Thursday, May 31, 2012

Do Auditing and Assurance Service have a future?

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1 Introduction

Recent large corporate collapses- like Pasminco, Ansett, OneTel, Impulse Airlines, Harris Scarfe, and HIH Holdings, while the US giants include Enron, WorldCom, Waste Management, MicroStrategy, and Phar-Mor - have exposed gaping holes in the system of investor safeguards designed to ensure that investors receive full and fair disclosure about the companies in which they invest. The collapse has also focused attention on the issue of auditor independence. Although a company and not its auditors is ultimately responsible for the information it discloses (or declines to disclose) to the public, independent auditors have long played a critical role in protecting investors. By applying widely accepted accounting principles to their clients books, auditors are supposed to verify that what a company wants to report as profits are actually that, and that what a company doesnt want to call debts are nonetheless known. Here, auditors are supposed to provide the first line of defense against misleading financial disclosures, but in most of the cases auditors were blamed categorically not to fulfill their public watchdog function. This paper attempts to ascertain how far auditors are liable and their possible failings contributing to corporate collapse. Also this paper tries to find out how far investors confidence has been affected and whether auditing and other assurance services still have a future after all these unwanted developments.

. Auditors and their role

An audit is a verification of the information that others rely upon to make decisions-decisions that can have repercussions throughout the economy. Investors need assurance from an independent and reliable party on the accuracy of a company’s financial report. Naturally such an expectation and reliance makes the auditors’ role very critical in the capital market. To provide this assurance auditors are required to maintain the highest ethical and professional standards to ensure their independence.

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Moreover, through out the world the statutory regulation requires any company that offers securities - meaning, effectively, any major reporting company - to have independent, certified accountants sign off on their publicly available financial statements. This has, needless to say, created a highly lucrative franchise for accounting firms.

.1 The importance of independence

Independence in auditing means taking an unbiased viewpoint in the performance of audit tests, the evaluation of the results and the issuance of the audit report. If the auditor is an advocate for or influenced by an employee or the management of the auditee or have some other interests, the auditor cannot be considered independent or objective. Audit Guidance Statement (AUP) highlights three personal attributes essential to maintaining an in independent frame of mind integrity, objectivity and strength of character.

The two most important issues that need to be considered are independence of fact and independence in appearance. Independence in fact exists when the auditor actually maintains an unbiased attitude throughout the audit; whereas independence in appearance is the result of other’s interpretations of the situation. If auditors are independent in fact but users believe them to advocate for the auditee, most of the value of the audit function will be lost.

In Australia, this requirement is reflected in Section B.4 of the Joint Code of Professional Conduct (CPC) of CPA Australia and ICAA that states

Members must be and should be seen to be free of any interest which might be regarded, whatever its actual effect, as being incompatible with integrity and objectivity.

An auditor must not only be unimpeded from any conflict of interest (which may lead to an impairment of judgement), but be seen as objective and impartial by shareholders and third parties who rely on the audit report. When inappropriate financial or other relationships exist between the auditor and client management or directors, the reliability of the audit report may reasonably be questioned.

. Changing role of auditors

In recent years there have been tremendous changes in the auditing and assurance services profession. The auditing profession has identified that financial report auditing is a mature product and therefore does not have the growth prospects of other services generally offered by the accounting profession. This flattening in demand for audit services has at the same time been accompanied by a growing demand by various groups for various levels of assurance and management consulting services. This development creates an opportunity for auditing professionals to use their acknowledged skills and reputation for competence, objectivity and independence as a means of promoting themselves as the most appropriate providers of high quality management consulting services.

As a result traditional audit services are becoming a diminishing proportion of the services offered by accounting firms. Throughout the 10s, accounting firms began to offer consulting services along with traditional auditing services to their clients, and discovered that often, the consulting work was the more profitable.

But the incidence of recent corporate collapse has triggered a new debate. Many regulators, social commentators and the most of the academicians argue that the breadth of services offered by public accounting firms impairs independence to the extent that public confidence in the audit function loses much of its value. They deem that consulting and auditing services are incompatible. According to them, consulting enmeshes auditors in their clients business in ways detrimental to auditors’ independence. Investigations of the accounting profession in the United States in the late 170s by ‘Senator Metcalf and Congressman Moss concluded that management services were a detriment to the independent of performance of audits. They recommended restrictions be put on auditors in performing these service.

