Examining Arthur Andersens audit of Enron

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Arthur Andersen's audit of Enron has been the most notable failure of auditor independence, but it was by no means the first, the largest, or the last. The Enron audit was the fourth major audit failure affecting Andersen since 1999. At one time, Enron was the seventh largest firm in revenues in the United States and was highly touted as being an innovative marketer in natural gas and electricity. (Chaney, P. K., 2002)

After Enron's (October 16, 2002) third-quarter earnings announcement, Andersen's independence from Enron began to be questioned because the audit firm had provided significant non-audit services to Enron in addition to its fees associated with the Enron audit. Andersen received $47.5 million in fees from Enron. Of this amount, $34.2 million, or 72%, was audit related and tax work. Total fees for other services totaled $13.3 million. Also, Enron had outsourced some internal audit funcitons to Andersen. For this information, Enron has come under inspection for potentially shady management and a clear lack of independent financial monitoring. Moreover, U.S. regulators found that the company's auditor, Arthur Andersen, conspired to hide accurate accounting data from the public. (Chaney, P. K., 2002)

Independence requires that these audits be carried out without bias or subjectivity. Simply stated, auditors are required to be independent from and unbiased by their clients' interests. Outside auditors are hired to provide an independent, external opinion that can certify the truthfulness of a firm's own financial reports. If it were not for the claim of independence, there would be no reason for outside auditors to exist, as their function would be redundant with those of a firm's inside auditors. The assurance of independence is crucial to all of those who rely on audited financial statements for reliable information regarding a firm's financial health, including investors, lenders, employees, and strategic partners. (Sean M. O'Connor, 2004)

Accounting firms generally have incentives to avoid giving "bad news" to the managers who hire them and pay their auditing fees, not to mention their highly profitable consulting fees. The nature of this auditor error has three systematic causes. Firstly, the auditor can commit fraud by knowingly issuing a more favorable audit report than is warranted. This may occur when the auditor accepts a bribe or bows to client pressure or threats. Furthermore, the auditor can be unduly influenced by having a direct or indirect financial interest in the client. Last, the auditor can be unduly influenced because of having some personal relationship with the client beyond what is expected in a normal audit between independent parties.

To maintain independence, auditors have to follow professional conduct and moral ethics which require auditors to ensure they do not perform management functions or make management decision is relevant with their client firms. This seems to imply that the audit performs a consultancy function which conflicts somewhat with the idea of auditor independence. The value of auditing depends heavily on the public's perception of the independence of auditors. It is not surprising that independence is the first subject addressed in the rules of professional conduct. Independence is a crucial concept that sets auditors apart from the accountancy profession, as their core mission is to certify the public reports that describe companies' financial status. By expressing an opinion, the independent auditor assumes a public duty. The function of "public watchdog" demands that the auditor subordinates responsibility towards the client in order to maintain complete fidelity to the public trust. The peril in the lack of independence is that the shareholder as a class who reads and relies upon the financial statements upon which the auditor has rendered an opinion to its detriment has a cause of action against the auditor. To serve such a class of persons an auditor needs to take an unbiased viewpoint when performing audit tests, evaluating the results therein, and issuing an audit report and opinion with respect to financial statements. (Moore, D. A, 2004)

In another point of view, the revenues generated from consulting may be sufficiently large to influence the auditor's judgment regarding questionable accounting policies. In other words, the threat of the auditor becoming too closely that is involved with the interests of the directors, especially if problems arise with the Inland Revenue. It could be argued that this threat is mitigated if different personnel are involved in performing the personal tax work.

To keep away from auditor independent problem, prohibition of other services is significant. It has been suggested that auditors should be prohibited from performing any other work for client companies. Consequently this would remove the self-interest threat of losing lucrative work if the auditors displease the directors. Furthermore, the policy of mandatory rotation of audit partners for a particular audit is suggested as a means of improving audit quality and therefore increasing the quality of general-purpose financial statements. The benefits normally espoused are that the independence of the engagement partner is maintained or that a new perspective on the audit may result in the identification of issues that have been overlooked on previous audits. So periodically mandate rotation of auditors is worth mentioning. For example, if the audit firm is changed periodically every five to seven years, auditors will not become too familiar or trusting of directors. Also auditors would be less concerned about losing an audit that will be rotated in the near future anyway. Additionally this would have cost implications as first audits are more time consuming and the recommendation has not surprisingly proved unpopular with clients as well as audit firms. However, no doubt in an attempt to be seen to address this issue, the Rules of Professional Conduct now state "in relation to the audit of listed companies no engagement partner remains in charge of such an audit for a period exceeding seven consecutive years. An audit engagement partner who has ceased under the above provision should not return to that audit until a minimum of five years passed but is not precluded from other involvement with the client". (Zhao, S., 2006)