Principles of International Auditing and Assurance

4th Edition

Rick Hayes, Philip Wallage and Peter Eimers

Amsterdam University Press

Principles of International Auditing and Assurance, 4th Edition, by Rick Hayes, Philip Wallage and Peter Eimers, is an extensively revised and updated edition of Principles of Auditing. An Introduction to International Standaards on Auditing, 3d Edition, by Rick Hayes, Philip Wallage and Hans Gortemaker (ISBN 9780273768173) published in 2014 with FT Prentice Hall, an imprint of Pearson Education.

Cover illustration: Mircea Costina / Adobe Stock

Cover design: Gijs Mathijs Ontwerpers, Amsterdam
Lay-out: Crius Group, Hulshout

ISBN | 978 94 6372 006 9
e-ISBN | 978 90 4855 416 4
DOI | 10.5117/9789463720069
NUR | 784

© R. Hayes, P. Wallage, P. Eimers / Amsterdam University Press B.V., Amsterdam 2021

All rights reserved. Without limiting the rights under copyright reserved above, no part of this book may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise) without the written permission of both the copyright owner and the author of the book.

CONTENTS

List of Illustrations

Foreword

Preface to the Fourth Edition

Acknowledgements

SECTION I — HISTORY

1International Auditing Overview

1.1Learning Objectives

1.2An Audit Defined

1.3History

1.4Auditing Practice Today

1.5User Expectations and Landmark Legislation

1.6Summary

1.7Questions, Exercises and Cases

1.8Notes

SECTION II — THE PROFESSION

2The Institutional Setting: How Is the Audit Profession Organized

2.1Learning Objectives

2.2Introduction

2.3Types of Auditor

2.4Types of Audit

2.5Audit Firms

2.6Standard Setting

2.7Regulation

2.8Audit Firm’s Quality Control System

2.9Audit Firm Oversight

2.10Summary

2.11Questions, Exercises and Cases

2.12Notes

SECTION III — ETHICS

3Ethics for Professional Accountants

3.1Learning Objectives

3.2What Are Ethics?

3.3The International Code of Ethics for Professional Accountants

3.4Part 1 – Complying with the Code, Fundamental Principles and Conceptual Framework

3.5Part 2 – Professional Accountants in Business

3.6Part 3 – Professional Accountants in Public Practice

3.7Part 4 – Independence Standards

3.8Enforcement of Ethical Requirements

3.9Summary

3.10Questions, Exercises and Cases

3.11Notes

SECTION IV — FUNDAMENTAL CONCEPTS

4The Fundamental Concepts of Auditing and Assurance

4.1Learning Objectives

4.2The Objectives of Auditing in an Elevator Pitch

4.3Reasonable Assurance

4.4Sufficient Appropriate Audit Evidence

4.5Materiality

4.6The Importance of Internal Control Measures

4.7The Auditor Behaves Ethically

4.8The Auditor Exercises Professional Skepticism

4.9The Auditor Exercises Professional Judgement

4.10Two Levels of Quality Control

4.11The Auditor Is Accountable with Robust Documentation

4.12Audit Versus Assurance

4.13Summary

4.14Questions and Case

4.15Notes

5Fraud and Other Considerations of Law and Regulation in an Audit (ISA 240, 250)

5.1Learning Objectives

5.2Introduction

5.3Responsibilities of the Board

5.4Auditor’s Responsibility

5.5Fraud Defined

5.6Types of Fraud

5.7Fraud Triangle and Anti-Fraud Measures

5.8Audit Planning and Fraud Risk Assessment

5.9Responses to Fraud Risk Assessment

5.10Communication Related to Fraud with Management, Board and Third Parties

5.11Compliance with Law and Regulation, Corruption and Money Laundering

5.12Summary

5.13Questions, Exercises and Cases

5.14Notes

SECTION V — THE 4 PHASES OF EACH AUDIT (‘HOW TO PERFORM AN AUDIT’)

6Phase 1: Client and Engagement Acceptance / Continuance

6.1Learning Objectives

6.2Client Acceptance and Continuance: The First Step on the Journey to an Opinion

6.3Evaluate the Client’s Background

6.4Corporate Governance

6.5Ability to Meet Ethical and Specific Competence Requirements

6.6Use of Other Professionals in the Audit

6.7Communicating With the Predecessor (Existing) Auditor

6.8Acceptance by the Client – The Engagement Proposal

6.9The Audit Engagement Letter

6.10Summary

6.11Questions, Exercises and Cases

6.12Notes

7Phase II, Part 1: Planning Through Understanding and Risk Analysis

7.1Learning Objectives

7.2Planning Objective and Procedures

7.3Understanding the Entity and its Environment

7.4Audit Risk Model

7.5Materiality

7.6Fraud and Irregularities

7.7Using the Work of Others and Considering Auditee Use of Service Organizations

7.8Other Planning Activities

7.9Summary

7.10Questions, Exercises and Cases

7.11Notes

8Phase II, Part 2: Internal Control and Control Risk

8.1Learning Objectives

8.2Introduction

8.3Internal Control Defined

8.4The Importance of Internal Control

8.5IT Risk and Controls

8.6Components of Internal Control

8.7Control Environment

8.8Risk Assessment

8.9Information Systems, Communication and Related Business Processes

8.10Control Activities

8.11Monitoring of Controls

8.12Hard and Soft Control

8.13Design of Internal Controls

8.14Preliminary Assessment of Control Risk

8.15Summary

8.16Questions, Exercises and Cases

8.17Notes

9Phase III, Part1: Building and Execution of the Test Plan and Auditor’s Response to Assessed Risk

9.1Learning Objectives

9.2The Basis of Evidence

9.3Financial Statement Assertions

9.4Audit Procedures for Obtaining Audit Evidence

9.5Sufficient Appropriate Audit Evidence

9.6Tests of Controls

9.7Substantive Procedures

9.8Sampling

9.9Summary

9.10Questions, Exercises and Cases

9.11Notes

10Phase III, Part 2: Building and Execution of the Test Plan – Analytical Review

10.1Learning Objectives

10.2Analytical Procedures during Different Phases in the Audit Process

10.3The Analytical Review Process

10.4Formulating Expectations

10.5General Types of Analytical Procedures

10.6Analytical Procedures as Substantive Tests

10.7Follow-Up in Case of Unexpected Deviations

10.8Evaluation of Misstatements Identified During the Audit (ISA 450)

10.9Summary

10.10Questions, Exercises and Cases

10.11Notes

11Phase IV, Part 1: Evaluation and Completion

11.1Learning Objectives

11.2Introduction

11.3Specific Considerations Gathering Evidence for Selected Items

11.4Written Representations

11.5Review for Contingent Liabilities and Commitments

11.6Review for Discovery of Subsequent Events

11.7Related Parties

11.8Evaluation of Going Concern Assumption

11.9Review of Financial Statements and Other Information

11.10Wrap-up Procedures

11.11Summary

11.12Questions, Exercises and Cases

11.13Notes

12Phase IV, Part 2: Reporting

12.1Learning Objectives

12.2Introduction

12.3Basic Elements of the Auditor’s Report

12.4Key Audit Matters (KAMs)

12.5Emphasis of Matter Paragraph

12.6Type of Audit Report

12.7Opinion on Internal Controls over Financial Reporting

12.8Communications with those Charged with Governance

12.9Long-Form Audit Report

12.10Management Letter

12.11General Meeting of Shareholders

12.12Summary

12.13Questions, Exercises and Cases

12.14Notes

SECTION VI — SPECIFIC THEMES AND TOPICS

13Specific Themes and Special Topics during The Audit

13.1Learning Objectives

13.2Quality Control (ISQC 1, ISA 220, SOX)

13.3Technology in the Audit

13.4Group Audit

13.5Audit of Accounting Estimates (ISA 540)

13.6Summary

13.7Questions, Exercises and Cases

13.8Notes

13AGroup Audit Extended Example

13A.1Learning Objectives

13A.2Context of Extended Example of a Group Audit

13A.3The Audit Planning Memorandum – Strategy Part

13A.4The Audit Planning Memorandum – Plan Part

13A.5Audit Programme (Audit Plan)

13A.6Completion Memorandum

13A.7Questions, Exercises and Cases

13A.8Notes

SECTION VII — OTHER ASSURANCE AND RELATED SERVICES

14Other Assurance and Related Services

14.1Learning Objectives

14.2The Concepts

14.3Elements of an Assurance Engagement

14.4Highlights of Various Kinds of Assurance Engagements

14.5Assurance Engagements Other Than Audits or Reviews of Historical Financial Information

14.6Related Services

14.7Summary

14.8Questions, Exercises and Cases

14.9Notes

Glossary

Index

LIST OF ILLUSTRATIONS

1.1Theories Explaining Audit Supply and Demand

1.2Overview of the Audit Process

1.3The Result of Planning

1.4The COSO Report Objectives

2.1Auditor Certification Designations Around the World

2.2Types of Audit

2.3Big Four Organizational Pyramid

2.4Global Adoption of Clarified ISAs

2.5List of 2018 International Standards on Auditing

2.6Specific Country Oversight Boards

3.1Characteristics of Ethical Behavior

3.2Overview of the IESBA Code of Ethics

3.3Overview of Principles, Threats and Safeguards in the Code of Ethics

3.4Part 2: Professional Accountants in Business

3.5Independence in the Sarbanes–Oxley Act of 2002

3.6Part 4A Independence – Audit and Review Engagements

3.7Part 4B: Independence – Other Assurance Engagements

3.8Examples of Violations of Independence (Derived from SEC Press Releases)

4.1The Four Phases of the Audit

5.1Fraud Detection Measures and Their Effect on the Duration of the Fraud and the Size of Loss (ACFE, 2018)

5.2Synthesis of Fraud-Related Research (Trompeter et al, 2013).

5.3Fraud Triangle

5.4What Anti-Fraud Measures Are Most Common? ACFE, 2018, Figure 17, p. 27

5.5How Is Occupational Fraud Initially Detected? (ACFE, 2018, p. 17, Figure 9)

5.6KPMG’s Independent Auditor’s Report 2018 of Leaseplan Corporation NV

5.7Key Audit Matter Annual Report 2018 SBM Offshore NV

5.8Corruption Perception Index 2018, Transparency International

5.9External Auditors’ Guide for Detecting Bribery

5.10Sketches how Cash Generated by Illicit Activities Can Be Used to Acquire Legitimate Assets

6.1Standard Audit Process Model – Phase I Client Acceptance

6.2Preliminary Information Search

6.3Influences on the Client-Auditor Relationship

6.4Corporate Governance Structures

6.5Corporate Governance Committees and Reports

6.6Review of Corporate Governance Statement (UK)

6.7Sample Table of Contents of New Client Proposal

6.8Sample Audit Engagement Letter

7.1Audit Process Model

7.2aRevised ISA 315 Requires a More Robust Risk Identification and Assessment

7.2bExplicit Use of Automated Tools & Techniques in the ISA 315 (Revised 2019)

7.3Global Perspective of Client Risk

7.4Industry, Regulatory and Other External Factors, Including the Applicable Financial Reporting Framework Auditors Might Consider

7.5Considerations when Obtaining an Understanding of the Nature of the Entity

7.6Entity Level Business Model

7.7Examples of Legal Documents and Records to Consider in the Context of Understanding the Entity’s Nature

7.8Considerations Concerning Entity Objectives, Strategies and Related Business Risks

7.9Measurement and Review of the Entity’s Financial Performance

7.10Documentation Formats for Strategic Risk and Significant Classes of Transactions

7.11How Audit Risk Works

7.12Interrelationship of the Components of Audit Risk

7.13Relationship between Detection Risk and Inherent/Control Risk

7.14Relationship between Audit Risk and Materiality

8.1The COSO Framework

8.2Understanding and Responding to IT Is an Integral Part of Understanding and Risk Analysis

8.3Components of Internal Control Framework

8.4Company Organization Segregation of Duties

8.5Factors on Which to Assess Internal Control Environment

8.6Risk Assessment Blank Evaluation Tool

8.7Typical Input, Subsystems and Output of an Information System

8.8Overview of Segregation of Duties

8.9Overall Internal Control Evaluation Tool

9.1Legal Evidence and Audit Evidence

9.2Assertions Used by the Auditor

9.3Audit Procedures (Evidence-Gathering Techniques)

9.4Do’s and Don’ts when Conducting an Audit Interview

9.5Characteristics of Confirmation

9.6The Attributes and Factors Used to Evaluate Information to Be Used as Audit Evidence

9.7Factors Effecting Sufficiency and Appropriateness of Evidence

9.8Reliability of Audit Evidence

9.9Linking Transactions Related Objectives, Controls and Tests of Controls for Purchases

9.10Test of Accounts Receivable Balance

9.11Audit Objectives and Substantive Tests

9.12Factors Influencing Sample Sizes for a Substantive Test of Details in Sample Planning

9.13Allowable Risk of Incorrect Acceptance (TD) for Various Assessments of CR and AP; for AR = .05 and IR = 1.0

10.1Important Characteristics of Analytical Procedures at Three Stages of an Audit

10.2Four Phase Process Model, Inputs and Outputs

10.3Five Types of Ratio Analysis

10.4Standard Client and Industry Ratios

10.5Indications that the Going Concern Assumption Might be Questioned

11.1Audit Process Model – Phase IV Evaluation and completion

11.2Legal Letter

11.3Management Representation Letter

11.4Audit Procedures to Identify Events that May Require Adjustment of, or Disclosure in, the Financial Statements

11.5Circumstances that May Indicate Unidentified Related Parties

11.6Financial Statement Disclosure Checklist: Inventory

11.7Disclosures (UK Corporate Governance Code, 2018, 26)

11.8Typical Wrap-up Procedures

11.9Review Checklist

11.10Independent Review Checklist

12.1Report of Independent Registered Public Accounting Firm

12.2Facebook, Exhibit 31-1 Annual Report 2018. Certification of Periodic Report under Section 302 of SOX Act of 2002

12.3An Auditor’s Report on Financial Statements Prepared in Accordance with a Fair Presentation Framework Designed to Meet the Common Financial Information Needs of a Wide Range of Users

12.4Auditors’ Report Rolls Royce, 2018 Reporting on other Information

12.5Auditors’ Report Air France-KLM, 2018 Reporting on other Information

12.6Auditor’s Name and Address in Auditors’ Report Siemens 2018, Rolls Royce, 2018

12.7Disclosure of Materiality in the Auditor’s Report Rolls Royce 2018

12.8Audit Scope from Auditors’ Report of Leaseplan Corporation NV 2018

12.9Example of Focus of Audit Scope in Relation to Fraud and Non-Compliance with Laws and Regulations (Derived from Auditors’ Report of Leaseplan Corporation NV 2018)

12.10KAMs (Auditors’ Report 2018 of Pharmaniaga Berhard, Malaysia)

12.11Emphasis of Matter Paragraph (Auditors’ Report Volkswagen 2018)

12.12Text of a Going Concern Paragraph (Derived from Toshiba 2017 Annual Report)

12.13Going Concern Reporting in the UK (Rolls Royce Auditors’ Report 2018)

12.14Qualified Opinion

12.15Adverse Opinion

12.16(Basis for) Disclaimer of Opinion (Due to the Auditor’s Inability to Obtain Sufficient Appropriate Audit Evidence about Multiple Elements in the Financial Statements)

12.17Unqualified Opinion on Both Internal Control over Financial Reporting and the Financial Statements

12.18Adverse Opinion on Internal Control over Financial Reporting, Toshiba, 2017

13.1Responsibilities of the Engagement Partner

13.2Data Analytics as a Modern Technique for Traditional Audit Procedures

13.3Challenges when Using Data Analytics in the Audit.

13.4Type of Work to Be Performed for Components

13.5Determining Scope for a Component Audit

13.6Information Required in Group Auditor Communication to the Component Auditor

13.7The Component Auditor Must Communicate to the Group Auditor

13.8ISA 540 (Revised) Auditing Estimates

13A.1Contents of Group Audit Instructions

13A.2Subsidiaries of MaasTec and Business Structure

13A.3USATec and Subsidiaries REVENUE, ASSETS AND REC

13A.4Contents of Audit Planning Memorandum – Strategy Part

13A.5Contents of Audit Planning Memorandum – Plan Part

13A.6Audit Program

13A.7Contents of Completion Memorandum

13A.8Outline of Management Letter to MaasTe

13A.9Summary of Unadjusted Audit Differences Found in the Audit

14.1Pronouncements Issued by the IAASB, and Their Relationship to Each Other and the IESBA Code

14.2Relationships between the Five Elements of an Assurance Engagement

14.3Relationships between 5 Components of Assurance Engagements

14.4Components of an Assurance Report

14.5Unqualified Review Report on the Financial Statements.

14.6ISAE 3402 Report

14.7Assurance Report on Sustainability

14.8Agreed-Upon Procedures

14.9Compilation Report

FOREWORD

‘The world has grown into a global marketplace at an exceedingly fast pace in recent years…changes in one part of the world can have significant effects on other parts.’ Had I not used quotation marks, one could easily read this statement as a reference to the global financial crisis that shocked the world in 2008, or the very recent COVID-19 virus crisis. Rather, this was the observation of the then IAASB Chairman Prof. Robert Roussey, with which he started his Foreword to the first edition of this book, Principles of Auditing, in 1999. Robert continued by describing how this global marketplace had triggered the emergence of International Accounting Standards (now IFRS) and International Standards on Auditing (ISAs), and stated: ‘In the late 1990s, these international standards are on the brink of becoming the global standards of the future.’

Indeed, that is what they have become – and so have the ‘Clarified’ International Standards on Auditing. In his Foreword to the second edition of this book in 2005, my immediate predecessor, John Kellas, started with: ‘In the last few years the auditing environment has changed dramatically. The failure of Enron was perhaps the biggest single catalyst for change…. The International Auditing and Assurance Standards Board (IAASB), the independent standards-setter that operates under the auspices of the International Federation of Accountants (IFAC), has sought to respond effectively to the new environment.’ Under John’s leadership, the IAASB has completely rewritten the ISAs to make them more understandable and better fit for use. All 36 ISAs and International Standard on Quality Control (ISQC) 1 have clearly distinguished the auditor’s objectives, the requirements of the standards, and the standards’ application and other explanatory material. Many contained considerations specific to audits of smaller entities and of public sector entities, and as part of this ‘clarification’ effort many ISAs were also thoroughly revised for their content. This impressive exercise was essentially completed when I succeeded John as Chairman in January 2009. The full suite of these Clarified ISAs and ISQC 1 became effective for audits of financial statements for periods beginning or after 15 December 2009.

