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External Auditors’ Roles and Responsibilities . Chapter IX . External Auditing and Corporate Governance . External Auditor Responsibility .

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external auditor responsibility

External Auditor Responsibility

Current auditing standards require that independent auditors provide reasonable assurance that the financial statements are free from material misstatements, whether caused by error or fraud, to render an unqualified opinion on the financial statements.

External auditors are not and should not be expected to provide absolute assurance regarding reliability of financial statements, but the public expectations concerning external auditors performance are high.

Users of audited financial statements generally expect external auditors to detect financial statement fraud and employees’ illegal acts and fraud, which affects the integrity of financial reports. External auditors, however, are more concerned with material misstatements in the audited financial statements.

auditor competency

Auditor Competency

Professional competencies.To audit public companies, auditors should register with the PCAOB and meet all registration and inspection requirements.

Technical competencies. Auditors should be knowledgeable in professional standards, rules, laws and regulations, and understand their clients’ industry and business, corporate governance, financial reporting process, and internal controls.

Process competencies. Auditor’sability to choose appropriate evidence-gathering procedures (tests of controls, substantive tests) and execute auditing procedures

Reporting competencies. Reporting competencies refer to the auditors’ ability and willingness to discover and report material misstatements.

reports accompanying financial statements
Reports Accompanying Financial Statements
  • Report on financial statements and related disclosures (prepared by auditor)
    • Are financial statements and disclosures according to GAAP?
  • Report on internal control over financial reporting (prepared by management)
    • Has company maintained effective internal control over financial reporting?
  • Report on internal control over financial reporting (prepared by auditor)
    • Is management’s assessment of its internal control appropriate?
    • Has company maintained effective internal control over financial reporting?
the purpose of the audit report
The Purpose of the Audit Report
  • Definition of auditing: “... communicating results to interested users.”
  • Indicate whether the FS are in accordance with GAAP
    • Provide indication of what the FS would be like if GAAP were followed
    • Provide any company-omitted disclosures
  • Indicate any unusual aspects of the audit examination
    • Scope limitations
    • Division of responsibility
  • Indicate any unusual matters related to the company
    • Going concern uncertainty
    • Consistency
    • Emphasize a matter
four categories of audit reports
Four Categories of Audit Reports
  • Standard unqualified (clean opinion)
  • Unqualified with explanatory paragraph or modified wording
  • Qualified
  • Adverse or disclaimer
definitions webster s new unabridged dictionary
Definitions: Webster’s New Unabridged Dictionary
  • Qualified:
    • Having met conditions or requirements set
    • Limited, modified
  • Unqualified:
    • Not having the usual or requisite talents, abilities, or accomplishments
    • Not modified, limited, or restricted by conditions or exceptions
standard unqualified report
Standard Unqualified Report

The five necessary conditions have been met:

  • All four required statements are included.
  • The three general standards have been followed in all respects on the engagement.
  • Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables the conclusion that the three standards of field work have been met.
standard unqualified report1
Standard Unqualified Report
  • 4. The financial statements are presented in accordance with GAAP (including adequate disclosures.
  • 5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the report wording.
standard unqualified audit report nonlisted companies
Standard Unqualified Audit Report (Nonlisted Companies)


Report of Independent Auditor

Address to client

To the Board of Directors and stockholders of Any company

Audit notice

Audit notice

We have audited the accompanying balance sheets of Any company as of December 31, 1990 and 1989, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

Management responsibility

Identify the financial statements

Auditor responsibility


We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

Description of the audit

Opinion on financial statements

No special mention of adequate disclosure or consistency

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Any company as of December 31, 1990 and 1989, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.

Refer to GAAP



February 28, 1991

audit failures and audit quality

Audit Failures and Audit Quality

Following is the list of the initiatives that have been suggested to improve audit quality, as well as transparency.

Publication of audit engagement letters

Shareholders’ rights to question auditors

Publication of auditor resignation statements

Lead audit partner’s signature on audit reports

Active audit committee participation in evaluating the scope and results of the integrated audit of both ICFR and financial statements

Mandatory rotation of the audit firm every seven to twelve years in the context of the quality of audit work performed by the firm and the audit efficacy

Mandatory shareholder vote on the ratification of the independent auditor each year

public company accounting oversight board

Public Company Accounting Oversight Board

The PCAOB created by SOX to regulate the auditing profession.

