Auditing Reading and Questions
Auditing Reading and Questions BUS A 100
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Auditing One of the most common services is the In general to audit means to conduct a thorough assessment In accounting to audit an entity means to thoroughly examine the bookkeeping records nancial accounts and the policies and procedures of that entity An quotentitvquot could be a partnership corporation trust or governmental unit Audited nancial statements are the accepted manner in which companies report the status of their operations to interested parties outside the company Preparation of the nancial statements is the responsibility of the company being audited It is the auditors job to express an opinion on the statements management has prepared Other companies may also want or need an audit possibly because of requirements of bankers or others who have invested in the company Also stockholders who are not involved in the operations of the business may want an audit to give them con dence in the company s nancial statements In a corporation the stockholders elect the quotboard of directorsquot The basic responsibility of the board of directors is to determine the mission and purpose of the organization The Board hires the quotchief executive of cer CEOquot as well as other top management and periodically reviews their performance The Board sets policies for the organization It is responsible for ensuring that the company has suf cient resources to operate and when necessary to raise additional funds decides how these resources should be raised Overall it is the responsibility of the Board to represent the interest of the stockholders who are often too distant from the company to do this for themselves The type of audit covered in this course is called a quot quot In a nancial audit the objective is to form an opinion on the nancial statements produced by the management of the company There are other types of audits that businesses may undergo including operational audits informational audits investigative audits tax audits and followup audits This course focuses on audits performed by independent or external auditors These auditors are quali ed CPAs Certi ed Public Accountants who are not af liated with the company being audited The independent component of the external auditors is important because the public needs assurance that the auditors are separate and apart from management and do not have a vested interest in the outcome of the audit Many companies also have internal auditors These auditors are employed by the company and they audit departments within the company While internal auditors are not independent of the company they typically report directly to top management as well as the audit committee which is a subcommittee of the company s Board of Directors Because internal auditors have a voice with both top management and the audit committee they have considerable power in the company 66 Histhe One of the ways internal auditors do this is by creating and managing internal controls Internal controls are covered in more detail later in this reading but basically these are the rules and procedures that help ensure that the employees comply with the policies of the company as well as those of outside regulators which include the etc In a nancial audit the objective of the external auditors is to gather enough information so they are reasonably satis ed that the nancial statements have no material misstatements To make this determination the external auditors must gather and evaluate suf cient information called audit evidence The audit evidence needs to be of suf cient quantity and quality so the auditors are able to form an opinion based on the information they have evaluated Notice that the auditors are not guaranteeing that the nancial statements are absolutely correct Instead they are stating that they have conducted suf cient tests to allow them to issue an opinion that the nancial statements do not contain any material errors When CPAs audit nancial statements their work must be in accordance with The purpose of these standards is to help insure that audits performed by various CPAs will be as uniform as possible The standards were originally written in 1947 and were very broad Since then more detailed interpretations have been added to give auditors more guidance Even with the guidance provided by the American Institute of Certi ed Public Accountants AICPA and other organizations professional judgment is still an important part of every audit in part due to the concepts of materiality and audit risk Materiality relates to the potential impact that a misstatement could have on the nancial statements The Financial Accounting Standards Board FASB de nes a material error as the magnitude of an omission or misstatement of accounting information that in light of surrounding circumstances makes it probable that the judgment of a reasonable person relying on the information would have been changed or in uenced by the omission or misstatementquot Notice that whether or not an item is material is dependent on the auditors perceived needs of the readers of the nancial statements An omission or misstatement is more likely to be seen as material if it is large especially in comparison to the company as a whole or felt to be of signi cant importance to the users of the nancial statements This is the risk that the auditors indicate the nancial statement give a true and fair picture of the status of the company when the statements are in fact misleading Audit risk is a real concern in any audit because to be feasible audits must be conducted by examining only a portion of the transactions that occurred during the year 67 and verifying only a portion of the company s account balances This is usually accomplished by a technique called sampling Sampling occurs when less than one hundred percent of an account balance or a class of transactions is veri ed by the auditors In practice sampling must be used frequently because the amount of work the auditors are able to do is limited by time and money Auditors will often select random samples using statistical techniques In addition to examining a random sample auditors will frequently examine all transactions or account balances for example accounts receivable balances over a predetermined amount The techniques used in each audit vary depending on many things including the company the company s control over its assets and the industry in which the company operates Even with the auditing standards and the enormous amount that has been published on auditing techniques over the years much of auditing still relies on the professional judgment of the auditor In a typical