But…adoption and commitment to the use of standards is one thing. Implementation, including a thorough understanding and proper application of the standards, is another. This requires education, training, monitoring and enforcement. That is why Professors Rick Hayes, Philip Wallage en Hans Gortemaker issued the third edition of Principles of Auditing – An Introduction to International Standards on Auditing in 2014. As a co-author on the previous editions, I know how much effort that takes. But it was urgently needed, as I have learned time and again in my many outreach activities across the world. This indeed is a global marketplace, with dramatic and ongoing changes, and practitioners and students need to update themselves about such changes. The Clarified ISAs are one striking example, but the IAASB issues other standards as well. The third edition addressed those standards in a special chapter about other assurance and non-assurance engagements. This included revised standards on review engagements and compilation engagements, which are of particular relevance for services to smaller entities that are exempted from mandatory audits in many countries. The IAASB had also issued new assurance standards, such as International Standard on Assurance Engagements (ISAE) 3410 addressing greenhouse gas statements, a landmark standard in the area of sustainability-related assurance services engagements.

I then wrote in the Foreword: ‘Will the changes stop here? A rhetorical question, of course. It is very likely that we will see expanded audit reports in the future, to better inform users of financial statements about significant audit matters. We may see the further emergence of Integrated Reporting, and assurance standards thereon. The IAASB may decide to update the ISAs for key areas such as professional skepticism, risk assessment, group audits, quality control, and may enhance the ISAs further in relation to audits of financial institutions. But that will take time, and the authors rightly decided not to wait for that.’

That is indeed what has happened, and it has resulted in a number of key revised or new standards, or exposure drafts, as well as practical guidance. A key innovation has been the revised auditor’s report, including the introduction of Key Audit Matters in a new ISA 701. This has dramatically changed the contents of the auditor’s report; whereas in the past it expressed only a one line conclusion (accompanied by what many saw as ‘boilerplate’ text), it now often contains a number of pages explaining what the auditor felt were the most significant matters in that particular audit. This makes the audit much more relevant to users of these reports such as investors, analysts and many others.

But the IAASB has also thoroughly revised fundamental standards like ISA 315 on risk assessment and ISA 540 about the audit of estimates – including explicit attention for professional scepticism, separate treatment of inherent and control risk, fraud, automated tools and techniques, and other key concepts. Furthermore, the IAASB has published exposure drafts of revised standards on quality control (now: ‘quality management’) and group audits, and draft guidance on ‘extended external reporting’ (including integrated reporting), to be finalized in 2020/21. And the ethics board IESBA has substantially revised and enhanced the Code of Ethics for Professional Accountants.

The authors of this fourth edition, Professors Rick Hayes, Philip Wallage and Peter Eimers, have revised and updated this book as far as they could, given that some revised standards are not final yet. That makes the book again highly relevant for a large variety of users all over the globe.

Have the ISAs become the ‘global standards’ as Chairman Roussey had anticipated in 1999? Yes, they have. The authors show in Chapter 2 that as of June 2019, 130 jurisdictions are using the ISAs. An impressive list (just think of the many translations needed!). Further, the 27 larger international networks of accounting firms have committed to using the Clarified ISAs in their global audit methodologies. The Supreme Audit Institutions (SAIs) are also using the Clarified ISAs through a special public sector version called ISSAIs. So, it is fair to say that there is one global language for auditing, both for the private and the public sector. And this is warmly supported by the International Organization of Securities Commissions (IOSCO), by banking and insurance regulators, and by global institutions like the World Bank, UNCTAD and IMF.

We hear, and will continue to hear, critical comments with regard to the relevance and effectiveness of audit and assurance, in light of crises and failures, as well as findings from audit inspections across the world. However, underlying these comments are the positive expectations that many have of the contributions that auditors can make to this global, dynamic marketplace, and, in turn, to financial stability and trust. That is the public interest that all of us want to serve.

I wish this book – again – a global uptake, and the readers much success with their professional endeavors.

Professor Arnold Schilder

Chairman, International Auditing and Assurance Standards Board,
January 2009–June 2019

PREFACE TO THE FOURTH EDITION

Welcome to the world of auditors by opening this book!

The audit profession has been relevant to society for several centuries. Living in a complex and dynamic world, there is a growing interest in reliable corporate reporting. Many stakeholders presume that trust is a fundament for doing business. An auditor’s work is your window into the heart of an enterprise. Investors, bankers, suppliers, employees, unions, business partners in the value chain, NGOs, governments, regulators. all make use of the work and reporting by auditors.

Auditing is not like financial or managerial accounting. Accounting is a system where an objective representation of reality is recorded and summarized. Auditing is a set of procedures and techniques by which that representation is ‘agreed’ to specific criteria. So, accounting endeavors to record economic values, categorize them, and then summarize them in a report. Using a set of proscribed procedures (audit standards), and given specific criteria (financial accounting standards), auditing analyses whether that representation is properly recorded, categorized and reported.

You are studying auditing to further your professional goals, if you are like most people reading this book. In addition to your university or college degree you would like to get a professional credential (such as CPA, CA, RA, CFE, WP, GR, CMA, etc.), or you have heard, correctly, that auditing is a ‘high demand’ profession. In other words, you would like some practical knowledge which will help you in your career. To fulfil your goals is our wish.

This textbook is written from the view of the professional auditor. Theory and academic concerns are covered. The emphasis is on the professional standards promulgated by the International Auditing and Assurance Standards Board (IAASB) and the practical day-to-day experience of international auditing firms. The authors of both the current and previous editions were all extremely successful professional auditors even before writing this book. The authors are also university professors who have taught hundreds of students from around the world, so this textbook is from the point of view of the international student.

Auditing is not just about accounting issues. Auditors don’t just look at (financial) data, but also at systems and processes, behavior, and how an enterprise is governed. All sorts of enterprises are audited – profit oriented, not for profit, government, private and public. Auditors may be independent of the enterprise, a valuable internal analyst or working for the government. Audit-trained accountants are also hired to do forensic analysis. Today, as fraudulent schemes become ever larger and more harmful, it is auditors who are an important line of defense. Auditors’ detailed analytical skills have created jobs in areas as diverse as marketing and divorce consulting.

Even before we co-authors began to write the first edition of this book over 30 years ago, we all agreed that our only concern was to produce a high-quality audit text for the international student. This meant that it had to be fully up to date, use outstanding material, have a sound balance of audit theory and real practice, and be based on international auditing and assurance standards. We see the world from a truly global, cross-cultural perspective. This fourth edition is fully revised and includes the latest developments in the international Standards on Auditing, such as technology in the audit, the extended auditors report and auditing estimates.

We co-authors have a special place in our hearts for our students. We believe that it is our duty to convey our joy as auditors and audit teachers to you.

ACKNOWLEDGEMENTS

As always, this book was not the work of the co-authors alone, but also of the many professionals who helped us shape our ideas and give depth to the knowledge contained here.

We would like to thank to our former co-author Prof. Arnold Schilder for writing again the Foreword. Besides Arnold has been an inspiration for us in our years in the audit profession, Arnold has been the chairman of the IAASB for 11 years. Under his chairmanship, IAASB became the global standard setter for 130 countries across the globe and earned respect with the various innovations in standard setting reflecting the changing needs in society.

To make this book we have used relevant material from other books. We would like to thank these publishers and professional organizations: American Accounting Association, American Institute of Certified Public Accountants, International Auditing and Assurance Standards Board, International Ethics Standard Board of Accountants, International Federation of Accountants, European Union, US Securities and Exchange Commission, US Public Company Accounting Oversight Board, UK Financial Reporting Council and The Netherlands Royal Institute of Accountants.

And, of course, who can do any massive undertaking without the support of our families granting us to focus on this book and the many co-author skype-videocalls in our study rooms.

Rick Hayes, Philip Wallage, Peter Eimers

Latest updates as per October 2020

SECTION I

HISTORY

CHAPTER 1

INTERNATIONAL AUDITING OVERVIEW

1.1LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1Know the definition of auditing.

2Recount requirements relating to an audit of financial statements.

3Convey the concept of materiality.

4Relate some of the early history of auditing.

5Communicate management’s influence over financial statements.

6Convey the theories of the demand for audit services.

7Understand the basic definition of auditing in an international context.

8Define data level assurance.

9Describe the four-phase standard audit process model.

10Discuss some of the audit expectations of the general public.

1.2AN AUDIT DEFINED

International auditing education starts with a thorough understanding of what we mean by an audit. There is no definition of an audit, per se, in the International Standards on Auditing. ISA 200, however, describes an audit of financial statements,¹ which we will discuss shortly.

A GENERAL DEFINITION OF AUDITING IS²

An audit is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and established criteria, and communicating the results to interested users.

COMPONENTS OF THE AUDIT DEFINITION

Investors and creditors may have different objectives than management (e.g. management prefers higher salaries and benefits (expenses), whereas investors wish higher profits and dividends). Investors and creditors must depend on fair reporting of the financial statements. To give them confidence in the financial statements, an auditor provides an independent and expert opinion on the fairness of the reports, called an audit opinion.

An audit is a systematic approach. The audit follows a structured, documented plan (audit plan). In the process of the audit, accounting records are analysed by the auditors using a variety of generally accepted techniques. The audit must be planned and structured in such a way that those carrying out the audit can fully examine and analyse all important evidence.

An audit is conducted objectively. An audit is an independent, objective and expert examination and evaluation of evidence. Auditors are fair and do not allow prejudice or bias to override their objectivity. They maintain an impartial attitude.

The auditor obtains and evaluates evidence. The auditor assesses the reliability, relevance and sufficiency of the information contained in the underlying accounting records and other source data by:

studying and evaluating accounting systems and internal controls on which she³wishes to rely and testing those internal controls to determine the nature, extent and timing of other auditing procedures; and

carrying out such other tests, inquiries and other verification procedures of accounting transactions and account balances, as she considers appropriate in the particular circumstances.

The evidence obtained and evaluated by the auditor concerns assertions about economic actions and events. The basis of evidence-gathering objectives, what the evidence must prove, is the assertions of management. Assertions are representations by management, explicit or otherwise, that are embodied in the financial statements. One assertion of management about economic actions is that all the assets reported on the balance sheet actually exist at the balance sheet date. The assets are real, not fictitious. This is the existence assertion. Furthermore, management asserts that the company owns all these assets. They do not belong to anyone else. This is the rights and obligations assertion.

The auditor ascertains the degree of correspondence between assertions and established criteria. The audit programme tests most assertions by examining the physical evidence of documents, confirmation, inquiry, and observation. The auditor examines the evidence for the assertion presentation and disclosure to determine if the accounts are described in accordance with the applicable financial reporting framework, such as International Financial Reporting Standards (IFRS), local standards or regulations and laws.

The goal, or objective, of the audit is communicating the results to interested users. The audit is conducted with the aim of expressing an informed and credible opinion in a written report. If the item audited is the financial statements, the auditors must state that in their opinion the statements ‘give a true and fair view’ or ‘present fairly, in all material respects’ the financial position of the company. The purpose of the independent expert opinion is to lend credibility to the financial statements. The communication of the auditor’s opinion in the United States is called attestation, or the attest function. In an audit this attestation is called the ‘audit report’. In an international context the audit report is an example of an ‘assurance’ report. (See Chapter 12).

GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS⁴

Although a public auditor can also examine non-financial information, such as effectiveness of internal controls, compliance with company policies or environmental regulations, the majority of audit work is concerned with the financial statements. The financial statements audited under international standards are the balance sheets, income statements and cash flow statements and the notes thereto.

REQUIREMENTS OF A FINANCIAL STATEMENT AUDIT

ISA 200 sets out several requirements relating to an audit of financial statements.⁵ The auditor is required to comply with relevant ethical requirements, including those pertaining to independence, relating to financial statement audit engagements. The auditor shall plan and perform an audit with professional skepticism⁶ recognising that circumstances may exist that cause the financial statements to be materially misstated.⁷ Professional scepticism is an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of evidence. The auditor shall exercise professional judgement⁸ in planning and performing an audit of financial statements. Professional judgement is the application of relevant training, knowledge and experience, within the context provided by auditing, accounting and ethical standards, in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. To obtain reasonable assurance that the financial statements are accurate, the auditor must obtain sufficient appropriate audit evidence.⁹ This evidence is required to reduce audit risk to an acceptably low level and thereby enable the auditor to draw reasonable conclusions on which to base the auditor’s opinion.

PURPOSE AND CHARACTERISTICS OF A FINANCIAL STATEMENT AUDIT

It can be said that the function of auditing is to lend credibility to the financial statements. The financial statements are the responsibility of management and the auditor’s responsibility is to lend them credibility. By the audit process, the auditor enhances the usefulness and the value of the financial statements, but she also increases the credibility of other non-audited information released by management.¹⁰

In conducting an audit of financial statements, the overall objectives of the auditor are given in ISA 200.¹¹

The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework (such as IFRS or ‘accounting principles generally accepted in the United States’). The financial statements subject to audit are prepared by management of the entity with oversight from those charged with governance.

ISAs do not impose responsibilities on management or those charged with governance and do not override laws and regulations that govern their responsibilities. However, an audit in accordance with ISAs is conducted on the premise that management and those charged with governance have acknowledged certain responsibilities that are fundamental to the conduct of the audit. The audit of the financial statements does not relieve management or those charged with governance of their responsibilities.

The concept of materiality¹² is applied by the auditor in planning and performing the audit, and in evaluating the effect of identified misstatements on the financial statements. Misstatements, including omissions, are considered to be material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. Judgements about materiality are made in the light of surrounding circumstances, and are affected by the auditor’s perception of needs of users of the financial statements, and by the size or nature of a misstatement, or a combination of both. The auditor’s opinion deals with the financial statements as a whole and the auditor is not responsible for the detection of misstatements that are not material to the financial statements as a whole.

The ISAs require that the auditor exercise professional judgement and maintain professional scepticism throughout the planning and performance of the audit and, among other things:

Identify and assess risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control.

Obtain sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate responses to the assessed risks.

Form an opinion on the financial statements based on conclusions drawn from the audit evidence obtained.

The form of opinion expressed by the auditor will depend upon the applicable financial reporting framework and any applicable law or regulation. The auditor may also have certain other communication and reporting responsibilities to users, management, those charged with governance, or parties outside the entity.

LIMITATIONS OF THE AUDIT

There are certain inherent limitations in an audit that affect the auditor’s ability to detect material misstatements. These limitations result from such factors as the use of testing, the inherent limitations of any accounting and internal control system and the fact that most audit evidence is persuasive rather than conclusive. Furthermore, the work performed by an auditor to form an opinion is permeated by judgement. Judgement is required to determine the nature and extent of audit evidence and the drawing of conclusions based on the audit evidence gathered. Because of these factors, an audit is no guarantee that the financial statements are free of material misstatement.

RISK IN FINANCIAL STATEMENTS, TRANSACTIONS, ACCOUNT BALANCES AND DISCLOSURES

In order to design audit procedures to determine whether financial statements are materially misstated, the auditor considers the risk at two levels. One level of risk is that the overall financial statements may be misstated. The second risk is misstatement in relation to classes of transactions (asset, revenue, etc.), account balances and disclosures. See chapters 7 and 8 for a more detailed discussion. The risk of material misstatement at the overall financial statement level often relates to the entity’s control environment¹³ (although these risks may also relate to other factors, such as declining economic conditions). This overall risk may be especially relevant to the auditor’s consideration of fraud. The auditor also considers the risk of material misstatement at the class of transactions, account balance and disclosure level.

While the auditor is responsible for forming and expressing an opinion on the financial statements, the responsibility for preparing and presenting the financial statements is that of the management of the entity being audited. The audit of financial statements does not relieve management of responsibility.

1.3HISTORY

AUDITING THROUGH WORLD HISTORY

Auditing predates the Christian era. Anthropologists have found records of auditing activity dating back to early Mesopotamian times (around 3000 BC). There was also auditing activity in ancient China, Greece and Rome. The Latin meaning of the word ‘auditor’ was a ‘hearer or listener’ because in Rome auditors heard taxpayers, such as farmers, give their public statements regarding the results of their business and the tax duty due.

SCRIBES OF ANCIENT TIMES

Auditors existed in ancient China and Egypt. They were supervisors of the accounts of the Chinese Emperor and the Egyptian Pharaoh. The government accounting system of the Zhao (1046–221 BC) dynasty in China included an elaborate budgetary process and audits of all government departments. From the dawn of the dynastic era in Egypt (3000 BC) the scribes (accountants) were among the most esteemed in society and the scribal occupation was one of the most prestigious occupations.

Egyptian Pharaohs were very severe with their auditors. Each royal storehouse used two auditors. One counted the goods when they came in the door and the second counted the goods after they were stored. The supervisor looked at both accounts. If there was a difference, the auditors were both killed.

Bookkeeping as a support mechanism for the determination of profit or wealth, or as a decision support system for achieving profit maximization, was basically unknown in ancient cultures like the Mesopotamian, Egyptian, Greek or Roman. Auditing in English-speaking countries dates to AD 1130. Then, although they had highly developed economic systems, registration of economic facts or events was limited to the recording of single transactions whose sole purpose was to support the short-term memory of the trading partner.

Rational maximization of wealth or profit did not fit into the systems of these cultures. Wealth was not a function of keen entrepreneurship or of smart cost-benefit trade-offs. It was merely a reward for one’s loyalty to the government or for living in accordance with religious and moral principles and rules.

PROFIT MAXIMIZATION AND DOUBLE ENTRY

The attitude of profit maximization developed at the end of the Middle Ages, with the emergence of large merchant houses in Italy. Trading was no longer the domain of the individual commercial traveller; it was now coordinated centrally at the luxurious desks of the large merchant houses in Venice, Florence or Pisa. As a result, communication became vital. Not unexpectedly, therefore, the system of double entry bookkeeping was first described in Italy, used by a Genoa commune in 1340 AD. The first book on double entry accounting was Luca Pacioli’s Summa de Arithmetica dated 20 November 1494.

The practice of modern auditing dates back to the beginning of the modern corporation at the dawn of the Industrial Revolution. In 1853, the Society of Accountants was founded in Edinburgh. Several other institutes emerged in Great Britain, merging in 1880 into the Institute of Chartered Accountants in England and Wales. This nationwide institute was a predecessor to institutes that emerged all over the Western world at the end of the nineteenth century, for example, in the USA (in 1886) or in the Netherlands (in 1895).

