The first part of the assignment will look at the role of the external auditors, and the history of auditing will be briefly discussed. Then the second part will look at fraud, its definition, examples of fraud and the implications of fraud.
Then finally before concluding the impact of International Auditing Standards on external auditors will be discussed.
According to Arens et al. (2003) the auditor is responsible for planning and performing the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether this is caused by error or fraud. They also state that because of the nature of the audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable but not absolute assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatement, whether caused by errors or fraud, that are not material to the financial statements are detected. (Arens et al., 2003)
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Mclnnes and Stevenson (1997) stated that even though the law doesn’t identify the detection of fraud as the primary objective of the external audit, the general public perceive the external auditor as being the main defence against corporate fraud.
Due to the nature of auditing and its inherent limitations, fraud is difficult to detect for many reasons. First it can be committed by people who are familiar with accounting procedures and can cover it up. According to the APB (1995) auditors simply do not possess all the necessary skills to detect fraud. Wells (1993) explains that there is a built in conflict since the auditors have to investigate people who indirectly hired them, the upper management. Monroe and Woodliff (1994) describe how the ability of the external auditor to detect fraud has come under increasing scrutiny and auditors are under considerable pressure to accept legal responsibility for detecting material fraud.
Glover et al. (2006) propose that the external auditors rely on internal auditors to different extents depending upon task subjectivity. And they go on to suggest that the external auditors are hesitant in some settings to rely on internal auditors’ work. Gramling et al. (2004) clarify that because reliance on internal audit can affect nature, timing, and extent of the annual audit program, discretion should be utilised when determining if reliance on internal audit work will increase the efficiency of the audit, yet not compromise quality.
Carcello et al. (2005) suggest that internal auditors’ interaction with audit committees has significantly increased since SOX. External auditors, on the other hand, are not able to embed themselves as deeply within their clients’ daily operations. External auditors also have limited exposure to the client compared to internal auditors because their role is typically performed during only a few months of the year.
Smith et al (2005) explain that in the Statement on Auditing Standards (SAS) No. 99 by AICPA, it is stated that “because fraud is usually concealed, material misstatements due to fraud are difficult to detect”. This hints that auditors “need to consider events that indicate the existence of incentives/pressures to perpetrate fraud, opportunities to carry out the fraud or attitudes/rationalisations to justify a fraudulent action”. These are referred to as fraud risk factors and are identified in the fraud triangle.
Smith et al (2005) also suggest that because auditing poses potential risk factors for auditors, the assessment of the risks of errors and fraud are vital when planning an audit.
In making risk assessments for fraud, auditors should keep in mind that fraud typically includes three characteristics, which are identified as the “fraud triangle:”
The Fraud Triangle (by Ilter, 2010)
Montgomery, et al. (2002) explains that three conditions are generally present when fraud occurs, these are:
Incentive/Pressure: Pressures or incentives on management to materially misstate the financial statements, Fraud Triangle
Opportunity: Circumstances that provide an opportunity to carry out material misstatement in the financial statements,
Attitude/Rationalisation: An attitude, character or set of ethical values that allows one or more individuals to knowingly and intentionally commit a dishonest act, or a situation in which individuals are able to rationalise committing a dishonest act.
Understanding and considering the likeliness of fraud in the context of these three conditions will enhance the evaluation of information about fraud (Montgomery, et al., 2002). This will provide the auditor with more professional scepticism when assessing fraud risk. Auditors are advised to consider the client’s receptiveness to fraud, regardless of the auditor’s past experience with the client or prior assessments about management’s honesty and integrity (Heim, 2002).
The demand for both external and internal auditing is sourced in the need to have some means of independent verification to reduce record-keeping errors, asset misappropriation, and fraud within business and non-business organisations.
“The origin of auditing goes back to times scarcely less remote than that of
accountingâ€¦……Whenever the advance of civilisation brought about the necessity of one man being intrusted to some extent with the property of another, the advisability of some kind of check upon the fidelity of the former would become apparent.” (Mautz & Sharaf, 1961)
The purpose of an external audit has been viewed as a public service since the 1800s (Langenderfer, 1987). This role was further confirmed during the 1930s when the US Securities and Exchange Commission was formed to monitor the trading process after the crash of 1929. Wallace (1987) and Watts and Zimmerman (1986) have described the auditor as an economic agent who serves as a monitor and a form of insurance for investors and regulators. In other words, according to agency theory, auditors play a key role in the relationship between owners and their representatives – both the board of directors and management.
