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6.2 The Role of the Independent Auditor in Financial Reporting
At the end of this section, students should be able to meet the following objectives:
- Understand the purpose of an independent audit.
- List the two primary components of an independent audit.
- Explain the function of an independent audit firm.
- Describe the steps required to become a Certified Public Accountant (CPA).
- List the various types of services provided by many public accounting firms.
- Discuss the necessity for the creation of the Public Company Accounting Oversight Board (PCAOB) and describe its function.
The Need for an Independent Audit of Financial Statements
Question: The SEC allows FASB to set U.S. GAAP. Does the SEC physically visit each company that issues securities to the public to ensure that periodic financial statements properly follow the rules and guidelines of U.S. GAAP?
Answer: A detailed examination of the financial statements produced by thousands of publicly traded companies around the world would require a massive work force with an enormous cost. Therefore, this essential role in the financial reporting process has been left by the SEC to auditing (also known as public accounting) firms that operate both inside and outside the United States. Before submitting statements to the SEC and then to the public, reporting companies such as IBM and Wells Fargo must hire an independent auditing firm to do the following:
- Perform an auditAn examination carried out by an independent CPA of the evidence underlying the information presented in a set of financial statements followed by the issuance of a report as to whether the statements contain material misstatements in accordance with U.S. GAAP; this opinion is intended to provide reasonable assuranace that the statements are fairly presented, which adds credibility to the information provided. (examination) of the company’s financial statements
- Provide a report stating whether sufficient supporting evidence was obtained to enable the auditor to provide reasonable assurance that the statements are presented fairly because they contain no material misstatements according to U.S. GAAP
The independent auditor’s written report is then attached to the financial statements for all to read. This expert opinion is essential to the integrity of the reporting process because it tells decision makers whether they should feel safe relying on the financial information. Even many companies that are not affected by the rules of the SEC have their statements audited by an independent firm to enhance credibility. For example, a convenience store seeking a bank loan could pay for an audit in hopes of increasing the chances that the application will be approved (or because bank officials have required the audit for the bank’s own protection).
Not surprisingly, companies that have independent audits performed on their financial statements are able to get loans at lower interest rates than comparable organizations that do not have such examinations.David W. Blackwell, Thomas R. Noland, and Drew B. Winters, “The Value of Auditor Assurance: Evidence from Loan Pricing,” Journal of Accounting Research, Spring 1998, 57–70. The audit and the related audit report serve to reduce the lender’s risk of loss. Thus, banks and other institutions require a lower rate of interest to compensate for their risk of default.
In the United States, independent auditing firmsOrganizations operated by individuals recognized by a state government as Certified Public Accountants (CPAs) to provide independent auditing and other accounting services to the public; also known as CPA firms or public accounting firms. can only be operated by individuals who have been formally recognized by a state government as Certified Public Accountants (CPAs)Individuals who have met state requirements of education, practical experience, and passing the Uniform CPA Examination; the CPA designation is a license that allows a person to provide auditing and other accounting services to the public and serves as a symbol of technical expertise..The rules for becoming a CPA vary by state but usually include a specific amount and level of education as well as a passing grade of at least 75 or above on the four parts of the uniform CPA Exam. Some states also require a defined length of practical experience such as one or two years. Considerable information about the auditing profession and the possibility of becoming a CPA can be found at http://www.thiswaytocpa.com. Such firms range in size from massive (KPMG employs 137,000 individuals working in 144 countries and generated revenues of approximately $20.6 billion for the year ended September 30, 2010See http://www.kpmg.com as of August 12, 2011.) to organizations comprised of only one or two people.
Obviously, for the financial statements of the biggest organizations (the ExxonMobils and Walmarts of the world), only a public accounting firm of truly significant size could effectively perform an audit engagement. Consequently, four firms (known collectively as the Big FourTerm used to encompass the four largest CPA firms operating internationally: Deloitte Touche Tohmatsu, Ernst & Young, KPMG, and PricewaterhouseCoopers; these four firms perform independent audits on most of the world’s largest companies.) have become huge global organizations:
- Deloitte Touche Tohmatsu
- Ernst & Young
However, thousands of smaller independent CPA firms exist providing numerous services, such as audit, tax planning and preparationOne of the professional services performed by many CPA firms, including the preparation of tax returns and the creation of tax strategies to help minimize tax payments., and advisory workOne of the professional services performed by many CPA firms to assist businesses in operating more effectively and efficiently, and, therefore, more profitably. for a wide range of clients. Ernst & Young indicates on its Web site (http://www.ey.com) that the following services are provided to its clients with each explained in detail: advisory, assurance, tax, transactions, strategic growth markets, and specialty services.
Financial statements have been produced by the management of the Southern Central Corporation. Unfortunately, a significant expense was accidentally recorded as an asset, so the company’s net income was overstated by a large amount. Who is most likely to discover this mistake?
- The board of directors for the company
- Employees of the Securities and Exchange Commission
- The company’s independent CPA audit firm
- Major investors in the company’s stock
The correct answer is choice c: The company’s independent CPA audit firm.
The purpose of a financial statement audit performed by an independent CPA firm is to provide reasonable assurance that information is presented fairly according to U.S. Generally Accepted Accounting Principles because no material misstatements are present. While accumulating evidence to support this assertion, the independent auditor should discover that the expense has been improperly capitalized as an asset. Various testing techniques are designed to bring problems such as this to light.
