Auditors Role in Enron free essay sample

The responsibility of an auditor is to express an opinion on the financial statements based on his audit which means verification or check in accordance with International Standards on Auditing. These standards require that the author complies with ethical requirements and performs the audit to obtain reasonable assurance whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal controls relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.   Enron was established in 1985 following the merge of Houston Natural Gas and InterNorth. In year 2000, Enron reported a remarkable growth of revenue of $ 100. 8 billion, putting it at number seven in the Fortune 500 list of the country’s biggest companies. However, in October 2001, things were reversed with its report of $638 million third-quarter loss and $1. 2 billion reduction in stock value . Following the revise of financial statements for past five years which accounted for $586 million in losses , in December, Enron filed for Chapter 11 bankruptcy, and became the US’s largest ever corporate collapse. Behind this world-shaking collapse is the fact of executives’ self-dealing, greed and the accountancy company’s default. Enron’s collapse recalls the debate of Anglo-Saxon corporate governance model, which supports deregulation, ‘shareholder value’ and opposition of public intervention. One of the important lessons from the Enron collapse is that no one in the ‘audit chain’ could alarm, disclose, and correct its weak financial status and bad business behaviour. The audit chain, including the audit committee of the board, the board, the outside auditor, the market specialists in stock, the stock exchanges, major creditors, and the credit rating agencies, etc. , appears to have not had an enough incentive to find out and disclose the truth of the behaviour of Enron. Among them, Arthur Andersen, the outside auditors, who should be independent from the audited company, failed to report the accurate information because of a conflict of interest between the auditing and consulting activity for Enron. Enron was Arthur Andersens second largest U.S. customer, paying $25 million in audit fees. Failure by auditors to detect a material error or misstatement in accounting information at Enron can arise from three main causes, two of which may be attributed to audit failure . First, auditors may either fail to detect a material error or misstatement, or, having detected an error, fail to recognize it, because they have carried out a substandard audit – i. e. the auditors are incompetent. Second, auditors may identify an error or misstatement and fail to report it or get the directors to put it right – i. e. the auditors lack independence. Third, directors may deliberately deceive auditors. In cases of deliberate deception, auditors may not be held responsible for failure to detect a problem. Andersen’s audit failed due to unconscious bias which is the propensity to interpret data in accordance with our desires. Biased judgments, rather than criminal collusion between auditors and management often cause audit failures. The so called â€Å"integrated audit† that Andersen employed at Enron where it sought to combine its role as external auditor with internal auditing, the process whereby an enterprise checks its own books. Internal audits seek to ensure that an enterprise follows its procedures, safeguards its assets, and operates efficiently. Management has historically selected the accounting principles that an enterprise uses to prepare its financial statements. An audit essentially endorses or rejects the accounting choices that management has made. The auditors have a large part of responsibility while endorsing or rejecting the accounting principles. The Enron collapse has focused world attention on accounting standards and the role of auditors. Accounting bodies have been reviewing the issue because it concerns members in two ways. As investors they need to consider the quality management on accounting standards, corporate governance implications and possible regulatory impact, especially with reference to the impending government review. As preparers of accounts, they need to reassure themselves that the practice is sufficiently robust and that any regulatory changes following Enron will lead to genuine improvements without adding unnecessary cost. It focuses on the need to ward against conflicts of interest between auditors and their clients. Evaluation of external and internal auditors on independency and diligence A number of separate groups have an interest in a company’s accounts: management, shareholders and lenders, and where relevant regulators. While all have a genuine interest in understanding the business and its prospects, the motivation may not be the same in every case. Management has an incentive to paint a positive picture to the other groups. Shareholders and creditors need an objective view. Accounting rules need to be robust in order to ensure that the picture is objective. The audit process needs to be independent in order to prevent undue influence by management. It is thus appropriate to review of accounting bodies practice from these standpoints. There may be a case for change in some areas, but these should not generally go in the direction of detailed prescription and additional rule making. This approach should also be preserved for the elaboration of international standards, which are due to enter force in the future accounting conference. It would be wrong to shift towards a more rule-based approach in the wake of Enron, not least because that would encourage companies and their auditors to seek loopholes. Nonetheless it is appropriate that investors and audit committees should tighten their scrutiny of the audit process. Auditors must be in a position to resist pressure from management to present an overly positive view of the business. They must not make themselves vulnerable to such pressure by coming to rely heavily on fees for non-audit consultancy work from companies whose accounts they audit. External and internal auditors continually strive for improvement and eliminating the conflict of Interest Two main means of preventing conflicts of interest have featured in the debate over Enron. Some have suggested that auditors should be rotated on a