Further developments of the separation between provision of capital and management and in the complexity of companies, along with the occurrence of several fraud cases and financial scandals (e.g. City of Glasgow Bank, 1883; Afrikaansche Handelsvereeniging, 1879),¹⁴ have led to a steady growth of the audit profession and regulation. The British Companies Acts (1845–62) were models for US auditing. The first US authoritative auditing pronouncement was issued in 1917.

ECONOMIC CONDITIONS FOR AUDIT REPORTS

At the same time, companies across the world experienced growth in technology, improvement in communications and transportation, and the exploitation of expanding worldwide markets. As a result, the demands of owner-managed enterprises for capital rapidly exceeded the combined resources of the owners’ savings and the wealth-creating potential of the enterprises themselves. It became necessary for industry to tap the savings of the community as a whole. The result has been the growth of sophisticated securities markets and credit-granting institutions serving the financial needs of large national, and increasingly international, corporations.

The flow of investor funds to the corporations and the whole process of allocation of financial resources through the financial markets have become dependent to a very large extent on financial reports made by company management. One of the most important characteristics of these corporations is the fact that their ownership is almost totally separated from their management. Management has control over the resources including the accounting systems. They are not only responsible for the financial reports to investors, but they also have the authority to determine the way in which the information is presented.

THEORIES ON THE DEMAND AND SUPPLY OF AUDIT SERVICES

The demand for audit services may be explained by several different theories. Some theories like the Agency Theory have been well researched and reported on. Other theories based on public perceptions such as the Policeman Theory and the Lending Credibility Theory serve more as a point of reference than as a researched construct. These three audit theories are shown in Illustration 1.1.

THE POLICEMAN THEORY

Is an auditor responsible for discovering fraud, like a policeman? Think of this idea as the Policeman Theory. Up until the 1940s it was widely held that an auditor’s job was to focus on arithmetical accuracy and on prevention and detection of fraud. However, from the 1940s until the turn of the 21st century there was a shift of auditing to mean verification of truth and fairness of the financial statements. Recent financial statement frauds such as those at Société Générale, Satyam, Ahold, Enron, etc. have resulted in careful reconsideration of this theory. There now is an ongoing public debate on the auditor’s responsibility for detection and disclosure of fraud returning us to the basic public perceptions on which this theory derives.

ILLUSTRATION 1.1

THEORIES EXPLAINING AUDIT SUPPLY AND DEMAND

THE LENDING CREDIBILITY THEORY

Another public perception is that the primary function of auditing is the addition of credibility to the financial statements. We may think of this as the Lending Credibility Theory. Audited financial statements are used by management to enhance the stakeholders’ faith in management’s stewardship. If stakeholders such as stockholders, government, or creditors have to make their judgments based on the information they receive, they must have faith that this is a fair representation of the economic value and performances of the organization. In audit research terms an audit reduces the ‘information asymmetry’ (the fact that management knows more than the stakeholders).

AGENCY THEORY

In the agency theory, originally proposed by Watts and Zimmerman,¹⁵ a reputable auditor – an auditor who is perceived to meet expectations – is appointed not only in the interest of third parties, but also in the interest of management. A company is viewed as the result of more or less formal ‘contracts’, in which several groups make some kind of contribution to the company, given a certain ‘price’. Company management tries to get these contributions under optimum conditions for management: low interest rates from bankers, high share prices for stockholders, and low wages for employees.

In these relationships, management is seen as the ‘agent’, trying to obtain contributions from ‘principals’ such as bankers, stockholders and employees. Costs of an agency relationship are monitoring costs (the cost of monitoring the agents), bonding costs (the costs, incurred by an agent, of insuring that agents will not take adverse actions against the principals), and residual loss (effective loss that results despite the bonding and monitoring costs incurred).

Agency Theory also includes consideration of ‘moral hazard’. A moral hazard occurs when entering into contract with another company or an agent being deliberately skewed or altered in order to attempt to make a profit.

A clear example of a moral hazard occurs in the case of a salesperson who is compensated at an hourly rate with no commission. The salesperson in this situation may be inclined to put less effort into his performance, as the rate of pay doesn’t change regardless of how hard he works. Typically this sort of situation can be avoided by an (independent) audit or altering the pay structure to include both an hourly salary and commission to serve as a performance incentive.

INFORMATION ASYMMETRY WITHIN THE AGENCY THEORY

Several types of complexities arise in these agent-principal relationships, such as information asymmetry. The agent (management) has a considerable advantage over the principals regarding information about the company. Basically, management knows more about the company’s ability to repay loans than the banker does, and it knows better than the stockholders what the actual profit is, or whether it enjoys excessive bonuses. Furthermore, management knows better than the employees whether the company’s financial condition is such that everybody will still be employed next year. However, management needs the principals to look favorably on them, because they ultimately depend on principals for running the business that management supervises.

In order for the principals (who buy shares in the company, loan the company money, or work for them) to have faith in the information given by management, it must be reliable. This means that there is an incentive for both managers and outside investors to engage reputable auditors.

SUPPLY SIDE OF AGENCY THEORY

Agency theory can also be used to explain the supply side¹⁶ of the audit market. The contribution of an audit to shareholders is basically determined by the probability that the auditor will detect errors in the financial statements (or other irregularities, such as fraud or illegal acts) and the auditor’s willingness to report these errors (e.g. by qualifying the auditor’s report), even against the wish of the auditee (auditor independence). Costs as a result of reputation damage have been demonstrated in several empirical studies, which showed that audit firms, having suffered a public rebuke, were confronted with a decline in their market share.

THE EXPECTATIONS OF AUDITORS

The importance of the company as a potential generator of wealth is increasingly understood, and so is the impact that a company’s activities have on society and the environment. This has led to the expectation by investors that more information than just financial statements should be provided about a company. Public expectations go further and include questions such as:

Is the company a going concern?¹⁷

Is it free of fraud?

Is it managed properly?

Is there integrity in its database?

Do directors have proper and adequate information to make decisions?

Are there adequate controls?

What effect do the company’s products and by-products have on the environment?

Can an ‘unfortunate mistake’ bring this company to its knees?

The auditors are very important to the directors of these corporations. As Sir Adrian Cadbury commented:¹⁸

The external auditors are not part of the company team, but the chairmen (members of a corporate board of directors) have a direct interest in assuring themselves of the effectiveness of the audit approach within their companies. No chairman appreciates surprises, least of all in financial matters. The relationship between auditors and managers should be one where the auditors work with the appropriate people in the company, but do so on a strictly objective and professional basis, never losing sight of the fact that they are there on the shareholders’ behalf. Chairmen need auditors who will stand up to management when necessary and who will unhesitatingly raise any doubts about the people or procedures with the audit committee. Weak auditors expose chairmen to hazards.

FUTURE OF AUDITING

With the explosion in the use of information technology the auditor needs sufficient expertise, coupled with the knowledge of his client’s affairs, to enable her to obtain and interpret all the evidence needed to provide reasonable assurance¹⁹ that the financial statements are fairly presented. The new auditing environment will demand new skills of auditors if they are to be reporters and assessors of governance and measurements. They must have a questioning mind and be able to analyse and critically assess evidence.

In the future, as is the case today, the annual report, financial statements, notes and auditors’ reports will be required. In addition to these, however, there will also be a director’s report on corporate governance²⁰ (including effectiveness of internal control systems,²¹ going concern, and adherence to best practice), and presumably an ISO Standard environmental management report.²² These new reports come from the widespread concern about corporate governance resulting from major accounting scandals in the beginning of the twenty-first century. Auditing is spreading to audit of non-financial, textual and electronic data such as emails, phone messages, social media, human resources, intellectual capital, brand valuation and management, and other intangibles.

DATA LEVEL ASSURANCE

Data level assurance is auditing assurance of the data that the auditor uses to form their opinion. It involves use of authentication technologies to reduce existing and emerging risks, enable new service opportunities, and validate the audit information supply.

The reliability of the data used to develop the expectations should be appropriate for the desired level of assurance. The auditor should assess the reliability of the data by considering the source of the data and the conditions under which it was gathered, as well as other knowledge the auditor may have about the data. The following factors influence the auditor’s consideration of the reliability of data for purposes of achieving audit objectives:

Whether the data was obtained from independent sources outside the entity or from sources within the entity.

Whether sources within the entity were independent of those who are responsible for the amount being audited.

Whether the data was developed under a reliable system with adequate controls.

Whether the data was subjected to audit testing in the current or prior year.

Whether the expectations were developed using data from a variety of sources.

Professor J.P. Percy outlined a perspective on the auditor’s future.²³ He predicted that auditors will account for information not only in financial but also non-financial terms. Furthermore, not only retrospective, but more and more prospective information will be in the annual report. The public desire will be for external and internal assessors on the board of directors. External assessors will appraise the integrity of information and business conduct, and internal assessors will appraise the efficiency and effectiveness of systems and their adequacy. Independent directors or assessors working on behalf of the shareholders within the board will ensure proper governance is being observed. (See Chapter 14 for further discussion of assurance services.)

1.4AUDITING PRACTICE TODAY

THE OBJECTIVE ON AN AUDIT

In conducting an audit of financial statements, the overall objectives of the auditor are:

(a)To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and

(b)To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings.

In all cases when reasonable assurance cannot be obtained and a qualified (financial statements materially misstated) opinion in the auditor’s report is insufficient in the circumstances for purposes of reporting to the intended users of the financial statements, the ISAs require that the auditor disclaim an opinion or withdraw (or resign) from the engagement, if withdrawal is possible under applicable law or regulation.

WELL-DEFINED METHODOLOGY

In the international environment today, the professional auditor audits financial statements, internal control, compliance with policies, compliance with laws and regulations, and codes of best practice. However, no matter what subject matter the audit is designed to evaluate, the audit process is a well-defined methodology to help the auditor accumulate sufficient competent evidence.

EMPIRICAL SCIENTIFIC CYCLE AND THE AUDIT

The audit process may be compared to the empirical scientific cycle.²⁴ The empirical scientific cycle is a systematic process of experimenting that starts with a research question, then a plan for an empirical test of the question is made, the test is done, feedback is analysed, and the scientist makes a judgement. The scientist’s opinion is that the experimental hypothesis is false or not false, or perhaps that the test is inconclusive.

Although the numerous judgments made during a financial audit (about audit approach, sampling, audit risk, etc.) make it more of an art than a science, the audit process follows a systematic process. The audit process begins with a client’s request for an audit of financial statements, which is followed by a plan of the audit and tests of evidence, culminating in a judgement or opinion. The auditor’s judgement is whether the financial statements are as to their fairness, unmodified (unqualified)²⁵ qualified²⁶ or disclaimed.²⁷

A scientist poses a question; this is similar to the client asking an auditor to audit a set of financial statements. A plan is drawn up for the experiment (an audit plan). The scientist tests her theory and evaluates the evidence and an auditor tests the assertions made in the financial statements. The scientist writes up a report on the experiment and an auditor writes a report on the representational quality of the financial statements based on the underlying accounting evidence.

Assessing risk is the core of the audit. The rest of the audit is designed to provide a response to these identified risks. In this book, we will provide a ‘business risk’ orientated approach. Business risks result from significant conditions, events, circumstances, actions, or inactions that could adversely affect a company’s ability to execute its strategies, for example, changes in customer demand, government regulations, etc. Most business risks will eventually have financial consequences and, therefore, an effect on the financial statements. As such, the auditors are required to discuss business risks as part of the planning process.

STANDARD AUDIT PROCESS MODEL IN FOUR PHASES

In this book a four-phase standard audit process model is used based on the scientific empirical cycle. The phases of the audit are:

1Client acceptance and audit engagement

2Assess the risk of material misstatement

3Respond to identified risks

4Evaluate evidence and report findings

Illustration 1.2 shows the four-phase audit process model and its major sub-components.

PHASE I: CLIENT ACCEPTANCE AND AUDIT ENGAGEMENT (PRE-PLANNING)

An audit firm carries out audits for both existing clients and new clients. For existing clients, there is not much activity involved in accepting the client for another year’s audit. The audit firm is familiar with the company and has a great deal of information for making an acceptable decision. However, in the case that it is concluded that the auditor’s business risk is unacceptably high (for example, client is a fraudster or acts illegally) the auditor reconsiders continuation of the agreement. Audit firms have strict procedures for reconsidering high-risk engagements.

When prospective clients approach the audit firm with a request to bid on their financial audits, audit firms must investigate the business background, financial statements, and industry of the client. The firm must also convince the client to accept them. The process of client acceptance involves evaluation of the client’s background, selecting personnel for the audit, and evaluating the need and requirements for using the work of other professionals. (The client acceptance phase of the auditing methodology is discussed in detail in Chapter 6 ‘Client and Engagement Acceptance / Continuance’.)

PHASE II: ASSESS THE RISK OF MATERIAL MISSTATEMENT (PLANNING)

The auditor must plan her work to enable her to conduct an effective audit in an efficient and timely manner. Plans should be based on knowledge of the client’s business.

Plans are developed after assessing risk of financial material misstatement by obtaining a basic understanding of the business background, control environment, and control activities (procedures),²⁸ and the client’s accounting system which might include performing analytical procedures.²⁹ The second part of the planning process is to determine the riskiness of the engagement and set materiality levels. Finally, the auditor prepares an audit plan (programme)³⁰ which outlines the nature, timing and extent of audit procedures required to gather evidence that responds to the identified risks.

ILLUSTRATION 1.2

OVERVIEW OF THE AUDIT PROCESS

ISA 315 (Revised) sets out the risk assessment procedures that form the foundation for an audit of financial statements. ISA 315 offers detailed guidance for auditors to perform consistent and effective identification of the risks of material misstatement. See chapters 7 and 8.

One of the most widely accepted concepts on auditing is the importance of the client’s internal control system³¹ to reliable financial information. If the client has adequate internal controls for proving reliable data and safeguarding assets and records, the amount of audit evidence required, and planned for, is significantly less than where internal controls are inadequate. Therefore, assessing the design and operating effectiveness of internal controls is a very important part of the planning process.

An entity’s internal control structure includes five basic categories of policies and procedures. Management designs and implements this in order to provide reasonable assurance that its control objectives will be met. These components of internal control are:³²

1the control environment

2risk assessment

3control procedures

4information system

5monitoring

Planning concepts are discussed in Chapter 7 ‘Phase II, part 1: Planning through Understanding and Risk Analysis’ and Chapter 8 ‘Internal Control and Control Risk’. Illustration 1.3 shows a diagrammatic view of the result of planning – devising the audit programme from an understanding of the company, internal control analysis, and analysis of assertions.

PHASE III: TESTING AND EVIDENCE

The audit should be performed and the report prepared with due professional care by persons who have adequate training, experience and competence in auditing. The auditor should also be independent of the audit and keep the results of the audit confidential, as required by international ethics. ‘Due professional care’ means that the auditor is a professional responsible for fulfilling her duties diligently and carefully. Due care includes the completeness of the working papers, the sufficiency of the audit evidence and the appropriateness of the audit report.

The testing and evidence-gathering phase of the audit requires first planning the test procedures. Then testing is done of any controls that the auditor expects to rely upon. Once the controls are tested, the auditor must decide on additional, substantive, tests. The understanding of controls is needed to determine what kind of tests (the nature), when they should be done (timing), and what the number (extent) of the tests should be.

GATHERING EVIDENCE

The auditor should obtain sufficient appropriate audit evidence through the performance of control and substantive procedures³³ to enable her to draw reasonable conclusions on which to base her audit opinion. Tests of controls³⁴ are audit procedures designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level; substantive procedures are designed to obtain evidence as to the completeness, accuracy, and validity of the data produced by the accounting system. A substantive procedure is an audit procedure designed to detect material misstatements at the assertion level. Substantive procedures comprise: (1) Tests of details (of classes of transactions, account balances, and disclosures) and (2) Substantive analytical procedures.

ILLUSTRATION 1.3

THE RESULT OF PLANNING

There are three types of tests: details of transactions, account balances, and analytical review. (Audit evidence is discussed in Chapter 9 ‘Phase III: Building and execution of the test plan – controls and substantive procedures’ and Chapter 10 ‘Phase III: Building and execution of the test plan – Analytical Review’.)

PHASE IV: EVALUATION, COMPLETION, AND REPORTING (EVALUATE EVIDENCE AND REPORT FINDINGS)

After the fieldwork is almost complete, a series of procedures are generally carried out to ‘complete the audit’. The intent of these procedures is to review the audit work, get certain assurances from the client, uncover any potential problems, check compliance with regulations, and check the consistency of the material that is to be presented to the users of financial statements. We discuss this further in Chapter 11.

The auditor must perform final audit procedures before the audit report can be written. The auditor must:

obtain legal letters,

identify subsequent events,

carry out an overall review,

review all material that goes into the annual report, report to the board of directors

obtain a written representation from management (management representations letter),³⁵

carry out wrap up procedures.

The auditor should review and assess the conclusions drawn from audit evidence on which she will base her opinion on the financial information. We discuss this in Chapter 12. This review and assessment involves forming an overall conclusion as to whether:

the financial information has been prepared using acceptable accounting policies, consistently applied;

the financial information complies with relevant regulations and statutory requirements;

the view presented by the financial information as a whole is consistent with the auditor’s knowledge of the business of the entity; and

there is adequate disclosure of all material matters relevant to the proper presentation of the financial information.

THE AUDIT OPINION

The audit report should contain a clear written expression of opinion on the financial information. An unmodified (unqualified) opinion indicates the auditor’s satisfaction in all material respects with the matters. When a qualified opinion, adverse opinion or disclaimer of opinion is given, the audit report should state the reasons in a clear and informative manner.

Completing the audit is discussed in Chapter 11 ‘Phase IV: Evaluation and Completion’. Audit reports are discussed in detail in Chapter 12 ‘Phase IV: Reporting’.

1.5USER EXPECTATIONS AND LANDMARK LEGISLATION

In our discussion of audit theories, the Policeman Theory was mentioned and its inability to explain the historic shift from prevention and detection of fraud to verification of truth and fairness of the financial statements. The development of the auditor’s duties, linked to changes in the audit market, is still an object of public debate, often referred to as the audit expectation gap debate. The expectations gap is defined as the gap between society’s expectations of auditors and auditors perceived performance, comprising ‘reasonableness’ and ‘performance’ components. This gap results from the fact that users of audit services have expectations regarding the duties of auditors that exceed the current practice in the profession.

A good deal of research has been done on the audit expectation-performance gap by Brenda Porter and others.³⁶ Early empirical research was conducted by Porter to investigate the audit expectation-performance gap. The study highlighted the duties which constitute the reasonableness, deficient standards and deficient performance components of the gap. The research provided insights into the structure, composition and extent of the audit expectation-performance gap and suggested a rational, comprehensive approach towards narrowing the gap.

