The Value of an Audit - Case Study Example

Introduction: Recent financial crisis and developments have highlighted and depicted the need of providing reliable financial reports. Take for example, in 2001, with the fall of Enron Company. Due to poor auditing practices, the company was able to cease its operations, leading to bankruptcy. Enron, an energy company was formed in the year 1985, and its Chief Executive, Jeffey Skilling used accounting loopholes for purposes of preparing inaccurate financial records. These loopholes were able to make the company to hide billions of dollars of failed projects and deals. The auditors of the firm, Arthur Andersen were unable to detect these discrepancies, and they failed to report them. This situation led to the failure of the companies, and loss of billions of dollars, of shareholders money. Elliot and Elliott (2008) explain that reliable and effective auditing can be used to prevent the collapse of a company. Had the auditors of Enron identified these discrepancies, the board of directors of the company would have developed strategies aimed at preventing the fall of the company, and preserving the shareholders money (Mathuva, 2012). The major goal of an audit report is to test if the policies procedures and practices of a company are reliable. The regulations of the government normally require that financial institutions should pass through an independent financial audit. However, the standards of the industry have an impact in regulating the manner in which auditing is carried out in areas such as technology and safety. Needles and Powers (2004) explain that regardless of the auditing subject, there are various factors that have an impact on the final results of a company. One of the theories that explain the existence of these factors, during the auditing process is the contingency theory. This paper explains the value of an audit, and assurance service to an organization. In meeting its objectives, this paper uses the following theoretical frameworks to explain the role of auditing in an organization; Contingency Theory Agency Theory Police Man Theory Theory of inspired confidence Lending Credibility Theory. Theories of Auditing and Role of Auditing: Contingency Theory: The contingency theory denotes that no standard exists, which can be used to manage, control, and lead an organization. According to this theoretical framework, the functions of an organization depend on a variety of factors, and this includes internal and external factors. It is because of these internal and external factors that auditors need to apply the contingency theory in this process. According to this theoretical framework, the auditing process is task oriented, and it is loosely structured (Elliot and Elliott, 2008). Furthermore, this theory denotes that the functions of the auditing process vary to a great extent. This depends on the business model of a company, and the industry which the company operates in. This would force auditors to have an effective plan on how to manage their inspections, and consider other variables while undertaking their duties. This theoretical framework is useful in the auditing process because it helps in the identification and use of experienced auditors to carry out the auditing process (Holtzman, 2008). Contingency theory enables auditors to investigate virtually all operations of a given company. This is because it breaks down the various units of the company, into smaller units for purposes of study. This helps an auditor to identify the various areas where the company is inefficient in meeting its own objectives. The quality of the reports produced through the use of contingency theory is high. This is because the auditors responsible for performing the auditing process are experienced; hence they have the necessary skill and capability of conducting the auditing process. Furthermore, under the contingency theory, auditors will only audit an institution or unit that they have the experience and knowledge about (Elliot and Elliott, 2008). For instance, an auditing professional, with an experience in the evaluation of financial instruments will be assigned to audit hedge funds, or financial institutions. Through this action, they will manage to give accurate information concerning the capabilities of the financial institution (Billings, 2011). This can be used by the government when approving the financial activities of the company, and shareholders to determine the net worth of the business organization. Needles and Powers (2004) explains that inability for auditors to examine smaller units of the operations of a company may result to inefficiency in financial reporting. This is because the auditor may provide inaccurate information regarding the financial position of the company. Elliot and Elliott (2008) therefore explains that under the contingency theory, experts emphasize on accurate reporting of the operations of the company. This is the only sure way of ensuring that the value and properties of the company are protected. Agency Theory According to this theoretical framework, an auditor exists because of the need of protecting the interests of the management and other third parties. This theory views a company as a web of contacts, and several groups within and outside the company make a contribution towards the well being of the company. These groups include bankers, employees, suppliers, customers, etc. Furthermore, the role of the management of an organization is to coordinate these groups, for the benefit of the company. Based on these facts, the