Chapter 01

CHAPTER
1 Quality Auditing: Why It Matters
Johnstone, Auditing: A Risk-Based Approach, 11th Edition. ©2019 Cengage. All Rights Reserved. May
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Learning Objectives
LO 1 Describe decision makers’ needs for reliable financial and
internal control information, and discuss how a financial
statement audit helps meet those needs.
LO 2 Define audit quality and list drivers of audit quality
provided in the Financial Reporting Council’s Audit Quality
Framework.
LO 3 Identify professional conduct requirements that help
auditors achieve audit quality.
LO 4 Describe and apply frameworks for professional and
ethical decision making.
LO 5 Describe factors considered by audit firms making client
acceptance and continuance decisions.
2
An Overview of External Auditing
● External auditors performing a financial statement audit
provide independent assurance on:
● Reliability of the financial statements
● Internal control effectiveness
3
Decision Makers’ Need for Reliable Information and
the Role of a Financial Statement Audit
● Decision makers need information that is transparent and
unbiased
● Exhibit 1.1 identifies potential financial statement users
and the decisions they make based on financial and
internal control information
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Exhibit 1.1
5
Need for Independent Assurance
● The need for independent assurance arises from several
factors:
● Potential bias
● Remoteness
● Complexity
● Consequences
6
What Is a Financial Statement Audit?
● A systematic process of objectively obtaining and
evaluating evidence regarding assertions about
economic actions and events to ascertain the degree
of correspondence between those assertions and
established criteria; and communicating the results to
interested users
7
Overall Objective of an Audit
● Obtain reasonable assurance about whether the financial
statements are free from material misstatement
● Report on the financial statements based on the auditor’s
findings
● To accomplish these objectives, the auditor:
● Complies with relevant ethical and professional conduct
requirements
● Conducts the audit in accordance with professional auditing
standards
● Exercises professional judgment, professional skepticism, and
critical thinking
● Obtains sufficient appropriate evidence, via a structured process, on
which to base the auditor’s opinion
8
Exhibit 1.2
9
Exhibit 1.3
● Refer to Exhibit 1.3 for an example of an unqualified audit
report.
10
Parties Involved in Preparing and Auditing Financial
Statements
● Management
● Internal audit function
● Audit committee
● External auditor
11
Exhibit 1.4
12
Providers of External Auditing Services
● Sole-practitioner firms
● Local and regional firms
● Large multinational professional services firms such as
the Big 4
● KPMG
● Deloitte Touche Tohmatsu (Deloitte in the United States)
● PricewaterhouseCoopers (PwC)
● EY
13
Skills and Knowledge Needed by External Auditors
● Technical knowledge
● Leadership skills
● Teamwork skills
● Communication skills
● Decision-making skills
● Critical thinking skills
● General professionalism
● CPA license
14
Check Your Basic Knowledge—True/False
1-1 When the auditor has no reservations about management’s
financial statements or internal controls, the auditor will
issue an unqualified audit opinion. (T/F)
1-2 The sole responsibility of management with regard to
financial reporting involves preparing and presenting
financial statements in accordance with the applicable
financial reporting framework. (T/F)
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Check Your Basic Knowledge (1-3)
1-3 Which of the following are the responsibilities of the
external auditor in auditing financial statements?
a. Maintaining internal controls and preparing financial
reports.
b. Providing internal assurance on internal control and
financial reports.
c. Providing internal oversight of the reporting process.
d. Providing independent assurance on the financial
statements.
16
1-4 Which of the following factors does not create a demand for
external audit services?
a. Potential bias by management in providing information.
b. Requirements of the state boards of accountancy.
c. Complexity of the accounting processing systems.
d. Remoteness between a user and the organization.
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What Do You Think? (p. 11)
● External auditing is a “special function” as described by Chief
Justice Warren Burger in a 1984 Supreme Court decision:
● By certifying the public reports that collectively depict a corporation’s
financial status, the independent auditor assumes a public
responsibility transcending any employment relationship with the
client. The independent public accountant performing this special
function owes ultimate allegiance to the corporation’s creditors and
stockholders, as well as to the investing public. This “public
watchdog” function demands . . . complete fidelity to the public trust.
● Auditors serve a number of parties. Which party is the most
important?
● Do you agree with Chief Justice Burger’s characterization of the
auditor as a public watchdog?
