Question

EC Interior Design and Construction Company Limited (“EC”) is a private company in Hong Kong specializing in residential and commercial interior design. It was founded by Mr Eagle Chan, an interior designer. For each project, Eagle first draws the design according to the client’s request. Then a team of construction workers complete the refurbishment. Eagle follows up the project and makes any necessary adjustment to his original design if the construction team meet any difficulty or if the client further requests for any change.

Eagle mainly focuses on design work. His sister, Winnie Chan, is responsible for the financial and hiring of each project. Winnie hires construction workers based on the project size. All workers are hired as part-time basis and paid daily. No detailed record of workers is kept. On each working day, Winnie takes notice of how many workers are on the site, then calculates and prepares the cash for the daily salaries. Eagle is a risk-taker. His design is bold and creative and has earned him several design awards in the current year. He considers EC is ready for listing now especially when he becomes famous. If EC successfully gets listed, every top executive will get a bonus. Thus, Winnie is eager for the listing because she hopes to get more bonus to settle down her personal debts.

Required:

(a) Evaluate the risk of material misstatement due to fraud by considering the fraud risk factors.

(b) Winnie Chan understands that you, who are the audit partner of EC, have experience in auditing similar industry as EC and you have also been involved in audits related IPOs. She asks you to share some experience with her so that she can better prepare for the listing. Evaluate whether you can share this experience with Winnie Chan.

[Total for Question 1: 16 marks]

Answer 1

A.

Paragraph .02 of AS 1001, Responsibilities and Functions of the Independent Auditor, states, "The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. [footnote omitted]"1 This section establishes requirements and provides direction relevant to fulfilling that responsibility, as it relates to fraud, in an audit of financial statements.2

Note: When performing an integrated audit of financial statements and internal control over financial reporting, refer to paragraphs .14-.15 of AS 2201, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, regarding fraud considerations, in addition to the fraud consideration set forth in this section.

.01A        AS 2110, Identifying and Assessing Risks of Material Misstatement, establishes requirements regarding the process of identifying and assessing risks of material misstatement of the financial statements. AS 2301, The Auditor's Responses to the Risks of Material Misstatement, establishes requirements regarding designing and implementing appropriate responses to the risks of material misstatement. AS 2810, Evaluating Audit Results, establishes requirements regarding the auditor's evaluation of audit results and determination of whether he or she has obtained sufficient appropriate audit evidence.

.02        The following is an overview of the organization and content of this section:

• Description and characteristics of fraud. This section describes fraud and its characteristics. (See paragraphs .05 through .12.)
• The importance of exercising professional skepticism. This section discusses the need for auditors to exercise professional skepticism when considering the possibility that a material misstatement due to fraud could be present. (See paragraph .13.)
• Responding to fraud risks. This section discusses certain responses to fraud risks involving the nature, timing, and extent of audit procedures, including:
  • Responses to assessed fraud risks relating to fraudulent financial reporting and misappropriation of assets (see paragraphs .52 through .56).
  • Responses to specifically address the fraud risks arising from management override of internal controls (see paragraphs .57 through .67).
• Communicating about fraud to management, the audit committee, and others. This section provides guidance regarding the auditor's communications about fraud to management, the audit committee, and others. (See paragraphs .79 through .82.)
• Documenting the auditor's consideration of fraud. This section describes related documentation requirements. (See paragraph .83.)

[.03]   [Paragraph deleted.]

.04        Although this section focuses on the auditor's consideration of fraud in an audit of financial statements, it is management's responsibility to design and implement programs and controls to prevent, deter, and detect fraud.3 That responsibility is described in AS 1001.03, which states, "Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, initiate, record, process, and report transactions (as well as events and conditions) consistent with management's assertions embodied in the financial statements." Management, along with those who have responsibility for oversight of the financial reporting process (such as the audit committee, board of trustees, board of directors, or the owner in owner-managed entities), should set the proper tone; create and maintain a culture of honesty and high ethical standards; and establish appropriate controls to prevent, deter, and detect fraud. When management and those responsible for the oversight of the financial reporting process fulfill those responsibilities, the opportunities to commit fraud can be reduced significantly.

