Chapter 17. Role, Duties and Responsibilities of Auditors – Business Ethics and Corporate Governance

CHAPTER 17

Role, Duties and Responsibilities of Auditors

INTRODUCTION

Ethics and values get short shrift in business in two ways; first, by the failure of management and second, by the failure of auditors. Auditors who are expected to be the watchdogs of the organization are often bought in by managements through some profitable assignments. This has led to the rise of the concept of corporate governance which is about promoting corporate fairness, transparency and accountability relating to various participants of organizations.1 Recent unearthing of corporate frauds both in developed countries and developing and transitional economies revealed the fact that auditors had failed to do what they were assigned to do. They involved themselves in unethical practices and failed to whistle-blow when things went wrong in the organization. To have a check on the auditors’ role and to prevent them from unethical practices, the Indian government and regulatory bodies as elsewhere have come out with many regulations, re-establishing corporate accountability and reinforcing investor confidence.

ROLE OF AUDITORS

The allegation that annual reports presented by companies today lack truthfulness and transparency need not be dealt with in great details here. ‘Window-dressing, manipulation of profit and loss accounts, hedging and fudging of unexplainable expenditures and resorting to continuous upward revaluation of assets to conceal poor performance are malpractices companies resort to with the help of obliging auditing firms.’2

The role of auditors who are expected to certify the veracity of accounts maintained by companies for the benefit of all stakeholders of the company including fair and transparent governance leaves a lot be desired. Instances are galore where obliging auditors have helped companies falsify accounts and in window-dressing for small monetary gains.

DEFINING AUDIT

The Institute of Chartered Accountants of India (ICAI) has defined audit as ‘… the independent examination of any entity, whether profit oriented or not and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon’.3 In other words, auditing is the process by which a competent independent person objectively obtains and evaluates evidence regarding assertions about an economic activity or event for the purpose of forming an opinion about and reporting on the degree to which the assertion conforms to an identical set of standards.

OBJECTIVES OF AN AUDIT

As per Standard Auditing Practices (2) of the Institute of the Chartered Accountants of India: ‘The objective of an audit of financial statements is to enable an auditor to express an opinion on financial statements which are prepared within a framework of recognized accounting policies and practices and relevant statutory requirements.’

TYPES OF AUDIT

We can identify three types of audits,4 namely,

  1. Financial statement audit
  2. Compliance audit
  3. Operational audit.

Financial Statement Audit

An audit of financial statements is conducted to determine whether the overall financial statements are stated in accordance with specified criteria. The financial statements commonly audited are balance sheet, the income statement, the cash flow statement and the statement of stockholders’ responsibility.

Compliance Audit

The purpose of compliance audit is to determine whether the auditee is following specific procedures, rules or regulations set down by some higher competent authority.

Operational Audit

An operational audit is a review of any part of an organization’s operating procedures and methods for the purpose of evaluating effectiveness and efficiency.

DEFINING AUDITOR

An auditor is defined as a person appointed by a company to perform an audit. He is required to certify that the accounts produced by his client companies have been prepared in accordance with normal accounting standards and represent a true and fair view of the company. Usually, chartered accountants are appointed as auditors.

An auditor is a representative of the shareholders, forming a link between government agencies, stockholders, investors and creditors.

TYPES OF AUDITORS

There are three types of auditors,5 namely, (i) internal auditors; (ii) independent auditors; and (iii) government auditors.

Internal Auditors

Internal auditors are employed by the organization for which they perform audits. Their responsibilities vary and may include financial statement audits, compliance audits and operational audits. They may assist the external auditors in completing the financial statement audit or perform audits for use by management within the entity. Internal auditors must have no operating involvement in activities they audit. An organization may have a small or very large internal audit staff. They cannot be independent as long as the employer-employee relationship exists. Independence is often accomplished by giving the highest ranking person in internal auditing the status of vice president and having that person report directly to a committee of the board of directors.

Independent Auditors

Independent auditors are usually referred to as CPA (Certified Public Accountants) firms. The opinion of an independent auditor about financial statements makes the statements more credible to such users as investors, bankers, labour unions, government agencies and the general public.

Government Auditors

Government auditors work in various local, state and federal or central government agencies performing financial, compliance and operational audits. Local and state governments, for example, employ auditors to verify that businesses collect and remit sales taxes and excise duties as required by law.

DUTIES OF AN AUDITOR

The duties of an auditor are defined under Section 227 (1A) of the Companies Act 1956. It says that an auditor can enquire6

  • whether loans and advances made by the company on the basis of security have been properly secured;
  • whether transactions of the company which are represented merely by book entries are not prejudicial to the interests of the company;
  • where the company is not an investment company within the meaning of Section 372 or a banking company, whether so much of the assets of the company as consist of shares, debentures and other securities have been sold at a price less than that at which they were purchased by the company;
  • whether loans and advances made by the company have been shown as deposits;
  • whether personal expenses have been charged to revenue account. In other words, the auditor is responsible for;
  • verifying that the statements of accounts are drawn up on the basis of the books of business;
  • verifying that the statements of accounts drawn up on the basis of the books exhibit a true and fair state of affairs of the business; and
  • confirming that the management has not exceeded the financial/administrative powers vested in it by the Articles of Association of the Company and/or resolutions of shareholders.
RESPONSIBILITIES OF AUDITORS

The Institute of Chartered Accountants of India (ICAI) has issued the Standard Auditing Practices and Auditing and Accounting Standards with emphasis on effective auditing practices. It talks about the integrity, objectivity, independence, confidentiality and responsibility of an Auditor.7

As per the Standard Auditing Practices (2), an auditor has the following responsibilities:

  • He is responsible for forming and expressing his opinion on the financial statements. He assesses the reliability and sufficiency of the information contained in the underlying accounting records and other source data by making a study and evaluation of accounting systems and internal controls.
  • He determines whether the relevant information is properly disclosed in the financial statements by comparing the financial statements with the underlying accounting records and other source data to see whether they properly summarize the transactions and events recorded.
  • He has to ensure that his work involves exercise of judgment, e.g., in deciding the extent of audit procedures and in assessing the reasonableness of the judgments and estimates made by management in preparing the financial statements.
  • He is not expected to perform duties which fall outside the scope of his competence, e.g the professional skill required of an auditor does not include that of a technical expert for determining physical condition of certain assets.
RESPONSIBILITIES REGARDING THE MIS-STATEMENT OF FINANCIAL STATEMENTS

With regard to the responsibility of an auditor concerning mis-statements, the position is as follows: If appropriate disclosures regarding the material mis-statement affecting the prior period financial statements is not made, then the auditor should issue a modified report on the current period financials modified with respect to the corresponding figures included. Moreover, when the prior period financial statements are not audited, the incoming auditor should state in the auditor’s report that the corresponding figures are unaudited. The auditor should obtain sufficient appropriate audit evidence that the closing balances of the preceding period have been correctly brought forward to the current period and the opening balances do not contain mis-statements that materially affect the financial statements for the current period.

When the auditor has determined that a mis-statement is, or may be, the result of fraud, the auditor evaluates the implications, especially those dealing with the organizational position of the person or persons involved.

For example, fraud involving misappropriations of cash from a small petty cash fund is ordinarily of little significance to the auditor in assessing the risk of material mis-statement due to fraud. This is because both the manner of operating the fund and its size tend to establish a limit on the amount of potential loss, and the custodianship of such funds is ordinarily entrusted to an employee with a low level of authority. Conversely, when the matter involves management with a higher level of authority, even though the amount itself is not material to the financial statement, it may be indicative of a more pervasive problem. In such circumstances, the auditor reconsiders the reliability of evidence previously obtained since there may be doubts about the completeness and truthfulness of representations made and about the genuineness of accounting records and documentation. The auditor also considers the possibility of collusion involving employees, management or third parties when reconsidering the reliability of evidence.

The auditor is also responsible to communicate that information (mis-statement resulting from fraud) to management, those charged with governance and, in some circumstances, when so required by the laws and regulations, to regulatory and enforcement authorities also. The auditor should communicate these matters to the appropriate level of management on a timely basis, and consider the need to report such matters to those charged with governance.

RESPONSIBILITIES OF AN AUDIT FIRM

An audit firm needs to implement appropriate quality control policies and procedures to ensure that all audits are carried out in accordance with Statements on Standard Auditing Practices, cited earlier.

