Exploring Auditor independence and audit scepticism

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Section 1 - Introduction

The purpose of an audit is to enable whether the client's financial statements are give a true and fair view and prepared, in all material respects, in accordance with suitable financial reporting standards. The auditor to express an opinion on these financial statements based on independent sources from audit procedures. The auditor should comply with the ethical requirements of the International Standard on Auditing, to obtain reasonable assurance about whether the financial statements are free from material misstatement.

Auditor Independence

The International Federation of Accountants (IFAC) Code of Ethics for Professional Accountants, section 290.8 provides a conceptual framework on independence requirements for assurance engagements:

"Independence of mind - The state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional scepticism."

"Independence in appearance - The avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm's, or a member of the assurance team's, integrity, objectivity or professional scepticism had been compromised."

To express an opinion, auditor independence is the most important factor for establish the credibility of that. Independence enhances auditor's ability to carry out their work with integrity, to be objective and maintain professional scepticism.

Auditor Scepticism

The International Standard on Auditing 200 (ISA200) attributed the meanings of professional scepticism:

"Professional scepticism - An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence."

The auditor should maintain professional scepticism during audit procedures. An attitude of professional scepticism is important to detecting the risks of material misstatement, whether due to error or fraud.

Section 2 - Data and an analysis of recent history, criticism and developments

Case 1 - Enron

Enron Corporation, an American energy company, declared bankruptcy in 2001. Enron has listed US$63 billion in assets which is the largest bankruptcy case in United States at that time. In this case, many of Enron's profits were recorded as inflating, assets were not existence, debits and losses were not included in the financial statements.

Case 2 - WorldCom

WorldCom Inc., an American telecommunications company, declared bankruptcy in 2002. WorldCom listed US$103 billion in assets that filed the largest bankruptcy case in United States history at that time.

WorldCom prepared the financial statements by fraudulent accounting methods. It used a false picture of financial and profit growth to hidden its declining earnings for maintain its stock price in the market. WorldCom was improperly record its expenses as capitalised items on the balance sheet; and inflated its revenues by bogus accounting entries with "corporate unallocated revenue accounts".

Case 3 - Lehman Brothers

Lehman Brothers Holdings Inc., a global financial services firm, declared bankruptcy in 2008. Lehman used cosmetic accounting methods at the end of each reporting period to make its financial position appear less risky than actual. Lehman listed US$639 billion in assets that marked the largest bankruptcy case in United States history.

Sarbanes-Oxley Act

Subsequent to the corporate accounting and auditing scandals of the early 2000s, these scandals shook public confidence to invest in capital market. Due to a number of large corporate with accounting scandals, the Sarbanes-Oxley Act of 2002 was enacted as a United States federal law. This bill set out new standards and enhanced the existing standards for all America public companies and public accounting firms.

The Sarbanes-Oxley Act aimed to improve the effectiveness of internal control of corporate governance over financial reporting, and oversight of accounting professionals. This legislation is used to enhance the corporate accounting controls and to restore the public confidence in capital market, by increasing the credibility of corporate financial statements. More important, this act also restriction of auditor to provide a number of non-audit services to their audit clients.

Public Company Accounting Oversight Board (PCAOB)

The Public Company Accounting Oversight Board (PCAOB) was established, which appointed and overseen by the Securities and Exchange Commission (SEC). All public accounting firms are required to registration with the PCAOB. The PCAOB is responsible to establishes auditing and quality control standards, to oversight and inspection whether public company's auditor compliance with the rules.

Professional Ethics - Auditor Independence

Independence of mind exists when the auditor is able to make independence decisions or express professional opinion, without bias, conflict of interest or undue influence of others, even if there seem to be lack of independence, or if the auditor is placed in a potential compromising position by the client's management.

If the auditor is independent of mind, but many factors may lead the public to conclude the auditor is not independent. This may lead the users of the financial statements not to trust on that financial information. It is essential element that auditor not only act independent in facts, also be independence in appearance.

Service Limitations

In Enron's case, its auditor Arthur Andersen, was attributed a big audit failures. There was perceived lack of independence because Arthur Andersen earned revenue from non-audit services much more than from auditing services.

After the bankruptcy of Enron, auditor perceive the provision of provide non-audit services to their audit clients as impaired auditor independence, this perceive is much more after Enron's bankruptcy than before.

To avoid the conflicts of interest, audit firm shall not earn the revenue from one client that as a high percentage of the firm's total income. Otherwise, the firm should disclose this to the client's those charged with governance, and to select the safeguard to maintain their professional judgement. To this date, this is a guideline rather than a requirement.

Peer Assessment

In United States, all the audit firm's audit procedures must review by another firm once each three years. This can ensure external auditor to carry out their work with the utmost professional and independence at all times.

Rotating External Auditors

The engagement partner should be rotating after serving a client for five years, and should not return to the engagement until five years elapsed.

Detection of Material Misstatement

Auditor should have independence to plan and perform the most appropriate procedures to obtain sufficient audit evidence, and gives a reasonable assurance that the financial statements are free from material misstatement, whether due to error or fraud.

Notwithstanding the client's management is honesty and integrity from the auditor's past experience. The auditor also shall maintain professional scepticism, to perform risk assessment procedures for evaluate the client's internal control and to identify the possibility of material misstatement.

Section 3 - Conclusions

When a company fails, the quality of audit is often called into question. Usually, public accusation against auditor was that allowed inappropriate accounting treatments of financial statements. It is because the auditor independence has been compromised by the close relationship between the accounting firm and the client company, or their objectivity and professional judgment is challenged by over-reliance on the income of that source.

Auditor is engagement by a company's auditor committee, and audit fees paid by the company's management. The audit fee represented a substantial portion of the incoming sources.

Auditor owed a standard of care to the user of the audited financial statements.

The compliance cost of the Sarbanes-Oxley Act is high. How can we to balance the management cost, auditor's liability and protection of the investor's interest to achieve effective and efficient prevention and detection of material accounting error or fraud?

Section 4 - Recommendations

Internal auditor can help to prevent their organisation to become the next big corporate scandal, as they understanding what their organisation went wrong in case.