Auditing An International Approach Bahram Soltani Solution Manuals

Instructor’s Manual Auditing: An International Approach

Bahram Soltani

Contents Chapters

Pages

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

6 14 23 34 43 52 63 75 86 97 106 118 137 146 156 163 173 181 190

An introduction to auditing and assurance Demand for and supply of external audit services Auditing, organization and governance The audit committee, internal and external auditing International auditing and assurance services Auditing in the European context Auditor independence and professional ethics: international issues Audit risk, materiality and business risk management Audit sampling techniques Evidence and decision making in auditing Internal control over financial reporting and IT environment Audit reporting Information technology and auditing Continuous auditing and continuous reporting Quality control and oversight systems in auditing: international issues Auditor liability in a changing environment The independent auditor, stock markets and lending decisions Corporate fraud, corporate scandals and external auditing Auditing: looking ahead

3 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

INSTRUCTOR GUIDANCE AND SUGGESTIONS This book discusses auditing concepts for a changing environment and how auditing responds to public expectations. It analyzes the role of external auditors today as a vital part of decision making in the market economy and the need to expand their role beyond traditional financial statement audits. It treats auditing as a whole discipline – the theory and the practice – rather than discussing only auditing techniques. This approach raises the essential question of what auditing ‘ought to be’ and how it should keep pace with change.

This book is organized around four fundamental areas in auditing: international issues including international standards, theoretical as well as practical aspects of auditing, major research work in auditing and multidisciplinary topics. It views the audit process in a changing environment, and in this respect, it concerns the examination of the financial statements information relating also to an organization’s ability to effectively manage strategic and business process risks.

This textbook is different from many others available in the market in a number of ways. Firstly, the book reflects on auditing as a discipline emphasizing its theoretical foundation and issues as a basis, rather than discussing only the practices of auditing. It presents auditing as a complex judgement and decision process affected by real-world behavioural and environmental factors, rather than just as a mechanical, standard-driven process. Second, Auditing: An International Approach emphasizes the international aspects of auditing covering the International Standards on Auditing (ISA) issued by IFAC and IAASB as well as the US auditing standards and regulations. This is a significant feature of this textbook compared with the other major textbooks in auditing, which cover mainly the US approach to auditing and financial reporting.

Thirdly, this book differs significantly from other texts in terms of philosophical approaches, as it presents auditing as a field of knowledge. This difference is reflected in the discussions in several chapters focusing on the expectation gap in auditing, audit judgement, decision making, bounded rationality and heuristic in auditing, personal ethics, professional ethics, legal liability etc. This innovative approach, which considers the audit process as judgement-based rather than a standards-driven process, provides a much broader vision than the merely technical aspects of this field discussed in most auditing textbooks. Moreover, the multidisciplinary approach taken in this book provides a significant difference when compared to other texts. In several chapters, the relationships between auditing and organization, auditing and finance with regard to corporate governance and financial market, and auditing and information technology systems have been highlighted.

This does not seek to undermine the importance of practical aspects of auditing – indeed they are extensively covered in the book – but to understand and explain them better, and even to look ahead into the future. However, in a changing world, the move away from the traditional role of an auditor as simply an attestor of historical financial statements reflects the shift in the audit process from a detail-driven substantive approach to a strategic risk approach to audit planning and execution. Although the detailed discussion on audit planning and execution is not the major objective of this book, it provides extensive coverage of major topics in audit practices. These include the discussions on auditing standards, evidence gathering, audit committee, internal control, auditor independence, audit reporting, strategic and business process risks, audit testing, auditing and IT, quality control and legal liability.

4 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Special note to instructors The questions at the end of the chapters in this book are designed to promote deeper thought about the auditing issues. The answers given in this instructor’s manual are provided in a summarized form. They are intended to provide the highlights and major elements related to the review and discussion questions. Since the questions are general and are not always related to a specific point, the answers can be found not only in the related chapter but in other chapters also.

Instructors are encouraged to provide their own opinions and perceptions when discussing the questions. As the instructors may notice, there are not always specific answers to the questions, and this opens the door to further discussions around the topics raised in the chapters. The students should be encouraged to express their opinions on the topics raised in the questions even if their points of view are not specifically related to the chapter under discussion.

5 .

CHAPTER 1

AN INTRODUCTION TO AUDITING AND ASSURANCE Instructor guidance This chapter discusses the conceptual development of auditing and some fundamental theoretical aspects of auditing as a field of knowledge, and its philosophical background. It is desirable that the instructors put sufficient emphasis on the questions on p. 3. As indicated in the introduction of the chapter, the major objective here is ‘to adopt a critical approach to auditing’ and try to build up an appropriate framework for the fundamental areas of auditing that will be discussed in the following chapters.

The following is the suggested outline for the instructors when teaching this introductory chapter. Most of the learning objectives include the major topics that need to be emphasized by the instructors when teaching this introductory chapter.

•

Reflections on the core questions indicated on p. 3 about the critical role of auditors;

•

Discussion about the demand for assurance services (pp. 14–18). It is desirable to provide a brief definition of an audit of financial statements and how recent changes affect the audit environment and its framework (pp. 4–7), including the changes in auditors’ evaluation of companies’ internal control systems (pp. 20–22);

•

Emphasis on the theoretical approach to auditing by discussing the philosophy of auditing (pp. 7–14). Reference should be made to the seminal works of Limperg (1930s), Mautz and Sharaf (1961), Flint (1988) and Power (1990).

6 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 1-1 What types of assurance services are provided by the public accounting profession?

What factors create a need for assurance services?

Answer 1-1 The public accounting firm can provide three major professional services: assurance, tax and consulting. Assurance can be categorized into attestation and non-attestation services. In general, there is a broad range of assurance engagements which includes any combination of the following: •

Engagements to report on a large number of subject matters covering financial and nonfinancial information.

•

Engagements intended to provide high (examinations) and moderate (reviews) levels of assurance. Examinations which provide decision makers with a high level of assurance as to the reliability of information are related to all financial statement audits. Reviews which provide only a moderate level of assurance to decision makers concerning the reliability of information are substantially narrower in scope than examinations.

•

Attestation and direct reporting engagements.

•

Engagements to report internally and externally.

•

Engagements in the private and public sector.

The need for assurance services is mainly affected by the desire of different interested parties (investors, managers, regulators, financial institutions, employees etc.) for high-quality corporate financial information. Not only are the assurance services provided by independent auditors determinant in the decision-making process, they provide credibility to information quality. The concept of credibility is directly related to the reliability of financial information as an essential characteristic of information quality.

1-2 What is an attestation function? What major factors create a demand for the performance of attestation services by public accounting firms?

Answer 1-2 An attestation is the process of providing assurance service in which the public accountant issues a report about the reliability of any information provided by one party to another. The examples of attestation are a financial statement audit and the auditor’s attestation on management’s assessment of the effectiveness of the company’s internal control over financial reporting. The audit of financial statements is mostly demanded by the investors and creditors who are seeking an independent opinion on a company’s financial statements. The auditor’s report provides the external users with the reliable financial information they need in their decision-making process.

7 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

1-3

What is the essence of the ‘theory of inspired confidence’ developed by Professor Limperg in 1930s.

Answer 1-3 The ‘theory of inspired confidence or rational expectations’ basically tries to link a society’s need for reliable financial information and the auditor’s performance. It emphasizes the extent to which the auditing techniques and the content of audit report meet the users’ satisfaction for high-quality financial statements. In a general sense, the independent auditor acts as an intermediary agent providing confidence to economic agents making business decisions in the society.

1-4

What are the main objectives of audits of financial statements? How does an audit enhance the quality of financial statements?

Answer 1-4 In a financial statement audit, the auditor attests to the fairness of a company’s financial statements by expressing an opinion about whether the statements are in conformity with generally accepted accounting principles or other recognized criteria. The financial statements are assertions by management regarding the financial performance and financial condition of the company.

The objective of the audit is to assist users of accounting information and financial reporting in determining the quality of information being received. The audit function ought to add to the credibility of information because the user of the information needs to have confidence in it when making decisions.

1-5

How do assurance services differ from audit services? How have these differences developed in recent years?

Answer 1-5 Assurance services can be categorized into attestation services and nonattestation services. Audit services are typically forms of attestation services involving a report that goes to a third party. Assurance is a much broader concept than auditing. In contrast to attest engagements, non-attest assurers either improve the relevancy of information that originates with other parties, or create entirely new information for the use of interested parties.

Assurance also applies limited specific audit procedures to the examination of one or more specified accounts or elements of the financial statements, rather than conducting the complete audit of financial statements. Audit services usually provide a high level of assurance, whereas other forms of assurance services provide limited assurance.

The changes due to financial markets, information technology and a greater demand for continuous reporting probably affect the audit function more than other forms of assurance services. Several developments in recent years have considerably affected financial information users’ perceptions of audit services and the manner in which these differ from other assurance services. These mainly include real-time reporting, the need to put more emphasis on attestation of internal control over financial reporting, reports on prospective financial statements and demand for continuous auditing.

1-6

What are the main differences between reasonable and limited levels of assurance engagements?

Answer 1-6 These terms are mainly discussed in the IFAC auditing standards (2005).

Accordingly, the objective of a reasonable assurance engagement is a reduction in assurance engagement risk to an acceptably low level. The objective of limited assurance engagement is to reduce this risk to a level that is acceptable in the circumstances of the engagement, but where that risk is greater than for the former type of engagement. The nature, timing and extent of procedures for gathering sufficient appropriate evidence in a limited assurance engagement are deliberately limited relative to a reasonable assurance engagement.

8 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

1-7

Explain the objective of agreed-upon procedures engagement and provide five examples of such procedures.

Answer 1-7 Agreed-upon procedures engagement is related to the examination of one or more specified accounts or elements of the financial statements using limited but specific audit procedures, without conducting an audit of the entire financial statements. By definition, these procedures are narrower in scope than an audit or review of financial statements. The examples of such procedures include examining the detailed accounts-receivable data used in loan agreements, narrative description of a company’s compliance with specific laws, regulations, rules or contracts, the debtor’s compliance with certain financial covenant provisions stated in a loan agreement, a representation by management in the case of trading of a company’s investment securities based on its investment policies and an auditor’s attestation regarding the information contained in a company’s forecasted financial statements.

1-8

To what extent is it reasonable to view the external auditor as a guarantor in the capital market economy? Explain.

Answer 1-8 The external auditor as an intermediary economic agent helps to reduce the information asymmetry between management and shareholders. The audit also contributes to alleviating the conflicts of interest between the information preparers and users of information.

The external auditor adds to the credibility of financial reports, facilitating the regulatory bodies’ attempts to protect public interest. However, external auditors cannot be viewed as a guarantor in a capital market involving numerous risk factors.

1-9

In your opinion, what are the potential threats facing an external auditor when conducting all types of assurance services?

Answer 1-9 The potential threats mainly relate to the lack of auditor independence and professional competence and training, as well as not attaching sufficient importance to environmental factors including business risk. The developments of these elements and other related matters are mainly presented in chapter 7 of the textbook.

1-10 What are the major aspects of the relationship between the structure of the audit market and its regulation?

Answer 1-10 The relationship between the audit market and regulatory bodies is significantly affected by the increasing number of statutory entities requiring audit, a new pattern of governance, advances in information technology and developments of the capital market economy. This requires the increasing involvement of regulatory bodies in the audit market by proposing several reforms for the better protection of investors and avoiding further corporate financial scandals.

Public oversight of the audit market, which was mainly in the hands of professional bodies, has been recently passed over to market regulators. In the United States, the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) have recently proposed several important measures affecting the structure of the audit market and its relationship with the capital market.

1-11 What is the primary rationale for market regulatory bodies to require mandatory reporting on internal accounting controls and the auditor’s involvement in this respect?

Answer 1-11 Due to the importance and effect of the assessment of internal control in the audit of financial statements, external auditors should attest to management’s assertion about the effectiveness of internal control over financial reporting. Several important elements, such as the reliability of financial reporting, the effectiveness of management decision making, compliance with applicable laws and regulations and safeguarding of assets, depend to a great extent on an efficient internal control system of the company.

9 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Discussion Questions 1-12 To what extent do the factors such as: (a) economic developments; (b) globalization and internationalization of capital markets; (c) the complexity of financial operations and (d) information technology advances affect the demand for and the performance of auditing services?

Answer 1-12 All these environmental factors affect the demand for and the performance of external auditors. (a) Economic developments affect the demand for audit as a result of an increasing number of companies and/or higher volume of activities. (b) The globalization and internationalization of the capital market affect the competition among audit firms and may create a higher concentration in the audit market. It may result in a higher quality of audit if the auditors acquire the necessary competency, training and specialization. However, the concentrated audit market may also impair auditor’s independence and the auditor’s performance. (c) The increasing number of financial instruments and financial operations which require more sophisticated accounting standards and auditing techniques significantly affect the audit scope and auditor performance. These also create the demand for specialized audit and high level of competency and training in different related domains. (d) The rapid advance of online technologies and the World Wide Web (W W W) and other forms of IT systems considerably affect the auditor’s performance and demand for audit. As part of the audit process, the auditor should make an assessment of company’s information system and different types of risks. When IT systems are used extensively within an organization, the auditor should also obtain an understanding of the IT environment and the extent to which this influences the company’s financial reporting and the quality of information disclosed to third parties.

1-13 Discuss the historical perspective of auditing with regard to Limperg (1930s) and Mautz and Sharaf (1960s).

Answer 1-13 The seminal works of Limperg and Mautz and Sharaf are discussed on pp. 8–14.

However, for an in-depth historical discussion, refer to the original sources. In the case of Mautz and Sharaf (1961), it would be interesting to read particularly Chapter 1 (Toward an Auditing Philosophy), Chapter 2 (the Methodology of Auditing), Chapter 8 (Independence), Chapter 9 (Ethical Conduct) and Chapter 10 (Auditing in Perspective). For the work of Limperg, it would be interesting to refer to the end-of-chapter references (Carmichael 2004, Flint 1988 and Blokdijk et al 1995).

1-14 Discuss the arguments supporting the idea that auditing is a field of knowledge.

What are the contributions of Mautz and Sharaf in this area?

Answer 1-14 This topic, which is briefly discussed on pp. 11–12 of the chapter, is well developed in Chapter 1 (Toward an Auditing Philosophy) and Chapter 10 (Auditing in Perspective) of Mautz and Sharaf (1961). They defined the structures of auditing as a field of knowledge (see pp. 243–248 of their book) on the basis of five essential elements (philosophical foundation, postulates, concepts, precepts and practical applications).

10 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

1-15 A company’s management, shareholders and creditors (mainly financial institutions) are directly concerned with the auditors’ function and performance, particularly in the case of publicly traded companies. (a) Briefly discuss who among the above groups is the most important beneficiary of an auditor’s report on a company’s financial statements. (b) Describe the circumstances in which there are potential conflicts of interest between these groups. How should auditors resolve such conflicts in the needs of the above parties?

Answer 1-15 (a) Shareholders are the main recipients of the financial statements and reports of corporations. The audited financial statements are an essential part of investors’ information for their decision-making process. However, the audited financial statements may substantially benefit the company’s management when evaluating its performance and facilitating the conflictual shareholder–manager relationship. (b) The critical areas such as investment, financing, dividend policies as well as management remuneration are some examples in which there may exist conflicts of interest between shareholders and managers and also between both of these groups and creditors. Many of these conflicts result from the information asymmetry between these groups. The presence of independent auditors not only contributes to the reduction of information asymmetry, it also provides credibility to the company’s financial statements disclosed to various interested parties, provided that the auditor performs his/her function perfectly.

1-16 Market concentration has been a feature of auditing in the past few decades. Large accounting firms have come to dominate audit and assurance services. Discuss the effect of market concentration on audit quality in the context of capital market efficiency.

Answer 1-16 Audit market concentration and mergers among top audit firms in the 1990s are critical issues in the capital market economy. The market regulatory agencies have recently shown some concerns over this matter. It would be interesting to discuss this by putting forward both the for and against arguments, as the impact of market concentration on audit quality is a controversial topic. Audit quality may benefit from audit market concentration because of increasing specialization and competency of auditors in charge of publicly listed companies. On the other hand, it may impair auditor independence and credibility in some respects.

1-17 What is the role of regulatory bodies such as the SEC and PCAOB in the US and the European Commission in the audit market? Discuss this in terms of: (a) setting audit standards; (b) monitoring and performing the quality control reviews.

Answer 1-17 The SEC and PCAOB have played an important role in the US audit market, particularly since the approval of the Sarbanes-Oxley Act (SOX Act) in 2002. The PCAOB has been designated by US regulators as the major body in establishing audit standards and oversight of audit quality control. The audit profession has been playing a major role in both areas, but important changes have taken place since the SOX Act. Although the role of the European Commission in these areas is not as significant as that of the US regulators, this has evolved in recent years and the EU Commission has also adopted several recommendations concerning auditor independence, audit quality control and auditors’ responsibilities.

11 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

1-18 Discuss the following statement with regard to internal control over financial reporting within publicly traded companies. Evaluate the importance of this issue from the viewpoint of various interested parties (shareholders, managers, external auditors, regulators, potential investors, etc.).

The PCAOB notes in its release (Auditing Standard March 2004 United States) that: ‘The primary benefit [of an effective internal control structure]…is to provide the company, its management, its board and audit committee, and its owners and other stakeholders with a reasonable basis on which to rely on the company’s financial reporting’.

Answer 1-18 The SOX Act requires management’s assessment and the auditor’s opinion to address whether company’s internal control was effective as of the end of the company’s most recent fiscal year. To make decisions, a company’s management and its owners – public investors – and others must be able to rely on the financial information reported by companies.

As part of the audit function, the independent auditor has to express an opinion about whether management’s assessment, or conclusion, on the effectiveness of internal control over financial reporting is stated fairly, in all material respects.

Evaluating a company’s internal control over financial reporting is sometimes costly, but there are also many far-reaching benefits. Some of the benefits of a company developing, maintaining, and improving its system of internal control include identifying cost-ineffective procedures, reducing the costs of processing accounting information, increasing productivity of the company’s financial function and simplifying financial control systems. It may also result in fewer financial statement restatements and less litigation. Effective internal control contributes to the better functioning of the company and promotes reliable financial reporting, which in return adds value and also can offset risks in a cost-beneficial manner. In that sense, the interested parties benefit from effective internal control and reliable financial reporting.

1-19 Discuss the following statement.

Michael Power (1997)∗ states that the rise of auditing has its roots in political demands for accountability and control. He argues that the new demands and expectations of audits live uneasily with their operational capabilities. Not only is the manner in which they produce assurance and accountability open to question but also, by imposing their own values, audits often have unintended and dysfunctional consequences for the audited organizations.

Answer 1-19 Many aspects of the corporate failures resulting from fraudulent financial reporting raise concerns about auditing practices, auditors’ independence, their social responsibilities and duties to third parties (including stakeholders) who rely on their reports. The question of auditors’ duties to report fraud to regulators has long been an issue of concern in many developed countries and remains so, particularly when news about corporate misbehaviour becomes public. External auditors are increasingly coming under critical scrutiny. This raises important social and political questions about the responsiveness and accountability of the auditing profession and auditors’ role within the capital market economy.

To provide fair and objective answers to these questions requires further reflection on the role, objectives and responsibilities of external auditors. The auditing profession has faced unprecedented challenges, particularly during the last decade. Severe pressures have caused a re-examination of the auditors’ role and their place in the economy. Auditors are often portrayed as public watchdogs but according to the current rules and standards, their public obligations remain fairly limited. They do not owe a ‘duty of care’ to participants in the market economy such as employees, individual shareholders and/or bank depositors. Moreover, external auditors

∗ The Audit Society: Rituals of Verification (1997, Oxford University Press).

12 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

are themselves economic agents who try to maximize profit, and this does not always conform to the responsibilities attributed to them by public opinion.

What can perhaps contribute to this debate is first to provide some clear definitions about the objectives of external auditing, the nature of auditing services and auditors’ social responsibilities. The next step is to consider the other technical issues regarding the conduct of audits and the processes used to serve companies. The integrity of corporate financial information must take priority over a desire for cost efficiencies or competitive advantages in the audit process. High-quality auditing requires well-trained, well-focused and well-supervised auditors.

1-20 Visit the website of the AICPA (www.aicpa.org), IFAC (www.IFAC.org) and PCAOB (www.pcaobus.org). Identify attestation services that have been recently defined by these accounting bodies. Prepare a report describing the nature of those services, and include a brief description of the criteria that have been developed for auditors to use in providing those services. Indicate significant differences between US and international approaches in terms of definitions for assurance and attestation services.

Answer 1-20 This question requires the search by students on the web sites of auditing bodies in the US (AICPA and PCAOB) and at international level (IFAC and the International Auditing and Assurance Standards Board ‘IAASB’ in charge of developing auditing standards). The students must be encouraged to do this as a case study in order to identify the major differences between US and international approaches. They can refer to the discussions in Chapters 1 and 5 (international auditing and assurance services) for further information.

However, it would be interesting to search for the most recent and update information including the changes made since the publication of the book.

13 .

CHAPTER 2

DEMAND FOR AND SUPPLY OF EXTERNAL AUDIT SERVICES Instructor guidance This chapter discusses the importance of auditing in corporate financial reporting. It provides a discussion on the implications of the economics of information, the needs of various users of financial statements, the issue of the expectation gap and the role of external auditors in reducing the problem of information asymmetry.

The following is the suggested outline for instructors when teaching this chapter: •

Emphasize the importance of the economics of information and insist on the theoretical elements (e.g. information asymmetry);

•

Discuss the expectation gap in auditing and its evolution with a changing environment;

•

Emphasize the role of external auditors in corporate financial reporting and major features of this relationship;

•

Provide the theoretical explanations for the demand for auditing.

14 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 2-1

What are the main aspects of the communication process by which accounting information reaches the potential users of this information?

Answer 2-1 Corporate financial reporting and communication processes are essential to a company’s strategy. The major aspect of the process is the quality of information transmitted to various users of financial information and the presence of independent auditors adds credibility to this information. It is important to refer to the qualitative characteristics of accounting and financial reporting discussed on p. 15 of Chapter 1. The worth of the financial communication process depends, to a great extent, on its utility for the decision making of potential users and its impact on their perceptions.

2-2

Why is there a need for regulation of disclosure in capital markets? What types of disclosures should be regulated and which should not?

Answer 2-2 The market regulators play an important role in capital markets by regulating the type of information which must be disclosed by publicly listed companies. This oversight role is required to protect the investors and various stakeholders, and also to provide confidence and credibility as major factors in the better functioning of financial markets. This cannot be achieved without regular monitoring of the quality of information disclosed by listed companies and a demand for efficient control mechanisms.

The market regulatory bodies are generally concerned with mandatory financial information such as financial statements, notes to the accounts, and periodic reporting (annual, quarterly reports). Although the regulators are interested in the quality of the information voluntarily transmitted by companies to users of information, it would be rather difficult to exercise any direct control on disclosures of this type (public releases on earnings, share prices, investment and financing policies etc.).

2-3

Explain the role of the independent audit function in the communication of corporate accounting information.

Answer 2-3 The company’s management is responsible for preparing and implementing the appropriate financial accounting and reporting systems and communicating reliable financial information to interested parties. The presence of independent auditors is an essential factor in adding credibility to the information disclosed by companies. The recent regulations require the active presence of external auditors in the company’s reporting process in the areas of internal control over financial reporting and financial information needed for business decision making.

Moreover, the external auditors are increasingly considered by market participants as an independent intermediary in corporate financial reporting for reducing the information risk, efficient resource allocation and market control mechanisms.

2-4

Discuss the importance of the notions of ‘expectation gap’ and ‘credibility gap’ in the corporate financial reporting process.

Answer 2-4 The expectation gap is the shortfall between the amount of information that a decision maker possesses, and the amount of information required or he/she expects to have for a given decision. This gap can be filled by an independent auditor. The independent auditor backs up the financial statements prepared by the company’s management, thereby lending 15 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

credibility to the company’s financial reporting process. It is also expected that the presence of an external auditor adds to the credibility of information and mitigates the credibility gap caused by conflicts of interest between the users of a company’s financial information. Changes in society’s expectations and in information technology have significantly affected the demand for auditing, and the expectation gap in this field has become much wider and the implications much more complex.

2-5

Discuss the factors influencing the mandatory and voluntary disclosures of financial information.

Answer 2-5 The need for better protection of potential users of corporate financial information, efficient monitoring of a company’s reporting process, better functioning of financial markets, a higher level of transparency of financial data and increasing demand for reliable financial communication systems are among the major factors affecting the financial disclosure of publicly listed companies. Efficient monitoring of financial reporting and the information disclosed by publicly listed companies requires the active presence of market regulatory bodies in the capital market economy. Above all, efficient control mechanisms such as internal and external auditing and effective internal control over a company’s financial information are necessary for efficient resource allocation in a market economy.

2-6

How and to what extent do regulatory bodies (such as SEC in the US and the European Commission) affect the supply of financial statement information by publicly held corporations?

Answer 2-6 The market regulatory bodies such as SEC in the United States and similar bodies in other countries are responsible for the protection of the public interest and better functioning of capital markets. The regulatory bodies are mainly exercising their oversight role with regard to mandatory financial information and control mechanisms needed for high-quality financial reporting within corporations. The importance of protecting public interest and implementing effective market control mechanisms requires the direct intervention of regulatory bodies concerning the mandatory supply of financial information, and it does not very much concern the voluntary disclosure of information. However, the regulatory market bodies are also concerned with any irregularities and fraudulent financial reporting resulting from voluntary disclosures by publicly listed companies.

2-7

‘A Statement of Basic Auditing Concepts’ (American Accounting Association, 1973) explains different conditions creating demand for auditing. Discuss these conditions.

Answer 2-7 These conditions (conflict of interest, consequences, complexity and remoteness) are discussed on pp. 46–49 of Chapter 2. In spite of the fact that the Statement of Basic Auditing Concepts was released more than thirty years ago, it deals clearly with major issues facing the current audit market and demand for auditing. It is important that the instructors emphasize the validity of the theoretical foundation of this statement, even if the current demand for auditing is mainly characterized by environmental changes and not only concerns the auditor-client and/or auditor-manager-shareholder relationships.

2-8

What are the major hypotheses with regard to the sources of demand for audit services? Explain each of these hypotheses.

Answer 2-8 These hypotheses are explained on pp. 49–55 of Chapter 2 and provide the theoretical explanations of the demand for audit services. It is essential that the students grasp the main points of this discussion to be able to analyze the role of external auditors in the capital market economy. To define the role of the auditor with regard to the economics of information not only supports the increasing demand by market regulatory bodies for high-quality audit services, but it also helps us to understand better the major issues such as auditor independence

16 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(Chapter 7), quality control (Chapter 15), auditor liability (Chapter 16), the role of the external auditor in the financial market (Chapter 17) and several other topics discussed in the following chapters.

2-9

How effective are auditors in enhancing the credibility of financial statements?

What factors influence their effectiveness?

Answer 2-9 The effectiveness of external auditors depends very much on how the major users of financial information perceive the quality of the audit. The presence of independent auditors is an integral part of reliable financial reporting. However, the increasing demand of stakeholders for high-quality information and real-time reporting requires the move from annual assurance to continuous assurance. The effectiveness of auditors also depends on their ability to satisfy the users’ expectations for high-quality financial information. It relates to the auditors’ capabilities to respond to increasing environmental changes and complex information systems by expanding the audit scope and improving audit quality control mechanisms.

2-10 What is the relationship between financial disclosure, corporate governance and management incentives? What role do boards of directors and audit committees play in the disclosure process?

Answer 2-10 Management is responsible for preparing and communicating high-quality financial information. Corporate governance mechanisms, particularly the audit committee, play a central role in the financial reporting process. The evaluation of management’s performance and its incentives should logically be based on a company’s financial statements. The audited financial statements should help the owners to link the company’s financial performance and management’s performance. However, factors such as temptation to manage earnings, big bath accounting operations and irrational market expectations make this evaluation difficult. The more efficient the control mechanisms and accountability systems within the company are, the better the management evaluation system and incentive policies will be. High quality and transparent financial reporting significantly contributes to achieving this.

2-11 How effective are accounting standards (e.g. US GAAP, IFRS (or IAS)) in facilitating credible communication between corporate managers and outside investors? What factors determine their effectiveness?

Answer 2-11 Financial reporting includes financial statements and other forms of communication that provide accounting information (corporate annual reports, prospectuses, annual reports filed with the market regulatory agencies, news releases and management forecasts). The financial statements and attached notes are the essential components of the financial reporting of companies, and their preparation is essentially based on generally accepted accounting standards (IFRS or US GAAP) established by recognized bodies such as the International Accounting Standards Board (IASB) or the US Financial Accounting Standards Board (FASB).

The accounting standards are officially recognized as authoritative by the market regulatory agencies and professional accounting bodies. Such standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information.

There are a number of limitations of accounting standards in areas such as the evaluation of immaterial assets, intellectual capital, internally generated goodwill and financial derivatives.

The discretionary nature of income statements and earnings management are the other areas in which the lack of clear-cut accounting standards and guidelines allow the managers to produce fraudulent financial reporting. Many aspects of recent corporate failures are directly related to ineffective accounting standards and financial reporting. In order to contribute to the credibility of the communication process of companies, particularly those listed on financial markets, the standard-setters should develop high-quality accounting standards that are relevant to the business decision-making process, easy to understand and facilitate comparability of financial information.

17 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

2-12 In what way is the globalization of capital markets affecting the globalization of financial reporting?

Answer 2-12 The globalization of capital markets has been accompanied by calls for the globalization of financial reporting. This requires a common set of high-quality accounting standards which will enhance the consistency, comparability and efficiency of the financial statements of publicly listed companies, enabling global markets to move with less friction.

High-quality financial reporting is an imperative of orderly and efficient globalized capital markets. They require appropriate accounting standards and adequate financial disclosure at a world-wide level. The IASB is committed to developing, in the public interest, a single set of high quality, global accounting standards that require transparent and comparable information in general purpose financial statements. In pursuit of this objective, the IASB co-operates with the FASB and other national accounting standard-setters to achieve convergence in accounting standards around the world.

2-13 To what extent, in your opinion, do the current format and content of audit reports respond to the needs and expectations of investors and lenders in capital markets?

Answer 2-13 The audit report is the most common and highest level of assurance provided by an independent auditor to those interested in a company’s financial information. The audit report in its current form is based on historical financial statements. Users of financial information are no longer satisfied with annual reports and conventional ‘backward-looking’ audit reports on companies’ financial statements. Several factors are leading to a higher expectation gap between what the public expects or needs and the information content of audit reports. These include the ever-increasing expectations of various interested parties for real-time reporting, market expectations for value relevance of audit reports, information technology advances and problems relating to earnings management.

Discussion Questions 2-14 Comment on and discuss the following statement and the related questions.

‘Notwithstanding the efforts made by regulatory bodies and accounting policymakers in disclosure and corporate reporting, there is still some ambiguity surrounding several important topics in this area’. Consider the following questions regarding the informational role of mandatory financial reporting: (a) What information about a company’s financial conditions should be released to investors and other stakeholders in a financial report? (b) Where should the information be released? Should it be recognized explicitly in the body of the financial statements, disclosed in notes or revealed in some other fashion? (c) When should the information be disclosed?

Answer 2-14 The market regulatory agencies are responsible for protecting public interest. This requires monitoring of the financial reporting process of publicly listed companies. With regard to mandatory disclosure of financial information, the following points are important.

18 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(a) The financial reports should include the information useful for business decision making. This primarily includes the information regarding the company’s economic resources, obligations, owners’ equity, economic performance and earnings, liquidity, solvency and fund flows. (b) Corporate annual reports, quarterly financial reports, management forecasts and other types of information filed with market regulatory bodies should include this information. The company’s financial statements and the attached notes should generally include all the necessary information useful for business decision making. (c) The users of a company’s financial information generally require timely and reliable information. However, because of the difficulties surrounding the company’s disclosure in real-time reporting, companies currently disclose the mandatory information on a periodic basis and supply the additional information on a voluntary basis, for example, in the area of earnings management. As a result of market expectations and the regular demand for information, voluntary disclosure becomes part of the company’s reporting and communication process. The financial market may sanction the companies who do not respect the voluntary disclosure of information on scheduled dates. This sanction is mainly exercised on the company’s share prices since the absence of regular disclosure may be considered as a negative sign in terms of company’s performance.

2-15 ‘Managers generally have superior information to outside investors about their company’s expected future performance’.

Discuss the above statement in a theoretical context. How does the managers’ superiority in information affect the efficiency of the financial market? To what extent does this affect the attitude of managers in terms of voluntary disclosures?

Answer 2-15 It is essential to discuss the problem of information asymmetry (pp. 37–39), the economics of information (p. 39) and the supply and demand for financial information. The fact that the management is responsible for preparing corporate information inevitably puts them in a privileged position of having access to more information than those interested parties outside the company. At the same time, part of this information may be used to evaluate the managers’ performance. If a manager tries to benefit from his/her position in this respect, this will have a negative impact on the company’s performance and shareholders’ interest.

Managers’ misconduct and abuses of power are more likely when they do not establish the appropriate control mechanisms (internal control, internal audit, etc.) within the company, and they are reluctant to disclose information. The temptation to manage earnings in an unreasonable manner, the disclosure of financial statements that contain misrepresentations, producing fraudulent financial statements and unrealistic future cash flows are good examples of the cases in which the management’s actions would unfavourably affect market efficiency in the long term. Although fraudulent financial reporting may be disclosed both on a mandatory and voluntary basis, management abuses in the area of financial reporting are mostly revealed through voluntary disclosures, especially to satisfy market expectations. The best way to avoid managers’ misconduct in producing and communicating biased information is to implement effective and appropriate internal and external control mechanisms over the company’s financial reporting. The presence of oversight systems implemented by market regulatory bodies also contributes significantly to controlling managers’ actions.

2-16 Discuss the question of whether investors, when pricing a security (e.g. in the case of initial public offerings (IPO)), value the auditor’s ability to provide an insurance role. Discuss this in the context of the relationship between the insurance hypothesis and auditor liability status (limited liability). Explain the link with securities’ prices in the flotation.

19 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Answer 2-16 To discuss this question, it would be interesting to suggest to students to read the research conducted by O’Reilly (2000), Menon and Williams (1994) and Kothari et al. (1988) (see references at the end of chapter). The literature on the audit market has suggested that a valued attribute of audits is implicit insurance. The insurance stems from the investor’s right to recover from auditors, the losses sustained by relying on audited financial statements that contain misrepresentations. For example, Menon and Williams (1994) examined the effect on stock prices of the clients of Leventhol & Horwath (L&H) of two related events (L&H was the seventh largest accounting firm in the United States. It was agreed to file for bankruptcy in November 1990): firstly, the disclosure of their auditor’s bankruptcy, and second, the appointment of a successor auditor. The disclosure of L&H’s bankruptcy was found to have a negative impact on L&H clients’ stock prices. No corresponding increase in stock prices on the announcement of a replacement auditor was observed. The paper suggested that the value of the expected insurance coverage included in the price of the stock was hypothesized to vary with the magnitude of the losses previously sustained by the security and with the security’s classification either as an IPO or as a seasoned security. Evidence suggests that investors in IPOs take advantage of the protection provided under the securities’ laws and file suit when they sustain investment losses. This protection includes the right to recover from auditors the losses resulting from misstatements of a company’s financial statements which have been audited. Investors appear to be willing to pay a premium for the right to recover potential investment losses from auditors through litigation.

2-17 ‘Improving the quality of financial reporting necessarily involves the imposition of certain burdens and costs on publicly listed companies. Despite these costs, it is believed that a more transparent and reliable financial reporting process ultimately results in a more efficient allocation of resources and in a lower cost of capital.

Nevertheless, in terms of cost and benefit, these additional costs need to be offset against the impact of reduction of outright fraud and other practices that result in lower quality financial reporting’.

Discuss the following questions with regard to the conflicts of interest between companies’ shareholders and management, and corporate lenders such as bankers: (a) Provide some examples of actions the company’s shareholders and management can take that are at variance with the interests of corporate lenders. (b) Give examples of actions management can take that are at variance with the interests of shareholders. (c) What mechanisms might serve to reduce potential conflicts between the various parties involved in corporate financial reporting (e.g. between shareholders and corporate lenders and/ or management and shareholders)?

Answer 2-17 A company’s financial reporting must be useful to be beneficial to the users. The provision of transparent and useful information is an essential component of business decision making. However, internal financial information users have superior information compared to outside parties, such as bankers and analysts. Additionally, several aspects of corporate strategy may be the sources of conflicts between various interested parties. Good quality information must reflect all the necessary details including those relating to conflicts of interest.

The following brief responses provide examples of such conflicts and how the useful financial information helps to solve the conflicts. (a) The areas such as the company’s investment and dividend policies and the forecasted cash flows may be the source of conflicts between the management and corporate lenders when a company seeks financing. Company shareholders defending their interests may also support management actions against the lenders.

The disclosure of reliable and transparent financial information and the existence of

20 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

effective control mechanisms can lessen the conflicts. In this respect, the predictive value of disclosed information is an essential qualitative characteristic of information. (b) There may be conflicts of interest between the shareholders and management over dividend policy, investment decisions using internal financing and management remuneration. Once again, the principles of reliable and transparent information and accountability are determinant factors in resolving a part of the conflict between the related parties. (c) An adequate reporting policy, effective internal control mechanisms, respect of transparency and accountability principles, selection of appropriate accounting standards and high-quality independent audit are among the most important factors contributing to the resolution of conflicts of interest between various interested parties.

2-18 The expectation gap usually refers to what the public expects or needs and what auditors can reasonably do. Users of financial reports expect auditors to provide assurances concerning material fraud, irregularities and the viability of the business and its management. Discuss the following questions with regard to the expectation gap: (a) In your opinion, what are the major factors affecting the expectation gap between users of financial statements and auditors? (b) Auditors’ responsibilities have increased over recent years. In your opinion, to what extent has public pressure affected the developments in auditor responsibilities? (c) Discuss the role and performance of external auditors in detecting corporate fraud, one of the areas in which they are subject to continuing public criticism due to society’s ever-increasing expectations of auditors. (d) What type of solutions and/or strategies would you recommend to reduce the expectation gap in auditing? (e) What is the role of market regulators in reducing the expectation gap in auditing?

Answer 2-18 This question discusses the development of expectation gap in auditing and the role of external auditors in the capital market economy. (a) Several factors have significantly contributed to widening the gap between what the public expects or needs and what auditors can and should reasonably be expected to do. These include rapid economic growth, the bubble economy, unexpected advances in information technology, the globalization and internationalization of capital markets, the complexity of financial products and operations and the high profile financial crises of recent years. The audit profession and accounting firms have not always been successful in responding to the increasing demands of users of financial information arising from such factors. (b) Public pressures and financial market expectations have had an important impact on the market regulatory bodies’ decisions to develop new rules with regard to the responsibilities of the auditors in charge of publicly held companies. This also affects the audit market and the perception of auditors regarding their social responsibilities.

21 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(c) This question has been widely discussed in Chapter 18 (corporate fraud, corporate scandals and external auditing). The active involvement of external auditors in corporate fraud detection, adopting the preventive approach and the appropriate auditing techniques, widening the scope of the auditor’s evaluation of a company’s internal control over financial reporting and the requirement to report on these issues are the most important changes with regard to the auditor’s role. (d) Emphasizing auditor independence and ethics as an imperative, considering as a central issue the auditor’s knowledge about the company’s financial and business activities, widening the audit scope and increasing the quality of the auditors’ training are important steps in reducing the expectation gap. It is essential that the audit profession and the accounting firms play a more active role in developing reflection on the social responsibilities of independent auditors in the capital market economy. (e) Market regulatory bodies have recently increased their level of oversight in the audit market. A more active co-operation between the regulatory bodies and accounting profession, adopting a transparent evaluation policy of external auditors’ performance, and adequate quality control mechanisms in auditing provide more confidence to potential users of financial information, which in turn contributes to the reduction of the expectation gap in the audit market.

22 .

CHAPTER 3

AUDITING, ORGANIZATION AND GOVERNANCE Instructor guidance This chapter discusses auditing in the context of organization and its relationship with corporate governance structure. It deals with theoretical aspects of organization, its functioning and control mechanisms. External auditing has been given special attention as an independent attestor of a company’s financial statements.

Instructors are encouraged to put emphasis on the following points before discussing the questions.

•

theoretical foundations of organization and its contribution to corporate governance structure;

•

the economics of corporate governance and its essential elements;

•

control mechanisms and accountability systems within organization;

•

financial reporting process and the roles of management, governance structure and external auditing in this area.

It is desirable that the students refer to research works and books regarding the theoretical foundations of organization and corporate governance. Some important references are provided at the end of the chapter (e.g. Williamson (1975, 1985 and 1996) and Williamson and Winter (1991) and Jensen and Meckling (1976)). The work of Coase can be found in Williamson and Winter. Examples of other essential readings in this area are Cyert and March (A Behavioural Theory of the Firm 1963, 1992), March and Simon (1958, 1993), and several other valuable works of Herbert Simon.

23 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 3-1

What are the fundamental aspects of the theory of the firm?

Answer 3-1 The theory of the firm consists of a number of economic theories which describe the nature of the firm, including its behaviour and its relationship with the market. This theory considers the firm as an alternative system of allocation to the market, which exists because in many cases and for various reasons, it is more efficient to organize production in a non-price environment.

The First World War period saw a change of emphasis in economic theory away from industrylevel analysis to analysis at the level of the firm, as it became increasingly clear that perfect competition was no longer an adequate model of how firms behaved. The need for a revised theory of the firm was emphasized in empirical studies by Berle and Means (1932), which made it clear that ownership of a typical corporation is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves. Hall and Hitch (1939) (see below for the full reference) found that executives made decisions by rule of thumb rather than in the marginalist way.

Since its foundation in the 1920s, the theory of the firm and its fundamental aspects has been developed in several seminal research works. Williamson and Winter (1991) (see Chapter 3 references) presented the essential part of their own research and the research done by Ronald Coase, Sherwin Rosen, Paul Joskow, Oliver Hart, Harold Demsetz, and Benjamin Klein. It would be interesting for students to refer to these papers to understand important topics such as the ‘the Nature of the Firm (Coase)’, ‘The Logic of Economic Organization (Williamson)’, ‘Incomplete Contracts and the Theory of the Firm (Hart)’, ‘A Legal Basis of the Firm (Masten)’ and ‘The Theory of the Firm Revisited (Demsetz)’.

The essential theories concerning the foundation of the firm are ‘The Transaction Cost Theory’, ‘Managerial and Behavioural Theories’, ‘Team Production’, and ‘Agency Theory’, which are briefly discussed in the chapter. The behavioural approach as developed in particular by Richard Cyert and James G. March (1963) (see below for the full reference) places emphasis on explaining how decisions are taken within the firm, and goes well beyond neo-classical economics. Much of this depends on Herbert Simon’s work in the 1950s concerning behaviour in situations of uncertainty, which argues that ‘people possess limited cognitive ability and so can exercise only “bounded rationality” when making decisions in complex, uncertain situations’.

Thus individuals and groups tend to ‘satisfice’ – to attempt to attain realistic goals – rather than maximise a utility or profit function. Cyert and March argued that the firm cannot be regarded as a monolith, because different individuals and groups within it have their own aspirations and conflicting interests, and that the firm’s behaviour is the weighted outcome of these conflicts.

Organizational mechanisms (such as ‘satisficing’ and sequential decision taking) exist to maintain conflict at levels that are not unacceptably detrimental. Compared to the ideal state of productive efficiency, there is organizational slack.

Cyert, R. M. and March, J. G. (1963) A Behavioural Theory of the Firm, Second Edition Malden, MA: Blackwell Publishers.

Hall, R. L. and Hitch, C. J. (1939) ‘Price theory and business behaviour’, Oxford Economic Papers, 2-12-45, reprinted in Wilson, T. and Andrews, P. W. S. (eds.) Oxford Studies in the Price Mechanism, Oxford Clarendon: 1951.

24 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

3-2

What reasons support the creation of governance systems within corporations?

Answer 3-2 The separation of ownership and control within the firm, the way this separation affects the behaviour of a corporation, the demand for efficient allocation of resources and the need for effective control mechanisms in an organization are the most important reasons supporting the creation of a governance system within a corporation. Corporate governance is also largely concerned with relating the corporation to the environment in which it functions. This includes the relationship with governmental and regulatory agencies which are responsible for regulating and monitoring the capital market economy. To provide confidence to various interested parties inside and outside the organization can be considered as a basic reason to establish the governance structure within different types of organizations, including those run under the governmental command.

3-3

Explain the importance of accountability in the corporate governance structure.

Answer 3-3 Accountability refers to the need for market participants, mainly decision makers, to justify their actions and policies and accept responsibility for managerial decisions and results.

Accountability is an important evaluation and control instrument that legitimizes the exercise of managerial power within the organization. If it is implemented efficiently, it is a useful means to ensure that the managers do not misuse the power which has been delegated to them by the major shareholders. In the absence of effective accountability instruments within organizations, it would be difficult to make a fair evaluation of management performance and the responsibilities delegated to them. Managers have incentives to design and implement an adequate accountability system in terms of active and independent governance, disclosure of information of high quality, balanced financial and non-financial systems of measurement, integrated planning and control and implementation of an effective audit committee.

3-4

Discuss how better transparency in financial reporting improves accountability within corporations.

Answer 3-4 Transparency and accountability are mutually reinforcing. Transparency enhances accountability by facilitating monitoring and providing more credibility for corporate reporting. It is necessary for the concept of accountability to take hold amongst all three major groups of market participants: borrowers and lenders, issuers and investors, as well as national authorities and international financial institutions. Greater transparency will affect the perceptions of the users of financial information by providing a better understanding of how decisions are taken.

This contributes to the process of accountability, internal control mechanisms and efficient governance.

To be useful, the financial reporting process must be relevant, reliable, timely and possess predictive and feedback values. Together, transparency in financial reporting and accountability will contribute to the improvement of the quality of decision making in corporations.

3-5

What are the main reasons for the corporate malaise of recent years?

Answer 3-5 The major causes of the corporate malaise in recent years are as follows (some of these are included on p. 76 of Chapter 3): •

irrational development of the bubble economy;

•

ineffective accountability mechanisms within publicly listed corporations;

•

lack of sufficient control and disciplinary mechanisms within corporations;

•

widespread corporate management abuse and mismanagement;

25 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

insufficient supervision by regulatory agencies in applying the corporate financial reporting requirements;

•

ineffective non-executive directors;

•

largely passive institutional shareholders;

•

lack of sufficient independence, integrity and objectivity among external auditors.

3-6

How can efficient corporate governance affect the company’s performance?

Answer 3-6 To what extent an efficient corporate governance system affects the company’s performance is an important issue for corporate management and market regulatory bodies.

One of the objectives put forward by the regulatory bodies in mandating the governance requirements is to improve the company’s performance. This may concern the internal functioning as well as the company’s reputation and public image. The implementation of an efficient corporate governance system requires effective monitoring and control mechanisms and a good quality financial reporting process. The efficient corporate governance system is mainly based on creating committees whose members are independent from the company’s management and possess qualities such as objectivity, integrity, proficiency and expertise.

Above all, the efficient governance structure also requires the implementation of effective accountability and evaluation systems within organizations and this in turn affects the management and employees’ incentives and corporation performance. All these mechanisms and factors contribute to the better functioning of the organization and its performance.

This question can also be examined in terms of the impact of the corporate governance system on a company’s performance in the financial market (share capitalization, rate of return, liquidity and volume of transactions). This issue has been subject to several empirical research studies and it would be interesting to recommend to the students to read the relevant papers published in academic journals.

3-7

What are the elements of agency relationship according to Jensen and Meckling (1976)?

Answer 3-7 The paper of Jensen and Meckling (1976) integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. The authors defined (1976, p. 308) an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interests by establishing appropriate incentives for the agent and by incurring ‘monitoring costs’ designed to limit the aberrant activities of the agent. In addition, in some situations it will pay the agent to expend resources ‘bonding costs’ to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions.

It is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. Jensen and Meckling defined agency costs as the sum of: (1) the monitoring expenditures by the principal (the term monitoring includes more than just measuring or observing the behaviour of the agent. It includes efforts on the part of the principal to ‘control’ the behaviour of the agent through budget restrictions, compensation polices, operating rules etc.);

26 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(2) the bonding expenditures by the agent; (3) the residual loss.

3-8

What is the importance of the implementation of control mechanisms in organizations?

Answer 3-8 Control mechanisms are arrangements in corporation law, securities and bankruptcy law, boardroom practices, as well as accounting, auditing, management control and corporate governance. The implementation of control mechanisms is required for the better functioning of all types of organizations. The demand for control mechanisms has existed since the development of the modern corporation, when owners first delegated part of their powers to agents. The idea of the separation of ownership and control has made a significant contribution to the development of control mechanisms within corporations.

The control mechanisms deal with the question of how to make corporate executives accountable to the other parties contributing to the activities of the company. They are an essential part of corporate planning and must be implemented in such a way as to provide the management with the opportunities, incentives and controls over resources they need to create value for the corporation. The control mechanisms can also be considered as constraints and requirements imposed on those who are in charge of a company’s management.

3-9

Describe the major characteristics of shareholder-manager-auditor relationships in the governance framework.

Answer 3-9 The shareholder-manager relationship can be defined in the agency context as a contract under which the principal(s) (shareholder) engage another person (the agent-manager) to perform some service on their behalf which involves delegating some decision-making authority to the agent. The shareholder-manager relationship is generally conflictual as both parties are utility maximizers. There is good reason to believe that the manager will not always act in the best interests of the principal. Several important areas such as investment, financing and dividend polices may be subject to divergences between shareholder and manager.

It would be possible for the shareholder to limit divergences from his interests by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the losses arising from the irrational activities of the manager. Apart from the monitoring and control mechanisms which can be implemented within the organization, the independent auditor plays an important role in regulating the shareholder-manager relationship. The presence of the external auditor is also necessary in reducing the information asymmetry arising from the divergence in preferences between the manager and the shareholder with respect to the manager’s actions, and the imperfect observation of the manager’s actions by the owner.

However, it would be difficult to propose ad hoc solutions, taking into account the divergences of interest among groups of shareholders and managers. Institutional shareholders do not necessarily have the same interests as individual shareholders. The executives nominated by financial institutions and independent members of management do not act in the same manner.

3-10 Describe the role of boards of directors, corporate governance and independent auditors with regard to general meetings of shareholders.

Answer 3-10 A general meeting is the central place for important corporate decisions. Although the board of directors has the authority in a company’s strategic decisions, it must be accountable to the general meeting of shareholders, which takes place on an ordinary (end of year) and/or extraordinary (during the year for important events) basis. The board must submit a written report concerning the general activities of the company and important events such as board members’ nominations, share issues, mergers and acquisitions, forecasted earnings and treasury stock operations. The independent auditors, by attesting the financial statements of

27 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

company and addressing their report to the shareholders’ general meeting, provide assurance on the fairness of statements. The corporate governance structure also provides the shareholders with information regarding the company’s performance, its functioning and the effectiveness of accountability and control mechanisms implemented by management.

Shareholders may express their concerns over management behaviour and adopt resolutions limiting the board of directors’ actions. Effective corporate governance and independent auditors contribute to the better functioning of shareholders’ general meetings.

3-11 Explain the concepts of information asymmetry, moral hazard and adverse selection.

Answer 3-11 This question is related to Chapter 2 and is posed here to refresh students’ memories. Information asymmetry generally refers to situations in which one of the parties involved in the contractual relationship has some material information and/or has more information about certain relevant variables than the other party. The problem of information asymmetry can be extended to corporate financial disclosure by noting that corporate managers have more information about the value of the corporation than do shareholders. Given the uncertainty about a company’s activities and its financial performance, managers have incentives to supply the set of information that they believe will find favour with interested parties.

If a manager tries to profit from information by keeping it private, the investor’s problem is to find a way to reduce this information disadvantage. Because of the divergence of preferences between the shareholder and the manager and also because of the exclusivity of the information held by the latter, the manager may misrepresent information to the shareholder.

This could involve manipulation of the financial information, production of fraudulent financial data and departure from the terms included in the contract between the parties.

‘Moral hazard’ and ‘adverse selection’ are classical incentives and monitoring problems. In the case of ‘moral hazard’ the owner cannot observe the manager’s behaviour but is able to judge the optimality of the behaviour. The owner relies on imperfect surrogate measures, which can lead the manager to modify his or her behaviour towards the surrogates in order to appear to be behaving well. The manager is then rewarded whether or not his or her behaviour is actually what the owner desires. The case of ‘adverse selection’ refers to the situation in which the owner is able to observe the manager’s behaviour but cannot judge its optimality. The owner’s information about the manager’s actions is mainly based on the latter’s level of ability to do a particular job, perhaps supported by imperfect signals such as the manager’s level of education or membership of organizations.

3-12 What changes in the Sarbanes-Oxley Act of 2002 reinforce the governance system?

Answer 3-12 The US Sarbanes-Oxley Act of 2002 deals with several important aspects of accounting, auditing, financial reporting and corporate governance structure. In the context of corporate governance, the essential elements are the reinforcement of audit committee functions (Section 204), the selection of corporate executives and conflicts of interest (Section 206), corporate responsibility for financial reports (Section 302), forfeiture of certain bonuses and profits (Section 304), officer and director bars and penalties (Section 305), the prohibition of insider trading during pension fund black-out periods (Section 306), the prohibition of personal loans to executives (402(a)), disclosures of transactions involving management and principal stockholders (Section 403) and management assessment of internal controls (Section 404).

28 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

3-13 What do you suggest for reforming post-crisis corporate governance?

Answer 3-13 The efficiency of corporate governance largely depends on the effectiveness of the monitoring and internal control systems, accountability mechanisms and high-quality financial reporting and auditing services. These issues have been developed in Chapter 3.

Several important suggestions are as follows: •

reinforcing the accountability mechanisms within organizations by implementing independent monitoring and control systems and appropriate code of conducts and ethics;

•

implementing an adequate performance evaluation policy for members of the board of directors based on appropriate criteria and the overall success of the company in investment, financing, financial market and environmental areas;

•

reinforcing the role of independent members of the board of directors and/or creating an independent supervisory board;

•

providing the possibility for the active role of shareholders, including the minority investors, in a company’s general meeting;

•

reinforcing the oversight role of regulatory bodies in the financial market;

•

mandatory implementation of the internal audit, internal control and providing sufficient financial resources for these functions;

•

improving the quality of the financial reporting and the communication system of a company;

•

reinforcing auditor independence, implementing more appropriate quality control systems in auditing, and establishing an effective evaluation system for the auditor’s performance;

•

implementing severe penalties and sanctions in cases of management abuses.

