CH-18-21 Reports on Audited Financial Statements – Auditing and Assurance Services: A Systematic Approach : Chapter Notes

This Document Contains Chapters 18 to 21 Chapter 18 Reports on Audited Financial Statements Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases LO 18-1: Understand the various components of the standard unqualified financial statement audit report. 1 (INTRO ) 10,11,12 22,23,27, 28 LO 18-2: Know the situations that result in the addition of explanatory language to the standard unqualified audit report. 2 10,11,12 , 13 22,23,24, 25 29 LO 18-3: Be able to explain the conditions that lead to a departure from the standard unqualified/unmodified audit report. 3 14,15,16 22,23,25, 27 LO 18-4: Know the types of financial statement audit reports other than unqualified/unmodified. 14,15,16 22,23,25, 27 LO 18-5: Be able to explain the effect of materiality on the auditor’s choice of audit reports. 3,4 15,16 LO 18-6: Understand the situations that may require different types of reports on comparative financial statements. 5 17,18 25,27 LO 18-7: Know the auditor’s responsibility for other information in documents containing audited financial statements. 6,7 19 LO 18-8: Understand the auditor’s reporting responsibility when financial statements are prepared on a basis other than GAAP. 8,9 20 22,23,26, 28 This Document Contains Chapters 18 to 21 LO 18-9: Understand the auditor’s responsibility for reporting on specified elements, accounts, or items of a financial statement. 8 21 LO 18-10: Understand the auditor’s reporting responsibility when compliance with contractual agreements or regulatory requirements related to financial statements. 8 LO 18-11: Understand that the recent changes to the auditor reporting model are significant–the first major changes in over seventy years! NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 18-1 Unchanged 18-1 18-2 Unchanged 18-2 18-3 Unchanged 18-3 18-4 Unchanged 18-4 18-5 Updated/Revised 18-5 18-6 Unchanged 18-6 18-7 Unchanged 18-7 18-8 Unchanged 18-8 18-9 Unchanged 18-9 18-10 Revised 18-10 18-11 Revised 18-11 18-12 Revised 18-12 18-13 Unchanged 18-13 18-14 Revised 18-14 18-15 Revised 18-15 18-16 Unchanged 18-16 18-17 Revised 18-17 18-18 Revised 18-18 18-19 Unchanged 18-19 18-20 Revised 18-20 18-21 Revised 18-21 18-22 Revised 18-22 18-23 Revised 18-23 18-24 Revised 18-24 18-25 Revised/Updated 18-25 18-26 Updated 18-26 18-27 Updated 18-27 18-28 Revised/Updated 18-28 18-29 Updated 18-29 Chapter 18 covers the reporting standards for audited financial statements. For a first auditing course, we cover Learning Objectives 1-5, which relate to basic audit reporting. We usually cover the remaining topics on special reporting issues in a second audit class. [LO 18-1] Reporting on the Financial Statement Audit: The Standard Unqualified/Unmodified Audit Report We start by referring the students to Exhibit 18-1 and 18-2 and by briefly reviewing the eight elements of the standard unqualified audit report (PCAOB) and nine elements of the standard unmodified report (ASB). We remind them that this material was first introduced in Chapter 2. You may wish to emphasize new portions of the audit report, including “Basis for Opinion,” “Critical Audit Matters” and how long the auditor has served as the entity’s auditor (referred to as (“auditor tenure”). Discussing why these changes were made may prove enlightening for students. Use Exhibit 18-1 [LO 18-2] Explanatory Language Added to the Standard Unqualified/Unmodified Audit Report The students should know that there are a number of situations where the auditor will modify the wording or add an explanatory paragraph to the standard unqualified/unmodified audit report. Six situations are covered in the text: • Modified wording for opinion based in part on the report of another auditor. • Reference to the report on the audit of internal control for public companies. • Substantial doubt about an entity’s ability to continue as a going concern. • Lack of comparability of the financial statements between periods. • Other circumstances requiring an explanatory paragraph. • Circumstances in which the auditor wishes to emphasize a matter. We point out to the students that the first situation results in a modification of the wording for the introductory/scope or auditor’s responsibility, and opinion paragraphs included in the standard unqualified/unmodified audit report. The other five situations lead to the addition of an explanatory paragraph that follows the opinion paragraph without any modification of the wording of the preceding paragraphs. 1. Opinion based in part on the report of another auditor. We discuss the need for the principal auditor to assess the professional reputation and independence of the other auditors and clearly indicate the division of responsibility between portions of the financial statements covered by the principal and other auditors in adherence to PCAOB standards. Then we present Exhibit 18-2 as an example of how the wording of the audit report is modified. Use Exhibit 18-2 2. Going concern. We show the students the explanatory paragraph with an appropriate title in Exhibit 18-3. Use Exhibit 18-3 3. Lack of Comparability of Financial Statements Between Periods. We tell the students that FASB ASC Topic 250, "Accounting Changes and Error Corrections," governs the accounting for changes in accounting principles. Note that this standard requires "retrospective application" for accounting changes and corrections of errors; thus, it not only affects financial reporting, but it may also affect the auditor's report. We then point out that, from an auditor's perspective, lack of comparability of financial statements can be placed in three categories: • Changes in accounting principle or method of application - We cover the auditor’s responsibility to offer an opinion on the appropriateness of the change. Use Exhibit 18-4 • Correction of a material misstatement in previously issued financial statements – We cover situations in which misstatements must be corrected because of: 1. Inappropriate application of accounting principles. 2. Changes from an incorrect classification of transactions or balances. 3. The correction of a material error. Use Exhibit 18-5 • Other changes that affect comparability – We cover changes in accounting estimates and reclassification from an acceptable classification to another. 