2a AI The Audit Market

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Principles of Auditing: An Introduction to

International Standards on Auditing
US Classes – PCAOB Standards
Chapter 2 – The Audit Market
Rick Hayes, Hans Gortemaker

and Philip Wallage
Hayes, Gortemaker and Wallage, Principles of Auditing PowerPoints on the Web, 3rd edition © Pearson Education Limited 2014
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• Management controls the accounting systems,

the internal controls and the
financial reports to investors.
• Management is not independent or objective
because their success depends on positive
reports.
• The auditor increases the confidence of the
report users by giving an independent opinion
on the fairness of these reports.
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Demand for audit services explained by

several different theories
• The Policeman Theory
• The Lending Credibility Theory
• The Theory of Inspired Confidence
• Agency Theory
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Agency theory
• A company is viewed as the result of ‘contracts’,
in which several groups make some kind of
contribution to the company, given a certain ‘price’.
• Management is seen as the ‘agent’, trying to obtain
contributions from ‘principals’ such as bankers,
stockholders and employees.
• Management tries to do what is best for management
and has a considerable advantage over the principals
regarding information about
the company (information asymmetry).
• Cost of an agency relationship are monitoring
costs, bonding costs and residual loss.
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Audits required
• In most countries, audits are now legally required
for some types of companies
(statutory audits).
• For example, listed companies, companies
receiving government money, certain industries.
• Major bourses (including NYSE, NASDAQ,
London Stock Exchange, Tokyo NIKKEI and
Frankfurt DAX) have listing rules that require all
companies to have an audited annual report.
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Audit regulation
Although there is regulation around the world,

two that may be the most influential are:
•The Sarbanes–Oxley Act of 2002 required the US
Securities and Exchange Commission (SEC) to
create a Public Company Accounting Oversight
Board (PCAOB).
•European Union Eighth Council Directive
84/253/EEC and EU Directive 2006/43/EC.
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Independent oversight
• International Forum of Independent Audit
Regulators (IFIAR)
• In Australia – Financial Reporting Council
• In the UK – The Review Board
• In the Netherlands – Authority for the Financial
Markets (AFM)
• France – Autorité des marchés financiers (AMF)
• USA – Public Company Accounting Oversight
Board
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The International Forum of Independent

Audit Regulators (IFIAR) Core Principles
• Comprehensive and well defined accounting and
auditing principles and standards
• Legal requirements for the preparation and
publication of financial statements according to those
principles and standards
• An enforcement system for preparers of financial
statements to ensure compliance with accounting
standards
• Corporate governance practices that support high‐
quality corporate reporting and auditing practice
• Effective educational and training arrangements for
accountants and auditors.
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In the United States who supervises auditing rules

and auditing firms for Publicly listed companies?
Public Company Accounting Oversight Board
(PCAOB)
Created by the Sarbanes–Oxley Act of 2002
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PCAOB’s audit standards

• PCAOB has passed 16 audit standards as
of December 2010.
• They also enforce as ‘temporary standards’
the existing audit standards by the Audit
Standards Board called Statements of Audit
Standards (SAS).
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PCAOB’s audit standards – US classes

• AS No. 1: References in Auditors’ Reports to the Standards
of the Public Company Accounting Oversight Board
• AS No. 2: on internal control report replaced by AS No. 5.
• AS No. 3: Audit Documentation
• AS No. 4: Reporting on Whether a Previously Reported Material
Weakness Continues to Exist
• AS No. 5: An Audit of Internal Control Over Financial
Reporting That Is Integrated with An Audit of Financial Statements
• AS No. 6: Evaluating Consistency of Financial Statements
• AS No. 7: Engagement Quality Review
• AS No. 8: Audit Risk
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PCAOB’s audit standards – US classes

(Continued)
• AS No. 9: Audit Planning
• AS No. 10: Supervision of the Audit Engagement
• AS No. 11: Consideration of Materiality in Planning and
Performing an Audit
• AS No. 12: Identifying and Assessing Risks of Material
Misstatement
• AS No. 13: The Auditor's Responses to the Risks of Material
Misstatement
• AS No. 14: Evaluating Audit Results
• AS No. 15: Audit Evidence
• AS No. 16: Communications with Audit Committees
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PCAOB audit standard # 1: References in auditors’ reports

to the standards of the Public Company Accounting Oversight
Board
• Adopted as interim standards, on an initial,
transitional basis, GAAP in AICPA’s Auditing
Standards Board’s Statement on Auditing
Standards No. 95.
• The auditor in their opinion must refer to ‘the
standards of the Public Company Accounting
Oversight Board (United States).’
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Report of independent Registered Public Accounting Firm

