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Grad Audit Midterm
Midterm
| Question | Answer |
|---|---|
| Three main goals of SOX: | • First Goal: To ensure management takes their responsibility seriously • Second Goal: To ensure Audit Committee effectively fulfills its role • Third Goal: Refocus accounting firms on auditing |
| Creation of the PCAOB | is a private sector, nonprofit corporation, created by the SOX, to oversee the auditors of companies in order to protect the interests of investors& further the public interest in the preparation of informative, fair and independent audit reports |
| Creation of the PCAOB | • Composed of 5 financially literate members • Only two CPAs |
| Required duties of PCAOB | • Registering accounting firms • Establishing audit standards • Conducting inspections • Imposing sanctions |
| Creation of the PCAOB | is a private sector, nonprofit corporation, created by the SOX, to oversee the auditors of companies in order to protect the interests of investors& further the public interest in the preparation of informative, fair and independent audit reports |
| Creation of the PCAOB | is a private sector, nonprofit corporation, created by the SOX, to oversee the auditors of companies in order to protect the interests of investors& further the public interest in the preparation of informative, fair and independent audit reports |
| Creation of the PCAOB must disclose: | • Composed of 5 financially literate members • Only two CPAs |
| Required duties of PCAOB | • Registering accounting firms • Establishing audit standards • Conducting inspections • Imposing sanctions |
| Requirements for Issuers of Financial Statements: | Must make an annual assessment of IC&auditors must attest to these§404 no multiple service Prohibited from emp suspended/barred Coolingoffperiod1yr Must reconcile pro forma info w GAAP Proformaearnings exclude GAAP items mgmt deems nonrecurring or no |
| Must disclose | PCAOB budget $227.7mil '12 •The majority of issuers pay $5k< •Very few issuers pay >$1mil •As of yrend 2011, over 9,700 issuers •Fees paid by issuers w/ avg mkt cap > $25 mil&inv cos w/ avg asset val >$250mil •Auditor may not issue opinion if fee un |
| AC requires regular updates from auditor on: | • Accounting treatments • Discuss alternative GAAP treatments • Discuss auditor’s preference • Accounting disagreements btwn auditor and managemen |
| Requirements for Audit Committees | AC members must be independent of issuer establish complaint procedures about accounting and auditing matters have ability to engage advisors receive reports of evidence of violation of securities laws if necessary “Financial expert”on AC be disclosed |
| Requirements for Boards of Directors and Corporate Officers: | •F Expert must sign f reports§302. Criminal penalties ensue for willful certification of false reports (§906) •Prohibited from fraudulently misleading auditors •CEO/CFO must forfeit bonuses& profits on stock sales if issuer is required to issue a restmt |
| AC members must be independent of issuer | • Excludes family and employees of management • Excludes people with significant business relationships with company • Excludes some interlocking directors |
| Requirements for Audit Committees | AC members must be independent of issuer establish complaint procedures about accounting and auditing matters have ability to engage advisors receive reports of evidence of violation of securities laws if necessary “Financial expert”on AC be disclosed |
| Requirements for Audit Committees: | • Must pre-approve all audit and non-audit services • Pre-approval authority can be delegated to one member of AC • Is responsible for oversight of auditor |
| AC requires regular updates from auditor on: | • Accounting treatments • Discuss alternative GAAP treatments • Discuss auditor’s preference • Accounting disagreements btwn auditor and managemen |
| Requirements for Accounting Firms: | • Be subject to oversight by PCAOB • Must register with the board and pay fees to the board o There are approximately 2,400 firms registered |
| Requirements for Accounting Firms: Must: | o comply with auditing and professional standards o comply with quality control standards o submit to quality control inspections by PCAOB |
| Must retain documents for | 7 years – 5 year felony imposed for failure to maintain “all audit or review work papers” |
| Requirements for Accounting Firms: Must: | attest to management’s representations on internal controls S404 use a second/concurring partner review rotate audit partners every 5 years comply with IC testing standards obtain AC pre-approval for services be responsible to the AC |
| PCAOB by numbers Source: PCAOB 2011 Annual Report. Staff: Review ___ audits: Firms registered: | 700 staff members reviewed nearly 7000 audits since inception almost 2400 firms registered |
| Ch. 19 | Professional conduct, Independence, and Quality control |
| Ch. 20 | Legal liability |
| Three purposes AICPA Code of Conduct: | – Help maintain public trust and confidence in the profession – Help members of the profession act in a professional way – Provide a means of sanctioning members who do not live up to the profession’s standards |