4. Management Reports on ICFR but Audit of ICFR Not Required. We ensure students understand when auditors are required to add an explanatory paragraph for non- accelerated filers indicating the entity was not required to have an audit of ICFR performed, that the auditor obtained an understanding of controls to assist in the audit of financial statements, and the auditor nevertheless expresses no opinion on the effectiveness of ICFR. 5. Other Circumstances Requiring an Explanatory Paragraph. We touch on other circumstances which require the auditor to include an explanatory paragraph, as when comparative financial statements previously expressed an opinion which has changed, when required supplementary information is omitted, and when other information is materially inconsistent with information appearing in the financial statements. 6. Circumstances in which the Auditor Wishes to Emphasize a Matter. We inform students of conditions where an auditor may wish to emphasize an item in the way the financial statements are presented. We discuss the examples in the text if students have difficulty understanding. We also cover the difference between PCAOB reporting standards and those of the ASB and the ASB’s emphasis-of- matter and other-matter paragraphs as well as their appropriate use. Departures from an Unqualified/Unmodified Financial Statement Audit Report We find that Figure 18-1 is a good tool for covering the material in this section. We use it as a framework for discussing the conditions for departure, the types of audit reports, and the effect of materiality. Use Figure 18-1 [LO 18-3] Conditions for Departure We first cover the three basic reasons for a departure from a standard unqualified/unmodified audit report when circumstances indicate a need: (1) scope limitation; (2) departure from GAAP; and (3) lack of independence of the auditor. [LO 18-4] Types of Financial Statement Audit Reports Other than Unqualified/Unmodified We then cover the other types of reports: Qualified, Disclaimer, and Adverse. [LO 18-5] The Effect of Materiality on Financial Statement Reporting We review the effect of materiality and its pervasiveness on the auditor's choice of reports. We point out that if the situation is immaterial, a standard unqualified/unmodified audit report can be issued. However, as the materiality of the situation increases, the auditor must judge the effect of the item on the overall financial statements. Discussion of Conditions Requiring Other Types of Financial Statement Audit Reports We find that the material in this section can be approached in two ways. It can be integrated with the material presented in the prior section or it can be covered separately. The material in this section covers the types of reports and conditions for departure in more detail and, most importantly, provides examples of each type of report. It is helpful to the students' understanding if they see examples of the other types of reports. Use Exhibits 18-6 to 18-9 Special Reporting Issues We usually start this section by referring back to the EarthWear Clothiers in Exhibit 18-1, which is an unqualified report that covers the balance sheet for two years and statements of income, stockholders’ equity, and cash flows for three years. [LO 18-6] Reports on Comparative Financial Statements We cover the three common situations discussed in the text: • Different reports on comparative financial statements. • A change in report on the prior-period financial statements. • Report by a predecessor auditor. Each of these situations is discussed and the example reports contained in Exhibits 18-10 and 18- 11 are presented. Use Exhibits 18-10 and 18-11 [LO 18-7] Other Information in Documents Containing Audited Financial Statements We point out that an entity may publish documents such as annual reports and registration statements that contain other information in addition to the audited financial statements. Auditing standards require that the auditor read the other information and consider whether such information is consistent with the information contained in the audited financial statements. We usually provide an example and discuss the auditor's actions when the information is not consistent. Special Reports Relating to the Financial Statements We start by discussing the fact that auditors are sometimes engaged to report on financial statements that are not prepared on a basis of GAAP or to report on an entity’s compliance with contractual agreements. Three situations are covered: • Financial statements prepared on a basis of accounting other than GAAP. • Specified elements, accounts, or items of a financial statement. • Compliance with aspects of contractual agreements or regulatory requirements related to audited financial statements. [LO 18-8] Financial Statements Prepared According to a Special Purpose Framework We point out that auditing standards define special purpose financial statements as including those prepared under (1) a regulatory basis, (2) a tax basis, (3) cash (or modified cash) basis, and (4) a contractual basis. [LO 18-9] Specified Elements, Accounts, or Items of a Financial Statement We tell the students that there are situations where the auditor may be engaged to audit only part (specified elements, accounts, or items) of the financial statements. We then introduce the fact that the auditor may not conduct a complete audit but only apply agreed-upon procedures. These types of engagements are becoming more common. We point out that auditing standards require that the responsible party take responsibility for the sufficiency of the agreed-upon procedures. [LO 18-10] Compliance Reports Related to Audited Financial Statements We inform the students that many loan agreements require that the entity provide an audit report that the company is in compliance with the covenants of the loan agreement. We show Exhibit 18-11 to the students and point out that the report only provides negative assurance. Use Exhibit 18-12 Problems 18-22 and/or 18-23 could be used here. Problem 18-28 requires the students to find deficiencies in an auditor’s report. [LO 18-11] The First Significant Change to the Auditor’s Report in Over Seventy Years We complete our discussion of audit reporting by discussing the recent changes to PCAOB reporting standards. Key enhancements to the report include: 1. The Opinion section of the report is now presented first, followed by a Basis for Opinion section, which explains the rationale for the opinion. 