The Board of Directors and Shareholders of Wal-Mart Stores, Inc.
We have audited the accompanying consolidated balance sheets of Wal-Mart Stores, Inc.
as of January 31, 2010 and 2009, and the related consolidated statements of income,
shareholders’ equity and cash flows for each of the three years in the period ended
January 31, 2010. 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.
We conducted our audits in accordance with the standards of the

Public Company Accounting Oversight Board (United States).
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 audits provide a
reasonable basis for our opinion.
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In our opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Wal-Mart Stores, Inc. at
January 31, 2010 and 2009, and the consolidated results of its operations and its
cash flows for each of the three years in the period ended January 31, 2010, in
conformity with US generally accepted accounting principles.
As discussed in Note 8 to the consolidated financial statements, effective
February 1, 2007, the Company changed its method of accounting for uncertainty
in income taxes.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), Wal-Mart Stores, Inc.’s internal
control over financial reporting as of January 31, 2010, based on criteria
established in Internal Control – Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission and our report dated
March 30, 2010 expressed an unqualified opinion thereon.
Ernst & Young
Rogers, Arkansas
March 30, 2010
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PCAOB audit standard # 3: Audit documentation
(#3) This standard establishes general requirements for

documentation the auditor should prepare and retain
in connection with engagements.
(#3) Audit documentation is the written record of the basis
for the auditor’s conclusions that provides the
support for the auditor’s representations, whether those
representations are contained in the auditor’s report or
otherwise.
(#3) The auditor must retain audit documentation for seven
years from the date the auditor grants permission
to use the auditor’s report in connection with the
issuance of the company’s financial statements
(report release date).
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PCAOB audit standard # 4: Reporting on whether a

previously reported material weakness continues to exist
Establishes requirements and provides direction that

apply when an auditor is engaged to report on whether
a previously reported material weakness in internal
control over financial reporting continues to exist as of a
date specified by management.
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Report of Independent Registered Public Accounting Firm

We have previously audited and reported on management’s annual assessment
of XYZ Company’s internal control over financial reporting as of December 31,
200X based on (Identify control criteria, for example, ‘criteria established in
Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO)’). Our report, dated (date of
report), identified the following material weakness in the Company’s internal
control over financial reporting:
(Describe material weakness)
We have audited management’s assertion, included in the accompanying (title
of management’s report), that the material weakness in internal control over
financial reporting identified above no longer exists as of (date of management’s
assertion) because the following control(s) addresses the material weakness:
(Describe control(s))
…
In our opinion, the material weakness described above no longer exists as of
(date of management’s assertion).
…..
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PCAOB audit standard # 5: An audit of internal control over financial

reporting that is integrated with an audit of financial statements
(#5) This standard establishes requirements when an auditor is

engaged to perform an audit of management’s assessment of
the effectiveness of internal control over financial reporting
(‘the audit of internal control over financial reporting’) that is
integrated with an audit of the financial statements.
(#5) If one or more material weaknesses exist, the company’s
internal control over financial reporting cannot be considered
effective.
(#5) The audit of internal control over financial reporting should be
integrated with the audit of the financial statements.
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Report of Independent Registered Public Accounting Firm on Internal Control

Over Financial Reporting
The Board of Directors and Shareholders of Wal-Mart Stores, Inc.
We have audited Wal-Mart Stores, Inc.’s internal control over financial reporting as of January 31, 2010,
based on criteria established in Internal Control – Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (the COSO criteria). Wal-Mart Stores, Inc’s
management is responsible for maintaining effective internal control over financial reporting, and for its
assessment of the effectiveness of internal control over financial reporting included in the
accompanying ‘Management’s Report to Our Shareholders’. Our responsibility is to express an opinion
on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over financial reporting,
assessing the risk that a material weakness exists, testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk, and performing such other procedures as
we considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A company’s internal
control over financial reporting includes those policies and procedures that: (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company.
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(2) provide reasonable assurance that transactions are recorded as necessary to