financial audit there are several areas the auditor is attempting to verify These include the following 1 Are all assets and liabilities which should be on the balance sheet recorded correctly and are the balances in these accounts accurately re ected on the balance sheet 2 Are all assets and liabilities that are reported on the balance sheet correct in that they are in existence at the date of the statement and that the entity being audited is the owner of these assets and liabilities 3 Are all assets and liabilities disclosed and classi ed correctly with the description being clear and not misleading to the reader of the nancial statements 4 Are all transactions of the period reported in accordance with GAAP or IFRS 5 Are any amounts entered inappropriately as transactions A test typically performed during an audit is con rmation of balances with banks and creditors This can be done by sending out a statement explaining that the company is being audited and the company is stating that it has a bank balance of XX The statement may ask for a reply specifying whether or not this is correct positive con rmation or a reply only if this is not correct negative con rmation Another common audit test is to observe the counting of inventory to test whether it is being handled appropriately and that the inventory does exist and is in a marketable condition Auditors will often select by using a sampling technique a list of transactions These transactions will be followed through from the supporting documentation to the accounting entries The auditors feeling about the strength of the company s internal 68 controls will play a role in determining the sample size Strong internal controls allow the auditors to feel con dent relying on a smaller sample The most common audit opinions are which means that the auditors have found the nancial statements to be in accordance with GAAP or IFRS with no modi cations This is the best audit opinion a company can receive Another relatively common audit opinion is quot The external auditors sign and date the audit and address it to the board of directors and the stockholders SarbanesOxley In 2001 one on the largest and what the world perceived to be the one of the most successful companies Enron collapsed Along with it went the highlyacclaimed CPA rm which had been Enron s external auditor Arthur Andersen Shortly afterwards other large companies including WorldCom Global Crossing Adelphia Waste Management Sunbeam and Tyco followed suit with scandals of their own Enron s story stands apart because of its size its greed and its unethical use of power Enron Enron began business as a pipeline company and quickly grew to become a major trading player in gas electricity water and even bandwidth Before its downfall the executives of Enron were symbols of success in the United States They were the center of social attention in Texas as well as Washington where they had considerable political clout Fortune magazine named Enron quotAmerica s Most Innovative Companyquot every year from 1996 to 2001 In Houston Enron was seen as an excellent place to work because it was universally admired for its constant growth and pro tability and because the company paid its employees well Enron was so admired because of its unprecedented growth lts management was consistently relentless in trying to nd new markets into which it could expand They used their in uence in Washington to have new trading markets opened for their company As time went by the level of growth and rising pro ts demanded by the company s executives and its investors became impossible to maintain The company was carrying a huge debt load Some of the company s ventures into new areas had paid off but many hadn t Every time Enron had gone into a new area the company had needed to borrow large amounts of money It was so important to management to keep their image and lifestyle going that when the legal options were exhausted they began using illegal and unethical methods to continue making their company look good Whether or not the ventures paid off the executives were always rewarded with large bonuses To do this required continually increasing the amount of borrowing Management did not want the public to know that it was in trouble and looked for ways to hide the large amount of debt from the public The company began concealing much 69 of its debt by establishing offshore partnerships and transferring the debt to these partnerships thereby keeping their existence off the Enron balance sheet Some of these extra offthebalance sheet entities were in existence only to hide debt and some existed only to bene t Enron of cials and their families Other illegal accounting tricks were also employed The company illegally in ated its net income by showing the revenues from the sales but instead of recording the expenses associated with these revenues as expenses it recorded these costs as assets This overin ated assets which made the balance sheet look better and reduced expenses which made the income statement look better As time went on the company became more and more a house of cards with very little substance behind it or its accounting reports What had begun as ambition of the Enron executives turned into uncontrolled greed In one particular group of investments Enron s chief nancial of cer and several others invested 161000 The company used this investment to prove Enron s involvement in the subsidiary and was able to borrow millions based on it The of cers of Enron received 42 million as a return on their investment Much of this was literally overnight and was made at the expense of innocent investors Where were the auditors while all of this was occurring The purpose of the independent audit is to ensure that the company is reporting the truth As the auditor for Enron Arthur Andersen was the internal audit rm responsible At this time Arthur Andersen was one of the Big Eight accounting rms and a large portion of the company s revenue came from Enron Enron paid Andersen 52 million a year and approximately half of that was for consulting services and half was for auditing In retrospect it is easy to see that since Andersen had been a consultant for Enron this should have impaired the independence of the company and so Andersen should not have been allowed to be the independent auditors However at this time that was allowable In just a few relatively short years the situation at Enron was out of control and Andersen was too tied into it to be able to extricate itself When it became obvious that Enron was going down the auditors responsible for the Enron audit spent the next sixteen days shredding documents and deleting les and other information that could condemn them