The Role of External Auditors in Accounting - Essay Example

?The Role of External Auditors in Accounting Introduction Pertaining to the profession of auditors, auditors’ liability has always been one of the main concerns of the public. Often dealt with common law, tort law or both, auditors’ liability could arise out of unfair or unjust practices when it comes to auditing a company’s financial standing (Lambe, 2007). The act of approving a defective account on behalf of a business organization can make external auditors held liable for fraudulent acts. Auditor liability or auditors’ inability to detect and report illegal manipulations of the financial statement could lead to serious damages on the part of the shareholders of the company (Schaefer, 2004). In most cases, a fraudulent act exist when one or more auditors approve inaccurate accounting on behalf of a company for the reason of tax evasion or to strategically register for an Initial Public Offering (IPO). To prevent moral hazzards associated with the auditors’ liability, the British Serious Fraud Office has imposed heavy penalities for swindlers and white collar criminals to shut down or suspend a suspicious business (Country Updates, 1997). On the other hand, auditors who are found guilty of professional negligence may end up facing a monetary loss or penalty through punitive fines and/or the confiscation of their license to practice auditing in the United Kingdom. As stated by Michael Power of London School of Economics, “it may not be reasonable to expect that auditors would be challenging business models directly and raising strategic issues with finance directors, that is not their job and if we want it to be their job then things would have to change quite substantially … The direction of my comment is that we might be expecting too much from this black box [External Audit] in terms of what it actually delivers” (Priddy, 2011, p. 59). In response to the statement made by Power, this report will first discuss the role and responsibilities of external auditors followed by providing a brief overview with regards to the corporate governance. In line with this, there is a strong need to go through business theories and concepts that will enable the readers have a better understanding on how businesses in a corporate world function. Based on the individual roles and responsibilities of shareholders, internal and external auditors, the board of directors, and the CEO, this report will explain the limits in the role and responsibilities of external auditors when it comes to detecting and controlling fraud activities in business. Role and Responsibilities of External Auditors External auditors are professionals who are hired to conduct audit based on the rules or laws on creating financial statements for the government, a private company, or a legal organization (The Institute of Internal Auditors, 2011). According to Kwok (2005, pp. 151 – 161), accounting irregularities can be made for the purpose of tax evasion or theft by creating ghost employees, skimming of the proceeds, or theft of an asset. Specifically in the United Kingdom, the Chartered Accountants or the Certified General Accountants are the group of individuals who are qualified to conduct external auditing. According to Poorter (2008), auditors within the United Kingdom has to perform a special duty of care to a liable third party. It means that the external auditors are made responsible in making fair, just and reasonable treatment to the company’s external shareholders. In case external auditors have a binding contract between the company and the shareholders of the said company, it is a general rule for the external auditor(s) to fulfil his/her statutory duty as an auditor to shareholders collectively or as a group. As a standard operating procedure, external auditors are expected to evaluate the financial statement of another organization on a yearly basis (Hicks and Goo, 2008, p. 261). Upon going through the financial statement of a government, a private company, or a legal organization, external auditors are expected to come up with their professional opinion with regards to the financial statement presented to them by the organization (Kwok, 2005, p. 178). In line with this, external audit committee are expected to determine whether or not the accountants are able to adopt with the generally accepted accounting principles or has made appropriate judgments and financial estimates, and complete disclosures in the financial statements (Hicks and Goo, 2008, p. 259; Kwok, 2005, p. 178). Given that the external auditors find something inappropriate in the presented financial statement, the external auditors should report their complaints to the company to allow the board of directors to review their reports. As part of protecting the company and the shareholders of the company, external auditors are expected to determine any possible damages that could result from the company owners’ major business decisions. Considering that external auditors are liable to both the company they work for and the shareholders of the company as the third party, external auditors should avoid coming up with a bias judgment by making use of their best professional knowledge to protect the interests of both the company and the company’s shareholders. Although internal and external auditors technically have the same role and responsibilities when it comes to auditing a financial statement, the only difference between the two is that an external auditor is an independent party outside the organization being audited (The Institute of Internal Auditors, 2011). Another difference between internal and external auditors is that the general public, a large group of investors, and the government agencies have the tendency to rely more on the audit report coming from the external auditors more than the report presented to them by the internal auditors for the reasons that “external auditors are the eyes and ears of all current and future investors in, and lenders to the companies they audit” (Haskins, 2008, p. 169). Likewise, external auditors are not involved directly in the daily business operations of the company. In other words, there is a less risk wherein external auditors would lobby with the business owners. Brief Overview with regards to the Corporate Governance According to Colley et al. (2005), corporate governance is referring to a system of authoritative direction or government which carefully examines the individual role and