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Slide 2.1
Principles of Auditing: An Introduction to
International Standards on Auditing
Chapter 2 – The Audit Market
Rick Hayes, Hans Gortemaker
and Philip Wallage
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.2
• Management controls the accounting
systems, the internal controls and the
financial reports to investors.
• Management is not independent or objective
because their success depends on positive
reports.
• The auditor increases the confidence of the
report users by giving an independent opinion
on the fairness of these reports.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.3
Demand for audit services explained by
several different theories:
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•
•
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The Policeman Theory
The Lending Credibility Theory
The Theory of Inspired Confidence
Agency Theory
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.4
Agency theory
• A company is viewed as the result of ‘contracts’, in
which several groups make some kind of contribution
to the company, given a certain ‘price’.
• Management is seen as the ‘agent’, trying to obtain
contributions from ‘principals’ such as bankers,
stockholders and employees.
• Management tries to do what is best for management
and has a considerable advantage over the principals
regarding information about the company (information
asymmetry).
• Costs of an agency relationship are monitoring costs,
bonding costs and residual loss.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.5
Audits required
• In most countries, audits are now legally required
for some types of companies (statutory audits).
• For example, listed companies, companies
receiving government money, certain industries.
• Major bourses (including NYSE, NASDAQ,
London Stock Exchange, Tokyo NIKKEI and
Frankfurt DAX) have listing rules that require all
companies to have an audited annual report.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.6
Audit regulation
Although there is regulation around the world,
two that may be the most influential are:
• The Sarbanes–Oxley Act of 2002 required the
US Securities and Exchange Commission (SEC)
to create a Public Company Accounting
Oversight Board (PCAOB).
• European Union Eighth Council Directive
84/253/EEC and EU Directive 2006/43/EC.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.7
Independent oversight
• International Forum of Independent Audit
Regulators (IFIAR)
• In Australia – Financial Reporting Council
• In the UK – The Review Board
• In the Netherlands – Authority for the Financial
Markets (AFM)
• France – Autorité des marchés financiers (AMF)
• USA – Public Company Accounting Oversight
Board
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.8
The International Forum of Independent Audit
Regulators (IFIAR) core principles
• Comprehensive and well-defined accounting and
auditing principles and standards
• Legal requirements for the preparation and publication
of financial statements according to those principles
and standards
• An enforcement system for preparers of financial
statements to ensure compliance with accounting
standards
• Corporate governance practices that support
high‐quality corporate reporting and auditing practice
• Effective educational and training arrangements for
accountants and auditors.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.9
Big Four firms and non-Big Four
• Deloitte, Ernst & Young, KPMG and Pricewater
house Coopers
• Second Tier – Grant Thornton; BDO Seidman;
McGladrey & Pullen; Moss Adams; Myer,
Hoffman & McCann; Crowe Group; American
Express; and BKD.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.10
Legal liability of the auditor
• Varies from country to country, district to district.
• Based on one or more of the following:
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•
•
•
common law;
civil liability under statutory law;
criminal liability under statutory law;
liability for members of professional accounting
organisations.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.11
Common Law Ultramares – Touche case
(Ultramares Corporation vs. Touche et al.)
• The accountants were negligent for not finding
that a material amount of accounts receivable
had been falsified when careful investigation
would have shown it to be fraudulent.
• Not liable to a third party bank because the
creditors were not a primary beneficiary, or
known party.
• Called the Ultramares doctrine, that ordinary
negligence is not sufficient for a liability to a third
party because of lack of privity of contract
between the third party and the auditor.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.12
Caparo Industries, PLC vs. Dickman
• The question in Caparo was the scope of the assumption
of responsibility of the auditor if a clean opinion was
given for negligent accounts, and what the limits of
liability ought to be.
• The House of Lords of the UK, following the Court of
Appeal, set out a ‘three-fold test’ for an obligation
(duty of care) to arise from negligence:
• harm must be reasonably foreseeable;
• the parties must be in a relationship of proximity;
• it must be fair, just and reasonable to impose liability.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.13
Civil liability under statutory law
• The Securities Act of 1933 established the first
US statutory civil recovery rules for third parties
against auditors.