In Australia, CPC F.7 generally prohibits members in public practice from concurrently engaging in any business, occupation or activity, which is inconsistent and incompatible with the provision of professional services to clients. But, currently the ethical rules contain no restrictions on the management services that can be performed, provided the auditor or any person in the practice does not participate in the executive function of the auditee.

At this point, it is helpful to examine some conflicts of independence that have arisen out of the recent corporate collapses, evaluate their significance and determine how the profession of auditing has been affected.

. Enron case

Investors blamed Arthur Anderson for its failure to pick up on some of the most obvious signs that Enron was not as healthy as its financial statements made it out to be. Although Andersen now claims to have been misled about key transactions, the evidence that Andersen was well aware of Enrons financial artifice is overwhelming. Arthur Andersen CEO Joseph F. Berardino acknowledged in congressional testimony that auditors had identified serious problems with Enrons financial statements as early as 17.

But the real question, then, is not how Andersen failed to see the warning signs, but why, having seen the signs, they agreed to put their seal of approval on the companys misleading financial statements. One reason is that Andersens audit of Enron was independent in name only. Because Anderson had a lot more at stake than their accounting fees. Traditional accounting for Anderson was, compared to consulting, less and less profitable. In 000, half of Arthur Andersens fees from Enron (approximately $50 million) came from consulting work. Moreover, the Enron account was simply too big an account to lose, first because of the $100 million it was expected to produce in the near future, but also for its symbolic value to Andersens image as the lead auditor for the energy industry.

There is also a specific problem with the type of consulting that Andersen did for Enron. One type of consulting that most of the major accounting firms continue to do themselves relates to the accounting and information systems for their clients. Andersen helped set up Enrons internal accounting procedures.

The problem, of course, is that such work vitiates the notion of independence. Auditing is supposed to provide a second set of eyes. But if Andersen created Enrons accounting procedures and trained its people, how can it also step back and review those procedures critically? At that point, criticism would be tantamount to an admission of incompetence or worse.

4. More examples of similar cases

Onetel HIH

A similar lack of independence can be found in other high profile accounting scandals of recent years. Transcripts from a lawsuit following the accounting failure at Phar-Mor Inc., for example, showed its Coopers & Lybrand auditor received bonuses and performance evaluations based, at least in part, on his success in cross-selling the firms non-audit services. A lawsuit against MicroStrategy, which in March 000 disavowed years of financial statements that hid extensive losses, uncovered the fact that a senior PricewaterhouseCoopers manager assigned to the audit was applying for a job as chief financial officer of a MicroStrategy subsidiary while working on the audit. The high-profile accounting scandal at Waste Management, in which the SEC accused Arthur Andersen of repeatedly signing off on financial statements it knew to be misleading, bore many of the hallmarks of the Enron disaster. Arthur Andersen had been the companys auditor for 0 years. From 171 to 17, all of Waste Managements chief financial officers and chief accounting officers were former Andersen auditors. The partner assigned to lead the audit was responsible for coordinating marketing of non-audit services, with compensation directly influenced by the volume of such services sold. And Andersen was billing Waste Management more than twice as much for non-audit work as it was for the independent audit.

A recent analysis of proxy statement revelations of non-audit fees shows such conflicts are widespread, at least among large companies. The study, conducted by University of Illinois professor Andrew D. Bailey, looked at the first 56 proxy statements filed by Fortune 1000 companies after new disclosure rules went into effect in February 001. Among the 56 companies examined, only two paid no non-audit fees to their auditor, and, on average, clients reported paying their accountant $.6 in fees for non-audit services for every dollar spent on audit fees. In some cases, however, the imbalance was far greater. In the most extreme examples, Puget Energy paid PricewaterhouseCooper $17 million for non-audit fees and just $54,000 for its audit, and Marriott International Inc. paid $0 million to Arthur Andersen for non-audit services, compared with only $1 million for its audit. The evidence is clear conflicts that impair auditor independence are rampant.