responsibilities of the business owners / the shareholders, the board of directors (executive and non-executive directors), the Chief Executive Officer (CEO), and accountants. Since corporate governance is composed of neutral and more objective corporate values (Solomon, p. 4; Haller and Shore, 2005, p. 18), a lot of people consider good corporate governance as an acceptable business ethics and a moral duty on the part of a corporation’s board of directors and executives. Board of Directors Aguilera et al. (2008) revealed that corporate governance is often considered as a basis when making a policy for business organization in relation to the actual structure of the board, the activism of the shareholders, and overall business performance. With regards to organizational policies and procedures, the board of directors within a business organization has a significant role to play when it comes to having a success of corporate governance (Nordberg, 2007; Kim and Nofsinger, 2006: p. 41). For this reason, the members of the board are required not only to carefully analyze the corporate financial report but also to meet regularly to discuss the proposed strategic plans and issues that will significantly affect the success of the business (Solomon, 2007, p. 103). Executive and Non-Executive Directors The board of directors is composed of composed of executive and non-executive directors. As part of strengthening the corporate governance, the company’s board of directors is made responsible in making important decision-making for the best interests of the company and its shareholders (Mallin, 2007, p. 125). Aside from determining the corporate goals, development of strategic plans that will enable the business meet its corporate goal, and implementing organizational policies to meet the business objectives (Mallin, 2007, p. 124; Kim and Nofsinger 2006, p. 41), the board of directors is responsible in controlling the business operations, making decisions for resource acquisitions, and improvements in the quality of service (Carpenter, 1988; Pfeffer and Salancik, 1978). Since not all of the directors are directly or actively engaged in the daily business operations of a company, the readers should be aware of that the role and responsibilities of the executive and non-executive board of directors with regards to corporate governance is totally different from one another. As a common business knowledge, it is the executive directors who are the ones who are directly involved in the daily business transactions that occurs within and outside the company whereas the non-executive or outside board of directors are not. Despite the differences in the responsibilities of executive and non-executive directors, the Commission has publicly announced under the modernized company law and the enhanced corporate governance though out the European Union states that all of the board of directors (regardless of whether they are executive or non-executive) should at all times ensure their collective responsibility when it comes to monitoring the financial and non-financial information behind the corporation (Communication from the Commission to the Council and the European Parliament – Modernising Company Law and Enhancing Corporate Governance in the European Union: A Plan to Move Forward, 2003). Unlike the non-executive directors, the executive board of directors can easily access valuable business information such as the corporate financial statement. By examining the financial statement of the company, executive directors are able to have an access over the company’s record on daily sales and expenses and other major business transactions like public shares, loans, and investments. In the process of going through the company’s financial statement, executive shareholders should somehow look for signs of unusual business records that could adversely affect the long-term business operations. Similar to the role of executive directors in corporate governance, the role and responsibility of the non-executive directors is to reduce conflicting interests between the actual shareholders, executive board of directors, and the management team who works behind the company (Solomon, 2007 p. 82 and 92). For this reason, Waldo (1985, p. 5) strongly suggest that the best way for the executive and non-executive directors to perform their duty effectively is to go through the actual company’s business information which includes the corporate financial statement. Even though the non-executive directors are inactive in terms of monitoring the daily operations of a company, several studies revealed that the non-executive directors are expected to strictly and regularly monitor the progress of the overall business, legal and ethical performance, strategic choices and implementation techniques used by the top management, including the appointing or removal of the members of the senior management aside from giving the rest of the board members some advice with regards to the strategies used in enabling the company reach the corporate goals and business objectives (Solomon, 2007, p. 82; Carpenter, 1988)1. By closely monitoring the daily activities of the company’s executive directors, the non-executive directors could somehow make the executive directors accountable for the company’s shareholders and external investors (Mallin, 2007, p. 132; Solomon, 2007, p. 88; Fama and Jensen, 1983). Solomon (2007, p. 86) revealed that there is a link between the role of non-executive directors and the role of institutional investors in the sense that the non-executive directors’ effort in ensuring that the business is free from any forms of corruption could somehow protect the socio-economic welfare of the company’s public investors. To make a good board member, several authors suggest that the non-executive board of directors is strongly encouraged to actively participate in the board meetings with the rest of the directors and shareholders to protect the interests of the public investors (Mallin, 2007, p. 125; Solomon, 2007, pp. 86 – 88). Role and Responsibilities of Accountants In general, accountants are not only made responsible in producing an accurate, true, and fair financial statement that could enable the senior managers to make important business decisions but also give the public stockholders the privilege to accurately monitor their investments with the company. Considering the fact that it is the duty and responsibilities of the corporate accountants to maintain accurate and transparent