AUDITORS’ DUTIES AND THE EXPECTATIONS OF AUDIT SERVICES USERS

The users of audit services can broadly be classified as auditees (management, the board of directors) and third parties (shareholders, bankers, creditors, employees, customers, and other groups). Each of these groups has its own set of expectations with regard to an auditor’s duties. Expectations were found with regard to the following duties of auditors in giving an opinion on the:

fairness of financial statements;

company’s ability to continue as a going concern;

company’s internal control system;

occurrence of fraud;

occurrence of illegal acts.

Current developments in each of these duties will be described in the remainder of this section.

OPINION ON THE FAIRNESS OF FINANCIAL STATEMENTS

Giving an opinion on the fairness of the financial statements is generally regarded as the auditor’s core business. Most of the national and international auditing guidelines are concerned with this particular duty. Expectation gap studies demonstrate that public expectations are high. Basically, it seems that a large part of the financial community (users of audit services) expects that financial statements with an unmodified (unqualified) audit opinion are completely free from error. Companies like Enron, Parmalat and WorldCom which reported fraudulent financial statements had financial statements that did not fairly reflect the underlying financial condition of those companies. The inherent limitations of auditing, expressed in materiality and audit risk (see Chapter 4 ‘The Fundamental Concepts of Auditing and Assurance’) are not entirely accepted and/or understood by all groups of users.

Standard on Auditing (ISA) 705³⁷ deals with the auditor’s responsibility to issue an appropriate report in circumstances when, in forming an opinion in accordance with ISA 700,³⁸ the auditor concludes that a modification to the auditor’s opinion on the financial statements is necessary. ISA 700 requires the auditor, in order to form an opinion on the financial statements, to conclude as to whether reasonable assurance has been obtained about whether the financial statements as a whole are free from material misstatement.

OPINION ON THE COMPANY’S ABILITY TO CONTINUE AS A GOING CONCERN

Perhaps the most disturbing events for the public’s trust in the audit profession are cases where an unmodified (unqualified) audit report has been issued shortly before a company’s bankruptcy.

Under ISA 570³⁹ and most national regulations, auditors need to determine whether the audited entity is able to continue as a going concern. Although warning the financial statement users of any threatening financial distress is appropriate, the disclosure of a possible future bankruptcy – especially when the future course of events is hard to predict – may prove to be a self-fulfilling prophecy which deprives management of its means to save the company.

OPINION ON THE COMPANY’S INTERNAL CONTROL SYSTEM

The issue of testing and reporting on the quality of a company’s internal control system has been recognized as one of the focal issues in auditing. ISA 315⁴⁰ states that ‘the objective of the auditor is to identify and assess the risks of material misstatement … through understanding the entity and its environment, including the entity’s internal control.’ ISAE 3000⁴¹ states that ‘the assurance report should be in writing and shall contain a clear expression of the practitioner’s conclusion about the subject matter information.’ Furthermore, the United States Sarbanes–Oxley Act of 2002 requires that company officers certify that internal controls are effective and requires that an independent auditor verify management’s analysis.⁴² US Public Company Accounting Oversight Board (PCAOB) has promulgated reorganized Audit Standard 2201 ‘An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements’ (originally Audit Standard No. 5⁴³) that addresses internal control audits.

Expectation gap surveys show high expectations of the auditor’s role in testing whether a satisfactory system of internal control is being operated. These expectations are likely to be met in current audit environments.

BARINGS BANK EXAMPLE

Barings Bank is an example of a company whose breakdown in internal controls, specifically segregation of duties, led to the ultimate destruction of the company.⁴⁴ In 1995 Nicholas Leeson, manager of the Singapore Branch of Barings, not only made investments in the Nikkei exchange index derivatives, but also was able to authorize and account for his investment (account settling). This ultimately led to the multi-billion dollar collapse of Barings and a jail sentence for Leeson.

REPORTING ON EFFECTIVENESS OF INTERNAL CONTROL

There has been much discussion in Europe, Canada and the USA about reporting on the effectiveness and functioning of internal controls. The Sarbanes–Oxley Act requires auditors to report on internal control.⁴⁵ Support for reporting lies in the belief that users of financial information have a legitimate interest in the condition of the controls over the accounting system and management’s response to the suggestions of the auditors for correction of weaknesses. Those who argue against reporting on controls say that such reporting increases the cost of audits, increases auditor (and director) liability and is not relevant information.

Section 404 of the Sarbanes–Oxley Act (see ‘Landmark Studies…’, below) requires each annual report of a company to contain an ‘internal control report’ which should:

1.state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting;

2.contain an assessment, as of the end of the fiscal year, of the effectiveness of the internal control system and procedures for financial reporting;

3.contain an ‘attestation’ to management’s assessment by the company’s independent, outside auditors; and

4.contain an attestation by an independent auditor to any difference between management’s required assertions and the audit evidence on internal controls.

The Combined Code of the Committee on Corporate Governance,⁴⁶ (see ‘Landmark Studies …’ below) which represents the Code of Best Practice of the London Stock Exchange, states in Provision D.2 that: ‘The board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.’ Provision D.2.1 states that: ‘The directors should, at least annually, conduct a review of the effectiveness of the group’s system of internal control and should report to shareholders that they have done so. The review should cover all controls, including financial, operational and compliance controls and risk management.’

OPINION ON THE OCCURRENCE OF FRAUD

The audit expectation gap is frequently associated with the fraud issue. Both governments and the financial community expect the auditor to find existing fraud cases and report them. The fact that this part of the expectation gap has attracted so much attention is partly attributable to the evolution of auditing. As stated in our brief description of the history of auditing, the detection of fraud has been one of the profession’s cornerstones. (See Chapter 5 ‘Fraud and Other Considerations of Law and Regulation in an Audit (ISA 240, 250)’)

FAMOUS FRAUDS

The largest non-financial statement fraud of all time was the Ponzi scheme of Bernard Madoff, who ran a $60 billion fraudulent hedge fund.⁴⁷ Major companies that issued fraudulent financial statements in the early twenty-first century included: US companies Enron, WorldCom, Xerox, Tyco, Health South, Bristol Myers, Citibank, Kmart and NextCard; European firms Ahold, Parmalat and Comroad; Japanese bank Resona; and Australian insurance company HIH. Famous frauds before Enron include: Lincoln Savings and Loan, Penn Square, Sunbeam, Regina, ZZZZ Best, Crazy Eddy, Waste Management, and Mattel. Some of these cases are discussed in ‘Concept and a Company’ cases throughout this book.

The current position of the audit profession as to fraud is described in ISA 240.⁴⁸ According to ISA 240, the primary responsibility for the prevention and detection of fraud and error rests with both those charged with the governance and the management of an entity. Fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. The auditor is responsible for obtaining reasonable assurance that the financial statements are free from material statement, whether caused by fraud or error.

OCCURRENCE OF ILLEGAL ACTS

Closely related to the subject of fraud is the auditor’s reaction to the occurrence of illegal acts in a company. Both ISA 250⁴⁹ and most national regulators state that the auditor’s responsibility in this area is restricted to designing and executing the audit in such a way that there is a reasonable expectation of detecting material illegal acts which have a direct impact on the form and content of the financial statements. In reporting illegal acts most national regulators require the auditor to assess the potential impact on the financial statements and determine the consequences of the uncertainty or error in the financial statements for the nature of the opinion.

The professional regulations in some countries require the auditor to inform members of the audit committee or board of directors. Informing third parties is allowed in certain circumstances. (See Chapter 5 ‘Fraud and Other Considerations of Law and Regulation in An Audit (ISA 240,250)’.) ISA 240 and ISA 250 address what should be reported in auditor communication of illegal acts. Most expectation gap studies reveal that respondents expect the auditor to detect and report illegal acts that have a significant impact on the financial statements.

EXAMPLES OF LANDMARK STUDIES AND LEGISLATION THAT INFLUENCED THE INTERNATIONAL AUDIT MARKET

Partly as a response to some of the expectation gap issues, there have been two landmark studies (the COSO Report⁵⁰ and the Cadbury Report⁵¹ which lead to the Combined Code⁵² and the Turnbull Report)⁵³ and most recently responses have been legislated into the US accounting profession by the Sarbanes–Oxley Act of 2002.⁵⁴

THE COSO REPORT

The COSO report was published by the Committee of Sponsoring Organizations of the Treadway Commission. The COSO report envisaged (see Illustration 1.4):

harmonizing the definitions regarding internal control and its components;

helping management in assessing the quality of internal control;

creating internal control benchmarks, enabling management to compare the internal control in their own company to the state-of-the-art; and

creating a basis for the external reporting on the adequacy of the internal controls.

Although all of these objectives might have an influence on the audit service, the latter subject is particularly relevant, because it might lead to certification by the auditor of management’s assertions regarding the quality of a company’s internal control system. (The COSO report is discussed extensively in Chapter 6 ‘Client and Engagement Acceptance/Continuance’.)

ILLUSTRATION 1.4

THE COSO REPORT OBJECTIVES

THE CADBURY REPORT, COMBINED CODE AND TURNBULL REPORT

CADBURY REPORT

The Cadbury Report was published in the UK by the Committee on the Financial Aspects of Corpo-rate Governance. Cadbury deals with the responsibilities and duties of the executive and non-executive members of the board of directors. The report suggests that companies listed on the London Stock Exchange should adhere to a Code of Best Practice, in which these responsibilities and duties are listed. In June 1998 the London Stock Exchange published a new Listing Rule together with related Principles of Good Governance and Code of Best Practice (called ‘the Combined Code’). The Combined Code combines the recommendations of the so-called Cadbury, Greenbury and Hampel committees on corporate governance.

In the published financial statements, the board should declare the adherence to this code and should, much like the later Sarbanes–Oxley Act of the US, explicitly assume responsibility for the financial statements. In addition, the Cadbury Report suggested that the board should report that it tested the adequacy of the company’s internal control as well as the company’s ability to continue as a going concern, also like the Sarbanes–Oxley. Amongst the changes in Combined Code versus the Cadbury Best Practices, perhaps the greatest is the extension of the requirement to report on the review of internal controls beyond financial controls. The Cadbury Report originally suggested reporting on all controls, but had subsequently modified its stance to include only financial controls.

TURNBULL REPORT/COMBINED CODE

Internal Control: Guidance for Directors on the Combined Code, called the ‘Turnbull Report’ after Nigel Turnbull, Chairman of the Committee which wrote the Report, provides guidance to assist London Stock Exchange listed companies to implement the requirements in the Combined Code relating to internal control. The Report states that the board of directors should set appropriate policies on internal control and seek regular assurance that the internal control system is functioning effectively in managing risks in the manner that the board has approved.

THE SARBANES–OXLEY ACT OF 2002

The accounting scandals begun by the Enron collapse and extending to such giant companies as WorldCom, Xerox and Tyco, caused a backlash in the USA, resulting in legislation being signed into law by the US President in July 2002. The Sarbanes–Oxley Act is the first accounting law passed by the US since the Securities and Exchange Act of 1934.

SARBANES–OXLEY ACT REQUIREMENTS FOR AUDIT FIRMS AND AUDIT COMMITTEES

The Act had new requirements for audit firms and audit committees. Auditors must report to the audit committee,⁵⁵ not management. The lead audit partner and audit review partner must be rotated every five years. A second partner must review and approve audit reports. It is a felony with penalties of up to ten years in jail to wilfully fail to maintain ‘all audit or review work papers’ for at least five years. Destruction of documents carries penalties of up to 20 years in jail. The Act lists eight types of services that are ‘unlawful’ if provided to a publicly held company by its auditor: book-keeping, information systems design and implementation, appraisals or valuation services, actuarial services, internal audits, management and human resources services, broker/dealer and investment banking, and legal or expert services related to audit service. The Public Company Accounting Oversight Board (PCAOB), created by the Act, may also determine by regulation other services it wishes to prohibit. Non-audit services not banned by the Act must be pre-approved by the audit committee. Management must assess and make representations about the effectiveness of the internal control structure and their auditor will be required to attest to the assessment and describe the tests used.

1.6SUMMARY

A general definition of auditing is ‘An audit is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and established criteria, and communicating the results to interested users.’

ISA 200 sets out several requirements relating to an audit of financial statements. The auditor is required to comply with relevant ethical requirements, including those pertaining to independence, relating to financial statement audit engagements. The auditor must plan and perform an audit with professional skepticism recognising that circumstances may exist that cause the financial statements to be materially misstated. The auditor must also exercise professional judgement in planning and performing an audit. To obtain reasonable assurance, the auditor must obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level and thereby enable the auditor to draw reasonable conclusions on which to base the auditor’s opinion.

The concept of materiality is applied by the auditor in planning and performing the audit, and in evaluating the effect of identified misstatements on the financial statements. Misstatements, including omissions, are considered to be material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users based on the financial statements.

Auditing predates the Christian era. Anthropologists have found records of auditing activity dating back to early Mesopotamian times (around 3000 BC). There was also auditing activity in ancient China, Greece and Rome. The Latin meaning of the word ‘auditor’ was a ‘hearer or listener’ because in Rome auditors heard taxpayers, such as farmers, give their public statements regarding the results of their business and the tax duty due. Auditors existed in ancient China and Egypt. They were supervisors of the accounts of the Chinese Emperor and the Egyptian Pharaoh. The government accounting system of the Zhao (1046–221 BC) dynasty in China included an elaborate budgetary process and audits of all government departments. From the dawn of the dynastic era in Egypt (3000 BC) the scribes (accountants) were among the most esteemed in society and the scribal occupation was one of the most prestigious occupations.

The attitude of profit maximization emerged at the end of the Middle Ages, with the emergence of large merchant houses in Italy. A system of double entry bookkeeping was first described in Italy, used by a Genoa commune in 1340 AD. The first book on double entry accounting was Luca Pacioli’s Summa de Arithmetica dated 20 November 1494.

The practice of modern auditing dates back to the beginning of the modern corporation at the dawn of the Industrial Revolution. In 1853, the Society of Accountants was founded in Edinburgh. Several other institutes emerged in Great Britain, merging in 1880 into the Institute of Chartered Accountants in England and Wales.

Today the flow of investor funds to the corporations and the whole process of allocation of financial resources through the securities markets have become dependent to a very large extent on financial reports made by company management. One of the most important characteristics of these corporations is the fact that their ownership is almost totally separated from their management. Management has control over the accounting systems. They are not only responsible for the financial reports to investors, but they also have the authority to determine the way in which the information is presented.

The demand for audit services may be explained by several different theories. Agency Theory has been well researched and reported on. Other theories based on public perceptions such as the Policeman Theory and the Lending Credibility Theory serves more as a point of reference than as a researched construct.

In the agency theory, originally proposed by Watts and Zimmerman, a reputable auditor – an auditor who is perceived to meet expectations – is appointed not only in the interest of third parties, but also in the interest of management. A company is viewed as the result of more or less formal ‘contracts’, in which several groups make some kind of contribution to the company, given a certain ‘price’. Company management tries to get these contributions under optimum conditions for management: low interest rates from bankers, high share prices for stockholders, and low wages for employees. Agency Theory also includes consideration of ‘moral hazard’. A moral hazard occurs when entering into contract with another company or an agent being deliberately skewed or altered in order to attempt to make a profit.

Data level assurance is auditing assurance of the data that the auditor uses to form their opinion. It involves use of authentication technologies to reduce existing and emerging risks, enable new service opportunities, and validate the audit information supply.

In conducting an audit of financial statements, the overall objectives of the auditor are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and (b) To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor ‘s findings.

In this book a four-phase standard audit process model is used based on the scientific empirical cycle. The phases are: 1 client acceptance and audit engagement (pre-planning); 2 assess the risk of material misstatement (planning basis for an audit approach); 3 respond to identified risks (tests for evidence) and 4 evaluate evidence and report findings.

The users of audit services can broadly be classified as auditees (management, the board of directors) and third parties (shareholders, bankers, creditors, employees, customers, and other groups). Each of these groups has its own set of expectations with regard to an auditor’s duties. Expectations were found with regard to the following duties of auditors in giving an opinion on the: (a) fairness of financial statements; (b) company’s ability to continue as a going concern; (c) company’s internal control system; (d) occurrence of fraud; and (e) occurrence of illegal acts.

Partly as a response to some of the expectation gap issues, there have been two landmark studies (the COSO Report and the Cadbury Report which lead to the Combined Code and the Turnbull Report) and most recently responses have been legislated into the US accounting profession by the Sarbanes–Oxley Act of 2002.

1.7QUESTIONS, EXERCISES AND CASES

QUESTIONS

1.2An Audit Defined

1-1What is the general definition of an audit? Briefly discuss the key component parts of the definition.

1-2Explain the concept of materiality.

1-3Discuss the two levels of risk an auditor must consider when designing audit procedures.

1.3History

1-4Identify and briefly discuss factors that have created the demand for international auditing.

1-5Ever larger and more international corporations resulted in the demands of owner-managed enterprises for capital rapidly exceeding the combined resources of the owners’ savings and the wealth-creating potential of the enterprises themselves. How did corporations respond?

1-6What are the most important theories on the demand of audit services?

1-7Give a brief description of the agency theory as applied to both the demand and the supply of audit services.

1.4Auditing Practice Today

1-8In conducting an audit of financial statements, what are the overall objectives of the auditor?

1-9How can one compare the empirical scientific cycle to the financial audit process?

1-10What are the four phases of an audit process model? Briefly describe each.

1-11Based on the evaluate evidence and report findings phase (IV) of the audit process model the overall conclusions are formed on what judgements?

1.5User Expectations and Landmark Legislation

1-12Discuss the following statement: ‘Auditors perform extensive tests on a company’s internal control system in order to determine whether they can rely on that system in the course of their audit. Therefore, auditors can express an opinion on the adequacy of the audited company’s internal control system.’

1-13Discuss the impact of the Cadbury Report, Combined Code and COSO report on the audit profession.

1-14Discuss the following statement: ‘Auditors should not be allowed to combine an audit for one client with advisory services to that client.’

PROBLEMS AND EXERCISES

1.2An Audit Defined

1-15Based on ISA 200, what are the general principles governing an audit of financial statements? Discuss ethics and professional scepticism.

1.3History

1-16In this chapter, the history of auditing has been briefly described from an international perspective. Identify the major differences with the developments specific for your country and try to explain these based on differences in the economic system or development.

