Week 5 A

Week 5 A

Auditors have come into a department as part of a company-wide audit prior to issuing an audit opinion for the company’s financial reports. In a one- to two-page paper (not including the title and reference pages), explain what the staff should expect the auditors to do. Be sure to include the requirements of the Sarbanes Oxley Act in your explanation.

Your paper must be formatted according to APA style as outlined in the Ashford Writing Center, and it must include citations and references for the text and at least two scholarly sources.

5.4 The Auditor’s Role Company outsiders need to be sure that the information they see on financial reports is an accurate reflection of the company’s financial situation. This is accomplished by hiring an impartial third party to review the company’s operations and financial statements and to confirm that the reports are materially correct and that proper internal controls are being used. This process is called an audit and is crucial for verifying the accuracy of a company’s financial reports.

Every public company that sells stock on one of the public markets must hire an independent certified public accountant (CPA) to audit its financial statements. Managers, employees, investors, financial institutions, vendors, suppliers, and everyone else who depends on knowledge about a company’s financial status expect these audited statements to be materially correct. The CEO and CFO must approve the financial statements that are ultimately issued to the public. The auditors’ only responsibility is to issue an opinion that the financial statements are materially accurate.

Auditors must abide by the rules set by the Public Company Accounting Oversight Board (PCAOB), which is a private sector, nonprofit corporation created by the Sarbanes-Oxley Act to oversee the auditors of public companies. Even though the PCAOB is a private entity, it has many government-like regulatory functions in relation to setting rules for auditors and how they do their work, which is similar to the role of the FASB for setting GAAP rules. The PCAOB is considering rule changes regarding mandatory firm rotation, which is discussed in further detail in “New World of Financial Oversight.”

The Sarbanes-Oxley Act also requires that public companies with market capitalizations of $75 million or more include an attestation report of their independent auditors on the effectiveness of the company’s internal controls over financial reporting. This requirement has become part of the audit process.

New World of Financial Report Oversight Research by Marion McHugh and Paul Polinski in the CPA Journal (2012) indicates that there is value to requiring firms to change their auditors more regularly. In fact, some findings indicate that it is important to change not only the lead auditor but audit firms as well.

5.4 The Auditor’s Role

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Personal relationships can develop between auditors and company management that call into question the independence of the audit team. To address this issue, PCAOB is considering a regulation that would mandate regular changes in company auditors.

© Ievgen Chepil/iStock/ThinkstockIn this CPA Journal article, the authors indicate that the PCAOB is looking for ways to improve the quality of audits and whether there is a need for mandatory audit rotation.

Now that it has been several years since Sarbanes-Oxley passed, the PCAOB has noticed that there are fewer changes in auditors from year to year, which the PCAOB believes may be due to a reduction in firm scrutiny and independence. The PCAOB is considering the costs and benefits of additional regulatory measures.

The authors of this CPA Journal article believe that “improved disclosures would give audit firms a formal opportunity to demonstrate their independence” (McHugh, 2012, p. 30). They also believe that the necessary changes could result in the PCAOB requiring mandatory audit firm rotation to ensure independent audits. If this occurs, managers would need to adapt to regular changes in auditors, which would mean a reduction in personal relationships between auditors and company management.

Consider This:

1. Do you think it is important for auditors and company managers to develop personal long-term relationships? Why or why not?

2. Will the public be better served by frequent changes of auditors? Why or why not?

Meeting the Qualifications To become a licensed CPA, candidates must complete extensive training. This includes completing at least a bachelor’s degree with a major emphasis in accounting, passing a state administered uniform CPA exam, and completing work under the supervision of a CPA to satisfy work-experience requirements that vary by state. To keep a current license, CPAs must take continuing education courses. The amount of time devoted to continuing education and educational requirements varies by state.

Each state has a board of accountancy that monitors the activities of its CPAs. The state boards have the right to revoke or suspend a CPA’s license if he violates the laws, regulations, or ethics governing CPAs. If a CPA’s license is revoked or suspended, she can no longer serve clients as an independent CPA unless she can get her license reinstated.

In order to audit a company’s financial statements, a CPA must be in public practice and be an employee of a CPA firm. A CPA’s independence from the companies he

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serves is critical to assure an independent report. Major publicly traded corporations usually use one of the top four CPA firms: PricewaterhouseCoopers, Deloitte, Ernst & Young, or KPMG.

A good CPA will approach an audit with skepticism. He may need to challenge management’s assertions if those assertions differ from the evidence collected in the audit. Sometimes independent auditors will have views different from those held by management about how to record a particular transaction or disclose accounting information. When there is a difference of opinion, the auditor must act in the public’s interest, not the interest of company management.

If differences cannot be resolved, the audit committee of the company’s board of directors may be asked to step in. In rare circumstances, if the auditor cannot come to an agreement with the board, she may resign from the audit and inform the SEC of the issue. In these occasions, the SEC may open an investigation of the company.