5. Responsibility of different parties in corporate collapse

There has been a tendency for many of the affected groups to go into denial mode. The regulator saying that the problem is with the auditors, the auditors saying that the problem is with corporate governance, and the companies blaming the ineptitude of the regulators. So it is imperative to determine the degree of responsibility of each party involved.

5.1. Degree of auditor’s responsibility

Auditors are not the gatekeepers of corporate crime, nor are they responsible for the success or failure of the company’s business operations and management. They perform very specific statutory duties, primarily aimed at providing a form of check of the company’s annual and half year financial reports to shareholders aimed at ensuring that they provide a “true and fair’ view of the company’s financial position. AUS 10 require that an audit be designed to provide reasonable assurance of detecting material misstatements in the financial report arising from irregularities including fraud, other illegal acts and error. Thus an auditor’s responsibility ends with giving high level of assurance but not absolute assurance.

5..Degree of management’s responsibility

The responsibility for adopting sound accounting policies, maintaining adequate internal controls and making fair representation in the financial statement rests with management rather than auditor. Because it operates the business daily a company management knows more about the company’s stakeholders, transactions and related assets, liabilities and equity than the auditor does. In recognition of this responsibility borne by management, the Corporation Act require the directors of a public company to include a directors’ declaration in the financial report before the auditor reports on them. So the prevention and detection of fraud and error is primarily the responsibility of management, and ultimately the directors.

The major role of a board of directors is to provide stewardship to a company. The key function of the board is to ensure the integrity of the corporations accounting and financial reporting systems. This includes independent audit and appropriate systems of control; in particular systems for monitoring risk, financial control, and compliance with the law.

The auditor does have the responsibility to plan and perform the audit to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. As an audit does the selective testing of transactions and balances it cannot guarantee the detection of all material irregularities, as such irregularities or fraud are often concealed from auditors through forgery or collusion. So it is not a good idea to responsible the auditor for a corporate collapse without considering the circumstances.

6. Factors to be considered

The quality of an audited report sometimes depends of the following factors. Besides, the expectation of the investor on the audited report also play a major role how an auditor will be blamed if something goes wrong with the company.

6.1.Expectation gap factor

The difficulty arises when there has been a business failure, but not an audit failure. For example, when a company fails or cannot pay its debts, it is common for statement users to claim that there was an audit failure, especially when the most recently issued auditor’s opinion indicates the financial statements were true and fair. Even worse, if there is a business failure and the financial statements are later determined to have been misstated, users may claim that the auditor was negligent even if the audit was conducted in accordance with auditing standards. Their duty is limited in only providing a reasonable assurance and writing an audit report on the basis of the findings. However, there are inherent limitations of auditors on auditing annual and other reports

1. The reports are historical, and do not predict the future-as such, they are only but one tool among several that investors and their advisers need in order to make informed investment decisions about companies.

. The auditor looks only at the accuracy of the company’s financial records, and does not consider other data, relevant to the company’s performance.

. The role of the auditor does not extend into what is probably the most important area of disclosure-continuous disclosure.

As a result, an unqualified audit report cannot guarantee absolutely that the financial statements are free of error; nor can it guarantee the future viability of the company. But the investors when evaluating audit report hardly consider these limitations in the report. They tend to rely heavily on auditor’s assurance and expect that the auditor will be able to pick up any signal of catastrophe to warn the investors. This expectation is often the source of misunderstanding of the audit objective and is referred to as the audit expectation gap that is, the gap between the publics expectation of auditor performance and the publics perception of the auditors actual performance. While the public may expect infallibility in relation to the accuracy of financial reports, the early warning of failure and the detection and reporting of irregularities, auditors have no duty to report on a companys internal control structure unless specifically requested to do so.

Perhaps the profession has a responsibility to educate statement users about the role of auditors and the difference between business failure, audit failure and audit risk. It is important to distinguish the difference between business failure and audit failure. An auditor is responsible of the audit failure only. In a legal battle, the auditors will be tested on the ground that whether the audit failure is the result of an underlying failure to comply with the requirements of appropriate auditing standards. Auditing is limited by sampling, and particular misstatements and well-concealed frauds are extremely difficult to detect; there is always some risk that the audit will not uncover a material misstatement even when the auditor has complied with auditing standards.