1-17Agency Theory. Identify principals and agents in the cases mentioned below. Describe the contributions and ‘prices’ associated with these relationships, identify potential risks for the principal and give suggestions for limiting these risks:

A.The Pasadena Bank lends money to the Alhambra Construction Company.

B.Employee Mario Auditorio considers leaving his current job and starting a new career with Instituto Milanese.

C.Manager Yu-Chang receives an annual bonus, based on last year’s profit of company Shang-Zu.

D.Supplier ‘Vite et Juste’ delivers goods to company ‘Merci’. Payment is due 60 days after the date of the invoice.

1.4Auditing Practice Today

1-18Objectives of an Audit. Tracy Keulen, the sole owner of a small bakery, has been told that the business should have financial statements reported on by an independent Registeraccountant (RA). Keulen, having some bookkeeping experience, has personally prepared the company’s financial statements and does not understand why such statements should be examined by an RA. Keulen discussed the matter with Petra Dassen, an RA, and asked Dassen to explain why an audit is considered important.

Required:

A.Describe the objectives of the independent audit.

B.Identify five ways in which an independent audit may be beneficial to Keulen.

1-19Audit Process Model. What are the four Phases of an Audit? Discuss each. Determine which is the most important of the four and explain why.

1-20Audit Process Model. Based on the standard Audit Process Model, trace the procedures an auditor would use to audit a retail clothing business (continuing client) from the initial client contact to the audit opinion.

1.5User Expectations and Landmark Legislation

1-21Opinion on the Occurrence of Illegal Acts. Ostling, Auktoriserad Revisor, accepted an engagement to audit the financial statements of Sandnes Company of Göteborg, Sweden. Ostling’s discussions with Sandnes’s new management and the predecessor auditor indicated the possibility that Sandnes’s financial statements may be misstated due to the possible occurrence of errors, irregularities and illegal acts.

Required:

A.Identify and describe Ostling’s responsibilities to detect Sandnes’s errors and irregularities. Do not identify specific audit procedures.

B.Identify and describe Ostling’s responsibilities to report Sandnes’s errors and irregularities.

C.Describe Ostling’s responsibilities to detect Sandnes’s material illegal acts. Do not identify specific audit procedures.

1-22Compare the COSO Report, Combined Code and the Sarbanes–Oxley Act on what each says about the following:

A.Corporate governance

B.Audit firms

C.Internal controls

CASES

1-23International Standards on Auditing (ISA). International Standards on Auditing (ISA). Download the latest version of Handbook of International Quality Control, Auditing Review, Other Assurance, And Related Services Pronouncements from the IAASB website https://www.iaasb.org/publications/2018-handbook-international-quality-control-audi-ting-review-other-assurance-and-related-services-26 OR by way of https://www.iaasb.org/standards-pronouncements. Pick one ISA and discuss how that standard would influence the work of an auditor.

1-24Qualifications of Auditors. From the library get a copy of the EC Eighth Company Law Directive which is about the qualifications and work of auditors.

Required:

Based on the Eighth Directive, answer the following questions.

A.How many years of work experience must an auditor have before he can receive an auditing credential?

B.How many years of education must an auditor have before certification?

C.Name some of the requirements for the work of auditors.

1-25Due Professional Care. Discuss lawsuits resulting from negligence of ‘due professional care’. Required:

A.Consult the library, a database like Lexis-Nexis or the internet for lawsuits resulting from negligence of ‘due professional care’. Discuss at least two.

B.Describe briefly the court’s final conclusion and results from the court decision.

1.8NOTES

1International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing 200 (ISA 200) ‘Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing’, paragraphs 1–9. International Federation of Accountants, New York, Handbook of International Quality Control, Auditing Review, Other Assurance, and Related Services Pronouncements, 2018 ed, Part I, International Federation of Accountants, New York.

2American Accounting Association, 1973, A Statement of Basic Auditing Concepts, Studies in Accounting Research (6), American Accounting Association, Sarasota, Florida, p. 2.

3Throughout this book, as a matter of convenience, we will use the terms ‘she’ and ‘her’ and ‘hers’ which will be meant to indicate all genders: she, he, him, her, his, hers, and any persons whatsoever.

4This section paraphrases ISA 200; op. cit. paragraphs 3–9.

5ISA 200, op. cit. paragraphs 14–17.

6Professional scepticism – an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of evidence (discussed in more detail in Chapter 4).

7Material misstatement – a significant mistake in financial information which would arise from errors and fraud if it could influence the economic decisions of users taken on the basis of the financial statements.

8Professional judgement – the application of relevant training, knowledge and experience, within the context provided by auditing, accounting and ethical standards, in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. (Discussed in more detail in Chapter 4.)

9Sufficient appropriate audit evidence – sufficiency is the measure of the quantity (amount) of audit evidence. Appropriateness is the measure of the quality of audit evidence and its relevance to a particular assertion and its reliability. (We will discuss evidence at some length in Chapters 9 and 10.)

10Such non-financial information might include footnote disclosures, the management’s report, the report of the directors, or even the whole annual report.

11ISA 200, op. cit. paragraph 11.

12Materiality – information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful. (We discuss materiality in greater depth in Chapter 6.)

13Control environment – includes the governance and management functions and the attitudes, awareness and actions of those charged with governance and management concerning the entity’s internal control and its importance in the entity. The control environment is a component of internal control.

14The Afrikaansche Handelsvereeniging was a company controlled by a very reputable citizen of Rotterdam, the Netherlands. He managed to conceal important losses of his company to bankers, creditors and stockholders by providing false balance sheets.

15See Watts, R.L. and Zimmerman, J.L., 1978, ‘Towards a Positive Theory of the Detemination of Accounting Standards’, The Accounting Review, January, pp. 112–134; and Watts, R.L. and Zimmerman, J.L., 1979, ‘The Demand for and Supply of Accounting Theories: The Market for Excuses’, The Accounting Review, April, pp. 273–305.

16The supply side of the audit market is concerned with the determination of the level of audit labor and independence.

17Going concern assumption – under the going concern assumption, an entity is ordinarily viewed as continuing in business for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading, or seeking protection from creditors pursuant to laws or regulations. Accordingly, assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business.

18Cadbury, Adrian, 1995, The Company Chairman, 2nd ed, Prentice Hall, Hemel Hempstead, England, p. 116.

19Reasonable assurance – in the context of audit engagements and in quality control is a high, but not absolute, level of assurance. In an audit engagement, the auditor provides a high, but not absolute, level of assurance, expressed positively in the audit report as reasonable assurance, that the information subject to audit is free of material misstatement.

20Required of companies listed on the London Stock Exchange. Recommended in 1992 by the Committee on the Financial Aspects of Corporate Governance (the Cadbury Report). At the heart of the Cadbury Report is a Code of Best Practice designed to achieve the necessary high standards of corporate behavior.

21The Committee of Sponsoring Organizations of the Treadway Commission (COSO) recommended a management report on internal control in 1992. In 1989, one public company in four reported in some way on internal controls. For Fortune 500 companies, the number was about 60 per cent. Now internal control is required for all companies listed on the US Stock Exchange or otherwise reporting to the SEC under the Sarbanes–Oxley Act.

22See: International Standards Organization (ISO), 2009, Environmental Management, The ISO 13 family of International Standards, https://www.iso.org/ics/13/x/.

23Percy, J.P., 1995, ‘The Relevance of Research in the Development of Interpersonal Skills for Accountants’, FEE/ IFAC 1995 International Accountancy Conference, 12 May 1995, Amsterdam and Breukelen, the Netherlands.

24Wallage, Philip, 1993, ‘Internationalizing Audit: A Study of Audit Approaches in the Netherlands’, European Accounting Review, 1993, No. 3, pp. 555–578.

25Unmodified (unqualified opinion) – an audit opinion expressed when the auditor concludes that the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the identified financial reporting framework.

26Qualified opinion – a qualified opinion is expressed when the auditor concludes that an unqualified opinion cannot be expressed but that the effect of any disagreement with management, or limitation on scope, is not so material and pervasive as to require an adverse opinion or a disclaimer of opinion.

27Disclaimer of opinion – a disclaimer of opinion is expressed when the possible effect of a limitation on scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and accordingly is unable to express an opinion on the financial statements.

28Control activities – those policies and procedures that help ensure that management directives are carried out. Control activities are a component of internal control.

29Analytical procedures – evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount.

30Audit plan – a work plan that reflects the design and performance of all audit procedures, consisting of a detailed approach for the nature, timing and extent of audit procedures to be performed (including the performance of risk assessment procedures) and the rationale for their selection. The audit plan begins by planning risk assessment procedures and once these procedures have been performed it is updated and changed to reflect the further audit procedures needed to respond to the results of the risk assessments. Also called audit programme.

31Internal control structure – the set of policies and procedures designed to provide management with reasonable assurance that the goals and objectives it believes are important will be met.

32Committee of Sponsoring Organizations of the Treadway Commission (COSO), 1992, Chapter 1 ‘Definition’ Internal Control Integrated Framework – Framework, American Institute of Certified Public Accountants, Jersey City, New Jersey, 1992.

33Substantive procedure – an audit procedure designed to detect material misstatements at the assertion level. Substantive procedures comprise: (a) Tests of details (of classes of transactions, account balances, and disclosures); and (b) Substantive analytical procedures.

34Tests of controls – an audit procedure designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level.

35Written representation – a written statement by management provided to the auditor to confirm certain matters or to support other audit evidence. Written representations in this context do not include financial statements, the assertions therein, or supporting books and records.

36Porter, Brenda, ‘An Empirical Study of the Audit Expectation-Performance Gap’, Accounting and Business Research, Volume 24, 1993 – Issue 93 and others: Richard T. Fisher and Samuel T. Naylor (2016), ‘Corporate reporting on the Internet and the expectations gap: new face of an old problem’, Accounting and Business Research 46:2, pp. 196–220. / Klaus Ruhnke, Martin Schmidt (2014), ‘The audit expectation gap: existence, causes, and the impact of changes’, Accounting and Business Research 44:5, pp. 572–601 / Ivo Blij IV, Harold Hassink, Gerard Mertens, Reiner Quick (1998), ‘Disciplinary practices and auditors in Europe: a comparison between Germany and the Netherlands’, European Accounting Review 3, pp. 467–491.

37International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing 705 (ISA 705) ‘Modifications to the Opinion in the Independent Auditor’s Report’, Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part I, International Federation of Accountants, New York.

38International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing 700 (ISA 700) ‘Forming an Opinion and Reporting on Financial Statements’, Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part I, International Federation of Accountants, New York.

39International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing (ISA 570) ‘Going Concern’, Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part I, International Federation of Accountants, New York.

40International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing 315 (ISA 315) ‘Identifying and Assessing the Risks of Material Misstatement Through Understanding The Entity And Its Environment’, Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part I, International Federation of Accountants, New York.

41International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Assurance Engagements (ISAE) 3000 ‘Assurance Engagements Other Than Audits or Reviews of Historical Financial Information’, Paragraph 67, Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part II, International Federation of Accountants, New York.

42Congress of the United States, 2002, Sarbanes–Oxley Act of 2002, s 404 ‘Management Assessment of Internal Controls’, Washington, DC.

43PCAOB, 2007, Audit Standard No. 5, (currently Audit Standard 2201) ‘An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements’, Public Company Accounting Oversight Board.

44A movie was made in 1999 about this event called Rogue Trader (Warner Brothers).

45PCAOB, 2007, Audit Standard No. 5, op. cit., Sec. 405.

46The Committee on Corporate Governance, 1998, the Combined Code, London Stock Exchange, London, January.

47US Securities and Exchange Commission Office of Investigations, 2009, ‘Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme’, Report No. OIG–509, April 31, 2009, Washington, DC.

48International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing 240 (ISA 240) ‘The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements’, Handbook of International Quality Control, Auditing Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part I, International Federation of Accountants, New York.

49International Auditing and Assurance Standards Board (IAASB), 2018, International Standard on Auditing 250 (ISA 250) ‘Consideration of Laws and Regulations in an Audit of Financial Statements’, Handbook of International Quality Control, Auditing Review, Other Assurance, and Related Services Pronouncements, 2018 edn, Part I, International Federation of Accountants, New York.

50Committee of Sponsoring Organizations of the Treadway Commission (COSO), 1992, Internal Control – Integrated Framework, American Institute of Certified Public Accountants.

51Committee on the Financial Aspects of Corporate Governance, Report of the Committee on the Financial Aspects of Corporate Governance (the Cadbury Report), Gee and Co. Ltd, London, December 1992.

52KPMG Review, 1999, The Combined Code: A Practical Guide, KPMG, UK, January.

53Internal Control Working Party, 1999, Internal Control: Guidance for Directors on the Combined Code, published by the Institute of Chartered Accountants in England and Wales, London, September.

54107th US Congress, 2002, Sarbanes–Oxley Act of 2002, Public Law 107–204, Senate and House of Representatives of the United States of America in Congress Assembled, Washington, DC, 30 July.

55An audit committee is selected members of the company’s outside directors who take an active role in overseeing the company’s accounting and auditing policies and practices.

SECTION II

THE PROFESSION

CHAPTER 2

THE INSTITUTIONAL SETTING: HOW IS THE AUDIT PROFESSION ORGANIZED

2.1LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1Understand drivers for audit regulation.

2Understand the role of audit oversight.

3Identify organizations that affect international accounting and auditing.

4Name the standards set by International Auditing and Assurance Standards Board.

5Give an overview of the IAASB International Standards on Auditing (ISA).

6Understand the basic definition of auditing in an international context.

7Differentiate the different types of audits.

8Distinguish between the types of auditors and their training, licensing and authority

9Comprehend auditor liability.

10Discuss the requirements of International Standard on Quality Control 1.

2.2INTRODUCTION

How is the audit profession organized? What types of auditors are there and what type of audit do they perform?

2.3TYPES OF AUDITOR

There are two basic types of auditor: independent external auditors and internal auditors. Governmental auditors take both the functions of internal and external auditor. The independent auditor and his qualifications will be discussed in the next section.

INTERNAL AUDITORS

Many large companies and organizations maintain an internal auditing staff. Internal auditors are employed by individual companies to investigate and appraise the effectiveness of company operations for management. Much of their attention is often given to the appraisal of internal controls. A large part of the internal auditor’ work consists of operational audits (reviews of operations). In addition, they may conduct compliance audits (reviews of compliance with policies and regulations). In many countries internal auditors are heavily involved in financial audits. If the internal auditor performs financial audits the external auditor should review their work.

The internal audit department ordinarily reports directly to the president or board of directors. An internal auditor must be independent of the department heads and other executives whose work she reviews. Internal auditors, however, can never be independent in the same sense as the independent auditors because they are employees of the company they are examining.

Internal auditors have two primary effects on a financial statement audit:

1Their existence and work may affect the nature, timing and extent of audit procedures.

2External auditors may use internal auditors to provide direct assistance in performing the audit. If this is the case the external auditor must assess internal auditor competence (education, experience, professional certification, etc.) and objectivity (organizational status within the company).

CONCEPT AND A COMPANY 2.1

WORLDCOM INTERNAL AUDITOR DISCOVERS MISSTATEMENTS

Concept
The work of internal auditors in the review of financial statements.

Story

To illustrate the importance of internal auditors to companies we can look at what happened at WorldCom (now merged with Verizon Business, a US telecommunications company). It was the $9 billion fraud that was perpetrated at WorldCom, at the time the Number 2 long-distance telephone carrier in the USA that formed the motivation to pass the first US accounting law since 1934. At the time the fraud was disclosed, US President George W. Bush said, ‘I’m deeply concerned … There is a need for renewed corporate responsibility in America’ (Wolffe 2002). One month later Bush signed the Sarbanes–Oxley Act.

The fraud that created, at that time, the largest bankruptcy in US history and resulted in the payment of the largest fine ever imposed up until that time by the Securities and Exchange Commission ($500 million (Larson and Michaels 2003)) involved transferring on the corporate books some $9 billion of telephone line leases and other expenses to ‘capital investments’, an asset. This allowed the expenses to be spread over 40 years. The accounting effect was to increase four crucial financial numbers: operating profit, cash flow from operations, total assets and retained earnings. This, in turn, increased WorldCom’s share price and made those who exercised low-cost stock options rich. Chief Executive Officer (CEO) Bernard Ebbers made $35 million in June 1999, Chief Financial Officer Scott D. Sullivan made $18 million in August 2000, and chairman of the audit committee, Max Bobbitt, made $1.8 million in 1999 (Romeo and Norris 2002).

Cynthia Cooper, vice president for internal auditing, was the one who discovered the fraud at WorldCom and reported it to the board of directors. She may be the only internal auditor in history to be named Time magazine’s person of the year (2002).

The story begins when a worried executive in the wireless division told Cooper in March 2002 that corporate accounting had taken $400 million out of his reserve account and used it to boost WorldCom’s income. Cooper went to Arthur Andersen, the CPA firm. They told her it was not a problem. When she didn’t relent, CFO Sullivan told Cooper that everything was fine and she should back off. Cooper, concerned that her job might be in jeopardy, cleaned out personal items from her office. Cooper told Time magazine, ‘when someone is hostile, my instinct is to find out why’ (Ripley, 2002).

As the weeks went on, Cooper directed her team members to widen their net. Having watched the Enron implosion and Andersen’s role in it, she was worried they could not necessarily rely on the accounting firm’s audits. So they decided to do part of Andersen’s job over again. She and her team began working late into the night, keeping their project secret. And they had no allies. At one point, one of Cooper’s employees bought a CD burner and started copying data, concerned that the information might be destroyed before they could finish.

In late May, Cooper and her group discovered a gaping hole in the books. In public reports the company had categorized billions of dollars as capital expenditures in 2001, meaning the costs could be stretched out over a number of years into the future. But in fact the expenditures were for regular fees WorldCom paid to local telephone companies to complete calls and therefore were not capital outlays but operating costs, which should be expensed in full each year. The trick allowed WorldCom to turn a $662 million loss into a $2.4 billion profit in 2001.

On 11 June, CFO Sullivan called Cooper and gave her ten minutes to come to his office and describe what her team was up to. She did, and Sullivan asked her to delay the audit. She told him that would not happen. The next day, Cooper told the head of the audit committee of the board of directors about her findings. On 25 June, after firing Sullivan, the board revealed the fraud to the public.

Nowadays, the SEC has its own Office of the Whistle-blower, which was formed as a part of the Dodd–Frank Act (2010). See http://www.sec.gov/whistleblower for more information.

Discussion Question

What advantages does an internal auditor have over an external auditor in discovering fraud?