But by that time it was too late and when Enron collapsed so did Arthur Andersen By the time of the Enron s collapse in late 2001 the greed of management had left the company a sham Their behavior had been astoundingly unethical and illegal and it continued right up to the end As the company was caving in the executives were secretly selling their Enron stock while the general public unaware of the upcoming scandal was continuing to buy the stock In addition these same executives changed the company s pension plan so that any Enron stock held in the retirement plans of Enron employees was frozen and could not be sold While doing this the executives themselves continued to sell their own stock The collapse of Enron changed public accounting because the public demanded that it be changed Before this turn of events the accounting industry as a whole was one of the most trusted of all professions As the collapse of Enron was unraveled several things 70 about the company s independent auditors had become clear These auditors who the public had relied upon to ensure that the information they received was truthful had knowingly allowing false information to be published In addition they destroyed documents and erased computer les in an effort to obstruct justice The actions ofjust a few auditors had let down the public and it was extremely costly to innocent victims If the auditors had come forth with what they knew about Enron earlier investors and creditors of Enron would have saved billions of dollars The SEC s Response to Enron Enron s situation was unique in that it was a spectacular failure by a deeply corrupt company In addition its independent auditors were inextricably entwined in the client s affairs The SEC s job is to protect the investing public so they set out to ensure that controls would be put in place to keep this situation from happening again There is an inherent con ict of interest when public accounting rms consult for the companies they audit Because these accounting rms know accounting and know that company as well as the industry as a whole they are in a good position to help their audit cients establish their accounting policies and internal controls However the problem is that once they have done that how can they claim to be independent while performing an audit In 2002 Congress passed the SarbanesOxley Act of cially the quotPublic Company Accounting Reform and Investor Protection Act of 2002quot The informal name came from its sponsors Senator Paul Sarbanes and Representative Michael Oxley This law applies to all companies that have debt or equity registered under the Securities Exchange Act of1934 About Sa rba nesOxley SarbanesOxley also called quotSarboxquot or just quotSoxquot tightened requirements for public companies in three areas corporate governance securities analysis and the performance of audit work 1 Requirements for Corporate Governance Broadly speaking this term refers to both internal factors such as the of cers stockholders or bylaws of the corporation and external factors such as customers consumer groups and the law The purpose of wellde ned corporate governance is to encourage management to maintain an ethical operation and to adhere to quotbest practicesquot as well as legal requirements quotBest practicesquot refer to the techniques or methods that have been proven to lead to desired results When a company makes a commitment to follow the best practices it is making a commitment to use the most current information and technology available to reach a desired result 71 The SEC wanted to ensure that company of cials and directors are aware and held accountable for the nancial condition of their company One way it went about doing this is to require most publiclyheld companies to have an known as the quotsupervisory committeequot The committee is in charge of hiring the external audit rm and regulating its work Rather than reporting to management the external auditors now report directly to the audit committee They cannot be employees of the company It is the responsibility of the audit committee to address any complaints about the company s accounting practices SarbanesOxley also requires the chief executive of cer CEO and the chief nancial of cer CFO to certify that its nancial statements are in compliance with the law and fairly show the status of the company quotSec 302quot of the law also requires management to sign a statement as to the effectiveness of the company s internal controls It is a federal crime for directors or of cers of the company to pressure an auditor to issue misleading nancial statements The law also outlaws most loans to directors or of cers of the company These individuals may not sell stock in the company if employees and retirement plans are not allowed to sell their stock In the spirit of trying to encourage employees to feel free to report wrongdoing when they see it SarbanesOxley gives protection to any employee who acts as a quotwhistle blowerquot and brings forth information about management not complying with these requirements 2 Requirements for Auditors SarbanesOxley prohibits auditors from providing a myriad of services to the companies they audit This includes such things as bookkeeping services nancial information systems design appraisals valuations management functions and human resources The law still does allow the auditors to provide tax services for their clients The law requires a oneyear waiting period before a client can hire an auditor as its employee in the positions of CEO CFO chief accounting of cer CAO or controller In addition SarbanesOxley created the quotPublic Company Accounting Oversight Board PCAOBquot This is a nonpro t corporation controlled by the SEC and all companies which provide audit services are required to register with it The purpose of the PCAOB is to regulate watch over and if necessary discipline public accounting rms SarbanesOxley now requires the auditors to give an opinion on the nancial statements quotSec 404quot also requires them to give an opinion on the internal controls of the company A company s quotinternal controlsquot are all of the methods it uses to safeguard its assets determine the accuracy and reliability of its accounting information 72 promote operational ef ciency and encourage employees to adhere to the company s policies Strong internal controls are important for the auditors to trust that the information obtained from the company s accounting system is accurate For internal controls to be strong they must be effective and efficient comply with the law and regulations governing the company and reliable Some examples of internal controls are the manual listing the company policy required use of a password