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The roles of external auditors in reporting fraud

In Latin, the word audit means 'to hear'. One person creates the Financial Statements, whilst the auditor 'hears' what they are saying, and passes his opinion to them. External auditing (EA) is “an examination of the annual financial report of an organization by someone independent”. The purpose of an EA, to express an opinion on whether the information presented in the financial statements, reflect the financial position of the organization at a given date and reported to the clients or shareholders. For example, are details of what the organization owns and owes properly recorded in the balance sheet? Are profits or losses properly assessed?

There are two types of external auditors, statutory audits which are compulsory by the law and Non-statutory audit which is not compulsory by the law. The EA report must includes different areas to show a true and fair value such as, going concern, consistency, prudence, matching principle and aggregation principle. Also, the International Federation of Accountants lays down fundamental principles as follows, independence, integrity, objectivity, confidentiality, technical standard, etc. External Auditors have duties and rights related to the Company Act 1985 which was defined by ISA, CMA and Statutory law which enable them to perform a good job.

This paper is about the roles of external auditor to report financial statements fraud. Number of corporate scandals in the world has increased year by year like Enron, Tyco, and Parmalat. Researchers will discuss the case of WordCom Company to highlight the main issues.

Key words: Fraud, External Audit and WordCom

The role of external Audit

There are certain roles that the external auditors do in auditing F.S of the company. These are as follows:

The primary role of external auditors is to express an opinion on whether an entity's financial statements are free of material misstatements.

Auditors just want to make sure that company's financial statements are true and fair representation of its actual position.

Normally, external auditors review the entity's information technology control procedures when assessing its overall internal controls.

They must also investigate any material issues raised by inquiries from professional or regulatory authorities, such as the local taxing authority.

The independence of external auditors is crucial to a correct and thorough appraisal of an entity's financial controls and statements.

Literature Review

Many scholars had discussed in their empirical studies the external auditor responsibilities in accounting scandals which result in filling chapter 11 of bankruptcy protection by those cooperate firms.

Recognition of revenue and the auditor's responsibility for detecting financial statement fraud were most issues been discussed in the research by Intal & Thuy (2002) titled "Financial Statement Fraud". One of the most objectives of the research is to identify the reasons of why auditors have not detected financial statements fraud. Researchers are looking to proposing solutions for improving the audit process in these issues. Researchers approach a descriptive and explanatory research and it is a case-based study. They make interviews with audit technical board in 10 audits firms in Sweden and one Swedish professional accounting institution. The found that the reasons which makes auditors have not discovered the fraud are: application of analytical review procedures as "sufficient audit evidence;" weaknesses in audit risk model and risk assessment concerning internal control; and audit failure in revenue recognition and related party transaction disclosure.

Others like NEUMEISTER (2009) found that external auditor was responsible for fraud in ‘Bernard L. Madoff Investment Securities LLC’. He added that Friehling & Horowitz pleaded guilty for this alleged fraud as it was auditing its client financial statements for 15 years. It failed to verify the disgraced money manager’s financial records. The firm reported to AICPA that it did not performed audit since 1993. Thus, the firm license had not been renewed for all that period. In addition Christodoulou (2010) mentioned that KPMG was also the auditor of Madoff. Although the court held that KPMG found not guilty in the case which it had sued by Madoff feeder fund, the firm failed to put more effort in accessing information necessary to ensure investors were not cheated.

OJO (2006) agreed the view of NEUMEISTER (2009) and Christodoulou (2010) in their study of ‘The Role of the External Auditor in Financial Regulation and Supervision’ in which the statutory auditor played role to avoid further commercial scandals such as Enron. One of major problem that happen in Enron was the balance sheet debt which resulted from following rules because the accounting standards did not authorize. The audit firm had shredded documents related to Enron, thus it terminated the evidence that could lead to deducted fraud which resulted to Enron scandal. This was also considered as an offence against Andersen in the court of law.

Sheely (2000) also realized in ‘A Simple Recipe for Cooking the Books’ audit failure in deduction fraud as in case of WorldCom although there were alert about the company’s financial position. When invoices were paid, they were properly coded to an operating expense account. The audit firm Arthur Andersen’s staffs were followed an invoice through the accounts payable system and could not find any fraud. This fraud occurred by reclassified the line-cost as capital expenditures. For example, $500 million in undocumented computer expenses were logged as a capital expenditure. However, the internal auditors discovered that $2 billion of the company’s expenses had been spent on capital expenditures during the first three quarters of 2001 had never been authorized for capital spending.

Moreover, Sheldon and Reena (2007) mentioned that the government also plays in reducing or eliminating frauds. However the propose of external audit is to certify that the financial statement reflect the true and fair view. First, they discussed the role of external auditor in deduction fraud from an accounting scandal case in Turkey. The Imar bank case was collapsed although this bank was in list of administrative ability for about 10 years. The collapse of the bank was mainly due to IT- related fraud which occurred in two ways. The records of the bank had been deleted and then, it had double record-keeping system where the original records kept at the bank and the fake one sent to the Banking Regulation and Supervision Authority. The auditor failed to test the system which results to fraudulent activity. Second, they discussed the role of government in deciding the appropriate standards to be used and that the external auditor should be authorized by BRSA before auditing the banks.

On other hand, Agrawal and Chadha (2005) focused in their study about “Corporate Governance and Accounting Scandals” aimed to examine whether certain corporate governance mechanisms are related to the probability of a company restating its earnings. The authors choose a sample size of 318 US public companies including those which restated their earnings, such as Adelphia, Gateway and Xerox and non-restating firms. The researchers empirically investigate the relation between the likelihood of restatement and independence of boards and audit committees. Also, they discuss about financial expertise of boards and audit committees. In the last section researchers discuss other governance mechanisms. They found that several key governance characteristics are essentially unrelated to the probability of a company restating earnings including the independence of boards and audit committees and the extent to which outside auditors provide non audit services to a firm. Also they found the use of Arthur Andersen or another big 5 (previously) audit firm is also unrelated to this probability. Researchers also found that the probability of restatement is significantly lower in companies whose boards or audit committees include an independent financial expert.