permit preparation
of financial statements in accordance with generally accepted accounting principles, and
that receipts and expenditures of the company are being made only in accordance with
authorisations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorised acquisition, use or
disposition of the company’s assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of effectiveness to
future periods are subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or procedures
may deteriorate.
In our opinion Wal-Mart Stores, Inc. maintained, in all material respects, effective internal
control over financial reporting as of January 31, 2010, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of Wal-Mart
Stores, Inc. as of January 31, 2010 and 2009, and related consolidated statements of
income, shareholders’ equity and cash flows for each of the three years in the period
ended January 31, 2010 and our report dated March 30, 2010 expressed an unqualified
opinion thereon.
Ernst & Young
Rogers, Arkansas
March 30, 2010
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PCAOB audit standard # 6: Evaluating consistency of

financial statements
(#6) This standard establishes requirements for the
auditor’s evaluation of the consistency of the
financial statements.
(#6) The auditor should recognise the following matters
in an explanatory (emphasis of a matter)
paragraph a relating to the consistency of the
company’s financial statements in the auditor’s report if
those matters have a material effect on the financial
statements:
– A change in accounting principle
– An adjustment to correct a misstatement in
previously issued financial statements.
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PCAOB audit standard # 7: Engagement quality review
(#7) An engagement quality review and concurring

approval of issuance are required for each audit
engagement and for each engagement to review interim
financial information.
(#7) The objective of the engagement quality reviewer
is to perform an evaluation of the significant
judgments made by the engagement team and the related
conclusions reached in forming the overall conclusion on the
engagement in order to determine whether to provide
concurring approval of issuance.
(#7) An engagement quality reviewer must have
competence, independence, integrity and objectivity.
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PCAOB audit standard # 8: Audit risk
(#8) This standard discusses the auditor’s

consideration of audit risk.
(#8) Risk of material misstatement at the assertion
level consists of the following components:
Inherent risk and Control risk.
(#8) The auditor uses the assessed risk of material
misstatement to determine the appropriate level
of Detection risk for a financial statement
assertion.
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PCAOB audit standard # 9: Audit planning
(#9) Establishes requirements regarding planning

an audit.
(#9) The engagement partner is responsible for
planning the audit.
(#9) Planning the audit includes establishing the
overall audit strategy for the engagement and
developing an audit plan, which includes, in
particular, planned risk assessment procedures and
planned responses to the risks of material
misstatement.
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PCAOB audit standard # 10: Supervision of the audit

engagement
(#10) This standard establishes requirements
regarding supervision of the audit engagement,
including supervising the work of engagement team
members.
(#10) The engagement partner is responsible for
the engagement and its performance including
PCAOB standards and the work of engagement
personnel, specialists, other auditors, internal
auditors and others who are involved in testing
controls.
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PCAOB audit standard # 11: Consideration of materiality

in planning and performing an audit
(#11) Establishes requirements regarding the auditor's

consideration of materiality in planning and
performing an audit.
(#11) The Supreme Court of the United States – a
fact is material if there is ‘a substantial likelihood
that the…fact would have been viewed by the
reasonable investor as having significantly
altered the “total mix” of information made available’.
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PCAOB audit standard # 11: Consideration of materiality

in planning and performing an audit (Continued)
(#11) To obtain reasonable assurance about whether

the financial statements are free of material
misstatement, the auditor should plan and
perform audit procedures to detect misstatements that,
individually or in combination with other
misstatements, would result in material
misstatement of the financial statements.
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PCAOB audit standard # 12: Identifying and assessing

risks of material misstatement
(#12) Establishes requirements regarding the process

of identifying and assessing risks of material
misstatement of the financial statements.
(#12) The auditor should perform risk assessment
procedures that are sufficient to provide a
reasonable basis for identifying and assessing
the risks of material misstatement, whether due
to error or fraud.
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PCAOB audit standard # 12: Identifying and assessing

risks of material misstatement (Continued)
• This standard discusses the following risk assessment procedures:
• Obtaining an understanding of the company and its environment
(paragraphs 7–17).
• Obtaining an understanding of internal control over financial reporting
• Considering information from the client acceptance and retention
evaluation, audit planning activities, past audits and other engagements
performed for the company (paragraphs 41–45).
• Performing analytical procedures (paragraphs 46–48).
• Conducting a discussion among engagement team members regarding
the risks of material misstatement (paragraphs 49–53).
• Inquiring of the audit committee, management, and others within the
company about the risks of material misstatement (paragraphs 54–58).
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PCAOB audit standard # 13: The auditor’s responses to

