Framing Audit Failure - Assignment Example

Name………………………………………………………………xxxxxx Tutor………………………………………………………………. xxxxxx Institution………………………………………………………….xxxxxx Title………………………………………………………………..Auditing Course……………………………………………………………….xxxxxx @ 2010 Q1 The reason why individual audit firms commission independent reports on their quality control procedures and makes them available to the general public Over the recent past years, there have been several cases that have been caused by audit failure. An example of such cases is accounting scandals like Enron and WorldCom. The audit failure has brought about critics regarding the confidence and credibility of the accounting profession (Knapp 2008). The audit failure is as a result of poor quality control procedures. In auditing, Quality control procedures placed within an accounting firm has several elements: The ethical requirements concerning auditors. Human resources Terms of engagement, documentation and performance. Leadership responsibility concerning quality control within the audit firm. Monitoring These quality control procedures are implemented at the audit firm level and individual audits. There are several causes of audit failure that called for the need of disclosure on the quality control procedures to the public by the audit firms. These causes may be classified as either internal or external causes. a) Internal causes Audit failure may occur if the financial statements are seriously distorted leading to fraud or errors in the auditors reports. It does not occur simply by not following the accounting standards such as the generally accepted accounting standards (GAAP’s), the international standards of accounting (ISA) or the international financial reporting standards (IFRS). In short properly done audits do not mean that there are no financial distortions though creative accounting through the standards is believed to be the cause of the many scandals (Dauber 2009). The Enron scandal is a good example of creative accounting by auditors. The scandals lead to the closure of the company and the audit firm. These in turn caused lack of confidentiality by the investors, shareholders and other stakeholders (Knapp 2008). Apart from creative accounting, an auditor can accept bribes out of threats from clients to manipulate the financial statements. The auditor may also have a personal relationship with client thus compromising audit work or creating a conflict of interests. b) External causes To begin with, business risk is an example of an external cause of audit failure. Business risk is as a result of tough economic times such as the global financial crisis, intensified market competition, new technology and financing requirements. The business risk forces the management to manipulate the financial statements so as to create good impression to the public. Moreover, the management has over some time used corporate governance as a tool to override the quality control procedures. This is by having a poorly balanced board, lack of audit committees, non-executive board members and remuneration committees. Therefore, because the management wants to reflect that the financial statements are reliable, they will practice poor governance to override any external pressures. To combat the causes and effects of audit failure, it has therefore been made mandatory for individual audit firms to disclose the quality control procedures in the reports. The auditors therefore have to make disclosures regarding their independence, compliance with the financial reporting standards and audit approach used. Q2 HIH Royal commission (2003) HIH royal commission (2003) was as a result of the liquidation of HIH insurance company in 2001. The company is based in Australia and according to the liquidators; the total losses amounted to $5.3 billion. Therefore, the prime minister then john Howard called for the need of a royal commission to establish the cause of HIH insurance collapse. The commission was headed by Justice Neville Owen and after much investigation and scrutiny; the royal commission report was tabled to the parliament on 16th April 2003. According to royal commission report, there were three key main issues that led to collapse of HIH Insurance Company. They included: a) Stock market manipulation Stock market manipulation fraud was realized after an investigation by the Australian securities and investment commission (ASIC). According to the report HIH shares were purchased by pacific eagle equities Pty limited a company that was controlled by Adler the director of HIH. Pacific eagle equities had bought 1,873,661 shares and 951,339 shares on 15th June 2000 and 16th June 2000 respectively. In addition, the purchase was made using HIH insurance funds amounting to $10 million. b) Dissemination of false information Adler the director of HIH insurance had induced investors to purchase HIH shares in the year 2000 by informing the finance journalist that the share price was undervalued. When shares are undervalued, it means that when the prices in future rise the investors will make a profit. Apart from the information on the price, the director informed the journalist that he had bought HIH shares of 1,873,661 0n 15th June 2000 and 951,339 on 16th June 2000. c) Acting dishonestly intentionally It was established that Adler had financed a company he had interest. Business thinking systems (BTS) got $2 million from HIH insurance. HIH board called