Auditing Exam 1
Auditing Exam 1 ACCT 4150
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This 21 page Study Guide was uploaded by Victoria Andreski on Sunday January 31, 2016. The Study Guide belongs to ACCT 4150 at Clemson University taught by Nancy Harp in Spring 2016. Since its upload, it has received 83 views. For similar materials see Auditing in Accounting at Clemson University.
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Date Created: 01/31/16
CHAPTER 1 • Reliable information is important for managers, investors, creditors, & regulatory agencies to make informed decisions o Auditing helps ensure this information is reliable, credible, & relevant • Why spend money on an audit? o Required by law o Need for accountability when business owners hire others to manage their businesses • Capital market—allows public companies to sell small pieces of ownership (stocks) or borrow money in form of small loans (bonds) so that large sums of money can be raised from a wide variety of investors & creditors o Public company—sells its stocks/bonds to the public § Gives public valid interest in the proper use of company’s resources § Owners—stockholders (no tie in running business) § Professional managers—hired by owners to run corporation on day-to-day basis • Serves as agents for the owners (aka principals) & fulfill a stewardship function by managing the corporation’s assets § Relationship between the 2 results in information asymmetry • Manager has more information about the “true” financial position & results of entity’s operations compared to absentee owner • Goals may not coincide= conflict of interest o If both seek to maximize their own self-interest, the manager may not always act in the best interest of the owner o Owner could try to protect himself by against possible misuse of resources by reducing the manager’s compensation by the amount of the company’s resources that the owner expects the manager to use § Or include monitoring provisions in manager’s employment contract—provides owner assurance • Accounting—primary role of accounting information is to hold manager accountable to the owner o Must follow set of agreed-upon accounting principles • Role of Auditing o Manager is in a position to manipulate the reports § Owner adjusts by assuming that manager WILL manipulate reports & by reducing manager’s compensation o As the amount of capital & # of potential owners increase, the potential impact of accountability increases o Auditor’s roleà determine whether reports prepared by manager conforms to the contract’s provisions § Auditor’s verification of financial information adds credibility to the report & reduces information risk (risk that information circulated by company’s management will be false/misleading) § Reducing information risk could benefit owner & manager o Users of financial statements rely on external auditor to act w/ honor & integrity in protecting public interest o Auditing is demanded b/c it plays a valuable role in monitoring the contractual relationships between entity & stockholders, managers, employees, & debt holders § CPAs add credibility to information produced/reported by management to outside parties • Example: buying an older home o Information asymmetry is present b/c seller typically knows more information about the house compared to buyer o Natural conflict of interest between buyer & seller § Sellers prefer a higher selling price & may be motivated to overstate the positive characteristics & understate/remain silent about negative characteristics of the property they are trying to sell § Information risk to the buyer o Seller makes assertions about the property § Roof is watertight, sound foundation, no rot/pest damage, plumbing & electrical systems are in good working order o Buyer can reduce information risk by hiring a house inspector § Seller may not have necessary expertise to evaluate all the structural/mechanical aspects of the property o Important Characteristics of House Inspectors & Inspections § Inspectors • Competent—possess the required training, expertise, & experience to evaluate the property for sale • Objective—have no reason to side w/ the seller; they’re independent of the seller’s influence • Honest—will conduct themselves w/ integrity & share all of their findings w/ the buyer • Skeptical—will not simply take the seller’s assertions at face value; will conduct their own analysis & testing • Responsible/Liable—stand behind their assessment w/ a guarantee and/or be subject to litigation if they fail to act w/ due care § Inspection Service • Timely—results of service reported in time to benefit decision maker • Reasonably priced—costs of service must not exceed benefits; service provider must focus attention on most important/risky assertions & can’t provide absolute assurance • Complete— service addresses all of the most important/risky assertions made by seller • Effective— service provides some degree of certainty that it’ll uncover significant risks/problems • Systematic/Reliable—service based on systematic process; conclusion based on reliable evidence o Another comparable inspector would find similar things & come to similar conclusions • Informative—service provides sense for how likely mechanical/structural failure is in near future & provides an estimate of cost to repair known defects • Assurance services must focus on the assertions that are most important & must be conducted in a timely & effective manner o Some assertions are more important than others b/c of their potential risk or cost • If managers are overly optimistic or wish to inflate their bonus compensation, they may unintentionally/intentionally overstate the company’s earnings & assets • Company hires & pays for auditors b/c a reputable independent auditor’s opinion can provide assurance to thousands of potential investors o Initial demand for auditing comes from the agent (manager) o By purchasing the assurance provided by an