Auditor’s Public Interest Responsibilities And Audit Quality: Lessons From The Enron Scandal Essay.

Topic: Auditor’s Public Interest Responsibilities and Audit Quality

In a recent interview with ABC news, the now former Chairman of the Australian Securities and Investment Commission (ASIC) Greg Medcraft warned that:

“We don't want to have another Enron. And the key to not having another Enron is making sure auditors do their job and to get assurance that financials are free of material misstatement" 

Enron was an energy, commodities, and services company based in Texas, USA. It was founded in 1985. Prior to its bankruptcy on 3^rd December, 2001, Enron employed close to 30,000 staff and was a significant electricity, natural gas and communications company, which had reported revenue of nearly US$101 billion during the year 2000.

By the end of 2001, it was revealed that Enron's reported financial position was manipulated by a systematic and preconceived accounting fraud, known since as the “Enron Scandal”. Enron has since become known as an infamous case of audacious corporate fraud and corruption.

The scandal also brought into question the accounting practices and activities of many corporations in the USA and was a factor in the creation of the Sarbanes–Oxley Act of 2002. The scandal also led to the demise of the accounting firm, Arthur Andersen, which was Enron's auditor.

In more recent times, according to ASIC, based on samples of key audits performed by Deloitte, KPMG, PWC and Ernst & Young, over an 18 month period up to December 2016, 23% had not provided reasonable assurance that accounts were accurate or free of misstatements.

As stated in the Accounting Professional and Ethics Standards Board (APESB) APES 110 Code of Ethics for Professional Accountants, under Section 100 Introduction and Fundamental Principles,

“A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest.”

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.

The importance of auditors doing their job to prevent material misstatement

The auditor’s report serves as a reasonable assurance as to the quality of audit being conducted and shows that the accounts of the company have been prepared without errors, omissions and material misstatements.  It has direct repercussions on the decision making by the stakeholders and hence it warrants for due diligence and utmost importance. Greg Medcraft, Chairman of the Australian Securities and Investment Commission (ASIC) has warned in one of his interviews that the auditors do need to understand the responsibilities and conduct their jobs honestly and do ensure that the quality is not being compromised (Bizfluent, 2017). Whistleblowing is one of the ways in which the employees and the management can report the discrepancies in the organizations, the audit or reporting to one of the teams in the organization so as to ensure transparency and avoid wrong doing.

In the given section, a stakeholder analysis has been conducted for one of the companies listed on the Australian Stock Exchange named Wesfarmers Limited. The company is a widely known conglomerate which has its presence in Australia, New Zealand, India, Ireland and United Kingdom (Werner, 2017). The company deals in chemicals, mining, safety and industrial products, coal mining, fertilizer and retail sector. The company is the largest in Australia in terms of revenue as well as in terms of employment giving work to over 220000 employees. The company has a history of over 100 years and is still growing and has a presence in the lives of almost all the Australians.  

In terms of the stakeholders, every company does have a unique set of internal as well as external stakeholders who are interested in the results and performance of the company and the auditor’s report serves as the basis of their economic and financial decision making (Visinescu, et al., 2017). The external stakeholders may be in the form of banks and financial institutions, the government and the tax authorities, the prospective customer and the shareholders/investors whereas the internal stakeholder includes the employees, the management, the vendor and the existing customers and shareholders. Each one of the above stakeholder group is engaged or interested in the set of financial statements for their own reasons and if the same is materially misstatement and includes errors, frauds and omissions, all their decisions may be wrong and they might suffer losses. For example, wrong picture of financial statements and the auditor’s report may lead to wrong planning, budgeting, forecasting and financial decisions by the Board of Directors, management group and might mislead the employees in terms of growth and career options. Furthermore, the investors may also suffer losses and negative returns and thus it may lead to erosion of capital. For the external stakeholders wrong or misstated financial statements might lead to wrong tax calculation or under reporting of profitability and later on might result in penalties (Chaudron, 2018). The prospective customers may later on find that the company is not worth it and this might lead to losing of customers. The banks and financial institutions may not agree to grant loan and financial assistance to the business once they come to know of the window dressing as it leads to huge loss in terms of credibility of the company. The prospective investors are also on the losing side as they are unaware about the exact and actual situation of the company and thereby end up on the losing side due to the wrong financial decision made based on the incorrect audit report.

