Auditing and Assurance in Australia

This report examines the accounting issues that can occur due to auditing failures across the business entities. The failure of auditors to report materialistic errors is responsible for the occurrence of corporate scandals of Enron, WorldCom and Lehman Brothers. The report discusses the key audit risk to the independency of auditors that can result in compromising the independence of auditors.

Auditing and Assurance in Australia
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Executive summary
This report has been undertaken to examine the accounting issues that can occur due to
auditing failures across the business entities. The accounting issues that have occurred due to
failure of the auditors to report the materialistic errors are responsible for the occurrence of
corporate scandals of Enron, WorldCom and Lehman Brothers. It has been ascertained form the
corporate failures that auditors have compromised on their independence and thus have resulted
in having a negative impact on the integrity of the audit firms. The report has discussed the key
audit risk to the independency of auditors that can result in compromising the independence of
auditors. The key lessons about the accounting professions obtained from the corporate failure of
Enron, Worldcom and Lehman Brother’s have also been discussed in the report.
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Introduction
Nowadays auditor independence is one of the most important topic as world has
witnessed so many cases of accounting fraud in many big companies around the world. The
auditor’s independence is the integral part of the audit process and in general it means
independence of external auditor. In simple terms it can be said that auditor is independent when
the auditing is carried in a freely and in an objective manner. The independence of auditor has
been measured through evaluating the honesty of Auditor in reporting material misstatements in
its audit report that were found during the audit process. Independence of auditor can be
maintained through not having conflict of interest with the client (Managers of Company). As
external auditor does what has been written in audit engagement and no other liabilities arises
other than mentioned in auditor engagement. It is important that auditor must maintain its
independence in the sight of investors to the extent the audit fees cover the cost of complete audit
process.
The main purpose of this report is to evaluate the various literatures on auditor’s
independence in order to understand the major audit risks and threats in the whole audit process.
In addition to this the failure of Worldcom, Enron, and Lehman Bros has been discussed in
detailed in order to evaluate causes of failure and lessons learned from these cases.
Part 1: Review of Literatures on audit risk and independence
There have been so many literatures that discusses about the concern of audit risk at
various level of audit process. According to Fearnley, Beattie & Brandt (2005), audit risk has
been defined in Auditing Standard 312 and as per this standard it is responsibility of auditor to
consider audit risk and materiality when making the planning for conducting the audit of
financial statements. Typically audit risk has three key components: detection risk, control risk
and inherent risk. The detection risk arises when the substantive procedure applied by the auditor
are not sufficient to detect the material misstatement that are left in the audit process of financial
statements. Control risks on the other hand can be defined as risks that are material in nature but
they cannot be prevented, detected and corrected by the internal control system and accounting
process on timely manner. Lastly inherent audit risks refer to the errors of various account
balances or class of transactions that are material in nature and they cannot be determined
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through applying the internal control procedures. The level of audit risk is completely dependent
upon the substantive testing carried by the auditor. The main concern is the detection risks as
auditor is completely responsible for the detection risks and his liability lies to the level of efforts
he has put for identification of risks that are material in nature (Fearnley, Beattie & Brandt,
2005).
In the view of Adelopo (2016) audit risks have been replaced by the business risks which
is defined as risks that does allow the audited entity to fulfill the objectives. The auditors are now
more concerned to the business risk assessment in order to focus on the risks of material
misstatements of financial statements. In this way auditors can improve the auditor independence
and reduce the level of threats in the audit practices (Adelopo, 2016).
As per Austin & Herath (2014), auditor must be independent to his or her client in order
to have true and fair audit opinion and not to be influenced by the relationship between them. It
is technically expected from the auditors by the investors of the company to provide unbiased
and honest audit opinion on the financial statements so that they can wise decision on their
financial investment (Austin & Herath, 2014). There are multiple threats that affect the auditor’s
opinions and thus impact the auditor’s independence. The six threats that worst affect the
auditor’s independency are as follows:
 Self-Interest Threats: As per this audit threat external auditor is financial dependent on
the client or where someone closely related to auditor has some financial or other interest
with the audit client. As an external auditor, it is critically thinking of every auditor to
secure its re-appoint in the auditor firm that creates a sense of dependency on the
management.