2. The respective responsibilities of management and the auditor are more clearly described. 3. The requirement that the auditor be independent of the entity is explicitly stated. 4. The key features of an audit, such as that amounts and disclosures, are examined “on a test basis,” and “the accounting principles used and significant estimates made by management” are evaluated and more clearly laid out. 5. Critical audit matters that involve especially challenging, subjective, or complex auditor judgment are explicitly disclosed in a separate section of the report. We also discuss ways in which the new reporting standards are anticipated to improve the relevance and transparency of the auditor’s report by providing additional information to stakeholders and increasing communication between investors, auditors, and management. Discussion Case Discussion Case 18-29 can be used to cover going concern issues. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. Hands-On Cases IDEA and TABLEAU The Chapter 18 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 19 Professional Conduct, Independence, and Quality Control Learning Objectives Review Questio ns Multipl e- Choice Questio ns Proble ms Discussi on Cases Internet Assignmen ts/ EarthWea r Mini- Cases (EWMC) LO 19-1: Know the definitions and general importance of ethics and professionalism. 14 LO 19-2: Be able to explain three basic theories of ethical behavior and understand how to deal with ethical challenges through an example situation. 1,2 14,22,23 32,35,36 EWMC LO 19-3: Know how professional ethics standards for auditors have developed over time and the entities involved. LO 19-4: Understand the framework for the reorganized AICPA Code of Professional Conduct, including principles, rules, and interpretations. 3,5,6 14,17,21 30 33,35,36 LO 19-5: Acquire a working knowledge of the rules of conduct that apply to independence, integrity, and objectivity, as well as the Code’s “threats and safeguards” conceptual framework for evaluating and responding to ethical situations. 4,7 15,18,19 , 20,21 28,29,30 , 31 32,34 37 LO 19-6: Know the basic differences between the SEC’s independence rules for public company auditors and AICPA 8 16,21 27,28,30 , 31 32,34 37 standards for audits of nonpublic entities. LO 19-7: Know the rules of conduct that apply to general standards and accounting principles, confidential information, fees and other types of remuneration, acts discreditable, advertising and other forms of solicitation, and form of organization and name. 9,10,11 21,24 30 33 37 LO 19-8: Be able to explain the definition and elements of a system of quality control and how the AICPA’s peer review program relates to quality control. 12,13 25 LO 19-9: Be familiar with the PCAOB inspection program for accounting firms that audit public companies. 13 26 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 19-1 Unchanged 19-1 19-2 Unchanged 19-2 19-3 Unchanged 19-3 19-4 Revised 19-4 19-5 Unchanged 19-5 19-6 Unchanged 19-6 19-7 Unchanged 19-7 19-8 Unchanged 19-8 19-9 Unchanged 19-9 19-10 Unchanged 19-10 19-11 Unchanged 19-11 19-12 Unchanged 19-12 19-13 Unchanged 19-13 19-14 Unchanged 19-14 19-15 Revised 19-15 19-16 Unchanged 19-16 19-17 Unchanged 19-17 19-18 Unchanged 19-18 19-19 Updated 19-19 19-20 Unchanged 19-20 19-21 Unchanged 19-21 19-22 Unchanged 19-22 19-23 Revised 19-23 19-24 Revised 19-24 19-25 Unchanged 19-25 19-26 Revised 19-26 19-27 Revised 19-27 19-28 Unchanged 19-28 19-29 Revised 19-29 19-30 Revised 19-30 19-31 Revised 19-31 19-32 Revised 19-32 19-33 Revised 19-33 19-34 Revised 19-34 19-35 Unchanged 19-35 19-36 Unchanged 19-36 19-37 Revised 19-37 The focus of Chapter 19 is professional conduct, independence, and quality control. We point out to the students that any professional organization must indicate to its members what acceptable behavior is and must also demonstrate to the public that it is willing to monitor the actions of its members. The students should understand that the Code of Professional Conduct deals mainly with behavior and actions of individuals, while the Quality Control Standards are concerned with a firm's monitoring of its own practice. [LO 19-1] Ethics and Professional Conduct We begin the discussion of this chapter with why there is a strong need for ethics in our society. Then we talk about professionalism and why it is valued. We go back to the house inspector example used at the beginning of the course, and we ask the students what it means to be a professional house inspector. Then we bridge the discussion to auditors and what professionalism means to them. [LO 19-2] Theories of Ethical Behavior This leads us to begin to get a theoretical understanding of ethics. The text presents elements of the following three theories of ethical behavior: • Utilitarianism. • Rights-based approach. • Justice-based approach. We start by describing each theory and then applying those theories to the ethical dilemma posed by the Sun City Savings and Loan Company example. We try to impress upon the students that auditors regularly face such dilemmas and that ethical auditors find a way to do the right thing. [LO 19-3] Standards for Auditor Professionalism We spend some time clarifying for the students the principles, rules, and regulations governing ethics and professionalism in public accounting. Figure 19-1 does a good job summarizing the differences between public and private company audits, and we cover it thoroughly. Use Figure 19-1 [LO 19-4] The AICPA Code of Professional Conduct: A Comprehensive Framework for Auditors The newly reorganized AICPA Code of Professional Conduct is one of the foundations of defining ideal principles and minimum acceptable behavior for auditors. We begin coverage with the new organization of the Code of Professional Conduct: Principles of Professional Conduct, Rules of Conduct, and Interpretations of the Rules of Conduct (see Figure 19-2). Use Figure 19-2 We find that it's a good idea to present each of the Principles to the students. We use Table 19- 1 to provide the definition of each principle. Use Table 19-1 We use Table 19-2 to provide an overview of Part 1 of the Rules of Conduct. We point out to the students how the rules are organized in terms of sections. Use Table 19-2 While we make reference to the rules in our presentation, we prefer to discuss the underlying concepts. For example, in order to be independent, an auditor should not have any financial or managerial interests in an