Auditing 1: Audit Risk, Independence, and Case Studies Analysis Report

This report provides a comprehensive analysis of audit risk and auditor independence, crucial concepts in the field of auditing. It begins by defining audit risk and its components, including inherent, control, and detection risks, along with the equation AR=IR*CR*DR. The report then explores the importance of auditor independence, detailing factors that can undermine it, such as financial interests, undue client dependence, and threats from former employees. The second part of the report delves into significant case studies, including Enron, WorldCom, and Lehman Brothers, highlighting the failures that led to their collapse. It examines the accounting irregularities, mismanagement, and ethical breaches that contributed to these scandals. Each case study includes lessons learned and analyst reviews, providing insights into the consequences of audit failures and the importance of robust regulatory frameworks and independent auditing practices. The report underscores the critical role of auditors in ensuring the integrity of financial reporting and maintaining investor confidence.

Auditing
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Table of Contents
Part 1................................................................................................................................................3
Audit risk.........................................................................................................................................3
Constitution of audit risk.................................................................................................................3
Auditor Independence......................................................................................................................3
Actual forces which losses independence of auditor.......................................................................4
Factors undermines the weakness of an auditor..............................................................................5
Part 2................................................................................................................................................5
Case of Enron...............................................................................................................................5
Case of WorldCom.......................................................................................................................6
Case of Lehman...........................................................................................................................8
References......................................................................................................................................10
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Part 1
Audit risk
Audit risk is the risk in relation to the fraud and material misstatement of the financial
statement of the corporations. This is a risk when the financial statement is materially
incorrect(Knechel, & Salterio, 2016).
Constitution of audit risk
Audit risk includes inherent risk, detection risk, and control risk. The equation of audit
risk is AR= IR*CR*DR.
Here, IR is an inherent risk refers to the risk of material misstatement takes place due to
error, omission and failure of controls. This risk is a result of factors which are not due to failure
of controls.
CR is control risk refers to the risk where misstatement may be occurred due to failure
and absence of effective control at place.
DR is detection risk under which auditor is not able to detect the material misstatement in
the financial statements.
Audit risk is a product of various risks which is encountered at the time of conducting
audit and need to be assessed the level of risk in relation to composition of audit to keep the
overall risk below the acceptable level. Each risk need to be managed effectively in order reduce
the overall risk.
Auditor Independence
Independence of an auditor is an external and internal auditor independence from the
parties of entity having financial interest in the business for which audit is conducted. Hence,
independence of an auditor is loose when the auditor has a financial interest in the business.
Independence of an auditor requires proper integrity and objectivity and carrying the work freely.
An auditor need to be independent so that true and fair picture of the financial affairs of
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Company can be revealed for the users and other interested parties. Independence of auditor is
also required to prevent any influence from relationship whether financial or non financial.
Auditor must provide unbiased and honest professional advice on financial statements.
Actual forces which losses independence of auditor
There are areas of risk which forces auditor to lose independence such as when Company
is undue dependent on audit client, when auditor directly or indirectly make loan to its client, or
involved in guarantees and overdue fees. If an auditor or any other member from its firm
receives benefit in the form of goods and services then it forces auditor to lose independence.
When auditor participate in the affairs and there is any litigation involved and any mutual
business interest is there then it forces auditor to lose independence.
The auditor may prepare some accounting for the fund to fulfil its personal fund
requirement. Hence it is always preferred to separate the work of audit and accounting
independently between two different partners or firm. When the auditor has large business
dealing from its one client then the independence of auditor is threatened as the auditor may not
provide a qualified opinion on the significant portion of the business (Jones, 2011). Issuing a
qualified report can also impact negatively on their referrals relationship. There is also ex-staff
and partners threat where the auditor leaves to start its own business and perform the function of
audit for the former client. This requires Company to carefully check the independence of the
audit firm by looking at every aspect and also on the familiarity between the audit and
accounting firm (Koch, Weber, & Wüstemann, 2012). The threat can also be there from advising
where auditor provides financial advice. The auditor can be distinguished in three level of ethical
recognition where it can lose its independence:-
Pre-conventional- When an auditor places its self-interest above the interest of society
and penalty attributes.
Conventional- When an auditor matches the rules of society and also sensitive to the
penalties attributes, it undertakes small or ignorable activities to earn some profits above the
salary.
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Post-conventional- Where an auditor forms judgment where it follows ethics principles
and not the rules of society.