for a meeting to approve the $2 million investment in Business thinking system of which Adler attended but failed to disclose his financial interest in the company. How the accounting profession and accounting bodies addressed these concerns As a result of these frauds, the accounting bodies decided from thereon to adopt the international accounting standards by the year 2005. The main intention was to create a harmonization program so as to create reliability and relevancy in the financial reporting framework. Previously, it was a requirement by the law to use the Australian standards only. There was debate on whether to use the US GAAP’s and the IASB standards (Dauber 2009). The government chose the IASB standards as it has several advantages such as being used for cross-border listing and offerings. The US GAAP were considered to be black standard letters developed for the US environment and enforcement regime which the Australians have no influence. Therefore, the standards cannot fulfill the role in Australia and even in the other countries. As part of the reforms, a provision was made in section 228 stating that the accounting standards were to be interpreted by reference of object or purpose of the standards. The Australian government over the years is satisfied with the IASB standards as they have greatly improved the economic substance rather than the form of transactions (Dauber 2009). Q3 Internal controls The internal controls are policies and procedures placed in an organization so as to help it achieve its objectives. The internal controls are effected by the organizational structure, work flow, people and the information’s system. Examples of controls are the controls over sales, payments and creditors, inventories and cash. They are established to ensure smooth efficient and effective operations, prevent and minimize fraud and errors, ensure good management and improve the credibility of financial reports. The integrity of financial reports reflects that of the management and the company as a whole (Minaxi 2010). The responsibility of maintaining an organizations system of internal controls rests with the management. Therefore, it is vital for the management to take into consideration the following factors in its deliberations: To begin with, the nature and extent of any risks facing the organization. The categories of the risk which the organization can bare and their likelihood of occurrence. The management should consider the cost of operating the particular controls it intends to institute. This can be done using the cost-benefit analysis. The management should consider changes in their management policies and procedures and how they can impact the internal controls. Substantive tests Substantive tests entail the activities performed by the auditor during the audit so as to obtain evidence regarding the completeness, validity and accuracy of the account balances and the underlying classes of transactions (Minaxi 2010). Therefore, evidence that the account balances and transactions are not complete is a sign that the financial statements are materially misstated. The substantive tests aim at gathering information about the financial statement assertions which include: existence, occurrence, valuation, rights and obligations completeness, presentation and disclosure. There are two types of substantive tests; analytical procedures and the tests of detail. Analytical review procedures make use of the significant accounting ratios in identifying areas of potential material misstatements in the financial statements. Apart from ratio analysis, there are other standards tools that can be used as analytical procedures such as trend analysis and reasonableness tests. The tests of detail touch on the account balances. The analytical review procedures can be carried out at any stage of audit while the test of detail is only carried out during the substantive testing stage. The relationship between the internal controls and substantive tests The relationship between internal controls and substantive tests is that the internal controls help in determining the level of risk during substantive testing. Substantive testing is concerned with the material misstatements of account balances and transactions (Minaxi 2010). Therefore, if the auditor establishes that the internal controls over the account balances and transactions are weak, then the level of risk in the audit is said to be high. For example, performing controls over debtors to establish on the collectivity of the customers accounts. Also, performing controls over purchases to establish the amount owing as at the balance sheet date. References Thomas Carrington (2007). Framing audit failure: four studies on audit quality discomforts. Stockholms universitet. Frank L. Clarke, G.W.Dean, Kyle G. Oliver (2003). Corporate collapse: accounting, regulartory and ethical failure. Cambridge university press. Mark westfield (2003). HIH: The inside story australia’s biggest corporate collapse. John wiley and sons. David Elias (2005). Adler guilty on 4 charges. The Age Spencer Pickett (2010). The internal Auditing Handbook. Wiley & Sons publishers. Rachchh Minaxi (2010). Financial accounting and auditing. Pearson education India. Nick A. Dauber (2009). The complete guide to auditing standards and other professional. Wiley publishers. Micheal knapp (2008). Contemporary Auditing: real issues and cases. Cengage learning Read More