Auditing Midterm 1

What is an audit?

Accumulation and evaluation of evidence to give reasonable assurance that the F/S are materially accordance w/ GAAP

Why do we need audits?

• For shareholders/creditors can rely on info

• Examine internal controls

• Assess validity of assumptions

• Going concern assessment

• SEC publicly traded required

• Nonprofits/grants must meet a threshold

• IPOs

What is assurance?

Independent professional services that improve the quality of information for decision makers

What is an attestation service?

Where a CPA firm issues a written opinion about reliability of an assertion of another party

Some causes of information risk

• Remoteness of information: Where is user of F/S in relation to the company?

• Biases/motives of provider: Person providing information may be biased

• Voluminous data: Large organizations have high volume of transactions that increase the chance of mistakes

• Complex transactions: Accounting transactions are often complex & difficult to record properly

Types of audits

• Financial statement: External F/S

• Operational: Evaluate efficiency & effectiveness

• Compliance: Examines whether client follows specific rules & regulations

Types of auditors

• Certified public accountants: external from company being audited

• Internal revenue agents: IRS tax return audits

• Government auditors: Work for state or federal government

CPA Requirments

• Education: Varies by state, can range 4-5 years

• Experience: Varies by state, ranges from 1-3 years

Types of CPA firms

• “The Big Four”: international firms

• National: Across all states but not as large

• Regional: Across multiple states, but not all

• Local: Stay within one state

Types of services

• Attestation (Audits, reviews)

• Accounting and bookkeeping (Compilations)

• Tax (Individuals, corporations, and partnerships)

• Management advisory services (consulting)

Audit vs Review

Audit examines original documentation and provides high level of assurance and reviews are oral inquiry and analytical procedures which provides less assurance

Typical CPA structure

• Partners (shareholders)

• Principals (some firms)

• Managers (oversee audits with 5+ years of experience)

• Seniors (oversee field work performed at client location 2-3 years of experience)

• Assistants/Associates (0-2 years of experience)

Sarbanes-Oxley and the PCAOB (Public Company Oversight Board)

• SEC established PCAOB in 2002

• PCAOB is overseen by the SEC

• Provide oversight for public company audits

American Institute of Certified Public Accountants (AICPA)

• For all non publicly traded companies including government and non profit

• Standard settings

• CPA exam preparation and grading

Standard Setting by AICPA

• Auditing standards-Statements on Auditing Standards (SAS)

• Compilation and review standards-Statements on Standards for Accounting and Review Services (SSAR)

• Code of Professional Conduct

Authoritative Literature (AICPA/PCAOB/SAS)

• Both issue professional guidelines which CPAs must follow AICPA for non public and PCAOB for public companies

• International Standards on Auditing apply only to entities outside the US (most standards are similar to those in US)

Principles Underlying an Audit (Purpose, responsibilities, performance, reporting)

• Purpose of an audit: Provide F/S users with an opinion on whether F/S are fairly presented

• Responsibilities: 1. Appropriate competence and capabilities, 2. comply with relevant ethical requirement, 3. maintain professional skepticism and judgement

• Performance: Relate to evidence accumulation

• Reporting: express opinion on F/S in a written report

What does Appropriate competence and capabilities encompass? (responsibilities of audit)

• Formal education and training, including CPE (Continuing Professional Education)

• Technical qualifications and appropriate experience in client’s industry

What does comply with relevant ethical requirements encompass? (responsibilities of audit)

AICPA code of professional conduct particularly independence

What does maintain professional skepticism and exercise professional judgement encompass? (responsibilities of audit)

Auditors must have a “healthy skepticism” aka a questioning mind

4 Factors of performing an audit

• Adequate planning and supervision: planning can be complex and time consuming+supervision is critical due to assistant’s lack of experience)

• Determine and apply materiality levels: Auditor responsible for determining and applying appropriate materiality levels throughout the audit

• Assess risks of material misstatement: Understanding client’s business & industry and assessing client’s internal controls

• Sufficient appropriate evidence: auditor must obtain enough good quality evidence about whether material misstaement exist

Four Categories of audit reports

• Unmodified (aka unqualified)

• Unmodified with an explanatory paragraph or modified wording

• Qualified

• Adverse or disclaimer

Elements of the standard unmodified report (AICPA-non public companies) 8 things

• Report title: must include the word “independent”

• Audit report address: Usually to board of directors, company, or stockholders (could be different for govt or NPF)

• Opinion Section: Heading opinion is first due to is importance

• Basis for opinion

• Management’s responsibility section

• Auditor’s Responsibility: Must include: “auditor’s responsibilities for the audit of the F/S”

• Name and address of the CPA firm

• Audit report date: Last day of field work and indicates last day of auditor’s responsibility for review of “subsequent events”

