Audit and Assurance: Accounting Fraud Cases - Essay Example

Audit and Assurance Audit and Assurance The blame game which initiated after a series of accounting fraud erupting through the surface of the US corporate sector lead to many arguments and suggestions regarding who should be blamed for such misfortune which caused billions of shareholders’ dollars wiped off from the US capital markets. There was a vacuum of trust and confidence in the capital markets and everyone started to point fingers at the regulators and those who were associated with the profession of auditing. Some also argued that inherent loop holes that existed in the US GAAP principles and standards allowed the management of corporations to manipulate their accounts easily and according to their own desires leaving behind misery for shareholders and a whole lot of mess for the regulators and the government to manage. This discussion paper will examine the arguments targeting the auditing profession that blamed auditors for not performing their responsibilities and for not doing enough to detect and prevent these cases of fraudulent activities of major corporations in the US. This discussion is supported by presenting details of five important accounting fraud cases which made the headlines and in some cases where auditors were also involved in assisting management in their malpractices. The auditors’ role is primarily viewed as that of verification of financial statements prepared by businesses. However, traditional view of it remained that auditors are responsible for detecting and preventing accounting frauds. The transition from this view to that of independent verification of financial statements was led by emergence of huge conglomerates where shareholdings are dispersed and the concentration of auditors’ investigation is not on the management’s honesty in preparing their accounts (Singh 2003). ISA 200 provides details of overall responsibilities of independent auditor and sets out the scope and nature of audit activities to be performed in accordance with international auditing standards. It states that the auditors’ role is to increase the confidence of users of financial statements by making a presentation on all material aspects of information disclosed in financial statements. However, it emphasizes that auditors do not relieve management from their role in corporate governance and ensuring the correctness of information provided in financial statement. The auditors are required to provide reasonable or high assurance regarding that financial statements are free from material misstatement. However, it is not in anyways an absolute assurance as their inherent limitations and some issues confronted by auditors require professional judgments and scepticisms by auditors where evidence provided to them unsatisfactory (IAASB 2009). This situation therefore relieves some pressure as auditors cannot be held completely responsible for not detecting fraud or omissions. Argument against this could be suggested as auditors are not relieved from their role of mitigating audit risk. Audit risk is the function that is derived from material misstatements and omissions being undetected by auditors which is mainly due to misunderstanding, misconceptions and poorly designed audit tests. It is the responsibility of auditors to reduce the level of audit risk to minimum and therefore they could be held accountable for not performing their duties accordingly (Gray and Manson 2007). The outcome of activities performed by auditors to form an opinion on financial statements affects the attitude of shareholders towards a particular company. If auditors do not perform these activities a sense of ethical commitment to the shareholders then the blame for an accounting fraud is surely going to be shared between the management and the auditors. ISA 240 underlines auditors’ responsibilities for detection of fraud in the financial statements. Fraud could be in the form of misappropriation of assets, earnings management, fictitious transactions, concealing of vital information etc and is typically expected from those who are responsible for corporate governance and the management of business. In extension of ISA 200 auditors are required to ensure lower levels of audit risk to minimum by addressing issues which could result in material misstatement in financial statements due to fraud. At all times professional scepticism is required to ensure that auditors can detect areas which have higher risks of fraud. The standard thus attempts to lay out greater responsibility upon auditors to carry out their audit activities in a way that the management of businesses is not able to exert influence and change the course of audit procedures aimed curtailing fraud possibilities (ACCA 2009). Deception is crucial essence for differentiating between error and fraud implying that where errors could be ascertained to be formulated through deception then it is considered as fraud. However this standard has its inherent limitations in the form of ISA200 which clearly suggests the limitations of auditor’s role in any audit engagement (IAASB 2006). The objectivity, integrity and independence of auditors are deemed crucial for determining the extent of blame for accounting manipulation to be placed on the auditors (Ojo 2009). Integrity suggests that auditors need to be committed to the public interest by maintaining a level of professionalism. Objectivity claims that auditors need to perform their duties without biasness and impartial consideration. Finally independence which is arguably most crucial and difficult to define could be viewed as auditors performing their duties without any influence from the management of the company they are engaged with (Ojo 2009). In order to understand these ethical concepts of audit profession and how conditions and situations determine their achievability the following sections of this paper will present five different cases of accounting fraud and involvement of auditors in these cases leading to audit firms’ prosecution. Perhaps the biggest and most notorious accounting scandal was that of Enron