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Chapter 2

THE FINANCIAL STATEMENT

AUDITING ENVIRONMENT

LEARNING OBJECTIVESUpon completion of this chapter you will

Understand the events that led up to the recent change and turmoil in the auditingprofession.

Recognize that auditing takes place in a context that is shaped largely by the auditclient’s business.

Understand a high-level model of a business entity, including the elements ofcorporate governance, objectives, strategies, processes, controls, transactions, andfinancial statements.

Be familiar with a five-component model of business processes (or cycles) that auditorsoften use in organizing the audit into manageable components.

Recognize the sets of management assertions that are implicit in a business entity’sfinancial statements.

Understand the role of the International Auditing and Assurance Standards Board(IAASB).

Be aware of the widespread use and influence of the International Standards onAuditing (ISAs) issued by IAASB, including that the European Union (EU) is expected torequire the use of the ISAs for all statutory audits.

Be familiar with the structure of the standards issued by IAASB.

Understand the nature and structure of the ISAs.

Understand that auditing is a profession that places a premium on ethical behaviourand that is internationally governed by the IFAC Code of Ethics for ProfessionalAccountants.

Know that management is primarily responsible for the entity’s financial statementsand understand the auditor’s responsibility for detecting errors and material fraud.

Know the basic elements of audit reporting.

Understand the organization and composition of audit firms.

Be familiar with the various services offered by assurance providers.

Be familiar with the different types of auditors.

Identify and be familiar with the major international organizations that affect theaccounting profession’s environment.

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THIS CHAPTER covers the context, or environment, in which auditors function. It starts byproviding an overview of the events leading up to the recent turmoil in the accountingprofession. One of the most important and useful skills auditors develop is the ability toquickly understand and analyse various business models, strategies, and processes, and toidentify key risks relevant to a particular client. Accordingly, the chapter introduces a high-level model of business and then offers a model of business processes that is useful fororganizing an audit. The chapter then expands on the concept of management assertionsintroduced in Chapter 1 and introduces the International Standards on Auditing (ISAs),explaining how these standards are established and structured. Ethical behaviour andreputation play key roles in shaping the accounting profession and its environment, and thechapter explains that the auditing profession worldwide is governed by the InternationalFederation of Accountants’ (IFAC) Code of Ethics for Professional Accountants.Management’s primary responsibility for the financial statements is then discussed, along withthe auditor’s responsibility to provide reasonable assurance. Because the reportingrequirements shape the way auditors perform their work, the basic elements of audit reportingare then introduced to provide an initial understanding of the output of the audit process. Thechapter discusses audit firms and the major categories of services they offer and introduces thevarious types of auditors other than financial statement auditors. The chapter concludes with adiscussion of the major organizations that affect the accounting profession and itsenvironment worldwide.

A TIME OF CHALLENGE AND CHANGE FOR AUDITORSThe professional and regulatory environment in which financial statement auditors work hasbeen dramatically reshaped by the events taking place in the business world during the firstfew years of this new century. In fact, the profession is going through a period of almostunprecedented change. Changes in regulation, public oversight, and professional standardshave put great pressure on the profession. The responsiveness of the profession to the needs ofthe public, investors, and regulators is a key to restore public confidence in financial reporting.This section briefly discusses some of the issues and controversies that led up to the manychanges experienced by the profession. While the profession has undergone profound changes,the events of the last few years have served to solidify the crucial role of accounting andauditing.

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RELEVANT ACCOUNTING AND AUDITING PRONOUNCEMENTSIAASB, International Framework for Assurance Engagements

ISA 200, Objective and General Principles Governing an Audit of Financial Statements

ISA 240, The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements

ISA 315, Understanding the Entity and Its Environment and Assessing the Risks of MaterialMisstatement

ISA 500, Audit Evidence

ISA 700 (Revised), The Independent Auditor’s Report on a Complete Set of General PurposeFinancial Statements

ISA 700, The Auditor’s Report on Financial Statements

ISA 701, Modifications to the Independent Auditor’s Report.

ISA 705, Exposure Draft, Modifications to the Opinion in the Independent Auditor’s Report

ISA 706, Exposure Draft, Emphasis of Matter Paragraphs and Other Matters Paragraphs in theIndependent Auditor’s Report

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Problems and Warning SignsDuring the economic boom of the late 1990s and early 2000s, audit firms aggressively soughtopportunities to market a variety of high-margin non-audit services to their audit clients. Theconsulting revenue of the largest audit firms grew extremely quickly, until in many instancesconsulting revenues from audit clients greatly exceeded the fee for the external audit.Exhibit 2�–�1 provides a sample of audit and non-audit fees reported in 2001.

During the same time period significant concern was raised that many companies wereinvolved in inappropriate earnings management and even fraud. For example, in September2001 the UK Auditing Standards Board (ASB) issued a Consultation Paper ‘AggressiveEarnings Management’. The Paper alerts directors, auditors, regulators, and users of financialstatements to the potential threat that increasing commercial and economic pressure maycause aggressive earnings management. Such pressure includes:

● Adverse market reactions to the share price of a listed entity when results fail to meet themarket’s expectations (which directors and management may have encouraged), whetheror not the expectations were reasonable.

● Directors and management’s incomes being highly geared to results and�or heavily supple-mented by stock options and other possibilities for large capital gains.

● The desire to understate profits to reduce taxation liabilities.● Legal and regulatory requirements to meet specific financial thresholds or ratios.● The need to ensure compliance with loan covenants or to pacify bankers.

Auditors were accused of directly or indirectly assisting management by not challengingmanagement’s actions. Specifically, the often massive provision of non-audit services to auditclients was perceived to pose significant threats to auditors’ objectivity.

Against this background auditors’ independence issues gained renewed focus both by theaudit firms, the auditors and their professional organizations; regulators and the public. Majoraudit firms started reorganizing their portfolio of non-audit services offered. The InternationalFederation of Accountants (IFAC) as well as the European Commission (EC) issued newrules on auditor independence. The new independence rules required the auditor to identifythreats to his or her independence, to consider safeguards that may mitigate the threats, andevaluate if the residual independence risk is appropriate. This conceptual framework approachwas supplemented by mandatory safeguards and prohibitions on providing certain services.(Chapter 19 discusses in detail the conceptual framework approach to independence.) Theprofession’s honest commitment in applying the threats and safeguards approach will bedecisive for any further regulation of the provision of non-audit services to audit clients.

An Explosion of ScandalsStarting in October 2001 with the failure of energy giant Enron once valued at $66 billion, aseries of high-profiled accounting scandals hit both the USA and Europe. The scandalsinvolved high-profiled major companies such as Adelphia, Ahold, Parmalat, Tyco, WorldCom,

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Exhibit 2�–�1 A Sample Disclosure of Audit and Non-audit Fees in 2001

Types of Fees (in k millions)

Company Auditor Statutory Audit Non-audit

Barclays PricewaterhouseCoopers 8 52BP Ernst & Young 24 59HBOS KPMG 11 36Shell KPMG/PricewaterhouseCoopers 18 32Vodafone Deloitte & Touche 6 34Unilever PricewaterhouseCoopers 16 76

Source: Annual reports 2001. Non-audit fees may include fees for audit-related services.

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and Xerox. In addition, serious questions were raised about the quality of corporategovernance, financial reporting, and�or auditors of a large number of other companies. InEurope such companies include: Independent Insurance and Equitable Life and Cable &Wireless (UK); Shell (the Netherlands and UK); Elan (Ireland); ABB (Switzerland); BBVAand Gescartera (Spain); Cirio (Italy); Lernout & Hauspie (Belgium); Skandia (Sweden);Alstom and Vivendi (France); and EM.TV and Kirch (Germany). Many other countries inEurope as well as in other parts of the world experienced similar cases, for example Kanebo(Japan), HIH Insurance (Australia), and SK Group (South Korea). The scandals also involvedglobal brokerage firms, investment banks, mutual funds, credit rating agencies, and majoraudit firms. The ‘unthinkable’ happened, one of the major audit firms, Arthur Andersen, wasforced out of business. Exhibit 2�–�2 illustrates how the dairy-food giant Parmalat, onceconsidered the jewel of Italian capitalism, became one of the largest frauds in history.

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Exhibit 2�–�2 The Parmalat Scandal

The Italian dairy giant Parmalat (Parmalat Finanziaria S.p.A.) was one of Europe’s largest and most globalcompanies. The company was founded by Calisto Tanzi in the 1960s in northern Italian city Parma. Parmalathad by 2003 grown global, selling long-lasting milk and other dairy products in 30 countries and employing36,000 people. The Tanzi family owned 51 per cent of the company. Parmalat was raising money by sellinghuge amounts of bonds to the public. Leading global banks such as Citicorp and Deutsche Bank were amongthe bond placers.

In December 2003 Parmalat had difficulty making a i150 million bond payment. This was alarming sinceParmalat had reported to hold a bank account in the Bank of America (BAC) of i3.95 billion through its off-shore subsidiary Bonlat. On 19 December BAC shocked by reporting that no such account existed. Parmalatwas forced into bankruptcy proceedings on 27 December 2003. The company’s shares and bonds becameworthless. The same day Parmalat’s founder and former CEO Tanzi was arrested on suspicion of fraud,embezzlement, false accounting, and misleading investors.

Until 1999 the Italian arm of second-tier international audit firm Grant Thornton was Parmalat’s principalauditor. (The Italian firm, Grant Thornton S.p.A., was expelled from the Grant Thornton International networkin January 2004, now trading as Italaudit S.p.A.) Following the Italian rule of mandatory rotation of auditingfirms every nine years, the Parmalat group switched to the Italian unit of Deloitte & Touche, Deloitte Italy, asprincipal auditor in 1999. Grant Thornton, however, continued to audit Parmalat subsidiaries, including thesubsidiary Bonlat where the scandal began.

When Grant Thornton audited the Bonlat bank account with BAC, the auditor received a letter on BAC let-terhead confirming the existence of the account. The confirmation letter, however, had been forged byParmalat. This prompted the questions if Grant Thornton acted properly in the confirmation process and ifDeloitte behaved properly as the group auditor.

The Italian prosecutors soon discovered that financial fraud had been going on for 15 years and that thecompany as of 30 September 2003 had understated its reported debt of i6.4 billion by at least e7.9 billion.Charges have also been made for fraudulent transfers of uncollectible and impaired receivables to ‘nominee’entities where their diminished or nonexistent value was hidden, fraudulent use of the same nominee entities tofabricate nonexistent financial operations intended to offset losses of its operating subsidiaries, and fraudulenttransfers of money to various businesses owned and operated by Tanzi family members. The charges reflect thatParmalat may have engaged in one of the largest and most brazen corporate financial frauds of history.

Parmalat continues operations under new management and under bankruptcy protection. The companyhas sued Credit Suisse First Boston (i250 million), Citigroup ($10 billion), UBS (e290 million), and DeutscheBank (e17 million). All the banks are contesting the cases. A law suit filed on 18 August 2004 in Illinois isseeking $10 billion in damages from the two audit firms, Deloitte & Touche and Grant Thornton. Both firmshave denied any wrongdoings.

Sources: ‘How Parmalat Went Sour’, Business Week (12 January 2004); ‘Statement on Behalf of Deloitte Italy Regarding Parmalat’, Deloitte (2004); ‘Europe’sCorporate Governance: Parma Splat’, Economist (15 January 2004); ‘Parmalat Files i250m Suit against CSFB’, Financial Times (20 August 2004); ‘Statement fromGrant Thornton International 18 August 2004’, Grant Thornton (2004); ‘Parmalat: All You Need to Know about the Collapse of the Italian Dairy Giant’, Guardian(6 October 2004); ‘SEC Charges Parmalat with Financial Fraud’, US Securities and Exchange Commission (2003); and ‘SEC Alleged Additional Violations by ParmalatFinanziaria, S.p.A., and Simultaneously Settles Civil Action’, US Securities and Exchange Commission (2004).

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In Europe, the Parmalat scandal effectively dampened the argument that the scandalscould be isolated to the USA.