audit, company can sell its stocks/bonds to prospective owners/creditors at more favorable prices, significantly reducing the cost of capital • Manager’s Assertions & Financial Statements o Transactionà actually occurred, are complete (no valid transactions were left out), are classified properly (inventory is an asset, not an expense), & are recorded accurately & in the correct period o Account balanceà exists, entity actually owns it, the balance is complete, & asset is properly valued o Presentationà present in proper place on financial statements (inventory listed as current asset on balance sheet) & all required disclosures are complete, accurate, & understandable o Classes of transactions & events for period under audit: § Occurrence—been recorded, occurred, & pertain to entity § Completeness—all that should have been recorded have been § Authorization—properly authorized § Accuracy—amounts & other related data reported appropriately § Cutoff—recorded in correct accounting period § Classification—recorded in proper accounts o Account balances at period end: § Existence—assets, liabilities, & equity interests exist § Rights & obligations—entity holds/controls rights to assets, & liabilities are the entity’s obligation § Completeness— all assets, liabilities, & equity interests that should have been recorded have been recorded § Valuation & allocation—all assets, liabilities, & equity interests are included in financial statements at appropriate amounts & any resulting valuation/allocation adjustments are appropriately recorded o Presentation & Disclosure § Occurrence, rights, & obligations—disclosed events, transactions, & other matters have occurred & pertain to entity § Completeness—all necessary disclosures are included § Classification & understandability—financial information properly presented & described; disclosures clearly expressed § Accuracy & valuation—all information disclosed fairly & at appropriate amounts • Auditing, Attest, & Assurance Services o Terms used interchangeably o “The evaluation of evidence to determine whether information has been recorded & presented in accordance w/ predetermined set of criteria, together w/ the issuance of a report that indicates the degree of correspondence” o Assurance [Attest (Auditing)] o Auditing § Specialized type of attest service § “Systematic process of objectively obtaining & evaluating evidence regarding assertions about economic actions & events to ascertain the degree of correspondence between those assertions & established criteria & communicating the results to interested users” • Systematic processà well-planned & thorough approach for conducting the audit • Objectivity obtaining & evaluating evidenceà auditor must objectively search for & evaluate the relevance & validity of evidence • Assertions about economic actions & events • Degree of correspondence between assertions & established criteriaà auditor compares evidence gathered to management’s financial statements • Communicate results to interested users o Attestation § Subset of assurance services § Auditors have reputation of independence & objectivity § “Occurs when a practitioner is engaged to issue… a report on subject matter, or an assertion about subject matter, that is the responsibility of another party” § Not limited to economic events/actions § Subject matter can take many forms o Assurance § Broadest category • Almost any service provided by accounting professionals that involves capturing information, improving quality, or enhancing usefulness for decision makers § Focuses on relevance & timeliness § “Independent professional services that improve the quality of information, or its context, for decision makers” • Decision making—requires quality information (financial/nonfinancial) • Improving quality of information or context o Increase confidence in the information’s reliability/relevance o Context improved by clarifying format/background • Independence—objectivity of service provider • Professional Services—application of professional judgment & due care by provider • Conducting Financial Statement Audit o Auditor’s assessment of audit risk & materiality influence the nature, timing, & extent of audit evidence to be gathered o Materiality § “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity” § Amount that financial statements could be misstated without affecting the judgment of reasonable people § Immaterialà very small differences that are unlikely to affect an investor’s decisions in any significant way § Auditor must assess the magnitude of a misstatement that mat affect the users’ decisions • Helps auditor determine nature, timing, & extent of audit procedures § Total (aggregated) misstatements of more than 3-5% of income before tax would cause the financial statements to be materially misstated § Clean audit reportà expresses auditor’s opinion that financial statements are NOT materially misstated § “Present fairly in all material respects…”à auditor communicates notion of materiality § NO guarantee that auditor will uncover all material misstatements—auditor provides no assurance that immaterial misstatements will be detected o Audit Risk § Risk that the auditor may unknowingly give a “clean” opinion on financial statements that are materially misstated § Audit provides only reasonable assurance • Some risk that a material misstatement could be present in financial statements & auditor will fail to detect it § Auditor plans & conducts audit to achieve an acceptably low level of audit risk • Controls level through effectiveness & extent of audit work conducted o Audit Evidence § Underlying accounting data & any additional information available to auditor • Originates from client or externally § Sufficient & appropriateà 2 key descriptors § Sufficiency—quantity of evidence the auditor obtains • Does the auditor have enough evidence to justify a conclusion as to whether management’s assertions are fairly