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Essay: Reliability of auditors

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  • Published: 21 June 2012*
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Reliability of auditors

Auditor independence:

Independence is fundamental to the reliability of auditors’ reports. Those reports would not be credible, and investors and creditors would have little confidence in them, if auditors were not independent in both fact and appearance. To be credible, an auditor’s opinion must be based on an objective and disinterested assessment of whether the financial statements are presented fairly in conformity with generally accepted accounting principles. As expressed by Council of the American Institute of Certified Public Accountants (AICPA) in a statement adopted in 1947: “ Independence, both historically and philosophically, is the foundation of the public accounting profession and upon its maintenance depends the profession’s strength and its stature.” (John L. Carey, p. 182.)

Independence—Comprises:

  1. Independence of mind—the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional skepticism.
  2. Independence in appearance—the avoidance of facts and circumstances that are so significant a reasonable and informed third party, having knowledge of all relevant information, including any safeguards applied, would reasonably conclude a firm’s, or a member of the assurance team’s, integrity, objectivity or professional skepticism had been compromised. (IFAC, 2009)

Company law in the UK requires that auditors act with independence and integrity. It further requires accountancy bodies recognised to supervise auditors to set ethical standards and audit rules designed to ensure this. These follow a “principles” approach – that is, they set out principles of auditor independence against which likely threats to independence can be identified and assessed; they identify the likely threats and possible safeguards which might be used to manage those threats; and they conclude that where there are no adequate safeguards a particular relationship between auditor and audit client is not permitted.

Need of Auditor Independence:

The external auditor plays a critical role in lending independent credibility to published financial statements used by investors, creditors and other stakeholders as a basis for making capital allocation decisions. Indeed, the public’s perception of the credibility of financial reporting by listed entities is influenced significantly by the perceived effectiveness of external auditors in examining and reporting on financial statements. While any consideration of the effectiveness of external audits involves a wide variety of issues, it is fundamental to public confidence in the reliability of financial statements that external auditors operate, and are seen to operate, in an environment that supports objective decision-making on key issues having a material effect on financial statements. In other words, the auditor must be independent in both fact and appearance.

Evaluation of the importance of the auditor independence in the field of accounting:

Accounting is a multifaceted system involving different people with different needs and after analyzing the various uses and applications of accounting information the American Accounting Association (AAA) has come up with this definition: “the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.” (AAA, 1966)

Accounting is defined by the AICPA as "The art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof."( Singh Wahla, Ramnik, Bulletin No. 1).

Today, accounting is called "the language of business" because it is the vehicle for reporting financial information about a business entity to many different groups of people. But here in this context we can understand that the accounting considerably discusses about the information that is used by managers, shareholders, banks, creditors, the government, the public, etc… to make decisions involving the organization and its operations. Shareholders want information about what their investment is worth and whether they should buy or sell shares, bankers and other creditors want to know whether the organization has an ability to pay back money lent, managers want to know how the company is doing compared to other companies.

Audit is a vital part of accounting. Traditionally, audits were mainly associated with gaining information about financial systems and the financial records of a company or a business. The Definition for Auditing and Assurance Standard (AAS) 1 by ICAI "Auditing is the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon."

Auditing is an accounting process used in business. It uses an independent body to examine a business’ financial transactions and statements. The ultimate purpose of financial auditing is to present an accurate account of a company’s financial business transactions. The practice is used to make sure that the company is trading financially fairly, and also that the accounts they are presenting to the public or shareholders are accurate and justified. The results of the financial auditing procedure can be presented to shareholders, banks and anyone else with an interest in the company. One of the main reasons for a financial audit is to ensure that the trading company is not practicing any deception. This is the reason that the financial auditing body is an independent third party. From this point of view there comes the auditor independence. If the auditor fails to keep himself independent from being influenced by any party then the report of the auditors shall be affected and bias which may result the break-down of the purposes of audit of financial statements.

Scandals of perceived lack of auditor independence:

Scandals

It is in the context of the huge (but largely unaccountable) impact of accounting and accountants that the demise of Arthur Andersen and the financial scandals of the past few years need to be seen. These scandals raise questions of independence and the role of the audit industry in alerting investors, employees, suppliers, customers and the general public to the realities of corporate wrongdoing and weakness.

Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives that, through the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions in debt from failed deals and projects.

Chief Financial Officer Andrew Fastow and other executives were able to mislead Enron’s board of directors and audit committee of high-risk accounting issues as well as pressure Andersen to ignore the issues. Enron’s stock price, which hit a high of US$ 90 per share in mid-2000, caused shareholders to lose nearly $11 billion when it plummeted to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and Dynegy offered to purchase the company at a fire sale price. When the deal fell through, Enron filed for bankruptcy on December 2, 2001 under Chapter 11 of the United States Bankruptcy Code, and with assets of $63.4 billion, it was the largest corporate bankruptcy in U.S. history until WorldCom’s 2002 bankruptcy.

Reason for downfall

Enron’s nontransparent financial statements did not clearly detail its operations and finances with shareholders and analysts. In addition, its complex business model stretched the limits of accounting, requiring that the company use accounting limitations to manage earnings and modify the balance sheet to portray a favorable depiction of its performance. According to McLean and Elkid in their book "The Smartest Guys in the Room," The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control."(McLean, Bethany; Peter Elkind.pp.132-133).From late 1997 until its collapse, the primary motivations for Enron’s accounting and financial transactions seem to have been to keep reported income and reported cash flow up, asset values inflated, and liabilities off the books.

