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Chapter2

Corporate
Governanceand
Audits

Copyright 2012 South-Western/Cengage Learning


AuditOpinionFormulationProcess
LO1:CorporateGovernance
Aprocessbywhichtheownersand
creditorsofanorganizationexertcontrol
andrequireaccountabilityforthe
resourcesentrustedtotheorganization.
Theowners(stockholders)electaboard
ofdirectorstoprovideoversightofthe
organizationsactivitiesand
accountabilitytostakeholders
Primarypartiesinvolvedin
corporategovernance
Stockholders
BoardsofDirectors
AuditCommitteeasasubcommitteeoftheBoard
Management
InternalAuditors
SelfRegulatoryAccountingOrganizations(e.g.AICPA,
FASB)
OtherSelfRegulatoryOrganizations(e.g.NYSE,NASD)
RegulatoryAgencies(e.g.SEC,FDIC,Environmental
ProtectionAgency)
ExternalAuditors
OverviewofCorporate
Governance
LO2:PrinciplesofGoodCorporate
Governance
Theboardsfundamentalobjectiveshouldbetobuildlong
termsustainablegrowthinshareholdervalueforthe
corporation
Successfulcorporategovernancedependsuponsuccessful
managementofthecompany,asmanagementhastheprimary
responsibilityforcreatingacultureofperformancewith
integrityandethicalbehavior
Goodcorporategovernanceshouldbeintegratedwiththe
companysbusinessstrategyandnotviewedassimplya
complianceobligation
PrinciplesofGoodCorporate
Governance
Transparencyisacriticalelementofgoodcorporate
governance,andcompaniesshouldmakeregulareffortsto
ensurethattheyhavesounddisclosurepoliciesandpractices
Independenceandobjectivityarenecessaryattributesofboard
members;however,companiesmustalsostriketheright
balanceintheappointmentofindependentandnon
independentdirectorstoensureanappropriaterangeandmix
ofexpertise,diversity,andknowledgeontheboard
LO3:EventsoftheLast
Decade
Thefirstdecadeofthetwentyfirstcenturyhasseenmore
changesincorporategovernancethanatanytimesincethe
GreatDepression
Therewasincrediblevolatilityinthefinancialmarkets
beginningin2000,leadingtothefinancialcrisisandrecession
hittingthemarketsin2008and2009,andcontinuingintothe
nextdecade
Therewerealsoanumberoffinancialfailurese.g.,Enron
andWorldComwhichrepresentedfundamentalbreakdowns
inthestructureofcorporategovernanceandinvolvedmany
parties
EventsoftheLast
Decade
Thecorporategovernancefailureswerebroadandanumberof
differentpartiescontributedtothosefailures
Therewasmuchfingerpointingattheauditingprofessionfor
itsfailures
Practicingprofessionalsshouldplacethepublicinterest
abovetheinterestsofclients,particularlywhenparticipating
inaprocessdesignedtodevelopstandardsexpectedtoachieve
fairpresentation.Unfortunately,theauditortodayisoftena
participantinaggressivelyseekingloopholes
SECConcern
TheSECwasincreasinglyconcernedwithwhatitviewedasa
declineinprofessionalismandcitednumerousinstancesin
whichtheaccountingthathadbeencertifiedbypublic
accountingfirmsdidnotreflecteconomicreality,although
theymightbeinaccordancewithGAAP
Cookiejarreservestomanageearnings
Improperrevenuerecognition
Creativeaccountingformergersandacquisitionsthatdidnotreflect
economicreality
Increaseduseofstockbasedcompensationthatputincreasedpressure
onmeetingearningstargets
PublicOversightBoard(POB)
Concerns
Analyticalproceduresusedinappropriatelytoreplacedirect
testsofaccountbalances
Auditfirmsnotthoroughlyevaluatinginternalcontroland
applyingsubstantiveprocedurestoaddressweaknessesin
control
Auditdocumentation,especiallyrelatedtoauditplanning,did
notmeetprofessionalstandards
Auditorsignoredwarningsignsoffraudandotherproblems
Auditorswerenotprovidingsufficientwarningtoinvestors
aboutcompaniesthatmightnotcontinueasgoingconcerns
LO4:TheSarbanes/OxleyActof
2002
WaspassedbyCongressinresponsetomassive
accountingscandals
Significantprovisionsinclude:
EstablishesthePublicCompaniesAccountingOversight
Board(PCAOB)withbroadpowers,includingthepowerto
setauditingstandardsforauditsofpubliccompanies
RequirestheCEOandCFOcertifythefinancialstatements
Requirescompaniestoprovideacomprehensivereporton
internalcontrolsoverfinancialreporting
TheSarbanes/OxleyActof2002
(continued)

