The Essay On Risks Of Sub-Standard Audits And Audit Quality Importance.

When sub-standard audits are performed and reasonable assurance cannot be reliably ascertained, there are consequential risks for key stakeholders, including auditors. In light of this, perform the following key assignment tasks:

1. Perform a key stakeholder analysis for an ASX listed company. Explain how the key stakeholders would be affected if material misstatements are not properly identified, disclosed or adjusted for in the finalised financial statements. What are the key risks posed to each key stakeholder you have identified?

2. Consider the concepts of independence and “whistleblowing” in relation to auditors. How do these concepts relate to the public interest requirements mentioned in the APES 110 Code of Ethics for Professional Accountants document?

3. What lessons can auditors learn from the Enron scandal and in particular from the behaviour of Arthur Andersen?

4. With reference to the APES 110 Code of Ethics for Professional Accountants document and the ASIC website, research “audit quality” and discuss what auditors need to do to address the “warning” noted in the statement made by Greg Medcraft above.

Perform a Key Stakeholder Analysis for an ASX Listed Company

Audit quality plays a very instrumental and monumental role in decision making by the stakeholders. In case the quality of audits performed is substandard, it is having a serious implication on the decision making and poses numerous risks for the key stakeholders. Due importance should be given to independence by the auditors and whistleblowing is the tool which needs to be used by the employees and the management in case they see any discrepancies in the organization or audit or financial reporting. The Chairman of the Australian Securities and Investment Commission (ASIC) Greg Medcraft did warn that the key of not having to face another Enron like accounting scandal and fraud is to make sure that auditors do understand their responsibility and do their job honestly such that there is reasonable assurance that the financial statements are free from frauds, errors and material misstatements.

The company which has been selected here for analysis is BHP Billiton. It is one of listed companies on the Australian and the New Zealand stock exchange. It is an extensive retail conglomerate with second largest turnover in Australia and New Zealand as well. It is also the largest takeaway liquor merchant in Australia. It is one of the largest private employers in Australia with 205000 employees. It primary operations include the super market chain, hotel, liquor retailing and pubs as part of the hotel and leisure industry. The company has posted one of the largest losses in the year 2016 since it has been listed mainly due to the major losses recorded in Big W business and write off of the Masters business which failed miserably.

The company has both the internal as well as external stakeholders who are interested in the results of the company and the audit opinion by the auditors. The internal stakeholders of the company mainly include the employees, the board of directors, management, existing shareholders whereas the external stakeholders include the government authorities, banks and financial institutions, the consumers or the customers, the prospective investors and the suppliers, etc. All of these stakeholders are interested in the financial statements and performance of the company for various reasons and if the material misstatements is not being identified, disclosed or adjusted, the same will lead to various risks for each of these stakeholders like for the employees, management and board of directors, it will present wrong and incorrect financial information which will also have an impact on the management decision making for the future course of action and planning, budgeting and forecasting for the upcoming year. The existing shareholders would also get the distorted view and thus, it may result in wrong investment decision and thus lower or even negative ROI. From the perspective of the market and the external stakeholders, the less tax may be paid to the government and the tax authorities if the window dressing of the financials is being done to show less profit. The debtors as well as the creditors may be in the wrong impression of the current affairs of the company and may later come to know that the same is not worth it. The banks and financial institutions may also suffer a set-back as the collectability of the funds becomes a major issue when the accounts is materially misstated as there are high chances that the amount lent may be spilled over in case of liquidation. It also affects the future investors’ big time as it may lead to wrong investment decision and they may suffer a loss.

Consider Independence and Whistleblowing in Relation to Auditors

From the perspective of the audit and the auditors, independence means Independence of mind and independence in appearance. Independence of mind means the state of mind not being influenced by anything while giving an opinion on the financial statements. As per this, the auditor should apply the professional judgement, act with integrity and objectivity and apply professional scepticism while giving an opinion on the financial statements. Independence in appearance means taking relative and appropriate action which is so reasonable that even the third party would have considered it in the circumstances of the case. As per conceptual framework as well as the Code of Ethics, the auditors should remain independent in their conduct in the public interest and in case the same is being compromised with anytime then it may lead to frauds, errors and omission in the financial statements which may then lead to wrong decision making by the shareholders. The auditor should issue the audit report accordingly as per the circumstances of the case as their actions and report provide reasonable assurance to the investors on the financial situation of the company. If they are involved in fraud and window dressing or crafting of the financial statements, it would result in the scandal like those of Enron and WorldCom.