18
Achieving Audit Quality
● Performed in accordance with generally accepted
auditing standards (GAAS)
● GAAS provides reasonable assurance about the audited
financial statements and related disclosures:
● Presented in accordance with GAAP
● Are not materially misstated whether due to errors or fraud
19
Financial Reporting Council’s Audit Quality
Framework
● Identifies five primary drivers of audit quality
● Audit firm culture
● Skills and personal qualities of audit partners and staff
● Effectiveness of the audit process
● Reliability and usefulness of audit reporting
● Factors outside the control of auditors that affect audit quality
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Exhibit 1.5
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Audit Firm Culture
● Audit firm culture contributes to audit quality
● Audit firm leaders influence culture
● Value and reward audit quality
● “Do the right thing”
● Provide appropriate time and resources
● Ensure monetary considerations do not adversely affect audit
quality
● Seek guidance as needed
● Provide quality systems
● Foster evaluation and compensation practices
● Monitor audit quality
22
Skills and Qualities of the Engagement Team
● Auditors positively contribute to audit quality when they:
● Understand the client’s business
● Adhere to auditing and ethical standards
● Exhibit professional skepticism
● Address issues identified during the audit
● Ensure appropriate levels of experience and supervision for
staff performing audit work
● Ensure mentoring and on-the-job training opportunities for
staff performing audit work
● Participate in training
23
Effectiveness of the Audit Process
● The audit process contributes in a positive way to audit
quality when:
● The audit methodology is well structured
● Quality technical support is available when auditors encounter
unfamiliar situations requiring assistance or guidance
● Ethical standards are communicated and achieved, thereby
aiding auditors’ integrity, objectivity, and independence
● Auditors’ evidence collection is not constrained by financial
pressures
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Reliability and Usefulness of Audit Reporting
● Audit reporting contributes positively to audit quality when:
● Audit reports are written in a way that clearly and unambiguously
conveys the auditor’s opinion on the financial statements and addresses
the needs of users of financial statements
● Auditors appropriately conclude as to the truth and fairness of the
financial statements (e.g., in the United States, concluding that the
financial statements are fairly presented in accordance with GAAP)
● The auditor communicates with the audit committee about:
● Audit scope (in other words, what the auditor is engaged to accomplish)
● Threats to auditor objectivity
● Important risks identified and judgments that were made in reaching
the audit opinion
● Qualitative aspects of the client’s accounting and reporting and possible
ways of improving financial reporting
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Factors Outside the Control of Auditors
● Some factors affecting audit quality are outside of the
direct control of the external auditor, such as client
corporate governance
● Good corporate governance includes audit committees
that are robust in dealing with issues and a greater
emphasis by the client on getting things right as opposed
to getting done by a particular date
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● The Financial Reporting Council’s Audit Quality
Framework
● IAASB—A Framework for Audit Quality: Key Elements that
Create an Environment for Audit Quality
● Review these two frameworks.
● Compare and contrast them with the FRC’s framework.
● Which framework do you think might be most helpful to
an auditor who wants to conduct a quality audit?
27
1-5 Audit quality is achieved when the audit is performed in
accordance with GAAS and when it provides reasonable
assurance that the financial statements have been
presented in accordance with GAAP and are not materially
misstated due to errors or fraud. (T/F)
1-6 One of the key drivers of audit quality is the gross margin
achieved by the audit firm and the ability of the
engagement partner to maintain those margins over the
duration of the audit engagement. (T/F)
28
1-7 Audit quality involves which of the following?
a. Performing an audit in accordance with GAAS to provide reasonable assurance that the
audited financial statements and related disclosures are presented in accordance with
GAAP and providing assurance that those financial statements are not materially
misstated whether due to errors or fraud.
b. Performing an audit in accordance with GAAP to provide reasonable assurance that the
GAAS and providing assurance that those financial statements are not materially
c. Performing an audit in accordance with GAAS to provide absolute assurance that the
GAAP and providing assurance that those financial statements are not materially
d. Performing an audit in accordance with GAAS to provide reasonable assurance that the
GAAP and providing assurance that those financial statements contain no
misstatements due to errors or fraud.