financial accounting information at all times, accountants are among the few individuals who play an important role in the development of effective corporate governance. To ensure that the company is able to come up with an accurate corporate financial statement, the business organization should hire internal and external auditors who are qualified in monitoring fair and true financial values. Discussion Romano (1996) explained that the shareholders have the authoritative power to influence the manifestations of legal and/or illegal business transactions. Given that the corporate shareholders is composed of mostly the business owners, this group of individuals are the ones who are in the position to select and elect their preferred members of the board in managing the business affairs. On the other hand, it is the board of directors who appoint, hire, and delegate specific role and responsibility to selected CEO. In a normal business setting, it is the CEO who is in-charge of managing the actual business operations. For this reason, the CEO is often made accountable not only to the business owners but also to the board of directors. Upon analyzing the corporate structure that is commonly used in large-scale companies, it is often the business owners together with the voluntary participation of the executive directors, the CEO, and the accounting manager who have the authoritative power to manipulate the company’s official business documents. By going through the corporate financial statement, the non-executive board of directors should search for any signs of unusual business records that could create serious business consequences. To prevent coming up with a bias judgment, the non-executive board of directors should consult signs of unusual business transaction with the group of internal or external auditors. Considering the flow of authoritative power within a business organization, it is possible on the part of the shareholders, the members of the board, and the CEO to enter into business collusion with the business owners. By convincing the accountants to participate with the group of corporate leaders, it is made easily on the part of the business owner(s) to manipulate the actual corporate financial records at the expense of the stakeholders and external shareholders. According to Becht, Jekinson and Mayer (2005), collusion among the corporate leaders makes corporate governance one of the most controversial topics related to business and finance. By voting for major financial decisions, Cassill and Hill (2007) explained that the study of corporate governance made the board of directors responsible in balancing the business owners’ monetary interests and the actual profit-sharing with the company’s employees and the rest of the other stakeholders. Several authors revealed that corporate governance should be base on neutral and objective corporate values (Solomon, 2007, p. 4; Haller and Shore, 2005, p. 18). Since there is a strong possibility for the business owners to manipulate the board of directors to support their own personal interests of the business owners, the concept of corporate governance can easily be violated at the expense of the a large group of employees and the public investors. A corrupt business culture is not limited in terms of accepting bribery but also the acceptance of practicing illegal offshore financing or intentional act of manipulating the actual financial statement (Dine, 2008). Within a business organization, it is the board of directors and executives of a corporation who are among the few individuals behind the practice and development of a corrupt culture. For this reason, Dine (2008) revealed that the European corporate law behind the UK model of companies are focused on investigating shareholders and board of directors. Some of the good examples of real-case scenarios in the history of finance are the case of WorldCom and Enron. In the case of WorldCom, its board of directors failed to fulfil their duty in terms of closely monitoring the WorldCom’s management activities (Monks and Minom, 2004, p. 509). This made them unable to protect the interests of its stakeholders. In the case of Enron, a total of 18 directors, the CFO, ex-CEO, chief accounting officer, and chief risk officer voluntarily participated in the CEO’s decision to manipulate the company’s financial statement (Kim and Nofsinger, 2006, pp. 52 – 53; Davis, 2005; CNN Money, 2004). Limitations in the Role and Responsibilities of External Auditors when it comes to Detecting and Controlling Fraud Activities in Business Although the general public, a large group of investor and the government agencies are heavily relying on the audit report coming from the external auditors, there are still some limitations with regards to what the external auditors can do in detecting and controlling fraud activities that could happen within a profit or non-profit organizations. In line with this, Hicks and Goo (2008, p. 258) explained that “it is the managements’ responsibility to prepare a complete and accurate financial statements and disclosures in accordance with the financial reporting standards and applicable rules and regulations”. For this reason, it is wrong to believe that the external auditors are solely responsible for the incidence of financial fraud. As stated by Kwok (2005, p. 168), “an audit does not guarantee the detection of all material mis-statements because of such factors as the use of judgements, the use of sample testing, the inherent limitations of internal control and the fact that much of the evidence available to the auditors is persuasive rather than conclusive in nature”. Since external auditors are auditing financial statements that are presented to them by the corporate accountants, it is expected that external auditors could only provide the general public, a large group of investor, and the government agencies with a reasonable assurance that the audited financial statements are free of mis-statements, alteration of the accounting records, an honest accounting error, or falsification of the financial statements. Based on the Court’s decision in the case of Caparo, “in the absence of any contract between the auditor(s) and either the investor, a potential investor, or any other third party involved, no duty of care will be owed”2 (Richards, 2004). Despite the external auditors’ responsibility to double check the accuracy of a company’s financial statements, external auditors who are working for a public company owes no duty