Controversies Behind Accounting and Audit Profession - Essay Example

Controversies Behind Accounting and Audit Profession Table of Contents I. Introduction ''''''''''''''''''''''''.. 3 II. Compare and Contrast Management's Responsibility for an Entity's Financial Statements with the Auditors' Responsibility for Detecting Fraud and Error ''''''''''''''''''.. 4 III. Evaluate Recent Suggestions made by the Audit Profession in Respect of the Auditors Responsibility in Detecting Fraud ''''' 5 IV. Audit Expectation Gap ''''''''''''''''''''. 8 V. Factors that Makes Audit Expectation Gap to Increase ''''''. 8 VI. Strategic Ways to Reduce the Gap on Audit Expectation '''''. 9 VII. Conclusion '''''''''''''''''''''''''. 10 References ''''''''''''''''''''''''''''. Introduction Accounting and auditing are two of the most important tools that many private and non-private companies are using to solve any types of corporate governance problem. As a part of monitoring the payment of taxes and satisfy the curiosity of the public share holders, UK government requires each of the public profit and non-profit organizations to prepare, submit, and publish their financial statement reports. Since the Enron's bankruptcy (Chartier, 2008), a lot of controversies arises behind the profession of Accounting and Auditing in relation to fraud or manipulation of a company's accounting earnings. To prevent accounting fraud, many literature states that it is common for the body of institutional investors to act as the company's monitors. (Chen, Harford, & Li, 2007; Chung, Firth, & Kim, 2002) Therefore, it is possible that fraud firms have a low level of institutional investment before committing fraud due to the fact that these companies lack effective accounting monitoring. For this study, the researcher will compare and contrast the management's responsibility for an entity's financial statements with the auditors' responsibility for detecting fraud and error follow by evaluating the most recent suggestions made by the Audit profession in respect with the auditors responsibility in detecting fraud. The researcher will also discuss about the audit expectation gap as well as the factors that contributes to the increase of the audit expectation gap. The researcher will also examine whether the audit expectation gap is similar to the accounting expectation gap. Prior to the main discussion, the researcher will provide some strategic ways on how auditors could reduce the gap on audit expectations. Compare and Contrast Management's Responsibility for an Entity's Financial Statements with the Auditors' Responsibility for Detecting Fraud and Error Using the generally accepted accounting principles in UK, the top management behind a company is responsible for the preparation of financial statement based on the highest integrity, objectivity and clarity. (Price, 2002) As part of the management's responsibility in developing an accurate financial statement, the top management should ensure that the company hires and trains qualified employees to work behind the establishment and communication of the company's accounting policies and procedures. Since businesses are more concerned with the company's profitability, there is a higher chance for top management to manipulate the company's financial statement. In order to lessen the incidence of accounting fraud and misrepresentation of the accounting figures, there is a strong need for each company to hire the service of an external auditor to perform the auditing of the company's financial statements. The main responsibility of the auditors is to ensure that each company submits an accurate financial statement1 by detecting any possible accounting fraud or errors based on the current United Kingdom Law and Accounting Standards known as the United Kingdom Generally Accepted Accounting Practice. (Ernst and Young LLP, 2007) In relation to determining whether the company practices accounting procedures, auditors are responsible to follow the relevant legal and regulatory requirements set by the UK's International Standards on Auditing. In case the auditor(s) has detected any signs of accounting fraud, corruption and accounting error(s) within its financial statement, the auditors must report the case to appropriate authority particularly the Assistant Director of Audit and Anti-Fraud Division who will eventually conduct a further investigation. In general, members of the top management are responsible in ensuring the profitability of the company. On the other hand, auditors are responsible in protecting the welfare of both the company and its public shareholders. Evaluate Recent Suggestions made by the Audit Profession in Respect of the Auditors Responsibility in Detecting Fraud Companies that are engaged in accounting fraud are less likely to disclose its accurate financial statement or any information that could reveal accounting manipulations to the public. For this reason, it is advisable for the audit committees to establish an official procedure wherein responsible employees should report questionable accounting methods, auditing issues or bribery from the top management