The Main Role of the Auditors - Case Study Example

International Issues in Audit Audit Audit can be referred as the critical examination of the accounting data of a particular entity by a group of people known as auditors for ascertaining whether a proper accounting statement has been prepared or not (Cosserat and Rodda, 2009; Kumar and Sharma, 2011). The critical evaluation is done on behalf of the entity so to avoid any non-compliance to accounting principles. These entities can be renowned companies as well as small firms. Through auditing, companies assure the external stakeholders that financial data provided in the annual reports is adequately accurate to be relied upon and take investment decision. The financial statements in the annual reports provide a clear picture regarding financial status of a company, which is why it is very vital and regarded as the cornerstone for commerce. The audit works are carried out by the auditors who are responsible for checking the accountability of company accountants. Audit focuses on three key functions. It helps in underpinning confidence of the market that is crucial for functioning of the modern economy. It serves the function of evaluating financial information, which can support successful operation of the capital market. Finally, audit performs the function of a public watchdog. According to Section 311 of Corporation Act, the auditors have to report non-compliances of the Corporation Act, which the companies have undergone (Institute of Chartered Accountants, 2005; Kumar and Sharma, 2011). Role of auditors The main role of the auditors is to examine the historical financial statements of companies and evaluate whether or not it has followed the respective accounting policies. When their roles were scrutinized after collapse of the corporate, it is observed that they played a very crucial and negative role in reviewing the financial statements. They failed or rather ignored the frauds or misstatements present in financial statements of the companies. Consequently, their roles were questioned. There are many cases where auditors are blamed for performing their tasks inappropriately. There are number of issues regarding the collapse of many established companies. In majority of the cases, the auditors were blamed directly or indirectly for not exercising their duties properly. The issues in international auditing are briefly described below along with their effect on a company (Todea and Stanciu, 2009). International issues regarding audit There are many international issues that have resulted in the collapse of big companies due to compromise made on audit quality and auditor’s independence. The most important and memorable incident related to the international issues are described briefly. The Collapse of WorldCom The main reason behind collapse of WorldCom is that of mishandling of accounts by the auditors. In May 2002, Cynthia Cooper who was the internal auditors of WorldCom had identified that line cost incurred by the company were treated as capital expenditures in the financial reports (Yahoo! Inc., 2007). Cooper, as a responsible auditor, did her duty by then discussing this misrepresentation with Scott D. Sullivan, the financial officer and David F. Myers, the controller of WorldCom. On June 12, 2002, Cooper also informed the issue to Max Bobbitt, the head of audit committee at that time. The audit committee operated under the company’s board of directors. Bobbitt asked the external auditor, KPMG, to conduct inspection on the issue (Kumar and Sharma, 2011; Romero, 2002). On 16th May, 2002, WorldCom replaced the external auditor, Arthur Andersen LLP and appointed KPMG as the new external auditor. Sullivan was asked to provide explanation regarding the treatment of line cost as capital expenditure. However, his explanation was not approved and he was dismissed in June 2002 through public announcement of 25th accounting statement (Julkaisuja, 2010). Mr. Myers also resigned during the announcement session. The main finding of the case is that Mr. Sullivan did not consult with the external auditor, Arthur Andersen, about treating line costs as capital expenditures. Andersen also did not inform the company about their misrepresentation then (Teather, 2005). Later on 15th July, 2002, Tauzin, the chairman of House Energy and Commerce Committee, had identified that internal documentation and e-mails messages of the company indicated that the company executives had knowledge pertaining to improper treatment of accounting since 2000. It is evident that internal auditors form the line of defence for a particular company against any kind of accounting frauds and errors. As a result, it was hard to fathom the reason behind the fact that internal auditors had taken more than a year to identify the misclassification. The auditors simply argued that the amounts were capitalised, which had affected assets and income of company (Reecce, 2011). Fraud of KPMG In August 2005, one of Big Four Company, KPMG admitted that they had averted multi-billion dollar tax fraud in the United States (US). However, the audit firm agreed to pay $ 456 million as penalty and settle the situation as part of the agreement with the US Justice Department and Internal Revenue Service (Reecce, 2011). The audit firm feared being excluded from the list of the Big Four. Hence, they agreed to compensate on behalf of the wrong doing. The six partners and the deputy chairman of KPMG were prosecuted for conspiring tax evasion related to design, marketing and implementation of deceitful tax shelters. The agreement passed after confession of KPMG had imposed several restrictions on the tax practices carried out by KPMG and banned the firm from being involved in pre-packaged tax products. KPMG was gratified to pay a fine of £ 495,000 and £1.15 million as the cost of fraud on June 2008 to accountancy body in the United Kingdom, which is self-regulatory (Reecce, 2011). On December 2006, Fannie Mae, the biggest mortgage finance company in the US, had started legal proceedings against fraud of KPMG, hoping that they could retrieve $2 billion. Fannie alleged