The Demand for Audit and Other Assurance Services

Chapter 1

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Enron story illustrates the importance of the role of auditors and their responsibility to the users of the financial statements. In the aftermath of Enron and other major financial reporting frauds, Congress passed the Sarbanes-Oxley Act
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Sarbanes-Oxley Act
Enron

WorldCom

The Act established the Public Company Accounting Oversight Board. It also requires auditors to report on the effectiveness of internal control over financial reporting. Tyco
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Adelphia
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Learning Objective 1
Describe auditing.

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Nature of Auditing
Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria. Auditing should be done by a competent, independent person. The definition includes several key words and phrases, well now disscuss them
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Information and Established Criteria

To do an audit, there must be information in a verifiable form and some standards (criteria) by which the auditor can evaluate the information.

FASB

Criteria

IASB
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Auditors routinely perform audits of quantifiable information, including companies financial statements and individuals federal income tax returns. They also audit more subjective information, such as the effectiveness of computer systems and efficiency of manufacturing operations

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Information and Established Criteria

The criteria for evaluating information also vary depending on the information being audited. In the audit of historical financial statements by CPA firms, the criteria may be GAAP or IFRS For more subjective information it is more diffucult to establish criteria

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Accumulating Evidence and Evaluating Evidence

Evidence is any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria.
Transaction data

Client inquiry

Written and electronic Communications with outsiders

Observations

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Accumulating Evidence and Evaluating Evidence

Evidence takes many different forms including;

electronic and documentary data about transactions written communication with outsiders observations by the auditor oral testimony of the auditee (client)

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Competent, Independent Person

The auditor must be qualified to understand the criteria used and must be competent to know the types and amount of evidence to accumulate to reach the proper conclusion after the evidence has been examined.
The auditor must also have an independent mental

attitude

The competence of the individual performing the audit is of little value if he or she is biased in the accumulation and evaluation of evidence.
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Competent, Independent Person

Competence Judgment and Experience

Independence

Evaluation of Evidence

Proper Conclusion
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Competent, Independent Person

Auditors strive to maintain a high level of independence to keep the confidence of users relying on their reports Auditors reporting on company financial statements are often called independent auditors Even though such auditors are paid fees by the company, they are normally sufficiently independent to conduct audits

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Audit Report
The final stage in the auditing process is preparing the Audit Report, which is the communication of the auditors findings to users.

Results differ in nature, but all must inform readers of the degree o correspondence between information and established criteria.

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Audit Report
To the Board of Directors and Stockholders of ABC Corporation and Subsidiaries Anywhere, USA We have audited the accompanying consolidated balance sheets of ABC Corporation and Subsidiaries (the Company) as of December 31, 2010 and December 31, 2009, and the related consolidated statements of income, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of ABC Corporation and Subsidiaries as of December 31, 2010 and December 31, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2011, expressed an unqualified opinion on the Companys internal control over financial reporting. INTERNATIONAL CPA FIRM LLP Anywhere, USA February 28, 2011

The final step communicates the findings to users.

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Audit of a Tax Return Example

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Learning Objective 2
Distinguish between auditing and accounting.

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Distinguish Between Auditing and Accounting

Accounting is the recording, classifying, and summarizing of economic events for the purpose of providing financial information used in decision making. Auditing is determining whether recorded information properly reflects the economic events that occurred during the accounting period.
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Learning Objective 3
Explain the importance of auditing in reducing information risk.

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Economic Demand for Auditing

To illustrate the need for auditing, consider the decision of a bank officer in making a loan to a business

(Risk-free interest rate, business risk for the customer, nformation risk

Information risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. Auditing can have a significant effect on information risk.
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Learning Objective 4
List the causes of information risk, and explain how this risk may be reduced.

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Causes of Information Risk

Remoteness of information
When information is obtained from others,likelihood of it being intentionally or unintentionally misstated increases

Biases and motives of the provider

If information is provided by someone whose goals are nconsistent with those of the decision maker, the nformation may be biased in favor of the provider

Voluminous data

As organizations become larger, so does the volume of their exchange transactions. This increases the likelihood that mproperly recorded information is included in the records

Complex exchange transactions

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Reducing Information Risk

User verifies information User shares information risk with management Audited financial statements are provided

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Reducing Information Risk

User verifies information
The user may go to the business premises to examine records and obtain information about the reliability of the statements

User shares information risk with management

If users rely on inaccurate financial statements and as a result incur a financial loss, they may have basis for a lawsuit against management But users may not be able to collect on losses

Audited financial statements are provided

The most common way for users to obtain reliable information s to have an independent audit
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Relationships Among Auditors, Client, and External Users

Client or audit committee hires auditor

Auditor

Auditor issues report relied upon by users to reduce information risk

Provides capital

Client
Client provides financial statements to users
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External Users
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Learning Objective 5
Describe assurance services and distinguish audit services from other assurance and non-assurance services provided by CPAs.

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Assurance Services
An independent professional service that improves the quality of information for decision makers.

