The Responsibility of the Auditor for Fraud and Error - Lab Report Example

The Responsibility of the Auditor for Fraud and Error Introduction Fraud is an area that is highly controversial and none more so than when fraud is committed on financial statements. The past financial statement fraud cases in big companies, the more recent ones and their resulting effects have caused this concern to be highlighted even more. With these high – profile fraud cases, the role that the external auditors play in detecting and, even, preventing these fraudulent activities are, most oftentimes than not, also highlighted and criticized. But this begs the question, just what is the role or responsibility of the auditor for fraud and error? This paper discusses the auditor’s responsibility for fraud and error. It studies the link of the objectives of external audit to this responsibility. It draws on relevant auditing standards that provide guidance on the responsibility of the auditor for fraud and error in the financial statements. It also discusses the responsibilities of the business entities’ board of directors and management. Lastly, it provides some discussions on the more high – profiled fraud cases in the past and the effect on the auditing profession of these high – profiled cases. Definition of Fraud and Error The Glossary to the International Standards on Auditing or ISA (p. 19, IFAC, 2010) officially defines fraud as “an intentional act”, committed by a certain individual or certain individuals by using deception “to obtain an unjust or illegal advantage” that inevitably leads to the misstatement of the financial statements. Error, on the other hand, is defined as an “unintentional misstatement in financial statements” which may include omitting a certain amount or a certain disclosure (p. 18, IFAC, 2010). Both fraud and error may lead to financial statements misstatements. Both of them may lead to restatements misstated financial statements. However, what sets the two apart is whether the financial statements misstatement is deliberate or not, with fraud considered more serious (and illegal) than error. Financial statements fraud is done due to a variety of reasons. Some of the reasons may include trying to obtain new credit or more investments; “creating favorable stock value”; trying to conceal inability to improve performance of the company; increasing management or the board compensation by showing higher earnings; “obtaining a promotion…within the company” and “hiding improper business transactions” (p. 58, Rezaee and Riley, 2010). Clearly there are a lot of underlying reasons why fraud is committed by those in a position to commit them. Management’s Responsibility for Fraud and Error The main responsibility for fraud and error prevention and detection lies squarely with the business entity’s management and those who are “charged with the governance” of the business entity (p. 278, Hendriske and Hendriske, 2004). They have the authority and the responsibility to ensure the orderly conduct of the company’s business. This includes “implementing and ensuring the continued operation of accounting and internal control systems which are designed to prevent and detect fraud and error” (p. 169, Kwok, 2005). Judgments on financial statements fraud cases have cemented the notion of who is responsible for fraud prevention and detection. One such case is HealthSouth Corporation (Weld, Bergevin and Magrath, 2004). In this case, the Chief Executive Officer (CEO), as well as finance and accounting executives, were charged with accounting fraud for overstating the company’s earnings. Another such case is Parmalat, a food conglomerate based in Italy. In December 2008, the founder and former chairman and CEO of the company was sentenced to ten (10) years of imprisonment for fraudulent activities (BBC News, 2008). The Auditor’s Responsibility for Fraud and Error ISA 240 The auditor’s responsibility for fraud is clearly stated out in ISA 240 (p. 155, IFAC, 2010), the primary set of auditing standards that set down the guidelines for the auditor’s responsibilities related to financial statement fraud. Paragraph 5 of ISA 240 (p. 158, IFAC, 2010) recognizes the fact that, due to “inherent limitations of an audit”, there is the risk that some misstatements will not be detected. Par. 8 of ISA 240 (p. 158, IFAC, 2010), however, requires the external auditor to maintain his professional skepticism at all times and to always consider the possibility of a misstatement of the financial statements due to fraud. ISA 240 also lays down how the auditors can go about planning for procedures that are designed to detect fraud, designing and performing procedures that are more responsive to fraud detection (particularly management override), obtaining written representations from management, documenting the results of such procedures and evaluating the results of the audit procedures. ISA 240 also outlines what the external auditors should do if fraud has been identified through the audit procedures performed such as reporting the discovery to management and to the board of directors, communicating with regulatory agencies and even withdrawal from the audit engagement. Needless to say, the company and its management are required to restate the balances affected by the fraudulent activities before the external auditor can issue a clean opinion on these balances. The Kingston Cotton Mill Co. Case of 1895 Perhaps no fraud case is more supportive of the above auditor responsibility than the Kingston Cotton Mill Co. Case of 1895. This case was a very controversial one and is considered a “basic authority for the reasonable limitations upon the responsibility of the auditor” as far as failure to uncover irregularities during an audit (p. 18, Levy, 1980). In this case, the presiding justice (Lord Justice Lopez) stated that an auditor is a “watchdog, but not a bloodhound”, that they should not be held liable for unearthing “ingenious and carefully laid schemes of fraud when there is nothing to arouse their suspicion” and that expecting the same would make the auditor’s position “intolerable” (as quoted by Sarup, 2004). This landmark case emphasized that the auditor is not actually responsible for tracking and unearthing fraudulent activities. The Expectations’ Gap Clearly from the contents of ISA 240 and the Cotton Mill Co. case, the responsibility of the auditor for fraud and error is limited. As long as the auditor exercises professional