agency theory is used to explain the role of auditors within an organization. Harrison and Horngren (2001) explains that according to the principles of agency theory, the auditing process is aimed at finding a solution to the problems that exists between the different stakeholders of the business organization. For example, the auditing process can be used to reconcile the difference that exists between the suppliers of the organization, and the purchasing department of the organization. Through accurate and reliable reporting, auditors would manage to give accurate details of the capability of a business organization, leading to efficiency in the manner in which stakeholders of a business organization conduct their operations or business. For example, a banking organization will rely on the audited reports to make a decision on whether to give a loan to the organization or not. Suppliers can also rely on the audited reports, to make a decision on whether to advance credit to the organization or not. Therefore, Elliot and Elliott (2008) explain that the agency theory justifies the use of auditing based on these concepts. Police Man Theory According to this theoretical framework, it is the responsibility of the auditing process to prevent, discover, and search for fraud. During the beginning of the 20th century, auditors were regarded as financial policemen, and they had the responsibility of looking for any information that would compromise the company. Elliot and Elliott (2008) therefore explain that an auditor was responsible for preventing fraud from happening within an organization. This concept of fraud prevention is still practiced today. In the current world, the main objective of an auditing process is not to prevent fraud. The auditing process is used to help managers on how to come up with a better and more efficient method of managing their organizations (Agyei-Mensah, 2013). Prevention and detection of crime is just amongst the many roles of the auditing process. Take for instance the collapse of Enron Company. This company collapsed because the auditors failed to provide accurate information regarding the debts the company had, and the failed projects the company experienced. This is because the auditors were focused on how to come up with policies that could help the organization to achieve efficiency in the manner in which it conducts its operations. However, it is this failure of Arthur Andersen, to identify the fraudulent activities at Enron, which led to its collapse. Arthur Andersen was the auditor of the company, and its failure to effectively audit the financial activities of Enron, led to its dissolution. Harrison and Horngren (2001) explain that the detection of fraud is a controversial topic in the current auditing process or world. However, with incidences where fraud has been detected, there is pressure from auditing stakeholders to increase the responsibility of an auditor to detecting fraudulent activities within an organization (Guerard and Schwartz, 2007). Theory of Inspired Confidence: This theoretical framework is similar to the contingency theory of auditing. Under this theory, the auditing service occurs because of the demand by the third parties of the organization. This includes all the stakeholders of an organization (Greuning, 2006). These stakeholders are bankers, suppliers, employees, shareholders, etc. Provision of the auditing service by a third party, who is independent, would inspire confidence in the operations of the business organization. Furthermore, these third parties normally require the company to be accountable in all its activities, before making any investment. Based on these facts, the reports that emanate from the auditing process are used for purposes of inspiring confidence to the stakeholders of the company Tasios and Bekiaris, 2012). For example, when a prospective investor seeks to invest in the shares of the company, then he or she would look for the financial records or reporting of the organization (Greuning, 2006). Accountability is normally realized through the production of periodical financial reports. However, if the management provides this information, it may be biased. Therefore, an independent auditor has to be hired, for purposes of providing these periodic reports to inspire the confidence of all the stakeholders of the organization (Siegel, 2003). Lending Credibility Theory: According to this theoretical framework, the main and primary function of an auditing process is to add some credibility to the financial records and statements provided by an organization. Based on this theoretical framework, the service that an auditor is able to sale to its customers is credibility (Greuning, 2006). The financial statements that are audited have the capability of increasing the confidence of its users. There is a perception that these users will gain from the credibility of these information. This is by making wise investment decisions that can help them get some returns for their investments. Kimmel and Weygandt (2007) explains that this theory recognizes the role of an auditor as a person who is tasked with the responsibility of providing credible information that can be used for purposes of making decisions, either by the government, investors, banking institutions, or even shareholders. Hypotheses on the Role of Auditing: There are three major hypotheses that are related to these theoretical frameworks, and they explain the role of auditors. These hypotheses are, information, monitoring, and insurance hypotheses. Under the monitoring hypotheses, an