The Function Of External Auditors Accounting Essay

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This study is an examination of the different perceptions of users of general purpose financial statements and external auditors with regards to the primary objective of the external audit function. The expectations of users of general purpose financial statements and the function of external auditors may not always be in unison.

This chapter discusses the background to the study and the statement of the problem. It also highlights the aim of the study, objectives and research questions. The chapter also discusses the significance, assumptions, scope and limitations. Finally the chapter defines the key terms used in the study.

Background to the Study

The primary function of external auditing is to verify the accounts and report whether the Balance Sheet and the Profit and Loss Account have been drawn properly according to the Companies Act and whether they exhibit a true and fair view of the state of affairs of the concern (Bhatia, 2005). Users of general purpose financial statements seem to have a different view point on the audit function carried out by external auditors. Users often make the assumption that audits have a broader scope than they actually have. For example, users frequently associate audits with an approval of management adequacy, a guarantee for absence of fraud, and a recommendation to invest in the respective firm (Frank, Lowe, & Smith, 2001).

In the case of re-Kingston Cotton Mills (1896), the liquidator of Kingston Cotton Mills tried to claim from the company's auditors, Mr Pickering and Mr Peasegood, amounts that had been improperly declared and paid out as dividends out of the assets of the company on the faith of certain financial statements prepared and signed by the external auditors. However, the financial statements were inaccurate because of fraud which was perpetrated by the custodian of the company. The liquidators blamed the auditors for failing to discover the fraudulent act from the audit work they had performed. However, Lord Justice Lopes ruled in favour of the auditors and stated the following:

"He is a watchdog, not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest and rely upon their representations, provided he takes reasonable care" (Morgan, 2000). The liquidator believed that the primary objective of the auditor was to uncover the fraud being and report it accordingly. The auditors' failure to do so meant that they had failed in their duties and thus were held liable for damages caused by failing to detect the fraud. However, the auditors believed that it was management's responsibility put in measures to uncover such fraud and that they could not be held accountable for the manipulation of accounts carried out by the trusted custodians of the business entity of which they had no reason to suspect were taking place. An auditor is supposed to exercise reasonable care and skill in terms of the detection of fraud. If the auditor performs this in examining the accounting records then he cannot be held liable for not detecting the errors or fraud (Bhatia, 2005).

In Cenco Inc. v. Seidman & Siedman, 686 F.2d 449 (7th Cir. 1982), Cenco managers had inflated inventory values over a period of five years so as to make the company appear more valuable, which in turn increased the price of its stock. The company's apparently strong position allowed it to buy up other companies cheaply and borrow money at low rates. The fraud was eventually discovered and led to a class action suit by Cenco stockholders against Cenco, its corrupt managers and its auditor Seidman & Seidman. Cenco alleged that Seidman was liable to it for failing to prevent the fraud. Seidman alleged that it was a victim of the fraud and thus entitled to damages. The court ruled in favour of Seidman because the fraudulent acts of Cenco's managers, which were perpetrated on behalf of the corporation, were attributable to Cenco. Judge Posner declared:

"Fraud on behalf of a corporation is not the same thing as fraud against it." In this case, the stockholders had received a benefit from the fraud and outsiders had borne the primary costs. Judge Posner was not willing to allow stockholders to escape all responsibility for the fraud (Shepard, 2012). Shareholders believed that the role of the external auditors was to prevent corporate fraud from occurring. The auditors argued that it was not their primary objective to prevent fraud since that was the responsibility of management. The shareholders had gained an advantage from the fraud, hence, could not find the auditors liable.

In Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP, No. 454, 2009 (Del. March 4, 2010), the Delaware Supreme Court denied a motion to dismiss claims against the top officials of AIG (American International Group) for breach of fiduciary duty based on Delaware law. However, the claims against the auditor, PwC, were dismissed. The senior officers at AIG had manipulated the corporation's accounts resulting in the financial statements being materially misleading which overstated the value of the corporation by billions of dollars. Plaintiffs accused PwC of failing to perform its auditing responsibilities in accordance with professional standards of conduct and thus failed to detect or report the fraud perpetrated by AIG's senior officers. The Courts held that the misconduct of AIG's senior officers is attributable to AIG. The Court of Chancery concluded that, once the fraudulent acts were attributable to AIG, AIG's claims against PwC were barred by New York's in pari delicto doctrine1. Shareholders believed that the auditors had failed in carrying out their auditing responsibilities in accordance with professional standards of conduct by failing to detect the fraud. PwC believe that they had no part in committing the accounting fraud that took place and that they had carried out their audit procedures to the best of their knowledge.