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1-8 Which of the following factors is not a driver of audit quality
as discussed by the FRC?
a. Audit firm culture.
b. Skills and personal qualities of client management.
c. Reliability and usefulness of audit reporting.
d. Factors outside the control of auditors
30
Professional Conduct Requirements that Help
Auditors Achieve Audit Quality
● Codes of professional conduct and related guidance on
professional responsibilities
● Organizations providing such guidance for U.S. auditors
include:
● AICPA
● SEC
● PCAOB
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AICPA Requirements: Code of Professional Conduct
● AICPA has a code of professional conduct to aid auditors
in conducting a quality audit
● The Code applies to professional services performed by
AICPA members
● Compliance with the Code
● Depends primarily on the voluntary cooperation of AICPA
members
● Depends secondarily on public opinion, reinforcement by
peers, and ultimately, on disciplinary proceedings
32
Principles Of Professional Conduct
● AICPA’s Code of Professional Conduct consists of a set of
principles of professional conduct
● Topics include:
● Responsibilities
● Public interest
● Integrity
● Objectivity and independence
● Due care
● Scope and nature of services
● Refer to Exhibit 1.6 for a summary
33
Exhibit 1.6
34
Conceptual Framework
● AICPA’s Code of Professional Conduct includes a
conceptual framework for members in public practice
● This framework incorporates a “threats and safeguards”
approach to help auditors analyze relationships and
circumstances that the Code does not specifically address
● Exhibit 1.7 provides a flowchart of the steps in the
conceptual framework
35
Exhibit 1.7
36
Conceptual Framework Threats
● Threats are circumstances that could result in an auditor
lacking independence in fact or in appearance
● Threats to independence include:
1. Self-review threat
2. Advocacy threat
3. Adverse interest threat
4. Familiarity threat
5. Undue influence threat
6. Self-interest threat
7. Management participation threat
37
Conceptual Framework Safeguards
● Safeguards are actions or other measures that may
eliminate a threat or reduce a threat to an acceptable
level
● These safeguards include:
● Safeguards created by the profession, legislation, or regulation
● Safeguards implemented by the audit client
● Safeguards implemented by the audit firm
38
AICPA Rules of Conduct for Members in Public
Practice
● The rules and related interpretations address many
situations; however, they cannot address all relationships
or circumstances that may arise
● Refer to Exhibit 1.8 for summaries of all rules applicable
to members in public practice
39
Independence Rule
● The Independence Rule requires that a member in public
practice be independent in the performance of
professional services as required by standards
promulgated by bodies designated by the AICPA
● Covered Member
● Financial Interests
● Employment of Family Members
● Loans
● Performing Other Nonaudit Services
● Network Firms
40
SEC and PCAOB: Other Guidance on Professional
Responsibilities
● The Securities and Exchange Commission (SEC) and Public
Company Accounting Oversight Board (PCAOB) have
independence requirements that apply only to auditors of
public companies
● These two organizations have complementary
independence requirements
41
SEC’s Commitment to Independence
● The independence requirement serves two related, but
distinct, public policy goals:
● Foster high-quality audits by minimizing the possibility that any
external factors will influence an auditor’s judgments
● Promote investor confidence in the financial statements of
public companies
42
Impairment of Auditor Independence
● Auditor independence is impaired when auditor has a
relationship that:
● Creates a mutual or conflicting interest between the
accountant and the audit client
● Places the accountant in the position of auditing his or her own
work
● Results in the accountant acting as management or an
employee of the audit client
● Places the accountant in a position of being an advocate for
the audit client
43
Additional Requirements For Professional Conduct
● Auditors of public companies have additional
requirements for professional conduct that extend
beyond those of the AICPA
● Requirements include:
● Preapproval of services
● Fee disclosures
● Audit partner rotation
● Not performing prohibited services
44
Prohibited Services
● The types of nonaudit services that audit firms can provide to public
company audit clients are more restricted than those that can be
provided to non-public companies
● Prohibited nonaudit services for public company audit clients include:
● Bookkeeping or other services related to the accounting records or financial
statements of the audit client
● Financial information systems design and implementation
● Appraisal or valuation services, fairness opinions, or contribution-in-kind
reports
● Actuarial services
● Internal audit outsourcing services
● Management functions or human resources
● Broker or dealer, investment adviser, or investment banking services
● Legal services and expert services unrelated to the audit
● Any other service that the PCAOB determines, by regulation, is impermissible
45
International Professional Requirements That Help
Auditors Achieve Audit Quality
● The International Ethics Standards Board for Accountants
(IESBA), under the International Federation of
Accountants, outlines fundamental principles that should
guide auditors’ ethical decision making.
46
IESBA Code of Ethics for Professional Accountants
● Five fundamental principles
● Integrity
● Objectivity
● Professional Competence and Due Care
● Confidentiality
● Professional Behavior
● In addition to these five principles, the Code contains
specific standards addressing many of the same topics
contained in the AICPA’s Code of Professional Conduct.
