Exploring the realities of Audit-Related Litigation

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Research the auditing standards for "reasonable assurance" and provide your assessment as to the accuracy of Ms. Stitt's description of that concept in her testimony.

First of all, we made a research on the Auditing Standards (AU), which are reorganized from the Statements on Auditing Standards (SAS). Establishing the Statements on Auditing Standards (SAS) was the responsibility of the Auditing Standard Board (ASB), a committee of the American Institute of CPAs (AICPA), which is a private, nongovernmental professional association. On top of that, we also researched on the Auditing Standards (AS) which was issued by the Public Company Accounting Oversight Board (PCAOB). PCAOB is overseen by the Securities and Exchange Commission (SEC).

Reasonable Assurance

According to Paragraph .10 AU Section 230 Due Professional Care in the Performance of Work, it states that while exercising due professional care, the auditor must plan and perform the audit to obtain sufficient appropriate audit evidence so that audit risk will be limited to a low level that is, in his or her professional judgment, appropriate for expressing an opinion on the financial statements. The high but not absolute level of assurance that is intended to be obtained by the auditor is expressed in the auditor's report as obtaining reasonable assurance about whether the financial statement are free of material misstatement (whether caused by error or fraud). Absolute assurance is not attainable because of the nature of audit evidence and the characteristics of fraud. Therefore, an audit conducted in accordance with generally accepted auditing standards may not detect a material misstatement.

Besides that, paragraph 17 of PCAOB Auditing Standard No.2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements, describe reasonable assurance as " Management's assessment of the effectiveness of internal control over financial reporting is expressed at the level of reasonable assurance. The concept of reasonable assurance is built into the definition of internal control over financial reporting and also is integral to the auditor's opinion. Reasonable assurance includes the understanding that there is a remote likelihood that material misstatement will not be prevented or detected on a timely basis. Although not absolute assurance, reasonable assurance is nevertheless, a high level of assurance."

Nature of Audit Evidence

The limitation on the level of assurance that can be obtained by auditor due to the nature of audit evidence generally results from two matters: (1) the concept of selective testing and (2) the fact that accounting presentations include accounting estimate that are inherently uncertain.

AU sec.230.11 stated that the independent auditor's objective is to obtain sufficient appropriate audit evidence to provide him or her with a reasonable basis for forming an opinion. The nature of most evidence derives, in part, from the concept of selective testing of the data being audited, which involves judgment regarding the areas to be tested and the nature, timing and extent of the tests to be performed. In addition, judgment is required in interpreting the results of audit testing and evaluating audit evidence. Even with good faith and integrity, mistakes and errors in judgment can be made. Furthermore, accounting presentations contain accounting estimates, the measurement of which is inherently uncertain and depends on the outcome of future events. The auditor exercises professional judgment in evaluating the reasonableness of accounting estimates based on information that could reasonably be expected to be available prior to the completion of field work. As a result of these factors, in the great majority of cases, the auditor has to rely on evidence that is persuasive rather than convincing.

Selective testing is necessary to perform an audit within reasonable time and cost constraints, but audit sampling techniques, if properly applied, can help the auditor control the level of assurance achieved through selective testing. Because estimates are approximations of financial statement amounts based on subjective as well as objective factors, they are less precise than other financial statement amounts. In addition, even when management's estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Furthermore, fraudulent financial reporting often is accomplished through intentional misstatement of accounting estimates. Accounting estimates that involve subjective judgments that are difficult to corroborate may be used to intentionally distort the financial statements.

Characteristics of Fraud

The characteristics of fraud that are identified as making absolute assurance unattainable and that create a possibility that a properly planned and performed audit may not detect a material misstatement are described in AU sec.230 paragraph 12.

Based on AU sec.230.12, we know that because of the characteristics of fraud, a properly planned and performed audit may not detect a material misstatement. Characteristics of fraud include (a) concealment through collusion among management, employees, or third parties; (b) withheld, misrepresented, or falsified documentation; and (c) the ability of management to override or instruct others to override what otherwise appears to be effective controls. For example, auditing procedures may be ineffective for detecting an intentional misstatement that is concealed through collusion among personnel within the entity and third parties or among management or employees of the entity. Collusion may cause the auditor who has properly performed the audit to conclude that evidence provided is persuasive when it is, in fact, false. In addition, an audit conducted in accordance with generally accepted auditing standards rarely involves authentication of documentation, nor are auditors trained as or expected to be experts in such authentication. Furthermore, an auditor may not discover the existence of a modification of documentation through a side agreement that management or a third party has not disclosed. Finally, management has the ability to directly or indirectly manipulate accounting records and present fraudulent financial information by overriding controls in unpredictable ways.