The Enron scandal and its impact on auditing practices

As per APES 110 on Code of Ethics for Professional Accountants, independence of the auditor is one of the very basic requirements of the auditors and it is a pre-requisite which should be met for the quality of the audit report (Defond & Lennox, 2017). It means independence not only in terms of the mind but also in terms of the appearance. Independence of mind is a situation whereby the auditor is not influenced emotionally or by any other means and gives his opinion on the financial statements of the entity based on integrity, objectivity, professional judgement and applies professional scepticism before reaching to any conclusion. On the other hand, independence in appearance means taking the decision and preparation of the audit report based on facts and figures and taking actions which is reasonable and would have been the same had it been conducted by the 3^rd party. As per the conceptual framework for the auditors, he/she should be independent in his/her approach or else it might lead to frauds, errors, omission, etc. in the financial statements which might affect the stakeholder directly. The auditors’ report serves as a guidance and it gives reasonable assurance to the investors that the financial statements of the company are giving true and fair view of the state of affairs of the company and that it has been prepared by the independent auditors with any prejudice (Fay & Negangard, 2017). In case the auditors are involved in window dressing of the financial statements, this might lead to another scandal like that of Enron.

Whistleblowing is one of the ways of reporting the wrongdoing in the company to a dedicated team which helps in identifying the wrong doing and thereby reducing the chances of the fraud. It is a situation whereby any employee, contractor, management personnel or supplier goes beyond the normal course and channels of communication to report something unusual and suspicious to the whistleblowing committee in the interest of the organization (Fukukawa & Mock, 2011). Normally, many companies in the modern era set up the whistleblowing committee or else set up the processes to report these kind of inefficiencies. In some cases, auditors do make the public disclosure as well as the same highlights the possibility of fraud and errors in the organization and the lack of internal control as well. The Code of Professional Ethics gives due importance to this fact and mentions that in case any of the auditors do find that their fellow colleagues are involved in any such wrong doing, then the same should be immediately highlighted to the audit committee or directly to the head of the audit committee as the same is in public interest and it would help in avoiding frauds and mismanagement (Kaufmann, 2017).

Stakeholders' interests in audit reports

Enron Scandal is still one of the biggest accounting scandal that has materialised till now and it led to the erosion of $ 60 billion worth of shareholder’s wealth. The company was the one dealing in the energy, commodities and services in USA. It was founded in 1985 and was bankrupt in 2001. It was the 7^th largest company in USA at the time of its liquidation and employed nearly 30000 employees and has reported a revenue of $ 101 Billion in the year 2000 (Linden & Freeman, 2017). In the year 2001, it was identified that the reported profits of the company were over and above the actual and the same was effected by systematic and preconceived accounting and the then auditors Authur Anderson, one of the reputed big 4 accounting and consulting firms failed to highlight these points in the auditors’ report. Since then, both these entities have become infamous for audacious corporate fraud and corruption. This is the only reason which put a question mark on the integrity and the accounting practices of many big companies in USA and thereby leading to the emergence of Sarbanes Oxley Act, 2002. The shares of Enron Company dwindled from $ 90.75 to $ 1 in the wake of this corruption as the company along with the auditors Arthur Anderson inflated the profits as well as the assets in the books, ultimately leading to the downfall of the company. Some of the major learnings from this entire episode are as follows:

1. Not to invest in anything which is not understandable or manageable: The Company Enron was in the business of energy and utility sector but it made a huge investment in the derivatives as well as commodity market. The investors clearly did not understand the business model of the company and went just by the motion of the markets. The financial statements of the company were complex and scandalous so much so that even world’s most successful investor Warren Buffett was not able to understand and interpret the same. The company also used a number of non GAAP entries in the financial books in a bid to hide the actual expenses and thereby showing excessive and supernormal growth forecasts(Marques, 2018).
2. Understanding and taking appropriate measures to avoid counterparty risks: It was not only the company Enron which suffered massively due to its liquidation but even the counterparties were adversely affected as they not foresee the same earlier. The counterparty risk may be defined as the risk to both the parties to the contract that the other party will not be able to meet the obligations(Mubako & O'Donnell, 2018). Some of the most affected counter parties include the creditors, banks and financial institutions and derivative counterparties who did not receive the funds rendered as loan to Enron. Even the auditor, Arthur Anderson was one of the most deadly affected counterparty as one of the 5 biggest consulting firms in US known for risk management and high quality audits had to close down its operations due to the involvement in the Enron Accounting Fraud.
3. Over use of the Debt in the capital structure can be risky: The use of excessive leveraging in the capital structure of the company can act just like 2 sides of the coin. It can help in multiplying the gains of the company if the value of assets is rising. Similarly, it can also lead to the erosion of the wealth if the asset values are declining. The biggest concern with the use of the debt capital is the fixed interest burden which has to be paid irrespective of the profitability of the company and therefore the same should be used with utmost care(Appelbaum, et al., 2018). It has been seen in the past that many companies like liquidation of Lehmann Brothers, WorldCom and even the US housing loan bubble in 2007, all of which occurred due to excessive use of the debt capital.
4. The investor should always avoid investing in the companies which employ fancy derivatives: Enron was hugely dependent on the speculative income and had huge investments in the derivative contracts which are quite uncertain in nature. Warren Buffett has mentioned these instruments to be quite risky in nature which may even lead to the downfall of the company. Besides this, the company was also involved in accounting practices like that of mark to market such that the profit from the derivatives was being accounted for even before they were being accrued or realised(Raiborn, et al., 2016). Enron, being one of the major energy giants all over the world at that of time, it can only be said that the excessive use of the derivative instruments can also led to a massive downfall.
5. Management integrity is a must: For any organization to prosper and flourish, it is very important that the proper and skilled management is a work. The best part about having a quality management team is that it leads to proper allocation of the capital, minimising of risk and multiplication of wealth(Lu, et al., 2017). Enron proves to a classic example for the same as the investors cannot directly meet and check with the management about the operations of the company and therefore they rely on the operations report of the company, the quarterly investors’ conference, the insider trading transaction assessment, etc. and Enron failed in all these aspects.

