Independant Auditors Reports On Financial Statements Accounting Essay

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The term 'independence' is crucial to the credibility of the auditor's reports on financial statements. The auditor magnifies the value and practicability of these reports. Creditors and investors would not rely on the reports if the auditors were not independent in both fact and appearance. Many International Standards for Accounting and safeguards have been adopted by different countries but independence has always been regarded as one of the guiding principles of the audit profession. Independence, both historically and philosophically, is the foundation of the public accounting profession and upon its maintenance depends the profession's strength and stature. [1] John L. Carey described independence as a state of mind and a matter of character. [2] The Generally Accepted Accounting Principles (GAAP) state that the opinion provided by the auditor on the audit should be an objective one, where there is no bias and must be presented in a fair manner.

The external auditor plays a significant role in the corporate governance function. They are public accounting firm employees brought in under contract to review the accounting and financial books of the company (audit client). Jill Solomon regards external audit function as one of the cornerstones of corporate governance. [3] It represents one of the most indispensable corporate governance checks and balances that help to monitor company management's activities, thereby increasing transparency. The role is to provide an unbiased and independent evaluation of all the financial records.

The external auditor is responsible to the general public regarding the truth of the information presented in the financial statements. This information provided is relied upon by the public at large; thus it is imperative that the firms are independent, objective and free from influence.

CHAPTER 2: AUDITOR INDEPENDENCE

The importance of accounting is best seen from the status of the "profession" that is given to the job of auditing rather than terming it as an employment or service. [4] Audit is a process of assuring fairness of the financial statements and their conformity with the legal requirements in accordance with the generally accepted principles. Audit, can thus be defined as, 'an independent examination of statements, prepared by another qualified accountant by means and to the extent determined by the auditor of a company's financial statements for the purpose of his rendering an opinion on them'. [5] Thus, what emerges as the most important characteristic, which may also be termed as the fundamental qualification of an auditor is his independence.

According to Association of Chartered Certified Accountants (ACCA) Code of Ethics objectivity or independence is essential for the exercise of professional judgement. The appointment of quality auditors serves as an assurance to the investors that the companies' financial disclosures would be accurate and truthful. The assurance is credible because the auditors, with their reputation at stake, will closely scrutinize their client's books and truthfully disclose their findings. [6] The audit function is one of the most vulnerable areas, recommending urgent attention to improve the effectiveness (Solomon, 2009). This function helps the shareholders in their monitoring and control of the company management. The failure would result in the downfall of the company.

The Cadbury Report clearly emphasizes that the auditor's role is not to prepare the financial statements, nor to provide a guarantee that the company will continue as a going concern, but the auditors have to state in the annual report that the financial statements show 'a' true and fair view rather than 'the' true and fair view. [7] The main reason for the auditor independence being compromised is close and cosy relationships between the auditors and the company management. Such relationships with the clients may affect the financial statements they are auditing. A balance has to be attained by them. This is a difficult path to tread and one that is clearly bedecked with obstacles.

External auditors are independent service providers whose impact can influence the organization that is being audited. As outsiders, they play an important role in developing internal control. They comment on the weaknesses in the accounting records, systems and controls that they review. They provide a statistical clarity and effectiveness of the accounting policies. Their main role is to advice the company management through recommendations in their audit notes or discussions. Each of these opinions is vital for an organization.

There are two main issues in auditor independence.

PROVISION OF NON-AUDIT SERVICES

A problem raised in the Cadbury Report is regarding the independence and effectiveness of the audit function that involves multiple services offered by auditors to their clients. It is controversial whether the provision of non-audit services (NAS) by auditors impairs auditor independence, or is instead economically efficient (because of benefits from knowledge spillovers, reduction of search costs, or mitigation of contracting frictions). [8] The scope of non-audit services has been a subject of intense policy debates. The main argument is that the provision of (NAS) could threaten auditor independence because it creates economic incentives for the auditor to preserve the auditor-client relationship (Simunic, 1984; Beck et al., 1988). The Smith Report (2003) stated that: "…we do not believe it would be right to seek to impose specific instructions on the auditor's supply of non-audit services through the vehicle of Code guidance. We are sceptical of a prescriptive approach, since we believe that there are no clear-cut, universal answers…there may be genuine benefits to efficiency and effectiveness from auditors doing non-audit work". [9] The Smith recommendations seem to pass the buck on to the audit committee.

