Auditing Implications of COVID-19
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Lesson2Slides.pptx
Auditing & Assurance Services 8e Chapter 2
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Chapter 02
Professional Standards
“In today’s regulatory environment, it’s virtually impossible to violate rules.”
– Bernard Madoff, money manager, approximately one year prior to being arrested for embezzling $50 billion from investors in a Ponzi scheme.
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History of Professional Standards-Setting
AICPA Auditing Standards Board: Non-issuers (Nonpublic entities)
Statements on Auditing Procedure (1939 – 1972)
Statements on Auditing Standards (1972 – current)
PCAOB: Issuers (Public entities)
Auditing Standards
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Overview
GAAS and Principles
Responsibilities
Performance
Reporting
Quality of Public Accounting Firms’ Practices
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Generally Accepted Auditing Standards
Identify necessary qualifications and characteristics of auditors and guide the conduct of the audit
Purpose of GAAS is to achieve the following objectives of an audit examination
Obtain reasonable assurance about whether financial statements are free of material misstatement
Report on the financial statements and communicate in accordance with auditor’s findings
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Watch more detailed explanation on these standards (Video 2-A)
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In this chapter, we look at Generally Accepted Auditing Standards, or GAAS in short. It sounds similar to GAAP, only that the second A in GAAP is accounting whereas in GAAS, it is auditing. When management prepares financial statements, their reporting should conform to GAAP. When auditors conduct an audit of those financial statements, auditors should conform to GAAS.
As you saw on page 3, there are two organizations that write these auditing standards. For decades, AICPA Auditing Standard Board had been the only one who write these standards, but in 2002, a new agency called PCAOB was founded to oversee the audits of public companies, and they started to write auditing standards for public company audits. That means an auditor has to conform to AICPA standards when they audit a private company and follow PCAOB standards when they audit a public company.
Components of GAAS
Fundamental Principles
(Guide general conduct of audits)
PCAOB Auditing Standards and ASB Statements on Auditing Standards
(Requirements supporting principles)
Interpretive Publications
(Guide application of GAAS)
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I will let you read about the overview of GAAS on your own, but I wanted to explain these fundamental principles of GAAS further in this video. These are concepts that are very important, and will come up frequently throughout the course.
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Engagement Overview and Principles
OBTAIN
(OR RETAIN)
CLIENT
RISK
ASSESSMENT
AUDIT
EVIDENCE
REPORTING
ENGAGEMENT
PLANNING
Responsibilities: Professional skepticism, Professional judgment, Due care
Performance
Reporting
Responsibilities: Competence and capabilities, Independence
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Overview
GAAS and Principles
Responsibilities
Performance
Reporting
Quality of Public Accounting Firms’ Practices
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Fundamental Principles of GAAS consists of three components: Responsibilities, Performance, and Reporting. Let’s start with responsibilities.
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Responsibilities Principle
Competence and capabilities
Experience and expertise
Independence
Independence in fact vs. independence in appearance
Financial and managerial relationships
Due care
Level of performance by reasonable auditor in similar circumstances
Professional skepticism and judgment
Skepticism: Appropriate questioning and critical assessment of evidence
Judgment: Application of training, knowledge, and experience in making informed decisions during audit
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These are the responsibilities of individuals who performs financial statement audits.
First, the individuals should be equipped with competence and capabilities that are necessary for auditors. That is why auditors can be licensed only when they have passed CPA exams and have a certain amount of relevant experiences.
Second, auditors should be independent. Remember the purpose of auditing we discussed in chapter 1? Information users have auditors examine financial statements because they need an independent body to assure that these financial statements are not materially misstated. If auditors are not independent from the client company or the management of the company, the assurance auditors provide does not mean anything. When we say independence, we are not only talking about auditors’ actual mindset toward clients, but also whether auditors do not have any ties to the client and ‘look’ independent. We will talk about this more next week in Lesson 3, Module B, Professional Ethics.
And auditors have to adhere to the required audit process and deliver a certain level of performance expected from a reasonable auditor, and exercise professional skepticism and judgements. We talked about the concept of professional skepticism last week in chapter 1.
Overview
GAAS and Principles
Responsibilities
Performance
Reporting
Quality of Public Accounting Firms’ Practices
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Next principle to see, performance.