The objectives of the quality control policies to be adopted by an audit firm will ordinarily incorporate the following:

  • Professional requirements: Personnel in the firm are to adhere to the principles of independence, integrity, objectivity, confidentiality and professional behaviour.
  • Skills and competence: The firm is to be staffed by personnel who have attained and maintained the technical standards and professional competence required to enable them to carry out their responsibilities with due care.
  • Assignment: Audit work is to be assigned to personnel who have the degree of technical training and proficiency required in the circumstances.
  • Delegation: There has to be sufficient direction, supervision and review of work at all levels to provide reasonable assurance that the work performed meets appropriate standards of quality.
  • Consultation: Whenever necessary, consultation within or outside the firm is to occur with those who have appropriate expertise.
  • Acceptance and retention of clients: An evaluation of prospective clients and a review on an ongoing basis, of existing clients is to be conducted. In making a decision to accept or retain a client, the firm’s independence and ability to serve the client properly are to be considered.
  • Monitoring: The continued adequacy and operational effectiveness of quality control policies and procedures are to be monitored.
AUDIT FAILURES LEADING TO CORPORATE SCAMS

In December 2001, in what is termed as the biggest bankruptcy in US history, Houston-based transnational trader of natural gas and power, Enron Corporation, filed for bankruptcy under Chapter 11, and downward restatement of earnings of $500 million. Enron was believed to have created a Special Purpose Vehicle (SPV) which involved setting up partnership firms to mask its losses.

The mega corporation’s auditor, Arthur Andersen, the fifth largest audit and consultancy firm worldwide and a member of the Big Five league, also faced investigation by the Securities and Exchange Commission (SEC) for fudging official documents and for not being able to detect accounting jugglery undertaken by Enron. However, Arthur Andersen blamed Enron for not providing complete information.

Arthur Andersen also allegedly colluded with Enron officials and destroyed some financial documents related to its audit. Consequently, the auditor was asked by a US Congressional Committee to explain how it had missed large-scale fudging of profits in the accounts of Enron over many years and also the destruction of documents.

Besides conducting statutory audit for Enron, Arthur Andersen offered consulting services. It was said to have collected $25 million as audit fees and another $27 million for consultancy services in fiscal 2000. Arthur Andersen had to face a slew of litigations, crippling damages, tarnished reputation, regulatory action by SEC, a Congressional Enquiry and, last but not the least, sacking by Enron.

Shockingly, US-based Deloitte & Touche, another accounting firm in the Big Five league, gave a clean chit to Arthur Andersen, asserting that it had met all quality control standards for accounting and auditing practices established by the American Institute of Certified Public Accountants, prompting observers to comment that it was a game of mutual back-scratching.

There seems to be a deviant steak running through the history of audit firms as shown by the following shocking incidents:

  • In May 2001, Arthur Andersen connived with its client, Sunbeam Corporation for financial fraud and fudging of accounts.
  • In June 2001, an American Superior Court fined Arthur Andersen towards damages to shareholders for certifying false statements of accounts of Waste Management Inc. Three of Arthur Andersen’s partners were fined between $30,000 and 50,000 each and banned from auditing work for three to five years.
  • Deloitte & Touche also landed in trouble in 2002 for applying a valuation model for fast-food franchisees which misled bankers into extending credit to unworthy clients and incurring a colossal bad debt of $10 billion.
  • In 1999, another reputed US based accounting firm, Ernst & Young paid $335 million to settle a lawsuit related to accounting problems to a client.
  • Another American auditing firm, KPMG attracted censure from SEC for engaging in improper professional practice. While serving as an audit firm for Short Term Investment Trust, it also made substantial investments in it. Its money market account opened in May 2000 with an initial deposit of $25 million, constituted 15 of the fund’s net assets at one point of time.

Box 17.1 represents the viewpoints of auditors who feel justifiably that auditors are not meant to be detectives, as their job of auditing books of accounts of companies is not meant to detect frauds but only to assess the financial position of the company.

BOX 17.1 ‘AUDITS ARE NOT DESIGNED TO DETECT FRAUDS’

Samuel A.D. Piazza Jr., CEO Price Waterhouse Coopers, was interviewed by correspondents of Economic Times (18 February 2003). He was asked: How would you define the role of an auditor? Is it fair to expect auditors to detect all frauds? According to him, who is the CEO of the famous global audit firm:

Generally, audits are not designed to detect fraud. They are designed to assess the financial position of a company. While doing that we look very carefully to see if there are things that appear unusual and yes, at times we may uncover fraud. Material fraud like you had in WorldCom would, I agree, generally surface in an audit. As to how the fraud at WorldCom went undetected, I would be very hesitant to explain that to your readers as I don’t know any more than what you do from the reports in the newspapers. All I can say is that we were not their auditors.

I must add it is also not fair to expect that all cases of fraud would come to light in an audit. But I agree, there is an expectation issue here—the public thinks we should be able to detect fraud and so we believe we have to increase our focus on fraud. It is this gap between what the public expects us to do and what we actually do that is partly responsible for the present crisis of confidence. But in the process of trying to address this issue, we need to be realistic. Because, if we pursue audits with the objective of unearthing all frauds which might have taken place, the audit fees would go up ten to 20 times. So, the risk-reward trade-off has to be evaluated. On our part, we have told our people that when something looks out of line, they’ve got to follow it up and then if they are not satisfied, we push it higher and higher within the company and in our organization until we get a satisfactory answer. It is of course, a question of materiality, but our auditors are told to be sceptical, ask questions, track anything suspicious and never leave any questions unanswered.8

Box 17.2 discusses the ‘famous’ Enron fiasco which demonstrats clearly that even if a company’s accounts are audited by qualified and reputed auditors, there is still a strong possibility that if the firms executives want to hide their dubious accounting practices, they can do so under the present dispensation.

BOX 17.2 THE ENRON DEBACLE

A Fortune-500 company with reported revenues touching $100 billion in 2000, Enron had enjoyed a market capitalization of $63 billion and a stock price close to $90. It was then ranked number 7 on Fortune-500 list of the biggest US corporations. But from a peak of $90.56 in August 2000, the stock price slumped 85 per cent to 61 cents ($0.6) in November 2001, and further to 30 cents ($0.3) in December 2001 as the financial scandal unfolded. Its market capitalization sank to $200 million. It has laid off 1,100 workers, constituting more than 80 of its workforce in Britain.

The collapse of Enron, indicated by a corresponding collapse in market capitalization, is not solely due to losses incurred; the real reason is the collapse of public confidence in the process of examining a company’s health by auditors because audit firms are considered to be watchdogs of a company’s financial and accounting practices and their certification considered to be the ‘true and fair value’ of financial statements.

With the financial world still reeling from the collapse of Enron, and the conviction of its former auditor, Andersen for obstruction of justice, world financial markets were sent into further turmoil by allegations of massive fraud by global telecom, WorldCom.

The disgraced firm, Andersen, attacked former WorldCom Chief Financial Officer, Scott Sullivan, for withholding vital information, as it faced up to accusations of an alleged billion accounting fraud. The firm pointed the finger at the resigned CFO Sullivan as the telecom company WorldCom stated it would have to restate its financial results to account for billions of dollars in improper book-keeping. And then, the US financial watchdog, the Securities and Exchange Commission (SEC) charged the US telecommunications giant with fraud. Thus, an important point which has raised its ugly head post-Enron fiasco is the role of auditors and the unholy nexus between them and the audited companies. The focus is also on the ethics of audit firms and their failure to detect companies’ accounting jugglery.

The problem is more acute in case of smaller audit firms which are unable to invest in improving upon quality standards, thus hampering the overall quality of financial reporting, because, the concept of audit has moved from detailed audit to checking of systems which can work efficiently only for companies with sound internal controls.

The SEC, on its part, has taken the required steps to repair the damage which has been done by the Enron debacle. To put a full stop to this scam series, President Bush signed into law on 30 July 2002, the Sarbanes-Oxley Act of 2002. The Act which applies in general to publicly-held companies and their audit firms dramatically affects the accounting profession and impacts not just the largest accounting firms, but any CPA actively working as an auditor of, or for, a publicly traded company.

Audit firms in the US have been debarred from offering consultancy services. Besides, the SEC has a rule which mandates audit firms to report their discovery of violating clients to the regulator.

THE AMERICAN LAW GOVERNING AUDITORS’ RESPONSIBILITIES

Sarbanes’ Oxley Act (SOX) was passed by the US Congress in 2002 with an aim to protect the investors from the fraudulent accounting practices of corporations.