6.. The Economic Factor

Whilst accounting is not a regulated profession, auditing is regulated, in that only persons who are registered company auditors are allowed to sign the audit reports of companies. The registration of company auditors is regulated by the Government Agencies, but the Government regulation is heavily supplemented by self-regulation by the Accounting Bodies and the big firms themselves. Hence the process is described as co-regulation.

It is extremely fragmented and such a system can only possibly work if there is very close co-operation and co-ordination between the various parties. However currently there is precious little openness, there is a general reluctance or legal inability to exchange information, and there is a considerable risk of serious issues falling into a hole between the parties. The big risk in a co-regulation scheme like the one the present system has is that no one is really in charge.

Besides, no degree of regulation will avoid or prevent these certainties although it may reduce the risk of recurrence of old problems. What is more, in an increasingly international world, regulation within any individual country cannot reduce the risks attendant on the auditors. Standards and practices of auditing and governance vary widely country to country. Consequently, the problems of auditing international groups remain and cannot be dealt with in a single country. Problems also arise from the higher levels of abstraction at which the auditors of global groups necessarily operate.

6.. Going concern assumption

Many of Enrons complex, related party transactions involved off-balance sheet financing arrangements guaranteed by Enrons stock. Additionally, the companys stock price depended on earnings growth and continued access to capital. Combined, these circumstances created a high-risk environment from an audit perspective. Going Concern (Issues SAS 5, The Auditors Consideration of an Entitys Ability to Continue as a Going Concern) requires the auditor to evaluate conditions or events discovered during the engagement that raise questions about the validity of the going-concern assumption. The auditor is not required to design specific audit procedures to identify such conditions and events. Instead, when evaluating the results of the overall audit, the auditor should consider whether certain conditions or events discovered during the course of the audit contradict the going-concern assumption. The projection of the going-concern concept is defined as not exceeding one year beyond the date of the audited financial statements. The current standard places the responsibility for identifying any exceptions to the going-concern assumption with the auditor.

Because a going-concern opinion may cause stockholders and creditors to lose confidence in the company and ratings agencies to downgrade the debt, leading to an inability to obtain new capital and an increase in the cost of existing capital, auditors are extremely cautious in giving such opinions. Because in most cases companies’ debt guarantees tied to its credit rating, a going-concern opinion will seal the companys fate even sooner.

If Andersen had included a going-concern paragraph in its opinion on Enrons 000 financial statements, its fate might have been very different. The above statement is also true in other cases of corporate failures. Auditors, however, cannot predict the future. Failure to issue a going-concern opinion is not sufficient evidence of an audit failure, and the absence of a going-concern qualification should not be viewed as providing assurance. Post-SAS 5 research shows that 40% to 50% of failed companies do not receive going-concern qualifications in the year immediately preceding bankruptcy. Of three recent high-profile bankruptcy filings-Enron, K-Mart, and Global Crossing-none received a going-concern opinion.

7. The Case for Independence

Everyone agrees that auditors need to be independent. The question is how to ensure independence without unnecessarily hamstringing other economic activity. On one level, of course, this type of consulting makes sense. Accounting firms know a lot about accounting; they ought to be good at telling companies how to set up their own internal procedures. There is not enough evidence, yet, that consulting is uniquely responsible for the recent well-publicized auditing failures. In the infamous case of Microstrategy, whose stock collapsed from a high of $0 per share to around $ per share in the wake of earnings restatements, the accountants did not appear to have a significant consulting relationship with the company. Nonetheless, they signed off on financial statements that were largely works of fiction.

The chief of Andersen, Mr Joseph Berardino, has come out with a revealing statement, a virtual mea culpa about his firm’s role in the disaster. While he has tried to take cover under an alleged warning that his firm issued to Enron’s audit committee about the possible flaws in its complicated accounting structure, he has been categorical in his criticism of Enron, although he maintained his view that the whole system of self-regulation and discipline of auditing as a profession needed to be improved.

