Audit risks can be defined as the risk that the auditor faces while conducting an audit of a company. The risk is related to presence of material misstatements in the books of accounts even though the auditor has issued an unqualified report which suggest that the books of accounts are free from material misstatements (Louwers et al., 2015). This sort of risks also has legal liabilities which falls on auditor unless appropriate show cause is provided.
In order to effectively carry out the process of audit and provide accurate judgement an auditor needs to be independent. The auditor’s independence is one of the fundamental requirements for the scope of audit (Griffiths, 2016). The principle of independence states that the auditor should be independent from the management of the company in which the audit is being conducted and also from parties who have financial interest in the company. This principle is important as it is closely related to report which is generated by the auditor and also on the judgements of the auditor (Tepalagul & Lin, 2015).
The components which are included in audit risks are risk of material misstatement and detection risks. Risk of material misstatement deals with a situation that the financial statements of the company might already contain material misstatement before the auditing process starts. These risks consist of two types of risks inherent risks and control risks. Inherent risks refer to the fact that certain account balances which might have a significant impact on the financial statements have been misstated by the management of the company (Ojo, 2013). On the other hand, control risks relate to the ineffectiveness of the internal control system which is unable to detect such risks or even take corrective measures for the same. Detection risk is related to the fact that the audit procedures which are conducted by the auditor is not able to detect a material misstatement which is present in the financial statements which is prepared by the management of the company.
The factors which affect the independence principle of an auditor are classified as direct reasons and indirect reasons which are stated below in details:
Inherent risks are created in the financial statements due to some omission or misstatement which is caused not because of failure of internal control system. Inherent risks are mostly noticeable in transactions which are complex in nature and wide implications in the business. Besides Inherent risks there are also other types of risks which are associated with auditing process which are listed below in details:
The overall risks which are faced in an audit process can be effectively represented with the help of a formula which is reflects, audit risk, inherent risks, control risks and detection risks The formula for the same is shown below:
The above formula shows that Inherent risks is presence of material misstatement which has nothing to do with the internal control which means misstatement are already present in the financial statements. The control risks of a business are due to ineffectiveness of the internal control policies which fails to recognize significant risks. Detection risks is related to the auditor not being able to detect financial misstatement from the books of accounts.
Thus, it can be said that the audit risks and detection risks can be controlled by the auditor to some extent but inherent risks and control risk are independent from the auditor and cannot be controlled. The audit procedure which the auditor is to apply will be based on the level of significance of detection risks which can be high or low.
The principle of independence is one of the pillars which make the audit process effective and efficient without any biasness and the same aims to provide opinion whether the financial statements which is prepared by the client business are showing true and fair view or not. The general threat which is most common to independence principle is the dependence of the auditor on the fees of one client and also the hospitality shown by the client.
In case an auditor has a shareholding in a business for which the auditor is conducting an audit than the same will be affecting the independence of the auditor as self-interest will cloud the judgement of the auditor and also influence the opinion which the auditor plans to give. This shows that an auditor should not accept an audit of a client for which the audit or some members of his family have self-interest.
In an overall situation, the auditor is expected to be unbiased, honest and straightforward when providing an opinion on the financial statements of the company. This is affected if the independence of the auditor is compromised. Some of the times, auditor provide favorable audit opinions just to keep a good relationship with the client and not to loss out on business. In such cases, the shareholders cannot rely on the opinion of the auditors. Similarly, auditors also provide non-audit services for earning more and in certain cases, there is a conflict between the commercial interest of the auditor and the responsibility of the auditor towards the shareholders of the company. This can also be recognized as one of the serious threats to independence principle of the auditor. An example can be given of the relationship which the auditor had with Enron and the auditor provided significant non-audit services to the clients. It was after the fall of Enron that the auditor was charged of not acting independently during the course of audit. Therefore, independence of an auditor not only improves the quality of opinion but also helps the shareholders to get a clear view and protects them from frauds and misconduct.
Conclusion
On the basis of the discussion which is conducted in the above paragraphs, the independence of the auditor plays a vital role in the entire audit process. The independence of the auditor determines the overall quality of the audit conducted and also allows the users to have faith in the auditor’s report. In addition to this, the definition of an auditor requires the auditor to be unbiased, independent and skeptic in nature and in order to do all theses, the Independence of the auditor is a key determinant. Similarly, the risks which are associated with the audit can be minimized by appropriate planning by the auditor on the scope of audit.
The main purpose of this part of the assessment is to analyze the cases which have taken place which relates to audit risks and the part also analyzes the reasons for the fall of the businesses. Some of the case studies which are considered for this part are explained in paragraphs which are provided below.
The case study of Enron is related to the detection risks which the auditor of the company was not able to identify and when the practices of the company was revealed than the lead to the downfall of the company. Enron corporation was a company which provided energy, commodities and services to the consumers and has its operations set in Houston, Texas. The company was formed in 1985 by merger of two small regional companies. The company was well known in wall street and also among the investors community. The company was considered to be one of the largest producers of electricity, paper pulp and natural gas in Australia. The company also was named to be most innovated company in the country by Fortuna Magazine. The company has too file for Bankruptcy in December 2001.
