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8/14/2019 Presentation Chapter 9.pptx
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External uditors’ Roles and
Responsibilities
Chapter IX
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Chapter Objectives:• Recognize the role independent auditors play in achieving effective corporate
governance and reliable financial reports.
• Understand the history of auditing, the traditional roles of auditors, and regulations
recently placed on them.
• Address the expectation gap regarding what auditors can provide in the way of
reasonable assurance and the expectations of investors for a higher level of
assurance.
• Identify the roles and responsibilities of the PCAOB, and discuss the auditing
standards published by the PCAOB.
• Demonstrate the importance of auditor independence both in fact and in appearance.
• Discuss an integrated audit of both financial statements and ICFR.
• Address the issue of a liability cap for independent auditors, and understand the
rationale on both sides of the issue.
VIDEO ( VIDEO)
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Key TermsThe Accountancy Investigation Discipline Board (AIDB)
Audit quality
Audit riskAudit strategy
Auditor independence
Control risk
Detection risk
Expectation gap
Inherent risk
Integrated audit approach
Internal Revenue Service (IRS)
International Standards on Auditing (ISAs)
PCAOB-US
Professional Ethics ExecutiveCommittee (PEEC)
Standing Advisory Group (SAG)
Statements on Auditing Standards
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External Auditing and Corporate
Governance
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External Auditor Responsibility
Current auditing standards require that independent auditorsprovide re son ble ssur nce that the financial statementsare free from material misstatements, whether caused byerror or fraud, to render an unqualified opinion on the financialstatements.
External auditors are not and should not be expected toprovide absolute assurance regarding reliability of financialstatements, but the public expectations concerning externalauditors performance are high.
Users of audited financial statements generally expectexternal auditors to detect financial statement fraud andemployees’ illegal acts and fraud, which affects the integrityof financial reports. External auditors, however, are moreconcerned with material misstatements in the auditedfinancial statements.
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Auditor Competency
1. Professional competencies. To audit public companies,
auditors should register with the PCAOB and meet all
registration and inspection requirements.
2. Technical competencies. Auditors should be knowledgeable
in professional standards, rules, laws and regulations, and
understand their clients’ industry and business, corporate
governance, financial reporting process, and internal
controls.
3. Process competencies. uditor’s ability to choose
appropriate evidence-gathering procedures (tests of
controls, substantive tests) and execute auditingprocedures
4. Reporting competencies. Reporting competencies refer to
the auditors’ ability and willingness to discover and report
material misstatements.
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Reports Accompanying
Financial Statements
• Report on financial statements and related disclosures(prepared by auditor) Are financial statements and disclosures according to GAAP?
• Report on internal control over financial reporting(prepared by management) Has company maintained effective internal control over financial
reporting?
• Report on internal control over financial reporting
(prepared by auditor) Is management’s assessment of its internal control appropriate?
Has company maintained effective internal control over financialreporting?
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The Purpose of the Audit Report
• Definition of auditing: “... communicating results tointerested users.”
• Indicate whether the FS are in accordance with GAAP Provide indication of what the FS would be like if GAAP were
followed
Provide any company-omitted disclosures
• Indicate any unusual aspects of the audit examination Scope limitations
Division of responsibility
• Indicate any unusual matters related to the company Going concern uncertainty
Consistency
Emphasize a matter
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Four Categories of
Audit Reports• Standard unqualified (clean opinion)
• Unqualified with explanatory paragraph ormodified wording
• Qualified
• Adverse or disclaimer
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Definitions: Webster’s New
Unabridged Dictionary
• Qualified:
Having met conditions or requirements set
Limited, modified
• Unqualified:
Not having the usual or requisite talents,
abilities, or accomplishments Not modified, limited, or restricted by conditions
or exceptions
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Types of Audit ReportsType of Report Interpretation
Unqualified
Opinion
Financial statements taken as a whole present fairly
the financial position, results of operations, and cash
flows in conformity with generally accepted
accounting principles (GAAP).
Qualified Opinion ―Except for ‖ the effects of a particular matter, thefinancial statements present fairly the financial
position, results of operations, and cash flows in
conformity with GAAP.
Adverse Opinion Financial statements do not present fairly the financial
position, results of operations, and cash flows inconformity with GAAP.
Disclaimer of
Opinion
Auditor does not express an opinion on the financial
position, results of operations, or cash flows.
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Unqualified Reports
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Standard Unqualified Report
The five necessary conditions have been met:
1. All four required statements are included.
2. The three general standards have beenfollowed in all respects on the engagement.3. Sufficient evidence has been accumulated
and the auditor has conducted theengagement in a manner that enables theconclusion that the three standards of fieldwork have been met.
