Chapter 2
CORPORATE GOVERNANCE ENHANCING THE AUDIT
FUNCTION
Define Corporate Governance
"a process by which the owners and
creditors of an organization exert
control and require accountability for
the resources entrusted to the
organization. The owners
(stockholders) elect a board of
directors to provide oversight of the
organization's activities"
List primary parties involved in
corporate governance
Stockholders
Boards of Directors
Audit Committees of the Board
Management
Self-Regulatory Accounting Organizations
(e.g. AICPA, FASB)
Other Self-Regulatory Organizations (e.g.
NYSE, NASD)
Regulatory Agencies (e.g. SEC)
External Auditors
Internal Auditors
What are SEC concerns regarding
the auditing profession?
Auditors were no longer willing to
confront clients over questionable
accounting practices
Consulting fees were impairing auditor
independence
Accountants were using technical
interpretations of GAAP to push the
limits of accounting
What are the Public Oversight
Board (POB) concerns?
 Analytical procedures used inappropriately to
replace direct tests of account balances
 Audit firms not thoroughly evaluating internal
control and applying substantive procedures to
address weaknesses in control
 Audit documentation, especially related to audit
planning, did not meet professional standards
 Auditors ignored warning signs of fraud and other
problems
 Auditors were not providing sufficient warning about
companies that might not continue as 'going
concerns'
The Sarbanes/Oxley Act of 2002 was
passed by Congress in response to
massive accounting scandals.
Significant provisions include:
 Establishes the Public Companies Accounting
Oversight Board (PCAOB) with broad authority,
including the power to set auditing standards for
audits of publicly traded companies
 Requires the CEO and CFO certify the financial
statements
 Requires companies to provide a comprehensive
report on internal controls over financial reporting
and that auditors report on internal controls
 Audit Committees given expanded powers as the
'audit client' and must pre-approve any non-audit
services by its external auditors
 Audit Committees must report their activities to the
public
The Sarbanes/Oxley Act of 2002
Continued
 Audit Committees must have at least one person who
is a financial expert. Other members must be
knowledgeable in financial accounting and control
 Audit engagement partners, as well as other partners
and managers with significant roles in the audit, must
be rotated off the engagement every five years
 A "cooling off" period before an audit partner or
manager can take a high-level position with an audit
client without jeopardizing the independence of the
public accounting firm
 Increased disclosure of "off-balance sheet"
transactions or agreements that may have a material
effect Requires the GAO to study a number of issues
including the effect of consolidation on competition
with the accounting profession, and an analysis of
mandatory audit firm rotation
Sarbanes/Oxley granted the PCAOB
broad authority including the power to
 Set auditing standards - the PCAOB has chosen to
set auditing standards
 Set financial accounting standards - the PCAOB has
chosen to let the FASB continue to set accounting
standards
 Set standards for the reports on internal control and
risk management
 Perform quality reviews of public accounting firms
and recommend penalties if the firms fail to perform
 Establish quality control standards for the audits of
public companies
 Require all public accounting firms that audit public
companies to register with the PCAOB and become
licensed to perform such audits
What are auditor independence
provisions?
Prohibits audit firms from performing
consulting work for their audit clients (in
most cases)
Makes the Audit Committee the auditor's
client
Requires the Audit Committee to pre-approve
any non-audit services by the audit firm
Requires partner rotation on all public
company audits every five years
Discuss Corporate Responsibility
for Financial Reports
Sarbanes/Oxley Act requires the CEO and
CFO to certify the accuracy of the financial
statements and provides criminal penalties
for misrepresentation
The Act also- Requires management to describe whether
they have implemented a Corporate Code of
Conduct
Requires management to report on the
effectiveness of internal control over
financial reporting
What is the enhanced role of audit
committees under Sarbanes?
Is designated as the audit client
Has oversight responsibilities over the
internal audit and financial reporting
processes
Must be comprised of "outside" directors, i.e.
not members of management or have other
relationships with the organization
Must report on its activities, including the
results of significant discussions with the
external auditor
Audit committee responsibilities
include
 Be appraised of all significant accounting decisions
made by management
 Be appraised of all significant changes in accounting
systems and system controls
 Have authority to hire and fire the external auditor
 Review the audit plan and discuss audit results with
the auditor
 Have authority to hire and fire the head of the
internal audit function and set the budget for the
internal audit function
 Review the audit plan and discuss all significant
results
 Receive all regulatory audit reports and meet with
regulatory auditors to discuss findings
What are the required
communications to the audit
committee?