Last but not least, in AU sec.230.13, they stated that since the auditor's opinion on the financial statement is based on the concept of obtaining reasonable assurance, the auditor is not an insurer and his or her report does not constitute a guarantee. Therefore, the subsequent discovery that a material misstatement, whether from error or fraud, exists in the financial statement does not, in and itself, evidence (a) failure to obtain reasonable assurance, (b) inadequate planning, performance, or judgment, (c) the absence of due professional care, or (d) a failure to comply with generally accepted auditing standards.

Accuracy of Ms. Stitt's concept of Reasonable Assurance

In our own opinion, we strongly feel that Ms. Stitt's description of the reasonable assurance concept in her testimony is consistent with the auditing standard that we have mentioned above. In Ms. Stitt's testimony, she had mentioned that the auditors cannot provide absolute assurance or a guarantee because of a nature of audit evidence and the characteristics of fraud, which is the same as the AU sec. 230.10.

For the nature of audit evidence part, Ms. Stitt had highlighted that in order to give absolute assurance, the auditors would need to sort of look at every transaction and every balance that a company would be involved with, it will be time consuming. So, she explained that the whole concept of an audit is on the premise of selective testing and there is a huge amount of judgment that goes in to decide sort of, for example, the areas to be tested; the type, extent, and timing of those test; and the evaluation of test results significant auditor judgment. (consistent with AU sec.230.11)

While for the characteristics of fraud, Ms. Stitt gave the example that a fraud may involve collusion among individuals, concealment of information; it may involve falsification of documentation that the auditors receive; it may involve overriding of internal controls that based on the testing the auditors did. (consistent with AU sec.230.12)

Ms. Stitt testified that audit evidence is often not conclusive. Describe the GAAS fieldwork standard related to the need to collect audit evidence and provide a summary of what is meant by "sufficient appropriate audit evidence".

GAAS Fieldwork Standard

AU sec.150 Generally Accepted Auditing Standards paragraph .02 stated that the generally accepted auditing standards are composed of three categories of standards: general standards (three), standards of field work (three) and standards of reporting (four). The GAAS are approved and adopted by the membership of the American Institute of Certified Public Accountants (AICPA), as amended by the AICPA Auditing Standards Board (ASB).

The three standards of field work related to accumulating and evaluating evidence sufficient for the auditors to express an opinion on the financial statements.

Adequate Planning and Supervision

Adequate planning is essential to a satisfactory audit. Some portions of the audit can be performed prior to the end of the year under audit; some information may be compiled by the client's staff and made available for the auditors' analysis. The appropriate number of audit staff of various levels of skill and the time required of each need to be determined in advance of field work. Most of the field work of an audit is carried out by staff members with limited experience. The key to successful use of relatively new staff members is close supervision at every level. This concept extends from providing a specific written audit program to staff members all the way to an overall review of the work by the partner in charge of the engagement. (Whittington, O.R, Pany, K. 1995)

Sufficient Understanding of Internal Control

The second standard of fieldwork requires that the auditor gain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements, whether due to error or fraud, and to effectively plan the nature, timing and extent of further audit procedures. The degree to which the auditor relies on the auditee's internal control directly affects the nature, timing and extent of the work performed by the independent auditor. In addition, if the auditor can identify areas of weakness in a client's internal control, this information can help the auditor focus on areas where misstatements may be more likely to occur. (Messier, Jr., W., Glover, S. M. & Prawitt, D. F. 2008)

Sufficient Competent Evidential Matter

Sufficient, appropriate evidence is the focus of the third fieldwork standard. Most of the auditor's work involves the search for and analysis of evidence to evaluate and support management's assertions in the financial statements. The auditor uses various audit procedures to gather this evidence such as sending confirmation, physical examination, documentation and observation. While auditing standards give general guidance, the point at which the evidence for a particular management assertion is sufficient and appropriate is generally a matter of professional judgment on the part of the auditor. (Messier, Jr., W., Glover, S. M. & Prawitt, D. F. 2008)

Sufficient Appropriate Audit Evidence

The third standard of field work in GAAS provided that "The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit". AU sec.326 Audit Evidence paragraph .02 stated that audit evidence is all information used by the auditor in arriving at the conclusions on which the audit opinion is based and includes the information contained in the accounting records underlying the financial statements and other information. Because of the nature of audit evidence and the cost considerations of doing an audit, it is unlikely that the auditor will be completely convinced that the opinion is correct. However, the auditor must be persuaded that the opinion is correct with a high level of assurance. Two determinants of the persuasiveness of evidence are appropriateness and sufficiency.

