E.1. External Audit and Reporting

Question 1

What is the primary purpose of an external audit?

Answer 1

To provide an opinion on the fairness with which the financial statements present the financial position, results of operations, and cash flows of the organization in conformity with generally accepted accounting principles.

Question 2

Which organizations oversee the external audit process in the United States?

Answer 2

• The Auditing Standards Board of the American Institute of CPAs (AICPA) provides guidance and standards for external audits of companies that are not publicly traded.
• The Public Company Accounting Oversight Board (PCAOB) provides standards for external audits of companies that are publicly traded.

Question 3

What is the mandate of the Public Company Accounting Oversight Board (PCAOB) as established under Title I of the Sarbanes-Oxley Act?

Answer 3

To oversee the auditing of public companies, protect investors’ interests, and enhance public confidence in independent audit reports.

Question 4

What must public accounting firms do before they can issue audit reports for public companies, other issuers of securities, or broker-dealers?

Answer 4

They must register with the PCAOB.

Question 5

What are the PCAOB’s responsibilities?

Answer 5

• Registering public accounting firms
• Establishing auditing and related standards
• Conducting inspections of registered public accounting firms
• Enforcing compliance with relevant laws, rules of the Board, and standards
• Conducting investigations and disciplinary proceedings
• Management of the operations and staff of the Board

Question 6

What services are auditors prohibited from providing to audit clients under Section 201 of the Sarbanes-Oxley Act?

Answer 6

• Bookkeeping services
• Financial information systems design and implementation
• Appraisal or valuation services
• Actuarial services
• Internal audit outsourcing services
• Management functions
• Human resource services
• Broker/dealer, investment adviser, or investment banking services
• Legal services
• Expert services unrelated to the audit
• Any other service prohibited by the PCAOB

Question 7

What is the requirement for audit partner rotation under Section 203 of the Sarbanes-Oxley Act?

Answer 7

The lead audit partner or the concurring review audit partner must not have performed audit services for that client in each of the five previous fiscal years of the client.

The SEC has added a requirement that other audit partners who are part of the engagement team must rotate off after seven years and remain off for two years if they meet certain criteria.

Question 8

What is the purpose of audit partner rotation as required by Section 203 of the Sarbanes-Oxley Act?

Answer 8

To ensure a “new look” is periodically taken at the financial statements.

Question 9

Section 204 of the Sarbanes-Oxley Act requires public accounting firms registered with the PCAOB that perform audits for issuers of publicly traded securities to report certain things to the issuers’ audit committees.

What must auditors report to audit committees according to Section 204?

Answer 9

• All critical accounting policies and practices
• All alternative treatments of financial information within generally accepted accounting principles that have been discussed with the issuer’s management, the ramifications of such use, and the treatment preferred by the registered public accounting firm
• Other material written communications with management
• PCAOB Auditing Standard 1301 adds that the communication with the audit committee should take place prior to the issuance of the auditor’s report

Question 10

What opinions are contained in the independent auditor’s opinion letter that is included in the company’s annual report?

Answer 10

1. An opinion about the financial statements
2. An opinion about the effectiveness of the company’s internal control over financial reporting (for companies for which it is required)

Question 11

What does the independent auditor’s opinion letter that is included in the company’s annual report state about the responsibilities of the auditor and the responsibilities of management?

Answer 11

1. Management is responsible for the financial statements, for maintaining effective control over financial reporting, and for its assessment of the effectiveness of its internal control over financial reporting.
2. The auditor’s responsibility is to express opinions on the financial statements and (for a company for which it is required) on the effectiveness of the company’s internal control over financial reporting based on its audit.

Question 12

What are the types of audit opinions an external auditor can issue?

Answer 12

• Unqualified (PCAOB) or unmodified (ASB) - the results are “clean”
• Qualified (PCAOB) or modified (ASB) - in some respect, the financial statements do not present fairly the financial position, results of operations, and cash flows of the company.
• Adverse - the exceptions are so material that, in the auditor’s judgment, a qualified opinion is not appropriate.
• Disclaimer - the auditor has not been able to gather enough information on the financial statements to express an opinion

Question 13

What is a critical audit matter (CAM) according to PCAOB standards?