that KPMG had avoided their duty as an independent watchdog and failed to prevent the errors in accounts that amounted to $ 6.3 billion (Reecce, 2011). Fraud of Ernst & Young (Window-dressing) Ernst & Young (EY) LLP was sued by a New York (NY) attorney, General Andrew Cuomo, for undertaking severe accounting fraud by assisting Lehman Brothers Holdings Inc. in misleading the public regarding the latter’s financial condition. Lehman Brothers window-dressed the balance sheet and deceived the public by concealing their financial facts. Window-dressing is defined as an accounting technique that is employed to enhance appearance of a company’s balance sheet in a temporary manner to the creditors and investors. This misrepresentation is carried out by not modifying the values of asset and liabilities permanently. In 2008, Lehman Brother announced bankrupted. EY moved the debt of Lehman to the off balance sheet records and showed that the company had less leverage. This act was executed with the help of Repo 105 transactions. This practice was employed in order to hide liabilities of Lehman for a year, before it finally collapsed. The government sued the company because they had a plan for recovering $ 150 million as a fine from Ernst & Young for their fraudulent activities, which they had encouraged along with Lehman from 2001 to 2008. EY had to pay for investor damages and equitable reliefs (Reecce, 2011). These fraudulent activities by the audit firms have resulted from the dependency on one single audit company for a prolonged period of time. The audit firms were not afraid from any inspection as they reckoned that they would not be exposed. In this manner, the audit firms pleased their clients and deceived the creditors and investors of the client company. In order to avoid such incidents, a stringent rule was developed that is described below. Mandatory audit rotation Mandatory Audit firm Rotation (MAR) is not a recent phenomenon. Rather its relevance, importance and usefulness are debated for decades by the academic practitioners and scholars. The debate had gained importance after the above mentioned reporting failures were encountered by the renowned companies. These events had directed the government to incorporate necessary modifications in accountability of the companies while preparing the financial statements. The government also changed the rules for auditors, which would enable them to reduce the possibilities of fraud. The rules related to MAR sets a limit on the number of years for which a particular audit company can audit the financial statements of a particular company. After a specific time, the audit company becomes ineligible to serve as an auditor for the company. The rules preserve auditor’s independence as well as escalate confidence of the investors by improving quality of the audit performed (The Economist Newspaper Limited, 2014; Gray and Manson, 2008; Sarup, 2004). Auditors’ independence can be referred as the freedom involved for both external and internal auditors in auditing financial statement of the parties who are interested. Independence is accompanied by integrity and a definite approach that directs the audit process. Post Sarbanes Oxley Act, Government Accounting Office (GAO) that was formed by Security Exchange Commission (SEC) had studied importance of the MAR rules and concluded that there is no relevant proof pertaining to its potential benefits. Then again, the GAO report did not deny the idea and recommended that such a rule may become useful or justifiable in future (Tran, 2002). There are positive results pertaining to impact of the MAR rule on increasing accountability of the auditors. The influence of MAR on audit quality and independence has been studied for years. MAR serves a medium for strengthening independence of the auditors and also helps in minimizing occurrences of the events of audit failure by concentrating upon improving quality of audit. MAR rule protected confidence of both the investors and the users of the financial statements of companies. After the global financial crisis, European Commission (EC) in October 2010 had addressed few financial changes in regulatory system of the financial market. The regulation included mandatory rotation of audit firms after every six years. In Brazil, the regulation is directed at listed companies, which did not include banks. The MAR rule was imposed on the state owned companies and financial institutions in China. In India, the MAR rule was made obligatory for insurance companies, banks, public sector companies and provident fund entities. In Indonesia, the central bank has to change its auditor in every five years, whereas the private and public companies have to do so after every six years. In Italy, the listed companies have to change audit firms after every nine years (Institute of Chartered Accountants, 2005; Kumar and Sharma, 2011). In general, it is observed that companies switch audit firms only after an audit failure. Otherwise, an audit firm is seen to serve a particular company for several years. Limitations on independence of auditors have resulted in financial reporting failures. The accountants of companies have realized that independence of the auditors is very crucial in order to validate the profession. MAR is established in order to increase auditor’s independence. The reason behind the need to enhance an auditor’s independence is that customers or companies do not require changing the judgment of professional auditors. As per the MAR rule, the auditor need not feel burdened from pleasing the company’s management, which also reduces the scope of losing customers or clients of the audit firms. This is because the rule mentions that audit firms will be replaced after a certain period of time. According to Sarbanes Oxley Act (SOX), mandatory rotation is an obligation of changing the audit firm after a definite period of time (Dopuch, King and Schwartz, 2001; Elder, Beasley and Arens, 2010). Therefore, the auditors do not have to satisfy the companies every time that they prepare an audit report. Auditor’s independence and MAR The independence of