Changes in Audit Relationship with Clients and Third Parties - Assignment Example

Corporate audit assignment-Changes in audit relationship with and third parties Introduction: Sole proprietorships, partnerships and joint stock companies are some of the common channels through which business is conducted today. In the case of sole proprietorships, the responsibilities and obligations with regard to proper conduct of the business is towards its employees, creditors and other stakeholders like the government and family members. A partnership enlarges this obligation to other partners as well. However, running a modern joint stock company or corporations requires utmost care since public money is involved in most cases. Moreover, the stakes are much higher when compared to other forms of business. It is essential that under such circumstances, a legal body that has the authority to look into the affairs of corporations be created. As a result, most countries have created the qualified accountants referred to as auditors to undertake this responsibility. However, the existence of such a group has not entirely been successful in attaining its primary objectives of safeguarding company assets and public money. Consequently the profession of auditing has evolved over the years with new statutes, regulations, and practices coming up to prevent new types of mismanagement practices, white collar crimes and frauds over the years. This paper looks at the evolution of the auditing profession over the past decade or so with regard to the relationship between auditors and third parties. Corporate greed, scandals, and white-collar crime have made a deep impact on this profession over the years. The focus will be on the corporate auditing profession in Australia, along with changes and trends in other areas like the United States and United Kingdom. A brief history of the auditing profession: The concept of checking and verifying accounting records existed even in ancient Greece, Babylonia, and Rome (Puttick et al 2008, p. 2). The authors state that this practice probably started even earlier, when the concept of keeping written records of transactions evolved. The advent of double entry bookkeeping developed by Luca Pacioli (during the 15th century) resulted in this activity being regarded as a regular profession in human financial activities (Tsuji and Garner 1995, p. 165). Those involved in the activity checking and verifying accounting records are referred to as auditors. They are called certified public accountants in the United States and chartered accountants in the UK. In fact, the term ‘chartered’ seems to have originated from the Royal Edinburgh Charter in 1854, which legally recognized a body of accountants qualified to look into the accounting activities of companies at that time (Solomons and Zeff 1996, p. 124). The situation in Australia is more complicated due to the existence of two distinct bodies of auditors namely the Certified Public Accountants (CPA) of Australia and the Institute of Chartered Accountants in Australia. CPAs conduct audit on government organizations and chartered accountants conduct audit on corporations (O’Regan 2003, p. 134). The author add that even if this is the case, both bodies have common areas or roles and the two have not be able to form a merged entity till date. The prominent governmental regulatory bodies and statutes include the Auditing and Assurance Standard Board, the Australian Accounting Standard Board (AASB), the Australian Securities Investment Commission (ASIC), the Corporations Act 2001 and the Trade Practices Act 1974. Definitions of auditing: There are several definitions of auditing that have evolved over the years. This is been done to provide some information on the relationship between auditors and other stakeholders mentioned above. The International Standards on Auditing looks at the term with regard to its function – “The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework” (Gray and Manson 2007, p. 21). Giove is of the opinion that auditing assures the ‘fairness and reliability’ of accounting or financial data based on guidelines, standards and rules (Giove 2003, p. 1). Gupta, referring to Mautz is of the opinion that auditing is concerned with ascertaining the ‘accuracy and reliability’ of financial statements (Gupta 2004, p. 7). All these definitions do provide generalized functions of an audit team. For example, the term fairness does not specify the parties concerned. It does not specify whether they are the directors, the shareholders, the government, the employees or the public. Again, accuracy and reliability does not specify whether it is arithmetical accuracy or a true and honest picture of the financial situation of the company. Nevertheless, other more comprehensive definitions now provide a more relevant picture of auditing in the modern world. It takes into consideration, the entry of new factors like information technology, which now plays a major role in business accounting. One modern view of auditing function is as follows – “External auditors are required to anticipate and keep up with the changing needs of the public, as well as changes in financial markets, corporate structure and information and communication technologies. Thus, the audit profession should evolve to meet new market needs, taking into consideration regulators’ measures regarding the types of services provided by auditors and the changes the standard-setters and regulators envisage in the areas of accounting and auditing standards” (Pearson Education n.d. p. 5). This view indicates that the profession and practice should remain dynamic, keeping in tune with contemporary events. It also stresses the importance of public interest in safeguarding the assets of a corporation. A bankruptcy of a large corporation can harm many direct and indirect stakeholders. Therefore, apart from employees, creditors, and shareholders, other stakeholders like customers, ancillary industries, and the government should also become a part of audit interest. The bankruptcy of a large insurance company due to corporate