Things within the opinion section (Elements of standard unmodified AICPA)

• Introductory paragraph: Makes a statement that the CPA has a performed an audit and lists financial statements audited and time period audited

• Opinion paragraph: states auditors’s conclusions based on audit results

• Present fairly to GAAP

Things within the Basis for opinion section (Elements of standard unmodified AICPA)

• States the audit was conducted in accordance with GAAS

• Provides statements that auditors are: 1. Independent of the company and fulfilled pro ethics responsibilities 2. auditor believes sufficient evidence is collected

Things in the Management’s responsibility section (Elements of standard unmodified AICPA) 4 things

• Heading and pp state that F/S are the responsibility of management

• Responsible for maintaining I/C over financial reporting

• F/S are free from material misstatement

• Required to evaluate whether there is substantial doubt about the ability to continue as a going concern

Things in the auditor’s responsibility section (Elements of standard unmodified AICPA) 3pp

• First pp states the audit is designed to obtain reasonable assurance and F/S are free from material misstatement

• Second pp is the scope pp and describes the scope of the audit and evidence accumulated. 1. Auditor uses professional judgement 2. identifies risk of material misstatement 3. auditor considers internal controls 4. evaluates accounting policies and significant estimates and assesses going concern

• Third pp indicates auditor communicates with those charged with governance the scope of the audit and significiant findings

Why does the audit report lag vary?

• How fast management is providing info

• Complexity of the audit

• Found problems

• Size of the audit firm

• Natural disasters

• Staff turnover

Elements of standard unmodified report (Public company audits)

• Report title

• Audit report address

• Opinion section (still first)

• Basis for opinion section (no sep sections for auditor and management responsibilities)

• Critical audit matters section

• Name of CPA firm and how long they’ve been auditing

• Audit report date

These 4 conditions must be met in order to use a standard unmodified audit report

• All financial statements and required disclosures are included (BS, IS, Cash flows, SSE, including footnotes)

• Sufficient appropriate evidence has been collected and audit was performed in accordance with auditing standards

• Financial statements are fairly presented, materially in accordance with GAAP

• There are no circumstances requiring the addition of an explanatory paragraph or modification of the report’s wording

SOX section 404 (Public companies)

• Combined reports on F/S and I/C

• Requires auditors of public co’s to attest to management’s report on I/C over financial reporting

• Auditor can issue separate reports or combine them

Audits in accordance with US and International audit standards (ISA’s)

The scope pp is modified to indicate the audit is in accordance with both auditing standards in the US and ISA’s.

Two forms of unmodified reports with explanatory paragraph

Emphasis-of-Matter paragraph and the Other-Matter paragraph

Reasons for the Emphasis of Matter pp 4 things

• Lack of consistent application of GAAP: 1. Is the CY consistent with the PY? 2. If change in accounting principle/method

  • Consistency is auditor responsibility and comparability is client responsiblity

• Substantial doubt about going concern: will the company continue in the foreseeable future?

• Auditor agrees with a departure from promulgated accounting principles (rare): violating GAAP but it’s ok

• Emphasis of other matters: Want to bring certain info to F/S users attention

Reasons for Other-Matter paragraph

When CPA relies on another CPA firm to perform part of the audit. The principal auditor can do 3 things:

1. Modify two paragraphs of the standard unmodified report “shared report”

2. Make no reference to the other auditor, principal CPA takes full responsibility

3. Issue qualified opinion or disclaimer depending on materiality (when other auditor’s work includes material misstatement

3 Conditions requiring a departure from an unmodified audit report or unmodified with explanatory pp wording

• Scope limitation: Restriction imposed by client (ie. client refuses to give supports) and circumstances beyond anyone’s control (ie. natural disasters)

• Financial statements are not prepared according to GAAP (GAAP departure or violation)

• Auditor is not independent

Qualified Audit report

• Can only be issued if the auditor believes financial statements are fairly stated but must use the term “except for”

• Issued under two conditions

  • Scope limitation: qualify both the opinion and basis for opinion sections

  • GAAP violation: qualify the opinion section only

Adverse

Auditor has knowledge that financial statements are so materially misstated that they do not fairly present client’s financial position

Disclaimer

Auditor is unable to be satisfied that overall financial statements are fairly presented. Lack of knowledge on auditor’s part su auditor is not rendering a position

Levels of materiality effect on type of report issued

Immaterial: Unmodified report

Material: Qualified report

Highly Material: Adverse or disclaimer

Exception: Lack of independence requires disclaimer regardless of materiality

Difference between AICPA, PCAOB, and SEC

• AICPA provides standards of conduct for all public & private companies

• PCAOB establishes ethics and independence standards for auditors of public companies

• SEC establishes independence standards for auditor of public companies

Rule 101

• AICPA rule on independence

• Rule applied to people on the engagement and people in a position to influence the engagement

• Taking an unbiased attitude in conducting your work

• Independence in fact and appearance

• Prohibits direct investments in audit clients

Why are CPA’s concerned with ethics?

