Moving Audits From A Traditional To A Risk Based Approach Accounting Essay

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Recent years saw lots of financial frauds which have led to huge losses borne by innocent investors, creditors, employees, and others. Enron provides dramatic example of how internal control breakdowns and defective and dishonest management and auditing can result in misstated financial statements that ultimately do great harm to national economy. Audit failures meant that the accounting profession is confronted with a crisis of confidence and credibility. Criticism of the profession is widespread and harsh in the changing economic, social and regulatory climate in which the profession at present functions. Audit failures will endanger the existence of the profession and its development in the long run.

In this report we have tried to analyzed critically Enron in USA as the criteria of the assignment. It shows how is climbed dramatically and how it fell within few years of time. We have also tried to show the consequences to abolish the company and what the role of directors, auditors, corporate governance and accounting policies.

Background (Enron)

Enron began in 1985, when it started operations as an interstate pipeline company created from the merger of Houston Natural Gas and Omaha-based InterNorth. Kenneth Lay, the former chief executive officer of Houston Natural Gas, became CEO. A year later he was named chairman. 

By 1999, the company had moved into new fields, including Enron Online, the company's website for trading commodities. It soon became the largest business site in the world. About 90 per cent of Enron's income eventually came from trades over Enron Online. 

The company enjoyed spectacular growth with annual revenue hitting $100 billion US in 2000, making it the seventh-largest company on the Fortune 500 and the sixth-largest energy company in the world. The company's stock price peaked at $90 US.

Downfall of Enron: 

But by 2001, cracks began to appear. In August Jeffrey Skilling, a driving force in Enron's revamp and the company's CEO of six months, announced his departure, and Lay resumed the post of CEO. In October 2001, Enron reported a loss of $618 million - its first quarterly loss in four years. 

Chief financial officer Andrew Fastow was replaced, and the U.S. Securities and Exchange Commission launched an investigation into investment partnerships led by Fastow. That investigation would later show that a complex web of partnerships was designed to hide Enron's debt. By late November, the company's stock was down to less than $1 US. Investors had lost billions. 

On Dec. 2, 2001, Enron filed for bankruptcy protection in the biggest case of bankruptcy in the United States up to that point. Roughly 5,600 Enron employees subsequently lost their jobs. 

The next month, the U.S. Justice Department opened its investigation of the company's dealings, and Ken Lay quit as chairman and CEO. Hundreds of charges would eventually be laid - and 19 former executives would either plead guilty or be convicted for their part in what would become known as one of the biggest frauds in American history. Founder Ken Lay and former CEO Jeffrey Skilling were both convicted in May. But Lay died two months later, escaping what would surely have been a lengthy jail sentence.

Faulty Financial Reporting

The recent Enron collapse has sent shockwaves all over the financial world and raised serious questions regarding corporate governance: How could America's seventh largest corporation suddenly descend to bankruptcy? What has contributed to its sudden implosion? Currently, there are more than 10 separate committees investigating possible wrong doings and illegal activities, such as fraud and insider trading.

Available information suggests that Enron made its money with smoke and mirrors. With a set of off-the books, unregulated private partnerships to take on debts, hide losses and kick off inflated revenues, Enron executives were able to keep bond-rating agencies happy. They were able to sustain this shell game through persistent refusal to disclose to analysts, who questioned where the money came from. Arthur Anderson, the auditing firm, turned a blind eye to questionable accounting practices because they did not want to lose the lucrative consulting fees.

However, under mounting pressure, Enron's eventual disclosure of its overstatement of profits in November 2001 immediately triggered the collapse of the company and its bankruptcy filing on December 2, 2001.

A special panel of Enron's Board recently issued a 217-page report, condemning Enron's management for inflated profit reports and failure of controls at every level. According to Eichenwald (2002), "As oversight broke down at Enron, the report states, a culture emerged of self-dealing and self-enrichment at the expenses of shareholders. Accountants and lawyers signed off on flawed and improper decisions every step of the way, the reported concluded." . [Leung, P., Coram, P., Cooper, B.J., and Richardson, p 81, 4th edition and]

Enron used hundreds of special purpose entities to hide its debts. Special purpose entities are specific purpose to fund or manage risk associated with specific assets. By doing this, Enron understated its liabilities and overstated its equity, and its earnings were overstated. Enron disclosed to its shareholders that they applied hedging to downside risk in its own illiquid investment using special purpose entities. By that way Enron protected itself from the downside risk.