 Threat of familiarity: As the relationship of auditor and client become familiar due to
long relation that make auditor involved in the process of management and make him
advise on various matter that defines the management role (Gray and Manson, 2007).
 Self Review Threat: As an external auditor it is the responsibility of auditor to have a
check on the previous year work as it will use to make financial report of current year. So
external auditor either has to re-evaluate or challenge the previous auditor work in case if
it is not performed previously by the same auditor.
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 Threat of trust: It is nature of auditor that they become too trustworthy for management
and directors that make them or allow them to perform proper testing of information
provided by the management and other representation given by them.
 The intimidation threat: The auditor frequently faces pressure from the client and other
parties that is the main reason of intimidation threat.
 The advocacy threat: It has been seen in many cases that auditors start taking active
interest in defending and promoting the interest of client (Adelopo, 2016).
Part 2: Literature Review from Failure of Enron, Worldcom and Lehman Bros about the
Accounting Profession
According to Dodo (2017), there have been fundamental changes in the role of the
auditor influenced by the critical economic events such as corporate failures that occurred due to
accounting scandals in Enron, Worldcom and Lehman Bros that are discussed as follows:
Corporate Failure of Enron
This accounting scandal has highlighted the importance of auditors to make unbiased
audit decisions for protecting the trust and confidence of the external stakeholders of a business
entity. This is because the accounting scandal have known to occur due to inability of auditor to
act independently and making their judgments under pressure and other factors. The corporate
scandals of Enron, a US based energy, commodities and services company that eventually leads
to bankruptcy after attaining the dramatic heights of profitability. The company is known to have
manipulated the financial statements and thus presenting a false view of its financial position to
the end-users (Dodo, 2017).
As per the views of Abodia (2018), the scandal have highlighted the role of accountants
in developing and disclosing the financial statements to depict the true and fair view of the
company. The auditor of Enron, Arthur Andersen, was held responsible for presenting a false
view of the company financial position. The auditors properly shredded many documents of the
company and was proved to be guilty of intentionally reflecting the manipulated financial
information to the end-users. It has been claimed that Enron has maintained a long-term relation
with its auditors for about 10 years and some of the partners of Andersen has been hired by the
company as financial officers. Thus, it may have contributed to influence the independence view
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of the auditors in relation to Enron financial statements and thus hiding materialistic facts about
its financial position from the investors (Abodia, 2018).
Corporate Scandal of Worldcom
Alabede (2012) have stated that the corporate scandal of Worldcom, one of the largest
telecommunication company across the world, that went bankrupt in the year 2008 for
representing false financial information by disclosing the inflated value of assets by about $11
billion. Andersen was the auditor of the Worldcom too and has come under scrutiny for hiding
the information in relation to accounting irregularities within the financial statements of the
company. However, Andersen has claimed that the company has concealed significant
materialistic information such as line-costs transfer and neither did consult with the auditors
about the accounting treatment and policies adopted. The role of auditor in protecting the trust
and faith of the stakeholders so that they cannot get deceived by the false financial information
has also been highlighted by this corporate scandal (Alabede, 2012).
Corporate Failure of Lehman Brothers
In addition to this, Norris (2011) stated that the corporate failure of Lehman Brothers, a
global services firm, has also highlighted the importance of auditing profession in protecting the
interests of the investors. The scandal has also known to believe to occurred due to failure of its
auditors Ernst &Young to present true and fair view of the financial position of the company.
The auditor of the company is accused to hide its financial problems and communicating the
pertinent financial issues to the audit committee of the Board of Director’s. It has been identified
that the company has adopted the use of Repo 105 for making its financial results better. It has
been claimed that the auditors were aware of its use and thus have not fulfilled its responsibility
and adopted the use of fraudulent behavior towards the stakeholders (Norris, 2011).