The PCAOB’s primary functions are to:

1. Register public accounting firms that audit public companies.

2. Inspect the registered public accounting firms on a regular basis.

3. Establish auditing, attestation, ethics, quality control, and independence standards.

4. Conduct investigations and disciplinary proceedings.

pcaob auditing standards

PCAOB Auditing Standards

The PCAOB has issued five auditing standards as of September 2007:

1. PCAOB Auditing Standard No. 1 (audit is conducted in accordance with auditing standards of PCAOBUS, the city and state has to be disclosed)

2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR)

3. PCAOB Auditing Standard No. 3 (auditors are required to maintain the audit documentation in a sufficient manner and keep the records for at least seven years)

4. PCAOB Auditing Standard No. 4 (voluntary engagement for the auditor’s report on the company’s elimination of previously reported material weaknesses in its ICFR)

roles and responsibilities internal control over financial reporting
Roles and Responsibilities—Internal Control over Financial Reporting

Management: Designs and implements the system of internal control over financial reporting; evaluates the effectiveness of the company’s internal control over financial reporting and provides a public report on that assessment; prepares the financial statements.

Audit Committee: Has responsibility for oversight of the company’s financial reporting process.

Independent Auditor: Performs an audit of internal control over financial reporting and issues a report on management’s assessment of internal control over financial reporting and on the effectiveness of internal control over financial reporting; also performs an audit of the company’s financial statements.

what management s report will include
What Management’s Report Will Include

Under the SEC rules, management’s report on internal control over financial reporting should include the following information:

Statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting.

Statement identifying the framework used by management to evaluate the effectiveness of internal control over financial reporting.

Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year, including an explicit statement as to whether that control is effective and disclosing any material weakness identified by management in that control.

Statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management’s internal control assessment.


PCAOB Auditing Standard No. 2:An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements

AS No. 2 required three integrated reports on:

Financial statements audited by registered public accounting firms.

Management’s assessment of the effectiveness of internal control over financial reporting (Section 404).

The effectiveness of internal control over financial reporting over financial reporting based on the auditor’s attestation of internal control.

AS No. 2 was effective beginning June 17, 2004.

the independent auditor s opinion
The Independent Auditor’s Opinion

The content of the auditor’s report is prescribed by the PCAOB standard. The most common opinions on the effectiveness of internal control over financial reporting will be:

Unqualified Opinion. An opinion that internal control over financial reporting is effective: no material weaknesses in internal control over financial reporting exist as of the fiscal year-end assessment date.

Adverse Opinion. An opinion that internal control over financial reporting is not effective: one or more material weaknesses exist as of the fiscal year-end assessment date.

Disclaimer of Opinion. A report stating that restrictions on the scope of the auditor’s work prevent the auditor from expressing an opinion on the company’s internal control over financial reporting.


Report of Independent Registered Public Accounting Firm

1. Introductory


2. Scope


3. Definition


6. Inherent



5. Explanatory


4. Opinion


7. Signature

8. City and

State or


9. Date

pcaob auditors independence

PCAOB Auditors Independence

The new rules restrict public accounting firms in performing a variety of tax services to their audit clients. The new rules are intended to prevent the selling of abusive tax shelters.

audit committee oversight of external auditors

Audit Committee Oversight of External Auditors

The extended oversight responsibilities for the audit committee are:

1. Appointment, compensation, and retention of registered public accounting firms

2. Preapproval of audit services and permissible nonaudit services

3. Review of the independent auditor’s plan for an integrated audit of both ICFR and annual financial statements

4. Review and discussion of financial statements audited or reviewed by the independent auditor

5. Monitoring the auditor’s independence

6. Auditor rotation requirement

audit committee oversight of external auditors1

Audit Committee Oversight of External Auditors

The number of companies that change auditors, and the number of auditors changed

auditor independence

Auditor Independence

Auditor Independence

consolidation and competition in public accounting firms

Consolidation and Competition in Public Accounting Firms

SEC rules require public companies that change their public accounting firms to file a Form 8-K, Item 4.01, to disclose changes within four days, whereas auditors are required to provide standard letters within ten days stating whether they agree with the company’s disclosure without specifying any reasons.

