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Chapter 2 Notes: The Financial Statement Auditing Environment

The Goal of the Audit

  • The sequence of topics shown: The Goal of the Audit, Management's Assertions, Auditor Evidence, Opinion.
  • Key idea: the audit process culminates in an auditor’s opinion on the financial statements based on evidence gathered to support management’s assertions.

Context: The Financial Statement Auditing Environment (Chapter 2)

  • The material covers the environment surrounding financial statement audits, including regulatory framework, standards, and governance.

The Goal of the Audit (expanded)

  • Purpose: to obtain sufficient appropriate audit evidence to provide an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.
  • Management's Assertions: assertions by management about the recognition, measurement, presentation, and disclosure of information in the financial statements (e.g., existence, completeness, rights and obligations, valuation, accuracy, cutoff, understandability).
  • Auditor Evidence: the information collected by the auditor to support or refute management’s assertions (sufficient and appropriate evidence).
  • Opinion: the auditor’s formal expression about the financial statements (unqualified, qualified, adverse, or disclaimer) based on evidence and GAAP/IFRS compliance.

1930s Regulatory Foundations

  • Securities Act of 1933 and Securities Exchange Act of 1934.
  • Securities and Exchange Commission (SEC) established.
  • Designed to restore _ in capital markets by providing more _ information and clear rules of honest dealing.
  • Purpose: increase investor confidence and market integrity through better information and governance.
  • Note: The fill-in blanks correspond to restoring investor confidence and providing more reliable information, with rules for honest dealing.

Common SEC Filings (SEC Filing Landscape)

  • 10-K: annual report with comprehensive summary of financial performance, risks, and controls.
  • 10-Q: quarterly report with updated financial information and disclosures.
  • 8-K: current report for material events.

Common SEC Filings – Contd. Proxy Statements

  • Proxy Statements provide information to shareholders to vote at the next stockholder’s meeting.
  • They disclose items such as executive compensation, potential related-party transactions, and other governance information (content not exhaustively listed in the transcript).

Regulatory Changes (SOX era onward)

  • 1990s boom and expansion of services (e.g., consulting) by audit firms.
  • High-profile scandals: Enron, Tyco, WorldCom, etc.
  • Public confidence eroded; Arthur Andersen collapsed.
  • Sarbanes–Oxley Act (SOX) 2002: created the PCAOB; expanded internal control audits; strengthened audit committee and auditor independence provisions.
  • Dodd-Frank Act 2010: whistleblower protections; clawback provisions for incentive compensation; enhanced governance and risk management.

SOX (Section 201) – Non-Audit Services Restrictions

  • Major restrictions on non-audit services for external auditors (cannot provide the following and remain the external auditor):
  • - _
  • - financial information system design/implementation
  • - ___ audit
  • - ___ or _____ services
  • - Appraisal or services
  • Context: Pre-SOX cases (e.g., HealthSouth) highlighted conflicts of interest and audit failures; high-profile litigation and penalties followed.
  • Additional anecdote: E&Y faced fees and scrutiny in HealthSouth cases; Richard M. Scrushy implicated; HealthSouth overstated net income 1996–2002 by $2.7B; legal outcomes included acquittals on some charges but later liability in other matters.

SOX – Contd. (Section 101–Section 404)

  • Section 101: Established the (PCAOB) – quasi-government agency overseen by the SEC; inspects public accounting firms and their audits; can discipline firms and employees.
  • Section 203: Audit must rotate off every five years (lead partner rotation is a common interpretation).
  • Section 301: Audit Committee must be and is responsible for hiring/firing __.
  • Section 302: Chief Executive Officer (CEO) and Chief Financial Officer (CFO) certify regarding the financial statements and internal controls; take responsibility for __ (not aware of any false or misleading statements or omissions); disclose changes in ICOFR that materially affect ICOFR.
  • Section 404: Requires internal control (ICFR) report to accompany the annual report; Internal Controls are the responsibility of __; assess the effective design and operation of internal controls; Auditor must attest to management’s assessment.

SOX – Contd. (Section 404 – Contd.)

  • Internal controls must be designed and operating effectively:
  • - Need to be both ____ effectively and _____ effectively.
  • Permanent exemption from 404(b) for (e.g., EGCS under JOBS Act, with 404(b) exemptions commonly noted for Emerging Growth Companies).
  • Public Float is defined as share price × shares available for public trading.
  • Public Float = ext{Public Float} = ext{share price} imes ext{shares available for public trading}

Filer Status Summary (Table 2-2 highlights)

  • Entry thresholds for filer status categories used to determine ICFR attestation requirements and Form 10-K/10-Q filing deadlines.
  • Categories include: SRC/non-accelerated, SRC/accelerated, Accelerated (not SRC), Large accelerated filer, and EGCS exemptions.
  • Key relationships:
  • - Public float and annual revenues determine required ICFR attestation.
  • - 10-K due dates: typically 90 days for larger filers; 10-Q due dates vary (e.g., 45 days).
  • - EGCS exemption: Emerging Growth Companies are exempt from the auditor attestation requirement of Section 404(b) even if accelerated filers.
  • Note on table formatting: Some numeric thresholds in the transcript are garbled; the intended structure is a tiered set of categories with corresponding ICFR attestation requirements and due dates.