Requirescompaniestocertifycorrectnessoffinancial
statementsqualityofitsinternalcontrols
AuditCommitteesgivenexpandedpowersasthe
auditclientandmustpreapproveanynonaudit
servicesbyitsexternalauditors
AuditCommitteesmustreporttheiractivitiestothe
public
AuditCommitteesmusthaveatleastonepersonwho
isafinancialexpert.Othermembersmustbe
knowledgeableinfinancialaccountingandcontrol
TheSarbanes/OxleyActof2002
(continued)

Auditengagementpartners,aswellasotherpartnersand
managerswithsignificantrolesintheaudit,mustbe
rotatedofftheengagementeveryfiveyears
Acoolingoffperiodbeforeanauditpartneror
managercantakeahighlevelpositionwithanaudit
clientwithoutjeopardizingtheindependenceofthe
publicaccountingfirm
Increaseddisclosureofoffbalancesheettransactions
oragreementsthatmayhaveamaterialeffectRequires
theGAOtostudyanumberofissuesincludingtheeffect
ofconsolidationoncompetitionwiththeaccounting
profession,andananalysisofmandatoryauditfirm
rotation
ThePCAOB
Sarbanes/OxleygrantedthePCAOBbroad
authorityincludingthepowersto
SetauditingstandardsthePCAOBhaschosento
setauditingstandards
SetfinancialaccountingstandardsthePCAOBhas
chosentolettheFASBcontinuetosetaccounting
standards
Setstandardsforthereportsoninternalcontroland
riskmanagement
Performqualityreviewsofpublicaccountingfirms
andrecommendpenaltiesifthefirmsfailtoperform
ThePCAOB(continued)
Establishqualitycontrolstandardsfortheauditsof
publiccompanies
Requireallpublicaccountingfirmsthataudit
publiccompaniestoregisterwiththePCAOBand
becomelicensedtoperformsuchaudits
StockExchangeListing
Requirements
Boardsneedtoconsistofamajorityofindependentdirectors
Boardsneedtoholdregularexecutivesessionsofindependent
directorswithoutmanagementdirectorspresent
Certaincommitteesoftheboard(nominating/governance,
compensation,audit)needtopublishcharters
CEOsneedtoprovideanannualcertificationofcompliance
withcorporategovernancestandards
Websitedisclosureofspecificcorporategovernanceissues
DoddFrankWallStreetReformand
ConsumerProtectionActof2010
Mandatesenhancedstockexchangelistingstandardson
compensationcommitteeindependence
Requiresadditionaldisclosureoftherelationshipbetween
executivecompensationandfinancialperformance,aswellas
internalpayequity
Mandatescorporatepoliciesontheforfeitureofexecutive
compensationincertaincircumstances
LO5:RoleofAuditCommittees
AsindicatedintheSarbanesOxleyAct,acommitteeofthe
boardofdirectorsthathasimportantsignificancetothe
auditoristheauditcommittee
Theauditcommitteeisastandingcommitteeoftheboardof
directorswhosepurposeistooverseetheaccountingand
financialreportingprocessesofthecompanyandthefinancial
statementaudits
Thatcommitteeisdesignatedastheauditclienttowhomthe
externalauditorshouldreport
RoleofAuditCommittees
Forpubliccompanies,theauditcommitteemustbecomposed
ofoutsidedirectors,i.e.,directorswhoarenotmembersof
managementanddonothaveotherrelationshipswiththefirm
(e.g.,asvendor,consultant,orgeneralcounsel)
Theauditcommitteeshouldincludeatleastonefinancial
expertwhohasanunderstandingofGAAPandhasrelevant
accountingandauditexperience
RoleofAuditCommittees
Theauditcommitteehasthreeprimaryresponsibilitiesrelated
tothefinancialreportingprocess:
Provideoversightoftheaccountingandfinancialreportingprocesses
andofthefinancialstatementaudits
Appoint,compensate,andoverseetheexternalauditor,
includingapprovinganynonauditservicestobeprovided
bytheexternalauditor
