Accounting 107: Auditing and Assurance

AUDIT QUALITY

Audit quality encompasses the key elements that create an environment which maximizes the likelihood
that quality audits are performed on a consistent basis.

A quality audit is likely to have been achieved by an engagement team that:

– Exhibited appropriate values, ethics and attitudes;

– Was sufficiently knowledgeable, skilled, and experienced and had sufficient time allocated to
perform the audit work;
– Applied a rigorous audit process and quality control procedures that complied with law,
regulation and applicable standards;
– Provided useful and timely reports; and
– Interacted appropriately with relevant stakeholders.

The responsibility for performing quality audits of financial statements rests with auditors. However,
audit quality is best achieved in an environment where there is support from and appropriate
interactions among participants in the financial reporting supply chain.

The Importance of Audit Quality

Investor confidence is fundamental to the efficient operation of the world’s financial markets and
contributes to economic growth and stability worldwide. Investors need to know that the financial
information on which they base capital allocation decisions is credible and reliable. Audits, and audit
opinions on financial reports, are crucial to achieving this. Independent auditors play a vital role in
enhancing the reliability of financial information produced by companies, not-for-profits, government
agencies, and other entities by providing assurance on the reliability of the financial statements.

While the primary responsibility for the quality of financial statements is with the management of the
company producing those statements, external auditors provide independent assurance about that
quality.

The International Auditing and Assurance Standards Board (IAASB) has developed a Framework for Audit
Quality that describes the input-, process- and output factors that contribute to audit quality at the
engagement, audit firm and national levels, for financial statement audits.

The Framework also demonstrates the importance of appropriate interactions among stakeholders and
the importance of various contextual factors.

The key elements of audit quality identified by the Framework are:

a. Inputs

Inputs are grouped into the following input factors:

1. The values, ethics and attitudes of auditors, which in turn, are influenced by the culture
prevailing within the audit firm; and
 2. The knowledge, skills, and experience of auditors and the time allocated for them to perform
the audit.

Within the above input factors, quality attributes are further organized between those that apply
directly at:

1. The audit engagement level;

2. The level of an audit firm, and therefore indirectly to all audits undertaken by that audit firm;
and
3. The national (or jurisdictional) level and therefore indirectly to all audit firms operating in that
country and the audits they undertake.

b. Process

The rigor of the audit process and quality control procedures impact audit quality.

c. Outputs

Outputs include reports and information that are formally prepared and presented by one party to
another, as well as outputs that arise from the auditing process that are generally not visible to those
outside the audited organization. For example, these may include improvements to the entity’s financial
reporting practices and internal control over financial reporting, that may result from auditor findings.

The outputs from the audit are often determined by the context, including legislative requirements.
While some stakeholders can influence the nature of the outputs, others have less influence. Indeed, for
some stakeholders, such as investors in listed companies, the auditor’s report is the primary output.

d. Key Interactions within the Financial Reporting Supply Chain

The stakeholders in the financial reporting supply chain include users, management, those charged with
governance and regulators.

While each separate stakeholder in the chain plays an important role in supporting high-quality financial
reporting, the way in which the stakeholders interact can have a particular impact on audit quality.
These interactions, including both formal and informal communications, will be influenced by the
context in which the audit is performed and allow a dynamic relationship to exist between inputs and
outputs. For example, discussions between the auditor and the audit committee of a listed company at
the planning stage can influence the use of specialist skills (input) and the form and content of the
auditor’s report to those charged with governance (output). In contrast, for privately owned businesses,
there may be close proximity to the owners during the course of the audit. In these circumstances, there
may be frequent informal communications, which contribute to audit quality.

e. Contextual Factors.

There are a number of environmental – or contextual – factors, such as laws and regulations and
corporate governance, which have the potential to impact the nature and quality of financial reporting
and, directly or indirectly, audit quality. Where appropriate, auditors respond to these factors when
determining how best to obtain sufficient appropriate audit evidence.
FRAUD

Accounting fraud occurs when an entity, such as a company or government, deliberately falsifies its
financial records. Fraudulent behavior is sometimes hard to define within accounting since many
components in the financials are based on estimates.