Sufficiency of Evidence

AU sec.326 Audit Evidence paragraph .06 provided that sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence needed is affected by the risk of misstatement (the greater the risk, the more audit evidence is likely to be required) and also by the quality of such audit evidence (the higher the quality, the less the audit evidence that may be required). Accordingly, there is an inverse relationship between the sufficiency and appropriateness of audit evidence.

In addition to the quantity of audit evidence (sample size), the individual items tested affect the sufficiency of evidence. Samples containing population items with large dollar values, items with a high likelihood of misstatement, and items that are representative of the population are usually considered sufficient. (Arens, A. A., Elder, R. J., Beasley, M. S., Amran, N. A., Fadzil, F. H., Muhammad Yusof, N. Z., et al. 2008)

Appropriateness of Evidence

AU sec.326 Audit Evidence paragraph .06 provided that appropriateness is the measure of the quality of audit evidence, that is, its relevance and its reliability in providing support for, or detecting misstatements in, the classes of transactions, account balances, and disclosures and related assertions.

Relevance

The appropriateness of audit evidence depends on its relevance to the assertion being tested. If the auditor relies on evidence that is unrelated to the assertion, he or she may reach an incorrect conclusion about the assertion. AU sec.326 Audit Evidence paragraph .07 further explained that a given set of audit procedures may provide audit evidence that is relevant to certain assertions but not to others. On the other hand, the auditor often obtains audit evidence from different sources or of a different nature that is relevant to the same assertion.

Reliability

This refers to the degree to which evidence can be believable or worthy of trust. AU sec.326 Audit Evidence paragraph .08 explained that the reliability of audit evidence is influenced by its source and by its nature and is dependent on the individual circumstances under which it is obtained. For example, evidence obtained from a source outside the entity is more reliable than that obtained from within and evidence obtained when a client's internal control are effective is more reliable compare with when they are weak. Besides that, there are a few factors influence the reliability of the evidence such as auditor's direct knowledge, qualifications of individual providing the information, degree of objectivity and timeliness.

As part of Ms.Stitt's testimony, she describes auditor responsibility for detecting material misstatements due to fraud. Review AU 316, Consideration of Fraud in a Financial Statement Audit, and assess whether her testimony is consistent with auditing standard.

AU sec. 316 Consideration of Fraud in a Financial Statement Audit paragraph .01 provided that the section 110, Responsibilities and Functions of the Independent Auditor, paragraph .02 states, "The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud." The section 110 further explain that the auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statement are detected. On top of that, the AU sec.316 paragraph .04 also highlighted that the financial statements are management's responsibility. The auditor's responsibility is to express an opinion on the financial statements. Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control. Management along with those charged with governance, should set the proper tone; create and maintain a culture of honesty and high ethical standards; and establishes appropriate controls to prevent, deter and detect fraud.

In the Kingston Cotton Mill case (1896), the court held that the auditors are not required to ferret out every fraud but they are expected to exercise reasonable skill, care and caution appropriate to the particular circumstances. Further, if anything comes to their attention which arouses their suspicion, they are expected to "probe the matter to the bottom" and to report it promptly to the appropriate level of management. (Porter, B., Simon, J., Hatherly, D. 2008). Ms. Stitt had mentioned in her testimony that "we are generally not necessarily out doing a whole bunch of procedures to find necessarily fraud or illegal activity, but we keep our radar up in terms of if there is something that comes to our attention…". From this conversation, we strongly feel that her testimony is consistent with the auditing standard and the case that provided above.

According to the AU sec.316, they required auditors to assess, specifically, the risk of material misstatement in the financial statements resulting from fraud and to consider that assessment when planning and performing the audit. Besides that, AU sec 316 paragraphs .20 indicated auditors were required to consider whether risk factors that might indicate the existence of fraud are present and to make enquiries of management to obtain management's understanding and assessment of the likelihood of fraud occurring within the entity. For example, the auditor should inquire of management about programs and controls the entity has established to mitigate specific fraud risks the entity has identified, or that otherwise help to prevent, deter, and detect fraud, and how management monitors those programs and controls. In our point of view, we feel that Ms.Stitt's testimony which she said that "an audit requires us to make assessments up front in that planning stage as to where there may be a risk of fraud. We engage in discussions with the client around those. Make use professional judgment in understanding how those risks may have been mitigated…" is consistent with the Standard that highlighted above.

