Audit Exam 1 Material

Why Have An Audit?

Reason #1: It’s the Law 

• Securities laws, SOX, and Dodd-Frank require it 

• All public companies must have a financial statement audit 

• Most must also have an internal controls audit 

Reason #2: It’s Good Business 

• Want a bank loan? Lenders want audited numbers 

• Want investors? They demand assurance 

• Markets NEED trust to function 

Who Runs the Company vs. Who Owns It?

Who Runs the Company vs. Who Owns It? 

Stockholders                    ----> hire ----> Managers 

(Principals) (Agents) 

Own the company Run the company 

NOT involved in day-to-day Know everything 

Why Trust Breaks Down?

Information asymmetry –> Managers know more than investors & creditors 

Conflict of interest –> Managers may not act in owners’ best interest 

Information risk –> Managers might misrepresent the financials 

Management’s Claims: The Assertions 

Three Nested Services

Assurance – improves the quality of information for decision makers 

Within assurance there's.... 

Attestation – a report on subject matter that is another party’s responsibility 

Within attestation there's.... 

Auditing – objectively obtain and evaluate evidence to assess another party’s assertions that it has presented info in accordance with GAAP 

Auditing

• Provides positive assurance 

• Provides reasonable assurance 

• Audit report accompanies annual SEC filing (Form 10-K) 

• Is a subcategory of service type within both attestation and assurance

Three Concepts That Explain Everything

Materiality: How big does a misstatement need to be to matter to a decision maker? 

Audit risk: The risk the auditor gives a clean opinion on materially misstated statements 

Reasonable assurance: High – but not absolute – confidence. Audit are NOT guarantees.

Four Types of Auditors

Inside a CPA firm: The Team

1. STAFF (you, soon!) - Performs procedures: inventory counts, confirmations 

2. SENIOR – Supervises staff and fieldwork 

3. MANAGER – Helps supervise & plan; key audit judgements 

4. PARTNER – Supervises audit; signs the opinion

2001-2022: The Profession’s Reckoning 

What went wrong?

The question Congress asked:  

• Can you objectively audit a system you designed – for a client paying you millions in consulting fees?

• Massive accounting scandals – Enron, WorldCom (remember Chapter 1!) 

• Auditors were selling non-audit services to audit clients: 

• IT System design 

• Tax services and bookkeeping 

• Outsourced internal audit 

Question: Can you objectively audit a system you designed – for a client paying you millions in consulting fees?

Congress Responds: Sarbanes-Oxley (SOX) 

SOX Changes:

SOX Changes:

1. Created the PCAOB -> Independent board: inspects firms, set standards, funds scholarships 

2. Internal controls focus -> Public companies get a controls audit, not just an FS audit 

3. CEO & CFO certification -> Executives personally certify the financial statements

SOX: Protecting Auditor Independence

What SOX requires: 

• Bans most non-audit services for audit clients 

• Mandatory PARTNER rotation: 5 years on, then 5 years off (lead and EQR partners) 

What SOX does NOT require: 

• Audit FIRM rotation is NOT mandated – the firm can stay indefinitely; only the partners rotate.

The Auditor’s Mindset: Professional Skepticism

Questioning mind: Don’t assume management is honest OR dishonest - verify

Critical assessment of evidence: Ask: is this evidence sufficient? Reliable? Consistent?

Alert on contradictions: Follow up when documents or explanations don’t add up

Know Your Client Before You Audit

Corporate governance: who oversees management? 

• Board of directors – elected by shareholders 

• Audit committee – independent contractors who hire, pay, and oversee the external auditors 

Why industry matters 

• Different companies = different risks and different accounting (banking vs. Retail vs. Software) 

• The auditor must understand the business to know where misstatements are likely

Who Sets the Rules?

