ACCT 4301: Exam 1 Review

What is external auditing?

An independent, systematic process of objectively obtaining and evaluating audit evidence about management’s assertions in the financial statements in order to express an opinion on whether the statements are presented free from error or fraud, in all material respects, in accordance with GAAP, and communicating that opinion to external users.

What is the Principal-Agent problem?

There is a conflict of interest present with management due to information asymmetry and information risk.

How has the modern capital market structure created the Principal-Agent problem?

Ownership is dispersed among many investors who are not directly involved in managing the business, requiring managers to act on their behalf and creating a separation between ownership and control.

In the Principal-Agent relationship, who is considered the Principal?

Shareholders (the absentee who is not involved in day-to-day operations)

In the Principal-Agent relationship, who is considered the Agent?

Management (hired to run the business, manage resources, and daily operations of the business; also known as stewards)

Information Asymmetry

The agent has more information about the “true” financial position and operations compared to the principal.

There is a natural __________ between agents and principals, creating a risk for both parties to maximize their self-interest. Therefore, agents may not always act in the best interest of owners.

Conflict of Interest

Who hires/pays the auditor to report on the fairness of the agent’s financial reports, ultimately reducing information risk?

The Agent

How do audits mitigate moral hazard and reduce information risk for outside stakeholders?

• They independently and objectively verify financial information

• They discourage opportunistic management

• They reduce information risk for outside stakeholders who rely on financial statements

Why do auditors provide reasonable rather than absolute assurance?

It’s impractical/virtually impossible to examine all transactions or eliminate all risk of material misstatement due to sampling, cost-constraints, etc.

What is meant by reasonable assurance?

• A high, but not absolute, level of assurance

• An audit done in accordance with auditing standards may still fail to detect a material misstatement

Key Takeaways from the Enron Video

• Auditors failed to maintain independence due to consulting relationships with the companies they audited

• While financial statements were in alignment with GAAP, they did not represent economic reality

• Professional skepticism was weak, and aggressive accounting went unchallenged

• Boards and audit committees failed to effectively oversee management and auditors

• Audit opinions helped legitimize misleading financial reporting, which increased information risk for investors

How did accounting conditions around the time of Enron lead to the enactment of SOX?

They reduced investor/public trust, prompting Congress to enact SOX to strengthen auditor independence, corporate governance, internal controls, and accountability.

Audit Profession Environment Pre-2002

• Self-Regulation of the Audit Profession

• An economic boom created a demand for information systems design and consulting

• Many accounting firms vied for business and growth, occurring through lowering audit fees and incentive compensation pressure tied to “marketing” services

• Auditors were more than just auditors, threatening their independence

• Consulting fees exceeded audit fees

Major Changes After SOX

• Creation of the PCAOB

• Prohibition of non-audit services to public companies if already being audited

• Rotate audit partners on an engagement every five years

• Requirement of integrated audits

• CEOs and CFOs are responsible for financial statements and must certify that the financial statements are prepared fairly

• The audit committee is responsible for the appointment, compensation, and oversight of the work of the auditors

Securities and Exchange Commission (SEC)

• Regulates U.S. public companies and the securities markets

• Has ultimate oversight over financial reporting and auditing for public companies

• Delegates audit standard-setting to the PCAOB

Public Company Accounting Oversight Board (PCAOB)

• Sets auditing, quality control, ethics, and independence standards for public company audits; inspects audit firms

• Overseen by the SEC

American Institute of Certified Public Accountants (AICPA)/Auditing Standards Board (ASB)

• Sets auditing standards for nonpublic entities in the U.S.

• Handles CPA examinations and certifications

International Auditing and Assurance Standards Board (IAASB)

• Sets international auditing and assurance standards

• Issues International Standards on Auditing (ISAs)

Independence Standards Board (ISB)

• Issued standards on independence, but no longer exists

• Independence is governed by PCAOB, SEC, and AICPA

Financial Accounting Standards Board (FASB)

• Sets U.S. financial accounting and reporting standards

• Issues U.S. GAAP

What standards apply to public company audits?

PCAOB (regulated by the SEC) and U.S. GAAP for accounting

What standards apply to nonpublic company audits?

AICPA/ASB (GAAS) and U.S. GAAP for accounting

What are the PCAOB GAAS Standards?