the risks of material misstatement
(#13) Establishes requirements regarding designing

and implementing appropriate responses to the
risks of material misstatement.
(#13) Responses that have an overall effect on how
the audit is conducted (‘overall responses’),
(paragraphs 5–7) – e.g. appropriate staff
assignment, supervision, unpredictable audit
procedures.
(#13) Responses involving the nature, timing and
extent of the audit procedures to be performed,
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PCAOB audit standard # 14: Evaluating audit results
Establishes requirements regarding the auditor’s evaluation of audit

results and determination of whether he or she has obtained sufficient
appropriate audit evidence which should include evaluation of the
following:
– The results of analytical procedures performed in the overall review of the
financial statements (‘overall review’)
– Misstatements accumulated during the audit, including, in particular,
uncorrected misstatements
– The qualitative aspects of the company’s accounting practices
– Conditions identified during the audit that relate to the assessment of the
risk of material misstatement due to fraud (‘fraud risk’)
– The presentation of the financial statements, including the disclosures
– The sufficiency and appropriateness of the audit evidence obtained.
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PCAOB audit standard # 15: Audit evidence
(#15) Explains what constitutes audit evidence and

establishes requirements regarding designing and
performing audit procedures to obtain sufficient
appropriate audit evidence.
(#15) Audit evidence is all the information, whether
obtained from audit procedures or other sources,
that is used by the auditor in arriving at the
conclusions on which the auditor’s opinion is
based.
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PCAOB audit standard # 15: Audit evidence (Continued)

Sufficient Appropriate Audit Evidence
(#15) Sufficiency is the measure of the quantity of

audit evidence affected by the following:
• Risk of material misstatement or the risk
associated with the control (risk increase 
amount of evidence increases)
• Quality of the audit evidence obtained.
(#15) Appropriateness is the measure of the quality of
audit evidence, i.e. its relevance and
reliability.
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PCAOB audit standard # 16: Communications with audit

committees
(#16) This standard requires the auditor to communicate
with the company’s audit committee regarding
certain matters related to the conduct of an audit
and to obtain certain information from the audit
committee relevant to the audit.
(#16) This standard also requires the auditor to establish
an understanding of the terms of the audit
engagement with the audit committee and to record that
understanding in an engagement letter. (Included in
the engagement letter)
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PCAOB audit standard # 16: Communications with

audit committees (Continued)
The auditor should communicate to the audit committee the
following matters:
(#16) Significant accounting policies and practices
• Management choice of accounting policies and
effect on f/s and disclosures of controversial areas
and areas which lack authoritative guidance.
(#16) Critical accounting policies and practices
• Those that are both most important to the portrayal of the
company’s financial condition and results, and require
management’s most difficult, subjective or complex
judgements.
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audit committees (Continued)
The auditor must also communicate to the audit committee
(#16) Critical accounting estimates

• Management’s process in developing the
estimates including significant assumptions
used, and any significant changes management
made in the process.
(#16) Significant unusual transactions
• Significant transactions outside the normal
course of business or that appear unusual in
timing, size or nature.
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audit committees
(Continued)
• Overall audit strategy, timing of the audit and significant
risks
• Auditor’s evaluation of the quality of the company’s
financial reporting
• Other information in documents containing audited
financial statements
• Difficult or contentious matters for which the auditor
consulted
• Auditors going concern evaluation.
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audit committees
(Continued)
• Uncorrected and corrected misstatements
• Other material written communications between the
auditor and management
• Departure from the auditor’s standard report
• Disagreements with management
• Difficulties encountered in performing the audit.
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Current standard-setting and related

rulemaking activities
• Proposed auditing standard on related parties and related
amendments to PCAOB auditing standards
• Concept release on auditor independence and audit firm
rotation
• Proposed auditing standard on auditing supplemental
information accompanying audited financial statements
and related amendments to PCAOB standards
• Concept release on possible revisions to PCAOB
standards related to reports on audited financial
statements and related amendments to PCAOB
standards.
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List of PCAOB temporary standards