officials confidentially and anonymously. (Akin Gump Strauss Hauer & Feld LLP, 2004: 17, 24) Despite the limited information that most auditors receive from a company, there are still many ways wherein the auditors are able to trace the signs of possible accounting manipulations by monitoring the measurements of accruals quality, the stock market variables, the non-financial statement variables, and the company's accounting performance. (Dechow et al., 2007; Beneish, 1999) In general, there are five categories that auditors has to look onto. This includes: (1) expense deferral; (2) bogus revenues; (3) premature revenue; (4) burying liabilities; and (5) other factors such as the disclosure of inadequate information within the company's footnotes written in its financial statements. (Akin Gump Strauss Hauer & Feld LLP, 2004: 6) Among these five categories, companies who seek to go into public often reflects a bogus or a falsified high amount of sales and revenue in order to attract the potential public shareholders to invest their money in the company. This strategy can be trace based on the stating a premature sales revenue in the financial statement. To enable the auditors to trace the possible manipulation in the company's sales revenue, auditors must investigate on the possible customer complaints or the movements of the company's raw materials and production output in the case of manufacturing companies. (Akin Gump Strauss Hauer & Feld LLP, 2004: 8) Similar to the case of Enron, burying or hiding the company's liability and other financial obligations from the company's financial statement enables the company to have the power to attract more public investors. Therefore, even if the people behind the company's management appears to be trustworthy, auditors should still conduct a background checks on the company's management for any signs of history of fraud, embezzlement or any forms of dishonest and unethical business behaviors. (Akin Gump Strauss Hauer & Feld LLP, 2004: 10) According to Chung, Firth, & Kim (2002), a company with large institutional shareholders is more likely to reduce the earnings management with the use of accruals. The decision-making of a company with long-term investments on acquisitions is also worth monitoring (Chen, Harford, & Li, 2007) because a high levels of short-term investors are highly associated with under-weighting of the long-term expected earnings and over-weighting of the short-term expected earnings. (Bushee, 2001) Based on these evidences, companies that are practicing fraud accounting methods are expected to have a much higher levels of short-term, institutional ownership and transient as well as a lower levels of long-term, loyal institutional ownership. Since it is common for investors to guard their investments with the company, the study of Balsam, Bartov, & Marquardt (2002) concludes that the companies with lesser number of investors are most likely to incorporate the valuation of large discretionary accruals into the stock prices more often as compared with large organization that is investor-based. In most cases, these investors are expected to exploit the accounting based stock price anomalies in relation to the announcement of its post-earning flow (Ke & Ramalingegowda, 2005) including any signs of anomalies in the company's accruals (Collins, Gong, & Hribar, 2003). According to Lev & Nissim (2006), a lot of these investors are able to exploit the anomalies on accruals in a small-scale based on the company's trading performance. The investors' small idea on a company's accuals anomaly enables them to detect small-scale companies that are unprofitable and risky. Although accounting fraud and restating of financial statements leads to the consequences of the irregularities in the accounting practices, these two concepts are literally not the same. Restatements do not necessarily mean that a company has been accused by the SEC for practicing accounting frauds or manipulations of the company's earnings. (Palmrose, Richardson, & Scholz, 2003; Palmrose, Scholz, & Wahlen, 2004; Hribar & Jenkins, 2004) Among the common reasons for issuing restatments include: unintentional accounting errors or a legitimate disagreement with the use of the generally accepted accounting principles (GAAP). In the case when a company has been suspected for the practice of accounting fraud, these companies often reports bankruptcy just like the case of Enron. Filing a bankruptcy even before these companies have the chance to restate their earnings is the easiest way out of intentionally manipulating the company's earnings. Audit Expectation Gap The concept of audit expectation gap was first introduced in the study of audit more than twenty years ago. (Liggio, 1974) Back then, the phrase 'audit expectation gap' was defined as the differences in the levels of expected auditors' performance as compared with what is expected by the accountants and other users of the financial statements. (Liggio, 1974: 24) In some cases, the phrase audit expectation gap is used to refer to not only to the performance gap but also the communication gap between role of an