Due to the competitive nature of business, there is a growing demand for advice provided by specialists in order to help them, attain maximum growth and profits. Auditors, as specialists fulfil this role to a great extent. They understand the varying dynamics of the business world. Their independent view on matters related is significant for the development of the companies they audit. Many professional member organizations like the Institute of Chartered Accountants in England and Wales (ICAEW) clearly state that the failure of a company is more or less related to the quality of audit provided. The Institute perceives provision of non-audit services as a potential threat to the independence of the auditing firm. The Institute has come up with a Code of Ethics to ensure that auditors provide highest standards of business and protect public interest. The provisions of the (Combined Code 1998) also take into account the extent to which non-audit services are being provided by firms. It's the duty of the audit committee to act as representatives of the shareholders. As representatives, they need to keep a check to ensure that auditor independence is not impaired. The shareholders should be free to assess the extent of non-audit services provided. The UK Companies Act, 2006 has time and again required the total amount of non-audit fees paid to the auditors to be disclosed. Such disclosure pushes the independence of the auditor to the forefront. Accurate systems of checks and balances have to be maintained to assure that auditor's perform their tasks without any pressure.

The esteemed U.S. Securities and Exchange Commission (SEC) after the Enron scandal has progressively tightened regulations related to the non-audit services. [10] The standardization and tuning of the SEC would be further discussed in the next chapter by bringing to light the Enron episode which changed the world's perspective towards the audit profession. One more reform which was the immediate response to Enron was the Sarbanes-Oxley Act, 2002. Section 201 of the Act, clearly states that to be considered independent, a registered public accounting firm that audits a public company's financial statements would not be permitted to provide, any of the non-audit services listed in the section or any other service the Public Company Accounting Oversight Board (PCAOB) determines by regulation to be impermissible. The PCAOB is a non-profit organization constituted by the Congress in order to oversee the audits of public companies and protect the interests of the investors and further the public interest at large. Some examples of these prohibited services include financial information systems design and implementation; actuarial services; legal services and expert services unrelated to the audit; management functions or human resources; internal audit outsourcing services.

On the other hand nowadays auditing companies along with audit services also offer consultancy and IT services. Thus there has been a rapid change in the nature of services offered. It is difficult to decide whether providing non-audit services would impair the firm's independence but adequate safeguards need to be implemented by the companies themselves. If they are determined on using the auditors for non-audit services, it should be in accordance with the professional guidelines.

In the author's opinion, audit firms shouldn't go beyond providing audit services. Firstly, auditing, itself is a difficult task. Along with qualifications, auditors need to possess a business understanding approach. The quality of the audit is more important to the client. They should devote significant time and resources to the audit reports rather than worrying about non-audit services. They should build up on their technical skills which would help improve the reporting. They should focus on the job at hand. They should come up with innovative ideas and plans to attract audit clients. Within the audit firms, there needs to be an internal inspection process to make sure independence is not impaired in anyway. High priority should be given to the companies that they audit. There should be alternatives to improvise the accounting activity in the company. The non audit consulting services lead to a serious decline in auditor independence. As 'independence' is the hallmark of the accounting profession, it needs to be free from personal interest. Secondly, there is fierce competition in the market for revenue among the audit firms. By providing non-audit services, they attempt to increase their revenue. Since these services yield a greater amount of earning for the auditing firm. So the goal here is profitability of the firm. Although providing non-audit services helps the auditors to understand their client better, it is extremely tough for them to remain independent as they do not wish to jeopardize their combined audit consulting relationship with the client. Examples of Enron and WorldCom bring to light a clear cut case of lack of independence and objectivity among the auditors which resulted in the collapse of these giant companies. Mechanisms should be in place to protect the independence and professional skepticism of the audit profession.

ROTATION OF AUDITORS

Whether there should be a system of rotation of auditors in companies is being debated in various quarters in view of the recent developments resulting in corporate failures due to deficiencies in reporting by some audit firms. The Cadbury Report (1992) discussed the possibility of having compulsory rotation of auditors, as it could be a means of avoiding cosy auditor-client relationships. However, the report concluded that the costs of such an initiative would outweigh the benefits, as it would result in a loss of confidence and trust between the auditor and their client company. [11] 

The ultimate question here is that does rotation of auditors enhance the quality of audit provided and if it does at what cost. Rotation of auditors can lead to two scenarios either it would have more-independent auditors performing better audits by reporting material fabrication and falsification of financial statements or constant rotation would result in inferior audit performance. There are three related conditions which affect the quality of audit to a great extent, they are closeness to client management, lack of attention to detail due to staleness and redundancy and eagerness to please the client. [12] These conditions are further discussed below.