to access sensitive company information and separation of duties such as having one employee open the mail and deposit the funds received while another employee records payments received from the client All of the rules of this type that a company puts in place help to ensure that its assets are safeguarded and its records are reliable SarbanesOxley is a tough law designed to help reinstate public trust in the nancial statements published by public companies and certi ed by independent auditors It has been controversial because it adds considerable costs to all companies required to comply often millions of dollars even for small companies Internal Controls While auditors have always needed to rely on a company s internal controls Sec 404 of SarbanesOxley now requires that auditors go one step further and render an opinion on the quality of the company s internal controls Just what are quotinternal controlsquot and why are they needed The technical de nition of an internal control as published by the Committee of Sponsoring Organizations COSO of the Treadway Commission is that internal controls are a process effected by an entity s board of directors management other personnel designed to provide reasonable assurance regarding the achievement of objectives in the following categories Effectiveness and ef ciency of operations Reliability of nancial reporting Compliance with applicable laws and regulations Taken as a whole the internal controls of an organization are the procedures used to help ensure that its goals and objectives will be met as ef ciently and economically as possible At its roots internal controls are in place to help safeguard assets COSO divides the internal control process into ve elements which are 1 Control environment This is the environment set by management called quottone at the topquot It recognizes that the basis of any business is its employees and their integrity ethics and competence and that management has the power to have a major in uence on these 73 To help with controlling the environment it is important to ensure that the entity has established clear lines of authority and accountability There needs to be a code of conduct including ethical standards to which employees may refer as needed Every company needs a formal budget with frequent comparisons from budgeted gures to actual An effective audit committee as well as an internal auditing department also helps strengthen the control environment 2 Risk assessment The entity must realize the risks it faces and it must take appropriate steps to control the risk as much as possible Management should work with all areas such as sales production marketing nance etc to ensure that all departments of the company are working in concert There should periodically be an entitywide review to assess and evaluate the entity s risk potential 3 Control activities Procedures must be established to effectively implement management s policies regarding how to protect the entity s assets To help control activities it is important for the company to segregate duties For example cash received should be deposited by a different person than the person who records the receipt on the customers record and if possible another person should reconcile the bank account Another type of control activity is to ensure that only the people who need to know certain information are allowed access and to make sure there is adequate backup in place in case of a disaster 4 Information and communication All of the activities should be surrounded by information and communication systems This is to empower employees with the information they need to conduct manage and control the operations of the business Reporting risky situations should be encouraged by a policy such as a quotwhistleblowers policyquot This could be used to report anything from a slight irregularity to an illegal act 5 Monitoring There must be a continual monitoring of the entire process so that modi cations can be made if they are necessary This keeps the system reacting dynamically as conditions change Management should encourage and act upon information from either external or internal auditors regarding problems with internal controls Management should quickly follow up on any unusual variances from budgets There are limits on what any system of internal controls can do Internal controls cannot stop some legitimate human errors Even the best system of internal controls cannot prevent all fraud For example if several employees are working together they can potentially override any system Also even the best internal control system cannot work if the employees intentionally disregard the procedures Other Services Provided by Independent Accountants While most large companies and all companies traded on a public exchange are required to have an annual independent audit many companies are not subject to this requirement An audit is expensive and time consuming so a company which is not 74 required to undergo an audit may choose not to have one There are some other options which may serve the needs of these companies and save them money and time Review A review is another service provided by CPAs It gives the reader limited assurance less than with an audit because the CPA conducts fewer tests on the entity s books and records In a review the CPA is attempting to assess only 1 whether management s representations are accurate and 2 whether or not the company is correctly applying generally accepted accounting principles GAAP When independent accountants perform a review they must understand the industry in which the company operates and must learn about the key aspects of the company such as its products and services and be aware of any material transactions It must also understand the company s accounting policies and procedures and any major changes that have occurred within the company The accountants will look at the nancial statements to see if they appear reasonable but will not apply the tests typically done in an audit In a review CPAs usually inquire about the accounting procedures of the company and perform analytical procedures in an attempt to recognize any unusual transactions or trends While these procedures are more limited than those of an audit they are generally sufficient to allow the CPA to express a limited assurance about the nancial statements A review may be used instead of an audit by companies whose stock is quotprivately heldquot This means that their stock is not exchanged on a public stock exchange Compilation A compilation gives the reader of the nancial statements no assurance from the CPA Instead the independent accountants have been hired only to put together or compile the nancial statements