• Original purchasers have recourse against the
auditor for up to the original purchase price if the
financial statements are false or misleading.
• The auditor has the burden of demonstrating that
reasonable investigation was conducted or that all
the loss of the purchaser of securities (plaintiff)
was caused by factors other than the misleading
financial statements.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.14
Sarbanes–Oxley Act of 2002 civil penalties
for CEOs and CFOs
•
If there is a material restatement of a company’s reported
financial results due to the material non-compliance of
the company, as a result of misconduct, the CEO and CFO
shall reimburse the company for any bonus or incentive or
equity-based compensation received within the 12 months
following the filing with the financial statements subsequently
required to be restated (Section 304).
•
Financial statements filed with the SEC by any public company
must be certified by CEOs and CFOs. If all financials do not
fairly present the true condition of the company CEOs and
CFOs may receive fines of up to $1 million. If certifications are
made knowing the statements are incorrect, the fine can be up
to $5 million.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.15
Criminal liability under statutory law
• The Securities Exchange Act of 1934 in the
United States sets out (Rule 10b-5) criminal
liability for the auditor to employ any device,
scheme or artifice to defraud or intentionally
or recklessly misrepresent information for third
party use.
• Not In Text Cases: In United States vs. Natelli
(1975), United States vs. Weiner (1975), ESM
Government Securities vs. Alexander Grant &
Co. (1986).
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.16
Sarbanes–Oxley Act of 2002 criminal penalties
for CEOs, CFOs and auditors
• To knowingly destroy, create, manipulate documents
and/or impede or obstruct federal investigations is
considered felony, and violators will be subject to fines
or up to 20 years imprisonment, or both.
• All audit reports or related workpapers must be kept by
the auditor for 7 years. Failure to do this may result in
10 years imprisonment.
• CFOs and CEOs who falsely certify financial statements
or internal controls are subject to 10 years imprisonment.
Willful false certification may result in a maximum of
20 years imprisonment.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.17
Liabilities as members of professional
organisations
Nearly all national audit professions have some sort of
disciplinary court.
The disciplinary court makes its judgment and
determines the sanction. It may be:
1. a fine;
2. a reprimand (either oral or written);
3. a suspension for a limited period of time
(e.g. 6 months); or
4. a lifetime ban from the profession.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.18
Under common law in order to hold the auditor
successfully legally liable in a civil suit, the following
conditions have to be met:
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•
•
•
An audit failure/neglect has to be proven (negligence issue).
The auditor should owe a duty of care to the plaintiff
(due professional care).
The plaintiff has to prove a causal relationship between his
losses and the alleged audit failure (causation issue).
The plaintiff must quantify his losses (quantum issue).
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.19
Financial risks resulting from litigation for
audit firms
European Union Commissioner
Charlie McCreevy has said:
‘We have concluded that unlimited liability combined
with insufficient insurance cover is no longer tenable.
It is a potentially huge problem for our capital
markets and for auditors working on an international
scale. The current conditions are not only preventing
the entry of new players in the international audit
market, but are also threatening existing firms.’
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.20
Suggested solutions to auditor liability
 Some countries (e.g. Germany) have put a legally
determined cap on the liability of auditors (to the
client in the case of Germany).
 A system of proportionate liability – an audit firm is
not liable for the entire loss incurred by plaintiffs
but only to the extent to which the loss is
attributable to the auditor.
 In order to protect the personal wealth of audit
partners, some audit firms are structured as a
limited liability partnership (e.g. in the UK).
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.21
Suggested solutions to auditor liability
(Continued)
• To make insurance of all liability risks compulsory
using new legislation was one of the
recommendations of a EU commission.
• Exclude certain activities with a higher risk profile
from the auditors’ liability. A mechanism to
achieve this outcome would be to introduce
so-called safe harbor provisions by legislation.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.22
Audit expectations with regard to the following
duties of auditors: giving an opinion on
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•
•
•
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the fairness of financial statements;
the company’s ability to continue as a going concern;
the company’s internal control system;
the occurrence of fraud;
the occurrence of illegal acts.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.23
The fairness of financial statements:
The company’s ability to continue as a going concern
A large part of the financial community (users of audit
services) expects that financial statements with an
unmodified (unqualified) audit opinion are completely
free from error. The inherent limitations of auditing are
not accepted.