| Principles of Professional Conduct (6) | Responsibilities, public interest, integrity, objectivity, due care, scope , nature of services. |
| Rules for CPAs in public practice (6) | Independence, Confidentiality, Contingent Fee, Advertising, Commissions, Form of Organization or Name. |
| Rules for ALL CPAs (4) | Integrity and Objectivity, General Standards, Compliance with Standards, Accounting Principles |
| Integrity and Objectivity- | should be free of conflicts of interest and shouldn't knowingly misrep the facts or subordinates ones judgment to others |
| General Standards: | 1. Professional Competence 2. Due prof care 3. planning and supervision 4. sufficient relevant data |
| Compliance with Standards- | for and service a firm should comply w/ std of the Council. |
| Accounting Principles- | a member shouldnt express an opinion or state unawareness of material modifications that should be made if the stmt has a material effect |
| Acts Discreditable- | kicked out; lose CPA |
| Independence Requires auditor to be: | In fact and Appearance |
| Reasonable Investor Rule: | Independence violated if in light of all relevant facts & circumstances, a reasonable investor would conclude that the auditor would not be capable of acting without bias |
| An accountant (and the firm) is NOT independent when: | 1. Has a mutual or conflicting interest with the audit client. 2. Audits his or her own work. 3. Functions as management or an employee of the client. 4. Acts as an advocate for the client. |
| Attest engagement team: | Individuals (from audit, tax, consulting, and clerical) participating in the attest engagement including those performing concurring and 2nd partner review |
| Immediate family: | spouse or equivalent and dependents |
| Close relative: | parents, siblings or nondependent children |
| who is a covered member? | on egmt team inposition to influence egmt Partner/mngr provides>10hrsnonattest services Partner in office of lead egmt partner The firm, including the firms empbenplans entity whose op, fin,/acct policies can be controlled by any above/2/> acting tog |
| Individual in position to influence attest engagement: | Evaluates performance/recommends compensation of engagement partner Directly supervises/manages engagement partner Consults with engagement team on technical or industry-related matter Participates in quality control activities |
| Key Position (at the client): | an individual has primary responsibility for Significant accounting functions Preparation of F/S Ability to exercise influence over contents of F/S |
| Example of Key Position? | CEO, Controller, CFO, CAO.... |
| Direct Financial Interests Includes: | Covered persons& immediate family are prohibited from direct investments in the client! -stocks, bonds, or investments through an intermediary if the covered person/ family member participates in the investment decisions or has control. |
| Indirect Financial Interests occurs when: | the firm,a covered member/immed.fam has a f.int in entity that is associated w/ attest client the f.int is beneficially owned through an inv vehicle the auditor doesnt control the intermediary/have auth to supervise/ participate in the intermediarys inv |
| Indirect financial interests are only permissible if | the amount involved is immaterial with respect to the covered member’s wealth |
| Examples of indirect financial interest: | 1. If a covered member owns < 5% of a diversified mutual fund, this isn't considered a material indirect financial interest; 2. If a covered member owns > 5% of a diversified mutual fund, the investment must be evaluated for materiality. |
| Other financial relationships: | Loans to/from audit client prohibited except consumer loans (mortgages & car loans) in normal course of business Bank, brokerage accounts > insured amounts prohibited Credit card balances >$10k prohibited Holding insurance policies and firm’s professio |
| Employment Relationships: Key Positions | Covered members and immediate family members prohibited from Key Positions in audit client A covered member’s spouse may be employed by a client if NOT employed in a Key Position. |
| Employment Relationships: (2) Job Offer | If a covered member has a job offer or even has the intent to seek or discuss potential employment, independence is impaired, unless situation is reported. |
| Employment Relationships: (3) Former employees for firm and client | Former partner or professional employee prohibited from Key Positions – one year cooling off period required by SOX Former audit client employees prohibited from being involved in audit /being in a position to influence the engagement |
| Independence is impaired if: | A close relative has a financial interest in the client that is material to the close relative and the covered member is aware of the financial interest; A close relative holds a key position. |
| Business Relationships | A covered member is not independent if, during the audit engagement period, he/she has any direct or material indirect business relationship with an audit client, including the audit client’s officers, directors, or major stockholders. |
| Other SEC Rules | • To remain independent, a partner may not serve as the lead engagement partner for more than five consecutive years; • Any partner may not be on an audit in any capacity for more than seven consecutive years. |