Thus, from all the points mentioned above, it is clear as to how big a role the auditors play in financial decision making as it is their reputation and the audit report based on which the stakeholders take risks and invest in companies. It thus becomes very important that they understand their responsibility and not get involved in fraudulent practices.

The quality of audit plays a very crucial and important role as in the modern era all the economic, financial and investment decision regarding any company is based on the opinion by the auditors. It may be defined as the systematic examination of the books of accounts either by the internal or the external auditor. It is also one of the basic requirements of the quality management system and is a major constituent of the ISO quality standards (Vieira, et al., 2017). Audit are conducted with the objective that the auditors after duly examining the books of accounts, will arrange for sufficient and appropriate audit evidences based on which they will express and opinion on the financial statements and the same is being used by the stakeholders for economic and investment decision making. The auditors are responsible for giving reasonable assurance to the investors that the company is quite stable and that the financial statements are free from errors and misstatements and are showing a true and fair view of the affairs. For those who do not understand the financial statements, it is the auditor’s report based on which the decision making is done. Therefore, it is very important to maintain the quality of the audit and it will help in fostering the element of trust in the stakeholders. Some of the major objectives of framework on the quality of audit are:

1. Encouraging the awareness of the stakeholders to suggest ways to improve the quality of audit.
2. Encouraging greater dialogue by the key stakeholders(Sonu, et al., 2017).
3. Increasing awareness on key topics of audit quality and its overall impact.

Auditor's independence and its significance

It was seen in the recent interview with Greg Medcraft, Chairman, Australian Securities and Investment Commission (ASIC), that he warned the accounting and the auditing fraternity as a whole that in order to avoid the accounting scandals like that of Enron and WorldCom, it is high time that the auditors do understand their responsibility and the give a true and fair view on the audits conducted by them. It is important to have professional scepticism all throughout the audit and give opinion based on sufficient and appropriate evidences only (Knechel & Salterio, 2016). They should highlight all the material misstatements as well as the inefficiencies in the system such that there is an improvement in the transparency of information. It has been mentioned in APES110 on Code of Ethics for Professional Accountant that the most distinguishing feature of the accountant is to work in a responsible manner in the public interest. Some of ways to improve the quality of audit are as follows:

1. Provision of useful and timely information to all the stakeholders.
2. Interaction and enquiry with the relevant stakeholders.
3. Exhibition of proper values, ethics and attitude at work as there is a huge responsibility towards all the stakeholders and that they rely on the professional skills and judgement of the auditors.
4. Have sufficient knowledgeable and skilled people at work with experience so that they are able to do the sufficient analytical review and then come to the conclusions thereof.
5. Application of the different audit procedures and the quality checks to ensure that the financial statements have been prepared in accordance with the applicable financial framework and requisite laws(Erik & Jan, 2017).
6. The auditors should be in continuous discussion with those charged with governance and should be highlighting all the doubts and issues which they come across during the course of the audit for proper justification and explanation.
7. They should practice professional scepticism and should have a questioning mind all throughout the course of the audit and must check the management assertions, estimates and judgements for any foreseeable risks.
8. There should be an audit planning and procedure phase well before the start of the audit such that no critical and significant area of audit is being missed out. They should also be ready to make the requisite changes in the audit plan, if required(Gerlach, et al., 2018).

Along with the above mentioned points, it should also be ensured that the proper support is rendered by the management and the directors of the company to the auditors so as to improve the level of transparency and audit as a whole.

Conclusion

From the above discussion, viewpoints and analysis of the various aspects of audit, we can conclude that it is not only the auditors who are responsible for ensuring the quality of the financial statements but even the management and accountants of the company should not involve in the fraudulent malpractices and creative accounting techniques as it hampers the quality of information and ultimately leads to the downfall of the company. From the perspective of the auditors, it is very importance to practice professional ethics and be independent in their approach only then the quality of work and audit report would improve.

References

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