Context of Financial Statement Auditing

  • The auditor is concerned with the client’s industry and business context.
  • Every business is different; the auditor must adapt to specific __ for each client.
  • Fill: circumstances (or similar context-specific factors).

Corporate Governance (Examples)

  • Example statements from 3M and Caterpillar illustrate governance principles:
    • 3M: governance framework defines the roles, rights, and responsibilities of different groups within the organization.
    • Caterpillar: governance ensures we serve stockholders and other stakeholders with high standards of responsibility, integrity, and compliance with laws.
  • Key governance entities:
    • Board of Directors
    • Audit Committee
    • Management
  • Purpose: align objectives/strategies with business processes and the design of internal controls/accounting information systems.

Standard Setting Organizations

  • AICPA (private organization) and its Auditing Standards Board (ASB) – sets SASs (now AU-C sections) for nonpublic entities (universities, states, school districts, etc.).
  • SEC (government) and PCAOB (quasi-government) – post-2003, PCAOB issues its own Audit Standards (AS) for public companies; initially adopted ASB standards existing as of April 2003.

Other Standard Setting Organizations

  • IAASB (International Auditing and Assurance Standards Board) – issues International Standards on Auditing (ISA).
  • FASB – sets U.S. GAAP standards for financial accounting and reporting.
  • IASB – issues IFRS (International Financial Reporting Standards).

General Standards (PCAOB GAAS) – Table 2-2

  • General Standards:
    1) The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor.
    2) In all matters relating to the assignment, independence in mental attitude is to be maintained by the auditor or auditors.
    3) Due professional care is to be exercised in the performance of the audit and the preparation of the report.
  • Standards of Field Work:
    1) The work is to be adequately planned and assistants, if any, are to be properly supervised.
    2) A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed.
    3) Sufficient appropriate evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.
  • Standards of Reporting: 1) The report shall state whether the financial statements are presented in accordance with GAAP. 2) The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period. 3) Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report. 4) The report shall contain either an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. If an overall opinion cannot be expressed, the reasons should be stated. When an auditor’s name is associated with financial statements, the report should contain a clear indication of the character of the auditor’s work and the degree of responsibility the auditor is taking.
    • Page reference: 2-16

PCAOB GAAS Shortcuts (Study Aid)

  • Shortcut for PCAOB GAAS:
    • Standards: 1) Training and proficiency 2) Independence in mental attitude 3) Due professional care.
  • Standards of Field Work: 4) Planning and supervision 5) Understanding of internal control and determine nature, timing, and extent of audit tests 6) Obtain sufficient appropriate evidence.
  • Standards of Reporting: 7) State whether financial statements are in accordance with GAAP 8) GAAP applied consistently (only report if not consistent) 9) Adequacy of disclosures (only report if not adequate) 10) Express or disclaim an opinion.

Due Professional Care and Professional Skepticism

  • Due professional care: Auditor plans and performs the work with the knowledge and skill expected of an accounting professional.
  • Professional skepticism: Not merely “being skeptical” is insufficient; it is an attitude with a questioning mind and a critical assessment of evidence.
  • You are expected to maintain professional skepticism in challenging evidence and representations.
  • Areas requiring heightened skepticism:
    • Significant accounting estimates
    • Transactions outside the ordinary course of business or outside the normal course of operations
    • Possible misstatements or fraud indicators

Auditor Ethics

  • Ethics: A system or code based on moral duties and obligations that guide behavior.
  • Professionalism: Conduct, aims, or qualities that characterize a profession or professional person.
  • Independence: State of objectivity in fact and in appearance, including the absence of significant relationships or conflicts of interest.
  • Public trust: If the public has doubts about the auditor’s integrity and objectivity, it undermines the value of the audit.

Public Accounting Firms (Big Four and Others)

  • Big 4 firms:
    • PricewaterhouseCoopers (PwC)
    • Deloitte
    • KPMG
    • Ernst & Young (EY)
  • Other firms (international/national): Grant Thornton, RSM McGladrey, BDO Seidman, Forvis, Mazars, Eide Bailly

Audit Teams – Selected Duties by Role

  • Partner:
    • Reaching agreement with the client on the scope of services
    • Ensuring the audit is properly planned
    • Ensuring the audit team has required skills and experience
  • Manager:
    • Supervising the audit team and reviewing working papers
    • Concluding on adequacy of audit evidence and signing the audit report
    • Planning and scheduling the audit; approval of audit program; reviewing financial statements and audit report; invoicing and collections
  • Senior/In-charge:
    • Informing the partner about auditing/accounting problems
    • Assisting in development of the audit plan; preparing budgets
    • Assigning tasks to associates; directing day-to-day performance
  • Associate/Staff:
    • Supervising/Reviewing work of associates
    • Informing the manager about problems; performing audit procedures
    • Preparing adequate documentation; informing the senior about problems

Types of Auditors

  • External Auditors: perform procedures to help ensure that financial statements are fairly presented and free of material misstatement.
  • Internal Auditors: conduct financial and operational audits; their work can help improve internal controls and governance.
  • Government Auditors: help ensure compliance with government rules and regulations.
  • Forensic Auditors: investigate financial crimes and gather evidence to convict someone of fraud.