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1-9 The AICPA’s principles of professional conduct articulate
auditors’ responsibilities and their requirements to act in
the public interest, to act with integrity and objectivity, to
be objective and independent, to exercise due care, and to
perform an appropriate scope of services. (T/F)
1-10 Per the AICPA’s Code, independence would be impaired if
his or her immediate family member were employed by
the audit client in any capacity or personnel level. (T/F)
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1-11 Which of the following is not a threat to auditor
independence?
a. Self-review threat.
b. Advocacy threat.
c. Adverse interest threat.
d. Regulatory interest threat.
49
1-12 Which of the following statements is false?
a. An auditor in public practice shall be independent in the
performance of professional services.
b. In performing audit services, the auditor shall maintain
objectivity and integrity, be free of conflicts of interest,
and not knowingly misrepresent facts or subordinate his
or her judgment to others.
c. In performing audit services, the auditor may accept
only contingent fees for publicly traded audit clients.
d. An auditor in public practice shall not seek to obtain
clients by advertising or other forms of solicitation in a
manner that is false, misleading, or deceptive.
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● In the U.S. there is a requirement for audit partner rotation, but no
requirement for audit firm rotation. Requirements differ
internationally. For example, European Union Countries have
mandatory audit firm rotation. Deloitte has been the audit firm used
by Procter & Gamble since 1890. In fact, as of January 2017, 13
public companies have engaged the same auditor for at least a
century.
● Should investors be concerned about the remarkable length of these
relationships and the ability of an audit firm to be independent
when conducting the audit?
● Does a relationship of this length improve or diminish audit quality?
● Should there be a requirement for mandatory firm rotation for audit
firms of U.S. public companies?
51
Frameworks for Professional and Ethical Decision
Making
● To achieve audit quality, auditors need to make quality
decisions throughout the audit
● Quality decisions are:
● Unbiased
● Meet the expectations of reasonable users
● Comply with professional standards
● Incorporate sufficient appropriate evidence
52
Exhibit 1.9
53
Importance of Professional Skepticism in Making
Professional Judgments
● The auditor must exercise professional skepticism when
completing the steps in Exhibit 1.9
● Professional skepticism is an attitude that includes a
questioning mind and a critical assessment of audit evidence
● Critically question contradictory audit evidence
● Carefully evaluate the reliability of audit evidence
● Reasonably question the authenticity of documentation
● Reasonably question the honesty and integrity of
management, individuals charged with governance, and third-
party evidence providers
54
A Framework for Ethical Decision Making
● The auditing profession has worked hard to gain the
public trust, and the profession benefits from that trust as
the sole legally acceptable provider of audit services for
companies and other organizations
● To maintain that trust and economic advantage, it is
essential that professional integrity be based on personal
moral standards and reinforced by codes of conduct
55
Utilitarian Theory
● Utilitarian theory holds that what is ethical is the action
that achieves the greatest good for the greatest number
of people
● Utilitarianism requires:
● Identification of the potential problem and possible courses of
action
● Identification of the potential direct or indirect impact of
actions on each affected party (stakeholders)
● Assessment of the desirability (goodness) of each action
● An overall assessment of the greatest good for the greatest
number
56
Rights Theory
● Rights theory focuses on evaluating actions based on the
fundamental rights of the parties involved
● Not all rights are equal – higher-order rights take precedence over
lower-order rights
● The highest-order rights include the right to life, to autonomy, and to
human dignity
● Second-order rights include rights granted by the government, such as
civil rights, legal rights, rights to own property, and license privileges
● Third-order rights are social rights, such as the right to higher education,
to good health care, and to earning a living
● The fourth-order rights relate to one’s nonessential interests or one’s
personal tastes
● Rights theory requires that the “rights” of affected parties be
examined as a constraint on ethical decision making
57
Applying the Ethical Decision Making Framework
● Exhibit 1.10 contains a framework derived from the
utilitarianism and rights theories that can help individuals
resolve ethical dilemmas in a quality manner.
● Refer to Exhibit 1.10 for detail.
58
1-13 Utilitarian theory holds that what is ethical is the action
that achieves the greatest good for the most important
people. (T/F)
1-14 In rights theory, the highest-order rights are those granted
by the government, such as civil rights, legal rights, rights
to own property, and license privileges. (T/F)
59
1-15 Which of the following statements related to rights theory
is false?
a. The highest-order rights include the rights to life,
autonomy, and human dignity.
b. Second-order rights include rights granted by the
government, such as civil rights and legal rights.
c. Third-order rights include social rights, such as the right
to higher education, to good health care, and to earning
a living.
d. Fourth-order rights include one’s essential interests or
personal tastes.