greed and auditor inefficiency/collusion can create problems for policy holders and shareholders. This paper will discuss some of the major corporate issues which have impacted the auditing profession, especially in Australia. Such events have resulted in governments stepping in and bringing about relevant changes to corporate governance and audit practices in Australia, USA, and the UK. This had the effect of changing the relationship of auditors with stakeholders and third parties in various degrees. Relationship trend of auditors with clients and third parties: Relationship with clients: Companies could appoint auditors with the approval of the board of directors and utilize their services as long they wanted. Many companies also utilised their services for non-audit purposes. This practice was welcomed because appointing a separate firm for such services was costly and due to familiarity of company affairs by the auditors. However, such practices led to higher levels of familiarity and interdependence between the auditor and the client. These non-audit services may lead to loss of audit independence according to some studies (Ye, Carson and Simnett 2006, p.3). Major corporate collapses and scandals in Australia, UK, and USA have brought about new regulations, statues, and practices that affect the audit-client relationship at present and in future. The AUASB is an independent statutory board of the Australian Government established under section 227 A of the Australian Securities and Investments Commission Act 2001, as amended (ASIC Act) (Auditing and Assurances Standard Board n.d.). The body provides statutes under Section 336 of the Corporation Act to regulate and control auditing practices. It is also responsible for formulating policies and procedures in this area. The International Ethics Standards Board for Accountants (IESBA) had also provided some strong recommendations regarding compulsory audit rotation (Chartered Accountants 2009). Companies in the past usually appoint an auditor of their choice and keep them for as long as they wish. This could result in unnatural familiarity between the two parties, which could ultimately lead to collusion or non-disclosure. Audit rotation will ensure that the relationship between auditors and their clients does not extend beyond a certain period. The recommended time-period is seven years after which the audit partner has to be changed. Many audit partners resign and join as directors of client firms. This is been seen as an unhealthy practice since such ex-auditor directors can influence both the client and the audit firm. The Institute of Chartered Accountants recommend a period of one year before a former auditor can be appointed to the board of directors of a former client. Companies considered to be of ‘significant public interest’ come under the purview of these regulations and are expected to come into force by the end of 2009. Relationship with third parties: There are several relevant theories that explain a perceived relationship between auditors and those not involved in managing a corporation. These include people who have no inside access to corporate information. The ‘expectation gap theory’ states that the section of people mentioned above will tend to believe anything that an auditor states in their reports (United States General Accounting Office 2003, p. 18). The public had an unreasonable expectation of auditor ability in Australia during a study conducted during the 1980s (Koh and Woo 1998, p. 149). This could have come down after the great corporate scandals of the past decade. Another related theory where auditors and public stakeholders have a negative relationship is the ‘deep pocket’ theory. “Third parties will often look towards the auditor ‘when searching for a solvent party from whom losses may be recovered’, even though the auditors do not provide a guarantee as to the viability of a company” (Nguyen and Rajapakse 2008, p. 15). The deep pocket theory is discussed later in this paper. The authors state that Australian auditors are subject to higher levels of public litigation when compared to the United States and UK. Factors leading to change (Corporate scandals and white-collar crime): Literature on the area indicates that the perception of the role of auditors have been subject to change directly as a result of corporate scandals and instances of white collar crime. Corporate and personal greed on the part of the directors seem to be the primary driving force behind such incidents. The key word perhaps to be used corporate governance. The board of directors are expected to act is such a way that a company is managed efficiently, generate profits, provide dividend to its shareholders, and finally protect the interests of all its other stakeholders (Du Plessis, McConvill and Bagaric 2005, p. 6). Poor corporate governance and auditor collusion can contribute to corporate scandals and white-collar crime. There have been many such instances in the corporate world and continues to occur even today. What most accounting and regulatory bodies do is to change the statutes and rules as and when such incidences occur. This is in tune with the definition given regarding auditing, that it is dynamic and needs to be changed or modified according to new developments and events. The HIH Insurance story is the biggest scandal and collapse in the history of corporate Australia. The relevance of the deep pocket theory is evident in the HIH Insurance Collapse. Shocked creditors sued the company’s auditors, Arthur Anderson for negligence and recovery of money due to them by HIH Insurance. Another factor that precipitated the action was the two non-executive directors of the insurance company were retired partners of Arthur Andersen. Moreover, they were also a part of HIH’s audit committee (Dan and Stephen 2002, p. 1). In this instance, it is reported, “creditors will receive about $80m as a result of the settlements, with most of it coming from Arthur Andersen” (Delisted.com 2006). If the final decision of the Courts are in favour of the creditors, then auditors too could