C HAPTER 1

AUDITING AND THE PUBLIC ACCOUNTING PROFESSION INTEGRITY OF FINANCIAL REPORTING

Learning Check
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Several common attributes of activities defined as auditing are (a) systematic process, (b) objectively obtaining and evaluating evidence, (c) assertions about economic actions and events, (d) degree of correspondence, (e) established criteria, (f) communicating the results, and (g) interested users. A financial statement audit involves obtaining and evaluating evidence about an entity's financial statements for the purpose of e pressing an opinion on !hether the statements are presented fairly in conformity !ith established criteria""usually #AA$. %hus, the nature of the auditor's report is an opinion on the fairness of the financial statement presentation. A compliance audit involves obtaining and evaluating evidence to determine !hether certain financial or operating activities of an entity conform to specified conditions, rules, or regulations. A report on a compliance audit ta&es the form of a summary of findings or assurance regarding degree of compliance. An operational audit involves obtaining and evaluating evidence about the efficiency and effectiveness of an entity's operating activities in relation to specified objectives. 'eports on such audits include an assessment of efficiency and effectiveness and recommendations for improvements. Independent auditors are individual practitioners or members of public accounting firms !ho render professional auditing services to clients. %hese services may involve financial statement audits, compliance audits, and operational audits. Internal auditors are employees of the companies they audit. %hey are involved in an independent appraisal activity, called internal auditing, as a service to the organi)ation. *nternal auditors are primarily concerned !ith compliance and operational audits. Government auditors are employed by various local, state, and federal governmental agencies. %hey may be involved in all three types of audits. a. %he financial statement audit is a form of an e amination engagement in !hich the auditor provides reasonable assurance that the financials statements are free of material misstatement. %he ,$A might also perform an engagement to e amine a forecast or a projection in !hich the auditor provides reasonable assurance that the forecast or projection reflects the underlying assumptions and that there is support reasonable for the underlying assumptions. A ,$A might also perform an engagement to e amine an

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assertion regarding compliance !ith la!s or regulations in !hich the auditor provides reasonable assurance that the entity complied !ith la!s or regulations. b. A revie! of financial statements is an engagement in !hich the ,$A provides negative assurance that he or she is not a!are of any material modifications that need to be made to the financial statements in order for them to be in conformity !ith #AA$.

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Accounting and compilation services provide financial statement users and decisions ma&ers !ith relevant information. .o!ever, they are not designed to test the reliability of such information. %he primary benefit received is information that may be relevant to a decision, even though evidence is not obtained about the reliability of such information. %he follo!ing table summari)es several assurance services provided by ,$As and e plains the ho! they improve the relevance or reliability of information used by decision ma&ers. Assurance Service .o! the service improves the relevance or reliability of information used by decision ma&ers $rovides relevant information to management or the board of directors about business ris&s faced by an entity. *t ma also provide information about the reliability of management0s system for identifying and monitoring business ris&s. $rovides relevant financial and nonfinancial information to management or the board of directors about the entity0s performance. *t ma also provide information about the reliability of management0s system for monitoring the entity0s performance.

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,$A 'is& Advisory

,$A $erformance 1ie!

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a. %he audit provides reasonable assurance that financial statement information is free of material misstatements. 3ecision ma&ers can uses financial information to anticipate business opportunities and to ma&e business decisions based !ith reasonable assurance that the information set used to ma&e decisions is reliable. b. A revie! of financial statements provides less assurance about the reliability of financial information than that provided by an audit. %he ,$A provides negative assurance that he or she is not a!are of any material modifications that need to be made to the financial statements in order for them to be in conformity !ith #AA$. %his service is focused on both the relevance and reliability of information used by decision ma&ers. A compilation does not provide assurance about the reliability of financial statement information used by decision ma&ers. .o!ever, a compilation service may provide decision ma&ers !ith relevant information that they !ould not other!ise have.

c. %he ,$A ris& advisory service may transform comple information into &no!ledge by helping management better understand business ris&s. %he ,$A ris& advisory service may also provide assurance about the reliability of information produced by management0s system of evaluating business ris&s.

