Auditing is the conduction of anexamination of several events to verify that those events are being managed anddocumented in agreement with established guidelines, policies and procedures.
The auditing profession initially existed for governmental accounting purposes.It was mainly involved with reporting instead of accounting procedures. Itwasn’t until the Industrial Revolution, that the auditing profession beganprogressing into an area of fraud discovery and financial liability. Asbusinesses expanded immensely during this extent of time, company owners couldnot directly manage all of their operations and had to hire managers.
Those owners recognized anexpanding need to oversee managers’ financial tasks, both for accuracyand for fraudavoidance. In the years between the McKesson & Robbins scandal and the Enron and Worldcom scandals,administrators made many changes to accounting and auditing policy in theUnited States. One of thesenumerous changes was that of the Sarbanes-Oxley Act of 2002 (“SOX”).The auditing profession in the United States was subject toself-regulation beforeSOX was introduced.Self-regulation is the fact of something such as an organization regulating itself withoutinterference from external bodies. According to the International Federation of Accountants (2011),”Self-regulation withpublic oversight and accountability would typically involve some form ofoversight being carried out by an independent agency (p.
4).” Independentagencies are important because audit requires bringing attention to the auditprofession challenges, weaknesses, and risks. Zeff (2003) discussed the needfor self-regulation as follows:From the earliest days of theprofession, accounting firms rendered consulting services.
By the 1910s, theyincluded the installation of factory cost systems, studies of organizationalefficiency, investigations in connection with possible investments in other businesses, and anarray of other services to management, which, as Carey writes, were often rendered in conjunctionwith audits (Carey 1969, 146). But accounting, auditing, and taxationconstituted the solid core of the firms services. In 1922, the AmericanInstitute of Accountants, now known as the American Institute of Certified Public Accountants(AICPA), banned certain forms of self-promotion by accounting firms. Thefollowing year, A. C.Ernst and two of his partners in Ernst & Ernst, by then a national firm,were accused of violating the Institutes rules against soliciting andadvertising, and all three promptly resigned their Institute membership.
Evenafter his firm no longer engaged in those practices, A. C. Ernst never rejoinedthe Institute (Carey 1969, 233-234). Federal agencies sought the advice of the organizedaccounting profession because of its growing reputation. In 1917, at therequest of the Federal Trade Commission (FTC) and the Federal ReserveBoard, the Institutesupplied a technical memorandum for publication by the Board as a bulletinon auditing procedures.The FTC sought to promote uniform accounting, while the Board wanted to apprisecommercial bankers of the importance of securing audited financial statementsfrom their borrowers. Despite the title of the bulletin, Uniform Accounting, itactually dealt with recommended auditing procedures and the format of thebalance sheet and profit and loss statement.
This represented the first authoritative guidanceon auditing procedures published in the U.S. In 1929, at the request of the Federal ReserveBoard, the memorandumwas revised by the Institute and published anew (Carey 1969, 129-135, 159-160;Previts and Merino 1998, 229-234, 250-251; Zeff 1972, 113-115, 118-119). Auditwork developed apace in the 1920s, as an increasing number of listed companiesissued audited financial statements. By 1926, more than 90 percent of industrial companies listed on the NewYork Exchange were audited (May 1926, 322), even though the Exchange did not require auditedstatements by newly listedcompanies until 1933 (Rappaport 1963, 39-40). Yet the Exchange had informally encouragedcompanies to publish auditedfinancial statements for some years before then (Staub 1942, 14-15).
(p.191) Reporting by the professionalaccountancy organizations to an independent agency in the dismissal of itsresponsibility, and oversight tasks exercised by that agency, enhance and addsubstance to self-regulation. The early implementation of regulation amongstthe auditing profession made it easier to adopt SOX.
Manycases shaped the auditing profession to whatit is today. From McKesson& Robbins to Enron and WorldCom, they each played a major part in developing SOX. In 1937, McKesson & Robbins recorded total assets of $87million. It waslater detected that this$87 million was comprised of$10 million innonexistent inventory and$9 million in phonyreceivables. The fraud was executed by the c-suite executives of McKesson &Robbins and involved fabricated purchases from and sales to counterfeitCanadian companies, which were indeed just vacant offices staffed bysecretaries who forwarded mail. The widely known McKesson & Robbins fraudtriggered the auditing profession to endorse two auditing standards that areadhered to today.