3-14 How is the field of corporate governance related to other disciplines?

Answer 3-14 Corporate governance is considered as a multidisciplinary field and has direct and indirect links with economic sciences, organizational sciences, organizational behaviour, law, corporate finance and accounting and management control. The theoretical foundations of corporate governance are mainly derived from the economic sciences and law. The functioning of corporate governance depends, to a great extent, on the codes of law and regulations imposed by market regulatory bodies, ethical principles implemented within organizations and accountability and control mechanisms.

3-15 Why is an appropriate level of understanding of a client’s business and environment important in conducting a financial statement audit?

Answer 3-15 Environmental factors are essential to a company’s functioning and performance.

The conduct of the business is also dynamic and the company’s strategies and objectives change over time. The company’s financial statements contain the accounting operations and the selected policies based on management assertions. However, the preparation of these statements also depends on environmental conditions (the company’s product market share, economic variables, financial market, labour market, inflation rate, interest rate etc.) and the management’s evaluation of such conditions.

The auditor must acquire sufficient knowledge of the environment in which the company operates. By understanding the environmental factors affecting the company’s operations and performance, and the pressures the company and its management are facing, the external 29 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

auditor will make more accurate evaluations of various types of risks. The auditor should try to evaluate the business risk resulting from significant conditions, events, circumstances or actions that could reduce the company’s ability to achieve its objectives and execute its strategies.

Moreover, the external auditor’s examination of financial statements is significantly affected by the factors such as rapid economic development, changing environment and information technology advances which in return affect the nature of company’s activities and the way the management runs the company. Part of this investigation must be done by the auditor at the time of client acceptance and audit preplanning.

Discussion Questions 3-16 Discuss briefly the economics of corporate governance in the context of agency, transaction cost economics and control theories.

Answer 3-16 This question has been discussed on pp. 72–75. This discussion includes the highlights of control theories, transaction cost economics and agency theory. For an in-depth discussion on this subject, it would be interesting to recommend that the students read the relevant papers of some of the references mentioned at the end of the chapter, for example Coase’s papers in Williamson and Winter (1991), Masten (1991), Jensen and Meckling (1976), Williamson (1996), Abdel-Khalik (2002) and Soltani (2005).

The origin of agency theory goes back to the Alchian and Demsetz (1972) analysis of team production, which is an extension and clarification of earlier work by Coase. For Alchian and Demsetz, the firm is an entity which brings together a team which is more productive working together than at arm’s length through the market, because of informational problems associated with monitoring of effort. This is a ‘principal–agent’ theory, since it is asymmetric information within the firm which, according to Alchian and Demsetz, must be overcome.

The paper of Shleifer and Vishny (1997) ‘A Survey of Corporate Governance’, in ‘The Journal of Finance’ (Vol. LII, No. 2, June) is also interesting (this reference was not included in the chapter). The paper of Shleifer and Vishny is based on agency perspective and separation of ownership and control. It also focuses on incentive contracts as a possible solution to the agency problem.

The transaction cost theory of the firm developed by Coase was one of the first (neoclassical) attempts to define the firm theoretically in relation to the market, where previously neo-classical theory saw the firm as simply another part of the industry. According to Coase, a firm’s interactions with the market may not be under its control, but its internal allocation of resources clearly represents, in Robertson’s words, an ‘island of conscious power’ where the decisions of the entrepreneur are also important. ‘Within a firm,…. market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur–co-ordinator, who directs production’ (Coase 1937). Coase begins from the standpoint that markets could, in theory, carry out all production, and that what needs to be explained is the existence of the firm, with its ‘distinguishing mark…[of] the supercession of the price mechanism’.

The control theory emphasizes the importance of control mechanisms within the firm that have some effect on its performance. The major objective is to improve financial performance and productivity through the implementation of efficient internal control systems and also to regulate the company’s relationship with the environment in which it operates.

30 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

3-17 Discuss the importance of qualitative characteristics of financial reporting (full disclosure, transparency, relevance, timeliness, etc.) in corporate governance structure.

Answer 3-17 Efficient financial reporting is one of the three core areas upon which depends corporate governance within organizations (the other two being accountability and internal control mechanisms). However, only high-quality financial reporting contributes to the effectiveness of corporate governance within organizations and, in the absence of appropriate qualitative characteristics, the reporting process cannot satisfy its major purpose, to provide the interested parties with useful information. The good governance largely depends on harnessing an effective communication process to achieve more fully the goal of quality corporate financial reporting.

Full disclosure and transparency of information constitute the cornerstone of corporate governance, enabling shareholders to make informed decisions about their investments and the performance of corporate management. The communication to the audit committee of relevant, timely and verifiable financial information free from bias and material misstatement is necessary for the effective functioning of this structure. Although corporate governance through the audit committee plays a significant role in reinforcing a high-quality financial reporting process, the company’s management is mainly responsible for implementing and maintaining such a process.

3-18 Discuss the following with regard to agency relationships within organizations. (a) Explain the major reasons for the divergence in objectives between shareholders and managers. (b) How should we best, and at the lowest cost, monitor the manager to make sure he/she serves the interests of the shareholder? (c) What are the major solutions to agency problems? (d) To what extent does the auditor play a determinant role in this respect? How has the presence of an external auditor as a monitoring instrument been defined in agency theory?

Answer 3-18 This question is mainly related to the agency problem and the shareholdermanager-auditor relationship. (a) Shareholder and manager are generally utility maximizers and in this respect there is good reason to believe that the manager will not always act in the best interests of the shareholder. (b) The shareholder can limit divergences from his/her interests by establishing appropriate incentives for the manager and by incurring monitoring costs designed to limit the manager’s activities that are not beneficial to the shareholder. In some situations, the owner will pay the manager to expend resources (bonding costs) to guarantee that he/she will not take certain actions which would harm the shareholder or to ensure that the shareholder will be compensated if he/she does take such actions. To establish accountability and stewardship mechanisms is one of the important steps in regulating the shareholder-manager relationship. (c) High quality and transparent financial reporting, appropriate incentive and evaluation systems, appropriate accountability mechanisms, effective internal control and monitoring systems are all helpful in mitigating the agency problem.

31 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(d) The external auditor as an effective monitoring mechanism plays an important role in agency relationship. The presence of the auditor is necessary in regulating the shareholder-manager relationship. The auditor also provides credibility to the financial information disclosed by a company, defending both shareholder’s and manager’s interests.

3-19 ‘There is a closer relationship between company management and auditors than between the latter and shareholders. Both parties are actively involved in the corporate financial reporting process’. Discuss the above statement.

Answer 3-19 For practical reasons, the relationship between a company’s management and external auditor is closer than the relationship between the latter and the company’s shareholders. Management and external auditors are actively involved in the company’s financial reporting process. Although the main responsibility for the preparation and implementation of financial accounting and reporting processes and appropriate internal control systems remains with the management, the external auditor needs to examine the financial statements and internal control system of the company. This examination involves regular contact and discussion between the two parties.

On the other hand, the external auditor is generally nominated by the shareholders’ general meeting, but in many cases, the auditor’s selection and/or nomination is made in line with management’s proposal. In fact, one of the reasons for the auditor’s presence in the managershareholder relationship is to monitor the manager’s actions and inform the shareholder of the results of the examination. In both ‘adverse selection’ and ‘moral hazard’ cases (see Question 3-11 and the relevant discussion in Chapter 2), the shareholder does not obtain accurate information about the manager’s actions and this partially justifies the auditor’s presence.

3-20 In view of the complexity of the modern corporation and the increased demands for corporate accountability, the auditor’s role has grown in importance. The financial crises of recent years involving auditors raised concerns about their role, their responsibilities and the extent of their independence in corporate reporting.

Auditors as the independent third party have a key role to play in ensuring the accountability of directors and management.

Discuss the following issues with regard to the auditor’s responsibilities: (a) What is expected to be the auditor’s role and what difficulties do they have in carrying it out? (b) The responsibilities of external auditors in corporate financial reporting go beyond the audit report addressed to the board and/or general meeting. Discuss auditors’ responsibilities to communicate their consideration of the risk of material misstatement due to fraud and illegal acts. Consider these responsibilities towards the audit committee and appropriate regulatory agencies. (c) Consider the above questions (a and b) with regard to the regulatory changes made for publicly listed companies in your own country.

Answer 3-20 This is a very broad discussion question and it would be interesting to ask the students to write an essay about the critical role of the independent auditor in the capital market economy. This discussion may include the rules recently introduced by market regulatory bodies in different countries. The students should be encouraged to refer to market regulations implemented in the area of auditor’s responsibilities in their own countries. The subject is discussed in several chapters of the book. The following general points are important when discussing this question.

32 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(a) The problem of expectation gap, the social role of the external auditor in the capital market economy and the fact that current auditing standards and practices do not satisfy the increasing public demand for high-quality audit. External auditors are required to anticipate and keep up with the changing needs of the public, as well as changes in financial markets, corporate structure and information and communication technologies. (b) The external auditor must communicate in writing to the audit committee all significant deficiencies and material weaknesses identified. Moreover, when auditing internal control over financial reporting, the auditor may become aware of fraud or possible illegal acts. If the matter involves fraud, it must be brought to the attention of the appropriate level of management. If the fraud involves senior management, the auditor must communicate the matter directly to the audit committee. In the case of possible illegal acts, the auditor must be certain that the audit committee is adequately informed. In the absence of appropriate actions by the audit committee, the auditor may inform the regulatory bodies if the impact of the illegal acts and detected fraud on the company’s operations and functioning of the financial market is significant. The auditor’s consideration of risk factors and his/her judgement are important elements in taking appropriate action. (c) The disclosure of possible fraud to parties other than the client’s senior management and its audit committee is not ordinarily part of the auditor’s responsibility and would usually be precluded by the auditor’s ethical or legal obligations of confidentiality, unless the matter is recorded in the auditor’s report. However, following recent financial scandals, the market regulatory bodies in major financial markets have expanded the auditor’s responsibilities in detecting and reporting the risks of material misstatements due to fraud. Complying with legal and regulatory requirements such as the SEC and PCAOB in the United States is an obligation for external auditors, and their duty of confidentiality does not apply to such cases. This subject will be more developed in the following chapters, especially Chapters 12, 18 and 19.

33 .

CHAPTER 4

THE AUDIT COMMITTEE, INTERNAL AND EXTERNAL AUDITING Instructor Guidance This chapter continues the discussion of corporate governance in Chapter 3. It emphasizes the importance of the audit committee, its composition, its responsibilities and its relationship with internal and external auditors. Two approaches can be used for the discussion of the issues raised in this chapter. The first is related to theoretical arguments, and in this respect the students should be encouraged to refer to academic journals such as ‘The Accounting Review’, ‘Auditing: A Journal of Practice and Theory’, ‘The Journal of Accounting Research’, and the publications of ‘The Institute of Internal Auditors Research Foundation’ for an in-depth discussion on the audit committee and its characteristics. Some of the important references are indicated at the end of the chapter but there are several other research papers which have been recently published in top accounting and auditing journals.

The second approach to discussing this chapter is to refer to recent regulatory developments in financial markets and apprehend the characteristics of the audit committee for publicly listed companies in different capital markets. The rules and recommendations of the SEC in the United States and the comparable regulatory bodies in different countries, as well as the publications of professional bodies and Big Four accounting firms, are a useful basis for discussion. As the characteristics of the audit committee of publicly listed companies in different countries largely depend on environmental factors and the countries’ legal policies, it would be useful to ask the students to prepare essays and studies relating to their own countries’ rules.

34 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 4-1

Describe the main functions of the audit committee as an oversight board.

Answer 4-1 The audit committee has an oversight function that is a critical corporate governance mechanism involving different managerial activities, corporate reporting and auditing. This oversight includes ensuring that quality accounting policies, internal controls, and independent external auditors are in place to deter fraud, anticipate financial risks and promote accurate, transparent, and timely disclosure of corporate information to different users. The primary responsibilities of the audit committee as indicated on p. 95 can be summarized as assisting the board of directors’ scrutiny of: •

the integrity of the company’s financial statements. This includes the review of significant accounting and reporting issues and understanding their impact on the financial statements;

•

the independence, integrity, qualification and performance of the company’s external auditors;

•

the performance of the company’s internal audit function;

•

the appropriateness of internal control systems of the corporation. This includes the effectiveness of the company’s internal control systems and the scope of internal and external auditors’ reviews of internal control over financial reporting;

•

the establishment and maintenance, by periodic meetings, of direct lines of communication between the board of directors, financial management, internal auditors and the company’s independent auditors;

•

the monitoring of corporate policies relating to compliance with laws and regulations, ethics, conflicts of interests and the investigation of misconduct and fraud.

4-2

Explain the importance of the audit committee’s independence in performing its activities.

Answer 4-2 The financial crisis of recent years demonstrates the importance of the audit committee and its members’ independence. Following these events, the regulatory and professional bodies have universally accepted audit committees on the basis that these committees can be effective. This requires measures to assure committees’ independence and objectivity. The audit committee’s independence is the cornerstone of its effectiveness, particularly when overseeing a company’s financial integrity and ensuring appropriate internal control and audit systems within the company.

The audit committee obviously needs to work closely and co-operatively with the management, on which the committee depends for information and resources. At the same time, this relationship should not be jeopardized by any collusion or compromise. The audit committee must remain at arm’s length to the management to be independent in its judgement and decisions and to pursue its responsibilities and functions without undue influence. The same approach towards audit committee independence should be also adopted with regard to external auditors, including the appointment and dismissal of auditors, evaluation of their performance and the quality of financial statements and audit reports.

35 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

4-3

Define the terms ‘insiders’ and ‘outsiders’ with reference to corporate board members.

Answer 4-3 The terms ‘insiders’ and ‘outsiders’ discussed here refer to the nature of the relationship between certain outside parties and the company and its management. ‘Insiders’ refer to those persons who have strong economic or personal ties to the company or its management. They include current or former officers or employees of the company or of a related entity, relatives of management, professional advisors to the company (e.g. consultants, bank officers and legal counsel), officers of significant suppliers or customers of the company and interlocking directors.

An outside or independent director is a person not having any affiliation with the company other than serving as a director. The outside directors are classified as either ‘independent’ or ‘grey’.

Outside directors are classified as ‘grey’ if they are affiliated with the corporation or its management although they are not its full-time employees. Outside directors are ‘independent’ if they are free of any affiliation/business ties with firms/management other than board membership. These ‘grey’ directors generally include interlocking directors, suppliers or customers, affiliated bankers, lawyers, consultants, former employees and relatives of management.

Major non-insider shareholders can participate in the audit committee and they may use this opportunity to monitor the firm’s financial reporting process as an alternative to other means.

4-4

What are the conclusions of empirical studies on audit committee independence?

Answer 4-4 An audit committee’s independence has been subject to several research studies published in accounting and auditing academic journals. Audit committee independence and its economic determinants were discussed on pp. 97–100 of Chapter 4. Several research papers have looked at audit committee independence with regard to board size, the company’s growth opportunities, creditors’ demands, board composition and members’ fees. It would be useful to recommend to students to read the relevant research papers in leading accounting and auditing journals. Some of the published papers in this area are Krishnan (2005, The Accounting Review), Klein (1998, 2002, see end-of-chapter bibliography), Abbott et al. and also Raghunandan and Rama (2003, Auditing: A Journal of Practice & Theory), Carcello and Neal (2000, The Accounting Review).

4-5

What are the major oversight roles of the audit committee in corporate financial reporting?

Answer 4-5 The audit committee is critical in overseeing the financial reporting process and provides an independent review of it. The audit committee can help to ensure that management properly develops and adheres to a sound system of internal controls, that procedures are in place to objectively assess management’s practices, and that the outside auditors through their own review objectively assess the company’s financial reporting practices.

The following is a summary of the audit committee role in corporate financial reporting: •

to monitor the integrity of the financial statements of the company;

•

to review major matters regarding accounting policies and financial statement presentations, including any significant changes in the company’s selection or application of accounting principles, and major issues concerning the adequacy of the company’s internal controls and any special audit steps adopted in the light of material control deficiencies;

36 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

to review management letters and audit reports setting forth significant financial reporting matters and judgements made in connection with the preparation of the financial statements, including analyses of the effects of alternative accounting principles and methods on the financial statements;

•

to understand the legal aspects of the audit committee role with regard to fraudulent financial reporting.

4-6

What are the characteristics of the relationship between the audit committee, management and external auditors in financial reporting?

Answer 4-6 The audit committee has a significant role in corporate governance accountability.

In carrying out this function the audit committee relies on the company’s management and its independent auditors. The full co-operation of management, audit committee, and external auditors can contribute to high quality financial disclosures and effective scrutiny of the financial reporting process within the corporation. This relationship was highlighted on p. 102 under the title of ‘the three-legged stool of financial reporting’.

4-7

Define the relationship between the audit committee and internal auditing.

Answer 4-7 The audit committee has a major responsibility in assuring that the mechanisms for corporate accountability are in place and functioning properly. Clearly, one of these mechanisms is a well-defined, well-orchestrated, solid, co-operative relationship with the internal auditors. Internal auditors assist both management and boards of directors and audit committees by examining, evaluating and reporting on the adequacy and effectiveness of managements’ risk processes and by recommending improvements when necessary.

The relationship between the internal auditor and the audit committee should be one that includes both reporting and oversight functions. The audit committee is highly dependent on the internal auditing function for feedback on risk assessment, management and internal control systems. As a consequence, the tasks, responsibilities, and goals of the audit committee and the internal auditing function are closely intertwined in many ways. Internal auditing may be used by the audit committee as a source of information on major frauds or irregularities as well as on a company’s compliance with laws and regulations. The audit committee should determine if the internal auditor is adequately auditing all areas of risk within the organization – including those related to information technology, computer systems and corporate culture.

4-8

What are the main responsibilities of the audit committee with regard to the internal audit function?

Answer 4-8 Summaries of the roles and responsibilities of the audit committee in internal auditing with respect to reporting relationships, oversight relationships and other issues are included on pp. 106–108. These include reviewing and approving the internal audit activities, reviewing plans and budgets of the internal audit function, reviewing audit results, appointment of the internal audit team and some other functions. See Appendix B on p. 122 for an example of an audit committee agenda.

4-9

Explain the responsibilities of the audit committee in risk management. What are the important features of Enterprise Risk Management (ERM)?

Answer 4-9 Risk management consists of identifying risks that may prevent a company from achieving its objectives, analyzing those risks and trying to find appropriate solutions to avoid or to control them. Enterprise Risk Management (ERM) is an integrated, structured and futurefocused approach to risk management. It helps find new ways to manage and optimize the risks of most importance to the board of directors and the management.

37 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

In recent years, the responsibilities of the audit committee have been expanded to include risk management control. This requires the audit committee to identify the company’s risks and to make sure that controls are adequate, in place, and functioning properly. An independent investigation by the audit committee to identify the different types of risks can result in a better ability to protect and enhance the organization in fulfilling its visions and strategies. In order to perform its responsibilities with respect to risk management, the audit committee should develop a process in the areas of risk identification and management as a part of the company’s overall control environment. As a part of this process, the audit committee should receive from management an overview of the risks, policies, procedures and controls surrounding the integrity of financial reporting.

4-10 Explain the role and the importance of the audit committee in a company’s internal control.

Answer 4-10 Corporate management should design and implement the appropriate internal control process (see also Chapter 11) to provide reasonable assurance of the achievement of specified objectives. The audit committee has a significant role with regard to the appropriateness of the internal control systems of the corporation. It has an oversight role in financial risks and internal control. The audit committee has to be aware of its oversight responsibilities in these areas.

The audit committee should encourage procedures that promote accountability throughout the organization, ensuring that the management properly develops and adheres to a sound system of internal control. It should review the effectiveness of the company’s internal control system for monitoring corporate policies relating to compliance with laws and regulations, ethics, conflicts of interest and the investigation of misconduct and fraud. The details of the audit committee’s oversight role in internal control are explained on pp. 108–111.

4-11 What are the features of the current audit committee structures in major capital market economies?

Answer 4-11 There has been a growing interest in the audit committee as part of overall corporate governance in recent years, with a specific emphasis on members’ independence, the committee’s relationship with independent auditors and its impact on corporate financial reporting. The importance of the audit committee has become more evident in the wake of the increased incidence of fraudulent and misleading financial reporting, business failures and alleged audit failures.

In recent years, the market regulatory agencies in major capital markets have adopted new rules and recommendations with regard to the audit committee. The regulations adopted by the SEC in the United States in April 2003, Smith’s report in the United Kingdom (2003) and the recommendations made by the Tabaksbalt Committee in the Netherlands (2003) are good examples of proposals made to improve the functioning of the audit committee in capital markets. These rules and recommendations mainly emphasize the independence of the audit committee members, its supervisory and monitoring roles with regard to company’s financial reporting and internal control systems as well as the relationship with the external auditor. The major features of the audit committees in France, Germany, the Netherlands, the United States, and the United Kingdom can be found in Soltani (2005) reference cited on p. 89.

4-12 How do you evaluate the importance of the audit committee in the corporate governance structure of publicly listed companies in your own country?

Answer 4-12 Students should be asked to prepare an essay on the role, importance and performance of audit committees of publicly listed companies in different financial markets. They can also use the working papers and the research articles published in academic journals for empirical results in the area. It would be interesting to ask the students to do a comparative

38 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

study concerning the performance of audit committees in their country and the major financial markets such as the United States and the United Kingdom, where the audit committee has traditionally had an outstanding role to play.

Discussion Questions 4-13 Discuss the role and place of the audit committee within the corporate governance structure in a capital market economy. Your discussion should include the main responsibilities of the audit committee in risk management.

Answer 4-13 The audit committee is an essential part of the control mechanisms within the capital market economy. It has an oversight function that involves different managerial activities, corporate reporting and auditing. This oversight includes ensuring that quality accounting policies, internal controls, and independent external auditors are in place to deter fraud, anticipate financial risks and promote accurate, transparent, and timely disclosure of corporate information to different users.

For several years the audit committees of publicly traded companies have been under intense pressure to be accountable in their role as financial stewards. Audit committees have evolved from informal committees with few defined responsibilities to what they are today– essential watchdogs with growing responsibilities. It is no longer enough for the audit committee to focus its attention solely on the past. The audit committee must also play its preventive role in a company’s management control system and ensure that proper attention is paid to control tools and policies that will prevent financial or operational disasters. The paradigm shift for the audit committee comes when it focuses on the future by being attuned to organizational changes that can affect overall control and risk management processes. Risk management consists of identifying risks that may prevent a company from achieving its objectives, analyzing those risks and trying to find appropriate solutions to avoid or to control them. In order to perform its role in the area of risk management, the audit committee should develop a process of risk identification and management as a part of the company’s overall control environment. The major responsibilities of the audit committee with regard to risk management are defined on pp. 108–110.

4-14 Analyze the factors affecting the evolution of the role of the audit committee from traditional financial verification towards overseeing responsibilities. What are the features of the changing role of the audit committee?

Answer 4-14 The erosion of confidence in the process of corporate financial reporting and auditing has placed pressure on corporate management for increased responsibility, accountability and supervision. In addition, given technological progress, for example, the advent of the internet, users of corporate financial reporting are much more attuned to environmental changes. The financial market, regulatory and legislative bodies in most developed countries have expressed great concern about the issue of corporate accountability and particularly the role of the audit committee in companies. Environmental factors such as the globalization and internationalization of capital markets, information technology advances and increasing demand for high quality financial information have been determinant in changing the audit committee’s approach. The current audit committee framework is increasingly suggesting taking account of regulatory and legal requirements. This clearly indicates the drastic shift from a passive to a more proactive approach of audit committees in terms of their accountability and control functions. As a consequence, the audit committee is also responsible for providing assurance that the corporation is in reasonable compliance with the relevant laws and regulations, is conducting its affairs ethically and is maintaining effective control over conflicts of interest and fraud within an organization.

39 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

4-15 Has the audit committee and its composition helped reduce fraudulent financial reporting? Discuss this with regard to financial debacles of recent years.

Answer 4-15 This question has been discussed on pp. 103–105 of this chapter. The audit committee is essential in overseeing the financial reporting process and provides an independent review of this process. The audit committee will contribute to the reduction of fraudulent financial reporting in several ways. These include the design of more efficient internal control systems for prevention and detection, the implementation of a transparent and useful financial information system and selection of appropriate accounting measurement and standards. The audit committee should try to identify and understand the factors that can lead to fraudulent financial reporting. The regular assessment of the integrity of a company’s financial statements and close co-operation with internal and external auditors are determinant factors in fulfilling this objective.

4-16 Discuss the increasing role played by the audit committee within publicly listed companies and assess the strengths and weaknesses of the current audit committee structure and its oversight function.

Answer 4-16 This question is similar to Question 4-12 but covers broader issues. The effectiveness of the audit committee should be discussed in the light of the increasing role of the audit committee in the capital market economy. It would be interesting to ask the students to prepare an essay on the characteristics and effectiveness of the audit committees of publicly listed companies similar to what is required in Question 4-12. The major topics of discussion include the importance of the audit committee as a control instrument within the corporate governance structure, the increasing public concern for more transparent and efficient accountability systems within organizations and the active role of the audit committee in establishing a formal communication channel between the board of directors and the internal and external auditors.

The strengths of the current audit committee structure are mainly related to the broad areas of responsibilities of the audit committee in auditing, financial reporting and risk management.

These have mainly been defined by the recent rules introduced by market regulatory agencies in several developed capital markets. In spite of the fact that these rules emphasize the importance of audit committee independence and the specialization required to exercise this function, there are obvious weaknesses when considering the financial debacles of several multinational corporations. Another weakness of the current audit committee structure may be related to the lack of sufficient monitoring of the audit committee with regard to compliance of corporate policies with laws and regulations, ethics, conflicts of interests and the investigation of misconduct and fraud.

4-17 To what extent does the creation and reinforcement of an audit committee help protect shareholders and other corporate stakeholders better?

Answer 4-17 This question needs to be discussed using the empirical studies published in academic journals and/or the working papers and dissertations published in different countries.

There is no ad hoc response to this question and it would be appropriate to ask the students to express their opinions on this topic. The protection of shareholders and other corporate stakeholders is not the direct role of the audit committee. However, the audit committee can play a determinant role in this area provided that it exercises its responsibilities in an efficient manner. The success of the audit committee in performing its functions depends to a great extent on the management’s desire to respect the fundamental principles of the audit committee independence and proficiency. This requires the full co-operation of the management with the audit committee members and facilitating their access to all the necessary information in assessing and improving the company’s financial reporting, internal control and risk management. This also requires the management’s desire to follow the appropriate recommendations of the audit committee and external auditors relating to financial reporting and

40 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

internal control. The effectiveness of the audit committee in key corporate areas contributes to better protection of shareholders and other stakeholders such as employees, bankers and clients.

4-18 What are the significant factors affecting audit committee effectiveness? Discuss this in respect to some empirical findings.

Answer 4-18 In general, audit committee effectiveness refers to a committee’s collective ability to meet its oversight objectives. Firstly, the success of the audit committee very much depends on internal governance structures and effective collaboration between different control mechanisms within the company’s corporate structure. A major factor which contributes to the improvement of the effectiveness of the audit committee is also related to the strong emphasis on increasing the role of outside directors in monitoring corporate management. The effectiveness of the audit committee also depends on the competence and integrity of its members, as it is their responsibility to diligently oversee management while adhering to full ethical standards.

Some of the empirical studies cited at the end of this chapter have considered the factors affecting audit committee effectiveness (e.g. Carcello and Neal 2003 and 2000, Park 1998, Fama and Jensen 1983). Some authors examined the relationship between the effectiveness of the oversight role of audit committees and the quality of financial reporting (see, Park 1998). It would be interesting to ask the students to prepare an essay on this question by referring to more recent research papers published in academic journals.

4-19 What are the fundamental economic determinants of audit committee independence?

Discuss the effect of each one.

Answer 4-19 This question has been discussed in-depth on pp. 97–100 of this chapter by referring to the size of board of directors, growth opportunities, creditors’ demands for audit committee independence, non-executive shareholders, and the fees of the members of the audit committee. Reference has been made to several empirical studies on this question. The purpose of this question, however, is to give the students the opportunity to express their opinion on the subject and refer to most recent research papers in this area. It would also be interesting to discuss how it would be practically possible to assure audit committee independence for publicly listed companies, taking account of conflicts of interests which may exist between various groups of a company’s stakeholders.

4-20 To what extent can the composition of the audit committee, particularly with regard to the presence of outside directors, influence the reliability of financial reporting?

Discuss the empirical findings regarding this relationship.

Answer 4-20 The relationship between the composition of the audit committee and the reliability of financial reporting has been discussed on p. 101 and Appendix A on pp. 120–121. The most interesting part of this question concerns the effect of audit committee composition on the quality of financial reporting, especially with regard to financial statement fraud. Several research papers (e.g. Beasley et al. 2000, Park 1998, Beasley 1996 and McMullen 1996) have been discussed by emphasizing the importance of the role of independent outside directors within audit committees of publicly listed companies. Generally speaking, the higher the proportion of independent members of the audit committee the less the likelihood of financial reporting fraud. The presence of independent members on the audit committee should enhance the committee’s effectiveness in monitoring management for the prevention of financial statement fraud. Above all, the oversight role of the audit committee in financial risks and internal control can greatly contribute to the integrity of financial reporting (see the discussion on pp. 108–111). The students should be encouraged to read other empirical studies on this issue published in academic journals.

41 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

4-21 Discuss the main responsibilities of the audit committee towards independent auditors. What are the effects of audit committee on the external auditors’ performance and effectiveness?

Answer 4-21 The audit committee should play a significant role in the area of external auditing particularly with regard to the independence, integrity, qualification and performance of the external auditors. These issues have been discussed on pp. 112–113, and Appendix C on pp. 124–125. The audit committee members should review with the board of directors any issue that might arise with respect to the independence and the performance of the company’s external auditors. The audit committee plays a determinant role in selecting, evaluating and, if needed, replacing the independent auditors. The audit committee should also understand the scope of the audit engagement, any difficulties the external auditor has encountered in the course of audit work and the results of the auditor’s examination. The audit fees’ engagements and terms as well as all significant non-audit engagements by the independent auditors are among the issues considered by the audit committee. The external auditors are ultimately accountable to the audit committee and the shareholders’ general meeting.

42 .

CHAPTER 5

INTERNATIONAL AUDITING AND ASSURANCE SERVICES Instructor guidance This chapter discusses auditing issues within the international and European contexts. The chapter includes the international standards on auditing issued by the International Auditing and Assurance Standards Board (IAASB). The chapter also discusses US auditing standards (GAAS and PCAOB) and international accounting standards, IFRSs. Although the chapter presents the essential issues of international auditing standards, it would also be interesting to ask the students to refer to the websites of the IFAC, PCAOB and IASB for more updated information on auditing and accounting.

The following suggestions would be helpful for lectures who would like to discuss the questions of this chapter in an in-depth manner. Firstly, any discussion should take account of significant developments in financial markets in developed countries in recent years. There has been an increasing demand for international standards of accounting and auditing as a result of the globalization and internationalization of financial markets and multiple listings. The second suggestion would be to ask the students to refer to the international standards on auditing of the IFAC and international financial reporting standards (IFRSs) of the IASB and to review these standards. This review could be done by making a comparison between these international standards and the comparative standards in different countries. For example, one could make a comparison between the standards of the IFAC and the auditing standards recognized in the United Kingdom and United States.

43 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 5-1

What are the objectives of international standards on auditing?

Answer 5-1 International Standards on Auditing (ISAs) are developed by the International Auditing and Assurance Statements Board (IAASB), an independent standard-setting body, under the auspices of the IFAC. The major objectives of ISAs are to propose a core set of standards which can contribute significantly to ensuring the credibility of the information upon which investors and other stakeholders depend. These standards are general guidelines to aid auditors in fulfilling their professional responsibilities in the audit of financial statements. They require consideration of almost all the auditing issues including professional qualities such as competence and independence, reporting requirements and evidence. The ultimate objective is common global auditing standards applicable to auditing and assurance services around the world.

5-2

To what extent do the globalization of financial markets and multiple listings reinforce the application of international standards on auditing?

Answer 5-2 Globalization and cross-border stock markets have had a significant impact on developing the International Standards on Auditing (ISAs). The increasing number of multinational corporations and the need for a common set of auditing standards reinforces standard setting in auditing at a world wide level. The auditors in charge of auditing the financial statements of multinational corporations need a common base for standards, particularly when auditing the consolidated accounts of a group. Moreover, ISAs contribute to the better functioning of capital markets as they reinforce oversight systems and control mechanisms implemented by the market regulatory forces in auditing and assurance, in related areas such as ethics and education, as well as the performance of auditing firms. The development of global capital markets and the protection of the public interest are determinant factors in the process of international convergence of auditing standards and related matters. In the absence of international auditing standards, public accounting firms may have some difficulties when auditing the accounts of public companies reporting outside their national borders.

5-3

Discuss the role and major objectives of the International Federation of Accountants (IFAC) in harmonizing auditing standards.

Answer 5-3 The IFAC’s main objective is to enhance and develop the global accountancy profession through its activities in auditing and assurance services. The IFAC plays its role by developing international standards on auditing and assurance services, ethics, education and public sector accounting, and internationally quality assurance reviews and quality control for firms that audit transnational entities. The IFAC seeks to contribute to the creation of sound global financial markets by working with market regulators, standard-setters and financial institutions around the world. To achieve this, the IFAC has introduced the harmonized framework to meet the increasingly international demands that are placed on the accountancy profession. Components of this framework include International Standards on Auditing, the IFAC Code of Ethics for Professional Accountants, International Education Standards and the International Public Sector Accounting Standards (IPASs).

44 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

5-4

What are the steps taken by the International Auditing and Assurance Standards Board (IAASB) in strengthening public confidence in the global auditing profession and serving the public interest?

Answer 5-4 The IASB acts on behalf of the IFAC Board and is in charge of developing standards and guidance for financial statement audits and other assurance or related services pertaining to both financial and non-financial information. It has developed ISAs and International Auditing Practice Statements (IAPSs) as the standards to be applied in reporting on the credibility of financial statements information. These standards and statements serve as the benchmark for high-quality auditing standards and statements worldwide. The IAASB has also established quality-control standards covering the conduct and performance of such services.

The major actions taken by the IAASB are as follows: •

establishing auditing standards and guidance for audits of financial statements;

•

establishing high-quality standards and guidance for other types of assurance services on both financial and non-financial matters;

•

establishing standards and guidance for other related services;

•

establishing quality-control standards covering the scope of services addressed by the board;

•

publishing other documents on auditing and assurance matters, thereby advancing the public understanding of the roles and responsibilities of professional auditors and assurance service providers.

5-5

What are the references used with regard to international standards on auditing and international practice statements?

Answer 5-5 The IAASB has also developed the following standards and guidelines: International Standards on Assurance Engagements (ISAE), Quality Control (ISQC) and Related Services (ISRS). The IAASB issues Practice Statements as appropriate to provide practical assistance in implementing its standards and to promote good practice. These documents outline basic principles and essential procedures for auditors, and provide them with the necessary tools to cope with the increased and changing demands for reports on financial statements, and guidance in specialized areas.

5-6

Explain the fundamental differences between audits of financial statements and related services.

Answer 5-6 An audit of financial statements is a form of attestation service in which the auditor issues a written report expressing an opinion about whether the financial statements are free of material misstatements. The audit of financial statements gives investors and creditors confidence in their decision-making process.

Auditors also provide assurance services on other historical and prospective financial information as well as non-financial information. These may include reporting on prospective financial statements, pro forma financial information, compliance with laws and regulations and agreedupon procedures. The related services provide some assurance about the quality of information included in the financial statements but does not provide as much assurance as an audit. It does not also require the same burden of evidence as for that of an audit.

45 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

5-7

Discuss briefly the notions of review, agreed-upon procedures and compilation in the context of audit related services.

Answer 5-7 These are the different categories of attestation services performed by independent auditors: The objective of a review of financial statements is to enable an auditor to state whether, on the basis of the procedures that do not provide all the required evidence, anything has come to the auditor’s attention that causes the auditor to believe that the financial statements are not prepared, in all material respects, in accordance with an identified financial reporting framework. Whereas an audit provides a high level of assurance, a review service provides a moderate level of assurance on the financial statements, and therefore requires less evidence. A review also provides less assurance than an examination because the auditor expresses only negative assurance about the assertion, that is, he/she is not aware of any reasons to conclude that the assertions are not in conformity with established criteria.

An agreed-upon procedures engagement generally involves issuing a report on specific findings obtained by performing particular procedures agreed to by all parties prior to the start of the engagement. In an engagement to perform agreed-upon procedures, an auditor is engaged to carry out those procedures of an audit nature to which the auditor and the entity and any appropriate third parties have agreed, and to report on factual findings. It is narrower in scope than an audit or review. Such an engagement involves reporting findings based upon the procedures, rather than a conclusion.

In a compilation engagement, the auditor is engaged to use accounting expertise as opposed to auditing expertise to collect, classify and summarize financial information. The procedures employed are not done in an organized manner and do not enable the auditor to express any assurance on the financial information. However, users of the compiled financial information derive some benefit as a result of the accountant’s involvement because the service has been performed with due professional skill and care.

5-8

Discuss the fundamental ethical principles governing the auditor’s professional responsibilities, using the IFAC Code of Ethics for Professional Accountants as a basis of your discussion.

Answer 5-8 These principles include independence, integrity, objectivity, professional competence and due care, confidentiality, professional behaviour and technical standards. The independence of the external auditor has long been a subject of debate, particularly amongst regulators. It is critical in examining the accounting information in terms of its reliability.

Independence is also the accounting profession’s main means of demonstrating that external auditors and audit firms are performing their attestation and monitoring tasks at a level that meets established ethical principles, in particular those of integrity and objectivity.

The importance of auditor independence is also related to the attempt by the public accounting profession in recent years to redefine itself, in part by expanding the types of services it provides. This expansion of services has raised questions about whether public accounting firms can maintain their independence and yet provide audit clients with an ever-increasing array of other types of services.

The fundamental ethical principles of the audit profession have been defined in-depth in Chapter 7 (pp. 185–190).

5-9

Describe the features and objectives of International Standards on Assurance Engagements.

Answer 5-9 Assurance engagements performed by professional accountants are intended to enhance the credibility of information about a subject matter by evaluating whether the subject matter conforms in all material respects with suitable criteria, thereby improving the likelihood that the information will meet the needs of an intended user. The International Standards on 46 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

‘Assurance Engagements’ (ISAE 3000) presents an overall framework for assurance engagements intended to provide either a ‘reasonable assurance engagement’ or ‘limited assurance engagement’. It establishes the principles and essential procedures for professional accountants in public practice for the performance of engagements intended to provide a reasonable assurance.

5-10 Explain briefly the concepts of ‘reasonable assurance’ and ‘inherent limitations’ in (a) an assurance engagement and (b) an audit of financial statements.

Answer 5-10 The definitions provided by IFAC, 2005 (ISAE 3000 revised) are as follows): In the context of an assurance engagement, the objective of a reasonable assurance engagement is a reduction in assurance engagement risk to an acceptably low level in the circumstances of the engagement as the basis for a positive form of expression of the practitioner’s conclusion. The objective of a limited assurance engagement is a reduction in assurance engagement risk to a level that is acceptable in the circumstances of the engagement, but where that risk is greater than for a reasonable assurance engagement, as the basis for a negative form of expression of the practitioner’s conclusion.

An audit in accordance with ISAs is also designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole.

However, there are inherent limitations in an audit that affect the auditor’s ability to detect material misstatements. These limitations result from factors such as the use of testing; the inherent limitations of company’s accounting and internal control systems and the fact that most audit evidence is persuasive rather than conclusive.

5-11 Discuss the role and importance of IAS and IFRS in developing international auditing standards.

Answer 5-11 The IASB is in charge of developing a single set of reliable, consistent, understandable and enforceable global accounting standards in the form of IAS and IFRS. These standards intend to enhance comparability of financial information and should make the allocation of capital across borders more efficient. The move towards stronger international accounting standards is an essential element in corporate financial reporting. Financial information will become more comparable, as openness and transparency improve under the harmonized international accounting standards. The development and the acceptance of international standards should also reduce compliance costs for corporations and improve consistency in audit quality.

5-12 Explain briefly the positions of EU and US regulators with regard to the auditing of financial statements of corporations subject to multiple listings.

Answer 5-12 A regulation proposed by the European Commission requires all EU listed companies to prepare group financial statements in accordance with IFRS/IAS from 2005. In all EU member states a common framework exists for a statutory audit obligation through the accounting directives, and for governing the approval of statutory auditors through the new directive and recommendations on audits of company accounts. The European Union’s directives and communications reinforce existing policy on statutory audit.

Of the approximately 13,000 companies whose securities are registered with the US Securities and Exchange Commission, 1,200 are non-US companies (Deloitte Touche Tohmatsu 2006: p. 17). Before 2005, there were about fifty IFRS filers with the SEC. Another 350 European

47 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

companies listed in the United States have switched to IFRS in their SEC filings for 2005. In this respect, the adoption of the Sarbanes-Oxley Act of 2002 (SOX) and subsequent implementing measures by the SEC and the Public Company Accounting Oversight Board (PCAOB) in the United States are of particular interest and importance. The European Commission is particularly concerned about the required registration of EU audit firms with the US ‘PCAOB’ and the application of Section 404 of the Sarbanes-Oxley Act 2002. The Section 404 of the SOX Act requires companies and their auditors to report on internal controls that should detect fraud and ensure sound financial reporting.

Discussion Questions 5-13 Financial reporting, auditing and corporate governance ‘The effective functioning of capital markets is essential to our economic wellbeing. In my opinion, a sound financial reporting infrastructure must be built on four pillars: (1) accounting standards that are consistent, comprehensive, and based on clear principles to enable financial reports to reflect underlying economic reality; (2) effective corporate governance practices, including a requirement for strong internal controls that implement the accounting standards; (3) auditing practices that give confidence to the outside world that an entity is faithfully reflecting its economic performance and financial position and (4) an enforcement or oversight mechanism that ensures that the principles as laid out by the accounting and auditing standards are followed’.

Sir David Tweedie, Chairman, International Accounting Standards Board (Deloitte 2005, p. 2) Required Read the above statement and write an essay on this topic considering the following issues: (a)

the impact of the choice of accounting standards on a company’s reporting policy and performance;

(b)

the importance of the relationship between accounting and auditing standards and corporate governance;

(c)

the internationalization of accounting and auditing standards and effective functioning of capital markets.

Answer 5-13 This question deals with the impact of accounting, auditing and corporate governance issues on the performance of capital markets. The four pillars referred to by the chairman of the IASB are interrelated matters essential for the effective functioning of capital markets. It would be interesting to develop the discussion on this question around the relationship between accounting, auditing, organization and finance. The discussion is also related to the materials covered in Chapters 1 to 4. The students’ essays on this question should consider the following points: (a) The accounting standards selected by the company’s management are determinant factors in corporate financial reporting, and more specifically in a company’s financial statements. The way management deals with issues such as earnings, financial derivatives and valuation of assets is important in showing the company’s financial performance. The discretionary nature of income may allow management manipulation of earnings such as income smoothing, big bath behaviour and

48 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

accounting changes. (The full discussion of these elements can be found in Chapter 18). The choice of accounting standards depends, to some extent, on management’s attitude towards the company’s earnings policy. Some managers are strongly motivated to meet market earnings expectations, and they try to override commonsense business practices and ethical principles in financial reporting. The choice of accounting standards by the company’s management and its efforts to manage earnings to deceive financial statement users as to the company’s performance and profitability may be considered as the source of fraudulent financial reporting. In the capital market economy, management’s attitude is very much affected by market expectations and analysts’ perceptions of company’s financial performance. (b) Issues such as transparency, accountability, corporate reporting, corporate governance, accounting standards, auditing standards and practices are essential to this part of the question. Full disclosure and transparency of information are the important factors in corporate governance. Accounting standards and the company’s financial reporting policy significantly affect the performance of corporate governance.

The audit committee as one of the cornerstones of the corporate governance system is also an essential part of the company’s reporting policy particularly with regard to accounting standards selected by company’s management and in the area of external auditor’s performance. The audit committee plays a significant role in terms of the integrity of the company’s financial statements, and with regard to the independence, integrity, qualification and performance of the external auditors. The audit committee is critical in overseeing the financial reporting process and provides an independent review of this process. The audit committee also plays a significant role in preventing fraudulent financial reporting.

5-14 Foreign listings: Despite onerous listing requirements and high costs, some large companies seek listing of their stocks in foreign financial markets. This signifies the management belief that the benefits accruing from being listed outweigh the inconveniences and costs. Companies, however, may desire a foreign listing for different reasons (financial, strategic and commercial…).

Required: Discuss at least five major motivations for and advantages of foreign listings.

Answer 5-14 This question is directly related to the harmonization of accounting and auditing standards. The differences in accounting and auditing practices and the economic environments in which companies operate result in different listing procedures, and more importantly, different reporting requirements of the stock markets. These differences increase the cost of raising funds and reduce the efficiency of stock markets within the international environment. The regulatory and market bodies responsible for protecting the stakeholders, together with the accountancy profession, have been making considerable efforts in the development of highquality standards in accounting, auditing and financial reporting that can be implemented in the global as well as domestic capital markets.

In considering this question, it should be noted that the globalization and cross-border financial markets are major features of the current capital market economy. Many companies select multiple listings. For example, of the approximately 13,000 companies whose securities are registered with the US Securities and Exchange Commission, over 1,200 are non-US companies (IFRSs in Your Pocket 2006, Deloitte IAS Plus).

The major motivations for multiple listings are as follows: •

Financial: having access to a high level of financial resources through public listings in major capital markets (stock and bond markets);

49 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

Financial: having close relationships with a higher number of financial institutions and commercial banks compared to the local market; the company can benefit from a comparatively low interest rate and this has some effects on its cost of capital;

•

Expansion: the foreign listing may facilitate the company’s expansion in potential markets;

•

Commercial: the presence of a company in a foreign capital market may be beneficial to its activities in terms of sales performance, the cost of goods sold etc.;

•

Mergers and acquisitions: the presence of company in a foreign capital market may create the possibility of external expansion and restructuring;

•

Reputation: the company may benefit from its presence in a capital market in terms of international recognition and reputation.

5-15 Towards greater convergence in the European Union. ‘There has been increasing support for a single set of global accounting standards in the European Union. The European Commission supports the drive for better communication and transparent information. However, its attempts go beyond the adoption of just IFRS. Work is also in progress on company law, auditing, corporate governance and reporting, prospectuses for raising capital etc. In terms of accounting standards, the objective could be achieved by the global adoption of International Financial Reporting Standards (IFRS) or by convergence between national standards and IFRS. IFRS users and non-users strongly agree that the introduction of IFRS will help create a more favourable capital market environment for European companies’.

Required Comment on the above statement with reference to the following questions: (a) Will IFRS help establish a pan-European equity and debt market? (b) Would such a market bring benefits to Europe? (c) Does conversion to IFRS affect the way shareholders and analysts view company performance? (d) To what extent does the success or failure of IFRS adoption by European publicly traded companies affect the harmonized auditing standards and global corporate governance rules within the EU? (e) What one piece of advice would you give to the IASB as it develops IFRS? Answer 5-15 This question concerns the European Commission’s decision to recommend the adoption of IFRS for all publicly listed companies in the capital markets of the European Union from January 2005. There may be two ways to discuss this question with the students. Firstly, it would be interesting to ask them to write an essay and express their opinion on the question.

This discussion should consider the impact of IFRS adoption on European companies’ accounts, particularly with regard to changes to income statements and stockholder’s equity.

The second possibility is to ask each student to consider this question in their own country if it is one of the members of the European Union. In both cases, it would be interesting to refer to empirical studies on the effect of first time adoption of IFRSs by publicly listed companies.

Some of the questions can be discussed in a general manner. For example, questions (a) and (d) concern the effect of IFRS adoption on capital market performance and/or on auditing

50 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

practices and corporate governance. Other questions such as (b), (c) and (e) ask the readers to express their own opinions on the matters raised. It is important to highlight that the mandatory use of IFRSs in the EU would not only contribute to a high quality of financial reporting of companies, but would also provide a sound basis for international mutual recognition of accounting practices around the world.

In all the above cases, it would be interesting to suggest supplementary reading to the students: books in international accounting and published articles and working papers regarding the effects of IFRSs on companies’ accounts in Europe. Accounting journals such as The European Accounting Review, The International Journal of Accounting and the Journal of International Accounting Research contain some articles in these areas.

5-16 Accounting standards and the interests of the users of financial statements Three solutions have been proposed for resolving the problems associated with filing financial statements across national borders (a) mutual recognition (also known as reciprocity), (b) reconciliation and (c) use of International Financial Reporting Standards ‘IFRS’).

Required Present a concise evaluation of each of the three approaches. What do you expect is the preferred approach from the perspective of each of the following interested groups: (1) investors, (2) company management, (3) regulatory authorities and (4) stock exchanges.

Answer 5-16 This question concerns the harmonization of accounting standards and issues such as the mutual recognition and/or mandatory adoption of US accounting standards by foreign companies. However, the question is very general and directly related to the case of European companies listed on US stock markets. As discussed in the book, more than 400 European companies are listed in the United States and their major concerns are the adoption of US GAAP, the Sarbanes-Oxley Act (SOX) and the respect of the requirements of SEC and PCAOB. Although the European Commission shares the objectives of SOX and supports many of its measures, differences in the EU’s cultural and legal environments require mutual acceptance by the United States of equally effective European solutions. A transatlantic (and global) capital market cannot be achieved unless the EU and the United States mutually recognize the equivalence of high-quality regulatory systems in the fields of accounting and auditing. Recently there has been the significant progress in terms of the recognition of the IFRSs adopted by European corporations listed on US capital market. The US market regulator has accepted the adoption of IFRSs by foreign companies listed in the United States but further discussion is needed to solve some technical issues.

51 .

CHAPTER 6

AUDITING IN THE EUROPEAN CONTEXT Instructor guidance This chapter discusses the audit environment and audit market within the European Union. It aims to present, in a general manner, the European directives and recommendations in the areas of statutory auditing, corporate governance and the audit committee. The important issues such as auditor independence, quality assurance mechanisms, oversight of the audit profession, and the European Commission’s strategy with regard to US regulations are of particular interest.

Some of these themes are also discussed in an in-depth manner in the following chapters (e.g. auditor independence in Europe is discussed on pp. 202–206 of Chapter 7, auditors’ reports in Europe are examined on p. 368 and in the appendix to Chapter 12, issues concerning auditors’ reports in the European countries are on pp. 382–386, quality control and oversight systems in auditing are found in Chapter 15 and auditor liability in Chapter 16).

The bibliography and references at the end of this chapter include the major directives and recommendations made by the European Commission. However, as the chapter covers some current issues, and taking account of the ever-increasing changes in business environment, it would be useful to ask the students to refer regularly to the website of the European Commission and related websites (e.g. the European Federation of Accountants). This suggestion is also valid for the other chapters containing topics subject to regular changes. This provides the students with updated information on changes in these areas. It is also important to follow the progress made with regard to the European Commission priorities in auditing (this topic is discussed on pp. 167–176 of this chapter). As the SOX Act of 2002 and the regulations of the SEC are also applicable to foreign companies listed on US stock exchanges, it would also be interesting to look for relevant, up-to-date information on the websites of the SEC and PCAOB. Finally, European students could write an essay on the audit environment and audit profession of their respective countries. This would help in comparing the rules and practices in auditing in European countries.

52 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 6-1

What actions undertaken by the European Union apply to statutory auditing?

Answer 6-1 In recent years the European Union has taken important steps in reinforcing the position of statutory auditing. The following are the major recommendations and communications issued by the European Commission with regard to the external auditor function. The full references can be found at the end of chapter: •

‘New Eighth Company Law Directive on Statutory Audit’(September 2005);

•

Creation of European Group of Auditors’ Oversight Bodies (EGAOB) in December 2005 (European Commission, 2005a);

•

Creation of ‘Auditors’ Liability: New European Forum on Limitation of Financial Burdens’ (European Commission, 2005c);

•

European Commission Proposal for a Directive on Statutory Audit (European Commission, 2004);

•

Modernizing Company Law and Enhancing Corporate Governance in the EU (European Commission, 2003a);

•

Statutory Auditors’ Independence in the EU (European Commission, 2002b);

•

Quality Assurance for the Statutory Auditor in the EU (European Commission, 2000).

6-2

Discuss the points raised in the context of the European directives (particularly in the new Eighth Directive) concerning the statutory audit.

Answer 6-2 The new Eighth Company Law Directive on Statutory Audit (September 2005) aims at reinforcing and harmonizing the statutory audit function throughout the EU. It sets out principles for public supervision in all member states. It also introduces a requirement for external quality assurance and clarifies the duties of statutory auditors. Moreover, sound and harmonized principles of independence applicable to all statutory auditors through the EU have been defined.

The new Eighth Directive puts emphasis on the independence of auditors by requiring listed companies to set up an audit committee (or a similar body) with clear functions to perform. It also foresees the use of international standards on auditing for all statutory audits conducted in the EU. The directive provides a basis for effective and balanced international co-operation between regulators in the EU and with regulators in third countries, such as the US Public Company Accounting Oversight Board (PCAOB). The latter is particularly important because of the global nature of modern capital markets, demonstrated again by the international nature of the financial scandals in recent years, which have affected several jurisdictions.

6-3

What is the European Commission’s strategy on statutory auditing?

Answer 6-3 In recent years the European Commission has considered the scope and need for further action at EU level on the statutory audit function. On one hand, the Commission is trying 53 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

to modernize its previous directives and recommendations such as the Eighth Company Law Directive on Statutory Audit (2005) and/or Company Law and Corporate governance (2003), and on the other hand it is aiming to propose new recommendations concerning critical issues such as auditor liability, auditor independence, and quality assurance for the statutory auditor in the EU. The European Commission’s strategy is in line with the general desire expressed by regulatory bodies in major capital markets to improve the quality of the statutory audit throughout the EU and ensure compatibility with international standards.