Individuals who are responsible for making business decisions seek assurance services to help improve the reliability and relevance of the information used Can be performed by CPAs or by a variety of other professionals
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Assurance Services
CPAs have provided many assurance services for years, particularly assurances about historical financial statements They have also performed assurance services related to lotteries and contests to provide assurance that winners were determined in an unbiased fashion in accordance with contest rules

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Attestation Services
A type of assurance service CPA reports on the reliability of an assertion That is the responsibility of another party.

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Attestation Services
1. Audit Historical Financial Statements
2. Internal Control over Financial Reporting

3. Review

5. Other

4. Information Technology
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1. Audit of historical financial statements

The auditor issues a written report expressing an opinion about whether the financial statements are fairly stated in accordance with the applicable accounting standards.

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2. Audit of Internal Control over Financial Reporting

Management asserts that internal controls have been developed and implemented following well established criteria Section 404 of the SOX act requires public companies to report managements assessment of the effectiveness of control The act also requires auditors to attest to the effectiveness of internal control over financial reporting This evaluation increases user confidence about future financial reporting

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3. Review of Historical Financial Statements

Management asserts that the statements are fairly stated in accordance with accounting standard The CPA provides only a moderate level of assurance for reviews of financial statements, compared to a high level for audits, therefore less evidence is needed

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4. Attestation Services on Information Technology

Management makes various assertions about the reliability and security of electronic information WebTrust and SysTrust also meet the criteria of attestation service

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5. Other Assurance Services

Most of the other assurance services that CPAs provide do not meet the formal definition of attestation services. The CPA is not required to issue a written report. The assurance does not have to be about the reliability of another partys assertion about compliance with specified criteria.
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Green Initiatives Bring Assurance Opportunities, Competition

Global interest has triggered a surge in reports.
80% of the Global Fortune 250 released environmental, social, and governance data. Presented in standalone reports or integrated into annual financial reports.
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Other Assurance Services Examples

Assess risks of accumulation, distribution, and storage of digital information
including

assessing security risks and related controls over data and other information stored electronically, including the adequacy of backup and off-site storage.
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Other Assurance Services Examples

Compliance with trading policies and procedures Compliance with entertainment royalty agreements ISO 900 certification

Environmental audit

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Nonassurance Services Provided by CPAs

1. Accounting and bookkeeping services 2. Tax services 3. Management consulting services

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Assurance, Attestation, and Nonassurance Services

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Learning Objective 6
Differentiate the three main types of audits.

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Types of Audits
Operational Compliance Financial Statement

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Operational Audit
Evaluates the efficiency and effectiveness of any part of an organizations operating procedures and methods At the end, management normally expects recommendations for improving operations The reviews are not limited to accounting. They can include the evaluation of organizational structure, computer operations, production methods

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Operational Audit
It is impossible to characterize the conduct of a typical operational audit It is more diffucult to objectively evaluate whether the efficiency and effectiveness of operations meets established criteria than it is for compliance and financial statement audits In this sense operational audit is more like management consulting

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Operational Audit
Example Information Established Criteria Available Evidence Evaluate computerized payroll system for efficiency and effectiveness

Number of records processed, costs of the department, and number of errors

Company standards for efficiency and effectiveness in payroll department Error reports, payroll records, and payroll processing costs
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Compliance Audit
Conducted to determine whether the auditee is follow,ng specific procedures, rules, or regulations set by some higher authority Governmental units, such as school districts are subject to considerable compliance auditing because of extensive government regulation Results of compliance audit is typically reported to management

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Compliance Audit
Example Information Established Criteria Available Evidence Determine whether bank requirements for loan continuation have been met Company records Loan agreement provisions Financial statements and calculations by the auditor
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Financial Statement Audit

Conducted to determine whether the financial statements are stated in accordance with specified criteria (GAAP or IFRS) The auditor gathers evidence to determine whether the statements contain material errors or other misstatements

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Audit of Historical Financial Statements

Example Information Established Criteria Available Evidence Annual audit of Boeings financial statements Boeing's financial statements Generally accepted accounting principles Documents, records, and outside sources of evidence
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XBRL Electronic Data to Improve Financial Reporting

Extensible Business Reporting Language

Enables sorting and comparing of financial data

Public companies required to provide interactive financial statement data
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Learning Objective 7
Identify the primary types of auditors.

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Types of Auditors
Independent certified public accounting firms Governmental general accounting office auditors

Internal Revenue agents

Internal auditors

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Learning Objective 8
Describe the requirements for becoming a CPA.

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Three Requirements for Becoming a CPA

Educational requirement Uniform CPA examination requirement Experience requirement

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CPA Examination Sections

Auditing and Attestation
Financial Accounting And Reporting

Business Environment and Concepts

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Regulation
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CBT-e: The CPA Exam Gets a Makeover

New content and skill specification outline revisions. Exam structure changes and weighting of individual exam components. Coverage of international auditing and financial reporting standards.
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Three Requirements for Becoming a CPA

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End of Chapter 1

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