Chapter 8: Internal Auditors Roles and Responsibilities Chapter 9: External Auditors Roles and Responsibilities

L. Murphy Smith Texas A&M University

Chapter 8: Internal Auditors Roles and Responsibilities

Chapter Objectives Review the qualities of an effective internal audit department. Discuss the role of internal auditors as assurance providers and consultants. Review the trends of the internal auditing profession. Discuss the relationship of internal audits and the audit committee. Analyze the determinants of an effective internal audit. Discuss the professional practices framework (PPF) adopted by The Institute of Internal Auditors (IIA). Promote the best practices and internal audit framework.

Chapter 8: Internal Auditors Roles and Responsibilities

Comparison of Internal Audit (Pre- and Postcorporate Governance Reforms)

Chapter 8: Internal Auditors Roles and Responsibilities

Internal Auditors Consulting Services: 1) Consulting services to the board of directors and audit committee. 2) Consulting services to management. 3) Internal auditor training services. Trend and Relevance of Internal Auditors: 1. The Foreign Corrupt Practices Act (FCPA) 1977 2. COSO Report of the National Commission on Fraudulent Financial Reporting (1987) 3. The IIA redefined internal auditing in 1999 4. SOX Sections 302 and 404 (keep in mind that SOX does not directly address internal auditor responsibilities or internal audit function.) 5. The PCAOB in its AS No. 2

Chapter 8: Internal Auditors Roles and Responsibilities

Authorities and Responsibilities: The internal audit function should have (1) full and free access to the companys audit committee; (2) unrestricted access to the companys records, documents, property, and personnel; and (3) authority to discuss initiatives, policies, and procedures regarding risk assessment, internal controls, compliance, financial reporting, and governance processes with management and other corporate governance participants.

Chapter 8: Internal Auditors Roles and Responsibilities

Internal Audit Outsourcing: The decision of whether to establish and maintain an internal audit function or outsource the function should be made by the companys board of directors and its representatives. The SEC rule permits internal audit outsourcing to the clients independent auditor in the following areas: 1. Operational internal audits that are not related to internal accounting controls, financial systems, or financial statements. 2. Nonrecurring assessment of discrete items or other programs unrelated to outsourcing of the internal audit function. Teamwork: DQ6: What are the benefits and negative results of outsourcing the internal audit function?

Chapter 8: Internal Auditors Roles and Responsibilities

IIAs Performance Standards

Chapter 8: Internal Auditors Roles and Responsibilities

IIAs Ethics Code

Chapter 8: Internal Auditors Roles and Responsibilities

Internal Audit Education:

The Institute of Internal Auditors Research Foundation (IIARF) is in the process of establishing the Common Body of Knowledge (CBOK) for internal auditors. The IIA has established the Internal Auditing Education Partnership (IAEP) program to promote internal auditing in colleges and universities in educating the next generation of auditors.
Teamwork: DQ8: Explain how internal auditors expertise in internal control can help ensure effectiveness of the corporate governance process.

Chapter 8: Internal Auditors Roles and Responsibilities

Summary The internal audit function of corporate governance provides objective and independent assurance and consulting services designed to add value and improve the companys sustainable performance in the areas of operations, risk management, internal controls, financial reporting, and government processes. Internal auditors are well trained and positioned to provide numerous assurance services to their organization. The emerging trend toward more emphasis on MBL of governance, economic, ethical, social, and environmental performance requires organizations to provide assurance on a variety of their performance measures and achievements. SOX does not directly address internal auditor responsibilities or internal audit function. The internal audit function should have (1) full and free access to the companys audit committee; (2) unrestricted access to the companys records, documents, property, and personnel; and (3) authority to discuss initiatives, policies, and procedures regarding risk assessment, internal controls, compliance, financial reporting, and governance processes with management and other corporate governance participants.

Chapter 9: External Auditors Roles and Responsibilities

Chapter Objectives Recognize the role independent auditors play in achieving effective corporate governance and reliable financial reports. Understand the history of auditing, the traditional roles of auditors, and regulations recently placed on them. Address the expectation gap regarding what auditors can provide in the way of reasonable assurance and the expectations of investors for a higher level of assurance. Identify the roles and responsibilities of the PCAOB, and discuss the auditing standards published by the PCAOB. Demonstrate the importance of auditor independence both in fact and in appearance. Discuss an integrated audit of both financial statements and ICFR. Address the issue of a liability cap for independent auditors and understand the rationale on both sides of the issue.

Chapter 9: External Auditors Roles and Responsibilities

Chapter 9: External Auditors Roles and Responsibilities

1. 2. Auditor Competency Professional competencies. To audit public companies, auditors should register with the PCAOB and meet all registration and inspection requirements. Technical competencies. Auditors should be knowledgeable in professional standards, rules, laws and regulations, and understand their clients industry and business, corporate governance, financial reporting process, and internal controls. Process competencies. Auditors ability to choose appropriate evidencegathering procedures (tests of controls, substantive tests) and execute auditing procedures. Reporting competencies. Reporting competencies refer to auditors ability and willingness to discover and report material misstatements. Teamwork: DQ3: Confidence and public trust in auditors have been reduced due to concern that auditors serve the interests of management who write their checks rather than the shareholders who eventually pay their fees. Do you agree or disagree? Why?

