Acct. Ethics Chapter 5

COSO Findings in Fraudulent Financial Reporting: 1998-2007

-347 alleged cases of public company fraudulent financial reporting -CEO and/or CFO had some level involvement in 89% of the fraud cases -Most common fraud techniques >Improper revenue recognition >Overstatement of existing assets >Capitalization of expenses -26% of fraud firms changed auditors during fraud period, over double the rate of non-fraud firms

Private Securities Litigation Reform Act (PSLRA)

-Additional requirements upon public companies and their auditors when -The illegal act has a material effect on financial statements -senior management and the board have not taken appropriate remedial action -failure to take remedial action may warrant departure from a standard audit report (or resignation of auditors) -When illegal act has material effect on the financial statements >Auditors must report act to the client >client must inform Board of Directors which has one day to inform the SEC -If client does not inform the SEC >auditors must furnish the report to the SEC within one day >or resign from the engagement within one day >ethical obligation of confidentiality is waived

Nature and Causes of Misstatements

-An inaccuracy in gathering or processing data from which financial statements are prepared -A difference between the amount, classification, or presentation of a reported financial statement element, account, or item in accordance with GAAP -The omission of a financial statement element, account, or item -A financial statement disclosure that is not presented in conformity with GAAP -The omission of information required to be disclosed in conformity with GAAP -An incorrect accounting estimate due to oversight, misrepresentation of facts, or fraud -Management's judgments concerning an estimate or the selection or application of accounting policies that the auditor may consider unreasonable or inappropriate

Illegal Acts

-Assess the impact and materiality of the acts on the financial statements -consult with legal counsel and other specialists -report the acts to audit committee -Consider client's remedial actions >disciplinary actions >controls to safeguard against recurrence >reporting effects of the acts -if client does not take remedial actions necessary, the auditor should consider withdrawing from engagement

Audit Committee Responsibilities for Fraud Risk Assessment

-Audit Committee should >Evaluate management's identification of fraud risks >Implementation of antifraud measures >Creation of the appropriate tone at the top -Active oversight by the audit committee can help reinforce management's commitment to create a culture with "zero tolerance" for fraud -Audit committee's evaluation and oversight can serve as a deterrent to senior management engaging in fraudulent activity -Audit committee should encourage management to provide a mechanism for employees to report concerns about unethical behavior, suspected fraud, or violations of ethical codes or policies

Generally Accepted Auditing Standards (GAAS)

-Auditing standards provide a measure of audit quality and the objectives to be achieved in an audit -Auditing standards differ from auditing procedures because the procedures are steps taken by the auditor during the course of the audit to comply with GAAS -The application of auditing standards entails making judgments with regard to the nature of audit evidence, sufficiency, competency, and reliability -Materiality considerations are important to assess whether the audit opinion should be modified

Auditing Evidence

-Consideration of the competency and sufficiency of evidence -Management representations are not a substitute for application of proper audit procedures -Audit risk and materiality considered together >Determination of nature, timing and extent of procedures >Evaluation of results of procedures -Assess risks of material misstatements due to fraud Application of professional skepticism -Audit procedures - specific acts performed to gather evidence about specific assertions

Opportunity

-employees who have access to assets such as cash and inventory -Internal controls to help safeguard assets >segregation of duties >reconciliations -backdating stock options -override internal controls by management

Documentation to provide evidence that the audit was planned and performed in accordance with GAAS

-Document the thought process, alternative views considered, judgments made, audit evidence gathered, and support for final conclusion -Document challenges to management's views and assumptions -Document the basis for unusual, one-time transactions and related business rationale Include a complete and comprehensive record of discussions with management -Document assessments of the reliability of the source of documents -Document professional skepticism in significant matters

Audit Deficiencies

-Failure to gather sufficient competent evidence -Failure to exercise due care -Insufficient level of professional skepticism -Failure to obtain adequate evidence related to management representations -Failure to express an appropriate audit opinion

The Fraud Triangle

-Incentives/Pressures to Commit Fraud -Opportunity -Rationalization

Specific Items to Communicate Quality of Financial Reporting

-Qualitative aspects of accounting policies and procedures -Assessment of reasonableness of estimates in financial statements -Assessment of management's disclosures re: critical policies/procedures -Whether presentation and disclosures are in conformity with applicable financial reporting framework -Management's response to issues raised -Possibility of alternative treatments in financial statements

Audit Committee Communications

-Significant accounting policies and practices -Critical accounting policies and practices -Critical accounting estimates -Significant unusual transactions -Quality of financial reporting information -Contentious issues with management/disagreements -Modifications to audit report

Tyco Fraud

-Tyco board members did business with the company -directors and officers had loans from the company -related party disclosures were not made -other red flags >acquired personal assets with company funds >lavish parties using company funds >decorating NY apartment with company funds -PwC partner on Tyco was issued a cease and desist order >failed to follow GAAS >violated antifraud provisions of securities law