Question 2:

The following requirements relate to Ms. Stitt's testimony about the CanWest non-compete payments:

The concept of a "related party" is defined by generally accepted accounting standards (GAAP). Provide a brief overview of the concept of "related party transactions."

FASB Statement of Financial Accounting Standards No. 57 Related Party Disclosures (FAS57) states that related party transactions include (a) a parent company and its subsidiaries; (b) subsidiaries of a common parent; (c) an enterprise and trusts for the benefits of its employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of the enterprise's management; (d) an enterprise and its principal owners, management, or members of their immediate families; and (e) affiliates. Sales, purchases, and transfers of realty and personal property; services received or furnished, for example, accounting, management, engineering, and legal services; use of property and equipment by lease or otherwise; borrowings and lending; guarantees; maintenance of bank balances as compensating balances for the benefit of another; intercompany billings based on allocations of common costs; and filings of consolidated tax returns are example of some common types of related party transactions. It is also important to note that even if an enterprise may receive services from a related party without charge and not record receipt of services, it is still considered as a related party transaction although it does not have any accounting recognition.

FASB Statement No. 57 further defines related parties as the following:

Affiliates of the enterprise. An affiliate is a party that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with an enterprise. Control for purpose of FASB Statement No. 57 means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an enterprise through ownership, by contract, or otherwise.

Entities for which investments are accounted for by the equity method by the enterprise.

Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management.

Principal owners of the enterprise. Principal owners are owners of record or known beneficial owners of more than 10 percent of the voting interests of the enterprise.

Management of the enterprise. Management includes persons who are responsible for achieving the objectives of the enterprise and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management normally includes members of the board of directors, the chief executive officer, chief operating officer, vice presidents in charge of principal business functions (such as sales, administration, or finance), and other persons who perform similar policymaking functions. Persons without formal titles also may be members of management.

Members of the immediate families of principal owners of the enterprise and its management. Immediate family includes family members whom a principal owner or a member of management might control or influence or by whom they might be controlled or influenced because of the family relationship.

Other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests.

Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

Summarize what the auditing standards say regarding auditor's responsibilities with respect to identifying related party relationships and transactions.

According to AU Section 334 Related Parties paragraph .04, during the course of the audit, the auditor should be aware of the possible existence of material related party transactions that could affect the financial statements and of common ownership or management control relationship for which FASB Statement No. 57 requires disclosure even though there are no transactions. In addition, AU Section 334 paragraph .05 provided that in determining the scope of work to be performed with respect to possible transactions with related parties, the auditor should obtain an understanding of management responsibilities and the relationship of each component to the total entity.

In determining the existence of related parties, AU sec 334.07 further explained that the auditor should place emphasis on testing material transactions with parties he knows are related to the reporting entity. Certain relationships, such as parent-subsidiary or investor-investee, may be clearly evident. The auditor can identify other related parties by evaluating the client's procedures for identifying related parties, requesting a list of related parties from management, and reviewing filings with the Securities and Exchange Commission and other regulatory agencies. (Messier, Jr., W., Glover, S. M. & Prawitt, D. F. 2008)

Once related parties have been identified, the auditors should identify material transactions with known related parties and identify material transactions that may be indicative of the existence of undermined relationships which guided by AU sec. 334 paragraphs .08. After identifying related party transactions, according to AU sec. 334 paragraph .09, next the auditor should apply the procedures he considers necessary to obtain satisfaction concerning the purpose, nature and extent of these transactions and their effect on the financial statements. The procedures should be directed toward obtaining and evaluating sufficient appropriate audit evidence and should extend beyond inquiry of management.

Last but not least, AU sec 334.11 stated that certain accounting standards including FASB Statement No.57 require disclosure of material related party transaction or of common ownership or management control relationships. It further required that the auditors to consider whether sufficient competent evidential matter has been obtained during the audit to understand the relationship of the parties and for related party transactions, the effects of the transaction on the financial statements. The auditors should then evaluate all the information available concerning the related party transaction or control relationship and determine that the financial statement disclosures are adequate and appropriate. While, AU sec 334 paragraph .12 provided that it is difficult to substantiate representations that a transaction was consummated on terms equivalent to those that prevail in arm's-length transactions. If such representation is included in the financial statements and the auditor believes that the representation is unsubstantiated by management, he should express a qualified or adverse opinion because of a departure from generally accepted accounting principles, depending on materiality.

