One of the key issues identified as a cause of the Enron scandal is that the company managed to provide misleading financial information to investors and analysts over a period of several years, indicating around $100 billion of annual revenues. However, once the accurate numbers emerged showing the state of the company’s balance sheet, lenders withdrew their funding; the SEC increased the pressure on the company; and the company went bankrupt in less than two months. Sloan et al (2002) argue that the only way to avoid such incidents happening is to discourage companies from producing dishonest numbers, whilst making auditors afraid of certifying anything which could be seen as misleading. In general, the principle of auditor independence should mean that auditors are vigorous and unrelenting in their verification of accounting data.
However, in the case of Enron, the auditors: Arthur Andersen, were signing off significant amounts of accounting data from their own consulting arm, who were providing Enron with consulting and advisory services. As such, there was likely physical evidence that Arthur Andersen’s auditors ignored several material accounting violations caused by both Enron and Arthur Andersen’s consultants. Unfortunately, it is difficult to prove this evidence given that all documents related to Enron were shredded by the auditors as soon as the scandal came to light, making it difficult to be certain around the extent of the complicity or the conflicts caused by Arthur Andersen providing Enron with substantial amounts of consulting services, at the same time as signing off company accounts which were later found to be almost completely inaccurate (Sloan et al, 2002).
As a result of this, the legislation governing publicly listed companies in the United States was rapidly tightened through the Sarbanes-Oxley, or SOX, Act; which was intended to boost investor confidence. This legislation was based on the argument that a stock market is formed from a collection of share issuing firms; individual and institutional investors; and a body of accountants, lawyers and analysts. As such, the SOX Act was intended to ensure that each of these groups regained their own confidence in the system, and also confidence in each other. As such, the Act focused on promoting transparency and understandable data from the viewpoint of the final users of accounting data, rather that the provider (Kalafut, 2003).
The main method by which SOX attempts to minimise and avoid conflicts of interest within the firm is by requiring corporations to establish corporate auditing committees; which are responsible for dealing with the auditors. This is because, previously, if auditors had any queries around the content of the financial statements, they had to seek out the management personnel responsible for generating the data. This meant that the managers could potentially shape the auditor’s interpretation of the information, particularly if the auditing company were also providing consulting or advisory services as occurred at Enron. In such an instance, the advisory staff may well themselves have exerted influence over their own auditors to ensure that the information was treated in a way that is favourable to the consultants, and not in a way that provided a true representation of the actual situation and data.
The audit committee is supposed to avoid this by ensuring that the auditors only communicate with the committee members, who are all independent from the management of the firm, and hence can look at any advisory services provided by the auditor with an independent and critical eye (Lansing and Grgunch, 2004). As a result, the act also recommends that one of the audit committee members should be a financial expert with a good knowledge of accounting principles and financial statements from a firm or firms in similar industries. This allows the committee to accurately discern the true nature of any financial instruments, such as the off balance sheet financing and other special purpose entities used by Enron to cover up its financial difficulties. This will also be vital if an auditing firm is providing significant non auditing services, as they may well use their auditing experience to advise their client on how best to structure their business to present it more favourably from an accounting point of view. Financial experts on the audit committee will have similar experience, and hence will be able to help the auditors make a fair assessment of the true nature of any creative accounting.
The other main part of the SOX Act which is designed to minimise any conflicts between the provision of consulting services and advisory services is that the penalties for being caught have been increased dramatically. In particular, the Act has increased the penalties which any CEOs and CFOs found guilty of violating any provisions of the Act would face. As part of this, CEOs and CFOs now have to sign off on the audited accounts and other statements that their companies file with the SEC, and will thus be held responsible if they certify statements which contain any false or misleading information. CEOs and CFOs who do so could face fines of up to $5,000,000 and potentially imprisonment for up to 20 years. As such, this places a significant responsibility on CEOs and CFOs, who are typically the board members responsible for appointing auditors and any advisory services, to ensure that there is no conflict of interest between the auditing and advisory services provided.
With all this regulation, one would expect that the disadvantages of auditors providing their audit clients with other services would be so great that many companies would not even consider it. However, it is important to note that there are some benefits which can be obtained within the current legal and regulatory framework. For one, Marks (2007) argues that auditors’ in depth knowledge of their clients’ and comparable firms’ accounts can allow them to advise firms on their governance processes, efficiency and other aspects of their financial performance and how to improve them. In addition, audit firms will be better able to advise firms how to legally avoid as much tax as possible, whilst avoiding anything which could be considered tax evasion. This is particularly important in the modern business world, where the removal of exchange controls and trade barriers makes tax avoidance more possible than ever before, but also provides significant potential for companies to fall foul of one or more of the tax regimes in which they operate (Sikka and Hampton, 2005). This helps to explain why many auditing firms also have large tax practices, as well as advisory services.