from the books and records of the company These statements may be prepared on a monthly quarterly or annual basis Compilation services are often used when the company does not employ suf cient staff to prepare the nancial statements A compilation can only be used when the readers of the company s nancial statements do not need the assurance that comes with a review or audit However the CPA is still obliged to consider whether the nancial statements are appropriate in form and free of obvious material errors A compilation is typically used only for small companies that are not required to conform to the rigors of GAAP Compilations are generally used when the company does not expect their nancial statements to reach outside readers The compilation report from the CPA that accompanies the nancial statements is required to include a statement that no review or audit was performed and that the statements may not be appropriate for outside readers When the outside accountant is 75 only preparing a compilation it is not necessary that he or she to be independent of the CI i e nt Auditing Questions 1 An external auditor s opinion conveys good news rather than bad if it is a certified b quantifiable c qualified d certifiable e none of the above 2 The examination that is required under section 404 of SarbanesOxley is an audit of a BAAP b CEO and CFO integrity c compensation rules 1 internal controls e revenue recognition criteria 3 SarbanesOxley requires a the lead auditor to rotate every five years b creation of GAAP by the IRS c the audit committee to report directly to the compensation committee of the board of directors 1 a panel of 12 judges to evaluate the audit opinion before it can be issued e None of the above 4 With respect to auditing management is responsible for a the opinion rendered by the external auditors b the financial statements c research and development of environmentallysafe endproduct recovery systems 1 assuring that external auditors are truly independent e absolutely nothing 5 The two sections of SarbanesOxley that most business people know by section number are a 204 and 304 b 203 and 404 c 204 and 303 d 302 and 404 e None of the above 6 The letter in which an external auditor attests to whether or not a company has prepared its financial statements according to GAAP is referred to as either modified or unmodified 76 The letter itself is called an audit a 9906 rendition compilation opinion performance operation 77 10 11 Which of the following sections of SARBOX requires that top management of a publicly held company must bear responsibility for its financial statements a Section 302 b Section 203 c Section 404 d Section 204 e Section 304 After a company s financial statement have been audited by an independent CPA firm a the reader of the statements will know the numbers on the statements are accurate to the nearest penny b the financial statements are the sole responsibility of the CPA firm conducting the audit c the reader of the statements will know that any fraudulent activity would have been discovered d the statements will have more credibility to an outside party that they otherwise would have f None of the above Which of the following is not one of the levels of assurance for which a CPA may be engaged by a client a audit b review c examination d compilation e All of the above are levels of assurance SarbanesOxley a came about as a result of the stock market crash in 1929 has jurisdiction over all corporations operating in the United States lessens the role of independent auditors requires the periodic rotation of the lead independent auditor None of the above 9906 A public company that is traded on a major US stock exchange a must have an audit prepared once a year by an independent auditor b refers to a company that is owned at least partially by the government c must have their managerial statements audited at least annually by an independent auditor d may elect to have their annual audit prepared by the company s internal audit staff f None of the above 78 12 13 14 15 SarbanesOxley a 9906 requires a second partner to review and approve audit reports established the Public Company Accounting Oversight Board PCAOB increased senior management s responsibility for published financial statements required that an audit of internal controls be conducted accomplished all of the above Which of the following is not true regarding the audit committee 9909 Its main purpose is to report any misdeeds within the company to the United Nations Its members cannot be employees of the company Its function was strengthened by SarbanesOxley The internal auditor reports to the audit committee One or more members must have financial expertise Which of the following is not true regarding independent audits of public companies 9909 The auditor forms an opinion of the overall fairness of the financial statements The financial statements are the responsibility of the company s management The most favorable opinion an auditor can present is the modified opinion An annual independent audit is required of public companies Strong internal controls can reduce the independent audit fee A compilation by an auditor means that the auditor a b only compiled the records of the company into financial statements and did not verify the accuracy of the underlying transactions verified that the company s records were accurate before compiling the company s records into financial statements did an audit of the company s records before compiling the company s records into financial statements hired one of the company s employees to compile the financial statements for the company did an audit of the company s records after compiling the company s records into financial statements 79 Auditing Answers An external auditor s opinion conveys good news rather than bad if it is a certified b quantifiable c qualified d certifiable The examination that is required under section 404 of SarbanesOxley is an audit of a BAAP b CEO and CFO integrity c compensation rules C revenue recognition criteria SarbanesOxley requires b creation of GAAP by the IRS c the audit committee to report directly to the compensation committee of the board of directors 1 a panel of 12 judges to evaluate the audit opinion before it can be issued e None of the above With respect to auditing management is responsible for a the opinion rendered by the external auditors c research and development of environmentallysafe endproduct recovery systems 1 assuring that external auditors are truly independent e absolutely nothing The two sections of SarbanesOxley that most business people know by section number are a 204 and 304 b 203 and 404 c 204 and 303 None of the above 39D The letter in which