6-4

Following recent corporate financial failures around the world, what are the EU policy priorities on the statutory audit?

Answer 6-4 The Commission has proposed ten priorities for improving and harmonizing the quality of statutory audit throughout the EU (see end-of-chapter references, European Commission, 2002c). The first priority is reforming and extending amendments to existing legislation. The European Commission’s plan is divided into short- and medium-term priorities (Figure 6.4). Among the short term aims are strengthening public oversight of auditors at member state and EU level, requiring International Standards on Auditing (ISAs) for all EU statutory audits, and the creation of an EU Regulatory Committee on Audit. The Commission’s proposals should provide a comprehensive set of EU rules on how audits should be conducted and on the audit infrastructure needed to safeguard audit quality. (See pp. 167–168 for the details of these priorities).

6-5

Why are some measures directed at auditors of public interest entities (listed corporations, banks and insurance companies) in the EU? What are those measures?

Answer 6-5 Because of the size of their assets and share capitalization, and also because of the nature of their activities, listed corporations, banks and insurance companies need specific rules and recommendations in accounting and auditing. The specific measures proposed by the European Commission for a Directive on Statutory Audit (2005b) include the educational curriculum for auditors, structural ownership and management of audit firms, definition of basic principles of professional ethics, auditor independence, audit fees, using international standards on auditing (ISA) for all EU statutory audits, and effective common rules for quality control and disciplinary systems as well as the appointment and the resignation of statutory auditors and audit firms. (See pp. 162–165 for more details).

6-6

What are the reasons for and benefits of the European Commission’s recommendation on auditor independence?

Answer 6-6 In recent years, the European Commission has put significant emphasis on auditor independence. US regulators, the SEC and PCAOB have made strong recommendations to the European Commission to take the necessary measures. The Commission has been interested in a legal underpinning of principles of auditor independence, and the factors which may affect his/her independence. The EU’s Eighth Company Law Directive establishes the principle that auditors should not conduct statutory audits if they are not independent. The Commission has also tried to improve harmonization of auditor independence within the EU at the highest level, which could serve as a basis for a future common approach. The Commission also intends to provide European statutory auditors with a sound framework to assess independence risks.

6-7

How does the EU Directive (2005) respond to corporate scandals (such as Parmalat and Ahold) in the EU?

Answer 6-7 Following several high profile financial scandals in the EU, the European Commission wants to examine issues causing concern to market regulators, including financial reporting, statutory audit, corporate governance and securities markets. The Commission has proposed ten priorities for improving and harmonizing the quality of the statutory audit throughout

54 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

the EU. It has also issued in parallel to its communication on audit priorities a document entitled Communication from the Commission to the Council and the European Parliament – Reinforcing the Statutory Audit in the EU (European Commission, 2003b). This sets out a European agenda for auditing, company law and corporate governance.

Because of the importance of audit quality in restoring the credibility of financial reporting and protecting the EU against corporate financial scandals, the European Commission has put some essential issues on its agenda. These include the introduction of a modern regulatory audit framework within the EU, the creation of the audit regulatory committee, oversight of the audit profession, systems of disciplinary sanctioning in the audit profession, the code of ethics, auditor independence and quality assurance and the transparency of audit firms and their networks. .

6-8

What level of uniformity would be achieved by the European Commission’s directive on auditor independence?

Answer 6-8 Although there are regulations on auditor independence in all member states, these differ in approach, scope, terminology and substance. This makes it difficult to provide investors and other stakeholders in EU companies with a uniformly high level of assurance that statutory auditors perform their audits independently throughout the EU. Therefore, the objective of the European Commission’s recommendation on auditor independence is to drastically improve the harmonization of auditor independence within the EU. With regard to auditor independence, the European Commission’s initiatives apply to the EU statutory audit profession as a whole. They clarify the duties of statutory auditors, their independence and ethics, by introducing a requirement for external quality assurance and by ensuring robust public oversight of the audit profession. They aim at setting a benchmark for member states’ requirements on statutory auditors’ independence throughout the EU. 6-9

What are the detailed provisions of the European Commission directive on auditor independence?

Answer 6-9 Both the EU’s Eighth Company Law Directive and the European Commission Recommendation on Auditor Independence, which was adopted on 16 May, 2002 (590/EEC), refer substantially to auditor independence. It would be interesting to recommend that the students check the website of the European Commission for updated information on this issue.

The major provisions of the Commission’s recommendation of 2002 are as follows. It requires the statutory auditor to consider for each audit engagement independence threats and risks as well as the safeguards for mitigating those risks. Auditors should constantly apply safeguards against threats to auditor independence such as self-review in order to be seen as independent.

The ultimate safeguard (prohibition) is not to enter into certain relationships or not to provide certain services additional to the statutory audit.

Firstly, the Recommendation deals with safeguards of a horizontal nature applicable to all audit engagements such the presence of audit committee, external quality assurance, ownership and control over audit firms, audit firms' internal safeguard systems and the public disclosure of audit and non-audit fees.

The Recommendation also defines the scope of the independence requirements of the statutory auditor and those who can influence the outcome of the statutory audit. Those are persons directly involved in the statutory audit such as audit partners, the audit team, staff from other disciplines (e.g. lawyers, IT and taxation specialists) or persons in the ‘chain of command’. The Recommendation also addresses complex structures such as audit firms with local offices and those which are a member of an international network of audit firms.

55 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Secondly, the Recommendation addresses ‘specific circumstances’, providing examples of application of the principles-based approach for the most frequently occurring situations and relationships where auditor independence may be compromised. In other words, the Recommendation describes what specific safeguards the auditor should consider to mitigate any threat to his independence.

The following specific situations and relationships are mentioned: •

financial interests

•

business relationships

•

employment with the audit client and the audit firm

•

managerial or supervisory role in the audit client and

•

family and personal relationships.

The Recommendation also deals with various aspects of audit fees such as the provision of contingency fees for non-audit engagements, the relationship between the total fee from one audit client and the total turnover of the audit firm, as well as the adequacy of audit fees. Finally, the Recommendation states that there should be an internal rotation of key audit partners within seven years.

6-10 Would the European Commission directive on auditor independence prohibit the provision of any additional service to the audit client?

Answer 6-10 The European Commission’s Directive (2002) does not allow the provision of any non-audit service to the audit client that compromises auditor independence. This means that provision of additional services to the audit client is only possible if the auditor documents the related risks and the application of adequate safeguards. According to the Directive, auditors cannot be independent if the provision of additional services would include participation in audit client decision making. Moreover, the Directive contains a number of horizontal safeguards on auditor’s independence such as a declaration in writing to the governance body of the audit client that none of the services provided compromises auditor independence, as well as a detailed public disclosure of audit and non-audit fees.

From this general deontology on additional services, the Directive provides examples of specific services such as the preparation of accounts and financial statements, design and implementation of financial Information Technology systems, valuation services, internal audit services, resolution of litigation for the audit client, and recruiting senior management. For several additional services, the statutory auditor should apply the ultimate safeguard of prohibition, which implies that the auditor is not allowed to provide those services.

6-11 What is the position of the EU Commission with regard to public oversight of the audit profession?

Answer 6-11 The European Commission has set up a European Group of Auditors’ Oversight Bodies” (EGAOB) (see Figure 6.3 regarding the measures included in the EU Directive (2004)) to reinforce public oversight of the audit profession. The EGAOB will ensure effective coordination of new public oversight systems of statutory auditors and audit firms within the European Union. It may also provide technical input to the preparation of measures for the new Eighth Company Law Directive. The EGAOB is composed of high-level representatives from the entities responsible for public oversight of statutory auditors and audit firms in member states or, in their absence, of representatives from the competent national ministries. Only nonpractitioners can be members of the EGAOB. The new Eighth Company Law Directive, which was agreed by the European Parliament and the Council in 2005, requires member states to set up public oversight systems for statutory auditors and audit firms.

56 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

6-12 Would small and medium-sized firms be able to comply with the European Commission Directive on auditor independence?

Answer 6-12 The European Directive emphasizes the importance of auditor independence for small and medium-sized firms. It states that there is no justification to differentiate between small and large audit firms in terms of being seen as independent. However, the Directive recognises that the size of the audit firm can influence the availability and proportionality of some safeguards. For example, internal rotation in a small firm is not realistic and alternative safeguards are suggested. Furthermore, the Directive differentiates between the significance of threats to independence in public interest entities, where a higher level of safeguards is considered desirable. In practice, small audit firms often audit non-public interest entities. In this case, the Directive suggests proportionate safeguards. For example, the Directive allows, with the necessary safeguards, the preparation of accounts and financial statements of audit clients other than public interest entities.

6-13 What does the European Commission’s directive require in terms of international standards on auditing?

Answer 6-13 The Commission and its Audit Advisory Committee have expressed a desire to implement ISA for all EU statutory audits of publicly listed companies. As stated in the 2003 Communication on ‘Reinforcing the Statutory Audit in the EU’, the Commission proposes that all statutory audits prescribed by Community law should be carried out in accordance with ISA. The Commission presented a number of preliminary actions to be taken before the full adoption of ISA. These include the analysis of EU and member state audit requirements not covered by ISA; the development of an endorsement procedure; a common audit report and high quality translations. The principle of compliance with ISA has been included in the revised Eighth Directive. The Commission will work towards further improvements to the IFAC/IAASB audit standard setting process, notably by ensuring that public interest is taken fully into account. As for audit reporting, the Commission plans to use the revised ISA 700 (audit reporting) as a starting point for analyzing the differences between national audit reports by EU professional bodies, facilitated by the European Federation of Accountants (FEE).

6-14 Why does the approved EU directive (2005) remove nationality restrictions on ownership and management of audit firms?

Answer 6-14 The Directive would no longer allow a member state to require that the majority of the voting rights and the majority of the members of the administrative or management body should be in the hands of statutory auditors or audit firms that are approved in that specific member state. The Directive of 2005 removes these restrictions on ownership and management by stating very clearly that the majority of the voting rights of an audit firm should be held by statutory auditors or audit firms approved in any member state and that the majority of the members of the administrative or management body of an audit firm must be statutory auditors or firms approved in any member state. This change enhances compatibility with internal market rules and will also allow for the creation of more fully integrated EU audit firms. That in turn will contribute to the opening up of the audit market. Allowing auditors to set up an audit firm in another member state than their own and to manage such a firm might bring about more competition. The statutory auditor who carries out a statutory audit on behalf of a firm must, however, be locally approved.

57 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Discussion Questions 6-15 Discuss the European Commission’s directive (2005) on statutory audit with regard to the following topics: (a) Independence and ethics; (b) Public oversight over the audit profession.

Answer 6-15 The EC Directive (2005) clarifies the duties of statutory auditors, their independence and ethics, by introducing a requirement for external quality assurance and by ensuring robust public oversight of the audit profession. This considerably broadens the scope of the former Eighth Council Directive on Company Law, which only dealt with the approval of statutory auditors. (a) The Directive emphasizes the clear definition of basic principles of professional ethics. It also defines the principles of auditor independence including the duty of the statutory auditor or audit firm to document factors which may affect auditors’ independence and safeguards against these sorts of risks.

The Commission has proposed to analyze, together with the Audit Advisory Committee, existing national codes of ethics and the international Code of Ethics of the IFAC. With regard to auditor independence, the EU directive states that the statutory auditor should not carry out an audit if there are any financial, business, employment or other relationships between the auditor and the client (including the provision of non-audit services) because this might compromise the auditor's independence. (b) With respect to public oversight over the audit profession, the Directive requires member states to organize an effective system of public oversight for all statutory auditors and audit firms. The Directive emphasizes that this system must be independent of the profession and must have the ultimate responsibility for the oversight of the way in which the regulatory process works in practice. This means that the system must oversee the process of approval of statutory auditors and audit firms, the process of adoption of standards on ethics, internal quality control and auditing, and the implementation of continuous education, quality assurance and investigative and disciplinary systems.

6-16 Europe and the United States have different financial, legal, historical and cultural traditions. They are not identical and their regulatory action may spill over into the other’s jurisdiction.

Discuss the new measures in the EU Directive (2005) on the audit of company accounts in terms of the relationship with the Public Company Accounting Oversight Board (PCAOB) in the United States. To what extent does the EU directive respond to the requirements of market regulator (SEC) in the United States?

Answer 6-16 The EU directive aims to provide a basis for effective and balanced international co-operation between regulators in the EU and the regulators in third countries, such as the SEC and PCAOB in the United States.

The European Commission is particularly concerned about the required registration of EU audit firms with the US PCAOB and the application of Section 404 of the Sarbanes-Oxley Act 2002.

Section 404 of the SOX Act requires companies and their auditors to report on internal controls that should detect fraud and ensure sound financial reporting.

58 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

In recent years, the European Commission has discussed accounting and auditing issues with the SEC and PCAOB, and there is a great deal of agreement between the EU and the United States on the regulation of the audit profession. Europe and the United States have different financial, legal, historical and cultural traditions. However, serious efforts have been undertaken to ensure parallel measures on both sides to avoid regulatory difficulties as much as possible.

Through close co-operation and work sharing, the Commission has been cooperating with the PCAOB to produce compatible regulation.

6-17 Discuss the European Commission’s proposals with regard to the following topics: (a) Permission or prohibition of non-audit services undertaken by statutory auditor or audit firm for audit client; (b) A common standard report for all EU statutory audits; (c) Mandatory rotation of audit firms.

Answer 6-17 Similar to some other questions, it would be interesting to suggest to the students to visit regularly the website of the European Commission for more updated information on the issues raised in this question. However, the following responses are relevant to the proposals made in the Directive (a) This question discusses whether the Commission’s Directive prohibit a statutory auditor or audit firm from delivering additional services to the audited entity. It does not, but it enhances safeguards against such situations leading to damaging conflicts of interest. The proposed Directive takes over the basic principles laid down in the Commission's Recommendation (2002/590/EC) of 16 May, 2002 on ‘Statutory Auditors’ Independence in the EU: A set of fundamental principles' (see IP/02/723). It states that statutory auditors or audit firms cannot provide any additional service that would compromise their independence and that they cannot in any way be involved in management decisions.

The proposed Directive follows the principle-based approach of the Recommendation and does not include a list of non-audit services, which statutory auditors or audit firms cannot perform. However, the examples quoted in the Recommendation continue to apply. This means that auditors should not provide those non-audit services (such as bookkeeping or valuation services) which the Recommendation has indicated are of a nature that they would almost always compromise the auditor's independence.

The statutory auditor or audit firm has to document any risks which might be perceived as compromising its independence and the safeguards the auditor put in place to mitigate these risks. Furthermore, the audited entity has to disclose, in the notes to its financial statements, the audit fee and the fee for non-audit services paid to its statutory auditor or audit firm. For the statutory audit of publicly listed companies, the audit committee will have to review and monitor the independence of the statutory auditor or audit firm and in particular the provision of additional services to the audited entity. (b) Based on the proposed Directive, the Commission may adopt a common standard audit report for annual or consolidated accounts which have been prepared in accordance with adopted IAS/IFRS. For the audit of financial statements in general, the audit report will at least have to comply with Article 51a of the Fourth Council Directive (78/660/EEC) of 25 July, 1978 on annual accounts and Article 36 of the Seventh Council Directive (83/349/EEC) of 13 June, 1983 on consolidated accounts, which are largely based upon the relevant international auditing standard (ISA 700).

59 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(c) In order to reinforce the independence of auditors of publicly listed companies, the proposed Directive requires mandatory rotation of auditors. Member states would have the option of requiring either a change of key audit partner dealing with an audited company every five years, if the same audit firm keeps the work (‘internal rotation’), or a change of audit firm every seven years (‘external rotation’). The Commission believes that mandatory rotation will contribute to avoiding conflicts of interest.

6-18 The new EU Directive requires the establishment of an audit committee within publicly listed companies. Discuss the objectives and benefits of such requirements. What would be the rules on the membership and work of that committee?

Answer 6-18 The requirement to set up an audit committee will strengthen independent monitoring of the financial reporting process and of the statutory audit and help to prevent any undue influence by the executive management. The audit committee must be composed of nonexecutive members of the administrative body or members of the supervisory body of the audited entity, in other words non-executive directors. In order for the committee to fulfil its tasks effectively, at least one of the independent members must be competent in accounting and/or auditing.

The tasks of the audit committee include: •

supervision of the financial reporting process;

•

monitoring of the effectiveness of the internal control system, the internal audit and the risk management system;

•

supervision of the statutory audit including the independence of the statutory auditor or audit firm;

•

proposal of the statutory auditor or audit firm for appointment.

6-19 According to the information published by the European Federation of Accountants (FEE 2005), the membership of this professional body consists of forty-four professional institutes of accountants from thirty-two countries. FEE member bodies are present in all twenty-five member states of the EU and three member countries of EFTA. FEE member bodies represent more than 500,000 accountants in Europe.

In your opinion, how it would be possible to harmonize the audit profession in the EU taking into consideration the differences in terms of legal, economic, financial, educational and cultural situations within the European member states?

Answer 6-19 There is a broad agreement in Europe on the need to improve the quality and comparability of financial statement audits and auditors’ reports on the basis of International Standards on Auditing (ISAs) developed by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC). For example, the European Commission’s Green Paper (1996) ‘The Role, the Position and the Liability of the Statutory Auditor within the European Union’ underlined the importance of considering ISAs as a starting point for standards to be applied by statutory auditors within the EU. In spite of some major differences between member states, the European Commission has tried in recent years to achieve its harmonizing objectives through two main instruments: directives, which must be incorporated into the laws of member states; and regulations, which become law throughout the European Community without the need to pass through national legislatures.

60 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The examples of the measures undertaken by the European Commission which are in line with its harmonizing objectives are as follows: •

requirement to use international standards on auditing for all EU statutory audits once those standards have been endorsed under an EU procedure; member states can only impose additional requirements in certain defined circumstances;

•

possibility for the adoption of a common audit report for financial statements that have been prepared on the basis of International Accounting Standards (IAS). This would ensure that all audit reports for financial statements prepared on the basis of IAS are identical throughout the EU;

•

adoption of common rules concerning the appointment and the resignation of statutory auditors and audit firms (e.g. statutory auditors to be dismissed only if there is a significant reason why they cannot finalize the audit) and introduction of a requirement for companies to document their communication with the statutory auditor or audit firm;

6-20 There are several areas of conflict between the EU Commission and audit profession similar to those that may exist in the United States. Discuss briefly the positions of the EU Commission and auditors of the European companies, particularly with regard to the following topics. (a) Ownership and management of audit firms; (b) Corporate governance in relation to statutory auditing (appointment, dismissal, remuneration); (c) Legal recognition of a European co-ordination of national public oversight (EGAOB); (d) Auditor legal liability; (e) Evaluation of possible endorsement systems for International Standards on Auditing (ISAs) similar to the criteria used in the IFRS-regulation for endorsement of IFRS/IAS. Answer 6-20 The following are the measures proposed by the European Commission with regard to the issues discussed in this question. The position of the audit firms is usually quite different from that of the EC. (a) The European Commission proposes to remove all unnecessary restrictions that could create problems in the areas of management and ownership of audit firms in the European Union. The Commission would favour any legal form for audit firms.

The Commission believes that market access for audit firms should be facilitated by minimizing ownership requirements within the limits of safeguarding auditor’s independence. (b) The European Commission has considered the development of principles in a modernized Eighth Directive on the appointment, dismissal and remuneration of statutory auditors that would guarantee fundamental ‘sovereignty’ from executive directors. Equally important issues are the communication between the statutory auditor and the corporate governance structure, mainly the audit committee, and principles of the independence and competence of the members of the governance body and effective working procedures.

61 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(c) The creation of the ‘European Group of Auditors’ Oversight Bodies (EGAOB)’ responds to the European Commission’s concerns about oversight of the audit profession. The proposed Directive would also set out common criteria for public oversight systems, in particular that they should predominantly be led and staffed by non-practitioners independent from the audit profession, but including a sufficient number with experience and/or expertise in audit. (d) The audit profession strongly defends the capping of auditor liability. Auditors are concerned about the concept of joint and several liability which means that plaintiffs can claim their total damage from one party, regardless of proportionality. In contrast, the European Commission considers auditor liability primarily as a driver for audit quality and does not believe that the harmonization or capping of auditor liability is necessary. However, there may be a need to examine the broader economic impact of present liability regimes. (e) The Commission requires publicly listed companies to use ISAs for all EU statutory audits. However, implementation of this depends on a number of preliminary actions: the update and completion of the analysis of differences between ISAs and national audit requirements; the development of a set of principles ‘framework’ for the assessment of ISAs; the evaluation of possible endorsement systems; the development of a common audit report; and the availability of high quality translations into all community languages.

62 .

CHAPTER 7

AUDITOR INDEPENDENCE AND PROFESSIONAL ETHICS: INTERNATIONAL ISSUES Instructor guidance This chapter discusses one of the core issues of auditing, which has been a subject of debate between the audit profession and market regulatory bodies for the last several decades. As a result of the negative impact of high-profile financial scandals and ever-increasing fraudulent financial reporting in recent years, not only are market regulatory bodies strongly concerned with auditor independence, this issue has been one of the major challenges facing the audit profession itself. Auditor independence is vital to the integrity of financial reporting, and is associated with one of the important touchstones of accounting information – ‘reliability’.

One of the particularities of this chapter is that the discussion on auditor independence and ethical principles must be based on both theoretical and practical approaches. Instructors are strongly encouraged to combine both approaches when discussing the issues raised. It would be interesting for instructors to give particular attention to theoretical issues of auditor independence as well as the practical matters, and opinions expressed by the market regulators, auditors and other financial market participants. With regard to theoretical matters, it would be interesting to refer first to the valuable work of Mautz and Sharaf (1961). Two chapters of Mautz and Sharaf (Chapter 8 on independence and Chapter 9 on ethical conduct) discuss the issues directly relevant to this topic. Chapters 1 and 10 of Mautz and Sharaf also provide some discussions on this issue. Students who are interested in the discussion on auditor independence are strongly recommended to read the relevant chapters of the book of Mautz and Sharaf. For an in-depth discussion on auditor independence and ethical matters, the students should also refer to research papers published in accounting and auditing journals. Some of these papers, which are considered as the first research works in this area, are briefly discussed in the chapter (e.g.

Antle1984; Antle et al. 1997; DeAngelo 1981; Lowe et al. 1999; Simunic 1984) but more papers relevant to this topic can be found in academic journals of accounting and auditing.

Finally it is important to note that the auditor independence is directly or indirectly relevant to other topics in this book such as the audit committee (Chapter 4), quality control in auditing (Chapter 15), auditor liability (Chapter 16), and corporate fraud, corporate scandals, and external auditing (Chapter 18). Instructors could provide an overview of the importance of auditor independence in these areas when discussing the chapter. The introduction on p. 185 and the materials provided on pp. 190–192 and 197 may be used as the basis of this discussion.

63 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 7-1

List and describe the ethical principles in the audit profession and their importance and impact on auditors’ performance.

Answer 7-1 The Code of Ethics of the IFAC Ethics Committee and the AICPA’s ethical rules defined the fundamental principles as follows: •

Integrity and objectivity: fair-dealing and truthfulness with respect to audit clients;

•

Professional competence and due care: performing audit and other attestation services with due care, competence and diligence and maintaining professional knowledge and skill;

•

Prohibited ethical conflicts: avoiding situations which may involve potential conflicts affecting directly or indirectly auditor independence and its performance;

•

Confidentiality: respecting the confidentiality of the information acquired during the course of performing the audit and not using or disclosing any such information;

•

Professional behaviour: acting in a manner consistent with the good reputation of the profession and refraining from any conduct that might discredit it;

•

Basic requirements for compliance with ethical standards: the audit firm should establish policies and procedures for the use of its staff, and communicate these to those who are in a position to influence the conduct and outcome of the audit.

7-2

Discuss the importance of ethical values such as integrity, objectivity and independence of auditors in terms of enhancing public confidence and the better functioning of capital markets.

Answer 7-2 The credibility of the auditor’s opinion strongly affects the users’ perceptions of the company’s financial statements. This credibility cannot be achieved in the absence of ethical values such as the integrity, objectivity and independence. These values have a tremendous impact on the quality of the auditor’s work and performance. The rapid development of financial markets and the increasing level of public expectations of the auditors’ role in the capital market economy require a high level of professionalism and outstanding audit quality, which in return depend upon the respect of ethical values.

7-3

How can auditor independence best be defined?

Answer 7-3 Auditor independence depends on several interrelated values such as integrity, objectivity, professional judgement, freedom from bias and prejudice and expert skill and ability.

These values enable the auditors to preserve the independence of mind and perform the audit function of review and verification in a satisfactory manner. Auditor independence adds credibility to published financial information and value for the various interested parties.

7-4

What are the reasons for auditor independence in a capital market economy?

Answer 7-4 The better functioning of capital market largely depends on the quality of corporate financial information. A well-performed audit by a diligent auditor remains the best way to ensure that the financial statements prepared by management represent, as fairly as possible,

64 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

the financial condition and performance of the company. On the other hand, the credibility of a company’s information which in return depends on auditor independence and the audit quality strongly affects public confidence in the functioning of the capital markets and in the operations of publicly listed companies.

Corporate financial failures of recent years have considerably affected the attitudes of regulatory and professional bodies, vis-à-vis auditor independence. This has pushed market regulatory agencies and professional audit bodies to redefine the role of external auditors and the values representing auditor independence.

7-5

What are the ‘threats’ affecting auditor objectivity and independence, and the possible ‘safeguards’ to eliminate such ‘threats’ or reduce them to an acceptable level?

Answer 7-5 In conducting the audit of financial statements, an external auditor may face different types of threats affecting audit quality and performance. Auditors must recognize that threats to their independence may arise not only from their relationships with audit clients but also from other direct or indirect relationships with other individuals and firms within the business community and in the audit environment. Auditors have to identify not only the people who are in a position to influence the outcome of the audit, but also the circumstances which may create the actual and potential threats to their work.

With the help of market regulatory bodies, the audit profession should do its best to create the appropriate safeguards to mitigate or eliminate threats to auditor independence. Auditors should regularly identify and assess the circumstances which could adversely affect auditors’ objectivity (‘threats’), including any perceived loss of independence. They should also apply procedures (‘safeguards’) to either eliminate the threat or reduce it to an acceptable level. Auditors should pay particular attention to issues such as public disclosure of fees, financial interests, business relationships, employment with the audit client, managerial or supervisory role in the audit client, family and other personal relationships, non-audit services, audit and non-audit fees and litigation.

7-6

In the context of compliance with ethical standards in auditing, define the policies and procedures that should be established by audit firms to promote a strong control environment.

Answer 7-6 The audit firm should establish appropriately documented and communicated policies and procedures, to ensure that the audit firm, and all those who are in a position to influence the conduct and outcome of the audit, respect fundamental ethical principles. This requires a careful analysis of the circumstances in which the ethical standards are applicable.

This analysis should also consider monitoring policies of compliance with ethical requirements in conjunction with quality control processes in the audit firm. It is therefore important that there be a common understanding of what is meant by ethical requirements in auditing and their relationship with auditor independence requirements.

7-7

What are the features of the economics of auditor independence?

Answer 7-7 Apart from the standards and rules governing the external auditor’s role in the financial market, audit activities are also affected by the environmental factors of the capital market economy, economies of scope and scale, and the expectations of society as imposed through legal liability. The economics of auditor independence can be defined in the context of the relationship between auditor and manager, and the characteristics of the auditor’s activities.

The important issue with regard to this relationship is the extent to which the auditor co-operates with management in pursuit of their self-interests. The extent of such co-operation affects the optimal compensation scheme for the auditor.

65 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Several authors have defined independence in terms of an auditor’s resistance to managerial pressure or interference. This notion of independence is defined as the independent auditor’s refusal to engage in side-payment schemes with the manager. This refusal is in fact a denial of completely self-interested behaviour by the external auditor.

7-8

To what extent can auditor independence affect the quality and credibility of corporate financial statements?

Answer 7-8 Investors and other parties interested in a company’s financial statements need reliable information to make rational decisions. Poor quality and biased information usually lead to wrong investment and financing decisions. The presence of external auditors contributes to the reliability and credibility of financial information but this presence by itself is not sufficient and the auditor must be independent to provide an objective and impartial opinion about a company’s financial statements. If auditors are to maintain confidence in financial reporting, they must be objective in reaching their opinions. The quality of the audit opinion is a vital element in maintaining confidence in financial reporting and the key to this is that the audit opinion be free from bias. This requires independence of mind from the company being audited, and auditors also need to consider the external perception of their independence.

7-9

What are the reasons affecting the change in attitude of regulators to ethics and the independence of external auditors?

Answer 7-9 Market regulators are in charge of the better functioning of capital markets and this cannot be achieved without efficient oversight and control systems. Maintaining auditor independence as one of the control mechanisms has been a challenge for regulators in recent years. The violations of auditor independence rules associated with the high-profile financial failures of recent years, and a changing audit and business environment, have led financial market regulators to question the ability of the existing rules to maintain public confidence.

These scandals have also raised serious concerns about the ethical failures of the accounting and auditing profession. For all these reasons, the regulators have chosen a tougher attitude towards the audit profession by prohibiting joint provision of audit and non-audit services, and mandating the rotation of auditors. This intervention should hopefully bring confidence to market participants, helping them to rely on oversight and control mechanisms in their decision-making processes.

7-10 In your opinion, to what extent can non-audit services fees compromise auditor independence?

Answer 7-10 This question can be discussed from the viewpoints of both the market regulators and audit profession. Opponents of audit firms performing non-audit services pose the following question: Does the involvement of the auditor in non-assurance services impair his/her independence? The rationale for this question is that either these activities are not compatible with the appearance of objectivity, or have primary objectives that are fundamentally different from those of attestation services.

The arguments in favour of prohibiting certain non-audit services are based on the assumption that performing such services for audit clients would compromise auditor independence, especially if the non-audit fees were more lucrative than the audit work fees. Regulators and financial statement users are concerned that auditors compromise their independence by allowing high-fee clients more financial statement discretion relative to low-fee clients. This supports the basic argument that provision of non-audit services affects the independence of the external auditor.

Advocates performing activities other than the attestation services by auditors, state that auditors could engage in activities where no dependence was in fact created, and auditors would learn more about their clients, thereby ensuring that auditors continued to satisfy their

66 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

obligation to know the companies while conducting better audits. According to this view, which is supported by the audit profession, the greater the knowledge of the client’s business, the better the audit team will understand the client’s procedures and controls, and the business and financial risks that it faces.

This argument is also based on the view that the public will benefit as a result of allowing auditors to engage in non-audit services. Additionally they argue that because of their expertise and resources, auditors are often in a position to provide cost-effective advisory services, some of which are non-traditional, and increase competition in the industry for such services. Audit firms could provide better services at lower cost, which would benefit the public.

7-11 What definitions of auditor independence are provided by different capital market regulators and professional bodies (European, US, international)? What are the recent developments in defining auditor independence?

Answer 7-11 The definition of auditor independence has been subject to different views expressed by regulatory and professional bodies. Most of these definitions consider that independence has two elements: independence in fact and in appearance. Independence in fact is defined as ‘the absence of mental bias in the conduct of an audit’ and is more concerned with auditor objectivity. A similar concept has been used in the International Standards on Auditing (ISAs) issued by the IFAC to define independence of mind. This definition of independence refers to ‘the state of mind’ that permits the provision of an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional scepticism. Independence in appearance, concerned with apparent conflicts of interest, is generally associated with users’ opinions about auditor independence in a given situation.

The European Commission (the Commission 2002a) stated that ‘when carrying out a statutory audit, a statutory auditor must be independent from his audit client, both in mind and in appearance’. In 1997, the AICPA and the SEC established the Independence Standards Board (ISB) and in taking this initiative, they expressed concerns about the need to preserve the appearance of maintaining objectivity, as well as independence in fact.

Consistent with the tenor of Section 208(a) of the SOX Act of 2002, the SEC has adopted (May 2003) the Final Rules. The SEC, in its report on strengthening the requirements regarding auditor independence, defined its principles of independence with respect to services provided by auditors according to three basic rules. The principles whose violation would impair an auditor’s independence include (1) an auditor not functioning in the role of management, (2) an auditor not auditing his or her own work and (3) an auditor not serving in an advocacy role for his or her client.

7-12 Discuss the effect of the corporate failures of recent years on public confidence in terms of ethics and auditor independence.

Answer 7-12 Corporate financial failures of recent years have considerably affected the attitudes of regulatory and professional bodies towards auditor independence. This has pushed regulatory bodies in major capital market economies to redefine the role of external auditors and the types of services provided by them. Following a number of corporate collapses and fraudulent financial reporting of multinational groups, national and international regulators have placed emphasis on ethical principles in auditing and the independence of external auditors, encouraging the professional accounting bodies to continue to work with regulators to strengthen existing standards governing independence.

Particular attention has been given to auditor independence, because the external auditor plays a critical role in lending credibility to published financial statements that are used by investors, creditors and other stakeholders. Because of the effect of corporate financial failures on the

67 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

perceptions of users of financial statements, more attention is also being paid to ethical principles in auditing, and judgements on these principles are now made in a firmer and more professional manner. Accordingly, the audit profession is now faced with higher public expectations of integrity, objectivity and the independence of external auditors.

7-13 What are the steps that have been taken by the European Commission, and why have they been taken, to reinforce auditor independence in recent years?

Answer 7-13 Several high-profile financial scandals in the United States and Europe have forced the European Commission to take action to reinforce oversight and control mechanisms in the European financial markets. The issue of auditor independence was among the most important matters brought to the attention of the European Commission. The European Commission’s Recommendation (May 2002) and the Commission’s Communication to the Council and the European Parliament for reinforcing the statutory audit (2003) represent the first most important attempts to raise the issue of auditor independence in the EU. The European Commission Recommendation of 2002 adopts an innovative principles-based approach that provides the statutory auditor with a sound framework for assessing independence risks. The European Commission has also updated the Eighth Directive (2005) to provide a legal basis for all statutory audits conducted within the EU. The Commission has considered auditor independence in terms of the appointment, dismissal and remuneration of statutory auditors to guarantee fundamental ‘sovereignty’ from executive directors. The European Commission Directive also clarifies the duties of statutory auditors, their independence and ethics, by introducing a requirement for external quality assurance and by ensuring robust public oversight of the audit profession.

7-14 What are the objectives and elements discussed in the IFAC Code of Ethics?

Answer 7-14 The position of the International Federation of Accountants (IFAC 2004 and 2005) on ethical matters and auditor independence has evolved in recent years. The IFAC, like market regulators in developed market economies, places emphasis on ethical principles in auditing and on the independence of external auditors, encouraging professional accounting bodies to continue to work with regulators to strengthen standards on independence.

The IFAC has adopted a revision of the independence chapter of the IFAC code of ethics of 2004 and 2005. The overall IFAC approach is also very similar to that of the EU (some members of the IFAC ethics committee are also members of the EU Committee on Auditing).

Compliance with these requirements of integrity, objectivity and independence is the responsibility of the audit firm, individual partners and professional staff.

7-15 In your opinion, to what extent can the presence of an audit committee affect auditor independence?

Answer 7-15 The importance of the audit committee and its relationship with external auditors have become more evident in the wake of the increased incidence of fraudulent and misleading financial reporting, business failures and alleged audit failures. The audit committee has, to a great extent, contributed to effective external audits. The independent auditor and audit committee should have a strong and candid relationship. This committee has the important responsibilities with regard to the independence, integrity, qualifications and performance of the external auditors.

The audit committee, as the representatives of shareholders, is considered as the ultimate entity to which the auditors are accountable. The audit committee, as part of the corporate governance structure, is responsible for overseeing the entire process of the relationship between the company and independent auditors. Independent auditors are likely to prefer governance mechanisms that address their concern for a reduction in the risk of fraudulent financial reporting. Accordingly, it is the audit committee that has the responsibility to regularly

68 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

review the relationship between management and the external and internal auditors. The audit committee should also be informed of any difficulties the external auditor has encountered in the course of the audit work, including any restrictions on the scope of the independent auditor’s activities or on access to requested information, as well as of any significant disagreements with the management. It is also the responsibility of the audit committee to protect external auditors from dismissal following disagreement with management on the issuance of qualified audit reports.

7-16 Discuss the US regulators’ position on (a) non-audit services provided by external auditors of publicly listed companies and (b) partner rotation within audit firms.

Answer 7-16 US regulators have taken serious measures to reinforce auditor independence.

Among these measures were restrictions on performing non-audit services by an audit firm for the same audit client. (a) The SEC Rules (2003) are intended to support the independence of the auditor from management by providing a clearer definition of the types of non-audit services that would be deemed to impair an auditor’s independence. Examples of non-audit services that have been prohibited by SEC based on the SOX Act of 2002 are indicated in Figure 7.1 of this chapter. (b) The SEC Rules (2003) are also intended to support the independence of the auditor from management by requiring the ‘rotation’ of ‘audit partners’ on the audit engagement team to assure a periodically fresh look at the accounting and auditing issues related to the issuer’s financial statements; 7-17 Explain the differences between US and EU approaches towards auditor independence.

Answer 7-17 Compared to the European approach towards the auditor’s function, the SOX Act and the subsequent SEC implementation of rules on auditor independence have introduced a very restrictive and rule-based approach in the United States. In contrast, the European Commission’s action is mainly a principles-based, risks–safeguards approach. One of the reasons for the tougher position of the US regulator is that the question of auditor independence has been extensively treated in the United States for several decades whereas this issue has been considered by the European Commission only in recent years. Consistent with Section 208(a) of the SOX Act of 2002, the SEC has adopted (May 2003) the Final Rules. Potential benefits resulting from these rules include increased investor confidence in the independence of accountants, in the audit process and in the reliability of reported financial information.

7-18 What are the responses of the audit profession in the EU and the US to regulatory measures in the area of auditing? Discuss these.

Answer 7-18 The European Federation of Accountants (FEE), similar to the AICPA in the United States, is the representative organization for the accountancy profession in Europe. Both bodies have been active for many years in auditor independence. The FEE supported the legal underpinnings of the European Commission recommendation when the Commission introduced the principle of independence in the Eighth Directive. In its formal response to the Commission’s proposal to revise the Eighth EU Directive on Auditing, the FEE (2004) presented a comprehensive submission to the Commission, the Council of Economic and Finance Ministers and the European Parliament. The FEE also made significant contributions to the European Commission’s recommendations of 16 May, 2002 on ‘Statutory Auditors’ independence in the EU: ‘A Set of Fundamental Principles’.

69 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

In the United States, the AICPA was in charge of auditing issues for many years. In 1997, the AICPA and the SEC established the Independence Standards Board (ISB) and delegated to it authority for determining new independence standards, to serve the public interest better and to protect and promote investor confidence in capital markets. However, since the introduction of the SOX Act, the power of the AICPA in auditing issues has been severely limited and the PCAOB has taken over several responsibilities particularly with regard to the audit of publicly listed companies.

Discussion Questions 7-19 In your opinion, what are the important issues affecting auditor independence in a capital market economy? Why is the inquiry into auditor independence becoming increasingly important?

Answer 7-19 This question is reflective in the sense that the students should be asked to express their opinions on auditor independence. Similar to some other questions, it would be interesting to ask the students to prepare an essay on this topic discussing the issue on the basis of their experiences and the information acquired from the media. The students’ discussions should include the challenges facing auditor independence, particularly with regard to the following issues: •

The importance of ethical principles and auditor independence in the audit function;

•

Increasing pressure on the audit profession and market regulatory bodies to emphasize auditor independence following several corporate failures, financial scandals and fraudulent financial reporting;

•

Problems relating to the definition of auditor independence and how it can be acquired;

•

Relationships between auditor independence, reliability of corporate financial information and public confidence in the functioning of the capital markets;

•

Differences between the views of market regulatory agencies and audit professional bodies with regard to the role of auditors in the capital market economy;

•

The rules and recommendations proposed by market regulatory bodies in the different countries of origin of the students;

•

The relationship between auditor independence, the auditor’s reputation and audit quality;

•

The discussion of non-audit services and their possible effect on auditor independence from the viewpoint of the students;

•

Discussion about the measures undertaken by market regulatory bodies in the area of auditor independence and the strengths and weaknesses of such measures;

•

The role of the audit committee in reinforcing auditor independence;

•

Other issues such as audit fees, audit concentration, training and competence of audit staff.

70 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

7-20 What are the characteristics of the rules adopted in the EU environment governing auditor independence? Discuss this question with reference to (a) the SarbanesOxley Act of 2002 and (b) the SEC Final Rules of 2003.

Answer 7-20 Auditor independence has been a long-standing topic on the EU Commission’s agenda and recent European recommendations constitute a significant step forward in resolving this issue, which is controversial and difficult to regulate. The differences between EU and US approaches are mainly related to two major points. Firstly, in contrast to the US environment, there are differences across jurisdictions within the European Union, particularly with regard to economic, cultural, professional and political issues. Secondly, US policy makers have taken tougher measures compared to the EU approach. The following are some of the specific differences between the US and EU approaches. (a) The SOX Act of 2002 has taken a wide range of measures in auditing, including some concerning auditor independence. The SOX Act is a very restrictive and rulebased approach compared to the EU directives and recommendations. The measures undertaken in the act are also more detailed and specific. For example, the SOX Act adds a Section (201(a), 10A (g)) to the SEC Act of 1934. This section of the SOX Act states that it shall be unlawful for a registered public accounting firm, in charge of the audit of a company’s financial statements, to provide to that issuer, contemporaneously with the audit, any non-audit services, including nine categories of services set forth in the Act. (b) The European Commission’s recommendations are more based on general principles and risks–safeguards approach. For example, among the measures undertaken in the new Eighth Directive (2005), the Commission has stressed the importance of sound and harmonized principles of auditor independence applicable to all statutory auditors. This EU directive further improves the independence of auditors by requiring listed companies to set up an audit committee (or a similar body) with clear functions. (c) The SEC Rules (2003) are consistent with Section 208(a) of the SOX Act of 2002.

These rules, which are intended to facilitate the independence of the auditor from management, provide clear indications with regard to non-audit services – mainly those that would be deemed to impair an auditor’s independence as well as the audit committee and the rotation of audit partners.

7-21 ‘The relationship of ‘management-auditor-shareholder’ is potentially conflicting and in today’s society the independence of auditors is considered a major issue. In addition to the problems associated with this relationship, auditors are themselves acting as economic agents who maximize their utilities. Therefore it is rather difficult to provide a fair and independent judgement on the company’s financial performance and on its directors’.

Discuss the statement with regard to auditor independence in the context of agency relationships. What are the theoretical grounds for having reliable reporting by auditors?

Answer 7-21 This question should be discussed in a general context as it relates to several important topics such as the economics of information, asymmetry of information, demand for auditing from an agency perspective and the role of auditors as an intermediary agent in the capital market economy. More specifically, it would be interesting to emphasize that a demand for auditing in agency relationships is justified because the presence of an independent auditor will limit the amount of biased information made public. Agency theory is therefore closely associated with the idea that the demand for auditing services stems from the conflict of interest between those who prepare the information (managers) and those who use it (shareholders and other interested parties), although this is not the only justification for having an auditor.

71 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

However, the presence of external auditors in the shareholder–manager relationship would be useful if their opinions and reports were considered credible by interested parties. This is one of the conditions for creating public confidence in the capital market economy, which is essentially based on the reliability of companies’ financial information, the quality and performance of audits and the usefulness of financial information in investors’ decision-making processes. Many of these factors are also related to the auditor’s capacity to perform a high-quality audit respecting fundamental ethical principles and professionalism. In other words, the credibility of auditors’ opinions and reports depends, to a great extent, on public belief in the integrity, objectivity and independence of auditors and the quality of their work. The whole question is whether an external auditor would be able to stick to these values despite his/her financial interest. It would also be interesting to refer to auditor reputation, quality control and oversight systems implemented by market regulatory bodies as the essential factors contributing to auditor independence.

7-22 ‘The audit committee is usually responsible for supervising the relationship between the auditors and the company and of the conduct of the audit process. As the shareholders’ representatives, the audit committee has ultimate authority for selecting, evaluating, and, if needed, replacing the independent auditor. As a consequence, the external auditors are ultimately accountable to the audit committee and shareholders’ general meeting’.

Discuss the following questions with regard to the above statement: (a) To what extent is the relationship with the audit committee beneficial to auditors? (b) How can the auditor’s performance be affected by an effective audit committee? (c) What type of information should the external auditors provide to those charged with governance? (d) To what extent does the composition of the audit committee and its independence affect (1) the company’s financial reporting and (2) the auditor’s performance?

Answer 7-22 This question is mainly related to the role of the audit committee with regard to external auditing and more specifically auditor independence. The functions of the audit committee and external auditor are strongly interrelated. It would be interesting to recommend to the students to revise the contents of Chapter 4 before answering this question. The importance of this question is related to the significant role of the audit committee, which has become more evident in the wake of the increased incidence of fraudulent and misleading financial reporting, business failures and alleged audit failures. The following are some major points in response to the questions. However, it would also be suitable to ask the students to prepare their answers with reference to rules and recommendations implemented in their own countries.

The audit committee plays a significant role with regard to financial reporting and internal control systems of companies, and has a close relationship with external auditors. The audit committee constitutes the essential link between the management, independent auditors, internal auditors and the board of directors. This committee can facilitate the task of external auditors by mitigating the possible conflicts of interest between auditors and a company’s management.

72 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(a) The audit committee is directly concerned with the independence, integrity, qualifications and performance of the external auditors. It is associated with external auditors in several respects. Firstly, the audit committee should have the sole authority to approve all audit engagement fees and terms, as well as all significant non-audit engagements by the independent auditors. Secondly, once an independent auditor has been appointed, the audit committee needs to understand the scope of the audit engagement and how it is to be approached. The audit committee should also be involved in the discussion with external auditors concerning the results of their audit examination. Thirdly, the audit committee should be informed of any difficulties the external auditor has encountered in the course of the audit work, including any restrictions on the scope of the independent auditor’s activities or on access to requested information, as well as of any significant disagreements with the management. (b) The external auditor should communicate in writing to the audit committee all significant deficiencies and material weaknesses identified. When auditing internal control over financial reporting, the auditor may become aware of fraud or possible illegal acts. If the matter involves fraud, it must be brought to the attention of the appropriate level of management. If the fraud involves senior management, the auditor must communicate the matter directly to the audit committee. (c) An audit committee’s independence is the cornerstone of its effectiveness, particularly when overseeing a company’s financial integrity and ensuring appropriate internal control and audit systems within the company. The independence of audit committee members is an essential factor in ensuring that the committee fulfils its oversight objectives in financial reporting. One of the primary functions of an audit committee is also to safeguard the independence of external auditors and so the committee must maintain a very clear and transparent relationship with them to ensure their objectivity. Several studies suggest that audit committees strengthen auditors’ positions in conflictual relationships with management.

7-23 Auditor independence and non-audit services The following statement relates to some of the potential conflicts that impair auditor independence when auditors perform audit and non-audit services for the same client.

Read and discuss the statement. Provide your opinion on each individual question indicated below. You are strongly recommended to provide the practical examples to justify your comments: When an audit firm performs valuations of figures that appear in its client’s financial reports, the mandate for independence is threatened. When an audit firm performs the internal audit function its client would otherwise do, the ethics of independence is tarnished. When an audit firm also keeps its clients books, the principle of independence is undermined. All these issues can, to some extent, jeopardize the auditor’s objectivity when performing the audit of publicly listed companies.

With regard to the above-mentioned issues, it is appropriate to address certain fundamental questions: (a) Should there be more appropriate limits on the types of services that an audit firm can render to a company publicly listed on the stock exchange? (b) How should audit firms be structured in order to assure independence? (c) Should a firm be permitted to become an affiliate with entities that provide services to its audit clients that the firm itself would not be allowed to provide?

73 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(d) What are the potential conflicts that impair auditor independence when auditors perform audit and non-audit services for the same client?

Answer 7-23 This is a very broad question dealing with external auditors’ activities. It would be interesting to discuss this question from the differing viewpoints of regulatory and professional bodies. Similar to some other questions, it would also be interesting for the students to refer to the rules and recommendations implemented in their countries. The followings are some general guidelines and points relating to the questions. (a) This is a reflective question and it would be suitable to ask the students to express their opinions on it. The idea is to clarify the role of external auditors and the types of services they could perform in financial markets. The students should also consider the responsibilities of market regulatory bodies with respect to public confidence and the protection of interested parties through the company’s financial statements. (b) The organizational structure of large audit firms is a major concern for market regulatory agencies, since it is characterized by partnerships with separate legal entities operating under the same brand name, but with a structure subject to the laws and regulations of different jurisdictions. The nature and structure of audit firms may have the impact on the performance and quality of audit, and eventually on auditor independence. This question is particularly important since the Big Four audit firms are dispersed around the world, and practice in many different cultures and legal systems. (c) This is a controversial question as the responses of regulatory and professional bodies may not be similar. The question is mainly related to performing non-audit services for audit client and the impact of this on auditor independence. The students should be asked to express their opinions and provide arguments for and against this type of affiliation. (d) This question is related to the concerns expressed by the market regulatory bodies with respect to performing non-audit services for client companies. Market regulators argue that the delivery of non-audit services by audit firms often requires a close relationship with a company’s management and, for example, with taxation advice, may place the audit firm in the position of articulating clients’ positions before regulators. Regulators’ concerns are also based on the premise that the provision of non-audit services increases the fees paid to the audit firm, thereby increasing the economic dependence of the audit firm on the client. This probably stems from evidence that audit clients usually pay significant amounts for non-audit services.

According to this view, auditors may be willing to sacrifice their independence in exchange for retaining clients that pay large non-audit fees.

74 .

CHAPTER 8

AUDIT RISK, MATERIALITY AND BUSINESS RISK MANAGEMENT Instructor guidance This chapter looks at two practical auditing topics: risk and materiality. These are included in most auditing textbooks, but the main difference is that this book, in this chapter, presents detailed materials relating to the audit risk-based approach and emphasizes business risk. It would be interesting to stress both points when teaching this chapter. The audit risk approach is a classical topic in auditing but the students should understand the different components of this model, and its limits. It is also important to explain the relationship between these components and how these may affect the audit work.

The second particularity of this chapter is its emphasis on business risk. It is essential to explain to the students that the auditor usually conducts the audit in an environment surrounded by uncertainty. The auditor should obtain an understanding of the company’s objectives and strategies, and the related business risks. Taking into account the conditions under which several audit failures have occurred in recent years, the students should realize the importance of a thorough analysis of a company’s environment and business risks in an audit on financial statements. As the business risk may arise from environmental changes or its complexity, the auditor’s understanding of these changes and the dynamic nature of the business environment are the determinant factors in the audit work. The students should particularly realize that risk assessment in auditing is a continuous process and the auditor should try to gather and update his/her information about the business environment.

Finally, as the topics discussed in the chapter are regularly under examination by accounting and regulatory bodies, it would be good to recommend to the students to refer to the websites of these bodies for any new approach or proposal in this area. It would also be interesting to refer to the academic accounting and auditing journals for research papers on this topic.

75 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 8-1

Define, and differentiate between audit risk, inherent risk, control risk and detection risk.

Answer 8-1 Audit risk relates to the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a combination of three risks: inherent risk, control risk and detection risk. Inherent risk is the risk that a material error enters into a client’s accounts. Inherent risk presumes that related financial statement accounts will contain misstatements. It concerns the susceptibility of an assertion to a material misstatement, assuming that there are no related controls. Control risk concerns the failure of a client’s system of internal controls to detect a material misstatement, and it depends on the effectiveness of the design and operation of internal controls. Detection risk is the risk that the auditor will not detect a material misstatement in an assertion. This risk depends on the effectiveness of an audit procedure and of its application by the auditor.

8-2

What is meant by the term ‘materiality’? What requirements are imposed on the auditors by this definition?

Answer 8-2 Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. This concept has been widely used in the audit of financial statements and at the time of planning the audit, the auditor should consider what would make the financial statements materially misstated. Materiality and audit risk are interrelated and an external auditor considers them at two levels: that of the overall financial statements, and in relation to the individual classes of transactions, account balances and disclosures and the related assertions.

The auditor’s assessment of materiality helps the auditor to determine what items to examine and whether to use sampling and analytical procedures. This enables the auditor to select audit procedures that, in combination, can be expected to reduce audit risk to an acceptably low level.

8-3

What is the relationship between materiality and the phrase obtain reasonable assurance used in the auditor’s report?

Answer 8-3 In conducting the audit of financial statements, the auditor expresses an opinion as to whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework. The auditor is not in a position to provide absolute assurance because of factors such as the nature of selective testing, the shortcomings of the company’s internal controls, the characteristics of audit evidence and the importance of the auditor’s perceptions in performing audits and formulating audit opinion.

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. The auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements, but the nature (quality) of the misstatements also needs to be considered. The concept of reasonable assurance acknowledges that there is a risk that the audit opinion is inappropriate.

76 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

8-4

Explain the interrelationships between audit risk, materiality and audit evidence.

Answer 8-4 These three concepts are interrelated. The role of evidence in the production of audit opinion is a significant part of the audit process. It provides the means by which the auditors can acquire knowledge and achieve a state of assurance about the company’s operations. Materiality and audit risk are interrelated concepts and are both applied to the evidence obtained by the auditor in the course of audit of financial statements. Materiality directly influences audit risk and audit planning. Thus, it is presumed that if the materiality level is set too high, the discrepancy between actual and detected errors will increase.

Evidence collection and audit judgement upon which audit risk and materiality are based are important interrelated subjects in the audit of financial statements. The work of auditors in forming an opinion is permeated by the exercise of judgement, and the gathering of evidence is a determinant factor particularly in deciding the nature, timing and extent of audit procedures.

8-5

Describe two major sources of detection risk that can be identified and controlled by the auditor.

Answer 8-5 Detection risk is the risk that the auditor will not detect a material misstatement in an assertion. The major sources of such risk are mainly related to the auditor’s ability to use the suitable procedures in the audit of financial statements. For instance, the auditor might select an inappropriate audit procedure, misapply an appropriate audit procedure, or misinterpret the results. The best solution for reducing this type of risk to a negligible level is adequate planning, proper assignment of audit staff, and supervision and review of the audit work.

8-6

Define what is meant by inherent risk. Identify the factors that make for high inherent risk in audits. Provide some examples.