Answer 13

A matter that:

1. relates to accounts or disclosures material to the financial statements and
2. involved especially challenging, subjective, or complex auditor judgment.

Question 14

What must an auditor do for each critical audit matter communicated in its report?

Answer 14

• Identify the critical audit matter
• Describe the principal considerations
• Describe how it was addressed in the audit
• Refer to relevant financial statement accounts or disclosures that relate to the critical audit matter

Question 15

What is the auditor’s responsibility with respect to a company’s ability to continue as a going concern?

Answer 15

To evaluate whether substantial doubt exists about the company’s ability to continue as a going concern for a reasonable period, not exceeding one year beyond the date of the financial statements.

Question 16

What factors might indicate substantial doubt about a company’s ability to continue as a going concern?

Answer 16

• Recurring operating losses
• Working capital deficiencies
• Loan defaults
• Unlikely prospects for more financing
• Work stoppages
• External issues like legal proceedings or loss of a key customer or supplier

Question 17

What should an auditor do if they believe there is substantial doubt about a company’s ability to continue as a going concern?

Answer 17

The auditor should ask about management’s plans to turn things around and assess the likelihood that the plans can be effectively implemented.

If the auditor is not satisfied by management’s plans and still has a substantial doubt about the company’s ability to remain a going concern, the auditor will add an explanatory paragraph describing the problem to the opinion letter immediately following the opinion paragraph.

Question 18

Does doubt about a company’s ability to stay in business automatically prevent a “clean” auditor’s opinion?

Answer 18

No, if:

1. the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the company, in conformity with generally accepted accounting principles, and
2. if the company’s financial situation is adequately disclosed in the notes to financial statements.

Question 19

If a company’s disclosures about its ability to continue as a going concern are inadequate in the independent auditor’s opinion, what should the auditor do?

Answer 19

Because a departure from generally accepted accounting principles exists, it may result in either a qualified opinion or an adverse opinion.

Question 20

If financial statements have been prepared using the going concern basis of accounting but, in the auditor’s judgment, assets should be presented at their liquidation values because use of the going concern basis is not appropriate, what should the independent auditor do?

Answer 20

The auditor should express an adverse opinion.

Question 21

For companies that are publicly traded and are categorized by the SEC as “accelerated” or “large accelerated” filers, what is required by Section 404(b) of the Sarbanes-Oxley Act?

Answer 21

The company’s independent auditor must report on and attest to the effectiveness of management’s internal control over financial reporting (ICFR).

The auditor’s opinion on the effectiveness of the company’s ICFR is included with its opinion on the financial statements when the auditor performs an audit of the company’s ICFR that is integrated with an audit of its financial statements.

Question 22

What kinds of companies are exempt from the requirement in Section 404(b) of the Sarbanes-Oxley Act for the company’s independent auditor to report on and attest to the effectiveness of management’s internal control over financial reporting.?

Answer 22

The independent auditor’s internal control opinion is not required for publicly traded companies categorized as “non-accelerated” filers or for privately held companies.

Non-accelerated filers are public companies with public float (outstanding common equity held by non-affiliates) of less than $75 million.

Question 23

What approach does PCAOB Auditing Standard 2201 prescribe for independent auditors to use in evaluating management’s internal control over financial reporting?

Answer 23

A top-down, risk-based approach.

Question 24

What does an independent accountant’s review report provide in terms of assurance?

Answer 24

Negative assurance

Negative assurance means that the accountant states in the report that he or she is not aware of any material modifications that should be made to the financial statements in order for them to be in conformity with generally accepted accounting principles.

Question 25

What is the scope of a compilation compared to a review and an audit?

Answer 25

A compilation is less in scope than a review and significantly less in scope than a full audit, and it provides no assurance whatsoever to users regarding the accuracy of the financial statements. ## Footnote It is simply a formatted financial statement presenting the assertions of management.