Cengage (1999) described the two standards as follows:1. The physical existence ofinventory must be confirmed through direct observation. This simple procedureapplied in the McKesson & Robbins case would have revealed that thereported purchases from the Canadian suppliers were phony.2. The existence and accuracy ofreported receivables must be independently confirmed by contacting a sample ofthe parties who allegedly owe the money. Sixty-two years after the originalMcKesson & Robbins scandal, this simple procedure, applied by a staffauditor at Deloitte & Touche, uncovered the modern-day McKesson HBOC fraud.The accounting scandal of McKesson & Robbins was onlythe beginning of many issues to be uncovered within the auditing profession.The cases that changed the auditing profession took place some thirty yearslater.
The case of Enron played a valuablepart in illustrating what the auditor-client relationship should not be. It isthe main accounting scandal that gave way to the implementation of SOX. ArthurAndersen LLP (“Andersen”) was Enron’s, a corporation during the 1990s thatswapped its business from operation of natural gas pipelines to an energyconglomerate, auditor. They audited Enron’s publicly filed financial statementsand provided internal audit and consulting services to it. In 2000, Enron beganto suffer financially and continued to diminish in 2001. Enron was headed byglobal managing partner David Duncan (“Duncan”). On August 14, 2001, JeffreySkilling, Enron’s CEO, surprisingly resigned. Within days of his resignation,Sherron Watkins, a senior accountant at Enron, informed Kenneth Lay, Enron’snew CEO, Duncan, and Michael Odom, an Andersen partner who supervised Duncan,of the potential accounting problems facing Enron.
A key accounting problem involvedEnron’s use of special-purpose entities (“SPEs”) used to engage in “off-balance-sheet”activities. Andersen’s engagement team had allowed Enron to “aggregate”the SPEs for accounting purposes so that they showed a positive return, aninfraction of generally accepted accounting principles. On August 28, 2001, theSEC opened an informal investigation. On October 8, Andersen retained outsidecounsel to represent it in any litigation that might emerge from the Enronmatter. On October 10, Odom spoke at a general training meeting stating that ifall documentation is destroyed in the normal course of business, then it isacceptable.
Odom was informed by Enron’s lawyer that each engagement fileshould contain only information compatible with the work completed. On October 16, Enron announced itsthird quarter results, disclosing $1.01 billion charge to earnings. Thefollowing day, the SEC sent a letter to Enron about the investigation againstthem and they forwarded it to Andersen.
A meeting was called with Enron’scrisis response team to make sure everyone was complying with the documentretention policy. On October 30, the SECopened a formal investigation and petitioned for accounting documents fromEnron. As a result, Andersen continued to destroy documents. On November 8,Enron restated its earnings and assets. The SEC also subpoenaed Enron andAndersen for its records. In March 2002, Andersen was indicted on one count ofbreaching witness tampering provisions 18 U.S.
C. § §1512(b)(2)(A) and (B). Theindictment alleged that Andersen knowingly, intentionally, and corruptlypersuaded Andersen’s employees, with intent to cause them to withhold documentsfrom, and alter documents for use in, an official proceeding.The case of WorldCom, atelecommunications company, turned out to be one of the largest accounting scandalsin United States history. An internal audit of the company found that improperaccounting practices were employed. More than $3.
8 billion in expenses werereported as capital investments over five quarters. Tran (2002) stated,”WorldCom’s chief executive, John Sidgmore, blamed the company’s formerchief financial officer, Scott Sullivan, and the former controller, DavidMyers. The two were fired for claiming $3.8bn in regular expenses as capitalinvestment in 2001.” Also, as another client of Anderson, they began tofeel the pressure. Anderson auditedthe company’s 2001 financial statements and reviewed their books in the first quarter of 2002.