In contrast, the only real disadvantage of a company providing both audit and other services is the potential for regulatory violations and conflicts of interest. Of these, the potential regulatory violations were immediately seized on by the US Congress following the Enron scandal, as it emerged that Enron paid Arthur Andersen $25 million in auditing fees, but a further $23 million in fees for other consulting work. However, it was the potential for conflicts of interest which emerged as the strongest disadvantage, with many corporate boards worrying that continuing to buy consulting services and auditing services from the same firms would damage investor confidence, and lead to a drop in share prices (Kahn, 2002).
As a result, of the Big Four accounting firms currently in the market: Deloitte, Ernst and Young, PWC and KPMG; PWC stopped providing consulting services to audit clients; Ernst and Young sold it consulting business and KPMG and Deloitte both divested of their consulting businesses throughout 2001 and 2002 (Kahn, 2002). This meant that none of the Big Four auditors, which together audited around 90% of the major companies in the US and UK, provided any substantial consulting services following the Enron scandal, although they did continue to provide tax and some transactions advisory services. However, by 2003 Deloitte had reversed its decision, and brought the consulting business back into the overall business, which then comprised auditing, tax accounting, corporate finance and consulting. This decision was taken in spite of industry concern around conflicts of interest and the provisions of the SOX Act, in the belief that Deloitte could provide its clients with the advantages of integrated professional and accounting services, whilst avoiding any of the potential regulatory concerns (Bryan-Low, 2003).
Indeed, five years after the Enron scandal, Accountancy (2006) reported that the majority of accountancy firms, particularly the Big Four firms, have begun offering a wider range of services, and that the boundaries between these services are blurred, with inconsistent levels of disclosure. For example, PWC details specific revenues for audit, accounting and tax; however it also includes ‘advisory services’ in its revenues as an umbrella term for consultancy, corporate finance, and corporate recovery services. Also, whilst KPMG details separate categories including corporate finance, forensic accounting, transaction services and risk advisory services, the ‘risk advisory’ services are effectively the same as the consulting work offered by other accounting firms (Accountancy, 2006). This indicates that, even if the regulatory conflicts can be completely resolved, it will be difficult for shareholders to assess the true nature of their auditor’s revenues, and hence the potential for any damaging conflicts of interest.
Unfortunately, future steps to address any issues as a result of this are likely to be hampered by the fact that SOX is already proving a significant regulatory burden to publicly listed companies in the United States. In addition, Fisher and Quick (2004) claim that the true problem is not the conflict between auditing and other services, but the fact that the Big Four accounting firms are so dominant, auditing all of the FTSE 100 companies in the UK. With there being no true competition to the Big Four amongst their main clients, the market has come to resemble and oligopoly, and with many senior accountants at clients coming from the Big Four firms, there is a danger that former accountants working in senior management may simply favour their alumni firms when choosing auditors. Whilst this should be mitigated by the presence of the audit committee, minimising the impact of this ‘old boys’ network’ amongst the major accounting firms would go a long way towards reducing any potential conflicts of interest, and increasing the scrutiny given to the provision of additional services, particularly amongst the Big Four.
In conclusion, and as the Enron scandal demonstrated, whenever an auditor of a publicly listed company also obtains significant revenues from providing their client with additional services, there is always the potential for a conflict of interest. In Enron’s case, this led to Arthur Andersen covering up significant losses which ultimately caused Enron to go bankrupt. The SOX Act should help to reduce this, by enforcing the use of an audit committee to prevent such conflicts, and increasing the pressure on executives to ensure that accounting data is fair. However, most of the major accounting firms continue to provide these services, hence the potential for conflict of interest remains. Possibly the only way to avoid this would be to attempt to break up the dominance of the Big Four, and create a more competitive market where the top firms have a wider choice of auditors, and hence can hold these auditors to higher standards of quality and transparency.
References Accountancy (2006) Blurred boundaries. Accountancy; Vol. 137, Issue 1355, p. 35.
Bryan-Low, C. (2003) Deloitte Chief Wrestles to Get Consultants Back in Firm. Wall Street Journal – Eastern Edition; Vol. 242, Issue 33, p. C1-C7.
Fisher, L. and Quick, C. (2004) The Big Four old boys’ club. Accountancy; Vol. 133, Issue 1327, p. 29.