audit strategy

Audit Strategy

Audit Strategy:

No limited tests of controls

No use of cycle rotation in tests of controls

Dual testing of controls and substantive audit procedures

Auditors should focus on prevention, detection, and correction of controls at both the company level and the transaction level. Auditors should perform tests of controls as a basis for forming an opinion on the effectiveness of ICFR. Auditors should also perform substantive tests as a basis for expressing an opinion on the fair presentation of financial statements, regardless of the identified significant deficiencies and material weaknesses in internal controls.

brief history fraud investigation
Brief History Fraud Investigation
  • 1900s -- Fraud detection was a primary objective of the audit
  • 1940s -- Detection of fraud considered to be a “responsibility not assumed”
  • 1960s -- Auditor acknowledged responsibility for detecting fraud that would normally be uncovered by an examination performed in accordance with GAAS.
  • 1980s -- Auditor had responsibility to search for fraud that may have a material affect on the financial statements.
  • 1997 -- SAS No. 82; 2002 – SAS No. 99
types of fraud
Types of Fraud

Financial Statement Fraud

Misrepresentation of material facts

Misappropriation of assets

Concealment of material facts

Management Fraud

Illegal Acts


Conflict of Interest


Embezzlement of money or property

Breach of fiduciary duty

Employee Fraud

Theft of trade secrets of intellectual property

Illegal acts

why people commit fraud
Why People Commit Fraud

Studies show that employees are likely to commit fraud when four conditions exist:

embezzlement formula
Embezzlement Formula





profile of fraud perpetrators
Profile of Fraud Perpetrators

The fraud perpetrator is more likely to be an ordinary member of the community: intelligent, respected, never suspected of dishonesty, NOT YOUR TYPICAL CRIMINAL TYPE.

  • A woman
  • Married
  • Church member
  • Older
  • Heavier
  • Have children
  • Have a higher education
  • Never been arrested
  • Have high self-esteem
  • High achiever
  • Divorced
  • Alcoholic
  • Tattooed
financial statement fraud
Financial Statement Fraud
  • Definition – Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors
  • Financial statement fraud has become a daily thing. Press reports challenge the corporate responsibility and integrity of major companies such as Lucent, Xerox, Rite-Aid, Waste Management, Microstrategy, KnowledgeWare, Sunbeam, Cendent, and ZZZ Best, Enron, WorldCom, Qwest, Madoff, Satyam, Stanford Financial, and Parmalat.
symptoms of financial statement fraud
Symptoms of Financial Statement Fraud
  • Continuous Deterioration of Quality and Quantity of Earnings
  • Inadequacy of Cash Flow
  • Overstatement of Inventories
  • Overly Aggressive Accounting
  • Management “Short-termism”
  • Improper Revenue Recognition
  • Overstatement of Assets
elements of fraud
Elements of Fraud
  • A false representation of a material nature
  • Knowledge that the representation is false or reckless disregard for the truth (Scienter)
  • Reliance on the false representation by the victim
  • Financial damages are incurred (to the benefit of the perpetrator).
  • The act was intentional.
auditor and investigator responsibilities
Auditor and Investigator Responsibilities
  • External Auditors (CPAs)
    • SAS 99: Consideration of Fraud in a Financial Statement Audit
      • Design audit to provide reasonable assurance of detecting fraud that could have a material effect on the financial statements.
      • Perform fraud-related procedures
    • SAS 54: Illegal Acts
      • Focused primarily is on direct-effect illegal acts
    • SAS 61: Communication with Audit Committees
  • Internal Auditors (CIAs)
    • SIAS 3: Deterrence, Detection, Investigation, and Reporting of Fraud
  • Governmental Auditors
    • Focus on laws and regulations (compliance), design audit to detect abuse and illegal acts, report to the appropriate authority
  • Certified Fraud Examiners (CFEs)
    • Assignments begin with predication (probable cause)
auditor s responsibility for detecting fraud1
Auditor’s Responsibility for Detecting Fraud
  • GAAS makes NO DISTINCTION between the auditor’s responsibilities for searching for errors or for fraud
  • Per SAS No. 99, auditors must specifically assess the risk of material misstatement due to fraud
assessing the risk of fraud
Assessing the Risk of Fraud
  • Pressure or incentive to commit the fraud
    • Direct financial gain, such as misappropriation of assets or retaining job
    • Indirect financial gain, such as increase in stock price
  • Perceived opportunity to commit the fraud
    • Can fraud be perpetrated without detection?
misappropriation of assets risk factors
Misappropriation of Assets Risk Factors
  • Susceptibility of assets to misappropriation
  • Employee relationships or pressures
  • Deficiencies in internal control
red flags
Red Flags
  • Personal financial pressure
  • Vices (drugs, alcohol or gambling)
  • Extravagant lifestyles
  • Real or imagined grievances against company
  • Related parties
  • Increased stress
  • Internal pressures
how frauds occurred
How Frauds Occurred
  • Poor internal controls
  • Management override of internal controls
  • Collusion between employees and third parties
  • Collusion between employees or management
  • Lack of control over management
  • Poor or nonexistent corporate ethics policy
reasons auditors fail to detect fraud
Reasons Auditors Fail to Detect Fraud
  • Over reliance on client representations
  • Lack of awareness or failure to recognize that an observed condition may indicate a material fraud
  • Lack of experience
  • Personal relationships with clients
sas no 99
SAS No. 99

