Factors Affecting Audit Independence: Literature Review Of Enron, Worldcom, And Lehman Bros

Factors That Undermine Auditor Independence

Analyze the literature review on key audit risks and threats to auditor’s independence lying.

The report is prepared to analyze the literature review on key audit risks and threats to auditor’s independence lying. It deals with further discussion on the factors that exactly undermines the independence of auditors. Moreover, analysis of literature review on the cases of Enron, Worldcom and Lehman Bros has been done for generating information’s on the lessons that have been learnt. Independence is considered as critical issue in the auditor’s profession as it has considerable impact n audit quality. There is a possibility of auditors impairing audit quality if they are not independent as they are less likely to report irregularities. Establishment of relationship between independence and risk helps in identification of where the key audit risks and threat to their independence lies. Audit activity is considered as holistic activity where the independence in fact, issues of competence and audit risks are linked inextricably (Appelbaum & Vasarhelyi, 2017). Quality of audit is determined by auditor’s independence and it is regarded as one of the fundamental causes of many corporate failures and leading to their collapse and triggering global economic meltdown of the middle 2000.

Independence is one of the most crucial attributes and it is measured by the honesty of auditors in measuring material misstatements in the financial statements of any organizations. Several factors are responsible for undermining the independence of auditors and independence can be impaired depending upon circumstances. The possibility of being perceived as not being objective increases by lack of independence of auditors (Arens et al., 2016). Auditor’s impaired evidence results in poor quality of audit and allows for greater earning quality and greater earning management.

Audit risks are defined as framing an inappropriate audit opinion of financial statement of any particular organization. There are three components of audit risks and it comprises of control risk, inherent risk and detection risks. Control risks is defined as risks of the possibility of occurrence of misstatement that cannot be prevented, detected and corrected on timely basis by internal control and accounting system. Inherent risk is the susceptibility of the class of transactions or account balances to material misstatement and it is irrespective of internal control system. Detective risk is the risk of auditors failing to detect the materiality of misstatement by using its substantial procedures. Auditors’ independence on other hand is defined as state of mind of provisioning an opinion that does not affect the influences of compromising personal judgment, professional skepticism, exercising objectivity and allowing an individual to act with integrity (Knechel & Salterio, 2016).

Audit Risks

The factors affecting independence of auditors have often been debated and there are basic factors that lead to threats of auditor independence and cause and effect on quality of audit.

(Source: Schmidt et al., 2015)

Main threat to independence of auditors arise from auditor client relationships as clients and auditors in different level and in different firms have diverse incentives resulting in different perceptions and its impact on auditor independence. The quality of audit is likely to be impacted considerably by threats such as non-audit services, auditor tenure, client importance and affiliation of client with firm (Byrnes et al,. 2014). However, it is difficult to determine the threats of quality of audit on their influences on dependence. Normally, the independence of auditors are reduced by threats and the net effect between independence and auditors capabilities helps in determining the impact of independent threat on audit quality.

Auditor tenure may also lead to impairment of auditor independence as auditors tent to develop close relationship with clients if the auditor client relationships lengthens and they are more likely to act in favor of management and thereby reducing audit quality and objectivity (Ahmed & Anifowose, 2015). In some of recent corporate scandals that occurred simultaneously involved auditors and the lack of auditors, independence was attributable to occurrence of such scandals. There are certain situations that results in creation of threat to auditor’s independence as deduced by reviewing literature.

Threats’ arising from self interest- It is a type of threat that incorporates self-interest or any other financial conflicts and including a direct and indirect financial interest, motivation of retaining the client and dependence on non-audit and client fees. Auditor’s independence could be impaired by auditor fee dependence. They would try to retain their clients in order to secure future revenues. Intuitively, auditors will be depending upon clients to a greater degree if they generate higher revenue. In order to retain the clients, auditors will be hesitating in taking actions that would have any adverse impact on them. It has been argued that auditor independence will decrease by a greater share between auditors and their clients.

Familiarity and advocacy threat arises from audit tenure and long-term consecutive assignments with the same clients. The longer auditors conduct auditing for the same clients, there will be more impairment of auditor independence. Long tenure lead to impairment of auditors independence due to auditors experiencing a belief perseverance syndrome that lead to failure of auditors in revising the appropriateness of assertion of management  even though there has been change in conditions and facts (Leung et al., 2014).

Threats to Auditor Independence

Furthermore, auditors might be deterred to exercise their professional skepticism and act independently due to threat that are caused by intimidation and that arises on management part. Threat of replacement is one of the common types of intimidation threat. Due to imbalance of power and asymmetrical relationship between auditors and their clients, auditors are considered in weak position. In a conflict situation, auditors are vulnerable to intimidation by clients in the events when there occurs disagreements between auditors and clients over accounting issues such as appropriateness of accounting principles applied by clients, any sort of adjustments in the financial statements and inadequacy of disclosure of financial statements (Caya, 2016).