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Performance Principle
Goal is to provide reasonable assurance that financial statements do not contain material misstatements
Planning and supervision
Preparation of audit plan
Materiality
Influences decisions of financial statement users
Considered throughout the audit
Risk assessment
Understand entity and environment (including internal control)
Determine necessary effectiveness of substantive tests
Audit evidence
Sufficient = quantity (How many transactions or components?)
Appropriate = quality (What level of reliability needed? Source?)
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The goal of any audit is to provide reasonable assurance. What does that mean? You can compare this with ‘absolute assurance’. If auditors were to provide absolute assurance, auditors should chase every misstatement to a dollar. But unfortunately, auditors do not have that kind of time or resources. And clients would not want to pay for that much of auditors’ time either. And no company would be able to meet the filing deadline.
So auditors provide reasonable assurance by making a plan to conduct an audit, focusing on areas that are especially risky, meaning that there is a higher probability of misstatements in those areas, and auditors focus on discovering ‘material’ misstatements. This is where I want you to refer to the vignette we watched last week, ‘Auditing is a People Business’. There, auditors and the client both talked about how they wanted to resolve this marketing expense issue before the earnings announcement call, although the amount is ‘not material’. Remember?
Whether something is material in financial reporting is decided by whether that issue makes any difference in decision making of an information user. I will use Microsoft’s 10-K, that we looked at last week, as an example.
[MS’s income statement]
This is this year’s income statement of Microsoft. It looks like they reported the total revenue of 143 billion dollars. So what if it turns out that they actually overstated the revenue by 1 million and the true amount of revenue should have been 1 million dollars less than what we see in this report? It would make absolutely no difference for investors. Right? What is 1 million when the total number is 143 billions? In this case, we can say 1 million dollars of misstatement is NOT MATERIAL, and auditors would not insist that the management should adjust the revenue balance.
[MS audit report]
This is the auditor’s report of Microsoft we saw last week. So when auditors say they believe the financial statements of Microsoft is not materially misstated, they are saying there could be some immaterial misstatements that have not been corrected. Auditors are only responsible to detect material misstatements.
Also, while we are at it, let’s look at the second section once more. Here we can see that auditors conform to PCAOB auditing standards. If this was an audit report for a private company, this sentence would have said that ‘We conducted our audit in accordance with GAAS’ and wouldn’t have mentioned PCAOB.
[Go back to page 11]
Lastly, when conducting audit procedures, auditors should obtain sufficient and appropriate audit evidence. Remember in chapter 1, when I was explaining professional skepticism, I said that auditors must always obtain evidence and not take the client’s words for anything?
Overview of Evidence
Detection Risk
Sufficiency (Quantity of Evidence)
Relevance (What Does Evidence Tell the Auditor?)
Reliability (Can the Auditor Trust the Evidence?)
Appropriateness (Quality of Evidence)
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But actually how sufficient and appropriate each evidence should be can vary depending on clients, accounts, or assertions. We will talk about this detection risk and others in Lesson 6, chapter 4, when we look at audit risk, so I won’t be explaining this in too much detail here. Just keep in mind that auditors should consider both quantitative and qualitative aspect of audit evidence.
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Sufficient evidence
Related to quantity (number of transactions or components examined)
Influenced by effectiveness of entity’s internal control
| Effective internal control | Lower level of control risk | Evaluate less evidence | ||
| Ineffective internal control | Higher level of control risk | Evaluate more evidence |
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Quantitative aspect is about how many observations auditors should obtain. Let’s say auditors want to examine whether revenue transactions were properly recorded. Auditors should decide how many transactions they want to look at, because it is usually impossible to look at all transactions occurred that year. And when the auditors already know that the client has good internal control system in place, auditors can decide to examine fewer observations because they know that this client is not that risky and the probability of misstatements is relatively low.
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Appropriate Evidence
Relates to the quality of evidence
Relevance: Does evidence address assertion(s) of interest?
Reliability: Source of evidence
Auditors’ direct personal knowledge
External documentary evidence
Internal documentary evidence
High
Low
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Appropriateness of evidence is about relevance and reliability. How does this piece of evidence directly support the transaction auditors want to examine? That is relevance. How do auditors know the evidence is not fake? That is reliability.
Usually, evidence auditors obtained directly from external parties, like the client’s bank, is more reliable than a sales invoice created ‘by’ the client.
