Chapter 1

Auditing: Integral to
the Economy
 Free Market Economy
 A free market economy exists
only if accurate, reliable data is
available
 Auditors contribute to an
effective capital market by
providing independent
evaluations about the reliability
of an organization's financial
statements or the efficiency and
effectiveness of various aspects
 What is auditing?
 Auditing is both more and less
than public accounting
 More because it includes internal
and operational auditing,
governmental auditing, and
other services that evaluate and
report on managerial
performance
 Less because public accounting
firms provide a variety of other
 Define Auditing
A systematic process of
objectively obtaining and
evaluating evidence regarding
assertions about economic
actions and events to ascertain
the degree of correspondence
between those assertions and
established criteria and
communicating the results to
 What is attestation?
 Attestation involves gathering
evidence about assertions,
evaluating the evidence against
objective criteria, and
communicating the conclusion
reached.
 Auditing is specific attestation
service where the auditor gathers
evidence to determine whether
the financial statements are fairly
presented in accordance with
Generally Accepted Accounting
Principles and issues an opinion
 Auditing is all about
evidence
 The auditor gathers evidence to
determine if the client's processes
are working correctly, its financial
data are recorded and presented
correctly, and its financial statements
as a whole are fairly presented.
 This implies that--
 the process of auditing is to gather
and evaluate evidence to test
assertions
 the audit process is systematic
 the auditor must be independent of
the entity audited and the process
followed in gathering evidence must
 Discuss Management &
GAAP
 When management prepares financial
statements, they assert that those
statements are fairly presented in
accordance with GAAP
 GAAP is the criteria by which
"fairness" of financial statement
presentation is judged
 However, the interpretation and
application of GAAP is difficult
 The auditor's task is to determine
whether the financial statements
 OCBOA
 There are other basis where
management prepares financial
statements that are not GAAP:
Other Comprehensive Basis of
Accounting (OCBOA) which
includes: cash basis of
accounting, income tax basis and
statutory basis of accounting.
 Comment on
Communication
 Communication of audit results
to management and third parties
completes the audit process
 To minimize misunderstandings,
this communication follows a
prescribed format that states
the responsibilities of both
management and the auditor,
summarizes the audit process,
and expresses the auditor's
 Define an Unqualified Audit
Report & List Its Three
Paragraphs
 Most audits result in reports that do
not contain reservations about the
fair presentation of the financial
statements (see Exhibit 1.2).
1.Introductory paragraph - identifies
company, statements, and accounting
periods examined, management's
responsibility for the financial
statements, auditor's responsibility
for expressing an opinion
2. Scope paragraph - performance of
the audit in accordance with GAAS
and limitations of the audit
3. Opinion paragraph - statements
 Why is there a need for
assurance services?
1. Potential bias in providing information -
management has a vested interest in
providing information that will make
management look good
2. Remoteness of users - most users do not
have the opportunity or time to interview
management, tour company facilities, or
review financial records firsthand.
Instead, they rely on the financial
statements
3. Complexity - many transactions are more
complex than they were a decade ago.
Users depend on auditors to ensure they
are fairly presented and fully disclosed in
 Discuss the accounting
profession’s decade of
unprecedented turmoil &
change
1. The failure of one of the largest
public accounting firms
(Andersen)
2. Five of the largest bankruptcies
ever - each in companies where
financial statement
misrepresentation had taken
place
3. Billions of investment and
retirement dollars lost
 Cost of Fraud
The 10 Largest Bankruptcies 1980 - Present*

Company Bankruptcy Date Assets in Billions

Worldcom, Inc. 2002 $104
Enron Corp. 2001 $63
Conseco, Inc. 2002 $61
Texaco, Inc. 1987 $36
Financial Corp. of America 1988 $34
Refco Inc. 2005 $33
Global Crossing Ltd. 2002 $30
Pacific Gas and Electric Co. 2001 $30
Calpine Corporation 2005 $27
UAL Corp. 2002 $25
*Source: BankruptcyData.com