Important provisions contained in SOX Act regarding auditors are given below:

  • Establishment of Public Company Accounting Oversight Board (PCAOB): The SOX Act created a new board consisting of five members of whom only two will be certified public accountants. All accounting firms will have to register themselves with this board and submit inter alia particulars of fees received from public company clients for audit and non-audit services, financial information about the firm, list of firm’s staff who participate in the audit. The board will establish rules governing audit, ethics and the firm’s independence.
  • Audit committee: The Act provides for a new improved audit committee. The members of the committee are drawn from among the directors of the board of the company, but it should be the independent directors. The audit committee is responsible for appointment, fixing of fees and oversight of the work of independent auditors. The committee is also responsible for establishing, reviewing the procedures for the receipt, treatment of accounts, internal control and audit complaints.
  • Conflict of interest: Public Accounting firms should not perform any audit service for a publicity traded company if the CEO, CFO, Controller, CAO or any person serving in an equivalent position was employed by such firm and participated in any capacly in the audit of that company during the 1-year period preceding the date of the initiation of the audit.
  • Audit partner rotation: The Act provides for the mandatory rotation of lead audit partner and partner reviewing audit every five years.
  • Prohibition of non-audit services: Auditors are prohibited from providing non-audit services concurrently with audit review services. Non-audit services include book keeping, financial and information system design, internal audit, HRD services, investment advice, investment banking services, legal advice, appraisal, valuation and actuarial services.
  • Responsibility for financial reports: The SOX Act stipulated that the CEO and CFO of a company should prepare a statement to accompany the audit report to certify the ‘appropriateness of the financial statements and disclosures contained in the periodic report and that those financial statements and disclosures fairly present, in all material respects, the operations and financial conditions’ of the company.
  • Improper influence on conduct of audits: As per the SOX act, ‘It shall be unlawful for any officer or director of an issuer to take any action to frandulently influence, coerce, manipulate, or mislead any auditor engaged in the performance of an audit for the purpose of rendering the financial statements materially misleading’.
INDIAN SITUATION

Questions about professional competence, ethics and credibility of companies and audit firms have been raised in India too. After all, who can forget the fraud by the largest Indian non-banking finance company, Tata Finance, and its investment subsidiary, Niskalp, which was found to have invested heavily in K-10 scrips. Certain unauthorized financial transactions (including diversion of funds to Niskalp), allegedly undertaken by its (then) management, led by managing director, Dilip Pendse, reportedly caused a loss of INR 1.25 billion to Tata Finance. In October 2001, the entire board of Tata Finance including its auditors, S.B. Billimoria & Co. resigned owning moral responsibility for the controversy and the losses suffered.

PREVENTING FRAUDULENT AUDITING PRACTICES

With an aim to protect the investors from the fraudulent accounting practices of corporations, the Indian government as well as the regulatory bodies have appointed many committees. Till date, four committees played a vital role in framing the responsibilities of the auditors and the audit committees: The R.D. Joshi Committee, the Kumar Mangalam Birla Committee, the Naryana Murthy Committee and the Naresh Chandra Committee. All these committees’ recommendations focussed mainly on the following aspects of auditing: formation of the audit committee, their responsibilities, rotation of auditors, prohibition of non-audit services and the transparency of financial statement.9

A more recent and ominous case is that of Ramalinga Raju, who promoted Satyam computers, which was credited as the then fourth largest software company in India. The spectacular breakdown of the audit function that enabled Raju to commit fraud in the region of INR 40,000 million through manipulation, insider trading, formation of innumerable sister concerns has made a mockery of the audit function as is being practised now. Naturally, this elicited calls for reform and review of the audit system for public companies in the country. Joint audits, audit rotation and peer review are some of the suggestions that have been floated in recent times. Salman Khurshid, the minister of state for corporate affairs, has recently suggested ‘dual audit’ so that there are two firms keeping a check on each other.

AUDIT COMMITTEE

An audit committee is the committee comprising independent directors. It is responsible for appointment, fixing of fees and oversight of the work of independent auditors. The committee is also responsible for establishing, reviewing the procedures for the receipt, treatment of accounts, internal control and audit complaints. All the committees emphasized more on the formation of audit committee, but the proposed size of the committee differed from one to the other.

The Birla Committee, for instance, specified that the committee should have three minimum independent directors. The committee is required to meet at least thrice a year with a gap of not more than 6 months, with one meeting before the finalization of annual accounts. Naryana Murthy committee suggested more power and responsibilities for the audit committee. The committee suggested that there should be a mandatory review of crucial information of publicly listed companies. The audit committee, according to them, should review the following information:

  • Financial statements and draft audit reports, including quarterly/half yearly information.
  • Management discussion and analysis of financial conditions and the results of operations.
  • Report relating to compliance with laws and risk management.
  • Management letters/letters of internal control weakness issued by statutory and internal auditors.
  • Records of related pay transactions.
ROTATION OF AUDITORS

The Naresh Chandra and the R.D. Joshi Committees insisted upon the rotation of auditors. It is specified that no company shall appoint or re-appoint same auditor for more than five consecutive accounting years. The Naresh Chandra Committee went one step further saying that at least 50 per cent of the engagement team responsible for the audit should also be rotated every five years.10

NARESH CHANDRA COMMITTEE

Set-up against the background of massive accounting frauds in companies abroad, the Committee on Corporate Audit and Governance headed by the former Cabinet Secretary, Naresh Chandra, has recommended the Chief

Box 17.3 provides the professional view of auditors with regard to audit firm rotation.

BOX 17.3 AUDIT FIRM ROTATION—PROFESSIONAL VIEWS

There are certain views in the profession of auditors which approve audit rotation of partners. Commenting on this issue, Mike Rake, chairman of KPMG International, one of the world’s Big Five auditing firms, has this to say: ‘After the series of scandals, there has been a lot of reform, regulation and legislation-some well thought through, some not so well thought through. All the academic studies in the US, Italy, etc. show that rotation of audit firms actually leads to lowering of audit quality and a higher incidence of audit failures. A more sensible solution is to have rotation of audit partners. In the US and the UK, this is required after every five years, in the EU, it would be after seven years. It also means that audit committees must be established throughout public companies, and perhaps not just in public companies. It must be ensured that auditors are independent and effective carrying out their role.’

Likewise, Samuel A. DiPiazza, Jr. CEO, Price Waterhouse Coopers, the largest of the big four global audit firms said in an interview to Economic Times (18 February 2003):

As for the provision of rotation, let me clarify that it relates not only to the lead auditor but the concurring auditor as well. I think it is a good thing because it immediately raises the focus on the crucial issue of independence of these partners. At PwC, we rotate our auditors as a matter of routine—there is no specific periodicity but it is not common for one auditor to spend more than five to six years on a single account.11

Executive Officers (CEOs) and Chief Finance Officers (CFOs) of listed companies and public limited companies with paid-up capital and free reserves exceeding INR 10 crores or turnover exceeding INR 50 crores should certify the correctness of the annual audited accounts of such companies.

The committee has not favoured audit firm rotation, but has suggested that compulsory audit partner rotation. Elaborating on this, the committee said the partners and at least 50 per cent of the engagement team (excluding article clerks and trainees) responsible for the audit of either a listed company or companies whose paid-up capital and free reserves exceed INR 10 crores or companies whose turnover exceeds INR 50 crores, should be rotated every five years. However, if required such rotated personnel could be allowed to return after a break of three years.

Another recommendation is that a special resolution, disclosing the reasons, be required whenever an auditor, who is otherwise eligible for re-appointment, is proposed to be replaced.

It has also suggested that certain business and other relationships, between an auditing firm and the client, should preclude the audit firm from undertaking audit assignments for that client.

Prohibition of Non-audit Services

The Naresh Chandra Committee has also recommended the prohibition of non-audit services in line with the Sarbanes—Oxley Act of the US. It recommended that auditors should be prohibited from providing non-audit services concurrently with audit review services. Non-audit services include book keeping, financial and information system design, internal audit, HRD services, investment advice, investment banking services, legal advice, appraisal, valuation and actuarial services.