regular basis. Others have suggested that there should be a formal separation of the roles of auditor and consultant. Both ideas have attractions. Both have flaws. Of the two, that of rotating auditors is the more problematic, because there would be regular periods of transition during which scrutiny would be weak. Critical issues might thus be overlooked. A more practical approach might be to impose more frequent rotation of audit partners than the current seven-year norm. This would be part of a process that would also ensure a steady and continuous rotation of audit teams. Some members believe the audit partner should be rotated every three years. Another suggestion is that the audit partner be named in the annual report. This, it is argued, would instill a greater sense of personal responsibility and raise the quality of the audit. Another idea, to which shareholders attach considerable importance, is that the audit partner should not move across to a senior position within the client company, particularly as finance director. While shareholders are not in favor of rotating auditors, they do believe that such an appointment should automatically trigger the appointment of new auditors. The idea of separating audit and consultancy work also finds some support. However there are reservations on two counts about prescribing such change. Some types of non-audit work fall naturally to auditors. An example is the preparation of regulatory returns for insurance companies. For this reason the accounting bodies has resisted the temptation to prescribe a formal separation of the audit/consultancy role or to prescribe any maximal for the ratio of non-audit to audit fees. There is, however, scope for strengthening governance in this area, even as an interim measures pending the conclusion of broader debate. The U. S. accounting bodies already monitors the ratio of audit to non-audit fees. When the latter exceed the former and now plan to follow through with a letter to the chairman of the audit committee, asking for an explanation of the fees, confirmation that the committee is comfortable with the award of non-audit work to its auditor and to state whether non-audit work had been put out to tender. If institutional shareholders want to ensure that company accounts are properly audited, they must be prepared to sanction appropriate fees. It may well be that audit fees should raise as standards are tightened in the wake of Enron. Shareholders should support this if it leads to higher quality audits and reduces the temptation for audit firms to raise additional revenue through consultancy. Alas it would be wrong to concede higher fees simply because a contraction in the number of large audit firms had reduced competitive pressure. Companies need a diversity of choice when looking for an auditor. Second, higher fees would also require higher standards of supervision. There is a strong case for revisiting the role of the audit committee and for requiring it to make regular disclosure in the annual report about its activity in supervising the audit process. Section 404 of the act requires management to acknowledge its responsibility for establishing and maintaining adequate internal controls, including asserting their effectiveness in writing. The financial statement auditor, in turn, must report on management’s assertion about the effectiveness of its internal controls as of the company’s yearend. These provisions apply to entities with market capitalization of more than $75 million for fiscal years ending on or after June 15, 2004. (Smaller companies must comply as of the first fiscal year ending on or after June 15, 2005. The Sarbanes-Oxley internal control certification provisions impose significant responsibilities on both management and the auditor. The former will have to take ownership of the process of identifying, documenting and evaluating significant controls, as well as determining which locations or business units to evaluate. For auditors, providing an opinion on the effectiveness of an entity’s inter nal controls is a significant engagement. Management and auditors should recognize the process will be valuable for several reasons. Management’s assessment of internal controls should enhance the entity’s risk identification processes by lending entity wide consistency. The assessment also should enhance controls consciousness throughout the company and may reveal unnecessary or duplicate controls, as well as areas for improvement. Better control processes could result in operating efficiencies and reduced litigation and fraud. Key Proposed Tests of Controls An effective detective control can compensate for a deficient preventative control, therefore avoiding a significant deficiency or material weakness. The auditor should more extensively test controls on which other significant controls depend. Evidence about the control environment (including fraud programs) often is highly subjective; the auditor should not rely on results of tests others perform. The auditor should limit use of the work of others in areas such as controls over significant nonroutine and nonsystematic transactions and the period-end financial reporting process. Unless the control environment is deficient, the auditor can test controls at an interim date, but should consider obtaining additional evidence for the remaining time period. Where the entity has changed controls, the auditor need not ordinarily consider those superseded controls to render an opinion on controls effectiveness as of yearend; however, changed controls may relate to reliance on controls in the financial statement audit due to the nature of earnings and cash flow measurement. If reasons for a control exception do not indicate weakness in general design or control operation, the deviation may not indicate a significant deficiency. Regardless of reasons, numerous or repeated instances of a deficiency may constitute a significant deficiency. Although individually insignificant, numerous control deficiencies having a common feature or attribute may constitute a significant deficiency. A material misstatement the auditor detects, but the entity does not identify, ordinarily is a material weakness in controls. Where multiple locations exist, the auditor should perform tests of controls if a location is Individually important.