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1-16 Utilitarianism does not require which of the following
actions when a person considers how to resolve an ethical
dilemma?
a. Identification of the potential problem and courses of
action.
b. Identification of the potential direct or indirect impact of
actions on each affected party who has an interest in the
outcome.
c. Identification of the motivation of the person facing the
ethical dilemma.
d. Assessment of the desirability of each action for each
affected party
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● If auditors are not appropriately skeptical, then their
opinions lose value to investors and other decision
makers.
● Auditors who are not appropriately skeptical might be
seen as seeking only to corroborate management’s
assertions or rationalize evidence that doesn’t make
sense.
● What circumstances do you think might impede an
auditor’s application of professional skepticism?
● Do you think that auditors can trust clients and be
skeptical at the same time?
62
Importance of Client Acceptance and Continuance
Decisions to Audit Quality
● Conducting a quality audit begins with client acceptance and
continuance decisions
● New clients become part of an audit firm’s portfolio based on the
client acceptance decision, which includes an evaluation of the
client’s relative risk and audit fee profile
● Each year, the audit firm makes a client continuance decision to
determine whether the audit firm should continue to provide
services in the next period
● Similar to the client acceptance decision, the client continuance
decision is based on a consideration of the client’s relative risk
and audit fee profile
● Discontinued clients are those the audit firm decides to eliminate
from its portfolio
63
Exhibit 1.11
64
Risks Considered in Client Acceptance
and Continuance Decisions
● Audit firms consider many key risks when making client
acceptance and continuance decisions
● Types of key risks
● Client entity characteristics
● Independence risk factors
● Third-party/due diligence risk factors
● Quantitative risk factors
● Qualitative risk factors
● Entity organizational or governance risk
● Financial reporting risk
65
Other Considerations in Client Acceptance
and Continuance Decisions
● An audit firm should not perform an audit that it is not
qualified to perform
● Firms should not provide audit services if they do not have
the size or expertise to serve the client as the client grows
larger, becomes more geographically dispersed, or
increases in complexity
● Auditors should provide audit services only when the
preconditions for an audit are present
● Management’s use of an acceptable financial reporting
framework
● The agreement of management that it acknowledges and
understands its responsibilities
66
Engagement Letters
● An engagement letter states the scope of the audit work to be performed
and letter documents the expectations agreed to by the auditor and the
client
● Items in the engagement letter typically include:
● The objective and scope of the audit of the financial statements
● The responsibilities of the auditor
● The responsibilities of management
● A statement that because of the inherent limitations of an audit, together with the
inherent limitations of internal control, an unavoidable risk exists that some
material misstatements may not be detected, even though the audit is properly
planned and performed in accordance with relevant auditing standards
● The identification of the applicable financial reporting framework for the
preparation of the financial statements
● A reference to the expected form and content of any reports to be issued by the
auditor and a statement about circumstances that may arise in which a report may
differ from its expected form and content
67
1-17 Existing clients for which the audit firm provided services in
the preceding period are evaluated by the audit firm and
by the individual engagement partner at the completion of
the audit to determine whether the audit firm should
continue to provide services again in the next period. The
process by which this evaluation occurs is called the client
continuance decision. (T/F)
1-18 Audit firms may discontinue serving a client because the
client does not fit the profile or growth strategy of the
audit firm. (T/F)
68
1-19 With regard to client acceptance/continuance decisions,
which of the following is false?
a. Client acceptance/continuance decisions are one part of
the audit firm’s overall portfolio management activities.
b. The primary driver of the client acceptance/continuance
decision is the level of audit fees that the audit firm can
charge the client.
c. One can view an individual audit client as analogous to
an individual stock in an investment portfolio.
d. Audit firms are not required to provide audit services for
all organizations requesting an audit.
69
1-20 Which of the following factors is not an example of a risk
relevant to the client continuance decision?
a. Client entity characteristics.
b. Independence risk factors.
c. Third-party/due diligence risk factors.
d. Advocacy threat.
70
● Assume that you are the owner of a small audit firm.
● A prospective client calls in late November asking, “Can you audit my
company?
● We have a December 31 year-end, and we need the audit report by March 31.”
● After some discussion, you think the fee will be around $125,000, which
should provide your firm with a nice profit.
● You have auditors with the appropriate knowledge needed to conduct the
audit.
● After some preliminary analysis, you believe that this client would be a good
addition to your client portfolio.
● Your audit staff is already working more than 60 hours a week during this time
of the year, and it is not very likely that you will be able to hire additional
auditors.
● Should you take the engagement? What factors will influence your decision?
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1 Quality Auditing: Why It Matters

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