Independence of Auditors

Even though all the committees insisted upon the independence of auditors, it is the Naresh Chandra Committee that insisted much on auditor’s independence in the following lines:

  • Prohibition of direct financial interest in the audit client by the audit firms, its partners or members of the engagement team as well as their direct relatives.
  • Prohibition of receiving any loan and/or guarantees from or on behalf of the audit client by the audit firm, its partners or any member of the engagement team and their direct relatives.
  • Prohibition of business relationship with the audit client by the audit firm and other associated persons as mentioned above.
  • Prohibition of audit partners and other associated persons from joining an audit client or key personnel of the audit client wanting to join the audit firm, for a period of two years from the time they were involved in the preparation of accounts and audits of the client.
  • Prohibition of undue dependence on audit client by ensuring that fees received by a firm from any one client and its subsidiaries and affiliates should not exceed 25 per cent of the total revenue of the audit firm, providing certain exceptions in case of small audit firms.
  • Prohibiting audit firms from performing certain non-audit services.

Disclosures

Full disclosures of accounts and decisions of management involving the funds of the company to all its stakeholders is a desiderata of good corporate culture. The R.D. Joshi Committee has suggested the imposition of responsibility on the auditors to check and, report diversion, mis-utilization or misappropriation of funds by companies. Likewise, the Naresh Chandra Committee has recommended that the auditors should disclose implications of contingent liabilities so that investors and shareholders have a clear picture of contingent liabilities.

Qualification in Audit Report

In addition to the existing provisions in the Companies Act regarding qualifications in audit reports, the committee has made further recommendations that the auditor should read out the qualifications with explanations to shareholders at the company’s annual general meeting and the audit firm is mandated to send separately a copy of the qualified report to the Registrar of Companies, SEBI and the Principal Stock Exchange with a copy of the letter of the management of the company.

Replacing Auditors

In the event of an auditor being appointed in the place of a retiring auditor, the committee has recommended that Section 225 of the Companies Act be amended to require a special resolution for the purpose and that an explanatory statement giving reasons for such replacement be provided. The outgoing auditor will have the right to comment on the statement.

Formation of Boards for Monitoring Audit Process

The Naresh Chandra Committee has suggested setting up of the Corporate Serious Fraud Office (CSFO) with specialists inducted into a multi-disciplinary team that not only uncovers the fraud but is able to direct and supervise prosecutions under various economic legislations through appropriate agencies. The committee also suggested that three independent quality review boards be constituted, one each for the ICAI12, ICSI13 and ICWAI14 to periodically examine and review the quality of audit, secretarial and cost accounting firms and pass judgment and comments on the quality and sufficiency of systems and practices.

Penalties

Under Section 539 of the Companies Act 1956, penalties for the falsification of the books is laid down. It is said that if an auditor is found to be involved in unethical practices, he will be punishable with imprisonment for a term which may extend to seven years and shall also be liable to a fine.

Besides, under Section 21 of the Chartered Accountants Act, such an auditor will be prevented from exercising his duty and his license will be cancelled by the ICAI.

COMPANIES (AMENDMENT) BILL, 2003

The Companies Amendment Bill 2003 was introduced in the Rajya Sabha15 on 7 May 2003. This has been based on the Naresh Chandra Committees’ recommendations and the Joint Parliamentary Commission’s report. Prompt measures are being taken to ensure better governance imposing more responsibilities on auditors.

Provisions of the Bill Regarding Auditing

  • Chief accounts officer under Section 2 (9B) and 215 A of the bill: Every public company having a paid up capital of INR 3 crores or more shall appoint a whole time qualified Chief Accounts Officer, who shall be a member of the ICAI or the ICWAI. The CAO will be responsible for the proper maintenance of the books of account of the company and shall ensure proper disclosure of all required information and also ensure compliance of the provisions of the Companies Act 1956 relating to the accounts of the company. This provision is in line with the recommendations contained in the R.D. Joshi Committee report.
  • Disqualification of auditors under Section 226 of the bill: Any person who has a direct financial interest in a company or who receives any loan or guarantee from the company or who has any business relationship other than that of an auditor or who has been in the employment of the company or whose relatives are in the employment of the company is said to be disqualified to be an auditor under this section.

    Further, a person shall not be qualified to be appointed as an auditor of a company, if he receives or proposes to receive more than 25 per cent of his total income in any financial year as his remuneration from the company, provided that this disqualification would not apply during the initial five financial years beginning from the date of commencement of the profession of any auditor or to the auditor whose total income is less than INR 15 lakhs in any financial year. This provision is based on Naresh Chandra Committee’s recommendations.

  • Prohibited services for an auditor under Section 226 A of the bill: To ensure the independence of statutory auditors and to prevent any kind of conflict of interest, an auditor is prohibited from rendering certain services. The prohibited services are as follows:
    • Accounting and book keeping
    • Internal audit
    • Financial system design and implementation
    • Actuarial services
    • As broker or as intermediary referred to in Section 12 of the SEBI Act or investment adviser or investment banking services
    • Outsourced financial services
    • Management functions
    • Any form of staff recruitment
    • Valuation services and fairness opinion.
  • Audit committee of the bill under Section 292 A: The audit committee shall consist of not less than two independent directors and not more than such number of maximum independent directors as the central government may prescribe.
COMPANIES (AUDITORS REPORT) ORDER (CARO), 2003

This order came into effect on 1 July 2003 replacing the Manufacturing and Other Companies (Auditor’s Report) Order (MAOCARO). This new order has placed increased responsibility on auditors and calls for greater corporate disclosures. According to chartered accountants, the propriety concept has made greater inroads in the new reporting order.

For example, the auditor will now have to look at whether a term loan has been used for the purpose it was taken. In other words, the end use of funds will have to be correctly assessed. The auditor is also expected to state if funds raised for short-term purposes are being used for long-term investments.

Keeping in mind the increasing number of corporate frauds coming to light, nationally and internationally, MOCARO requires auditors to report whether any fraud on or by a company has been noticed or reported during the year under audit. If yes, the nature and amount involved has to be indicated. Thus, the burden of identifying fraud has now shifted from a company’s directors to its statutory auditors.

MOCARO requires auditors to report defaults in repayment of dues to banks, FIs or debenture holders. The period and amount will have to be reported. Additionally, MOCARO requires auditors to provide sufficient reason for offering unfavourable or qualified opinion in case of transactions, which they feel do not follow the general accepted principles of accounting.16

The auditors would be further required to state whether the company is regular in depositing undisputed statutory dues pertaining to Investor Education and Protection Fund. The audit report should certify whether the management has disclosed on the end use of money raised by public issues and the same has been verified.

The report should also comment whether a company which has been registered for a period of not less than five years, has accumulated losses at the end of the year that are not less than 50 per cent of its net worth and whether such company has incurred cash losses in such financial year and in the year immediately preceding such financial year.

The auditor has also to certify that whether a company has made any preferential allotment of shares to parties and companies covered in the register maintained under Section 301 of the Companies Act 1956.17

CORPORATE GOVERNANCE AND INTERNAL AUDITORS

Internal Audit/Cost Audit

The subject matter of cost audit can never be studied independently of the cost accounting framework. The evolution of cost management domain in our country can be traced to four stages in brief:

  1. The first stage: the decade of 1950s and 1960s: This was the period of setting up of industrial activities and cost plus regime. The genesis was the demand for very many products for which the government administered Fair Prices. This was the time when the Tariff Commission and the Bureau of Industrial Costs and Prices were set up by the government. The ICWAI itself came into being during this time.
  2. The second stage: the period between 1970 and 1985: The period between 1970s and mid-1980s was an era of cost, volume and profit analysis, as an integral part of the cost accounting function. This was the time when the country was in sellers’ market.
  3. The third stage: the years between 1985 and 1990: During the period between mid 1980s and early 1990s, the concept of Zero Base Budgeting, Capacity Utilization and Product Profitability gained importance with the onset of global competition. This was also a period when the quality movement started gaining momentum with an entirely structured methodology departing from a quality control syndrome to a quality management paradigm.
  4. The fourth stage: the era since 1991: The period starting from early 1990s onwards witnessed the dawn of an era of liberalization and global competition in the strictest sense. This brought in the necessity to move towards market-driven prices, where the end price was determined by the customer in the domestic and international markets.

The now well-known target costing became the mantra in business and industry in the domestic as well as international markets. The full impact of global competition came into play during this period and what we find today is that the entire business activity revolves around cost, quality and delivery—be it manufactured goods or services. The country is already on its mission of restructuring on the above parameters for being on world class wavelength.

