Audit and Assurance Week 1 Lecture Introduction to Audit and Assurance • Auditors commonly provide an audit report to the financial reports (prepared by client management). • Auditor should conduct a comprehensive financial reports audit to provide an audit report. Importance of Auditing • Integrity of financial reporting is crucial for a healthy functioning of a market economy • auditor’s play a key role in enhancing credibility of financial reports • major corporate collapses over that past decades gave important lessons in this regard, • Examples: ➢ Enron in the USA ➢ Lehman Brothers in the USA ➢ HIH in Australia (both were audited by Arthur Anderson) ➢ Dick Smith in Australia (2016) Example: Failure of Enron Corporation (2001-2) • Enron was a giant energy company • With steady growth, Enron became largest natural gas company in the US by the mid-1980s. • Kenneth Lay, Enron’s CEO, and his top subordinate, Jeffrey Skilling were behind Enron’s growth. • Created several special purpose entities (SPEs) to artificially increase reported profit using complex related party transactions. • Enron’s financial condition eventually deteriorated. • Enron filed for bankruptcy in December 2001. • Lay and Skilling and Enron’s CFO (Andy Fastow) went to jail. • Arthur Andersen was one of the Big 5 accounting firms and was Enron’s auditor • Andersen enjoyed a reputation for honesty and integrity as independent auditors • Andersen succeeded in generating $-billions of revenues from consulting and auditing services • Professional ethics – did Arthur Andersen do the right thing as auditors? • Arthur Andersen received its share of the criticism regarding the Enron collapse: ➢ Earned substantial consulting revenues from Enron ➢ Questionable role in relation to Enron’s SPE transactions, ➢ Obstructed justice by shredding audit documents for Enron. • Arthur Andersen was convicted in 2002 and its proud history ended. Example: Failure of Dick Smith (2016) • Dick Smith was an Australia-wide chain of electronic consumer retailer. • The company was founded in Sydney in 1968 by Dick Smith and owned by him and his wife until they sold 60% to Woolworths in 1980, the remaining 40% in 1982. • It has been then acquired by Anchorage Capital Partners in 2012. • Causes for the failure: ➢ The consumer electronics market is highly competitive with rapid changes in consumer demand patterns. ➢ Dick Smith had a store network much larger than its competitors, and so a higher cost base, with considerable exposure to and reliance on the fast moving office/computer products market. ➢ Dick Smith was losing market share by experiencing declining comparable sales. ➢ Revenue growth was based on store growth and commercial sales at low margins. ➢ Dick Smith’s expansion plan required considerable financial commitment, utilised all cash resources, required considerable supplier commitment and required bank borrowings. ➢ Inventory decisions made in this environment were not consistent with consumer demand, and Dick Smith was ultimately left with a considerable level of obsolete and inactive stock, requiring a major write-down. ➢ Clearance sales did not generate enough sales or margin to alleviate the cash pressure. ➢ Inability to obtain favourable credit terms impacted on stock levels, product mix and store presentation. ➢ Cash flow pressures led to banking covenants being breached that could not be remedied. • The accounting profession has questions to confront with this business failure. • Dick Smith's long-time auditor Deloitte has come under scrutiny. • The major question is why the auditor didn't raise red flags about: 1. refinancing problems and 2. inventory issues in the company's financial reports. Assurance Engagement • ‘An engagement in which an assurance practitioner aims to obtain sufficient appropriate evidence in order to express a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the measurement or evaluation of an underlying subject matter against criteria’. • Key terms: ➢ Assurance Practitioner: Accounting firm ➢ Evidence: More information about transactions and events ➢ Conclusion: Audit opinion ➢ Users: Shareholders ➢ Responsible party: Client management ➢ Subject matter: Financial reports ➢ Criteria: Accounting standards Different Assurance Services • Financial Report Audits: an engagement designed to express an opinion whether the report is prepared in all material respects in accordance with a financial reporting framework • Compliance Audit: Involves gathering evidence to ascertain whether rules, policies, procedures, laws and regulations have been followed. • Performance Audit: Refers to the economy, efficiency and effectiveness of an organisation’s activities. • Comprehensive Audit: Combines elements of financial report audit, compliance audit and performance audit. • Internal Audit: Provides assurance about various aspects of an organisation’s activities. • Corporate Social Responsibility (CSR) Assurance: Includes voluntary reporting about environmental, employee and social subject matter. Assurance Providers • Assurance services are provided by accounting and consulting firms. • Australia has three tiers of assurance providers: 1. ‘Big 4’ firms (Deloitte, EY, KPMG and PWC) 2. Mid-tier firms (most have international affiliations). 