Kahn, J. (2002) Deloitte restates its case. Fortune; Vol. 145, Issue 9, p. 64-69.
Kalafut, P. C. (2003) Communicate Value to Boost Investor Confidence. Financial Executive; Vol. 19, Issue 5, p. 28-29.
Lansing, P. and Grgunch, C. (2004) The Sarbanes-Oxley Act: New Securities Disclosure Requirements in the United States. International Journal of Management; Vol. 21, Issue 3, p. 292-299.
Marks, N. (2007) Internal Audits of Governance. Internal Auditor; Vol. 64, Issue 6, p. 31-32.
Sikka, P. and Hampton, M. P. (2005) The role of accountancy firms in tax avoidance: Some evidence and issues. Accounting Forum; Vol. 29, Issue 3, p. 325-343.
Sloan, A. Isikoff, M. Hosenball, M. and Thomas, R. (2002) The Enron Effect. Newsweek; Vol. 139, Issue 4, p. 34.
Auditing Regulations in the UK
Introduction Following the financial disasters that led to the collapse of corporations such as Enron and WorldCom, international and national regulators sought to strengthen legislation relating to the internal and external auditing of corporations. This resulted in the introduction of a number of international and national Acts and enforceable codes, commencing with the Sarbanes-Oxley Act 2002 in the US (www.sarbanes-Oxley .com). In the UK the government introduced the Combined Code (FSA 2006) in 2003, which has subsequently been revised and strengthened, and revised the Companies Act (2006). These became the foundation for corporate governance and appropriate auditing procedures. This paper seeks to evaluate the effectiveness of this regulatory framework in creating an auditing environment that will prevent a repeat of the disasters that led to their introduction. This will follow a brief overview of the auditing processes is provided initially.
The Audit Process
There have been several definitions of the term audit; perhaps the most succinct of which is that based upon the American Accounting Association’s, which states that: –
“Auditing is a systematic process of objectively gathering and evaluating evidence relating to assertions about economic actions and events in which the individual or organisation making the assertion has been engaged, to ascertain the degree of correspondence between those assertions and established criteria, and communicating the results to users of the reports in which the assertions are made.” Porter et al (2003, p.3).
In other words, the task of an auditor is, through the use of a structured programme, to gather evidence relating to the financial statements made by a corporation, evaluate the accuracy of the statements made in the light of this evidence and also to ensure that any opinions and reports presented are in accordance with the prevailing rules, regulations and criteria. They then have to present a certified unbiased view of their findings from the audit to external stakeholders, such as the shareholders and government authorities (See figure 1).
There are several types of audits conducted throughout an organisation. However, this paper concentrates upon the external and internal audit. A licensed and qualified firm of auditors, whose independence from the organisation must comply with the definitions set out the combined code and accompanying guidance notes, carries out an external audit.
The essential purpose of the internal audit is, in the words of the Institute of Internal Auditors (Spencer-Pickett 2003, p.2), intended to “improve the effectiveness of risk management, control and corporate governance processes.” Whilst the intention of this process, as with external auditing, is to provide and independent assurance on these processes and controls, the internal audit personnel are employed directly by the corporation.
Current regulations The auditing process relates to most corporations (Gray and Stuart (2004), but this paper concentrates upon the Public Limited Company. In respect of financial reporting within the UK, commercial organisations are governed by the rules of the Combined Code (2006) and the international reporting standards set by the IFA, as explained within their handbook (2006).
Combined Code The combined code concentrates upon five areas of the corporation’s activity and internal structure. These include: –
Directors – which include advice on suitability, proportion of executive to non-exec directors on the board and their roles and independence. It also defines a clear distinction of duties between CEO and Chairman.
Remuneration – This relates formula for the make-up and levels of director’s pay, together with the inclusion of an independent remuneration committee.
Accountability and audit –Requires the board, through an independent audit committee, to maintain an adequate system of internal control that should be audited, the selection and independence of external auditors and outlines the process of accountability of the organisation to the various stakeholders.
Relations with shareholders – Outlines the responsibility of the board to its shareholders and the reverse. This section of the code also sets out the requirements of the board to include the shareholders rights within their voting and operating procedures.
Institutional shareholders – Section E of the code concentrates specifically upon the relationship that exists between the board and its institutional shareholders and outlines the dialogue that should occur between the two stakeholders of the business.
Perhaps most important aspect of the financial reporting and auditing process is contained within the FRS and SSAP (ASB 2007) regulations, the former of which are based upon the international standards, which have been subjected to a series of amendments in recent years.