Closeness to Management

The term 'closeness to management' clearly indicates a very cosy and close relationship with the executives of a company. More than 40 years ago, in The Philosophy of Auditing, authors Robert K. Mautz and Hussein A. Sharaf warned auditors: [T]he greatest threat to his independence is a slow, gradual, almost casual erosion of this honest disinterestedness­---the auditor in charge must constantly remind his assistants of the importance and operational meaning of independence. The nature of auditing requires auditors to interact extensively with their clients. This long-term relationship between the two results in an alarming degree of closeness between the company management and the auditing firm. This creates conflicts of interest. The issue on conflicts of interest is discussed in the next chapter. It showcases how the entire auditing process is affected by such a conflict of interest. There is also a possibility that the company management would take advantage of this closeness. It may lead to an interpersonal relationship where the company management appeal to the auditors for personal gain and support. The graphic example here would be Enron and Arthur Andersen. Familiarity rarely breeds contempt between companies and their auditors. More often than not, it results in a level of comfort that weakens auditor independence and reduces audit quality. The price of that closeness is borne by the non-promoter shareholders, investors, employees and other stakeholders in the company. Sometimes, it threatens the survival of the company.

The auditors must correspond and exchange information with the company management during the audit. As they meet on a daily basis to transfer information such relationships are bound to occur. It should be more of a comfortable relationship, where the client can discuss his problems and share information pertaining to the audit. While auditors must maintain a level of professionalism, this auditor-client relationship is a function of mutual understanding and experience. The main problem here is that by rotation, the new firm is faced with the "getting to know each other" stage. This closeness contributes to knowledge sharing and is very critical to the entire audit process.

Staleness and Redundancy

Staleness has been noted as a common problem among non rotation of auditors. The majority view is that it leads to a repetition of prior undertakings. The auditors fail to highlight the important changes occurring. This leads to staleness, whereby the originality and effectiveness of the audit function is lost. Many prior used schedules and work papers are relied upon to provide valuable information. Thus reliance is a significant problem. It affects the auditor's response to the company management on various subjective issues. An example would be whether the earnings estimate decided by the company management are in line with Generally Accepted Accounting Principles (GAAP).

It cannot be denied that, prior year audit often produces substantial benefits which result in increased audit effectiveness. The auditor is familiar with the matter at hand. He is able to distinguish from the issues at hand. He appreciates the changes taking place from time to time. Due to complexity in many of the companies, it is very difficult for an auditor to understand the working of the company management within a very short period of time. Under non-rotation, the auditor does not need to start auditing from scratch, the management is familiar with what the auditor would ask for, and there is a less chance of interruption to the normal business of the company. As auditors spend a great deal of their time with the client, they create a smooth, time-saving and valuable audit.

Eagerness to please the client

There exists an eagerness or enthusiasm to please the client. This stems from a long-term remuneration or earnings in the form of future audit fees. In order to retain a client, the audit firms do what it takes to please the client to ensure that they are in the good books. There is an unconscious urge of the auditors to satisfy the client. Psychological research has demonstrated that even when people attempt or try to remain objective and impartial, often they are unconsciously and unintentionally unable to remain impartial, due to a "self-serving bias" that causes them to reach decisions that favour their own interests. [13] 

There is always a temptation to be in the good books of the client. If a difference occurs, there is a potential of losing the client prematurely. During the final year of the audit, the firms pay less attention to detail and may not be motivated to serve the client. He may treat the client as a "lame-duck". Rotation of auditors require companies to choose a new auditing firm, which in itself may lead to the search for auditors who would give a positive view or opinion about the accounting practices of the company (opinion-shopping).

In the author's opinion, rotation of auditors can be regarded as a key to the never ending problem of closeness to management. Rotation can bring about a massive improvement in the quality of audit and the attitude of auditors. It would help to prevent auditing scams. The company management should take a more active role in supervising the system to prevent abuse of power by the auditors. Investor confidence hit an all-low time during various auditing scams such as Enron in the USA, Satyam in India and many others in different parts of the world. Due to these scams the audit profession has come under the public eye, persuading the governments to come up with statutory restrictions. In India, under Clause 123 (1A) of the Companies Bill, no company can re-appoint any individual or audit firm for a period of more than five consecutive years. Section 203 of the Sarbanes-Oxley Act, 2002 in USA, provides for audit partner rotation every five years. Thus by mandatory rotation the effectiveness of the audit process would not be impaired. Auditors would be more independent and not have close ties with the audit clients.