And what disadvantages?

References

Larsen, Peter and Adrian Michaels, 2003, ‘MCI Fined $500m Over Fraud Charges’, Financial Times, p. 1, 20 May.

Ripley, Amanda, 2002, ‘The Night Detective’, Time, Vol. No. 160, 27, p. 58, 30 December.

Romeo, Simon and Floyd Norris, 2002, ‘New Bookkeeping Problems Disclosed by WorldCom’, New York Times, pp. A1–C8, 2 July.

Spiegel, Peter, 2003, ‘WorldCom Finance Chief “Tried to Delay Inquiry”’, Financial Times, p. 1, 9 July.

Wolffe, Richard, 2002, ‘Bush Condemns New Scandal as Outrageous’, Financial Times, p. 1, 27 June.

THE INDEPENDENT EXTERNAL AUDITOR: TRAINING, LICENSING AND AUTHORITY

Independent auditors have primary responsibility to the performance of the audit function on published financial statements of publicly traded companies and non-public companies. Some countries have several classes of auditors who have different functions. Independent auditors are typically certified either by a professional organization or a government agency.

The authority for auditors to carry out the attest function (certifying the audit) comes from national commercial or company law in most countries, but in some cases (e.g. the USA and Canada) the individual provinces or states exercise considerable control over who the auditor is and how she becomes qualified. All Certified Public Accountants (CPA) in the USA are licensed by the individual states. Most countries have strong professional accountant organizations which may also influence who become an auditor.

Certified designations for auditors in different countries are listed in Illustration 2.1.

ILLUSTRATION 2.1

AUDITOR CERTIFICATION DESIGNATIONS AROUND THE WORLD

Certified Public Accountants (CPA)
Australia, Belize, El Salvador, Guatemala, Hong Kong, Israel, Japan, Kenya (CPA (K)), Korea, Malaysia, Malawi, Myanmar, Philippines, Singapore, Taiwan, Western Samoa and the USA.

Chartered Accountants (CA)
Australia (ACA), Bahamas, Bermuda, Botswana, Canada, Cayman Islands, Channel Islands, Cyprus, Fiji, Guyana, Hungary, India, Jamaica, Nigeria, Trinidad, New Zealand, Papua New Guinea, Saudi Arabia, South Africa (CA-SA), Swaziland (CA (SD)), United Arab Emirates, the UK and Zimbabwe.

Contador Publico (CP)
Argentina, Brazil (Contador), Chile, Columbia (CP Titulado), Costa Rica (CP Autorizado -CPA), Dominican Republic (CPA), Ecuador (CPA), Mexico, Panama (CPA) and Peru.

Expert Comptable
France (or Commissaire aux comptes), Luxembourg and Senegal.

Auditors
Bahrain, Czech Republic, Qatar and Solomon Islands.

Other titles
Register accountants (RA) and Accountants Administratie-Consulenten (AA) in the Netherlands and Netherlands Antilles; Wirtschaftsprufer in Austria and Germany; Statautoriseret Revisor in Denmark and Norway; Dottore Commercialista in Italy; Revisor Official de Contas (ROC) in Portugal; Auktoriserad Revisor (AR) in Sweden; Wirtschaftsprufer and Expert Comptable in Switzerland; Reviseur d’Entreprises in Belgium; KHT or CGR in Finland; Soma Orkoton Logiston (SOL) in Greece; Licenciado en Contaduria Publico in Venezuela; Akuntan Publik in Indonesia; Loggilturendurskodandi in Iceland; Licensed Accountant (LA) in Iraq; Technician Superior in Lebanon; and Sworn Financial Advisor (SFA) in Turkey.

LICENSING REQUIREMENTS

The auditor is someone who is trained in an academic program and who meets certain licensing requirements. Countries may have requirements for minimum age, citizenship, university degree and completion of a qualifying examination. The Eighth European Union (EU) Directive¹ has a minimum experience requirement of three years, whereas the USA only requires one or two years. It is common for people in the USA and Canada to become professional accountants in their early twenties, but in Germany and Japan many people do not attain their credentials until their mid-thirties.

The EU Eighth Company Law Directive sets minimum qualifications for statutory auditors. This directive specifies that an individual must attain at least entrance-level qualifications at university level, engage in a program of theoretical instruction, receive at least three years’ practical training and pass an examination of professional competence. Furthermore, the Eighth Directive puts an obligation on Member States to ensure that statutory audits are carried out with professional integrity and that there are appropriate safeguards in national law to protect the independence of auditors.

2.4TYPES OF AUDIT

Audits are typically classified into three types: audits of financial statements, operational audits and compliance audits.

AUDITS OF FINANCIAL STATEMENTS

Audits of financial statements examine financial statements to determine if they ‘give a true and fair view’ or ‘present fairly in all material respects’ the financial statements in conformity with specified criteria. The criteria may be, for example, International Financial Reporting Standards (IFRS), United States generally accepted accounting principles (US GAAP), national company laws as in Northern Europe, or the tax code in South America. This book primarily discusses audits of financial statements.

OPERATIONAL AUDITS

An operational audit is a study of a specific unit of an organization for the purpose of measuring its performance. Audit of the inventory from the initial order to shipping out the door with a goal of one-day shipping is an operational audit. So is an audit of production methods used in a manufacturing process. Operational audits review all or part of the organization’s operating procedures to evaluate effectiveness and efficiency of the operation. Effectiveness is a measure of whether an organization achieves its goals and objectives. Efficiency shows how well an organization uses its resources to achieve its goals. Operational reviews may not be limited to accounting. They may include the evaluation of organizational structure, marketing, production methods, computer operations or whatever area the organization feels evaluation is needed. Recommendations are normally made to management for improving operations.

COMPLIANCE AUDITS

A compliance audit may not necessarily be related to accounting. It is a review of an organization’s procedures to determine whether the organization is following specific procedures, i.e., rules or regulations set out by some higher authority (i.e., US tax code, employee safety, or environmental regulations). The performance of a compliance audit is dependent upon the existence of verifiable data and recognized criteria or standards. Results of compliance audits are generally reported to management within the organizational unit being audited.

Compliance audits are usually associated with government auditors – for example, the tax authority, the government internal auditing arm, or audit of a bank by banking regulators. An example of a compliance audit is an audit of a bank to determine if they comply with capital reserve requirements. Another example would be an audit of taxpayers to see if they comply with national tax law such as the audit of an income tax return by an auditor of the government tax agency such as the Internal Revenue Service (IRS) in the USA.

Compliance audits are quite common in not-for-profit organizations funded at least in part by government. Many government entities and non-profit organizations that receive financial assistance from the federal government must arrange for compliance audits. Such audits are designed to determine whether the financial assistance is spent in accordance with applicable laws and regulations.

Illustration 2.2 summarizes the three types of audit. Each of these types of audit has a specialist auditor, namely the independent auditor (including the government auditor), and internal auditor. The independent auditor is mainly concerned with financial statement audits, the internal auditor concentrates on operational audits, and the governmental auditor is most likely to determine compliance. However, given information technology developments, the different processes are becoming more and more integrated, and as a consequence the split between these categories may become theoretical.

ILLUSTRATION 2.2

TYPES OF AUDIT

Audits of financial statements | Operational audits | Compliance audits
Examine financial statements, determine if they give a true and fair view or fairly present the financial position, results and cash flows. | A study of a specific unit of an organisation for the purpose of measuring its performance. | A review of an organisation’s procedures and financial records performed to determine whether the organisation is following specific procedures, rules or regulations set out by some higher authority.

2.5AUDIT FIRMS

In previous sections we have extensively discussed the demand side of the audit market. But what about the supply side? How is it structured? Usually, audit firms are classified into two distinct categories:

the Big Four firms; and

the Non-Big Four firms.

THE BIG FOUR FIRMS

The four largest accountancy firms in the world (known as ‘the Big Four’) influence international auditing because of their day-to-day operations in many countries and their membership in most of the world’s professional accounting organizations. All of these firms have revenues of billions of dollars. The Big Four are: Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers.

These firms resulted partially from several major mergers in the late 1980s. These audit firms have a global network of affiliated firms. Actually, there were the Big Five firms after a series of mergers, including Arthur Andersen. However, as a result of the Enron accounting scandal, the market lost its confidence in Arthur Andersen and this firm had to forfeit its business in 2002 after almost 90 years of having been a highly respected firm (see Concept and a Company 2.7). This case study demonstrates how important it is for auditors to fully respond to the inspired confidence of their stakeholders. (We discuss these ethics issues in Chapter 3.)

Although most of these firms are still structured as national limited liability partnerships with national instead of international profit sharing, these national member firms participate in an international head office, in which global technologies, procedures, and directives are developed. In addition to sharing the methodology, the networks are also used for the coordination of international audit engagements. The group auditor of a worldwide operating company uses the services of auditors of the member firms in the countries where the client has subsidiaries. As a result of the developments in communications technology, the effectiveness of these networks and the efficiency of the coordination of international engagements have increased significantly.

For the Big Four firms, audit and accounting services represent approximately half of the firms’ total fee income.

THE NON-BIG FOUR FIRMS

Non-Big Four firms can hardly be treated as a homogeneous group. At one extreme there are a very large number of small local firms, with only a handful of professionals. At the other extreme there are a small number of second-tier firms, which also have an international network, although not quite as extensive as the Big Four network. In between, there are a large number of medium-sized national or regional audit firms with several offices. The second-tier firms in the United States include BDO, RSM, Grant Thornton, Crowe, Nexia International, Baker Tilly International, Moore Stevens International, HLB International, Kreston International, PFK International and ECOVIS International. To give you an idea of size: Grant Thornton International is the seventh largest accounting network in the world by combined fee income.² The firm operates 59 offices across the US with approximately 7,000 employees, 550 partners, and produces annual revenue in excess of US$1.74 billion. Member firms within the global organization operate in over 130 countries employing over 56,000 personnel for a combined global revenue of US$5.72 billion (Grant Thornton corporate website https://www.grantthornton.com/).

ORGANIZATION OF THE AUDIT

In the earliest days of multinational accountancy firms, the organizational form of audit firms was a partnership or professional corporation. This legal form still predominates, but legal forms vary around the world between countries as well as between firms. Recently the limited liability forms of organization, such as Limited Liability Partnership (LLP), have come into widespread use.

PROFESSIONAL STAFF

The partners hire professional staff to assist them in their work. The organizational hierarchy in a typical international auditing firm (shown in Illustration 2.3) includes partners, managers, supervisors, seniors or in-charge auditors, and staff accountants. A new employee usually starts as a staff accountant and spends several years at each classification before eventually achieving partner status.

In the remainder of this section the allocation of personnel to an audit is discussed. However, it must be remembered that human resource models will vary between auditing firms. The following describes the common threads of work.

CONCEPT AND A COMPANY 2.2

THE BASIC THEORY

Concept

Auditor’s search for materiality.

Story

There was once a group of very famous accountants and auditors who joined together as a mutual study group. They determined that they could find the basic truths of auditing. They read all manner of philosophical, scientific and religious works and discussed those theories amongst themselves. They felt that knowledge of the pure truths of auditing would form a basis for discovering the core truths of business and, indeed, life itself.

They studied the great works of accounting for many years, but felt that they were getting nowhere. Finally, they decided to take leave of their day jobs and search the world to find the answer. They sought the advice of great teachers all over the world. They would ask each great teacher to recommend one who was even wiser. Thus, they collected these recommendations until their search pointed to one man – a teacher of teachers.

The group journeyed to an isolated area in the great desert wastes of Africa. There they met the great man and, paying their respects, they told him of their heart-felt desire and long suffering to find the pure truths of auditing. He said, ‘I cannot give you the answers. These you must find yourself.’ He instructed them to collect the entire world’s accounting knowledge, encompassing everything from the Sarbanes–Oxley Act 2002 back to cuneiform tablets of 3400 BCE. Then they were to condense all that knowledge to ten volumes.

The group went away and gathered and summarized knowledge for all the ages. After years of work, they again sat at the feet of the teacher of teachers and presented their ten volumes. The sage picked up the volumes and thumbed through them. He handed the volumes back to the group and then said, ‘Go and make this into one volume.’

After years of toil, the group, whose membership was now thinning appreciably, returned with their one volume of the world’s audit truths. The teacher of teachers said, ‘Make this into one sentence.’

Taking on this almost impossible task, the remaining members of the group locked themselves into a cave and ate nothing but soup made of nettles to sustain them until they came up with the one true answer. When they returned to the guru with this sentence, he smiled and said to them, ‘You got it.’ This was the sentence:

‘There is no such thing as a free lunch.’

Discussion Question

Why can we expect that a fraud that works now may not work in the future?

Why can a company not continue to grow indefinitely at 15 per cent per year?

Why can a management that make up fictitious sales not profit in the long run?

Why does every form of earnings manipulation have its cost?

Based on this one sentence, how would you justify the existence of ethics?

References

The great audit works.

ILLUSTRATION 2.3

BIG FOUR ORGANIZATIONAL PYRAMID

STAFF ACCOUNTANTS

The first position when someone enters the public accounting profession is that of staff accountant (also called assistant or junior accountant). The staff accountant often performs the more detailed routine audit tasks.

SENIOR ACCOUNTANTS (OR SUPERVISOR)

The senior (‘in-charge’) auditor or ‘supervisor’ is in charge of audit fieldwork and typically has two or more years’ experience in public auditing. The senior takes a major part in planning the audit and is primarily responsible for conducting the audit engagement at the client’s place of business. Planning and supervision of more complex audits may involve the partner or director in planning and the manager in supervising the engagement.

The senior supervises the work of the audit staff, reviews working papers and time budgets, and assists in drafting the audit report. The senior maintains a continuous record of staff hours in each phase of the audit examination and maintains professional standards of fieldwork. This work is subject to review and approval by the manager and partner.

MANAGERS

The manager supervises the audits conducted by the seniors. The manager helps the seniors plan their audit programs, reviews working papers periodically, and provides other guidance. The manager is responsible for determining the audit procedures applicable to specific audits and for maintaining uniform standards of fieldwork. Often managers have the responsibility of compiling and delivering the firm’s billings to the audit client. The manager, who typically has at least five years’ experience, needs a broad and current knowledge of tax laws, accounting standards and government regulations. A manager is likely to specialize in accounting requirements of a specific industry.

PARTNERS/DIRECTORS

Partners are the owners of the auditing firm. The change in legal structure means that in some countries those formerly known as partners are directors. They are heavily involved in the planning of the audit, evaluation of the results and determination of the audit opinion. The degree to which they are involved in the audit will vary between firms and assignments because firms have to ensure that partners allocate their time in an appropriate way. Partners will delegate as much of the work as possible to experienced managers and seniors. Moreover, the larger the accountancy firm the more variation there is likely to be in practice depending on the nature of the engagement.

Other partner or director duties include maintaining contacts with clients, resolving controversies that may arise, and attendance at the client’s stockholders’ meetings to answer any questions regarding the financial statements or the auditor’s report. They may also recruit new staff members, review audit working papers, supervise staff and sign the audit reports, depending on the complexity of the engagements. Partners may specialize in a particular area such as tax laws or a specific industry. The partner is the person who must make the final decisions involving complex judgments.

CONCEPT AND A COMPANY 2.3

HISTORY OF DELOITTE

Concept

Founding fathers and international mergers of Big Four audit firms.

Story

In 1990 Deloitte Touche Tohmatsu was created following a number of earlier mergers. In 2003 the names of Touche and Tohmatsu were dropped, leaving Deloitte as the firm’s full name. Deloitte was established by three founders: William Welch Deloitte, George Touche and Admiral Nobuzo Tohmatsu.

In 1845, at the age of 25, W.W. Deloitte opened his own office opposite the Bankruptcy Court in Basinghall Street, London. At that time three Companies Acts created joint-stock companies, laying the foundation for modern company structures. Deloitte made his name with the industry of the day – the railways – and in 1849 the Great Western Railway appointed Deloitte the first independent auditor in that industry. He discovered frauds on the Great North Railway, invented a system for railway accounts that protected investors from mismanagement of funds, and was to become the grand old man of the profession. As president of the newly created Institute of Chartered Accountants, Deloitte found a site for its headquarters in 1888. In 1893 he opened offices in the USA.

Financial disasters in the new and booming investment trust business in England gave George Touche his business opportunity. His reputation for flair, integrity, and expertise brought him a huge amount of work setting these trusts on the straight and narrow. A similar flair for saving doomed businesses from disaster and restructuring them led to the formation of George A. Touche & Co. in 1899. In 1900, along with John Niven, the son of his original Edinburgh accounting mentor, Touche set up the firm of Touche, Niven & Co. in New York. Offices spread across the USA and Canada and were soon attracting clients like R.H. Macy, a large US nationwide department store. In the UK, General Electric Company was an important client and still is. Meanwhile Touche himself took his reputation for probity and ran for public election in England and became MP for North Islington, England, in 1910, and was knighted in 1917. He died in 1935.

After Tohmatsu qualified as a certified public accountant at the age of 57 in 1952, he became a partner in a foreign-affiliated accounting firm and a director of a private corporation. In 1967, he became president of the Japanese Institute of Certified Public Accountants. In the 1960s, the Japanese government wanted to see national audit corporations established, and Tohmatsu asked Iwao Tomita, a former student and a graduate of the Wharton School in Chicago, to respond to that challenge. In May of 1968, Tohmatsu & Co. (formerly Tohmatsu Awoki & Co.) was incorporated.

Discussion Question

What events and circumstances contributed to the growth and international scope of Deloitte’s operations?

References

http://www.Deloitte.com.

CONCEPT AND A COMPANY 2.4

A HISTORY OF ERNST & YOUNG

Concept

Founding fathers and international mergers of Big Four audit firms.

Story

The founders of Ernst & Young were Arthur Young, who had an interest in investments and banking which led to the foundation in 1906 of Arthur Young & Co. in Chicago, USA, and A.C. Ernst, who was a bookkeeper while still in high school, joined his brother and started Ernst & Ernst in 1903.

Ernst pioneered the idea that accounting information could be used to make business decisions – the forerunner of management consulting. He also was the first to advertise professional services. Young was profoundly interested in the development of young professionals. In the 1920s he originated a staff school; in the 1930s, his firm was the first to recruit from university campuses.

Both firms were quick to enter the global marketplace. As early as 1924, they allied with prominent British firms – Young with Broads Paterson & Co. and Ernst with Whinney Smith & Whinney. In 1979, Ernst’s original agreement led to the formation of Ernst & Whinney. These alliances were the first of many for both firms throughout the world – and they are the roots of the global firm today.