3. Next tier made up of regional and local accounting firms. • Big firms are associated with high audit quality Demand for Audit and Assurance Services • The demand for assurance services basically come from the shareholders and business owners. • Other users of financial reports also have an interest in assurance services. • Examples: ➢ Investors ➢ Suppliers ➢ Customers ➢ Lenders ➢ Employees ➢ Governments; ➢ General public. Reasons Users Demand Assurance Services • Remoteness of information: Users do not have access to internal information of the company, hence they depend on auditor's certification. • Complexity: Users’ lack of understandability of financial reports can be compromised with the audit report. • Competing incentives: Users may find it difficulty to identify if management presents bias information. • Reliability: Independent and competent third party’s assurance provides the reliability of information in financial reports. Theoretical frameworks for the Demand for Auditing • The demand for audit has been explained with the following three theories: 1. Agency Theory: Auditor intervenes as an independent third party to resolve the agency conflict between owners and managers of the company. 2. Information Hypothesis: Audit reports enhance the reliability of information in financial reports. 3. Insurance Hypothesis: Investors prefer to invest in companies that issue audited financial statements, hoping to spread the risk of business failures. • Auditors are required to take professional indemnity insurance. Audit Opinion • The final phase of an audit is reporting findings • ASA 700:Forming an Opinion and Reporting on a Financial Report http://www.auasb.gov.au/admin/file/content102/c3/Jun11_Compiled_ASA_700.pdf ➢ establishes mandatory requirements ➢ provides explanatory guidance ➢ form and content of the auditor’s report Different Audit Opinions • Unmodified (unqualified) opinion ➢ clean opinion – as in a “clean bill of health” ➢ financial report is true and fair, ➢ presents fairly the financial position of the company, ➢ information complies with AAS and Corp Act • Modified (qualified) opinion ➢ Modifications that do not affect the auditor’s opinion o Emphasis of Matter ➢ Modifications that affect the auditor’s opinion: o Qualified Opinion o Adverse Opinion o Disclaimer of Opinion Regulators and Regulations • There are a number of regulators that impact the audit process. • They include: 1. Financial Reporting Council (FRC) ➢ oversees the process used for setting accounting and auditing standards. Also monitors and reports on auditor independence. 2. Auditing and Assurance Standards Board (AUASB) ➢ responsible for the formulation of auditing standards. 3. International Auditing and Assurance Standards Board (IAASB) ➢ Develops and issues International Standards on Auditing (ISAs). 4. Accounting Professional and Ethical Standards Board (APESB) ➢ established as an independent body by CPA Australia and ICAA to issue professional and ethical standards. 5. Australian Securities and Investments Commission (ASIC) ➢ government body that administers the ASIC Act and much of Corporations Act. 6. Australian Securities Exchange (ASX) ➢ provides additional obligations for entities wanting to list on the exchange. 7. Companies Auditors and Liquidators Disciplinary Board (CALDB) ➢ responds to ASIC and APRA regarding breaches of Corporations Act or ASIC Act. ➢ The Board may: o cancel or suspend auditor o give a warning; or o ask for undertaking to improve conduct. 8. Professional bodies ➢ CPA; CA ANZ, and IPA in Australia Regulations • Corporations Act • CLERP 9 – now incorporated in Corporations Act 2001 • Corporations Legislation Amendment (Audit Enhancement) Bill 2012 Audit Expectation Gap • Is the difference between the expectations of assurance providers and financial report users. • Causes for the expectation gap: ➢ Unrealistic expectations of users ➢ Deficient performance of auditors and ➢ Deficiencies of accounting standards Reducing the Audit expectation gap • The audit expectation gap can be reduced by: ➢ Educating the public about the auditor’s duties and the audit process ➢ Improve the quality of audits o Peer reviews of audit work performed; o Pay high level of attention towards the risk of occurring material errors and frauds ➢ Continuous review and update of auditing standards .