B.

explore the issue, Aobdia and his coauthors, Chan-Jane Lin of National Taiwan University and Reining Petacchi of MIT, looked to Taiwan, where individual partners are required to sign audit reports.

“Given that the identity of the partners is disclosed, audit partners develop a track record over time, which is observable to investors,” the researchers write.

The role of an audit is to obtain reasonable assurance that a company’s financial statements, including its earnings numbers, are accurate. If the use of high-quality audit partners was important to investors, the research team expected to see companies with good auditors perform better in areas like investor response to earnings announcements, debt terms, and IPO pricing. If the skill and history of the partner did not matter, performance would be similar regardless of the auditor’s track record.

“If a company is not doing well, and all its financial statements are inflated because earnings are cooked, a bad partner may not notice it,” Aobdia says. “Whereas if you have a good partner, they are likely to notice that the earnings are cooked. Therefore, they are going to ask the company to modify the numbers, especially prior to an IPO.”

For their study, the researchers first had to define a “high-quality” audit partner. Aobdia says it was important to separate the quality of the partner from the quality of the auditing firm, as well as from the client being audited. After all, a great auditor should not be judged poorly if the company she audited had very poor quality financial reporting to begin with. Likewise, a bad auditor should not be buoyed simply because she audits a great company.

So the researchers looked at the performance of auditors’ clients from 1995 to 2005 in Taiwan and developed a complex model to pinpoint the contribution of the auditing partners to the financial-reporting quality of the company.

Instead of relying simply on the strength of an auditor’s firm, the researchers defined “high-quality” auditors as those who have a positive influence on the financial-reporting quality of their clients, beyond what can be normally expected from these clients or their audit firms. When audited by these high-quality partners, clients tended to have more accurate financial reports and were less likely to need to restate their financial statements. “Low-quality” auditors, on the other hand, were more likely to have clients that, while working with these auditors, had less accurate financial reports. These partners were also more likely to be subject to sanctions or other disciplinary action by regulators.

The Markets Respond to a Quality Audit

Next, the team looked at market results in the subsequent five years, from 2006 to 2010. The findings were clear: in Taiwan, auditor quality had an impact in four key areas.

IPO value was better. Pre-IPO firms experienced less underpricing when working with good auditors. Since a firm’s value is not always clear to investors at IPO, the quality of the auditor can be a signal that the company’s financials are strong and have been thoroughly vetted by a skilled professional. Aobdia says this was one of the most important findings of the study.

Equity markets responded more to earnings announcements. The better the auditor, the more investors respond to unexpected portions of earnings announcements. Essentially, investors pay more attention to the earnings of clients audited by better partners, because they can trust the numbers more.

Auditor upgrades mattered. Markets respond positively for companies when a poor or mediocre auditing partner they have been using is replaced with a better partner. The researchers found this move generated a positive return of 0.7 to 1.2 percent to investors—again because investors have more confidence in the value of the clients.

Debt terms improved. The impact of a strong auditor extended beyond equity markets. Companies that engaged high-quality auditing partners got better debt terms. This may indicate that banks like to see high-quality auditors as a signal that the company’s financial statements are sound.

Spurring Action in the U.S.

The research is already having an impact on efforts to make audits more transparent.

The research team started circulating its working paper in 2013. Soon after, the PCAOB, which regulates audits in the U.S., began citing the research in its campaign to require audit-partner disclosure, something it had been considering since 2009.

In December 2015, the PCAOB voted unanimously to require audit firms to disclose the names of their partners in charge of each audit. The move is still subject to Securities and Exchange Commission approval.

Of course, it is unclear whether U.S. investors will react as definitively as Taiwanese investors to audit-partner quality, Aobdia says. Taiwan’s financial sector has some marked differences, including being much smaller with different rules and less litigation. However, it is also possible that data-driven U.S. financial professionals and institutions will use audit-partner information even more than in Taiwan as part of their investment and lending decisions, he says.

Either way, the new rule adds another dimension of transparency.

“We got some results that showed that capital markets care about this information,” he says.

Editor’s note: Daniel Aobdia is currently a Senior Economic Research Fellow at the Public Company Accounting Oversight Board (PCAOB). This research was conducted before that affiliation, and the views expressed here are his own and do not necessarily represent those of the Board, individual Board members, or staff of the PCAOB.