ACC 450: Exam 1

Assurance Services

Independent professional services that improve the quality of information, or its context, for decision makers.

Examples

• XBRL reporting

• Information risk assessment

• Evaluation of investment management policies

• Sustainability reporting

Non-Assurance Services

• Tax services

• Consulting services

• Bookkeeping

(Independence is not required)

Attestation Services

To provide assurance as to its reliability. Individuals attest to an assertion from a third-party.

• An assertion is a declaration or set of declarations about whether the subject matter is based on or in conformity with the suitable criteria selected.

• Attest engagements result in a report

Attestations that involve the financial statements

1) Examinations (Audits)

2) Reviews

3) Agreed-upon procedures

Examinations (Audits)

Result in reasonable (or high) assurance, also referred to as an opinion.

• In an examination, the CPA selects from all available procedures any combination that can limit attestation risk to an appropriately low level.

• When financial statements are being reported upon instead of the term “examination” we use “audit.”

Reviews

Result in moderate assurance, also referred to as limited assurance.

• The objective is to accumulate sufficient evidence to limit attestation risk to a moderate level.

• Similar to “interim reviews” → primary difference is that the SEC interim review requires understanding of internal control.

Agreed-upon procedures

Result in a report with procedures performed and findings. The scope of procedure performed are determined by the “specified party” that wants them to be performed.

• Report is issued ordinarily “restricted use” in the sense that it is for the specified party (and management).

Example: A bank may ask CPA to perform certain procedures on XYZ Company’s Inventory because inventory is to be the security on a loan that is going to be granted. The agreed-upon procedures report would be for the bank and management of XYZ Company.

Independence is required for…

All assurance, attestation, and audit services

• Not required for other services such as tax, compilations, and consulting.

Procedures

Involves preparation of financial statements, but the minimum requirement is reading them. If the information is incorrect the CPA should insist on revision (or resign).

Report issued provides no assurance and is dated as of the date of completion of the compilation. Report modifications are similar to those for reviews.

True

A CPA need not be independent to issue a compilation report. If the CPA is not independent s/he should so indicate and may disclose the reason for the lack of independence if s/he so desires

True

Examination (Table)

AKA Audit

Attest Engagement: Yes

Level of Assurance Provided: High (“Reasonable”)

Risk of Material Misstatement: Low

Nature of Assurance in Report: “In our opinion…”

Procedures: Select from all available procedures any combination that can limit attestation risk to a low level.

Review (Table)

Attest Engagement: Yes

Level of Assurance Provided: Moderate (“Limited”)

Risk of Material Misstatement: Moderate

Nature of Assurance in Report: “We are not aware of any material modifications that should be made…”

Procedures: Generally limited to inquiry and analytical procedures

Agreed-upon Procedures

Attest Engagement: Yes

Level of Assurance Provided: Summary of findings

Risk of Material Misstatement: Varies by specific engagement

Nature of Assurance in Report: Includes a summary of procedures performed and findings

Procedures: Procedures agreed upon with the specified user or users.

Compilations

Attest Engagement: No

Level of Assurance Provided: None

Nature of Assurance in Report: No assurance

Procedures: Preparation of financial statements

Demand for auditing is based on…

1) Business risk

2) Information risk

Business risk

The threat that a company will fail to meet its financial or operational goals due to economic shifts, competition, or poor execution.

Information risk

The specific danger that the financial data or reports used to make decisions are inaccurate, biased, or incomplete.

Who prepares financial statements?

Management and they should follow GAAP to ensure financial statements are not misstated.

Assertions (declarations) made by management to ensure financial statements are prepared in accordance with GAAP…

Acronym: PERCCV

1) Presentation & Disclosure

2) Existence or occurrence

3) Rights & obligations

4) Completeness

5) Cut-off

6) Valuation or allocation

Presentation and disclosure

Accounts are described and classified in the financial statements in accordance with GAAP, and all material disclosures are provided.

Existence or occurrence

Assets, liabilities, and owners' equity reflected in the financial statements exist; the recorded transactions have occurred.

Rights & obligations

The client has rights to assets and obligations to pay liabilities that are included in the financial statements.

Completeness

All transactions, assets, liabilities, and owners' equity that should be presented in the financial statements are included.

Cut-off

Transaction and events have been recorded in the correct accounting period

Valuation or allocation

Assets, liabilities, owners' equity, revenues, and expenses are presented at amounts that are determined in accordance with GAAP.

External auditing

Focus is on financial statements: The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present fairly, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles. (AU 100.01)

• Close supervision/Structured audit approach

• Audits of public companies require an integrated audit that includes providing assurance on both the financial statements & the effectiveness of internal control.