Cost Audit Methodology

The Cost Audit methodology as structured originally under Section 233B of the bill has the following two perspectives:

  • The attestation of cost structure.
  • The efficiency review perspective, which is more methodology driven.

In a period of price control and administered interventions attested cost structure had a major role to play and hence the attestation perspective got the emphasis. The profession had to play a major role of verifying and validating the cost figures in selected industries before they were submitted to the government. The efficiency review was relatively less emphasized and, therefore, did not receive much impetus in the form of new auditing techniques and methodology. We now need to develop a new vision and strategy for cost audit mechanism.

With the economy moving away from being a centrally controlled model to a competitive, relatively free market model, the role of cost, quality and timely delivery have become the basis for survival. The role of efficiency review from angles of quality, cost and delivery has assumed utmost importance today.

The concept of corporate governance, which has been attracting a lot of hype and public attention these days is nothing new and quite a few of the progressive firms even in our country have voluntarily been practising good corporate governance. SEBI has enlisted the services of CRISIL and ICRA for rating good corporate governance.

Desirable corporate governance and practices need legal support as well as evolution of internal standards—where the more progressive elements and the corporate sector design best practices that are constantly updated to complement and enhance legal provisions. Nations that have good corporate practices do not rely exclusively upon law. Conversely, those with poor records have never evolved internal codes of best practice. The question before us now is as to how the objectives of cost audit can be revisited to suit corporate governance and evolve related practices with or without the required legal support.

Quality Audit

The quality movement has gained momentum with new techniques of quality management as well as refinement of the existing practices in Indian industry. Quality audits have been accepted as a value-adding framework, and industry is concerned about non-conformances. Quality practices are being benchmarked with world-class standards and focus on bridging quality gaps is accepted as a part of corporate governance. This has happened not through legal provisions, but with a pseudo-mandatory force of mechanisms such as the ISO 9000, ISO 14000, QS 9000, TQM, Deming Awards, Malcolm Baldridge Awards, etc.

A similar story has to be repeated for cost as well by taking advantage of the existing framework instead of scrapping it without wisdom. In the comity of nations, India alone has the advantage of having envisaged a scheme of cost audit. What needs to be done is to redefine the audit objectives without losing the legal backup and the mandatory force it gives for compliance. This is something similar to the compliance framework we see in the quality management domain. Instead of the attestation perspective, which was emphasized earlier for price control, the efficiency review aspect should be blown in full force to enable better corporate governance. This will make the entire mechanism a value adding framework in today’s context of challenges of competitiveness. Ultimately, cost audit should augment the cost competitiveness of Indian business and industry. The profession and the industry should accept this challenge and evolve mutually acceptable audit objectives as per the changed context.

Annually unitised cost structure attestation and its review will not be meaningful for the industry, which is now focussing even on hourly variations in process for cost control. The concepts such as Zero Defect, PPM and Six Sigma are gaining credence in the manufacturing sector. We need to revisit the current methodologies and reporting frameworks.

Most of the organizations have well-oiled cost and management accounting system mainly used for budget formulation, performance review reporting and identifying cost leaks and price fixing. Cost audit is selective in the sense that it is not applicable to all industrial units such as statutory audit and to this extent can be construed as infirmity. Independent of this, the cost practitioner, whether he is a cost manager or cost auditor, should be fully equipped to subserve the management’s objectives of ensuring the operational effectiveness and make risk assessment and compliance control at various internal processes. In its broad scope, the focus is not only on improving operational efficiencies, but strategic as well, having to cull out and provide information for managerial decisions on optimum utilization of resources on a continuous basis and aid the organization’s growth objectives. Cost practitioners, aspiring for a rightful place in the corporate sector, would inevitably involve enlarging their vision and business outlook without confining themselves to the rights and privileges of the profession through legislative support.

Recently at a conference of the Institute of Internal Auditors, a view was expressed that in some ways the accountancy profession in the last few decades has not kept pace with developments in other branches of knowledge such as engineering or marketing and that control and compliance aspects have been overemphasized while ethical values have not gained greater importance in the conduct of business. The board of directors, the audit committee or the senior management, internal auditors, and statutory auditors form the foundation on which effective corporate governance has to be built. For statutory auditors, the essential driving force has been the legislative and regulatory requirements to make independent verification and attestation as to the true and fair view of the financial state of affairs for the benefit of the shareholders and the financial community. Internal auditors, being well-versed in the organization’s culture, structure and policies and procedures are essentially called upon by senior management to continuously review operations and obtain an assurance as to the level of efficiency and profit improvement. It is here that the cost auditor, as part of internal audit function, has a unique role to play.

KEY WORDS
  • Audit partner rotation
  • Auditors’ responsibilities
  • Chief accounts officer
  • Cost audit methodology
  • Disclosures
  • Disqualification of auditors
  • Formation of boards
  • Fraduluent auditing practices
  • Independence of auditors
  • Internal auditors
  • Mis-statement of financial statements
  • Monitoring audit process
  • Non-audit services
  • Oversight board
  • Prohibited services
  • Quality audit
  • Role of auditors
  • The Enron debacle
DISCUSSION QUESTIONS
  1. Define the function of auditing. what are the types of audit?
  2. Who is an auditor? Discuss the different types of auditors.
  3. What are the duties of an auditor? Also explain the responsibilities of auditors with regard to the mis-statement of financial statements.
  4. What are the responsibilities of auditors with regard to the mis-statement of financial statements?
  5. What are the responsibilities of audit firms? Give a couple of examples leading to corporate scams in India.
  6. To what extent would you concur with the statement that ‘audits are not designed to detect frauds’?
FURTHER READINGS

Kapoor, N.D. Corporate Laws and Secretarial Practice, New Delhi: Sultan Chand & Sons.

Publications of the Institute of Chartered Accountants of India.

Rajagopalan, R. Directors and Corporate Governance, Company Law Institute of India Pvt. Ltd.

Report of Narayana Murthy Committee on Corporate Governance, SEBI (2003).

Report of the Kumar Mangalam Birla Committee on Corporate Governance, SEBI (1999).

Report of the Naresh Chandra Committee on Corporate Audit and Governance (2002).

Taxman’s Companies Act (Sept. 2003).

(This case is based on reports in the print and electronic media. The case is meant for academic purpose only. The writer has no intention to sully the reputations of the corporates or the executives involved.)

ARTHUR ANDERSEN’S EARLY REPUTATION

The name of Arthur Andersen was once synonymous with honesty, integrity and uncompromising values in the auditing and accounting profession. The audit firm’s name stood tall even among the company of mammoth corporations for well over seven decades. However, with the change in circumstances, deteriorating value systems, low-moral standards and the never-ending greed of the firm’s hundreds of partners in the USA brought about its downfall in the beginning of the new millennium.

Arthur Andersen was founded in 1913 by two partners, Arthur Andersen and Clarence Delaney, in Chicago. The partnership firm was originally known as Andersen, Delaney & Co and offered accounting services to companies. The firm changed its name in 1918 to Arthur Andersen and grew over the next 89 years to become one of the five largest accounting firms (after PricewaterhouseCoopers, Deloitte Touche & Tohmatsu, Ernst & Young, and KPMG) with more than 1,800 partners and 85,000 employees in as many as 84 countries. Arthur Andersen entered the 1990s with an unmatched reputation in audit and accounting based on the unrivalled commitment of its founder, Arthur Andersen, to rigorous and uncompromised audits performed by highly trained competent professionals. The reputation of Arthur Andersen and his willingness to refuse to change audits even if it resulted in the loss of a valuable client was an integral part of the culture at Arthur Andersen. For many years, Andersen’s motto was ‘Think straight, talk straight’. It was reported that Andersen was approached by a senior executive of a railway company to approve by signing on accounts, containing flawed accounting. He was informed that refusal would mean the loss of the account. Andersen refused in no uncertain terms, replying that there was ‘not enough money in the city of Chicago’ to make him do it. However, the carefully built reputation came under severe strain in the late 1990s. Arthur Andersen suddenly found itself at the centre of an endless series of accounting scandals including Waste Management in 1997, Sunbeam in 1998, and the Baptist Foundation of Arizona in 1999. However, it was the collapse of Enron in November/December 2001 that finally caused clients to begin questioning the reputation of Arthur Andersen and eventually to defect to other accounting firms.

