Lessons Learned From Litigation - Case Study Example

Lessons Learned From Litigation An audit refers to the topmost financial ment service offered to by accounting firms. Over the years, accounting firms have been entrapped in various litigations citing unprofessionalism and overstepping established auditing standards. Consequently, the public, including investors, has become skeptical about the accounting profession. In the wake of major accounting and audit firm failures including Enron and Andersen case, the urgency of reviewing audit standards have become evident.

Consequently, the AICPA swerved into action by amending various sections of the accounting standards as well as code that guide professionalism during audit work. In order to ensure that accounting firms operate within the established standards, the AICPA has also placed more responsibility on auditors and also increased accountability on part of the management for their decisions. With reference to cases in Michael c. Knapp’s Contemporary Auditing: Issues and Cases, second edition, this paper explore various changes made by AICPA in response to litigation facing four different firms.

Independent auditor’s overall objectives and responsibilities (AU 200): this section focuses on the goals of the independent auditor, emphasizing on the accountability of the auditor when performing financial statements audit under the guidance of GAAS. Paragraphs .17, .A22 - .A26, demand that auditors approach their work with professional skepticism. An auditor is expected to apply professional skepticism when planning and conducting a financial statements audit in order to establish circumstances likely to yield material misstatements in financial statements.

Further, AU-C 200, Paragraphs .18, .A27 - .A31 place responsibility on the auditor to use professional judgment when planning and auditing financial statements. In case 1.9: Gemstar-TV Guide International, Inc., there is manifestation of audit failure in relation to skepticism and professional judgment. The auditors of KPMG heavily relied on the representations by Gemstar management, even after establishing that the management representations disagree with their audit revelations. By relying on the management representations, KPMG auditors displayed failure to exercise professional skepticism in discharging their work.

KPMG auditors should have used professional skepticism and judgment to know that the management of Gemstar fraudulently reported material amounts relating to licensing and advertising revenue. The auditors of KPMG thus failed to apply relevant knowledge and experience in pursuant to [.A27] in Gemstar’s case. Gemstar litigation demonstrates that accounting firms should bear responsibility so that individual auditors can discharge duties according to expectations and in accordance with generally acceptable standards.

Due professional care (AU 230): AU 230.07 demands that auditors utilize professional skepticism when performing audit assignments. Professional skepticism reduces the reliance on management representations and thus increases the likelihood of early discovery of accounting fraud and irregularity in accounting practices. In case 1.8, ZZZZ Best Company Inc., the auditors and audit firms placed excess trust on the company. When ZZZ Best went public, it sought for the services of an independent auditor, George Greenspan.

Minkow, the founder established a fake insurance company, with Padgett attaining the highest position in the fictitious insurance firm so that the independent auditor, Greenspan did not discover the fraud. Minkow relieved Greenspan of his duties and retained the services of Ernst & Whinney to boost his operations trustworthiness on restoration contracts. Ernst & Whinney agreed to provide three basic services to the company including: review of the company’s financial statements for the last three months, offering guidance on preparation of SEC required statements and writing a comfort letter to underwriters and implementation of full audit.

However, before the audit firm could implement a full scope audit, it resigned from offering its services to the company. Ernst & Whinney resign amidst manifold fraud that was deeply imbedded in the company’s restoration contracts. The House subcommittee scrutinized how the company generated over 80 percent of fictitious revenue. Instead of resigning before launching a full scope audit, Ernst & Whinney should have done better. The auditing firm should have performed better audit and alert relevant officials of potential fraud in the company.

Ernst & Whinney resigned from its role without raising any red flag over the fraudulent practices of ZZZZ Best. Professional care relates to how well an independent auditor executes his or her duties. In the case, Greenspan failed to employ professional skepticism in his tenure as the auditor of the firm to uncover the widespread fraud in the company’s financial statements. Further, Ernst & Whinney failed to employ professional care to uncover all the fraudulent dealings of ZZZZ Best. If adequate professional skepticism and professional care were applied during audit processes, the company’s fraudulent engagements would have been uncovered earlier.

Consideration of Fraud in a financial statement Audit (AU 240): AU 240 [.42] states that an auditor needs to establish his or her responsibility of reporting potential of occurrence of fraud to parties external to the company. The legal responsibilities of an auditor may supersede his or her duty of confidentiality to the client. As such Sherron was right in delving deeper in Enron’s fraud case. The legal responsibilities of Sherron prevail over the duty of confidentiality to Enron. Consequently, Sherron would not have violated confidentiality agreement by bringing the company’s fraudulent practices to light through informing regulatory authorities.

AU-C 240: Fraudulent Financial Reporting enlists incentives or Pressures, opportunities, and attitudes/Rationalizations as some of the most common red flags of fraud in companies. In the case of Enron, it was difficult to explain the company’s cash flow, insider trading on the company’s stock, incentives, evasiveness on questions raised about financial statements, unusual swift growth, overly optimistic company news releases and failure to enforce conduct code of the company. Communicating internal control issues (AU 265): In relation to AU-C 265, an auditor is expected to appropriately communicate to relevant internal control management personnel the identified shortcomings in a company’s internal control that according to the professional judgment of the auditor deserves attention and urgent action.

AU-C 265[.A28] requires an auditor to develop good understanding of the company and its operation environment. In Crazy Eddie’s case, the auditors overlooked the internal controls of the company. The entire management team of the company was constituted of one family. This was a red flag of fraud perpetuation in the company. Close family ties would be a reason enough to conceal fraud or material misstatements in the company’s financial statements. The culture of the company was attuned to fraud with the management reporting false taxable income to reduce tax liability of the company.

As such, the auditors in Crazy Eddie’s case should have done better by thoroughly investigating the internal controls of the company to identify and make recommendations about potential weakness in the internal control that merits attention. Earlier detection of shortcomings in the company’s internal control would have ensured early discovery and purging of the fraud.