7.1. Incentive for independence

Auditors are paid by their clients. Theoretically, if Arthur Andersen wont let a client book the latest contract the way it wants to, the client can fire them and hire Ernst and Young. But there are real barriers to shopping for auditors. First, it makes investors nervous. Second, because auditing is ongoing, there are huge costs associated with axing one set of auditors and inserting another. Finally, there are not an endless number of accounting firms that can handle Americas largest and most profitable companies. Changing auditors is hard, and so companies have an incentive to listen when their accountants bring bad news.

7.. Market’s self-healing process

A new survey of some 50 asset managers and analysts, conducted by public relations firm Citigate Dewe Rogerson in the USA, revealed that almost 5 percent of the respondents believe investors might have concerns about companies that purchase consulting services from their auditors.

More worrisome, over a third of that group felt investors will, in fact, discount the share prices of such companies. Further, a number of the asset managers and analysts in the survey believe the even the perception of a conflict of interest between a corporations auditor and consultants could cause investors to apply a discount to that companys stock price.

This survey proves that the market will activate its self-healing process to rectify the problem. Many of the Anderson’s client have severed ties with Anderson to restore the confidence in their audited report.

8. Steps taken to restore confidence

Assurance service is a highly lucrative franchise for accounting firms. If accountants want to keep this license to make money, it is not unreasonable to impose structural limits on their other businesses. There are several practices that are especially problematic. First, linking auditors pay to consulting fees seems like the most straightforward sort of conflict. The press has widely reported that Andersens accounting partners received bonuses in proportion to how much consulting work was done. Those arrangements should be flatly illegal auditors cant be in the position of selling consulting services.

The Security and Exchange Commission in the USA has proposed to ban auditors from also performing internal audits for audit clients. It stated that ... performing an internal audit function results in the auditor assuming a management function and, during the audit, relying on a system that the auditor has helped to establish or maintain. Thus, performing internal audits violates at least two of the four key factors the commission identified as impairing an auditors independence -- functioning as management of the audit client and auditing the accounting firms own work -- and possibly a third, having a mutual interest with the audit client.

The International Federation of Accountants (IFAC) ethics committee, in its recent exposure draft on independence, also focused on the issue of auditor independence. The draft proposes a move to a conceptual framework requiring the identification and evaluation of threats to independence and the application of safeguards to reduce any threats to an acceptable level. Threats to independence include self-interest, self-review (for example, providing both non-assurance and assurance function), advocacy (for example, dealing or promoting shares in an assurance client), intimidation and familiarity. Mitigation of such threats may require resignation or refusal of the assurance engagement. This IFAC exposure draft recommends a more rigorous assessment of independence, supported by appropriate evidence.

In response to all the media fuss over auditor independence, around July 001 the Federal Government in Australia appointed Professor Ian Ramsay of Melbourne University to perform an enquiry on Auditor Independence and to make recommendations for reform of the independence rules Professor Ramsay received submissions from the big firms and other interested groups, and issued his report in October 001. In view of the amount of work that had been done in connection with the development of the IFAC independence rules, Professor Ramsay had little choice but to endorse these rules, which at the time of his report were still in exposure draft from.

. Conclusion

There are two certainties, which must not be ignored. One of them is that corporate failure will inevitably happen particularly when a period of economic difficulty follows a bull market. In a proportion of the failures, it will be shown that managements made unwise assumptions about the future prospects of their business. In others it will be shown that managements ignored or obscured the evidence of trading difficulty. In either event, second certainty is that when there is a spate of corporate failures, then auditors as individuals and as a group will be blamed or, at least, questioned.

Though some of the most publicized corporate collapse as stated above have repeatedly pointed fingers to auditors because they had gone beyond their professional capacity and thus had been hold responsible in the failure of their professional duty, but it does not in any way undermine the importance of assurance service nor the role of auditors. Perhaps, investors need to be reminded of one important thing is that the audited financial statements are an insufficient basis for financing decisions . They need to be aware of the inherent limitations on the audit process and the fact that an audit is essentially a broad professional opinion rather than a precise verification of the figures provided by the company management. While some corrective actions in the form of promulgating new regulations or strict implementations of code of conduct will restore the public confidence in the assurance service, but it will not be the panacea of preventing corporate collapse. Of course, the main responsibility lies with the management of any company and the investors must need to understand that.

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