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Standard Unqualified Report
4. The financial statements are presented in
accordance with GAAP (including adequate
disclosures.
5. There are no circumstances requiring the
addition of an explanatory paragraph or
modification of the report wording.
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Auditnotice
Standard Unqualified Audit Report
(Nonlisted Companies)
Title Report of Independent Auditor
Address
to client
To the Board of Directors and stockholders of Any
company
Auditnotice
We have audited the accompanying balancesheets of Any company as of December 31, 1990
and 1989, and the related statements of income,
retained earnings, and cash flows for the year
then ended. These financial statements are the
responsibility of the company’s management. Our
responsibility is to express an opinion on these
financial statements based on our audits.
Identify
the
financial
statements
Management
responsibility
Auditor
responsibility
continued
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Descriptio
n of the
audit
We conducted our audits in accordance with
generally accepted auditing standards. Those
standards require that we plan and perform the
audit to obtain reasonable assurance about
whether the financial statements are free of
material misstatement. An audit includes
examining, on a test basis, evidence supporting
the amounts and disclosures in the financial
statements. An audit also includes assessing the
accounting principles used and significant
estimates made by management, as well asevaluating the overall financial statement
presentation. We believe that our audit provides a
reasonable basis for our opinion.
No special
mention of
adequate
disclosure
or
consistenc
y
In our opinion, the financial statements
referred to above present fairly, in all material
respects, the financial position of Any company as
of December 31, 1990 and 1989, and the results
of its operations and its cash flows for the yearsthen ended in conformity with generally accepted
accounting principles.
Opinion on
financial
statement
s
Refer toGAAP
___________________________________,
CPAFebruary 28, 1991
Signature
Date
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Audit Failures and Audit QualityFollowing is the list of the initiatives that have beensuggested to improve audit quality, as well as transparency.
1. Publication of audit engagement letters
2. Shareholders’ rights to question auditors3. Publication of auditor resignation statements
4. Lead audit partner’s signature on audit reports
5. Active audit committee participation in evaluating thescope and results of the integrated audit of both ICFR andfinancial statements
6. Mandatory rotation of the audit firm every seven to twelveyears in the context of the quality of audit work performedby the firm and the audit efficacy
7. Mandatory shareholder vote on the ratification of theindependent auditor each year
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Public Company Accounting
Oversight Board The PCAOB created by SOX to regulate the auditing
profession.
The PC OB’s primary functions are to:
1. Register public accounting firms that audit public
companies.
2. Inspect the registered public accounting firms on a regular
basis.
3. Establish auditing, attestation, ethics, quality control, andindependence standards.
4. Conduct investigations and disciplinary proceedings.
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PCAOB Auditing Standards
The PCAOB has issued five auditing standards as ofSeptember 2007:
1. PCAOB Auditing Standard No. 1 (audit is conducted inaccordance with auditing standards of PCAOBUS, the city and
state has to be disclosed)2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No.5 superseded AS No. 2 and requires the independent audit toopine only on the effectiveness of ICFR, not the managementprocesses and assessments concerning ICFR)
3. PCAOB Auditing Standard No. 3 (auditors are required to
maintain the audit documentation in a sufficient manner andkeep the records for at least seven years)
4. PCAOB Auditing Standard No. 4 (voluntary engagement forthe auditor’s report on thecompany’s elimination of previouslyreported material weaknesses in its ICFR)
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20
Roles and Responsibilities—Internal Control over
Financial Reporting
• Management: Designs and implements the system ofinternal control over financial reporting; evaluates theeffectiveness of the company’s internal control over financialreporting and provides a public report on that assessment;
prepares the financial statements.• Audit Committee: Has responsibility for oversight of the
company’s financial reporting process.
• Independent Auditor : Performs an audit of internal controlover financial reporting and issues a report onmanagement’s assessment of internal control over financialreporting and on the effectiveness of internal control overfinancial reporting; also performs an audit of the company’sfinancial statements.
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21
What Management’s Report
Will Include
Under the SEC rules, management’s report on internal control overfinancial reporting should include the following information:
• Statement of management’s responsibility for establishing andmaintaining adequate internal control over financial reporting.
• Statement identifying the framework used by management to evaluate
the effectiveness of internal control over financial reporting.• Management’s assessment of the effectiveness of the company’s
internal control over financial reporting as of the end of the company’smost recent fiscal year, including an explicit statement as to whether thatcontrol is effective and disclosing any material weakness identified bymanagement in that control.
• Statement that the registered public accounting firm that audited thefinancial statements included in the annual report has issued anattestation report on management’s internal control assessment.