On the other hand, the term “whistleblowing” has become very popular in the corporate world off late post the number of accounting scandals which have taken place. Whistle blowing is when the employee, contractor, supplier or any person in the organization goes beyond the normal channels of communication and to report any suspected wrongdoing at work and does speaks it in a confidential manner in the interests of the organization. This can be done through the internal processes in the organization or through setting up an external whistleblowing committee. Disclosure made in public is also considered to be of interest to the auditors as it shows the possibility of lack in the internal control of the organization and thus the possibility of fraud and errors. As per the Code of Ethics for Professional Accountants this is of utmost importance and should be taken care off in the public interest and in case if any of the auditors do find it that the fellow colleagues are involved in fraud, mismanagement or window dressing, the same should be reported to the audit committee or the head of the audit department such that it is in the public interest.

Lessons Learned from the Enron Scandal and Arthur Andersen's Behaviour

Enron scandal is one of the biggest accounting scandals and fraud that has taken place in all times. Its impact has been magnanimous and it destroyed more than $ 60 Bn of the shareholder’s wealth. It was the 7^th largest company in USA at the point of its liquidation. It was also the largest bankruptcy in terms of assets until then and has clearly been a poor investment as its shares declined from $ 90.75 to almost $1. The auditors Arthur Anderson played a very major and instrumental role in the downfall of the company as the wrong accounting techniques were being used to inflate the revenue as well as the assets in the balance sheet and later on when the same was disclosed to the market, it led to the downfall of the company. Few of the major learnings from this scandal are listed below:

1. Excessive leveraging in the company can be highly risky: Financial leverage is the use of the borrowed funds to do the business and it is generally a two sided sword as it can multiply the gains to the company if the assets values are going up and reduce the wealth of the company if the asset values are going down. On top of that, there is always a fixed burden to pay the interest and therefore the same should be used amicably. There are numerous instances which has led to bankruptcy for the companies due to use of excessive debt capital like that the Lehmann Brothers, the WorldCom, US housing loan bubble and burst in 2007 and therefore the lesson is to make use of the leverage adequately and that it is prudent to have the backing of equity while asset purchase.

2. Adequate liquidity is always the good thing: this is a very significant part of the corporates and in case of Enron, this was the case when it was not able to meet the short term obligations on time and hence had to liquidate. The primary reason for the same was lower levels of the working capital and inadequate liquid assets to meet the short term obligations.
3. Don’t invest in anything which is not understandable by you: Most of the investors in Enron did not understand the model of business which the company employed into as it was into a lot of commodity and derivative trading. The financial statements of Enron were scandalous and ambiguous to such a high extent that even Warren Buffett was unable to understand the same. The company also used a lot of non GAAP financial metrics in order to hide the actual expenses of the company coupled with the excessive growth forecasting contributed to its fall.
4. Avoid investing in the companies which employ fancy derivatives: The Company was using excessive derivative contracts and was hugely reliant on the speculative income from these contracts which were quite uncertain in nature. Warren Buffett describes these financial instruments as the “time bomb” as he assumes them to be quite risky in nature. Furthermore, the company was also involved in the mark to market accounting scheme where they were recording the profit from the derivatives even before they were earned and accrued. This could have played a very major role had the profit not been realised. All said and done, Enron was the only company in the energy sector at that point of time to declare the bankruptcy and the major reason for the same was excessive use of the derivative instruments.
5. Understand and access the risks from the counterparty: It were not only the shareholders of the company which suffered the losses but the counterparty as well as they did not access the counterparty risk when they were entering into the contract with Enron. It is defined as the risk to both the parties of the contract that the opposite party will not meet the contractual obligations. Some of the counterparties who suffered the most are derivative counterparties, creditors of the business, the banks and the financial institutions which have rendered loans to the group. One of them was also Arthur Anderson, the auditor of the company which was one of the 5 largest firms in USA at that time and had high reputation for risk management and high quality operating standards. Its involvement in the accounting fraud is undisputed and it is for this reason that the firm has to close its operations within 6 months of the Enron Scandal.
6. The Importance of Management Integrity Cannot Be Understated: It is pertinent and very important to have a quality management at the helm of the business. Good managers with good capital allocation skills can contribute a great deal to the success of the organization, on the other hand, the bad management can lead to bad results. Enron does proves this. It is difficult for the investors to check in and meet the management officials directly and so there are 3 techniques to examine them and monitor their performance. The first of it the quarterly investor conference call where they should be willing to answer any and every question, the next is assessment of the insider trading transaction and the last tool is to monitor the executives of the investees in the broader media level.