Ensurethattheboardestablishesawhistleblowerprogram
RoleofAuditCommittees
Additionalresponsibilitiesoftheauditcommitteemay
include:
Theauthoritytohireandfiretheheadoftheinternalauditfunction
Setthebudgetfortheinternalauditactivity,andreviewtheinternal
auditplananddiscussallsignificantinternalauditresults
Performingorsupervisingspecialinvestigations,reviewingpolicieson
sensitivepayments,maintainingcommunicationbetweentheboard,
management,theexternalauditors,andtheinternalauditors,and
coordinatingperiodicreviewsofcompliancewithcompanypolicies
suchascorporategovernancepolicies
RoleofAuditCommittees
Theauditcommitteemustmakeinformedchoicesaboutthe
qualityofworkitreceivesfromtheauditors:
Theauditcommitteemustmonitorandassesstheindependenceand
competenceofallauditfunctions
Itshouldreviewqualitycontrolreportsonboththeexternalauditfirm
andtheinternalauditfunction,anditshouldevaluatethequalityof
reportsitreceivesfromtheauditorsandthequalityoffinancial
reportingandcontroldiscussions
Theauditcommitteewillreceivefeedbackfromboththe
internalandexternalauditorsonanumberofissuesincluding
thequalityofinternalcontrolsoverfinancialreporting
RoleofAuditCommittees
Aspartofitsoversightresponsibility,theauditcommittee
expectstheexternalauditortoreporttotheauditcommittee:
Allcriticalaccountingpoliciesandpracticesusedbymanagement
AllmaterialalternativeGAAPtreatmentsthathavebeendiscussed
withmanagement
Othermaterialwrittencommunicationsbetweentheauditorand
management
Theauditcommitteeshouldreviewallregulatoryaudit
findings,whereapplicable,todetermineiftheyprovide
importantfeedbackonthequalityofcontrols,operational
problems,orfinancialissues
RoleofAuditCommittees
OneprimaryroleoftheAuditCommitteeistoensure
theindependenceoftheexternalauditfirm
MakestheAuditCommitteetheauditorsclient
RequirestheAuditCommitteetopreapproveall
nonauditservicesbytheauditfirm
Requiringtheauditcommitteetopreapproveany
nonauditservicesprovidedbythepublicaccounting
firm
LO6:PrinciplesofEffectiveAudit
Committees
CommitteePurpose
CommitteeResponsibilities
Interaction
Independence
ExpertiseandIntegrity
PhilosophyandCulture
InternalControl
RiskAssessment
MeetingsandInformation
ExternalAuditor
InternalAudit
OversightofWhistleblowerProcedures
CompensationandStockOwnership
ServiceandTermLimits
Disclosure
LO7:ExternalAuditorCommunication
totheAuditCommittee
AuditorsResponsibilityunderGenerallyAcceptedAuditingStandards
SignificantAccountingPolicies
ManagementJudgmentsandAccountingEstimates
SignificantAuditAdjustments
JudgmentsabouttheQualityoftheCompanysAccountingPrinciples
OtherInformationinAnnualReports
DisagreementswithManagement
ConsultationwithOtherAccountants
MajorIssuesDiscussedwithManagementBeforeRetention
OverviewandPlannedScopeoftheAudit
DifficultiesinPerformingtheAudit
RepresentationsRequestedfromManagement
LO8:CorporateGovernanceand
theAudit
Goodgovernanceisimportanttotheconductofanauditfor
oneverysimplereason:companieswithgoodcorporate
governancearelessriskytoaudit
Thesecompaniesgenerallyhavethefollowingcharacteristics:
Arelesslikelytoengageinfinancialengineering
Haveacodeofconductthatisreinforcedbyactionsoftop
management
Haveindependentboardmemberswhotaketheirjobsseriouslyand
havesufficienttimeandresourcestoperformtheirwork
Taketherequirementsofgoodinternalcontroloverfinancialreporting
seriously
Makeacommitmenttofinancialcompetenciesneeded

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