an external auditor attests to whether or not a company has prepared its financial statements according to GAAP is referred to as either modified or unmodified The letter itself is called an audit f rendition g compilation i performance j operation 80 81 Which of the following sections of SARBOX requires that top management of a publicly held company must bear responsibility for its financial statements h Section 203 i Section 404 j Section 204 k Section 304 After a company s financial statement have been audited by an independent CPA firm a the reader of the statements will know the numbers on the statements are accurate to the nearest penny b the financial statements are the sole responsibility of the CPA firm conducting the audit c the reader of the statements will know that any fraudulent activity would have been discovered F 10 ll 1 None of the above Which of the following is not one of the levels of assurance for which a CPA may be engaged by a client g audit h review j compilation k All of the above are levels of assurance SarbanesOxley a came about as a result of the stock market crash in 1929 has jurisdiction over all corporations operating in the United States lessens the role of independent auditors None of the above 9906 A public company that is traded on a major US stock exchange b refers to a company that is owned at least partially by the government c must have their managerial statements audited at least annually by an independent auditor d may elect to have their annual audit prepared by the company s internal audit staff 1 None of the above 82 12 SarbanesOxley a requires a second partner to review and approve audit reports established the Public Company Accounting Oversight Board PCAOB increased senior management s responsibility for published financial statements required that an audit of internal controls be conducted can 13 Which of the following is not true regarding the audit committee Its members cannot be employees of the company Its function was strengthened by SarbanesOxley The internal auditor reports to the audit committee One or more members must have financial expertise 9906 14 Which of the following is not true regarding independent audits of public companies a The auditor forms an opinion of the overall fairness of the financial statements b The financial statements are the responsibility of the company s management d An annual independent audit is required of public companies e Strong internal controls can reduce the independent audit fee A compilation by an auditor means that the auditor b verified that the company s records were accurate before compiling the company s records into financial statements c did an audit of the company s records before compiling the company s records into financial statements d hired one of the company s employees to compile the financial statements for the company e did an audit of the company s records after compiling the company s records into financial statements Vivian Winston 7 22 1 3 SARBANESOXLEY ACT of 2002 SummaryHighlights Section 3 Commission Rules and Enforcement A violation of Rules of the Public Company Accounting Oversight Board Board is treated as a violation of the 34 Act giving rise to the same penalties that may be imposed for violations of that Act Section 101 Establishment Board Membership The Board will have five financially literate members appointed for five year terms Two of the members must be or have been certified public accountants and the remaining three must not be and cannot have been CPAs The Chair may be held by one of the CPA members provided that he or she has not been engaged as a practicing CPA for five years The Board s members will serve on a fulltime basis No member may concurrent with service on the Board share in any of the profits of or receive payments from a public accounting firm other than fixed continuing payments such as retirement payments Members of the Board are appointed by the Commission after consultation with the Chairman of the Federal Reserve Board and the Secretary of the Treasury Members may be removed by the Commission for good cause Section 103 Auditing Quality Control And Independence Standards And Rules The Board shall 1 register public accounting firms 2 establish or adopt by rule auditing quality control ethics independence and other standards relating to the preparation of audit reports for issuers 3 conduct inspections of accounting firms 4 conduct investigations and disciplinary proceedings and impose appropriate sanctions 5 perform such other duties or functions as necessary or appropriate 6 enforce compliance with the Act the rules of the Board professional standards and the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto 7 set the budget and manage the operations of the Board and the staff of the Board Auditing standards The Board would be required to cooperate on an ongoing basis with designated professional groups of accountants and any advisory groups convened in connection with standard setting and although the Board can to the extent that it determines appropriate adopt standards proposed by those groups the Board will have authority to amend modify repeal and reject any standards suggested by the groups The Board must report on its standardsetting activity to the Commission on an annual basis The Board must require registered public accounting firms to prepare and maintain for a period of not less than 7 years audit work papers and other information related to any audit report in sufficient detail to support the conclusions reached in such report The Board must require a 2nd partner review and approval of audit reports Registered accounting firms must adopt quality control standards The Board must adopt an audit standard to implement the internal control review required by section 404b This standard must require the auditor evaluate whether the internal control structure and procedures include records that accurately and fairly reflect the transactions of the issuer provide reasonable assurance that the transactions are recorded in a manner that will permit the preparation of financial statements in accordance with GAAP and a description of any material weaknesses in the internal controls Section 102a Mandatory Registration Section 102f Registration And Annual Fees Section 109d Funding Annual Accounting Support Fee For The Board In order to audit a public company a public accounting firm must register with the Board The Board shall collect a registration fee and an annual fee from each registered public accounting firm in amounts that are sufficient to recover the costs of processing and reviewing applications and annual reports The Board shall also establish by rule a reasonable annual