Development Of Audtiting
Length: 1430 words (4.1 double-spaced pages)
In recent years the integrity of the auditing profession has been called into question, especially in the case of auditor independence. Perhaps the most spectacular of these was the Enron-Andersen scandal which saw the collapse of auditing giant Arthur Andersen and sent tremors throughout the auditing industry.
In 2001, Andersen was the fifth largest auditing firm in the world and had a reputation for outstanding auditing integrity based on a history of some 100 years in business. In contrast by the end of 2002 it had all but disappeared from the auditing radar. There were definite red flags being raised in regards to the standard of the audits being conducted at Andersen; the company was involved in lawsuits relating to two other clients, Waste Management and Sunbeam in 2001. Andersen was also in charge of the audit for WorldCom which was another major scandal that raised questions on auditor independence.
It was however Andersen’s relationship with Enron, in particular their actions in shredding documents and deleting of emails in the thousands including documentation relating to the Enron engagement prior to the US Securities and Exchange Commission (SEC) investigation into Enron, that was to be its downfall. The industry could not allow such a blatant disregard of auditor independence to go unpunished and Andersen was barred from conducting and reporting on SEC-registered companies, thereby ending its auditing practice. (Soltani, 2007, pp. 556-562)
Whereas the Enron/Andersen scandal related to definitive action taken by Andersen in conspiring with Enron a later scandal involving HealthSouth Corporation and Ernst & Young raised other problems with auditor independence. Again issues arose with auditor independence this time when taking a risk based approach to auditing. HealthSouth’s fraudulent activity was conducted in the area of contractual adjustments, and while Ernst & Young conducted “analytical type procedures” in this area, HealthSouth management knew that the auditors did not look at increases of less than $5,000 and therefore kept the balance-sheet entries below this level. That Ernst & Young acknowledges that they were aware management knew of this criterion and didn’t adjust their procedures accordingly raised questions regarding the integrity of the audit. Further when planning the audit, Ernst & Young meet with the companies executives and took them at their word when they stated they were not aware of any instances of fraud. In their planning papers it was stated that the HealthSouth system for generating financial information was reliable and its executives were ethical.
It is suggested that this assessment was based on Ernst & Young’s dealings with management on other non-audit services rather than a true audit risk analysis. (Weil, 2004)
There is further evidence that Ernst & Young should have been more sceptical in their risk analysis when in a hearing to decide whether one of HealthSouth’s executives assets should be unfrozen, two partners from Ernst & Young testified that they had received an email from a HealthSouth employee advising them to examine three specific accounts for fraudulent activities relating to asset capitalisation. While they did conduct an investigation, and found no fault, Ernst & Young did not detect or investigate beyond the scope of normal audit procedures any other substantive questionable activities. (Weld, Bergevin, & Magrath, 2004) There are now a number of lawsuits and countersuits between HealthSouth and Ernst Young in regard to if Ernst & Young were negligent in conducting the audit or were truly hoodwinked by the HealthSouth’s executive.
As a result of these two scandals and the high number of similar occurrences Governments, Auditing Standard Boards and Securities Commissions are reassessing the rules concerning audit independence.
In the United States the Sarbanes-Oxley Act (2002) established new rules under Section 208(a) dealing with auditor independence. Under the new rules an audit firm will not be considered independent if any member of the audit engagement team was also involved in a ‘financial reporting oversight role’ in the year prior to the start of the audit. Further the Act had decreased the scope of services that the audit company can provide in the way of non-audit services. Now included in prohibited non-audit services are bookkeeping or other services related to accounting records or financial statements, financial information systems design and implementation, appraisal or valuation services, fairness opinions, or contribution-in-kind reports, actuarial services, internal audit outsourcing, legal services, expert services and tax services. It also introduces the need for partner rotation. The new rules requires lead and concurring partners to be rotate off the client after five years and have a stand down period of a further five years. The Act also clarifies the position of the Audit Committee and that the audit firm is accountable firstly to them. (Lander, 2003, pp. 75-84)
Closer to home, in Australia, was the introduction of the Corporate Law Economic Reform Program (CLERP) whose papers have been introduced into the Corporations Act (2001) or the Financial Services Reform Act (2001). The area that dealt specifically with auditor independence was introduced in the CLERP 9 Act (2004). The key changes indentified in CLERP 9 relate to auditor appointment, independence and rotation are found in the expanded Part 2M.4 of the Corporations Act.