Also, if auditors calculated the investment losses by directly obtaining market value of investment securities from Wall street journal, that would be the most reliable compared to any other evidence that supports that loss amount.
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Summary: Appropriateness of Evidence
| Effective internal control | Lower level of control risk | Use less effective substantive procedures | ||
| Ineffective internal control | Higher level of control risk | Use more effective substantive procedures |
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Similarly to quantitative aspect of evidence, how relevant and reliable the audit evidence should be can vary depending on how good the client’s internal control system is and therefore, how risky the client is. We will revisit this relationship between controls and the type of evidence in lesson 6, chapter 4.
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Overview
GAAS and Principles
Responsibilities
Performance
Reporting
Quality of Public Accounting Firms’ Practices
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Reporting Principle
Express an opinion (or indicate that an opinion cannot be expressed) on entity’s financial statements
Assess financial statements against financial reporting framework
Set of criteria used to determine the measurement, recognition, presentation, and disclosure of material items in the financial statements
Examples include GAAP, IFRS, or special purpose framework
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Independent Auditors’ Report NEW! (AS3101 – Click HERE)
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Title (Report of Independent Registered Public Accounting Firm)
Addressee: Board of Directors and Shareholders
Opinion on the Financial Statements
Conducted audits of financial statements and internal control over financial reporting
Opinions on financial statements and internal control over financial reporting
Basis for Opinion
Responsibility of management and auditors for financial statements
Description of audit conducted under PCAOB standards
Critical audit matters
Material accounts and disclosures
Challenging, subjective, or complex judgments
Other
Signed by firm
Identify office of firm and date audit completed
Identify auditor tenure
Watch more detailed explanation on auditors’ reports and audit opinions (Video 2-B)
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In this video, we will talk about what the standard auditor’s report looks like and deviations auditor’s reports can take from this standard form, and when that deviation takes place.
What you see on this page is how an audit report is structured for an issuer, a public company. The private company’s audit report looks a little different, because it follows AICPA auditing standards.
This structure is relatively new. PCAOB issued an auditing standard, AS 3101 that includes a number of changes and new requirements for audit reports. This week, you have an assignment related to that. Read more detailed instruction on the Blackboard lesson page, but basically you’ll need to compare an audit report issued for the fiscal year ended before December 2017 to another audit report that is issued for the fiscal year ended after June 2019, and discuss the differences. The length of the write-up does not affect your grade as long as you discuss all the significant changes.
This section ‘critical audit matters’ in particular is a requirement only for ‘large accelerated filer’ companies at this point, and the rest of the public companies ‘will’ include this paragraph from fiscal years ending on or after Dec. 15, 2020. So make sure you use one of the largest companies as an example so that the critical audit matters paragraph is included in the 2019 audit report that you are using for this assignment.
Types of Audit Opinions (click each opinion for an example)
F/S are in conformity with GAAP
Qualified
(due to non-conformity with GAAP or Scope Limitation)
Except for limited items, F/S are in conformity with GAAP
F/S are not in conformity with GAAP
Auditors do not express an opinion
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Now we will look at different types of audit opinions. The most common type of audit opinion is unmodified or unqualified standard opinion. It means the opinion paragraph is not modified from the standard form. I found that a lot of students hear ‘unqualified’ opinion and automatically think that it is a negative opinion, but here, unqualified is a merely synonym for unmodified. So unqualified opinion is a good thing. It means auditors did not find any material misstatement. The opinion in the Microsoft audit report I showed you in the previous video is an example of an unmodified/unqualified opinion.
But if there was a material misstatement, or there was a section of the financial statements that auditors could not examine, maybe because the records had been damaged or for some other reasons, auditors issue a qualified opinion. If you click on these two links for qualified opinions, you can see examples.
[Go to qualified opinion for departure from GAAP example]
You can recognize that it is a qualified opinion by finding this ‘except for’ clause in the opinion. Basically, auditors are saying most of the financial statements looked fine, except for one particular area. Here, auditors claim that the uncollectible receivables should have been included as 2019 loss rather than 2020 loss and that is a material misstatement.