• AU Section 100 – Statements on Auditing Standards
– Introduction
• AU Section 200 – The General Standards
• AU Section 300 – The Standards of Field Work
• AU Section 400 – The First, Second and Third
Standards of Reporting
• AU Section 500 – The Fourth Standard of Reporting
• AU Section 600 – Other Types of Reports
• AU Section 700 – Special Topics AU Section 800 –
Compliance Auditing
• AU Section 900 – Special Reports of the Committee
on Auditing Procedures
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Big Four firms and non-Big Four

• Deloitte, Ernst & Young, KPMG and
PricewaterhouseCoopers
• Second Tier – Grant Thornton; BDO Seidman;
McGladrey & Pullen; Moss Adams; Myer,
Hoffman & McCann; Crowe Group; American
Express; and BKD.
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Legal liability of the auditor

• Varies from country to country, district to district.
• Based on one or more of the following:
• common law;
• civil liability under statutory law;
• criminal liability under statutory law;
• liability for members of professional accounting
organisations.
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Common Law Ultramares – Touche case

(Ultramares Corporation vs. Touche et al.)
• The accountants were negligent for not finding
that a material amount of accounts receivable
had been falsified when careful investigation
would have shown it to be fraudulent
• Not liable to a third party bank because the
creditors were not a primary beneficiary, or
known party
• Called the Ultramares doctrine, that ordinary
negligence is not sufficient for a liability to a third
party because of lack of privity of contract
between the third party and the auditor.
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Caparo Industries, PLC vs. Dickman

• The question in Caparo was the scope of the assumption
of responsibility of the auditor if a clean opinion was
given for negligent accounts, and what the limits of
liability ought to be.
• The House of Lords of the UK, following the Court of
Appeal, set out a ‘three-fold test’ for an obligation (duty
of care) to arise from negligence
• harm must be reasonably foreseeable;
• the parties must be in a relationship of proximity;
• it must be fair, just and reasonable to impose liability.
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Civil liability under statutory law

• The Securities Act of 1933 established the first US
statutory civil recovery rules for third parties against
auditors.
• Original purchasers have recourse against the auditor
for up to the original purchase price if the financial
statements are false or misleading.
• The auditor has the burden of demonstrating that
reasonable investigation was conducted or that all the
loss of the purchaser of securities (plaintiff) was
caused by factors other than the misleading financial
statements.
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Sarbanes–Oxley Act of 2002 civil penalties for

CEOs and CFOs
• If there is a material restatement of a company’s reported
financial results due to the material non-compliance of the
company, as a result of misconduct, the CEO and CFO
shall reimburse the company for any bonus or incentive or
equity-based compensation received within the 12 months
following the filing with the financial statements subsequently
required to be restated (Section 304).
• Financial statements filed with the SEC by any public company
must be certified by CEOs and CFOs. If all financials do not
fairly present the true condition of the company CEOs and
CFOs may receive fines of up to $1 million. If certifications are
made knowing the statements are incorrect, the fine can be up
to $5 million.
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Criminal liability under statutory law

• The Securities Exchange Act of 1934 in the United
States sets out (Rule 10b-5) criminal liability for the
auditor to employ any device, scheme or artifice to
defraud or intentionally or recklessly misrepresent
information for third party use.
• Not In Text Cases: In United States vs. Natelli
(1975), United States vs. Weiner (1975), ESM
Government Securities vs. Alexander Grant & Co.
(1986).
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Sarbanes–Oxley Act of 2002 criminal penalties

for CEOs, CFOs and auditors
• To knowingly destroy, create, manipulate documents
and/or impede or obstruct federal investigations is
considered felony, and violators will be subject to fines
or up to 20 years imprisonment, or both.
• All audit reports or related workpapers must be kept by
the auditor for 7 years. Failure to do this may result in
10 years imprisonment.
• CFOs and CEOs who falsely certify financial statements
or internal controls are subject to 10 years imprisonment.
Willful false certification may result in a maximum of
20 years imprisonment.
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Liabilities as members of professional

organisations
Nearly all national audit professions have some sort of
disciplinary court.
The disciplinary court makes its judgment and
determines the sanction. It may be:
1. a fine;
2. a reprimand (either oral or written);
3. a suspension for a limited period of time (e.g. 6
months); or
4. a lifetime ban from the profession.
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Under common law in order to hold the auditor

successfully legally liable in a civil suit, the
following conditions have to be met: US classes
• An audit failure/neglect has to be proven (negligence

issue).
• The auditor should owe a duty of care to the plaintiff
(due professional care).
• The plaintiff has to prove a causal relationship between
his losses and the alleged audit failure (causation issue).
• The plaintiff must quantify his losses (quantum issue).
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Financial risks resulting from litigation for

audit firms
European Union Commissioner
Charlie McCreevy has said:
‘We have concluded that unlimited liability combined
with insufficient insurance cover is no longer tenable. It
is a potentially huge problem for our capital markets
and for auditors working on an international scale. The
current conditions are not only preventing the entry of
new players in the international audit market, but are
also threatening existing firms.’
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Suggested solutions to auditor liability