The causes of audit failure

Internal causes

Audit failure occurs when there is a serious distortion of the financial statements that is not reflected in the audit report, and the auditor has made a serious error in the conduct of the audit (Arens, 2002). Audit failure does not occur if the auditor has followed Generally Accepted Auditing Standards, regardless of the fairness and accuracy of the financial statements. A properly done audit does not guarantee that serious distortions of the financial statements have not occurred. However, a properly done audit does make serious distortions unlikely. Thus, audit failure cannot occur unless there is serious auditor error or misjudgment. The nature of this auditor error has four systematic causes.

First, the auditor can blunder by misapplying or misinterpreting GAAS. Such a blunder is unintentional and could be caused by fatigue or human error.

Second, 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. Third, the auditor can be unduly influenced by having a direct or indirect financial interest in the client.

Fourth, 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.

External causes

In current economic environment, business risks result from intensified market competition may force the dishonest management of the entity to commit financial fraud. Such risks may arise from: (1) Industry developments and consequent potential business risks that entity does not have the personnel and expertise to deal with the changes in the industry; (2) New products and services, and consequent potential business risks that there is increased product liability; (3) Expansion of the business, and consequent potential business risks that the demand has not been accurately estimated; (4) Current and prospective financing requirements, and consequent potential business risks on loss of financing due to the entity's inability to meet requirements, etc. Moreover, poor corporate governance provides management opportunities to override controls and commit fraudulent financial report. Therefore, in order to manipulate the profit and

mislead financial statements users' judgment about the entity's performance or profitability, fraud may involve sophisticated and carefully organized schemes designed to conceal it.

The countermeasures of audit failure

Under section 307 of the Corporations Act stipulates the overriding principle adopted by the law regarding the role of the auditors. An auditor who conducts an audit of the financial report for a financial year or half-year must form an opinion about whether the financial report is in accordance with Corporation Act, including compliance with accounting standards and showing a true and fair view of the financial state of affairs of the audited body. As the credibility of the audit opinion lies in the independence of the auditors, independence of the key aspects of the recent audit reform. The Corporation Act was updated by the Corporate Law Economic Reform Program (CLERP 9Act) to reflect a set of provisions concerning auditor's independence. The key statutory provisions for auditor independence in the Corporation Act are described below:

Part 2G s. 250RA: Members are permitted to provide written questions to the auditor within 5 days before the AGM and the auditor is required to prepare a list of questions to the listed company and to attend the AGM.

Part 2M Div 3 s.307C: Auditors must give the directors of disclosing entities a written statement that the requirements of auditors' independence provisions of the Act have not been contravened.

Part 2M.4 Div 6 s.323A: Auditors have the power to obtain information controlled entities and the controlled entities must provide information or other assistance to the auditor concerning the consolidated financial statements being audited.

Part 2M.4 Div3 ss. 324CA, 324CB, 324CC: Auditors are required to inform ASIC regarding any conflicts of interest or ensure that such conflicts cease within 7 days of becoming aware of the situation. Detailed situations are listed for each category of auditors based on s.324CD.

Part 2M.4 Div 3A s. 324CD: Conflict of interest situations applicable for the above sections where an auditor or professional member of audit team becomes incapable of exercising objective and impartial judgment, with regard to the company, the managers or directors currently or formerly involved in the company and the auditor.

Part 2M.4 Div 3B ss. 324CE, 324CF, 324CG: Specific requirements for auditor independence applicable to individual auditors, audit firms, and audit companies where the auditor must take all reasonable steps to ensure the audit activity is not continued or inform ASIC within 7 days of becoming aware of the situation it the situation continues.

Part 2M.4 Div 3B s.324CH: Lists the relevant relationships which may be the subject of contravention of ss. 324CE, 324CF and 324CG. These relevant relationships apply to the individual auditor, a professional member of the audit team conducting the audit of the audited body or an immediate family member of a professional member of the audit team.

Part 2M.4 Div 3B ss. 324CI, 324CJ: Special rules for retiring partners of audit firms and retiring directors of audit companies and special rules for retiring professional member of the audit team conducting the audit of the audited body or an immediate family member of a professional member of the audit team.[Leung, P., Coram, P., Cooper, B.J., and Richardson, p 81, 4th edition]

Above mentioned are the statuotory laws prescribed by the CLERP 9 Act but is also urgent to take measures to cope with the severe situation of audit failures. Some are suggested as follows.

Maintain 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.