[Go to qualified opinion for scope limitation example]
And as I said, auditors can issue a qualified opinion for a different reason. Here auditors had to issue a qualified opinion because auditors could not participate in a physical inventory count for some reason. Inventory count is one of the most important audit procedure on inventory, and without that procedure, auditors might not be able to provide assurance on inventory balance, which was the case here. So auditors are saying that, on other areas of financial statements, they are providing am unqualified opinion, but for this particular account of inventory, auditors are refusing to issue either a positive or negative opinion.
[Back to page 19]
Also, it is not that departure from GAAP always results in a qualified opinion. When the misstatement can be isolated to a certain area and the issue is not that pervasive, auditors issue a qualified opinion. But, if the problem affects a large area of financial statements, auditors cannot say, anymore, everything is fine except for this one thing. In that case, the opinion to issue is an ‘adverse opinion’. If the auditors decide to issue an adverse opinion…
[Go to adverse opinion example]
They are saying the financial statement of this company is ‘misstated’ as a whole, period. You won’t see this type of audit report for public companies because if a company receives this kind of opinion from their auditors, the company cannot file their annual report with SEC anymore. That means, while this type of opinion can be issued, it won’t be available to the public because SEC would not have that annual report.
[Back to page 20]
The last type of audit report is disclaimer of opinion. This type of opinion is related to qualified opinion due to scope limitation.
In the case of qualified opinion, we saw that auditors could audit everything except for inventory. And inventory was viewed to be material but the number is not a significant portion of the total asset. But there could be situations where inventory was the largest and most important asset in the company. Then, this scope limitation becomes not only material, but also a pervasive problem for the audit. Or sometimes, management may refuse to provide important documents that auditors need to see, claiming it is classified information that nobody outside the company can see. In these cases, auditors can decide that the problem is too big to just isolate as a separate issue, and publish a disclaimer of opinion.
[Go to Disclaimer of Opinion example]
Then auditors would say that they were engaged to audit the financial statements of this company but due to this material AND pervasive problem, they were not able to form an opinion, which means they could not finish the audit. That is why the first sentence of the report looks different.
[Back to page 19]
We are going to look at these types of opinions and also different types of audit reports in more detail at the end of this course, Lesson 15, Chapter 12. So if you want to read more about this topic now, it may be a good idea to take a look at chapter 12 of the textbook.
Overview
GAAS and Principles
Responsibilities
Performance
Reporting
Quality of Public Accounting Firms’ Practices
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System of Quality Control
Audit firms routinely take actions to ensure their work is of high quality and meets the professional standards discussed in this chapter.
A system of quality control provides the firm with reasonable assurance that the firm and its personnel
Comply with professional standards and regulatory/legal requirements
Issue reports that are appropriate in the circumstances
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Elements of System of Quality Control
Leadership responsibilities for quality within the firm (“tone at the top”)
Relevant ethical requirements
Acceptance and continuance of client relationships and specific engagements
Human resources
Engagement performance
Monitoring
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Public Company Accounting Oversight Board (PCAOB)
In addition to establishing auditing standards, PCAOB monitors the quality of work done by public accounting firms through inspections
Firms auditing > 100 issuers: inspected annually
Firms auditing ≤ 100 issuers: inspected every 3 years
Inspection reports list deficiencies in audits conducted by registered firms (available to the public)
(http://pcaobus.org/Inspections/Reports/Pages/default.aspx)
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Report Examples
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Report on the Audit of the Financial Statements
Opinion
We have audited the financial statements of Dunder-Mifflin, Inc., which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.
In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of Dunder-Mifflin, Inc. as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Opinion
Responsibilities of Management for the Financial Statements
Auditor’s Responsibilities for the Audit of the Financial Statements
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Opinion Section
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Report on the Audit of the Financial Statements
Opinion
Basis for Opinion
We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of Dunder-Mifflin, Inc. and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.
Responsibilities of Management for the Financial Statements
Auditor’s Responsibilities for the Audit of the Financial Statements
Basis for Opinion Section
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Report on the Audit of the Financial Statements
Opinion
Basis for Opinion
Responsibilities of Management for the Financial Statements
Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.
In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about Dunder-Mifflin, Inc.’s ability to continue as a going concern for one year following the issuance of the financial statements.
Auditor’s Responsibilities for the Audit of the Financial Statements
Responsibilities of Management Section
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Report on the Audit of the Financial Statements
Opinion
Basis for Opinion
Responsibilities of Management for the Financial Statements
Auditor’s Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users made on the basis of these financial statements.
