Standards of Reporting
• Generally accepted accounting principles.
• Consistencysame GAAP as in prior period.
• Disclosureall information useful for decision
  making.
• Expression of an opinion on financial statements
  taken as a whole.

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Major Sections of the AICPA and IAASB
Codification Framework
AICPA Codification AICPA Codification IAASB Codification IAASB Codification
AU Section Description ISA Section Description
100 Introduction 100 Introductory Matters
200 The General Standards 200 General Principles and Responsibilities
300 The Standards of Fieldwork 300-499 Risk Assessment and Response to Assessed Risks
400 The First, Second, and Third Standards of Reporting 500 Audit Evidence
500 The Fourth Standard of Reporting 600 Using Work of Others
600 Other Types of Reports 700 Audit Conclusions and Reporting
700 Special Topics 800 Specialized Areas
800 Compliance Auditing 1000 International Auditing Practice Statements
900 Special Reports of the Committee on Auditing Procedure
Source http//pcaobus.org/
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Potential Codification Framework for PCAOB
Professional Standards (Top-level View)

• Overview of PCAOB professional standards
• PCAOB Auditing standards (Rule 3200T)
• Introduction to PCAOB auditing standards
• Fundamental principles and auditors'
  responsibilities
• Audit planning and risk assessment
• Staffing, supervision, review and control of
  audit work
• Internal control
• Audit evidence
• Audit conclusions and reporting
• Auditors' responsibilities for special purpose
  financial information
• PCAOB Attestation standards (Rule 3300T)
• PCAOB Quality control standards (Rule 3400T)
• PCAOB Ethics standards (Rule 3500T)
• PCAOB Independence standards (Rule 3600T)
• (Note Appendix D shows an expanded view of this
  codification framework.)

Source http//pcaobus.org/
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Illustrative Audit Quality Control System
Professional standards values Including
independence, objectivity integrity
Investor protection
Firm culture, values codes of conduct
Power, authority, responsibility firm governance
Compensation and rewards
QC risk assessment and controlregarding risk of
violating professional standards/values or
issuing inappropriate reports
Functions
Basic
Audit Quality
Client acceptance and continuance
Engagement performance processes
HR mgmt.
Engagement consultation and engagement quality
review
Monitoring and internal inspections Concern all
QC elements and include whistleblowing and other
mechanisms to detect/report/correct QC problems,
assess audit quality control processes, and
continuously improve audit quality
Source http//pcaobus.org/
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Statements on Auditing Standards

• Periodically issued by Auditing Standards Board.
• Considered to be interpretations of GAAS.
• Auditor must justify any departures from SAS.
• PCAOB now will issue auditing standards so future
  of SAS is uncertain.

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Audit Procedures
The third standard of field work
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Competency of Audit Evidence

• Evidence must be valid (reliable).
• External sources more reliable than internal
  sources.
• Evidence from an effective control system is more
  reliable than evidence from a weak control
  system.
• Direct evidence is more reliable than indirect
  evidence.
• Relevant to assertion being tested.
• Unbiased.
• Objectivity (objective versus subjective).
• Qualifications of the provider.
• Timeliness of the evidence.

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Sufficiency of Audit Evidence

• Sufficiency relates to the quantity of evidence
  gathered and relates to
• Quality of internal controls
• Nature of procedure being performed

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Characteristics of Appropriate Evidence

• Relevance
• Testing what you want to test (e.g., direction of
  testing)
• Evidence Source
• Generally an externally generated piece of
  evidence more reliable than an internal
  (client-generated) piece of evidence
• Evidence Hierarchy
• Direct personal knowledge
• External evidence
• External-internal evidence
• Internal evidence
• Verbal and written
• Objective v. Subjective Evidence

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Reliability of Evidence (Most to Least)

• Direct evidence
• Physical observation by the auditor
• Calculations made by the auditor
• Evidence received directly from outside sources
• Confirmations
• Bank statements

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Reliability of Evidence (Most to Least)

• Evidence created by outside sources but received
  from client
• Bank statement from client files
• Vendor invoices
• Evidence created by the client
• Invoices for sales made to customers
• Cost allocations and other internal records
• Verbal and written representations

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The Legal Environment
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The Legal Environment

• Why Does Liability Arise?
• Responsibilities of Auditor
• Responsibilities to Clients
• Responsibilities to Third-Party Users
• Expectation Gap

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The CPA Profession

• Legal responsibilities
• Common law
• Statutory law
• Civil
• Criminal
• Code of Professional Conduct
• Principles
• Rules

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Areas of Liability in Auditing

1. Contract law
2. Tort law

1. Liability to clients

2. Civil liabilities to third parties

1. Common law
2. Statutory law

3. Criminal liability

1. Prudent man concept
2. Liability for the acts of others
3. Lack of privileged communication

Legal concepts
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Concepts Related to Auditors Liability
Due Professional Care
Auditors are expected to exercise the same
reasonable care which others in the profession
would exercise in similar circumstances.
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Concepts Related to Auditors Liability
Sources of Responsibility
Common lawbased on the opinions of
courts Statutory lawthe body of laws passed by
legislative bodies
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Concepts Related to Auditors Liability
Degree of Wrongdoing
NoneAuditors perform appropriately Negligence Gro
ss Negligence or Constructive Fraud FraudAuditors
knowingly deceive
Liability
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Common Law

• Tort LiabilityA private wrong against a person
  or his property, usually arising from
  intentional, wrongful action, or negligence
• Ordinary Negligence
• Gross Negligence
• Fraud