Five of the Ten Largest U.S. Bankruptcies

since 1980 had significant financial and
reporting frauds
 What was Congress’
response?
 Passing the Sarbanes-Oxley Act of
2002. That focused on five critical
improvements in how financial
information is presented.
1. Improved corporate governance
2. Reporting on internal controls
3. Greater independence of audit
function
4. Acknowledgment of greater audit
responsibility
5. Audit standard setting moved to a
 Improved Corporate
Governance
 The lack of corporate governance was
a major factor in business failures;
most notably, a failure of Boards of
Directors to oversee management,
and effectively utilize the audit
function.
 Sarbanes requires Boards of Directors
be independent of the organization
and exercise oversight over
management and the audit function
 Further, the Board of Directors,
through its audit committee, is the
"client" of the public accounting firm.
 Reporting on Internal
Controls
 In most cases of major fraud,
companies had poor internal
controls over financial reporting
 Sarbanes requires the CEO and
CFO of SEC registered companies
to assess and publicly report on
the quality of its internal
controls over financial reporting
 Greater Independence of Audit
Function
 The audit function must be independent and
objective if assurances are to be trusted by
third parties. Auditor independence has been
strengthened by requiring:
 1. The audit committee has the authority to
hire and fire the external auditors
 2. Mandatory rotation of the audit
engagement partner every five years
 3. Consulting work cannot be performed for
audit clients
 4. Increased oversight of potential
independence conflicts by the audit
committee
 Non-public companies and smaller audit firms
 Audit Standard Setting
Moved
 The public lost confidence in the
ability of the profession to serve the
public interest. Sarbanes created the
Public Company Accounting Oversight
Board (PCAOB).
 The PCAOB has authority to develop
audit standards for audits of publicly
traded companies.
 The PCAOB is also charged with
performing peer review of all public
accounting firms that perform audits
of public companies.
 The PCAOB is comprised of five public
members appointed by the SEC. No
 Discuss AICPA’s definition of
assurance services
 The AICPA's Special Committee on
Assurance Services defines assurance
as: "independent professional
services that improve the quality of
information, or its context, for
decision makers."
 Assurance services involve three
components:
 - Information or a process on which
the assurance is provided
 - A user or group of users who derive
What are the attributes needed
to perform assurance services?
1. Subject matter knowledge
2. Independence from parties
requesting assurance
3. Agreed upon criteria to
evaluate quality of presentation
4. Expertise in the process of
gathering and evaluating
evidence
 What are the levels of
assurance provided?
1. Positive assurance (such as
an audit opinion)
2. Limited or negative
assurance (such as a review
of financial statements)
3. No assurance (such as a
compilation of financial
statements)
The AICPA's Special Committee on
Assurance Services has identified
six areas of potential service:
1. Risk Assessment - the quality of processes
implemented by an organization to identify,
assess, and manage risks.
2. Business Performance Measurement - the
processes to identify, measure, and
communicate alternative measures of
performance
3. Information System Reliability - the quality of
controls to ensure system security, reliability,
timeliness, and accuracy
4. Healthcare Performance Measurement - provide
information about the quality of services
provided by healthcare providers
5. Electronic Commerce - provide assurance that
systems and tools are designed and functioning
with integrity and security
6. ElderCare Plus - provide assurance whether the
 What are attest services?
 Attest services are a subset of
assurance services
 Attest services always involve
evaluation of an assertion made
by one party to a third party
 Attest services always involve a
report sent to a third party
 Requirements to Enter the
Public Accounting Profession
 Accounting and Auditing Expertise -
in addition to technical knowledge,
auditor must have sound conceptual
understanding of financial reporting
and auditing
 Knowledge of Business and its Risks -
auditor must understand the basic
structure of a business in order to
identify significant risks affecting the
client
 Understanding Accounting System
Complexity - auditor must understand
the challenges posed in a system in
 Who Are the Providers of
Assurance Services?
 ThePublic Accounting
Profession
 TheInternal Audit
Profession
 TheGovernmental Audit
Profession
 The Public Accounting
Profession
 More than 45,000 CPA firms in the United
States, ranging sole-practitioners to large
multinationals such as the Big 4.
 These firms provide a variety of services in
the areas of assurance and financial
statement services, tax planning and
compliance, and consulting
 The SEC has prohibited accounting firms
from providing most consulting services to
public companies that they audit
 Such restriction on services has not been
specified by the AICPA or regulatory
authorities for public accounting firms that
do not audit SEC registered clients
 Organization of CPA Firms
 The organizational hierarchy of CPA firms
has been described as a pyramidal
structure.
 Partners (or owners) are at the top and are
responsible for the overall conduct of each
audit
 Next, managers review the detailed audit
work performed by staff auditors
 Seniors are responsible for overseeing
much of the day-to-day activities on a
specific audit
 Staff auditors perform the basic, detailed
audit work.
 Partners and managers may be involved in a
 The Internal Audit
Profession
 Internal auditing is defined as
 " an independent, objective
assurance and consulting activity
designed to add value and improve an
organization's operations. It helps an
organization accomplish its objectives
by bringing a systematic, disciplined
approach to evaluate and improve the
effectiveness of risk management,
control, and governance processes."
 Internal auditors add value to
an organization by
 evaluating processes to identify and
management risk, develop and implement
effective internal controls
 assuring management and the Board of
Directors on the company's compliance with
policies or regulatory requirements, or the
effectiveness of processes and operations
 providing consulting services such as
analyzing problems and identifying
potential solutions
 performing operational audits designed to
evaluate the effectiveness, economy, and
efficiency with which resources are
employed
 Its broad scope makes internal auditing an
 Governmental Auditing
Profession
 Employed by various Federal,
state, and local agencies
 Governmental auditors perform
all the types of audits that
internal auditors perform
including compliance,
operational, and performance
audits
 Professional and Regulatory
Organizations
 The PCAOB established as part of the
Sarbanes-Oxley Act of 2002 has authority to
set auditing standards for audits of public
companies and to perform quality reviews
of all registered CPA firms
 The SEC oversees the PCAOB and all
companies publicly traded on the U.S.
capital markets. It has the authority to
establish GAAP for publicly traded
companies, and to prosecute companies
who violate SEC laws
 The AICPA has long served as the primary
governing organization of the public
accounting profession. It provides a variety
of continuing education programs and
 Professional and Regulatory
Organizations
 The State Boards of Accountancy are
responsible for certifying and
licensing CPAs in their state. While all
state boards require passage of the
Uniform CPA Examination, education
and experience requirements vary by
state.
 The Institute of Internal Auditors
issued internal auditing standards
and administers the Certified Internal
Auditor program
 The U. S. General Accounting Office is
the nonpartisan audit agency for
Congress. The GAO develops auditing