The widespread nature and dimension of the scandals caused the public and investors todoubt the integrity of the entire system of corporate accountability, including the role ofauditors and the effectiveness of the audit process. This put great pressure on all participants inthe financial reporting process and the regulators to restore public confidence.

Regulatory PressureThe crucial function of auditing in the economy and its role of serving the public interest havefor a long time driven substantial government involvement and regulation of the auditingsector. The degree of regulation has varied between countries, from a fairly self-regulatedprofession to a strongly governmental regulated auditing sector. Individual countries andjurisdictions found their own balance of elements of self-regulation and regulation by thegovernment. Following the corporate scandals and the undermining of the public confidencein the financial reporting process, a reconsideration of the regulatory systems took place. Thishas generally resulted in stronger public oversight and stricter regulation. In some countriessuch as the USA, new legislation has effectively ended the era of ‘self-regulation’ for theprofession. For example, the setting of USA auditing standards is no longer with theprofession. Most countries rely on systems with elements of external monitored self-regulationof the profession, joint regulation by the profession and government regulatory bodies, andgovernment regulations. A clear shift, however, throughout the world towards strongerelements of external oversight and regulation of auditing is evident. In addition, the pressurefor international convergence of regulatory systems and standards has grown. As will beapparent from this text the International Standards on Auditing (ISAs) issued by theInternational Auditing and Assurance Standards Board (IAASB) has become more restrictive,public oversight over IAASB’s standard setting process has been strengthened and mandatoryapplication of the standards is expanding. The responsiveness of the profession to the needs ofthe public, investors, and regulators will be crucial for future regulatory measures.

Back to BasicsThe impact of the events of the past decade, including regulatory pressure on the profession,cannot be overemphasized. While the events and changes have caused pain and turmoil, theyhighlight the essential importance of auditing in the economic system. The regulatory andmarket pressures for improved financial reporting have forced the audit firms and the auditorsto refocus their effort once again on their core service: financial statements audits.

THE CONTEXT OF FINANCIAL STATEMENT AUDITINGThe first chapter explained why assurance is in demand, defined what auditing is and laid outthe phases through which financial statement auditing is carried out. This chapter is designedto help you understand the forces of change in the auditing profession as well as the overallbusiness and regulatory environment in which auditing operates.

Business as the Primary Context of AuditingThe context with which an auditor is concerned on a day-to-day basis is the industry orbusiness of his or her audit client(s). In studying subsequent chapters, you will be buildingyour auditing tool kit. How you apply auditing tools on any particular engagement will dependgreatly on the nature of the client’s business. For example, if you are auditing a computerhardware manufacturer, one of your concerns will be whether your client has inventories thatare not selling quickly and are becoming obsolete due to industry innovation. Such aninventory might not be properly valued on the client’s financial records. If you are auditing a

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jeweller, on the other hand, you will probably not be overly concerned with whether the clientpossesses warehouses full of obsolete diamonds – the possibility of a competitor producing a‘new model’ of diamond is probably not a serious threat in the diamond business. However,you would be interested in inventory valuation. You may need to hire a diamond appraiser toprovide objective evidence, and you would certainly want to keep up on the dynamics of theinternational diamond market. The point is that the context provided by the client’s businessgreatly impacts the auditor and the audit, and is thus a primary component of the environmentin which financial statement auditing is conducted. While every business is different, businessorganizations can be conceptualized or modelled in common ways. The next section describesthe essential characteristics of a business: governance; objectives; strategies; processes; risks;controls; and reporting.

A MODEL OF BUSINESSBusiness organizations exist to create value for their stakeholders. To form a businessenterprise, entrepreneurs decide on an appropriate organizational form (e.g. corporation orpartnership) and hire managers to manage the resources that have been made available to theenterprise through investment or lending.

Corporate GovernanceDue to the way resources are invested and managed in the modern business world, a system ofcorporate governance is necessary, through which managers are overseen and supervised.Simply defined, corporate governance consists of all the people, processes, and activities inplace to help ensure the proper stewardship over an entity’s assets. Corporate governance isthe implementation and execution of processes to ensure that those managing an entityproperly utilize their time, talents and available resources in the best interest of absenteeowners. Good corporate governance creates a system that ensures proper stewardship overinvested capital and faithfully reports the economic condition and performance of theenterprise. The bodies primarily responsible for management oversight are the supervisory boardin countries with a two-tier board structure or the board of directors in countries with a singleboard structure. In the latter case, an audit committee may be established to oversee theinternal and external auditing work done for the organization. Through the audit of financialstatements which can be seen as a form of stewardship report, auditors play an important rolein facilitating effective corporate governance.

Objectives, Strategies, Processes, Controls, Transactions andReportsManagement, with guidance and direction from the board of directors or the supervisoryboard, decides on a set of objectives, along with strategies designed to achieve those objectives.The organization then undertakes certain processes in order to implement its strategies. Theorganization must also assess and manage risks that may threaten achievement of its objectives.While the processes implemented in business organizations are as varied as the different typesof businesses themselves, most business enterprises establish processes that fit in five broadprocess categories, sometimes known as cycles. The five categories that characterize the processesof most businesses are the revenue process, the purchasing process, the human resource managementprocess, the inventory management process, and the financing process. Each process involves a varietyof important transactions. The enterprise must design and implement accounting informationsystems to capture the details of those transactions and must design and implement a system ofinternal control to ensure that the transactions are handled and recorded appropriately and thatits resources are protected. The accounting information system must be capable of producingfinancial reports, which summarize the effects of the organization’s transactions on its account

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balances and which are used to establish management accountability to outside owners. Thenext section provides a brief overview of the five process categories. Auditors often rely on thisprocess model to divide the audit of a business’s financial statements into manageable pieces.Chapters 10 to 16 go into considerable detail regarding how these processes typically functionand how they are used to organize an audit.

A MODEL OF BUSINESS PROCESSES: FIVE COMPONENTSFigure 2�–�1 illustrates the five basic business processes in context with the overall businessmodel presented in the previous section.

The Financing ProcessBusinesses obtain capital through borrowing or soliciting investments from owners andtypically invest in assets such as land, buildings, and equipment in accordance with theirstrategies. As part of this process, businesses also need to repay lenders and provide a return onowner investments. These types of transactions are all part of the financing process. For

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An Overview of BusinessFigure 2–1

Business Processes

Information

SystemsandInternalControltoEnsureTransactionsAreProperlyExec

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Processed

PerformanceMeasurement and

Assessment

ExternalFinancialReporting

Financingprocess

Humanresource

managementprocess

Purchasingprocess

Revenueprocess

Inventorymanagement

process

BusinessTransactions

Risk

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Corporate Governance

Business Objectives and Strategies

Management and Board of Directors

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example, while EarthWear tends not to rely on long-term debt financing, it primarily usescapital provided by shareholders to invest in such long-term assets as its headquarters building,retail stores, and various order and distribution centres.

The Purchasing ProcessBusinesses must acquire goods and services to support the sale of their own goods or services.For example, EarthWear must purchase inventory for sale to customers. The company mustalso purchase office supplies, needed services, and many other items to support its activities.

The Human Resource Management ProcessBusiness organizations hire personnel to perform various functions in accordance with theenterprise’s mission and strategy. For example, at EarthWear (see EarthWear Report inChapter 1) this process starts with the establishment of sound policies for hiring, training,evaluating, counselling, promoting, compensating, and terminating employees. The maintransaction that affects the financial statement accounts in this process is a payroll transaction,which usually begins with an employee performing a job, and ends with payment being madeto the employee.

The Inventory Management ProcessThis process varies widely between different types of businesses. Service providers (such asauditors) rarely have significant inventories to manage, since their primary resources typicallyconsist of information, knowledge, and the time and effort of people. Manufacturers,wholesalers, and retailers, including EarthWear, all typically have significant, numerous andoften complex transactions falling in the inventory management process. While the actualpurchasing of finished goods or raw materials inventories is included in the purchasing process(see above), the inventory management process for a manufacturer includes the costaccounting transactions to accumulate and allocate costs to inventory.

The Revenue ProcessBusinesses generate revenue through sales of goods or services to customers, and collect theproceeds of those sales in cash, either immediately or through collections on receivables. Forexample, EarthWear retails high-quality clothing for outdoor sports. To create value for itscustomers, employees, and owners, EarthWear must successfully process orders for, anddeliver its clothing to customers. It must also collect cash on those sales, either at the point ofsale or through later billing and collection of receivables.

Relating the Process Components to the Business ModelManagement establishes controls to ensure that sales and collection transactions areappropriately handled and recorded. Management establishes processes in the five categoriesdiscussed above to implement the organization’s strategies and achieve its objectives.Management then identifies risks, or possible threats to the achievement of establishedobjectives (including compliance with applicable laws and regulations and reliable externalreporting) and ensures that the organization’s system of internal control mitigates those risksto acceptable levels. The organization’s accounting information system must be capable ofreliably measuring the performance of the business to assess whether objectives are being metand to comply with external reporting requirements. Financial statements represent animportant output of the entity’s efforts to measure the organization’s performance and animportant form of external reporting and accountability.

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MANAGEMENT ASSERTIONSIn Chapter 1, we introduced the concept that the financial statements issued by managementcontain explicit and implicit assertions. Table 2�–�1 summarizes and explains managementassertions. Take a few minutes to examine and understand these assertions – you will see overthe next several chapters that this simple conceptual tool is actually quite powerful andunderlies much of what auditors do. Assertions are evaluated within three categories:transactions; account balances; and presentation and disclosure. For example, managementasserts among other things that transactions relating to inventory actually occurred, that they arecomplete (i.e. no valid transactions were left out), that they are classified properly (e.g. as an assetrather than an expense), and that they are recorded accurately and in the correct period.Similarly, management asserts that the inventory represented in the inventory account balanceexists, that the entity owns the inventory, that the balance is complete, and that the inventory isproperly valued. Finally, management asserts that the financial statements properly classify andpresent the inventory (e.g. inventory is appropriately listed as a current asset on the balancesheet) and that all required disclosures having to do with inventory (e.g. a note indicating that thecompany uses the FIFO inventory method) are included appropriately, accurately, and clearly.

Although all balance-related assertions apply to every account, the assertions are notequally important for each account. Recognizing the assertions that deserve the most emphasisdepends on an understanding of the business and of the particular type of account beingaudited. For example, for liability accounts the completeness assertion is typically the most

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Summary of Management Assertions by CategoryTable 2–1

Assertions about classes of transactions and events for the period under audit● Occurrence – transactions and events that have been recorded have occurred and pertain

to the entity.● Completeness – all transactions and events that should have been recorded have been

recorded.● Authorization – all transactions and events have been properly authorized.● Accuracy – amounts and other data relating to recorded transactions and events have

been recorded appropriately.● Cutoff – transactions and events have been recorded in the correct accounting period.● Classification – transactions and events have been recorded in the proper accounts.

Assertions about account balances at the period end● Existence – assets, liabilities, and equity interests exist.● Rights and obligations – the entity holds or controls the rights to assets, and liabilities

are the obligations of the entity.● Completeness – all assets, liabilities, and equity interests that should have been recorded

have been recorded.● Valuation and allocation – assets, liabilities, and equity interests are included in the

financial statements at appropriate amounts and any resulting valuation or allocationadjustments are appropriately recorded.

Assertions about presentation and disclosure● Occurrence and rights and obligations – disclosed events, transactions, and other

matters have occurred and pertain to the entity.● Completeness – all disclosures that should have been included in the financial statements

have been included.● Classification and understandability – financial information is appropriately presented

and described, and disclosures are clearly expressed.● Accuracy and valuation – financial and other information are disclosed fairly and at

appropriate amounts.

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important assertion for two reasons. First, when all obligations are not properly included inthe liability account, the result is often an overstatement of net income (profit). Second,management is more likely to have an incentive to understate a liability than to overstate it.

AUDITING STANDARDSAuditing standards serve as guidelines for and measures of the quality of the auditor’sperformance. Auditing standards help ensure that financial statement audits are conducted in athorough and systematic way that produces reliable conclusions. The International Auditingand Assurance Standards Board (IAASB) develops and issues the international standards onauditing, assurance, quality control, and related services. These standards are referred to in thisbook.