which was unveiled in 2001. The magnitude of this accounting fraud reached into billions of dollars as the company was investigated for inflating its profits and hiding its enormous obligations. The company was the largest energy supplier and communication vendor before its fraudulent activities surfaced involving fictitious off shore companies and use of creative accounting to hide operating losses which ran into billions and presented a healthier and growing trend of the company. This particular case of Enron involved a Big 5 accounting firm – Arthur Andersen resulted in claim of US$100 billion from the audit firm’s directors and later its accounting and auditing licenses were revoked by the SEC. This scandal that completely distorted the image of accounting and auditing profession suggested great weaknesses in the audit engagements where the audit firm - Arthur Andersen was engaged by Enron not only to provide audit services but also was rendering management consultancy services to it. Its ex-partners were amongst board of directors of Enron which truly violated the essence of independence and integrity of auditors. This overshadowed auditor’s responsibilities to identify and prevent accounting manipulation that appeared on financial statements. The audit firm was blamed for too much involvement in the client’s business and later on the audit firm was also alleged for obstructing evidence collection by prosecutors by destroying all audit documents. The audit firm finally shut down its operations and was restricted from working for its existing clients (Thomas 2002). Even banks like Citigroup and Chase were accused of knowing about creative accounting practices followed by the company but continued their financing activities and earned millions of dollars in commission. The banks overlooked the company high leverage position and failure to estimate its solvency problems led to heavy credit offerings which led to litigation against these banks as well (Iwata 2002). In this prime example it is clear that accounting fraud is not possible without the involvement of all parties who have vested interests in each other’s businesses. Another case of using the old trick in the book for manipulating accounts was that of WorldCom defying expectations regarding the role of auditors. The cash flows were overstated by $3.9 billion in 2001 and first quarter of 2002 by transferring ordinary expenses into capital expenditure on cash flow statement. In this way the company instead of reporting a loss of $1.5 billion reported a net profit in 2001 and first quarter of 2002. The company’s CFO and Controller were fired for their alleged role in accounting fraud. The audit firm Arthur Andersen once again came under public scrutiny as it audited company’s financial statements for the year 2001 and 2002 (Backover, Valdmanis, Krantz and Kessler 2002). The auditors were blamed for not verifying company’s treatment of merger reserves or line costs. Furthermore, the records of the company were not thoroughly investigated and too much reliance on the management confirmations caused major flaws in audit work. During litigation the senior management of the company admitted that they had concealed information regarding its international operations from the audit firm (Hecht 2003). Thus, in this case weaknesses in the audit procedures are held responsible for letting the accounting manipulation go undetected and ethical issues were ignored by them. However, auditors cannot solely be held responsible for this as it is the senior management which had deliberately uninformed auditors about the working of the company. In comparison to fraud cases of major corporations there are other cases which made the headlines and are considered worth describing in this paper. The first case of this kind appeared amid of the current banking crisis in the UK. This case involved William Thorpe who was the Chairman of Apex Bank in Ireland. He was involved in borrowing money within prescribed limits from organizations to be invested in projects through banking system. However, loans from the bank to him exceeded the allowed limits which were not disclosed by the bank. These loans were refinanced through connections with another bank. The cover up of these loans was in the form of the timing of disclosure of these loans by both banks as they had different ending dates for their accounting periods and arranged for imbursements and settlements between these dates to avoid disclosure in their financial statements. The audit implications were obvious for this case as the company’s that both internal and external auditors of the company did not align their work and weaknesses in internal audit function and covering up of the issue by the company’s audit committee did not let the external auditors detect the fraudulent activities of the bank’s CEO. As the government appointed external auditors to investigate the matter it was clear that bank’s management including CEO, CFO and risk analyst did not do anything which would be considered as good corporate governance and transactions which should have been pointed out by anyone in the company did not happen. This raises concerns about the role of auditors in the company who blindly gave opinion on bank’s loans without carrying out appropriate investigative procedures. However, auditors are not the only to be blamed for this mischief as regulators of banking sector also admitted that they had an idea of such loans to the bank’s director however they did not take actions on time (McNeal 2009). Thus, this case is an example where all three stakeholders were at mistake at one point or another and not just auditors to be blamed for it. Yet another case of accounting manipulation and fraud that further damaged the reputation of auditing profession was that of Tyco a major security systems supplying company in the US. The top management of the company including CEO, CFO and Chief Legal Officer had taken loans from the company without approvals from the compensation committee. Furthermore, seven million shares worth $430 million were sold without notifying shareholders (LawyerShop 