Rick Stephan Hayes, Roger Dassen, Arnold Schilder, Philip Wallage

1. The Audit Market Principles of Auditing: An Introduction to International Standards on Auditing - Ch. 2 Rick Stephan Hayes, Roger Dassen, Arnold Schilder, Philip Wallage

2. Demand for audit services explained by several different theories: • The Policeman Theory • The Lending Credibility Theory • The Theory of Inspired Confidence • Agency Theory

3. Agency Theory • a reputable auditor is appointed in the interest of third parties and of management. • 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'. • agent 'management' has a considerable advantage over the principals regarding information about the company.

4. Audit Regulation • The Sarbanes-Oxley Act of 2002 required the U.S. Securities and Exchange Commission (SEC) to create a Public Company Accounting Oversight Board (PCAOB). • In Australia, the Corporate Law Economic Reform Program Act 1999 established a new body, the Financial Reporting Council (FRC) • The Review Board Limited in the UK whose work is being transferred to the UK Financial Reporting Council • Public Interest Oversight Board founders include: Basel Committee, IOSCO, IAIS, World Bank, Financial Stability Forum (FSF) and EU.

5. Who supervises Auditingrules and Auditing Firms? Public Company Accounting Oversight Board (PCAOB) Created by the Sarbanes-Oxley Act of 2002

6. PCAOB’s Audit Standards (Not in Text) • PCAOB Audit Standard No. 1 Reference in Audit Report • PCAOB Audit Standard No. 2 Internal Control • PCAOB Audit Standard No 3 Audit Documentation • PCAOB Audit Standard No 4 Reported Weakness Continues

7. Key Provisions of Audit Standard No. 2 (Not in Text) • Evaluating Management's Assessment 2. Obtaining an Understanding of Internal Control Over Financial Reporting, Including Performing Walkthroughs • Identifying Significant Accounts and Relevant Assertions • Testing and Evaluating the Effectiveness of the Design of Controls 5. Testing Operating Effectiveness • Timing of Testing • Using the Work • of Others

8. Key Provisions of Audit Standard No. 2 8. Evaluating the Results of Testing 9. Identifying Significant Deficiencies 10. Forming an Opinion and Reporting 11. No Disclosure of Significant Deficiencies 12. Material Weaknesses Result in Adverse Opinion on Internal Control 13. Testing Controls Intended to Prevent or Detect Fraud

9. Who used to make auditing rules in the U.S.? ASB the Auditing Standards Board

10. Big Four Firms & Non-Big Four • Deloitte, Ernst & Young, KPMG, PricewaterhouseCoopers • Second Tier – Grant Thornton; BDO Seidman; McGladrey & Pullen; Moss Adams; Myer, Hoffman & McCann; Crowe Group, American Express, BKD

11. Technical and Functional Audit Quality • Technical audit quality is the degree to which an audit meets a consumer's expectations with regard to the detection and reporting of errors and irregularities - the quality of the outcome of the audit process. • Functional audit quality is the degree to which the process of carrying out the audit and communicating its results meets a consumer's expectations - the process itself.

12. Audit Fees Important determinants of audit fees are: • the size of the auditee and the geographical dispersion; • the size of the audit firm (Big Four firms seem to demand a fee premium); • the quality of the auditee's internal control system; • the type of fee contract (fixed fee versus variable fee).

13. 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, and • liability for members of professional accounting organizations.

14. Common Law Ultramares - Touche case (Ultramares Corporation v 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.

15. Civil Liability Under Statutory Law • The Securities Act of 1933 established the first U.S. 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 all that the loss of the purchaser of securities (plaintiff) was caused by factors other than the misleading financial statements.

16. 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 v. Natelli (1975)*United States v. Weiner (1975) * ESM Government Securities v. Alexander Grant & Co. (1986).

17. Liabilities as Members of Professional Organizations Nearly all national audit professions have some sort of disciplinary court. The disciplinary court makes its judgment and determines the sanction. It may be: • a fine; • a reprimand (either oral or written); • a suspension for a limited period of time (e.g. 6 months); or • a lifetime ban from the profession.

18. 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 her losses and the alleged audit failure (causation issue) The plaintiff must quantify her losses (quantum issue).

19. Suggested Solutions to Auditor Liability • 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. • Some countries (e.g. Germany) have put a legally determined cap on the liability of auditors (to the client in the case of Germany). • 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).

20. 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; and • the occurrence of illegal acts.

21. Company's Internal Control (not in Text) 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, and (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 authorization, 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

22. 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.

23. US Fraud Standard • 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 consider ing fraud risk factors

24. The Occurrence of Illegal Acts • Both ISA 250 and most national regulators state that the auditor's responsibility 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

25. 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.

26. COSO Report The COSO report was published by the Committee of Sponsoring Organizations of the Treadway Commission. The COSO report envisaged: 1 harmonizing 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; and 4 creating a basis for the external reporting on the adequacy of the internal controls.

27. 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.

28. 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 10 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.

29. Thank You for Your Attention Any Questions?