The Role of the International Auditing and AssuranceStandards Board (IAASB)The IAASB is a Board established by the International Federation of Accountants (IFAC).IFAC is the global organization of the accounting profession. The IFAC Board appoints the 18members of IAASB based on recommendation from the IFAC Nominating Committee. Themembers are approved by IFAC Public Interest Oversight Board (PIOB). PIOB comprises ofrepresentatives from regulators and related organizations. The IAASB goal is to develop a setof international standards generally accepted worldwide. The standards are developedfollowing a due process that includes input from the general public, IFAC member bodies andtheir members, and an IAASB Consultative Advisory Group (CAG) that represents regulators,preparers, and users of financial statements. The authority to approve standards lies by IAASB.

IFAC’s Statement of Membership Obligation (SMO) 3 obliges member bodies toincorporate IAASB standards into their national standards. With IFAC’s 163 memberorganizations in 119 countries, the IAASB standards are global standards.�i For example, almostall European countries have adopted the international standards in full or with minor nationalamendments. The EU is currently considering a process and timetable for endorsing IAASBstandards on auditing.

Figure 2�–�2 illustrates the structure of the IAASB standards and other pronouncements.

International Standards on Quality Control (ISQCs) are applied for all services fallingunder IAASB engagement standards. ISQC 1 establishes the audit firm’s responsibilities for itssystem of quality control.

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Structure of IAASB PronouncementsFigure 2–2

International Framework for Assurance Engagements

InternationalStandardson Review

EngagementsISREs

InternationalStandards

on AssuranceEngagements

ISAEs

InternationalStandardson RelatedServicesISRSs

InternationalStandards

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InternationalAuditing

Practice StatementsIAPSs

International Standards on Quality ControlISQCs

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Engagement standards are assurance standards or related services standards. IAASB hasissued a framework for all assurance engagements (International Framework for AssuranceEngagements). The framework defines and describes objectives and elements of an assuranceengagement.

Assurance standards are International Standards on Auditing (ISAs), InternationalStandards on Review Engagements (ISREs) and International Standards on AssuranceEngagements (ISAEs). ISAs are applied in an audit of historical financial information such as afinancial statement audit. ISREs are applied to reviews of historical financial information suchas reviews of interim financial statements. ISAEs are applied in assurance engagements dealingwith subject matters other than historical financial information such as assurance ofprospective financial information and sustainability reporting.

Related services are covered by the quality control standards, but are not assuranceservices. International Standards on Related Services (ISRSs) are applied to compilationengagements and engagements to apply agreed-upon procedures to information. In acompilation engagement the auditor is presenting, ordinarily in the form of financialstatements, information that is the representation of management without undertaking toexpress any assurance on the statements. An agreed-upon procedures engagement is one inwhich an auditor is engaged by a client to issue a report of findings based on specificprocedures performed on financial information, i.e. without expressing any assurance.

Currently IAASB standards contain basic principles and essential procedures, identified inthe standards in bold-type lettering, together with related guidance in the form of explanatoryand other material, including appendices. The basic principles and essential procedures are tobe understood and applied in the context of the explanatory and other material that provideguidance for their application. Thus, it is therefore necessary to consider the whole text of astandard to understand and apply the basic principles and essential procedures. In exceptionalcircumstances, an auditor may judge it necessary to depart from a basic principle or essentialprocedure of a standard to achieve more effectively the objective of the engagement. Whensuch a situation arises, the auditor should be prepared to justify the departure. The readershould be aware that IAASB has undertaken a project to clarify the language and style of itspronouncements, including separating the ISAs into sections for objectives, requirements, andapplication guidance.

Practice statements are issued to provide interpretive guidance and practical assistance inimplementing standards and to promote good practice. Currently, IAASB practice statementsare International Auditing Practice Statements (IAPSs). Practice statements for otherengagements may be developed in the future. Auditors should be aware of and considerpractice statements applicable to the engagement.

The ISAs are discussed extensively throughout this book. Chapter 19 covers quality controlstandards (ISQCs). Chapter 20 covers IAASB’s framework for assurance engagements andIAASB engagements standards other than auditing standards, i.e. ISREs, ISAEs, and ISRSs.

International Standards on Auditing (ISAs)Auditing standards apply to audits of all sizes and in all sectors of the economy, tend to begeneral in nature, and emphasize guidance to the auditor. The auditor must apply due care andsound professional judgement given the particular circumstances of the engagement in conductingan audit. Keep in mind that the auditor never has sufficient evidence to ‘guarantee’ that thefinancial statements do not contain material misstatements. An audit in accordance with ISAsis designed to provide reasonable assurance that the financial statements taken as a whole arefree from material misstatement.

ISAs are numbered and grouped into categories, typically according to which phase of theaudit process they relate to. The categories are:

● 100�–�199 Introductory Matters.● 200�–�299 General Principles and Responsibilities.● 300�–�499 Risk Assessment and Response to Assessed Risks.

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200�–�299 General Principles and ResponsibilitiesISA 200 Objective and General Principles Governing an Audit of Financial StatementsISA 210 Terms of Audit EngagementsISA 220 Quality Control for Audits of Historical Financial Information*ISA 230 Audit Documentation*ISA 240 The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements*ISA 250 Consideration of Laws and Regulations in an Audit of Financial StatementsISA 260 Communications of Audit Matters with Those Charged with Governance**

300�–�499 Risk Assessment and Response to Assessed RisksISA 300 Planning an Audit of Financial Statements*ISA 315 Understanding the Entity and Its Environment and Assessing the Risks of Material

Misstatement*ISA 320 Audit Materiality**ISA 330 The Auditor’s Procedures in Response to Assessed Risks*ISA 402 Audit Considerations Relating to Entities Using Service Organizations

500�–�599 Audit EvidenceISA 500 Audit Evidence*ISA 501 Audit Evidence – Additional Considerations for Specific ItemsISA 505 External ConfirmationsISA 510 Initial Engagements – Opening BalancesISA 520 Analytical ProceduresISA 530 Audit Sampling and Other Means of TestingISA 540 Audit of Accounting Estimates**ISA 545 Auditing Fair Value Measurements and DisclosuresISA 550 Related PartiesISA 560 Subsequent EventsISA 570 Going ConcernISA 580 Management Representations

600�–�699 Using Work of OthersISA 600 Using the Work of Another Auditor**ISA 610 Considering the Work of Internal AuditingISA 620 Using the Work of an Expert

700�–�799 Audit Conclusions and ReportingISA 700 The Independent Auditor’s Report on a Complete Set of General Purpose Financial

Statements*ISA 701 Modifications to the Independent Auditor’s ReportISA 710 ComparativesISA 720 Other Information in Documents Containing Audited Financial StatementsISA 710 Comparatives

800�–�899 Specialized Areas:ISA 800 The Auditor’s Report on Special Purpose Audit Engagements**

* New or recently revised standard.

** Exposure drafts for revision of the standard are issued by 15 October 2005.

All the ISAs listed in this table are effective for audits beginning on or after December 2004 at latest, except for ISA 230(effective for periods commencing on or after 15 June 2006) and ISA 700 and 70 (effective for auditor’s reports dated onor after 31 December 2006).

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● 500�–�599 Audit Evidence.● 600�–�699 Using Work of Others.● 700�–�799 Audit Conclusions and Reporting.● 800�–�899 Specialized Areas.

Auditing standards are periodically modified to meet changes in the auditors’ environment.Over the past years the ISAs have undergone substantial changes, including issuing of the newaudit risk standards (ISA 315, ISA 330 and ISA 500), and the revised standards on fraud (ISA240) and auditor’s report (ISA 700). As a result of changes in these core standards, conformingamendments had been made to many of the other standards. Table 2�–�2 contains the ISAs asissued by 15 October 2005. (No standards in the category of introductory matters standardsexist currently.)

This text primarily refers to the issued ISAs as of 15 October 2005. Exposure draft ofstandards issued by this date will also be discussed. An exposure draft is a proposed new orrevised ISA. For example, in Chapter 3 when discussing materiality the proposed new ISA 320(exposure draft) Materiality in the Identification and Evaluation of Misstatements is referred to.Revision and updates of standards are a continuing process. The reader should regularly visitIAASB’s home site (www.ifac.org/IAASB/) to learn about planned, ongoing, and recentchanges in standards. IAASB also develops Action Plans that represent the intended focus ofIAASB for the next two years.

ETHICS, INDEPENDENCE AND THE IFAC CODE OFETHICS FOR PROFESSIONAL ACCOUNTANTSEthical behaviour and independence on the part of the auditor are vital to the audit function.The demand for auditing arose from the need for a competent, independent person tomonitor the contractual arrangements between principal and agent. If an auditor isincompetent or lacks independence, the parties to the contract will place little or no value onthe service provided.

Ethics refers to a system or code of conduct based on moral duties and obligations thatindicates how we should behave. Professionalism refers to the conduct, aims, or qualities thatcharacterize or mark a profession or professional person.�ii All professions (e.g. medicine, law,and accounting) operate under some type of code of ethics or code of conduct. The Code ofEthics for Professional Accountants issued by IFAC’s Ethics Committee establishes acceptablebehaviour for professional accountants around the world. No IFAC member body or firm isallowed to apply less stringent standards than those stated in the Code unless prohibited fromcomplying with a certain part of the Code by law or regulation. Part A of the Code defines thefundamental principles for behaviour and the conceptual framework for applying thoseprinciples. The fundamental principles are integrity, objectivity, professional competence anddue care, confidentiality, and professional behaviour. The conceptual framework should assistthe professional accountant to identify, evaluate and respond to threats to compliance with thefundamental principles. Part B and C of the Code illustrate how the conceptual frameworkcontained in Part A is applied in specific situations, including in Part B in situations whereindependence may be challenged. A distinction is made between independence of mind andindependence in appearance. An auditor must not only be independent of mind but also avoidactions that may appear to affect independence. If an auditor is perceived as not beingindependent, users may lose confidence in the auditor’s ability to report truthfully on financialstatements. The IFAC Code of Ethics is an important element worldwide of the environmentin which the auditors work.

Auditors are frequently faced with situations that may test their professionalism, ethicalcharacter, and independence. For example, auditors’ independence is tested when clientsengage in opinion shopping – that is, when clients seek the views of other auditors, hoping theywill agree with the client’s desired accounting treatment. Clients sometimes attempt toinfluence the auditor to go along with the desired accounting treatment by threatening to

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change auditors. Chapter 19 contains an in-depth discussion of professional ethics and theIFAC Code of Ethics for Professional Accountants.

THE AUDITOR’S RESPONSIBILITY FOR ERRORS ANDFRAUDMany readers of financial statements believe that auditors are ultimately responsible for thefinancial statements or at least that they have a responsibility to detect all errors and fraud. Thisis simply not true. The financial statements are the responsibility of management (note thatthe assertions are called management assertions); the auditor’s responsibility is to express anopinion on the financial statements. It is important to remember that while auditors do haveimportant responsibilities, management is primarily responsible for the fairness of thecompany’s financial statements.

Auditing standards (ISA 240) provide the following responsibility for auditors:

An auditor conducting an audit in accordance with ISAs obtains reasonable assurance that thefinancial statements taken as a whole are free from material misstatement, whether caused byfraud or error. An auditor cannot obtain absolute assurance that material misstatements in thefinancial statements will be detected because of such factors as the use of judgment, the use oftesting, the inherent limitations of internal control and the fact that much of the audit evidenceavailable to the auditor is persuasive rather than conclusive in nature.

Auditing standards also require that the auditor exercises professional scepticism, which is anattitude that includes a questioning mind and a critical assessment of audit evidence.

If the auditor fails to comply with auditing standards, he or she can be held liable for civildamages and even criminal penalties. The risk of litigation has an important function indisciplining auditors’ behaviour and securing the quality of auditors’ performance.�iii Theauditor’s responsibility to provide reasonable assurance with respect to errors and fraud clearlyshapes the auditor’s environment. More information on the auditor’s responsibility for errorsand fraud is contained in Chapters 3 and 5.