The combination of these issues later led to the bankruptcy of the company, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling, Andrew Fastow, and other executives. Lay served as the chairman of the company in its last few years, and approved of the actions of Skilling and Fastow although he did not always inquire about the details. Skilling, constantly focused on meeting Wall Street expectations, pushed for the use of mark-to-market accounting and pressured Enron executives to find new ways to hide its debt. Fastow and other executives, "…created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now."

Responsibility of the auditors

In the event of the overstated information of Financial Statements and hiding liabilities it revealed that the auditor was unable to report the extensive result overstated of the earnings which causes the share price increasing in the abnormal rate and therefore collapsing at a certain stage. The possible causes of this revealed after the incident occurred by the company, Enron was able to convince the auditor with its non-audit service that was done by the Arthur Anderson.

Enron’s auditor firm, Arthur Andersen, was accused of applying reckless standards in their audits because of a conflict of interest over the significant consulting fees generated by Enron. In 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees (this amount accounted for roughly 27% of the audit fees of public clients for Arthur Andersen’s Houston office). The auditors’ methods were questioned as either being completed for conflicted incentives or a lack of expertise to adequately evaluate the financial complexities Enron employed.

Enron hired numerous Certified Public Accountants (CPA) as well as accountants who had worked on developing accounting rules with the Financial Accounting Standards Board(FASB). The accountants looked for new ways to save the company money, including capitalizing on loopholes found in the accounting industry’s standards, Generally Accepted Accounting Principles(GAAP). One Enron accountant revealed "We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness." (McLean, Bethany; Peter Elkind. p.142)

Andersen’s auditors were pressured by Enron’s management to defer recognizing the charges from the special purpose entities as their credit risks became clear. Since the entities would never return a profit, accounting guidelines required that Enron should take a write-off, where the value of the entity was removed from the balance sheet at a loss. Although Andersen was equipped with internal controls to protect against conflicted incentives of local partners, they failed to prevent conflict of interest. In one case, Andersen’s Houston office, which performed the Enron audit, was able to overrule any critical reviews of Enron’s accounting decisions by Andersen’s Chicago partner.

Thus, Arthur Anderson was unable to certify the lacking rather they reported at their report of Enron Company’s Financial Statements as not misleading.

Good auditor practice

The good auditor practice in this context is very highly required. In the context of Independency, practiced by the auditor, several steps that may undertaken by the auditor are stated in the following manner:

Segregation of Duties

Duties within the department or function should be separated so that one person does not perform processing from the beginning to the end of a process. Best Practicesis to design a system of checks and balances to decrease the likelihood of errors and irregularities.The person who prepares documentation should not be the same person to authorize and execute the transaction (i.e. one person should not be able to accept cash, record deposits for banking, make the bank deposits, and reconcile the account).

Policies and Procedures

Written policies and procedures codify management’s criteria for executing an organization’s operations. Developing and documenting policies and procedures is the responsibility of management, thus, they shoulddocument business processes, personnel responsibilities, departmental operations, and promote uniformity in executing and recording transactions. Thorough policies and procedures serve as effective training tools for employees.

Safeguarding Assets

Assets are the economic resources a business owns that are expected to be of benefit in the future. Cash, office supplies, merchandise, furniture, equipment, land, buildings, and sensitive or confidential data are some examples. Protective measures must be taken to ensure that assets are maintained in a properly controlled and secured environment. The most important type of protective measure for safeguarding assets is the use of physical precautions.

Efficiency and Effectiveness

Efficient performance accomplishes goals and objectives in an accurate and timely fashion using minimal resources. Inefficiencies in operations occur when processes are performed that provide no additional benefit or value. Operations are considered effective when they are functioning as intended. If, for example, two individuals are both responsible for executing the same function within a process, a duplication of efforts would exist. This is an inefficient and ineffective use of time and resources. Inefficiency and ineffectiveness may result in a lack of resource availability and may cause a unit to be unable to meet its objectives. Frequently, this results in added operational costs to the organization. Those costs could be measured in additional overtime wages needed to accomplish goals and objectives, unmet targets, lost productivity, or the inability to accept additional responsibility. Accordingly, inefficiencies result in the inability to be effective in attaining objectives.

Reporting

Reporting is defined as disclosing facts about an entity. These facts could be financial, regulatory, or statistical in nature. Decision makers use these facts to make assumptions about an entity.

Accounting

Accounting is a system that measures business activities, processes that information into reports, and communicates these findings to decision makers. Two major controls of an accounting system are accurate posting of transactions and adequate account review and reconciliation.

Timeliness

In simple terms, timeliness means meeting prescribed deadlines.Best practices is that frequently, the timeliness of processing is not a major priority on an individual’s “to do” list. As organizations continue to push to do more with less and create increased operational efficiencies and profits, timeliness has become important to the overall success of the organization as whole. It’s the one area where all employees can analyze their workflows and identify ways to work smarter and save time.

Conclusion

We come to conclude that in the practical sense of auditing in a company the auditor have many barriers that come to influence the auditor’s opinion in regards the audit. These disadvantages build up the relations of the auditor with the company personnel at the stage of privilege in both the sides. Therefore, the auditor in providing services fails to comply with his Code of Ethics that should be complied with at the time of auditing the company. But to keep the auditor’s business alive as well as the interest of some corrupted personnel sometimes the auditor give and privilege to the company he is auditing which may result very effect to his responsibility and interest of the shareholders. If the auditor help himself by being independence in mind and in appearances then it will be fruitful to the shareholders as well as to the intended users of the information of the company. Even though the various bodies like IFAC, AICPA, etc. is trying to save the auditor independence by issuing various principles. Therefore, it may be taken into consideration that the auditor himself if fail to be independence then many example may be seen in future like Enron scandal.

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