Lessons Leant in Context of the Accounting Profession from these corporate Scandals
As per the information from Public Company Accounting Oversight Board (2017), the
occurrence of these corporate scandals has highlighted the significance of auditors to carry out
their responsibility independently and fairly to protect the interest of the investors. As such, the
audit rules and regulations have been amended and the Public Company Accounting Oversight
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Board (PCAOB) have been established for inspecting the deficiencies in the work of the
auditors. PCAOB have been established that large public accounting companies need to audit
their financial reports on an annual basis and smaller firms need to audit it at least once in every
three years. The scandals have also emphasized on the need for adopting the rotation of auditor
for ensuring that they provide their independent view about a company’s financial position. The
European Union have called the need for listed companies to change their auditors in every tend
years. The auditors are directed to report the company specific issues as Part I findings and the
company wide related issues under Part 2 Findings. The auditors are held responsible for
ensuring that firms have adopted adequate internal controls for reporting financial truncations
and are stated to provide their opinion free from nay pressure with reasonable assurance and free
from any error (Public Company Accounting Oversight Board, 2017).
It can be stated from analysis of the causes of corporate failures of these big firms that the
most important role of the accounting professionals in present contemporary world is to develop
and disclose quality financial information to investors, creditors, lenders and other end-users. In
this context, the role of auditors can be regarded as extremely important for companies in
preventing the occurrence of fraud by reviewing effectively the internal controls and other
accounting irregularities in the financial reporting of businesses. The role of auditors is
extremely important for independent examination of the financial statements to increase the
value and credibility of financial information. The audit of the company is essential for
increasing the confidence of the users and thereby reducing their investment risk and maximizing
the value developed for stakeholders (Scandals and regulation lead to an auditing merry-go-
round, 2015).
Conclusion
It can be stated from the overall discussion held in the report that auditor’s independency
is critically dependent upon the threat and risks that are integral in the auditing process. Thus, it
is recommended to the auditors to perform substantial audit so that material misstatement can be
avoided. The occurrence of corporate scandals has emphasized on the need for developing
relevant auditing standards for ensuring that they provide their view in an independent and fair
manner. It is the key responsibility of auditors to protect the interest of investors by providing
them an honest and assured view of the financial position of a company.
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References
Abodia, D. (2018). Audit Regulations Meant to Curb Accounting Scandals Are Working,
Mostly. Retrieved 4 September, 2017, from
https://insight.kellogg.northwestern.edu/article/audit-regulations-meant-to-curb-
accounting-scandals-are-working-mostly
Adelopo, I. (2016). Auditor Independence: Auditing, Corporate Governance and Market
Confidence. Routledge.
Alabede, J. (2012). The Role, Compromise and Problems of the External Auditor in Corporate
Governance. Research Journal of Finance and Accounting 3(9), pp. 114-126.
Austin, E. & Herath, S.K. (2014). Auditor independence: a review of literature. International
journal Economics and Accounting 5(1), pp. 1-14.
Dodo, A. (2017). Corporate Collapse and the Role of Audit Committees: A Case Study of
Lehman Brothers. World Journal of Social Sciences 7(1), pp. 19-29.
Fearnley, S., Beattie, V. & Brandt, R. (2005). Auditor independence and audit risk: a
reconceptualisation. Journal of International Accounting Research 4(1):pp. 39-71.
Gray, I. and Manson, S. (2007). The Audit Process: Principles, Practice and Cases. Cengage
Learning EMEA.
Norris, F. (2011). Lehman Case Hints at Need to Stiffen Audit Rules. Retrieved 4 September,
2017, from https://www.nytimes.com/2011/07/29/business/in-lehman-case-a-hint-that-
audit-rules-are-lacking-floyd-norris.html
Public Company Accounting Oversight Board. (2017). Retrieved September 4, 2017, from
https://pcaobus.org/Standards/Auditing/Documents/PCAOB_Auditing_Standards_as_of_
December_15_2017.pdf
Scandals and regulation lead to an auditing merry-go-round. (2015.) Retrieved 4 September,
2017, from http://theconversation.com/scandals-and-regulation-lead-to-an-auditing-
merry-go-round-41904
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