accounting support fee as may be necessary or appropriate to maintain the Board This fee will be assessed on issuers only Section 104 Inspections of Registered Public Accounting Firms Annual quality reviews inspections must be conducted for firms that audit more than 100 issues all others must be conducted every 3 years The SEC andor the Board may order a special inspection of any firm at any time Section 105b5 Investigation And Disciplinary Proceedings Investigations Use Of Documents Section 105 2 Investigations And Disciplinary Proceedings Disciplinary Procedures Public Hearings Section 105 4 Investigations And Disciplinary Proceedings Sanctions Section 105d Investigations And Disciplinary Proceedings Reporting of Sanctions All documents and information prepared or received by the Board shall be confidential and privileged as an evidentiary matter and shall not be subject to civil discovery other legal process in any proceeding in any Federal or State court or administrative agency unless and until presented in connection with a public proceeding or otherwise released in connection with a disciplinary action However all such documents and information can be made available to the SEC the US Attorney General and other federal and appropriate state agencies Disciplinary hearings will be closed unless the Board orders that they be public for good cause and with the consent of the parties Sanctions can be imposed by the Board of a firm if it fails to reasonably supervise any associated person with regard to auditing or quality control standards or otherwise No sanctions report will be made available to the public unless and until stays pending appeal have been lifted 2Section 106 Foreign Public Accounting Firms The bill would subject foreign accounting firms who audit a US company to registrations with the Board This would include foreign firms that perform some audit work such as in a foreign subsidiary of a US company that is relied on by the primary auditor Section 107a Commission Oversight Of The Board General Oversight Responsibility Section 107b Rules Of The Board Section 107d Censure Of The Board And Other Sanctions in the same manner as it can with regard to SROs such as the NASD The Board in its rulemaking process is to be treated as if the Board were a registered securities association that is a selfregulatory organization The Board is required to file proposed rules and proposed rule changes with the SEC The SEC may approve reject or amend such rules The SEC may by order censure or impose limitations upon the activities functions and operations of the Board if it finds that the Board has violated the Act or the securities laws or if the Board has failed to ensure the compliance of accounting firms with applicable rules without reasonable justification Section 107 Commission Review Of Disciplinary Action Taken By The Board The Board must notify the SEC when it imposes any final sanction on any accounting firm or associated person The Board s findings and sanctions are subject to review by the SEC The SEC may enhance modify cancel reduce or require remission of such sanction Section 108 Accounting Standards The SEC is authorized to recognize as generally accepted any accounting principles that are established by a standardsetting body that meets the bill s criteria which include requirements that the body 1 be a private entity 2 be governed by a board of trustees or equivalent body the majority of whom are not or have not been associated persons with a public accounting firm for the past 2 years 3 be funded in a manner similar to the Board 4 have adopted procedures to ensure prompt consideration of changes to accounting principles by a majority vote 5 consider when adopting standards the need to keep them current and the extent to which international convergence of standards is necessary or appropriate Section 201 Services Outside The Scope Of Practice Of Auditors Prohibited Activities or other services related to the accounting records or 3 9 any other service that the Board determines by regulation is impermissible The Board may on a casebycase basis exempt from these prohibitions any person issuer public accounting firm or transaction subject to review by the Commission The audit committee will disclose to investors in periodic reports its decision to preapprove nonaudit services Statutory insurance company regulatory audits are treated as an audit service and thus do not require preapproval The preapproval requirement is waived with respect to the provision of nonaudit services for an issuer if the aggregate amount of all such nonaudit services provided to the issuer constitutes less than 5 of the total amount of revenues paid by the issuer to its auditor calculated on the basis of revenues paid by the issuer during the fiscal year when the nonaudit services are performed such services were not recognized by the issuer at the time of the engagement to be nonaudit services and such services are promptly brought to the attention of the audit committee and approved prior to completion of the audit The authority to preapprove services can be delegated to 1 or more members of the audit committee but any decision by the delegate must be presented to the full audit committee Section 203 Audit Partner Rotation Section 204 Auditor Reports to Audit Committees Section 206 Conflicts of Interest Section 207 Study of Mandatory Rotation of Registered Public Accountants The GAO will do a study on the potential effects of requiring the mandatory rotation of audit firms Section 209 Consideration by Appropriate State Regulatory Authorities Section 301 Public Company Audit Committees The SEC may make exemptions for certain individuals on a casebycase basis Section 302 Corporate Responsibility For Financial Reports A violation of this section must be knowing and intentional to give rise to liability Section 303 Improper Influence on Conduct of Audits Section 304 Forfeiture Of Certain Bonuses And Profits Section 305 Officer And Director Bars And Penalties Equitable Relief If an issuer is required to prepare a restatement due to material noncompliance with financial reporting requirements the chief executive officer and the chief financial officer shall reimburse the issuer for any bonus or other incentivebased or equitybased compensation received during the twelve months following the issuance or filing of the noncompliant document and any profits realized from the sale of securities of the issuer during that period In any action brought by the SEC for violation of the securities laws federal courts are authorized to grant any equitable relief that may be appropriate or necessary for the benefit of investors Section 305 Officer And Director Bars