auditor and the expectations of the people who monitors a company's financial statement. (Pierce & Kilcommins, 1995 - 1996) Several experts and philosophers argued that it is not possible to totally remove the auditor expectations gap. (Gloeck & Jager, 1993; Sikka et al., 1992; CACA, 1992) This is possible because of the nature of the auditor expectation gap. (APB, 1991: 125) Factors that Makes Audit Expectation Gap to Increase Among the main factors that contributes to the widening audit expectation gap is caused by the people's lack of sufficient knowledge on the company law as well as the auditing standards. (Porter, 1993) Particularly the lack of sufficient knowledge leads to a lot of misunderstanding with regards to the fundamental role of the external auditors. Basically, the auditor expectation gap can increase in two ways: (1) when the people's expectations on auditing increases; and (2) when there is a decrease in the perceived auditors' performance. Strategic Ways to Reduce the Gap on Audit Expectation In order to narrow down the gap on audit expectation, there is a strong need to either reduce the people's expectations in the role of auditors or increase the auditors' perceived performance. This can be done by continuously promoting and improving the educational system on auditing with regards to the precise role and responsibilities of the auditors. (Pierce & Kilcommins, 1995 - 1996) By strengthening the perceived independent roles of the auditors (ICAI, 1992; Sikka et al., 1992; Moizer, 1991) and educating the public with regards to the limitations of auditing (Moir, 1989; Mednick, 1986), these professionals could perform a better responsibility which is necessary in decreasing the expected auditing gap. Another strategy that can be used in reducting the audit expectation gap, Innes, Brown, & Hatherly (1991) suggest that the expanded audit report should include the information with regards to the main responsibility of the auditors. By including this information in the audit report, the gap between the expected auditing and the perception of the financial statement users will be narrowed down. On the other hand, the Institute of Chartered Accountants in Ireland (1992) recognizes the need to prepare for a more informative audit report. It is also possible to reduce the expectation gap by widening the role and responsibilities of the auditors in terms of resolving accounting fraud cases (Humphrey et al., 1992; Sikka et al., 1992) or any forms of illegal acts such as corruption and bribery (MacDonald Commission, 1988). Conclusion Similar to the case of Enron, it is but normal for the stock market to negatively react with any revelations of accounting manipulations. In general, accounting manipulations could significantly result to investors' financial investment losses. For this reason, several studies show that the estimated decline in a company's market value is roughly 20 to 40% right after publicly announcing of a company's manipulation in accounting. (Karpoff, Lee, & Martin, 2007; Palmrose, Richardson, & Scholz, 2003) There are a lot of ways wherein both the internal and external auditors could detect the possibility that a company is manipulations its earnings. In general, auditors are responsible in ensuring that each company presents an accurate financial statement as a protection on the part of the company's stakeholders and shareholders. Due to insufficient knowledge and information with regards to the main role and responsibilities of the auditors, there is a tendency of having an increased audit expectation gap. To minimize this gap, education on audit plays a crucial role in strengthening and specifying the auditors' responsibility in detecting accounting fraud. Another way of minimizing the gap is to educate the people by informing them the necessary information with regards to the main responsibilities of the auditors References: Akin Gump Strauss Hauer & Feld LLP. (2004). Retrieved April 3, 2008, from How to Detect, Prevent and Litigate Accounting Fraud: http://www.akingump.com/docs/publication/709.pdf AuditingPracticesBoard(APB). (1991). Statement of Auditing Standards 0600, 'Auditors' Reports on Financial Statements'. London: APB. Balsam, S., Bartov, E., & Marquardt, C. (2002). Accruals management, investor sophistication, and equity valuation: evidence from 10-Q. Journal of Accounting Research , 40(4):987 - 1012. Beneish, M. (1999). The detection of earnings manipulation. Financial Analyst Journal , 55(5):24 - 36. Bushee, B. (2001). 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(1995 - 1996). The Audit Expectations Gap: The Role of Auditing Education. DCUBS Research Paper. No. 13. Porter, B. (1993). 'An Empirical Study of the Audit Expectation-Performance Gap'. Accounting and Business Research , 24(93):49 - 68. Price, B. L. (2002). Vanderbuilt University. Retrieved April 3, 2008, from Management Responsibility for Financial Statements: http://www.vanderbilt.edu/divadm/finrprt2002/management.html Sikka, P., Puxty, T., Willmott, H., & Cooper, C. (1992). Eliminating the Expectations Gap', ACCA - Research Report No. 28. London: ACCA. Read More