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%he origin of the company audit as !e &no! it can be lin&ed to 5ritish legislation during the industrial revolution in the mid"1466s. 7ne or more stoc&holders designated by other stoc&holders initially performed company audits, but subse8uent revisions in the legislation permitted the use of outside independent auditors, giving rise to the formation of auditing firms. %he focus of these early audits !as on finding errors in the balance sheet accounts and stemming the gro!th of fraud associated !ith the increasing phenomenon of professional managers and absentee o!ners. Several important milestones in the rise of the 9.S. profession !ere (1) the passage of legislation (2) the stoc& mar&et crash of 1:2: !hich dre! attention to deficiencies in financial reporting and produced a challenge to the accounting profession to provide stronger leadership, (() adoption of a re8uirement by the ;e! <or& Stoc& = change in 1:(( that all listed corporations obtain an audit certificate from an independent ,$A, and (+) passage of the Securities Act of 1:(( and the Securities = change Act of 1:(+ !hich added to the demand for audit services for publicly o!ned companies. %hree important changes in audit practice that evolved by the 16+6s !ere (1) a shift from detailed verification of accounts to sampling or testing as the basis for rendering an opinion on the fairness of financial statements, (2) development of the practice of lin&ing the testing to be done to the auditor's evaluation of a company's internal controls, and (() deemphasis of the detection of fraud as an audit objective. *n recent years, the profession has come under increasing pressure to reverse the deemphasis on detecting fraud as the public's e pectation that the auditor !ill detect fraud persists. %he 8uality of audits !as 8uestioned !hen a series of restatements of earnings from public companies such as Sunbeam, >aste ?anagement, @ero , Adelphia, =nron and >orld,om brought about a crisis of confidence in the !or& of auditors. 5y 2662 the collapse of =nron and >orld,om led ,ongress to pass the Sarbanes"7 ley Act of 2662. %his act created the $ublic ,ompanies Accounting 7versight 5oard ($,A75) and gave it responsibility for setting auditing, ethics, independence, and 8uality control standards for audits of public companies.

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Aour factors that contribute to the need for independent audits are (a) conflict of interest, (b) conse8uence, (c) comple ity, and (d) remoteness. ,ollectively these factors contribute to information ris&.

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Ainancial statement audits enable companies to (a) meet statutory and other regulatory re8uirements that must be satisfied in order to gain access to capital mar&ets, (b) obtain debt

and e8uity financing at a lo!er cost of capital, (c) deter inefficiency and errors in the accounting function and reduce the ris& of fraud in the accounting and financial reporting process, and (d) ma&e internal control and operational improvements based on suggestions made by the auditor as a by"product of the audit.