auditee. The remaining presentation in the text follows the sections of the Rules of Conduct. [LO 19-5] Integrity, Objectivity, and Independence We first present Part 1 of the AICPA Code of Professional Conduct, Section 1.100 on Integrity and Objectivity. We then discuss Section 1.200 on Independence. We discuss each of the following issues: • Financial Relationships (refer students to Table 19-3 and Exhibit 19-1). • Business Relationships (use Table 19-4). • Effect of Family Relationships. • Effect of Actual or Threatened Litigation. • Provision of Nonattest Services. When discussing the above items, we bring into the conversation the SEC independence requirements for audits of public companies and how they are the same or differ from the AICPA requirements. Use Exhibit 19-1 Use Tables 19-3 and 19-4 [LO 19-6] SEC and PCAOB Independence Requirements for Audits of Public Companies In this section, we discuss the primary areas in which the SEC and PCAOB independence rules differ from those of the AICPA Code of Professional Conduct. Until the past few years, the SEC’s independence rules for auditors of public companies closely followed those of the AICPA. However, the SEC implemented more stringent rules in November 2000, which were further revised in January 2003, after Title II of the Sarbanes-Oxley Act (2002) required additional independence restrictions. We review the recent differences which include: • Provision of other professional services. • Human resource and compensation-related issues. • Required communications. [LO 19-7] Other Rules in the Code of Professional Conduct General Standards and Accounting Principles The rules that fall under this section are fairly straightforward. The General Standards Rule captures much of what is contained in the ten GAAS, and the Compliance with Standards Rule merely states that an auditor must follow standards promulgated by bodies designated by the AICPA Council. The Accounting Principles Rule deals with compliance with accounting principles. Confidential Client Information The Confidential Client Information Rule stipulates that a member in public practice shall not disclose any confidential client information except in five specific situations: • To meet disclosure and performance requirements for GAAP and GAAS. • To comply with a valid subpoena. • To allow a review of a member’s professional practice under the authority of the AICPA, a state CPA society, or a state board of accountancy. • To comply with an investigative or disciplinary proceeding. • To allow a review of a CPA’s professional practice in conjunction with the purchase, sale, or merger of the practice. Contingent Fees We remind students that contingent fees are not allowed for attest services. If contingent fees were allowed for attestation-related services, users of those services might question the CPA’s independence. Acts discreditable The students should know that an auditor should not commit acts discreditable to the profession, including: • Discrimination and harassment in employment practices. • Solicitation or disclosure of CPA Examination questions and answers. • Failure to file a tax return or pay a tax liability. • Negligence in the preparation of financial statements or records. • Failure to follow requirements of governmental bodies, commissions, or other regulatory agencies. • Confidential information obtained from employment or volunteer activities. • False, misleading, or deceptive acts in promoting or marketing professional services. • Improper use of the CPA credential. • Failure to comply with records requests. Advertising and other forms of solicitation The Advertising and Other Forms of Solicitation Rule allows advertising and solicitation unless they are false, misleading, or deceptive. Examples of such activities include: • Creating false or unjustifiable expectations of favorable results. • Implying an ability to influence any court, tribunal, regulatory agency, or similar body or official. • Claiming that specific professional services in current or future periods will be performed for a stated fee, estimated fee, or fee range when it is likely at the time of representation that such fees will be substantially increased and the prospective auditee is not advised of that likelihood. • Making any other representations that would be likely to cause a reasonable person to misunderstand or be deceived. Commissions and referral fees Commissions and Referral Fees Rule generally does not allow commissions or referral fees when the member or member's firm provides attestation-related services. Form of organization and name Form of Organization and Name Rule requires that the form of a CPA's public accounting practice conform to state law or regulations whose characteristics conform to AICPA resolutions. This allows most forms of organizations, including limited liability partnerships. The students should also know that this rule prohibits firms from operating under names that may mislead the public. Disciplinary Actions It is useful to review with the students the ways that the AICPA can discipline members for violations of the Code of Professional Conduct. Before leaving this discussion, we point out to the students that professional conduct and auditor independence are complicated subjects with much technical detail. We urge them to master the technical issues but to also keep in mind the primary purpose of it all: independence in fact and in appearance is critical to the CPA’s reputation and the value he or she provides to society. To conclude the discussion of professional ethics, we recommend coming back to the principles that underlie the rules. In our experience, students are inspired by the fact that the profession they are entering has, at its base, principles that center on integrity and honor. [LO 19-8] Quality Control Standards We clarify for the students both the AICPA’s and the PCAOB’s roles in quality control. In 2004, the PCAOB assumed the AICPA’s responsibilities relating to firms that audit public clients and instituted a mandatory quality inspection program for those firms. However, the AICPA continues to administer a two-tiered quality review system in order to enable firms to meet their state licensing, federal regulatory, and AICPA membership requirements and to serve firms that audit only privately held clients. Then we cover the SQCS No. 8 in the following manner: • Define a firm's system of quality control. • Present the