Wallace and Parker (1991) point out that by 1948, fraud and error detaction was ranked as a lesser audit objective. They also describe how the audit focus has changed, they state that “because auditing has moved away from the audit of persons to the audit of financial statements, it does not seek to detect corruption but to lend credibility to financial statements”. (Wallace and Parker, 1991)
According to Lee (1986), the main reasons for the change in the audit objectives include the increased awareness of the needs of capital market participants for independently verified reports and the increased acceptance by company management of its responsibility for the prevention and detection of fraud and error
Fraud(Definition and examples)
Fraud can be described as a crime of obtaining money or some other benefit by deliberate deception. In auditing, fraud occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive. Vanasco (1998) explained that fraud includes intentional deception of irregularities and illegal acts. Alleyne and Howard (2005) suggested that fraud included intentional deception, cheating and stealing.
There are two types of fraud in auditing, namely misappropriation of assets (defalcation) and management fraud (Arens et al., 2008). Misappropriation of assets, commonly termed as employee fraud, is characterised by assets being stolen from the company (Albrecht and Romney, 1986). Management fraud – the second type of fraud – is essentially fraudulent financial reporting or misapplication of accounting principles.
Palshikar (2002) describes how fraud is amongst the most serious corporate problems and challenges in today’s business environment. He also goes on to suggest that fraud is a dominant white collar crime in today’s business environment, and that amongst many businesses and government organisations, financial services experience different kinds of fraud.
Examples of Fraud
There are many examples of fraud across the world, such as WorldCom, Enron, Satyam, Xerox and Waste management.
But for the purpose of this assignment I will only focus on WorldCom. One of the largest frauds in corporate history, $11 billion. (Teather, 2005)
Trouble began at WorldCom when they failed to meet the revenue expectations communicated earlier to the investment community. In 2004, the CFO pleaded guilty stating that he and the CEO met concerning the problem. The CEO refused to meet with the investment community to announce the shortfall. Rather, the CFO said he was instructed by the CEO to fix the problem.
Allegations are that the CEO was keenly aware of the likely impact on share price and was more concerned about $400 million he had personally borrowed from WorldCom secured by WorldCom stock (Padgett, 2002).
Over a five-year period, accountant’s at WorldCom systematically altered records, often after the books were closed, to meet analyst’s expectations. According to the WorldCom indictment, CEO Ebbers, CFO Sullivan and others created a process called ”close the gap” which identified improper accounting adjustments and then instructed staff to carry out the manipulations. Initially reserves were used to absorb expenses. When the reserves ran out a variety of accounting frauds were used to enhance revenues and decrease expenses. Unlike Enron, this did not involve manipulation of complex accounting rules, but rather a straight-forward capitalisation of expenses.
Accounting managers were given promotions, raises, and made to feel responsible for the likely collapse of the stock price if they did not manipulate the books (Pulliam, 2003).
The WorldCom corporate culture encouraged unethical behaviour both by appealing to individuals’ sense of promoting the greatest common good for the workers, shareholders, and community and by raising fears of losing their jobs if they did not comply with requests to falsify records.
WorldCom staff knew it was wrong and went along with the schemes anyway (Pulliam, 2003).
Again, an individual, Cynthia Cooper, blew the whistle to the audit committee and started the resulting disclosure of the fraudulent financial practices (Ripley, 2002).
Following WorldCom’s failure and scandals, studies have demonstrated that Bernard
Ebbers and Scott Sullivan, the CEO and CFO of the organisation at that time, had created an organisational ideology, or culture, in which leaders and managers were not to be doubted or questioned (Scharff 2005).
Rezaee (2002) determines how ‘CRIME’ can be used to explain financial statement fraud. Below is a model of ‘CRIME’:
Source: Rezaee (2002)
Cooks, in most of the cases, are the people who participate in financial statement fraud, these can be senior management such as the Chief Executive Officer (CEO) or Chief Financial Officer (CFO).
Recipes are fraudulent schemes, which the management of the companies have used for their cooking. These can be Improper Related-Party Sales Transactions, Illegitimate Sales Transactions or Side Agreements. (Rezaee, 2002)
Incentives are the typical reasons and motivations why companies and their cooks have engaged in financial statement fraud. These can range from the company facing economic pressure to achieve targets, show steady growth and improve performance to keep investors happy, the auditors trying to retain their top clients and executives bonuses tied to company performance. (Rezaee, 2002).
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Monitoring- responsible corporate governance and the presence of adequate and effective internal control systems are the most important factors in preventing and detecting financial statement fraud. This can include friendly relations between the CEO and the owner of the company or the board. (Rezaee, 2002).
Rezaee (2002) also stated that “external auditors have a significant role in monitoring the company. But the external auditors’ ability to detect fraud is somewhat limited to the extent of internal control system of the company.