Audit Partner

• Reach agreement with the auditee on the scope of the service to be provided.

• Ensure that the audit is properly planned and that the audit is conducted in accordance with applicable auditing standards.

• Assemble an audit team that has the required skills and experience.

• Supervise the audit team and review the working papers.

• Conclude on the adequacy of audit evidence and sign the audit report.

Audit Manager

• Ensure that the audit is properly planned, including scheduling of team members.

• Supervise the preparation of and approve the audit program.

• Review the working papers, financial statements, and audit report.

• Deal with invoicing and ensure collection of payment for services.

• Inform the partner about any auditing or accounting problems encountered.

Audit Senior

• Assist in the development of the audit plan.

• Prepare budgets.

• Assign tasks to associates and direct the day-to-day performance of the audit.

• Supervise and review the work of associates.

• Inform the manager about any auditing or accounting problems encountered.

Audit Associate

• Perform the audit procedures assigned to them.

• Prepare adequate and appropriate documentation of completed work.

• Inform the senior about any auditing or accounting problems encountered.

Internal Auditing

Focus is on how well is business run

• Review policies & procedures for compliance & effectiveness

• Recommendations to reduce costs & increase revenues

Operational Audits

1. Effectiveness of, and compliance with, policies and procedures. Is the operation effective, efficient, economical?

2. Independent review of operating and financial activities.

3. Promote attainment of organization's objectives (economy and efficiency).

Compliance Audits

1. Compliance to laws.

2. Government auditing.

• Testing internal controls for management’s reports required by SOX.

• Most often, internal auditors report to the audit committee and the CEO

Securities & Exchange Commission (SEC)

1. Regulates accounting and auditing of public companies.

2. Accounting Series Releases

3. Power over companies selling stock to public only.

State Boards of Accountancy

1. Regulates the practice of public accounting.

2. Determines rules for certification & lic.

3. Initial requirements & continuing education

• License CPAs and CPA firms to practice public accountancy in their respective states.

• Regulate CPAs in their states- can suspend or revoke CPA’s license.

Public Company Accounting Oversight Board (PCAOB)

Established in 2002 by the Sarbanes-Oxley Act) to regulate audits and auditors of public companies.

Responsibilities include:

1. Register public accounting firms that prepare audit reports for financial statement issuers (SEC registrants).

2. Establish or adopt auditing, quality control, ethics, independence and other standards relating to audit reports for issuers.

3. Conduct inspections of registered public accounting firms.

4. Perform other duties or functions to promote high professional standards for audits, enforce compliance with the enabling act establishing the Board, set the budget, and manage.

American Institute of CPAs (AICPA)

Non-Public Regulation

1. Individual members & division of firms

2. Issues Statements on Auditing Standards (SASs / AU’s)

3. Power from SEC & state boards

4. Quality control standards & peer review

5. Membership requirements

A. Members must be enrolled in a firm with a peer review program.

B. 150 hours of college education. (NOTE – this is changing).

C. CPE—average of about 40 CPE hours a year.

6. Ethical rules in the Code of Professional Conduct. (see Chapter 3)

7. Center for Audit Quality (CAQ)

The International Federation of Accountants (IFAC)

A. Membership consists of approximately 160 professional accounting bodies from

about 125 countries.

B. Established to provide a coordinated worldwide accounting profession with

harmonized standards.

C. The International Auditing and Assurance Standards Board (IAASB).

Sarbanes-Oxley Act (SOX)

1) Public Company Accounting Oversight Board

2) Offering specified non-audit services prohibited → auditors are prohibited from offering certain non-audit services to audit clients such as bookkeeping, appraisals/valuation services, etc. (services unrelated to audit services).

3) Audit partner rotation → audit partner must be rotated every 5 years on public company engagements. Then subject to a 5 year cool-off period

4) Audit committee → must be composed of at leas 3 independent directors and that it has direct responsibility for appointing, compensating, and overseeing the external auditors

5) Management assessment of internal controls

6) Audit reports must contain description of internal controls testing → specific notation about any significant defects or material noncompliance found on the basis of such testing

7) SOX Costs → Audit fees for public companies avg. 1.5 million; nonpublic companies avg. $254,000

Financial Statements are prepared using…

An applicable financial reporting framework: US GAAP

Other possibilities:

• International Financial Reporting Standards (IFRS)

• Accounting standards of various countries

• Special purpose frameworks (e.g., cash or tax basis)

Audit is conducted following…

AICPA- GAAS for non-public or PCAOB Auditing Standards for public companies

Other possibilities:

• International Auditing Standards

• Auditing standards of various countries

Financial Accounting Standards Board (FASB)

Sets the standards for financial accounting

Government Accounting Standards Board

Sets the standards of accounting and financial reporting by state & local government organizations.

