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AuditingConcepts for a Changing Environmentfifth editionLarry E.RittenbergUniversity of Wisconsin MadisonBradley J.SchwiegerSt.Cloud State UniversityThomsonSouthwesternChapter 1Importance of Auditing Free Market Economy qA free market economy exists only if accurate,reliable data is availableqAuditors contribute to an effective capital market by providing independent evaluations about the reliability of an organizations financial statements or the efficiency and effectiveness of various aspects of its performanceWhat is auditing?qAuditing is both more and less than public accountingqMore because it includes internal and operational auditing,governmental auditing,and other services that evaluate and report on managerial performanceqLess because public accounting firms provide a variety of other assurance and non-audit services Define Auditing“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 users.What is attestation?qAttestation involves gathering evidence about assertions,evaluating the evidence against objective criteria,and communicating the conclusion reached.qAuditing is specific attestation service where the auditor gathers evidence to determine whether the financial statements are fairly presented in accordance with Generally Accepted Accounting Principles and issues an opinion to be used by third-party users,management,and the Board of DirectorsAuditing is all about evidenceqThe auditor gathers evidence to determine if the clients processes are working correctly,its financial data are recorded and presented correctly,and its financial statements as a whole are fairly presented.qThis implies that-qthe process of auditing is to gather and evaluate evidence to test assertionsqthe audit process is systematicqthe auditor must be independent of the entity audited and the process followed in gathering evidence must be unbiasedDiscuss Management&GAAPqWhen management prepares financial statements,they assert that those statements are fairly presented in accordance with GAAPqGAAP is the criteria by which fairness of financial statement presentation is judgedqHowever,the interpretation and application of GAAP is difficultqThe auditors task is to determine whether the financial statements present fairly in accordance with GAAP Comment on CommunicationqCommunication of audit results to management and third parties completes the audit processqTo minimize misunderstandings,this communication follows a prescribed format that states the responsibilities of both management and the auditor,summarizes the audit process,and expresses the auditors opinion on the financial statements Define an Unqualified Audit Report&List Its Three ParagraphsqMost audits result in reports that do not contain reservations about the fair presentation of the financial statements.1.Introductory paragraph-identifies company,statements,and accounting periods examined,managements responsibility for the financial statements,auditors responsibility for expressing an opinion2.Scope paragraph-performance of the audit in accordance with GAAS and limitations of the audit3.Opinion paragraph-statements present fairly,in all material respects,in conformity with GAAPWhy is there a need for assurance services?1.Potential bias in providing information-management has a vested interest in providing information that will make management look good2.Remoteness of users-most users do not have the opportunity or time to interview management,tour company facilities,or review financial records firsthand.Instead,they rely on the financial statements3.Complexity-many transactions are more complex than they were a decade ago.Users depend on auditors to ensure they are fairly presented and fully disclosed in financial statements Discuss the accounting professions decade of unprecedented turmoil&change1.The failure of one of the largest public accounting firms(Andersen)2.Four of the largest bankruptcies ever-each in companies where financial statement misrepresentation had taken place3.Billions of investment and retirement dollars lost4.Perception that auditors were not independent from their clientsWhat was Congress response?qPassing the Sarbanes-Oxley Act of 2002.That focused on five critical improvements in how financial information is presented.1.Improved corporate governance2.Reporting on internal controls3.Greater independence of audit function4.Acknowledgment of greater audit responsibility5.Audit standard setting moved to a new quasi-public organization Improved Corporate GovernanceqThe lack of corporate governance was a major factor in business failures;most notably,a failure of Boards of Directors to oversee management,and effectively utilize the audit function.qSarbanes requires Boards of Directors be independent of the organization and exercise oversight over management and the audit functionqFurther,the Board of Directors,through its audit committee,is the client of the public accounting firm.Reporting on Internal ControlsqIn most cases of major fraud,companies had poor internal controls over financial reportingqSarbanes requires the CEO and CFO of SEC registered companies to assess and publicly report on the quality of its internal controls over financial reportingGreater Independence of Audit FunctionqThe audit function must be independent and objective if assurances are to be trusted by third parties.Auditor independence has been strengthened by requiring:q1.The audit committee has the authority to hire and fire the external auditorsq2.Mandatory rotation of the audit engagement partner every five yearsq3.Consulting work cannot be performed for audit clientsq4.Increased oversight of potential independence conflicts by the audit committeeqNon-public companies and smaller audit firms are not required to follow all these guidelinesAudit Standard Setting MovedqThe public lost confidence in the ability of the profession to serve the public interest.Sarbanes created the Public Company Accounting Oversight Board(PCAOB).qThe PCAOB has authority to develop audit standards for audits of publicly traded companies.qThe PCAOB is also charged with performing peer review of all public accounting firms that perform audits of public companies.qThe PCAOB is comprised of five public members appointed by the SEC.No more than two members can be CPAs.Discuss AICPAs definition of assurance servicesqThe AICPAs Special Committee on Assurance Services defines assurance as:independent professional services that improve the quality of information,or its context,for decision makers.qAssurance services involve three components:q-Information or a process on which the assurance is providedq-A user or group of users who derive value from the assurance providedq-An assurance service provider What are the attributes needed to perform assurance services?1.Subject matter knowledge 2.Independence from parties requesting assurance3.Agreed upon criteria to evaluate quality of presentation4.Expertise in the process of gathering and evaluating evidenceWhat are the levels of assurance provided?1.Positive assurance(such as an audit opinion)2.Limited or negative assurance(such as a review of financial statements)3.No assurance(such as a compilation of financial statements)The AICPAs Special Committee on