Audit Failure in Result of Shredded Reputation to Auditors - Case Study Example

Audit failure in result of shredded reputation to auditors Literature Review- Auditing is a process by which the examination and evaluation of booksof accounts are undertaken, in order to ensure that all transactions are true and fair in nature and present a true and fair view of the financial state of affairs of the Company. At the end of the audit process, auditors are to pass their professional opinions and judgments to the stakeholders, based on the data made available to them and on their independent assessment of the facts and figures presented to them. Auditors occupy a prominent status, and the expression of opinion made by them should be relevant and unbiased in nature. Where as, the reputation of an auditor is based on the quality and independence of their nature of work, without making any comprises of any sort, which reflects the potential capability of an auditor to handle several inclement circumstances. However, at the same time, even though the auditors are holding an outstanding image, as far as the public is taken in to consideration, if there is any misconduct or mal practices being takes place, and the auditor does not report about it, the status so held by the auditors will fell down in a drastic manner. However, sometimes it happens that the auditor himself gives unlawful instructions to the client, as is evident in the Enron case. “ Instead of being advised to preserve documentation so as to assist Enron and the SEC, ANDERSEN employees on the Enron engagement team were instructed by ANDERSEN partners and others to destroy immediately documentation : (United States District Court Southern District of Texas 2007). The working nature of carry out the auditing work is quite risky. Because, based on the expression of opinion and the reports signed by the auditor should become one of the prime evidence in the eyes of Laws and Legislations. In this particular project, it is necessary to make an evaluation about why should the work of audit became a failure as a result of opaque nature of auditors. Therefore, it is very essential to make a discussion about this matter, it is very important to analyze the fact behind the reason of Enron audit failure causing the shredded reputation of auditors. The fundamental reason underlying on such an audit failure is that of its share prices. Because, the share prices of Enron were inflated, as a result of this, the stock price movements were adversely effected. Due to this, a subsequent aftereffect took place in case of Arthur Anderson also. “ARTHUR ANDERSEN, LLP ("ANDERSEN), is a partnership that performs, among other things, accounting and consulting services for clients that operate businesses throughout the United States and the world. ANDERSEN is one of the so-called Big Five" accounting firms in the United States. ANDERSEN has its headquarters in Chicago, Illinois, and maintains offices throughout the world, including in Houston, Texas.” (United States District Court Southern District of Texas 2007) This reason reduced the quality of audit works of both Arthur Anderson and Enron strongly and paved the way for the demise of both the companies. “The failure of Enron sent shock waves through the economy, resulting in a series of reforms and proposals that will significantly change accounting standards setting, auditing practice, and the legal and regulatory environment of financial reporting.” (Accounting issues at Enron 2003). Subsequently, Sarbanes- Oxley (SOX) Act, is providing some relevant counteractive steps for overcoming the problems faced by both Enron and Arthur Anderson. It is a “a corporate governance law which came into effect in 2005. Created in the aftermath of a raft of high-profile financial scandals, including Enron and Worldcom, Sarbanes-Oxley aims to overhaul corporate financial reporting by improving its accuracy and reliability.” (Sarbanes Oxley 2005). SOX Act, which bring in to the light of public about the reputation of independent auditors in the US market, in addition to this it is important to stress on Section 302 of the SOX Act, which is providing a much more emphasis about the concept of stock market, and also about the corporate governance and ethical behavior. Moreover, the main theme of this SOX Act is that to provide adequate protection to the appropriate investors. Section 302 of the Act, is dealing with the corporate responsibility in respect of providing financial in formations. “Periodic statutory financial reports are to include certifications that: • The signing officers have reviewed the report • The report does not contain any material untrue statements or material omission or be considered misleading • The financial statements and related information fairly present the financial condition and the results in all material respects • The signing officers are responsible for internal controls and have evaluated these internal controls within the previous ninety days and have reported on their findings • A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities • Any significant changes in internal controls or related factors that could have a negative impact on the internal controls”. (Sarbanes- Oxley Act 2002. 