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The world's financial system has changed dramatically during the last three years. The financial crisis has a global effect. Some industries have shown some slowness in their growth while some others are facing bankruptcy. Banks and other financial institutions are among the companies most affected by this crisis. In fact, they are responsible for this crisis. The practices of providing sub-prime mortgages to costumers who are not likely to be able to repay them and loose credit criteria have resulted in the collapse of many banks such us; Lehman Brothers and Merrill lynch.
Since the beginning of the crisis, the focus has changed towards the auditing practices which may be accountable for this crisis. Arens & Loebbecke (1997) define audit as "the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria'' (p2). The fact that Governments have injected banks with money to bail them out, which has cost the UK government 1,300 billion Pounds, raises the need for stricter internal and external auditing to prevent any problems in the future.
The purpose of this essay is to evaluate how the audit roles and responsibilities have changed during the financial crisis and to illustrate the importance of auditing. This paper will be divided into four parts: internal and external audit traditional roles and responsibilities, the background to the financial crisis, the financial crisis and the impact on auditing practices and a conclusion.
Internal and external audit traditional roles:
A) Internal audit:
Internal auditing is the first line of defence in any company. The main objectives of internal auditing are: To ensure that the operations are competent and effective. Secondly, to ensure the creditability of the financial statements. Thirdly, to comply with laws and regulations and to ensure the compliance of staff and operations (Allegrini, 2008).
One of the most important tasks of internal auditing is to focus on the financial aspect of the business. The internal audit department has many responsibilities such as; to ensure that every transaction is executed with an authorisation, to monitor and assure the firm's risk and liabilities , to prevent frauds and conduct investigations if that occurred and to implement an internal control system to control the expenses bonuses and allowances (Parker, 1995).
However, internal auditing has developed to be a comprehensive system which called Corporate Governance which can be defined as: "the frame work of rules and practices by which a board of directors ensures accountability, fairness and transparency in the firm relationship with its all stakeholders'' (Businessdicstionary.com).It aims to implement different policies internally to protect stakeholders' rights and to ensure that the business complies with standards, laws, practices and ethics of the industry.
B) External audit:
There are many famous audit companies around the world such as: Earnest & Young, KPMG and Deloitte & Touche. By law, every public listed company must hire one of these firms to audit their financial statements for a specific fee. Usually, shareholders appoint two external auditors by voting. For private companies, an audited financial statement is essential to obtain funds and loans.
The objective of the external auditing is the"expression of an opinion on the fairness with which they present fairly, in all material respects, financial positions results of operations and its cash flows in conformity with generally accepted accounting principles" (Arens & Loebbecke, 1997:142).
External auditor responsibilities are to check and ensure the reliability and credibility of the financial statements. Not only do they ensure reliability and credibility but also to address all the errors or mistakes the company have done. However, the auditor should provide reasonable assurance of the errors. If an auditor fails to find or report an error, he is not liable or responsible for it.
The background to the financial crisis
Banks are very active in providing long-term mortgage loans. The increase in property prices and the lower interest rates have encouraged banks to lend more. To increase profitability, banks also engaged in sub-prime mortgage loans which provide loans to high risk segments with higher interest rates. At the same time, banks started to use a new product called Asset backed securities which enables them to sell those high risk loans to another investor. Banks, Federal banks, Funds, Insurance companies and different companies from all over the globe have purchased these securities.
In 2006, the prices of the properties declined while the interest rates rose dramatically. As a result, people had stopped repaying their mortgage loan instalments to the banks which caused liquidity problems. Banks started to sell houses but the prices were lower than the value of the loan which results in insufficient collateral to cover the cost of the mortgage. As a result, Freddie Mac and Fannie Mae which were the major mortgage companies in the USA collapsed. In the UK, Northern Rock bank which was highly exposed to these loans also collapsed.
As a result, the asset backed securities defaulted and the effect has become more widespread. Banks which invested heavily on these securities have faced liquidity and bankruptcy risk such as; Lehman Brothers. Others had sought government support to survive such as: AIG while another part had been acquired by other banks. These securities are called "toxic assets". Several governments have helped banks by buying these assets, buying shares of the bank or by providing long term loans with low interest rates.
Audit and the financial crisis:
The financial crisis has affected many countries and industries. It has shown that banks may need better and stricter internal and external audit. Governments, taxpayers and shareholders have led a move towards a reform in the financial sector. Corporate governance and external auditors have failed to prevent the crisis. In 2009, The Organisation for Economic Co-operation and Development launched a plan to improve the role of corporate governance. The OECD suggests that the board of directors needs to be monitored. Moreover, it suggests that every company in the financial sector should emphasise the role of the risk management department. In addition, top management bonuses which created concerns among the public should be controlled. Furthermore, Compliance and standards of the financial sector should be improved (OECD, 2009).
However, co-operation between all the stakeholders is necessary to implement these recommendations. Companies might refuse any interference in their operations. Moreover, the board of directors might have the ability to hide information from the public which could limit any improvement in the internal control area. On the other hand, the U.S department of the Treasury has introduced a financial stability plan. This plan might have a better impact on corporate governance within a company because the United States government has obtained shares of some financial institutions. The plan aims to implement several standards on banks. The Capital Assistance program is the one of these standards which aims to ensure the capital adequacy of the financial institutions. Moreover, the plan has different objectives such as: a private investments program which aims to enhance and fix the financial statements to give banks the ability to lend to households and business to help the economy to move from the recession.
Externally, audit firms might be part of the problem. Their inability to highlight the risk of exposure of banks has lead to this crisis. Moreover, the credibility of these firms has been affected by the crisis since they approved all the financial statements of the banks. On the other hand, audit companies profits have suffered as they lost big clients such as: Lehman Brothers and Merrill lynch.
For those reasons, Earnest and Young organised an audit committee meeting in 2008 which recommended that external auditors should: Scrutinise the financial statements, check the risk exposure of the companies as well as their clients, check the financial plans and budgets and verify that companies are disclosing all important information regularly. In addition, the committee stated that internal audit should have greater role in companies and it encourages the external auditors to raise and address any concerns to the stakeholders. In fact, the report has covered many areas which may need to improve. However, the implementation of these recommendations might be vital to auditors to regain their credibility and save their business. It seems that external audit businesses will implement new strategies to improve the auditing process and governments might need to monitor and control auditors' activities.
In general, internal and external audit played an important role in the past. However, the financial crisis has shown that audit might have failed to do its task. Furthermore, it shows that audit might need improvements to be able to play an important role in the future. This essay illustrated the traditional role of the internal and external audit. Moreover, it provided a brief summary of the financial crisis and evaluated the role of internal and external audit during the crisis. Furthermore, it showed auditors response to the financial crisis and the way they have faced this problem. More research may be needed on corporate governance as it might prevent future problems.