• Some countries (e.g. Germany) have put a legally
determined cap on the liability of auditors (to the
client in the case of Germany).
• A system of proportionate liability – an audit firm is
not liable for the entire loss incurred by plaintiffs but
only to the extent to which the loss is attributable to
the auditor.
• In order to protect the personal wealth of audit
partners, some audit firms are structured as a
limited liability partnership (e.g. in the UK).
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Suggested solutions to auditor liability

(Continued)
• To make insurance of all liability risks compulsory
using new legislation was one of the
recommendations of a EU commission.
• Exclude certain activities with a higher risk profile
from the auditors’ liability. A mechanism to
achieve this outcome would be to introduce so-
called safe harbour provisions by legislation.
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Audit expectations with regard to the following

duties of auditors: giving an opinion on
• the fairness of financial statements;
• the company’s ability to continue as a going concern;
• the company’s internal control system;
• the occurrence of fraud;
• the occurrence of illegal acts.
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The fairness of financial statements: The

company’s ability to continue as a going concern
A large part of the financial community (users of audit

services) expects that financial statements with an
unmodified (unqualified) audit opinion are completely
free from error. The inherent limitations of auditing not
accepted.
In most national regulations, auditors need to determine
whether the audited entity is able to continue as a going
concern.
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Opinion on the company’s internal control

system
• The objective of the auditor is to identify and
assess the risks of material misstatement …
through understanding the entity and its
environment, including the entity’s internal
control.
• The United States Sarbanes–Oxley Act of 2002
requires that company officers certify that internal
controls are effective and requires that an
independent auditor verify management’s
analysis.
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Company’s internal control

Section 404 of the Sarbane–Oxley Act requires each annual report
of a company to contain an ‘internal control report’ which should:
1.State the responsibility of management for establishing and
maintaining an adequate internal control structure and procedures
for financial reporting.
2.Contain an assessment, as of the end of the fiscal year, of the
effectiveness of the internal control structure and procedures for
financial reporting.
3.Companies must select suitable criteria (COSO-based) against
which it may evaluate the effectiveness of internal controls for
authorisation, safeguarding assets, and properly recording of
transactions.
4.An independent auditor attests to any difference between
management’s assertions under 404 and the audit evidence on
internal controls.
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Opinion on the occurrence of fraud

• Both governments and the financial community
expect the auditor to find existing fraud cases
and report them.
• Audit history has gone from the fraud detection
as the objective of an audit to not taking any
responsibility for fraud, to the current position
that the auditor is responsible for obtaining
reasonable assurance the financial statements
are free from material statement, whether
caused by fraud or error.
Slide 2US.60
The occurrence of fraud

• ISA 240 – the responsibility for the prevention and
detection of fraud and error rests with both those
charged with the governance and the management.
• ISA 210 states that when planning and performing
audit procedures and in evaluating and reporting the
results, auditors should consider the risk of
misstatements in financial statements resulting in
fraud.
• In planning the audit, the auditor must assess the
risk that material fraud or error has occurred.
Slide 2US.61
US fraud standard – US classes

• Auditing Standard Number 99 (SAS 99).
• The standard requires that as part of the planning
process the audit team must consider how and
where the client’s financial statements may be
susceptible to fraud.
• Gather information by inquiring of management
and considering fraud risk factors.
US classes
Slide 2US.62
The occurrence of illegal acts