stated? § Appropriateness—evidence is relevant & reliable • Relevance—evidence relates to the specific management assertion being tested • Reliability—diagnosticity of the evidence o Can evidence be relied upon to signal the true state of the account balance or assertion being examined? § Auditor is able to obtain only persuasive evidence that the assertion is fairly stated • Sampling: Inferences based on limited observations o Can’t test all transactions b/c of cost & feasibility of such an audit o Trade-off between the exactness or precision of the audit & its costs o Auditor selects a subset of transactions/accounts to examine § Based on previous audits, understanding of the client’s internal control system, or knowledge of the client’s industry, is aware of items in an account balance that are more likely to contain misstatements o When auditor has no special knowledge, random sampling procedure is used § Increases likelihood of obtaining a sample that is representative of the population of transaction/account items § Laws of probability § Size of subset • Inverse relation between sample size & materiality o Must gather more evidence (larger sample) to have a reasonable likelihood of detecting smaller errors • Direct relation between sample size & desired level of assurance o As desired level of assurance increases for a given materiality amount, the sample size necessary to test an assertion becomes larger • Audit Process o Auditor can collect evidence in 3 stages in a client’s accounting system to determine if financial statements are fairly stated: § 1) Internal control put in place by the client to ensure proper handling of transactions (evaluate & test the controls) § 2) Transactions that affect each account balance (examine a sample of transactions that happened during the period) § 3) Ending account balances themselves (examine a sample of the items that make up an ending account balance at year-end) • Evidence relating to ending account balances=highest quality & costliest o Major Phases § Phases are interrelated § A. Client Acceptance/Continuance • Obtain a thorough understanding of the client, its business, & its industry • Understand the risks the client faces, how it deals w/ those risks, & what remaining risks are likely to result in a material misstatement • Must establish policies/procedures for decide to accept new clients or not & retain current clients o Minimizes the likelihood that auditor will be associated w/ client who lacks integrity • Required to confer w/ previous auditor • Frequently conducts background checks on top management § B. Preliminary Engagement Activities • Main activities: o 1) Determine the audit engagement team requirements § Determine whether specialists are needed o 2) Ensure the independence of the audit team & audit firm § Make sure audit firm & individual team members are free from prohibited relationships that might threaten auditor’s objectivity o 3) Establish an understanding w/ the client regarding the services to be performed § Timing of audit & expected audit fees • Once decision is made to accept audit engagement, auditor begins preliminary engagement activities by updating his understanding of entity & environment o Nature of entity & industry it operates in, how it measures its own performance, & quality of internal controls § C. Plan the Audit • Ensures that audit is conducted in an efficient & effective manner • Must make preliminary assessment of client’s business risk & determine materiality • Includes auditor’s understanding of entity’s internal control system o Reports on both the company’s internal control over financial reporting & company’s financial statements • Outcome: written audit plan that sets forth the nature, extent, & timing of audit work § D. Consider & Audit Internal Control • Put in place by company’s board of directors & management to help company achieve reliable financial reporting, effective & efficient operations, & consistent compliance w/ applicable laws & regulations • Quality is of direct relevance to auditors • Helps auditor assess risk & identify areas where financial statements might be misstated § E. Audit Business Processes & Related Accounts • Group financial statement accounts based on processes that primarily affect those accounts • Applies audit procedures to accounts to obtain audit evidence about management’s assertions relating to each account & reduce the risk of undetected material misstatement to an appropriately low level § F. Complete the Audit • Obtain sufficient appropriate evidence to reach & justify a conclusion on the fairness of financial statements • Assesses the sufficiency of the evidence & obtains additional evidence where necessary § G. Evaluate Results & Issue Audit Report (aka audit opinion) • Main product/output of the audit • If uncorrected misstatements are material, auditor will request the client to correct the misstating • If client refuses, audit issues an opinion that clearly indicates that the financial statements are materially misstated & explains the nature of misstatement • If uncorrected misstatements are insignificant enough or if client is willing to fix misstatements, auditor will issue an unqualified (“clean”) report • Unqualified/Unmodified Audit Report o Most common type of report issued o Unqualified—free of material misstatements § Auditor does not find it necessary to qualify his opinion about fairness of statements o Audit clients are almost always willing to make necessary adjustments to receive clean opinion • Other Types of Audit Reports o Requirements for being unqualified: § Completed in accordance w/ applicable standards (PCAOB standards) § Auditor must be independent § No significant limitations imposed on auditor’s procedures § Client’s financial statements must be free of material departures from GAAP o Auditor will qualify the report if financial statements are fairly stated except for misstatement o Adverse opinion—misstatement