1.     - the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated

a.     Reasonable assurance implies some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it

1.     the magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement

a.     There can be no guarantee that the auditor will uncover all material misstatements

1.     the manager generally has more information about the “true” financial position and results of operations of the entity than does the absentee owner

2.     There is a natural conflict of interest between managers and the absentee owner

1.     Principal/Agent Problem à Information Asymmetry à (information risk) à Principals demand higher rate of return à demand for monitoring

1.     Started a process of broad reform in corporate governance practices that would affect the duties and practices of public companies, financial analysts, external auditors, and securities exchange markets.

2.     Transferred authority to the PCAOB

3.     Mandated that the SEC impose strict independence rules, prohibiting the provision of many types of nonaudit services to public company audit clients

4.     Audit firms must rotate audit partners off audit engagements every 5 years and that public companies obtain an integrated audit (both over financial statements and internal controls)

a.     Due professional care requires that the auditor exercise professional skepticism, which is an attitude that includes a questioning mind and a critical assessment of audit evidence

b.     To provide reasonable assurance with respect to errors, fraud, and illegal acts

a.     Financial statements are ultimately management’s responsibility

b.     SOX requires that CEOs and CFOs of public companies take explicit responsibility for their company’s financial statement by “certifying” that they are responsible for establishing and maintaining internal control, and that the financial statements fairly present the entity’s financial conditions and operations

1.     General

a.     Adequate Technical training & proficiency

b.     Independence

c.      Due professional care

2.     Fieldwork

a.     Adequate planning and supervised assistants

b.     Obtain sufficient understanding of internal controls

c.      Obtain sufficient appropriate evidential matter

3.     Reporting

a.     GAAP

b.     Consistency

c.      Disclosures

d.     Opinions

1.     - the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of the users

1.     the amount of the planning materiality that is allocated to a financial statement account. Helps establish a scope for the audit procedures for the audit procedures for the individual account balance or class of transactions.

a.     The lower the tolerable misstatement, the more extensive the required audit testing

Step 1 – Determine a materiality level for the overall financial statements (planning materiality)

·      Examples of benchmarking- total revenues, gross profit, other reported income.

·      Common rule – 5% of net income before taxes for profit-oriented entities

Step 2 – Determine tolerable misstatement

·      Usually set tolerable misstatement for each account between 50-75% of planning materiality

·      Take into account quantitative and qualitative materiality

Step 3 – Evaluate Findings

·      If, based on the best audit evidence, the auditor believes the estimated amount included in the financial statements is unreasonable, the difference between that estimate and the closest

1.     aspects concern areas involving characteristics and beyond

1.     Include size and complexity of the account

2.     Importance of changes in the account to key performance indicators

3.     Debt covenants

4.     Meeting published forecasts or estimates

the risk that an auditor expresses an unqualified opinion on materially misstated financial statements

a.     Financial statement level

b.     Individual account balance or class of transactions level

is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a material misstatement that exists and that could be material, either individually or when aggregated with other misstatements

an auditor’s exposure to financial loss and damage to professional reputation. I.e. client and third party lawsuits and negative publicity

1.     Set a planned level of audit risk such that an opinion can be issued on the financial statements

2.     Assess the risk of material misstatement (IR x CR)

3.     Use the audit risk equation to solve for the appropriate level of detection risk:

a.     Audit risk = inherent risk x control risk x detection risk

b.     Detection risk = audit risk / (inherent risk x control risk)

1.     Errors are unintentional misstatements

2.     Fraud involves intentional misstatements

Fraudulent financial reporting- “bad” accounting.