• Both ISA 250 and most national regulators state that
the auditor’s responsibility in this area is restricted to
designing and executing the audit in such a way that
there is a reasonable expectation of detecting
material illegal acts which have a direct impact on
the form and content of the financial statements.
• The professional regulations in some countries
require the auditor to inform members of the audit
committee or board of directors.
Slide 2US.63
Responses to accounting controversies
In response to the controversies there have been

in two landmark studies (the COSO Report and the
Cadbury Report which lead to the Combined Code
and the Turnbull Report) and most recently have
been legislated into the US accounting profession
by the Sarbanes–Oxley Act of 2002.
Slide 2US.64
COSO report
The COSO report was published by the Committee
of Sponsoring Organizations of the Treadway
Commission. The COSO report envisaged:
1.harmonising the definitions regarding internal control
and its components;
2.helping management in assessing the quality of
internal control;
3.creating internal control benchmarks, enabling
management to compare the internal control in their
own company to the state-of-the-art;
4.creating a basis for the external reporting on the
adequacy of the internal controls.
Slide 2US.65
Combined Code UK
• In 1998 London Stock Exchange published a new
Listing Rule together with related Principles of
Good Governance and Code of Best Practice
(called ‘the Combined Code’).
• The combined code combines the
recommendations of the so-called Cadbury,
Greenbury, and Hampel committees on corporate
governance.
Slide 2US.66
The Sarbanes–Oxley Act of 2002

Restrictions on auditors
• Auditors must report to the audit committee.
• The lead audit partner and audit review partner
must be rotated every five years.
• A second partner must review and approve audit
reports.
• It is a felony with penalties of up to 20 years in
jail to willfully fail to maintain ‘all audit or review
work papers’ for seven years.
• Auditors are prohibited from offering certain
information system and accounting services.
Slide 2US.67
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2a AI The Audit Market

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Slide 2US.

Principles of Auditing: An Introduction to

Chapter 2 – The Audit Market

Rick Hayes, Hans Gortemaker

• Management controls the accounting systems,

Demand for audit services explained by

Although there is regulation around the world,

The International Forum of Independent

In the United States who supervises auditing rules

Created by the Sarbanes–Oxley Act of 2002

PCAOB’s audit standards

PCAOB’s audit standards – US classes

PCAOB’s audit standards – US classes

PCAOB audit standard # 1: References in auditors’ reports

Report of independent Registered Public Accounting Firm

We conducted our audits in accordance with the standards of the

PCAOB audit standard # 3: Audit documentation

(#3) This standard establishes general requirements for

PCAOB audit standard # 4: Reporting on whether a

Establishes requirements and provides direction that

Report of Independent Registered Public Accounting Firm

PCAOB audit standard # 5: An audit of internal control over financial

(#5) This standard establishes requirements when an auditor is

Report of Independent Registered Public Accounting Firm on Internal Control

(2) provide reasonable assurance that transactions are recorded as necessary to

PCAOB audit standard # 6: Evaluating consistency of

PCAOB audit standard # 7: Engagement quality review

(#7) An engagement quality review and concurring

PCAOB audit standard # 8: Audit risk

(#8) This standard discusses the auditor’s

PCAOB audit standard # 9: Audit planning

(#9) Establishes requirements regarding planning

PCAOB audit standard # 10: Supervision of the audit

PCAOB audit standard # 11: Consideration of materiality

(#11) Establishes requirements regarding the auditor's

PCAOB audit standard # 11: Consideration of materiality

(#11) To obtain reasonable assurance about whether

PCAOB audit standard # 12: Identifying and assessing

(#12) Establishes requirements regarding the process

PCAOB audit standard # 12: Identifying and assessing

PCAOB audit standard # 13: The auditor’s responses to

(#13) Establishes requirements regarding designing

PCAOB audit standard # 14: Evaluating audit results

Establishes requirements regarding the auditor’s evaluation of audit

PCAOB audit standard # 15: Audit evidence

(#15) Explains what constitutes audit evidence and

PCAOB audit standard # 15: Audit evidence (Continued)

(#15) Sufficiency is the measure of the quantity of

PCAOB audit standard # 16: Communications with audit

PCAOB audit standard # 16: Communications with

PCAOB audit standard # 16: Communications with

(#16) Critical accounting estimates

PCAOB audit standard # 16: Communications with

PCAOB audit standard # 16: Communications with

Current standard-setting and related

List of PCAOB temporary standards

Big Four firms and non-Big Four

Legal liability of the auditor

Common Law Ultramares – Touche case

Caparo Industries, PLC vs. Dickman

Civil liability under statutory law

Sarbanes–Oxley Act of 2002 civil penalties for

Criminal liability under statutory law