Federal Accounting Standards Advisory Board

Sets the accounting reporting standards of the US Government

Statements on Auditing Standards (SASs)

AICPAs issues these which are the “generally accepted auditing standards” for nonpublic companies.

• Written in the context of an audit of financial statements by an auditor.

Unconditional Responsibility

Auditor must comply with responsibilities in all cases where such a requirement is relevant.

Words used to indicate responsibility:

• Must

• Shall (PCAOB only)

• Is required (PCAOB only)

Presumptively Mandatory Responsibility

Auditor must comply with requirement in all cases in which the requirement is relevant, except in rare circumstances when the auditor makes a judgment that it is necessary to depart from the standard.

Words used to indicate responsibility:

• Should

Responsibility to consider (only established in PCAOB documents)

Auditor should consider: whether auditor follows depends on exercise of professional judgment in the circumstances.

Words used to indicate repsonsibility:

• May

• Might

• Could

• Other phrases indicating a responsibility to consider

Engagement Quality Reviews

A.  These reviews are generally done by a partner that is not on the engagement.

B.  They focus on the significant judgments and conclusions made by the audit team.

C.   They are performed prior to issuance of the audit report.

Completed engagement inspection

Inspect a sample of engagements to evaluate whether the firm’s quality policies & procedures are being followed.

Peer Review

Purpose: To make sure that the firms are following quality controls

Time frame: Once every 3 years

Who is required to have peer reviews? CPA firms that audit non-public companies

• Critics argues that this process is ineffective because CPA firms can choose their peer reviewers & the system is generally nonpunitive (non involving). 97% of peer reviews result in unmodified opinions.

Inspections (PCAOB)

A. Firms performing audits of over 100 public companies are required to have inspections annually.

  B. Firms performing audits of fewer than 100 public companies are required to have inspections every three years.

 C.  Firms are still required to have peer reviews.

Standard Unmodified Opinion

Unqualified → PCAOB term use

A "clean opinion" that may be issued when (1) financial statements presented in conformity with GAAP, (2) audit was performed in accordance with GAAS, including no significant scope limitations, and (3) when no conditions resulting in emphasis of matter or other matter paragraphs exist.

Unmodified Opinions (with emphasis of matter paragraph)

A paragraph is included that refers to a matter appropriately presented or disclosed in the financial statements.

Qualified opinions

A qualified opinion states that the financial statements are pre­sented fairly in conformity with generally accepted accounting principles "except for" the effects of some matter. Qualified reports are issued when the financial statements depart materially from generally accepted accounting principles, or when limitations are placed on the scope of the auditors' procedures. The likely effects, while material, are not considered pervasive.

Adverse opinion

An adverse opinion states that the financial statements are not pre­sented fairly in conformity with generally accepted accounting principles. Auditors issue an adverse opinion when the departures from GAAP are both material and pervasive. All significant reasons for the issuance of an adverse opinion should be set forth in a basis for modification paragraph.

Disclaimer of opinion

 A disclaimer of opinion means that due to a scope limitation, the auditors were unable to obtain sufficient appropriate audit evidence (a scope limitation) on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive.  A disclaimer is not an opinion; it simply states that the audi­tor does not express an opinion on the financial statements.

Causes of Misstatements

1) Errors

2) Fraud → Fraudulent Financial Representation & Misappropriation of Assets

Errors

Unintentional misstatements or omissions of amounts or disclosures in financial statements.

Fraud

Intentional misstatements or omissions of amounts or disclosures in financial statements. Audits are concerned with misstatements arising from two distinct types of acts:

A. Fraudulent Financial Reporting —Intentional misstatements in financial statements.  FFR carries a median loss of $2 million.  This is 13 times greater than the median loss for misappropriation of assets.  The CEO or CFO involved in a large majority of cases.

B.  Misappropriation of assets—Theft of company’s assets the effect of which has not been appropriately reflected in the financial statements.

Auditor Responsibilities

1.   Assess the risk of errors and fraud that may cause the financial statements to contain material misstatement

2.   Based on that assessment, design the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements.

3.   Exercise due care in planning, performing and evaluating the results of audit procedures, and the proper degree of professional skepticism to achieve reasonable assurance that material misstatements due to material errors or fraud will be detected.       

Laws & Regulations- Audit

1. The provisions of some laws have direct effect on the financial statements in that they determine the reported amounts and disclosures in the company’s financial statements (e.g., tax law violations). 