| Adversarial Relationship- threatened or actual litigation between the client and the auditor can: | –Management suing auditor for a deficient audit impairs independence; –The stated intention by management to sue auditor impairs independence; –The auditor suing client impairs independence –Lawsuits by stockholders may or may not impair independence |
| Non-audit services; The following cannot be provided to an audit client: | • Bookkeeping (Non-public okay) Appraisal/valuation Actuarial services Management function Human resources Broker-dealer services Legal services Financial info system design and implementation (Non-public okay) Internal audit services (Non-public |
| Contingent Fee: Members in public practice shall not | • Perform any professional services for a contingent fee • Prepare an original or amended tax return for a contingent fee |
| Quality Control: Rules provide limited exceptions from independence violations. Exceptions include: | 1.The individual did not know the situation gave rise to independence violation. 2. The violation was correcte promptly once it was apparent. |
| Proxy Disclosure Requirement | Disclose fees paid to auditor for audit, audit-related, tax& all other services provided State whether AC has considered whether provision of nonaudit services complys w/ind Disclose %hrs worked on audit by person other than CPA’s full time emps if >50% |
| Common Law | case law developed over time by judges issuing opinions |
| Statutory Law | written law enacted by the legislative branch of governments |
| Privity - | absent a contractual or fiduciary relationship (privity), the accountant does not owe a duty of care to the injured party. |
| Breach of contract | -fails to meet the terms and conditions established in contract |
| – Tort : | Liability depends on the relation between the 3rd party &the defendant & the nature of the wrongful act |
| Wrongful acts: | Ordinary negligence Gross negligence ( Constructive fraud) Fraud |
| – Ordinary negligence | -absence of reasonable care or due care in the conduct of an engagement. |
| – Gross negligence ( Constructive fraud)- | Extreme or reckless departure from professional standards of due care |
| Fraud | Actions taken with the knowledge and intent to deceive |
| Auditors expected to act with | due care |
| –Under privity, | liable for ordinary negligence (failure to exercise reasonable care) |
| To recover against an auditor for negligence, client must prove | o Auditor had a duty to the client o Auditor breached that duty o Direct causal connection between the auditor’s negligence and the client’s damage o Client suffered actual losses or damages as a result of auditor’s negligence |
| Auditor’s Defense against Client: | 1. Lack of duty to perform 2. Non-negligent performance 3. Contributory negligence 4. Absence of causal connection |
| Near Privity | Auditors clearly know purpose of audited F/S & 3rd party ( not really used) |
| Foreseen 3rd Parties – | 3rd parties that should be foreseen by auditor (Rusch Factors case) ( most favorable) |
| Reasonably Foreseeable 3rd Parties – | – rarely applied (rare) |
| • In all cases, third party must prove: | 1.The auditor had duty to exercise requisite level of care. 2.The auditor breached that duty by not following professional standards. 3.The breach was the proximate cause of the third party’s injury. 4.The third party suffered an actual loss. |
| Privity does not apply to: | Fraud |
| The Securities Act of 1933 covers | new stock issues. |
| Statutory Law: The plaintiff has to prove: | – A loss was suffered by investing in the securities. – The audited FS contained a material misstatement. |
| The Securities Act of 1934 covers | ongoing reporting of public companies |
| Under Section 10(b) and related Rule 10b-5, an investor can succeed by proving: | – A material misstatement – Reliance on the FS – Damages suffered by this reliance –Scienter- intent to deceive, manipulate or defraud. |
| 1933 and 1934 Securities Acts | Extend criminal liability to auditors for knowingly being associated with false Financial Stmts. |
| Private Securities Litigation Reform Act of 1995 | Favoritable to auditors – Changed liability from joint and severable liability to proportional liability (with some limits) in federal courts. |
| Securities Litigation Uniform Standards Act of 1998 | – Prevents large class-action lawsuits in state courts. lawsuits are now brought to federal court. |
| • Sarbanes-Oxley Act of 2002 | Makes it a felony to destroy or create documents to impede a federal investigation |
| Montgomery’s Auditing (1st Edition 1912) | The detection and prevention of fraud and errors are the “chief” objectives of an audit (pre-SEC). |
| Statement on Auditing Procedures No. 30 | Responsibilities and Functions of the Independent Auditor (1960, subsequently codified in SAS No. 1) |
| Equity Funding Scandal (1973) | Cohen Commission -first attempt to improve the audit process |
| SAS No. 16: | The Independent Auditor’s Responsibility for the Detection of Errors and Irregularities (1978) |
| SAS No. 53 | Auditor’s Responsibility to Detect Errors and Irregularities (1988) |
| SAS No. 82 | Consideration of Fraud in a Financial Statement Audit (1997) |