Answer 8-6 Inherent risk is the risk that a material error enters into a client’s accounts, and the company’s financial statements provided to the auditor contain misstatements or material errors.

The major sources of inherent risk are related to the factors such as the nature of a client’s business and industry, integrity of management, size of account balances, frequency of transactions, existence of related parties and a lack of sufficient working capital to continue operations.

8-7

Define the control risk and the basis of its assessment.

Answer 8-7 Control risk relates to the failure of the client’s system of internal controls to detect a material misstatement. The auditor should assess the effectiveness of the design and operation of a company’s internal control systems and evaluate the appropriateness of such systems. The auditor applies different types of procedures on a company’s control systems to check their appropriateness. These include inquiries of management and other company’s personnel, analytical procedures and observation and inspection.

8-8

Why is it inappropriate to apply the audit risk model to business risk?

Answer 8-8 The risks associated with environmental factors are regarded as business risk.

Business risk is broader than the risk of material misstatement of the financial statements, though it includes the latter. The audit risk model is not appropriate to measure business risk as it does not consider professional judgement. The audit risk model is not even suitable to measure the risks associated with material misstatement of financial statements as it simply demonstrates the general relationship of three audit risk components: inherent risk, control risk and detection risk. Business risk mainly involves qualitative aspects such as environmental risks, business processes, asset loss risks and information risks. The audit risk does not consider these elements and is not capable of measuring the effect of these factors on a company’s financial statements.

77 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

8-9

Define auditors’ responses to material misstatements and assessed risk.

Answer 8-9 In designing the planning of an audit of financial statements, the auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements. The auditor should also perform a thorough analysis of the risks identified and a study of whether the risks may result in material misstatement. The overall responses of the auditor mainly consider the risks of material misstatement at the financial statement level. The findings of the independent auditor in the process of risk assessment should be communicated to the company’s management and/or members of corporate governance board (particularly the audit committee) in a timely way. The auditor’s overall response to the risks of material misstatement is based on professional experience, supervision, training, use of professional judgement and any additional substantive procedures.

8-10 Define the ‘occurrence risk’ in the context of the audit risk model.

Answer 8-10 The ‘occurrence risk’ or ‘auditee risk’ represents the risk components that a misstatement exists before conducting the audit. It combines the inherent risk and control risk as both of them concern the auditor’s observations regarding the material misstatement of the company’s financial statements and weaknesses of its internal control systems. The auditor has no direct control over these risks, but must assess their level in order to determine the extent of testing given a planned level of audit risk.

8-11 Discuss the effect of the company’s internal control system on the auditor’s risk assessment.

Answer 8-11 The assessment of a company’s internal control systems is an essential step in the conduct of an audit of financial statements. If the auditor considers that the design and operation of internal control systems are not appropriate, there is a risk that a client’s internal control systems fail to detect material misstatements. In performing the audit, the auditor documents the client controls and assessed control risk. The evaluation of control risk may be done in two steps, once before the tests of controls are performed – if they are performed – and then again after the auditor has the results of the tests of controls. The attitude of the company’s management and its efforts towards the implementation of appropriate internal control systems is an important element in an auditor’s overall evaluation of a company’s financial statements.

Some control risk will always exist because of the inherent limitations of internal control.

8-12 Discuss the term ‘significant risks’ and how auditors should deal with them.

Answer 8-12 Significant risks refer to those which need special consideration from the viewpoint of the external auditor. These risks may result in material misstatement of financial statements and auditors should evaluate the design of the company’s internal controls and determine whether they have been implemented. External auditors should consider a number of issues with regard to significant risks including whether the risk is related to fraud, the likely magnitude of the potential misstatement, and the possibility that the risk may give rise to multiple misstatements. It is also important to determine whether the risk is related to recent significant economic, accounting or other developments and whether it involves significant transactions with related parties.

8-13 Define the terms ‘material misstatements’ and ‘uncorrected misstatements’. What are the auditor’s actions when such misstatements exist?

Answer 8-13 In conducting the audit of a company’s accounts, the auditor considers what would make the financial statements materially misstated. Materiality is defined as an amount that is large enough to influence the decision-making process of an independent auditor in an audit of financial statements. The uncorrected misstatements consist of (a) specific misstatements identified by the auditor including the net effect of uncorrected misstatements identified during the audit of previous periods; and (b) the auditor’s best estimate of other misstatements that cannot be specifically identified (i.e. projected errors).

78 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Materiality directly influences audit risk and audit planning. If the auditor concludes that the misstatements may be material, the auditor needs to consider reducing audit risk by extending audit procedures or requesting management to adjust the financial statements. If management refuses to adjust the financial statements, the auditor, taking account of whether the misstatements are material or not, can qualify the audit report. In the case of aggregate of uncorrected misstatements, if an external auditor finds that this aggregate is not material, he/she should modify the report on company’s financial statements.

8-14 Define the terms ‘risk assessment procedures’ and ‘analytical procedures.’

Answer 8-14 The term ‘risk assessment procedures’ refers to the procedures adopted by the external auditor to obtain an understanding about the company and its environment. These procedures serve mainly as a source of audit evidence to support assessments of the risks of material misstatement of the financial statements. They include inquiries of management and other employees, analytical procedures, observation and inspection. They should enable the auditor to identify and understand the events, transactions and practices that, in the auditor’s judgement, may have a significant effect on the financial statements or on the audit examination or audit report.

In the conduct of an audit of financial statements, the external auditor should perform certain detailed tests called the analytical procedures. These consist of the analysis of significant ratios and trends including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predicted amounts.

8-15 Explain the main sources of business risk and their influence on a company’s risk assessment process.

Answer 8-15 Every company is different and will be subject to its own risks or particular risks affecting its activities. Business risks will be driven by a number of basic factors. They are associated with environmental factors and result from significant conditions, events, circumstances or actions that could reduce the company’s ability to achieve its objectives and execute its strategies. Environmental changes or complexity are the types of business factors that significantly affect the company’s activities.

A company’s managers should obtain knowledge about the risks they face, whether internal and external. These risk factors can also be presented in a framework consisting of business process risks, financial risks, information risks, and those risks related to compliance with governance rules and codes of ethics. The auditor should obtain an understanding of the company’s objectives and strategies, and the related business risks. This requires a thorough analysis of the business risks that the company’s management has identified and a study of whether the assessed risks may result in material misstatement of the financial statements.

8-16 Discuss the characteristics of the IFAC new audit risk model.

Answer 8-16 The audit risk model proposed by the IFAC is quite similar to the standard type of this model and considers similar components. However, two major points characterize the IFAC approach. Firstly, the international standards on auditing (ISA) do not refer to inherent risk and control risk separately, but rather to a combined assessment of the ‘risk of material misstatement’. ISA 200 (IFAC 2005 p. 205) describes a combined assessment of the risk of material misstatement. Nevertheless, the auditor may make separate or combined assessments of inherent and control risk depending on preferred audit techniques or methodologies and practical considerations. According to ISA 200, inherent risk and control risk are highly interrelated and if the auditor attempts to assess these risk components separately, there is a possibility of inappropriate risk assessment. As a result, audit risk may be more appropriately determined in such situations by making a combined assessment (see also Figure 8.6, p. 227 of the chapter).

79 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Secondly, the ISA 315 (IFAC, 2004) proposes general guidelines to help the independent auditor to gain an understanding of controls and relates them to assertions in the context of the processes and systems in which they exist. The ISA 315 emphasizes the importance of multiple control procedures. This ISA proposes that the risk assessment should be based on the identification of risks by considering the company and its environment, including relevant controls that relate to the risks, and by considering the classes of transactions, account balances and disclosures in the financial statements. Then the identified risks should be related to what can go wrong at the assertion level.

8-17 How do you define a ‘high risk’ audit client? What are the characteristics of clients that are considered high risk?

Answer 8-17 This is subject to the judgement of an external auditor and there is no straightforward definition of ‘high risk’ audit client. However, several factors may affect the level of audit risk associated with a client’s accounts. For instance, a lack of sufficient control mechanisms and an appropriate accounting and financial reporting within an organization significantly affect the level of the company’s risk when examining its accounts. The nature of a client’s business and industry, lack of integrity of management and the absence of sufficient working capital to continue operations are also determinant factors in considering a company as a ‘high risk’. Poor business conditions and events, unfavourable environmental changes and unstable political systems in which the company operates may undermine the company’s ability to cope with financial and business operations and increase the level of risk with regard to the fair presentation of the company’s financial statements. Most of these risk factors are defined in the context of inherent, control and business risks.

High risk audit clients are generally characterized by the following factors: •

Management: questionable integrity and ethical values;

•

Production: An industry characterized by volatility, dependence on a limited product range;

•

Accounting and financial reporting: lack of full disclosure of financial and accounting information, history of questionable accounting practices and lack of adequate control mechanisms;

•

Financial: poor financial condition, instability of future cash flows and inadequate capital;

•

Stock market: significant fluctuations of a company’s stock prices;

•

Legal: previous inquiries by the regulatory bodies;

The best action an auditor can take is to understand and measure the risk factors the organization and its management face. It is also essential to evaluate the effect of these risk factors on the company’s accounts and financial reporting systems and the extent to which they may cause the financial statements to be materially misstated.

8-18 Regulatory bodies are very concerned that auditors consider the qualitative aspect of materiality judgements. Explain the meaning and the importance of ‘qualitative’ aspect of materiality.

Answer 8-18 Materiality has been widely defined in quantitative term and the auditor should establish an acceptable materiality level to detect material misstatements. However, to assess materiality an auditor needs to use his/her judgements and this involves the qualitative aspects of this concept. When planning the audit, the auditor needs to consider the qualitative material misstatements which could result from an inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled by this description.

80 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

It could also result from a failure to disclose a breach of regulatory requirements when it is likely that the consequent regulatory restrictions would significantly impair operating capability. The qualitative aspect of materiality recognizes that some items, because of their very nature, may be quite significant to users – even if the amount of these items is less than most quantitative measures of materiality.

8-19 What are the limitations of the audit risk model? To what extent do those limitations affect the auditor’s application of the audit risk model?

Answer 8-19 The audit risk model can only be considered as a general framework and a conceptual guideline and does not take account of all the factors that may influence the determination of individual risk components. It has several limitations as it defines only the general relationship of the risks associated with the auditor’s assessment of inherent and control risks. It is rather difficult to formally assess this model as its determination is based on an auditor’s subjective judgement. It consists of the multiplication of three risk components: inherent risk, control risk and detection risk. The multiplicative form of the audit risk model (AR = IR × CR × DR) indicates that the components are independent. However, several research papers suggest that there are dependencies between the components. If there is knowledgebased dependency between IR and CR, Waller (1993) predicts a positive association between IR and CR. Messier and Austen (2000) also tested the association between IR and CR. The model is not suitable for the evaluation of business risk, which requires an understanding of the company’s environment and professional judgement. The audit risk model also ignores nonsampling risks. The limitations, if understood, will minimize excess reliance on components of the audit risk model when such reliance is not justified.

8-20 Why are the quality of corporate governance and the audit committee a significant determinant of the auditor’s risk assessment of an entity?

Answer 8-20 Corporate governance and the audit committee play an oversight role in the areas of corporate financial reporting, control mechanisms and auditing. The audit committee is critical in overseeing the financial reporting process and provides independent review of this process.

Risk management process and control, particularly of financial reporting risks, are within the oversight activities of the audit committee. As part of its function, the audit committee should develop a process for risk identification and risk management in the context of a company’s overall control environment. Risk management consists of identifying risks that may prevent a company from achieving its objectives, analyzing those risks and trying to find appropriate solutions to avoid or to control them.

If the company’s corporate governance and audit committee perform their responsibilities properly with regard to risk management, internal control systems, monitoring of compliance with laws and regulatory requirements and the code of conduct, this significantly contributes to the auditor’s performance and particularly his/her assessment of the company’s risk. Risk assessment is considered as an important element in determining the scope of the auditing procedures and has important audit efficiency and effectiveness implications.

The audit committee also plays an important role in enterprise risk management (ERM) which concerns new ways to manage and optimize the risks of most importance to the board of directors and management. This approach takes into account corporate elements such as strategy, processes, planning and control, people, technology and knowledge to evaluate and manage the uncertainties facing a company. The actions taken by the audit committee and their risk assessments provide useful information for the external auditors.

81 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Discussion Questions 8-21 When planning the audit, the independent auditor considers what would make the financial statements materially misstated. Can an audit be conducted efficiently without specifying materiality before starting specific audit procedures? Explain.

What is the risk to the audit if materiality is not specified in advance of conducting audit procedures?

Answer 8-21 Materiality is an important concept throughout the audit process. This has a particular importance when designing the audit planning. Materiality should be considered by the auditor when determining the nature, timing and extent of audit procedures, and evaluating the effect of misstatements. Materiality directly influences audit risk. The auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements. The auditor’s assessment of materiality, related to specific accounts, balances and classes of transactions, helps the auditor to determine what items to examine and whether to use sampling and analytical procedures. This enables the auditor to select audit procedures that, in combination, can be expected to reduce audit risk to an acceptably low level. Materiality and audit risk are interrelated and an external auditor considers them at two levels: that of the overall financial statements, and in relation to the individual classes of transactions, account balances and disclosures and the related assertions. The auditor seeks to restrict risks at the individual class of transaction, account balance and disclosure level, so he or she can express an opinion on the financial statements taken as a whole at an acceptably low degree of audit risk.

In the absence of materiality assessment, the auditor will be obliged to increase the volume of audit activities and this will considerably affect the audit budget and timing. At the same time, this may have some effect on the audit quality and performance.

8-22 The audit risk model operationalizes a risk-based approach of selecting the amount of detailed testing necessary for an audit to be effective.

Discuss the following: (a) The components of the audit risk model. (b) The relationship between these components. (c) What criticisms can be made of the audit risk-based approach?

Answer 8-22 The audit risk model (ARM) serves as the major conceptual framework for the audit process. It is used by auditors in identifying three major components of risks associated with a company’s financial statements. The model should help the auditors to limit uncertainty about material misstatements in their assessment of a company’s accounts and financial statements. (a) The audit risk model decomposes the components of audit risk as inherent risk (IR), control risk (CR) and detection risk (DR). The audit risk (AR) is defined as the risk that the auditor might unknowingly fail to modify the opinion on materially misstated financial statements; IR is the susceptibility that material misstatements will occur assuming no related internal controls; CR is the risk that material misstatements that could occur will not be prevented or detected on a timely basis by internal controls and detection risk (DR) is the risk that the auditors’ tests will not detect a material misstatement in the financial statements. It includes analytical procedures risk and tests of detailed risk.

82 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(b) The ISA 400 of the IFAC (2004) stresses the interrelationship of the components of audit risk. For example, inherent risk and control risk are the company’s risks, and they exist independently of the audit of the financial statements. A number of research papers also suggest that there are dependencies between the three components of audit risk. According to Waller (1993) a knowledge-based dependency between IR and CR creates a positive association between IR and CR. Messier and Austen (2000) also looked at the relationship between IR and CR. (c) The students should also read the section of the limitations of the audit risk-based approach in the chapter (pp. 223–226) and refer to research papers discussing this question. The criticisms are mainly related to the limitations of this approach as it only expresses the general relationship of the risks associated with the auditor’s assessment of inherent and control risks. The independence of audit risk components can also be put under question. It does not also consider the business risk and several other factors involving the auditor’s professional judgement about the company’s environment. These limitations considerably affect the audit scope and the auditor’s examination of the company’s financial statements.

8-23 How are risks and controls related? Why is it important to assess risks before evaluating the quality of an organization’s controls?

Discuss the auditor’s risk assessment procedures and the measures that should be taken, particularly with regard to the company’s activities and the internal control systems.

Answer 8-23 Controls exist to address risks and the external auditor should try to perform the preliminary assessment of risk factors before evaluating the quality of an organization’s controls.

The company usually faces various types of risks from internal and external sources. The risks associated with the efficiency of a company’s internal control systems is only a part of the risk the organization faces.

A company’s risk assessment is a means of identifying and analyzing relevant risks to the achievement of financial reporting control objectives, and it forms the basis for determining how risks should be managed. The internal controls systems are part of the mechanisms to keep the company on course towards growth and profitability and the achievement of its mission. The internal control system enables management to deal with rapidly changing economic and competitive environments, selecting the best options and planning for growth. This system also provides the mechanisms required to understand risks in the context of the entity’s objectives, and for this purpose the management will put internal control activities in place and monitor and evaluate them.

If the auditor concludes that the control risk is high, then all the necessary audit evidence will have to be obtained by performing substantive procedures. The external auditor performs different types of tests on a company’s control systems to check their appropriateness. As expected, a higher control risk has been associated with a higher detected error rate. If the number of errors detected by the external auditor is within an acceptable and expected level of errors, the external auditor will consider this as evidence supporting the initial judgement of control risk. Conversely, if the number of errors detected is higher than expected, or if the nature of these errors creates concern for the auditor, the level of control risk may have to be reassessed. Some control risk will always exist because of the inherent limitations of internal control.

83 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

8-24 The risk model from the chapter can be restated as follows: AR = IR × CR × DR where: AR = audit risk IR = inherent risk CR = control risk DR = detection risk Using the audit risk model, compute the detection risk for the following values of audit risk, inherent risk and control risk. Then answer the questions below.

Types of risks

Case 1

Case 2

Case 3

Audit risk

5%

10%

1%

Inherent risk

25%

30%

50%

Control risk

50%

50%

15%

(a) Which of the above cases shows the highest (lowest) detection risk? What is the significance of these results in terms of evidence gathering by the auditor? (b) Describe the factors affecting the interpretation of these results. (c) Consider the results obtained for the cases 1 and 3. In your opinion, which of these two cases would require more audit effort?

Answer 8-24 Using the following formula, the results of detection risk are as follows: DR =

AR IR × CR

or Detection Risk = Acceptable Audit Risk / Inherent Risk × Control Risk

Detection risk

Case 1

Case 2

Case 3

40%

67%

13%

(a) Detection risk bears an inverse relationship to the assessment of the risk of material misstatement at the assertion level. This implies that the greater the risk of material misstatements, the less detection risk that can be accepted, and vice versa.

The above results indicate that the highest detection risk is found for Case 2. This enables the auditor to gather relatively less audit evidence to achieve the desired level of audit risk.

The lowest detection risk is found for Case 3 where the auditor will have to gather relatively more audit evidence to achieve the desired level of audit risk.

84 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(b) The interpretation of the above results is subject to several factors such as the materiality of the overall audit and tolerable error for individual accounts. If there is a low detection risk combined with a relatively high threshold for materiality, the auditor needs to gather less audit evidence than if materiality were set at a low level. (c) More audit effort concerns less required detection risk. Case 1 with 40% detection risk will require relatively less effort than Case 3. This enables the auditor to gather relatively less audit evidence for Case 1 to achieve the desired level of audit risk.

85 .

CHAPTER 9

AUDIT SAMPLING TECHNIQUES Instructor guidance This chapter presents an extensive discussion of statistical and non-statistical sampling and discusses the various sampling methods for testing controls, looking for evidence of fraud and testing the accuracy of account balances. It also explains the circumstances in which different sampling plans are appropriate. The chapter emphasizes the importance of sampling techniques in audits of financial statements.

The chapter also extensively covers judgemental sampling, and the instructor should contrast this method with statistical sampling. This discussion helps to determine the appropriate sampling methodology when conducting the audit. The students should understand that statistical sampling does not replace judgement. Rather it provides a framework that permits rational audit judgement to be consistently applied. It is therefore important to highlight the differences between sampling and non-sampling risks.

The steps in the statistical sampling process should also be discussed and the students should understand how the various judgements, the auditor has to make, (tolerable error rate, expected error rate, etc.) affect the required sample size. The chapter presents probability proportional to size (PPS) sampling and provides a comparison between PPS and classical sampling. These materials are increasingly used in practice.

The chapter is written in a practical way as sampling is widely used in audits to gather evidence to reach conclusions about the correctness of account balances, the operation of controls or the evidence of fraud. With regard to non-sampling risk, it would be good to remind students that audit firms adopt the appropriate methods to try and minimize this type of risk. The instructor should also point out that the risk of non-sampling risk would exist even if the auditor examined 100% of the client’s transactions.

Similar to other materials in the textbook, the content of the chapter is written for upper undergraduate and graduate students who have already taken the statistical course(s). However, for those students who do not have sufficient background in this field, the instructor should recommend them to review statistical concepts, and proceed rather slowly through this chapter.

86 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 9-1

Define audit sampling. Is selecting all of the items within a population appropriately described as a method of sampling? Explain.

Answer 9-1 The auditor constantly faces the challenge of gathering sufficient competent evidence as efficiently as possible. Audit sampling is a useful tool to obtain objective evidence about the correctness of an account balance or the correctness of processing. It is the application of an audit procedure to less than 100% of the items within an account balance or class of transactions so that all sampling units have a chance of being selected. The objective of sampling is to estimate the amount of misstatement in an underlying population such as an account balance.

Because of cost constraints, it is impractical to examine all of the company’s accounting information. The auditor has neither the time nor the budget to verify all a company’s accounting operations, and at the same time he/she must reach conclusions about the accuracy of the underlying populations that make up an account balance. Audit sampling enables the auditor to obtain and evaluate audit evidence about characteristics of the items selected while forming a conclusion concerning the population from which the sample is drawn.

9-2

Why is it so important to specify the audit objective before designing a sampling application?

Answer 9-2 An audit of a company’s financial statements is a costly operation and at every step the auditor must select the most suitable way to achieve his/her objectives. To perform an efficient and effective audit, the auditor must review the different steps in the company’s information process. When designing audit procedures, the auditor should determine appropriate means for selecting items for testing so as to gather audit evidence to meet the objectives of the audit test. In the absence of a specific audit objective, it is rather difficult to determine characteristics of a sample representative of the population. Moreover, in order to minimize the risk of drawing erroneous conclusions about the company’s accounting operations, the auditor must first define clear objectives for gathering sufficient competent evidence. This includes reliable evidence on the degree to which the client’s internal controls prevent or detect misstatements for any given class of transactions.

9-3

Distinguish between sampling risk and non-sampling risk. How can each be reduced?

Answer 9-3 Sampling risk is the risk that an auditor draws a conclusion from a sample that is not representative of the population. This type of risk exists because sample characteristics rarely match population characteristics exactly, yet sample results are projected to the population. The sampling risk is associated with the possibility that the auditor’s conclusion, based on a sample, may be different from the conclusion reached if the entire population were subjected to the same audit procedure. Increasing the sample size decreases sampling risk. In performing an audit of financial statements, the auditor can control how much risk he or she is willing to take that the sample taken might not be representative.

There are two types of sampling risks: sampling risks related to tests of control procedures and sampling risks related to substantive testing. Sampling risks related to tests of control procedures which are used to assess the effectiveness of controls over processing but if the 87 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

sample is nonrepresentative, the auditor risks assessing control risk too high or too low.

Sampling risks related to substantive testing can be used to estimate the amount of misstatement in an account balance. In this type of risk, the auditor is usually more concerned with the effectiveness of the audit as there is a risk of incorrect acceptance, which can lead to legal damages, loss of reputation and loss of clients.

In determining sample size, the auditor is influenced by two major factors: tolerable misstatement and the confidence level. The first is related to how big of a misstatement would make a difference to the auditor’s overall assessment of the account balance or the correctness of processing. The second concerns the correctness of the inference about population values based on the examination of sampled items.

9-4

Explain the characteristics of statistical sampling in auditing.

Answer 9-4 Statistical sampling is defined by any approach to sampling that has the following characteristics: (a) random selection of a sample; and (b) use of probability theory to evaluate sample results, including measurement of sampling risk.

Although statistical sampling has the theoretical basis, it is important that auditors understand the judgements required to use statistical sampling procedures effectively. Even if an auditor uses statistical sampling, he/she must still decide on a tolerable misstatement amount, assess related inherent and control risks and respond appropriately to test results.

9-5

What are the principal methods of selecting sample? Explain each of them briefly.

Answer 9-5 The principal methods of sampling can be classified under statistical and nonstatistical sampling. The major statistical sampling methods consist of the following: •

Random number sampling: every item in the population has an equal probability of selection regardless of its individual attributes;

•

Systematic selection: selecting every nth item in the population from one or more random starts;

•

Stratified sampling: dividing a population into discrete sub-populations that have an identifying characteristic;

•

Cluster or multistage sampling: this method is used when documents and records are so scattered or dispersed that random number or interval sampling would be arduous;

•

Value-weighted selection: used in identifying the sampling unit as the individual monetary units (e.g. dollars), particularly in substantive testing.

The non-statistical sampling methods consist of: •

Haphazard selection: selecting a sample without following a structured technique;

•

Block selection: applying audit procedures to items such as accounts, all of which occurred in the same ‘block’ of time or sequence;

•

Judgemental sampling: an auditor uses his/her judgement based on materiality and risk factors.

88 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

9-6

What are the benefits to the auditor in using statistical sampling?

Answer 9-6 Following the recent high profile financial failures, auditors are increasingly recognizing the need to perform detailed tests of account balances in lieu of overreliance on analytical procedures. The auditor is also required to test the operation of controls in order to attest to the effectiveness of a company’s internal controls. Statistical sampling helps auditors to perform audit tests and these allow them to control the risk that they might reach an incorrect conclusion.

The major advantage of statistical sampling is that it is possible to measure the reliability of the estimates computed from the sample results. This leads to the selection of a sample that corresponds to the desired reliability. Statistical sampling provides more objectivity, less likelihood of over- or under-auditing, better work paper documentation and greater confidence in the audit opinion.

9-7

Discuss the factors influencing sample size for (a) tests of control and (b) substantive procedures.

Answer 9-7 The auditor can use sampling to assess the effectiveness of controls over processing and also to estimate the amount of misstatement in an account balance. The auditor is generally influenced by two major factors in determining sample size. The first is related to tolerable misstatement and this shows how big a misstatement would make a difference to the auditor’s overall assessment of the account balance or the correctness of processing. The second is related to the confidence level needed in the correctness of the inference about population values based on the examination of sampled items.

With regard to tests of control procedures, if the sample is non-representative, the auditor risks assessing control risk too high, which leads to audit inefficiency, or assessing control risk too low, which shows that the auditor will rely on ineffective control procedures. This increases detection risk (see Figure 9.1).

In the case of substantive testing (see Figure 9.2) there is the risk of incorrect acceptance (audit ineffectiveness) which can result in the auditor being sued, experiencing diminished reputation and losing clients. On the other hand, there is the risk of incorrect rejection of a population that does not contain a material misstatement. This can make the audit inefficient and put the auditor under client pressure to perform additional work to correct the inappropriate inference.

9-8

What are the main characteristics of the population?

Answer 9-8 The population is that group of items that make up a class of transactions or an account balance that the auditor wants to test. The population should be appropriate to the objective of the sampling procedure. The completeness of the population is also important since if the population used in sampling is not correctly defined, or is incomplete, the audit conclusion may be wrong. For example, if the auditor intends to use the sample to draw conclusions about the operation of an accounting and internal control system during the financial reporting period, the population needs to include all relevant items from the entire period. A different approach may be to stratify the population and use sampling only to draw conclusions about the control during, say, the first ten months of a year, and to use other procedures or a separate sample for the remaining two months.

9-9

What are the features of (a) attribute sampling, and (b) variables sampling? Identify their differences in terms of objectives.

Answer 9-9 One of the most common applications of sampling is for tests of process controls and individual transactions. The sampling approach used for these audit procedures is designed to determine if a specific attribute of interest is present in a transaction. The attribute sampling

89 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

method may also be used for tests of transactions because it measures the frequency of occurrence. This sampling method is also designed to answer ‘how many?’. When the auditor is using sampling to test internal controls, the auditor tests to determine if an item was processed correctly or incorrectly. No degrees of error exist. The response will be ‘yes’ or ‘no’.

Variable sampling, in contrast, is most frequently used to test the monetary value of account balances or transactions. This sampling method is applied when the auditor desires to reach a dollar or quantitative conclusion about a population. Variable sampling applications are designed to answer the question ‘how much?’. Under this approach, normal distribution theory is used in evaluating the characteristics of a population based on the results of a sample drawn from the population.

9-10 What factors would an auditor consider when deciding whether to use statistical or non-statistical sampling?

Answer 9-10 Both statistical and non-statistical approaches require the auditor to use professional judgement in planning, performing and evaluating a sample and in relating the evidential matter produced by the sample to other evidential matters when forming a conclusion about the related account balance or class of transactions. However, the following factors should be considered when choosing between statistical and non-statistical sampling: •

Does an auditor need to quantify sampling risks?

•

Has the audit staff been sufficiently trained to properly implement statistical sampling?

•

Does an auditor accept to bear the additional costs of designing, selecting and evaluating a statistical sample?

•

Can the auditor use computer software in designing, selecting, and/or evaluating the sample?

9-11 What type of actions should an auditor take when errors are detected in the sample results?

Answer 9-11 The auditor should consider the nature and cause of any errors identified and their possible effect on the particular test objective and on other areas of the audit.

The auditor also needs to consider matters such as: •

the direct effect of identified errors on the financial statements; and

•

the effectiveness of the accounting and internal control systems and their effect on the audit approach when, for example, the errors result from management override of an internal control.

In analyzing errors, the auditor may observe an underlying common feature, for example, type of transaction, location, product-line or period of time. Under such circumstances, the auditor may decide to identify all items in the population that possess the common feature, and extend audit procedures in that stratum.

9-12 Discuss the application of probability proportional to size sampling (PPS) in auditing.

Answer 9-12 Probability proportional to size sampling (PPS) has been developed especially for use in auditing. This method was designed to test for overstatements in situations when few misstatements are expected. PPS sampling enables the auditor to make conclusions about the total monetary amount of misstatements in a population

90 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The main area of the application of PPS is when the auditor decides to use statistical sampling on populations of account balances or classes of transactions that normally contain a few overstatements, some of which may be large. Unless the population is stratified, the classical statistical sampling procedures may not be appropriate. Mean estimation sometimes proves to be inefficient because of large sample sizes. Allowance for sampling risk intervals cannot be calculated for ratio and difference estimation unless there are at least 30 differences between book and audited amounts in the sample.

9-13 Explain the evaluation of the sample results in the PPS method. What is tainting age and how is it determined?

Answer 9-13 PPS sample selection is based on random dollars or a systematic process with a random start. Each dollar in the population has an equal chance of being selected. In evaluating the results of the sample in the PPS method, the auditor calculates an upper misstatement limit (UML) from the sample data and compares it with the tolerable misstatement specified in designing the sample.

When the auditor analyzes misstatements of lower-stratum items, he/she can identify the percentage that the book value of each misstated sample item is overstated or understated (referred to as the tainting percentage). The tainting percentage found in each lower-stratum sample item is presumed to be representative of the interval from which it was selected. This can also be expressed in terms of tainting age which defines the age that the book value of each misstated sample item is overstated or understated. Its calculation is as follows: Tainting age = (book value – audit value) ÷ book value 9-14 When using non-statistical sampling, what are the steps to follow? Why is the auditor’s professional judgement important in determining sample size and sample selection method?

Answer 9-14 Non-statistical sampling is the determination of sample size or the selection of the sampled items using judgemental reasoning rather than probability concepts. This type of sampling is also called judgemental sampling and is considered an important tool in the auditor’s sample selection and evaluation procedures.

There is no way to mathematically control for sampling risk in a non-statistical sample; the auditor can only project the detected misstatements and make a judgement as to whether the account is likely to be materially misstated. This may lead the auditor to perform more audit work.

The same audit considerations as those used for statistical sampling are applied to nonstatistical sampling. These are as follows: •

Determine sample size: all significant items should be tested.

•

Select the sample: the auditor must select a sample that is representative of the population by using, for example, random-based methods or haphazard selection, which means selecting a sample without following a structured technique.

•

Evaluate the sample results: the misstatements found in the sample must be projected on to the population and consideration given to sampling error before reaching a conclusion.

The auditor can use both statistical and non-statistical approaches in the audit of financial statements. However, in both cases, the auditor must use professional judgement in planning, performing and evaluating a sample and in relating the evidential matter produced by the sample to other evidential matters when forming a conclusion about the related account balance or class of transactions.

91 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

9-15 What is meant by haphazard sample selection? Can it be used for statistical sampling? Explain why or why not.

Answer 9-15 Haphazard selection involves the selection of sample items without any conscious bias and without following a structured technique. Although no structure is used, the auditor nonetheless avoids any conscious bias or predictability (e.g. avoiding items that are difficult to locate, or always choosing or avoiding the first or last entries on a page) and so attempts to ensure that all items in the population have a chance of selection. As an example, an auditor may select disbursement vouchers from a filing cabinet, without regard to their size or location, as a haphazard sample.

Haphazard selection is not random based and not selected on defined probability concepts. For this reason, this method is not appropriate when using statistical sampling. It is mostly used for non-statistical sampling and is permitted if the auditor expects it to be representative.

9-16 Assume that you are auditing a random sample of 100 sales vouchers and find one improperly authorized error. The achieved upper limit of control failures is 4.7% at a 5% risk of assessing control risk too low. What does this achieved upper limit mean? How do you decide whether this result indicates that the control is working as expected?

Answer 9-16 The achieved upper limit or upper deviation rate indicates the maximum deviation rate in the population based on the number of deviations discovered in the sample. Referring to the Figure 9.11 with regard to the sampling risk of assessing control risk too low, (sample size 100, 5% risk of overreliance) the achieved upper limit means that there is only a 5% chance that the failure rate (the percentage of time the control procedure fails to operate properly) in the population exceeds 4.7%. The auditor compares the upper limit with the tolerable rate. If it exceeds the tolerable rate, the auditor should conclude that the control procedure is not working as effectively as expected and revise the assessment of control risk.

Discussion Questions 9-17 The risk that an error is not identified through sampling is generally considered as sampling risk. This relates to the probability that a misstatement exists in the population but is not selected in an auditor’s sample. In contrast, the non-sampling risk is related to an auditor’s failure to recognize errors, for instance, by misinterpreting the results of audit procedures or failing to use or conduct an effective test.

Discuss the criticisms of auditors, particularly with regard to claims of auditor negligence. Do you believe that either of the above scenarios (sampling and non-sampling risks) can justify the auditor’s failure? If so, why? What type of measures can be taken by auditors to protect themselves against both of these risks?

Answer 9-17 In the case of sampling risk, unless auditors examine 100% of a population, there is some risk that the items selected might not be representative of the overall population. It can happen with any selection process. It is important for the auditor to determine how to minimize the risk that a selected sample might not be representative. In most cases, the auditor is able to defend himself or herself by saying that sampling risk led to the failure to detect misstatements.

Statistical sampling decisions, by definition, allow for a 5 or 10% risk of drawing an incorrect inference. For a sampling risk defence to be successful, auditors must carefully perform sample selection and examine all items in the sample and choose the corresponding procedures in gathering evidence to evaluate the correctness of a transaction. The audit firm should control the possibility that a misstatement exists in the population but is not selected in an auditor’s 92 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

sample through proper training, adequate supervision, and carefully designed audit programs. If the auditor uses statistical sampling techniques, such as attributes sampling and dollar-unit sampling, this would make sampling risk defences easier in some cases.

Non-sampling risk includes all the aspects of audit risk that are not due to sampling. It cannot be quantified but can be minimized by improving the quality control procedures of the audit firm. In the case of non-sampling risk, if the auditors have evidence of a misstatement in their sample but fail to detect it, it would be rather difficult to defend such a case in legal action taken by the third parties or regulatory bodies. In order to reduce non-sampling risk, audit firms should do their best to improve the system of quality control, use an effective audit approach, and pay sufficient attention to training of employees and maintaining a good working environment for them. However, an audit firm may refer to a lack of co-operation of the company’s management, or demonstrate collusion by management or the complexity of the company’s operations as the lines of defence in the court.

9-18 Do the professional auditing standards require or support the use of non-statistical sampling for substantive testing? Explain the circumstances in which nonstatistical sampling might be used?

Answer 9-18 Judgemental sampling can provide auditors with some clues as to whether to proceed with a statistical sample. It may be used to select examples of deficiencies to support the auditor’s contention that an accounting system is weak. Judgemental sampling has its place in the audit process, so long as the auditor is aware of its limitations.

Sampling and non-sampling methods are similar regarding the actual audit procedures performed on the items in the sample in the sense that both approaches require auditor judgement during the planning, implementation and evaluation of the sampling plan. Auditors may use judgemental sampling when the auditor’s client has implemented well-designed and well-controlled accounting systems for the detection of errors. In such cases, the external auditor can save a great deal of time performing extensive tests by selecting a small sample at random, which provides some reasonable representation of the population. In the case of tests of control, the auditor’s analysis of the nature and cause of errors will often be more important than the statistical analysis of the mere presence or absence (that is, the count) of errors. In such a situation, non-statistical sampling may be more appropriate.

9-19 Discuss the advantages and disadvantages of the PPS method. How does this method differ from the classical methods in terms of audit objective? How does the selection of a sample differ between the classical variable sampling and PPS sampling? What are the potential implications of this difference on the detection of understatements in the population?

Answer 9-19 The PPS method has been defined on pp. 262–263 of the chapter. A comparison of PPS and classical sampling was also made on pp. 263–264. The major advantages of PPS sampling over other statistical methods include the following: •

PPS sampling is generally easier to use than classical variables sampling.

•

The size of a PPS sample is not based on any measure of the estimated variation of audit values.

•

The PPS method does not require calculation of the standard deviation to determine sample size or evaluate sample results. With PPS, the sample size is based on the key items of audit interest (tolerable misstatement and the test of details risk or the risk of incorrect acceptance).

93 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

Designing, selecting and evaluating the sample are relatively simple and can be done without computer assistance.

•

PPS sampling automatically results in a stratified sample.

•

PPS systematic sample selection automatically identifies any item that is individually significant if its value exceeds an upper monetary cut-off.

•

Testing can begin before the population is complete. For example, to audit fixed asset additions, the auditor could use the sampling interval and select and audit a sample of additions before the year’s end and finish the process after year’s end.

•

Sample sizes are relatively small when few or no misstatements are expected because of its automatic stratification, which also contributes to audit efficiency.

•

It can be applied to a combination of account balances. Accounts can be tested together because the sampling units are dollars.

•

It directly controls for the most important sampling risk, the risk of incorrect acceptance.

Some of the disadvantages of PPS sampling are as follows: •

It includes an assumption that the audit value of a sampling unit should not be less than zero or greater than book value. When understatements or audit values of less than zero are anticipated, special design consideration may be required.

•

As the number of misstatements increases, sample size increases, and sample size may be larger than the sample size computed under a classical variables application.

•

When frequent misstatements are found in the sample, PPS sampling tends to be very conservative and may cause the auditor to conclude that the account balance contains a material misstatement when, in fact it does not. This causes the auditor to reject a fairly stated client book value (called the risk of incorrect rejection).

•

It cannot be applied to accounts or physical units with zero or negative balances. Also, understated physical units have a lower probability of selection. PPS sampling is easier to use when the small number of expected misstatements will be overstatements.

The fundamental difference between classical statistical sampling methods and PPS is that PPS sampling is based on attribute sampling theory, whereas classical variables sampling is based on normal distribution theory. PPS sampling enables the auditor to make dollar conclusions about the total monetary amount of misstatement in a population. Unlike classical sampling techniques, which focus on physical units of the population such as sales invoices or disbursement vouchers, PPS sampling focuses on the monetary units of a population.

If the monetary amount of the misstatements is not large and the misstatements are few, the PPS method has some advantages over mean, ratio and difference estimations. This sampling method is more likely to result in the selection of a few large overstatements, should such a condition exist in the population.

94 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

9-20 In evaluating the results of the sample in the PPS method, the auditor calculates an upper misstatement limit (UML) from the sample data and compares it with the tolerable misstatement specified in designing the sample.

Discuss the following questions: (a) What are the major factors involved in calculating the UML? (b) What do tainting age and basic precision mean? (c) What courses of actions might an auditor take if the UML exceeds tolerable misstatement? (d) Are these options available when using non-statistical sampling and the sample evaluation indicates a possible material misstatement in the population?

Answer 9-20 The upper misstatement limit (UML) is the maximum potential amount of misstatement in a population based on sample results at a specified level of test of details risk.

It is the sum of the basic precision, most likely misstatement, and the incremental allowance for sampling error. (a) The UML is calculated as follows: UML = PM + ASR where PM = Total projected misstatement in the population ASR = Allowance for sampling risk The UML, PM and ASR factors, respectively, are analogous to the upper deviation limit, sample deviation rate, and allowance for sampling risk used in evaluating the results of an attribute sampling. However, in PPS sampling, each factor is expressed as a monetary amount rather than as an age. The evaluation differs in PPS sampling, depending on whether any misstatements are found in the sample. (b) Tainting age defines the age that the book value of each misstated sample item is overstated or understated. For each logical unit with a book value less than the sampling interval that contains a misstatement, a tainting age (TP) and projected misstatement are calculated as follows: Tainting age = (book value – audit value) ÷ book value Projected misstatement = tainting age × sampling interval The basic precision is the amount of uncertainty associated with testing only a part of the population (sampling error). It is equal to the UML if non errors are found in the sample. The basic precision (BP) is one of the two components of allowance for sampling risk (ASR) as the following formula shows.

ASR = BP + IA where BP = Basic precision IA = Incremental allowance for sampling risk

95 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(c) If the achieved upper limit exceeds the tolerable rate, the auditor should either (1) test a compensating control or (2) adjust the nature, timing, and/or the extent of the related substantive testing of the financial statement accounts. (d) When using non-statistical sampling, the auditor should also calculate projected misstatement and upper limit. In non-statistical sampling the upper limit should also be compared to tolerable misstatement when determining the possibility of a material misstatement in the accounts. In such case, the evaluation process involves a comparison of the projected misstatement with tolerable misstatements without considering sampling error.

96 .

CHAPTER 10

EVIDENCE AND DECISION MAKING IN AUDITING Instructor guidance The audit of financial statements is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria. In planning an audit, three basic questions need to be answered: what procedures should be performed, how much evidence is needed and when should the procedures be performed? Evidence collection and judgement is an important step in the audit of financial statements; firstly, for deciding the nature, timing and extent of audit procedures and second, as the basis of audit conclusions upon which the auditor forms an opinion.

This chapter provides an overview of the theoretical and practical aspects of audit evidence in audits of financial statements. It also discusses the audit decision-making process, judgement making and the effects of the decision heuristic. The chapter discusses the concepts of audit evidence and audit procedures for obtaining audit evidence. Evaluating audit evidence and electronic evidence as well as selecting items for testing in gathering audit evidence are also explored.

The instructors need to ensure the following when discussing audit evidence: (1) Define the concept of audit evidence and provide some examples. The discussion on theoretical aspects of audit evidence on pp. 283–284 is also useful to provide a rational basis for forming judgements.

(2) Emphasize the persuasive role of evidence and discuss the conditions under which reliable audit evidence will be obtained.

(3) Stress that different audit objectives are served by different forms of evidence; some forms of evidence serve more than one objective.

(4) Emphasize the importance of electronic audit evidence and the auditor’s role in examining the company’s security of information policies and controls.

The second part of this chapter refers to the decision-making process in auditing, a topic that is rarely discussed in auditing textbooks. The instructors need to explain the sequential nature of this process and the fact that the auditor’s decisions are subject to environmental factors. The discussion on auditors’ professional judgement and the importance of using the knowledge of the business in this regard must be stressed. The students must understand that the auditor uses his/her judgement in the whole audit process including audit planning, assessing risks, evaluating audit evidence and assessing the company’s accounting policies and internal control systems. The last part of this chapter is related to bounded rationality and heuristics in auditing.

Although it seems that these materials are rather theoretical, an understanding of heuristic contributes to a better understanding of an auditor’s decision making, and is useful for forewarning auditors of problems that may affect their ability to analyze evidence and reach appropriate conclusions.

97 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 10-1 What are the basic sources of audit evidence?

Answer 10-1 The independent auditor obtains audit evidence from an appropriate mix of tests of controls and substantive procedures. Audit evidence, which is cumulative in nature, includes that obtained from audit procedures performed during the course of the audit and from other sources.

In performing the audit of financial statements and reaching an overall conclusion on the fairness of a company’s financial statements, the auditor accumulates evidence from a number of different sources. The following sources are essential in planning an audit of financial statements: •

Knowledge of business, industry and other environmental factors;

•

Testing accounting records including electronic documents regarding direct tests of account balances and transactions;

•

Tests of control and transactions processing;

•

Analytical procedures, including comparison of the company results with (a) industry, (b) the company’s past results and (c) expectations;

•

Previous audits;

•

The firm’s quality control procedures for client acceptance and continuance.

10-2 What are the characteristics of reliable audit evidence?

Answer 10-2 The reliability of audit evidence is an important quality characteristic in auditing and it is generally influenced by its source and by its nature. The major characteristics of reliable audit evidence are as follows: •

Audit evidence is more reliable when the independent auditor obtains consistent audit evidence from different sources or of a different nature;

•

Evidence from independent outside sources is more reliable than that from internal sources;

•

Audit evidence that is generated internally and is based on an effective well-controlled information system is more reliable than evidence derived from a poorly or easily overridden information system;

•

Directly observable evidence (e.g. observation of the application of a control) is more reliable than audit evidence obtained indirectly or by inference (e.g. an inquiry about the application of a control);

•

Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles; 98 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other media (e.g. a contemporaneously written record of a meeting is more reliable than a subsequent oral representation of what was discussed).

10-3 Describe the assertions used by the external auditor in the audit of financial statements.

Answer 10-3 The assertions form the framework for gathering sufficient, competent audit evidence as required by the professional standards. The auditor uses management’s assertions for classes of transactions, account balances and presentation and disclosures in sufficient detail to form a basis for the assessment of risks of material misstatement and the design and performance of further audit procedures.

Based on AUS 502 (2005), issued by the Auditing and Assurance Standards Board, the following assertions are used by the auditor under the categories of classes of transactions, account balances, presentation and disclosures. The definition of each assertion is indicated on pp. 284–285 of the chapter. Note that the definition of assertions changes according to different categories used by the auditor.

•

Assertions about classes of transactions and events for the period under audit include occurrence, completeness, accuracy, cut-off and classification;

•

Assertions about account balances at the period end include existence, rights and obligations, completeness, valuation and allocation;

•

Assertions about presentation and disclosure consist of occurrence, completeness, classification and understandability and accuracy and valuation.

10-4 Provide some examples of the audit evidence in different stages of audit process.

Answer 10-4 The examples of audit evidence include the following: •

Knowledge of the business, industry and characteristics of the client in the acceptance/retention stage;

•

Evidence regarding the likely effectiveness of particular internal control procedures in the audit-planning stage;

•

Evidence concerning the effectiveness of internal controls and whether a particular control procedure is or is not supervised in the control-testing stage;

•

The existence or occurrence of evidence showing whether assets or liabilities of the entity exist at a given date in the substantive-testing stage;

•

Evidence regarding the completeness, validity and accuracy of the financial statements as a whole in the opinion-formulation stage.

10-5 Are inquiries of management considered reliable evidence? Under what conditions and for what assertions would inquiry of management be considered reliable evidence?

Answer 10-5 In preparing and presenting the company’s financial accounts and reports, management implicitly or explicitly makes assertions regarding the recognition, measurement, presentation and disclosure of the various elements of a financial report and related disclosures.

The auditor generally uses management’s assertions for classes of transactions, account balances, and presentation and disclosures. However, inquiries of management are subject to

99 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

management bias and rarely can be used without corroborating evidence. Auditors need to assess the quality of management responses and evaluate the integrity of management and the potential motivation to misstate an account balance.

Auditors can use the management assertions regarding corroborating evidence on valuation and existence issues, for example, accounts receivable. Nevertheless, they need to make sure of the validity of management assertions by outside evidence. Corroborating information obtained from a source independent of the company may increase the assurance the auditor obtains from a management representation.

10-6 Describe the sufficiency and appropriateness of audit evidence.

Answer 10-6 Sufficiency and appropriateness of audit evidence are interrelated factors and measure the quantity and quality of evidence respectively. The quantity of evidence needed depends on the risk of misstatement (the greater the risk, the more evidence is required), as does the quality of such evidence (the higher the quality, the less is required). Both show the extent to which particular audit evidence is relevant and reliable to provide support for, or detect misstatements in, classes of transactions, account balances and disclosures and related assertions. Independent auditors use professional judgement in determining the quantity and quality of audit evidence to support the audit opinion. Conditions such as the independence of the sources of audit evidence and an efficient, well-controlled information system within the company greatly contribute to the reliability of audit evidence. Sufficiency and appropriateness can usually be provided when the independent auditor obtains consistent audit evidence from different sources or of a different nature.

10-7 List and describe the procedures used in gathering audit evidence.

Answer 10-7 The auditor uses the following procedures to obtain audit evidence: •

Inspection: consists of examining records, documents, or tangible assets, whether internal or external, in paper form, electronic form or other media.

•

Observation of client personnel and procedures: consists of looking at a process or procedure being performed by others, for example, watching the counting of inventories by the entity’s personnel or the performance of control procedures that leave no audit trail.

•

Inquiry: consists of seeking information from knowledgeable persons inside or outside the entity.

•

Reprocessing transactions: by tracing documents from origin through accounting records to the general ledger.

•

Vouching of transactions: by selecting recorded transactions and tracing backward through accounting records to original documentation.

•

Confirmation: is the process of obtaining a representation of information or of an existing condition directly from a third party. It consists of the response to an inquiry to corroborate information contained in the accounting records.

•

Computation or recalculation: consists of checking the arithmetical accuracy of source documents and accounting records or of performing independent calculations.

•

Re-performance: is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control.

•

Analytical procedures: consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data.

100 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

10-8 Discuss the importance of electronic audit evidence in the audit process.

Answer 10-8 In line with ever-increasing technological developments, the audit process has evolved from the traditional manual audit of paper documentation to auditing through the computer, and is moving towards a paperless, electronic, online, real-time continuous audit.

Computers are changing the techniques of accumulating, manipulating and disseminating accounting data. Electronic audit evidence, which is presented in a digital form whose logical structure is separate from the information, has an important place in current auditing practices.

The increasing use of electronic audit evidence is mainly due to the simplicity of electronic processes for creating, transmitting, processing, recording and/or maintaining information that the auditor relies on. Electronic audit evidence gives rise to specific risks as regards the authentication, integrity, authorization and non-repudiation of the information. These elements should be considered by the auditors as criteria for assessing the reliability of electronic information intended to be used as audit evidence.

10-9 To what extent is the knowledge of the company’s activities and operations important in the audit process?

Answer 10-9 Knowledge of business and industry is an integral part of audit evidence. As the company conducts its business in an environment surrounded by uncertainty, the auditor needs to understand the external factors affecting the company’s operations. The auditor should obtain an understanding of the company’s activities and operations, as well as its objectives and strategies. The auditor benefits in a number of ways from a broad understanding of a company’s business and industrial activities. By understanding the environment and the pressure the organization and its management are facing, the auditor can evaluate whether risks are being identified and, most importantly, being mitigated. The auditor is required to perform a thorough analysis of the risks identified and to examine whether the assessed risks may result in material misstatement of the financial statements. The conduct of the business is also dynamic and the company’s strategies and objectives change over time and according to business conditions.

The auditor’s understanding of environment contributes to more efficient and effective audit planning.

10-10 Provide some examples of the areas in which the auditor uses professional judgement.

Answer 10-10 Professional judgement is an essential element of the auditor’s function and plays an important role in the whole audit process. The analytical procedures, risk evaluation and sample selection are some of the areas in which the auditor uses his/her professional judgement. The following are some of the examples: •

developing an overall audit plan and audit program;

•

assessing inherent risk and control risk;

•

considering business risks and management’s response;

•

determining a materiality level and assessing whether the materiality level chosen remains appropriate;

•

assessing audit evidence to establish its appropriateness and the validity of the related financial statement assertions;

•

considering the appropriateness of accounting policies and financial statement disclosures;

•

evaluating accounting estimates and management representations;

101 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

recognizing unusual circumstances (e.g. fraud and noncompliance with laws and regulations, unexpected relationships of statistical operating data with reported financial results).

10-11 What types of judgement biases affect the availability heuristic?

Answer 10-11 Auditors using the availability heuristic will judge an event as either frequent or likely to occur if it is easy or likely to occur and if it is easy to imagine or recall. If an event is truly frequent, availability can be an appropriate clue.

The availability heuristic can result in three types of judgement bias that may affect the auditor’s decisions process: •

Ease of recall: Using more recent information as it may be deemed to occur more frequently than information that is less vivid or recent. For example, the auditor may generalize his/her judgement on the basis of more recent information observed in one client to all other clients.

•

Retrievability: The auditor remembers the specific facts (e.g. a particular bad debt account) and concentrates more on those facts as these may be perceived as more likely than those that can’t be recalled. The recalling of a specific event prevents the auditor from considering the other issues that may exist in relation to a particular audit test or account.

•

Presumed associations: The auditor experiences certain facts in combination (e.g. increasing the salary of sales representatives and price of products) that may lead to an overestimate of the likelihood of their simultaneous occurrence together in the subsequent periods. This type of misjudgement based on past information prevents the auditor from considering the real reasons for events and the conditions under which they have taken place.

10-12 Describe the term ‘anchoring heuristic’.

Answer 10-12 Anchoring heuristic refers to the cases in which people use preconceived notions as a reference or starting point in the judgement process and adjust their opinion on the basis of acquired information. This notion is also used in auditing as the auditor similar to other decision makers approaches a decision in audit process with a preconceived notion or prior expectation of the appropriate choice to make. Accordingly, the auditors in performing the audit process may have several options but they always start with an implicitly suggested reference point (the ‘anchor’) and then make adjustments to it to reach their estimate.

The auditor might unknowingly overvalue or undervalue the attributes of the selected reference and generalize its impact on the whole decision process. With a selected reference as the starting point, the adjustments may not adequately reflect the meaning of the new information and this may lead to partial or complete ignorance of the attributes of other elements. This may lead to insufficient or incorrect conclusions. This can be the case of sample selection or time allocations on the basis of prior audit, and also the requirements to make adjustments for new conditions in the current year.

10-13 Discuss the relationship between the concepts of reliability of evidence and audit risk.