Unlike the Sarbanes-Oxley Act, CLERP 9 does not come down as hard on auditor independence. The focus for the Australian reforms appears to have been on disclosure rather than limiting instances where auditor independence may occur.
CLERP 9 requires audit companies to disclose in the director’s report the names of each officer who during the financial year was formerly a partner or director of an of an audit firm that was also involved in auditing the entity. Also included in the directors report is to be details of amounts paid to the auditing firm for non-audit services, a statement whether the directors are satisfied that the non-audit services provided did not impair the audits independence. The auditor must also provide a declaration that the auditor’s independence requirements outline in the Corporations Act and applicable codes of conduct have not been contravened in relation to the audit review, or that the only contraventions are those set out in the s.307 declaration. Division 3 of Part 2M.4 also introduces the concept that if an audit firm is not aware of a conflict in interests in relation to the auditor, but would have been were the appropriate controls in place then is it contravening the Act. CLERP 9 also places limitations on members of the audit team from becoming an officer of an audit client for a two year period, and the requirement of individuals who play a significant part in an audit to rotate in five out of seven years. (Leung, Coram, & Cooper, 2007)
New Zealand on the other hand has so far chosen not to bring in such sweeping reforms. The Securities Commission did include in its Corporate Governance in New Zealand: Principles and Guidelines a section on auditor independence where it highlighted the responsibilities of the auditors, the audit committee and the board, relating to audits. In this it reiterates the need for disclosure of any conflicts of interest by auditors and advises that an independent oversight body should act as a monitor. (Diplock, 2005)
The effect of the Enron/Andersen and HealthSouth scandals have caused differing reactions as to the extent of the limitations placed on auditors in controlling their exposure to accusations of auditor bias. New Zealand and Australia have continued to rely on the professional body’s code of ethics as the measure for auditor independence. America however chose to introduce clear limitations that would lessen the possible areas of conflict. This may be in part that scandals involving auditor independence are not occurring to the same extent and given the smaller economic and populations that the auditors are working in. That these scandals have had a direct effect on audit requirements, whether to lesser or greater extents, cannot be denied.
Diplock, J. (2005, November 11). Importance of Audit Quality and Auditing Standards: New Zealand and Internation Perspectives. Retrieved March 5, 2008, from Securities Commission New Zealand: http://www.seccom.govt.nz/speeches/2005/jds111105
Lander, G. (2003). What is Sarbanes-Oxley? (Electronic Version). New York, NY: McGraw-Hill Companies Inc.
Leung, P., Coram, P., & Cooper, B. J. (2007). Modern Auditing & Assurance Services (3rd Ed.). Milton, QLD: John wiley & Sons Australia Ltd.
Soltani, B. (2007). Auditing: An International Approach. Essex, UK: Pearson Education Limited.
van Peursem, K., & Pratt, M. (2006). Auditing Theory & Practice in New Zealand. Auckland: Pearson Education New Zealand.
Weil, J. (2004, March 25). Behind Wave of Corporate Fraud: A Change in How Auditors Work. The Wall Street Journal , p. A1.
Weld, L. G., Bergevin, P. M., & Magrath, L. (2004, October). Anatomy of Financial Fraud: A Forensic Examination of HealthSouth. Retrieved March 3, 2008, from The CPA Journal Online: http://www.nysscpa.org/cpajournal/2004/1004/essentials/p44.htm