2003). The major reasons behind the audit failure are mainly of the inability of an auditor to take appropriate decision in an autonomous manner, non-availability of adequate resources, and no proper relation between audit risk and audit materiality. The primary objective of conducting the audit is to express a true and fair opinion on the books of accounts, and secondly, to detect and prevent the occurrence of errors and frauds. Arthur Anderson, one of the leading audit firms, introduced various tools and measures for the purpose of conducting its business audits. The main aspect that may distinguishes the big five audit firms like Pricewaterhouse Coopers, KPMG, Ernst and Young, Deloitte and Touche, and Arthur Anderson, is that of its quality and capability of handling mega sized audit work. Arthur Anderson maintained a leading status in the country within a smaller period. But, one of the main reason for the demolition of Arthur Anderson were that of certain unexpected events took place in the field of auditing and accounting, especially disgraceful attitude in book keeping and accounting; this leads to the end of Enron. During the year 2001, Enron suffered liquidation and other economic failures, which lead to the collapse of Arthur Anderson also. Enron engaged in several violations of rules, which were against the order, and justice of SEC (Securities Exchange Commission). “Since interpretations are quite subjective, the American Institute of Certified Public Accountants (AICPA), added the stipulation that the treatment must also be applied consistently over time.  These rules are in place to make financial statements as accurate and reliable as possible.  Enron took these rules and circumvented them to allow certain individuals within the company to make money from the increased investments from stockholders.  They did this by bolstering their balance sheet with inflated asset values, and dispersing their liabilities to subsidiaries that they just didn’t consolidate.” (Stinson 2004). The main aim of both Enron and Arthur Anderson were to make maximum money within a short span of time, and they focused their attention towards this by ignoring the fundamental accounting principles, but finally it leads to bankruptcy of both these companies. During the time of its liquidation, Arthur Anderson was a leading accounting firm in US, with a high rate of revenues. The importance of audit declaration is clearly reflected in the financial reports disclosed by auditors. At the time of its emergence, Arthur Anderson held a global trademark due to its quality of audit work and ensuring the reliability of financial statements, which progressively build a prominent status for its auditors. But the cause behind bankruptcy is that of its legal action enacted by the country to certain extend, than that of the dominance of the audit work. “The vast majority of large publicly traded firms in the United States engage Big Five firms. Until now, it has been difficult to test the differences in quality among audit firms and its impact on clients because of this virtual oligopoly. With the indictment of Arthur Andersen for fraud in relation to a major audit client, we gain the chance to examine a service provider that has lost its reputation. The extent of this failure and the discovery of other concurrent failures make it less likely that Arthur Andersen would both discover and report a breach in a clients accounting system. By definition, then, Arthur Andersen has exhibited a poorer quality and suffered in reputation. As the empirical evidence suggests such an event is not expected, this loss of reputation raises many new questions.” (Rauterkus and Song 2005, P1) In addition to this, it is also very clear that the basic reason of Arthur Anderson’s failure as an auditor is that the absence of transparency of transactions, especially investments, in the audit work leading to the stock value falls in the stock markets and subsequently which leads to the decline in the level of market returns. Arthur Anderson were the external auditor of Enron, which utilised several malpractices and mis representations in the accounting and auditing works with the singular motive of improving their financial strengths. “Enron was not Arthur Andersens first exposure to allegations of massive audit failure. Anderson was accused of improper audits in financial scandals including Waste Management, Sunbeam Corporation and Baptist Foundation of Arizona, resulting in the firm paying large sums for settlement.” (Chan 2004). Arthur Anderson issued such a kind of an audit report, which is unqualified in nature. Only a good accountant or auditor should have the quality of professional judgment, then only it is possible for them to fulfill their responsibilities. “By issuing an unqualified audit report on the financial statements in the Restatement, Andersen acknowledged that the Companys original financial statements for the periods 1992 through 1996 were materially misstated and that its prior unqualified audit reports on those financial statements should not be relied upon. In the Restatement, the Company admitted that it had overstated its net after tax income as follows: Year Ending Originally Reported (in thousands) As Restated (in thousands) % Overstated 12/31/92 $850,036 $739,686 14.9% 12/31/93 $452,776 $288,707 56.8% 12/31/94 $784,381 $627,508 25.0% 12/31/95 $603,899 $340,097 77.6% 12/31/96 $192,085 $(39,307) 100+% (United States of America before the security & exchange commission 2001). Due to the reason that Arthur Anderson had lost its reputations, majority of its client members suffered in an adverse manner in respect of its issue of equities. The end results of this liquidation has adversely affected the security or stock markets. Because during that time, the security investors were unfamiliar about the adequate information required in respect of share market like under or over estimation of share prices. In addition to this, Arthur Anderson also conducted its audit procedures by ignoring steps like taking appropriate representation from third parties, because the information provided by third parties are considered more reliable than those given by its client members; Anderson also did not taken in to consideration about the inherent limitations of audit process. Finally, Arthur Anderson faced a lot of audit failures at Boston Chicken, Waste Management, Sunbeam, Arizona Baptist Foundation, Global Crossing, as well as at Enron and WorldCom. (Ketz 2007). The client companies of Arthur Anderson faced a lot of difficulties, especially in the matter of stock issues, as a result of lack of proper disclosure and transparency in the audited reports. Failure of audit means, providing an unqualified audit opinion by CPA (Certified