Answer 10-13 Audit risk and reliability of audit evidence are related. If audit risk is lower than required, it implies that the auditor has to gather more reliable evidence. Reliability relates to the quality of the evidence gathered and is affected by the independence of the evidence from the influence of the client, or by the quality of the client’s overall control structure. The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion. The efficient audit process and suitable audit conclusions depend upon the most reliable types of evidence. The reliability of audit evidence is a

102 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

determinant factor in the auditor providing reasonable assurance that the financial statements are free of material misstatement. The auditor uses risk assessment methods to assist in determining the potential reliance on internally generated audit evidence. Unreliable audit evidence increases the audit risk and the auditor is obliged to increase the number of tests to detect misstatement in classes of transactions, account balances and disclosures and related assertions. Audit evidence is more reliable when the independent auditor obtains consistent audit evidence from different sources or of a different nature.

Discussion Questions 10-14 Talk in detail about the role of evidence in audit decision making.

Answer 10-14 Evidence collection and professional judgement are important interrelated subjects in the audit of financial statements and both are part of an auditor’s decision-making process. The auditor must specify the evidence to be obtained, evaluate the evidence and proceed to conclusions from the evidence. All these matters need the auditor’s decisions and judgements to determine the pertinence, competence, sufficiency and persuasiveness of the evidence. Several questions with regard to audit evidence must be answered by the auditor during the audit process: what evidence should be sought and what weight should be given to different types of evidence, how much evidence is required, and what conclusions may be drawn from the evidence? To answer these questions, the auditor needs professional judgement.

10-15 Discuss the effect of information technology on evidence gathering in auditing.

Under what conditions is electronically stored evidence as reliable as paper-based evidence?

Answer 10-15 Information technology has increasingly affected the whole audit process, including evidence gathering. Electronic transactions continue to replace paper transactions. A well-designed computerized information system permits electronic information storage by taking into account the quality characteristics attributed to reliable and relevant evidence. However, electronic audit evidence may give rise to specific risks as regards the authentication, integrity, authorization and non-repudiation of the information. The auditor should consider these elements as criteria for assessing the reliability of electronic information intended to be used as audit evidence. The validity of the evidence depends on the nature and source of the information and on its intended use for audit purposes. The auditor should ensure that the controls and technologies used to create, transmit, record and maintain electronic information are sufficient to guarantee its reliability.

10-16 What are the characteristics of audit evidence in theoretical terms? Evaluate the arguments put forward by Mautz and Sharaf (1961).

Answer 10-16 Mautz and Sharaf (‘The Philosophy of Auditing’, 1961, Chapter 5 pp. 68–110) devoted a full chapter to audit evidence in their seminal research. It would be interesting for instructors to recommend to students to read this chapter to understand the theoretical arguments supporting the importance of evidence gathering in the audit of financial statements.

The main topics discussed in Mautz and Sharaf are as follows: •

the nature of evidence;

•

propositions and evidence in auditing;

•

types of audit evidence;

103 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

audit evidence and the theory of knowledge;

•

audit evidence and audit judgement.

It is hard to discuss the work of Mautz and Sharaf with regard to audit evidence in a few lines; however, the following sentence cited from the end-of-chapter summary shows the quality of this research conducted in more than forty-five years ago.

‘Audit evidence must be reviewed critically with respect to its validity and pertinence as evidence before it is permitted to influence the mind of the auditor with respect to the assertion at issue. (Mautz and Sharaf, 1961, p. 110.)’

10-17 Define bounded rationality and heuristics in auditing.

Answer 10-17 This is one of the most important topics concerning the audit decision-making process. Bounded rationality means that as a result of many constraints facing people when making decisions, they often need to use simplified approaches in this process. Similar to other economic agents, the auditor is presumed to be rational in making decisions but bounded rationality recognizes that all pertinent and necessary information may not be available in an understandable and clear-cut manner. The limitation may be mainly related to a lack of knowledge of many of the possibilities in the problem-solving process. The use of simplified approaches such as ‘stopping rules’ or ‘rules of thumb’ to limit the search for the solution may help the auditor to find the better solution rather than continuing to seek the very best.

The heuristic approaches are used as the guidelines for judgements in the audit decisionmaking process. Auditors use heuristics to judge the likelihood of an event, knowing that heuristics will usually result in acceptable decisions, although not necessarily the best decisions.

There are three basic heuristics (availability heuristic, representativeness heuristic and anchoring heuristic) that are discussed on pp. 294–298 of the chapter.

10-18 What is the pattern of the audit process proposed by Flint (1988)?

Answer 10-18 The audit process defined by David Flint (‘Philosophy and Principles of Auditing’, 1988) is based on a systematic examination of the matters which are the subject of audit to find out the relevant facts in arriving at conclusions (pp. 101–103). The nature of the examination carried out, the evidence required, the facts established, and the conclusions considered are dependent on the nature of the accountability and the relative objective of the audit in the particular circumstances. The audit objective dictates what should be examined and what evidence is required to enable the auditor to give the opinion or make the report in terms which meet the audit objective. In turn, what has been examined and the evidence that has been collected dictate what the auditor is able to say by way of report or opinion. Audit practices and procedures are directed to the end of assembling the evidence which will inform auditors on those matters on which they must exercise judgement in order to report, for without evidence there can be no audit. The final stage in the audit process is the communication in writing of the auditors’ opinion or report. According to Flint, the terms of this are crucial, since auditors must convey completely, concisely and unambiguously the outcome of what is in many cases an extensive and complex investigation.

10-19 Describe knowledge structures and memory in auditing. Provide some examples of the questions related to the audit function in this area. Provide your answers with references to research studies in this area.

Answer 10-19 Knowledge structure is one of the determinant factors of an auditor’s performance. The auditor's ‘knowledge structure’ – the way accounting and auditing knowledge is organized in the auditor's mind is thought to affect performance through its role in recall. Is it easier, for example, to recall relevant control procedures by thinking about control objectives or

104 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

by thinking about transaction flows? Knowledge structure is thought to impact task performance through its role in the storage and recall of knowledge, as well as in the formation of problems representations. Knowledge structure has relationships with the performance, education, experience and professional judgement of the auditor. It would be necessary to find research papers on this topic in referred journals such as Auditing: A Journal of Practice and Theory, The Accounting Review and Journal of Accounting Literature. For example, see Thibodeau (2003, Auditing: A Journal of Practice and Theory), Curtis and Viator (2000, Auditing: A Journal of Practice and Theory), Libby and Luft (1993, Accounting, Organizations and Society 18:425-450) and Bedard and Chi (1993, Auditing: A Journal of Practice and Theory, Supplement). Several other papers have been published on this topic and related subjects in the accounting and auditing journals.

Memory – which is an important topic in psychology – has some implications in auditing. Like experts in other disciplines, auditors generally rely on their memories in the performance of their daily activities. In addition, like their counterparts in other disciplines, auditors may be susceptible to systematic memory errors that, unrecognized, could negatively affect the efficiency and effectiveness of the audit process. An auditor’s memory of an event may consist of a series of separate memory traces. Several research papers on this subject can be found in the above-mentioned journals. See Libby and Trotman as the staring point in this area (‘The review process as a control for differential recall of evidence in auditor judgements. Accounting, Organizations and Society 18 (6): pp 559–574’).

10-20 Provide a comprehensive evaluation of the role of business knowledge in auditors’ professional judgement and the matters taken into consideration throughout the course of the audit.

Answer 10-20 An external auditor should obtain an understanding of the company and its environment. This knowledge is not only an essential part of planning and executing an audit, but also establishes a frame of reference within which the auditor exercises professional judgement about assessing risks of material misstatement of the financial statements and responding to those risks. This assessment should be sufficient to enable the auditor to design and perform further audit procedures.

The use of business knowledge and experience in professional judgement in auditing significantly contributes to the auditor’s decision-making process. Understanding the business and using this information appropriately assists the auditor in the following cases: •

assessing risks and identifying problems;

•

planning and performing the audit effectively and efficiently;

•

evaluating audit evidence;

•

providing better service to the client.

Business knowledge coupled with the auditor’s professional judgement also contributes to the auditor’s performance in determining a materiality level, evaluating accounting policies and estimates, recognizing conflicting information and identifying areas where special consideration and skills may be necessary.

Several issues should be taken into consideration with regard to the use of business knowledge.

Firstly, it should be borne in mind that obtaining an understanding of the entity and its environment, including its internal control, is a continuous, dynamic process of gathering, updating and analyzing information throughout the audit. Second, the effective use of knowledge about the business depends on how it affects the financial statements taken as a whole and whether the assertions in the financial statements are consistent with the auditor’s knowledge of the business.

105 .

CHAPTER 11

INTERNAL CONTROL OVER FINANCIAL REPORTING AND IT ENVIRONMENT Instructor guidance The internal control system is an integral part of an entity’s governance and risk management functions. It is put in place to keep the company on course towards growth and profitability and the achievement of its mission. Recent business failures and scandals have shed light on internal control weaknesses as one of the sources of corporate dysfunction in the capital market economy. It is not the forms of internal control tools and techniques themselves that have been questioned, but their implementation and suitability to the current business environment.

Moreover, in internal control processes, like with other activities of an organization, the essential issues are responsibility and accountability and scope and sufficiency.

In recent years, the regulatory agencies in major capital market economies have implemented new rules concerning companies’ internal control systems. These require management to report on the effectiveness of internal controls over financial reporting. The external auditor must also attest to management’s assessment of the effectiveness of internal controls. This chapter primarily aims to introduce the essential characteristics of the internal control process, its components and the ways to assess the effectiveness of management controls. It also discusses the procedures for the auditor to understand and assess the design of the internal control system, as well as to test the effectiveness of the controls. Particular attention has been paid to recent regulatory changes and the greater involvement of external auditors in the evaluation of companies’ internal controls. This includes discussion on auditors’ consideration of internal control in the information technology environment and the regulators’ rules and recommendations.

After an introductory discussion on the definition and the outstanding place of internal control in the audit process, the instructor should emphasize the importance of control environment factors and ‘tone at the top’ in management control systems by referring to the COSO report.

Also stress the importance of the auditor’s understanding of factors affecting the company’s activities in the context of the external environment. Instructors should explain how management monitors internal controls, and where control evaluation fails in the audit process and the interrelationship of internal controls with the rest of the audit. Go over the management’s and auditor’s reports on internal control and the responsibilities of each party. A substantial part of the chapter has been devoted to the effectiveness of internal control in an IT environment (pp. 323–331). The instructor should discuss this issue with the students by referring to the internal control provisions of the Sarbanes-Oxley Act and the PCAOB and IFAC auditing standards. Stress the importance of Enterprise Risk Management (ERM) and the connection between the auditor’s evaluation of controls and the ERM model.

Students usually find internal controls easy to comprehend in a general sense but they have difficulty in identifying the factors bearing on the effectiveness of such systems within publicly listed companies. The materials presented in this chapter aim to provide an overview of all essential issues dealing with internal control systems for large corporations. However, students should refer to recommendations (see end-of-chapter bibliography) made by major regulatory bodies for in-depth knowledge on internal control over financial reporting.

106 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 11-1 Why are internal controls so important within an organization?

Answer 11-1 Internal control is an integral part of the overall governance and risk management process. Internal control systems are used by organizations as checks on a variety of processes, including financial reporting, operating efficiency and effectiveness and compliance with laws and regulations. In the financial context, the quality of an organization’s internal controls affects not only the reliability of financial information, but also the ability of the organization to make good decisions and to remain in business. The appropriate internal control system enables good quality internal control systems and also provides better opportunities to detect and deter fraud.

11-2 Define ‘tone at the top’ or control environment.

Answer 11-2 The concept of ‘tone at the top’ is much broader than the internal control system within organization. Tone at the top is the impression the top management gives the organization about the importance of the internal control structure. To set the right tone, top management must identify and assess the factors that could lead to fraudulent financial reporting. All publicly listed companies should maintain internal controls that provide reasonable assurance that fraudulent financial reporting will be prevented or subject to early detection. The attitude of management in this respect is a determinant factor because if management is very strict about disciplining wrongdoings, the company’s staff will learn that they must follow the rules very carefully. If the tone set by management is lax, fraudulent financial reporting is more likely to occur.

11-3 Discuss the auditor’s understanding of control environment (internal and external).

Answer 11-3 The control environment reflects the overall attitude, awareness and actions of those in charge of control of the organization. The external environment is made up of the conditions, circumstances, and influences that affect operations beyond management’s direct control. These include matters affecting: the company’s industry, the business environment and regulatory and legal considerations.

The auditor’s understanding of the company’s control environment can be facilitated by a thorough assessment of the organizational culture. In evaluating the strength of the control environment, the auditor with sufficient wisdom, experience and judgement considers the factors affecting the organizational control environment (e.g. management’s philosophy and operating style, the entity’s organizational structure, human resource policies, the company’s competence evaluation and integrity and ethical values).

The auditor is also expected to understand the nature of strategic risks originating from the external environment. These may have a significant influence on the internal operations of an organization and ultimately on the audit of financial statements. These include environmental forces such as financial and economic conditions, social considerations, technological advances and innovation and legal and regulatory factors.

107 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

11-4 Explain the relationship between the objectives an organization intends to achieve and the internal control components.

Answer 11-4 There is a direct relationship between the company’s general objectives, which represent what an organization strives to achieve, and the internal control components, what is needed to achieve the general objectives. This relationship is shown in Figure 11.1 of the chapter which presents the objectives of accountability, compliance, operations, and safeguarding resources and internal control components (the control environment, risk assessment, control activities, information and communication and monitoring).

The management should take into account the nature of the company, its objectives and specific characteristics when designing the internal control framework. These factors include the organizational structure, risk profile, operating environment, size, complexity, activities and degree of regulation.

11-5 How have computerized systems influenced the auditor’s understanding of internal control?

Answer 11-5 The company’s use of information technology affects the company’s internal control over financial reporting. Internal controls can be used to mitigate many of the risks associated with electronic commerce. Similar to other aspects of auditing and reporting, the audit of internal control over financial reporting has been considerably affected by technological developments in the capital market economy. In line with these developments, internal and external auditors and audit committees place even more importance on new tools, techniques and audit models in order to enhance the quality and credibility of corporate reporting. The auditor considers the control environment and control procedures the entity has applied to its e-commerce activities to the extent of their relevance to the financial statement assertions.

11-6

What are the main features of the COSO report on internal controls?

Answer 11-6 The Committee of Sponsoring Organizations of the Treadway Commission (COSO) provides an integrated framework emphasizing qualities such as objectivity, measurability, completeness and relevance. The COSO report defines an internal control structure and breaks effective internal control into five interrelated components to simplify management’s task of administrating and supervising all of the activities that go into a successful internal control structure. The report describes five interrelated components (the control environment, risk assessment, control activities, information and communication and monitoring) and puts these components in relation to a company’s objectives in financial reporting, operations and compliance with rules and regulations.

11-7

What are the essential points included in the COSO report with regard to IT systems?

Answer 11-7 Following on from its recommendations in 1992 and 1994, COSO has developed the internal control framework in the IT context. The components of this framework (the control environment, risk assessment, control activities, information and communication and monitoring) have been defined taking account of the IT environment. The Information Technology Governance Institute also publishes a document that integrates the COSO framework with COBIT. This document emphasizes the importance of IT control competency in all COSO components and demonstrates how IT controls support the COSO framework. The COSO report considers the following points with regard to IT:

108 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

The organization integrating the IT system into its overall system of internal control taking account of additional risks and providing specialized skills in the area;

•

Choosing a pervasive approach towards the assessment of internal control risks by developing an IT internal control strategic plan and its effective and timely implementations;

•

Implementing general and applications controls to help ensure accurate information processing and the integrity of the resulting information used to manage, govern and report on the organization;

•

Implementing an appropriate information and communication system in the context of the IT environment;

•

Putting in operation monitoring systems to supervise internal control by management through continuous and point-in-time assessment processes.

11-8 Explain the importance of ‘transaction integrity’ in audit procedures.

Answer 11-8 ‘Transaction integrity’ is defined by IFAC as an important quality characteristic in the context of the IT environment. This quality concerns the integrity of information in the accounting system relating to e-commerce transactions. The auditor should consider the completeness, accuracy, timeliness and authorization of information provided for recording and processing in the company’s financial records. Automated controls help the auditor to evaluate the reliability of the accounting systems for capturing and processing accounting transactions.

To be effective, transaction integrity must be accompanied by other elements (security infrastructure and process alignment) in audits of internal control 11-9 To what extent does a computerized information system affect the auditor’s assessment of control risk?

Answer 11-9 In planning the portions of the audit that may be affected by the client’s IT environment, the auditor should obtain an understanding of the significance and complexity of the IT activities and the availability of data for use in the audit. This includes an understanding of the IT environment and whether it may influence the assessment of control risk. Control risk – that a client’s system of internal controls fails to detect a material misstatement depends on the effectiveness of the design and operation of internal controls. This risk and the control measurement introduced as a result of the characteristics of IT systems may alter the auditor’s assessment of risk, and the nature, timing and extent of audit procedures.

The control risk in an IT environment may have both a pervasive effect and an account-specific effect on the likelihood of material misstatements. The risks may result from deficiencies in pervasive IT systems activities such as programme development and maintenance, systems software support operations, physical IT systems security and control over access to specialprivilege utility programmes. The risks may also increase the potential for errors or fraudulent activities in specific applications, in specific data bases or master files, or in certain processing activities.

11-10 Describe the features of Auditing Standard No. 2 of PCAOB, particularly with regard to IT controls.

Answer 11-10 Standard No. 2 of PCAOB (2004) with regard to the company’s internal control over financial reporting pays particular attention to the IT environment and controls. The standard provides guidance on the controls that should be considered in evaluating an organization’s internal control, including software development, software changes, computer operations and access to software and data. The PCAOB auditing standard also suggests that various IT controls, including networks, databases and operating systems have a pervasive

109 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

effect on the achievement of many control objectives. It emphasizes that the most effective means of accomplishing the audit objective is for the auditor to perform a ‘walkthrough’ of the information system to be satisfied with the design and operation of the applicable controls.

Walkthroughs provide the auditor with audit evidence that supports or refutes his or her understanding of the process flow of transactions, the design of controls and whether controls are in operation.

11-11 What are the constraints on internal control effectiveness?

Answer 11-11 Several factors may influence the effectiveness of a company’s internal control system. These factors are mainly related to cost and human elements and environmental changes. A lack of sufficient financial resources may limit considerably the design of an internal control system as most internal control systems impose a significant cost on organizations. The human factor may also affect internal control in the case of errors of judgement or interpretation, misunderstanding, negligence, distraction, collusion, fraud, abuse or override. The environmental changes which affect the company’s strategy and the priorities of its objectives may create significant constraints in implementing an efficient internal control system within an organization.

Some of these changes are imposed by outside factors such as regulatory and market forces.

Thus, management needs to review and update controls continually, to integrate changes in control process and communicate the necessary recommendations to personnel.

Discussion Questions 11-12 Discuss the features and benefits of a ‘top-down approach’ to the audit of internal control over financial reporting. What are the reasons for its effectiveness and efficiency in audit process?

Answer 11-12 The ‘top-down’ approach helps auditors to apply controls over financial reporting in a sequential manner starting with company-level controls and then driving down to significant accounts, significant processes, and, finally, individual controls at the process, transaction or application levels. This approach also helps the auditor to identify and eliminate accounts, disclosures and assertions that have only a remote likelihood of containing misstatements that could cause the financial statements to be materially misstated.

In terms of effectiveness, the identification of significant accounts at the financial statements level (the ‘top’) drives the audit process ‘down’ to the individual control level. In this manner, the auditor is assured of identifying controls that address relevant assertions for significant accounts. This process prevents the auditor from spending unnecessary time and effort understanding a process or control that ultimately is not relevant to whether the financial statements could be materially misstated.

11-13 A company’s security infrastructure and related controls are important features of its internal control system. Discuss this issue with regard to the auditor’s consideration when examining the financial statement assertions.

Answer 11-13 Security of accounting information is a prerequisite for reliable information in terms of a company’s books and records and, hence, the financial statements. Since accounting data is obtained and processed using IT applications and the underlying IT infrastructure, the characteristics of IT applications and infrastructure become an essential part of accounting information security. The security infrastructure and related controls may include an information security policy, an information security risk assessment and standards, measures, practices and procedures.

110 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The auditor considers the effective use of firewalls and virus protection software as well as encryption. The auditor also examines the controls over the development and implementation of systems used to support e-commerce activities. The objective is to see whether the security controls that are in place continue to be effective and whether the control environment supports the control procedures implemented.

11-14 How does the auditor’s assessment of the risk of financial statement misstatement affect the work that must be performed in an audit of internal control over financial reporting?

Answer 11-14 Audit risk assessment is considered as part of the overall audit process. This assessment is a significant factor in determining whether adequate internal controls are in place and functioning properly. Risk assessments determine the scope of the auditing procedures and have important audit efficiency and effectiveness implications. The appropriate assessment of risk of financial statement misstatement contributes to the better understanding by the auditor of internal control systems. Evaluating the reliability of internal controls involves analyzing and testing risk factors affecting the company’s financial statements. At the same time, the relationship between risk assessment and the internal control system is double edged as efficient internal controls can be used to mitigate many risk factors.

11-15 In the aftermath of a series of high-profile business scandals, efforts were made to enhance corporate governance and risk management with the establishment of new regulations. In the US, the Sarbanes-Oxley Act of 2002 and the establishment of PCAOB address the essential issues on internal control reporting and the auditor’s role in this respect.

Discuss these changes along with how the proposed measures could be effective in bringing confidence in the capital market economy.

Answer 11-15 The introduction of the SOX Act and the creation of the PCAOB at the beginning of twenty-first century, aimed to restore the confidence of investors, and society generally. As stated in the SOX Act (Section 101) the PCAOB’s role is ‘to oversee the audit of public companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies, the securities of which are sold to, and held by and for, public investors’. The PCAOB supervises auditors of public companies, including establishing auditing and quality control standards for public company audits and performing inspections of the quality controls at audit firms performing those audits.

Standard No. 2 of PCAOB (2004) addresses the main issues for auditors when they assess whether managers of a public company have reported accurately on the company’s internal controls over financial reporting. Failures in internal control, particularly over financial reporting, were among the specific concerns addressed by the US Congress in the SOX Act. Congress required not only that management report on a company’s internal control over financial reporting, but also that auditors attest to the accuracy of management’s report. All these measures should hopefully provide some responses to public distrust of financial information and growing concerns over the quality of corporate reporting and auditing.

11-16 Auditors generally employ a ‘risk-based’ approach to auditing financial statements.

The auditor’s assessment of the risk that a financial statement amount or disclosure is misstated affects the nature, timing and the extent of the auditor’s work on that financial statement amount or disclosure. How is an audit of internal control over financial reporting risk-based?

(Adapted from PCAOB, 2005)

111 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Answer 11-16 A risk-based approach which has now been used by most audit firms for many years specifies the nature, timing and extent of testing. This approach provides the auditor with valuable information in assessing the company’s financial statements as it requires a thorough evaluation of the company’s internal controls and its operations before conducting the audit.

A direct relationship exists between the degree of risk that a material weakness could exist in a particular area of the company's controls and the amount of audit attention the auditor should devote to that area. Accordingly, the lower the risk that a material weakness could exist in a particular area, the less attention the auditor would need to devote to the area. On the other hand, the higher the risk that a material weakness could exist in a particular area, the greater the amount of attention the auditor should devote to the area. This relationship between risk and amount of audit attention is consistent with the auditor's responsibility to plan and perform the audit of internal control over financial reporting so that the risk that he or she fails to find a material weakness that does exist is appropriately low.

11-17 The identification of significant accounts plays a central role in the scoping of an audit of internal control over financial reporting. What role do qualitative factors and an assessment of risk have in the identification of significant accounts?

(Adapted from PCAOB, 2005) Answer 11-17 Risk assessment underlies the entire audit process described by Auditing Standard No. 2 of PCAOB. In this process, the auditor should determine that an account is significant based on an assessment of the risk that the account could contain misstatements that individually, or when aggregated with others, could have a material effect on the financial statements. Paragraph 65 of Auditing Standard No. 2 describes quantitative and qualitative factors that the auditor should evaluate together to determine whether an account is significant.

It is important for the auditor to take into account the total mix of information that is available in determining whether an account is significant. Accordingly, quantitative measures alone are not determinative of whether an account should be identified as significant.

If the auditor determines that an account is a significant account for the audit of internal control over financial reporting, the auditor should design his or her control testing strategy to be responsive to his or her assessment of the risk related to the account. The auditor should also consider that components of an account balance may be subject to differing risks or different controls. Accordingly, the auditor may be able to reduce or eliminate testing of controls for some components. To take an obvious example, the petty cash component of the financial statement line item ‘cash and cash equivalents’ rarely presents a more than remote risk that the financial statements could be materially misstated.

11-18 At many companies, management identifies and tests what it describes as ‘key’ or ‘significant’ controls as a part of its assessment of internal control over financial reporting. Is the auditor required to test all the controls that management tested because management described them as key or significant?

(Adapted from PCAOB, 2005) Answer 11-18 There is no need for the auditor to take account of ‘key’ or ‘significant’ controls identified by company’s management. In conducting the audit of financial statements, there may be circumstances in which management identifies and tests more controls than necessary for the purpose of its assessment of internal control over financial reporting. Such a decision on the part of management should not affect the scope of the auditor's work. The auditor need test only those controls that the auditor identifies as controls over assertions relevant to significant accounts. This direction applies to the auditor's tests of design effectiveness as well as operating effectiveness of controls.

112 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Depending on the way in which key or significant controls are identified, testing all of those controls might result in the auditor testing either more or fewer controls than necessary. Instead, paragraph 83 of Auditing Standard No. 2 of PCAOB states that the auditor should obtain evidence about the effectiveness of controls (either by performing tests of controls himself or herself or by using the work of others) for all relevant assertions related to all significant accounts and disclosures in the financial statements. This direction encourages the auditor to focus on assertions that are relevant to the accounts and disclosures that the auditor has determined are significant before deciding which controls to test.

11-19 How does the auditor’s assessment of risk affect the auditor’s decisions about the nature, timing and extent of testing of controls?

(Adapted from PCAOB, 2005) Answer 11-19 As discussed further in Question 11-16, a direct relationship exists between the degree of risk that a material weakness could exist in a particular area of a company's controls and the amount of audit attention the auditor should devote to that area. Accordingly, the provisions of Auditing Standard No. 2 of PCAOB discussed below provide the auditor with the ability to reduce his or her testing for lower-risk areas.

Nature As the risk associated with the control being tested decreases, the persuasiveness of the evidence that the auditor needs to obtain also decreases. On the other hand, as the risk associated with the control being tested increases, the persuasiveness of the evidence that the auditor needs to obtain also increases.

The procedures the auditor might choose to perform to test the effectiveness of a control include inquiry, observation, inspection of relevant documentation and reperformance of the application of the control. The auditor also may perform walkthroughs, which ordinarily consist of some combination of these types of procedures, as tests of design and operating effectiveness.

Timing Generally, as the risk associated with the control being tested decreases, the testing may be performed farther from the as-of date; on the other hand, as the risk associated with the control increases, the testing should be performed closer to the as-of date. In determining that the testing of a control should be performed closer to the as-of date because of increased risk associated with the control, the auditor may still test those controls as of an interim date and correspondingly adjust the nature and extent of his or her roll-forward procedures to be more extensive.

Extent As the risk associated with a control decreases, the extensiveness of the auditor's testing should decrease; as the risk associated with a control increases, the extensiveness of the auditor's testing also should increase. Paragraph 105 of Auditing Standard No. 2 describes three primary factors that the auditor should evaluate when determining the extent of testing on a given control: (1) the nature of the control, (2) the frequency of operation and (3) the importance of the control. Evaluating the nature of the control, and especially the importance of the control, is related directly to the auditor's assessment of risk associated with the control.

Company-level controls As described in Question 11-12 regarding the top-down approach, the auditor's evaluation of company-level controls will also affect the auditor's decisions regarding the nature, timing and

113 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

extent of testing a control. Because company-level controls have a bearing on the auditor's evaluation of risk associated with the controls operating at more detailed levels than the company-level controls, the auditor's evaluation of company-level controls can result in increasing or decreasing the testing that the auditor otherwise would have performed on controls at the process, transaction, or application levels. Although testing company-level controls alone is not sufficient, pervasive company-level controls can have a significant effect on the auditor's testing of other controls, particularly when strong company-level controls that have a direct relationship with lower-level controls result in the auditor decreasing the testing he or she otherwise would have performed.

11-20 The auditor’s opinion on the effectiveness of internal control over financial reporting is rendered as of a point in time (e.g. at year-end), whereas the auditor’s opinion on the financial statements covers the financial results over a period of time (i.e. for the entire year). In an integrated audit of internal control over financial reporting and the financial statements, how should the auditor generally structure his or her testing of controls – throughout the entire period under audit or compressed towards year-end?

(Adapted from PCAOB, 2005) Answer 11-20 In most circumstances, testing controls throughout the year will provide several benefits, perhaps the most important of which will be to fully integrate the audit of internal control over financial reporting with the audit of the financial statements.

In an integrated audit of internal control over financial reporting and the financial statements, the auditor would ordinarily design his or her testing of controls to accomplish the objectives of both audits simultaneously: (1) to obtain sufficient evidence to support his or her opinion on internal control over financial reporting as of year-end and (2) to obtain sufficient evidence to support a control risk assessment of low for the audit of financial statements. By obtaining sufficient evidence to support a control risk assessment of low for the financial statement audit, the auditor will be able to reduce the amount of audit work that otherwise would have been necessary to opine on the financial statements.

The auditor should also document the reasons for assessing control risk as other than low for any relevant assertions related to significant accounts. This documentation requirement reflects the expectation that the benefits associated with an integrated audit will best be achieved ordinarily by the auditor testing controls over a period of time. However, there may be circumstances in which it is appropriate and efficient for the auditor not to test controls throughout the period and so not to assess control risk in the audit of the financial statements as low, such as when a material weakness is eliminated late in the year.

11-21 Public companies are expected both to improve their processes and procedures for monitoring the operation of controls, and to make more use of control selfassessments. Management also plays a role as part of internal control itself. How should these factors affect the auditor’s evaluation of management’s assessment?

Answer 11-21 Management's daily interaction with the system of internal control provides it with a broader array of procedures to achieve reasonable assurance for its assessment of internal control over financial reporting than the auditor has available. The auditor should recognize this difference when evaluating the adequacy of management's assessment.

Paragraph 40 of Auditing Standard No. 2 of PCAOB (2004) cites examples of procedures that management could use to obtain sufficient evidence of the operating effectiveness of controls.

These could be ‘inspection of evidence of the application of controls, or testing by means of a self-assessment process, some of which might occur as part of management's ongoing monitoring activities’. For example, management might be able to determine that controls

114 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

operate effectively through its direct and ongoing monitoring of the operation of controls. This determination might be accomplished through performing regular management and supervisory activities, monitoring adherence to policies and procedures and performing other routine actions. For instance, a supervisor's review of a monthly account reconciliation prepared by one of his or her subordinates could provide management with evidence supporting its assessment of internal control over financial reporting, if the results of the supervisor's review were evaluated and documented as part of management's assessment. To appropriately evaluate the adequacy of management's assessment as directed by the standard, the auditor needs to recognize these other types of procedures that are available to management as part of the basis for its assessment.

11-22 It has been stated that information technology systems are an essential part of the overall financial reporting process. Discuss the place of information technology within the organization and how it contributes to an effective system of internal control over financial reporting.

Answer 11-22 The use of computers and advances in information technology are changing the techniques of accumulating, manipulating and disseminating accounting data. At the same time, not a day goes by without more news of the revolutionary effects of technology on the world economy. Technological developments are changing business and financial reporting. As a consequence, the way audits are conducted is also changing.

Similar to other aspects of auditing and reporting, the audit of internal control over financial reporting has been considerably affected by IT developments in recent years. Due to the rapid changes in information technology, controls must also adjust to remain effective. The application of IT may require additional emphasis on business alignment, roles and responsibilities policies and procedures. The use of information technology contributes to the determination of risks that are relevant to information assets and in assessing controls in order to reduce or mitigate these risks.

Internal control also needs to be applied to information systems – general and application control. General control applies to information systems such as the mainframe, network and end-user environments and includes agency-wide security program planning, management, control over data centre operations, system software acquisition and maintenance. Application control should be designed to ensure that transactions are properly authorized and processed accurately and that the data is valid and complete. Controls should be established at an application’s interfaces to verify inputs and outputs, such as edit checks. General and application controls over information systems are interrelated.

11-23 How should the auditor evaluate a company’s internal control over financial reporting when a company has implemented a significant change to information technology that affects the company’s preparation of its financial statements?

Answer 11-23 To evaluate the effect that a change to the company's IT has on the company's internal control over financial reporting, the auditor should evaluate the company's controls over program development and program changes, as well as any controls that the company might put in place temporarily during the conversion period. The temporary controls referred to here would include the various procedures, many of which would be manual or IT-dependent manual procedures, that management puts in place to detect and correct errors during the time immediately after the conversion (often referred to as the ‘shake-down’ period).

To evaluate whether the company's controls provide management with reasonable assurance that the company can produce complete and accurate financial statements before, during, and after the change to IT, the auditor should evaluate the combination of all these various types of controls. As discussed further in Question 11-19, the auditor's evaluation of company-level controls (and their relative strength or weakness), such as IT general controls, will affect the

115 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

auditor's assessment of risk and, therefore, the nature, timing, and extent of the auditor's testing of more detailed controls. It would be inappropriate for the auditor to conclude, as a rule, that management should not implement changes to IT for some arbitrary period of time before yearend.

11-24 The Committee of Sponsoring Organizations of the Treadway Commission has discussed in its document entitled 'COSO ERM Framework (2004)', the comprehensive approach to 'Enterprise Risk Management (ERM)''. Discuss the following questions: (a) What is the major objective of this framework? (b) What are the elements contained in the definition of ERM? (c) Identify the eight interrelated components of the ERM framework. (d) What is the internal auditor’s role in risk management and how will this framework help that role? (e) What are the benefits of implementing an effective ERM framework? What are the implications for the external audit if an organization does not have a comprehensive and effective ERM? Answer 11-24 (a) Enterprise Risk Management (ERM) has emerged as an important new business trend.

The COSO ERM framework defines essential components, suggests a common language, and provides clear direction and guidance for enterprise risk management.

ERM is a structured and disciplined approach aligning strategy, processes, people, technology and knowledge with the purpose of evaluating and managing the uncertainties the enterprise faces as it creates value. (b) COSO (2004) defined ERM as a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risks to be within its risk appetite, to provide reasonable assurance regarding the achievement of the entity’s objectives. The importance of ERM relates to its underlying principles that every entity, whether for profit or not, exits to realize value for its stakeholders. ERM supports value creation by enabling management to deal effectively with potential future events that create uncertainty and respond in a manner that reduces the likelihood of downside outcomes and increases the upside. (c) The essential components of the framework which are interrelated are internal environment, objective setting, event identification, risk assessment, risk response, control activities, information and communication and monitoring. (d) Internal auditors play an important role in monitoring ERM, but do not have primary responsibility for its implementation or maintenance. They should assist management and the board or audit committee in the process by monitoring, examining, evaluating, reporting and recommending improvements. (e) One of the characteristics of new ERM models is to expand the factors considered by management in the decision-making process by including environmental and behavioural factors. Risk management is moving beyond the tradition of risk mitigation (using controls to limit exposure to problems) towards risk portfolio optimization (determining the organization’s risk appetite and capacity from among a group of risks

116 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

across the enterprise, seizing opportunities within those defined parameters and capitalizing on the rewards that result).

External auditors must pay attention to different types of risks the company is facing. It is important to see whether the board of directors is adequately overseeing management’s process for identifying and monitoring principal business risks, what risks are acceptable to the company, and through what process are they being managed.

117 .

CHAPTER 12

AUDIT REPORTING Instructor guidance This chapter discusses the content of the audit report as the most common and highest level of assurance provided by an independent auditor to various parties interested in a company’s financial information. It covers the more common reporting situations and the evolving nature of assurance services. Audit reports range from positive assurance, where the auditor gathers sufficient evidence to render an opinion on the fairness of presentation, to no assurance, where the auditor is unable to provide any opinion on the company’s financial statements. The independent auditor also performs other services such as reviews and compilations, but in these cases the auditor does not provide positive assurance to third parties.

Instructors should first discuss the usefulness of the audit report for shareholders although part of this discussion relates to Chapter 17, which concentrates on the effect of the audit opinion on the agents of the market economy. The students should be informed that the vast majority of audit reports for public companies are unqualified. Discussion on the departures from an unqualified audit report helps to explain the circumstances under which the auditor needs to modify the report wording. These circumstances are also discussed in the chapter, along with their effect on the types of opinion to be expressed and the modification of report wording. The instructors should go over some of the special reporting situations that auditors increasingly face and discuss the demand for such reports. Stress materiality as a determinant of qualified versus adverse or disclaimer reports. It is also important to discuss the consequences of issuing inappropriate reports for publicly listed companies.

Although this type of report is considered the least severe type of departure from an unqualified report, and this is mentioned in the chapter, students must understand the cases of departure from GAAP, inadequate disclosure and non-approved change in accounting standards. Above all, throughout this chapter we refer to accounting and auditing standards, but the use of these terms depends on the particular context and jurisdiction in which they are applied. References to International Financial Reporting Standards (IFRSs issued by the IASB) and the International Standards on Auditing (ISAs issues by the IAASB and IFAC) are important since one of the particularities of this book is its emphasis on international standards rather than solely US or UK standards.

The last part of the chapter discusses the other reporting responsibilities of external auditors, making reference to the report on interim financial statements, the report on internal control over financial reporting, and the auditor’s report to the audit committee. Instructors should discuss the changes in audit reporting standards reflecting the positions of market regulators such as the SEC and the newly established accounting boards such as PCAOB in the United States.

Several examples are provided throughout the chapter of different types of audit reports. It would be interesting to ask the students to look for different types of reports in their own countries. This helps to identify the particularities of audit reports in terms of form and content issued by public firms in different countries. There are several discussion questions regarding the form and content of audit reports in different jurisdictions, particularly the cases 12-28, 12-29 and 12-30, which are devoted to a comparison between the audit reports issued in several European countries and the USA. 118 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 12-1 Distinguish between a qualified opinion, an adverse opinion and a disclaimer of opinion. Explain the circumstances under which each is appropriate.

Answer 12-1 These are three different forms of audit opinions expressed by an independent auditor. A qualified opinion, which is the least severe type of departure from an unqualified report, is expressed when the auditor feels that the financial statements are mostly, but not completely, fairly presented. The auditor expresses an adverse opinion when he or she believes that the financial statements as a whole do not present fairly in conformity with generally accepted accounting standards. A disclaimer report is expressed when auditor either lacks independence or is unable to obtain sufficient evidence to form an opinion on the overall fairness of the financial statements. In this case, the auditor does not express an opinion on the financial statements.

12-2 Under what circumstances must the auditor’s report refer to the consistency, or the lack of consistency, in the application of IFRSs or GAAP? What is the purpose of such reporting?

Answer 12-2 The changes in accounting principles used in preparing the company’s financial statements are admitted provided that such changes be fully disclosed in the financial statements and be noted in the auditor’s report. When the client has changed an accounting principle or method of application, and the effect of this change is material to the financial statements, the auditor should refer to such changes by adding a paragraph to the audit report.

This provides the users of financial statements with the information concerning the effect of the change in accounting principles when evaluating the company’s operations. This paragraph also informs the users of financial statements of the change in the company’s accounting policies because such changes may affect the comparability of this year’s financial statements with those of previous years. Examples are changes in the methods of inventory valuation, depreciation of assets and leasing.

12-3 What is the difference between a scope limitation and an uncertainty? Give an example of each.

Answer 12-3 The auditor should obtain sufficient competent evidential matter to have a reasonable basis for expressing an opinion on the financial statements. When the auditor has not accumulated sufficient evidence, a scope restriction exists. A scope limitation prohibits the auditor from performing audit procedures due to client instructions or other circumstances.

Examples are (1) the client asking the auditor not to confirm receivables or (2) inadequate client records and the auditor being unsatisfied with inventory verification.

The auditor should also gather sufficient and appropriate audit evidence to confirm or dispel whether or not a material uncertainty exists through carrying out necessary procedures. When there are no audit procedures that can be performed because the evidence does not yet exist, the auditor faces an uncertainty situation. Examples are (1) when there is substantial doubt about going concern for a reasonable period of time and (2) pending litigation, the outcome depending on the court’s decision.

119 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

12-4 What are the possible auditor’s actions when a company’s management is unwilling to make the suggested modifications or extend its assessment?

Answer 12-4 This is one of the scope limitation cases the auditor may face. Because auditors cannot express an unqualified opinion unless they can apply all the audit procedures considered necessary, scope limitations require auditors either to express a qualified opinion or to disclaim an opinion. Under these circumstances, the auditor should consider the need to modify his/her report as a result of the limitation on the scope of the auditor’s work. This choice is based on the importance of the omitted procedures to the auditor’s ability to form an opinion on the financial statements taken as a whole. If the potential effects of the scope limitation are not so material as to preclude the auditor from forming an opinion on the financial statements taken as a whole, the auditor should issue a qualified opinion.

If the potential effects of the scope limitation relate to many financial statement items, they may be so material as to preclude the auditor from forming an opinion on the financial statements taken as a whole. Also, if the client imposes the scope limitation, the auditor usually does not express an opinion. Under these circumstances, a disclaimer of opinion is appropriate.

12-5 Why should the auditor ordinarily disclaim an opinion when the client imposes significant limitations on the audit procedures?

Answer 12-5 Restrictions imposed by the client is one of the causes of scope limitations and in such cases the auditor should disclaim an opinion because audit risk is raised to an unacceptably high level. The disclaimer of opinion requires that the auditor does not express an opinion on the financial statements because he/she is unable to obtain sufficient evidence to form an opinion on the overall fairness of the financial statements.

12-6 Describe the term ‘substantial doubt about going concern status’ and the auditor’s responsibility in this respect. What are the different forms of audit opinions with regard to going concern assumption?

Answer 12-6 The going concern assumption is fundamental to the preparation of financial statements. According to the ISA 570 (IFAC 2004, p. 484) ‘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.’

If the auditor has concluded that there exists a substantial doubt about a client’s ability to survive as a going concern, but adequate disclosure is made in the client’s financial statements, he or she should issue an unqualified report modified with the addition of an explanatory paragraph after the opinion paragraph describing the cause of the concern.

If, on the basis of the additional procedures and the information obtained, the auditor’s judgement is that the company will not be able to continue as a going concern, and the going concern assumption used in the preparation of the financial statements is inappropriate, then the auditor should express an adverse opinion. This is done regardless of whether or not disclosure about the going concern assumption has been made.

12-7 Provide examples of events or conditions that underpin the going concern assumption under ISA 570 (IFAC) and SAS 59 (AICPA). How can an external auditor judge the validity of this assumption in different circumstances?

Answer 12-7 The auditor should consider whether there are events or conditions that may cast significant doubt on the company’s ability to continue as a going concern. The auditor is required to consider management’s plans for dealing with the adverse effects of the foregoing conditions and events. Examples of events or conditions which individually or collectively may cast significant doubt about the going concern assumption are listed on pp. 353–354. The

120 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

following is only a summary of financial, internal and external factors affecting the company’s going concern assumption.

•

Financial factors: the difficulties arising from financial problems such as insufficient cash flows from operations, working capital deficiencies, substantial operating losses and inability to reimburse the company’s loan.

•

Operating (internal matters): regarding labour difficulties or shortages of important supplies, work stoppages, substantial dependence on the success of a particular project and uneconomical long-term commitments.

•

Others (external factors): such as loss of a major market, franchise, license or principal supplier and changes in legislation or government policy expected to adversely affect the entity.

12-8 Define ‘materiality’ as used in audit reporting. What conditions will affect the auditor’s determination of materiality?

Answer 12-8 Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. In the context of audit reporting, materiality is considered as a determinant factor. For example, when there is a material departure from GAAP or a material limitation on the scope of the audit, the nature of the audit report depends on whether the situation involves a GAAP departure or a scope limitation, as well as the level of materiality. The auditor’s decision of whether an adverse opinion or except for qualification is appropriate in the case of a departure from a generally accepted accounting principle rests also on the materiality of the amounts involved.

12-9 In what areas might an auditor and management disagree? When would an adverse opinion become necessary?

Answer 12-9 There are several areas in which the auditor and management may have disagreement with regard to the company’s financial reporting and accounting, for example, changes in accounting standards, accounting provisions, quality of the company’s internal control system and going concern assumption. In certain circumstances (e.g. when management has not yet made a preliminary assessment, or management’s assessment of the entity’s ability to continue as a going concern covers less than twelve months from the balance sheet date) the auditor may believe that it is necessary to ask management to make or extend its assessment. If management is unwilling to do this, the auditor should consider modifying the report as a result of the limitation on the scope of the auditor’s work.

An adverse opinion should be expressed when the effect of a disagreement is so material and pervasive to the financial statements that the auditor concludes that a qualification of the report is not adequate to disclose the misleading or incomplete nature of the financial statements.

12-10 Assume that the client’s accounting for deferred income taxes is not in accordance with IFRSs or GAAP, and the external auditors are aware of this. However, because of a very significant scope limitation, the auditors have not been able to form an opinion on the financial statements taken as a whole. What type of report should they issue?

Answer 12-10 The auditor may have disagreement with management regarding the accounting polices selected, the method of their application or the adequacy of financial statement disclosures. In such cases, the auditor may express a qualified or adverse opinion, depending on the materiality of the amounts involved. If the departure from GAAP is not so material as to cause the financial statements taken as a whole to be misleading, the auditor will express a qualified opinion. If the effects of the departure from GAAP are so material that they cause the financial statements as a whole to be misleading, the auditor will express an adverse opinion.

121 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The non-conformity of a company’s method of accounting for deferred income taxes is not by itself a sufficient element in issuing an adverse opinion and the auditor can express a qualified opinion. However, the question refers to the existence of significant scope limitation, and in that case, the auditor should express an adverse opinion.

12-11 How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations resulting from conditions beyond the client’s control?

Under which of these two would the auditor be most likely to issue a disclaimer of opinion? Explain.

Answer 12-11 Both cases may lead the auditor to issue a disclaimer of opinion. A scope limitation occurs when the auditor is unable to obtain sufficient, competent evidence on which to base an opinion. Scope limitations may be caused by the circumstances of the audit, such as an inability to observe inventory at year-end or when there is inadequate evidence available to support accounting estimates involving future uncertainties.

Scope limitations require auditors either to express a qualified opinion or to disclaim an opinion.

This choice is based on the importance of the omitted procedures to the auditor’s ability to form an opinion on the financial statements taken as a whole. If the potential effects of the scope limitation are not so material as to preclude the auditor from forming an opinion on the financial statements taken as a whole, the auditor should issue a qualified opinion.

If the potential effects of the scope limitation relate to many financial statement items, they may be so material as to preclude the auditor from forming an opinion on the financial statements taken as a whole. Also, if the client imposes the scope limitation, the auditor usually does not express an opinion. Under these circumstances, a disclaimer of opinion is appropriate.

12-12 What words and phrases in the standard audit report imply that there is a risk that the financial statements might contain a material misstatement?

Answer 12-12 The first phrase implying some risk of not detecting all material misstatements is in the scope paragraph. For example, ‘we conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects’.

The second phrase is in the opinion paragraph and starts ‘In our opinion’. It is an opinion, not a statement of fact. This also implies a risk that the opinion could be wrong.

12-13 What are the objectives of a review of interim financial statements by external auditors and how would this review be beneficial to users of corporate financial reporting?

Answer 12-13 The objective of a review of interim financial information is to provide the auditor, based on applying his or her knowledge of financial reporting practices to significant accounting matters, with a basis for reporting whether material modifications should be made for such information to conform with generally accepted accounting principles.

Even if the objective of a review of interim financial information differs significantly from the objective of an audit of financial statements in accordance with generally accepted auditing standards, the users of a company’s financial statements will benefit from the auditor’s review of interim financial information as it may highlight significant matters affecting the statements. For example, the SEC requires publicly owned corporations to have their quarterly financial information reviewed by their independent auditors before it is issued.

122 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

12-14 What are the objectives of an audit of internal control over financial reporting and the content of the auditor’s opinion?

Answer 12-14 The auditor’s objective is to express an opinion about whether management’s assessment of, or conclusion on, the effectiveness of internal control over financial reporting is stated fairly, in all material respects.

If an independent auditor has identified no material weaknesses in the internal control of the company after having performed all of the procedures that the auditor considers necessary in the circumstances, then the standard on the audit of internal control over financial reporting (Auditing Standard No. 2, PCAOB 2004) would permit the auditor to express an unqualified opinion that management’s assessment of the effectiveness of internal control over financial reporting is fairly stated in all material respects. In the event that the auditor could not perform all of the procedures that the auditor considers necessary in the circumstances, then the Auditing Standard No. 2 would permit the auditor to either qualify or disclaim an opinion. If an overall opinion cannot be expressed, the auditing standard would require the auditor to explain why.

12-15 In your opinion, to what extent could a lack of auditor independence affect the auditor’s performance and how this should be expressed in the audit report?

Answer 12-15 Auditor independence is considered as a core feature of auditor performance and the success of the public accounting system in financial markets. When an auditor is not independent, any procedure performed is not be in accordance with generally accepted auditing standards, and he/or she is precluded from expressing an opinion on the financial statements.

The lack of independence of an auditor in such cases is quite rare but it does happen. For example, after performing the audit it might be discovered that one of the auditors (and/or partners) has a substantial financial interest in the client or financial relations with a member of board of directors. In such cases, a one-paragraph disclaimer should be issued specifically stating the lack of independence of the auditor but omitting the reasons for it. By omitting the reasons for the lack of independence, the auditor eliminates the possibility of any misinterpretation the reader may have on this issue.

12-16 What are the characteristics of audit reports in the European countries? How do these differ from the reports prepared in the US? Answer 12-16 In all EU member states, a common framework exists for a statutory audit obligation through the accounting directives, and for governing the approval of statutory auditors through the new directive and recommendations on audits of company accounts. Currently, it is left to national authorities and legal systems to define the form of audit report and to determine additional responsibilities of statutory auditors, how the standards applied by statutory auditors should be set, and how to monitor compliance with those standards. The relevant auditing standards are issued by national standard-setters, which are generally organized by professional bodies of accountants. There is no unique form of audit report in the European countries, but the European Commission intends to apply the International Standards on Auditing in the EU, including the standard on audit reports, and has conducted a benchmarking exercise of ISAs against member states’ audit requirements.

Audit reports in European countries are much longer and contain more issues than those in the United States. This question will fully be covered in the case number 12-30.

123 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Discussion Questions 12-17 The standard audit report is the most common report issued by an independent auditor. It contains an unqualified opinion stating that the financial statements ‘present fairly, in all material respects’ or ‘give a true and fair view’ (depending on the use of US practices and/or International Standards on Auditing-ISA) of the financial position, results of operations and cash flows of the entity in conformity with generally accepted accounting principles.

A careful reading of an unqualified audit report indicates several important phrases. Explain why each of the following phrases or clauses is used rather than the alternative provided: (a) ‘In conformity with International Financial Reporting Standards (IFRSs) or Generally Accepted Accounting Principles in the United States’ rather than ‘are properly stated to represent the company’s financial performance and true economic conditions’. (b) The financial statements referred to above present fairly in all material respects the financial position’ rather than ‘The financial statements mentioned above are correctly stated’. (c) ‘We conducted our audit in accordance with generally accepted auditing standards (or International Standards on Auditing)’ rather than ‘Our audit was performed to detect material misstatements in the company’s financial statements’. (d) ‘We believe that our audit provides a reasonable basis for our opinion’ rather than ‘Our audit provides sufficient assurance for our opinion’. (e) In our opinion, the financial statements “present fairly” or “give a true and fair view” rather than “We attest to the accuracy of the financial statements”.

Answer 12-17 (a) The reference to IFRSs and US GAAP specifies rules which are followed in accounting for the transactions to date; whereas the term ‘company’s financial performance and true economic conditions’ does not relate to accounting standards currently used to produce the financial statements. (b) The term ‘correctly stated’ is not appropriate as it implies absolute accuracy. The auditor should only state the existence of material misstatements. (c) The sentence ‘our audit was performed to detect material misstatements in the financial statements’ is not appropriate because the objective of the audit is to determine whether financial statements are fairly stated. It is not the major objective of the audit to search for material errors and irregularities. The sentence ‘we conducted our audit in accordance with generally accepted auditing standards (or International Standards on Auditing)’ is correct because it identifies the auditor’s responsibilities for the conduct of the audit with reference to accounting standards. (d) The term ‘our audit provides sufficient assurance for our opinion’ is not correct because the purpose of the audit is to determine whether the financial statements are fairly stated. The auditor is not in the position to provide sufficient assurance to support his/her audit opinion.

124 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(e) The term ‘we attest to the accuracy of the financial statements’ is not appropriate as the auditor cannot provide a guarantee of the accuracy and correctness of the financial statements. The auditor should only express his/her opinion based upon a reasonable assurance about whether the financial statements are free of material misstatements.

12-18 The role of the auditor has changed over the years in response to changes in economic and political institutions. Consequently, the nature of an audit today is different from what it was in the 1950s. However, the format of a standard audit report, which consists of a series of short coded messages, has remained unchanged for many years. There have been debates on the usefulness of the unqualified standard audit report in its current form for potential users of financial statements.

Discuss the usefulness of the current audit report in a changing environment.

Develop your opinion on the usefulness of the report in the decision-making process with regard to the users of the audit report (shareholders, lending institutions, regulatory agencies etc.).

Answer 12-18 In performing the audit function, the auditor prepares reports that are often the only means of communication between their actions and the users of financial statements. The credibility of the information disclosed by the company to the financial market depends largely on the opinion on the company’s financial statements expressed in the audit report. The audit provides assurance that the information presented to investors and creditors is reliable.

However, despite the importance of the audit report in investment and financing decisions, there has been, in recent years, increasing criticism of the form and content of the audit report. The increasing number of high profile financial scandals associated with auditors’ failures to properly examine the financial statements of public companies, raises concerns among the various interested parties, particularly investors and market regulatory bodies. Above all, the business environment is changing and auditing standards and practices have to keep pace. This may require substantial changes in terms of the form and content of the audit report, especially the unqualified standard report. This issue is among the topics currently being examined by standard-setters and professional accounting bodies.