Young and Ernst, never having met, both died in 1948 within only a few days of each other. In 1989, the firms they started combined to create Ernst & Young.

Discussion Question

What is the impact today of Ernst’s innovation of advertising professional services?

What do you think Young’s staff school taught to professional accountants in 1920?

What do you think Ernst & Young teach today in their staff school?

References

www.ey.com.

CONCEPT AND A COMPANY 2.5

HISTORY OF KPMG

Concept

Founding fathers and international mergers of Big Four audit firms.

Story

KPMG was formed in 1987 with the merger of Peat Marwick International (PMI) and Klynveld Main Goerdeler (KMG) and their individual member firms. Spanning three centuries, the organization’s history can be traced through the names of its principal founding members – whose initials form the name ‘KPMG.’

Kstands for Klynveld. Piet Klijnveld founded the accounting firm Klynveld Kraayenhof & Co. in Amsterdam in 1917.

Pis for Peat. William Barclay Peat founded the accounting firm William Barclay Peat & Co. in London in 1870.

Mstands for Marwick. James Marwick founded the accounting firm Marwick, Mitchell & Co. with Roger Mitchell in New York City in 1897.

Gis for Goerdeler. Dr Reinhardt Goerdeler was for many years chairman of Deutsche Treuhand-Gesellschaft and later chairman of KPMG. He is credited with laying much of the groundwork for the Klynveld Main Goerdeler (KMG) merger.

In 1911, William Barclay Peat & Co. and Marwick Mitchell & Co. joined forces to form what would later be known as Peat Marwick International (PMI), a worldwide network of accounting and consulting firms. William Barclay Peat & Co. was founded in 1870 in London; Marwick Mitchell & Co. was founded in 1897 in New York City.

Klynveld Kraayenhof & Co. was founded in Amsterdam in 1917. In 1979, Klynveld Kraayenhof & Co. joined forces with Deutsche Treuhand-Gesellschaft and the international professional services firm McLintock Main Lafrentz & Co. to form Klynveld Main Goerdeler (KMG). Goerdeler was Dr Reinhard Goerdeler, the chairman of Deutsche Treuhand-Gesellschaft.

In 1987, PMI and KMG and their member firms joined forces. Today, all member firms throughout the world carry the KPMG name exclusively or include it in their national firm names.

Discussion Question

What types of problem could result from combining four firms from different nations with different cultures into a working environment?

References

http://www.KPMG.nl.

CONCEPT AND A COMPANY 2.6

HISTORY OF PRICEWATERHOUSECOOPERS

Concept

Founding fathers and international mergers of Big Four audit firms.

Story

A merger in 1998 of Coopers & Lybrand and Price Waterhouse created PricewaterhouseCoopers. These two firms have historical roots going back some 150 years.

PricewaterhouseCoopers employs about 125,000 people in more than 142 countries throughout the world.

In 1849, Samuel Lowell Price started an accounting business in London. In 1865, William H. Holyland and Edwin Waterhouse joined him in partnership, and by 1874 the company name changes to Price, Waterhouse & Co. (or PW for short). In 1873, the firm conducted their first US project. The growing US practice lead to the establishment of permanent PW presence in the Western hemisphere, which began with the opening of the office in New York City in 1890. By the turn of the century, it had a register of clients that covered a wide range of industrial and commercial fields in most sections of the USA. Branch offices began to open throughout the USA and then in other parts of the world. In 1982 Price Waterhouse World Firm was formed.

In 1854, William Cooper established his own practice in London, which seven years later became Cooper Brothers. The firm’s history in the USA began in 1898, when Robert H. Montgomery, William M. Lybrand, Adam A. Ross Jr, and his brother T. Edward Ross formed Lybrand Ross Brothers and Montgomery in Philadelphia. During the early twentieth century their offices spread around the country and then in Europe.

From 1953, the firm experienced a major transformation from a medium-size company, focused on auditing and primarily national in scope, into a multinational player with a growing mix of consulting services. The boldest step was a 1957 merger between Cooper Brothers & Co. (UK), McDonald, Currie and Co. (Canada), and Lybrand, Ross Bros, & Montgomery (US), forming Coopers & Lybrand, which had 79 offices in 19 countries. In 1990, Coopers & Lybrand merged with Deloitte Haskins & Sells in a number of countries around the world. Finally, in 1998 Price Waterhouse and Coopers & Lybrand merged worldwide to become PricewaterhouseCoopers, and the trading name of the firm was shortened to PwC in 2010.

Discussion Question

Why did the Western hemisphere operations of Price and Coopers grow rapidly in the twentieth century?

References

http://www.columbia.edu/cu/libraries/indiv/rare/guides/PWC/main.http://www.pwcglobal.com.

2.6STANDARD SETTING

INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

Financial accounting standards are unique and separate from audit standards. By its nature, auditing requires that the real-world evidence of financial transactions be compared to financial standards. The standards to which an international auditor compares financial statements are generally standards in the reporting country (e.g. Financial Accounting Standards (FAS) in the USA, or national standards in European Union (EU) Member States which are based on EU Directives). In the future, companies and auditors in many additional countries will use International Financial Reporting Standards (IFRS), formerly called International Accounting Standards (IAS), which are set by the International Accounting Standards Board (IASB).

In March 2001, the International Accounting Standards Committee (IASC) Foundation was formed as a not-for-profit corporation. The IASC Foundation is the parent entity of the International Accounting Standards Board, an independent accounting standard setter based in London, UK. In April 2001, the International Accounting Standards Board (IASB) assumed accounting standard setting responsibilities from its predecessor body, the International Accounting Standards Committee. Standards issued by the IASB are called International Financial Reporting Standards (IFRS). For the great majority of the world IFRS are required for domestic public companies. For even more of the world’s countries IFRS are required or permitted for public listings of foreign companies.

Although all the European Union Directives influence international accounting, the Eighth Company Law Directive is especially applicable to auditing. The Eighth Directive sets the minimum requirements for accounting training and experience for the community.

INTERNATIONAL AUDITING STANDARDS

As international accounting standards acquired more authority, logic dictated a set of international auditing standards collateral to them. Auditing standards were very important for multinational corporations that wanted consistent auditing throughout the world.

With a set of international standards adopted for the world, international investors can be more confident in financial statements prepared in another country. The non-domestic auditor’s opinion will lend as much credibility as a domestic auditor’s opinion.

IAASB AUDITING, QUALITY CONTROL, AND RELATED SERVICES STANDARDS

The International Auditing and Assurance Standards Board (IAASB) is an independent standards board supported by the International Federation of Accountants (IFAC). Their objective is to improve the degree of uniformity of auditing practices and related services throughout the world by issuing pronouncements on a variety of audit and attest functions.

The IAASB consists of a full-time chairman and 17 volunteer members from around the world. The board is balanced between practitioners in public practice with significant experience in the field of auditing and other assurance services and individuals who are not in public practice; in addition, at least three members are nominated by the public. Members are appointed by the IFAC Board based on recommendations from the IFAC Nominating Committee and are approved by the Public Interest Oversight Board (PIOB). In addition, there are a small number of observer members who have speaking rights at IAASB meetings but no voting rights. The IAASB is supported by technical staff with a wide range of standard-setting experience.

IAASB issues several sets of standards to be applied to international auditing and assurance services. IAASB Standards contain basic principles and essential procedures together with related guidance in the form of explanatory and other material. IAASB issues:

International Standards on Auditing (ISAs) as the standards to be applied by auditors in reporting on historical financial information;

International Standards on Assurance Engagements (ISAEs) as the quality control standards to be applied by practitioners in assurance engagements dealing with information other than historical financial information;

International Standards on Quality Control (ISQCs) as the standards to be applied for all services falling under the standards of the IAASB;

International Standards on Related Services (ISRSs) as the standards to be applied to related services; and

International Standards on Review Engagements (ISREs) as the standards to be applied to the review of historical financial information.

COUNTRIES USING INTERNATIONAL STANDARDS ON AUDITING

The International Auditing and Assurance Standards Board aims for voluntary international acceptance of its guidelines. Therefore, the International Standards on Auditing (ISAs) are not intended to override national regulations or pronouncements relating to audits of financial information. These ISAs are not yet authoritative in the way that pronouncements of, say, the Public Company Accounting Oversight Board (PCAOB) are to determine Generally Accepted Audit Standards (GAAS) in the USA. ISAs were made mandatory in Europe in 2005 and other regions in the world, including the USA, followed.³

As of September 2015, the following 110 countries are using the Clarified ISAs:⁴ See Illustration 2.4

INTERNATIONAL STANDARDS ON AUDITING (ISA)

International Standards on Auditing (ISAs) are developed by the International Federation of Accountants (IFAC) through its International Auditing and Assurance Standards Board (IAASB). The efforts of IFAC, founded in 1977, are directed towards developing international technical, ethical and educational guidelines for auditors, and reciprocal recognition of practitioners’ qualifications. The membership of IFAC member bodies represents several million accountants in public and private practice, education, academe and government service.

The standard-setting activities of the IFAC are carried out by the International Auditing and Assurance Standards Board (IAASB), the Ethics Committee, the Education Committee, and the Public Sector Committee with an interest in governmental financial reporting.

ILLUSTRATION 2.4

GLOBAL ADOPTION OF CLARIFIED ISAS

ISAS AS HARMONIZATION STANDARDS

International Standards on Auditing (ISAs) are the standards that are of most interest to auditors because they are the standards for the most frequent work of auditors, that is, financial statement audits and special purpose engagements. Although not all countries require ISAs, they will be used as the basic standards throughout this book because they represent the highest and best international representation of generally accepted auditing standards (GAAS).

ISAs are harmonization standards, the application of which promotes consistent auditing across the world. The practice and theory of international auditing includes, in addition to knowledge of ISAs, consideration of quality control standards, allocating materiality, performing the audit, coordinating international reports and personnel, etc.

A listing of the International Standards on Auditing is given in Illustration 2.5.

ILLUSTRATION 2.5

LIST OF 2018 INTERNATIONAL STANDARDS ON AUDITING⁵

INTERNATIONAL STANDARDS ON QUALITY CONTROL (ISQCs)
International Standard on Quality Control (ISQC) 1, Quality Control for Firms that Perform
Audits and Reviews of Financial Statements, and Other Assurance and Related Services Engagements
AUDITS OF HISTORICAL FINANCIAL INFORMATION
200–299 | General Principles and Responsibilities
ISA 200 | Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing
ISA 210 | Agreeing the Terms of Audit Engagements
ISA 220 | Quality Control for an Audit of Financial Statements
ISA 230 | Audit Documentation
ISA 240 | The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements
ISA 250 | (Revised) Consideration of Laws and Regulations in an Audit of Financial Statements
ISA 260 | (Revised) Communication with Those Charged with Governance
ISA 265 | Communicating Deficiencies in Internal Control to Those Charged with Governance and Management
300–499 | Risk Assessment and Response to Assessed Risks
ISA 300 | Planning an Audit of Financial Statements
ISA 315 | (Revised) Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment
ISA 320 | Materiality in Planning and Performing an Audit
ISA 330 | The Auditor’s Responses to Assessed Risks
ISA 402 | Audit Considerations Relating to an Entity Using a Service Organization
ISA 450 | Evaluation of Misstatements Identified during the Audit
500–599 | Audit Evidence
ISA 500 | Audit Evidence
ISA 501 | Audit Evidence – Specific Considerations for Selected Items
ISA 505 | External Confirmations
ISA 510 | Initial Audit Engagements – Opening Balances
ISA 520 | Analytical Procedures
ISA 530 | Audit Sampling
ISA 540 | Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures
ISA 550 | Related Parties
ISA 560 | Subsequent Events
ISA 570 | (Revised) Going Concern
ISA 580 | Written Representations
600–699 | Using the Work of Others
ISA 600 | Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors)
ISA 610 | Using the Work of Internal Auditors
ISA 620 | Using the Work of an Auditor’s Expert
700–799 | Audit Conclusions and Reporting
ISA 700 | (Revised) Forming an Opinion and Reporting on Financial Statements
ISA 701 | Communicating Key Audit Matters in the Independent Auditor’s Report
ISA 705 | (Revised) Modifications to the Opinion in the Independent Auditor’s Report
ISA 706 | (Revised) Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report
ISA 710 | Comparative Information – Corresponding Figures and Comparative Financial Statements
ISA 720 | (Revised) The Auditor’s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements
800–899 | Specialized Areas
ISA 800 | (Revised) Special Considerations – Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks
ISA 805 | (Revised) Special Considerations – Audits of Single Financial Statements and Specific Elements Accounts or Items of a Financial Statement
ISA 810 | (Revised) Engagements to Report on Summary Financial Statements
International Auditing Practice Notes
IAPN 1000 | Special Considerations in Auditing Financial Instruments
New and Revised Statements Not Yet Effective (for 2018)
ISA 540 | (Revised) Auditing Accounting Estimates and Related Disclosures.

2.7REGULATION

AUDIT REGULATION: INTERNATIONAL PERSPECTIVE

In the previous section, the demand and the supply side of the audit market has been described. In most countries, this demand has long been on a voluntary basis, i.e. it was left to the companies to decide whether they had their financial statements audited or not. As for the supply side, the provision of audit services has been left open to the free market in some countries, without any official legal requirements for auditors. Although regulation and legislation differ, both the demand and the supply of audit services are currently regulated to some degree in most countries. Accounting and finance research suggests that national legal environments are among the key determinants of financial market development, corporate ownership structures, corporate policies, and the properties of accounting information around the world.⁶

In most countries, audits are now legally required for some types of companies. For example, in the USA and the European Union, large, and in some cases medium-sized enterprises, are required by law to provide audited financial statements. The European Union audit rules apply to all companies within the individual Member States that are required to be audited. The requirements may vary from state to state. The major bourses (including NYSE, NASDAQ, London Stock Exchange, Tokyo NIKKEI, and Frankfurt DAX) have listing rules that require all listed companies to have their annual report (including financial statements) audited.

The supply of audit services is currently also regulated in most countries. In the European Union, statutory audits, i.e. audits required by law, can only be performed by auditors who have met specific technical requirements with regard to education and experience. Laws in other countries require audits of companies issuing public equity or debt, companies receiving government money, and companies in certain industries (like banking and utilities).

US SARBANES–OXLEY ACT

Sparked by the Enron and WorldCom debacles and other widely publicized corporate and accounting scandals, the Sarbanes–Oxley Act of 2002 was passed almost unanimously by US Congress and signed into law by President George W. Bush on 30 July 2002. The Act, described by President Bush as incorporating ‘the most far-reaching reforms of American business practices since the time of [American President 1933–1945] Franklin Delano Roosevelt’, was intended to establish investor confidence by improving the quality of corporate disclosure and financial reporting, strengthen the independence of accounting firms, and increase the role and responsibility of corporate officers and directors for financial statements and corporate disclosures.

The Sarbanes–Oxley Act of 2002 required the US Securities and Exchange Commission (SEC) to create a Public Company Accounting Oversight Board (PCAOB). The Board oversees and investigates the audits and auditors of public companies, and sanctions both firms and individuals for violations of laws, regulations and rules.

EUROPEAN UNION REGULATION

Several European Union Directives on the annual accounts and consolidated accounts of financial and insurance corporations require that the annual accounts or consolidated accounts be audited by certified auditors. The conditions for the approval of qualified auditors were laid down in the Eighth Council Directive 84/253/EEC of 10 April 1984.⁷

EU Directive 2006/43/EC⁸ aims at high-level – though not full – harmonization of statutory audit requirements. The objectives of this Directive are requiring the application of a single set of international auditing standards, the updating of the educational requirements, the definition of professional ethics, and the technical implementation of the cooperation between competent authorities of EU Member States and the authorities of third countries.

Member states of the EU are given authorization by Directive 2006/43 (1) to register all auditors and audit firms and make such information accessible to the public; (2) adopt an International Auditing Practice Statement on a case-by-case basis; (3) adopt a common audit report for the audit of annual accounts or consolidated accounts prepared on the basis of approved international accounting standards; (4) decide if individual auditors have a common quality assurance policy; and (5) organize an effective system of public oversight for statutory auditors and audit firms on the basis of home country control.

For Statutory auditors and audit firms, Directive 2006/43 required independence when carrying out statutory audits. Statutory auditors and audit firms are responsible for carrying out their work with due care and thus should be liable for the financial damage caused by a lack of the care owed. In order to reinforce the independence of auditors, the key audit partner(s) should rotate management of the audit.

Michel Barnier, former EU Minister of Internal Market and Services, suggested three areas of audit regulation that are essential: (1) the independence of the profession; (2) opening up the audit market; and (3) creating a more integrated European market and stepping up its supervision.⁹ He said that the EU’s first concern is the quality and credibility of auditing. Further, the independence of auditors is ‘the condition sine qua non for their reports being fully trusted’.

OTHER WORLD REGULATION

Regulation in other parts of the world is summarized in Illustration 2.6.

LEGAL LIABILITY

There are many stakeholders who rely on audited financial statements: the client (with which there is a privity relationship), and third parties such as actual and potential stockholders, vendors, bankers and other creditors, employees, customers, and the government (like the tax authorities). Legal liability of the auditor to each stakeholder varies from country to country, district to district. This liability can generally be classified as based on one or more of the following: common law, civil liability under statutory law, criminal liability under statutory law, and liability as members of professional accounting organizations.

LIABILITY UNDER COMMON LAW

Liability for auditors under common law generally falls in two categories: liabilities to clients and third party liability.

LIABILITY TO CLIENTS

A typical civil lawsuit filed by a client involves a claim that the auditor did not discover financial statement fraud or employee fraud (defalcation) because the auditors showed negligence¹⁰ in the conduct of an audit. The legal action can be for breach of contract¹¹ or, more likely, a tort¹² action for negligence. Tort actions are the most common, for generally they generate larger monetary judgements than breach of contract.

LIABILITIES TO THIRD PARTIES

Third parties include all stakeholders in an audit other than the audit client. An audit firm may be liable to third parties such as banks that have incurred a loss due to reliance on misleading financial statements.

ULTRAMARES

The most famous US audit case in third party liabilities happened with the 1931 Ultramares-Touche case (Ultramares Corporation v Touche et al.).¹³ In this case, the court held that although the accountants were negligent in not finding that a material amount of accounts receivable had been falsified when careful investigation would have shown the amount to be fraudulent, they were not liable to a third party bank because the bank creditors were not a primary beneficiary, or known party, of whom the auditor was informed before conducting the audit. This precedent is called the Ultramares doctrine, that ordinary negligence (the failure to use reasonable care) is not sufficient for a liability to a third party because of lack of privity of contract¹⁴ between the third party and the auditor.