AUDIT REPORTINGThe auditor’s report is the main product or output of the audit. Just as the report of a buildingsurveyor communicates the surveyor’s findings to a prospective buyer, the audit reportcommunicates the auditor’s findings to the users of the financial statements. The audit report,also known as the audit opinion, is the culmination of a process of collecting and evaluatingsufficient appropriate evidence concerning the fair presentation of management’s assertions inthe financial statements. A brief overview of audit reporting is presented here so you canunderstand the final output of an audit. More detail is provided in Chapter 18. Figure 2�–�3gives an overview of audit reporting.

Financial Reporting Framework as Audit CriteriaIn order to evaluate a set of financial statements, benchmarks or criteria must exist againstwhich the fairness of the statements can be measured. The financial reporting frameworkprovides the criteria for the auditor’s evaluation of the fair presentation of financial statements.Acceptable financial reporting frameworks for financial statements include promulgatedaccounting standards by the International Accounting Standards Board (IASB) or generallyaccepted accounting principles promulgated by a recognized standards setter in a particularjurisdiction (ISA 200). The acceptable financial reporting framework is ordinarily identified inthe legislative and regulatory requirements governing the preparation of the financialstatements in the jurisdiction. In the ISAs an acceptable financial reporting framework isreferred to as the applicable financial reporting framework.

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The Standard Audit Report with an Unmodified OpinionThe most common type of audit report is a standard report with an unmodified opinion,because management’s assertions about the entity’s financial statements are usually found toconform to the financial reporting framework. Such a conclusion can be expressed only whenthe audit was performed in accordance with the acceptable auditing standards and regulationsin the particular jurisdiction, for example the ISAs. This is not to say that entities’ financialrecords rarely include errors or material misstatements. On the contrary, entities often have tomake auditor-proposed adjustments to the financial statements, but they are typically willingto make such adjustments to receive an unmodified opinion (‘clean opinion’).

In 2002 IAASB initiated a project for a comprehensive review of the audit report. Thisresulted in the ISA 700 The Independent Auditor’s Report on a Complete Set of General PurposeFinancial Statements.�iv In contrast to the prior ISA 700, the revised ISA 700 is restricted to thesituation when the auditor issues a standard audit report with an unmodified opinion. Astandard audit report with an unmodified opinion means in this book an audit report with anunmodified opinion that does not include an emphasis of matter paragraph or other mattersparagraph. Such matters paragraph that do not affect the auditor’s opinion, are discussed inChapter 18. (See also Fig. 2�–�3.)

The revised ISA 700 does not entail a fundamental reconsideration of the role andapproach to reporting. The standard, however, expands guidance on the auditor’sresponsibilities on conducting the audit in accordance with the ISAs and auditing standards ofa specific jurisdiction, with respect to: (1) unaudited supplementary information presentedwith the audited financial statements; (2) on forming the auditor’s opinion; and (3) on datingthe audit report. The details of this new guidance are discussed in Chapter 18. In addition tothe expanded guidance on these specific issues, the standard introduces a separate section forexplaining management’s responsibility, expands the explanations of the responsibilities ofmanagement and the auditor and updates the description of the audit process, includingthe scope of the auditor’s responsibilities with respect to internal control. (See Exhibits 2�–�3and 2�–�4.)

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Overview of Audit ReportingFigure 2–3

Immaterial

Type of Audit Opinion

Disclaimer Adverse

Scope limitation: • Client-imposed • Condition-imposed

Departure fromfinancial reporting

framework

Unmodifiedwith a matter

paragraph

Material

Materialand

pervasive

Unmodified

Qualified Qualified

Effect ofMateriality

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In some jurisdictions the auditor is, in addition to expressing an opinion on the financialstatements, required or permitted to report on other responsibilities. For example, the auditormay be required to express an opinion on the adequacy of the entity’s accounting records andbooks. Such responsibilities need to be identified and distinguished, preferably in a separatesection of the report. Thus, the standard sets out a two-part report. The first part deals with thefinancial statements, and should essentially be the same for all audits conducted in accordancewith ISAs. The second part deals with additional specific reporting requirements of aparticular jurisdiction. The separation attains comparability of reporting on the financialstatements and allows flexibility to deal with local circumstances.

The revised ISA 700 covers the reporting on a complete set of general purpose financialstatements. The financial reporting framework determines what constitutes a complete set offinancial statements. For example, under the International Financial Reporting Standards (IFRSs)the complete set of financial statements comprises a balance sheet, an income statement, astatement of changes in equity, a cash flow statement and a summary of significant accountingpolicies and other explanatory notes. General purpose financial statements are financial statementsprepared in accordance with a financial reporting framework that is designed to meet thecommon information needs of a wide range of users.

Exhibit 2�–�3 presents an example of a standard audit report with an unmodified opinion inline with the revised ISA 700. The report is headed with a title such as the ‘IndependentAuditor’s Report’. The title of the report affirms that the auditor has met the relevant ethicalrequirements regarding independence. Ordinarily the report addresses the shareholders or theboard of directors of the audited entity. The subheading ‘Report on Financial Statements’ isused when the auditor reports on other legal and regulatory requirements in addition to thefinancial statements.

The body of the report begins with the introductory paragraph, which discloses the entitywhose financial statements have been audited, that the financial statements have been audited,the title of each of the financial statements that comprise the complete set of financialstatements, a reference to the summary of significant accounting policies and otherexplanatory notes, and the date and period covered by the financial statements.

The second paragraph states that management is responsible for the preparation and fairpresentation of the financial statements in accordance with the applicable financial reportingframework (IFRSs in Exhibit 2�–�3), and specifies what this responsibility includes related tointernal control, accounting policies, and accounting estimates. The revised ISA 700introduces subheadings in the audit report such as ‘Management’s Responsibility for theFinancial Statements’ for the management’s responsibility paragraph.

The third paragraph communicates to the users the auditor’s responsibility, including invery general terms, what an audit entails. The auditor’s responsibility to express an opinion onthe financial statements contrasts management’s responsibility to prepare the financialstatements. The reference to the ISAs conveys to the readers that the auditor has compliedwith all ISAs relevant to the audit. Such compliance includes that the auditor has adhered tothe ethical requirements and has obtained reasonable assurance that the financial statementsare free from material misstatements. The scope of the audit refers to the audit proceduresdeemed necessary, including risk assessments, considerations of internal control relevant to afinancial statement audit, assessment of accounting principles used and significant estimatesmade, and an overall evaluation of financial statement presentation. Finally, the paragraphasserts the auditor’s belief that the audit performed provides a basis for the audit opinion.

The opinion paragraph contains the auditor’s conclusion concerning the fairness of thefinancial statements based on the audit evidence. In an unmodified opinion the auditorexpresses that the financial statements give a true and fair view or, are presented fairly, in allmaterial respects, in accordance with the applicable financial reporting framework (i.e. IFRSsin Exhibit 2�–�3). For the purpose of complying with the ISAs those two phrases are equivalent.A particular jurisdiction, however, may determine preference for one of the phrases. When theIFRSs are not used as reporting framework, the opinion paragraph identifies the jurisdiction orcountry of origin of the framework.

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Exhibit 2�–�3 The Standard Audit Report with an Unmodified Opinion (Revised ISA 700)

Title: INDEPENDENT AUDITOR’S REPORT

Addressee: To the Shareholders of the ABC Company

Report in Financial StatementsIntroductory paragraph: We have audited the accompanying financial statements of ABC Company,

which comprise the balance sheet as at 31 December 2006, and the incomestatement, statement of changes in equity and cash flow statement for theyear then ended, and a summary of significant accounting policies and otherexplanatory notes.

Management’s responsibility: Management’s Responsibility for the Financial StatementsManagement is responsible for the preparation and fair presentation of thesefinancial statements in accordance with International Financial ReportingStandards. This responsibility includes: designing, implementing andmaintaining internal control relevant to the preparation and fair presentationof financial statements that are free from material misstatement, whetherdue to fraud or error; selecting and applying appropriate accounting policies;and making accounting estimates that are reasonable in the circumstances.

Auditor’s responsibility: Auditor’s ResponsibilityOur responsibility is to express an opinion on these financial statementsbased on our audit. We conducted our audit in accordance with InternationalStandards on Auditing. Those standards require that we comply with ethicalrequirements and plan and perform the audit to obtain reasonable assurancewhether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about theamounts and disclosures in the financial statements. The procedures selecteddepend on the auditor’s judgment, including the assessment of the risks ofmaterial misstatement of the financial statements, whether due to fraud orerror. In making those risk assessments, the auditor considers internal controlrelevant to the entity’s preparation and fair presentation of the financialstatements in order to design audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the entity’s internal control. An audit also includes evaluatingthe appropriateness of accounting policies used and the reasonableness ofaccounting estimates made by management, as well as evaluating the overallpresentation of the financial statements.

We believe that the audit evidence we have obtained is sufficient andappropriate to provide a basis for our audit opinion.

Auditor’s opinion: OpinionIn our opinion, the financial statements present fairly, in all material respects,(or give a true and fair view of) the financial position of ABC Company as of31 December 2006, and of its financial performance and its cash flows forthe year then ended in accordance with International Financial ReportingStandards.

Report on Other Legal and Regulatory Requirements(The form and content of this section will vary depending on the nature ofthe auditor’s other reporting responsibilities.)

Auditor’s signature:

Date of the auditor’s report: 15 April 2007

Auditor’s address:

Source: Adapted from ISA 700 The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements, IAASB (2005).

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As discussed, in some jurisdictions the auditor has additional responsibilities to report onother matters that are supplementary to expressing an opinion on the financial statements.Such matters should preferably be addressed in a separate paragraph following and clearlydistinguished from the auditor’s opinion on the financial statements. The heading of theparagraph could be ‘Report on Other Legal and Regulatory Requirements’. The form andcontent of the paragraph will vary depending on the nature of the auditor’s responsibility.

Finally, the audit report is signed, dated, and the auditor’s address is disclosed. Theappropriate jurisdiction may decide if the auditor’s signature is the name of the audit firm, thepersonal name of the auditor or both. The auditor should date the report on the financialstatements no earlier than the date on which the auditor has obtained sufficient appropriateaudit evidence on which to base the opinion on the financial statements. The report shouldname the location in the country or jurisdiction where the auditor practices.

Exhibit 2�–�4 is an example of a standard audit report with an unmodified opinion in linewith the reporting prior to the revised ISA 700.

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Exhibit 2�–�4 The Standard Audit Report with an Unmodified Opinion (Prior ISA 700)

Title: INDEPENDENT AUDITOR’S REPORT

Addressee: To the Shareholders of the ABC Company

Introductory paragraph: We have audited the accompanying balance sheet of the ABCCompany as of 31 December 2004, and the related statementsof income, and cash flows for the year then ended. These finan-cial statements are the responsibility of the Company’s manage-ment. Our responsibility is to express an opinion on thesefinancial statements based on our audit.

Audit scope: We conducted our audit in accordance with InternationalStandards on Auditing. Those Standards require that we planand perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstate-ment. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial state-ments. An audit also includes assessing the accounting princi-ples used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for ouropinion.

Auditor’s opinion: In our opinion, the financial statements present fairly, in allmaterial respects, (or give a true and fair view of) the financialposition of the ABC Company as of 31 December 2004, and ofthe results of its operations and its cash flows for the year thenended in accordance with International Financial ReportingStandards.

Date of the auditor’s report: 15 April 2005

Auditor’s address:

Auditor’s signature:

Source: Adapted from ISA 700 The Auditor’s Report on Financial Statements, IAASB (2005).

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Reasons for Departures from an Audit Report with anUnmodified Opinion�v

There are two basic reasons why an auditor may be unable to express an unmodified opinion(see Figure 2�–�3):

1. Scope limitation. A scope limitation results from a lack of evidence, such as an inability toconduct an audit procedure considered necessary.

2. A departure from the applicable financial reporting framework. A departure from theapplicable financial reporting framework occurs when the financial statements areprepared using an accounting policy or disclosure that is not in accordance with theframework.