For example, a corporation may decide to make an estimate that ends up being revised later. It is not
considered fraudulent behavior, as long as the company produced the estimate in good faith by using
relevant information at the time of the estimation.

Accounting fraud occurs when deliberate misstatements are made, i.e., a company overstating its assets
to make itself appear more financially healthy. Another example is if a company overstates its revenues
to make itself appear more profitable than it actually is.

Fraud undermines the trust that is required for a well-functioning market economy. If you cannot trust a
company’s financial statements, you are unlikely to invest and entrust your hard-earned money to that
company.

However, if there is a protective system in place, even if you do not personally know anyone from that
company, the fact that you can trust their financial reporting will facilitate your decisions to invest and
provide capital.

Auditors are held to the same level of trust as well. If investors cannot trust the auditors who are
supposed to be providing unbiased opinions, it will undermine the financial system. Therefore, to have
an efficient and transparent market economy, there must be three elements:

1. Rules (accounting standards)

2. Verifiers (auditors)
3. Enforcers (laws and government agencies – SEC)

Example Case

1. Waste Management
Waste Management Inc. is a publicly-traded US waste management company. In 1998,
the company’s new CEO, A Maurice Meyers, and his management team discovered that the
company had reported over $1.7 billion in fake earnings.
The Securities and Exchange Commission (SEC) found the company’s owner and former
CEO, Dean L Buntrock, guilty, along with several other top executives. In addition, the SEC fined
Waste Management’s auditors, Arthur Andersen, over $7 million. Waste Management
eventually settled a shareholder class-action suit for $457 million.

2. Enron Scandal
Enron Corporation was a US energy, commodities, and services company based out of
Houston, Texas. In one of the most controversial accounting scandals in the past
decade, it was discovered in 2001 that the company had been using accounting
loopholes to hide billions of dollars of bad debt, while simultaneously inflating the
 company’s earnings. The scandal resulted in shareholders losing over $74 billion as
Enron’s share price collapsed from around $90 to under $1 within a year.

3. WorldCom Scandal
WorldCom was an American telecommunications company based out of Ashburn,
Virginia. In 2002, just a year after the Enron scandal, it was discovered that WorldCom
had inflated its assets by almost $11 billion, making it by far one of the largest
accounting scandals ever.

The company had underreported line costs by capitalizing instead of expensing them
and had inflated its revenues by making false entries. The scandal first came to light
when the company’s internal audit department found almost $3.8 billion in fraudulent
accounts. The company’s CEO, Bernie Ebbers, was sentenced to 25 years in prison for
fraud, conspiracy, and filing false documents. The scandal resulted in over 30,000 job
losses and over $180 billion in losses by investors.

4. Tyco Scandal
Tyco International was an American blue-chip security systems company based out of
Princeton, New Jersey. In 2002, it was discovered that CEO, Dennis Kozlowski, and CFO,
Mark Swartz, had stolen over $150 million from the company and had inflated the
company’s earnings by over $500 million in their reports. Kozlowski and Swartz had
siphoned off money using unapproved loans and stock sales.

The scandal was discovered when the SEC and the office of the District Attorney of
Manhattan carried out investigations related to certain questionable accounting
practices by the company. Kozlowski and Swartz were both sentenced to 8 to 25 years in
prison. A class-action suit forced them to pay $2.92 billion to investors.

5. HealthSouth Scandal
HealthSouth Corporation is a top US publicly traded healthcare company based out of
Birmingham, Alabama. In 2003, it was discovered that the company had inflated
earnings by over $1.8 billion. The SEC had previously been investigating HealthSouth’s
CEO, Richard Scrushy, after he sold $75 million in stock a day before the company
posted a huge loss. Although charged, Scrushy was acquitted of all 36 counts of
accounting fraud. However, he was found guilty of bribing then Alabama Governor, Don
Siegelman, and was sentenced to seven years in prison.