THE SEEDS OF THE DOWNFALL

The collapse of Arthur Andersen, though appeared sudden, had a long history. Perhaps the seeds of the downfall could be traced to a series of developments in the second half of the twentieth century. Arthur, one of the founders and the guiding spirit behind the firm, died in 1947 and one of the partners, Leaonard Spacek took over as the CEO. Spacek too followed the lofty traditions of the founder. The culture of honesty, integrity and ethical practices against all odds was so deeply ingrained in the firm that Arthur Andersen was accorded the rare honour of being elected to the Accounting Hall of Fame of Ohio State University in 1953.

By early 1950s, the firm went on an expansion spree overseas and also began consultation and installation services taking cognizance of the vast potential that lay in information technology. Its activities widened to include other areas of non-audit services. In the early 1960s, the entire range of the firm’s consulting activities was brought under Management Information Consulting Division (MICD), later on changed to Andersen Consulting in 1987. This consulting service was so successful that in 1994, Arthur Consulting’s income equalled the total Andersen revenue, and continued to grow.

During the 1990s, while US corporations grew by leaps and bounds, beyond expectations of their promoters with increased productivity that brought in huge profits, incomes of Andersen’s and its partners declined due to the firm having more than 1,800 partners. The audit partners, who earned less than those of Andersen Consulting, were looked down upon by their peers in the latter profession. Under these circumstances, the audit partners were constrained to accept even clients with unsavoury reputations and those who were involved in illegal activities with a view to boosting their incomes. Eager to make millions of dollars in consulting and auditing fees, the firm looked the other way as clients like Waste Management, Global Crossing, WorldCom and Enron cooked their books by manipulating accounts. Starting with Waste Management in 1998, the accounting irregularities came to light in quick succession. Enron was the last straw. In this case, the auditing firm reportedly approved falsified Enron financial statements concealing almost $20 billion of debt from stock and bond holders, regulatory agencies and Enron’s own employees.

THE ENRON FIASCO THAT BROUGHT DOWN ANDERSEN

The Enron scandal broke in October 2001 when the energy firm announced a huge third-quarter loss and Arthur Andersen was forced to write down its equity sending Enron in a free fall towards bankruptcy in December 2001. When the American capital market regulator, Securities and Exchange Commission (SEC) in its investigation, subpoenaed information from Arthur Andersen relating to Enron, it was made public that relevant computer files had been erased and documents shredded. Although it was Arthur Andersen itself that made the SEC aware of the problems in its Houston office and all the important files were recovered, it still led to the indictment of Arthur Andersen on obstruction of justice charges on 15 March 2002. Arthur Andersen was eventually convicted by a federal jury of a single count of obstructing justice on 15 June 2002. The firm announced shortly thereafter that it would stop auditing publicly traded clients as of August 2002. The verdict was largely irrelevant as the majority of Arthur Andersen’s publicly traded firms already had left the firm by that time and most of its international offices had been sold to the other four major accounting firms. Arthur Andersen had paid the ultimate price for the Enron audit failure.

WHY DID ENRON COLLAPSE?

The energy-trading company, Enron was one of Andersen’s biggest and longstanding clients. Arthur Andersen had been Enron’s auditors since the company’s formation in 1985. When Enron reported its third quarter results in October 2001, it showed huge losses that sent its share prices tumbling by more than 10 per cent. The results revealed a loss of $638 million, a $35 million write-down due to losses on its partnerships, and a decrease in shareholders’ equity by $1.2 billion. It was seen by analysts that millions of dollars of debts had been hidden in a complex web of transactions. It was also alleged that millions of dollars were funnelled to top executives, their families and selected friends and into partnerships they controlled. To disguise its true balance sheets, Enron used complex financial partnerships to conceal mounting debts. ‘Its trading operations relied heavily on complicated transactions, many relating to deals many years in the future.’ Most of these transactions ended in huge losses which were being shuttled around and hidden, eventually surfacing in 2001, when it was no more possible to hide such huge losses.

The SEC started an investigation into the firm and its results. Enron admitted it had inflated its profits and filed for bankruptcy in December 2001. Many of its top executives were convicted. Enron left behind huge losses—$15 billion in debts, worthless shares with investors and unemployment for 20,000 workers around the World. Banks that were exposed to Enron too lost huge sums—Citigroup $800 million, JP Morgan $900 million and an undisclosed amount by Merrill Lynch bankers who were also charged with fraud in connection with Enron transactions. Finally, Arthur Andersen which failed to audit the Enron books correctly too collapsed in the aftermath of SEC’s investigation and subsequent conviction by the court.

ANDERSEN’S DOCUMENT POLICY PUT IN FORCE

Arthur Andersen was convicted first because of its destruction of evidence relating to its audit work for Enron just as the Enron scandal started surfacing. Enron was one of Andersen’s biggest clients, earning for the firm audit fees of $25 million and consulting fees of $26 million in 2000. A large team of Andersen auditors and employees were based in Enron’s offices, while Enron employed several past and retired employees from Andersen. Thus the relationship between the client and audit firm was too close and blurred. Besides, David Duncan, the client engagement partner based in Andersen’s office at Houston was so close and committed toward his client that he was dubbed as a ‘client advocate’ with a name for ‘aggressive accounting’. But many audit employees within Andersen felt that Enron was a difficult and demanding customer who took liberty with accounts and was given to manipulations. There were serious doubts among Andersen staffers about the accounting practices of some of Enron’s off-balance sheet activities. But David Duncan and his team were able to override these expressed concerns by technical partners. In fact, one of such dissenters, Carl Bass, was removed from the engagement after Enron complained that he was being deliberately obstructive. Such was the unprofessional closeness between the Andersen lead auditors and the client Enron that the company was not only free to manipulate and fudge accounts that were inimical to shareholders’ interests, but also had the tacit, and sometimes, open support of the then ‘credible’ Andersen auditors.

In August 2001, immediately after the resignation of Enron’s CEO, Jeffrey Skilling, the company’s senior accountant Sherron Watkins, warned Kenneth Lay, the succeeding CEO and the Andersen partners of impending accounting problems. By 28 August, potential improprieties at Enron were reported in the Wall Street Journal and an informal investigation was opened by the Securities and Exchange Commission. Andersen started damage control measures. By early September, the audit firm had formed a ‘Crisis Response’ team that included Nancy Temple, the in-house counsel. By 8 October, Andersen had appointed outside counsel as well in connection with its role in any potential Enron-related litigation. On the following day, Ms. Temple’s note indicated that an SEC’s investigation was ‘highly probable’.

On 10 October 2001 the Andersen partner, who was warned by Ms Watkins earlier, attended a company meeting that included personnel of the Enron engagement team and urged compliance with Andersen’s document retention policy. Further investigation also revealed that Nancy Temple sent a number of memos and e-mails to Enron-related partners at the Houston office reminding them to comply with the firm’s document destruction and retention policy as late as 12 October. This policy enjoined all Andersen offices to destroy unnecessary information on their clients and retain only the most necessary information on them, after a client’s work has been completed. The objective of this policy was to prevent unnecessary and unwanted data overload at Andersen. Andersen’s policy was unquestionable inasmuch as it only called for retention in the firm’s central engagement file of only such information as is relevant to supporting Andersen’s work, but providing that document destruction should be discontinued once litigation is threatened. Andersen staffers complied with the policy by shredding documents related to Enron, though there was a lurking fear of government investigation in the minds of the Andersen engagement team. Andersen employees were told to stop the destruction of documents only after Andersen was formally served by the SEC with a subpoena for its records relating to Enron.

On 16 October, Enron announced that it would ‘take a $1.01 billion charge to earnings’. On 17 October, the securities and exchange commission notified the company of the investigation into the scandal and requested documents. On 19 October, the SEC’s request was forwarded to Andersen. The same day, Ms Temple sent an internal e-mail with a copy of the audit firm’s document retention policy as an attachment. On 20 October, the in-house counsel. Ms Temple advised everyone concerned to ‘make sure to follow the … policy.’ On 23 October, Kenneth Lay declined to answer questions during an analyst query because of ‘potential law suits, as well as the SEC’. After this call, the head of Andersen’s audit engagement team for Enron instructed other partners on the team to comply with the policy. Substantial destruction of paper and electronic records ensued in Andersen’s offices. It was reported that ‘The shredder at the Andersen office at the Enron building was used virtually constantly and, to handle the overload, dozens of large trunks filled with Enron documents were sent to Andersen’s main Houston office to be shredded. A systematic effort was also undertaken and carried out to purge the computer hard drives and e-mail system of Enron-related files. In London, a coordinated effort by Andersen partners and others, similar to the initiative undertaken in Houston, was put into place to destroy Enron-related documents within days of notice of the SEC inquiry’ (www.accountan-cyage.com, 5 April 2002). ‘Even after the SEC opened a formal investigation on October 30, the destruction continued until one day following service of a subpoena by the SEC’ (Mark D. Robins, 7 June 2005).