End Results- financial statement fraud always has consequences, even if it is not detected. (Rezaee, 2002).
Implications of Fraud
Since the collapse of some large firms, including WorldCom, Enron and others, many considerations were brought up, including:
The regulation of auditors- self-regulation and peer reviews simply not enough. (Enron, 2002)
Elimination conflicts of interests in accounting firms (Enron, 2002)
Compulsory rotation of auditors- most companies had been using the same auditors since their establishment, for example Enron was audited by Andersen since its establishment in 1983. (Enron, 2002)
Taking these considerations into account in 2002, Sarbanes-Oxley Act was established in the US to introduce major changes to the regulation of corporate governance and financial practice. This legislation impacts corporate governance of public companies, affecting their officers and directors, their Audit Committees, their relationships with their accountants and the audit function itself. The act states that the lead audit or coordinating partner and the reviewing partner must rotate off the audit every five years.
Brody et al (2005) clarified that the Sarbanes-Oxley Act was put in place by the US to help regain public confidence and to prevent future scandal. The ultimate goal was to improve the quality of external audits. The Sarbanes-Oxley Act has redefined the role of both auditors and corporate executives.
As a result of fraudulent activities occurring in Enron, WorldCom and other companies, the Sarbanes-Oxley Act of 2002 has required that internal controls be reviewed and that adequate fraud detection and prevention systems be implemented (Albrecht et al., 2009). This suggests that fraud detection must be high on the auditors’ agenda.
In 1988, SAS No. 53, The Auditor’s Responsibility to Detect and Report Errors and
Irregularities, was introduced and held the auditor responsible for detecting errors and irregularities that materially impacted on the financial statements. However, Moyes and Hasan (1996) argued that negligible attention was given to the auditors’ qualifications, particular organisational factors and audit procedures that could be very important in the detection of fraudulent financial reporting.
Then SAS No. 82 Consideration of Fraud in a Financial Statement Audit was implemented in 1997, and stated that the auditor is “.to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud” (ASB, 1997). SAS No. 82 provided guidance on how the auditor should achieve this by looking at areas and categories of heightened risk of fraud, how the auditor should respond, the evaluation of audit test results as they relate to the risk of fraud, and the communication about fraud to management, the audit committee and others.
Gramling et al. (2004) suggest that reliance on internal audit has taken on increased importance in today’s auditing environment, since internal and external auditors have become more aligned and developed deeper relationships since the passage of SOX.
Moyes and Hasan (1996) concluded that the degree of fraud detection was not dependent on the type of auditor, since both internal and external auditors have equal abilities to detect fraud. Moyes and Hasan (1996) also found that organisational success in detecting fraud was significantly enhanced in auditing firms with previous experience in fraud detection than auditing firms with no such history. It was also found that auditors who were certified as certified public accountants (CPAs) were more likely to detect fraud than auditors who were non-CPAs. Moyes and Hasan (1996) argued that this certification may imply a greater level of professional competence in fraud detection.
Impact of International Auditing Standards on external auditors
There are different International Auditing Standards, these are issued by the IFAC- International Federation of Accountants and the IAASB- International Auditing and Assurance Standards Board. (Vanstraelen et al, 2009)
The main role of International Auditing Standards is to provide a common ground and guidelines for good practice. These international standards on auditing aim to achieve uniformity and aim to generate a level of confidence in the audit.
There are many benefits of developing and enforcing international standards on auditing, the major one is the that there will be no difference in the purpose of an audit, sources of auditing standards, legal liability, ethical standards or the responsibility for the detection of fraud.
A standardised audit will make give the reader of audit reports more confidence in the auditor’s opinion, it will make the comparison of audited international financial statements easier. The standardised audit can also promote incentives to develop and broaden the set of international auditing standards.
On the other hand there are some issues with international standards on auditing, main ones include the need to consider local laws, this can be controversial because the local standards will move away from the common standard setting. This can lead to some countries having higher standards of regulation than others.
The Sarbanes-Oxley Act broadens and deepens sanctions and penalties for unethical management behaviour. The Sarbanes-Oxley Act also calls for much greater focus on internal controls by senior management. Internal control systems, including IT controls, can help reduce the opportunity for fraudulent or unethical behaviour but cannot eliminate it in a world where nearly 50 percent of large corporations still use spreadsheets in some aspect of financial reporting (Hackett Group, 2004).
I think that the international standards on auditing did not have much impact on auditing in the beginning. But now in recent times it has been found that it has had a great impact on auditing, especially external auditors and can be proved in the way in which it has shifted its standards to more up-to-date versions due to major frauds across the world. This now helps improve the way auditing is performed, it helps auditors perform their audit in a professional manner and gives them stricter guidelines.
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