There seems to be an apparent divergence between what users expect from the auditor and what the auditor actually provides. This is often called the 'audit expectation gap' (Frank, Lowe, & Smith, 2001). The research seeks to examine the different perceptions of the audit function by users of general purpose financial statements and external auditors.

1 When the parties to a legal controversy are in pari delicto, neither can obtain affirmative relief from the court, since both are at equal fault or of equal guilt. They will remain in the same situation they were in prior to the commencement of the action. (West's Encyclopedia of American Law, 2008.)

Statement of the Problem

International Standard on Auditing (ISA) 250 states the following, 'The auditor is responsible for obtaining reasonable assurance that the financial statements, taken as a whole, are free from material misstatement, whether caused by fraud or error' (IAASB 2012, p.201). However, as illustrated by the above cases of re-Kingston Cotton Mills (1896), Cenco Inc. v. Seidman & Siedman, 686 F.2d 449 (7th Cir. 1982) and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP, No. 454, 2009 (Del. March 4, 2010), there appears to be differing perceptions of the audit function by users of general purpose financial statements and external auditors. It is against this background that this study investigates the different perceptions of the audit function by users of general purpose financial statements and external auditors.

Sub-Problems

Conflict arising between users' expectations and the external auditors' primary objective.

Technical ability and independence of auditors in doubt.

External auditors not meeting the expectations of users.

Auditors performing managerial duties.

External audit function not adding value to users.

Aim of the Study

The aim of the study is to examine the different perceptions of the audit function by users of general purpose financial statements and external auditors.

Objectives of the Study

The specific objectives of the study are as follows:

To assess the conflict arising between users' expectations and the external auditors' primary objective.

To examine the competence as well as independence of audit clerks at discharging their duties.

To establish the extent to which external auditors are not meeting the expectations of users.

To ascertain the possible causes of external auditors straying away from their core objectives.

To determine whether users believe that the external audit function adds value to them.

Research questions

What are the expectations of users and what possible conflicts arise when comparing these to external auditors own perceived objectives?

How competent and independent are audit clerks at discharging their duties?

To what extent are external auditors meeting the expectations of users?

Are auditors straying away from their core objectives?

Does the external audit function really add value to users?

Significance of the Study

The findings of the research will serve as an addition to literature on the primary objective of auditors and what should be expected of them when discharging their duties. The study will attempt to reduce the misconceptions in the business sector and public at large about the core objectives of auditors as well as attempt to narrow the knowledge gap existing concerning this issue. Furthermore, the research will broaden the researcher's knowledge about the primary objective of auditors.

Assumptions

For the purposes of the research the following assumptions have been made:

The samples are true representatives of the total population.

Respondents will respond in a manner that provides true and accurate data.

Respondents will be cooperative when making their responses and upon collecting the data.

Financial resources will suffice for the purposes of the research.

Delimitations

The audit profession is very broad and encompasses internal as well as external auditors and public auditors. The primary objective of auditors in this research is restricted to that of external auditors only.

Professional Ethics tailored specifically for Chartered Accountants in Zimbabwe.

All registered Chartered Accountants in Zimbabwe, including Articled Clerks in accounting firms in Zimbabwe.

Limitations

The following limitations have been identified that may affect the research:

Incorrect and inaccurate data may be supplied to the researcher.

The researcher will be limited by financial constraints that will prevent the researcher from travelling to the various respondents as well as acquiring other necessary reference books which may undermine the quality of the research project.

Respondents may not be able to present the requested information in time.

Respondents may also be unwilling to present information as they may deem it strictly private and confidential thus limiting the researcher.

There is a time constraint since the research project is being carried out concurrently with final year courses.

Definition of terms

For the purpose of this project the following abbreviations and definitions will be used:

Audit Independence - Taking an unbiased and honest viewpoint in the performance of audit tests, the evaluation of the results and the issuance of the audit report.

GAAS - Generally Accepted Auditing Standards

IAASB - International Auditing and Assurance Standards Board

ICAZ - Institute of Chartered Accountants Zimbabwe

IFAC - International Federation of Accountants

ISA - International Standards Of Auditing

Professional Competence and Due Care - Undertaking assignments in which you have the required expertise, knowledge, training, skills and competence.

Statutory Requirement - Stipulated by laws that are determined by the national legislature contained in the Acts.

Summary

This chapter looked at the background to the problem and highlighted its setting. It also looked at what the research seeks to achieve and the necessary questions that the research should be able to answer upon its completion. The constraints of the research which may compromise the quality of the research were also highlighted. However, the researcher will do his best to overcome them if possible. Other areas that were discussed by the researcher also related to the aim of the study, objectives and research questions. The chapter also discussed the significance, assumptions, scope and limitations. Finally the chapter defined the key terms used in the study. The next chapter will be on literature review.

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