is so material that it pervasively affects the interpretation § Financial statements not fairly stated & should not be relied upon o Audit report represents culmination of audit process & the way the auditor communicates his opinion about client’s financial statements w/ outside parties CHAPTER 2 • External auditorsà independent auditors o May practice as a sole proprietor or as a member of CPA firm • Not employees of entity being audited • Audit financial statements for publicly traded companies, partnerships, municipalities, individuals, & other entities o Also conduct compliance, operational, & forensic audits • To sign an audit opinion, external auditor must be a certified public accountant (CPA) o CPA certificate—regulated by state law o Requirements—Education, Examination, & Experience • Auditors who are employees—internal auditors • Institute of Internal Auditors (IIA) o Support internal auditors o Mission: “provide dynamic leadership for global profession of internal auditing” o Internal auditing—independent, objective assurance & consulting activity designed to add value & improve an organization’s operations § Brings systematic, disciplined approach to evaluate & improve effectiveness of risk management, control, & governance processes • CPAs are the only licensed accounting professionals in the US o Purpose of exam—provide reasonable assurance to Boards of Accountancy that those who pass it have the level of technical knowledge & skills necessary for initial licensure in protection of the public interest • Government Auditors o Employed be federal, state, & local agencies o Type of internal auditor o At federal level, 2 agencies use auditors: § Government Accountability Office (GAO) § Internal Revenue Service (IRS) • Part of Treasury Department • Examines & audits entity’s books/records to determine federal tax liability • Forensic Auditors o Detect, investigate, & deter fraud & white-collar crime • Opportunities where auditors provide audit, attest, & assurance services result from the need for management to be accountable to employees, shareholders, customers, & communities • Types of Audits o Internal Control Audits § SOX requires public companies to engage an external auditor to provide an opinion on effectiveness of internal control • Internal control audit available but not required for private companies • Auditing standards for public companies require integrated audit o Compliance Audits § Extent to which rules, policies, laws, covenants, or governmental regulations are followed o Operational Audits (aka Performance/ Management Audit) § Systematic review of part or all of an entity’s activities to evaluate if resources are used effectively & efficiently § Assess performance, identify areas of improvement, & develop recommendations § Requires auditor to identify/create objective, measurable criteria to assess effectiveness & efficiency o Forensic Audits § Detect or defer fraudulent activities • Types of Services o Attest Services o Assurance Services o Other Nonaudit Services § SOX prohibits external auditors from providing many forms of nonaudit assurance & consulting work to a public company that the auditor is also providing financial statement auditing for § Tax Preparation & Planning Services • Assist clients w/ preparing & filing tax returns, provide advice on tax & estate planning, & represent clients on tax issues before IRS/tax courts § Management Advisory Services • Provide advice & assistance concerning an entity’s organization, personnel, finances, operations, systems, or other activities • For private entities or public companies whom they don’t provide financial statement audits for § Compilation & Review Services • When public accounting firm provides nonaudit accounting services relating directly to financial statements for companies • Less rigorous & provide less assurance • Public Accounting Firms o Organization & Composition § Organized as proprietorships, general or limited liability partnerships (LLP), or corporations § Public accounting firms organize as corporations when possible b/c of the risk of litigations against CPAs • Corporations created & governed by individual states • Some states don’t allow accounting firms to organize as corporations § LLP partners are NOT personally responsible for liabilities arising from other partners’ negligent acts • Personal assets of responsible partner(s) & assets of partnership are vulnerable to lawsuits resulting from these negligent acts § Firms categorized by size • Big 4 (Deloitte, EY, KPMG, PWC)—largest; audit over 90% of publicly traded companies in the US • National firms (BDO)—“mid-tier” firms • Regional & local firms—one or a few offices § Audits typically conducted by teams of auditors • Partner, manager, 1 or 2 seniors, & several staff members • Lead engagement partner has authority & decision-making responsibilities for auditing matters § Enron scandal alone weakened investor confidence in the stock market • Other later scandals caused a crisis of confidence in the integrity of the entire system of public ownership & accountability in the US o Government Regulation § SOX transferred authority to set & enforce auditing standards for public company audits to the Public Company Accounting Oversight Board (PCAOB) • Mandated that SEC impose strict independence rules, prohibiting auditors from providing many types of nonaudit services to public company auditees • Audit firms rotate audit partners on audit engagements every 5 years • Public companies obtain an integrated audit (audits of both financial statements & internal control over financial reporting) § Dodd-Frank Wall Street Reform & Consumer Protection Act of 2010 • Changed gov’t regulation of many types of financial service companies • Amended SOX—granted authority to PCAOB to inspect foreign audit firms that practice in the US or that have US auditees • Exempting public companies w/ under $75 million market capitalization