2. Exercise professional skepticism

An attitude of professional skepticism means the auditor makes an assessment, with a questioning mind, ofthe validity of audit evidence obtained and is alert to audit evidence that contradicts or brings into question the reliability of documents and information obtained from management and those charged with governance. Auditors are often liable when they are presented with information indicating a problem that they fail to recognize. Auditors need to strive to maintain a healthy level of skepticism, one that keeps them alert to potential misstatements, so that they can recognize misstatements whey they exist. Auditors should plan and perform an audit with an attitude of professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated.

3. Moving audits from a traditional to a risk-based approach

Risk-based audit represents the developing trend of modern audit. It requires that the auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to identify, assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. A risk-based audit allows CPAs to focus audit resources (dollars and people) on the highest risk areas. Resources are directed to areas where controls are weakest and audit procedures are tailored to the highest risk areas, thereby adjusting the audit scope. Thus, risk-based audit is more

cost-effective. The related procedures may include inquiries of management and others within the entity, analytical procedures, observation and inspection. The auditor's understanding of the entity and its environment consists of an understanding of the following aspects: (1) Industry, regulatory, and other external factors; (2) Nature of the entity; (3) Objectives and strategies and the related business risks that may result in a material misstatement of the financial statements; (4) Measurement and review of the entity's financial performance; (5) Internal control, which includes the selection and application of accounting policies.

4. Enhance audit quality control

Quality control policies and procedures should be implemented at both the level of the audit firm and on individual audits. The accounting firm should establish a system of quality control designed to provide it with reasonable assurance that the accounting firm and its personnel comply with regulatory and legal requirements, the Code of Ethics for CPAs, standards on auditing, etc., and that reports issued by the accounting firm and engagement partners are appropriate in the circumstances. The accounting firm's system of quality control should include polices and procedures addressing each of the following elements: (1) Leadership responsibilities for quality control within the accounting firm; (2) Ethical requirements; (3) Acceptance and continuance of client relationships and specific engagements; (4) Human resources; (5) Engagement performance; (6) Engagement documentation; (7) Monitoring.

Quality control policies and procedures should be implemented at both the level of the audit firm and on individual audits.

5. Improve audit committees

Corporate governance is one of the key factors that determine the health of the internal control. As one of the important components of corporate governance, audit committee plays a very important role in reducing the riskof financial fraud. It is necessary that auditors report to and are overseen by a company's audit committee. This audit committee must approve all audit and non-audit services, must receive all new accounting and auditing information from the auditor, and must serve as the official line of communication between the auditor and the client company.

Members of the audit committee are independent members of the board of directors of the company being audited, and at least one board member must be a "financial expert".

6 Strengthen supervision over the CPA profession

The administrative supervision conducted by the competent departments over the CPA profession should start from guaranteeing the healthy development of the CPA profession, and aim at restoring the confidence of the public towards the CPA profession. The departments should also, by imposing aggravated punishments on a few acts of violating laws or rules, protect most of the honest and law-abiding certified public accountants and accounting firms, rectify and regulate the accounting order, as well as promote and guarantee the development of the CPA profession.

Finally, Improving the control structure: The solution begins with senior corporate executives and corporate boards developing a better understanding of and appreciation for internal controls. Controls should be viewed in a positive light, as reinforcement designed to help a company achieve its goals and objectives, not as an onerous requirement unrelated to the company's business. A good internal control structure starts with the tone at the top-the board and senior management. They must make controls a central part of the company culture and communicate that culture to everyone in the rest of the organization. In fact, failure to set an appropriate tone at the top may have been Kenneth Lay's and the Enron board's major failing. A company without active board and management interest and support, regularly communicated to the rest of the organization, is unlikely to have an adequate internal control structure.


The circumstances in which companies operate have been more challenging and more than ever, fighting against financial frauds is of great importance to CPA profession. This paper analyses the causes of audit failure from both the external and internal aspects which mainly are poor corporate governance and lack of independence of the CPAs. This paper gives suggestions on how to cope with audit failure. It is critical For CPAs to maintain independence, professional skepticism. The CPA profession should perform the risk-based audit and improve audit procedures. Further more, it is quite necessary to improve audit quality control, audit committee and strengthen supervision over the CPA profession.

Generally, corporate culture refers to the prevailing implicit values, attitudes and ways of doing things in a company. It often reflects the personality, philosophy and the ethnic-cultural background of the founder or the leader. Corporate culture dictates how the company is run and how people are promoted.