Investigating the relationship between auditing and the financial scandals

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Auditors are considered as natural characters of the society. But, in recent years, quite a few corporate scandals over the world, such as, Enron and WorldCom in USA, Paramalat in Europe, and HIH Group of Companies and One.Tel accompanied with the financial crisis and the global credit crunch of the very recent time have the put the profession in a dispute (Dellaportas et al, 2008; Woods et al 2009). While raising questions on these issues, several renowned academics and scholars are trying to explore the relationship between the auditors & auditing profession and the corporate scandals, financials crisis & global credit crunch. These questions addressed issues such as, whether the auditors had been working in accordance with professional ethics and standards. "Questions were also asked about the auditing profession's ability to self-regulate, and governments responded by issuing new laws to regulate the auditor's work." (Marx and Dijkman 2009, p. 16).

This essay intends to examine some important findings from a number of critique journals of some well-known academics and scholars, whose research on this issue has given suggestions and in some cases, direction to explore the audit crunch in the modern corporate world. Sikka, Filling and Liew (2009) will be the main focus of the paper. This paper will try to discuss the ethical issues, auditing standards and relevant statutory act applicable to the auditing profession.

In the next part of the essay, an attempt has been made to discuss the effect of intensification of financial capitalism and the commercialisation of audit in the context of contemporary corporate world. These two factors could be identified as relevant issues for the audit crunch. In the context of agency theory, there is a separation of ownership and control. Directors, who work as agents pertains the control of corporation. The agents (directors) work on behalf of the owners of the corporation, who are the shareholders with the objective of maximizing shareholder's wealth. The directors are remunerated and rewarded based upon their success in doing so. But, since the directors have the control of information, with dishonest means they can maximise their personal welfare at the expense of shareholders by presenting them fraudulent or misleading financial statements. Therefore, to protect shareholder's right and to mediate the conflict between principle and agents under the agency framework, monitoring arrangements have been enforced by the law besides providing incentives. One of such monitoring arrangements enacted by the statutory act is the requirements for the directors to submit an annual financial report which has to be audited by expert auditors who are independent of the agents (Sikka, 2009).

Problem arises as the agency theory does not provide any guidance on how the expert auditors might be appointed. As quoted from Sikka (2009), "There is a concern that directors may shop for audit opinions and prefer to hire more compliant auditors (Lennox, 2000)". "Under the contemporary auditing model, it has been argued that the auditors have to depend on companies and their directors for fees and profits. Moreover, the model has been further complicated by the fact that, auditors are permitted to sell non-audit services such as, consultancy services to their audit client which in turns increases auditors fee dependency upon companies and can impair their perceived and actual independence" (Sikka, 2009).

The fundamental principles of professional ethics ask auditors to work with integrity, objectivity, professional competence & due care, confidentiality and professional behaviour. The findings of Sikka, Filling and Liew (2009) suggested that the contemporary auditing model is flawed. It makes auditors financially dependent on companies. The sale of non-audit service to audit clients have also raised question on the independence of auditors. "Independence is the most vital characteristics of auditors and it is fundamental to the principles of integrity and objectivity. The Code of Ethics discussed 'independence' in the context of freedom from any interest incompatible with integrity and objectivity. Provision of non-audit services to audit clients threatens the independence of auditors by means of self-review threat, where the auditor may need to review work performed by the auditor's firm and the sacrifice of audit integrity in order to produce non-audit work" (Arens, 2007).

The public accounting firms can take the form of sole proprietorship, partnership and incorporated company permitted under the Corporations Act. In section 100 of the code of ethics for professional accountants as stated in APES110, it says that "A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest" (Compiled APES110, February 2008). As with the growing number of corporations and internet and electronic commerce, demand for audit and other assurance & non-assurance service has been increasing substantially. Thus, competition has been intensifying among the public accountant firms. In such circumstance, the public accounting firms seek to increase profit and market share which shifts their business focus very firmly on being commercial and on performing service for the customer. This shift threatens the identity of the profession and puts question on the distinguishing mark of the profession to act in the public interest.

The consequence of this flawed contemporary audit model in practice has given rise to audit failures scandals, which was predominant in the last few decades. Barlaup (2009) mentioned that, "Trust and confidence is essential to the functioning of capital markets. Recent accounting scandals, where companies prepared fraudulent financial statements, and auditors issued clean opinions on the fraudulent statements, have eroded trust among participants in the financial markets" (Barlaup, 2009).

The above discussion shows that the contemporary 'flawed' auditing model is one of the main detriments to deepen the recent financial crisis all over the world. Studies on this issue of audit crunch by eminent academics and scholars revealed that the deepening financial crisis led by various corporate and business failure has not only resulted in innocent peoples losing their jobs, homes, pensions and investments but, also in people losing their trust on the auditing profession. And, thus, the audit expectation gap which can be attributed as the "differences between the views of auditors and the expectations of other stakeholders regarding: (1) the appropriate roles and responsibilities of auditors, and (2) the performance of auditors" (Arens, 2007) has continued to increase.

To address these vulnerable issues, legislative responses by government and regulatory bodies have given rise to new statutory requirements, regulations and standards such as: CLERP 9 Act in Australia, Sarbanes-Oxley Act in USA and the Auditing Profession Act, Corporate Laws Amendment Act & Companies Amendment Act in South Africa. All these efforts were aimed to strengthen auditor's independence and as well to improve the quality of auditor's work. Major changes that came through CLERP 9 include the following:

"Oversight of auditors has been strengthened through the Financial Reporting Council" (Leo, 2008).

"Non-audit consultancy income for auditors has been limited and must be clearly disclosed" (Leo, 2008).

"Make statement on whether the directors are satisfied that the provision of non-audit services is compatible with the general standards of independence under the Corporations Act and provide their reasons" (White, 2007).

Academics and scholars have expressed their opinion from different perspectives with different solutions addressing the crisis. The findings of Barlaup (2009) suggested increasing focus on ethical discernment and ethical behaviour. Critically appraising the existing Auditor's Code published by the Auditing Practices Board, the findings of Hatherly (2009) argued that, "The existing nine enduring principles should be replaced by suggested seven enduring tensions - the fault lines of auditing - so as to rethink the conceptual basis of auditing standards".

An alternative approach in appointing auditors to corporations has been suggested in the work of Sikka, Filling and Liew (2009). The paper suggested that unlike the way auditors are appointed and remunerated by the state rather than the auditee for health, safety, hygiene, taxes, immigration and many other fields, regulatory bodies such as SEC can directly appoint and remunerate auditors. The findings also suggested that, instead of annual ex-post audits, audits could be done on a continuous basis and instead focusing on traditional financial statements audits can run on a diverse regulatory matter. I completely agree with the findings of Sikka, Filling and Liew (2009) as discussed above. I believe, such an attempt will result not only in a more reliable audited financial statements but also it will reduce the audit expectation gaps and regain more confidence on auditors and the audit profession by the public.