elements of quality control (refer to Tables 19-5 and 19-6). • Define monitoring of quality control and present recommended procedures― ▪ Review of records pertaining to the quality control elements. ▪ Review of engagement working papers, reports, and entity financial statements. ▪ Discussions with the firm’s personnel. ▪ Review of summarized reports on the findings of the monitoring procedures. ▪ Determination of any corrective actions to be taken or improvements to be made. ▪ Communication of findings to appropriate firm management. ▪ Follow-up on a timely basis by appropriate firm management and determination of what actions are necessary. Use Tables 19-5 and 19-6 [LO 19-9] PCAOB Inspections of Registered Public Accounting Firms We then discuss the PCAOB’s inspections of public accounting firms that are registered with the board. Discussion Cases Discussion Case 19-32 extends the Sun City Savings and Loan case. This case introduces two independent situations that require the students to explore issues beyond those discussed in the text. Discussion Case 19-33 allows the students to discuss ethical issues that should be considered when an individual is considering a career move from public accounting to industry. Discussion Case 19-34 allows students to explore SEC independence-related rules. Discussion Cases 19-35 and 19-36 give students an opportunity to work through ethical dilemmas using the framework given in the text. Internet Assignment Internet Assignment 19-37 provides students with the opportunity to visit the AICPA’s website to investigate Part 1 of the Code of Professional Conduct. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. Hands-On Cases EarthWear Mini-Cases The Chapter 19 mini-case can be assigned as a stand-alone case and asks students to read about a staff auditor who is confronted with an ethical challenge and then evaluate what he should do. Please go to Connect for the mini-case assignments. Chapter 20 Legal Liability Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases LO 20-1: Understand the four general stages in an audit-related legal dispute. 1 LO 20-2: Know the definitions of key legal terms. 2 14 26 LO 20-3: Know the auditor’s liability to clients under common law. 2,3,4 14,15,16 26,27 LO 20-4: Understand the auditor’s liability to third parties under common law. 2,5 14,16,17 26,27 30 LO 20-5: Understand the auditor’s legal liability under the Securities Act of 1933. 6 18,19, 20,21 27,28,29 30 LO 20-6: Understand the auditor’s legal liability under the Securities Exchange Act of 1934. 6,7,11 22 27,28,29 30 LO 20-7: Be able to explain how the Private Securities Litigation Reform Act of 1995, the Securities Litigation Uniform Standards Act of 1998, and the Class Action Fairness Act of 2005 relieve potential legal liability from auditors. 8 23 LO 20-8: Understand the auditor’s legal liability under the Sarbanes-Oxley Act of 2002. 9 24 31 LO 20-9: Know how the SEC and PCAOB can 10,11 24 sanction an auditor or audit firm. LO 20-10: Understand how the Foreign Corrupt Practices Act can result in legal liability for auditors. 12 25 LO 20-11: Understand how the Racketeer Influenced and Corrupt Organizations Act can affect the auditor’s legal liability. LO 20-12: Be able to explain how an auditor can be held criminally liable under various federal and state laws. 9,13 24 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 20-1 Unchanged 20-1 20-2 Unchanged 20-2 20-3 Unchanged 20-3 20-4 Unchanged 20-4 20-5 Unchanged 20-5 20-6 Unchanged 20-6 20-7 Unchanged 20-7 20-8 Unchanged 20-8 20-9 Unchanged 20-9 20-10 Unchanged 20-10 20-11 Unchanged 20-11 20-12 Unchanged 20-12 20-13 Unchanged 20-13 20-14 Unchanged 20-14 20-15 Unchanged 20-15 20-16 Unchanged 20-16 20-17 Unchanged 20-17 20-18 Unchanged 20-18 20-19 Unchanged 20-19 20-20 Unchanged 20-20 20-21 Unchanged 20-21 20-22 Unchanged 20-22 20-23 Unchanged 20-23 20-24 Unchanged 20-24 20-25 Unchanged 20-25 20-26 Unchanged 20-26 20-27 Unchanged 20-27 20-28 Unchanged 20-28 20-29 Unchanged 20-29 20-30 Unchanged 20-30 20-31 Unchanged 20-31 Chapter 20 presents a discussion of legal liability. We usually start our discussion of this topic by referring back to the agency or stewardship notions included in earlier chapters. It is easy to show the students how parties to the contract (principals and agents) can have recourse against the auditor if an inappropriate audit report is issued. [LO 20-1] Overview of Auditor Legal Liability We start coverage here with a description of the four general stages in the initiation and disposition of audit-related disputes. We then cover the definitions of key legal terms in Table 20-1. It is important for the students to understand these terms. Next, we discuss the types of liability and actions that can result in liability for auditors (refer the students to Table 20-2). We point out that the remaining discussion will cover each of these types of liability. Use Tables 20-1 and 20-2 [LO 20-2] Key Definitions of Key Terms Auditors can be sued by clients, investors, creditors, and the government for failure to perform professional services with due professional care. Auditors can be held liable under two broad categories of law: • Common law. Case law developed over time by judges who issue legal opinions when deciding a case (the legal principles announced in these cases become precedent for judges deciding similar cases in the future). • Statutory law. Written law enacted by the legislative branch of federal and state governments. It is important for students to understand the differences between these two legal categories. Table 20-1 defines key legal terms, and Table 20-2 summarizes the auditor’s liability by category of law and actions resulting in liability. Use Tables 20-1 and 20-2 [LO 20-3] Common Law—Clients The students should realize that an auditor does not guarantee his or her work product. However, the auditor is required to perform professional services with due care. When the auditor fails to carry out contractual arrangements with the client, he or she can be held liable for: (1) breach of contract, (2) negligence, or (3) fraud. We point out that the auditor's liability for breach of contract arises from the obligations included in the engagement letter. For example, if the auditor agreed to provide audited financial statements by a certain date and the auditor misses the deadline because of inadequate performance, the client can sue for damages. When discussing