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E&Y Global Audit Methodology: Responding to the New Environment. University of Illinois at Urbana-Champaign March 10, 2005. Topics. Regulatory Backdrop Historical Timeline of Key Events Sarbanes-Oxley Act of 2002 Creation of PCAOB Responding to the New Environment

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e y global audit methodology responding to the new environment

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

University of Illinois at Urbana-Champaign

March 10, 2005

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

Auditing standards consolidated, name changed to AudSEC

Creation of the SEC

AudSEC, now ASB, sets rules for audits

Auditing standards consolidated

CPE required by all AICPA members

1933 & 1934 Securities Acts

1961

1972

1977

1978

1979

1990

1929

1933-34

1939

1938-1959

2002

Accounting standards moved from AICPA to FASB

First auditing standards issued

QCIC established

FCPA issued, POB created, peer review required by AICPA

Stock market crash

Sarbanes -Oxley Act, PCAOB formed

AICPA issued accounting standards

1929-1934

Nervous investors, low integrity market

1934–1995

Growth in capital markets increases need for standards, quality, and controls

1995–00

Dot.com era

2000-01

ENRONWorldcomAndersen

1929

Speculative boom leads to crash

2002-Now

Corporate reform, economic rebuild

sarbanes oxley act of 2002 soa
Sarbanes-Oxley Act of 2002 (SOA)
  • Most significant federal securities legislation since 1933/34 Securities Acts; Renewed focus on corporate governance practices and financial reporting integrity and transparency
  • SOA aims to:
    • Improve reporting/disclosures (e.g., new requirement to report on internal control – Section 404)
    • Strengthen corporate governance (e.g., new standards for audit committee practices)
    • Expand insider accountability (e.g., new requirements for code of ethics and protection for whistleblowers)
    • Increase oversight (e.g., creation of PCAOB; increased SEC review of company filings on 10-K/10-Q)
    • Broaden sanctions/penalties (e.g., criminal penalties strengthened when management issues false financial reports)
    • Heighten auditor independence (e.g., certain services can no longer be performed by auditors)
public company accounting oversight board
Public Company Accounting Oversight Board
  • Created by SOA
  • New regulator for public accounting profession
  • Three key functions of PCAOB:
      • Establish standards for Accounting Firms (auditing, quality control, ethics, and independence)
      • Conduct inspections of firms to assess compliance with professional standards
      • Take action to enforce PCAOB rules/standards
pcaob standards adopted to date
PCAOB – Standards Adopted to Date
  • In April 2003, the PCAOB adopted substantially all pre-existing standards issued by the AICPA Auditing Standards Board (ASB) to initially establish the “standards of the PCAOB”.
  • Key new standards/rules adopted by PCAOB to date:
    • Standard #1, References in Auditors’ Reports to the Standards of the PCAOB(December 2003) - now refer to the standards of the PCAOB, rather than to U.S. generally accepted auditing standards
    • Standard #2, Audits of Internal Control Over Financial Reporting(March 2004) - guidance for auditors to report on internal control over financial reporting as required by Section 404
    • Standard #3, Audit Documentation(June 2004) – increases documentation requirements on audits
    • Rule 3101, Rules Regarding Terms Used in Standards (June 2004) – establishes specific professional requirements when certain terms are used in standards (e.g., “should”, “must”)
responding to the new environment
Responding to the New Environment
  • Recent Changes to E&Y Global Audit Methodology
    • Changes focus on importance of professional skepticism, audit quality, and diligent execution of procedures
    • Increased emphasis on:
      • planning and coordinating multi-location engagements
      • procedures to test and report on internal controls (for public companies)
      • preparation and retention of documentation (presumption: if not documented, not done)
      • independent review partner and national consultation requirements
      • identifying and responding to fraud risks, including the use of journal entries to override controls
      • testing estimates, fair values, and income tax accounts
pcaob std 2 performing an integrated audit

Audit Of Internal Control Over Financial Reporting

Auditor opinion on 

management’s assessment that company maintained effective internal control as of year-end

PCAOB Std #2 – Performing an Integrated Audit

Financial Statement Audit

Auditor opinion on 

whether company financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows

An Integrated Audit Adds:

integrated audit significant increase in internal control work
Integrated Audit - Significant Increase in Internal Control Work

2005

Historical

2004

  • Understand the Business
  • Understand the Control Structure
  • Risk Assessment
  • Customize Audit Approach

Second Year of Integrated Audit

Financial Statement Audit

First Year of Integrated Audit

Range ofSynergies Anticipated

Account Balance Testing

I/C

Testing

Account Balance Testing

Account Balance Testing

I/C

Testing

I/C

Testing

Combination of Internal Control and Account Balance Testing for the Best Audit Coverage and Efficiency

Both Internal Control Testing and Account Balance Testing Required

Both Internal Control Testing and Account Balance Testing Required

Financial and Internal Control Reporting

integrated audit key changes affecting management and auditor
Integrated Audit - Key Changes Affecting Management and Auditor
  • Both must test controls over ALL significant accounts/disclosures and assertions
    • Management must have controls documented, in place, and operating effectivelythroughout the organization
  • Management must have their own resources/controls to get financial statements right
    • Cannot simply “rely” on auditor to adjust financial statements  can be Material Weakness in internal control and potentially an independence issue
  • Auditor evaluates effectiveness of audit committee
  • New rules have changed the auditor’s ability to leverage work of internal audit
  • New requirements to evaluate and communicate control deficiencies identified
identifying and responding to fraud risks
Identifying and Responding to Fraud Risks
  • SAS 99 was issued by ASB to increase emphasis on fraud risks during the audit
  • 2004 calendar year is second full year of implementation for SAS 99
  • Auditor’s responsibilities did not change with SAS 99– “to plan and perform the audit to obtain reasonable assurance” that financial statements are not materially misstated, whether caused by error or fraud
  • Fraud a top priority for PCAOB focus area in PCAOB inspections; may see additional rulemaking by PCAOB in 2005
most common fraud areas
Most Common Fraud Areas
  • Revenue Recognition (Deliberate Overstatement)
      • #1 Area of Fraud
      • Can be fictitious transactions or legitimate transactions that are recorded incorrectly (e.g., accelerating revenue recognition or misclassifying revenue in the income statement)
  • Understatement of Expenses
  • Significant Estimates
  • Related Party Transactions/Self-Dealing
  • Fair Values

Most fraud is perpetrated and/or concealed with inappropriate journal entries and other adjustments

fraud house summary of sas 99
“Fraud House” – Summary of SAS 99

Documentation

Professional Skepticism

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