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%he limitations of a financial statement audit include the fact that an auditor !or&s !ithin fairly restrictive economic limits that impose time and cost constraints and necessitate the use of selective testing or sampling of the accounting records and supporting data. Also, the auditor's report must usually be issued !ithin three months of the balance sheet date, !hich affects the amount of evidence that can be obtained. %he availability of alternative accounting principles permitted under #AA$, and the impact of accounting estimates and uncertainties on the financial statements represent additional inherent limitations on financial statement audits. Si public sector organi)ations include (1) the Securities and = change ,ommission, (2) state boards of accountancy, (() the 9.S. #eneral Accounting 7ffice, (+) the *nternal 'evenue Service, (-) state and federal courts, and the 9.S. ,ongress. Aive private sector organi)ations associated !ith the public accounting profession include (1) the $ublic ,ompanies Accounting 7versight 5oard, (2) the American *nstitute of ,ertified $ublic Accountants, (2) State Societies of ,ertified $ublic Accountants, (+) $ractice 9nits (,$A firms), and (-) Accounting Standard Setting 5odies "" principally the Ainancial Accounting Standards 5oard (AAS5) and #overnmental Accounting Standards 5oard (#AS5). %he Securities and = change ,ommission regulates the distribution of securities offered for public sale and subse8uent trading of securities on stoc& e changes and over"the"counter mar&ets. %he S=, also has the authority to establish #AA$ for companies under its jurisdiction, and it currently recogni)es the pronouncements of the AAS5 as constituting #AA$ in the filing of financial statements !ith the agency. *n some instances, ho!ever, the S=,0s disclosure re8uirements e ceed #AA$. Ainally, the S=, also e erts considerable influence over auditing profession. %he Sarbanes"7 ley Act of 2662 established a private sector, $ublic ,ompanies Accounting 7versight 5oard to oversee the audit of public companies that are subject to securities la!s. %he $,A750s rulema&ing process results in proposals that do not ta&e effect until the S=, approves them. a. %he $,A75 has authority in five major areas (1) registering public accounting firms that audit the financial statements of public companies, (2) setting 8uality control standards for peer revie! of auditors of public companies and conducting inspections of registered public accounting firms, (() setting auditing standards for audits of public companies, (+) setting independence and ethics rules for auditors of public companies, (+) performing other duties or functions to promote high professional standards for public company audits, and enforce compliance !ith the Sarbanes"7 ley Act of 2662. b. %hree important A*,$A divisions, or teams, that have a direct impact on auditors are (1) the A*,$A $ractice ?onitoring $rogram is responsible for 8uality control standards and peer revie!s of firms that provide assurance services to private companies, (2) the Auditing and Attest Standards %eam sets auditing and attest standards for audit,

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accounting, and revie! services provided to private companies, and (() the $rofessional =thics 3ivision is responsible for setting and enforcing the A*,$A ,ode of $rofessional ,onduct.

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A ,$A firm may be organi)ed as a proprietorship, partnership, $rofessional ,orporation, or any other form of organi)ation permitted by state la! or regulation (including limited liability partnerships (BB$s) and limited liability corporations (BB,s)). ,$A firms are often classified into the follo!ing four groupsC (1) 5ig Aour, (2) Second %ier, (() 'egional, and (+) Bocal. %he purpose of the profession's multilevel regulatory frame!or& is to help assure 8uality in the performance of audits and other professional services. %he four components of the profession's multilevel regulatory frame!or& areC

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Standard"setting. %he private sector establishes standards for accounting, auditing, ethics, and 8uality control to govern the conduct of ,$As and ,$A firms. Airm regulation. =ach ,$A firm adopts policies and procedures to assure that practicing accountants adhere to professional standards. Self"or peer regulation. %he A*,$A has implemented a comprehensive program of self"regulation including mandatory continuing professional education, peer revie!, audit failure in8uiries, and public oversight. #overnment regulation. 7nly 8ualified professionals are licensed to practice, and auditor conduct is monitored and regulated by state boards of accountancy, the S=,, and the courts.

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%he five elements of 8uality control are (1) independence, integrity and objectivity, (2) personnel management, (() acceptance and continuance of engagements, (+) engagement performance, and (-) monitoring. a. %he &ey elements of the $,A75 inspection program includesC *nspecting and revie!ing selected audit and revie! engagements of the firm. =valuating the sufficiency of the firm0s 8uality control systems and the firm0s documentation and communication of that system. $erforming such other testing of the audit, supervisory, and 8uality control procedures of the firm as are necessary or appropriate in light of the purpose of the inspection and the responsibilities of the board.

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%he $,A75 conducts annual inspections of firms that regularly provide audit reports for over 166 public companies. %he $,A75 inspects the 8uality control activities of firms that provide audit reports for 166 or fe!er public companies every three years. b. %he purpose of the A*,$A practice monitoring (peer revie!) program is toC 3etermine that a firm0s system of 8uality control for its accounting and auditing practice has been designed in accordance !ith 8uality control standards established by the A*,$A. 3etermine that a firm0s 8uality control policies and procedures !ere being complied !ith to provide the firm !ith reasonable assurance of conforming !ith professional standards. 3etermine that a firm has demonstrated the &no!ledge, s&ills, and abilities necessary to perform accounting, auditing, and attestation engagements in accordance !ith professional standards, in all material respects..