(d) What financial statement disclosures are required by generally accepted accounting standards (GAAP) for related party transactions?

According to IAS 24 Related Party Disclosure paragraph 12, relationships between parents and subsidiaries should be disclosed regardless of whether there have been transactions between a parent and a subsidiary. An entity must disclose the name of its parent and if different, the ultimate controlling party. If neither the entity's parent nor the ultimate controlling party produces financial statements available for public use, the name of the next most senior parent that does so must also be disclosed. On top of that, IAS 24 paragraph 16 highlighted that the company should disclose key management personnel compensation in total and for each of the following categories

Short-term employee benefits

Post-employment benefits

Other long-term benefits

Termination benefits

Equity compensation benefits

While, IAS 24 paragraph 17 & 18 stated that if there have been transactions between related parties, disclose the nature of the related party relationship as well as information about the transactions and outstanding balances necessary for an understanding of the potential effect of the relationship on the financial statements. These disclosures would be made separately for each category related parties and would include:

The amount of the transactions

The amount of outstanding balances, including terms and conditions and guarantees

Provisions for doubtful debts related to the amount or outstanding balances

Expense recognized during the period in respect of bad or doubtful debts due from related parties

Question 4

The following requirements relate to Ms. Stitt's testimony about the audit working papers:

(a) Based on your review of AU Section 339, Audit Documentation, why must auditors prepare audit documentation?

AU sec. 339 Audit Documentation paragraph .03 stated that the main objective of having audit documentation is to provide a clear understanding of the work performed, the audit evidence obtained and its source, and the conclusions reached. On top of that, paragraph .03 also mentioned that the audit documentation provides the principal support for the representation in the auditor's report that the auditor performed the audit in accordance with generally accepted auditing standards (GAAS) and also provides the principal support for the opinion expressed regarding the financial information or the assertion to the effect that an opinion cannot be expressed.

In addition to the objectives set out in paragraph .03, AU sec.339 paragraph .08 also listed down a number of other purposes of having audit documentation:

Assisting the audit team to plan and perform the audit

Assisting auditors who are new to an engagement and review the prior year's documentation to understand the work performed as an aid in planning and performing the current engagement

Assisting members of the audit team responsible for supervision to direct and supervise the audit work and to review the quality of work performed.

Demonstrating the accountability of the audit team for its work by documenting the procedures performed, the audit evidence examined, and the conclusions reached.

Retaining a record of matters of continuing significance to future audits of the same entity

Assisting quality control reviewers who review documentation to understand how the engagement team reached significant conclusions and whether there is adequate evidential support for those conclusions

Enabling an experienced auditor to conduct inspections or peer reviews in accordance with applicable legal, regulatory or other requirements

Assisting a successor auditor who reviews a predecessor auditor's audit documentation

(b) Discuss the concept of "experienced auditors" as described in AU Section 339 and highlight how that concept relates to the form, content and extent of audit documentation.

According to the AU sec. 339 Audit Documentation paragraph .09, we know that experienced auditor means an individual (whether internal or external to the firm) who possesses the competencies and skills that would have enabled him or her to perform the audit. These competencies and skills include an understanding of (a) audit processes, (b) the SASs and applicable legal and regulatory requirements, (c) the business environment in which the entity operates and (d) auditing and financial reporting issues relevant to the entity's industry.

AU sec. 339 Audit Documentation paragraph .10 provided that the auditor should prepare audit documentation to contain sufficient information to enable an experienced auditor, having no previous connection to the audit, to understand:

The nature, timing and extent of auditing procedures performed to comply with SASs and applicable legal and regulatory requirements.

The results of the audit procedures performed and the audit evidence obtained

The conclusions reached on significant matters

That the accounting records agree or reconcile with the audited financial statements or other audited information.

(c) Summarize the requirements in AU Section 339 for identifying the preparer and reviewer of audit documentation. Is Ms. Stitt's testimony consistent with those requirements? Briefly explain.

AU sec.339 Audit Documentation paragraph .18 indicated that in documenting the nature, timing and extent of audit procedures performed, the auditor should record:

Who performed the audit work and the date such work was completed

Who reviewed specific audit documentation and the date of such review

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