The Fraud Triangle


Incentives/ Pressures


the fraud triangle
The Fraud Triangle
  • Incentives/Pressures
    • 95 percent of all fraud cases involve either:
      • Financial pressures
      • Vice-related pressures, including drug or alcohol addiction
      • Expensive romantic relationships
      • Need to maintain a particular lifestyle
      • Medical problems
the fraud triangle1
The Fraud Triangle
  • Rationalization is the reconciliation of what we are doing with what our conscience tells us we should do.
  • "I was only borrowing it; I planned to return it after things improved."
the fraud triangle2
The Fraud Triangle
  • Opportunity
    • Easiest to control of the three components
    • Most frequently achieved with internal controls
      • Segregation of duties
      • Authorizations
      • Independent checks
      • Physical safeguards
      • Adequate documents and records

Evaluate Control Environment

Tests of Controls

Audit Risk


Inherent Risk

Control Risk


Detection Risk




Analytical Procedures


Misappropriation of Assets

Misappropriation of Assets

Misappropriation of Assets

Tests of Details

Financial Statement Fraud

Financial Statement Fraud

Financial Statement Fraud

Forensic Procedures

Evaluate Controls Over Assets

Management Integrity

Evaluate Top Management Controls



Incentive/ Pressure


Incentive/ Pressure Fraud Risk Factors

Attitude/ Rationalization Fraud Risk Factors

Opportunity Fraud Risk Factors

audit of defined benefit pensions

Audit of Defined Benefit Pensions

Employer-defined benefit pension reforms, as proposed by the administration and introduced by both the House and the Senate, would require plan sponsors to make minimum funding contributions equal to the greater of:

the contributions required under the plan’s funding standard account estimated based on the plan’s actuarial accrued liability,

deficient reduction contributions calculated under current liability rules.

These reforms would replace the current law’s “double-barrel”

system with a single measure of assets and liabilities and

required funding method.

auditors liability limitation agreement

Auditors’ Liability Limitation Agreement

In February 2006, the Federal Financial Regulatory Agencies issued an interagency advisory that raised concerns regarding the negative impacts on the quality and reliability

of audits when financial institutions agree to limit their independent auditors’ liability.

The advisory, while observing an increase in the types and extent of provisions in financial institutions’ external audit engagement letters that limit auditor liability, informs financial institutions that they should not enter into an audit engagement that includes unsafe and unsound limitation of liability provisions relevant to an integrated audit of their financial statements and ICFR.