And Penalties The SEC may issue an order to prohibit conditionally or unconditionally permanently or temporarily any person who has violated section 10b of the 1934 Act from acting as an officer or director of an issuer if the SEC has found that such person s conduct demonstrates unfitness to serve as an officer or director of any such issuer Section 306 Insider Trades During Pension Fund BlackOut Periods Prohibited Prohibits the purchase or sale of stock by officers and directors and other insiders during blackout periods Any profits resulting from sales in violation of this section shall inure to and be recoverable by the issuer If the issuer fails to bring suit or prosecute diligently a suit to recover such profit may be instituted by the owner of any security of the issuer Section 401a Disclosures In Periodic Reports Disclosures Required Each financial report that is required to be prepared in accordance with GAAP shall reflect all material correcting adjustments that have been identified by a registered accounting firm Each annual and quarterly financial report shall disclose all material offbalance sheet transactions and other relationships with unconsolidated entities that may have a material current or future effect on the financial condition of the issuer The SEC shall issue rules providing that pro forma financial information must be presented so as not to contain an untrue statement or omit to state a material fact necessary in order to make the pro forma financial information not misleading Section 401 Study and Report on Special Purpose Entities SEC shall study offbalance sheet disclosures to determine a extent of offbalance sheet transactions including assets liabilities leases losses and the use of special purpose entities and b whether generally accepted accounting rules result in financial statements of issuers reflecting the economics of such offbalance sheet transactions to investors in a transparent fashion and make a report containing recommendations to the Congress Section 402a Prohibition on Personal Loans to Executives Consumer credit companies may make home improvement and consumer credit loans and issue credit cards to its directors and executive officers if it is done in the ordinary course of business on the same terms and conditions made to the general public Section 403 Disclosures Of Transactions Involving Management And Principal Stockholders Directors officers and 10 owner must report designated transactions by the end of the second business day following the day on which the transaction was executed Section 404 Management Assessment Of Internal Controls An attestation made under this section shall be in accordance with standards for attestation engagements issued or adopted by the Board An attestation engagement shall not be the subject of a separate engagement The language in the report of the Committee which accompanies the bill to explain the legislative intent states the Committee does not intend that the auditor s evaluation be the subject of a separate engagement or the basis for increased charges or fees F Directs the SEC to revise its regulations concerning prompt disclosure on Form 8K to require immediate disclosure of any change in or waiver of an issuer s code of ethics Section 407 Disclosure of Audit Committee Financial Expert Section 409 Real Time Disclosure lssuers must disclose information on material changes in the financial condition or operations of the issuer on a rapid and current basis Section 501 Treatment of Securities Analysts by Registered securities Associations National Securities Exchanges and registered securities associations must adopt conflict of interest rules for research analysts who recommend equities in research reports Section 601 SEC Resources and Authority SEC appropriations for 2003 are increased to 776000000 98 million of the funds shall be used to hire an additional 200 employees to provide enhanced oversight of auditors and audit services required by the Federal securities laws Section 602a Appearance and Practice Before the Commission The SEC may censure any person or temporarily bar or deny any person the right to appear or practice before the SEC if the person does not possess the requisite qualifications to represent others lacks character or integrity or has willfully violated Federal securities laws Section 602 Study and Report SEC is to conduct a study of securities professionals public accountants public accounting firms investment bankers investment advisors brokers dealers attorneys who have been found to have aided and abetted a violation of Federal securities laws Section 602d Rules of Professional Responsibility for Attorneys The SEC shall establish rules setting minimum standards for professional conduct for attorneys practicing before it Section 701 GAO Study and Report Regarding Consolidation of Public Accounting Firms Title VIII Corporate and Criminal Fraud Accountability Act of 2002 from three years and one year respectively Employees of issuers and accounting firms are extended whistleblower protection that would prohibit the employer from taking certain actions against employees who lawfully disclose private employer information to among others parties in a judicial proceeding involving a fraud claim Whistle blowers are also granted a remedy of special damages and attorney s fees A new crime for securities fraud that has penalties of fines and up to 10 years imprisonment Title IX White Collar Crime Penalty Enhancements Maximum penalty for mail and wire fraud increased from 5 to 10 years SEC given authority to seek court freeze of extraordinary payments to directors offices partners controlling persons agents of employees US Sentencing Commission to review sentencing guidelines for securities and accounting fraud SEC may prohibit anyone convicted of securities fraud from being an officer or director of any publicly traded company Section 1001 Sense of Congress Regarding Corporate Tax Returns It is the sense of Congress that the Federal income tax return of a corporation should be signed by the chief executive officer of such corporation Section 1102 Tampering With a Record or Otherwise Impeding an Official Proceeding Section 1103 Temporary Freeze Authority The SEC is authorized to freeze the payment of an extraordinary payment to any director officer partner controlling person agent or employee of a company during an investigation of possible violations of securities laws Section 1105 SEC Authority to Prohibit Persons from Serving as Officers or Directors The SEC may prohibit a person from serving as an officer or director of a public company if the person has committed securities fraud
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