ANDERSEN’S RESPONSE TO ALLEGATIONS

In a statement given to the US Congress in December 2001, Andersen auditors stated that they had forewarned Enron executives of possible illegal acts by the company when it had withheld crucial financial information. When the SEC’s investigations commenced in January 2002 to unearth proofs against Enron and to find out the extent of Andersen’s involvement in the irregulatries, Andersen took a hostile and defensive strategy. Andersen, which had been both the external and the internal auditor of Enron when the company manipulated its financials, became the target of severe criticism for its failure to detect the irregularities. The audit firm which witnessed its reputation savaged by the Enron scandal came out fighting, pinning the blame for the company’s collapse squarely on the management of Enron. Andersen executives involved in the Enron audit blamed the company entirely for withholding sensitive and crucial financial data. Andersen’s chief executive, Joseph Berardino said he was not aware of any illegal behaviour behind the spectacular implosion of Enron. The failure of the company, he added, was simply a matter of economics and had nothing to do with the rigour of Andersen’s accounting. ‘This is a company whose business model failed,’ he said. Relations between Enron and Andersen deteriorated when the firm sacked the auditor for destroying Enron-related documents.

Andersen’s attempts to limit the damage from the fallout of Enron’s collapse faced further challenge when a number of top executives from the accounting company faced the government’s Energy and Commerce Committee. They included David Duncan, the Andersen partner for destroying documents related to Enron even as financial regulators investigated the company.

Mr Berardino, speaking on NBC, admitted there had been an error of judgment at Andersen but said information had also been held back from the auditors. ‘We have acknowledged in one case, we did make an error in judgment and that was corrected. And in another case, some information had been withheld that was extremely important to the decision on accounting. ‘The accounting reflects the results of business activities. And the way these events were being accounted for were clear to management and to the board, obviously in less detail to the board. But at its base, this is an economic failure.’

Arthur Andersen was also facing increased scrutiny as more and more of their audit clients were being investigated for accounting irregularities. Global Crossing, a telecommunications company that owned one of the world’s largest fibre optic networks; an Arthur Andersen audited firm, filed for the fourth largest bankruptcy in the US history. Amidst these scandals, and a few others, long time clients of Arthur Andersen deserted it and went to other auditors. Arthur Andersen’s inability to solve the devastating lack of faith by companies, shredding of Enron documents, suspected corruption within company ranks and two large client bankruptcies led to disastrous consequences for the accounting giant. Clients were not the only ones to leave Arthur Andersen. Other top accounting firms, also broke ties with Andersen because they believed that the firm’s tarnished image would hinder their collective ability to lobby Congress. To top it all, Enron also fired Arthur Andersen as their auditors, although this is probably not a surprise to many.

ANDERSEN’S EFFORTS TO WIN BACK THEIR CREDIBILITY

To Andersen’s credit, they took several steps to restore faith in their services and people. They instituted several self-imposed measures such as discontinuing internal audit services to audit clients that included the very lucrative IT consulting for audit clients. In addition, Andersen announced that they would no longer provide accounting services for EOTT Energy Partners and Nothern Border Partners. Both of these firms were affiliated in some manner with the bankrupt Enron. Neither firm claimed any problems existed with regards to Andersen’s accounting practices. Andersen commented that this action was necessary due to concerns about their ability to serve as an auditor to these firms given the connections to Enron. Arthur Andersen also hired on 25 January 2002 Paul A. Volcker, former Federal Reserve Chairman, to lead the firm’s reforms. Within two months it was reported that Volcker could not persuade the partners to accept his plan for change, as Andersen partners did not want to change how they did business. Moreover, all these initiatives were too little and came too late to revive the already terminally ailing Andersen.

THE LAST STRAW

In April 2002, the Department of Justice (DOJ) initiated proceedings against Andersen. Duncan pleaded guilty to DOJ’s charge of obstruction of justice by shredding documents. He further testified that the Andersen audit team did know about the accounting errors committed by Enron but the audit firm did not force the company to show these in its financial statements, as the amount involved was measly compared to Enron’s vast resources and shareholders’ equity. But in mid-2001, the audit team forced Enron to write down $1.2 billion in shareholders’ equity, and directed the company to attribute the write down to an accounting error. Further, Duncan also testified that Temple’s e-mails did influence his team to shred Enron related documents and e-mails.

The prosecutors felt that apart from Duncan, Temple was also aware of the accounting manipulations and the fact that this could lead to SEC’s probe. Her e-mails mentioned the need to protect Andersen from such a probe. Temple also asked Duncan to change an earlier internal memo to protect the firm from litigation as she strongly felt that there could be an SEC investigation into Enron. All these proved beyond any reasonable doubt that the thought of litigation either by SEC or by other public authorities was in the mind of Andersen officials.

In June 2002, when the trial began, it was the onus of the prosecutors to prove that Andersen deliberately destroyed Enron related documents and e-mails with a clear intention of obstructing the course of justice. During the course of the trial, the prosecutors were able to prove that Duncan’s orders to shred Enron related documents and Temple’s e-mails to various Andersen’s executives reminding of the audit firm’s document destruction and retention policy were meant to obstruct the course of justice when an official inquiry was about to commence.

The jury announced its verdict in the middle of June 2002 and held Andersen guilty of obstruction of justice. As a result, the SEC revoked Andersen’s licence to audit public limited companies and ordered the firm to pay the highest amount of fine the crime carried. Once the verdict was pronounced, and its appeal to a higher court also was rejected, Andersen stopped auditing corporate clients by August 2002. To make matters worse, the SEC announced accounting irregularities in one of Andersen’s most valuable clients and one of the leading Telecom companies in the US—WorldCom, which had filed for bankruptcy, becoming the largest ever company to do so in the US. The amount involved was also huge by any standards—it was estimated to be well over $9 billion. Though Andersen was already facing closure the irregularities in WorldCom proved beyond doubt that Enron was not an aberration, and that Andersen had been conniving with unscrupulous executives of big companies to fudge their accounts.

The colossal failure of Arthur Andersen, one of the Big Five’s in auditing has evoked a sharp reaction from not only the investors, but also the general public and tremendously shook the confidence of investors. It also raised serious doubts about the veracity and reliability of financial statements made by companies and people wondered as to how to trust audited statements. Naturally, all sections of society felt strongly that they were let down by this long-trusted auditing firm.

DEBATE ON THE ROLE OF AUDITORS

The collapse of Arthur Andersen in the wake of accounting manipulations found in Enron, WorldCom, Waste Management, Sunbeam, etc., brought about a heated debate among investors about the reliability of auditing. The debate threw in a number of reasons as to why even such reputed auditors failed to detect frauds in their clients’ accounting.