12-19 ‘Markly Werke, Inc.’ is a publicly held corporation that manufactures a line of home appliances. These comments were included in the Company’s 2004 annual report to the shareholders: ‘The integrity of the financial information reported by Markly Werke, Inc. is the responsibility of the company’s management. Fulfilling this responsibility requires the preparation of financial statements in accordance with applicable accounting standards.

Markly Werke, Inc. uses an established system of accounting and internal controls in gathering and processing financial data. Management believes that internal control is sufficiently maintained by the established business policies and procedures and the ongoing review of operations by Markly Werke’s internal audit department.

Don & Servan, an independent auditing firm, is engaged to issue an opinion on the financial statements of Markly Werke, Inc. The opinion is based upon the audit of the company’s financial statements in accordance with auditing standards. The audit committee of Markly Werke’s board of directors reviews the audit report submitted by Don & Servan, including the audited financial statements. The external auditing firm has full and free access to the audit committee’.

125 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Answer the following questions: (a) Judgement and estimates are necessary in the application of accounting standards. Whose judgement and estimates are reflected in the financial statements of Markly Werke, Inc? Explain your answer. (b) Explain who is responsible for the establishment and maintenance of the Markly Werke's accounting system and internal controls. (c) Explain the extent of the audit of Markly Werke’s financial statements in accordance with auditing standards by the external auditors, Don & Servan. (d) Assume Don & Servan has issued an unqualified opinion on the financial statements of Markly Werke, Inc. What inferences, if any, can be made from the opinion of Don & Servan about: the soundness of the decisions made by the management of Markly Werke; and the financial statements of Markly Werke, Inc.?

Answer 12-19. (a) The financial statements are the responsibility of management. Management should prepare the financial statements and take responsibility for their accuracy. The preparation of the company’s financial statements is subject to management’s judgement and estimates. The auditors should obtain from management all the information regarding the financial statements and how they are prepared. (b) In preparing the company’s financial statements, management needs to adopt sound accounting policies and establish and maintain internal controls consistent with the assertions embodied in the financial statements. (c) The auditor is responsible for expressing an opinion as to whether the financial statements are prepared, in all material respects, in accordance with a financial reporting framework, for example, the IFRSs or US GAAP. He/she has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error. This involves the evaluation of the company’s accounting policies and internal control systems. The auditor should not be involved in the preparation of the company’s financial reporting. (d) The unqualified audit report states that the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of the company in conformity with GAAP. This shows the appropriateness of accounting policies selected by management. It also shows that management’s assessment of the effectiveness of internal control over financial reporting is fairly stated in all material respects. An unqualified report also represents that the company’s financial statements are free from material misstatements including errors, irregularities and fraud. However, it is not intended to be a certification or a guarantee of the accuracy and correctness of the financial statements, but rather an expression of professional judgement based upon a reasonable audit of the statements and underlying records.

12-20 Write a report on your perceptions of the effectiveness of audit and review reports in communicating the nature of the service and the degree of assurance provided.

Answer 12-20 Instructors should recommend that the students make a distinction between audit and review reports. They should also specify the characteristics of each type of report

126 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

indicating the objective of each report and the level of assurance provided to users of company’s financial reporting system.

The audit of financial statements provides high but not absolute assurance on assertions made to interested parties. The auditor attests to the fairness of a company’s financial statements, which are assertions by management regarding the financial condition of the company. It is a form of attestation service in which the auditor issues a written report expressing an opinion about whether the financial statements are free of material misstatements. A review of financial statements provides some assurance about the quality of information included in the financial statements but does not provide as much assurance or the same burden of evidence as an audit.

12-21 Discuss the importance of timelines of corporate and audit reports as one of the quality characteristics of accounting information and the effect of this quality on investment decisions.

Answer 12-21 Corporate reporting is generally directed at providing information to assist the user in decision making. The timeliness of reports is recognized by the accounting profession, the users of accounting information, and the regulatory and professional agencies as an important characteristic of financial accounting information. Several empirical studies have investigated the timeliness of corporate and audit reports. These studies have looked at the relationship between the timeliness of corporate reports and stock prices. The researchers have also examined the effect of the information content of the audit report on the delay in annual earnings release.

The overall conclusion of these studies is that timeliness is a relevant characteristic when assessing the usefulness of accounting information. The studies generally report evidence of an improvement in the timeliness of corporate and audit reporting, particularly for public companies. It has also been shown that the existence of audit qualification tends to lengthen the delay. The results show that a longer delay generally corresponds to a more serious qualification (adverse and disclaimer of opinions).

12-22 Discuss the term ‘scope limitation’ and explain why the auditor should ordinarily disclaim an opinion when the client imposes significant limitations on the audit procedures.

Answer 12-22 A scope limitation due to client instructions or circumstances prohibits the auditor from performing audit procedures. Two main causes of scope limitation are restrictions imposed by the client and those caused by circumstances beyond either the client’s or auditor’s control.

Examples are (1) the client telling the auditor not to confirm accounts receivables, or (2) being hired to perform a first-time audit and, because of inadequate records, being unable to satisfy oneself with beginning inventory and the accounting principles used in the previous year.

In the case of restrictions imposed by the client, the auditor is obliged to express a disclaimer opinion since he/she is unable to obtain competent evidential matters. An example of limitations imposed by a company is when the terms of the engagement specify that the auditor cannot carry out an audit procedure that the auditor believes is necessary. An auditor should not accept an audit engagement when the limitation infringes on the auditor’s statutory duties.

12-23 Discuss the effect of scope limitation on audit opinion and report wording.

Answer 12-23 The necessity for disclaiming an opinion may arise because of a severe limitation on the scope of the audit or a non-independent relationship under the auditing code of professional conduct.

The audit report containing a disclaimer of opinion is not an opinion but a statement by the auditor that an opinion cannot be expressed. When a disclaimer of opinion is expressed: 127 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

The introductory paragraph is modified.

•

The scope paragraph is omitted.

•

An explanatory paragraph is included after the introductory paragraph explaining the reasons for the disclaimer of opinion.

•

The third and concluding paragraph contains a denial of an opinion.

12-24 Discuss the changes in accounting principles (1) when these changes are made in conformity with IFRSs or GAAP and (2) when these changes are not made in conformity with IFRSs or GAAP. Answer 12-24 A change in accounting methods can be made in conformity with accounting standards when (1) the new method is acceptable under the generally accepted accounting principles, (2) the change is properly accounted for and disclosed in the financial statements, and (3) management can justify that the new method is preferable. In such cases, when a change in an accounting principle has a material effect on the financial statements, the auditor may not modify the unqualified opinion on the financial statements. That is, the material change in accounting principle, if properly accounted for and disclosed in the financial statement, requires modification of the auditor’s standard report, but not qualification or modification of the opinion paragraph.

A departure from IFRSs or GAAP will require qualifications or adverse opinions if, in the auditor’s judgement, the effects are material or pervasive. A disclaimer of opinion is inappropriate, because the auditor is in a position to express an opinion and cannot avoid disclosing a known departure from GAAP by denying an opinion on the financial statements.

The auditor’s choice between a qualified or adverse opinion is based on the materiality of the departure from GAAP. If the departure from IFRSs or GAAP is not so material as to cause the financial statements taken as a whole to be misleading, the auditor will express a qualified opinion. If the effects of the departure from GAAP are so material that they cause the financial statements as a whole to be misleading, the auditor will express an adverse opinion.

12-25 What is the role of the company’s audit committee in dealing with the matters concerned with audit reporting?

Answer 12-25 While it is not the audit committee’s responsibility to certify the company’s financial statements or to guarantee the fairness of the auditor’s report, the audit committee constitutes the essential link between the management, independent auditors, internal auditors and the board of directors. This role is essential because the external auditors express their independent opinion of the fairness of the representations in the financial statements, which is required in accordance with auditing standards. The audit committee is thus able to use the information gathered by independent auditors in assessing a company’s internal controls, management performance, internal auditor effectiveness and the effect of each on the quality and reliability of the financial statements.

The external auditor must communicate in writing to the audit committee all significant deficiencies and material weaknesses identified. The written communication should be made before the auditor’s report on internal control over financial reporting is issued. The auditor’s communication should distinguish clearly between those matters considered significant deficiencies and those considered material weaknesses (e.g. inadequate documentation).

128 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

12-26 Discuss the recent changes made with regard to the auditor’s reporting responsibility (refer to the Sarbanes-Oxley Act of 2002, and the positions adopted by the IFAC, the PCAOB and the European Commission in this respect).

Answer 12-26 The SOX Act proposed significant changes with regard to auditing, particularly in Section 404 of the Act, which requires that annual reports of companies listed in the United States must contain a report describing internal controls for financial reporting. The PCAOB has issued Auditing Standard No. 2, ‘An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements (2004)’.

The International Federation of Accountants (IFAC) has also issued ISA 700 with regard to the auditor’s report on financial statements, and ISA 570 concerning events or conditions causing doubt about going concern.

In the European Union, there is currently no unique form of audit report. However, the Eighth European Commission’s Directive of 2005 has stressed the possibility of a common audit report for financial statements prepared on the basis of IFRS/IAS. This would ensure that all audit reports for financial statements prepared on the basis of IFRS/IAS are identical throughout the EU.

Problems 12-27 Audit situations 1 to 10 present various independent factual situations an auditor might encounter in conducting an audit. For each situation, do the following: (a) Identify which of the conditions requiring a modification of or a deviation from an unqualified standard report is applicable. (b) Given your answers in part a, state the appropriate audit report from the following alternatives: (1) unqualified opinion; (2) qualified opinion; (3) adverse opinion; (4) disclaimer of opinion Audit situations 1.

In performing the audit, you do not believe you had adequate access to important records of the company’s inventory. You conclude that there is a possibility that inventory is materially overstated. The client refuses to allow you to expand the scope of your audit sufficiently to verify whether the balance is actually misstated.

2.

The financial statements present fairly, in all material respects, the financial position, results of operations and cash flows in conformity with IFRSs or GAAP.

3.

Company’s management no longer estimates its uncollectible receivables each fiscal year-end, preferring instead the direct write-off method. They argue that it is not material. You believe otherwise.

129 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

4.

The company ‘Yoon.com’ is an internet-based start-up company created to sell computer equipment online. Although the company had a promising start, a downturn in e-commerce retailing has negatively affected the company. The company’s sales and cash position have deteriorated significantly, and you have reservations about the ability of the company to continue in operation for the next year.

5.

The auditor was unable to obtain confirmations from three of the client’s major customers that were included in the sample. These customers wrote on the confirmation letters that they were unable to confirm the balances because of their accounting systems. The auditor was able to satisfy himself through other audit procedures.

6.

Your client, Gamma & Co, has changed the method of depreciation from straightline to declining balance. The effect on this year’s income is immaterial, but the effect in future years is likely to be material. The facts are adequately disclosed in footnotes.

7.

In performing your audit of the Beta Corp for the second year, the management has decided to disclose an ongoing contingent liability in its financial statements for the first time. You have issued a qualified audit report in the first year mainly because of the client’s failure to make sufficient provision for this purpose.

8.

Detailed accounts receivable records of Delta Ltd have not been maintained and certain records and supporting data were not available for the audit. The auditors were not able to satisfy themselves about the amounts at which accounts receivable and allowance for doubtful accounts are recorded in the company’s financial statements. The items of accounts receivable are material in relation to the company’s financial statements. The auditors were unable to satisfy themselves by the use of alternative audit procedures.

9.

You are auditing Omega USA, Ltd, a subsidiary of a foreign company. The company reports its inventories, fixed assets, depreciation, and cost of goods sold on a current-value basis. Such accounting policy violates the accounting standards of both the foreign country and the United States. The effect of this departure from generally accepted accounting principles is quite significant.

10. You are auditing the accounts of Epsilon Inc. for the year 20x4. The company has purchased certain assets (machinery and equipment) from a corporation wholly owned by three major stockholders and officers of the company at management’s estimate of their values at the date of acquisition. You are unable to obtain adequate documentation to support the basis and purchase price of such assets.

Answer 12-27 Condition

Materiality level

Type of report

Comments

1. Scope of the audit has been restricted

Highly material

Disclaimer

This is a disclaimer opinion because the client refuses to allow the auditor to expand the scope of the audit.

2. Financial statements present fairly

Not applicable

Unqualified report

The auditor is satisfied with the financial statements.

130 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

3. A qualified report

Material

A qualified report with an explanatory paragraph

The company uses the ‘direct write-off’ method to account for bad debt although, in the auditor’s opinion, they should estimate bad debt at the end of each accounting period in accordance with IFRSs or GAAP.

4. Substantial doubt about going concern

Material

Unqualified explanatory paragraph

There is a question of the company continuing as a going concern. The auditor therefore must issue an unqualified report with a fourth (separate) explanatory paragraph.

5. Unqualified opinion

Immaterial

Unqualified reportstandard wording

There is no reason to issue a qualified report because sufficient competent evidence was obtained by the auditor. No explanatory paragraph is needed.

6. None

Immaterial

Unqualified standard wording

The amount is immaterial concerning the account of the current period. The facts are adequately disclosed in the footnote.

7. Unqualified opinion

Immaterial

Unqualified report with an explanatory paragraph

It is assumed that management restates the prior period’s financial statements for comparative purposes.

There is an explanatory paragraph regarding the changes in the prior period’s audit opinion.

8. Scope limitation

Material

Disclaimer opinion

The client has imposed substantial restrictions on the scope of the audit by not presenting the details of accounts receivable.

131 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

9. Failure to follow GAAP

Highly material

Adverse opinion

As the effect of this departure from generally accepted accounting principles is quite significant, and concerns several accounts(inventories, fixed assets, depreciation, and cost of goods) the statements do not present fairly the financial position, the results of the operations and the cash flows of the group.

10. Scope limitation

Highly material

Qualified opinion

An ‘except for’ qualified report is appropriate as the auditor was unable to obtain adequate documentation to support the basis and purchase price of such assets.

Cases 12-28 Some European corporations are listed on the US financial market. The Securities and Exchange Commission (SEC) generally requires foreign registrants to furnish financial information substantially similar to that required of domestic companies.

However, foreign registrants’ financial statements need not be prepared in accordance with US GAAP if they are presented in accordance with another comprehensive body of accounting principles (e.g. IFRSs), and are accompanied by a quantitative reconciliation to US GAAP of net income, shareholders’ equity and earnings per share, if materially different. Foreign issuers subject to the SEC filing requirement must file Form 20-F annual reports. Form 20-F must follow the SEC requirements as indicated above.

The following information is related to a Dutch Company (Psi, Inc.) listed on in the United States. It is extracted from the 2003 annual report ‘section of accounting policies’ of the company.

The consolidated financial statements of Psi, Inc. have been prepared in accordance with US GAAP. These accounting principles differ in some respects from generally accepted accounting principles in the Netherlands (Dutch GAAP). In addition to the US GAAP consolidated financial statements, Dutch GAAP financial statements on a consolidated and single company basis are provided. A reconciliation of material differences between the two is also prepared by the company. For purposes of Dutch corporate law, the company’s balance sheet under Dutch GAAP is determinative of the amount available for distribution to shareholders.

132 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The company adopted the application of US GAAP as of January 1, 2001. The 2000 statements were properly restated for this effect, with recognition of the effect in stockholders’ equity as of the beginning of the earliest period presented.

With regard to the above summary extracted from the annual report of Psi, Inc., answer the following questions: 1.

What information additional to the company’s annual report should be included in the Form 20-F submitted by the company to the SEC? Mention and discuss three types of this information.

2.

In your opinion, what are three big differences between Dutch accounting principles and US GAAP?

3.

Draft an unqualified audit report on the financial statements of 2003 in its complete format (assume December 31 as year-end), based on the information provided above.

Answer 12-28 Until 2004, most companies listed in the Netherlands prepared their reports under generally accepted Dutch accounting principles (‘Dutch GAAP’). As required by a European Union regulation, from 2005 onwards the consolidated financial statements of public companies in the EU financial markets have had to be prepared in accordance with International Financial Reporting Standards (IFRS) as adopted by the EU. 1.

Although most of the information required in the 20-F form is similar to the annual report prepared by a company listed in the Netherlands, there are some differences between these two reports. Some of these differences are as follows: (a) information capitalization and indebtedness; (b) the detailed information regarding research and development, patents and licenses; (c) quantitative and qualitative disclosures about market risk; (d) operating and financial review and prospects

2.

The accounting principles applied in the preparation of the US GAAP consolidated financial statements differ in some respects from those generally accepted in the Netherlands. For the determination of net income and stockholders’ equity in accordance with Dutch GAAP, the following differences with US GAAP have been taken into account: (a) Under US GAAP, SFAS No. 142, goodwill is no longer amortized but tested for impairment on an annual basis and whenever indicators of impairment arise. Under Dutch GAAP, goodwill is amortized on a straight-line basis not exceeding 20 years.

As a consequence, goodwill amortization and impairment charges under Dutch GAAP may be different from US GAAP. (b) The Dutch law requires that previously impairment charges for available-for-sale securities are reversed through income when the fair value of these securities increases to a level that is above the new cost price that was established on recognition of impairment. In view of this requirement, other-than-temporary increases in fair value of available-for-sale securities are recognized in financial income. US GAAP prohibit such recognition. (c) In the case of pensions plans and other retirement benefits, there are different assumptions applicable under US GAAP and Dutch GAAP.

133 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

3.

The following is a standard form of unqualified audit report of a company listed in the Netherlands for the year ended 2003.

‘We have audited the consolidated balance sheets of Psi, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2003, appearing on pages xx to xxx. These consolidated financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America and the Netherlands. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.

An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.

We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Psi, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in accordance with accounting principles generally accepted in the United States of America’.

Date Auditing Firm

12-29 The form and content of an audit report are affected by environmental factors such as the legal and economic circumstances, as well as the accounting and auditing practices used in each jurisdiction. Despite efforts to harmonize the accounting and auditing practices within the EU, there are still some differences regarding national auditing standards governing the form and content of auditors’ reports for statutory audit of financial statements within the EU member states. European Commission rules requiring publicly listed companies within the EU to comply with International Financial Reporting Standards (IFRSs) are part of the global strategy to harmonize the financial reporting within the EU member states.

Figure 12.11 shows the format of audit reports of three publicly listed companies within the EU for the year ended December 31, 2005 (France, Germany and the United Kingdom). All three reports are written in standard unqualified format to facilitate their comparisons. You are asked to read carefully the reports and discuss the following points: (a) Describe the form and the content of each report by making reference to the points raised in the chapter in terms of title of the report, addressing the report, introductory paragraph, scope paragraph, opinion paragraph and date of report. (b) Discuss the particular characteristics of each report by considering the following subjects: •

statutory law and regulations;

•

accounting and auditing practices;

•

corporate governance and management’s responsibilities;

134 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

auditor’s responsibility;

•

other elements you may think necessary to comment on with regard to economic, legal, accounting, auditing and reporting matters of the abovementioned countries.

Answer 12-29 (a)

Several important differences exist between audit reports issued within the European Union. The three reports on the accounts of the French, German and British companies are different in terms of content and form. The French report is specifically addressed to the shareholders and contains specific paragraphs on opinion, justification and specific verification. The German and British reports do not have such formats. The three reports refer to the company law of each country as one of the bases of the auditors’ assessments. It should be emphasized that the audit practices in these three countries, similar to other European countries, are to some extent influenced by legal requirements. Both the French and German reports are signed by two statutory auditors, whereas the British report is issued by an auditing firm with no reference to the principal auditor. The French report also contains a paragraph relating to specific matters in accordance with professional standards applicable in France. This paragraph does not appear in the two other reports.

(b)

All three reports refer to IFRS as the basis of the preparation of the companies’ financial statements. The British report contains a paragraph containing a separate opinion in relation to IFRS. The British report contains the specific paragraph referring to British codes of governance, directors’ report on corporate governance and internal audit and control. This issue is not stressed in the French and German reports. Although all three reports contain the specific references to commercial codes, the German report is highly influenced by legal maters. In terms of content, the British report contains more information concerning the auditor’s work, the scope of the audit, and the responsibilities of auditors.

12-30 There are major differences between accounting and auditing practices in the US and some of the EU member states1. An unqualified audit report prepared on the basis of US format is shown as Figure 12.12.

You are asked to compare the US format with those shown in Case 12-29. In your comments, consider the points raised in part (b) of Case 12-29.

Answer 12-30 There are some major differences between the audit report prepared in the United States and those prepared in Europe. The following are the areas in which these differences are significant: (a) The audit report prepared in the United States has changed a lot since 2003, following the introduction of the SOX Act and the establishment of the PCAOB. (b) Unlike the audit reports in major European countries (France, Germany and the United Kingdom), the US audit report does not refer to commercial law and legal requirements.

1 The International Accounting Standards Board (IASB) and the FASB (Financial Accounting Standards Board (FASB-USA) have jointly undertaken a short-term project to eliminate a variety of differences between IFRSs and US GAAP. This “convergence project” grew out of an agreement reached by the two boards in September 2002.

135 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(c) The US audit report puts more emphasis on corporate governance issues (paragraph 2) than do audit reports in France and Germany. In this regard, the UK audit report has some similarities with the US report. (d) The US audit report stresses the importance of the effectiveness of internal control in the audit process (the whole paragraph 4 and part of paragraphs 2 and 3).

136 .

CHAPTER 13

INFORMATION TECHNOLOGY AND AUDITING Instructor guidance Information technology systems currently provide most of the information needed for auditing, and auditors must understand the environment in which these systems operate. This helps to identify the risks associated with rapidly changing information technology – and how those risks apply to a particular client. The understanding of computer systems is necessary in order to evaluate (a) the availability of evidence, (b) the competence of evidence and (c) the risks associated with the system.

This chapter discusses the role of auditing with regard to information technology. It presents an overview of electronic commerce and electronic business, and identifies approaches to gaining an understanding of the risks and applicable controls associated with client computer systems. It also presents IT risk management and the auditor’s concerns in this respect. Due to the increasing application of computer software, test data and expert systems in auditing, the use, application and main characteristics of computer-assisted audit techniques (CAATs) are also discussed in-depth.

Instructors need to emphasize that audit objectives remain the same whether the client has a computerized or manual accounting system, but that the audit approach may need to be modified when the client’s accounting systems are automated. The instructor should first present the challenges facing auditors when auditing computerized accounting systems, and then get into a detailed discussion of e-commerce and e-business and the effect of these on the auditor’s assessment of risk. It is then important to emphasize the principles for accounting information security and for processing this information. When going over these principles, it is desirable to relate them to the objectives of a company’s internal control systems and the major differences that occur in the audit trail when applying computerized accounting systems.

Discuss the various tools available to test computer processing. Stress the importance of testing controls in a computerized environment.

IT risk management and the auditor’s risk assessment in a computerized accounting system should be discussed in the context of audit planning. An in-depth discussion of the CAATs in the chapter (pp. 402–411) requires the instructor to focus on how these techniques can improve the effectiveness and efficiency of auditing procedures. This discussion has practical implications in audit work as these techniques may provide effective tests of control and substantive procedures where there are no input documents or a visible audit trails, or where population and sample sizes are very large. Conclude by briefly discussing the future challenges that changes in technology will pose for auditors.

137 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 13-1 What are the requirements for auditing in an IT environment?

Answer 13-1 Because of the important effects of IT on the overall audit process, auditors must understand the risks associated with rapidly changing information technology – how those risks apply to a particular client, and the controls needed to respond to those risks. They should also understand and consider the characteristics of IT tools and the environment in which those tools are used. Auditors need to consider the characteristics of the IT environment as this has a significant effect on the selection of internal controls auditors rely on and the nature, timing and extent of audit procedures.

13-2 Describe e-business and e-commerce and their effects on auditing.

Answer 13-2 E-business comprises e-commerce (performing business transactions using internet technology), e-content (publishing content on websites) and e-collaboration (sharing data and applications between online tools and users). E-commerce integrates network technologies, information management, security service and value-added networks (VANs) to provide online services such as product delivery, electronic shopping, home banking and secured online payments. The auditor must consider the unique risks associated with e-business and e-commerce when planning and performing the audit of the financial statements. These risks include system security and protection against malicious intrusion, integrity and completeness of processing, integrity of data communication and system interdependence.

Audits of e-commerce will focus on tests of controls and processes. The auditors should consider the significance of e-commerce to business activities of the company and the effect of e-commerce on their assessments of risk for the purpose of forming an opinion on financial statements. There is also the need to design internal control procedures to ensure the integrity and authentication of e-business transactions.

13-3 What is the impact of the auditor’s understanding of an entity’s business activities within the scope of audit?

Answer 13-3 The auditor’s understanding of the company’s business activities and its environment is an essential part of planning and executing an audit, and establishes a frame of reference within which the auditor exercises professional judgement about assessing risks of material misstatements of the financial statements. The auditor’s knowledge of the company is fundamental to assessing the significance of e-commerce to its business activities and any effect on audit risk. The auditor should understand the company’s business processes, reassess audit risks and determine how these may affect the overall audit. This requires a thorough analysis of the risks identified and a study of whether they may result in material misstatements of the financial statements.

13-4 To what extent do computerized information systems affect the auditor’s function?

Answer 13-4 A computerized information system may affect the audit function in several respects. First it may affect the procedures followed by the auditor in obtaining a sufficient understanding of the accounting and internal control systems. It also affects the assessment of overall risk and of risk at the account balance and class of transactions level. The auditor should consider the inherent risk and control risk in his/her assessment of risk with regard to the client’s 138 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

computerized system. The computerized information system also affects the auditor’s design and performance of tests and control and substantive procedures appropriate to meet the audit objective. Auditors must expand their technological knowledge and skills, devise more effective audit approaches by taking advantage of technology and design different types of audit tests to respond to a new business processes.

13-5 What are the new types of audit risks in an e-commerce environment?

Answer 13-5 The new audit risks associated with e-commerce should be addressed by the company and considered by the auditor when planning and performing the audit of financial statements. This requires auditors to identify the specific matters affecting their missions when considering the significance of e-commerce to business activities and the effect of e-commerce on assessments of risk for the purpose of forming an opinion on financial statements. The evaluation of IT risks depends primarily on the quality of accounting and financial information.

The auditor should understand the effect on financial statements of the risks of e-commerce and the company’s approach to managing those risks, particularly the adequacy of the internal control system, including the security infrastructure and related controls, as they affect financial reporting. IT risks may also endanger the continuing existence of enterprises (the going concern problem) whose business activities are highly dependent on IT. Such risks should be identified, analyzed and assessed by the risk management system.

13-6 Discuss the features of the risk management approach proposed by the IFAC in the context of IT. Answer 13-6 To answer this question it would be most appropriate to refer to Figure 13.1 (p. 399 – IFAC Risk Management Approach in an E-Business Environment). It presents the management of IT risks regarding e-business accounting. The diagram emphasizes the risk management objectives and issues in conjunction with e-business accounting principles and criteria. IT business processes, applications and infrastructure can be regarded as an integral part of the IT system. Infrastructure risks relate to the adequacy of the IT infrastructure for information processing, including the accounting and financial information as an essential part of this process. IT business processes may directly affect the accounting system and, hence, the reliability of any information or data that it produces. The consideration of accounting information security and processing becomes inevitable in designing IT business processes because this is the only way to ensure the reliability of information produced by the company.

13-7 How would it possible to rely on accounting information in a changing IT environment?

Answer 13-7 The reliability of accounting information in an IT environment depends on several points, notably the two following factors. Firstly, information reliability depends on IT system reliability and this depends on IT controls. Second, the presence of audit committees and auditors can contribute considerably to the preparation and disclosure of reliable accounting information. With regard to the first factor, the company’s management implements controls to ensure that an IT system performs reliably. Information generated by an IT system will be reliable where that system is capable of operating without material error, fault or failure during a specified period. This also applies to accounting information. Two types of principles may be used to evaluate whether processed accounting information is reliable: •

principles for accounting information security; and

•

principles for appropriate accounting information processing.

139 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

13-8 What principles must be required to achieve the objective of the reliability of accounting information?

Answer 13-8 To respect the principle for accounting information security, it is necessary to develop, implement and maintain an appropriate security concept to ensure information security. A security concept comprises management’s assessment of the security risks resulting from the use of IT and, derived from this, the technological and organizational measures needed to help ensure an adequate platform for IT applications and the appropriate and secure execution of IT-aided business processes. The principles for appropriate accounting information processing are fulfilled where the e-business system and the entire IT system safeguards comply with the general criteria such as completeness, accuracy, timeliness, assessability, chronological order and inalterability (logging of alterations). These are the general criteria for the input, processing, output and storage of information and data about e-business transactions.

13-9 What are the features of computer-assisted audit techniques (CAATs)?

Answer 13-9 CAATs are computer programs the auditor uses as part of the audit procedures to process data of audit significance contained in a company’s information systems. CAATs include generalized audit software, utility software, test data, application software tracing and mapping and audit expert systems. CAATs may improve the effectiveness and efficiency of auditing procedures. They may also provide effective tests of control and substantive procedures where there are no input documents or visible audit trails, or where population and sample sizes are very large.

13-10 What factors should the auditor consider when using a CAAT? Answer 13-10 CAATs are important tools for information systems audits. They can contribute to auditors’ work in situations where the computer may be used to gather, or assist in gathering, audit evidence. When using and deciding about CAATs, auditors should consider the following factors: •

planning;

•

the IT knowledge, expertise and experience of the audit team;

•

the availability of CAATs and suitable IT facilities;

•

the impracticability of manual tests;

•

the effectiveness and efficiency of using CAATs over manual techniques; and

•

timing constraints.

13-11 What are the different classifications of CAATTs? Answer 13-11 Computer-assisted audit tools and techniques (CAATTs) are the major tools which can be classified in the various groups listed on pp. 407–408 of this chapter. These mainly include electronic working papers, electronic commerce and internet security, continuous monitoring, information retrieval and analysis, fraud detection, network security software and performance, databases of audit history, computer-based training and time tracking. The brief explanation of each is provided on the above pages.

140 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

13-12 What advantages does an integrated test facility (ITF) have over a test data approach and how does it use test data?

Answer 13-12 Test data is a CAAT in which test data prepared by the auditor is processed on the current production version of the client’s software, but separately from the client’s normal input data. Integrated test facility (ITF) is the part of the client's software that enables the auditor's test data to be integrated and processed with the client's live input data. ITF uses the test data approach, but to a higher level. The test data approach involves submitting individual fictitious transactions, while the ITF approach involves developing an entire dummy company.

ITF gives a more reliable and complete source of evidence for auditor’s to work with.

13-13 In what way(s) is the assessment of audit risk affected in terms of transaction trails and data?

Answer 13-13 With regard to e-commerce, a company’s management faces business risks arising from loss of transaction integrity, the effects of which may be compounded by the lack of an adequate audit trail in either paper or electronic form. In terms of potential loss of transaction trails and data, the assessment of audit risk in the examination of a company’s financial statements is affected in the following ways: •

The determination of detection risk by the auditor is affected by the validity of the internal and external electronic evidence, the security of transferring electronic information, the control of network applications and the standards and formats of electronic audit trails.

•

The cost effectiveness of the audit of financial statements depends on the controls implemented in terms of policies for retention and recovery of transaction data.

•

In a paperless environment, the business cycle is compressed and many of the balance sheet accounts (e.g. inventory, accounts receivable and payable) may be significantly reduced. This may have an important effect on the auditor’s assessment of the inherent and control risks of these accounts.

•

The increasing number of transactions made possible by IT systems may affect audit sampling and the assessment of inherent and control risks, because the auditor should consider small amounts, particularly in the case of cash and sales items.

13-14 Describe the requirements in terms of security concepts when referring to reliable accounting information.

Answer 13-14 A security concept comprises management’s assessment of the security risks resulting from the use of IT and, derived from this, the technological and organizational measures needed to help ensure an adequate platform for IT applications and the appropriate and secure execution of IT-aided business processes. The following requirements are essential to ensure reliable accounting information: •

Integrity: data and information are complete and accurate, systems are complete and appropriate and all of these are protected against unauthorized modification and manipulation.

•

Availability: the enterprise should ensure the constant availability of the hardware, software, data and information to maintain business operations within a reasonable period of time.

•

Confidentiality: organizational and technical measures, such as encryption technologies, include instructions to restrict the transmission of personal data to third parties, transmit encrypted data to authorized third parties, identify and verify the recipient of data and to delete stored personal data after a certain length of time.

141 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

Authenticity: the traceability of a business transaction to the individual who initiated it.

When data or information is exchanged electronically, it is important that the other party be identified or identifiable – for example, by using digital signature procedures.

•

Authorization: only certain persons, appointed in advance (so-called authorized persons), may access certain data, information and systems (e.g. password protection) and that only authorized persons can use the rights defined for this system.

•

Non-repudiation: the ability of IT-aided procedures to bring about desired legal consequences with binding effect.

13-15 Identify and briefly explain the general criteria to achieve appropriate accounting information processing in the case of e-business transactions.

Answer 13-15 The following general criteria for the input, processing, output and storage of information and data about e-business transactions should be fulfilled: •

Completeness: refers to the extent and scope of processed e-business transactions, that is, the recipient of transactions determines that all transactions are input completely into the e-business system.

•

Accuracy: processed information should accurately reflect e-business transactions, that is, recorded transactions should reflect the actual events and circumstances in conformity with the applicable financial reporting framework.

•

Timeliness: business transactions should be recorded as soon as possible after the transaction has occurred.

•

Assessability: each item and disclosure in the financial statements should be verifiable in that it can be traced back to individual entries in the books and records and to the original source documents that support that entry.

•

Chronological order: in an accounting system, accounting entries should be organized in both chronological order (a journal function) and by nature (e.g. by type of asset, liability, revenue or expense — a ledger function).

•

Inalterability (logging of alterations): no entry or record may be changed after the posting date so that its original content can no longer be identified, unless the change to the original content can be identified by means of a log of such alterations.

Discussion Questions 13-16 Advances in IT have changed the corporate reporting process. This has altered the traditional methods of handling accounting and auditing data.

Discuss the role of auditors in a changing IT environment. How do changes in IT affect the overall objective and scope of the audit of financial statements? To what extent do the changes in this area affect the auditors’ performance and quality of their work?

Answer 13-16 With the increasing place of IT in business, auditors are faced with the challenges of understanding a company’s IT processing and control environment.

142 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Rapid changes in information technology have resulted in the adoption of complex information systems by companies. Naturally, these developments have a parallel effect in financial reporting, where there is an increasing demand for more continuous reporting. This has a direct effect on the auditor’s scope of work and makes it necessary for them to go along with the technological changes. Above all, the changes in information technology require a reconsideration of what we know about financial-statement audit technology.

Auditors must understand the risks associated with rapidly changing information tools and techniques – and how those risks apply to a particular client.

Auditing standards stipulate that auditors are responsible for obtaining an understanding of the control environment as part of financial audits. This understanding should include IT controls, as these controls are a significant component of the control environment. The auditor’s involvement in IT controls largely depends on the size of the company, the importance of IT in its financial statement processes and the level of reliance on IT controls. IT knowledge is particularly required for auditors in charge of publicly listed companies.

13-17 One concern in the use of IT within companies is related to the considerable costs of such operations. The cost elements are not only related to the implementation phase of computerized accounting and information system but also to the continuous monitoring of such systems. In this regard, of course, a thorough analysis in terms of costs and benefits should be made. However, the resources of small- and medium-sized firms cannot compare with those of large and multinational companies.

Discuss the use of IT for small- and medium-sized companies. To what extent do the disparities between these types of companies and large companies in terms of financial and human resources affect the efficiency of such services for each category of company? Do differences in terms of resources play for or against the small- and medium-sized companies in a highly competitive and globalized capital market?

Answer 13-17 Similar to other planning and control systems, the adoption of an IT system within a company is a costly operation. The costs associated with the implementation and application of IT systems should be considered in the long term and on continuous process. The company should do a cost-benefit analysis before establishing a computerized system in order to evaluate the benefits obtained in terms of cost effectiveness and the efficiency of the information system. This analysis should take account of all relevant costs regarding staff training, using expertise and innovating the IT system. The management should consider if sufficient resources will be available in the future for investing in IT to keep pace with technological developments, otherwise the adoption of an IT system only for a short periods will not be very beneficial to the company.

It is true that the company’s size is a determinant factor in implementing efficient financial reporting and information systems based on computerized tools and techniques. However, the rapid spread of cheaper high-speed internet access, lower prices for networking technology and a push by vendors to be more accommodating will fuel a steady increase in small- and mediumsized firms spending on information technology.

Small- and medium-sized businesses usually find an extremely wide range of options available to them. For example, this type of firm could choose to enter almost any global market. A small/medium-sized firm looking to find the right supplier has any number of local and global options available to them. A small- and medium-sized business trying to decide on a marketing campaign has options of television campaigns, magazine advertisements, internet campaigns or a combination of the three. The range of decisions and the range of possibilities associated with each decision can make managing information in an IT environment an overwhelming task.

143 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

13-18 Discuss Question 13-17 with regard to the audit market. In current audit environments the big local audit firms as well as small and medium-sized firms are not in the same position in terms of financial and human resources and technical expertise as compared with the multinational accounting firms such as the Big Four. How do such disparities affect the audit quality, the auditors’ performance and in general terms competitiveness in audit market?

Answer 13-18 Due to advanced information technology and increasing market globalization, auditing is becoming more and more a specialized task. Competency and specialization in different economic and industrial areas are required criteria in the audit market not only because auditors should perform audits of increasingly large companies, but also because auditing of different branches of diversified activities in industry, banking, insurance, commerce etc. needs specific expertise.

The use of an IT system requires a specialist who understands how technology affects the financial statements. For public companies that are automated (most), the auditor has to be able to apply audit procedures and to test controls in a highly computerized environment. That requires the knowledge (or access to it) to test the entity’s general computer controls, application controls and controls that may be embedded in the system software. To discern whether they are operating effectively, the expert has to document and test all those controls: checking passwords, security elements and back-up procedures and conducting a basic audit of the status of the infrastructure.

It is naturally true that the size of the audit firm can influence the availability of sufficiently trained staff and high level of expertise required to audit the IT systems of publicly listed companies. Many small- and medium-sized audit firms face difficulties coping with the increasingly complex IT environment. Moreover, large accounting firms have a broader range of services to offer than small- and medium-sized firms so it might be expected that they have more facilities to deal with complexities involved in the IT environment.

Audit quality can be viewed as a composite phenomenon comprising auditor competence, correct application of auditing standards, application of high moral and ethical standards by the auditor, auditor independence, auditor reputation and application of professional judgement by the auditor. These qualitative characteristics cannot be achieved without a high level of training and specialization, which in turn require financial and human resources and technical expertise.

In that sense, auditor size (or international affiliation) may be considered a reasonable proxy of audit quality and performance.

13-19 Auditors’ planning is affected by several factors in an IT environment. The auditors express concerns about risk assessment. They have specific concerns regarding risk assessment in an IT environment. Discuss these issues and the extent to which they affect the audit scope. Refer also to the study of Yu et al. (2000) in respect of the elements affecting the audit risks and its components.

Answer 13-19 The major trends in information technology consist of automating procedures, developing more appropriate IT-based processes and replacing analogue with digital information. Progress has enabled revolutionary transformations in information technology. Due to recent advances in network technologies and the enhancement of cost effectiveness by using internet and World Wide Web applications, the development and practice of electronic commerce have grown rapidly.

The paper of Yu et al. (2000) identified possible impacts of e-commerce on the auditing practices with a view to future development, challenges and opportunities. They discussed new audit risks and internal control considerations. This discussion based on the Yu et al. paper on the new features affecting audit risk is presented on pp. 396–399 of the chapter. The instructor should recommend the students to read the above paper or other research studies on this topic published in the ‘Journal of Information Systems’ and ‘Auditing: A Journal of Practice and Theory’.

144 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

It would also be interesting to refer to the paper of Alles, Kogan and Vasarhelyi (The CPA Journal 2007) entitled ‘Accounting in 2015’ for a discussion on major technological advances and their implications for accounting and auditing.

13-20 Computer-assisted audit techniques (CAATs) and computer-assisted audit tools and techniques (CAATTS) play an important role in performing audits in a computerized environment. Discuss the features of these techniques and how they contribute to the auditor’s functioning and performing audit procedures. What are the advantages and disadvantages of CAATs? Answer 13-20 The CAAT and its different categories and characteristics are discussed on pp.

402–407 and 409–411. CAATTs have been explained on pp. 407–408. The idea behind this question is to draw the attention of instructors and students to these computer techniques and their applications to auditing. The chapter provides a brief analysis of the main areas where software tools are used in auditing, technology impacts on the auditing profession and other related issues. The sensible use of these techniques can offer considerable opportunities for quicker and more efficient audits. The instructor should recommend to the students that they refer to other documents such as those indicated on the bibliography at the end of the chapter and/or other papers for further discussion on this topic.

Because of the importance of the computer as an audit management tool and the application of IT tools in conducting audits, it is imperative to acquire an in-depth knowledge on the use of IT in auditing. For this purpose, it is worth first referring to the documents released by the IFAC, Information Systems Audit and Control Association, the Institute of Internal Auditors and International Organization of Supreme Audit Institutions (INTOSAI).

145 .

CHAPTER 14

CONTINUOUS AUDITING AND CONTINUOUS REPORTING Instructor guidance This chapter discusses emerging trends in technology and how they will alter both financial reporting and auditing. The chapter emphasizes the importance of continuous auditing and continuous monitoring processes, which provide organizations with new levels of assurance and more efficient reporting of audit information. Continuous auditing is a new and evolving audit methodology that has relevance and application potential for various types of organizations. By using the information technology, the companies can receive, process and report large sums of data on a continuing basis, which in turn can be used for continuous monitoring and auditing.

The content of the chapter should be of interest to the students and practitioners, because the future of auditing substantially depends on the evolution of real-time reporting and continuous examination of financial statements and reporting process of entities.

Instructors are recommended to make comparison between traditional and modern approaches of auditing and discuss the advantages of continuous auditing over the traditional model of auditing. In the traditional audit approach used by internal and external auditors, a period of time passes between the completion of fieldwork and issuance of the audit report. In many instances, the impact of this delay makes the information contained in the report less useful or beneficial to the user. This is caused by the historical nature of the information contained in the report, which can be affected by such issues as auditee corrections to identified deficiencies, and deterioration in the control environment (or related auditee data) resulting from identified control weakness or from significant subsequent events that materially affect the original audit opinion.

The students should be informed that in the context of external auditing, the ability to provide audit on real-time financial information could have a significant impact on an organization’s market capitalization and on its cost of capital. It is certain there is tremendous need for current disclosure of financial information. Furthermore, there is no doubt that the value of that information, when accompanied by an external audit opinion, will be enhanced. In the context of internal audit, the ability to provide management with real-time auditing on the functioning of controls and on financial transactions can enhance significantly management’s ability to make key business decisions.

Instructors should also discuss the other important issues such as the role of auditor with regard to IT controls, the use of COBIT framework and the application of XBRL which are also among the main topics of this chapter. Because of ever-increasing changes in IT environment and its effects on financial reporting and auditing, the students should refer to end-of-chapter references for further readings and an in-depth information in these areas.

146 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 14-1 Why are IT controls important within an organization?

Answer 14-1 In an IT environment, the IT controls are a significant component of organizational control processes because the key to maintaining profitability in a technological changing environment is how well you maintain control. The use of IT tools in a company’s operations significantly affects the financial-reporting process, and the reliability of financial reporting is heavily dependent on a well-controlled IT environment. In such environment, the IT controls are a significant component of control process. The automation of financial reporting may enable a more effective control environment for management, but this significantly depends on the level of reliance on IT controls and their appropriateness to the organization’s needs and objectives.

14-2 What are the characteristics of company-level controls, general controls and application controls within the IT services of an organization? Provide examples of each of the above controls.

Answer 14-2 As Figure 14.1 in the chapter demonstrates these are the IT control tools which are embedded within each element of business. Company-level controls which are the most important part of controls over the IT control environment set the tone for the organization. The examples include the policies and other enterprise-wide guidelines, governance mechanisms and information systems which are mainly established by executive management. General controls are mostly related to IT services within organization such as programme development and computer operations. Application controls are embedded in business process application and include the elements such as completeness, accuracy and authorization.

14-3 To what extent does a computerized information system affect the auditor’s assessment of control risk?

Answer 14-3 The nature and characteristics of a company’s use of IT in its information system affect the company’s internal control over financial reporting. The auditor is responsible for the assessment of the effectiveness of the company’s internal control over financial reporting, and this includes the issuance of an explicit statement as to whether internal control over financial reporting is effective. The auditor should consider the control environment, control activities and control procedures the company has applied to those activities involved with IT to the extent of their relevance to the financial statement assertions. The characteristics of IT systems require a more pervasive approach towards the assessment of internal control risks than other aspects of organizational controls because IT may introduce additional or increased risks that require new or enhanced control activities. These include the assessment of IT risks, for example, IT management, data security, programme change and development.

14-4 Describe the features of Auditing Standard No. 2 of PCAOB, particularly with regard to IT controls.

Answer 14-4 This audit standard establishes the requirements for performing an audit of internal control over financial reporting and provides some important directions on the scope and approach required of auditors. The PCAOB standard includes specific requirements for auditors to understand the flow of transactions, including how transactions are initiated, authorized, recorded, processed and reported. Such transactions’ flows commonly involve the use of application systems for automating processes and supporting high volume and complex transaction processing. The reliability of these application systems is in turn reliant upon various

147 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

IT support systems, including networks, databases, operating systems and more. Collectively, they define the IT systems that are involved in the financial-reporting process and, as a result, should be considered in the design and evaluation of internal control.

14-5 What are the main characteristics of the COBIT framework?

Answer 14-5 COBIT enables the development of clear policy and good practices for IT control within organization. It helps meet the multiple needs of management by bridging the gaps between business risks, control needs and technical issues. The COBIT framework provides a tool for the business process owner that facilities the discharge of this responsibility. It allows IT sources to be managed by a set of naturally grouped processes. The framework includes the following major components: •

a set of 34 high-level control objectives, one for each of the IT processes, grouped into four domains: planning and organization, acquisition and implementation, delivery and support and monitoring;

•

IT governance guidance which provides the structure that links IT processes, IT resources and information to enterprise strategies and objectives;

•

an audit guideline to enable the review of IT processes against COBIT’s 318 recommended detailed control objectives to provide management assurance and/or advice for improvement;

•

a management guideline for the purpose of answering the questions with regard to management strategy, performance, risk factors, and evaluation tools;

•

an implementation tool set that provides lessons learned from those organizations that quickly and successfully applied COBIT in their work environments.

14-6 What are the features of the compliance road map based on the COBIT framework in internal control, internal and external auditing?

Answer 14-6 The Sarbanes-Oxley Act of 2002 requires all qualifying SEC-registered organizations to document, evaluate, monitor and report on internal control over financial reporting and disclosure controls and procedures, which include IT controls. The IT control objectives known as COBIT aligns with the spirit of the SOX Act requirement.

The compliance road map provides direction for IT professionals on meeting the challenges of the SOX Act. Compliance with the Act from an IT controls standpoint must be integrated within the overall business-led compliance process. The following are the essential steps in compliance road map: 1.

plan and scope

2.

perform risk assessment

3.

identify significant accounts and controls

4.

document control design

5.

evaluate control design

6.

evaluate operational effectiveness

7.

identify and remediate deficiencies

8.

document process and results and

9.

build sustainability.

148 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

14-7 Describe the differences between the traditional approach of auditing and the approach of the continuous auditing process.

Answer 14-7 The traditional audit approach is based on the examination of historical financial statements but the balance sheet and income statement are losing their usefulness as relevant measures of a business as underlying processes undergo profound changes. Central to the future of accounting is the continuing relevance of accounting measurement for corporate management and firm evaluation. The traditional approach of auditing is based on ‘balance sheet’ audit and provides the conventional ‘backward-looking’ audit reports attached to financial statements. There is a clear necessity to increase the scope of audit coverage in areas of high organizational risk. The emerging real-time and electronic financial-reporting process, along with the urging of market regulatory bodies, has pushed auditors towards online and real-time, continuous audit. This has resulted in an evolution from manual audit of paper documentation to auditing by computer. Continuous auditing enables auditors to shift their focus from the traditional ‘balance sheet’ audit to the ‘system and operational results’ audit.

14-8 How will XBRL change the financial-reporting structure of corporations?

Answer 14-8 Instead of treating financial information as a block of text – as in a standard internet page or a printed document – XBRL provides an identifying tag for each individual item of data. The introduction of XBRL tags enables automated processing of business information by computer software, cutting out laborious and costly processes of manual re-entry and comparison. Computers can treat XBRL data ‘intelligently’: they can recognize the information in a XBRL document, select it, analyze it, store it, exchange it with other computers and present it automatically in a variety of ways for users. XBRL greatly increases the speed of handling of financial data, reduces the chance of error and permits automatic checking of information.

14-9 Discuss the benefits of XBRL in companies’ reporting.

Answer 14-9 These benefits are highlighted on p. 427 of the chapter. The major benefits can be described as follows: •

All types of organizations can use XBRL to save costs and improve efficiency in handling business and financial information;

•

XBRL is extensible and flexible and it can be adapted to a wide variety of different requirements;

•

By using XBRL, the companies can automate the processing of data collection;

•

All participants in the financial information supply chain can benefit, whether they are preparers, transmitters or users of business data;

•

Small businesses can benefit alongside large ones by standardizing and simplifying their assembly and filing of information to the authorities;

•

Users of data which is received electronically in XBRL can automate its handling, cutting out time-consuming and costly collection and re-entry of information. Software can also immediately validate the data, highlighting errors and gaps which can immediately be addressed;

•

Auditors can benefit from XBRL as it increases the opportunities to perform continuous auditing of financial information.

149 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

14-10 Is continuous monitoring the same as continuous auditing?

Answer 14-10 No. The objective of continuous monitoring is to obtain information about the performance of a process, system, or data, whereas the continuous auditing aims at issuing an audit report on financial operations. The main differences are as follows: •

The monitoring of processes and systems is a management function whereas the continuous auditing mainly performs by independent auditors;

•

Information from a continuous monitoring system provides indirect information about the performance of a process, system or data, whereas information obtained through a continuous auditing in the case of observance of a process or system, reperformance of a control, or testing of data provides direct evidence about the process, system or data;

•

In a continuous auditing engagement, the objective is to accumulate sufficient evidence to reduce risk to a level that is, in the practitioner’s professional judgement, appropriately low for the high level of auditing imparted by the report. In the case of continuous monitoring, the significant information about a process, system or data, is produced, but due to its indirect nature, that information alone would not be sufficient in a continuous auditing engagement.

14-11 How is continuous assurance defined?

Answer 14-11 Continuous assurance can be provided when auditors perform continuous control and continuous auditing in the context of risk assessment. It will be guided by data quality considerations, which will determine the relative accuracy of measurement and materiality thresholds. Its framework consists of the combination of the activities performed by auditors to evaluate the state of the controls, risk management within organization and assessment of the adequacy of management monitoring function. Based on real-time auditing and expanded scope of the audit to encompass broader assurance issues, the continuous assurance model will serve many clients and will likely be better tailored to their specific needs.

The continuous assurance model will turn the audit process into audit by exception: the timing, process and outcomes of the audit will be changed. It will also cover a wide set of quantitative and qualitative nonfinancial data. It can be envisaged that accounting firms might independently prepare reports for sale to any interested party, or users might commissioned them directly.

14-12 Explain briefly the contributions of the continuous risk assessment process within an entity.

Answer 14-12 Continuous risk assessment is part of continuous assurance process and refers to the activities of auditors in identifying and assessing the levels of risk within the organization.

The auditors risk assessment consists of examining trends and comparisons – within a single process or system against its own past performance, and against other processes or systems operating within the enterprise. For example, product line performance would be compared to previous year results, as well as assessed in context of one plant’s performance versus all others. Such comparisons provide early warning that a particular process or system (audit entity) has a higher level of risk than in previous years or than other entities. The audit response will vary depending on the nature and level of risk. The outcome of the auditor’s assessment is a thorough evaluation of management actions, and to see if audit recommendations have been implemented properly and are reducing the level of business risk.

14-13 What are the responsibilities of a company’s management in terms of monitoring business information in an IT environment?

Answer 14-13 Executive management has a responsibility to ensure that the organization monitors its use of information and IT. IT monitoring of information is fundamental to IT

150 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

governance and part of management’s stewardship responsibility to make certain that what was agreed to be done is being done and is being done in line with directions and policies set by the board. Monitoring is needed to make sure that those to whom responsibility has been delegated are doing the right things, are doing them right and can be held accountable if they do not. The main areas of management’s responsibilities in this respect are as follows: •

compliance with strategic goals and the achievement of tactical projects and activities;

•

the performance of people, systems and processes;

•

the proper functioning of the internal control systems;

•

ensure the improvements regarding risk management, quality management, and internal and external audit.

Discussion Questions 14-14 ‘Emerging trends in technology will fundamentally alter the way in which both business and accounting will be conducted.’ Discuss technological advances and their implications for accounting, auditing and reporting in the next ten years.

Answer 14-14 The major trends in IT consist of automating procedures, developing more appropriate IT-based processes, and replacing analogue with digital information. According to an article published in the CPA Journal (Michael Alles, Alexander Kogan and Miklos A. Vasarhelyi, 2005), the future technological advances will include the following: •

More development in XBRL and XML standards: allows real-time reporting and the increase in the scope of the reports;

•

Information capture technology: numerous types of innovative computerized information capture devices are likely to emerge (e.g. bar codes scanners, video cameras, biometrics devices such as iris scanners;

•

Access and monitoring technology: major transformations should be expected in access control and monitoring technology. The various biometric devices will be integrated into enterprise systems to provide security, safeguard assets and monitor important activities;

•

Storage: digital storage capacity is growing even faster than chip computing speed.

Terabyte storage devices make it possible to collect, store and analyze numerous attributes of business processes and provide detailed information for decision making;

•

Telecommunications and inter-networking: such as desktop video teleconferencing;

•

Pervasive computing: computing devices will become so integrated in regular objects that they will become transparent;

•

Cryptography: well-established cryptographic techniques of both secret-key and public-key encryption to ensure the confidentiality of information and authenticate users;

•

Automatic confirmation, automatic work papers, automatic inventory tracking and continuous process monitoring architectures.