face legal proceedings if found to be negligent or had been a part of a white-collar crime. One of the biggest corporate scandals in the world involved Enron Corporation and Arthur Anderson (auditors for HIH Insurance). Here again, purported collusion between a company and its auditors by not reporting a true, fair, and accurate picture had resulted in the public and other regulatory agencies being unaware of the facts. Thousands of investors lost their savings and the extremely large work force became jobless. It also resulted in the closure of one of the most respected audit firms in the world. This proves again that third party involvement can result in losses to a company’s auditors also. Impact of changes: Section 336 of the Corporation Act is now the yardstick to measure the extent of relationship between client and auditor. Moreover, bodies like the Auditing and Assurance Standard Board, the Australian Accounting Standard Board (AASB) and the Australian Securities Investment Commission (ASIC) act as bodies with more stringent practices and regulations. The International Ethics Standards Board for Accountants (IESBA) has also suggested strong recommendations for practices regarding audit rotation. The Institute of Chartered Accountants suggests a time gap between an ex-auditor been appointed to the director board of his former client. There could also be an impact of non-auditor services provided by current auditors of a company. The twin collapse of Enron and WorldCom prompted the US government to promulgate the Sarbanes-Oxley Act. The basic aim behind the move was to bring back public confidence in the accounting profession, better audit reporting and disclosure, and to ensure that rules and regulations are enforced effectively (Du Plessis, McConvill and Bagaric 2005, p. 296). The UK on the other hand brought in new regulations much earlier than the US and Australia. “Various corporate scandals in the UK in the 1980s and 1990s (Maxwell, BCCI, Plloy Pack) acted as wake-up call and led to the Cadbury Code of Best Practice, known as the Cadbury Report which was published in 1992 (ed. Reuvid 2006, p. 65). These scandals occurred before the Enron and HIH Insurance collapse, but neither the US and Australia acted with regard to bringing in regulations to ensure that such things did not happen in their respective countries. This shows that the auditing profession is largely conservative and only acts if something happens in the country’s own backyard. Third parties now can hold auditors accountable in certain cases. This could make auditors more cautious when examining the accounts of their clients. Whistle blowing is an accepted practice in legal environments and is even encouraged as a means of safeguarding the assets of companies and the interests of its shareholders. Provisions for protection of whistle-bower identity and retaliation (against them) has been made under Part 9 4AAA of the Corporations Act 2001 (Australian Legal Information Institute n.d.). Under the new statutes, any person such as an employee, officer, or a contractor (with the company) can act as whistle-blowers. A whistle-blower can pass on information to the Australia Securities Investment Commission (ASIC), an auditor, or directors of the company. An auditor could be held accountable in two ways if any confidential information regarding any issues had been made available to them by a whistle-blower. Disclosure of identity to a third person is not permissible under the new regulations. Any information provided by a whistle-blower needs to be shared with an audit partner. So, “if the revelation is not shared with the audit partner then the quality of the audit may be in jeopardy” (Australian Securities and Investment Commission 2009). This has brought in a new dimension to the relationship between auditors and third parties. Third parties still attest to the expectation gap and deep pocket theories. The suing of HIH Insurances’ auditors is illustrative of the fact. Third party confidence on auditor reports and confidence may have come down to some extent after these major collapses. It could be too soon to state whether the new inclusions in the Corporations Act or even the Sarbanes-Oxley Act could prevent further occurrences of scandals, collusions, or white-collar crime. It is true that it has brought about changes in relationship of different stakeholders and auditors. There are opinions that the government had acted in haste in the case of the Sarbanes Oxley Act with some experts opining that it is “unnecessary, harmful, and inadequate” (Niskanen 2005, p. 355). The effectiveness of the rules, regulations, statutes, and practices adopted in Australia is yet to be proved. There is no guarantee that another corporate collapse (like HIH Insurance) be prevented with the new statutes and regulations. Future events can change the auditor client/third party relationships depending on the circumstances of each case.. Conclusion: It can be seen that client audit-client relationship has changed over the years. The main reason was the major corporate scandals/collapses and instances of white-collar crime. Governments in affected countries have brought about new standards and rules in order to counter this threat. It has resulted in concepts like audit-rotation, restrictions on ex-auditors being directors, and disclosure of non-audit fees (in Australia). In the United States, there are restrictions on certain non-audit services. Relationship with third parties has also undergone a certain level of change. For example, creditors now look towards auditors to recover their dues in case of bankruptcy of the client company. The fact that Arthur Andersen may have to pay part of the amount could result in audit companies being liable to third parties if their reporting does disclose relevant facts. There is no apparent guarantee that these regulations and suggestions can prevent future corporate or white-collar crimes. In case it happens, the audit-client and audit-third party relationship will undergo further changes for sure. 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