the auditor's liability under common law for negligence, we cover the following items: • The definition of a tort. • What is meant by a “reasonable person” (we use the quote from Cooley's Tort). • The elements for establishing auditor liability for negligence include: o duty to conform to a required standard of care; o failure to act in accordance with that duty; o causal connection between the auditor's negligence and the client's damage; o actual loss or damage to the client as a result. • A brief discussion of the Cenco, Inc. v. Seidman & Seidman (Exhibit 20-2) and 1136 Tenants v. Max Rothenberg (Exhibit 20-3) cases. Use Exhibits 20-2 and 20-3 [LO 20-4] Common Law—Third Parties It is important for the students to know that auditor liability to third parties for negligence is very complex and that court rulings are not always consistent across federal and state jurisdictions. We first cover the elements that a third party must prove in order to prevail in a suit alleging negligence: • The auditor had a duty to the plaintiff to exercise due care. • The auditor breached that duty by not following professional standards. • The auditor's breach of due care was the proximate cause of the third party's injury. • The third party suffered an actual loss as a result. We then cover the four standards that have evolved for defining the extent of the auditor's liability to third parties for ordinary negligence: • Privity. We point out that privity is the traditional view that states that the auditor has no liability to any party who did not have a privity relationship with the auditor. It is a good idea to reference the students to the landmark case, Ultramares v. Touche (Exhibit 20-4). It is also important to comment on the more recent cases that led to the near privity doctrine discussed next. Use Exhibit 20-4 • Near Privity. We point out that more recently, there have been cases that have applied the concept of near privity which include third parties whose relationship with the accountant approaches privity. We reference the Credit Alliance v. Arthur Andersen and Barret v. Freifeld cases. As we cover this section, we continually remind students that these legal doctrines relate to ordinary negligence and that in any jurisdiction any third party damaged by the auditor may successfully sue the auditors for gross negligence or fraud. • Foreseen Third Party or Restatement Standard. We point out to the students that this standard is now the majority view and that it is based on Section 522 of Restatement (Second) of the Law of Torts. We refer the students to the 1968 Rusch Factors v. Levin case (Exhibit 20-5), which was the first case to apply this standard. This standard narrows the auditor's liability to a small group of persons or classes who are or should be foreseen by the auditor as relying on the financial information. We find it helpful to the students if we review the three examples included in the text. Use Exhibit 20-5 • Reasonably Foreseeable Third Parties. This is the most expansive view of auditor's liability to third parties. We briefly discuss the first case in this area, Rosenblum v. Adler (Exhibit 20-6) and mention the Citizens State Bank v. Timm, Schmidt & Co. case. Part of the logic behind the reasonably foreseeable third parties standard is that auditors are able to spread their risk through insurance. However, in the current legal environment, such insurance may be unavailable or prohibitively expensive. Use Exhibit 20-6 In discussing the auditor's liability to third parties for fraud, we note that the auditor must have acted with knowledge of the misrepresentation or with reckless disregard for the truth. We also review the five items that the plaintiff must prove to win a lawsuit for fraud. [LO 20-5] Statutory Liability We point out to the students that there are various statutes at both the federal and state levels that are intended to protect the public from malfeasance in the marketplace and that the discussion focuses on the following federal statutes: • Securities Act of 1933 (LO 20-5). • Securities Exchange Act of 1934 (LO 20-6). • Private Securities Litigation Reform Act of 1995, the Securities Litigation Uniform Standards Act of 1998, and the Class Action Fairness Act of 2005 (LO 20-7). • Sarbanes-Oxley Act of 2002 (LO 20-8). • SEC and PCAOB Sanctions (LO 20-9). • Foreign Corrupt Practices Act (LO 20-10). • Racketeer Influenced and Corrupt Organizations Act (LO 20-11). Securities Act of 1933 The students should be told that this act regulates the disclosure of material facts in a registration statement for a new public offering of securities and that Section 11 imposes a liability on auditors for losses suffered by third parties when false or misleading information is included in a registration statement. We point out to the students that, unlike common law, the plaintiff does not have to prove negligence or fraud, reliance on the auditor’s opinion, a causal relationship, or a contractual relationship. The plaintiff only has to prove that a loss was suffered and that the audited financial statements contained a material omission or misstatement. We find it useful to cover some of the major cases such as Escott v. BarChris Construction (on the book’s website) or Bernstein v. Crazy Eddie (Exhibit 20-7). Use Exhibit 20-7 [LO 20-6] Securities Exchange Act of 1934 This statute is concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange or meet certain other statutory requirements. Two sections of this statute are important for auditors: Section 18 and Section 10(b), including Rule 10b-5. We normally cover the four elements that a plaintiff has to establish in order to sue under Rule 10b-5: (1) a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as a result of reliance on the financial statements, and (4) scienter. We then talk about a major case in this area, Ernst & Ernst v. Hochfelder. The Phar-Mor case, provided on the book’s web site, can also be covered here as a case that fell under the Securities Exchange Act of 1934. Also, Continental Vending and Mini-Scribe can be used from the book’s website. [LO 20-7] Private Securities Litigation Reform Act of 1995, the Securities Litigation Uniform Standards Act of 1998, and the Class Action Fairness Act of 2005 This is a good place to compare joint and several liability with proportionate liability. We usually discuss that public accounting firms are “deep pockets” for plaintiffs’ lawyers and