2.  Other laws are to be complied with, but do not have a direct effect on the financial statements (e.g., occupational safety and health, equal employment opportunity). Noncompliance with laws of this sort may result in fines, litigation or other consequences.

Auditor responsibilities- compliance with laws & regulations

1.  Material direct effect on financial statement amounts (generally those requiring an adjusting journal entry)—Design the audit to obtain reasonable assurance that the financial statements are free from material misstatements arising from noncompliance (same as above for misstatements due to error or fraud).

2. Other laws that do not have a direct effect on amounts and disclosures—Limited to undertaking specified audit procedures that may identify noncompliance that may (ultimately) have a material effect on the financial statements.  Procedures:

A.   Inquire of management and, where appropriate, those charged with government about compliance.

 B.    Inspect correspondence if any, with the relevant licensing or regulatory authorities.

C.    Remain alert to possibility of such acts throughout the audit.

D.   When noncompliance is identified or suspected the auditor must pursue.

When the PCAOB was created in 2002, what did it adopt as its standards?

It adopted the existing auditing standards of the AICPA as its interim standards known as Generally Accepted Auditing Standards (GAAS).

Objectivity is always required, independence is only required for auditing and other attestation services.

True

Rules of Conduct- Enforceable ethical standards

1) Independence

2) Confidential Client Information

3) Contingent Fees

4) Acts Discreditable

5) Advertising

6) Commissions and Referral Fees

7) Form of Organization and Name

Audit Rotation

US: Audit partner rotation after 5 years.

Europe: Audit firm rotation after 10 years.

Covered Member

1. An individual on the attest engagement team

2. Individual who may influence engagement (e.g., boss of engagement partner).

3. Other partners in engagement office

Individual CPA Independence Concern

Certain circumstances impair only a CPA’s independence. The firms will remain independent if that CPA is not involved in the attest services (or other attest engagement).

CPA Firm Independence Concern

Certain circumstances impair both a CPA’s and his/her firm’s independence; also, sometimes only a firm’s independence is impaired. In these situations, the firm cannot provide attest services.

Independence requirements for all partners & professional employees

A. No partner or professional employee or his/her immediate family member or any group of such person acting together may own more than 5% of the client’s outstanding equity securities during the period of the professional engagement. 

B. No partner or professional employee may simultaneously be associated with the CPA firm and the client as a director, officer, employee, promoter, trustee, etc.

 If the above conditions are not met, not only is the independence of the partner/employee impaired, but CPA firm independence is impaired.

Additional Independence Requirements for Covered Members

A. Direct financial interests—not allowed, regardless of amount. (e.g., investment in client’s stock, loan, etc.).  Any direct financial interest of a covered member impairs both CPA and firm independence.

B.  Indirect financial interests—only immaterial amounts allowed. (e.g., investment in a mutual fund that owns stock in client).  A material indirect financial interest of a covered member impairs both CPA and firm independence.         

A CPA partner, employee, or an investment club of such partners, employees and immediate families acting through “an investment club” together own more than 5% of client’s outstanding equity securities or other ownership interests.

Covered Member: Firm independence Impaired

Not a Covered Member: Firm independence impaired

A CPA firm partner or employee is simultaneously associated with client as director, office, employee, promoter, trustee, etc.

Covered Member: Firm independence impaired

Not a Covered Member: Firm independence impaired

A CPA has any direct or a material indirect financial interest in the attest client.

Covered Member: Firm independence impaired

Not a Covered Member: Firm independence not impaired (direct must be less than 5% per 1 above).

A CPA has a material joint closely held investment with the client (or client’s officers, directors, etc.)

Covered Member: Firm independence impaired

Not a Covered Member: Firm independence not impaired

Effects on Independence- Immediate Family

Immediate Family: Spouse, spousal equivalent, or dependent

General Rule:  A COVERED MEMBER’S immediate family members must, in general, comply with the Independence Rule or one of its interpretations. Accordingly, when an immediate family member violates the Independence Rule or one of its interpretations, independence of the covered member and the firm is impaired.

Exceptions to the General Rule:  The accountant and firm are independent:

1.  When a family member is employed by a client in other than a key position. (positions that have the ability to influence contents of financial statements)

Effects on Independence- Close Relatives

Close relatives: Parent, sibling, or nondependent child

Accountant and firm independence is impaired if a COVERED MEMBER has a close relative who has:

1.  A key position with the client, or

2.  A material financial interest of which the accountant has knowledge.

Effects on Independence- Other relatives and friends

Independence is only impaired when a reasonable person, aware of all relevant facts relating to a situation would conclude that there is an unacceptable threat to independence.