151 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

14-15 ‘By assessing the combined results of the continuous monitoring and auditing processes, auditors are able to provide continuous assurance regarding the effectiveness of internal controls.’ Discuss the above statement with regard to the relationship of continuous auditing to continuous assurance and continuous monitoring.

Answer 14-15 One of the main objectives of continuous monitoring is to address management’s responsibility in assessing the adequacy and effectiveness of controls. This involves identifying the control objectives and assurance assertions and establishing automated tests to highlight activities and transactions that fail to comply. Management’s use of continuous monitoring procedures, in conjunction with continuous auditing performed by internal auditors, will satisfy the demands for assurance that control procedures are effective and that the information produced for decision making is both relevant and reliable. Above all, there will be additional benefits for the organization in terms of reduction in the instances of error and fraud, increase in operational efficiency and overall results. More effective use of information and data analysis technologies will contribute to these objectives.

When reading this chapter, it is worth to refer to and accounting and auditing journals for updating the knowledge on these topics as there will be continuous developments in these areas.

14-16 In the aftermath of a series of high-profile business scandals, efforts were made to enhance corporate governance and risk management with the establishment of new regulations. The Sarbanes-Oxley Act of 2002 and the establishment of PCAOB address the essential issues on IT control framework, internal control reporting and auditor’s role in this respect. Discuss this topic along with how the proposed measures could be effective in bringing confidence to the capital market economies.

Answer 14-16 Today’s corporate stakeholders expect more: greater assurance, more oversight and clear evidence of internal controls. The SOX Act has fundamentally changed the business and regulatory environment. The Act aims to enhance corporate governance through measures that will strengthen internal checks and balance and, ultimately, strengthen corporate accountability. One of the important aspects of the Act is the introduction of Section 404 which not only requires senior management and business process owners to establish and maintain an adequate internal control structure, but also to assess its effectiveness on an annual basis.

The focus of this Act is on improving transparency and accountability in business processes and corporate financial accounting to restore confidence in financial markets.

In the process of compliance with the Act, the IT plays a vital role particularly with regard to internal control since systems, data and infrastructure components are critical to the financialreporting process. The PCAOB suggests that the IT controls have a pervasive effect on the achievement of many control objectives. They also provide guidance on the controls that should be considered in evaluating an organization’s internal control, including programme development, programme changes, computer operations and access to programmes and data.

14-17 It has been stated that IT systems are an essential part of the overall financialreporting process. Discuss the place of IT within the organization and how it contributes to an effective system of internal control over financial reporting.

Answer 14-17 Executive management is required to document the effectiveness of the control environment and accuracy of information contained in financial reports. In response to increasing demand for reliable and timely information, companies’ managements seek to modernize internal controls in complying with the regulatory requirements. The use of IT tools in a company’s operations significantly affects the financial-reporting process, and the reliability of financial reporting is greatly dependent on a well-controlled IT environment. In this respect, the nature and characteristics of a company’s use of IT in its information system affect the company’s internal control over financial reporting.

152 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Although technological advances have brought some form of complexity to corporate reporting and audit function, they have contributed to accounting and auditing in terms of low-cost, accuracy and timeliness of information by using high-speed digital data transmission. The IT tools have been beneficial by providing more timely, flexible, accessible, transferable and transparent information in internal control process. Above all, in terms of cost-benefit analysis, it has been less costly, since electronic information can be more easily stored, retrieved, summarized and organized than paper-based information.

14-18 Developments in IT affect financial reporting and auditing. Discuss the effect of these changes on the demand for assurance services.

Answer 14-18 The advances in IT have significant effect on the way accounting and auditing will be conducted. Technological advances require organizations to produce standardized financial information in real-time and online. Assurance services will be shifted from historical and annual examinations to continuous process. Continuous assurance services are likely to become common place as companies shift to electronic real-time reporting system. The demand for assurance services will normally be expanded as a result of increasing demand for real-time reporting and auditing facilitated by IT developments. The continuous assurance model will serve many clients and will likely be better tailored to their specific needs.

The technological advances such as information capture technology, monitoring technology, telecommunications and inter-networking, cryptography, XML standards etc. have implications for assurance services. The future of assurance services lies in keeping pace with the IT advances, business environment and adequacy of the profession’s responses to public expectations.

14-19 ‘XBRL’ is a language for the electronic communication of business and financial data. It is believed that broadly adopting XBRL will benefit investors and other users of corporate financial reporting. (a) What level of restructuring is required if an organization intends to adopt XBRL? (b) To what extent does XBRL affect the audit process? (c) How can XBRL contribute to greater transparency in corporate financial reports?

Answer 14-19 (a) XBRL is a web-based markup language that provides seamless transmission of financial information between companies and the financial community. There are mainly there requirements for the successful deployment of XBRL in any organization. They are: creation of a specification that is the same for all companies and is consistent from one financial statement to another, an application that will allow the creation of financial statements ‘tagged’ with XML (Extensible Markup Language) that adhere to the specifications; style sheets which render information for a specific or variety of formats. (b) Emerging technologies, such as XBRL, will certainly affect the way auditing will be conducted. Currently, paper documents and electronic document files require data entry or cutting ad pasting to enter information into the receipt’s database. XBRL allows tagging of data and auditors can receive directly the database in XBRL form for further examination. XBRL provides continuous financial reporting, which may eventually lead to online real-time performance reporting. The use of XBRL affects the audit process as it increases the opportunities to perform continuous auditing of financial information. Continuous auditing involves the evaluation of transactions simultaneous to, or shortly after, their occurrence. The use of XBRL will enable the auditors to populate their databases for immediate evaluation directly and by using automated tools.

153 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(c) XBRL is platform-neutral – it is the same whatever type of computer or software you are using. It has several benefits in terms of qualitative characteristics such as transparency and accessibility of information. XBRL allows tagging of data so that it can be accepted directly into the receipt’s database for future analysis. The receipts of information transmitted by XBRL will have immediate and direct access to continuous financial reporting, which may eventually lead to online real-time performance reporting. In fact, XBRL allows all receipts of financial information provided in the XBRL format to analyze and use precisely categorized information instantly, with no need to rekey or convert to other formats. Above all, XBRL reduces the need for human intervention when moving financial and business reporting information from one system to another, or one organization to another.

14-20 ‘Continuous audits should be viable tools to satisfy the regulatory bodies’ requirements in the area of corporate reporting’. Discuss this statement and how continuous audits could have been effective in preventing the financial reporting and auditing failures that occurred at the beginning of twenty-first century. Is continuous auditing an attainable goal?

Answer 14-20 One of the major causes of the failures in financial reporting and auditing is related to lack of timely and transparent information available to regulatory bodies and users of corporate reporting. Changes in business prospects have made quarterly reports outdated, not to mention annual reports. To satisfy users’ demands, companies are conducting financial reports online and in real-time. There is growing awareness that real-time reporting may reduce market volatility, and eventually the cost of capital. It also reduces the effect of quarterly earnings surprises.

Real-time reporting requires a correspondence assurance of the reliability of what is being reported on a real-time basis, thus the need for continuous auditing. Continuous audits shift the audit approach from reported numbers (output) to more frequent reporting and system reliability (process). By conducting continuous auditing the auditor will focus his/her attention as early as possible on control deficiencies. The continuous auditing will also allow the continuous risk assessment which in turn will highlight processes or systems that experiencing higher-thanexpected levels of risk. Although, due to short history of continuous auditing as a viable approach of auditing, there is no empirical evidence on the beneficial effect of continuous auditing and reporting regarding recent financial corporate failures, all these advantages would have likely reduce the severity of recent high-profile financial collapses.

Continuous auditing can be an attainable goal under several conditions. First, the continuous auditing should be fitted into IT environment in which real-time accounting and reporting systems will be available. If the company is not ready to keep pace with technological advances, it would rather be difficult to implement continuous auditing process. Second, the implementation of real-time reporting and continuous auditing process in terms of cost and benefit analysis is only feasible in the long run as the perceived cost outweighing the perceived benefits in short and medium terms. Third, the organization subject to continuous auditing must have reached a maturity level in terms of planning and management control systems as the cost and time needed to perform a continuous auditing engagement increases as the strength of an organization’s processes and controls decreases. Organizations with strong processes and controls and mature systems are better suited to a continuous auditing engagement because the auditor can place greater reliance on the processes, controls and systems to reduce the extent, nature and timing of testing to support a continuous auditing opinion. Fourth, the implementation of continuous auditing is not costly if it is only done in the financial-reporting perspective. It should include other reporting aspects of the company, including nonfinancial data, performance measures and other form of information that was of value to users and could be audited at a reasonable cost.

When reading this chapter, it is worth to refer to and accounting and auditing journals for updating the knowledge on continuous auditing and real-time reporting as there will be continuous developments in these areas.

154 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

14-21 Discuss the COBIT objectives in relationship to the COSO components of internal control systems within an entity. To what extent do the provisions of the SOX Act of 2002 contribute to overall COBIT objectives?

Answer 14-21 While COSO identifies five components of internal control (see Figure 11.1 in Chapter 11 control environment, risk assessment, control activities, information and communication and monitoring), COBIT provides similar detailed guidance for IT. The components of ‘control activities’ and ‘information and communication’ are particularly involved in the IT processes.

Since the introduction of SOX Act in 2002, companies and accounting firms need to carefully consider the IT dimension of this Act and determine the manner and extent to which their technology systems satisfy the Act’s requirements. For compliance purposes, it is important to examine the key IT risk and control implications of Sections 302 and 404 of the Act. The companies should use a SOX compliance programme as a real opportunity to truly demonstrate the linkage between business and IT processes. With regard to COBIT framework, a key component of IT-related SOX Act involves mapping control objectives for financial reporting to the IT control objectives. Referring again to Figure 11.1 with regard to internal control components, authorization and safeguarding of assets – a key organizational control objective – is largely considered the IT-related objectives of ensuring information security, confidentiality and privacy. Referring also to Figure 13.1 in Chapter 13 the COBIT framework’s principles of ‘reliability and integrity of information’ can be useful in supporting SOX’s completeness assertion in the IT environment.

155 .

CHAPTER 15

QUALITY CONTROL AND OVERSIGHT SYSTEMS IN AUDITING: INTERNATIONAL ISSUES Instructor guidance Audit quality control is an important issue in the capital market economy as regulatory agencies and professional bodies are directly concerned with the auditor’s performance. These control mechanisms are determinant factors in ensuring that the profession meets its responsibilities to the interested parties who rely on external auditors to maintain the credibility of the financial statements. These mechanisms also indirectly contribute to maintaining the auditors’ reputation.

Although the topic of quality control and oversight systems in auditing is not new to the academic world, it has rarely been covered in auditing textbooks. Instructors should discuss with the students the importance of this topic for financial markets and the audit environment.

This importance must be stressed in the light of recent high-profile financial failures and scandals, and the regulators’ efforts to bring confidence to the financial market. The students must be informed that following the recent scandals, the oversight role of professional bodies with regard to audit quality control has been significantly diminished.

For further information on this topic, instructors should refer to the requirements and recommendations of regulatory and professional bodies such as the PCAOB, SEC, IFAC, the European Commission and similar bodies in different countries. Several aspects of quality control are important. It is necessary to consider the place of audit quality control and oversight systems in the provisions of the Sarbanes-Oxley Act (SOX Act) and the SEC requirements for accountancy firms in charge of foreign registrants in the United States. The end-of-chapter notes on pp. 467–468 also provide some information on this topic.

Although there are not yet sufficient research studies on quality control and oversight systems, instructors should refer students to the few papers on this topic published in academic journals.

156 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 15-1 Explain the general framework for quality control in auditing.

Answer 15-1 The framework of quality control in auditing consists of standards, ethical principles, public regulation, self-regulation and monitoring and disciplinary schemes. The market regulatory agencies, professional bodies, and standard-setters in accounting and auditing are directly involved in establishing the different control mechanisms and oversight systems. The characteristics of these control mechanisms and oversight systems are partially defined at a global level, for example, by the IFAC or the European Commission, and at national level by the laws and the rules specific to each country, such as the SEC or PCAOB rules and standards in the United States.

15-2 Why are ethical and self-regulatory procedures regarding external auditor performance not sufficient to protect the parties interested in financial information?

Answer 15-2 Quality control in auditing goes beyond the responsibilities of national accounting and auditing professional bodies. The performance of auditing firms and independent auditors, particularly with regard to publicly listed companies, affects financial markets as a whole and can not be limited to ethical rules, regulations and monitoring and disciplinary schemes imposed by professional bodies at national level. Above all, recent financial scandals have lead market regulatory bodies to take severe actions in monitoring and regulating auditors. These measures have been taken in order to bring more confidence to parties interested in the capital market economy.

15-3 What are the fundamental economic determinants of audit quality control systems?

Answer 15-3 The economic determinants of audit quality control systems are best explained in the context of the demand for audit services. If the demand for auditing is justified by the importance of the accounting information for its users, then regulatory bodies are vitally interested in the quality of that information. Theoretical elements such as monitoring hypothesis, the information hypothesis, and insurance hypothesis have considerable effects on the auditor’s performance and in turn are directly related to quality control in auditing. These issues are explained in details in Chapter 2 of the book.

15-4 Describe the features of international standards on quality control for audit and assurance services proposed by the IFAC. Answer 15-4 The International Federation of Accountants (IFAC) has been actively involved in setting standards for auditing, including quality control. This issue has been considered by the IFAC at: the engagement level, the firm level and the member body level. The IFAC standards, particularly ISA 220, emphasize the importance of the principles of independence, integrity, objectivity, confidentiality and professional behaviour, technical training and professional competence, adequate supervision and monitoring and the continuous review of the work of audit team members. The IFAC stresses the global convergence to high-quality auditing standards in quality control to serve the public interest.

157 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

15-5 In your opinion, what are the main factors in the effectiveness of audit quality control systems in the big financial markets?

Answer 15-5 An important element with regard to the effectiveness of audit quality control is the full application of rules and recommendations proposed by market regulatory agencies and professional bodies. Interested parties need to be assured that efficient oversight systems are being used without exception. Another major issue is that multiple forms of quality control mechanisms and oversight systems in auditing must be implemented in order to insure the full compliance with rules and recommendations. The presence of regulatory forces in this area contributes to the enhancement of confidence in the audit function since the general belief is that a self-regulating audit profession runs a serious risk of conflicts of interest in dealing with its shortcomings. Above all, as the audit market is subject to environmental changes, it is imperative that quality control mechanisms and oversight systems should be regularly revised to keep pace with changes.

15-6 How do you evaluate the role of government in overseeing quality control in auditing?

Answer 15-6 Governments play an indirect role through the regulatory agencies in overseeing quality control. Following the recent financial scandals, this role has been highlighted by laws in different countries, for example, the SOX Act in the United States. Although market regulatory agencies such as the SEC and AMF (Financial Market Authority) in France are independent bodies, they act on behalf of their respective governments to insure the public interest. In the United Kingdom, the Department of Trade and Industry (DTI) is actively involved in regulating the audit profession.

15-7 Discuss changes in quality control made in Europe.

Answer 15-7 The European Commission published two communications on 21 May, 2003: the first outlined ten priorities for harmonizing and improving the quality of statutory audit throughout the EU; and the second was an action plan focused on company law and corporate governance.

The new directive of the Commission adopted in March 2004 tightens the oversight of the audit profession, establishes rules on audit quality assurance, specifies the rules on independence and on ethics and imposes the use of high-quality auditing standards for all statutory audits.

Apart from the recommendations adopted by the European Commission, specific rules and regulations were implemented by regulatory agencies in major European markets.

15-8 What are the characteristics of the quality control system in the UK and the proposed changes in this area?

Answer 15-8 The UK has one of the most efficient and oldest systems of quality control in auditing at an international level. The professional accountancy bodies in the UK pay particular attention to the code of ethics, monitoring, qualifications complaints and discipline. The Department of Trade and Industry (DTI) has overall responsibility for regulating the audit profession. The DTI’s report in 2003 considered issues such as ethics, monitoring, discipline, auditor professional oversight and recognition and governance structure. DTI proposed the creation of a quality control body independent from the professional audit bodies (the Professional Oversight Board), and a new audit inspection unit. This unit is responsible for monitoring the audit of publicly listed companies and major charities and pension funds.

15-9 How do you evaluate the strengths and weaknesses of audit quality control in the current US financial market?

Answer 15-9 The major feature of the US system of quality control in auditing is that there have been historically several forms of controls in contrast to other developed financial markets, where the control is made by one or two regulatory bodies. Notwithstanding this element, recent 158 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

corporate financial scandals have shown the limits and deficiencies of audit quality mechanisms in the United States. Since the introduction of the SOX Act in 2002, two important changes were made in the area of audit quality control. These include the creation of the Public Company Accounting Oversight Board (PCAOB) and the direct involvement of the SEC. The PCAOB is responsible for establishing audit, quality control and independence standards. It inspects the work of public accounting firms and conducts investigations and disciplinary proceedings in auditing. The SEC has also proposed rules that would establish a framework for enhancing the quality of financial information by improving the oversight system of the auditing process.

15-10 What are the differences between the United States and the European approaches to governance of quality control in auditing?

Answer 15-10 The US approach to audit quality control is mainly based on rule-making, and the SOX Act is a good example of this approach. The European approach basically takes the form of recommendations and proposals. Another major difference between the United States and the European approaches is the multiple forms of control mechanisms in the United States, which is not currently the case in Europe. The PCAOB and SEC rules and standards in the area of audit quality control concern all listed companies in the United States whereas in the Europe there is no currently any mandatory rules in this area.

15-11 What are the arguments put forth by the SEC in reducing the role of professional bodies in monitoring the external auditors of publicly listed companies?

Answer 15-11 Audit quality control has been a matter of concern for the SEC. Before the introduction of the SOX Act, the AICPA played a significant role in monitoring the quality of auditors’ performance. The SEC believed that the professional accountancy bodies in the United States did not take tough actions in monitoring auditors’ performance and that the financial scandals partially resulted from the relaxed attitude of the accountancy bodies. Due to the complexity of financial and accounting operations and the variety of reasons for the scandals of 2001, the professional accountancy bodies’ oversight role in quality control became complicated. It is also believed that the large number of actions filed against auditors before 2001 may have contributed to a decline in investor confidence and provided the impetus for the SEC’s proposals concerning audit quality control and oversight systems.

15-12 What are the oversight functions of PCAOB in audit quality control?

Answer 15-12 The SOX Act established the PCAOB to oversee audits of public companies and related matters; to protect investors; and to further the public interest in the preparation of informative, accurate and objective audit reports. The PCAOB establishes auditing and related attestation standards, such as quality control and ethics standards. It undertakes key activities done previously by, or under the auspices of, the AICPA – including disciplinary functions and audit quality reviews. The PCAOB has the duty to regularly inspect public accounting firms. This includes an understanding of firm policies, procedures, methodologies and training programmes; visiting certain practice offices; and inspecting the working papers in certain areas of selected audit engagements. It has authority to refer violations of its rules, SEC rules, professional standards and audit firm quality control policies to the SEC and appropriate state regulatory authorities.

15-13 To what extent can the involvement of the audit committee contribute to enhancing quality control?

Answer 15-13 The audit committee is directly involved in appointing, compensating, retaining and overseeing the work of external auditors. This allows the audit committee to oversee the activities of external auditors who should in return provide the committee with the outcome of their audit. In performing its duties, the audit committee should review with the board of directors any issues that might arise with respect to the independence and the performance of the

159 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

company’s external auditors. By supporting the independence of external auditors and helping to solve any difficulties the auditors have encountered in the course of their work, the audit committee provides favourable conditions for external auditors, which should result in highquality work. Although the audit committee does not directly apply any quality control to auditors’ work, it contributes to this process by overseeing the auditor’s performance with regard to the company’s accounts.

15-14 What are the requirements of the US market regulators (SEC, NYSE and NASDAQ) with regard to audit quality control?

Answer 15-14 The SEC, had also been active in audit quality control before the introduction of the SOX Act in 2002. The SEC Practice Section (SECPS) was jointly created by the SEC and AICPA to perform quality control in auditing. However, after the introduction of the SOX Act, the power of the SEC was enhanced and it took a more active role in collaboration with the PCAOB. The accountancy profession lost its power in overseeing audit quality control. Above all, the NYSE and NASDAQ expanded their activities in evaluating the performance of auditors in charge of publicly listed companies.

The SEC, NYSE and NASDAQ proposed specific rules to establish a framework for enhancing the quality of oversight systems of the auditing process. Under the new rules, a registrant’s financial statements do not have to comply with the requirements of the securities laws and SEC rules unless the registrant’s independent accountant is a member of a Public Accountability Board (PAB). The registrant must engage an accountant to audit or review financial statements that filed with the SEC, and be an adjunct member of the same PAB to which the independent accountant belongs. The PAB has the authority to establish audit, quality control and ethics standards, or to designate and oversee other private sector bodies that to establish such standards.

15-15 To what extent would the changes proposed by the US regulators satisfy users’ expectations of quality control?

Answer 15-15 This question must be examined in the light of the observed outcomes of the benefits resulting from the direct involvement of US market regulators in overseeing audit quality control. Since the introduction of the proposed rules in 2003, there have not been many empirical studies to investigate the effect of such rules on improving auditors’ performance. It seems that the users of financial statements and auditors’ services reacted positively to the proposed measures immediately after the introduction of SOX Act and market regulators’ rules.

Nevertheless, it is too early to make an objective evaluation of the impact of the proposed changes on users’ perceptions of auditors’ performance and the quality of controls and oversight systems in auditing. Instructors should suggest to the students to review the recent academic journals in auditing and accounting for empirical findings and commentary views on this issue.

Discussion Questions 15-16 Discuss the role of the quality control procedures in enhancing the auditors’ reputation in a capital market economy.

Answer 15-16 Instructors should discuss this question around topics such as the effect of efficient quality control mechanisms on auditors’ performance, the relationship between the auditor’s reputation and high-quality audits and the effect of reputation on enhancing the demand for auditors’ services. The auditor’s reputation is a determinant factor in the demand for and supply of audit services. Reputation provides an auditor with an incentive to be independent, which in return affects the quality of audit services. The auditor’s reputation serves as a collateral bond for independence. Reputation effects can induce audit firms to produce 160 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

high-quality audits. It is highly likely that efficient quality control and oversight systems in auditing will benefit auditors by restoring confidence in their role in the financial market economy, which in return will contributes to their reputation. All the measures which provide credibility to the auditor’s role have a direct effect on the auditor’s reputation and ‘brand name’.

Quality control and oversight systems can be considered as a market mechanism to motivate the auditor to produce high-quality audits.

15-17 To what extent does the creation of an oversight board contribute to better protection of shareholders and other interested parties concerning audited financial statements? Discuss.

Answer 15-17 The discussion on this question should consider the independent role of the oversight board, its direct involvement in evaluating the auditor’s performance and efficient audit quality control mechanisms. The regulatory agencies in charge of financial markets aim to assure the investors of the quality of financial information disclosed to market participants. This quality in return depends, to a great extent, on the performance of external auditors. The creation of an independent oversight board brings confidence to investors and restores public interest in corporate financial reporting. The effective public oversight of the audit profession is a determinant factor in the maintenance and enhancement of confidence in the audit function. The direct involvement of an oversight board, independent from the audit profession, mitigates the conflicts of interest which may exist in this area. In the absence of an independent oversight board and efficient quality control mechanisms, it would be difficult to assure the preparation of informative and objective audit reports. Oversight boards such as the PCAOB in the United States are involved in the registration of auditors in charge of listed companies, standard setting, inspection and disciplinary programmes in auditing and all these contribute to a better protection of financial market participants.

15-18 Several changes have been made in audit quality control since the corporate financial failures at the beginning of the twenty-first century in developed capital markets. Discuss these changes.

Answer 15-18 The major change was the shift of powers from professional bodies to market regulatory agencies. Following the financial collapses of several multinational corporations, the accounting profession’s self-regulating framework was subjected to criticisms by regulatory forces and investors. The creation of oversight boards, independent from the accounting profession, was another important change to bring confidence to the markets. The direct involvement of market regulatory agencies in overseeing auditors’ performance and implementing quality control mechanisms in auditing was also considered an important change in this area.

15-19 Discuss the characteristics of audit quality control systems in the US before and after the Sarbanes-Oxley Act of 2002.

Answer 15-19 The major feature of quality control mechanisms in auditing before 2002 was the active involvement of the accounting professional body (AICPA) in monitoring auditors’ performance. Although the SEC, had a joint responsibility within the SEC Practice Section (SECPS) it did not have a direct role in overseeing the activities of external auditors. There were also multiple forms of control mechanisms. The Public Oversight Board (POB) was in charge of enhancing quality in auditing and financial reporting, strengthening the professionalism of the independent auditor and safeguarding the public interest.

Following the financial scandals of 2001, the accounting and auditing professions were put under scrutiny and the AICPA lost most of its power to monitor auditors’ performance. The POB was replaced by the PCAOB with a higher level of financial resources, more power and more direct involvement in oversight systems. Above all, the PCAOB took responsibility for the auditing standard-setting process and the registration of public accounting firms. The power of

161 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

the SEC was significantly enhanced in audit quality control and it became involved in overseeing the activities of the Auditing Standards Board (ASB), established by the AICPA to set generally accepted auditing standards.

15-20 To what extent do the quality control mechanisms established by market regulators and the audit profession affect the communication process between management and outside users of a company’s financial statement information?

How do these measures and/or communications affect the users’ perceptions of corporate financial information?

Answer 15-20 This question should be discussed with regard to the demand for reliable financial information, expectation gap, demand for auditing and the effect of control quality mechanisms on auditors’ performance. High-quality financial reporting and an effective communication process are essential to maintaining a robust and efficient capital market system. Investors and lenders and other stakeholders need reliable and transparent accounting information conforming to accounting standards. The audit function adds credibility to the communication process, and quality to the information being transmitted to the users of financial statements. Part of the expectation gap between what the users demand for audited financial information and what the auditors can and should reasonably be expected to do depends on the existence of efficient quality control and oversight systems to evaluate auditors’ performance.

The users of accounting and financial information need the assurance that there are efficient mechanisms to oversee the audit of public companies, protecting their interests in the preparation of informative, accurate, and independent audit reports. Effective quality control and oversight systems in accounting and auditing are critical to the quality of financial information and for trust in and reliance on that information. By having effective supervision, investors are assured that skilled and qualified professionals are performing the audits of companies under high ethical standards and strict quality control procedures.

162 .

CHAPTER 16

AUDITOR LIABILITY IN A CHANGING ENVIRONMENT Instructor guidance Independent auditors must always act in the public interest and provide a reasonable level of care and diligence while performing audits of financial statements. Due to the particular relationship between auditors and their clients, and because of the effect of auditors’ performance on stockholders’ wealth and the interests of other stakeholders, auditors face liability beyond that generally imposed on the businessperson.

Instructors should present legal liability as one of the important issues that has been facing the audit profession for many years. The increasing number of corporate financial failures and scandals in recent years has considerably affected the auditor’s legal liability. The globalization of financial markets and the expansion of financial operations provide external auditors with new opportunities but at the same time there is an increasing demand for auditors to be accountable for the deficiencies of their audits, particularly those of listed companies. The chapter contains the theoretical and practical issues and instructors should feel free to refer to current and previous legal actions against external auditors and the outcomes of such actions. It would also be interesting to compare the systems of legal liability of auditors in different financial markets with a view to analyzing the advantages and limitations of such systems. Note that there is no perfect system of legal liability in auditing and the existing systems in major financial markets such as the United States, the United Kingdom, Germany, etc., which have briefly been discussed in the chapter, do not satisfy all the parties involved. What would also be interesting is to make suggestions for a relatively objective and reasonable system of legal liability for auditors, taking into account the environmental factors and technological changes which affect auditors’ performance. Issues such as the role of external auditors in the IT environment, the demand for continuous auditing and assurance services, and how the auditors should face possible actions against them can be discussed as further topics. Students should refer to the websites of the SEC and PCAOB and other regulatory and professional bodies in major financial markets for updated information on related topics.

163 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 16-1 What are the potential causes of action against an auditor under a breach of contract lawsuit?

Answer 16-1 Independent auditors must perform their activities respecting all ethical requirements and with professional competence and due care. They should produce highquality audits and examine various risks the audited clients face. If the auditors fail, the company’s shareholders and any interested party may take legal action against them. A lack of confidentiality and professional behaviour may seriously impair the auditors’ independence and encourage clients to take actions against them. Nevertheless, in the case of financial difficulties and scandals involving listed companies, the risk of litigation exists regardless of the auditors’ performance.

16-2 Describe joint and several liability and the arguments for and against it.

Answer 16-2 Under joint and several liability, the external auditor as a co-defendant could be fully liable to the plaintiffs and held responsible for the entire losses incurred by users of the financial statements. This principle does not consider the extent to which other co-defendants shared in the wrongdoing. The market regulatory bodies who defend the public interest believe that joint and several liability provides the assurance to market participants that they will be fully compensated for financial damage. The audit profession considers that external auditors suffer from joint and several liability, mainly due to the ever-increasing size of the damages asked by plaintiffs and awarded by courts. This also has a significant impact on the cost of audit services, if the auditors want to perform high-quality audits. The extra cost may also affect the independence and objectivity of external auditors.

16-3 Discuss what factors a court should consider in determining the level of damages to be paid by an auditor to a plaintiff.

Answer 16-3 The answer to this question depends on the type of liability systems under which the case is judged, and whether there is joint and several liability or proportionate liability among co-defendants. To decide the extent to which the auditor has been responsible in any lawsuit is usually a difficult task. However, the court should consider the level of auditor responsibility in the wrongdoing, whether the case is related to fraudulent reporting presented by the company’s management or to a lack of diligence of the auditor with regard to accounting or auditing principles, or all these issues. Has the auditor applied all possible procedures to detect the fraud or misstated financial documents? It is also important to consider the environmental factors under which the auditor has performed the audit. Are there any limitations of scope or circumstances imposed by the client? Has the auditor acted in his/her own interests or has he/she respected fundamental ethical principles? Has the auditor faced any threats affecting his/her performance?

16-4 Discuss why an increasing number of accounting firms have willingly settled lawsuits out of court.

Answer 16-4 Many auditing firms willingly settle lawsuits out of court in an attempt to minimize legal costs and avoid adverse publicity. The courts may order the accounting firms to pay huge sums to the parties who have incurred financial losses. These decisions do not always consider the degree of responsibility of the auditors as auditors are sometimes considered as ‘deep 164 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

pockets’. Due to the complexity of such cases, it is rather difficult to express an objective opinion on the real causes and responsibilities of the parties involved. Above all, the auditor’s reputation is an essential element in financial markets and audit firms attach great importance to ‘brand name’ and how the public perceives them. For these reasons, accounting firms may prefer to negotiate directly with plaintiffs to find a compromise. Out-of-court settlements encourage more lawsuits and, in reality, increase the auditor’s liability because many firms pay even though they do not believe they are liable.

16-5 What are the arguments raised by the accounting profession with regard to proportionate liability amongst co-defendants?

Answer 16-5 Accounting firms defend the proportionate liability system because under such a system, defendants are required to compensate plaintiffs only in proportion to their involvement in any wrongdoing. Under this policy, the courts may be able to determine the percentage of financial damages based on the degree of the responsibility of each co-defendant. Taking into account the increasing pressure put on external auditors, particularly those in charge of publicly listed companies, auditors consider proportionate liability as a fair system of compensation since they pay only for the damages resulting from their poor performance and negligence. The accounting profession prefers proportionate liability to joint and several liability as the latter emerged at a time when external auditors had responsibility only to their clients, which is no longer the case.

16-6 Discuss mandatory insurance for corporate directors and its effect on auditor liability.

Answer 16-6 Auditing firms claim to be victims of unfair lawsuits, particularly under joint and several liability. The audit profession argues that the continued imposition of joint and several liability threatens the performance of external auditors as they are often obliged to incur the increasing costs of audit services. One of the possible solutions to reduce the risks from joint and several liability is to enable companies to buy insurance for their directors. This allows the directors potentially responsible for corporate losses, to partially compensate the plaintiffs, so removing the iniquities that may arise from joint and several liability. In spite of the favourable arguments advanced by the audit profession, there are several problems in implementing such a policy, mainly the additional costs for companies, effects of unjustified insurance premiums on audit fees and technical difficulties associated with this proposal.

16-7 In your opinion, how can the audit profession respond positively to stakeholders’ expectations and reduce liability in auditing?

Answer 16-7 This question needs to be debated in-depth in the classroom. Instructors are recommended to define the responsibilities of independent auditors in the capital market economy and ask the students about their perceptions of auditors’ actions towards users of financial statements. The main arguments which can be advanced are those related to achieving high-quality audits, maintaining independence and objectivity in all circumstances, acting in the public interest, continuing research in auditing, avoiding conflicts of interest and keeping pace with environmental changes. Auditors must realize that the business environment has evolved and consider the expectations of various interested parties. They should also pay attention to environmental factors, particularly business risks, during their audits of listed companies. The existence of efficient quality control and oversight systems also contributes to the high performance of auditors, and may avoid unjustified lawsuits against them. Auditing standard and rules must be revised to meet the changing needs of auditing.

16-8 What are the proposals made by UK professional bodies concerning auditor liability?

Answer 16-8 UK auditors are currently subject to joint and several liability. The professional audit bodies demand changes to this policy and ask for a form of proportionate liability, or at least, contractual limitation of liability. The Department of Trade and Industry is aware of an 165 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

increasing pressure on auditors due to environmental changes in financial market. The professional bodies in the United Kingdom want a limitation of auditor liability based on a minimum cap, which can be fixed on the basis of the client’s size and/or prescribed multiple of the audit fees. In the auditors’ view, the fee would generally be a reasonable proxy for the size, risk and complexity of the accounting system of the audited company.

16-9 Discuss auditor liability in the German context.

Answer 16-9 The German system of auditor liability is based on statutory capping, which is currently limited to €4 million. The German’s legislators’ view of auditor liability is conservative as the statutory law allows recovery of damages only if the statutory auditor acted intentionally and in bad faith in the audit of the company’s financial statements. The German codes allow the company who engaged the external auditors to demand damages when there is an evidence of culpability of auditors who have deliberately or negligently ignored their duties. This also includes violation of auditing standards and/or the ethical rules of the professional body. The auditor is also liable to third parties if he/she does not respect the rules of protective effect to third parties (e.g. violation of the duty to report financial information to interested parties or to keep clients’ business secrets confidential).

16-10 What are the safeguards available to auditors when evaluating the threats in assurance services?

Answer 16-10 The relationship between an external auditor and a company’s management may be conflictual and safeguards must exist to protect the auditors from any threats to their independence. It would be wise to first openly discuss with management any litigation and try to find solutions. The safeguards also include the possibility to resolve the problems through the audit committee, reporting to the audit committee on the extent and nature of litigation, and involving an additional qualified auditor to review the cases causing the litigation. If none of the above solutions helps to eliminate the threat or reduce it to an appropriate level, the auditor must withdraw from the engagement or should not enter into a contract with the client.

16-11 How do you evaluate the oversight role of PCAOB in minimizing the likelihood of lawsuits?

Answer 16-11 The creation of the PCAOB has provided independent quality control mechanisms for the auditor’s performance when working with publicly listed companies. The PCAOB inspects the work of public accounting firms and conducts investigations and disciplinary proceedings. This supervision should normally lead to two positive outcomes in terms of minimizing lawsuits against auditors. Firstly, regular independent scrutiny of auditors’ work will encourage them to maintain high quality by respecting the ethical principles and auditing standards in their entirety. Accounting firms will also be encouraged to implement effective quality control policies inside client auditing firms. Second, the oversight systems implemented by the PCAOB gives the assurance to users of financial information of the quality of the information and the auditor’s performance. Both these factors will generally contribute to the reduction of risk and the number of lawsuits against auditors.

16-12 What administrative sanctions can the SEC bring against auditors in the US? Answer 16-12 The SEC is actively involved in disciplining independent auditors of publicly held companies. The SEC investigates possible violations of the securities laws and takes action when appropriate, either in a federal court or before an administrative law judge, and negotiates settlements.

If the SEC’s investigations reveal that independent auditors are involved in fraudulent financial reporting and/or in improper conduct, the SEC may include the auditor as a co-defendant in the enforcement action or initiate a separate action against the auditor. Administrative sanctions that the SEC might impose on an auditor include: 166 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

disqualifying an auditor from practicing for lack of requisite qualifications, character or integrity, or engaging in improper or unethical conduct or violating the securities laws;

•

prohibiting, for some specified period of time, the firm or one of its officers from accepting new clients that are subject to SEC regulation;

•

remedial actions such as continuing professional education courses (CPE) or peer reviews;

•

limiting, permanently or temporarily, permission for an auditor to practice in some areas;

•

requiring an extensive quality review of the auditing practice.

16-13 Discuss the effect of lawsuits on the auditor’s reputation.

Answer 16-13 Reputation gives an auditor an incentive to be independent and perform highquality work. Companies may use a reputable auditor to add to the credibility to the financial documents presented by them. The confidence established between a company’s management and shareholders and an accounting firm that has acquired the reputation of being a good auditor reduces risk and the number of lawsuits against the auditor. At the same time, any lawsuit against a reputable auditing firm can seriously damage the position of the firm in the financial market. The big accountancy firms which have a ‘brand name’ are more vulnerable than small firms as it is generally expected that they produce high-quality audits and provide an objective opinion to the users of financial statements: Because of the high profile of their brand names, the big accountancy firms are more vulnerable than smaller firms to the adverse publicity arising from lawsuits. Any lawsuit against auditors, whether material or not, not only incurs tremendous financial costs for auditors, but may also affect the auditor’s reputation built over the years.

16-14 Search for information concerning the monetary size lawsuits against auditors in your own country in recent years. How does this compare to those in other big capital markets, for example, in the UK and the US? Answer 16-14 This is a good question for a discussion on comparative analysis of legal liability in different countries. As the chapter shows, the characteristics of legal liability systems depend on different environmental factors in different countries. The US approach is based on joint and several liability, whereas in Europe there are different policies in Germany, the United Kingdom, France, Austria, the Netherlands, Denmark etc. Differences also exist in Asian, African and other countries. Instructors are encouraged to go through the legal liability system in their respective countries and ask the students to search for information regarding the monetary size of lawsuits against external auditors. It should be borne in mind that this type of information is not always disclosed by professional bodies and market regulatory agencies. The websites of regulatory agencies and oversight boards in charge of monitoring auditors’ performance in different financial markets can be a good source of information. Financial journals may also report cases when the issue is brought to court. As public accounting firms are very concerned with this issue and pushing for changes in the legal liability of auditors, particularly joint and several liability, they may disclose some information with respect to the monetary size of lawsuits against the auditors to support their arguments.

167 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Discussion Questions 16-15 It has been argued that several economic, financial and judicial factors have served to increase the number of lawsuits against auditors in recent years. Identify the factors and the reasons for such factors.

Answer 16-15 This is an essential question about the auditor’s legal liability and students should express their opinions and observations in referring to the current financial market. The audit market is directly affected by environmental factors and this impact has become more significant in recent years. The important factors affecting the ever-increasing level of lawsuits in recent years are noted below. Instructors should discuss these and other related issues indepth: •

Globalization and internationalization of financial markets and the complexity resulting from these changes in the audit of publicly listed companies. This may cause the risk of increasing lawsuits against auditors;

•

The greater complexity of accounting standards due to their diversity and the use of innovative financial instruments. This also affects court decisions due to the lack of clear understanding and knowledge of judges of the technical areas of accounting and auditing;

•

High-profile scandals in recent years due to fraudulent financial reporting and the auditors’ negligence have increased the risk of lawsuits against accounting firms;

•

The inefficient quality control mechanisms and oversight systems of professional bodies based on self regulation. Changes have been made in this area since the introduction of the SOX Act in the United States and similar regulations in other major financial markets;

•

Public expectations of auditors’ responsibilities have increased and there is a growing awareness on the part of users of financial statements of the responsibilities of public accountants;

•

The increasing concerns of market regulatory bodies to protect the public interest by taking tough legal action against auditors in charge of audits of listed companies;

•

The difficulty courts have in understanding and interpreting technical accounting and auditing matters;

•

The absence of a clear definition for users of financial information of auditors’ and management responsibilities in fraudulent financial reporting;

•

The willingness of many external auditors to settle legal action out of court;

•

The increasing use of the ‘deep-pocket’ concept of auditor liability, coupled with joint and several liability, arising from the absence of public protection of injured parties who can bring lawsuits against anyone who might be able to provide compensation, regardless of who was at fault;

•

Class action suits increasing the potential damages and thus encouraging lawyers who might operate on a contingent fee basis to pursue cases that otherwise might not be pursued.

168 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

16-16 In some countries, a capping system has been introduced to deal with auditor liability. Discuss the characteristics of this system. What are the advantages and disadvantages of such a system from the viewpoint of investors and auditors?

Answer 16-16 The capping system of legal liability is based on limiting auditors’ financial responsibilities in compensating plaintiffs. This solution, which is mainly supported by professional auditing bodies, proposes a direct correlation between the nature and size of the audit engagement and the potential liability. The audit profession believes that joint and several liability is unfair and does not take into account the responsibilities of the parties involved. In most cases, the auditors are considered as ‘deep pockets’ and in the absence of sufficient insurance coverage for corporate directors, the plaintiff(s) try to recover all or part of their losses from the auditors.

The supporters of the capping system argue that it provides auditors with the assurance to perform in an independent and ethical manner without being threatened by users of financial statements. The audit profession believes that this would provide auditors with some protection from unreasonable claims while giving plaintiffs a realistic view of what they can expect from the auditor. The opponents of a ‘capping’ system, mainly the market regulatory agencies, argue that this policy does not respect the basic principle upon which a wrongdoer should compensate the plaintiff for loss caused by its tort or breach of contract, and consequently this would put the plaintiff in a position of disadvantage in negotiations with the auditor.

16-17 The loan decision-making process involves an actual or potential conflict of interest between the commercial bank and the company’s management. The independent auditor’s role has been emphasized in the risk assessment of loan decisions. Assume that an auditor issued an unqualified opinion on the financial statements of company A, which contain two material misstatements. The company’s management has failed to disclose that a significant portion of the accounts receivable probably could not be collected. Moreover, the company’s inventory has been considerably overstated. In both cases, the auditors did not apply due diligence to disclose the material misstatements to users of financial statements. The company subsequently declared bankruptcy.

What are the auditor’s responsibilities towards a commercial bank that lent money to company A on the basis of the financial statements? Under what concepts and to what extent might the bank recover its damages from the auditor?

Answer 16-17 The auditor is legally liable to third parties for violation of his/her professional duties causing financial damages to the users of financial statements. The auditor also has responsibility to respect auditing standards and the ethical rules of the profession, otherwise the damaged parties may sue the auditors. Professional negligence claims are dealt with under the principle of joint and several liability. According to this policy, the auditor and the company’s management are held fully liable towards to plaintiff(s).

Loan decision making is an important area in which the auditor’s report and opinion have a significant impact on the banker’s perception. The commercial bank might claim that the auditor was negligent and then ask for financial compensation. If a qualified or adverse opinion had been issued by the external auditor, the bank would probably not have lent money to the company. If such case were brought to the court, the court could order the auditor to cover losses incurred by the bank even though the auditor might have been only been partially responsible for the losses. The company’s management is mainly responsible for the lack of information disclosure and its financial difficulties

169 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

16-18 The number of lawsuits against accounting firms has increased in the past decade.

Discuss the following questions: (a) How successful might the measures taken by regulatory agencies be in reducing lawsuits in auditing? (b) What steps, in your opinion, should be taken by accounting firms to ease the pressure on auditors?

Answer 16-18 (a) The increasing number of lawsuits against auditing firms is mainly due to the factors indicated in Question 16-15. Most of these issues are related to environmental factors in the capital market economy and cannot be entirely controlled. However, market regulatory agencies have been somewhat successful in reducing the lawsuits against auditors by reinforcing control and oversight systems. For example, since the introduction of the SOX Act in the United States in 2002 and the establishment of the PCAOB and similar boards in other major financial markets, auditing firms have been brought under the direct authority of regulators. The increasing direct involvement of regulatory agencies in quality control, disciplinary procedures and monitoring of auditors’ performance will probably lead to higher quality audits, which will in return help reduce the number of lawsuits. (b) audit firms may reduce the lawsuits by making improvements in the following areas: •

quality control and peer review;

•

continuing education and promotion of research in critical matters of auditing;

•

better co-operation with market regulatory agencies and oversight boards in setting auditing standards and ethical procedures;

•

not accepting to settle litigation out of court and being ready to oppose all unfounded lawsuits in the courts.

16-19 Assume that accounting firm XYZ has issued an unqualified opinion on the financial statements of Field Company for a particular year, which contained a material misstatement. In the subsequent year, the company sustained significant operating losses, and the stock price went down by 60% whereas the market index declined by only 10% during the same period. An investor, who held a considerable number of the company’s stock for the last three years, was obliged to sell the shares at a substantial loss. The investor had reason to believe that the financial statements were misstated before purchasing stock in Field Company. On this basis, he is suing the audit firm and seeking to recover his loss from the auditor.

Discuss the above situation. What arguments might the investor and auditor use for defending their cases?

Answer 16-19 When the external auditor issues an unqualified opinion, he/she must be sure that the audited financial statements are presented on the basis of generally accepted accounting principles and there is no risk that the statements contain material misstatements.

When the company has financial difficulties, the auditor should be particularly interested in the going-concern principle and whether the cash flows generated from operating activities in the future will be sufficient to secure the company’s functioning.

170 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The independent auditor has a responsibility towards the users of financial statements, particularly the shareholders, who rely on audited financial statements in their financing and investing decisions. The auditor could try to prove that he/she has applied all necessary procedures in evaluating the financial position and operating results of the company and that its financial losses are due to unforeseeable environmental factors. However, the success or failure of auditors in putting forward acceptable arguments depends on the following factors: •

The nature of the material misstatement of financial statements and why the auditor was not able to detect it;

•

The relationship between the company’s financial losses and its stock price. Is the decline of the company’s share prices due to the reduction of its business activities? If so, does the same level of reduction exist for other companies in the same sector of activity? Did the auditor apply the necessary audit procedures to evaluate the company’s business risk?

Even if the auditor’s opinion concerns the financial statements as a whole and does not directly relate to the evaluation of the company’s financial performance, the line of auditor’s defence in this case is relatively marginal. Most users consider the auditor as a ‘deep pocket’ and link the company’s losses to the decline of stock market prices. They may argue about the responsibilities of auditors with regard to the going-concern principle, and claim a lack of auditor diligence and the inappropriateness of an unqualified audit opinion.

16-20 There are significant differences in economic, political, legal, financial and cultural situations between the EU and the United States: (a) What are the features of the legal liability system in auditing in the EU? (b) What are the differences between the European and the US approaches to auditor liability? (c) To what extent can these differences affect the performance of corporate directors and audit firms in charge of multinational groups operating in Europe and the United States?

Answer 16-20 (a) There is currently no harmonized approach towards auditor liability in the EU. In some member states, there is a civil liability cap, limiting the amount of damages that the statutory auditor might have to pay. In other member states, auditors can limit their liability by contract. Differences also exist regarding the possibility for the courts to limit the amount of damages. Various suggestions have been made in the European Union in order to arrive at a regime fairer to the auditor. (b) The auditor’s liability system in the United States is based on joint and several liability, whereas in the EU there is no single system. Several proposals have been put forward by the European Commission. These include the generalization of a legal liability cap, the possibility for the auditor to limit his/her liability by contract, the incorporation of the audit firm into a limited liability company, the introduction of proportional liability and the introduction of mandatory professional insurance for auditors and for directors. (c) The legal environment in which auditors operate is becoming so complex that the most efficient audit structures may face potential exposure and criticism for professional negligence, fraudulent acts or incompetent performance involving corporate failures and financial losses. The US approach is more restricted than the existing systems in most European countries and the external auditors and directors

171 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

of listed companies in Europe have been under strong pressure to comply with the SOX Act, other corporate rules and the consequences of regulatory changes in the US financial market.

172 .

CHAPTER 17

THE INDEPENDENT AUDITOR, STOCK MARKETS AND LENDING DECISIONS Instructor guidance The external auditor adds credibility to the company’s financial statements by issuing an audit opinion which is often the only means of communication between auditor and the users of the company’s financial information. The audit report, even if it includes a qualification, provides assurance to the users of the company’s financial statements that the information presented to them is reliable. The audit report can be considered as an important element in providing credibility to the financial market and contributing to its efficiency.

This chapter discusses the role of external auditors in the capital market economy and presents the relationship between the information content of audit reports and stock prices. It discusses the major empirical studies about the impact of qualified audit reports on stock prices. It also discusses the importance of the audit report in the lending decisions of commercial banks.

To discuss the impact of the information content of audit report on stock prices, instructors should first emphasize the role of the independent auditor as an intermediary agent between companies, particularly those listed on stock exchanges, and the users of financial statements.

This includes the review of the hypothesis of market efficiency and the debate on the importance of event studies in accounting and auditing. It would then be necessary to go thorough the empirical studies on the relationship between audit opinion and stock prices.

Instructors may ask students to present the important studies in this area by referring to the original sources. This discussion should particularly include the methodological problems of research design of these studies and the results obtained. A reference should be made to contradictory results of some of the studies and the reasons for such differences, which are mainly related to methodological research design. The same approach should be used with regard to the research studies on the impact of audit opinion on lending decisions and bankers’ perceptions.

Even though the content of the chapter seems be research oriented, the class discussion on this topic is particularly important because it relates to the value adding of the audit function for investors and bankers in charge of lending decisions. To show the importance of the external auditor’s role in the financial market, it is not sufficient to describe this role in normative way (or by referring to normative studies). It is imperative to discuss the empirical and experimental studies in this area. Instructors and students should also refer to research works (papers, dissertations, etc.) in their own countries.

173 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 17-1 What are major definitions provided by the founders of ‘market efficiency’?

Answer 17-1 Scholars such as Samuelson, Fama, Beaver and Ball have significantly contributed to the development of the market efficiency hypothesis. They defined efficiency of the capital market in the context of the relationship between stock prices and information available to investors. The market is efficient if security prices adjust rapidly to the disclosure of information so that the current prices of securities reflect all information about the securities. In such a market, the prices react instantaneously, and in an unbiased fashion to new information.

17-2 What is the importance of Fama’s definitions in capital market research?

Answer 17-2 Fama is one of the founders of empirical research in finance, particularly in the area of market efficiency. His research studies, especially those published in 1965, 1970 and 1991, provide valuable sources for market efficiency hypotheses. He was the first who defined an efficient market as one ‘in which prices always “fully reflect” available information’ by referring to weak-form tests, the semi-strong form and strong form of efficiency. He developed new ideas on the subject by defining ‘tests for returns predictability instead of weak-form tests, and ‘tests of the adjustments of prices to public announcements in lieu of the ‘semi-strong form’.

Instead of ‘strong-form’ tests of whether specific investors have information not included in market prices, he suggested the more descriptive title, tests ‘for private information’.

17-3 Summarize the arguments for and against the market efficiency theory.

Answer 17-3 Advocates of market efficiency suggest that an efficient financial market processes the information available to investors and incorporates it into the prices of securities.

Investors can benefit from trading in an efficient market because they can rely on prices reflecting a rich set of the total mix of information, including financial information, and they need not process all of that information directly.

Several criticisms have been formulated towards the market efficiency hypotheses. In several areas, accounting-based capital market research has produced evidence that is apparently inconsistent with market efficiency. Investors may not necessarily have the same amount of information of the same quality. If an investor does not have access to all the publicly available information that is reflected in prices, securities may appear to be mispriced because prices reflect information not available to that individual. The perceptions of individual investors may vary because this may largely depend on how they interpret the available information.

17-4 What are the characteristics of capital market research in auditing?

Answer 17-4 Beaver, in his work ‘Perspective on Recent Capital Market Research’, (The Accounting Review, 2002) and Kothari in ‘Capital Markets Research in Accounting’, Kothari (2001), defined the major characteristics of capital market research in auditing. Instructors should encourage students to thoroughly read these papers. Most studies in capital market research in auditing use the tests of capital market efficiency. These include several research studies examining the relation between the information content of audit reports and capital markets. Apart from the market reaction to audit qualifications, another subject of concern to researchers was the influence of the perceived quality of external auditing on the relationship between corporate earnings and security prices.

174 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

17-5

What problems occur in research design for ‘event studies’ in auditing?

Answer 17-5 In an event study, inference is made about whether an event (e.g. the release of an audit report) conveys new information to market participants as reflected in changes in the level or variability of security prices or trading volume over the short time period around the event. Three critical issues may affect the power of stock price tests of the information content of qualified audit opinions. These include the determination of the public announcement date, expectations and prior disclosures and the existence of concurrent disclosure.

17-6 What are the possible choices for determining the announcement date of audit qualification(s)? To what extent can the accuracy of this choice affect the findings of event studies in auditing?

Answer 17-6 The evidence shows that the first public announcements of qualified opinions for publicly traded companies can occur at any one of the following times: (i)

when annual earnings are first announced publicly;

(ii)

when the annual report is made available publicly;

(iii)

when the annual report on the company’s accounts (including the audit opinion) is delivered to the regulatory agency of the capital market;

(iv)

when a company issues a press release describing the qualification and, usually, the associated difficulties it faces. The date of media disclosure of the audit opinion can be considered as the first date of public announcement of this information.

The power of tests of information content depends on the precision of the event date, and conducting such an event study for audit reports requires the identification of the first public announcement of a qualified opinion. This is important because in efficient capital markets, price adjustments associated with information releases would be expected to occur when the information becomes available. In many cases, however, event time (the time of the information release) is not easily to identify.

17-7 In your opinion, to what extent does the media disclosure of audit opinions affect stock prices?

Answer 17-7 When a company issues a press release regarding an audit report, particularly one concerning a qualified opinion, the stock prices may be affected. Some studies (e.g. (Elliott 1982a and 1982b), and Dopuch, Holthausen and Leftwich’s 1986) have examined the market reaction to media disclosures of ‘subject to’ qualified audit opinions. These studies showed negative market reaction to media announcements. The authors raised two interesting questions about the effect of an audit qualification on security prices. First, very few audit qualifications receive coverage in the financial press. As a result, the first time the market learns of most qualifications is through the earnings announcements or the filings of annual reports.

Second, the issue of market expectations suggests the need to control for expectations in any examination of stock price reaction to a qualification.

17-8 What reasons lie behind the differences in findings of studies conducted in Europe and in the US in the area of capital market research in auditing?