Standards for a Proper Audit
Question: FASB creates U.S. GAAP, the official standards for the preparation of financial statements. What group sets the examination and reporting rules to be followed by independent auditors?
The work performed by auditors is not in accordance with accounting principles. Instead, these experts are seeking to determine whether U.S. GAAP was applied properly when financial statements were created. Auditing firms provide a vital service by adding credibility to that reported information. How do independent auditors know what actions should be taken in assessing the data disclosed by a company such as Xerox or Bank of America?
Answer: When an audit is performed on the financial statements of any organization that issues securities to the U.S. public, the examination and subsequent reporting is regulated by the Public Company Accounting Oversight Board (PCAOB)Private sector, nonprofit corporation brought into existence by the U.S. Congress through the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies in hopes of protecting and better serving investors.. The PCAOB was brought into existence by the U.S. Congress through the Sarbanes-Oxley Act of 2002Federal securities law passed by the U.S. Congress in response to the Enron, WorldCom, and other major accounting scandals; it brought about many changes in the audit process and in the relationship between reporting companies and their independent auditors., legislation passed in response to a number of massive accounting scandals, including Enron and WorldCom. Members of Congress apparently felt that the auditing profession had failed to provide adequate protection for decision makers who were relying on published financial information. Consequently, the federal government became more involved.
The PCAOB was established under the oversight and enforcement authority of the SEC. It holds wide-ranging powers that include the creation of official guidelines for the performance of a proper audit. Its vision is stated as follows: “Using innovative and cost-effective tools, the PCAOB aims to improve audit quality, reduce the risks of auditing failures in the U.S. public securities market, and promote public trust in both the financial reporting process and auditing profession.”See http://www.pcaob.org.
If an audit is performed on financial statements that are produced by an organization that does not issue securities to the public, the PCAOB holds no authority. For such smaller engagements, the Auditing Standards Board (ASB)Technical body within the AICPA that holds the authority to set the rules for appropriate audits of organizations that do not issue securities to the public (often referred to as privately held organizations). officially sets the rules for an appropriate audit. The ASB is a technical committee within the American Institute of Certified Public Accountants (AICPA)A national professional organization of CPAs that sets ethical requirements, conducts research, and helps set a high standard for the profession., a national professional organization of CPAs.
A local convenience store, a medical practice, or a law firm (for example) might choose to have an audit on its financial statements. These audits fall under the guidelines provided by the ASB rather than the PCAOB because the organizations do not issue securities that are publicly traded. Thus, the rules for performing an audit on a large company can differ somewhat from those applied to a smaller private one.
The Role of the SEC
Question: FASB sets U.S. GAAP. The PCAOB (and the ASB) establishes rules for performing an audit. What function does the SEC actually serve?
Answer: The goal of the work done by the SEC is summed up in the following statement from its Web site: “The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.”See http://www.sec.gov.
Thus, the SEC strives to make certain that the organizations that fall under its jurisdiction are in total compliance with all laws so that decision makers have ready access to information that is viewed as relevant. It reviews the required filings submitted by each organization to ensure that the rules and regulations are followed. The SEC also has the power to enforce securities laws and punish companies and individuals who break them. For example, if a company fails to disclose a significant transaction or other event that the SEC believes is necessary, all trading of that company’s securities can be halted until the matter is resolved. Such regulatory actions can cause a huge financial loss for a business. Thus, compliance is viewed as vital.
In addition, if corporate officials provide false or misleading data, fines and jail time are also possible: “L. Dennis Kozlowski, the former CEO of Tyco International, acquired hundreds of companies between 1996 and 2002 and created a conglomerate that made everything from fire suppression systems to health-care products, with worldwide sales of $40 billion. Now, while serving up to 25 years in jail for misleading investors and stealing money from Tyco, he’s watching the breakup of all he built.”John Kostrzewa, “After the Scandal, a New Tyco,” The Providence Journal, July 15, 2007, F-1.
Fairchild Corporation is a large retail organization that sells its stock on the New York Stock Exchange. Littleton Corporation is a small retail organization that is privately owned by three investors and raises money through bank loans. Both companies produce financial statements that are audited by independent CPAs. Unfortunately, each set of financial statements contains a material misstatement because, in both cases, a relatively large liability was never recorded. Which of the following statements is true?
- The rules of the SEC apply to both of these companies.
- The rules of the PCAOB apply to both auditing firms in connection with these independent audits.
- The rules of FASB apply to both of these companies.
- The misstatement is more of a concern in connection with the audit of the publicly owned company.
The correct answer is choice c: The rules of FASB apply to both of these companies.
Rules established by the SEC and the PCAOB are directed toward organizations (and their auditors) with publicly traded securities. State laws and the rules of the ASB are applicable to other entities. Misstatements are always a problem in financial statements because individuals rely on those statements in making decisions. However, in almost all cases, accounting rules developed by FASB apply to privately owned companies as well as those that are publicly held.
Independent auditing firms provide credibility to financial statements by examining the evidence that underlies the information provided and then reporting on those findings. Official oversight of the rules for this process is in the hands of the Public Company Accounting Oversight Board (PCAOB) if the audited company issues securities to the public and the Auditing Standards Board (ASB) if not. The role of the Securities and Exchange Commission (SEC) is to ensure that this reporting process is working as intended by the government. The SEC examines the filings of the various companies and can take disciplinarian action if either the company or its officials fail to act appropriately.