CHAPTER 3: US CASE STUDY

The year 2002 saw the end of an era of skyrocketing stock prices and booming businesses. Things that had seemed to be too good to be true were just that. Companies that were previously thought of as unstoppable didn't have the earnings they claimed to have. [14] This chapter examines the impact of weaknesses and failures of corporate governance on companies and on society. In this chapter, we examine the Enron saga in order to highlight the consequences that arise from the failure of corporate governance mechanisms. We also examine the downfall of Enron, looking at the main reasons for collapse and commenting on the corporate governance problems within the company. The reason for picking Enron is to explain why this case encouraged corporate governance reform worldwide, especially in the auditing process.

BACKGROUND

Enron was formed in July 1985 when Houston Natural Gas merged with Omaha-based Inter-North. The company was founded by entrepreneur, Kenneth Lay. As the energy markets, and in particular the electrical power markets were deregulated, Enron's business expanded into brokering and trading electricity and other energy commodities. In a period of 16 years the company transformed from a small entity, to the world's largest energy trading company (The Economist, 28 November 2002). Deregulation had a far reaching impact on all the energy providers. In this newly deregulated and innovative forum, Enron embraced a culture that rewarded "cleverness". Deregulation opened up the industry up to experimentation and the culture at Enron was one that pushed the employees to explore this new playing field to the utmost. [15] This led to enormous success for the company.

From the start of the 1990's until year-end 1998, Enron's stock rose by 311 percent, only modestly higher than the rate of growth in the Standard & Poor's 500. But then the stock soared. It increased by 56 percent in 1999 and a further 87 percent in 2000, compared to a 20 percent increase and a 10 percent decline for the index during the same years. By December 31, 2000, Enron's stock was priced at $83.13, and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market's high expectations about its future prospects. [16] 

Enron's success was phenomenal. It was rated as the most innovative large company in America in Fortune magazine's survey of the Most Admired Companies. It built up its glittering reputation and success before crashing down in such a monumental fashion. Ironically the company's commercial ended with the phrase, "Ask why, why, why?" Questions such as what happened, why did it collapse, why were there no backup plans, why did the world's leading energy company fail, bring us to the problems arising within the company before the filing for bankruptcy in 2001.

The word "Enron" has become synonymous with corruption on a colossal scale - a company where a handful of executives were able to pocket millions of dollars while carelessly eroding the life-savings of thousands of employees. The individual and collective greed of the executives had built within the company an atmosphere for arrogance. Arrogance and aggressiveness of the company management had pushed the law too far and this led to a heap of bad debts and ignominy.

An article in The Economist (26 February 1998) raised certain doubts over the permanency of Enron's success. There were three causes of concern. Firstly, deregulation was occurring in differing speeds in the different states of America and therefore the ability to achieve free competition. Secondly, Enron did not have enough resources to deal with small customers that they were taking on. And lastly the company's management team were arrogant and overambitious.

THE FALL OF ENRON

Transparency is an essential ingredient for a sound system of corporate governance. The lack of transparency and the disclosure of the financial statements had given rise to various liabilities and losses which were not accounted. This was one of the main reasons for the collapse of the company. This whole affair took place with the help of Arthur Andersen LLP, who kept a floor of auditors assigned at Enron year-round. [17] 

Kenneth Lay hired Jeffrey Skilling to assist him in developing Enron's business strategy. Skilling began to change the corporate culture at Enron. The company's reputation with the outside world flourished. But the internal culture, changed drastically. Skilling was responsible for the constitution of the Performance Review Committee (PRC) which was also known as the "360-degree review". It was the harshest employee ranking system. [18] This encouraged the employees to work longer and post earnings for the company. Thus there prevailed fierce internal competition. Enron's corporate leadership was in the hands of Lay and Skilling who travelled across the country to sell their concepts to other power companies and energy regulators.

By the end of 1998 Enron had eight divisions. The revenue growth was tremendous from $2 billion to $7 billion within a span of four years. Thus the company was flying high with double digit growth (at least on paper) with every venture. The main reason for these figures was the mark to market accounting rule. Under these rules, companies who had outstanding energy related or any other derivative contracts (either assets or liabilities) on their balance sheets had to adjust them to fair market value. Keeping into mind the unrealized gains or losses of the financial statement of that period. [19] The catch here was that commodities such as gas had no quoted prices to base valuations on. So the company was free to develop their own assumptions with regard to the base valuations. The Financial Accounting Standards Board's (FASB) stated that Enron had valuation estimates which overstated the earnings of the company.