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22
PCAOB Auditing Standard No. 2: An Audit of Internal Control over Financial Reporting Performed in Conjunction with
an Audit of Financial Statements
1. AS No. 2 required three integrated reports on:
a. Financial statements audited by registered public accounting
firms.b. Management’s assessment of the effectiveness of internal
control over financial reporting (Section 404).
c. The effectiveness of internal control over financial reporting
over financial reporting based on the auditor’s attestation of
internal control.2. AS No. 2 was effective beginning June 17, 2004.
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24
Report of Independent Registered Public
Accounting Firm
*The explanatory paragraph is required only when the auditor’s opinion is other than unqualified and may also be placed after the opinion paragraph
when the auditor issues two separate reports on the audit of financial statements and internal controls, thus making reference to opinion on the
financial statement audit in the report on the internal control audit.
1. Introductory
Paragraph
2. Scope
Paragraph
3. Definition
Paragraph
6. Inherent
LimitationsParagraph
5. Explanatory
Paragraph*
4. Opinion
Paragraph
7. Signature 8. City andState or
County
9. Date
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25Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.
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26Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.
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27Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.
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PCAOB Auditors Independence
The new rules restrict public accounting firms in
performing a variety of tax services to their audit clients.
The new rules are intended to prevent the selling of
abusive tax shelters.
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Audit Committee Oversight of
External Auditors
The extended oversight responsibilities for the audit
committee are:
1. Appointment, compensation, and retention of registered
public accounting firms2. Preapproval of audit services and permissible nonaudit
services
3. Review of the independent auditor’s plan for an integrated
audit of both ICFR and annual financial statements
4. Review and discussion of financial statements audited orreviewed by the independent auditor
5. Monitoring the auditor’s independence
6. Auditor rotation requirement
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Audit Committee Oversight of
External Auditors
The number of companies that change auditors, and the
number of auditors changed
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Independent Auditors
Communications with the Audit
CommitteeCommunications from the committee to the
independent auditor:
Communications from the independent
auditor to the audit committee:
1. Appointment and retention approval of the
independent auditor
2. Formal approval of audit and permissible nonauditservices
3. Formal approval of fees for both audit and nonaudit
services with a keen focus on improving the quality of
audit and nonaudit services
4. Any concerns or risks threatening management’s
reputation and integrity, etc.
5. Allegations of financial statement fraud
1. Seeking committee preapproval of all audit and
nonaudit services in a timely manner
2. The critical accounting policies and practices used bymanagement in the preparation of financial statements
3. All alternative treatments of financial information within
GAAP
4. Any accounting disagreements between the
independent auditor and the company’s management
5. Any material, written communications between the
independent auditor and the company’s management
throughout the course of the audit
6. Significant deficiencies and material weaknesses ofICFR
7. The audit report on annual f inancial statements
8. The review report on quarterly financial statements
9. The audit report on management’s assessment of the
effectiveness of ICFR
10. The audit report on the effectiveness of ICFR
11. Financial risks associated with financial reports
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Auditor Independence
Auditor Independence
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Consolidation and Competition
in Public Accounting Firms SEC rules require public companies that change their public
accounting firms to file a Form 8-K, Item 4.01, to disclose
changes within four days, whereas auditors are required to
provide standard letters within ten days stating whether they
agree with the company’s disclosure without specifying anyreasons.
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Integrated Audit Approach
Management assessment on
the effectiveness of ICFR
Effectiveness of both designand operation of ICFR based
on control criteria
Fair presentation of financialstatements in conformity withGAAP
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Audit StrategyAudit Strategy:
1. No limited tests of controls
2. No use of cycle rotation in tests of controls
3. Dual testing of controls and substantive audit procedures
Auditors should focus on prevention, detection, and correction
of controls at both the company level and the transaction
level. Auditors should perform tests of controls as a basis for
forming an opinion on the effectiveness of ICFR. Auditorsshould also perform substantive tests as a basis for
expressing an opinion on the fair presentation of financial
statements, regardless of the identified significant
deficiencies and material weaknesses in internal controls.
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The Audit
Video
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Brief History Fraud Investigation• 1900s -- Fraud detection was a primary
objective of the audit
• 1940s -- Detection of fraud considered to bea ―responsibility not assumed‖
• 1960s -- Auditor acknowledged responsibilityfor detecting fraud that would normally beuncovered by an examination performed inaccordance with GAAS.
• 1980s -- Auditor had responsibility to searchfor fraud that may have a material affect onthe financial statements.