Public Accountant) in respect of the Financial statements and other relevant books of accounts so audited when as a matter of fact fraud and misrepresentations were present in the affairs of the company but were not disclosed either due to ignorance or due to deliberance. “Beginning in 2000, Enron’s financial performance began to suffer, and, as 2001 wore on, worsened … Within days, Sharon Watkins, a senior accountant at Enron, warned Kenneth Lay, Enron’s newly appointed CEO that Enron could ‘implode in a wave of accounting scandals.” (Supreme Court of the United States 2004). Not only this, but also lack of independence and professional judgment are also became the reasons for audit failure of Arthur Andersen, and also other big companies in US whose accounts were audited by Arthur Anderson.. “In 2001, WorldCom Inc. paid Arthur Andersen service expense about 16.8 million dollars, including audit expense 4.4 million dollars, tax consultant service 7.6 million dollars, non-financial statements audit 1.6 million dollars, other consultation 3.2 million dollars. Enron Corp. paid Arthur Andersen audit expense 25 million dollars, consultations and other service expense 27 million dollars, and the total added up to 52 million dollars. It means that Enron Corp. paid Arthur Andersen 1 million dollars every week.” (Chen 2006). But, Arthur Anderson’s reputation was demolished mainly due to the impact of Enron. The main reason for the failure or collapse of Arthur Andersen was that audit work and audit reports were not internally checked by other responsible members. Moreover, Enron is mainly dealing with number of fraudulent activities like handling of ambiguous pro formas and statements. Therefore, all kinds of audit failures due to the negligence of Arthur Anderson indicates that it is necessary to make a proper control over financial statements, and a keen focus of internal and external auditors is also a must. The audit team members of Arthur Anderson for doing audit work for Enron were very keen to perform in accordance with the policy and procedures. “Andersen was prosecuted for acts (exercise of its document retention policy) that are not a crime. Moreover, despite that limited prosecution, the indictment is filled with largely irrelevant vitriol regarding Andersens association with Enron. By the time of trial, Andersen was already withering shell of a business and the conviction only reinforced the inevitable.” (George 2006) But the major difficulties faced in between while conducting the audit works were not only suffered by Arthur Andersen but also, shared by rest of the firms under Big Five. “The first tier included in 2001 the Big Five audit firms, i.e., PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young, KPMG, and Arthur Andersen..  All the Big Fives had more than 1,000 partners and a strong international presence and dominated the industry with a combined market share of more than 85% SEC clients.” (Jensen 2002). But the public knew the fact of misrepresentations being undertaken by Arthur Anderson only after the collapse of Enron as a result of bankruptcy. Arthur Anderson has depraved accounting standards and thus created many problems in US. It is necessary to overcome the weakness of lack of independence, in order to keep the auditor’s status intact. Likewise, the auditors of Arthur Andersen were also responsible in appointing some internal as well as external auditors for Enron, for performing accounting and auditing tasks. However, the closure of both Enron and its auditor Arthur Andersen was a significant event in the context of US economy. Moreover, unprofessional unethical attitudes of Arthur Anderson turned out to abolish number of other audit firms’ operations also.. Similarly, the inquiry done by SEC brings out the mal practices undertaken by Enron together with the aid of Arthur Andersen in connection with security offerings. The liability of an auditor is unlimited in nature, specially in the case of audit of public limited companies (PLC) depending on the scope, nature and public accountability of the of works being performed by them. “The accounting profession has emerged as one of the biggest victims of the sudden collapse of the once high-flying Enron Corp. The Houston energy-trading company filed for bankruptcy in December after accounting missteps forced it to restate earnings for several years. Enron executives put part of the blame on Arthur Andersen, the big firm that audited Enrons books.” (Jost, 2007). For the attainment of success in auditing it is very essential to ensure the quality of the work so performed, and the accuracy and reliability of the books of accounts will provide a true and fair view of opinion. "The wave of corporate financial scandals has served to emphasize the critical role of the external auditor in maintaining a market economy. Arthur Andersen had a distinguished history of being the gold standard of the profession. How this highly respected firm lost its bearings is the subject of a superb, serious study by former Andersen employees. Inside Arthur Andersen is and will remain the definitive explanation of the downward spiral to Enron. (Squires 2007). The Securities and Exchanges Commission (SEC) had filed a complaint stating that, between the accounting years 1997 to 2000, the Company, Xerox Corpn., has effected several accounting manipulations. This was done by wrongly accounting total Revenues received from the heads of Copier Machines at the time when the Contracts were signed, rather than at regular intervals when its accounting credits were to be proportionately accounted over the entire period of the lease. As a result of this, the Company was able to depict its financial position in a better state than what it really was, ‘At that time, the SEC charged that Xeroxs accounting accelerated the companys recognition of equipment revenue by more than $3 billion, and increased its pre-tax earnings by about $1.5 billion, between the years 1997 and 2000, rather than through 