Arthur Andersen LLP was widely considered the firm of choice for auditing businesses in the oil and gas industry, auditing 70 percent of Houston's oil and gas companies. [20] It was logical for Enron, one of the world's leading energy companies to choose Andersen to perform its financial statement audits. Thus Andersen was the professional gatekeeper [21] . They are reputational intermediaries who provide verification and certification services. The relationship began in 1985 when Andersen began auditing Enron, but soon became much closer. It performed the role of an external as well as an internal auditor. Enron frequently hired many of Andersen's auditors to the strategic positions of the CFO (Chief Financial Officer) and Chief Accountant. Because of these cosy relationships with Enron, Andersen's audit independence was called into question. This raised serious doubts about the quality of the audit process.

Both the audit function and the accounting function in Enron were fraudulent and opaque. Enron's accounting was anything but transparent. The company recorded profits, for example, from a joint venture with Blockbuster Video that never materialized (The Economist, 7 February 2002). Enron manipulated the accounting numbers to inflate the earnings figure. They removed substantial amounts of debt from their accounts by setting up a number of off-balance sheet entities. Off-balance sheet entities are used to artificially inflate profits and make firms look more financially secure than they actually are. Enron would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. This was done with the help of Andersen, in order to hide the company's liability from the balance sheet. In order to appease the credit rating agencies such as Moody's and Standard & Poor's, Enron made sure that the leverage ratios were within acceptable ranges. Andrew Stuart Fastow, the former CFO of Enron continuously lobbied around these agencies with the intention of influencing their decisions and raising Enron's credit rating. This entire process resulted in a cumulative profit reduction of $591 million and a rise in debt of $628 million for the financial statements from 1997 to 2000. [22] This triggered an investigation by the Securities and Exchange Commission (SEC) into the auditing work of Andersen.

As mentioned earlier, Andersen had a very cosy relationship with Enron which resulted in conflicts of interest. Conflicts of interest are a frequent problem in the audit profession. Independent appointment of the company's auditors by the company's shareholders is frequently replaced by subjective appointment by company bosses, where the auditor is all too often beholden to the company's senior management. Further, there are conflicts of interest arising from interwoven functions of audit and consultancy. [23] These special cosy relationships between the company management and the auditors compromise independent judgement and cloud the auditing function. Enron's bankruptcy called into question with disclosure mechanisms practised USA. It raised serious doubts over the integrity of the independent audit process.

REFORMS

There was a serious rise in debt of $628 million for the financial statements from 1997 to 2000. This figure triggered the SEC into conducting an investigation into the auditing process of the company. The result was a huge difference in the profit figures. Such inflation had allowed the company to increase its Earnings Per Share (EPS). EPS is equal to net income minus dividend on preferred stock, divided by average outstanding shares. The company had exaggerated its profits by manipulating Andersen. The goal here was short-termism, which refers to concentration on immediate profits at the expense of long-term results. The temptation is to cheat in order to get good results.

The collapse of the company led to a lack of confidence in the activities of the company management. Investors and creditors were shocked at the breakdown of such a gigantic company. The assumption, as in the recent economic recession, was that companies can be "Too Big to Fail". The immediate response to this situation was the enactment of the Sarbanes-Oxley Act, 2002. It was produced and signed by the former President George Bush on 30th July, 2002. Title two of this act contains nine sections (Section 201 to 209) devoted entirely to auditor independence. These sections have focused mainly on the scrutiny of the non-audit services being provided by the audit firms as well as the rotation of the audit partner for every five consecutive years. Audit committees, within the company should take on the task of supervising the entire audit process to ensure the efficiency of the reports being produced. As discussed earlier the act constituted the PCAOB, to provide oversight for the system. The Act has come up with independent audit standards and quality control checks. The Act improved the reliability of the audit reports to a great extent.

In June, 2002 the New York Stock Exchange (NYSE) issues a report on corporate accountability, which stated the role and authority of independent directors should be increased. Audit committees should consist of these independent directors who would have the sole authority to hire and fire auditors. [24] Thus the company management should not interfere with the activities of the audit committees.

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