Answer 17-8 Most of the studies in audit research (similar to other fields of management) have been conducted in the United States. In a few research papers written by the European scholars and published in the referred journals in auditing and accounting, similar research methodologies were used. However, several environmental factors affect the differences in the outcomes of the studies of auditing in Europe and the United States. These include the legal

175 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

framework governing the audit profession, the auditor’s legal liability, differences in audit reporting and level of disclosure, in accounting and auditing practices and in terms of rotation of external auditors in charge of publicly listed companies.

17-9 Discuss the term ‘concurrent disclosures’ in event studies in accounting and auditing.

Answer 17-9 The existence of concurrent disclosures is a major problem in event studies in audit research. Generally, the announcement of an audit qualification occurs at the same time that the earnings reports and other types of accounting and financial information are released.

The existence of concurrent disclosures can bias the results for the information content of audit reports.

The concurrent disclosure problem cannot be avoided entirely since in some cases the disassociation of audit reports from other information included in the companies’ financial statements is not realistic. No method of controlling for concurrent information in the reports presented to the market regulatory agencies has so far been proposed. Certain previous research studies have revealed that following earnings announcements, securities appear to yield systematic excess returns. Any information effect detected in studies of qualified audit reports can be explained as a response to the announcement of the earnings and not necessarily to the qualification.

17-10 In your opinion, why, in spite of the increasing role of the independent auditor in the capital market economy, is the audit opinion not considered as a determinant factor in investing and financing decisions?

Answer 17-10 It may be true that the credibility of the information disclosed by the company to the financial market depends considerably on the opinion on the company’s financial statements expressed in the audit report. Audit reports, particularly of listed companies, are generally ‘clean’ and do not include any qualifications. This ‘good news’ is generally anticipated by investors, bankers and financial analysts and so the release of unqualified audit report does not normally change the attitude of economic actors in investing and financing decisions. However, the content of the audit report is not always understood by the investors, particularly when it includes a qualification or adverse opinion. Some qualifications may provide no more information about the uncertainty than is already incorporated in prices, that is, the opinion may have no information content. Moreover, the audit report is not in most cases released on a timely basis and this does not contribute to the significant effect of the audit report on investment and financing decisions.

17-11 What factors does a loan officer take into account when granting a loan to a company?

Answer 17-11 Loan officers consider many types of qualitative and quantitative information when examining companies’ loan demands. These mainly include the relevant information about the capacity (the ability to service the debt), capital (the funds available for operations), profitability performance and cash flows, interest rates to be charged and collateral (assets available as sources for repayment of the debt) as well as other factors such as companies’ market shares, strategies and resource allocation policies. Loan officers also gather information on the economic environment, sector of activities, etc. from a variety of sources to form their opinions about companies’ financial conditions and the risks inherent in loan applications.

The audit report may provide useful information for loan decisions as it adds credibility to the information provided by the company. In the absence of an audit report, it is generally difficult for loan officers to rely on the accounting and financial information submitted by companies when demanding loans.

176 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

17-12 Among the different types of audit reports, which one should have most influence loan officers?

Answer 17-12 All types of audit reports may influence loan decisions, as the presence of an auditor is beneficial to the lending bank’s officers. The audit report on a company’s financial statements may reduce information risk and lending costs – and agency costs – associated with financial statements used in the loan applications. An adverse or disclaimers’ opinion from the auditor may have a substantial impact as the bank will usually refuse the loan, or adjust accordingly the interest rate, collateral and period of loan payments. An adverse and disclaimers’ audit opinions may call into question the ability of a company to service a proposed loan, as they increase the level of risk associated with the loan, which in turn requires higher interest rates to be charged by the bank.

17-13 In your opinion, why are the external auditor’s opinion and judgement not sufficient in evaluating the financial perspective of a company seeking a loan from a commercial bank?

Answer 17-13 The decision on granting a loan is a complex process and requires a thorough examination of many qualitative and quantitative data and information, including those related to environment. The audit report provides only an opinion on a company’s financial information and because of its limited scope, the audit function does not consider many types of information required in a loan decision. Although the audit opinion may be useful in the loan decisionmaking process, it is not considered as the most important piece of information required by loan officers. Commercial bank officers form their perception of the risks inherent in loan applications using a variety of information and a set of rules and criteria regarding the financial performance and conditions of companies applying for the loans. They also gather information on a company’s forecasted data, as well as on the economic environment, its sector of activities, etc.

This information is not generally examined and verified by the external auditor.

Discussion Questions 17-14 Discuss the characteristics of ‘event studies’ in auditing research. Describe the test of Efficient Market Hypothesis (EMH) in this area.

Answer 17-14 The major objective of the event studies in auditing is to assess the extent to which security price performance around the time of the event has been abnormal. The hypothesis maintained in an event study is that inference is made about whether an event (e.g. release of audit qualification) conveys new information to market participants as reflected in changes in the level or variability of security prices or trading volume over the short time period around the event. If the level or variability of prices changes around the event date, the assumption is that the announcement of that event has conveyed new information about the amount, timing, and/or uncertainty of future cash flows, revising the market’s previous expectations.

The Efficient Market Hypothesis (EMH) implies that when a piece of information becomes public it is immediately incorporated in an asset’s price. With the information content of audit reports and its impact on security prices at the time of its disclosure, any abnormal returns (superior risk-adjusted returns) should be measured by using the different market models. Given the semi-strong EMH, if abnormal returns are observed in the anticipatory period prior to public release of the qualified and/or disclaimers’ opinion, these returns may be attributed to the effects of other public information reaching the market during the anticipatory period. If abnormal returns are observed upon release of the qualified and/or disclaimers’ audit opinion, they may be attributed to the price relevant characteristics of the opinion.

177 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

17-15 Discuss the relationship between the efficiency of the capital market and the quality of financial information and financial statements.

Answer 17-15 The efficiency of the capital market depends to a large extent on the quality of financial information disclosed to market participants. The market processes the information available to investors and incorporates it into the price of securities. To achieve this objective, publicly listed companies must provide market participants with relevant, reliable and timely information. The worth of financial information to interested parties depends entirely on its quality. In order to be useful in determining security prices, accounting information must be both relevant and reliable. Both of these characteristics are affected by the completeness of the information provided.

The external auditor plays an important role in the financial market by adding credibility to a company’s financial statements, regardless of whether the information conveyed is good or bad news. An absence of reliable and verifiable financial information would choke off the flow of capital that feeds modern economies and make impossible efficient and orderly capital markets.

17-16 Explain the steps in measuring the information content of qualified audit reports in the context of capital market research.

Answer 17-16 To measure the impact of information content of qualified reports on security prices, several elements must be taken into consideration. These include appropriate research design using either the market models or experimental tests, samples of qualified audit reports and their classifications, determination of the public announcement date and analysis and interpretation of results obtained. The quality of research in this area largely depends on how certain questions are determined, namely the date of public announcement of audit qualification, the expectations and prior disclosure and concurrent disclosures.

As Figure 17.1 on pp. 507–508 (summary of the studies regarding the relationship between audit reports and financial markets) demonstrates, the results obtained in research studies in this area are not similar. The differences are mainly related to the quality of research design chosen, and the extent to which the effect of issues such as expectations and prior disclosures and concurrent disclosures is controlled. The environmental factors must also be taken into consideration in this type of research study.

17-17 Discuss the essential findings of the research studies in the US (notably Elliott (1982), Dodd et al. (1984), and Dopuch et al. (1986)). How do these results compare with those obtained in your own country?

Answer 17-17 Although these three papers were published in the 1980s, they are still considered as the major references in the research on the information content of audit reports.

This importance is mainly related to the fact that the authors were the first who examined the effect of audit qualifications on stock prices using powerful methodological research design, large sample size and considering the problems associated with event study. Instructors should consider the similar research work in their own countries by making comparisons of research design, sample size and results obtained.

Elliott (1982a and b) examined the relationship between abnormal security returns and ‘subject to’ (ST) audit reports in which the auditor says that the financial statements are presented fairly, conditional on the outcome of some uncertainty. The potential value of this study lies in its unique experimental design. The other market-based research concerning ST opinions uses different companies in the construction of the control group. The results provided by Elliott suggest that announcement of a qualified opinion in The Wall Street Journal may itself cause negative abnormal returns.

The seminal research studies of Dodd, et al. (1984) and Dopuch, Holthausen and Leftwich [1986] examined the information content of audit reports and stock prices, but the study of

178 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Dopuch et al. 1986 concerns the media disclosure of ‘subject to’ qualified audit opinions. These two American studies constitute the most important references in the area of market reaction to audit opinions for two reasons. First, the papers made use of a relatively large sample size and different methodological procedures. Second, the authors attempted to highlight for the first time the critical issues that affect the power of stock price tests for the information content of qualified audit opinions. Their results generally confirm the findings of Elliott (1982a and 1982b). Many companies suffer negative performance prior to the release of qualified opinions.

Dopuch, et al.’s (1986) study continued the work of Dodd et al. (1984) by examining the market reaction to media disclosures of ‘subject to’ qualified audit opinions. The authors observed the negative market reaction to media announcements. This may be related to the point that very few audit qualifications receive coverage in the financial press.

17-18 In your opinion, to what extent does the information content of the audit report affect the decisions of: the company’s shareholders; the investors in financial market; and commercial bank officers?

Answer 17-18 This is an important question for discussion of the value of the audit in the financial market and its effect on investment and financing decisions. Instructors should encourage their students to write an essay on this question and then ask them to express their opinions on the subject. The students should consider several reasons why the audit report does not fully satisfy the users’ requirements, including the following elements.

All these three groups need the audit report in their decision-making processes as the credibility of the information disclosed by the company to the financial market depends considerably on the opinion expressed by an independent auditor on the company’s financial statements. The audit provides assurance that the information set presented to investors and creditors is reliable.

However, for several reasons the audit report does not satisfy the increasing demand of investors, loan officers and other categories of users. The importance of the auditor’s function is not fully understood by the market participants. Also, the form and content of the audit report do not respond to the needs of users of financial statements, as they can not always evaluate the effect of qualifications and adverse opinions on their decision- making process. The fact that it is generally released with some delay may cause problem as for the information to be relevant, it needs to be timely. The users currently have access to quarterly financial information, which is not usually certified by auditors.

17-19 Discuss the following: (a) Among the different forms of audit opinions, which one should have most effect on stock prices? Discuss the reasons. (b) What is and what should be the role of the external auditor with regard to the protection of the public interest in terms of their investment decisions in public companies?

Answer 17-19 This question, particularly the first part, must be answered in reference to the content of Chapter 12. (a) The content of Chapter 12 and the empirical studies presented in Chapter 17 show that the effect of various types of audit opinion may be different depending on conditions surrounding the release of the audit report. The results of empirical studies are mitigated with regard to the impact of qualified audit reports, adverse and disclaimers’ opinions. Nevertheless, several empirical studies show that the adverse and disclaimer’s opinions expressed by an independent auditor might have tremendous effects on investment and financing decisions and also on stock prices.

These types of opinions are generally expressed in the case of a significant disagreement between the company’s management and auditor. They are

179 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

considered so material and pervasive to the financial statements that the auditor concludes that a qualification of the report is not adequate to disclose the misleading or incomplete nature of the financial statements. (b) The external auditor is considered as an important intermediary agent between the company and the users of financial statements in providing credibility to the financial statements and corporate reports, such as those which value a company’s securities.

Investors value the external auditor’s services and report as a means of improving the quality of the financial information, which in turn is used to assess the risk and returns on investment decisions. Auditing has an informative role by improving corporate reporting disclosures, reducing the chance of errors and bias, and contributing to the formation of investors’ expectations.

17-20 Discuss the role of the external auditor in reducing the information asymmetry between company management and commercial banks. What are the main findings of empirical studies with regard to the relation between audit report and lending decisions?

Answer 17-20 The problem of information asymmetry exists with regard to a loan contract signed between a company demanding a loan and commercial bank. Because a loan officer cannot generally verify the action of company management and the information disclosed by them, there will be information asymmetry between these parties. One important feature of the auditing function is its association with uncertainty and risk reduction in investment and financing decisions. An audit is performed on the basic premise that the resulting report will be useful to investors and creditors by telling them whether the reported financial data faithfully portray the true financial conditions and results of a company.

The overall findings of research studies on whether audit qualifications have informational value to bank loan officers suggest that audit reports do not significantly affect the lending behavior of commercial bank loan officers. In light of research studies, it would seem that loan officers perceive the differences in financial statement reliability communicated by the different audit reports, but they use the reports only as a guide to rating the financial statements for reliability.

Bank officers consider the historical information about the company and the quality of management to have the greatest influence in a decision to extend a loan, and pending litigation to have the greatest influence in a decision to reject it.

180 .

CHAPTER 18

CORPORATE FRAUD, CORPORATE SCANDALS AND EXTERNAL AUDITING Instructor guidance Recent corporate failures have raised concerns about auditing practices, auditors’ independence, their social responsibilities and duties to third parties who rely on their reports. External auditors are under increasing pressure and scrutiny, and there is now a debate and re-examination of the auditor’s role and place in the capital market economy.

This chapter discusses the corporate fraud and accounting irregularities of several multinational groups, and the auditors’ performance and failures. Special attention is paid to the role of corporate management in such events and the motivations to manage earnings in public companies. The contents of the chapter give instructors opportunities to discuss the accountability aspects of the external auditor’s role in the capital market economy, particularly with regard to various groups of stakeholders. Many aspects of the discussion on this chapter are included in the previous chapters.

Students should particularly be interested in ‘trendy’ topics such as fraudulent financial reporting, red flags of fraud or ‘warning signals’, big bath’ behaviour, management temptation to manage earnings, and external auditors and the ‘quality of earnings’. Above all, they should show interest in famous financial scandals such as Enron, and WorldCom in the United States and similar cases in Europe (Parmalat, Royal Ahold and Vivendi). The discussion may consider similar cases in other countries not cited in the chapter.

Instructors may ask the students to analyze the role of external auditors in corporate financial scandals. This would help to understand better the reasons for audit failures and discuss possible preventive measures. This would also contribute to a clarification of the auditor’s role with respect to earnings management and quality of earnings. There would not necessarily be clearcut answers to some of the questions raised in this discussion and to some of those at the end of the chapter. Some of these issues are currently on the agenda of market regulatory and accounting professional bodies.

181 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 18-1 What are the characteristics of fraud and the conditions required for financial fraud to occur?

Answer 18-1 Fraud can range from minor employee theft and unproductive behaviour to misappropriation of assets and fraudulent financial reporting. It refers to an intentional act by one or more individuals among management, those charged with governance, employees or third parties, involving the use of deception to obtain an unjust or illegal advantage.

When fraud occurs there are three conditions that must be present: (a) Incentive/pressure—a reason to commit fraud; (b) Opportunity: for example, ineffective controls, override of controls; (c) Attitude/rationalization: ability to justify the fraud to oneself.

Company management and employees engaged in fraud will take steps to conceal the fraud by withholding evidence or misrepresenting information in response to inquiries, or by falsifying documentation. Fraud also may be concealed through collusion among management, employees or third parties.

18-2 What are the auditor’s responsibilities for detecting fraud in a financial statement audit?

Answer 18-2 The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether financial statements are free of material misstatement, whether caused by error or fraud. Throughout the audit, an auditor maintains an attitude of professional scepticism, considers the potential for management override of controls and recognizes the fact that audit procedures that are effective for detecting error may not be appropriate for material misstatement due to fraud. In performing the audit process, information may come to the auditor’s attention that should be considered in identifying risks of material misstatement due to fraud. It is also important that the auditor obtains a written representation from management confirming that it has disclosed to the auditor the results of management’s assessment of the risk that the financial statements may be materially misstated as a result of fraud, and its knowledge of actual, suspected or alleged fraud affecting the company.

18-3 Why should an independent auditor have an attitude of professional scepticism in performing an audit?

Answer 18-3 Throughout an audit, the auditor should recognize the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor’s past experience with the entity about the honesty and integrity of management and those charged with governance.

When obtaining reasonable assurance, an auditor considers the potential for management override of controls and recognizes the fact that audit procedures that are effective for detecting error may not be appropriate in the context of an identified risk of material misstatement due to fraud. This requires professional scepticism by questioning of whether the information and audit evidence obtained suggests that a material misstatement due to fraud may exist.

182 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

18-4 What actions can companies take to prevent, deter and detect fraud?

Answer 18-4 Those charged with the governance of the company and with management have the primary responsibility for the prevention and detection of fraud. They should establish and maintain internal controls to provide reasonable assurance of the reliability of financial reporting, effectiveness and efficiency of operations and compliance with laws and regulations. They should create and maintain a culture of honesty and high ethics, including the creation of a positive workplace environment, training, hiring and promoting appropriate employees. They should also evaluate anti-fraud processes and controls and develop appropriate supervision (e.g. audit committee, internal auditors and certified fraud examiners).

18-5 Discuss briefly the auditor’s communications about possible fraud with various parties inside and outside the company.

Answer 18-5 If the auditor has identified a fraud or possible fraud, it is important that the matter be brought to the attention of the appropriate level of management as soon as practicable.

Fraud involving senior management and fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements should be reported directly to the audit committee. The auditor should also make those charged with governance (particularly the audit committee) and management aware of material weaknesses in the design or implementation of internal controls to prevent and detect fraud.

In specific cases (e.g. compliance with certain legal and regulatory requirements (such as the SEC and PCAOB in the United States), the auditor has the duty to disclose to parties outside the company a fraud or possible fraud involving management and employees in response to a subpoena or the inquiries of a successor auditor.

18-6 Define the fraud risk factors by providing some examples.

Answer 18-6 Fraud risk factors refer to events or conditions that indicate incentives/pressures to perpetrate fraud, opportunities to carry out the fraud or attitudes/rationalizations to justify a fraudulent action. While fraud risk factors may not necessarily indicate the existence of fraud, they have often been present in circumstances where frauds have occurred. The examples of such events or conditions are as follows: •

the need to meet expectations of third parties to obtain additional equity financing may create pressure to commit fraud;

•

the granting of significant bonuses if unrealistic profit targets are met may create an incentive to commit fraud; and

•

an ineffective control environment may create an opportunity to commit fraud.

18-7 What are the main ways in which the management manipulation of earnings may occur?

Answer 18-7 Earnings management is where companies artificially inflate (or deflate) their revenues or profits, or earnings per share figures. In most cases, management uses aggressive accounting tactics (estimates, policies, etc.) for ‘income smoothing’. Management may also manipulate earnings in such a way that in good years they make overly prudent subjective judgements, which have the effect of lowering profits; while in bad years they are less prudent and can release previous prudent provisions to the profit and loss account, thus increasing reported profits. They may also use a ‘cookie jar’ or reserve account to change the estimated life of a capital asset. ‘Earnings’ are held back from the period in which they should have been recognized and kept instead for a ‘bad year’.

183 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

18-8 What does the term ‘big bath behaviour’ mean and how does it affect the auditor’s opinion on financial statements?

Answer 18-8 Although the increasing or decreasing performance of companies in profit-making depends on several economic factors as well as the company’s policy and strategy, the market can interpret a failure in this area as a ‘bad news’. The unforgiving nature of the equity markets when companies fail to achieve projected earnings or other targets has created unprecedented pressures on corporate management to manipulate accounts, often called ‘making the numbers’ or ‘big bath behaviour’.

For example, under ‘big bath’ behaviour (in somewhat of a contrast to income smoothing) management will take additional losses in bad years in the hope that by taking all the losses at one time they will ‘clear the decks’ once and for all. The assumption is that this will lead to increased profits in the future. For further explanation on these issues, see ‘The Analysis and Use of Financial Statements’ (1994, p. 176), White, Sondhi and Fried, John Wiley & Sons, Inc. 18-9 With reference to auditing standards, what actions does the auditor take if he/she is unable to continue the audit engagement as a result of a misstatement related to suspected fraud?

Answer 18-9 The auditor’s objective is to plan and perform the audit to obtain reasonable assurance about whether financial statements are free of material misstatements, whether caused by fraud or error. The auditor has the responsibility to report directly to the audit committee cases of fraud involving senior management and fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements. The auditor should also inform those charged with governance (particularly the audit committee) of material weaknesses in the design or implementation of internal controls to prevent and detect fraud. However, if the auditor is unable to continue the audit engagement as a result of a misstatement related to suspected fraud, he/she may either express a disclaimer’s opinion or asked to be discharged from the audit engagement after discussing this with management and the audit committee. In certain cases, they should disclose the fraud o regulatory bodies (e.g. SEC and/or PCAOB in the United States) or to a funding agency or other specified agency in accordance with requirements for the audits of entities that receive governmental financial assistance.

18-10 Explain the importance of ‘tone at the top’ or ‘control environment’ in reducing the risk of fraud in companies.

Answer 18-10 The ‘tone at the top’ or ‘control environment’ reflects a supportive attitude at all times towards internal control, independence, competence and leading by implementing an appropriate ethical code of conduct within an organization. The control environment is pervasive, and the auditor should start the evaluation of internal control at this level.

One of the major reasons for the high-profile financial crises of recent years (e.g. Enron, Parmalat and Royal Ahold) was weak internal controls triggering financial failures. It is not the form of internal control tools and techniques themselves that have been questioned, but their suitability for the business environment and the ways that they have been implemented. As part of the audit process, external auditors should thoroughly examine and evaluate evidence from management and assess the reliability of internal controls. Evaluating the reliability of internal controls involves analyzing and testing risk management procedures that the organization has put in place to achieve these objectives. This may significantly contribute to the reduction of fraud because of the pervasive impact of such evaluations on management attitude and action in implementing an appropriate internal control system.

184 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

18-11 Why have external auditors not been entirely successful in reducing managers’ actions in ‘making the numbers’?

Answer 18-11 Earning management is a critical issue in regard to the auditor’s responsibilities in an audit of the financial statements of a publicly listed company. Management may use an aggressive earnings policy and the external auditor, because of audit scope limitations, is not always able to discover such accounting manipulations.

The discretionary nature of income is such that the external auditor may be unable to detect the management manipulation of earnings, particularly in the cases of classification of good news/bad news, income smoothing and big bath behaviour.

Above all, the auditor’s responsibility with regard to forecasted data, particularly quarterly earnings, are relatively limited. These responsibilities with regard to the quality of a company’s earnings, when fraud is not an issue, are quite different from their responsibilities to detect and report fraud. The auditing standard on audit committee communications requires auditors to discuss with audit committees the auditors’ judgements about the quality, not just the acceptability, of companies’ accounting principles and the estimates and judgements underlying financial statements.

18-12 In your opinion, what could be done to avoid further auditor failures?

Answer 18-12 This is a difficult and at the same times an interesting question. Instructors should encourage students to express their opinions on this issue as this promotes a constructive debate. It is difficult to provide a clear-cut answer to this question as auditor failure is the outcome of many issues and is not only related to auditor performance and the quality of auditing standards. However, the reinforcement of auditor independence and ethics may significantly contribute to audit quality and the reduction of audit failure. The better consideration by the external auditor of various types of risks particularly business risk and of the conditions of the capital market economy may certainly be useful in the audit of a company’s financial statements. The improvement of the auditor’s approach towards earnings management and big bath behaviour, and controlling the management temptation to manage earnings are among the challenges facing the auditing profession. This requires some structural changes in the audit market environment and increasing efforts of market regulatory bodies with respect to control mechanisms. The corporate governance and audit committee of a publicly listed company can play a significant role in reinforcing the auditor’s performance and quality.

Discussion Questions 18-13 Define the terms ‘earnings management’ and ‘quality of earnings’ with respect to the external auditor’s responsibilities. Discuss the auditors’ responsibilities and how to draw a line between ‘earnings management’ and fraud.

Answer 18-13 Management may use accounting and financial instruments and methods to manage earnings to deceive financial statement users as to the company’s performance and profitability. Earnings management is related to cases where companies artificially inflate (or deflate) their revenues or profits, or earnings per share figures, so the figures match a predetermined target.

The quality of earnings depends on appropriate measures taken to evaluate the company’s present and future earning power and its value relevance. The company’s quality of earnings may be affected by management selecting the appropriate accounting methods or providing adequate provision for the maintenance of assets and for the maintenance and enhancement of present and future earning power. The quality of earnings may also be affected by cyclical and other economic forces on the stability of their sources, and particularly on their variability.

185 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Auditors play a vital role in the quest for high quality and reliable financial reporting and they must make sure that the company’s financial statements particularly with respect to its earnings power do not contain misleading information.

External auditors must also be aware of the circumstances indicative of earnings management.

This consists of identifying circumstances that may cause financial statements to be materially misstated. The auditor should carry out specific investigations concerning ‘big bath’ provisions and generous reserve accounting, unsuitable revenue recognition and improper accruals and estimates of liabilities.

It is the acceptability of an accounting policy under GAAP or other accounting standards that draws the line on the continuum distinguishing legitimate earnings management from fraud.

18-14 In recent years, there has been an increasing number of legal actions against external auditors particularly with regard to public companies. In your opinion, what are the reasons for this? Discuss.

Answer 18-14 The mountain of litigation facing the audit profession as a whole, and the Big Four in particular, has been a major concern for the whole business community. This shows investors’ and other users’ willingness to seek recovery of losses from auditors. In addition to out-of-pocket damage payments, an auditor involved in litigation can incur indirect costs, such as management time, client switching and reputation loss.

Although there may be several reasons for the increase in lawsuits, the main issue is the growing public expectations of an auditor’s responsibilities and increasing awareness of users in capital market economy. In such circumstances, the market regulatory bodies show more concerns for protecting investors’ interests compared to the past.

The main reasons for the increasing number of lawsuits and higher financial damages demanded by plaintiffs include the globalization of the capital market economy, diversity of activities and complexity of operations, developments and advances in information technology and the increasing complexity of accounting standards due to their diversity and the use of innovative financial instruments. The increasing incidence of fraudulent financial reporting due to the efforts of management to manage earnings to deceive financial statement users is another reason to expect more diligence and objectivity from auditors. All these changes considerably affect auditors’ function and performance and make it difficult for them to perform audits of high quality.

18-15 A series of business scandals in the US (Enron, WorldCom, Tyco, Adelphia etc.) and in the European financial markets (Royal Ahold in the Netherlands, Vivendi in France, Parmalat in Italy etc.) have shaken the world capital markets. The auditors have been publicly criticized by market regulators. Discuss the responsibilities of (a) management, (b) external auditors, (c) board of directors and audit committee and (d) regulators, in corporate financial failures.

Answer 18-15 This discussion question has to be debated in-depth in the classroom as the students may have different points of views on the responsibilities of the parties involved in the financial crises. Instructors should encourage the students to express their opinions and the supporting reasons.

All these parties may, to some extent, be considered responsible for misfunctioning of financial markets. The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the company and with management. A company’s management has the responsibility and the means to reduce fraud. Management should try to implement and maintain a system of internal control to provide reasonable assurance that financial reports contain reliable information. This should include appropriate accountability mechanisms to ensure the disclosure of objective and transparent financial information. This

186 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

significantly contributes to the quality of financial reporting and has a dissuasive effect on management committing fraud.

It is the responsibility of those charged with governance, particularly audit committee members, to ensure, through oversight of management that the company establishes and maintains internal controls to provide reasonable assurance of the reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations.

External auditors and market regulatory bodies share responsibility for the financial scandals.

Auditors are responsible for not being able to exercise their functions in an independent manner and not detecting material misstatements and fraudulent financial reporting. The regulatory bodies also are responsible for not being able to provide sufficient diligence and oversight mechanisms in time to prevent the financial crisis.

18-16 During the audit process, the auditor performs different risk assessment procedures. (a) Discuss the characteristics of these procedures. (b) With reference to the auditing standards, what actions should be taken by external auditors to minimize the risks of material misstatement due to fraud?

Discuss.

Answer 18-16 (a) The auditor performs risk assessment procedures to obtain a good understanding of the company and its environment, including the company’s internal control. These procedures serve mainly as a source of audit evidence to support assessments of the risks of material misstatement of the financial statements. The external auditor may also choose to perform substantive procedures or tests of controls concurrently with risk assessment procedures. (b) The risk assessment procedures include inquiries of management, and those charged with corporate governance, particularly the audit committee. The information regarding how the audit committee exercises oversight in risk management, fraud detection and the internal control system contributes to the auditor’s knowledge in designing the appropriate audit procedures. The auditor should also consider whether one or more fraud risk factors are present. This includes the identification of events or conditions that indicate incentives/pressures to perpetrate fraud, opportunities to carry out the fraud, or attitudes/ rationalizations to justify a fraudulent action. The auditor should also take into consideration the results of the analytical procedures performed in planning the audit. Finally the auditor should consider other information, for example, that arising from discussions among the audit engagement team members or with regard to identified inherent risks that help to identify the risks due to fraud.

18-17 Provide some examples of corporate financial failures that occurred in your own country in the past two decades and discuss the auditors’ responsibilities in these events.

Answer 18-17 The chapter briefly discusses several corporate frauds such as Enron, WorldCom, Lincoln Savings and Loan, BCCI, Parmalat and Royal Ahold. The discussion includes the evidence of auditor failure and the consequences on the financial market. For full information on such cases, students should refer to published information in magazines, academic journals, books or articles.

187 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

Instructors may consider similar cases in their own countries. The discussion would be interesting if the students searched for relevant information and discussed the main characteristics of the corporate failures from the viewpoint of management responsibilities, auditor failure, the consequences for the financial market and the actions of regulatory bodies.

18-18 Define the term ‘red flags’ of fraud and discuss the auditor’s considerations in this respect.

Answer 18-18 The red flag of fraud refers to signs of possible anomalies that may exist in different forms, whether behavioural, statistical or organizational. There are various means and instruments of anomaly detection and fraud control, from simple human observation to complex technological methods. These may include artificial intelligence and neural networking to identify atypical transaction patterns.

The auditor’s observations with respect to indicators of fraud and fraud detection ‘warnings signals’ are determinant in identifying material misstatements due to fraud. The auditor should use different means to satisfy himself/herself on the absence of any fraudulent actions affecting the company’s operations and its financial statements. The auditor’s role mainly concerns the prevention, detection and the disclosure of fraud, particularly when committed by management, but also by employees or individuals. Examples of such cases are indicated on pp. 548–550.

18-19 If the auditor has identified a fraud or has obtained information that indicates that a fraud may exist, the auditor should communicate these matters to interested parties. Discuss the auditor’s responsibility with regard to: (a) communications with management and those charged with governance; (b) communications to regulatory and enforcement authorities.

Answer 18-19 (a) Management and those charged with governance must be informed by the external auditor as soon as practicable of cases of fraud or possible fraud. The auditor should also inform these parties of material weaknesses in the design or implementation of internal controls to prevent and detect fraud. The auditor should communicate to those charged with governance matters involving management, employees who have significant roles in internal control or other parties whose actions lead to material misstatement in the financial statements. Fraud involving senior management and fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements should be reported directly to the audit committee. (b) In some cases, the independent auditor has the obligation to disclose his/her information regarding fraud to regulatory bodies. These cases mainly involve the public interest and when the fraud may affect the conditions of the financial market and interests of society at large. The auditor should also communicate on request to a successor auditor, cases of possible frauds affecting the financial statements.

18-20 In the context of the Statement on Auditing Standards (SAS 99 AICPA) and/or ISA 240 (IFAC), what are the (a) incentives/pressures, (b) opportunities and (c) attitudes/rationalizations, with regard to the risk factors (misstatements) arising from misappropriation of assets? Discuss.

Answer 18-20 Three following conditions are generally present when fraud occurs.

•

Incentive/pressure: a reason to commit fraud;

188 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

•

Opportunity: for example, ineffective controls, override of controls;

•

Attitude/rationalization: ability to justify the fraud to oneself.

Management or other employees may have an incentive or be under pressure to commit fraud.

The lack of efficient internal control systems may also create the conditions for fraud. Therefore, the company’s management plays an important role since they are responsible for implementing an adequate internal control within the company. Individuals may, because they have an incentive or because they are under pressure, possess an attitude, character, or set of ethical values that allow them to commit dishonest acts.

The examples of risk factors under the above three conditions are provided on pp. 538–542 and instructors are encouraged to go through these cases with regard to auditor’s responsibilities.

189 .

CHAPTER 19

AUDITING: LOOKING AHEAD Instructor guidance This is the concluding chapter and is devoted to the review of some very important issues, which have already been discussed in previous chapters, such as auditor independence, audit quality, non-audit services, auditors and the financial market and audit legal liability. Some other important topics such as audit market concentration, pricing of audit services, audit tenure and education and research in auditing have also been discussed in this chapter. The main objective is to present a thorough analysis of the current situation in the audit environment and profession with the view to evaluating future developments. The chapter is rather dense as many topics have been presented in conjunction with recent developments in the financial market and audit environment.

Instructors should emphasize the importance of these topics for preserving the future of the audit profession. Taking into account the numerous challenges the audit profession is faced with, it would be rather difficult to think that the profession could continue its way in the future without significant changes and developments. Such a re-examination will certainly enhance the position of the audit profession and reinforce the auditor’s role in the capital market economy.

Instructors are directly concerned with the topics discussed in this chapter such as education and research in accounting and auditing. Recent financial scandals have raised the issue of the sufficiency and adaptability of auditing and accounting subjects taught in universities. There are more and more calls for change by taking a broader, less structured, and less technical approach to accounting and auditing in the classroom. There is also an increasing demand for integrating subjects such as ethics, organization and information technology into the curriculum. Instructors might consider the holistic approach and place greater emphasis on developing skills in line with the expectations of the capital market economy. The role of professional bodies should also be stressed, particularly with regard to topics required in entrance examinations, as this may have some significant effect on the performance of professional accountants. The importance of research in auditing should also be emphasized, as this would contribute to better understanding of topics.

Instructors may consider that the content of the chapter is not always sufficient, taking into account the number of issues discussed. For this reason, the students should be encouraged to undertake further reading on topics raised in the chapter. Bibliography and references in the end of chapter provide some interesting reading. Instructors may wish to suggest further reading by referring to academic research journals and documents published by accounting bodies.

190 .

SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS Review Questions 19-1 What are the arguments for and against performing non-assurance services?

Answer 19-1 The question of whether it is proper for audit firms to do paid non-audit related work for client companies, especially those listed in financial markets, has been controversial.

Advocates of auditors performing activities other than attestation services state that auditors could engage in activities where no dependence is in fact created, and that it would enhance their knowledge of their clients, thereby facilitating better audits. According to this view, supported by the audit profession, the greater the knowledge of the client’s business, the better the audit team will understand the client’s procedures and controls, and the business and financial risks that it faces.

The arguments in favour of prohibiting certain non-audit services are based on the assumption that performing such services would compromise auditor independence, especially if the nonaudit business was more lucrative than the audit work. Regulators and financial statement users are concerned that auditors compromise their independence by allowing high-fee clients more financial statement discretion relative to low-fee clients.

19-2 What do you think about auditor tenure in relation to audit quality?

Answer 19-2 Auditor tenure has been a controversial issue for years. The debate on the effect of auditor tenure on audit quality is being dominated by recent high-profile financial failures. The market regulatory bodies are very much concerned with the increase of the length of auditor tenure and its impact on audit quality. This is based on the belief that lengthy audit tenures may impair auditor independence, which in turn reduces audit quality. The question of the relationship between auditor tenure and audit quality is very interesting and needs to be empirically investigated. It seems that the regulators’ concerns about auditor rotation requirements are mainly related to enhancing public confidence in a highly demanding market, rather than to a solid economic analysis of the relationship between audit tenure and audit failures.

19-3 Discuss briefly the arguments for and against the mandatory auditor rotation.

Answer 19-3 Students may have different opinions on this issue. Those supporting mandatory auditor rotation may believe that this should offer stronger incentives for auditors to stand up to company management in any differences and disputes in the area of accounting adjustments.

They may also believe that in the absence of auditor rotation, auditor independence would be impaired, which in turn would affect audit quality.

The proponents of increased auditor tenure may argue that mandatory rotation would result in higher audit cost and increased audit failures. According to this view, new auditors lack sufficient knowledge of company-specific risks and, as a consequence, audit failures would probably increase.

19-4 To what extent does the implementation of new international financial reporting standards (IFRSs) affect the audit of financial statements?

Answer 19-4 The main aim of IFRSs is to achieve a high degree of comparability and transparency that will help investors make their decisions while reducing the costs to 191 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

multinational corporations of preparing multiple sets of accounts and reports. However, this will also improve the audit of financial statements as the quality and performance of the auditor, particularly with regard to publicly listed companies, depends to large extent on the accounting standards used by corporations. The move towards IFRS contributes to the quality of the financial reporting process upon which the audit work depends. Besides that, the development and the acceptance of international standards should also reduce compliance costs for corporations and improve consistency in auditing.

19-5 How does the globalization of financial markets affect the audit function and the quality of the audit?

Answer 19-5 The globalization of financial markets may have several significant effects on the audit market and audit quality. The globalization and internationalization of the capital markets affect competition among audit firms and may create a higher concentration in the audit market.

It may result in a higher quality of audit if the auditors acquire the necessary competency, training and specialization. However, a concentrated audit market may also impair auditor independence and performance. The internationalization of financial markets also requires a stronger move towards a single set of accounting standards to enhance comparability of financial statements. This will certainly benefit auditors’ performance, particularly of those in charge of publicly listed companies.

19-6 How do you evaluate the influence of audit concentration on audit quality and auditor performance?

Answer 19-6 Audit concentration may contribute to audit quality and auditor performance in the sense that it will increase specialization and competency. This will also improve auditor training as larger firms will be able to devote more resources to it. Some research studies support audit concentration (see Francis 2004). Relative to the size of their clients, smaller accounting firms have higher litigation rates and are the subject of more enforcement actions by market regulatory agencies. However, audit concentration may also have some unfavourable consequences for audited companies and users of financial statements. It may cause serious anti-competitive problems in financial markets. With fewer alternatives, companies may also have few options to their current auditors. The concentration of the audit profession raises the spectre that the collapse of a Big Four firm would threaten the profession itself. Three large firms may be too few to maintain audit quality and independence. This could happen as a result of ruinous litigation or a regulatory decision to dissolve a firm.

19-7 What are the features of the pricing of audit services and its impact on audit performance and audit quality?

Answer 19-7 Audit pricing may affect auditor performance and lead to audit failures in the case of disagreement between auditor and client over fees. ‘Low balling’ and ‘opinion shopping’ are two major problems. ‘Low balling’ relates to situations when audit firms quote audit fees that are below their start-up costs with new clients believing that future fees will exceed future marginal audit costs. This may lead to a change of auditors and it may also cause a loss of audit quality.

‘Opinion shopping’ is when a company can avoid an unfavourable report even when there are no additional revenues for the auditor. For example, a company can switch if it believes that a new auditor is more likely than the incumbent auditor to give a clean report. Practicing unfair audit pricing may compromise auditor independence as this creates an incentive for firms to stick with their clients for longer periods.

19-8 How do you evaluate the role of the audit committee in future audit services?

Answer 19-8 The audit committee can play an important role in providing audit services of high quality. The audit committee has an oversight function that is a critical corporate governance mechanism involving different managerial activities, corporate reporting and auditing. This

192 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

oversight includes ensuring quality accounting policies, internal controls, and independent external auditors to deter fraud, anticipate financial risks and promote accurate, transparent, and timely disclosure of corporate information to different users. All these can contribute to an efficient role for the external auditor in financial markets and improve audit quality and performance. Evaluating the independence, integrity, qualification and performance of the company’s external auditors is among the activities of the audit committee. Increasing the active presence of this committee within publicly listed companies will favour audit quality and auditor performance.

19-9 Do you agree with the idea that auditing is a multidisciplinary field? Why? Answer 19-9 Several aspects of auditing touch on other disciplines such as accounting and financial reporting, organization, corporate governance, ethics, finance, information systems etc.

This relationship has developed along with advances in the capital market economy and information technology. Auditing is a field whose quality and performance depend to large extent on the evolution of society and factors affecting the capital market economy.

Some technical aspects of auditing depend on other disciplines. For example, Mautz and Sharf (1961) recognize that the nature of evidence and the formation of audit opinions are dependent on the theory of knowledge; reliance on tests and samples is based on probability theory and mathematics; fair presentation draws upon accounting principles, financial analysis and communication theory; due audit care recognizes ethical and legal relationships. Moreover, auditing is an applied field, making its ultimate contribution at the practical level. It serves the interests of regulatory bodies and economic agents such as investors and bank lenders.

19-10 How do you define ‘real-time reporting’ and the change it brings to auditing?

Answer 19-10 Information technology (IT) continues to change how organizations function, communicate and conduct business with customers. The information technology enables organizations to receive, process, and report large amounts of data on a continuous basis, and this allows companies to do business and publish financial information in real-time. Companies currently have online real-time records of cash, accounts receivable, accounts payable, and inventories, as well as selected nonfinancial activities in production, human resources, patents etc. Reporting will become nearly continuous and hopefully, in the near future, there will be the development of a set of external reports of key variables in real-time.

At the same time, real-time financial reporting requires the auditor to conduct continuous auditing as a process that tests transactions based upon prescribed criteria. As management increasingly deploys continuous monitoring techniques, use of continuous auditing by both internal and external auditors will become inevitable. Consequently, information technology fuels the need for continuous monitoring and auditing.

Real-time accounting systems require auditors to employ continuous electronic auditing because most of the audit evidence in real-time accounting systems may only exist in electronic form.

Discussion Questions 19-11 In your opinion, what challenges face the audit profession in the current capital market economy? What solutions would you propose?

Answer 19-11 This is a reflective question and there is no clear-cut answer to it since the evolution of the audit environment largely depends on future development in the capital market economy. Instructors should encourage students to express their opinions on this question as this contributes to a better understanding of the characteristics of the audit environment. The

193 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

chapter highlights a number of challenges facing the audit profession. The discussion on suggested solutions has been provided throughout the book.

The major challenge facing the audit profession is how to deal with current issues regarding the auditor’s responsibilities in the financial market and his/her role in examining the financial statements of publicly listed companies, and also the extent of these responsibilities in detecting fraud and misstatements. This chapter discusses issues such as ethics, audit independence, development of IT, audit quality, audit education and audit concentration. Although the chapter does not discuss the auditor’s legal liability – since this has widely been covered in Chapter 16, this is one of major challenges facing the profession. This is mainly because of ever-growing public expectations of audit quality and the limitations on auditors’ abilities to control unforeseen events leading to corporate failures.

Strong emphasis has been placed on auditor independence in addition to what has been said in Chapter 7, since this is one of the critical issues for the future of auditing. Auditor performance, audit quality and quality control mechanisms as well as the attitude of market regulatory bodies towards external auditors depend on how the audit profession can successfully achieve this objective. The changes in audit education are also important and need to be considered by a profession keeping pace with developments in financial markets and IT. 19-12 The auditing industry, (especially the Big Four firms or their predecessors, the Big Eight or Big Six), was traditionally involved in ‘non-audit services’. This had been a concern for market regulatory agencies who decided to ban audit firms from performing some of these activities for their audit clients. How do you evaluate the impact of performing such services on auditor independence, his/her performance and audit quality?

Answer 19-12 The question of whether it is proper for audit firms to do non-audit related work for client companies, especially those listed in financial markets, has always been controversial.

Before market regulators imposed restrictions on audit firms simultaneously supplying audit and non-audit services, revenues from non-audit services were a significant and growing portion of the incomes of accounting firms. For this reason, non-audit services have been the most consistent target for those sceptical of the independence of auditors.

Instructors’ and students’ views on this question may be different from those of market regulatory bodies supporting the restrictions imposed on audit firms. They may argue that auditors could engage in activities where no dependence is created and that they could therefore learn more about their clients’ activities. This argument is based on the premise that the greater the knowledge of the client’s business, the better the audit team will understand the client’s procedures and controls, and its business and financial risks.

Regulators’ concerns are based on the premise that the provision of non-audit services increases the fees paid to the audit firm, thereby increasing the economic dependence of the audit firm on the client. The magnitude of non-audit services provided to audit clients introduces the risk that the client may be able to leverage its position with the external auditor and affect audit quality.

19-13 Following recent financial failures, there has been more and more institutional involvement in the market economy with respect to audit function, including the regulation of the audit profession. How do you evaluate this intervention? Do you believe that the auditing profession is unable to regulate itself?

Answer 19-13 The market regulatory bodies have traditionally been concerned with auditors’ activities and their performance. The main objective of regulatory bodies is to protect the public interest, which in turn depends on public confidence in the functioning of the capital markets and in the operations of publicly listed companies. External auditors play an important role in this

194 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

process by expressing an opinion on companies’ financial statements. However, public expectations of the ethics and professionalism of external auditors have grown in recent years, along with the changing business environment and expanding financial activities. This evolution has led market regulators to examine the adequacy of ethical standards and auditor independence rules in maintaining the confidence of users of financial statements.

Regulatory bodies intervene in issues of non-audit services, auditor rotation, audit quality control and auditor legal liability often to the detriment of audit professional bodies. Perhaps recent developments in the capital market economy and rapid advances in IT make it necessary for the regulatory bodies to exercise more control on external auditors. This includes standard setting and quality control, which have traditionally been under the direct or indirect control of the profession.

19-14 Discuss the bubble economy, particularly the way it leads management to adopt increasingly creative and sophisticated accounting practices to produce robust earnings. In your opinion, how does the earnings quality affect audit quality?

Answer 19-14 The bubble economy and artificially smoothed earnings have had significant influence on auditors’ performance and audit quality. The conditions imposed by the bubble economy have encouraged corporate management to adopt increasingly creative accounting practices to deliver the kind of predictable and robust earnings and revenue growth demanded by investors.

The concept of earnings quality arose out of a need to provide a basis of comparison among the earnings of different entities as well as from the need to recognize such differences in ‘quality’ for valuation purposes. Auditors play a vital role in the quest for high quality and reliable financial reporting. Independent auditors must earn the confidence of the investing public by adhering to high standards of professional conduct that provide assurance as to the integrity and objectivity of their services. Nevertheless, when audited financial statements turn out to be unreliable and must be restated, questions can be raised about the auditor’s performance. It is logical to ask ‘where were the auditors?’ and ‘why did they fail to report correctly?’

19-15 Relative to the size of their clients, smaller accounting firms have higher litigation rates and are the subject of more SEC enforcement actions’ (DeFond and Francis, 2005: 22). Discuss the importance of a firm’s size for audit of financial statements and audit quality.

Answer 19-15 This question deals with several interesting issues such as the effect of a firm’s size on audit quality, the relationship between firm size and audit litigation, and the impact of audit firm size on a company’s reporting policy and earnings management. The relationship between firm size and audit quality has been widely studied in auditing research. The study of DeFond and Francis (2005) was based on the assumption that all accounting firms, big or small, can potentially perform a competent audit in accordance with auditing standards. However, it seems that some accounting firms do not produce high-quality audits either because of lower fees and/or firm structure.

While most publicly listed companies in major capital markets are audited by Big Four accounting firms, there are still a large number of listed companies audited by local and regional accounting firms. Public Accounting Report (2004) notes that after the introduction of the SOX Act, the Big Four were dropping more of their riskier clients, which were mainly being picked up by second-tier national firms. Therefore it is reasonable to investigate the impact of firm size on audit quality by identifying the relevant variables. It would also be interesting to ask the effect of audit firm size on audit litigation. There is evidence that relative to the size of their clients, smaller accounting firms have higher litigation rates and are the subject of more SEC enforcement actions. Smaller accounting firms report less conservatively (issue fewer nonclean

195 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

audit reports), and their clients are more likely to have abnormal accruals, which is suggestive of more aggressive earnings management.

19-16 ‘In calling on academics to “fix” the auditing profession we feel it is important to recognize that there is an inherent threat to our own independence when we investigate the auditing profession. This threat arises because the auditing industry hires our students, makes donations to our departments and schools, funds professorships and chairs, gives us subjects for experiments and proprietary data and hires us as expert witnesses. All of these factors create a cozy relationship and a temptation for auditing researchers, referees and journal editors to adopt a sympathetic view to the profession, and while such sympathy might be driven by a rational fear of “biting the hand that feeds us” succumbing to this sympathy would seriously erode our intellectual integrity. If auditing researchers become apologists for the auditing profession then we are doing the profession, our students, society and ourselves, a huge disservice” (DeFond and Francis, 2005: p. 10)’.

Comment on the above statement. How can audit education and research contribute to enhancing audit quality and auditor performance?

Answer 19-16 This question is drawn from a statement cited in DeFond and Francis (2005) under the heading of ‘audit researcher independence’. The statement raises the question of the relationship between academia, the audit profession and accounting firms. The central issue is the quality of research in auditing and its relevance to the current needs of society. The audit profession and large accountancy firms play a dominant role in the audit environment, including research and education. They have not only become part of the institutional framework of the business community, they also play a significant role in educational institutions and research associations in accounting, auditing and related areas.

The question is whether the direct intervention of the audit profession and accountancy firms affects the objectivity of the researchers and their independence when dealing with crucial questions such as audit quality and performance, quality control mechanisms, auditor legal liability, the role of the external auditor, and the usefulness of audit reports in investment and financing decisions. It is a legitimate question, since the enormous financial resources of accountancy firms and their lobbying position may be used to protect their interests within the academic community. Accountancy firms may also use their power to influence politicians to soften the regulations imposed on auditors in charge of the audits of publicly listed companies.

However, it is also true that the provisions of the SOX Act of 2002 in the United States and similar laws in other major capital markets are much more restrictive than all the previous regulations throughout the twentieth century combined. The whole question is how to defend the public interest by enhancing audit quality, performance and independence, knowing that the auditor is also an economic agent seeking to maximize his revenue. The financial crises of recent years have called into question auditors’ role and their independence from audit clients.

19-17 Discuss the following topics with regard to auditor independence: (a) auditor objectivity and reliability; (b) auditor reputation; (c) auditor expertise and competence.

Answer 19-17 This question discusses several core topics that have a direct relationship with auditor independence, which in turn affects the credibility of the auditor’s opinions on a company’s financial statements.

196 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

(a) External auditors should be fair and should not allow prejudice or bias, conflict of interest or the influence of others to override their objectivity. Independent auditors serve in many different capabilities and need to demonstrate objectivity in diverse circumstances. The presence of an external auditor should bring credibility to a company’s financial statements, making them reliable for users of financial information. (b) The auditor’s reputation serves as a collateral bond for independence. Reputation has a strong impact on auditor independence as it is used as a control device to motivate the auditor to supply high-quality audit services. Although it is costly to establish a reputation in a high status profession such as auditing, such a reputation increases the demand for auditors’ services. (c) External auditors should perform attestation and other professional services with due care, competence and diligence, and have a continuing duty to maintain professional knowledge and skill to ensure that clients receive the advantage of competent professional service based on up-to-date developments in practice, legislation and techniques.

19-18 Consider the following questions. (a)

Taking into consideration all deficiencies and constraints in the audit environment, what is your overall assessment of the audit profession?

(b)

How do you evaluate the future of the audit profession? Do you believe it will be able to overcome the current difficulties?

Answer 19-18 This is a general question and aims at the student understanding the current role of the external auditor and his future place in the capital market economy. Although there is no clear-cut answer to this question, some answers are suggested in previous chapters, particularly those relevant to the auditor’s role (Chapter 1), demand and supply of external audit services (Chapter 2), auditor independence (Chapter 7), quality control (Chapter 15), auditor liability (Chapter 16) and corporate frauds and the auditor (Chapter 18). The following issues can contribute to constructive discussion in the classroom. (a)

An evaluation of the auditor’s role in the current capital market depends on several factors, particularly on whether we consider the viewpoint of the audit profession, regulatory bodies and/or users of financial information. However, an objective evaluation of the place of the audit must consider the recent development in the financial market and IT advances. In recent years, the audit profession has not been able to protect its reputation from the fallout of corporate collapses. The number and cost of lawsuits against auditors are increasing to the extent that they significantly affect the current and future positions of external auditors.

(b)

There are several important challenges facing the audit profession. Its future largely depends on how it deals with issues such as auditor independence, audit quality, increasing audit concentration, audit tenure, real-time reporting, IT advances, audit education, and the auditor’s responsibilities with regard to financial reporting, particularly earnings management.

19-19 Referring to Elliott (2002), discuss the changes affecting assurance services.

Answer 19-19 The main reason for asking this question is to encourage the students to read the paper of Elliott, which was published in 2002. The article explores some of the principal changes in the audit paradigm that are necessary to meet assurance-user needs in the future.

The central issues are related to continuous reporting, continuous assurance and IT advances.

197 .

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual

The fact that the paper has been written by a partner at KPMG shows the interest of accountancy firms in the development of auditing.

The paper is a summary and does not present an in-depth discussion of the impact of IT advances on the audit profession. Although there have been some other articles on similar topics in academic journals since 2002, continuous reporting and continuous auditing have not been much explored either in academic journals or in auditing textbooks. It seems that this issue has not been sufficiently covered in the auditing courses at universities and the examination syllabuses of professional bodies. An extensive discussion on this topic is presented in Chapter 13 on information technology and auditing and Chapter 14 on continuous auditing and continuous reporting.

19-20 Referring to DeFond and Francis, discuss the major issues of audit research.

Answer 19-20 The paper of DeFond and Francis attempts to stimulate research into some of the important questions implicitly raised by the SOX Act regarding the audit profession’s potential failings. The SOX Act has tremendously affected the audit function and this has also changed the research perspective in auditing. The paper discusses corporate governance mechanisms and audit education, and also takes a critical approach towards auditing, raising questions such as ‘is the auditing profession unable to regulate itself?’ ‘does auditor tenure or the ‘revolving door’ impair auditor independence?’ The paper presents a review of literature on some of the most important topics in auditing. An extensive list of references of the most important papers is also presented in the article.

Instructors should strongly recommend the article to students and then discuss the current status of audit research. Since the introduction of the SOX Act there have been some interesting papers published in academic journals on some important aspects of auditing, such as the place of audit committee in audit environment, auditor independence, and audit quality.

However, there are still several research possibilities in these areas. Some of these topics have also been stressed in a commentary note published in ‘Current Issues in Auditing’ (Top 10 Wish List for Audit Research, Commentary, Current Issues in Auditing, 2007, Vol. 1, pp. C3–C9). It would be interesting to read this commentary, which presents the views of a professional accountant – Edward E. Nusbaum (who is the chief executive officer of Grant Thornton, one of the big accountancy firms).

198 .