that these two statues provide some protection for auditors by forcing cases to federal courts and increasing the standard of information and evidence the plaintiff must present with the initial claim rather than conducting “fishing expeditions” in auditor’s workpapers and files to identify possible claims. [LO 20-8] Sarbanes-Oxley Act of 2002 Once again, we discuss the sweeping reforms of Sarbanes-Oxley. We try to discuss with the students items that we may have missed in earlier classes. We do remind them that most of the legal liability legislation of Sarbanes-Oxley represented enhancements or revisions to existing laws. We use Problems 27 and/or 28 here to review many of the concepts included in the chapter to this point. [LO 20-9] SEC and PCAOB Sanctions We point out that under Rule 102e of the Rules of Practice, the SEC can suspend an individual's or a firm's privilege of practicing before the SEC. Typically, if a firm is faced with suspension, it will agree to sanctions such as not accepting any new SEC clients for a specified period of time. The SEC can also impose fines such as the $7 million one imposed on Arthur Andersen in connection with Waste Management. We also discuss with the students the PCAOB’s authority to impose sanctions. [LO 20-10] Foreign Corrupt Practices Act (FCPA) We usually discuss why the FCPA was passed and that it was codified as an amendment in 1988 to the Securities Exchange Act of 1934. The students should understand what a corporation's responsibilities are under the FCPA. [LO 20-11] Racketeer Influenced and Corrupt Organizations Act (RICO) We point out that while RICO was passed to combat organized crime, it has been used against auditors. The most common acts alleged by auditors are mail fraud and wire fraud. One of the major reasons for plaintiffs' suing auditors under RICO is that the act provides for treble damages. We also discuss the Reves v. Ernst & Young case (see book’s website), which established an operations and management test for auditors that requires the plaintiff to prove that the accounting firm participated in the operation or management of the client's business. [LO 20-8, 20-12] Statutory Law—Criminal Liability Under federal and state laws, auditors can be held criminally liable if some type of criminal intent was present. We usually discuss one of the cases in this area from the book’s website as well as the Enron case (see Exhibit 20-8) and the impact of Sarbanes-Oxley, which included numerous criminal provisions. Use Exhibit 20-8 Discussion Cases Discussion case 20-30 provides a good example for discussing auditors' civil liability to shareholders and creditors. Discussion case 20-31 discusses some pros-and-cons to Sarbanes-Oxley. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. The 11th edition has several new practice insights, as well as updated versions of previous insights, that provide recent examples of auditor-related lawsuits. IDEA and TABLEAU The Chapter 20 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 21 Assurance, Attestation, and Internal Auditing Services Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases Internet Assignmen ts LO 21-1: Know the definition of assurance services. 1 15 LO 21-2: Be familiar with the types of assurance services offered by CPAs. 11 15 LO 21-3: Know the definition of an attestation engagement. 2,3 16 36 LO 21-4: Know the types of attestation engagements. 2,3 16 36 LO 21-5: Understand the type of attestation engagement that involves reporting on an entity’s financial forecasts and projections. 4,6 17,18 31,32 LO 21-6: Understand that audits of internal control over financial reporting for non-public entities, which formerly were conducted as AICPA attestation examination engagements, are now conducted under AICPA Auditing Standards 5 LO 21-7: Be familiar with accounting and review services. 7,8 19,20,21 , 22 30,33,34 LO 21-8: Understand the role of standards pertaining to and services provided by internal auditors. 9,10 23,24,25 37 LO 21-9: Be familiar with a specific assurance service offered by CPAs—Trust Services 12,13,14 26,27,28 , 29 35 38,39 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 9th edition Comparison Number in 10th edition 21-1 Unchanged 21-1 21-2 Revised 21-2 21-3 Revised 21-3 21-4 Unchanged 21-4 21-5 Revised 21-5 21-6 Unchanged 21-6 21-7 Unchanged 21-7 21-8 Unchanged 21-8 21-9 Unchanged 21-9 21-10 Unchanged 21-10 21-11 Revised 21-11 21-12 Revised 21-12 21-13 Revised 21-13 21-14 Revised 21-14 21-15 Unchanged 21-15 21-16 Revised 21-16 21-17 Unchanged 21-17 21-18 Unchanged 21-18 21-19 Unchanged 21-19 21-20 Unchanged 21-20 21-21 Revised 21-21 21-22 Revised 21-22 21-23 Unchanged 21-23 21-24 Unchanged 21-24 21-25 Unchanged 21-25 21-26 Unchanged 21-26 21-27 Unchanged 21-27 21-28 Revised 21-28 21-29 Revised 21-29 21-30 Unchanged 21-30 21-31 Unchanged 21-31 21-32 Revised/Updated 21-32 21-33 Revised/Updated 21-33 21-34 Revised/Updated 21-34 21-35 Revised 21-35 21-36 Deleted 21-37 Revised 21-36 21-38 Unchanged 21-37 21-39 Revised 21-38 21-40 Revised 21-39 Chapter 21 presents assurance and attest services as well as other types of accounting services offered by CPAs. The chapter also discusses the several services and standards relating to internal auditing. We find that it is helpful if we start out coverage of this material by pointing out that auditors are often asked to provide a variety of services beyond the audit of historical financial statements. [LO 21-1] Assurance Services We start our discussion of assurance services by presenting the history behind the AICPA Special Committee on Assurance Services (the Elliott Committee). We then go over the definition of assurance services and show them Figure 21-1. Figure 21-2 can be introduced to discuss how good decision-making requires quality information. We then discuss the types of assurance services. Usually, we only cover two of the three services included in the chapter. Use Figures 21-1 and 21-2 [LO 21-2] Types of Assurance Services The AICPA, through its Assurance Services Executive Committee, identified and developed six general categories of assurance services. They are: • Risk assessment. • Business performance measurement. • Information system reliability. • Electronic commerce. • Health care performance measurement. • PrimePlus. [LO 21-3] Attestation Engagements Here we define an attestation engagement and the types of attestation services an auditor might be involved in, reference