agent agrees to be monitored by the principle, if he or she possesses the information whose benefits would exceed the costs incurred in hiring the services under consideration. Kimmel and Weygandt (2007) explain that the monitoring theory aims at solving problems which arise because of information asymmetry and moral hazards. Moral hazard refers to a situation whereby an agent has superior information and he or she can use it, for purposes of serving their own self interest. This is at the expense of the principal. Public disclosures are also a method of placing a control on the monitoring hypothesis. This is because they help in restricting the concept of superior information advantage that an agent has over their principal. Harrison and Horngren (2001) explain that the managers and employees of an organization cannot be trusted to safely keep any sensitive information of the organization. It is based on these facts that an independent auditor comes in. Auditing is therefore viewed as a process of controlling this concept of the monitoring hypotheses (Tasios and Bekiaris, 2012). This is because it reduces the chances of an agent to withhold sensitive financial information to the shareholders of a company or an organization (Yilmaz and Ünveren, 2011). Take an example of Enron. The managers of this company were able to withhold sensitive information to its shareholders by use of complex accounting standards or principles. If there was an independent audit, then chances are high that auditors would have discovered these activities, and provided accurate information to the shareholders of the company. Kimmel and Weygandt (2007) therefore explains that an auditing process helps in monitoring the activities of the managers of an organization, to ensure that they do not withhold any information to the owners or shareholders of the company. During the 20th century, auditing was seen as a method of controlling and monitoring an organization (Kaliski, 2001). However, this role began to change in the 1960s, with the need of accurate and reliable financial information from the auditors. This information was to help the stakeholders of an organization to come up with reliable economic and financial decisions. Harrison and Horngren (2001) therefore explains that information hypotheses emerged because of the need of complementing the monitoring hypotheses of auditing. Kimmel and Weygandt (2007) explains that according to the information hypotheses, the demand of audited financial records or statements is based on the fact that they are useful to the investors, who need to make investment decisions. Investors normally make investment decisions by analyzing the cash flow of the company (Tripathi, 2008). These cash flows are always co-related with financial reports. Based on these facts, investors value an audit report because it helps in improving the quality of financial reports that an organization provides or has (Miller and Bahnson, 2002). Some of the information that emanates from the monitoring process are also useful in the information hypotheses. However, the difference is that under the monitoring purpose, an auditor is contracted to provide financial reports to shareholders. Under the information purposes, financial reports are needed by investors for purposes of determining the market value of the company. This would help in making a rational investment decision. Harrison and Horngren (2001) explains that there are three major benefits of financial reports or information. These benefits are, improving the decision making process, reducing the levels of risk, and earning the trading profits. Auditing has a direct relation with all these three benefits, because it provides reports or information that investors use for the mentioned benefits. Audited reports are not only useful to investors, but also to the managers of the organization. This is because an auditor will correct errors on the financial statements and records of an organization. This would make the employees of an organization to be cautious when making financial reports or statements (Siegel, 2003). As an insurance hypothesis, the management of an organization would shift their liability in provision of accurate financial data to the auditor. An auditor is required to provide accurate information, regarding the financial position of a company (Govindaraj, 2011). Failure to do this, the auditor will be liable for negligence. Conclusion: Based on these discussions, it is necessary to conclude that the values of auding and assurance services are important to businesses. For example, auditing helps in rectifying errors and fraud. Managers of business organizations would strive to protect their businesses from fraud, and this is through preparation of good financial reports and statements. Furthermore, a business organization will have the opportunity of acting upon the financial reports and statements for purposes of improving their operations. This is because the statements would identify loopholes, and it is up to the directors of the company to initiate policies that would help in closing these financial loopholes. Furthermore, accurate and reliable financial reporting would help a business organization attract capital. This is because investors would seek to invest in the business organization under consideration. It is also useful to businesses, because it would guide them on the amount of taxes they should pay, and areas where they qualify for tax exemptions. Bibliography: Kimmel, P., & Weygandt, J. (2007). 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