| SAS No. 99: | Consideration of Fraud in a Financial Statement Audit (2002) – supersedes SAS 82 Even more guidance and requires explicit fraud risk assessment (brainstorming meeting). |
| What every accountant should know about fraud, according to ‘Cooking the Books’ | Committed by desperate people with big egos Schemes are simple Auditor must understand client business Must seek out fraud Fraud can devastate the auditor and the profession |
| Interesting things from ‘Cooking the Books’ | Analytics would have shown interesting things on all 3 companies Collusion was present in all 3 companies (ZZZZ Best, Regina, ESM) What do you think of Barry Minkow’s idea on how fraud could be detected? |
| Skepticism: An Enemy of Fraud | but verify Def: An attitude that includes a questioning mind and a critical assessment of audit evidence |
| SAS 99 Impact on the Auditor | No change in the auditor’s responsibility to detect material fraud in financial statement audits Significant changes in required audit procedures and documentation in a financial statement audit |
| SAS 99 | Presume improper rev rec is a fraud risk- .41 ex: overstmt of rev, understmt of revs for later. consideration of the risk of mgmt override of controls-.42 even if a risk of material mstmt due to fraud arent identified override of controls could occur, th |
| Causes of Misstatements | Errors and Fraud |
| Two types of Fraud | mstmts arising from fraudulent f.reporting Intentional mstmts/omissions designed to deceive f.statement users Results in FS not in conformity w/GAAP Mstmts arising from misapprop of assets Asset theft:in FS not in conformity w/GAAP |
| The Fraud Triangle- | Incentive (pressure), Rationalization(attitude), and Opportunity |
| The importance of Professional Skepticism Def | an attitude that includes a questioning mind and a critical assessment of audit evidence” |
| The importance of Professional Skepticism | Auditor needs to recognize possibility that material mstmt due to fraud could be present, regardless of past experiences Requires on-going questioning of whether evidence suggests a possible fraud Withhold judgment; let evidence persuade you |
| Skepticism is not a lack of trust | verify through gathering evidence |
| The importance of Professional Skepticism | Auditors need to understand how client organizations make money (Rev Rec is common fraud area). |
| Fraud Audit Process | Brainstorming Obtaining Risk identifying risk risk assessment respond to risk evaluate evidence communicate document |
| Brainstorming | o How a fraud might be perpetrated and concealed o Set proper tone at the top for conducting the audit Should take place in planning phase of audit Emphasize the importance of professional skepticism |
| Things to consider during Brainstorming: | o Fraud triangle o How, where and why the FS are susceptible to fraud o Risk of management override of controls o How the fraud could be concealed o Effectiveness of Board and Audit Committee |
| Communication/Brainstorming should... | continue throughout the audit! |
| Identifying Risk | Requires professional judgment Think in terms of the fraud triangle: incentive, rational, opportunity SAS 99 requires auditors to presume improper revenue recognition is a fraud risk Consider management’s ability to override controls |
| Risk attributes to consider in identifying risk | o Type of risk: reporting or misappropriation? o Significance of risk: material? – not always important o Likelihood of risk: will it result in fraud? |
| Risk Assessment | Take into account evaluation of entity’s programs and controls that address fraud risk Tone at the top? Starting with mgmt with ethics and values. Training in ethics and values? |
| Respond to Risk Three ways to respond | Alter way audit conducted overall & nature,timing&extent procedures (incorpunpredictability) oprocedures to address the risks related to mgmt’s ability to override controls SAS 99:test JEs revrec:fraud risk pay attention to mgt ests,reviews of PYest |
| SAS 99 gives examples of responses related to risk of misstatements due to fraudulent financial reporting and misappropriation of assets | o Analytical procedures using disaggregated data o Speaking w/ customers and suppliers, not just confirmations o Observe goods being shipped o Physical inspection of assets |
| Evaluate Evidence | Evidence gathered may indicate additional risks. Things that may change your assessment: oDiscrepancies in acctg recs oConflicting/missing evidential matter (no original docs– photocopies) oProblematic/unusual relationships btwn audit& mgmt (limit sco |
| Communicating Fraud Evidence | Whenever evidence of fraud exists, it should be brought to the attention of the appropriate level of management Report directly to the audit committee when: o Fraud causes a material misstatement o Fraud involves senior management |
| Documenting Fraud Considerations | Brainstorming sesh Procedures performed:info needed to identify&assess fraud risks Specific fraud risks&the auditor’s response to those risks Additional audit procedures performed&the results of tests Communications about fraud made to mgmt, AC&others |