of care outside the company’s existing shareholders who purchase stocks in reliance on a statutory audit. It simply means that the external auditors can only be held liable to investor, a potential investor, or any other third party involved only if there is a written contract stating that the external auditor owes duty of care to investor, a potential investor, or any other third party involved. In fact, external auditor(s) who are held liable for pure economic loss are considered as a simple negligence under a contract law. In line with this, Schaefer (2004) explained that the case is different when the auditor(s) are being judged based on the tort law because tort law does not include a pure economic loss as a negligent act. Considering the difference between a contract law and a tort law, external auditor(s) who are found guilty of negligence will be held responsible and will be obliged to pay for the victims’ loss. In case an external auditor violates any of the auditing guidelines and has been found guilty, the accused external auditor(s) will not be held responsible to compensate the victims’ loss because of the fact that tort law excludes liability of a pure economic loss. In other words, the victim of a wrong audit can demand a claim against those people guilty behind the a wrong audit under a contract law (Ewert, 1999). Given that the general public can prove that both external auditor(s) and the managers of the company collude against the outside stakeholders, the stakeholders of a given company can demand a claim against both the parties involved. Even though external auditors can be held liable for negligence and misconduct, there is still a limit as to whether an auditor can be held liable for a misconduct or not. For example: In case an external auditor has not provided the actual report to the company he works for, any law suit filed during the time frame wherein the external auditor has not yet submitted his final report will not be considered punishable by the Court because technically since there is no duty of care that has exist between the company and the external auditor(s) (Poorter, 2008, p. 70).3 In other words, the duty of care between an external auditor(s), the company, and the shareholders of the company will only exist when the external auditor has already submitted his final report to his client – the company. Basically, the extent of auditor liability will depend on the Court judgement and the degree of damages caused by the act of negligence that has occurred in the process. In line with this, it is possible for the act of negligence to occur when the external auditor(s) and the owner or manager of the company agrees to underestimate the actual revenue of the company in order to pay lower taxes to the government; or both parties may agree to over value the company in order to be able to get a better price when selling the company’s shares to the public. Since there are different ways in which auditor liability may occur, the Court will be responsible for the investigation behind the said act of negligence. According to Schaefer (2004, p. 9), external auditor(s) with a binding contract towards the third party involved should not be held for the loss that may occur in the purchase of stocks given that the auditors did not make any actions that could trigger the decline in the stocks’ value. In other words, external auditor(s) who did not manipulate the value of stocks are free from being held responsible in case the value of stocks depreciated. Rather than considering the loss of a public investor as a result of negligence on the part of the external auditors, the public investors are expected to be responsible enough to study the market first before they invest their money in the stock market. In case the general public were able to prove that external auditors were behind the manipulation of stock prices in such a way that it depreciates over time, then the Court has the option to make the company including those people who were directly involved in the process of fraudulent act to be partially liable for the victims’ monetary losses. However, in case a buyer was able to sell his share of stocks at an overvalued price for the reason that the internal and external auditors were not able to accurately detect the true market value of the company’s stocks, the person who bought the overpriced stocks will have to compensate for the loss simply because it was the buyer’s decision to purchase an overpriced share of stocks. Conclusion The personal obligations of external auditors to the general public or public investors is limited for the reasons that the role and responsibility of the external auditors is limited in terms of determining whether or not the accountants were able to present the financial statement based on the rules or laws accepted for the development of financial statements for the government, a private company, or a legal organization. Likewise, external auditors are also made responsible in detecting any signs of potential accounting irregularities made for the purpose of tax evasion or theft by creating ghost employees, skimming of the proceeds, or theft of an asset. Based on the study of corporate governance, the board of directors (executive and non-executive directors), the Chief Executive Officer (CEO), and the accountants have different roles and responsibilities to play in protecting the socio-economic welfare of the corporate stakeholders including its public investors. In case of fraudulent scandal, it is a wrong conception to put the blame purely on external auditors since the board of directors (executive and non-executive directors), the Chief Executive Officer (CEO), and the accountants are responsible in securing the financial investment of the public investors and job security of the corporate employees. *** End *** References: Aguilera, R.V., Filatotchev, I., Gospel, H., and Jackson, G. (2008). An Organizational Approach to Comparative Corporate Governance: Costs, Contingencies, and Complementarities. Organization Science , 19(3), pp. 475 - 492. Becht, M., Jekinson, T., and Mayer, C. (2005). Corporate Governance: An Assessment. Oxford Review of Economic Policy , 21(2), pp. 155-163. Carpenter, R. (1988). Cooperative Governance: Directors' responsibilities. Directors and Boards , 12(3), pp. 3 – 6. Cassill, D.L., and Hill, R.P. (2007). A Naturological Approach to Corporate Governance. Business & Society , 46(3), pp. 286 – 303. 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