Other Types of Audit ReportsWhen an auditor is unable to express an unmodified opinion, three types of audit reports areavailable to the auditor (see Fig. 2�–�3):

1. Audit reports with a qualified opinion. The auditor’s opinion is modified for either ascope limitation or a departure from the applicable financial reporting framework withmaterial consequences, but the overall financial statements present fairly. With a qualifiedopinion, the opinion paragraph is modified by the words ‘except for.’

2. Audit reports with a disclaimer of opinion. When issuing a disclaimer, the auditor statesthat he or she cannot give an opinion on the financial statements because of a lack ofsufficient appropriate evidence to form an opinion on the overall financial statements.

3. Audit reports with an adverse opinion. The auditor’s opinion states that the financialstatements do not present fairly in accordance with the applicable financial reportingframework because the departure affects the overall financial statements.

The choice of which audit report to issue on a client’s financial statements depends on thecondition and the materiality of the departure, as indicated in Fig. 2�–�3.

AUDIT FIRMSVery small organizations can be audited by a single auditor, operating as the sole owner of anaudit firm. However, auditing larger business and other organizations requires significantlymore resources than a single auditor can provide. Thus, audit firms range in size from a singleproprietor to thousands of owners (or ‘partners’) and thousands of professional andadministrative staff employees. Audit firms typically offer a variety of professional services inaddition to financial statement audits.

Organization and CompositionAudit firms are organized as proprietorships, general or limited liability partnerships, orcorporations. Not all countries allow the audit firms to structure themselves using thecorporate form. Structuring audit firms as proprietorships and general partnerships offersadditional protection for users of their services because such organizational structures, unlike acorporation, do not provide limited liability for the owners or partners. Thus, users can seekrecourse not only against the audit firm’s assets but also against the personal assets ofindividual partners. This lends additional credibility to the services provided to the usersbecause the individual auditor is willing to risk the loss of his or her personal wealth. Becauseof litigation against auditors, audit firms tend to organize as corporations when possible.

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Audit firms are often categorized by size. The largest firms are the ‘Big 4’ firms: Deloitte;Ernst & Young; KPMG; and PricewaterhouseCoopers. These large international organizationsare able to serve clients throughout the world by tapping into its worldwide network of firms.The Big 4 audit most of the world’s largest enterprises. In addition to assurance and auditingservices, the Big 4 deliver tax services and other advisory services. Their annual globalrevenues range from $12 billion to more than $16 billion. For example, for 2004 Deloittereported aggregate revenues of $16.4 billion. Deloitte member firms from Europe�MiddleEast�Africa and Asia-Pacific�Japan contributed to more than half of this revenue. Globally,Deloitte’s auditing, consulting and advisory services, and tax services generated a revenue of$7.4 billion, $5.2 billion and $3.8 billion, respectively. To compare, the split between auditing,advisory and tax services of another of the Big 4, KPMG, was in billion $5.7, $3.1, and $3.3.

Following the Big 4 in size are several medium-sized, so-called second-tier internationalnetworks of audit firms. These include such firms as BDO International, Grant ThorntonInternational, Horwath International, Moores Rowland International and RSM International.The annual revenues of these firms range from $1 billion to more than $3 billion. Other auditfirms operate primarily within one country and may be substantial players nationally. Finally,there are thousands of regional and local audit firms that have one or a few offices. These auditfirms provide audit, tax, consulting, and accounting services, generally to smaller entities.

Audits are usually conducted by teams of auditors. The typical audit team is composed of,in order of authority, a partner, a manager, one or two seniors, and several staff members.Audit teams for large international entities are typically made up of several partners andmanagers and many seniors and staff. The lead engagement partner has the authority anddecision-making responsibility for accounting and auditing matters, including the issuance ofthe audit report. Table 2�–�3 summarizes the duties performed by each member of the auditteam.

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Selected Duties of Audit Team MembersTable 2–3

Audit Team Member Selected Duties

Partner ● Reaching agreement with the client on the scope of the serviceto be provided.

● Ensuring that the audit is properly planned.● Ensuring that the audit team has the required skills and

experience.● Supervising the audit team and reviewing the working papers.● Signing the audit report.

Manager ● Ensuring that the audit is properly planned, including schedulingof team members.

● Supervising the preparation of and approving the auditprogramme.

● Reviewing the working papers, financial statements, and auditreport.

Senior�In-charge ● Assisting in the development of the audit plan.● Preparing budgets.● Assigning audit tasks to associates and directing the day-to-day

performance of the audit.● Supervising and reviewing the work of the associate.

Associate�Staff ● Performing the audit procedures assigned to them.● Preparing adequate and appropriate documentation of

completed work.● Informing the senior about any auditing or accounting problems

encountered.

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TYPES OF ASSURANCE, RELATED AND OTHER SERVICESOpportunities where auditors can provide assurance services, including audits of financialstatements and other services arise from the need for management to be accountable toemployees, shareholders, customers and communities. In this section, examples of these typesof services are briefly discussed. More detailed information on assurance services is containedin Chapter 20.

Assurance ServicesIn addition to the financial statement audit, there are numerous types of assurance servicesincluding assurance on sustainability reporting, assurance on internal control reporting,assurance on compliance, assurance on operational performance, assurance on financialforecasts and projections, assurance on information system reliability and e-commerce, andforensic assurance. These types of assurance services can be performed by audit firms or byother types of auditors such as internal or governmental auditors, discussed below. Note thatsome of the services discussed are commonly referred to as audits such as internal controlaudits, compliance audit performance audit and forensic audit.

Assurance on Sustainability ReportingThe Bruntland Commission (1978) defined sustainable development as ‘meeting the needs ofthe present without compromising the ability of future generations to meet their needs’.Companies have found that addressing sustainability issues is fundamental to their long-termsuccess. Currently, a number of companies publish reports on sustainability. Assurance addsconfidence to such reporting. Auditors and others provide assurance on sustainability reports.

Assurance on Internal Control ReportingFinancial statement auditors have always had the option of testing controls to obtain indirectevidence about the fairness of the financial statements on which they have been engaged toexpress an opinion. In recent years auditors have increasingly been asked to provide reports onthe effectiveness of an entity’s internal control. In the USA the Sarbanes–Oxley Act of 2002imposed a requirement on all publicly held companies to report and the auditor to giveassurance on the effectiveness of the internal financial control.

Assurance on ComplianceCompliance assurance (audits) evaluates the extent to which rules, policies, laws, covenants, orgovernment regulations are followed by the entity being assured. For example, a company mayask auditors to evaluate whether corporate rules and policies are being followed bydepartments within the organization. Another example is examination of tax returns ofindividuals and companies by the tax authorities for compliance with the tax laws.

Assurance on Operational PerformanceOperational assurance involves a systematic review of part or all of an organization’s activitiesin relation to the efficient and effective use of resources. The purpose of an operational assuranceengagement is to assess performance, identify areas for improvement and developrecommendations. Sometimes this type of assurance is referred to as a performance audit ormanagement audit. Operational assurance offers different challenges than financial statementaudits or compliance assurance because an operational assurance requires the auditor toidentify or create suitable criteria against which to assess effectiveness and efficiency. Manyorganizations ask auditors to provide assistance in benchmarking their business processes and

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performance. While traditionally this service has mainly involved financial measures, clientsoften seek help with measuring such leading indicators as customer satisfaction, effectivenessof employee training and product quality. Operational assurance has increased in importancein recent years, and this trend will likely continue. An example is when entities employauditors to assess the efficiency and effectiveness of the entity’s use of information technologyresources.

Assurance on Financial Forecasts and ProjectionsEntities often prepare prospective (forward-looking) financial information and may requestthat auditors assure the information. Financial forecasts are prospective financial statements thatpresent expected financial results. Financial projections are prospective financial statements thatpresent, given hypothetical assumptions, financial results for an entity.

In such engagements, auditors typically assure the preparation, support for assumptionsand presentation of the prospective financial information. They do not offer assurance that theresults forecasted or projected will actually be realized.

Assurance on Information System Reliability and E-CommerceMore entities are becoming dependent on information technology, including e-commerceapplications, to run their businesses. As a result, it is critical that such systems be secure,available when needed and consistently able to produce accurate information. Auditors canprovide assurance on an entity’s information system and its e-commerce applications.

Forensic AssuranceThe purpose of a forensic assurance (audit) engagement is the detection or deterrence offraudulent activities. The use of auditors to conduct forensic assurance has increased

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Exhibit 2�–�5 PricewaterhouseCoopers Issues Report on Fraudulent Activities at Lernout & Hauspie

Lernout & Hauspie Speech Products NV (L&H), headquartered in Leper, Belgium, was a leader inspeech translation software. L&H went public and at one time had a market capitalization ofnearly $6 billion. In 2000, inflated reported revenues claims in Asia of the high-flying companycaught the attention of securities regulators in Belgium and the USA. Subsequently, thecompany filed for bankruptcy in both Belgium and the USA.

At the request of the company’s new management, PricewaterhouseCoopers (PwC) was hiredto conduct a forensic audit (assurance) of the accounting fraud. The PwC discovered that mostof the fraud occurred in L&H’s Korean unit. In an effort to obtain bonuses based on sales targets,the managers of the Korean unit went to great lengths to fool L&H’s auditor, KPMG. The PwCauditors reported that the Korean unit used two types of schemes to perpetrate the fraud. Oneinvolved factoring of receivables with banks to obtain cash to disguise the fact that the receiv-ables were not valid. L&H Korea gave the banks side letters that provided that the money wouldbe given back if the banks could not collect them. These side letters were concealed from KPMG.The second scheme arose after KPMG questioned why L&H Korea was not collecting more of itsoutstanding receivables. L&H Korea had its customers transfer their contracts to third partieswho then took out bank loans to pay L&H Korea. L&H Korea provided the collateral for the loans.PwC reported that nearly 70 per cent of the $160 million in sales booked in the Korean unit ofL&H were fictitious.

Sources: M. Maremont, J. Elsinger, and J. Carreyrou, ‘How High-Tech Dream at Lernout & Houspie Crumbled in a Scandal’, The Wall StreetJournal (7 December 2000), pp. A1, A18; J. Carreyrou and M. Maremont, ‘Lernout Unit Engaged in Massive Fraud to Fool Auditors, NewInquiry Concludes’, The Wall Street Journal (6 April 2001), p. A3; and J. Carreyrou, ‘Lernout Unit Booked Fictitious Sales, Says Probe’, The WallStreet Journal (9 April 2001), p. B2.

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significantly. Some examples where a forensic assurance engagement might be conductedinclude:

● Business or employee fraud.● Criminal investigations.● Shareholder and partnership disputes.● Business economic losses.● Matrimonial disputes.

For example, in a business fraud engagement, assurance might involve tracing funds or assetidentification and recovery. Exhibit 2�–�5 describes a forensic assurance engagement conductedby a major audit firm for the board of directors of Lernout & Hauspie Speech Products NV.Some audit firms specialize in forensic assurance services.

Related ServicesRelated services are either agreed-upon procedures regarding financial information or acompilation of financial information. An agreed-upon procedures engagement is one in whichan auditor is engaged by a client to issue a report of findings based on specific proceduresperformed on the subject matter. In a compilation engagement the auditor is engaged to useaccounting expertise to collect, classify, and summarize financial information. Related servicesare discussed in Chapter 20.

Other ServicesIn addition to the assurance and related services discussed in this chapter audit firms typicallyperform three other broad categories of services.

Tax ServicesAudit firms have tax departments that assist clients with preparing and filing tax returns,provide advice on tax and estate planning and provide representation on tax issues before thetax authorities or tax courts.

Management Advisory ServicesManagement advisory services (MAS) are consulting activities that may involve providingadvice and assistance concerning an entity’s organization, personnel, finances, operations,systems, or other activities. Because of independence and other issues, a number of the majorfirms have sold their consulting practices. However, these firms’ assurance practices continueto perform MAS.