• Many people rely on their work

• Regulations and laws require audits

• CPA's learn confidential information

Interpretations of Rule 101 Financial interests

1. Direct financial interests: Ownership of stock by members of immediate family materiality doesn’t matter (spouse, dependent children, or relatives supported by CPA)

2. Indirect financial interests: Close but not direct ownership between CPA and client. Must be material to close relative to be independence problem (Parents, siblings, non dependent children

Interpretations of Rule 101 Loans

Loans: Loans between CPAs and clients are not allowed except if existing prior to the audit

Interpretations of Rule 101 Family member’s employment

Family member’s employment: Independence impaired if immediate or close family member holds a key position that may affect accounting function

Interpretations of Rule 101 Board of Directors

Board of Directors: CPAs are allowed to conduct audits and hold honorary positions as directors of nonprofits but never ok for for-profit

Interpretations of Rule 101 Litigation

1. Litigation: Lawsuits or threats between CPA firm and client

2. Bookeeping services

3. Other consulting: Permissible as long as CPA doesn’t make management decisions

4. Unpaid fees: Independence is impaired if the fees remain unpaid for more than 1 year except if client is bankrupt

Rule 101 3 requirements for bookkeeping for same client

1. Client accepts responsibility for F/S

2. CPA can’t make management decisions or perform management functions

3. CPA must conform to auditing standards

Rule 301

• AICPA rule on confidential client information

• Members in public practice can’t disclose any client information without client consent

• Applies to all services, including tax and advisory

• Exceptions: Workpapers are subpeonaed, used in peer review process, and used to respond to an AICPA ethics complaint

Rule 302

• AICPA rule on contingent fees

• Contingent fees are not allowed for attestation services, tax return fees based on outcome, and non attestation services if CPA is already performing attestation service

Rule 501

• AICPA rule on acts discreditable (ethical rule that prohibits CPA from harming accounting profession)

• Retention of client records

• Discrimination

• Negligence in preparation of F/S: Leading to materially false F/S

• Solicitation or disclosure of CPA exam questions

• Failure to file tax return

Rule 502

• AICPA rule on advertising and other forms of solicitation

• False or misleading advertising is not allowed

Rule 503

• AICPA rule on commissions and referral fees: compensation paid for recommending or referring a 3rd party service to a client or client services to a 3rd party

• If attestation services are performed for client none are allowed

• If non attestation it is allowed but must be disclosed to client

• Referral fees is allowed but must be disclosed to the client

Rule 505

• AICPA rule on form of organization and name

• Form of organization must be permitted by state law

• Ownership of CPA firms by non CPA firms is okay under conditions

  • CPAs own majority of firm

  • CPA has ultimate authority for attestation and compilation engagements

• Any firm name permissible as long as it is not misleading

• Firm can designate members of AICPA only if all owners are members

• Acquisition of CPA firms by corporate entities allowed if they own the non attest side of services

• Failure to follow results in expulsion from AICPA for extreme cases and additional CPE for less serious cases

• State boards can grant/revoke license to practice

What services are not allowed under PCAOB rules?

• Bookkeeping

• Financial information systems design and implementation

• Appraisal or valuation system

• Internal audit outsourcing

• Management and HR function

• Actuarial services

• Broker, investment advisor, and investment banker

• Legal and expert services unrelated to audit

Audit Committees rule

• PCAOB Rule

• Audit committee members must be independent

• Companies must disclose whether the audit committee includes at least one financial expert

Employment of former Auditors rule

• PCAOB rule

• Members of an audit engagement have to wait one year before working for the client in certain important management positions (CEO, CFO, CAO)

• If violated then CPA firm cannot continue auditing the client

Mandatory Partner rotation rule

• PCAOB Rule

• Lead audit partner has to rotate off the engagement every five years

Pros and cons of audit firm providing non attest services

Pros:

• Very familiar with client + increase quality

• Easier to obtain support if you have stronger relationship with them

• SEC study shows audit quality is higher when firms do audit and advisory

Cons:

• Conflict of interest

• More inclined to give unmodified opinion that wasn’t warrented

• Advisory services can be higher margin and garner a high % revenue which pressures the firm

Pros and cons of Private Equity buying the firm

Pros

• Provides a cash infusion into the firm

• Helps CPA firm keep up with new tech

• Retain partnership model to help maintain independence

Cons

• PE can have ties to other businesses

• Independence in appearance is negatively affected

• Don’t really distinguish the physical separation

• PE issue debt often to finance investment which places pressure on the whole firm