• 1997 -- SAS No. 82; 2002 – SAS No. 99
37
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Types of Fraud
FRAUD
Management
Fraud
Employee
Fraud
Financial Statement Fraud
Misrepresentation of materialfacts
Misappropriation of assets
Concealment of material
facts
Illegal Acts
Bribery
Conflict of Interest
Embezzlement of money or
property
Breach of fiduciary duty
Theft of trade secrets of
intellectual property
Illegal acts
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Why People Commit Fraud
Studies show that employees are likely to
commit fraud when four conditions exist:
– PRESSING FINANCIAL NEED – OPPORTUNITY
– REASONABLE JUSTIFICATION
– LACK OF MORAL PRINCIPLES
39
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Embezzlement Formula
40
MOTIVE +
OPPORTUNITY +
RATIONALIZATION =
CRIME [FRAUD]
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Profile of Fraud Perpetrators
41
The fraud perpetrator is more likely to be an ordinary member of thecommunity: intelligent, respected, never suspected of dishonesty,NOT YOUR TYPICAL CRIMINAL TYPE.
MORE LIKELY TO BE:
• A woman• Married
• Church member
• Older
• Heavier
• Have children• Have a higher education
• Never been arrested
• Have high self-esteem
• High achiever
LESS LIKELY TO BE:
• Divorced• Alcoholic
• Tattooed
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Financial Statement Fraud
• Definition – Deliberate misstatements or omissionsof amounts or disclosures of financial statements todeceive financial statement users, particularlyinvestors and creditors
• Financial statement fraud has become a daily thing.Press reports challenge the corporate responsibilityand integrity of major companies such as Lucent,Xerox, Rite-Aid, Waste Management,Microstrategy, KnowledgeWare, Sunbeam,Cendent, and ZZZ Best, Enron, WorldCom, Qwest,Madoff, Satyam, Stanford Financial, and Parmalat.
42
Hi h P fil Fi i l t t t
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High-Profile Financial statement
FraudBasis of the Fraud Older Example Year Recent Example Year
Fictitious revenue,
documentation forgery and
theft of corporate assets
ZZZZ Best
1987
Enron2001
Personal use of assets, falsedocumentation and financial
statement fraud
Phar-Mor 1992 Adelphia 2002
Capitalizing expenses, among
other issues
Waste
Management
1997 WorldCom 2002
Abuse of accounting
standards
Savings and Loan
Crisis
1982 Stock Options
Backdating 2006
S t f Fi i l
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Symptoms of Financial
Statement Fraud
• Continuous Deterioration of Quality and
Quantity of Earnings
• Inadequacy of Cash Flow
• Overstatement of Inventories
• Overly Aggressive Accounting
• Management ―Short-termism‖ • Improper Revenue Recognition
• Overstatement of Assets
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Elements of Fraud
• A false representation of a material nature
• Knowledge that the representation is false orreckless disregard for the truth (Scienter)
• Reliance on the false representation by thevictim
• Financial damages are incurred (to the
benefit of the perpetrator).• The act was intentional.
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Auditor and Investigator
Responsibilities
• External Auditors (CPAs) SAS 99: Consideration of Fraud in a Financial Statement Audit
– Design audit to provide reasonable assurance of detecting fraud that could havea material effect on the financial statements.
– Perform fraud-related procedures
SAS 54: Illegal Acts
– Focused primarily is on direct-effect illegal acts SAS 61: Communication with Audit Committees
• Internal Auditors (CIAs) SIAS 3: Deterrence, Detection, Investigation, and Reporting of Fraud
• Governmental Auditors Focus on laws and regulations (compliance), design audit to detect abuse
and illegal acts, report to the appropriate authority• Certified Fraud Examiners (CFEs)
Assignments begin with predication (probable cause)
46
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Auditor’s Responsibility for
Detecting Fraud
• GAAS makes NO DISTINCTION
between the auditor’s responsibilities for
searching for errors or for fraud
• Per SAS No. 99, auditors must
specifically assess the risk of material
misstatement due to fraud
47
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Assessing the Risk of Fraud• Pressure or incentive to commit the fraud
Direct financial gain, such as misappropriationof assets or retaining job
Indirect financial gain, such as increase instock price
• Perceived opportunity to commit the fraud
Can fraud be perpetrated without detection?