Auditing standards (SAS 61) require specific
communications between the audit
committee and the external auditor:
Auditor's responsibility under Generally
Accepted Auditing Standards
Significant Accounting Policies
Management Judgments and Accounting
Estimates
Significant Audit Adjustments
Other Information in Annual Reports
Disagreements with Management
Comment on Generally Accepted
Auditing Standards
General Standards provide guidance in
hiring and training of auditors
Fieldwork Standards help auditors plan
and perform the audit
Reporting Standards help ensure clear
communication between auditor and
statement users
General Standards
The examination is to be performed by a
person or persons having adequate technical
training and proficiency as an auditor
In all matters relating to the assignment, the
auditor must maintain an independent mental
attitude
Due professional care is to be exercised in
the performance of the examination and
preparation of the report
Fieldwork Standards
 The work shall be adequately planned and
assistants, if any, properly supervised
 A sufficient understanding of the entity and its
environment, including its internal control, is to be
obtained to assess the risk of material misstatement
of the financial statements whether due to error or
fraud, and to design the nature, timing, and extent of
further audit procedures
 Sufficient competent audit evidence is to be
obtained through audit procedures performed to
provide a reasonable basis for an opinion regarding
the financial statements under examination
Reporting Standards
The audit report shall state whether
statements are fairly presented in
accordance with Generally Accepted
Accounting Principles
The audit report shall identify those
circumstances in which accounting
principles have not been applied on a
consistent basis with the preceding period
Informative disclosures in the financial
statements are to be regarded as reasonably
adequate unless otherwise stated in the audit
report
Reporting Standards
The audit report shall contain either
expression of opinion regarding the financial
statements, taken as a whole, or an assertion
that an opinion cannot be expressed. When
an opinion cannot be expressed, the reasons
should be stated. In all cases where an
auditor's name is associated with financial
statements, the report should contain a
clear-cut indication of the character of the
auditor's examination, if any, and the degree
of responsibility the auditor is taking
Attestation Standards
Financial statement audits are only a small part
of the demand for assurance services.
Attestation standards have been developed to
ensure quality for a broader array of services
beyond financial statement audits.
Such services include attesting to financial
forecasts and projections, pro forma
financial information, internal controls,
compliance with contracts or regulatory
requirements, and agreed-upon procedures
Attestation Standards
Similar to GAAS with the exception of
Assertions are specific to the area on which
the attestation is being performed
Practitioner must have adequate knowledge
in subject matter of the assertion
Practitioner shall perform engagement only if
the assertion is capable of evaluation against
an established reasonable criteria and
reasonable consistent estimation or
measurement
The report provides assurance related to the
specific assertion
Summary of Audit Standard
Settings and Authority
Audit Standard Setter
Public Company
Accounting Standards
Board (PCAOB)
Scope and Basis of Authority
Authority Base: U.S. Congress: Expressed in the
Sarbanes-Oxley Act of 2002
Scope: Sets audit standards for the audits of all
public companies that are registered with the SEC
American Institute
of CPAs (AICPA)
Authority Base: Historical, as self-regulatory
organization that had earned the public's trust
Scope:
Auditing standards for the audits of small
non-public companies
Attestation standards for areas other than public
company reports on internal control
Assurance services that are less in scope than an
audit such as reviews and compilations
Summary of Audit Standard
Settings and Authority
General Accounting
Office (GAO)
Authority Base: Congressional laws
establishing the GAO as audit arm of the
Congress and delegating to them the authority
to set standards for audits of governmental
entities
Scope: Sets audit standards for the audits
of all governmental entities in the U.S.
International Audit
Standards Committee
(IASC)
Authority Base: As agreed upon by countries
who agree to abide by their standards
Scope: Standards for financial statement
audits across most of Europe and many
developing countries
Summary of Audit Standard
Settings and Authority
International Audit
Standards Board
organization
Authority Base: Developed by the Institute
of Internal Auditors as a self-regulatory
Scope: Standards for the practice of
internal auditing around the world
Overview of Audit Process: A
Standards-Based Approach(1)
Planning the Audit
Understanding with the Audit Client
Scope of services to be provided
 Management responsibilities
Coordination of work with client personnel
Audit fees and expectations of each party
Develop an Understanding of Materiality
Audit must be planned to provide reasonable
assurance that material
misstatements will be detected
Overview of Audit Process: A
Standards-Based Approach(2)
Develop a Preliminary Audit Program
Develop understanding of client business and
industry
Develop understanding of risks client faces and
how they might affect
the company's financial statements
Develop understanding of management
compensation plans and how those
plans may motivate management actions
Develop preliminary understanding of
client's internal controls over
financial reporting
Overview of Audit Process: A
Standards-Based Approach(3)
Develop audit program on audit risk, internal
control quality,
accounting assertions, and materiality
Develop understanding of client's accounting
policies and procedures
Anticipate financial statement items likely to
require adjustment
Identify factors that might require
modification of audit tests
Determine the type of reports to be issued
Overview of Audit Process: A
Standards-Based Approach(4)
Gathering Audit Evidence: Testing Assertions
Third Standard of Fieldwork requires auditor to
gather "sufficient, competent, evidential
matter" in order to reach a conclusion on the
fairness of the financial statements
Audit Process is Designed to Examine
Assertions
The assertions inherent in the accounting
communication: existence,
completeness, rights and obligations,
valuation, and disclosure/
presentation
Overview of Audit Process: A
Standards-Based Approach(5)
Summarize Audit Evidence and Reach Audit Conclusion
 If the evidence supports fair presentation, auditor can move
on to
 other areas of investigation
 If the evidence does not support fair presentation, auditor will
gather
 additional evidence. This will lead auditor to one of three
states:
 Auditor reaches a conclusion and the client agrees to
adjust the

financial statements
 Auditor reaches a conclusion, but the client disagrees.
The auditor
will issue a report describing the differences in opinion
 Auditor is unable to reach a conclusion and the amounts
are so
material, the auditor cannot render an opinion
Overview of Audit Process: A
Standards-Based Approach(6)
Reach an Audit Conclusion and Issue a
Report
For most engagements, the auditor will reach
a conclusion that the financial statements
are fairly stated and will issue an unqualified
audit report
Before issuing the report, the auditor will
meet with the audit committee to discuss the
audit process and the overall fairness of the
company's financial statements