Factors undermines the weakness of an auditor
The conflict of interest of auditor may arrive when auditor responds to its personal belief
and more resist itself to the power of the client. The auditor can also respond to both
management power of client and personal belief whereas least resistant to the management
pressure of client (Chi, Douthett & Lisic, 2012). Lastly, the auditor can be more resistant to the
power of management and disregarding its beliefs. Independence in the audit of financial
statements is an important component of the framework of regulation and supporting and also for
capital market(Kasgari, Salehnezhad & Ebadi, 2013). Independence of auditor may also weaken
when at times the director threatens the auditor to provide unqualified books of account
otherwise they will lose the job. This makes the auditor coddle in unlawful activities with
realizing the future consequences of such actions.
Part 2
Case of Enron
Introduction
Enron was established in the year 1985 and declared as bankrupt in the year 2001.
Company fooled the regulator with the help of fake holdings and were also found to involve in
off the books accounting for long. The collapse of Enron was due to mismanagement, poor
business, and adoption of wrong accounting procedures. The true condition of the Company was
not disclosed to the public by Enron as required under law (Dibra, 2016). Enron keeps continued
presenting false accounts by transferring the losses to the Raptor entities which were actually
independent firms and entirely in control of Enron. Enron also disguised bank loans in the form
of energy derivatives with the aim of covering its indebtedness. It dispensed its losses and also
worthless assets to special purpose entities and unconsolidated partnership (Norman, Rose, &
Rose, 2010). As this allows the Company to enhance its leverage and return on assets without the
requirement of reporting of debt on the balance sheet.
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Failure of Enron
Auditor of Enron was involved in blind improper practices and also devised complex
financial structure and transaction facilitated fraud. Company employee’s account was wiped
out. The top management of Enron also sold the stock of Company in millions of dollars and
concealed serious financial problems (Hays & Ariail, 2013). Core energy business of Enron was
involved in derivative contract and sold terms of contracts with the aim of buying and selling
energy at a fixed price. But Enron was trading in the unfettered market and there was also no
requirement of reporting and only a little information related to activities of derivatives was to be
reported and it turned to a risky activity for Company with huge speculative losses (Oliveira,
Lima Rodrigues, & Craig, 2011). Mark to mark accounting rules required Company to adjust the
fair value of outstanding energy-related and booking unrealized gain or loss to a period of the
income statement (Stewart & Subramaniam, 2010). Future contracts on gas can be valued with
any model, method or assumption. The company was required to disclose the underlying
earnings and under continuous pressure, unrealized trading gains were shown at slightly high.
Lessons learned
The case implied that auditor is clearly violating the professional standards of accounting
and auditing. There is a need to give a response to the work of auditing. Private accounting firms
need to give lock, barrel, and stock to the government. The job of choosing the auditor needs to
be assigned to the third party instead of the bosses of Company. Government agency and
Securities and Exchange Commission can take a step to appoint the auditor disregard of the list
recommended by the Company (Edel Lemus, 2014). A ban should be there on the firms of
accounting who are found involved with the directors of Company in committing fraud
(Caliskan, Akbas, & Esen, 2014). Accounting firms working in the same Company for a long
period is another loophole in the law and for this good idea is a mandatory rotation of every four
years. The company should also not allow hiring managers and internal auditor from the external
auditor firm (Li, 2010). It has been learned from the case of Enron that off-balance sheet
transaction has many dodges and standards of America are too negligent and need to have sound
principles and good idea is to come with international standard.
Analyst review and disclosure information
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According to analyst review, toughest policy of Enron leads to collapse. Huge issue was
there with disclosure and there were growing number of earning restatements. Lack of species
allowed accountant to discrete transaction.
The disclosure information stated the shares of Enron were fall from $90 per share to
$30. The Company reports showed write off of $1 billion and $1.2 billion reduction in the
shareholder equity.
Case of WorldCom
Introduction
WorldCom was considered the second largest telecommunication Company in the United
States. The company is one of the largest bankruptcies and scandals in U.S. Company acquired
telecommunication and grew at a large level. The company acquired UUNET for becoming the
major backbone of the internet. The company was working with more than 30000 employees and
filed for bankruptcy protection in the year 2002. Company inflated assets which have not only
lost the jobs but also more than $175 billion loss to investors.
Failure of Worldcom
Company impressively focused on large acquisitions but the strategy did not work and to
started financial gimmick to sustain in the business. The company failed to manage a number of
acquisitions (Mishra & Bhattacharya, 2011). There was a lack of demand for the products with
the result of the recession and high competition in the industry of telecommunication. The
company started enhancing fake revenue for attracting investors. There was an improper
reduction of line cost and was the process of phone call and using phone lines of other
Companies was becoming a huge cost for Company. The company started showing less cost
such as 42% of revenue but in actual it was 50-52%. Entries of payables account were over and
underestimated. The company capitalized line cost which was a major fraud by Company (Chi,
et. al., 2012). Ebbers, the CEO of the Company to protect his personal financial condition
presented continuous net worth aiming to avoid margin calls on the stock pledged on the loans
secured.