• Independence and Ethics

• Reasonable Assurance

• Due Professional Care

• Professional Skepticism

• Competence

• Audit Documentation

• Fair Presentation

AS 1000: Independence and Ethics

Auditors must be ethical independent in fact and appearance so their opinion is unbiased and objective

AS 1000: Reasonable Assurance

Audits must be planned and performed to obtain reasonable, not absolute, assurance that financial statements are free of material misstatement and also to evaluate internal controls over financial reporting

AS 1000: Due Professional Care

Auditors must exercise professional judgment and care in planning, performing, reviewing, and reporting the audit

AS 1000: Professional Skepticism

Auditors must maintain a questioning mind and critically evaluate audit evidence throughout the audit

AS 1000: Competence

Auditors must have adequate technical training and proficiency to conduct the audit

AS 1000: Proper Documentation

Auditors must prepare and retain documentation that shows who performed the work, what was done, the evidence obtained, and conclusions reached

AS 1000: Fair Presentation

Auditors must evaluate whether the financial statements are presented fairly, in all material respects, in conformity with applicable reporting frameworks.

According to AS 1000, what are the objectives of the auditor?

• Obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud

• Issue an auditor’s report that expresses an opinion about whether the financial statements, taken as a whole, are presented fairly, in all material respects, in conformity with the applicable financial reporting framework

• Communicate externally in accordance with applicable professional and legal requirements

• Satisfy and fulfill the other general principles and responsibilities described in this standard

An auditor has financial interest in a client or provides prohibited non-audit services to them. What auditor responsibility is this violating?

Independence

An auditor fails to design procedures to obtain sufficient appropriate evidence. What auditor responsibility is this violating?

Reasonable Assurance

An auditor ignores conflicting evidence or fails to follow up on risk areas. What auditor responsibility is this violating?

Due Professional Care

An auditor accepts management representations without verification, especially in high-risk areas. What auditor responsibility is this violating?

Professional Skepticism

An auditor performs procedures without appropriate expertise or understanding of complex areas. What auditor responsibility is this violating?

Competence

An auditor is missing or has incomplete documentation, back-dated or altered work papers, and fails to take action. What auditor responsibility is this violating?

Audit Documentation

An auditor issues an unqualified opinion despite known material errors or misleading disclosures. What auditor responsibility is this violating?

Fair Presentation

What are the responsibilities of management regarding financial statements?

• Prepare and fairly present the financial statements in accordance with the applicable financial reporting framework

• Design, implement, and maintain internal control over financial reporting

• Select and apply accounting policies and make accounting estimates

• Prevent and detect fraud within the organization

• Provide auditors with information and access needed to conduct the audit

What are the responsibilities of auditors regarding financial statements?

• Obtain reasonable assurance that the financial statements are free of material misstatement, whether due to error or fraud

• Plan and perform the audit in accordance with auditing standards (PCAOB or GAAS)

• Exercise professional judgment and skepticism throughout the audit

• Obtain sufficient appropriate audit evidence to support conclusions

• Express an opinion on whether the financial statements are fairly presented, in all material respects

Why are auditor ethics and independence critical?

They ensure auditors provide unbiased, credible assurance to the public, reducing information risk and maintaining trust in financial reporting

Independence

A state of objectivity in fact and appearance, including the absence of any significant conflicts of interests

Independence in Mind

The state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment

Independence in Appearance

The avoidance of circumstances that would cause a reasonable and informed third party to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team has been compromised

A person or entity that is bound by independence requirements is called what?

A covered member

Who would be considered a covered member?

a. An individual on the client’s attest engagement team

b. An individual in a position to influence the client’s attest engagement

c. A partner or manager who provides more than 10 hours of non-attest services to the attest

client

d. A partner in the office in which the lead attest engagement partner primarily practices in

connection with the client’s attest engagement

e. The firm, including the firm’s employee benefit plans

f. An entity whose operating, financial, or accounting policies can be controlled by any of the

individuals or entities described in items (a)–(e) or by two or more such individuals or

entities if they act together.

Attest Services Subject to Rule 101 Independence requirements

• Audits

• Financial Statement Reviews

• Examinations of Prospective Financial Information

• Agreed-Upon Procedures

• Other Attestation Services (like internal control reports, compliance, etc.)

How does being hired by management create threats to auditor objectivity and independence?

There are economic and relational pressures that threaten auditor objectivity and independence by reducing professional skepticism and biasing judgment

Why must users perceive auditor independence (in mind and appearance)?

Confidence in the audit depends on reasonable third parties believing the auditor’s objectivity and professional skepticism have not been compromised