3. 4.

Chapter 9: External Auditors Roles and Responsibilities

List of the initiatives that have been suggested to improve audit quality as well as the transparency.

Publication of audit engagement letters Shareholders rights to question auditors Publication of auditor resignation statements Lead audit partners signature on audit reports Active audit committee participation in evaluating the scope and results of the integrated audit of both ICFR and financial statements. Mandatory rotation of the audit firm every seven to twelve years in the context of the quality of audit work performed by the firm and the audit efficacy. Mandatory shareholder vote on the ratification of the independent auditor each year.
Teamwork: DQ13: How do external auditors lend credibility to public financial information and the effectiveness of the corporate governance structure?

Chapter 9: External Auditors Roles and Responsibilities

The PCAOB: created by SOX to regulate the auditing profession. The PCAOBs primary functions are to: 1. Register public accounting firms that audit public companies. 2. Inspect the registered public accounting firms on a regular basis. 3. Establish auditing, attestation, ethics, quality control, and independence standards. 4. Conduct investigations and disciplinary proceedings.

Chapter 9: External Auditors Roles and Responsibilities

The PCAOB has issued five auditing standards as of September 2007

1. PCAOB Auditing Standard No. 1 (audit is conducted in accordance with auditing standards of PCAOBUS, the city and state has to be disclosed) 2. PCAOB Auditing Standards No. 2 and 5 (New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR) . 3. PCAOB Auditing Standard No. 3 ( auditors are required to maintain the audit documentation is sufficient manner and keep the records for at least seven years). 4. PCAOB Auditing Standard No. 4 (voluntarily engagement for the auditors report on the companys elimination of previously reported material weaknesses in its ICFR).

Chapter 9: External Auditors Roles and Responsibilities

The new rules restrict public accounting firms in performing a variety of tax services to their audit clients the new rules are intended to prevent the selling of abusive tax shelters.

Chapter 9: External Auditors Roles and Responsibilities

The extended oversight responsibilities for the audit committee are: 1. Appointment, compensation, and retention of registered public accounting firms 2. Preapproval of audit services and permissible nonaudit services 3. Review of the independent auditors plan for an integrated audit of both ICFR and annual financial statements 4. Review and discussion of financial statements audited or reviewed by the independent auditor 5. Monitoring the auditors independence 6. Auditor rotation requirement

Chapter 9: External Auditors Roles and Responsibilities

Disclosing Auditor Changes SEC rules require public companies that change their public accounting firms to file a Form 8-K, Item 4.01, to disclose changes within four days, whereas auditors are required to provide standard letters within ten days stating whether they agree with the companys disclosure without specifying any reasons.

Chapter 9: External Auditors Roles and Responsibilities

Integrated Audit Approach

Management assessment on the effectiveness of ICFR Effectiveness of both design and operation of ICFR based on control criteria fair presentation of financial statements in conformity with GAAP

Chapter 9: External Auditors Roles and Responsibilities

Summary The audit function should be regarded as an external corporate governance mechanism that serves to protect investors from receiving incomplete, inaccurate, or misleading financial information and thus adds value to the effectiveness of corporate governance. SOX drastically changed the characteristics of the accounting profession by connecting the audit function to the corporate governance structure by requiring that the audit committee be directly responsible for not only hiring, compensating, and firing external auditors, but also overseeing their work, monitoring their independence, and avoiding potential conflicts of interest. In the auditing profession, the so-called expectation gap is referred to as the difference between (1) what the investing public and other users of audited financial statements believe the responsibilities of auditors are, and (2) what auditors are willing to assume as responsibilities according to their professional standards. New PCAOB AS No. 5 superseded AS No. 2 and requires the independent audit to opine only on the effectiveness of ICFR, not the management processes and assessments concerning ICFR.

Chapter 9: External Auditors Roles and Responsibilities

Summary -- Continued Sections 201 and 202 of SOX require that all audit and permissible nonaudit services to be performed by the companys independent auditor be approved by the audit committee. Auditor independence is the backbone of the auditing profession, affecting the auditors planning, evidence-gathering procedures, findings, judgment, and credibility, and public trust in the auditors opinion.\ Auditor independence is derived and guided by the three principles of (1) independent auditors may not audit their own work, (2) independent auditors may not function in the role of their clients management, and (3) independent auditors may not serve in an advocacy role for their audit clients. Tests of controls must be broadened to include understanding of ICFR, and provide reasonable assurance about the effectiveness of both the design and operation of internal controls. Any contractual provisions that limit the external auditors liability or require waiving the right to a jury trial may have detrimental effects on auditor impartiality, objectivity, and quality.

Chapter 9: External Auditors Roles and Responsibilities