auditors is one of the main factors for examining reliability of the report presented. Independence of the auditors is related to several implications. The credibility of a financial report is enhanced by auditor’s independence, which adds value to the different stakeholders. The auditors, who are not aware of the fact that the client tends to depend on their estimation, are unable to form a health relationship with the same. The tenure of an audit firm and its independence is observed to share a negative correlation hypothetically, which indicates that longer tenure entails better and closer relationship with the clients. Here, the auditors tend to become less independent and also less critical (Dopuch, King and Schwartz, 2001). The opponents of the MAR rule stated different factors that motivate auditors for maintaining their independence. This is indentified as the requirement to preserve client revenue and reputation. Ernst and Young are of the opinion that MAR is not adequately effective in enhancing independence of the auditors. O’Leary (1996 cited in Julkaisuja, 2010) discussed the consequences of MAR. The study predicted that the cost of rotation plan surpassed the benefits. Nonetheless, respondents of the survey that he conducted had explained MAR as a useful medium for improving the auditor’s independence. Dopuch, King and Schwartz (2001) also researched on the effect of MAR on auditor’s independence. The outcome of the study revealed that auditors often compromise their independence for no rotation or no retention systems. However, it is observed that mandatory rotation along with retention have the ability to increase independence of auditors. The authors identified that the restrictions on mandatory rotation have limited the interaction between auditors and managers, thereby leading to a conflict between them. Hence, MAR rule focuses on enhancing independence of the auditors. Gietzmann and Sen (2002 cited in Julkaisuja, 2010) had identified the trade off between cost related to mandatory rotation and concerns of auditors pertaining to reappointment by clients or companies. The authors stated that long-term relationship can lead the auditors to concentrate upon the economic interest to satisfy the company as opposed to building independence. Several critics has identified MAR as unnecessary, given that it has the ability to protect a company against familiar threats only. MAR is not relevant when the threats are unknown and a company cannot rightly challenge an auditor for any unpredicted event. It is noticed that MAR increases risk of failure in auditing during preliminary years after firm rotation. The risk of failure in auditing profession increases when the client’s business is complicated in nature and belongs to a specialized industry or is a multinational company. It can be concluded that despite the limitations of MAR, it has numerous advantages pertaining to its application. The auditors act as the watchdog in an economy and thus, their independence is necessary for maintaining a fraud free financial reporting. Independence of auditors facilitates stable short-term relationship with clients; the auditors do not encourage fraud in order to satisfy their clients. The costs of MAR rule are high, but the benefit obtained is also immense if the rule is obeyed properly. It is evident that dependency of the client on one audit firm can make both of them succumb to greed in form of making inappropriate decision, which is harmful for the client in long run. Therefore, in order to avoid such events, MAR rule is followed by the companies so that they can change their auditors after a particular period of time. Hence, it can be stated that MAR succeeds in enhancing auditor’s independence (Limperg, 1932). Reference List Cosserat, G., W. and Rodda, N., 2009. Modern auditing. New York: John Wiley & Sons Ltd. Dopuch, N., King, R. and Schwartz, R., 2001. An experimental investigation of retention and rotation requirements. J Accounts, 39, pp. 93-118. Elder, R., J., Beasley, M.S. and Arens, A., A., 2010. Auditing and assurance services: An integrated approach. New Jersey: Prentice-Hall. Gray, I. and Manson, S., 2008. The audit process: Principles, practice and cases. Connecticut: Cengage Learning. Institute of Chartered Accountants, 2005. Agency Theory and the Role of Audit. [pdf] Institute of Chartered Accountants. Available at: [Accessed 10 July 2014]. Julkaisuja, V., 2010. A theoretical examination of the role of auditing and the relevance of audit reports. Accounting and Finance, pp.1-56. Kumar, R. and Sharma, V., 2011. Auditing: Principles and practice. New Jersey: Prentice-Hall. Limperg, T., 1932. The Social Responsibility Of The Auditor. [pdf] Limperg Institute. Available at: [Accessed 10 July 2014]. Reecce, D., 2011. Auditors Should Not Be Blamed For The Financial Crisis Any More Than MPs. [online] Available at: [Accessed 10 July 2014]. Romero, S., 2002. Worldcoms Collapse: The Overview; Worldcom Files For Bankruptcy; Largest U.S. Case. [online] Available at: < http://www.nytimes.com/2002/07/22/us/worldcom-s-collapse-the-overview-worldcom-files-for-bankruptcy-largest-us-case.html > [Accessed 10 July 2014]. Sarup, D., 2004. Watchdog or Bloodhound? The Push and Pull Toward a New Audit Model. [pdf] Information Systems Audit and Control Association. Available at: [Accessed 10 July 2014]. Teather, D., 2005. Ebbers Found Guilty Over $11bn Fraud At WorldCom. [online] Available at: [Accessed 10 July 2014]. The Economist Newspaper Limited, 2014. Accounting For Change. [online] Available at: < http://www.economist.com/node/1200748 > [Accessed 10 July 2014]. Todea, N. and Stanciu, I., 2009. Auditor Liability In Period Of Financial Crisis. [pdf] Annales Universitatis Apulensis Series Oeconomica. Available at: [Accessed 10 July 2014]. Tran, M., 2002. WorldCom Goes Bankrupt. [online] Available at: [Accessed 10 July 2014]. Yahoo! Inc., 2007. WorldCom Scandal: A Look Back at One of the Biggest Corporate Scandals in U.S. History. [online] Available at: < http://voices.yahoo.com/worldcom-scandal-look-back-one-biggest-225686.html > [Accessed 10 July 2014]. Read More