Accounting and Review ServicesAudit firms may perform a number of accounting services in addition to compilation servicesfor non-audit clients. These services include bookkeeping, payroll processing, and preparingfinancial statements.

TYPES OF AUDITORSA number of different types of auditors can be identified; however, they can all be classifiedunder four headings: external auditors; internal auditors; government auditors; and forensicauditors. One important requirement for each type of auditor is independence, in some form,from the entity being examined.

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External AuditorsExternal auditors are often referred to as independent auditors or professional accountants in publicpractice. Such auditors are called ‘external’ because they are not employed by the entity beingaudited. In this textbook, the terms external auditor, independent auditor, professional accountants inpublic practice, practitioner or simply auditor will be used interchangeably. A statutory auditor is anexternal auditor approved to carry out an audit of the financial statements required by law.Typically, statutory auditors hold some form of licence or authorization. For example, they arecertified, chartered, registered, or state-authorized.

External auditors audit financial statements for publicly traded and private companies,partnerships, municipalities, individuals and other types of entities. They may also conductcompliance, operational and forensic assurance (audits) for such entities. However, regulationand professional standards restrict the other types of services that an external auditor canprovide for financial statement audit clients.

The professional qualifications to act as a statutory auditor are regulated. Therequirements for licensing vary among nations, with many nations requiring a university orcollege degree with selected courses in topics such as accounting, auditing, businessadministration, and business and tax law. Most nations also require some type of professionalpractice before the licence is granted. In addition to achieving a qualification, auditors may berequired to participate in programmes of continuing professional education. Within the EUthe 8th Company Law Directive sets the minimum educational and professional practicerequirements for statutory auditors in member states. The IFAC and their EducationCommittee have taken initiatives to develop a common structure and content of professionalaccounting programmes worldwide.

Internal AuditorsAuditors employed by individual companies, partnerships, government agencies, individualsand other entities are called internal auditors. In major corporations, internal audit staff may bevery large and the director of internal auditing is usually a major job title within the entity.

The Institute of Internal Auditors (IIA) is the global organization supporting internalauditors. Its mission is to be ‘the primary international professional association, organized on aworldwide basis, dedicated to the promotion and development of the practice of internalauditing.’ The IIA has developed a set of standards to be followed by internal auditors and hasestablished a certification programme. An individual meeting the certification requirementsestablished by the IIA, which include passing a uniform written examination, can become acertified internal auditor (CIA).�vi Many internal auditors also hold a licence as externalauditor.

The IIA defines internal auditing as ‘an independent, objective assurance and consultingactivity designed to add value and improve an organization’s operations. It helps anorganization accomplish its objectives by bringing a systematic, disciplined approach toevaluate and improve the effectiveness of risk management, control, and governanceprocesses.’

Internal auditors may conduct financial, internal control, compliance, operational, andforensic assurance within their organizations (see previous section). They in some cases mayassist the external auditors with the annual financial statement audit. Chapter 20 offers moredetail on the IIA and the internal auditing profession.

Government AuditorsGovernment auditors are employed by national or local governmental institutions or by publicbodies. The majority of government auditors provide assurance on compliance and operationalperformance. At the national level most countries have established an Office of AuditorGeneral (Supreme Audit Institution). Such offices are normally empowered by theconstitution and are responsible to parliament or a similar political body. Offices of auditor

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general monitor the use of public funds, conduct assurance of activities, financial transactionsand accounts of the government. They may also assist parliament by performing special audits,surveys, and investigations. The fact that they report directly to parliament provides the officesof auditor general with an organizational arrangement that ensures objectivity andindependence. Most regional and local governments and municipals also have audit officesthat perform functions similar to the office of the auditor general. Finally, there areinternational initiatives for the development of the government audit profession such as theInternational Organization of Supreme Audit Institutions (INTOSAI) discussed later in thischapter.

Forensic AuditorsForensic auditors are employed by corporations, government agencies, audit firms andconsulting and investigative services firms.�vii They are trained in detecting, investigating, anddeterring fraud and white-collar crime (see the discussion of forensic auditing above). Someexamples of situations where forensic auditors have been involved include:

● Reconstructing incomplete accounting records to settle an insurance claim over inventoryvaluation.

● Probing money-laundering activities by reconstructing cash transactions.● Investigating and documenting embezzlement and negotiating insurance settlements.

The Association of Certified Fraud Examiners (ACFE) is the global organizationsupporting forensic auditors. The ACFE is a 25,000-member professional organizationdedicated to educating certified fraud examiners (CFEs), who are trained in the specializedaspects of detecting, investigating, and deterring fraud and white-collar crime.

The ACFE offers a certification programme for individuals wanting to become CFEs.Individuals interested in becoming a CFE must pass the Uniform CFE Examination.�viii CFEscome from various professional backgrounds, including auditors, accountants, fraudinvestigators, loss prevention specialists, attorneys, educators and criminologists. CFEs gatherevidence, take statements, write reports and assist in investigating fraud in its varied forms.

INTERNATIONAL ORGANIZATIONS THAT AFFECT THEACCOUNTING PROFESSIONA number of international, regional, and national organizations affect the practice of auditingwithin a specific country. The following section discusses the activities of some the mostinfluential organizations at the international level.

At the global scene, the International Federation of Accountants (IFAC) is the primeissuer of pronouncements on auditing matters. We have already learned about the activities oftwo of IFAC’s main committees; IAASB and the Ethics Committee. The InternationalAccounting Standards Board (IASB) issues international accounting standards. IASB’saccounting standards have gained widespread use throughout the world. For example, from1 January 2005 the international accounting standards have been the required financialreporting framework within the EU for consolidated accounts for all listed companies. TheInternational Organization of Securities Commissions (IOSCO) assembles securitiescommissions worldwide. IOSCO is important for the global acceptance of the internationalfinancial reporting and auditing standards. The International Organization of Supreme AuditInstitutions (INTOSAI) organizes national Supreme Audit Institutions (Offices of AuditorGeneral) at global level. INTOSAI has decided that their application guidance to theINTOSAI Auditing Standards to financial audits of public sector entities should, as far aspossible, draw upon the ISAs. The EU regulates the statutory audits in member states. TheEU is expected to introduce a requirement to apply the ISAs for all statutory audits. Finally,

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the USA regulatory environment is briefly discussed. The USA environment has radicallychanged during the last years, including the transfer of the auditing standard setting functionaway from the profession.

International Federation of Accountants (IFAC)�ix

The International Federation of Accountants (IFAC) was established in 1977 and is a globalorganization of national accountancy bodies. It has more than 163 member bodies in 119countries around the world. Membership of IFAC member bodies comprises more than 2.5million accountants in public and private practice. IFAC’s mission is:

To serve public interest, strengthen the worldwide accountancy profession, and contribute to thedevelopment of strong international economies by establishing and promoting adherence to highquality professional standards, furthering the international convergence of such standards andspeaking out on public interest issues where the profession’s expertise is most relevant.

In November 2003 IFAC approved an oversight reform of its organization and operatingprocedures. The purpose of the reform was to better serve the public interest by strengtheningpublic oversight, accountability and transparency of IFAC’s activities. At the organizationallevel the reform resulted in the establishment of a Public Interest Oversight Board (PIOB) in2005. International regulators and related organizations select the members of the Board. Theobjective of PIOB is to oversee IFAC’s standard setting and compliance regime. The IFACMember Body Compliance Programme was launched in 2004. A Compliance Advisory Panel(CAP) is set up to oversee the implementation and operation of the compliance programmefor the IFAC administration.

IFAC Forum of Firms (FOF) is an organization of international firms that perform auditsof financial statements that are used across national borders. The FOF is a key component ofthe international self-regulatory regime adopted by IFAC. The Transnational AuditorsCommittee (TAC) is the executive arm of the FOF and is important in supporting theactivities of IFAC’s standard setting committees.

In addition to IAASB and the Ethics Committee, the IFAC Education Committee and theIFAC International Public Sector Accounting Standards Board (IPSASB) issues internationalstandards. The Education Committee issues education standards for accountants and IPSASBissues accounting standards for public entities. Each of the four committees has anindependent authority to set standards. A Consultative Advisory Group (CAG) is establishedfor each of the committees. These groups serve to provide valuable public interest input intothe standard setting. Another one of IFAC’s committee is the Professional Accountants inBusiness (PAIB) Committee, serving professional accountants in private practice. Figure 2�–�4provides a representation of the main organizational units of the IFAC. The followingsummarizes the activities of IFAC’s organizational units. IAASB’s and the Ethics Committee’sactivities are more fully discussed in preceding subsections in this chapter.

● Public Interest Oversight Board (PIOB). PIOB is an independent body charged with theoversight of the public interest activities of IFAC. PIOB oversees IFAC’s auditing, ethics,and education standard setting committees and IFAC’s Member of Body ComplianceProgramme. International regulators and related organizations including representatives ofthe International Organization of Securities Commissions, the Basel Committee onBanking Supervision, the European Commission, the International Association ofInsurance Supervisors and the World Bank select the eight members of the Board. Thegroup of regulators and related organization is called the Monitoring Group.

● IFAC Council. IFAC Council is responsible for deciding constitutional questions and elect-ing the IFAC Board. The Council comprises one representative from each member bodyand meets once a year.

● IFAC Board. The Board is responsible for setting policy and overseeing IFAC operations,the implementation of programmes, and the work of IFAC committees and task forces.

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This includes issuing of Statements of Membership Obligations (SMOs). The members ofthe Board comprise of a President and 21 individuals of member bodies. The Board meetsthree times a year.

● Compliance Advisory Panel (CAP). CAP is the IFAC administration’s instrument tooversee the implementation and operation of the Member Body Compliance Programme.The Programme is set up to assess member body’s regulatory and standard setting frame-work and their self-assessment. The Statements of Membership Obligations (SMOs) arethe foundation of the Compliance Programme.

● Forum of Firms (FOF). FOF is an organization of international firms that perform audits offinancial statements that are used across national borders. Members of the Forum volun-tarily agree to meet certain requirements, including undergoing a global independentquality review.

● Transnational Auditors Committee (TAC). TAC is the executive committee of FOF.Specific responsibilities of TAC include identifying audit practice issues, proposingmembers to the IFAC leadership group and identifying qualified candidates to serve onIFAC standard setting committees, and offering a voluntary global quality review to FOFmembers.

● International Auditing and Assurance Standards Board (IAASB). IAASB develops andissues the international standards on auditing, assurance, quality control, and related ser-vices, as well as practice statements.

● Ethics Committee. The Ethics Committee develops ethics standards. The main product ofthe Committee is the Code of Ethics for Professional Accountants. The Code serves as thefoundation for codes of ethics developed and enforced by IFAC member bodies.

● Education Committee. The Education Committee develops guidelines related to the edu-cation of accountants. International Education Standards (IESs) express the benchmarksthat IFAC member bodies are expected to meet in the preparation and continual develop-ment of professional accountants. Additional international education guidelines (IEGs)interpret and expand on matters related to the education standards.

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International Federation of AccountantsFigure 2–4

Transnational Auditors

Committee (TAC)

Audit firms

Issuing quality control,assurance, auditing, and

related services standards

Public Interest Oversight Board

(PIOB)

Regulators andrelated organizations

Issuing education standards

Issuing Codeof Ethics

IFAC Board

IFAC Council

Nationalaccountancy

bodies

Member BodyCompliance Programme

and ComplianceAdvisory Panel

(CAP)

Issuing public sector accounting

standards

InternationalAuditing andAssurance

Standards Board(IAASB)

EducationCommittee

EthicsCommittee

InternationalPublic SectorAccounting

Standards Board(IPSASB)

ProfessionalAccountants in

Business (PAIB)Committee

Issuing guidance for accountants in

business

Forum of Firms (FOF)

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● International Public Sector Accounting Standards Board (IPSASB). IPSASB focuses on theaccounting and financial reporting needs of national, regional and local governments,related governmental agencies and the constituencies they serve. A main task of the Boardis issuing International Public Sector Accounting Standards (IPSASs) that apply to thegeneral purpose financial statements of public sector entities. IPSASs are based largely onthe International Accounting Standards developed by the International AccountingStandards Board. Note that IAASB’s international standards on auditing are generallyapplicable in the public sector. In circumstances where specific elements of an ISA are notapplicable in a public sector environment, or when additional guidance is appropriate insuch an environment, a so-called public sector perspective is added to the ISA.