From the above episode it was also very much clear that how important and bigger the role the auditors play as it is the reputation and report of the auditors on which the investors as well as the other stakeholders rely on when they are unable to understand the financial reporting and its constituents. It is therefore their responsibility to not get involved in any corrupt practices and do actual reporting.

Audit quality may be defined as the systematic examination of the books of accounts which may be carried out by the internal or the external auditor. It is the requirement of the quality management system and is one of the key elements of the ISO quality system standards. The very objective of the audit of the financial statements is that the auditor will arrange for sufficient and appropriate audit evidences so as to express an opinion thereof on which the investors and the other stakeholders would rely upon and take decisions accordingly. The role of the auditors is very crucial and critical with respect to the credibility of the financial statements as it ensures financial stability and for those who do not understand or are unsure on what has been reported in the annual report of the company, it is the auditor’s report which forms the basis of the decision making and it is therefore very important to maintain the quality of the audit. As per the accounting bodies over the world, audits can help foster the trust in the quality of the audits as it raises some of the pertinent questions which are relevant in the circumstances of the case. Some of the major objectives of the framework on audit quality are:

1. Raising awareness on the key elements that contribute to the audit quality
2. Encouraging the key stakeholders to come out with the ways that would aid in improving the quality of the audit.
3. Facilitation of the greater dialogue by the key stakeholders on this topic.

Research Audit Quality with APES 110 Code of Ethics and ASIC's Website

We have seen that the former Chairman of the Australian Securities and Investment Commission (ASIC) Greg Medcraft warned that in order to have no more Enron like accounting scandals the auditors need to understand their responsibility and ensure that they are doing their jobs responsibly and give a reason able assurance on the financial statements audited by them based on the sufficient and appropriate audit evidences collected by them. They also need to highlight the material misstatements and inefficiencies in the system, if any so that the informed decision can be taken by the investors and the other stakeholders. The Accounting Professional and Ethics Standards Board (APESB) mentions in APES110 on Code of Ethics for Professional Accountants that the most distinguishing feature of an accountant is to accept the fact that they need to work responsibly in the public interest. Some of the ways to ensure the quality of the audit by the engagement team is as follows:

1. Exhibit the appropriate values, professional ethics and the attitude which is required at work as they have a huge responsibility towards all the stakeholders who rely on their professional skills and judgement.
2. Providing the useful and timely reports and information.
3. Have sufficiently knowledgeable, skilled and experienced people at work and give them sufficient time to do the analytical review and come to the conclusion thereon.
4. Application of the rigorous audit procedures and checks and apply quality control procedure which are in line with the applicable financial framework, the laws and the regulations.
5. Interact and enquire with the relevant stakeholders.
6. They should be engaging with those charged with governance for any and every doubts and highlight them to the forum for proper justification.
7. They should critically access the financial statements and must have a questioning mind and thus professional scepticism in order to check and validate the appropriateness of the accounting estimates and management judgements. They should not readily accepting the explanation and representations from the management without challenging the issues.
8. They should have effective audit planning and implement the same thereon to address the findings. They should also be ready to revising it from time to time to ensure that they are effective.

Furthermore, it is not only the auditors who are responsible for ensuring the quality of the audit but the management as well as the directors of the company as well who should be supporting the audit process by providing appropriate and sufficient support to the auditors on a timely basis.

Some of the very important and critical aspects to be taken care of for ensuring the quality of audit are sustainability of the reviewers of the audit findings and supporting, the coverage of the review, how the review and reporting is being done and the audit working papers are being prepared, are there any remedial action which has been suggested and are they being taken into consideration. All this should be signed off.

Conclusion

From the above discussion and analysis, we can conclude that it is not only the malpractices of the company and the management and the creative accounting practices that lead to the downfall of the companies like Enron and WorldCom but the involvement and non-adherence to the professional ethics and practice by the concerned auditors which lead to the bankruptcy and liquidation. The auditor report being one of the most critical decision making document, should be prepared with utmost accuracy and that the quality of the audits should be ensured. Whistleblowing committee can one of the most effective ways in which such malpractices can be highlighted.

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