skepticism and complies with the relevant provisions of the auditing standards on financial statements fraud, the auditor is already assumed to exercise due diligence in his work, despite the fact that no fraudulent activities (even if there is one) were uncovered. With this and judging from the backlash received by the auditing profession whenever a new fraud case comes up, there seems to be an “expectations gap” or a difference between what the public expects should be the role of the external auditors and what the external auditors perceive as their duties and responsibilities (Ojo, 2006). Various ways to bridge this gap have been recommended. T. Sale (2001) in his book Advances in International Accounting, Volume 4, describes two ways to bridge the gap. One such way is through the improvement of communication through expanded reports. Another is through improvement of auditor performance through improvements of the auditing standards and through “quality assurance programs” (p. 183, Sale, 2001). Whether these measures will become effective in bridging this gap is still something to be seen. The Auditors in Fraud Cases Enron, WorldCom and Arthur Andersen Despite the presence of auditing standards and the results of the case as described in the previous page, the external auditors and their responsibilities have been spotlighted time and again during times when fraud cases have been discovered. Perhaps the most high – profiled of all these fraud cases are the Enron and the WorldCom cases. Enron was recognized as one of the most innovative company in the U. S. (p. 308, Fox, 2003). It was trading on a high in the stock market, was experiencing increasing earnings and a robust balance sheet and was courted by everybody, politicians and private personalities alike. However, the bauble burst. When Enron filed for bankruptcy in 2001, it was then touted as “the largest bankruptcy in U. S. history at that time” (p. 286, Fox, 2003). Enron’s bankruptcy may have been recognized as the largest in its time but this was soon overshadowed by the bankruptcy filing of WorldCom, another financial statements fraud case. At the time of its bankruptcy filing, WorldCom listed assets worth more than $100 billion (p. 286, Fox, 2003). Its reported accounting fraud amounted to more than $11 billion. Its fraudulent activities include capitalization of expenses, reduction of expenses through release of accruals and overstatement of earnings through questionable entries (Scharf, 2005). What do the two cases above have in common? They both involved fraudulent activities that caused the misstatements of their financial statements. They both declared bankruptcies and caused the destruction of large conglomerates that used to be highly – respected. They both resulted to the cessation of the business of the one of the largest accounting firm during that time: Arthur Andersen (AA). In Enron’s case, AA was accused and convicted of “the crime of obstructing justice by shredding working papers related to Enron audits” (Cunningham and Harris, 2006). In the case of WorldCom, AA was involved in legal battles with WorldCom’s investors. In 2005, AA agreed to finally settle with the investors, thereby ending the civil battle brought out by the fall of WorldCom (Taub, 2006). Lastly, these cases resulted in the promulgation and the implementation of the Sarbanes – Oxley Act of 2002. Sarbanes – Oxley Act of 2002 The Sarbanes – Oxley Act of 2002 (the Act) was signed into law on July 30, 2002 (p. 133, Fletcher and Plette, 2008). The Act affected not only the companies implementing its provisions but also the accounting world. Among others, the Act implemented restrictions on accounting firms in terms of the other services they can perform for audit clients (p. 133, Fletcher and Plette, 2008). It also requires public companies and their officers and directors to make new disclosures (p. 133, Fletcher and Plette, 2008). With its passing, regulators and the public alike are hoping that fraud cases such as Enron and WorldCom will become a thing of the past. Professional Indemnity Insurance Another offshoot resulting from the clamor to improve the accounting or auditing profession is the requirement by certain regulators that practicing auditors need to secure professional indemnity insurance policies before they can get a license to practice auditing (p. 136, Sherer and Turley, 1997). In fact, a guidance provided by The Institute of Chartered Accountants in England and Wales (ICAEW) in 2008 lays down the requirements, including the amount of coverage, for obtaining a professional indemnity insurance if one wants to have a public practice in the United Kingdom or in Ireland. Such a requirement was put into place to ensure that the auditors are able to indemnify their clients for mistakes that they made without necessarily crippling themselves or going out of business. Conclusion In summary, the primary responsibility for detecting and preventing fraud actually lies with management and the board of directors of the entities. This, however, does not take away the fact that the external auditors who sign off on the financial statements of the entities also have responsibilities for fraud and error. As shown by various fraud cases in the past, these fraud cases do not only damage the concerned company, they also caused severe damages to the auditing profession. Various auditing standards, in particular ISA 240, have laid down the requirements for planning and performing procedures related to fraud detection, as well as how the auditors should go about reporting their findings if fraud is detected. The provisions in the standards do not provide 100% assurance that fraud will be detected but if followed faithfully, the public will be assured that the auditors have done all they can to detect fraud. In addition, new regulations, such as the Sarbanes Oxley 2002, had been signed and implemented for the purpose of preventing such cases from occurring again. Whether such regulations are highly effective still remains to be seen but it is hoped that, through them, future fraud cases will be reduced to the minimum. References Cunningham, G. and Harris, J. (2006). Enron and Arthur Andersen: The Case of the Crooked E and the Fallen A. Global Perspectives on Accounting Education. Volume 3, 2006, 27 – 48. 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Available at: http://www.nysscpa.org/cpajournal/2004/1004/essentials/p44.htm (Accessed: May 5, 2010). Read More