from requirement to submit to an audit of internal control over financial reporting • Society’s expectations & auditor’s responsibilities o Due professional care—requires auditor to exercise professional skepticism § Attitude including a questioning mind & critical assessment of audit evidence o Financial statements are ultimately the responsibility of management o Auditor’s responsibility is to provide reasonable assurance w/ respect to errors, fraud, & illegal acts • Context of financial statement auditing o Context provided by entity’s business greatly impacts the auditor & the audit • Corporate Governance o Managers are overseen & supervised o Consists of all the people, processes, & activities in place to help ensure proper stewardship over an entity’s assets o Good corporate governance ensures managers of entity properly utilize their time, talents, & entity’s resources in best interest of absentee owners & they faithfully report the economic condition & performance of enterprise o Board of directors—responsible for management oversight in US corporations o Audit committee—oversees external/internal auditing work done for organization • Objectives—decided upon by management & board of directors • Strategies—designed to achieve objectives • Processes—organization undertakes processes to implement strategies (business cycle) o Financing process § Capital obtained through borrowing/soliciting investments from owners & typically invest in assets like land, buildings, & equipment in accordance w/ strategies § Must repay lenders & provide a return on owners’ investments o Purchasing process § Acquire goods/services to support operations o Human resource management process § Hire personnel to perform various functions according to company’s mission/strategy o Inventory management process § Varies between different types of businesses § Auditors rarely have significant inventories to manage • Primary resources are information, knowledge, & time/effort of people o Revenue process § Generate revenue through sale of goods/services to customers § Collect proceeds of sales in cash (immediately or through collections on receivables) • Controls—system of internal control ensure that transactions are handled & recorded appropriately & that resources are protected • Transactions—included in each process • Reports—accounting information systems capture details of transactions o Financial reports summarize the effects of organization’s transactions on its account balances that are used to established management accountability to outside owners • Securities & Exchange Commission (SEC) o Federal gov’t agency o Responsibility t& authority to oversee the establishment of accounting & auditing standards • Public Company Accounting Oversight Board (PCAOB) o Nonprofit corporation established by Congress o Oversee audits of public companies in order to protect investors’ interests & increase public interest in preparation of informative, accurate, & independent audit reports o Quasi-governmental agency overseen by SEC o SOX transferred authority for standard setting, inspection, investigation, & enforcement for public company audits from the profession to PCAOB § All public accounting firms required to register w/, pay fees to, & follow rules/standards of PCAOB o Conducts regular inspections to assess degree of compliance of public firms with SOX, PCAOB, & SEC rules & professional standards § Broad investigative & disciplinary authority over registered audit firms o Does not have authority over private companies o Can impose sanctions § Revoke firm’s registration § Barring individual from participating in audits of public companies § Monetary penalties • American Institute of Certified Public Accountants (AICPA) o Declaration of rules/standards that guide audit & related services provided to nonpublic companies, gov’t entities (states, counties, municipalities, school districts), & other entities (universities & charities) o Prepares & grades CPA exam o Auditing Standards Board (ASB) • Financial Accounting Standards Board (FASB) o Privately funded o Establishes standards for financial accounting & reporting o Emerging Issues Task Force (EITF)—established by FASB to meet accountants’ needs for timely guidance on accounting practices/methods & to limit # of issues requiring formal pronouncements from FASB • International Auditing & Assurance Standards Board (IAASB) o Sponsored & funded by IFAC o Develop international standards on ethics, education, & public sector accounting standards o Issues ISA & is the recognized international auditing standard setter outside the US • International Accounting Standards Board (IASB) o International counterpart to FASB o Recognized accounting standards outside of the US • Auditing Standards o Help ensure that financial statement audits are conducted in a consistent & thorough manner to produce reliable opinions & serve as important criteria for evaluating quality of auditor’s performance o PCAOB—has authority to set standards for US public company audits § Adopted ASB’s standards o Nonpublic entities—required to comply w/ ASB standards o Public companies—required to follow PCAOB standards o Smaller firms auditing nonpublic adhere to ASB standards o Larger firms auditing private & public must follow ASB & PCAOB standards o Global firms auditing private, public, & international firms follow ASB, PCAOB, & IAASB • 10 Generally Accepted Auditing Standards (GAAS) o General Standards (3) § Qualifications & quality of work • 1) Adequate training & proficiency o Gained through formal training, CEs, & experience o Stay up to date with pronouncements & developments in business world • 2) Attitude of independence on engagement o Independence—Prohibits relationships that may impair auditor’s objectivity o Independent in fact & avoid actions/relationships that may appear to affect independence • 3) Due professional care o Auditor plans & performs duties w/ skill & care