The following consulting services are prohibited by SEC & SOX if they are performed for Audit Clients (Applies to Public):

CPAs may only provide non-audit services upon the approval in advance by the audit committee.

a. Bookkeeping or other services related to the accounting records.

b. Financial information systems design and implementation;

c.  Appraisal or valuation services.

d.  Actuarial services.

e. Internal audit outsourcing.

f.  Management functions or human resources.

g. Providing various investment services.

h. Legal services.

i. Certain abusive tax planning transactions.        

j.  Any other service that the board determines, by regulation, is impermissible.

An accounting firm should not:

a. Audit its’ own work.

b. Function as part of management or as an employee of the audit client.

c.  Act as an advocate for the client.

AICPA: Activities that would impair a member’s independence

1. Authorizing, executing or consummating a transaction.

2. Preparing source documents (e.g., purchase orders, payroll time records, etc.)

3. Having custody of client assets.

4. Supervising client employees in their normal recurring activities.

5. Determining which recommendations should be implemented.

Does independence apply to retired partners?

Yes, but you can disassociate the retired partner from the firm. Retired partners can’t have any sort of relationship with the firm.

Independence impaired: What about performing accounting (bookkeeping) services for a client and also doing their audit? Think of “bookkeeping services” as having the following stages:

1. Prepare or originate source data underlying the financial statements.         

2. Maintain or prepare client’s accounting records.

3. Prepare financial statements.

SEC says you can’t do 1 and do 2/3. However, you can do 2 and 3. You can’t audit your own work.

Independence effect: Acceptance of gifts?

Accept no more than a “reasonable” gift/entertainment.

• Token gift would be ok, something reasonable.

Independence effect: At the time of your report, the prior year’s fees are still owed?

This presents an independence problem, almost like a receivable or a loan.

Independence effect: Litigation (or potential litigation) between the CPA firm and the audit client?

Independence problem as you can’t be neutral in this case.

Partner and covered members must tell their firm of any offer or intention to seek employment with client while on the audit engagement. They would then be removed from the engagement.

True

Confidential Client Information

. A member in public practice shall not disclose any confidential information without the specific consent of the client.

 A. Confidential Information vs. Privileged Information.

-       Privileged information even in court of law holds up (doctors, clergy) -> Protected, cannot talk in court.

-       Husband and wife can’t testify against each other.

C.  Exceptions:

1. Courts subpoena

2. Peer review by AICPA

3. Trial board of the AICPA

4. Illegal Practices of the Client

Contingent Fees

Example: % of savings due to a consulting job to design a cash disbursements system.

A.  A member in public practice shall not perform for a contingent fee any professional services for or receive such a fee from a client for whom the member also performs:

Audits        Reviews       Compilations        Prospective financial statements

If you are doing one of the above services, you can’t accept a contingent fee.

A.      What about contingent fees for tax returns? → Nope, can’t accept a contingent fee.

B. Exceptions: Court

Acts Discreditable

A. Felonies

B.  Knowingly misrepresenting the facts

C.  Discrimination

D.  Failure to comply with various laws or regulations relating to filing tax returns.

E. Unauthorized disclosure of confidential client information.

F.  Refusing to return client-provided records as a means of enforcing payment of fees.

Advertising- Can CPAs advertise their services?

YES, as long as it is not false, misleading or deceptive.

Commissions and Referrals Fees

Example: CPA refers clients to a computer hardware/software distributer.

A.  No commissions for referrals (products or services) when the member or member’s firm also performs for that client:

 Audits        Reviews      Compilations        Prospective financial statements

B.  If the member does not perform the above services, under what conditions can the individual collect commissions?

 You can collect, but you must disclose that you collected a commission. In other words, you must let them know.

Form of Organization

Can be sole proprietorship, partnership, or professional corporation, and limited liability company (limited liability partnership).

• A partnership may retain retired partners' names. 

• A firm may not designate itself as "Members of the AICPA" unless all partners or shareholders are members of the AICPA.

Professional Corporations

1) Certain tax advantages

2) Unlimited liability unless insured against

Limited Liability Partnerships (LLP)

1. These are now allowed in various forms in most of the states.

 2.  One may be sued only for engagements on which one has participated and the partnership may be sued for its capital. The difference is largely that partners (owners) cannot be held responsible for paying out of their personal assets for engagements they did not work on.

3. Example:  Think of the following sources of recovery against CPAs

a.  CPA firm assets (primarily financed through “capital” accounts of partners—so losses here really are those of the partners.)

b.  Personal assets of partners and others on the audit.

c.  Personal assets of other partners

d.  In LLP, recovery against CPAs and CPA firms is limited to a & b.