Definitions of Independence in the Audit Context
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).
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.
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 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.
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:-
Audit Risk and the Various Risks that Auditors Face
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.
Post-conventional- Where an auditor forms judgment where it follows ethics principles and not the rules of society.
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.
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.
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.
Managing Audit Risk Effectively
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.
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.
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.
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 from the Failure of Enron, Worldcom, and Lehman Bros
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 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.
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.
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.
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.
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.
References
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