In most national regulations, auditors need to determine
whether the audited entity is able to continue as a going
concern.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.24
Opinion on the company’s internal
control system
• The objective of the auditor is to identify and
assess the risks of material misstatement…
through understanding the entity and its
environment, including the entity’s internal
control.
• The United States Sarbanes–Oxley Act of
2002 requires that company officers certify that
internal controls are effective and requires that
an independent auditor verify management’s
analysis.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.25
Company’s internal control
Section 404 of the Sarbanes–Oxley Act requires each annual
report of a company to contain an ‘internal control report’ which
should:
1. State the responsibility of management for establishing
and maintaining an adequate internal control structure and
procedures for financial reporting.
2. Contain an assessment, as of the end of the fiscal year, of the
effectiveness of the internal control structure and procedures
for financial reporting.
3. Companies must select suitable criteria (COSO-based)
against which it may evaluate the effectiveness of internal
controls for authorisation, safeguarding assets and properly
recording of transactions.
4. An independent auditor attests to any difference between
management’s assertions under 404 and the audit evidence
on internal controls.
US classes
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.26
Opinion on the occurrence of fraud
• Both governments and the financial community
expect the auditor to find existing fraud cases
and report them.
• Audit history has gone from the fraud detection
as the objective of an audit to not taking any
responsibility for fraud, to the current position
that the auditor is responsible for obtaining
reasonable assurance the financial statements
are free from material statement, whether
caused by fraud or error.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.27
The occurrence of fraud
• ISA 240 – the responsibility for the prevention and
detection of fraud and error rests with both those
charged with the governance and the management.
• ISA 210 states that when planning and performing
audit procedures and in evaluating and reporting
the results, auditors should consider the risk of
misstatements in financial statements resulting in
fraud.
• In planning the audit, the auditor must assess the
risk that material fraud or error has occurred.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.28
US fraud standard – US classes
• Auditing Standard Number 99 (SAS 99).
• The standard requires that as part of the
planning process the audit team must consider
how and where the client’s financial statements
may be susceptible to fraud.
• Gather information by inquiring of management
and considering fraud risk factors.
US classes
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.29
The occurrence of illegal acts
• Both ISA 250 and most national regulators state that
the auditor’s responsibility in this area is restricted
to designing and executing the audit in such a way
that there is a reasonable expectation
of detecting material illegal acts which have a direct
impact on the form and content of the financial
statements.
• The professional regulations in some countries
require the auditor to inform members of the audit
committee or board of directors.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.30
Responses to accounting controversies
In response to the controversies there have been in
two landmark studies (the COSO Report and the
Cadbury Report which lead to the Combined Code
and the Turnbull Report) and most recently have
been legislated into the US accounting profession
by the Sarbanes–Oxley Act of 2002.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.31
COSO report
The COSO report was published by the Committee
of Sponsoring Organizations of the Treadway
Commission. The COSO report envisaged:
1. harmonising the definitions regarding internal control
and its components;
2. helping management in assessing the quality of
internal control;
3. creating internal control benchmarks, enabling
management to compare the internal control in their
own company to the state-of-the-art;
4. creating a basis for the external reporting on the
adequacy of the internal controls.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.32
Combined Code UK
• In 1998 London Stock Exchange published a
new Listing Rule together with related Principles
of Good Governance and Code of Best Practice
(called ‘the Combined Code’).
• The combined code combines the
recommendations of the so-called Cadbury,
Greenbury and Hampel committees on corporate
governance.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.33
The Sarbanes–Oxley Act of 2002
Restrictions on auditors
• Auditors must report to the audit committee.
• The lead audit partner and audit review partner
must be rotated every five years.
• A second partner must review and approve audit
reports.
• It is a felony with penalties of up to 20 years in
jail to willfully fail to maintain ‘all audit or review
work papers’ for seven years.
• Auditors are prohibited from offering certain
information system and accounting services.
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
Slide 2.34
Thank you for your attention
Any Questions?
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
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