The Main IFRS objective is to promote a universal financial reporting standard, with the intention of providing an equality of financial information that can improve comparison and reliability of content on a global basis. In addition, the standards set out to increase the trust and reliance on financial reporting system, thus reducing the likelihood and potential risk of financial disasters such as Enron.
Other objectives The objective of IAS 1:7 is directly related to the provision of financial information to be used for investment or other economic reasons, such as acquisitions. As such it concentrates upon the reliability of the accounting and reporting standards for the Balance Sheet and Cash Flow statements. Therefore, it focuses on a fair representation, attracting significant importance to the “fair value” of assets, liabilities and equity, allowing interested parties to ascertain the current real market value, thus making “historical cost accounting” redundant. Company officers have to prepare and sign compliance statements in terms of the veracity of the information and internal controls operated by the corporation and there must be a separate external audit certificate.
The IFRS measurements are applied to each of the standards, although there is intent to introduce measurement as a separate application. However, at present IFRS 2, relating to share based performance has specific measurement guidelines, as does the IFRS relating to the treatment of fixed assets, Here the initial measurement is the acquisition paid, but in later reports these values must reflect a fair current market value, unless there is a reason for this not being possible. In general, the measurements require a “current fair value” model to be used
The presentation of financial statements and disclosures is also addressed For example, the Balance Sheet must contain at least sixteen lines (IAS1.68), which include tangible and intangible assets, current and future liabilities and a breakdown of the equity structure. IAS 1.81 provides the requirements for the income statement including revenue, costs, profit or loss and its distribution.
As shown within the list of standards prepared by Deloitte (2005), in addition to the above there is a range of other requirements, including risk assessment corporate governance regulation compliance. If any disclosure cannot be made a certified statement has to be prepared by management and included within the financial reports giving the reasons for this omission.
The major task for external auditors is to certify the accuracy and compliance of the statements, and the effectiveness of internal controls ensure efficient business management and a secure level of protection for investors and shareholders exists. Where risks exist, this must be identified with recommendation for actions.
Concerns In spite of the regulations and codes, there are still concerns being expressed by investors and shareholders. These generally fall within three categories.
Auditor competence and independence
A recent survey shows shareholders are concerned about the external auditors. This focuses on their independence, experience and suitability and compliance with procedures.
Independence of internal controls
Similar concerns are being expressed regarding the internal controls and auditing process. Shareholders are not convinced that the level of effectiveness in identifying fraud and risk is effective or transparent enough and are thus seeking an expansion of financial reporting statements (John Lorinc 2002).
Shareholder concerns are supported by research at the university of Auckland (Cheung and Hay 2004), which particularly showed auditor independence to be a major concern to investors.
The concept of “fair value” is another issue causing disquiet. To date, the IFRS do not have a single definition for the term. Therefore it becomes subject to independent expertise and opinion. However, the fact that such opinions can vary significantly means that the level of reliance on “fair value” is considerably reduced.
Conclusion As can be seen from this evaluate, whilst the IFRS’s go a long way towards addressing the issues surrounding the accuracy, reliability and honesty of financial reporting, the issues of “fair value” and auditors independence are still a major concern in the minds of investors. This is supported by events such as the near collapse of Northern Rock PLC in the last quarter of 2007, which shows that that there are still inadequacies within the reporting standards that need to be addressed. In this case there are questions to be asked about the interpretation of “fair value” and the internal controls. By inference, this must also raise the issue of auditor suitability.
References ASB (2007). Accounting Standards and Practice. Retrieved 30 November 2007 from http://www.frc.org.uk/asb/technical/standards/accounting.cfm
Cheung, Jeff and Hay, David. (2004) Auditor Independence: The Voice of Shareholders. Business Review. Volume 6, issue 2. University of Aukland.
Copnell, Timothy (Director) (2006). Shareholders’ Questions 2006. Audit Committee Institute KPMG LLP. UK
Deloitte (2005). IFRS 7: A disclosure checklist. Retrieved 28 April 2007 from http://www.iasplus.com/fs/0510ifrs7checklist.pdf
FRC (2005). Guidance on Audit Committees (The Smith Guidance). Financial Reporting Council. London, UK.
Gray, Iain and Manson, Stuart (2004). The Audit Process: Principles, Practice and Cases. Third edition. Thomson Learning.
Handbook of International Auditing, Assurance, and Ethics Pronouncements. (2006). International Federation of Accountants. New York.
KMPG (2005). KMPG International Survey of Corporate Responsibility Reporting 2005. Retrieved 29 June 2007 from http://www.eldis.org/go/display/?id=19513