In performing an audit in accordance with GAAS, we:
[DETAIL OMITTED]
We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control–related matters that we identified during the audit.
Auditor’s Responsibilities Section
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Report on the Audit of the Financial Statements
Qualified Opinion
No revisions to first paragraph
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of Dunder-Mifflin, Inc. as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Qualified Opinion
As discussed in Note 16, an additional provision in the amount of $30,000,000 for possible uncollectible receivables at December 31, 2019, was charged to operations during the year ended December 31, 2020, which, in our opinion, should have been reflected in the financial statements for 2019. Had this provision been properly recorded in the 2019 financial statements, Dunder-Mifflin, Inc. would have reported net earnings of $700,000 for the year ended December 31, 2020, rather than the net loss of $29,300,000 as reflected in the statements of income, changes in shareholders’ equity, and cash flows for that period.
We conducted our audit in accordance with auditing standards...We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion.
Responsibilities of Management for the Financial Statements
Auditor’s Responsibilities for the Audit of the Financial Statements
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Departure from GAAP: Qualified Opinion
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Report on the Audit of the Financial Statements
Adverse Opinion
No revisions to first paragraph
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion section of our report, the accompanying financial statements do not present fairly [omit phrase "in all material respects"] the financial position of Dunder-Mifflin, Inc. as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Adverse Opinion
As discussed in Note 16, an additional provision in the amount of $30,000,000 for possible uncollectible receivables at December 31, 2019, was charged to operations during the year ended December 31, 2020, which, in our opinion, should have been reflected in the financial statements for 2019. Had this provision been properly recorded in the 2019 financial statements, Dunder-Mifflin, Inc. would have reported net earnings of $700,000 for the year ended December 31, 2020, rather than the net loss of $29,300,000 as reflected in the statements of income, changes in shareholders’ equity, and cash flows for that period.
We conducted our audit in accordance with auditing standards...We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our adverse audit opinion.
Responsibilities of Management for the Financial Statements
Auditor’s Responsibilities for the Audit of the Financial Statements
Departure from GAAP: Adverse Opinion
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Report on the Audit of the Financial Statements
Qualified Opinion
No revisions to first paragraph
In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of Dunder-Mifflin, Inc. as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Qualified Opinion
Dunder-Mifflin, Inc. did not make a count of its physical inventory in 2020, stated in the accompanying financial statements at $10,000,000 at December 31, 2020, and we were unable to observe the physical quantities on hand. Dunder-Mifflin, Inc.’s records do not permit the application of other auditing procedures to the audit of inventories. Consequently, we were unable to determine whether any adjustments to these amounts were necessary.
We conducted our audit in accordance with auditing standards...We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion.
Responsibilities of Management for the Financial Statements
Auditor’s Responsibilities for the Audit of the Financial Statements
Scope Limitation: Qualified Opinion
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Report on the Audit of the Financial Statements
Disclaimer of Opinion
We were engaged to audit the financial statements of Dunder-Mifflin, Inc., which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.
We do not express an opinion on the accompanying financial statements of Dunder-Mifflin, Inc. Because of the significance of the matter described in the Basis for Disclaimer of Opinion section of our report, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on the financial statements.
Basis for Disclaimer of Opinion
Dunder-Mifflin, Inc. did not make a count of its physical inventory in 2020, stated in the accompanying financial statements at $10,000,000 at December 31, 2020, and we were unable to observe the physical quantities on hand. Dunder-Mifflin, Inc.’s records do not permit the application of other auditing procedures to the audit of inventories. As a result, we were unable to determine whether any adjustments were necessary related to Dunder-Mifflin, Inc.’s physical inventories and the elements making up the balance sheet and statements of income, changes in stockholders’ equity, and cash flows.
Standard paragraph deleted
Responsibilities of Management for the Financial Statements
Auditor's Responsibilities for the Audit of the Financial Statements
Our responsibility is to conduct an audit of Dunder-Mifflin, Inc.’s financial statements in accordance with auditing standards generally accepted in the United States of America and to issue an auditor’s report. However, because of the matter described in the Basis for Disclaimer of Opinion section of our report, we were not able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements.
We are required to be independent of Dunder-Mifflin, Inc. and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit.
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Scope Limitation: Disclaimer of Opinion
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