Misappropriation of an asset- theft (embezzlement cash, stealing asset)

Incentive/pressures – management or other employees have an incentive or are under pressure that provides a reason to commit fraud

Opportunities – circumstances exist that provide an opportunity for a fraud to be carried out

Attitudes/Rationalization – those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act

1.     Management override

2.     Bias in accounting estimates

3.     Business rationale for significant unusual transactions

1.     Emphasize to the audit team the need to maintain professional skepticism

2.     Assign more experienced staff or those with specialized skills

3.     Provide more supervision

4.     Incorporate additional elements of unpredictability in the selection of audit procedures

1.     Report title

2.     Addressee

3.     Introductory paragraph

4.     Scope paragraph

5.     Opinion paragraph

6.     Explanatory paragraph

7.     Name of auditor

8.     Audit report date

·      For Private companies, there is a 9^th part (Management’s responsibility paragraph after the into paragraph)

modified wording

explanatory paragraph

a.     Opinion based in part on the report of another auditor

                                                        i.     Either make reference to other auditor (most common)

                                                       ii.     Get them to write a letter of representation

a.     Going concern

                                                        i.     Doubt about its ability to continue

b.     Lack of consistency

                                                        i.     Changes affecting consistency

1.     Change in accounting principle

2.     Change in reporting entity

3.     Correction of an error in principle

                                                       ii.     Changes not affecting consistency

1.     Change in accounting estimate

2.     Change in classification and reclassification

3.     Change expected to have a material future effect

4.     Correction of an error that does not involve an accounting principle

c.      Reference to report on audit of ICFR

d.     Additional emphasis

Qualified- when either a scope limitation or a specific departure from GAAP exists, but overall the financial statements present fairly in conformity with GAAP. Always use “except for” for qualified reports

·      Scope limitation – presented fairly “except for” the possible effects of the limitation

·      GAAP departure – the report describes the nature and impact of the faulty accounting, and indicates that the F/S present fairly “except for” the effects from the departure

insufficient appropriate evidence to form an opinion because there is a lack of independence. Technically no opinion is expressed

do not present fairly due to a GAAP departure that materially affects the F/S

1.     Scope limitation

a.     Inability to obtain sufficient competent evidence for F/S

b.     Issues a qualified opinion or disclaimer

2.     Departure from GAAP

a.     F/S are materially affected by a departure from GAAP

b.     Issues a qualified opinion or adverse opinion

3.     Lack of Auditor independence

a.     Auditor has some form of prohibited relationship with client

b.     Issues a disclaimer

** Auditor is required to read the other information and consider whether it is consistent with the information contained in the audited financial statements

            I.e. annual reports and registration statements

Types of law

1.     Common law

a.     Developed by judges

2.     Statutory law

a.     Written law enacted by the legislative branch of government

a.     A contract or specific agreement exists between 2 parties (obligation)

a.     Absence of due care (reasonable person test) employment service with reasonable care, skill, good faith and integrity but not fallibility (no errors in judgment)

a.     Actions taken with the knowledge and intent to deceive

a.     Extreme negligence, flagrant or reckless to professionalism

a.     Wrongful act that results in injury

Due care- requires that the auditor perform his or her professional services with the same degree of skill, knowledge, and judgment possessed by other members of the profession.

·      Will perform in accordance to GAAS or relevant professional auditing standards

·      Audited F/S will comply with GAAP

a.     A duty was owed to the client (breach of contract)

b.     Failure to act in accordance with that duty

c.      A causal connection between the auditor’s negligence and the client’s damage

d.     Actual loss or damage to the client

a.     No duty was owed to the client

b.     The client was negligent

c.      Auditor’s work was performed in accordance with professional standards

d.     The client suffered no loss

e.     Any loss was caused by other events

f.      The claim in invalid because the statute of limitations has expired

a.     The auditor had a duty to the plantiff to exercise due care

b.     Auditor breached that duty and was negligent in not following the professional standards

c.      The auditor’s breach of due care was the direct cause of the 3^rd party’s injury

d.     3^rd party suffered an actual loss as a result

a.     No duty was owed to the 3^rd party

b.     3^rd party was negligent

c.      The auditor’s work was performed in accordance with professional standards

d.     3^rd party suffered no loss

e.     Any loss was caused by other events

f.      The claim is invalid because the statute of limitations has expired

Securities act of 1933

what does it do

Securities act of 1933

3rd parties claims

a.     The 3^rd party suffered losses by investing in the registered security

b.     The audited financial statements contained a material omission or misstatement