2001. Xerox agreed to pay a $10 million penalty under an agreement with the SEC.” (Xerox duplicates problem 2007). The question of professional auditing ethics and shredding of auditors reputation can also be seen in the case of another member of the Big Five club, KMPG, who overlooked accounting malpractices committed by Xerox Corporation who heavily loaded their revenue earnings with unrealised profits to boost their bottom lines. When they were questioned about this anomaly in the accounting procedure by their auditors, KPMG, they replied that they (Xerox) would like to have a new Audit Partner to audit their accounts. Keeping in mind the fact that Xerox was a major client, paying substantial audit Remuneration to KPMG, and considering the longstanding relationship they have maintained with this client, Xerox, the top management at KPMG granted them this request. In response to the SEC compliant regarding accounting irregularities, Xerox was non-committal, but paid up the Penalty charges and also arranged to have the restatements done for its financial figures for the Accounting years 1997 through 2000. “The SECs Order finds that from 1997 through 2000, KPMG permitted Xerox to manipulate its accounting practices to close a $3 billion "gap" between actual operating results and results reported to the investing public. During this period, Xerox used topside accounting actions at the end of financial reporting periods to increase equipment revenue and earnings through the improper acceleration of revenue from long term leases of Xerox copiers and through manipulation of excess or "cookie jar" reserves.” (KPMG Pays $22 Million to settle SEC Litigation relating to Xerox Audits 2005). On January 19, 2003, SEC filed complaints against the Xerox auditors, KPMG, alleging that they had helped falsify the Accounts and in April 2005, KPMG settled this dispute with SEC for $ 22.48 Millions. On June 5, 2003, six senior Xerox executives also settled this issue with SEC and also agreed to pay Penalty, Taxes and Interest totaling $ 22 Million. “The payment settles legal action stemming from KPMGs involvement in Xeroxs fraudulent financial reporting for 1997 through 2000.” ( Farrell 2005). The above case study highlights the tremendous honesty, responsibility, and ethical values, which statutory auditors have to bear in mind while performing their duties in the modern business world. However nowadays, it is being seen that audit values and ethics have been grossly undermined by financial considerations. As mentioned by a leading consultant to a reputed daily, “accounting firms have become too dependent on consulting fees from the companies they audit and are unwilling to risk those fees by challenging corporate managers who stretch accounting rules.” (Armstrong 2002). Should there be laxity in the services provided by professional auditors, they may have to face similar unsavory situations, not only with the clients, but also with Government Controllers and Regulators, which may also shred their reputation that occurred in the case of Arthur Anderson. In this context, it needs to be said that the reputation that an audit firm builds in the market is through years and years of professionalism, hard work and ethical professional behaviour with clients and regulators. The Enron failure in the year 2001 also resulted in the liquidation of Arthur Anderson. The principal reason for this was that most of the revenues and profits accrued by Enron were through Special purpose entities (SPE) shown as earnings of independent companies. As a result, the results of these undertakings were not published in the accounts of Enron Company. “These shell companies, run by Enron executives who profited richly from them, allowed Enron to keep hundred of millions of dollars in debt off its books.” (kadlec 2007) The case of yet another client of Arthur Anderson, GlobalCom also deserves mention. Even “in this case, the auditors had assisted the company’s management falsify accounts and make it just another case of failed corporate governance accounting abuses and outright greed.” (Moberg and Romar 2007). The illegal and law breaking activities of Arthur Andersen in these cases has shred all its reputation and brought it on the doorsteps of liquidation. On June 15, 2002, Arthur Anderson was convicted of obstruction of justice for shredding of documents relating to the the audit of Enron. “In the criminal context, and pertinent for the present discussion, destroying documents can lead to a charge of obstruction of justice.” (To shred or not to shred: Document retention policies & federal obstruction of justice statutes 2003) Since the US Securities and Exchange Commission does not permit convicted professional firms to audit public limited companies, their practicing licenses were cancelled and with effect from 31.08.2002. “ A jury in the United States has found accountancy firm Arthur Anderson guilty of obstructing justice by shredding documents relating to the failed energy giant Enron.” (Anderson guilty in Enron Case 2002). This signaled the end of the 89-year-old Audit firm, which was one of the Big Five Auditing firms of the world. “Arthur Anderson LLP, formerly one of the "Big Five" international accounting firms, is today in disarray and probable dissolution. It was convicted of obstruction of justice for destroying Enron-related documents.” (Gutman 2002). Thus it is seen that many large audit firms have caused the shredding of their own reputations by associating itself with dubious transactions of their clients, and more importantly, not disclosing these facts to the stakeholders through their published annual statements They are thus making themselves a party to illegal and unethical procedures in direct violation or circumvention of existing statutes which are designed to protect investors from such spurious deals. Works cited Accounting issues at Enron. (2003). Decision analysis. The CPA journal. [online]. Bnet. 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