SSAE No. 18, and then use Figure 21-3 to discuss the relationship between the three parties to an attestation engagement. Use Figure 21-3 [LO 21-4] Types of Attest Engagements We then describe the types of engagements that can be conducted under attestation standards and that specific standards may prohibit certain types of engagements (examination, review, and agreed-upon procedures). We use Table 21-1 to provide an overview of attestation engagements. Use Table 21-1[LO 21-5] Financial Forecasts and Projections We generally cover this topic quickly. We focus on the following issues: • Types of prospective statements (financial forecasts and financial projections). • Minimum presentation guidelines (see Table 21-2). • Examination of prospective financial statements engagements, including example reports, using Exhibit 21-1 and Exhibit 21-2. • Agreed-upon procedures engagements, including the example report presented in Exhibit 21-3. Use Table 21-3 Use Exhibits 21-1 to 21-3 [LO 21-6] Reporting on an Entity's Internal Control over Financial Reporting (ICFR) To set the stage for the attestation service involving reporting on a private entity’s internal control over financial reporting, we note that certain large financial institutions are required to report on the effectiveness of the institution's internal control under the Federal Deposit Insurance Corporation Act of 1991. Sarbanes-Oxley imposes similar requirements on all publicly held companies. Then we point out that auditors also provide reports on management's assertions about the effectiveness of private entities’ internal control. Such services are provided to private entities under the generally accepted auditing standards. We highlight that audits of ICFR are covered under AU-C 940 and conducted in a manner very similar to audits of ICFR for public companies, which are covered in chapter 7 of the text. [LO 21-7] Accounting and Review Services We introduce this topic by discussing nonpublic companies’ need for services that are less comprehensive and less expensive than an audit. We also discuss some of the history (1136 Tenants' case) leading up to the issuance of the SSARS. We briefly introduce the three forms of services (preparation, compilation and review) and compare them to an audit, using Figure 21-4. Use Figure 21-4 We first cover a preparation of financial statements and draw attention to the idea that the accountant does not provide assurance but must provide a legend and disclose any departures from the financial reporting framework. We then cover a compilation of financial statements by focusing on the knowledge the accountant must have about the entity and on how the accountant is only required to read the compiled financial statements. We mention the three forms of compilation reports (with full disclosure, omitting substantially all disclosures, and auditor lacking independence) and show the students Exhibit 21-4. Use Exhibit 21-4 We then cover a review of financial statements by again focusing on the knowledge required of the accountant and the steps that must be performed (mainly inquiries of the entity's personnel and analytical procedures). Afterward, we present a standard review report (Exhibit 21-6) and an example of a modified review report (Exhibit 21-6). We use Problems 33 and/or 34 here. Use Exhibits 21-5 and 21-6 [LO 21-8] Internal Auditing We begin this section by relating to the students the increased emphasis being placed on the role of internal auditing in today’s corporations. We go over the definition of internal auditing with the students and explain why this might be a viable career option for them. This is a good time to invite a guest into the class to speak about internal auditing. If we do not have a guest speaker, we cover the material by first discussing the IIA, the certifications it offers, and the IIA International Professional Practices Framework, which is broken down into mandatory guidance (which consists of the definition of internal auditing, code of ethics, and standards) and recommended guidance (which consists of position papers, practice advisories, and practice guides). If we want to cover the material in detail, we use Tables 21-4, 21- 5, and 21-6 in our discussion. Use Tables 21-4, 21-5, and 21-6 We then talk about the role of the internal audit function and how internal audit functions differ widely in how they are managed and staffed. We talk about the advantages/disadvantages of “in- house” versus “co-sourced” and the two roles played by the internal audit function: assurance and consulting. We once again emphasize the increasing contribution the internal audit function is making to corporate governance within an organization. We then spend a few minutes discussing the more specific tasks of the internal audit function: evaluating risks, evaluating compliance, financial auditing, and operational auditing. The students should be familiar with most of the terms. We use Figure 21-5 and Exhibit 21-8 to illustrate the diversity of services offered by the internal audit function by showing how DuPont deploys its internal audit resources and defining the services provided by DuPont’s Internal Auditors. We close out this section by examining the relationship between the internal and external auditors. Use Figure 21-5 Use Exhibit 21-8 [LO 21-9] Advanced Module: An Example of An Assurance Service—Trust Services Trust Services and SOC 2®, SOC 3®, and SOC for Cybersecurity® Reports We begin by going over the five criteria that Trust Services are built on as listed in Table 21- 7: security, availability, processing integrity, privacy, and confidentiality. We then review SOC 1 reports and cover SOC 2, SOC 3, and SOC for Cybersecurity reports. Use Table 21-7 We also use Exhibit 21-9 to introduce an example of a SOC 2 report on EarthWear’s online customer ordering and fulfillment system. Use Exhibit 21-9 We use Problem 35 here. Discussion Case Discussion Case 21-37 addresses compliance auditing. This topic is not covered in the text. The case deals with environmental issues and compliance auditing. Internet Assignments Internet Assignments 21-38 through 21-40 can be used to demonstrate and reinforce various issues related to assurance services. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. IDEA and TABLEAU The chapter 21 IDEA and Tableau problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Instructor Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312