Standard setters 

1. PCAOB 

• .Applies to: Audits of U.S PUBLIC companies 

• Standards: Auditing Standards (AS) 

2. AICPA (ASB) 

• Applies to: Audits of U.S PRIVATE companies 

• Standards: Statements on Auditing Standards (SAS) 

3. IAASB 

• Applies to: International audits 

• Standards: International Standards on Auditing (ISA)

Premise and Purpose of an Audit

1. Auditor provides and opinion on whether the financial statements are presented fairly in all material respects 

2. Management Responsibilities (PIE) 

• Prepare the financial statements 

• Internal Controls 

• Evidence – provide relevant information to the auditor

GAAS: Three Categories of Principles

RESPONSIBILITIES: 

• Competence & capabilities 

• Ethics & independence 

• Professional skepticism & judgement 

PERFORMANCE 

• Plan the work 

• Assess risk & materiality 

• Gather sufficient, appropriate evidence 

REPORTING 

• Express an opinion 

• State whether statements follow the framework (GAAP)

Ethics:

A system of moral principles governing what is right and wrong conduct.

Professionalism:

The conduct, aims, and qualities expected of a professional – holding yourself to standards beyond personal interest.

Theories of Ethical Behavior:

AICPA

PCAOB

SEC

The AICPA Code: Ideals vs. Rules

Six principles: 

• Nature: Framework and ideals – What CPAs aspire to 

• Enforceable? No 

Rules of Conduct:  

• Nature: Minimum standards of behavior 

• Enforceable? Yes 

Our focus: Part 1 Rules – those applying to members in public practice (sections 1.100, 1.200, etc.) 

Only the rules are enforceable.

Who Must Be Independent?  The ‘Covered Member’ 

You are a COVERED Member if you are: 

1. On the attest engagement team 

2. In a position to influence the attest engagement team 

3. A partner/manager providing 10+ hours of nonattest services to the attest client 

4. A partner in the office associated with the attest engagement 

5. The CPA firm itself – including its employee benefit plan 

6. An entity controlled by any of the above

Your Family Can Impair YOUR Independence

Immediate Family: 

• Who Counts: Spouse, spousal equivalent, dependents 

• The Rule: Subject to the SAME Independent Rule as you 

Close Relatives 

• Who Counts: Parents, siblings, nondependent children 

• The Rule: Impair independence only if they have a MATERIAL investment (to the relative) in, or CONTROL over, the client 

Lawsuits and Job Offers 

Litigation by the CLIENT against the auditor impairs independence if: 

• Litigation has been filed, OR 

• Litigation is threatened AND reasonably probable to be filed 

Litigation by the AUDITOR against the client: 

• Always impairs independence 

A job offer on the table from the client: 

• Impairs independence – you cannot objectively audit your possible future employer 

Why All This Fuss? Fact vs. Appearance

Independence in FACT: The auditor’s actual state of mind – truly unbiased. It cannot be proven – It’s invisible 

Independence in APPEARANCE: Whether a reasonable outsider would BELIEVE the auditor is unbiased. It can be proven – judged by observable relationships. 

• Case in point: K-Mart vs Arthur Andersen – when auditor objectivity is questioned, the damage is done regardless of the facts 

Tan auditor can disclose confidential client information with Two Notable Exceptions

Client confidentiality has limits 

• Confidential info CAN be disclosed for: a valid subpoena/summons, a peer/quality review, an ethics investigation, or with client consent. 

Some loans FROM the client are permitted 

• Certain loans from client institutions are allowed – e.g., car loans (collateralized), fully collateralized loans, credit cards with balance within limits, obtained under normal lending terms. 

The Nine Prohibited Non-Audit Services 

1. Bookkeeping & accounting records 

2. Financial info systems/implementation 

3. Appraisal & valuation services 

4. Actuarial services 

5. Internal audit outsourcing 

6. Management or HR functions 

7. Broker-dealer / investment adviser / investment banking services 

8. Legal services & expert services unrelated to the audit 

9. Any other service the PCAOB decides is permissible

What Happens When Rules Are Broken? 

Who enforces:

• AICPA / state societies – Admonish, suspend, or expel members; require remedial CPE 

• State board of accountancy – Suspend or REVOKE the CPA license, the only body that can take your license 

• SEC & PCAOB – Fines, censure, bar individuals/firms from public company audits, refer that criminal prosecution.  

Acts Discredible