Usually when an auditor resigns in the middle of an audit, the company must send out a notice that its financial reports will be delayed. Discussion of an auditor change is typically found in the Notes to the Financial Statements, but it may also be discussed in the Management’s Discussion and Analysis section.

The Audit Process The audit process includes three key steps: defining the scope of the audit, performing fieldwork, and writing the audit report. Let’s take a look at each of these crucial steps.

Defining the Scope Auditors begin by meeting with top management and an internal committee of the board of directors (made up of directors appointed to this committee) to discuss the audit’s scope and objectives. Managers will bring a list of issues that should be reviewed as part of the audit. An audit may include a complete review of the company’s operations, or it may focus on just one aspect, such as collections from customers, which would be a limited scope audit.

The objectives of a full audit are usually to validate the company’s financial statements. The objectives of a more focused audit usually involve reviewing the operation’s efficiency or finding possible internal control problems that might put the company at risk of theft or fraud.

After determining the scope of the audit, the auditors meet with key managers to gather information about internal accounting processes, to evaluate existing controls, and to plan how the audit will be conducted inside the company. The internal accounting manager then sends a letter to the staff involved, announcing the audit and who has been assigned to conduct it. In the first meeting with accounting staff, the auditors review the available resources—including personnel, facilities, and

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funds—that are allocated to the audit. During these initial meetings, those involved identify areas of special concern.

Auditors then meet with the departments being audited, which may include all departments or just a few that are directly involved in the issues being investigated. The auditors survey key personnel and review financial reports, files, and other information. The auditors also review each department’s internal control structure. This review helps identify any holes in internal control processes and the key areas that need to be tested when auditing specific stores or other locations that the company owns.

After the preliminary review, the auditors design the process that will be used to collect needed information and to meet the objectives set out in the initial meetings with top executives and the board of directors.

Performing Fieldwork Auditors perform fieldwork when they visit a company’s individual offices and locations to determine whether the internal controls discussed at the company’s top levels are being implemented properly. For example, if a business requires a certain type of coding when an order is charged to a customer’s account, and that coding is not being used consistently, some customers may be getting merchandise without being billed.

In the field, auditors watch a company’s employees carry out certain tasks to be sure that they are performing them correctly. Additionally, auditors review files to be sure all the paperwork is in order to back up reports sent to the central corporate offices. For example, if the company requires a manager’s signature before a customer is given a refund, the auditor randomly reviews company refund records to be sure that the signature process is being followed.

Although the top manager at a location likely knows when the auditors will arrive, the rest of the staff is usually surprised by their arrival. Any findings during the fieldwork become part of the draft audit report.

After the auditors complete a preliminary review of the specific location, they randomly review various records to be sure that employees are following internal control procedures. For example, if an auditor is auditing a bank’s operations, the auditor will want to know whether employees are following the bank’s procedures for approving a loan. The auditor will likely check random loan files to be sure all needed approvals are in place.

The type of fieldwork that is required of auditors depends on the business type and the audit’s scope. Auditors for a bank will visit offices in the corporate headquarters as well as bank branches to complete their fieldwork. Auditors for a corporation with retail stores will do their fieldwork in the corporate headquarters, regional headquarters, and individual stores. If the scope of the audit is just to review the

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customer order and bill-paying process, the fieldwork may take place only in the corporate accounts receivable section of the accounting department.

Writing the Report As the auditors work in the field, they discuss any significant discrepancies with top management. Managers can comment on the findings before auditors submit a final report to the operating managers, top executives, and board of directors. Managers are usually given an opportunity to submit their own comments in areas of discrepancy.

Auditors often work with management to determine how best to resolve any problems before they complete their final audit report. If a problem can be easily resolved, they can do so verbally. If the problems are more serious or complex, auditors compile written reports and circulate them to managers, corporate executives, and board members. These reports summarize the auditors’ findings, identifying problems and making recommendations, before the auditors turn in their final report.

Most companies work to fix problems internally to avoid being reported to their outside stakeholders: investors, creditors, employees, vendors, and suppliers. If the auditor concludes that changes need to be made within the corporation, managers submit their plans to improve processes based on the auditor’s recommendations. If, for some reason, managers disagree with the auditor, they have to explain in the final report why they disagree and what they plan to do to fix the problem.

Top management or members of the audit committee of the board of directors usually find out about problems long before they are detailed in the business press or on the front page of the newspaper, as some company scandals are. Audit reports from fieldwork are not released publicly, so when scandals do make it to the front pages, it is usually after a whistle-blower comes forward or the SEC announces an investigation.

The summary of the audit report can be found in the annual report, as discussed in Chapter 1. The summary is usually one or two pages and does not provide significant detail about the audit’s findings.

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