Andersenaccused Mr. Sullivan of withholding material information from them. Accordingto Tran, “The deputy US attorney general, Larry Thompson(“Thompson”), said: We have to ask where the professionals were, the accountants and thelawyers.” Two major accounting scandals have happened beforeWorldCom.
The question posed by Thompson was a valid one to ask. Why were thereno accountants who caught the fraud from the beginning? From these three cases, one shouldunderstand the importance of auditing and the responsibilities that go alongwith it. Auditors are held accountable for having relevant competence and capabilitiesto execute the audit, complying with relevant ethical requirements, andmaintaining professional skepticism and exercising professional judgmentthroughout the preparation and performance of the audit. The Public CompanyAccounting Oversight Board (“PCAOB”) SAS No. 1, section 110 (1972),detailed the responsibilities and functions of the independent auditor. Theyare described as follows:The auditor has a responsibility toplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement, whether caused by erroror fraud.
Because of the nature of audit evidence and the characteristics offraud, the auditor is able to obtain reasonable, but not absolute, assurancethat material misstatements are detected. The auditor has no responsibility toplan and perform the audit to obtain reasonable assurance that misstatements,whether caused by errors or fraud, that are not material to the financialstatements are detected… The auditor’s responsibility is to express anopinion on the financial statements.Each auditor is held accountable to his profession, theresponsibility to adhere to the standards accepted by his fellow auditors.
Knowing this, each auditor should know the importance of their role.SOX was created with the intent to address the confusion and animosity in the country over the bankruptcies of WorldCom and other accountingscandals. The goalsof SOX are to complementthe clarity of financial information, redeclare auditor independence, and detail aspectsof corporate governance.SOX assigned specific SEC oversight and altered the self-regulatory, peerreview environment in which accounting firms had conducted business. It decreedthat the SEC set upthe PCAOB whichwould “establish auditingand related attestation, quality control, ethics, and independencestandards and rules to beused by registeredpublic accounting firmsin the preparation andissuance of audit reports.” SOX held c-suite executives to a greater standard ofaccountability, requiredthe use of independent audit committees, and enhanced auditorindependence.Today, the auditing profession is in a continual state of growth.
Auditorsare held to a higher standard so that accounting scandals are not as prevalent.There are four things that stand out amongst the auditing profession today.These four things are explained by Daniel Goelzer (2005), a board member of the PCAOB. The first is the refocus on auditing. “The profession is beginning to again view auditing as its core business — not merely an adjunct to consulting. Many non-audit services havebeen prohibited.
For those that remain legal, audit committee pre-approval isrequired, and audit committees are more reluctant to let their auditors perform significant non-audit services.”Secondly, the impact of inspections. “While there is a place forenforcement proceedings anda place forliability to privateparties who are injured by bad auditing, in myview, a well-thought-out inspection is more likely to improve the day-to-day qualityof auditing thanare those other, bluntertools.” Next, auditor risk aversion and client selectivity. “Our inspections and published figures show that the major firms have “fired” some clients, particular thosethat are riskier.Firms also havedeveloped more sophisticated toolsfor assessing client risk and using those assessments to tailor howthey audit.” Last, but not least, Section 404 internal controlaudits. “The audits of internal control have added an important newdimension to the auditor’s work.
The auditor is required to have a morecomplete understanding of the strengths and weaknesses of the client’s financial reportingsystems. Auditcommittees are also being forced to learn more about those systems in order to assess significantdeficiencies that the auditor reports to them.”The auditing profession will continue to develop to becomeadaptive to the new pressures placed on the profession. Constant training anddevelopment must be required for auditors to adapt to the changing culture ofauditing.
Theauditing profession has experienced many setbacks, but it is much stronger thanit was years ago. McKesson & Robbins, Enron, and WorldCom were includedamongst the many accounting scandals that led towards the implementation ofSOX. The implementation was a stride in the right direction for the auditingprofession. SOX helps to support audit quality and investor assurance. It alsoenhances the audit effectiveness and efficiency, while also increasing thereliability of financial reporting.
Because the profession will continue togrow, the auditing profession must continue to set regulations to push auditingin the right direction. In the years to come, regulations will make it easierfor auditors to do their jobs.