● Professional Accountants in Business (PAIB) Committee. Professional accountants in busi-ness work in commerce, industry, the public sector, education, and the not-for-profitsector. The PAIB Committee serves more than 1.3 million professional accountants inbusiness who are members of IFAC’s member bodies. The Committee develops goodpractice guidelines on issues affecting professional accountants in business, includingguidelines on a corporate code of ethical conduct. Professional accountants in business ofIFAC’s member bodies are required to adhere to IFAC’s Code of Ethics for ProfessionalAccountants. (For details see Chapter 19.)

IFAC has established two permanent task forces to serve the need of small and mediumpractices, and developing nations, respectively. From time to time, the IFAC appoints specialtask forces to address significant issues that warrant focused attention, for example such asanti-money laundering.

The European regional body of IFAC, Fédération des Experts Comptables Européens(FEE), organizes the professional accountancy bodies in Europe.�x FEE activities cover subjectssuch as accounting, auditing, ethics, public sector accountancy, capital markets, environmentalissues, and regulation of the profession. The organization strongly supports compliance withISAs throughout Europe. FEE commands substantial expertise in auditing matters andcontributes to audit sector initiatives taken by the EU. Other regional accountancyorganizations of IFAC are Confederation of Asian and Pacific Accountants, Eastern Centraland Southern African Federation of Accountants, and Interamerican Accounting Association.

International Accounting Standards Board (IASB)�xi

The International Accounting Standards Board (IASB) is an independent, privately fundedaccounting standard setter that develops international accounting standards for financialstatements. IASB publishes its standards in a series of pronouncements called InternationalFinancial Reporting Standards (IFRSs). It has also adopted the body of accounting standardsissued by its predecessor the International Accounting Standards Committee (IASC). Thosepronouncements continue to be designated International Accounting Standards (IASs). Mostcurrent international accounting pronouncements are IASs.

Some countries have adopted IASs�IFRSs as their national financial reporting framework.Most countries, however, have developed national accounting regulations and practices.IASs�IFRSs are generally influential on national regulations. A major boost to the applicationof IASs�IFRSs has been the EU Regulation requiring IASs�IFRSs to be applied for preparationof consolidated accounts for listed companies in member states from 2005. EU member statescan opt to adopt IASs�IFRSs for other entities.

IFAC and IAASB strongly support the work of IASB in the setting and promotion of theinternational accounting standards. When a particular financial reporting framework orspecific accounting rules are referred to in an IAASB International Standard on Auditing(ISA), the reference is to IASs�IFRSs.

This text also many times refers to relevant IASs�IFRSs. The illustrative financialstatements of EarthWear are prepared in accordance with IASs�IFRSs. However, it isrecognized that at present there is no financial reporting framework that is generally accepted

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throughout the world. This book also covers the audit of financial statements prepared inaccordance with applicable financial reporting frameworks other than IASs�IFRSs, includinggenerally accepted accounting principles promulgated by a recognized standards setter in aparticular jurisdiction.

International Organization of Securities Commissions(IOSCO)�xii

The International Organization of Securities Commissions (IOSCO) organizes nationalsecurities commissions around the world. Members of IOSCO cooperate to promote highstandards of regulation in order to maintain just, efficient, and sound capital markets. IOSCOhas a close dialogue with major standard setters, including IAASB. IOSCO participates on theIAASB Consultative Advisory Group (CAG) and in the selection of the members of IFACPublic Interest Oversight Board (PIOB). The IFAC has sought IOSCO’s endorsement of theIAASB standards for use in all the capital markets regulated by IOSCO members.

International Organization of Supreme Audit Institutions(INTOSAI)�xiii

The International Organization of Supreme Audit Institutions (INTOSAI) assembles over180 national Supreme Audit Institutions (Offices of Auditor General) at a global level.INTOSAI has issued Auditing Standards to financial audits in the public sector. In its goal ofdeveloping guidelines for financial audits for application of the standards, IOSCO has resolvedthat the guidelines should, as far as possible, draw upon the ISAs. INTOSAI cooperates closelywith IAASB in projects relevant for public sector auditing.

European Union (EU)�xiv

After the enlargement of 10 new member states in 2004, the European Union (EU) consists of25 member countries. The EU Council and the European Parliament take legislative decisionswithin the EU. National governments are represented within the Council. The EuropeanParliament is directly elected by EU citizens.

The European Commission (EC) takes policy initiatives and makes proposals for newlegislation and regulations for EU, including for the auditing sector. In addition, theCommission acts as the Union’s executive body and as the guardian of the EU treaties toensure that European legislation is applied correctly. The Commission consists of 37Directorates-General (DGs) and Services. The Internal Market DG is responsible forcompany law and financial reporting, including auditing matters. The Commission has issuedRecommendations on quality assurance on statutory audits (2000) and statutory auditors’independence (2002). The two Recommendations are discussed in Chapter 19.

There has been a lack of harmonization at EU level concerning the statutory audit. Acommon view has been that this can have a negative impact on audit quality and cause ahandicap in improving the access of European companies to the international capital markets.Against this background, the EU concluded a need for further action. Recent corporatescandals in the USA and the EU have reinforced the need for EU initiatives on statutoryaudits.

The EU 8th Company Law Directive of 1984 deals primarily with the approval ofstatutory auditors in member states. In March 2004 the Commission proposed a new 8thDirective on statutory audits. The EU Council and Parliament are expected to decide on thenew Directive in autumn 2005. The transposition of the new Directive by member states intonational law is expected to be completed by the beginning of 2008. The expected main featuresof the new Directive are:

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● Approval, ownership, and registration of auditors and audit firms, including liberalizedownership and management requirements for audit firms and enhanced public registrationof statutory auditors and audit firms.

● Audit performance and auditors’ behaviour, including adoption of the International Standardson Auditing issued by the International Auditing and Assurance Standards Board for all statutory audits,application of a conceptual framework approach to auditors’ independence, and introduc-tion of the principle that the group auditors bear full responsibility for the audit of the con-solidated accounts.

● Audit infrastructure, including provisions on statutory auditors’ appointment and dis-missal, quality assurance systems of auditors and audit firms, and public oversight of theaudit profession.

● Internal Market aspects, including mutual recognition of statutory auditors betweenmember states and cooperation between national public oversight bodies in the EU.

● Specific requirements for Public Interest Entities such as listed companies and bank andinsurance companies, including establishing an audit committee, additional rules on audi-tors’ independence, and publication of a report with information about the audit firm.

● International dimension, including provisions for cooperation with oversight bodies ofthird countries such as the USA Public Company Accounting Oversight Board.

Additionally, a proposal exists to amend the EU Accounting Directives, including provisionsto disclose the fees paid to statutory audit firms by its components.

The Regulatory Environment in the USAThe Securities and Exchange Commission (SEC) is a government agency that regulatesdisclosure of information in a registration statement for an initial public offering of securitiesand ongoing reporting by companies whose securities are listed and traded on a USA stockexchange. SEC has responsibility and authority to oversee the establishment of accounting andauditing standards for public companies.

The Public Company Accounting Oversight Board (PCAOB), created by the Sarbanes–Oxley Act of 2002, is a regulatory agency overseen by SEC.�xv The Sarbanes–Oxley Actessentially transferred authority for standard setting, inspection, investigation, andenforcement for public company audits from the profession to the PCAOB.

The Financial Accounting Standards Board (FASB) is a privately funded body whosemission is to establish USA standards for financial accounting and reporting. The Statementsof Financial Accounting Standards (SFAS) and interpretations issued by the FASB arerecognized as USA GAAP by the PCAOB.

The American Institute of Certified Public Accountants (AICPA) organizes the USAaccounting profession. Until the Sarbanes–Oxley Act, AICPA’s Auditing Standards Board(ASB) established USA auditing standards for all non-governmental audits. AICPA ASBcontinues to promulgate standards that guide audit practice and related services to non-publicly traded companies. PCAOB has adopted the ASB’s auditing standards on an interimbasis.

CONCLUSIONChapter 1 introduced the concept of assurance and discussed the basics of financial statementauditing. This chapter explains the broader context in which financial statement auditing takesplace. To fully understand auditing, you must be aware of the factors that shape the auditingenvironment, including the general business environment, clients’ businesses and industries,and the standards, legal responsibilities, codes of ethics, and reporting requirements that guidethe financial statement auditor’s work. You must also understand the nature of audit firmswithin which auditors organize themselves to conduct audits of organizations of various sizes,

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and you must be aware of the outside professional, regulatory, and standard setting bodies thatdirectly impact how auditing is done. This chapter provides an introduction to the complexand ever-changing environment in which financial statement auditing is performed.

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Key termsAgreed-upon procedures engagement. An

engagement in which an auditor is engaged tocarry out those procedures of an audit naturethat the auditor and the entity and anyappropriate third parties have agreed and toreport on factual findings.

Applicable financial reporting framework.The financial reporting framework adoptedby management in preparing the financialstatements that the auditor has determined isacceptable in view of the nature of the entity andthe objective of the financial statements, or thatis required by law or regulations.

Assertions. Representations by management,explicit or otherwise, that are embodied in thefinancial statements. The three sets of assertionsrelate to ending account balances, transactions,and presentation and disclosure.

Audit committee. A committee consisting ofmembers of the board of directors, charged withoverseeing the entity’s system of internal controlover financial reporting, internal and externalauditors, and the financial reporting process.Typically must be independent of management.

Board of directors. Persons elected by theshareholders of a corporation to overseemanagement and to direct the affairs of thecorporation.

Business processes. Processes implemented bymanagement to achieve entity objectives.Business processes are typically organized into thefollowing categories: revenue; purchasing; humanresource management; inventory management;and financing processes.

Compilation engagement. An engagement inwhich accounting expertise, as opposed toauditing expertise, is used to collect, classify, andsummarize financial information.

Corporate governance. The oversight mechanismsin place to help ensure the proper stewardshipover an entity’s assets. Management and theboard of directors play primary roles and theindependent auditor plays a key facilitating role.

Engagements standards (IAASB). Assurancestandards or related services standards.

Ethics. A system or code of conduct based on moralduties and obligations that indicates how anindividual should behave.

Financial statements. A structured representationof the financial information, which ordinarily

includes accompanying notes, derived fromaccounting records and intended to communicatean entity’s economic resources or obligations at apoint in time or the changes therein for a periodof time in accordance with a financial reportingframework. The term can refer to a complete setof financial statements, but it can also refer to asingle financial statement, for example, a balancesheet, or a statement of revenues and expenses,and related explanatory notes.

Fraud. An intentional act by one or more individualsamong management, those charged withgovernance, employees, or third parties,involving the use of deception to obtain an unjustor illegal advantage.

Internal auditing. An appraisal activity establishedwithin an entity as a service to the entity. Itsfunctions include, among other things,examining, evaluating and monitoring theadequacy and effectiveness of internal control.

Management advisory services. Consultingservices that may provide advice and assistanceconcerning an entity’s organization, personnel,finances, operations, systems, or other activities.

Professional scepticism. An attitude thatincludes a questioning mind and a criticalassessment of evidence.

Reporting. The end product of the auditor’s work,indicating the auditing standards followed, andexpressing an opinion as to whether an entity’sfinancial statements are fairly presented (give atrue and fair view) in accordance with theapplicable financial reporting framework.

Reasonable assurance. A term that implies thatengagement assurance risk is reduced to anacceptably low level in the circumstances of theengagement.

Review engagement. An assurance engagementthat enables an auditor to state whether, on thebasis of procedures which do not provide all theevidence that would be required in an audit,anything has come to the auditor’s attention thatcauses the auditor to believe that the financialstatements are not prepared, in all materialrespects, in accordance with an applicablefinancial reporting framework.

Those charged with governance. Those personsaccountable for ensuring that the entity achievesits objectives, financial reporting and reporting tointerested parties.