48
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Misappropriation of Assets
Risk Factors
• Susceptibility of assets
to misappropriation
• Employee relationships
or pressures
• Deficiencies in internalcontrol
49
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Red Flags
• Personal financial pressure
• Vices (drugs, alcohol or gambling)
• Extravagant lifestyles
• Real or imagined grievances againstcompany
• Related parties
• Increased stress
• Internal pressures
50
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How Frauds Occurred
• Poor internal controls
• Management override of internal controls
• Collusion between employees and thirdparties
• Collusion between employees or
management• Lack of control over management
• Poor or nonexistent corporate ethics policy
51
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Reasons Auditors Fail to Detect Fraud
• Over reliance on client representations
• Lack of awareness or failure to recognize
that an observed condition may indicate a
material fraud
• Lack of experience
• Personal relationships with clients
52
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SAS No. 99
53
Rationalization
Incentives/Pressures
Opportunities
The Fraud Triangle
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The Fraud Triangle
• Incentives/Pressures
95 percent of all fraud cases involve either:
– Financial pressures
– Vice-related pressures, including drug or alcoholaddiction
– Expensive romantic relationships
– Need to maintain a particular lifestyle
– Medical problems
54
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The Fraud Triangle
• Opportunity
Easiest to control of the three components
Most frequently achieved with internalcontrols
– Segregation of duties
– Authorizations
– Independent checks
– Physical safeguards
– Adequate documents and records
56
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3Cs of Financial statement Fraud
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58
Errors
Misappropriationof Assets
FinancialStatement
Fraud
AuditRisk
Errors
Misappropriationof Assets
FinancialStatement
Fraud
Errors
Misappropriationof Assets
FinancialStatement
Fraud
Tests of Controls
Evaluate ControlEnvironment
AnalyticalProcedures
Tests ofDetails
=
Incentive/
Pressure
ManagementIntegrity
Opportunity
R 1
R 2
Incentive/Pressure Fraud
Risk Factors
Attitude/Rationalization
Fraud RiskFactors
OpportunityFraud Risk
Factors
ForensicProcedures
Inherent Risk Control Risk Detection Risk
EvaluateControls Over
Assets
X X
Evaluate TopManagement
Controls
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Audit of Defined Benefit
PensionsEmployer-defined benefit pension reforms, as proposed by the
administration and introduced by both the House and the
Senate, would require plan sponsors to make minimum funding
contributions equal to the greater of:(1)the contributions required under the plan’s funding standard
account estimated based on the plan’s actuarial accrued
liability,
(2)deficient reduction contributions calculated under current
liability rules.
These reforms would replace the current law’s “double-barrel”
system with a single measure of assets and liabilities and
required funding method.
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uditors’ Liability Limitation
Agreement
In February 2006, the Federal Financial Regulatory Agencies
issued an interagency advisory that raised concerns regarding
the negative impacts on the quality and reliability
of audits when financial institutions agree to limit their
independent auditors’ liability.
The advisory, while observing an increase in the types and
extent of provisions in financial institutions’ external audit
engagement letters that limit auditor liability, informs
financial institutions that they should not enter into an audit
engagement that includes unsafe and unsound limitation ofliability provisions relevant to an integrated audit of their
financial statements and ICFR.
Auditors Liability Limitation
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Agreement
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Conclusion • The audit function should be regarded as an external corporate
governance mechanism that serves to protect investors from
receiving incomplete, inaccurate, or misleading financial information
and thus adds value to the effectiveness of corporate governance.
• SOX drastically changed the characteristics of the accounting
profession by connecting the audit function to the corporate
governance structure by requiring that the audit committee be directly
responsible for not only hiring, compensating, and firing external
auditors, but also overseeing their work, monitoring their
independence, and avoiding potential conflicts of interest.
• In the auditing profession, the so-called expectation gap is referred
to as the difference between (1) what the investing public and other
users of audited financial statements believe the responsibilities of
auditors are, and (2) what auditors are willing to assume asresponsibilities according to their professional standards.
• New PCAOB AS No. 5 superseded AS No. 2 and requires the
independent audit to opine only on the effectiveness of ICFR, not the
management processes and assessments concerning ICFR.
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Conclusion • Sections 201 and 202 of SOX require that all audit and permissible
nonaudit services to be performed by the company’s independent
auditor be approved by the audit committee.
• Auditor independence is the backbone of the auditing profession,
affecting the auditor’s planning, evidence-gathering procedures,
findings, judgment, and credibility, and public trust in the auditor’s
opinion.
• Auditor independence is derived and guided by these three
principles: (1) independent auditors may not audit their own work, (2)
independent auditors may not function in the role of their client’s
management, and (3) independent auditors may not serve in an
advocacy role for their audit clients.
• Tests of controls must be broadened to include understanding of
ICFR and provide reasonable assurance about the effectiveness ofboth the design and operation of internal controls.
• Any contractual provisions that limit the externalauditor’s liability or
require waiving the right to a jury trial may have detrimental effects
on auditor impartiality, objectivity, and quality.