  1. Excessive greed of auditors: If there had been a tremendous deterioration in ethical values at audit firms, it was mostly because the auditors seemed to be more concerned with getting huge payments from their clients for helping them amass wealth at the cost of investors. This changed attitude of auditing firms to whom revenues mattered more than ethics and integrity, was the reason for the downfall of Andersen.
  2. Obsolete accounting standards: It was also found that the then existing accounting standards in the US were not appropriate to match the accounting problems created by the fast-track growth-oriented companies like Enron and the changed value systems, wherein unethical practices, lack of integrity and transparency became the order of the day.
  3. Conflict between auditing and consulting: It was found that the auditing firms had shifted their focus from auditing to consulting, which offered highly lucrative compensations. Often times, there arose a conflict between auditing of a client and offering consulting services to the same client. This created certain problems that the partnership based audit firms could not tackle since they lacked the leadership necessary for coping with such problems.
  4. Non-audit services became the focal point of auditing firms: When auditors had only one primary responsibility, namely, auditing accounts and certifying to their veracity, there was no conflict of interest in the work place. But when Andersen became not only the internal and external auditor for the same company, and the firm also provided a number of non-audit services such as risk management and litigation support services, there arose a number of problems leading to conflict of interest. This unhealthy practice started by Andersen gave auditors not only the opportunity but also the necessity to manipulate the accounts in accordance with the client’s demands. Besides, companies like Enron and WorldCom offered huge remuneration for these services, which affected their loyalties. With such huge compensations in mind, the company’s interests mattered to the auditors more than the interests of the investors. It was reported Andersen received $51 million in 2000, $25 million dollars as audit fees and $26 million as consulting fees from Enron.
  5. Inefficient partnership model of audit firms: With its attendant disadvantages, the partnership model of the audit firms did not provide sufficient control mechanisms for the partners of the firm. In the absence of a well-defined system of central control, partners worked independently and gave into their whims and fancies, and specially imposed their personal weaknesses in the way the firm was run. This was one of the major reasons for the deterioration of ethical values at audit firms and for Andersen’s partners indulging in unethical practices. Auditors neglected their responsibilities towards investors, as they were more concerned about making a fast buck, rather than act as custodians of shareholders’ interests which they are expected to be. Hence they failed to appraise investors of the companies’ real financial position.
  6. Auditors created a need for non-audit services: It was increasingly found in the 90s that audit firms were literally trying to expand the scope of their work with their clients by creating a want in them for consulting services. Andersen also tried this trick to earn larger revenue through consulting services and generously rewarded auditors who managed to bring in more clients and revenues irrespective of their professional auditing skills.
  7. Retiring auditors finding berths in boards of companies they audited: This practice also became a cause for concern to many. There were many instances of retired auditors becoming members of boards of their client companies. This led to certain problems, as the auditors, because of their special relationship with former colleagues, did not strictly adhere to audit norms when manipulations were detected. It was reported that more than half of Waste Management’s top management were retired audit partners of Andersen. This unhealthy practice also contributed to the downfall of Waste Management, which went bankrupt and was indicted for fraudulent financial practices.
POST SCRIPT

The failure of Andersen evoked a knee-jerk reaction from the Department of Justice, the US Congress and the market regulator, Securities and Exchange Commission. This was so initially. But with the passage of time more mature thoughts got crystallized and a number of protective measures have been initiated to protect the investor and to ensure that corporate managements adopt transparency, full disclosure and internationally accepted corporate governance practices. Many of the misdeeds that came to the forefront during the 1990s stood corrected by the Sarbanes-Oxley Act which imposed huge fines for fraudulent acts, made it possible to send even top executives to jails and prevented non audit services of auditing firms. The Act also made it compulsory for top executives to affirm under oath the veracity of financial statements.

As seen earlier, Andersen was indicted in March 2002, after a jury trial, of corruptly persuading its staff to withhold information from government proceedings by destroying its Enron-related documents with full knowledge that an SEC probe was likely to take place. A jury of 12 persons agreed with the governments’ contention that one or more Andersen partners tried to interfere with an SEC investigation into Enron in October 2001. The conviction was affirmed by the Fifth Circuit Court of Appeals, when Andersen went on appeal, not only to clear its name but also to preempt hundreds of litigations from investors and of states in which thousands of workers and teachers lost their hard-earned savings. With its conviction, Andersen was fined the maximum $50,000 and put on five years’ probation.

When Andersen appealed against the conviction, the US Supreme Court unanimously reversed the 2002 conviction of Arthur Andersen on charges of obstruction of justice in connection with the collapse of Enron on 31 May 2005. When the Supreme Court overturned the Andersen conviction, it clarified and narrowed the application of one witness—tampering statue to the destruction of documents. The court held that ‘merely persuading a person to withhold documents or testimony from a government proceeding is insufficient to meet the elements of the crime, since there are many situations in which a person may lawfully persuade another to withhold documents or testimony from an official proceeding’. The court added further that it is not wrong for a manager to instruct employees to comply with a valid document retention policy under normal circumstances. The jury erred and got Anderson convicted because they were not properly briefed on the finer elements of law and that some type of ‘dishonesty’ was necessary to a finding of guilt. The court’s decision has thus narrowed the application of the section of law (18 U.S.C.§ 1512 (b)) under which Andersen was convicted considerably. To be found guilty under this statue, the defendant must be conscious of wrongdoing and there must be a nexus proved between the corrupt persuasion to destroy documents and a particular government proceeding.

The Sarbanes—Oxley Act that was prompted by the Enron and Andersen fiasco and passed by the US Congress also added 18 U.S.C.§ 519, which makes it a crime if a person. ‘knowingly alters, destroys, multilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any [bankruptcy case], or in relation to or contemplation of any such matter or case’.

This provision is much more comprehensive than § 1512(b) under which Andersen was convicted. In particular, it does not require a finding that a person was corruptly engaged in document destruction. Instead, to be guilty under this provision, a person who destroys documents merely must have intent to ‘impede, obstruct, or influence’ a government investigation, or even just ‘in relation to or contemplation of’ such an investigation. This seems to capture much of the conduct that the Supreme Court held § 1512(b) did not cover and which the jury instructions in the Andersen case erroneously captured.

Unfortunately, this reversal of Andersen’s conviction comes a bit late to help Arthur Andersen in any way whatsoever, as the conviction amounted to an almost immediate death sentence for the audit firm. So although Arthur Andersen did go out of business and all of its 28,000 employees lost their jobs, it does have the Supreme Court opinion, which on ‘technical grounds’ cleared its name in the case of obstruction of justice.

PRESENT STATUS OF ANDERSEN

On 31 May 2005, the US Supreme Court reversed Andersen’s conviction due to what it perceived as serious flaws in the vague instructions given to the jury. Once the court vacated Andersen’s felony conviction, the audit firm was free to resume auditing work. But then, Andersen’s name was so irreparably damaged, that as of now, it has not resumed its operations so as to be a viable entity. Besides, no company wanted Andersen’s name on an audit. Even before surrendening its right to practice to the SEC, many of its state licences to practice got revoked. A new verb, ‘Enroned’ to describe the demise of the company was coined and added to the auditing vocabulary. Its employee strength, which was 85,000 world wide at the peak of its glory, dwindled to a mere 200 in 2010, based mainly in Chicago. They are now primarily engaged in the handling of law suits and over the orderly dissolution of the company. Presently, Arssur Andersen 1LP has not been formally dissolved nor has it declared bankruptcy. Ownership of the partnership firm is vested with four limited liability corporations called Omega Management I through IV.

CONCLUSION

The story of Arthur Andersen is one of a meteoric rise and precipitous fall of an audit firm that was unable to maintain its core values in the midst of business turbulance when survival became the main issue. Its colossal failure evoked a sharp reaction from its investors and the general public and shook everyone’s confidence in the business of auditing. If nowadays investors take audited statements of companies with a pinch of salt, Arthur Andersen’s failure has a lot to do with it.

DISCUSSION QUESTIONS
  1. Describe the genesis and fast track growth of Arthur Andersen, an international audit firm that had its roots in Chicago, the USA. What was the reason behind its stupendous growth?
  2. Arthur Andersen had a dramatic downfall, just as it grew up by leaps and bounds. Discuss the reasons behind both the phenomena relating to the audit firm.
  3. Explain the rise and fall of the audit firm, Arthur Andersen. What factors led to its downfall?
  4. It is a well-publicised fact that the collapse of Arthur Andersen was due to its association with the energy company, Enron. Discuss the relationship between the two firms and how the close association led to the demise of Andersen.
  5. Discuss the role of auditors in corporate managements. Would you agree with the view that the auditors are responsible to the stockholders and not to corporate managements? Substantiate your answer with examples, from what you have studied in ‘Corporate governance’.
FURTHER READINGS

BBC News, “Andersen Attacked for Enron Role” (14 January 2002).

Hamilton, S., “The Enron Collapse,” International Institute for Management Development, Lausanne, Switzerland.

Kling, A., “Arthur Andersen Posthumously Exonerated.” http://econlog.econlib.org/archieves/2005/05/arthur_and ersen.html

Pratzel, J., “Consequences of the Enron/Arthur Andersen Fiasco,” http://www.themsj.com/media/paper207/news/ 2002/03/11/Corporate/Consequ...

Robins, M.D., “Supreme Court’s Reversal in Arthur Andersen Case Casts Spotlight on Document Retention Policies,” Corporate Responsibility Alert (7 June 2005).

Sachdev, A., “Andersen Appeal Keys on Definition,”

Chicago Tribune (10 October 2003).

Teather, D., “Arthur Andersen pins blame on Enron,” Guardian Unlimited (21 January 2002).