2008). In addition to these the top management of the company made huge withdrawals from the company for their personal use and purchase of assets for which they were indicted and fined and jailed (Associated Press 2005). The company’s shareholders blamed audit firm Price Waterhouse Coopers (PwC) for not uncovering huge fund misappropriation and overstatement of income by $5.8 billion. The audit firm paid $225 million as damages to shareholders and avoided further investigation into their dealing with Tyco (Johnson 2007). Another example of accounting fraud that emerged well before the era of accounting collapse in the early 2000 was that of ZZZZ Best. Barlow Minkow, owner of the company, was the mastermind behind of what could be considered as the prime example of credit card and insurance claims fraud and eventually a stock market bubble burst. Minkow started a small carpet cleaning in 1982 and sooner he added insurance restoration services to his business. Along with his counterpart he was able to claim insurances for sites which never existed. He prepared fraudulent financial statements to borrow money from banks and investments from rich investors who were seeking higher returns from projects Minkow offered to them. His carpet cleaning company did generate sufficient cash for expansion and therefore he took the company to go public in 1986 and was able to raise its company’s market value exceeding $200 million within few months. The major income of the company remained those from illegal insurance claims. The company eventually collapsed in 1987 with millions of reported losses by shareholders. The audit implication could be pointed out as the company’s earlier auditor Mr. Greenspan, who did point out income from insurance restoration projects, did restrict investigation to the written confirmation from insurance brokerage company which was under control of Minkow’s friend who was also partner in fraud. However, he did not visited sites where restoration work was claimed to be taking place and was later replaced by one of the Big Five accounting firms Ernst and Whiney. Mr. Greenspan did not inform the incoming auditor about the suspected manipulation by Minkow and his friend which left a communication gap between auditors. The new auditors insisted on visiting restoration sites however Minkow deliberately refused it. It was revealed that 90% of the company’s profits are from insurance restoration projects which were not justified in the evidence collected. Minkow in order to subdue raising concerns by the auditors took them to a site in Sacramento which was actually a building available for rent and Minkow took the keys from the agent and has put up sign boards that restoration work to hide his fraud. The audit firm eventually resigned and the company was collapsed in 1987 and Minkow prosecuted and jailed for 25 years (Knapp 2008). There is still a major misunderstanding between managers, shareholders, regulators and auditors about the current role of auditors and what it should be amid of the current financial crisis. Like previous accounting profession meltdowns the current economic crisis prevailing in major economies of the world is raising doubts about the ability of businesses to stay profitable and the likelihood of accounting manipulation is on the rise. There persists an expectation gap between the understandings of the role of auditors amongst different stakeholders. In this regard it has been suggested by regulators that auditors cannot be solely blamed for the financial crisis as this responsibility is shared by internal audit committees, management and accountants. The role of auditor is providing assurance about the true and fair view of financial statements and not predicting the future of the business (ACCA 2009). However, the redrafted ISA 240 clearly sets out the role of auditors that seems to be shifting from that of a watch dog to a bloodhound and greater emphasizes on sensing any accounting mistreatment and indicating the possible frauds by the management or employees of companies. List of References ACCA. (2009, March). ISA 240 (Redrafted) Auditors and Fraud. Student Accountant, pp. 50-52. ACCA. (2009). The Future of Audit after the Financial Crisis. [online] Available from Association of Certified Chartered Accountants: [accessed on November 20, 2009] Associated Press. (2005, September 20). Ex-Tyco executives get up to 25 years in prison. [online] Available from MSNBC: [accessed on November 20, 2009] Backover, A., Valdmanis, T., Krantz, M. and Kessler, M. (2002, July 26). WorldCom finds accounting fraud. USA Today, p. 7. Gray, I. and Manson, S. (2007). The audit process: principles, practice and cases. New York: Cengage Learning EMEA. Hecht, C. (2003, August). SEC Central Who Is Responsible? [online] Available from Smart Pros: [accessed on November 20, 2009] IAASB. (2006). IAS 240 The Auditors Responsibility to Consider Fraud in an Audit of Financial Statements. New York: The International Auditing and Assurance Standards Board. IAASB. (April 2009). Overall Objectives of the Independent Auditor. New York: International Federation of Accountants. Iwata, E. (2002, July 22). Banks face accusations in Enron Case. USA TODAY, p. 5. Johnson, S. (2007, July 6). PwC Settles Tyco Case for $225M. [online] Available from CFO: [accessed on November 20, 2009] Knapp, M. C. (2008). Contemporary Auditing: Real Issues & Cases. Mason: South-Western Cengage Learning. LawyerShop. (2008). Tyco Fraud. [online] Available from LawyerShop: [accessed on November 20, 2009] McNeal, A. (Ed.). (2009). Unethical deeds or outright fraud? (Cengage Learning) [online] Available from The Free Library by Farlex: [accessed on November 20, 2009] Ojo, M. (May 19, 2009). The Role of External Auditors and International Accounting Bodies in Financial Regulation and Supervision. Berlin: Centre for European Law and Politics. Singh, D. (2003). The Role of Third Parties in Banking Regulation and Supervision. Journal of International Banking Regulation, 4 (3), 8. Thomas, C. B. (2002, June 18). Called to Account. [online] Available from TIME: [accessed on November 20, 2009] Read More