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REVIEW QUESTIONS2�–�1 Briefly discuss the key events that led up to the recent years undermining of the

confidence in the accounting profession.

2�–�2 Discuss how the events that have so dramatically affected auditors and the accountingprofession since the Enron scandal may in some senses be ‘healthy’ for the profession.

2�–�3 Briefly discuss the essential components of the high-level model of business offered inthe chapter. Why might understanding the characteristics of a client’s business in each ofthese areas be important for a financial statement auditor?

2�–�4 What roles do information systems and systems of internal control play in the high-levelmodel of business discussed in the chapter, and why might it be important for an auditorto understand these roles?

2�–�5 How might the three categories of management assertions provide a powerful tool forthe financial statement auditor?

2�–�6 List the five categories of standards issued by IAASB. How are the ISAs grouped intocategories?

2�–�7 Why is independence such an important standard for auditors? How does auditorindependence relate to the agency relationship between owners and managers?

2�–�8 Compare and contrast management’s responsibility for the entity’s financial statementswith the auditor’s responsibilities for detecting errors and fraud in the financial statements.

2�–�9 Identify the elements of the standard audit report with an unmodified opinion.

2�–�10 Give one example each of compliance, operational and forensic assurance (audit).

2�–�11 List the various types of auditors.

2�–�12 Which are IFAC’s main committees (boards) and what are their functions?

2�–�13 What role do IASB, IOSCO, and INTOSAI play and how do these organizations affect theapplication of ISAs?

PROBLEMS2�–�14 Dale Boucher, the owner of a small electronics firm, asked Sally Jones, independent

auditor, to conduct an audit of the company’s records. Boucher told Jones that the auditwas to be completed in time to submit audited financial statements to a bank as part ofa loan application. Jones immediately accepted the engagement and agreed to providean auditor’s report within one month. Boucher agreed to pay Jones her normal audit feeplus a percentage of the loan if it was granted.

Jones hired two recent accounting graduates to conduct the audit and spent severalhours telling them exactly what to do. She told the new hires not to spend timeconsidering the internal control but to concentrate on proving the mathematical accuracyof the general and subsidiary ledgers and summarizing the data in the accountingrecords that supported Boucher’s financial statements. The new hires followed Jones’sinstructions and after two weeks gave Jones the financial statements excluding notes.Jones reviewed the statements and prepared a standard audit report with an unmodifiedopinion. The report did not refer to any auditing standards, and no audit procedureswere conducted to evaluate the appropriateness of accounting policies used and thereasonableness of accounting estimates made.Required:Indicate how the action(s) of Jones resulted in failure to comply with auditing standards andethical requirements.

(AICPA, adapted)

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2�–�15 The auditor’s report consists of an introductory paragraph identifying the financialstatements, paragraphs describing management’s and auditor’s responsibilities, and anopinion paragraph expressing the auditor’s opinion. In some circumstances a matterparagraph is added without affecting the auditor’s opinion.Required:Identify the circumstances necessitating departures from an audit report with an unmodifiedopinion. For each circumstance, indicate the type of opinion that would be appropriate.

2�–�16 Numerous assurance services exist including assurance on financial statements, internalcontrol, compliance, operational performance, financial forecasts, and fraud (forensicassurance).Required:For each of the following descriptions, indicate which type of assurance service bestcharacterizes the nature of the service being conducted. Also indicate which type of auditor(external auditor, internal auditor, government auditor, or forensic auditor) is likely to performthe audit engagement.

a Evaluate the policies and procedures of the Medical Control Agency in terms of bringingnew drugs to market.

b Determine the fair presentation of Ajax Chemical’s balance sheet, income statement andstatement of cash flows.

c Review the payment procedures of the Accounts Payable Department for a largemanufacturer.

d Examine the financial records of a division of a corporation to determine if any accountingirregularities have occurred.

e Evaluate the feasibility of forecasted rental income for a planned student housing project.f Evaluate a company’s Computer Services Department in terms of the efficient and

effective use of corporate resources.g Control the partnership tax return of a real estate development company.h Investigate the possibility of payroll fraud in a pension fund.

DISCUSSION CASES2�–�17 Part I: Merry-Go-Round (MGR), a clothing retailer located primarily in shopping malls,

was founded in 1968. By the early 1990s, the company had gone public and hadexpanded to approximately 1,500 stores, 15,000 employees and $1 billion in annualsales. The company’s locations in malls targeted the youth and teen market. Thecompany was listed by Forbes magazine as one of the top 25 companies in the late1980s. However, in the early 1990s, the company faced many challenges. One of its co-founders died, and the other left to pursue unrelated business interests. The companyfaced stiff competition from other retailers (e.g. The Gap and Banana Republic), fashiontrends changed, and mall traffic declined. Sales fell, and experts speculated that MGRfailed to anticipate key industry trends and lost sight of its customer market. To try toregain its strong position, the company acquired Chess King, Inc., a struggling chain ofmen’s clothing stores located in malls, in 1993.

The company’s sales continued to fall, and later in 1993, it brought back one of its co-founders to manage the company and wrote down a significant amount of inventory.However, this inventory write-down caused the company to violate loan covenants.Facing bankruptcy, the company, based on the advice of its newly hired law firm Swidlerand Berlin, hired turnaround specialists from Ernst & Young (E&Y) to help overcome thefinancial crisis and develop a long-term business plan. However, the company’s declinecontinued, and it filed for Chapter 11 reorganization in 1994. In 1996, the remainingassets were sold for pennies on the dollar.

Subsequently, a group of 9,000 creditors (including former employees andstockholders) began litigation against parties it deemed responsible for their losses. Theseparties included E&Y, which the creditors sued for $4 billion in punitive andcompensatory damages (E&Y’s fees from MGR totalled $4.5 million).

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The lawsuit alleged that E&Y’s incompetence was the main cause of MGR’s declineand demise. The lawsuit alleged in part that:● The turnaround team did not act fast enough.● The leader of the team took an eight-day vacation at a critical point during the

engagement.● The cost-cutting strategy called for only $11 million in annual savings, despite the fact

that the company was projected to lose up to $200 million in 1994.● While store closings were key to MGR’s survival, by 1995 only 230 of 1,434 stores

had been closed and MGR still operated two stores in some malls.● The turnaround team included inexperienced personnel – a retired consultant, a

partner with little experience in the USA and with retail firms, and two recent collegegraduates.

● E&Y charged exorbitant hourly rates and charged unreasonable expenses (e.g. chargesincluded reimbursement for a dinner for three of the consultants totalling in excess of$200).

● E&Y denied any wrongdoing but in April 1999 agreed to pay $185 million to settlewith the injured parties.

Required:Should there be specific professional standards for independent auditors who consult? Giventhat non-auditors who consult do not have formal professional standards, describe theadvantages and disadvantages that result from such standards.

2�–�18 Part II: Merry-Go-Round. Additional charges made against E&Y include the following(recall that MGR hired E&Y for turnaround consulting services):● E&Y had a close relationship with Rouse Co., one of MGR’s primary landlords (E&Y

was soliciting business from Rouse and provided significant tax services).● Swidler (the law firm that recommended E&Y to MGR) and E&Y had participated in at

least 12 different business arrangements, some of which resulted in Swidler receivingsignificant fees from E&Y.

● E&Y did not disclose either of these relationships to MGR.Required:a Do you think that E&Y acted unethically given it had these relationships?b How could these relationships have affected E&Y’s advice to MGR? In other words, refer

to the charges above and speculate as to whether any of the charges against E&Y mayhave stemmed from the relationships described above.

INTERNET ASSIGNMENTS2�–�19 Go to the IFAC’s website (www.ifac.org).

a Use the link ‘About IFAC’ and find the list of IFAC member organizations. See if thereare IFAC member organizations from your home country. If yes, learn about theprofessional organization(s) mission and activities.

b Use the link ‘Exposure drafts’ and learn about outstanding exposure drafts of IAASB.c Use the link ‘Standards and Guidance’ and (after register for free download)

download the most recent IFAC Handbook of International Auditing, Assurance andEthics Pronouncements. Get an overview of the content of the Handbook.

d Use the link ‘IFAC Boards and Committees’ and learn about IAASB’s and the EthicsCommittee’s activities.

2�–�20 Many companies post their financial statements and auditor’s report on their homepages. Use one of the Internet search engines to do the following:a Search the Web for the home page of a company and review its financial statements,

including its auditor’s report. For example, BMW’s home page (www.bmw.com)allows a visitor to download the financial statements as a .pdf file. The auditor’sreport on BMW’s financial statements is based on German auditing standards.

b Compare the audit report for company (e.g. BMW) with the audit report inExhibit 2�–�3.

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�i See Challenges and Successes in Implementing InternationalStandards: Achieving Convergence to IFRSs and ISAs (IFAC,September 2004), www.ifac.org/Members/Source_Files/Other_Publications/Wong_Report_Final.pdf.

�ii S. M. Mintz, Cases in Accounting Ethics and Professionalism,3d edn, McGraw-Hill, New York, 1997.

�iii The auditors’ legal liability and exposure to litigation varybetween countries. For example, legal liability regimes maydiffer according to which actions the auditor can be heldliable for, which third parties auditors have liability to, therules for allocation of litigation costs, joint and severalliability or proportional liability rules, and the presence oflegal or contractual liability caps. Joint and several liabilityprovides less protection against lawsuits since the auditor’sresponsibility will go beyond his or her proportional share ofthe damage. A liability cap sets a limit on the auditor’sfinancial liability. The number of audit failures, professionalindemnity insurance, and general litigation climate will alsobe factors affecting the cases of litigation against auditors.

Within Europe the professional liability rules of statutoryauditors are not harmonized. Differences are indeedsignificant. The diversity reflects that general rules of civilliability to a large extent are applied to statutory auditors.European harmonization either requires a fundamentalchange of national civil liability regimes, or the creation ofcommon specific rules concerning statutory auditors.

�iv The revised ISA 700 is effective for audit reports dated on orafter 31 December 2006. Since the outgoing ISA 700 TheAuditor’s Report on Financial Statements is effective foraudits of the 2005 financial statements, an audit report inaccordance with this standard is presented at the end of thissubsection.

�v ISA 701 Modifications to the Independent Auditor’s Reportwas issued as a conforming amendment to the revised ISA700 in December 2004, to become effective for auditor’sreports dated on or after 31 December 2006. In March 2005,however, IAASB proposed two new auditing standards(exposure drafts): ISA 705 Modifications to the Opinion in

the Independent Auditor’s Report and ISA 706 Emphasis ofMatter Paragraphs and Other Matters Paragraphs in theIndependent Auditor’s Report. These standards propose thatthe term ‘modified’ is used only in the context ofmodifications to the opinion in the audit report. This bookcomplies with the use of the term modified as proposed byISAs 705 and 706.

�vi See the IIA’s home page (www.theiia.org) for moreinformation on the IIA and the certified internal auditorprogramme.

�vii See J. T. Wells, Fraud Examination: Investigative and AuditProcedures, Quorum Press, New York, 1992, for a detaileddiscussion of forensic auditors.

�viii See the Association of Certified Fraud Examiners home page(www.acfe.org) for more information on the association andthe CFE programme.

�ix See IFAC’s website (www.ifac.org/) for other informationabout the IFAC.

�x See FEE’s website (www.fee.be/) for other information aboutthe FEE.

�xi See IASB’s website (www.iasb.org/) for other informationabout the IASB.

�xii See IOSCO’s website (www.iosco.org/) for other informationabout the IOSCO.

�xiii See INTOSAI’s website (www.intosai.org/) for otherinformation about the INTOSAI.

�xiv The European Economic Area (EEA) unites the 25 EU memberstates and the three EEA European Free Trade Association(EFTA) states, Iceland, Liechtenstein and Norway, into anInternal Market governed by the same basic rules. Thisimplies that EU regulatory measures of auditing discussed inthe current text also are relevant to Iceland, Liechtensteinand Norway.

�xv See the PCAOB’s website (www.pcaobus.org) for otherinformation about the PCAOB.

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