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Ordinary Negligence

• Failure to exercise the standard of care that a
  reasonable person would exercise in like
  circumstances.
• These elements must be present
• Duty of care
• Breach of that duty
• Causation
• Damages

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Gross Negligence

• Lack of even slight care reckless behavior.
• These elements must be present
• Duty of care
• Breach of that duty (more egregious than ordinary
  negligence)
• Causation
• Damages

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Negligence and Gross Negligence

• Defenses against negligence and gross negligence
• Lack of a duty of care
• Performance was not negligent
• Contributory negligence
• Absence of cause

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Fraud

• A false, material misrepresentation of fact
  knowing it to be false, or reckless disregard for
  the truth.
• These elements must be present
• Misrepresentation of material facts
• Intent to defraudScienter
• Reliance on the information
• Damages

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Common Law

• Important definitions
• PrivityContractual relationship between two
  parties
• Breach of ContractFailure (of the auditor) to
  perform (the examination) in accordance with one
  or more of the provisions in the contract

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Liability under Common Law
Plaintiff Minimum Basis for Potential Auditor Liability Burden of Proof upon Plaintiff
Client Third party Primary beneficiary Foreseen beneficiary Foreseeable third parties Ordinary negligence Ordinary negligence Gross negligence Gross negligence Damage or loss Misstated financial statements or erroneous advice Reliance upon financial statements or advice Deficient auditor conduct
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Securities and Exchange Commission

• Securities Act of 1933Requires audited financial
  statements in registration statements of initial
  public offerings.
• Securities Exchange Act of 1934Established the
  SEC and established requirement for annual
  audited financial statements.
• Regulation S-XEstablishes form, content, and
  requirements of financial statements.

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Securities Act of 1933

• Requirements of the Act
• Initial issuance of securities.
• File registration statement with the SEC.
• Issue a prospectus to any potential investors.

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Securities Exchange Act of 1934

• Requirements of the Act
• Subsequent trading of securities.
• File financial statement information with the SEC
  (10-K, 10-Q).

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SEC Registration Forms

• 1933 Act Forms (S-1)
• 1934 Act Forms
• 10-K
• 10-Q
• 8-K
• SEC forms filed electronically by companies are
  available on EDGAR

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Auditors Liability under 1933 Act

• A plaintiff seeking damages must prove
• The financial statements in a registration
  statement were false or misleading.
• The plaintiff was the purchaser of the
  securities.
• The plaintiff suffered damages.

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Auditors Defenses under 1933 Act

• The auditor had reasonable grounds to believe the
  statements were correct.
• The misstatement was not material.
• The plaintiff had prior knowledge of the
  misstatement.
• The incorrect statements had been issued more
  than one year before stock purchase.
• The damages were not caused by the inappropriate
  audit report.

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Auditors Liability under 1933 Act

• Auditor can be found guilty of both civil and
  criminal violations.
• Civil penalties typically involve only payment of
  damages.
• Criminal penalties can be a fine of not more than
  10,000 or a prison term of not more than five
  years, or both.

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Auditors Liability under 1934 Act

• A plaintiff seeking damages must prove
• The financial statements in a 10-K were false or
  misleading.
• The plaintiff was the purchaser or seller of the
  securities.
• The plaintiff suffered damages.
• The plaintiff relied on the financial statements.
• The auditor committed the appropriate degree of
  wrongdoing.

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Liability under Statutory Law
Plaintiff Minimum Basis for Potential Auditor Liability Burden of Proof Burden of Proof
Plaintiff Minimum Basis for Potential Auditor Liability Upon Plaintiff Upon Defendant
Under 1933 Act, Section 11 Security purchaser Ordinary negligence Damage or loss Financial statements misstated or advice erroneous Lack of reliance or Auditor conduct not deficient (due diligence)
Under 1934 Act, Section 10(b) Rule 10b-5 Security purchaser or seller Gross negligence or fraud Damage or loss Financial statements misstated or advice erroneous Reliance Deficient auditor conduct
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Liability under Statutory Law
Plaintiff Minimum Basis for Potential Auditor Liability Burden of Proof Burden of Proof
Plaintiff Minimum Basis for Potential Auditor Liability Upon Plaintiff Upon Defendant
Under 1934 Act, Section 18 Security purchaser or seller Gross negligence Damage or loss Financial statements misstated or advice erroneous Reliance Auditor conduct not deficient (due diligence)
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Summary of Differences in Key Section of 1933 and
1934 Acts
Item 1933 Act 1934 Act
Plaintiff Plaintiff must prove reliance Defendant liable for ordinary negligence Any person acquiring the security No Yes Either the buyer or seller of the security Yes No
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Racketeer Influenced and Corrupt Organizations
(RICO)

• Allows individuals to sue for damages when they
  have been affected by a pattern of racketeering
  activity.
• At least two occurrences during a ten-year period
  of
• Bribery and extortion indictable under a state or
  federal statute.
• Fraud under the securities acts.
• Plaintiff can recover triple damages.

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Precautions to Avoid Litigation

• Use engagement letters.
• Thoroughly investigate prospective clients.
• Emphasize quality of service rather than growth.
• Comply fully with professional pronouncements.
• Establish and maintain high standards of quality
  control.
• Exercise caution in engagements involving clients
  in financial difficulty.

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Auditors Responses

• More intensive client screening
• Avoiding clients in high-risk industries
• Increasing liability insurance
• Seeking reform in the legal system
• Converting to limited liability partnerships

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Next Time
Audit Reports Part I