expected o Standards of Field Work (3) § Actual conduct of the audit • 1) Planning & supervision o Proper planning leads to more effective audit, completing engagement in reasonable amount of time, & assistants are properly supervised • 2) Gain sufficient understanding of entity’s internal control to effectively plan nature, timing, & extent of further audit procedures (“scope” of procedures) o Nature—what procedures are performed o Timing—when audit work is done (at interim or period-end) o Extent—how much work is done • 3) Sufficient, appropriate evidence o Search for & evaluation of evidence o Use various audit procedures to gather evidence o Must use professional judgment o Standards of Reporting (4) § Before rendering audit report, consider each: • 1) Financial statements presented in accordance w/ GAAP • 2) Principles are consistently applied • 3) All appropriate disclosures have been made • 4) Degree of responsibility auditor is taking & character of auditor’s work Principles Underlying an Audit (GAAS) • Purpose o 1) Provide financial statement users w/ auditor’s opinion on whether statements are presented fairly, in all material aspects, in accordance w/ applicable framework § Auditor’s opinion enhances intended users’ confidence o 2) Management & those w/ governance have responsibility: § For preparation & fair presentation of financial statements in accordance w/ framework • Design, implementation, & maintenance of internal control—free from material misstatement (from fraud or error) § To provide auditor w/: • All information (records/documentation) relevant • Any additional information that auditor requests from management • Unrestricted access to those within entity that auditor determines necessary to obtain audit evidence from o Responsibilities § 3) Auditors responsible for having appropriate competence & capabilities to perform audit • Comply w/ ethical requirements, maintain professional skepticism, exercise professional judgment while planning/performing audit o Performance § 4) To express opinion, auditor obtains reasonable assurance regarding whether financial statements are free from material misstatement due to fraud/error § 5) To obtain reasonable assurance: • Plan work & properly supervise assistants • Determine & apply appropriate materiality level(s) throughout audit • Identify & assess risk of material misstatement based on understanding of entity & its environment • Obtain sufficient, appropriate audit evidence about if material misstatements exist o Design & implement appropriate responses to assessed risks § 6) Unable to obtain absolute assurance that statements are free from material misstatement b/c of inherent limitations arising from: • Nature of financial reporting • Nature of audit procedures • Need for audit to be completed within reasonable period of time & achieve balance between benefit & cost o Reporting § Expresses, in the form of written report, opinion in accordance w/ auditor’s finding, or states that opinion cannot be expressed § Opinion states if financial statements are prepared fairly, in all material respects, in accordance w/ framework • Statements on Auditing Standards (SAS) o Issued by ASB o Minimum standards of performance for auditors o Auditing Standards (AS)—issued by PCAOB § Add to/modify existing body of standards that PCAOB adopted from ASB o International Standards on Auditing (ISA)—issued by IAASB o SAS & AS relatively general in nature o Auditor must apply due diligence & sound professional judgment o Auditor never has sufficient evidence to guarantee no material misstatements & must use judgment to reach justified conclusion o SAS numbering—order in which standards are issued by ASB; chronological § Then reorganized/”codified” by topical content • Ethics—system/code of conduct based on moral duties & obligations indicating how we should behave • Professionalism—conduct, aims, or quantities that characterize a profession/professional person • AICPA’s Code of Professional Conduct—applies to all auditors • Opinion shopping—auditee seeks the views of other CPAs hoping to find an auditor who will agree w/ entity’s desired accounting treatment CHAPTER 19 • Most valuable asset as a professional are integrity & a solid reputation • Ethical Behavior Theories o 1. Utilitarianism § Trade-offs between benefits & burdens of alternative actions § Consequences of particular actions on individuals affected § Interests of all parties affected, not just one’s self-interest § Choose action that produces more pleasure/happiness (prevent more pain/unhappiness) than any other possible action § “Consequentialist” theory § Difficult to measure potential costs & benefits of actions to be taken § Difficult to balance interests of all parties involved when interests conflict o 2. Rights-Based Approach § Individuals have certain rights & others have duty to respect those rights § Undertake actions only if it doesn’t violate rights of any individual § Difficult/impossible to satisfy all rights of all parties § Public-interest responsibility § “Moral point of view”—auditors must be willing to see issues through others’ eyes & put interest of other stakeholders ahead of own self-interests & those of CPA firm o Justice-Based Approach § Equity, fairness, & impartiality § Each person has right to have maximum degree of personal freedom that’s still compatible w/ liberty of others § Social & economic actions should be to everyone’s advantage & benefits available to all § Fairly & equitably distribute resources among individuals/groups affected • SEC has legal authority to oversee the public accounting profession • AICPA Code of Professional Conduct o Principles of Professional Conduct (setting forth ideal attitudes/behaviors) § Provide framework for Rules of Conduct o Rules of Conduct (defining minimum standards) • Principals of Professional Conduct o Responsibilities o Public Interest o Integrity o Objectivity & Independence o Due Care o