CAPARO

The 1990 Caparo case (Caparo Industries, PLC v Dickman and Others)¹⁵ is a leading English tort law case on the test for a duty of care of an auditor. Prior to the decision, if a statement (like an audit opinion) was made negligently, then the person making the statement was liable for any resulting loss. The question in Caparo had to do with the scope of the assumption of responsibility, and what the limits of liability ought to be.

The UK House of Lords, following the Court of Appeal, set out a ‘threefold test’. In order for an obligation (duty of care)¹⁶ to arise in negligence: (1) harm must be reasonably foreseeable as a result of the defendant’s conduct; (2) the parties must be in a relationship of proximity; and (3) it must be fair, just and reasonable to impose liability. In the case of annual financial statements, this purpose was to give the shareholders the information necessary to enable them to question the past management of the company, to exercise their voting rights and to influence future policy and management.

GERMAN LIABILITY

In Germany, auditors have an unlimited liability to the client if there is an intentional violation of duties, but the liability is capped by law at €1,000,000 to €4,000,000, depending on circumstances, for negligent violation of duties. Liability to third parties as described by the Tort Law (§ 823–826 BGB) is restricted to certain prerequisites such as intent and violation of morality. There is also liability to third parties under Contract Law, which has less restrictive prerequisites than Tort Law. However. because of the bankruptcy of Wirecard AG during 2020, reinforcement of German audit regulation is to be expected.

CIVIL LIABILITY UNDER STATUTORY LAW

Statutory civil liabilities are liabilities under laws that require a preponderance of evidence to convict resulting in a civil penalty such as a fine or suspension of license to operate. Preponderence of evidence means that the proposition is more likely to be true than not true. In other words, the standard is satisfied if there is a greater than fifty percent chance that the proposition is true. Most countries have laws that affect the civil liabilities of auditors. Securities laws, for example, may impose strict standards on professional accountants. In the USA, the Securities Act of 1933 not only created the Securities and Exchange Commission (SEC), it established the first US statutory civil recovery rules for third parties against auditors. Original purchasers of securities of a firm newly registered to make a public offering have recourse against the auditor for up to the original purchase price if the financial statements are false or misleading.

Anyone who purchased securities described in the SEC registration statement (S1) may sue the auditor for material misrepresentations or omissions in financial statements published in the S1. The auditor has the burden of demonstrating that reasonable investigation was conducted or that the loss of the purchaser of securities (plaintiff) was caused by factors other than the misleading financial statements. If the auditor cannot prove this, the plaintiff wins the case.

The United States Sarbanes–Oxley Act of 2002 also prescribes civil penalties for Chief Financial Officers (CFOs) and Chief Executive Officers (CEOs). If there is a material restatement of a company’s reported financial results due to the material noncompliance of the company, as a result of misconduct, the CEO and CFO must reimburse the company for any bonus or incentive or equity-based compensation received within the 12 months following the filing with the financial statements subsequently required to be restated.¹⁷ Financial statements filed with the SEC by any public company must be certified by CEOs and CFOs. If all financials do not fairly present the true condition of the company, CEOs and CFOs may receive fines up to $1 million or up to $5 million for fraud.¹⁸

CRIMINAL LIABILITY UNDER STATUTORY LAW

Statutory criminal law generally requires evidence beyond a reasonable doubt to convict resulting in loss of freedom, imprisonment and fines. Proof beyond a reasonable doubt is met if there is no plausible reason to believe otherwise. If there is a real doubt, based upon reason and common sense after careful and impartial consideration of all the evidence, or lack of evidence, in a case, then the level of proof has NOT been met. A professional auditor may be held criminally liable under the laws of a country or district that make it a criminal offence to defraud another person through knowingly being involved with false financial statements.

US SECURITIES AND EXCHANGE ACT OF 1934 AND SARBANES–OXLEY ACT OF 2002

The Securities and Exchange Act of 1934 in the USA requires every company with securities traded on national and over-the-counter exchanges to submit audited financial statements annually (SEC form10-K) as well as other reports for quarterly financials (10-Q), unusual events (8-K) and other events. The Act also sets out (Rule 10b-5) criminal liability conditions if the auditor employs any device, scheme or artifice to defraud or make any untrue statement of a material fact or omits to state a material fact, i.e. the auditor intentionally or recklessly misrepresents information for third party use. The SEC also has authority to sanction or suspend an auditor from doing audits for SEC-registered companies.¹⁹

Several court cases have been subjected to an application of the Act’s criminal liability section. In United States v Natelli (1975) two auditors were convicted of criminal liability for certifying financial statements of National Student Marketing Corporation that contained inadequate disclosures pertaining to accounts receivable. In United States v Weiner (1975) three auditors were convicted of securities fraud in connection with their audit of Equity Funding Corporation of America. The fraud the company perpetrated was so massive and the audit work so sub-standard that the court concluded that the auditors must have been aware of the fraud. Management revealed to the audit partner that the prior years’ financials were misstated and the partner agreed to say nothing in ESM Government Securities v Alexander Grant & Co. (1986). The partner was convicted of criminal charges for his role in sustaining the fraud and was sentenced to a 12-year prison term.

The Sarbanes–Oxley Act of 2002 attaches criminal penalties to CEOs, CFOs and auditors. To knowingly destroy, create, manipulate documents and/or impede or obstruct federal investigations is considered a felony, and violators will be subject to fines or up to 20 years’ imprisonment, or both.²⁰ All audit reports or related workpapers must be kept by the auditor for 7 years. Failure to do this may result in 10 years’ imprisonment. CFOs and CEOs who falsely certify financial statements or internal controls are subject to 10 years’ imprisonment. Wilful false certification may result in a maximum of 20 years’ imprisonment.²¹

LIABILITIES AS MEMBERS OF PROFESSIONAL ACCOUNTING ORGANIZATIONS

Nearly all national audit professions have some sort of disciplinary court. In most countries, anyone can lodge a complaint against an auditor, regardless of one’s involvement with the auditor. The disciplinary court typically consists of representatives of the audit and legal professions, and sometimes representatives of the general public. Having heard the arguments of the plaintiff and the defendant, the court makes its judgment and determines the sanction – if any – against the auditor. The sanction may vary. It may be:

a fine;

a reprimand (either oral or written);

a suspension for a limited period of time (e.g. six months); or

a lifetime ban from the profession.

In some countries, the trials of these disciplinary courts are public. In most countries, the verdicts are made public, in particular if the verdict is either a suspension or a lifetime ban. Appeal against the verdict of the disciplinary court is usually possible.

CONCEPT AND A COMPANY 2.7

ARTHUR ANDERSEN AND OBSTRUCTION OF JUSTICE

Concept

Auditor statutory legal liability – illegal acts.

Story

Arthur Andersen, LLP, one of the former Big Five audit firms with 2,311 public company clients and 28,000 US employees, was found guilty of ‘obstruction of justice’. The obstruction of justice statute, 18 USC s 1512(b), makes it a crime for anyone to ‘corruptly persuade’ ‘another person’ to destroy documents ‘with intent to impair’ the use of the documents ‘in an official proceeding’. The US District Court for the Southern District of Texas sentenced Andersen to pay a $500,000 fine and serve five years of probation (WSJ, 2002).

The charge resulted from Andersen’s destruction of thousands of documents and email messages relating to work performed for Enron. The court found that Andersen illegally destroyed the documents with the intent of thwarting an investigation by the US Securities and Exchange Commission. On 15 June 2002, the tenth day of deliberations, the jury met for only 30 minutes, and then delivered its fatal verdict. This was the first time a major accounting firm had ever been convicted of a criminal charge (Manor, 2002).

Andersen contended that the document destruction was done in the standard course of business and was not illegal. The prosecution introduced evidence that Andersen billed Enron about $720,000 for consultation services relating to ‘SEC Inquiry’ at the same time the firm was destroying documents relating to the Enron audit. The Department of Justice said that the Andersen billing records presented strong evidence that the firm knew about the SEC investigation at the same time they were shredding documents that might have been subpoenaed in that investigation. This establishes that many people at Andersen who were involved in the document destruction had direct, personal knowledge of the investigation (Fowler, 2002).

The document destruction was precipitated by a memo from Nancy Temple in Andersen’s legal department which stated that, under the Andersen document retention policy, superseded drafts of memos should be discarded. David Duncan, the Andersen lead audit partner on the Enron account, ordered employees to adhere to the firm’s guidelines on ‘document retention’ and destroy irrelevant documents. In the trial, prosecution produced a binder of handwritten notes from Temple, taken from numerous conference calls with Andersen executives, to show that the attorney realized that the SEC would probably open an investigation into Enron (Beltran et al., 2002).

Andersen appealed the judgment on several grounds. Andersen complained that the judge allowed the government to tell jurors about SEC actions against Andersen for faulty audits of Waste Management and Sunbeam, thereby prejudicing the jury. They also said that the judge gave improper instructions to the jury. The jury gave a message to the judge asking for guidance on making their decision. The question they asked was: ‘If each of us believes that one Andersen agent acted knowingly and with a corrupt intent, is it for all of us to believe it was the same agent? Can one believe it was agent A, another believe it was agent B, and another believe it agent C?’ (Houston Chronicle, 2003).

Over strenuous objections from the prosecution, Judge Harmon returned a message to the jury, telling them they could find Andersen guilty of obstructing justice even if they could not agree on which employee committed the crime (McNulty, 2002).

However, in May 2005 the Supreme Court reversed the previous conviction of Andersen. This was a symbolic victory for Andersen, as by then the firm was already nearly out of business due to the previous conviction. In a statement, Andersen said they were ‘very pleased with the Supreme Court’s decision, which acknowledges the fundamental injustice that has been done to Arthur Andersen and its former personnel and retirees.’ As an audit firm, Andersen was not back in business as its reputation as an independent, high-quality auditor was pretty much gone.

Discussion Question

Should the whole audit firm be charged with an offence by a few of its auditors?

In what ways can auditor working papers (correspondence, plans and audit notes) be beneficial to an investigation of company fraudulent practices?

References

Beltran, L., J. Rogers and P. Viles, 2002, ‘U.S. Closes in Andersen Trial,’ CNNMoney, 5 June.

Fowler, Tom, 2002, ‘Soul Searching Led to Plea, Duncan Says,’ Houston Chronicle, 16 May.

Manor, R., 2002, ‘Andersen Finally Admits Demise,’ Chicago Tribune, 17 June.

McNulty, S., 2002, ‘Andersen Guilty in Enron Obstruction Case,’ Financial Times, 16 June.

WSJ, 2002, ‘Andersen Sentenced To 5 Years’ Probation,’ Wall Street Journal, 17 October.

Suppose the auditor is condemned by the disciplinary court for an audit failure. Is that enough for a civil suit against an auditor? No. In order to hold the auditor legally liable successfully in a civil suit, the following conditions have to be met:

An audit failure/neglect has to be proven (negligence issue). A verdict by the disciplinary court is often the basis for meeting this condition.

The auditor should owe a duty of care to the plaintiff (due professional care issue).

The plaintiff has to prove a causal relationship between his losses and the alleged audit failure (causation issue).

The plaintiff must quantify his losses (quantum issue).

CONCEPT AND A COMPANY 2.8

TRAFIGURA AND THE ILLEGAL DUMPING OF TOXIC WASTE

Concept

Auditor’s responsibilities regarding laws and regulation – illegal acts.

Story

TrafiguraBeheer BV is a Dutch multinational commodity trading company founded in 1993 and trading in base metals and energy, including oil.

On 2 July 2006, the Probo Koala, a ship leased by the company, entered a port in Amsterdam to unload several hundred tonnes of toxic waste. Amsterdam Port Services BV, the company that had been contracted to take the waste, raised their price to process the waste twenty-fold soon after determining the waste was more toxic than previously understood. So, after baulking at a competitor’s 1000 euro per cubic metre disposal charge near Amsterdam, Trafigura decided to have the ship take back the waste and have it processed en route to different offloading sites, which all refused it until Abidjan, Côte d’Ivoire, one of Africa’s largest seaports. According to Trafigura the waste was then handed over to a local newly formed dumping company, Compagnie Tommy, which illegally dumped the waste instead of processing it. Many people there became sick due to exposure to the waste, and investigations were begun to determine whether it was intentionally dumped by Trafigura. Trafigura stated in a press statement that their tests showed the waste not to be as toxic as had been claimed, and that they were unsure why so many people had become ill from exposure to it. The New York Times reported on 3 October 2006 that the dumping of the waste by Compagnie Tommy was indeed illegal.

On 13 February 2007, to release its jailed executives in response to the deaths of ten people and the various illnesses of over 100,000 people attributed to the waste, Trafigura paid €152 million to Côte d’Ivoire in compensation. The payment also exonerated Trafigura from further legal proceedings in Côte d’Ivoire.

On 16 November 2012 Trafigura and the Dutch authorities agreed to a settlement. The settlement obliges Trafigura to pay the existing €1 million fine and in addition the company must also pay Dutch authorities a further €300,000 in compensation – the money it saved by dumping the toxic waste in Abidjan rather than having it properly disposed of in the Netherlands. The Dutch also agreed to stop the personal court case against Trafigura’s chairman, Claude Dauphin, in exchange for a €67,000 fine.

Discussion Question

Do you think the auditor of TrafiguraBeheer BV should have discovered the illegal activities of TrafiguraBeheer BV, given the attention in the international press during 2006 and early 2007?

Do you think the financial statements of TrafiguraBeheer BV for the year ending 31 December 2006 are materially incorrect, if the contingent liability of €152 million is not included in these financial statements?

References

http://en.wikipedia.org/wiki/Trafigura.

SUGGESTED SOLUTIONS TO AUDITOR LIABILITY

In the last two decades, several auditor litigation cases have resulted in multi-million dollar claims to be paid by auditors. For example, some Big Four audit firms made settlements with the US government for more than US $500 million, because of audit failures regarding several US hedge funds and financial institutions. Insurance against litigation is now common for audit firms (and in some countries like The Netherlands, mandatory). Even though the premium rates for these insurance policies have risen dramatically over the last decade, these policies only cover damage to a certain amount. Claims paid above this ‘cap’ are not covered and have to be paid by the audit firm itself.

It is widely acknowledged that the financial risks resulting from litigation for audit firms and partners might be a threat to the viability of the audit profession. Former European Union Internal Market and Services Commissioner Charlie McCreevy has said:

We have concluded that unlimited liability combined with insufficient insurance cover is no longer tenable. It is a potentially huge problem for our capital markets and for auditors working on an international scale. The current conditions are not only preventing the entry of new players in the international audit market, but are also threatening existing firms. In a context of high concentration and limited choice of audit firms, this situation could lead to damaging consequences for European capital markets.²²

In order to reduce these risks several measures are considered:

A limit or cap on claims (a maximum settlement amount) is known in advance and limits settlements. Liability is now capped in Austria, Belgium, Germany, Greece and Slovenia.

In some countries, a system of proportionate liability is under study. In such a system, an audit firm is not liable for the entire loss incurred by plaintiffs (as is the case under joint and several liability), but only to the extent to which the loss is attributable to the auditor. The US has a system of proportionate liability, but only under the federal acts.

To make insurance of all liability risks compulsory using new legislation was one of the recommendations of an EU commission.

Exclude certain activities with a higher risk profile from the auditors’ liability. A mechanism to achieve this outcome would be to introduce so-called safe harbor provisions by legislation.

In order to protect the personal wealth of audit partners, some audit firms are structured as a limited liability partnership (e.g. in the UK).

2.8AUDIT FIRM’S QUALITY CONTROL SYSTEM

QUALITY CONTROL (ISQC 1 AND ISA 220)

Quality control is a very important consideration for auditors. International Standard on Quality Control 1 (ISQC 1)²³ applies to all firms of professional accountants in respect to audits and reviews, other assurance, and related services engagements. ISQC 1 gives the requirements designed to enable the accounting firm to meet the objective of quality control. In addition, it contains related guidance in the form of application and other explanatory material. ISA 220²⁴ sets out the engagement partner’s responsibilities with respect to ethical requirements. These include remaining alert for evidence of non-compliance with ethical requirements of the members of the engagement team determining appropriate action if there is non-compliance.

A major objective of the audit firm is to establish and maintain a system of quality control to provide it with reasonable assurance that the accounting firm and its personnel comply with professional standards, legal and regulatory requirements, and that reports issued are appropriate in the circumstances. The audit firm must establish and communicate to their personnel a system of quality control that includes policies and procedures that address each of the following elements:

Leadership responsibilities for quality within the firm.

Relevant ethical requirements.

Acceptance and continuance of client relationships and specific engagements.

Human resources.

Engagement performance.

Monitoring.

(See Chapter 13 for more detail.)

2.9AUDIT FIRM OVERSIGHT

There is a recent growth in accounting oversight boards – government or professional committees to review the work of auditors and take an active part in setting and enforcing standards. The global oversight organization is the International Forum of Independent Audit Regulators (IFIAR). Similar boards are in Australia (Financial Reporting Council), the Netherlands Authority for the Financial Markets (AFM), France Autorité des marchés financiers (AMF) and the USA (the Public Company Accounting Oversight Board). These boards are described in Illustration 2.6.

The International Forum of Independent Audit Regulators (IFIAR), whose membership includes the audit regulators from 52 jurisdictions representing Africa, North America, South America, Asia, Oceania, and Europe, was established on 15 September 2006. Its mission is to serve the public interest and enhance investor protection by improving audit quality globally.

2.10SUMMARY

Audits are typically classified into three types: audits of financial statements, operational audits and compliance audits. Audits of financial statements examine financial statements to determine if they give a ‘true and fair view’ or ‘present fairly in all material respects’ the financial statements in conformity with specified criteria. An operational audit is a study of a specific unit of an organization for the purpose of measuring its performance. A compliance audit is a review of an organization’s procedures to determine whether the organization is following specific procedures, rules or regulations set out by some higher authority (i.e., US tax code, employee safety, or environmental regulations).

There are two basic types of auditor: independent external auditors and internal auditors. Governmental auditors take both the functions of internal and external auditor. Internal auditors are employed by individual companies to investigate and appraise the effectiveness of company operations for management. Independent external auditors are primarily responsible for auditing published financial statements of an entity. External and internal auditors are typically certified or licensed either by a professional organization or a government agency.

ILLUSTRATION 2.6

SPECIFIC COUNTRY OVERSIGHT BOARDS