E&Y Global Audit Methodology: Responding to the New Environment

1. E&Y Global Audit Methodology: Responding to the New Environment University of Illinois at Urbana-Champaign March 10, 2005

2. Topics • Regulatory Backdrop • Historical Timeline of Key Events • Sarbanes-Oxley Act of 2002 • Creation of PCAOB • Responding to the New Environment • Recent Changes to E&Y Global Audit Methodology • Integrated Audit of Internal Control and Financial Statements • Identifying and Responding to Fraud Risks • Other E&Y Firm Changes to Improve Quality • Discussion/Questions

3. Regulatory Backdrop: Timeline of Key Events Auditing standards consolidated, name changed to AudSEC Creation of the SEC AudSEC, now ASB, sets rules for audits Auditing standards consolidated CPE required by all AICPA members 1933 & 1934 Securities Acts 1961 1972 1977 1978 1979 1990 1929 1933-34 1939 1938-1959 2002 Accounting standards moved from AICPA to FASB First auditing standards issued QCIC established FCPA issued, POB created, peer review required by AICPA Stock market crash Sarbanes -Oxley Act, PCAOB formed AICPA issued accounting standards 1929-1934 Nervous investors, low integrity market 1934–1995 Growth in capital markets increases need for standards, quality, and controls 1995–00 Dot.com era 2000-01 ENRONWorldcomAndersen 1929 Speculative boom leads to crash 2002-Now Corporate reform, economic rebuild

4. Sarbanes-Oxley Act of 2002 (SOA) • Most significant federal securities legislation since 1933/34 Securities Acts; Renewed focus on corporate governance practices and financial reporting integrity and transparency • SOA aims to: • Improve reporting/disclosures (e.g., new requirement to report on internal control – Section 404) • Strengthen corporate governance (e.g., new standards for audit committee practices) • Expand insider accountability (e.g., new requirements for code of ethics and protection for whistleblowers) • Increase oversight (e.g., creation of PCAOB; increased SEC review of company filings on 10-K/10-Q) • Broaden sanctions/penalties (e.g., criminal penalties strengthened when management issues false financial reports) • Heighten auditor independence (e.g., certain services can no longer be performed by auditors)

5. Public Company Accounting Oversight Board • Created by SOA • New regulator for public accounting profession • Three key functions of PCAOB: • Establish standards for Accounting Firms (auditing, quality control, ethics, and independence) • Conduct inspections of firms to assess compliance with professional standards • Take action to enforce PCAOB rules/standards

6. PCAOB – Standards Adopted to Date • In April 2003, the PCAOB adopted substantially all pre-existing standards issued by the AICPA Auditing Standards Board (ASB) to initially establish the “standards of the PCAOB”. • Key new standards/rules adopted by PCAOB to date: • Standard #1, References in Auditors’ Reports to the Standards of the PCAOB(December 2003) - now refer to the standards of the PCAOB, rather than to U.S. generally accepted auditing standards • Standard #2, Audits of Internal Control Over Financial Reporting(March 2004) - guidance for auditors to report on internal control over financial reporting as required by Section 404 • Standard #3, Audit Documentation(June 2004) – increases documentation requirements on audits • Rule 3101, Rules Regarding Terms Used in Standards (June 2004) – establishes specific professional requirements when certain terms are used in standards (e.g., “should”, “must”)

7. Responding to the New Environment • Recent Changes to E&Y Global Audit Methodology • Changes focus on importance of professional skepticism, audit quality, and diligent execution of procedures • Increased emphasis on: • planning and coordinating multi-location engagements • procedures to test and report on internal controls (for public companies) • preparation and retention of documentation (presumption: if not documented, not done) • independent review partner and national consultation requirements • identifying and responding to fraud risks, including the use of journal entries to override controls • testing estimates, fair values, and income tax accounts

8. Audit Of Internal Control Over Financial Reporting Auditor opinion on  management’s assessment that company maintained effective internal control as of year-end PCAOB Std #2 – Performing an Integrated Audit Financial Statement Audit Auditor opinion on  whether company financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows An Integrated Audit Adds:

9. Integrated Audit - Significant Increase in Internal Control Work 2005 Historical 2004 • Understand the Business • Understand the Control Structure • Risk Assessment • Customize Audit Approach Second Year of Integrated Audit Financial Statement Audit First Year of Integrated Audit Range ofSynergies Anticipated Account Balance Testing I/C Testing Account Balance Testing Account Balance Testing I/C Testing I/C Testing Combination of Internal Control and Account Balance Testing for the Best Audit Coverage and Efficiency Both Internal Control Testing and Account Balance Testing Required Both Internal Control Testing and Account Balance Testing Required Financial and Internal Control Reporting

10. Integrated Audit - Key Changes Affecting Management and Auditor • Both must test controls over ALL significant accounts/disclosures and assertions • Management must have controls documented, in place, and operating effectivelythroughout the organization • Management must have their own resources/controls to get financial statements right • Cannot simply “rely” on auditor to adjust financial statements  can be Material Weakness in internal control and potentially an independence issue • Auditor evaluates effectiveness of audit committee • New rules have changed the auditor’s ability to leverage work of internal audit • New requirements to evaluate and communicate control deficiencies identified

11. Identifying and Responding to Fraud Risks • SAS 99 was issued by ASB to increase emphasis on fraud risks during the audit • 2004 calendar year is second full year of implementation for SAS 99 • Auditor’s responsibilities did not change with SAS 99– “to plan and perform the audit to obtain reasonable assurance” that financial statements are not materially misstated, whether caused by error or fraud • Fraud a top priority for PCAOB focus area in PCAOB inspections; may see additional rulemaking by PCAOB in 2005

12. Most Common Fraud Areas • Revenue Recognition (Deliberate Overstatement) • #1 Area of Fraud • Can be fictitious transactions or legitimate transactions that are recorded incorrectly (e.g., accelerating revenue recognition or misclassifying revenue in the income statement) • Understatement of Expenses • Significant Estimates • Related Party Transactions/Self-Dealing • Fair Values Most fraud is perpetrated and/or concealed with inappropriate journal entries and other adjustments

13. “Fraud House” – Summary of SAS 99 Documentation Professional Skepticism

14. Other E&Y Responses to the Changing Environment • Other E&Y Firm Changes to Improve Quality • Taking significant steps to strengthen our independence policies and procedures • Focusing more directly on the audit committee as our client, and • Taking a more rigorous “risk management” approach when deciding whether to accept new clients or continue a relationship with existing clients

15. Discussion/Questions