Another such example can be given for the case of Lehman Brothers which had also collapsed for similar issues. Lehman Brothers holdings was involved in the business of providing financial assistance to businesses and the company mainly operated in United States. The company was a successful business and was regarded to be the fourth largest investment banking corporation in the country. The company engaged in providing investment banking functions, private equity, investment management operations in the country. At the time of liquidation, the market in US almost experienced a fall due to the bankruptcy of such a big company and can be considered to be one of the causes of 2000 financial crisis.
WorldCom was one of the largest company in US which was engaged in the business of Telecom industry. The company was founded in 1983 when the company was called Long Distance Discount Service (LDDS) and the name WorldCom was changed in 1995. The company had to enter bankruptcy in 2002 after a fraud was revealed in the business and the bankruptcy of the company is known to be the biggest bankruptcy in the history of America.
Enron was regarded to be one of the largest company which operated in US and has major contribution in the electricity energy supply in the economy. The main reason for the fall of the company can be attributed to the financial and other losses which the company faced and the same was hidden from the books of accounts of the business due to mark to market accounting policy which was followed by the business (McLean & Elkind, 2013). The accounting policy allowed the management of the company to measure the assets at market value rather book value. A policy of the business was to recorded estimated profits from a newly developed project as book profits even though nothing was earned from the project. This allowed the business to recognize the estimated profits from projects as real profits for the year which concealed the real performance of Enron The business had the practice of concealing the losses which was earned by the business during the year. One of the reason which lead to collapse of Enron was the concealment of losses of the business which was done through various subsidiaries and shell companies which would have affected the growth of the company much earlier. Another reason is the fall of credibility of the company. Even when the company was earning losses, the share prices of the business was soaring high and thus investors had faith regularly traded in stocks of the business but as the crediability declined, the stock prices of the business started to free fall and thus making it very difficult to raise any finances. In 2001 when the stock prices of the company started to fall in a free fall, analysts and SEC started investigating the case and the largest scandal was revealed.
In the case of Lehman brother, the collapse of the business was much greater than the collapse of Enron in 2001. The management of the company had to file for bankruptcy in 2008 following the massive losses which the company faced and writing down of the value of the assets of the business (Adu-Gyamfi, 2016). The problems for Lehman brothers started when the business acquired 4 to 5 mortgages contract including subprime lender as the business had plans to penetrate the housing market and had expectations that the same will improve the shareholdings of the business (Dodo, 2017). Due to the losses which the business suffered and also due to the high debt ratio of the business, the management had to file for bankruptcy in 2008. The reason for fall of Lehman brothers can be attributed to careless lending practices which includes the practice of the management to invest in mortgage in real estate sector. This was done with a view to regulate the risks of the business. Ineffective regulatory framework for risks can be attributed as another factor. Inability to raise finances can also be attributed as a reason for failure of the company (Chadha, 2016). Ineffective monitoring of risks of the business and taking up risky financial products are also one of the causes which lead to failure of the company.
The case of WorldCom can be recognized as one of the biggest frauds which went beyond Enron as well. The company was regarded as giants in telecom sectors and the business had become such purchasing other telecom businesses (Moepya et al., 2016). The main reason which lead to the downfall of WorldCom can be related to the loan which the business had taken from Bank of America to meet the margin call. The amount which was taken as loan was of $ 400 million and the same was taken keeping the shares of WorldCom as collateral securities. In addition to this, another reason is that the company faced high operating expenses and in order to maintain the profitability and growth outlook of the business, expenses of the business was shown to be investments which never earned a single penny for the company (Miller, 2014). The company with the use of manipulating accounting recordings and capitalizing expenses showed a profit of $ 3 billion in 2001. The fraud was revealed by the auditing firm of KPMG and the investors were also suspicious of the profits of the business after the fall of Enron.
Thus, from the analysis of the case which are shown above in relation to the companies of Enron, Lehman Brothers and WorldCom showed the following lessons which can be learned from their cases:
Reference
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Akpom, U. N., & Dimkpah, Y. O. (2013). Determinants of auditor independence: a comparison of the perceptions of auditors and non-auditors in Lagos, Nigeria. Journal of Finance and Accountancy, 14, 1.
Chadha, P. (2016). What Caused the Failure of Lehman Brothers? Could it have been Prevented? How? Recommendations for Going Forward. International Journal Of Accounting Research, s1. doi:10.4172/2472-114x.s1-002
da Silveira, A. D. M. (2013). The Enron scandal a decade later: lessons learned?.
Dodo, A. A. (2017). Corporate collapse and the role of audit committees: A case study of Lehman Brothers. World Journal of social sciences, 7(1), 19-29.
Donohoe, M. P., & Robert Knechel, W. (2014). Does corporate tax aggressiveness influence audit pricing?. Contemporary Accounting Research, 31(1), 284-308.
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