The Audit Market: Principles of Auditing: An Introduction To International Standards On Auditing - Ch. 2

Slide 2.
The Audit Market

Principles of Auditing: An Introduction to
International Standards on Auditing - Ch. 2
Rick Stephan Hayes,

Roger Dassen, Arnold Schilder,
Philip Wallage
[Hayes, Dassen, Schilder and Wallage, Principles of Auditing An Introduction to ISAs, edition 2.1] © Pearson Education Limited 2007
Slide 2.2
Demand for audit services explained by several

different theories:
The Policeman Theory

The Lending Credibility Theory
The Theory of Inspired Confidence
Agency Theory
Slide 2.3
Agency Theory
• a reputable auditor is appointed in the

interest of third parties and of
management.
• 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'.
• agent 'management' has a considerable
advantage over the principals regarding
information about the company.
Slide 2.4
Audit Regulation
• The Sarbanes-Oxley Act of 2002 required the

U.S. Securities and Exchange Commission
(SEC) to create a Public Company Accounting
Oversight Board (PCAOB).
• In Australia, the Corporate Law Economic
Reform Program Act 1999 established a new
body, the Financial Reporting Council (FRC)
• The Review Board Limited in the UK whose work
is being transferred to the UK Financial Reporting
Council
• Public Interest Oversight Board founders include:
Basel Committee, IOSCO, IAIS, World Bank,
Financial Stability Forum (FSF) and EU.
Slide 2.5
Who supervises Auditing

rules and Auditing Firms?
Public Company
Accounting Oversight
Board (PCAOB)
Created by the Sarbanes-
Oxley Act of 2002
Slide 2.6
PCAOB’s Audit Standards (Not in Text)
• PCAOB Audit Standard No.

1 Reference in Audit
Report
• PCAOB Audit Standard No.
2 Internal Control
• PCAOB Audit Standard No
3 Audit Documentation
• PCAOB Audit Standard No
4 Reported Weakness
Continues
Slide 2.7
Key Provisions of Audit Standard No. 2 (Not in Text)
1. Evaluating Management's Assessment

2. Obtaining an Understanding of Internal Control
Over Financial Reporting, Including Performing
Walkthroughs
3. Identifying Significant Accounts and Relevant
Assertions
4. Testing and Evaluating the Effectiveness of the
Design of Controls
5. Testing Operating Effectiveness
6. Timing of Testing
7. Using the Work
8. of Others
Slide 2.8
Key Provisions of Audit Standard No. 2
8. Evaluating the Results of Testing

9. Identifying Significant Deficiencies
10. Forming an Opinion and Reporting
11. No Disclosure of Significant Deficiencies
12. Material Weaknesses Result in Adverse
Opinion on Internal Control
13. Testing Controls Intended to Prevent or
Detect Fraud
Slide 2.9
Who used to make

auditing rules in the
U.S.?
the Auditing Standards Board

Slide 2.10
Big Four Firms & Non-Big Four
• Deloitte, Ernst & Young, KPMG,

PricewaterhouseCoopers
• Second Tier – Grant Thornton; BDO Seidman;
McGladrey & Pullen; Moss Adams; Myer,
Hoffman & McCann; Crowe Group, American
Express, BKD
Slide 2.11
Technical and Functional Audit Quality
Technical audit quality is the degree to which

an audit meets a consumer's expectations
with regard to the detection and reporting of
errors and irregularities – kualitas dari
dampak proses audit ( the quality of the
outcome of the audit process) .
Functional audit quality is the degree to
which the process of carrying out the audit
and communicating its results meets a
consumer's expectations – proses audit itu
sendiri ( the process itself ) .
Slide 2.12
Important determinants Audit Fees

of audit fees are:
$ the size of the auditee
and the geographical
dispersion;
$ the size of the audit firm
(Big Four firms seem to
demand a fee premium);
$ the quality of the
auditee's internal control
system;
$ the type of fee contract
(fixed fee versus variable
fee).
Slide 2.13
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, and
 liability for members of professional
accounting organizations.
Slide 2.14
Common Law Ultramares - Touche case (Ultramares Corporation

v 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.
Slide 2.15
Civil Liability Under Statutory

Law
• The Securities Act of 1933 established the first U.S.

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 all that the
loss of the purchaser of securities (plaintiff) was caused
by factors other than the misleading financial statements.
Slide 2.16
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 v. Natelli
(1975)* United States v. Weiner (1975) * ESM
Government Securities v. Alexander Grant &
Co. (1986).
Slide 2.17
Liabilities as Members of Professional

Organizations
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.
Slide 2.18
In order to hold the auditor successfully legally liable in a civil

suit, the following conditions have to be met:
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 her losses
and the alleged audit failure
(causation issue)
The plaintiff must quantify her
losses (quantum issue).
Slide 2.19
Suggested Solutions to Auditor Liability
 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.
 Some countries (e.g. Germany) have put a
legally determined cap on the liability of
auditors (to the client in the case of Germany).
 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).
Slide 2.20
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; and
• the occurrence of illegal acts.
Slide 2.21
Company's Internal Control (not in Text)
Section 404 of the Sarbanes-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, and
(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 authorization, 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
Slide 2.22
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 2.23
US Fraud Standard
• 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 consider ing
fraud risk factors
Slide 2.24
The Occurrence of Illegal Acts
 Both ISA 250 and most national regulators

state that the auditor's responsibility 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 2.25
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 2.26
COSO Report
The COSO report was published by the Committee
of Sponsoring Organizations of the Treadway
Commission. The COSO report envisaged:
1 harmonizing 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; and
4 creating a basis for the external reporting on the
adequacy of the internal controls.
Slide 2.27
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 2.28
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 10 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 2.29
Thank You for Your Attention
Any Questions?

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Slide 2.

The Audit Market

Rick Stephan Hayes,

Demand for audit services explained by several

The Policeman Theory

• a reputable auditor is appointed in the

• The Sarbanes-Oxley Act of 2002 required the

Who supervises Auditing

PCAOB’s Audit Standards (Not in Text)

• PCAOB Audit Standard No.

Key Provisions of Audit Standard No. 2 (Not in Text)

1. Evaluating Management's Assessment

Key Provisions of Audit Standard No. 2

8. Evaluating the Results of Testing

Who used to make

the Auditing Standards Board

Big Four Firms & Non-Big Four

• Deloitte, Ernst & Young, KPMG,

Technical and Functional Audit Quality

Technical audit quality is the degree to which

Important determinants Audit Fees

Legal liability of the auditor

varies from country to country, district to

Common Law Ultramares - Touche case (Ultramares Corporation

the accountants were negligent for not finding

Civil Liability Under Statutory

• The Securities Act of 1933 established the first U.S.

Criminal Liability Under Statutory Law

The Securities Exchange Act of 1934 in the

Liabilities as Members of Professional

Nearly all national audit professions have some sort of

In order to hold the auditor successfully legally liable in a civil

An audit failure/neglect has to be

Suggested Solutions to Auditor Liability

 A system of proportionate liability - an audit

Audit Expectations with regard to the

• the fairness of financial statements;

Company's Internal Control (not in Text)

Section 404 of the Sarbanes-Oxley Act requires each annual

The Occurrence of Fraud

• Auditing Standard Number 99

The Occurrence of Illegal Acts

 Both ISA 250 and most national regulators

Responses to Accounting Controversies

In response to the controversies there have been in

• In 1998 London Stock Exchange published a

The Sarbanes-Oxley Act of 2002 Restrictions on Auditors

Auditors must report to the audit committee

Thank You for Your Attention

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