Lessons learned
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Companies of America required a number of independent directors and authentic
independency in auditor role in order to safeguard the interest of few individuals or minorities
group and shareholders (Kasgari, et. al., 2013). Related party disclosures and other listing
requirements have also not followed by Worldcom. The regulatory framework and working
model is responsible for decreasing the importance of the work of the audit (Betta, 2016).
Effective monitoring and assessment of the risk in auditing are required to closely identify what
auditor is justifying their profession and also on the evaluation of the risk associated with the
independence of the auditor. Independence in auditor will only come from their mind (Blay &
Geiger, 2013). This will not allow being influence and compromise from their professional
duties and responsibilities. Directors of any Company should work practically and in harmony
with the auditor in order to provide true and fair reports of financial accounts. (Norwani, Chek &
Mohamad, 2011).Threats which is there in the audit process are not recognized under the current
model and also not included in the motivation of management. If management equally supports
auditor to manage its independence then there will no frauds take place in the financial reports of
any company. The restatement of Enron and collapse of WorldCom has shown a devastating
effect and loss of confidence in case of the integrity of the audit firm. Failure of an auditor to
identify fraud and misleading has weakened the economic value of an audit and ultimately
damaging firm in the long run. Companies need to equally support audit firm in order to sustain
in the market for long run.
Analyst review and disclosure information
Analyst review says that there was around $3.3 billion accounting error which doubled
the size of scandal of WorldCom. Internal audit recorded $3.3 billion of profits improperly as
capital investments. High manipulation was made to reserves in order to cover losses such as
uncollected payment.
The disclosure information reported revenue inflated and line cost was capitalized which
was under the knowledge of CFO of Company. Significant energy was used for personal interest
of CFO.
Case of Lehman
Introduction
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Lehman brother was engaged in providing financial services. The company was first
Wall Street firms which moved to the business of origination of mortgage. Lehman was one of
the highest forces in the subprime market (Mawutor, 2014). Lehman was found to made third
highest loan in the year 2003 and became at first number by lending $40 billion in the year 2006.
Lehman has disguised as an investment bank and accumulated huge real estate hedge fund. Bank
faced a subprime mortgage crisis which exceptionally vulnerable to the slump in the value of real
estate.
Failure of Lehmon Brothers
During the good times of Lehman, Lehman raised borrowings in order to invest in assets
and increased its borrowing to 12 times more than existing. Lehman raised borrowing to £12 for
cash of £1 and later Lehman even rose to 20 times (Caplan, Dutta, & Marcinko, 2012). Lehman
was having a massive asset with impressive liabilities and also lacked ready cash and assets
which can be easily sold. The other banks pulled Lehman’s line of credit and refused to trade
with Lehman. With the terrorist attack in the year 2001, the rates of interest rates fallen down
causing a five-year boom (Mishkin, 2011). By the end of 2007, Company had the big investment
in commercial real estate and huge exposure to collateralized debt obligations and credit default
swaps. In the year 2008, Lehman announced losses amounted to $6.5 billion. In the year 2008,
Lehman filed bankruptcy with having $619 billion in debt and $639 billion in liabilities.
Lessons learned
Lehman financial reports were looking healthy to regulators before they hit. This was due
to artificial hike and presentation of assets in the financial reports. Directors of Lehman were
equally supported auditor in not disclosing the mandatory accounting rules and lead to strict
punishment to both auditor and director of Company. So it can be said that it is the responsibility
of the directors to ensure that auditor are complying provisions with healthy and safely (Le Maux
& Morin, 2011). The credible system still requires where Company, any investor or auditor
should be punished for making mistakes. Third party disclosure should also be made mandatory
for Companies so that it cannot involve in such frauds and malpractices. (Kim & Song, 2017).
There should strict punishment for such apparent practices of auditor and director.
Analyst review and disclosure information
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As per the disclosure information of Lehman filed to US Bankruptcy code related party
transactions were not disclosed by Company which was a violation of corporation Act, 2001 by
not only auditor but also the director as both director and auditor are required to disclose such
transaction. Many financial numbers were manipulated.
As per analyst review, Company was having high amount of debts on debts and also
unsecured creditors. There was decrease in the value of mortgage properties on which top-up
loan was passed.
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