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Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014

Principles of Auditing: An Introduction to

International Standards on Auditing

Chapter 2 – The Audit Market

Rick Hayes, Hans Gortemaker

and Philip Wallage

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• 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.

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Demand for audit services explained by

several different theories:

• The Policeman Theory

• The Lending Credibility Theory

• The Theory of Inspired Confidence

• Agency Theory

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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.

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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.

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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.

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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

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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.

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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.

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Legal liability of the auditor

• Varies from country to country, district to district.

• Based on one or more of the following:

• common law;

• civil liability under statutory law;

• criminal liability under statutory law;

• liability for members of professional accounting

organisations.

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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.

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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.

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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.

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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.

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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).

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• 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.

Sarbanes–Oxley Act of 2002 criminal penalties

for CEOs, CFOs and auditors

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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.

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Under common law in order to hold the auditor

successfully legally liable in a civil suit, the following

conditions have to be met:

• 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).

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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.’

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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).

Suggested solutions to auditor liability

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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.

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Audit expectations with regard to the following

duties of auditors: giving an opinion on

• 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.

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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.

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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.

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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

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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.

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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.

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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

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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.

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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.

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COSO report

The COSO report was published by the Committee of Sponsoring Organizations of the TreadwayCommission. 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.

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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.

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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.

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Thank you for your attention

Any Questions?

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