Finally, Stirbu et al (2009) in "Fraud and error: Auditors' responsibility levels" aimed to identify the perceptions of users about financial report on the extent of fraud in Romania and to identify shareholders perception of the responsibilities in reporting fraud and the performance of auditor procedures. The question of the research was "Are auditors responsible for detecting fraud in the companies they inspect?” The sample of the research was 451 auditors. On-line questionnaires were sent by email and only 378 auditors were responded. Researchers found an expectation gap between respondents and present statutory requirements with respect to fraud reporting and detection.

The management team is the one who should discover the fraud at first place. However, External auditors play one of the most important role in cooperate scandal because of their failure to take some necessity steps, such as following ethical code of conduct. But they should not be blamed alone as government has also responsibilities in prevention these frauds. If it not has suitable procedures for appointing auditors as well as for punishments, the number of accounting scandals will be more.

WorldCom Scandal

Background

WorldCom (WCom) was the second largest long distance telecommunication company in USA. It also was the largest internet network in the world with around 60,000 employees over 65 countries worldwide. The company grew through merger and acquisition. It first merge was with MCI Inc which cost $37 billion making the largest merger in US. It acquired over 60 companies within 15 years.

On July 2002, it filed chapter 11 to seek bankruptcy protection. The estimation of corporate fraud scandal was $11 billion.

Staffs involved in scandal

The following is a list of WorldCom executives and other employees who implicated in the accounting fraud:

Bernard Ebbers – former CEO found guilty of all charges and convicted of fraud, conspiracy and filing false documents with regulators.

Scott Sullivan – former CFO was indicted on charges of securities fraud, conspiracy, and false statements to the SEC.

David Myers – former controller was charged with securities fraud, conspiracy, and false statements to the SEC.

Buford Yates Jr. – former accounting director pleaded guilty to charges of securities fraud and conspiracy.

Betty Vinson & Troy Normand – former accounting managers pleaded guilty to charges of conspiracy to commit securities fraud.

Causes of scandal

There was several reasons lead to corporate scandal as illustrated below:

Excessive projection. The WorldCom acquired many other companies at very high price in hope that the growth rate will be continued.

Expecting high demand. The firm was expecting that the demand for internet services will be leaped to sky high.

Over built the capacity. Only 10% of its fiber optic-cable is currently used.

Excessive leverage. The company’s boards of directors were not paying attention to how the company was run.

Analysis of Scandal

There were two major ways WCom had committed fraud which it occurred between 1999 and 2002. However the figures below are related to 1st quarter 2001 till 1st quarter 2002. One of these was underreporting the expenses by capitalized them in balance sheet as an investment. The table below explains how the improperly reported line cost affected on profit before interest and tax. It can be noticed that after restatement these costs into proper category, instead of getting profit around $ 2.6 billion the company suffer losses of $ 1.2 billion between the period of 1st quarter 2001 and 1st quarter 2002.

The other form of fraud was overstating company’s revenue. WCom was recording earnings from service provided to its subsidiaries as revenue. In addition, management charge which was provided to the subsidiaries recorded as income.

Auditor Responsibility

Arthur Andersen (the auditor) did not changed its audit procedures regardless of knowing that the line cost was one of the items where WCom could commit fraud. Moreover, Anderson ranked WCom as a high risk company because it was concerning about its share price. However it did nothing to change this situation.

Anderson also ignored the alert about WCom’s financial position. It ignored ratio indicators, such as profit margin, debt/equity rations and so on which most of them were giving result below the bench mark.

The firm was trying to get a good impression from its client in hope to have more business from the client. Therefore, Anderson did not try to take action when it was prevented to access the client’s ledger. Thus, it failed to take safe guard procedures for such conflict.

Lessons learned from the scandal

There are certain lessons can be learned from the above case for different points of view.

The investors should not depend only on company’s financial statements in deciding of whether it is worthy for their investments. They should also seek for second professional opinion.

The investors should diversify their investments widely and not to keep them in one basket.

The company should appoint more independent directors to take care of public interest, thus avoiding personnel interest.

The government has to selected appropriate standards and to follow excruciating punishment against those who breach the rules.

Conclusions and Recommendations

Arthur Andersen auditing firm which audited WorldCom Company failed to detect the fraud. It is clear now the Audit firm ignored some issues to find out financial fraud. We believe that the main reason of why audit have not detected fraud were "application of analytical review procedures, risk assessment concerning internal control”. Intal & Thuy (2002) had analyzed this reason in their thesis.

In WCom, five factors of fraud had been passed gradually which are cooks, recipes, incentives, monitoring and end results or called as crime and this because of failure of external audit as we mentioned above. In this paper we listed some analytical review of WCom scandal supporting our view with figures. We found that the reasons of why auditor had not stopped the fraud in early time including Ignore ratio indicators, such as profit margin, debt/equity rations. According to our review, we suggested some recommendations to both shareholders and audit firm to prevent fraud as following:

Shareholders should appoint different audit firms for different services, for examples auditing of financial statements and consultations.

Shareholders should appoint qualified audit committee with high level of experience and honesty.

Company should change its auditor regularly (every five years) to avoid the conflict of interest between the audit firm and its client.

Audit firms should develop the procedures of audit to detect staff members who suspected their intention to do fraud.


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