Securities act of 1934

what it does

Securities act of 1934

what 3rd parties must prove

a.     A material, factual misrepresentation or omission

b.     Reliance on the F/S

c.      Damages suffered as a result of reliance on the financial statements

d.     Scienter (gross negligence or recklessness may be enough)

fraud

what 3rd parties must prove

1.     3^rd party must prove

a.     A false representation by the CPA

b.     Knowledge or belief by the CPA that the representation was false

c.      The CPA intended to induce the 3^rd party to rely on the false representation

d.     The 3^rd party relied on the false representation

e.     The 3^rd party suffered damages

1.     Compensatory damages

a.     Awarded the damages to return them to a position equivalent to where they would have been in the absence of the auditor’s negligence

2.     Punitive damages

a.     Rewarded for outrageous conduct

b.     Example: Fraud

3.     Joint and Several

a.     Auditor can be responsible for the entire loss even if other parties contributed to the loss.

privity

near privity

foreseen 3rd parties

reasonable foreseeable 3rd parties

a.     Most restrictive view. Contract or specific agreement existed between 2 parties. Auditors have no liability for ordinary negligence to 3^rd parties who do not have privity relationship with the auditor

a.     Accountant must be aware that the F/S are to be used for a particular purpose or purposes

b.     In the furtherance of which a known party or parties was intended to rely

c.      3^rd party must be known to the auditor and that the auditor has directly conveyed the audit report or acted to induce reliance on the audit report

a.     Reliance is actually foreseen, even if the specific person or group is unknown to the auditor

b.     If you know the purpose of the F/S then you have an obligation. If the purpose changes then you’re okay

a.     Anyone you could potentially see using it leaves you liable

- members should be objective and free of conflicts of interest. When providing auditing or other attestation services, members, should be independent in fact and appearance

a.     Professional standards require a public accounting firm to be independent in accordance with the law

                                               i.     Financial statement audits

                                              ii.     Financial statement reviews

                                            iii.     Other attest services as defined by SSAEs

b.     Covered members must be independent

c.      Partners are limited to 5 years on an audit client

d.     A firm is not independent if an audit partner’s compensation is based on selling engagements to that client for services other than audit, review, and attest services

1.     In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others

2.     A member shall comply with the following standards and with any interpretations thereof by bodies designated by council

a.     Professional competence

b.     Due professional care

c.      Planning and supervision

d.     Sufficient relevant data

direct

material indirect

a.     Results when a covered member has a financial interest in an attest client, such as ownership of stock or a loan to or from the client

a.     Results when a covered member has a financial interest in an entity that is associated with an attest client, for example an investment in a mutual fund that owns the client’s stock

1.     Member of the attest engagement team

2.     Person in a position to influence the attest engagement

3.     A partner or manager who provides nonattest services to the attest client beginning once he or she provides 10 hours of nonattest services

4.     Partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement

5.     The firm, including the firm’s employee benefit plan

6.     An entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described above by two or more such individuals or entities if they act together

1.     Rule 101 and relevant interpretations essentially indicate that the independence of a CPA is impaired if the CPA performs a managerial or other significant role for a client’s organization during the time period covered by an attest engagement

2.     Rule 102 says that if a client leaves the firm and is then employed by a client in a key position unless conditions are met

1.     A covered member’s immediate family (spouse, spousal equivalent, or dependent) is subject to Rule 101 and its interpretations and rulings

a.     A close relative has a financial interest in the client that is material to the close relative, and the CPA participating in the engagement is aware of the interest

b.     An individual participating in the engagement has a close relative who could exercise significant influence over the financial or accounting policies of the client

2.     Close relatives = nondependent children, brothers, sisters, parents, grandparents, parents-in-law, and their respective spouses