Scope & Nature of Services • Rules of Conduct o Categories: § Independence, Integrity, & Objectivity (Section 100) § General Standards & Accounting Principles (Section 200) § Responsibilities to Clients (Section 300) § Responsibilities to Colleagues (Section 400) § Other Responsibilities & Practices (Section 500) • Rule 101—Independence § Member in public practice must be independent in professional services they perform • Financial statement audits • Financial statement reviews • Other attest services (defined by SSAEs) § “Covered members” • 1. Individual on attest engagement team (intern, staff, partner, etc.) • 2. Individual who can influence attest engagement • 3. Partner/manager providing nonattest services to attest client beginning once he/she provides 10 hours of nonattest services • 4. Partner located in same office as lead attest engagement partner where the main attest engagement takes place o Partners from other offices are fine unless they influence the company the partners are working w/ • 5. Firm (& firm’s employee benefit plan) • 6. Entity whose financial, operating, or accounting policies controlled by any individuals/entities described above by 2 or more such individuals/entities if acting together § Prohibited Financial Relationships • Direct—when covered member has financial interest in attest client (ownership of stock/loan) o Doesn’t matter how small amount is • Material Indirect—when covered member has financial interest in entity associated w/ attest client o Ex: investment in mutual fund that owns client’s stock—when owning more than 5% of shares • Exception—certain personal loans from financial institutions who are clients are permitted o Credit cards under $10,000 § Prohibited Business Relationships • Independence of CPA is impaired if they perform a managerial or other significant role for client’s organization during the time period covered by attest engagement o If partner/professional employee goes into key financial position at client’s firm, we couldn’t work with that client anymore § Effect of Family Relationships • Covered member’s immediate family is subject to Rule 101 & interpretations/rulings o Spouse, spouse equivalent, dependent • How close relatives impair independence: o 1. Has financial interest in client that is material to close relative & CPA in engagement is aware o 2. Individual in engagement has close relative with power to significantly influence financial/accounting policies of client § Close relatives—nondependent children, siblings, grandparents, parents-in-law, & respective spouses § Effect of Actual/ Threatened Litigation • Impair independence by management litigating about deficiencies in audit work for client o If manager sues you • Expressed intention by management to litigate against CPA alleging deficiencies in audit work • Litigation by CPA against management alleging management fraud/deceit o If we as auditors sued the managers § Provision of Nonaudit Services • AICPA Code of Professional Conduct restricts some nonaudit services to be provided to attest clients • SEC also has restrictions o Auditor should not audit his/her own work o Auditor should not function in management role o Auditor should not serve in advocacy role for client • Prohibited Nonaudit Services o Bookkeeping § If you’re preparing the books/records for client, you can’t audit it too—that would be auditing own work o Actuarial services o Broker/dealer o Financial information systems design & interpretation o Internal auditing outsourcing services o Legal services o Appraisal/valuation services o Management functions/human resources o Expert services § SEC Independence Requirements for Audits of Public Companies • Partners limited to 5 consecutive years o Tries to keep relationship from getting too close o Gives a fresh set of eyes for audit • 1 year “cooling off” period required for employees in a “financial reporting oversight rile” who previously worked w/ CPA firm performing audit • Firm no independent if audit partner’s compensation based on selling engagements to client for services other than audit, review, & attest services o Don’t want partner thinking of other things besides audit—audit should have 100% focus § SEC Required Communications for Audits of Public Companies • Public must know the audit fees so they can see the relationship— transparency • 102—Integrity & Objectivity § Member must maintain objectivity & integrity, be free of conflicts of interest, & not knowingly misrepresent facts or subordinate judgment to others • Can’t just say that you know something is wrong o Have the responsibility to blow the whistle • Ex: Can’t recommend a certain software system if they’re a client—conflict of interest • 201—General Standards § Comply w/: • Professional competence • Due Professional Care o Take your time & follow the rules • Planning & Supervision • Sufficient Relevant Data • 202—Compliance w/ Standards § Comply to standards you’re supposed to comply w/ § Requires members of AICPA to comply w/ professional standards when performing services (includes more than public accounting) • 203—Accounting Principles § Member should NOT: • Express opinion or affirmatively state that financial statement/data of entity are presented in conformity w/ GAAP • State that he/she is not aware of any material modifications that should be made to statements so that they’ll be in conformity w/ GAAP • 301—Confidential Client Information § Member should not disclose any confidential client information without specific consent of client • Don’t talk about your client to anyone § Exceptions: • 1) To meet GAAP/GAAS disclosure requirements • 2) As required by authorized peer review body • 3) Related to purchase, sale, or merger of the practice • 4) To comply with a subpoena • 5) As part of investigative/authoritative proceeding o If SEC is going after your client • 302—Contingent Fees § A member can NOT: • Perform any service for contingent fee or receive