Present Fairly-Limitations of the Audit Report

-auditor's assessment of fair presentation depends on whether -accounting principles used have general acceptance -accounting principles are appropriate -financial statements are informative -information presented is classified and summarized in a reasonable manner -financial statements reflect the underlying transactions and events in a manner that is consistent with materiality and reflects economic substance

Modifies the audit when

-based upon evidence financial statements are materially misstated -unable to obtain sufficient appropriate evidence

Qualified audit opinions

-concludes misstatements, individually or in the aggregate, are material but not pervasive to the financial statements -unable to obtain sufficient appropriate audit evidence; possible effect on financial statements could be material but not pervasive

Components of internal control under the COSO framework

-control environment -risk assessment -control activities -monitoring -information and communication

Auditor should exercise professional judgment and skepticism when:

-determining the nature, timing, and extent of audit procedures -determining the sufficiency, competency, and relevancy of avidence -evaluating management's judgments and estimates -considering fraud in the audit -determining the conclusions based on the audit evidence obtained

Reasonable Assurance-Limitations of the Audit Report

-due care -relation of independence and client relationships -not an absolute guarantee -followed GAAS, gathering sufficient competent evidential matter -failure to follow GAAS: allegation of negligence

Rationalization

-explain away actions as acceptable -perpetrators are often in denial -a good person may get caught up in the fraud -other rationalizations >company had to make numbers >fear losing job >I'm entitled since I'm underpaid >link to GVV *One-time event, loyalty, expected/standard practice, not your responsibility

Financial statements "present fairly" in an Unmodified/Unqualified Audit Opinion

-financial position -results of operations -cash flows -stockholders' equity

Error

-innocent mistake in math or application of GAAP -Innocent mistake in omission of information

Enterprise Risk management- Integrated Framework

-internal control enhanced with corporate governance and risk management -Aligning risk appetite and strategy -Enhancing risk response decisions -Reducing operational surprises and losses -Identifying and managing multiple and cross-enterprise risks -Seizing opportunities -Improving deployment of capital

Challenges to professional skepticism

-motivated blindness -results over efficiency -personality traits -levers

Incentives/Pressures to Commit Fraud

-self-serving -pressures to meet financial numbers -financial distress -home problems

Basis for Modifications

-separate paragraph describes matter giving rise to modification -placed immediately before the opinion paragraph -titled "Basis for (Qualified, Adverse, Disclaimer) Opinion

Illegal Acts examples

-violations of laws or regulations -bribery

Levers

Accountability to reviewers and regulators serve as a lever that impacts skeptical judgment and skeptical action(PCAOB inspections)

Section ISA 700 of International Standards Auditing

Allows the signature of the audit firm, the personal name of the auditor who directed the audit, or both

Professional Skepticism

An important role in gathering audit evidence and evaluating usefulness

Motivated Blindness

Auditors may see what they want to see and easily miss contradictory information when it's in their best interest to remain ignorant

Fraud

Deliberate decision made to deceive others through -fraudulent financial reporting -misappropriation of assets

Personality Traits

Diligence, thoroughness, objectivity and reliability are traits that influence level of professional skepticism

Results over Efficiency

Link between skeptical judgment and action and how it relates to reward structure in auditing: rewarding results rather than high-quality decisions

AU-C 240

Requires communication by auditors of evidence of fraud to appropriate level of management, even inconsequential or minor misappropriation. -Requires the auditor to evaluate risk assessment during the audit

Exhibit 5.5 (ASB)

Unmodified Opinion for Non-Public Companies

Exhibit 5.6 (PCAOB)

Unmodified or Unqualified Report For Public Companies

Auditing Std No. 5

audit of assessment of effectiveness of internal control over financial reporting

Auditing Std No. 16

communications with audit committees on significant issues

Adverse audit opinions

concludes that misstatements, individually or in the aggregate, are material and pervasive

Auditing Std No. 7

engagement quality review

Materiality- Limitations of the Audit Report

magnitude of an omission or misstatement of accounting information that the judgment of reasonable person relying on the information would have been changed or influenced by the omission or misstatement

Auditing Std No. 15

requirements for designing and performing audit procedures to obtain sufficient appropriate audit evidence to support the opinion expressed in the auditor's report

Auditing Std No. 14

requirements regarding the auditor's evaluation of audit results and determination of whether the auditor has obtained sufficient appropriate audit evidence

Internal Control Assessment

the risk that internal controls will not help prevent or detect a material misstatement is a critical evaluation to provide reasonable assurance

Disclaimer

unable to gather sufficient evidence to warrant the expression of an opinion on the statements as a whole