| Overall Approach to the Detection of Fraud PCAOB found…… | auditors merely checking off the std audit program. PCAOB requires additional consideration& doc. that auditors failed to expand audit procedures when identifying fraud risk factors – this is evidence:lack of supervision by senior members of egmt team |
| Brainstorming Sessions & Fraud-Related Inquiries PCAOB found in audits…… | there isn't evidence of a brainstorming meeting- (must be documented.) brainstorming occurred after planning phase key members of audit team didnt attend the brainstorming sesh No evidence work papers that the auditor made inquiries:mgmt/AC&others. |
| Auditor’s Response to Fraud Risk Factors Depending on risks identified, auditors should consider…. PCAOB found..... | Modifying the assignment of personnel Incorporating unpredictability into the audit and audit procedures performed. -instances in which auditors failed to respond appropriately to identified fraud risk factors |
| Financial Statement Misstatements when found.. PCAOB found….. | document the nature and effect of the misstatements and consider if indicative of fraud. Uncorrected misstatements not properly evaluated Not all proposed audit adjustments were posted to the summary schedule |
| Risk of Management Override of Controls PCAOB found instances... | Mgmt has unique ability to perpetrate fraud Which areas are auditors required to look at to address the risk of management override? -in which the auditor had not appropriately responded to this risk. Not looking at low $ amts |
| Other Areas to Improve Fraud Detection | Analytical Procedures Confirmations Roll-Forward of interim testing |
| Other Areas to Improve Fraud Detection: Analytical Procedures | Not testing integrity of underlying data When used as a substantive test, auditors must set expectations, identify threshold for significant differences, corroborate mgt explanations |
| Other Areas to Improve Fraud Detection Confirmations | Positive vs. Negative- only respond if you disagree. Auditors must apply alternative procedures |
| Other Areas to Improve Fraud Detection Roll-Forward of interim testing | Roll-forward procedures not adequate |
| • What do scandals have in common? | • Lack of transparency • Cozy relationships with management (shouldn't go beyond work.) • Weak oversight |
| Past issues could have been avoided with: | • Greater transparency ( Co.s need to more transparency in reporting numbers) • Independence • Avoidance of inherent conflicts • Better oversight & governance |
| • What is the lifeblood of capital markets? | -Transparent financial reporting; so investors can make informed decisions |
| • What is “earnings management”? | designed or structured to get a certain result that differed from the underlying economics of a transaction |
| • What is “big bath”? | -Recognizing revenue before its time// revenue reserves |
| • Use of SPE’s | gives a vast majority of economic benefits from asset it owned to the main corp EX: Enron |
| • Materiality- | -Co.s started using immateriality to an advantage, but it grew to be material yet were deemed immaterial still |
| • Pro Forma Earnings | reporting earning w/out the bad stuff |
| • Who fought FASB & SEC efforts to enhance transparency? | Congress, who was funded by the big firms |
| • Example: Treatment of stock options- | Congress and the FASB debated. Congress funded by firms and threatening the FASB to withdrawal their funding for FAF |
| How did audit firms expand their services? • How did this affect independence? | -Offering to broaden their scope of services to meet needs of clients -The firms basically became business "partners" to clients and told investors they were "independent" |
| • Issue of Peer Reviews | Each firm had another firm review their work.. didn't work; didn't want to tell on a firm. |
| • How did SOX address some of these issues? | -Focused on internal controls, -mgmt had to sign off, now personally liable -Separate service by firms-no doing tax, audit and consulting -Gave audit committees more power |
| Time for an Audit of the Auditors by: Francine McKenna | -"It has failed." -Audit Cos deny responsibility for frauds -Reasons why investors should question audit opinions: Co pays directly for audits they receive Audit co encourage partners to sell services to clients SOX gave AC power:hire/fire. |
| Boards Are Still a Problem by: Mark Rogers | -Didn't address the real problem w/corp governance -Congress failed to set a high enough bar -Thought-Should incorporate to regulate the BoD: -set term limits -limit public Bod services- can't sit on 5 dif boards at once -Require continuing edu fo |
| 5 yrs and Accounting: How has corporate America viewed SOX for the first 5 years? | -CFOs are not fans. 70 enforcement actions taken against firms& 2.9mil amt spent by cos during 3rd yr w/S404 3/4 CFOs think act should be reformed/repealed,&believe costs outweighed the benefits. 3 chairmen to date 68% decr in pgs bwn S404 185 pgs 59 |
| • Will they throw eggs? How to Speak with professionalism and pizzazz. By: Kelly Watkins | • Meet requirements of sarbox • Write an effective presentation • know audience • PP effective tool • Handle questions from audience |
| Montgomery’s Auditing (8th Edition 1957) | The responsibility to detect fraud “is not assumed." |
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