such a fee from, a client whom the member/member’s firm performs: o Audit/review of financial statements rd o Compilation of financial statements expected to be used by 3 party if compilation report does not disclose a lack of independence o Examination of prospective financial information • Prepare an original/amended tax return or claim for refund for a contingent fee for any client § Fee goes up or down depending on work resultsà prohibited for auditors • 501—Acts Discreditable § Member can not commit an act discreditable to profession • Something you do to make profession look bad § Examples: • Negligence in the preparation of financial statements/records (501-4) • Failure to file tax return or pay tax liability (501-7) • Financial interests (501-10) • 502—Advertising & Other Forms of Solicitation § Member in public practice cannot seek to obtain clients through advertisement in a way that is false, misleading, or deceptive § Can’t obtain through solicitation by use of coercion, over-reaching, or harassing conduct • 503—Commissions & Referral Fees § Prohibited Commissions • Members can’t recommend for a commission or refer to a client any product/service or receive a commission when a member or member’s firm also performs for that client: • Audit/review of financial statements rd • Compilation of financial statements expected to be used by a 3 party & report does not disclose lack of independence • Examination of prospective financial information § Disclosure of Permitted Commissions • Member who isn’t prohibited by this rule from performing services for/receiving commission & is paid /expects to be paid a commission can disclose that fact to any person/entity to whom member recommends or refers a product/service to which commission relates § Referral Fees • Any member who accepts referral fee for recommending/referring any service of a CPA to any person/entity or who pays a referral fee to obtain a client shall disclose this acceptance/payment to client o If you are allowed, you must let people know that you referred them & got a fee/payment for it • 505—Form of Organization & Name § May practice only in a form of organization permitted by law/regulation on whose characteristics conform to resolutions of Council § Can not practice public accounting under a misleading firm name § Firm may not designate itself as “Members of the American Institute of Certified Public Accountants” unless ALL of its CPA owners are members of institute • Disciplinary Actions o Professional Ethics Executive Committee (PEEC) can direct a member to take remedial/corrective actions o AICPA Trial Board Actions § Termination of AICPA Membership § Suspend AICPA Membership • Quality Control Standards o CPA firms required to implement policies/procedures to monitor the firms’ practices & ensure that professional standards are being followed § CPA firm itself must have internal controls in place o AICPA continues to administer quality review system in order to enable firms to meet state licensing, federal regulatory, & AICPA membership requirements & serve firms that audit only privately held claims o Peer review system for non-public o Elements § Leadership: tone at the top § Relevant ethical requirements § Client acceptance & continuance § Human resources § Engagement performance § Monitoring • PCAOB Inspections of Registered Public Accounting Firms o PCAOB conducts regular inspections of public accounting firms that are required to register w/ the Board o Firms who audit more than 100 public companies are inspected every year § The more clients a company audits, the more inspections they’ll get CHAPTER 3 • Client Acceptance & Continuance o Prospective Client Acceptance § Procedures documented in a memo or by completion of entity acceptance questionnaire/checklist § Make inquiries of previous auditor before accepting engagement • Request permission of client before contacting previous auditor • Prospective must authorize previous auditor to respond to new auditor’s requests for information • Inquiries to make: o Information revealing management integrity o Disagreements w/ management about accounting policies, auditing procedures, or other important matters o Communication to those charged w/ governance about fraud & noncompliance w/ laws/regulations by entity o Communication to management & those charged w/ governance regarding important deficiencies & material weaknesses in internal control o Previous auditor’s understanding about reasons for change of auditors • Inquiries help new auditor determine whether or not to accept engagement § After accepting engagement, need information on beginning balances & consistent application of GAAP in order to issue unqualified report • Request that entity authorize the previous auditor to document a review of his working papers § If entity hasn’t been audited before, auditor should review client’s financial information & carefully assess management integrity by communicating w/ entity’s bankers & attorneys o Client Continuance § Evaluate periodically whether to continue relationship w/ current clients § Red flagsà conflicts over accounting & auditing issues or disputes over fees • Preliminary Engagement Activities o 1. Determine audit engagement team requirements § Members must have proper degree of technical training & proficiency § Factors to consider: • Engagement size & complexity • Level of risk • Any special expertise • Personnel availability • Timing of work to be performed o 2. Assess compliance w/ ethical & independence requirements § Establish policies/procedures to ensure that people at organizational levels within firm meet profession’s ethical requirements • Maintain independence in accordance w/ Code of Professional Conduct § Document compliance • Complete annual independence questionnaire or report o Requests information about auditor’s financial/business relationships w/ firm’s clie
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