Assurance Services has identified six areas of potential service:1.Risk Assessment-the quality of processes implemented by an organization to identify,assess,and manage risks.2.Business Performance Measurement-the processes to identify,measure,and communicate alternative measures of performance3.Information System Reliability-the quality of controls to ensure system security,reliability,timeliness,and accuracy4.Healthcare Performance Measurement-provide information about the quality of services provided by healthcare providers5.Electronic Commerce-provide assurance that systems and tools are designed and functioning with integrity and security6.ElderCare Plus-provide assurance whether the needs of the elderly are being met by various caregivers What are attest services?qAttest services are a subset of assurance servicesqAttest services always involve evaluation of an assertion made by one party to a third partyqAttest services always involve a report sent to a third partyRequirements to Enter the Public Accounting ProfessionqAccounting and Auditing Expertise-in addition to technical knowledge,auditor must have sound conceptual understanding of financial reporting and auditingqKnowledge of Business and its Risks-auditor must understand the basic structure of a business in order to identify significant risks affecting the clientqUnderstanding Accounting System Complexity-auditor must understand the challenges posed in a system in which traditional source documents do not exist Who Are the Providers of Assurance Services?qThe Public Accounting ProfessionqThe Internal Audit ProfessionqThe Governmental Audit ProfessionThe Public Accounting ProfessionqMore than 45,000 CPA firms in the United States,ranging sole-practitioners to large multinationals such as the Big 4.qThese firms provide a variety of services in the areas of assurance and financial statement services,tax planning and compliance,and consultingqThe SEC has prohibited accounting firms from providing most consulting services to public companies that they auditqSuch restriction on services has not been specified by the AICPA or regulatory authorities for public accounting firms that do not audit SEC registered clients Organization of CPA FirmsqThe organizational hierarchy of CPA firms has been described as a pyramidal structure.qPartners(or owners)are at the top and are responsible for the overall conduct of each auditqNext,managers review the detailed audit work performed by staff auditorsqSeniors are responsible for overseeing much of the day-to-day activities on a specific auditqStaff auditors perform the basic,detailed audit work.qPartners and managers may be involved in a number of audit engagements being conducted simultaneously;seniors and staff are usually assigned to only one audit at a timeThe Internal Audit ProfessionqInternal auditing is defined asq an independent,objective assurance and consulting activity designed to add value and improve an organizations 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.Internal auditors add value to an organization byqevaluating processes to identify and management risk,develop and implement effective internal controlsqassuring management and the Board of Directors on the companys compliance with policies or regulatory requirements,or the effectiveness of processes and operationsqproviding consulting services such as analyzing problems and identifying potential solutionsqperforming operational audits designed to evaluate the effectiveness,economy,and efficiency with which resources are employedqIts broad scope makes internal auditing an excellent training ground for future management positions Governmental Auditing ProfessionqEmployed by various Federal,state,and local agenciesqGovernmental auditors perform all the types of audits that internal auditors perform including compliance,operational,and performance audits Professional and Regulatory OrganizationsqThe PCAOB established as part of the Sarbanes-Oxley Act of 2002 has authority to set auditing standards for audits of public companies and to perform quality reviews of all registered CPA firmsqThe SEC oversees the PCAOB and all companies publicly traded on the U.S.capital markets.It has the authority to establish GAAP for publicly traded companies,and to prosecute companies who violate SEC lawsqThe AICPA has long served as the primary governing organization of the public accounting profession.It provides a variety of continuing education programs and administers the Uniform CPA Examination.Membership in the AICPA is voluntaryProfessional and Regulatory OrganizationsqThe State Boards of Accountancy are responsible for certifying and licensing CPAs in their state.While all state boards require passage of the Uniform CPA Examination,education and experience requirements vary by state.qThe Institute of Internal Auditors issued internal auditing standards and administers the Certified Internal Auditor programqThe U.S.General Accounting Office is the nonpartisan audit agency for Congress.The GAO develops auditing standards for governmental audits.Chapter 2CORPORATE GOVERNANCE-ENHANCING THE AUDIT FUNCTIONDefine Corporate Governanceqa process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization.The owners(stockholders)elect a board of directors to provide oversight of the organizations activitiesList primary parties involved in corporate governanceqStockholdersqBoards of DirectorsqAudit Committees of the BoardqManagementqSelf-Regulatory Accounting Organizations(e.g.AICPA,FASB)qOther Self-Regulatory Organizations(e.g.NYSE,NASD)qRegulatory Agencies(e.g.SEC)qExternal AuditorsqInternal AuditorsWhat are SEC concerns regarding the auditing profession?qAuditors were no longer willing to confront clients over questionable accounting practicesqConsulting fees were impairing auditor independenceqAccountants were using technical interpretations of GAAP to push the limits of accountingWhat are the Public Oversight Board(POB)concerns?qAnalytical procedures used inappropriately to replace direct tests of account balancesqAudit firms not thoroughly evaluating internal control and applying substantive procedures to address weaknesses in controlqAudit documentation,especially related to audit planning,did not meet professional standardsqAuditors ignored warning signs of fraud and other problemsqAuditors were not providing sufficient warning about companies that might not continue as going concernsThe Sarbanes/Oxley Act of 2002 was passed by Congress in response to massive accounting scandals.Significant provisions include:qEstablishes the Public Companies Accounting Oversight Board(PCAOB)with broad authority,including the power to set auditing standards for audits of publicly traded companiesq Requires the CEO and CFO certify the financial statementsqRequires companies to provide a comprehensive report on internal controls over financial reporting and that auditors report on internal controlsqAudit Committees given expanded powers as the audit client and must pre-approve any non-audit services by its external auditorsqAudit Committees must report their activities to the publicThe Sarbanes/Oxley Act of 2002 ContinuedqAudit Committees must have at least one person who is a financial expert.Other members must be knowledgeable in f