In association of above discussed points, various other factors can lead to impairment of independence of auditors. One of such point is social pressures that can be exerted by any individual within authority in a hierarchical context such as upper level of management. Conformity pressure and obedience pressure are the two types of social pressures. Conformity pressure is a pressure that is exerted by colleague or peers and upper management in an organization exerts obedience pressure. These two pressures can impair Independence of audit when the independent principle is contracted by suggestions or command of auditor’s colleagues or superior. Recognition of audit risk existence is incorporated in the description of functions and responsibilities of independent auditors (Knechel & Salterio, 2016). Therefore, it can be seen that there are various factors that poses threat to auditor’s independence

Enron Corporation being the seventh largest company in United States misguided its shareholders by engaging them in fraud and reported its profit unfaithfully. Organization manipulated its financial statements along with financial strategy when they started facing financing difficulties. Collapse of Enron was preceded by three major violations of the principles of GAAP. Another accounting fraud principle is attributable to mark to market method that helped in pumping up the stock prices for gaining capital investments that was regarded as immoral and illegal. Derivative manipulation was another violation that helped in concealing derivative loss from investors (Messier et al., 2015). Several potentially fraudulent acts and unusual transactions were discovered and investigated by the auditor of Enron. Financial outcomes that was attributable to this organization resulting from poor accounting policies for recognition of revenue, lack of financial policies and improper segregation accounting duties (William et al., 2016). It has been ascertained after the failure of Enron that there has been increase in compliance costs with the internal costing systems with the largest accounting firms have increased over time.

Lessons Learned from Enron, Worldcom, and Lehman Bros

Lehman brother failure was one of the largest bankruptcies in United States. Business model used by this bank was mainly to rely on short-term loans and assets was predominantly long-term when they were largely large short-terms. Factors that accounted for the failure of the organization was poor choice of management accompanies with some unethical practices. Liquidity crisis, financial leverage, complex capital structure, subprime mortgage crisis and massive credit default swaps. Adversity in several organizations is reported by the collapse of Lehman brothers as the failure led to depreciation in price of commercial real estates and extinguishing billions of market value and market for trade receivables (Byrnes et al., 2015). 

Collapse of failure of Lehman brothers was unthinkable and the lessons that were learned from such failure are attributable to high hazard industries and preventing of such financial accidents by adopting an equivalent approach for managing and understating risks in culture of organization and control of management. Management of company was attributable to the failure as they were involved in manipulating financial documents and financial transactions leading to its ultimate collapse (Parwada et al., 2015).

Worldcom was engaged in accounting scandal and rapid erosion of profits that created illusionary earnings. The accounting practices of organization were questionable and internal auditors have uncovered an additional of $ 3.831 billion due to improper accounting (Knechel, 2016). Detecting errors is an easy task for auditors and sophisticated fraud involves earning management that it can covert. Management requirement for asserting that accounts have been prepared properly does not provide for any protections from entering into any fraud and deceits. Auditors need to make the identification of presence of intention and it was found in the case of Worldcom that there were changes in financial metrics due to accounting manipulations. Operating margin was not regarded as satisfactory and for making earning stable; Worldcom was engaged in accounting manipulations. The purpose of obtaining desired earnings in light of accounting manipulations was mainly to boost up the stock price of company. Auditors miss this elementary fraud conducted by Worldcom that ultimately led its failure (Duncan & Whittington, 2014).

Failure of such business have affected large spectrum of business globally and such collapse can be prevented by taking pro-active actions by management in spite of taking any reactive measures. After the crisis, it becomes difficult for management to identify any right solutions to curtail after effect of such crisis.

Enron Corporation

All the collapse of above-mentioned organization was attributable to their financial failure due to manipulation of financial activities and engaging in the financial activities. This has led to deterioration in quality of profits reported by company and the standards that have been applicable to companies. Management of organizations should prevent engagement in shoddy auditing; misleading accounts and appropriate measures should be taken to outright frauds (Sirois et al., 2016). All such scandals entail organization to make their corporate governance more stringent and taking adhering to all the principles of accounting standard without violating them. From auditors perspective, it can be seen that failure of auditors to conduct proper verification of all the related accounts and disclosing the same to public led to fall of such organization and loss of investors money (Chambers & Odar, 2015). Therefore, they should try to investigate into any sort of accounts that are misleading investors by providing irrelevant financial information.

Conclusion:

From the analysis, it can be inferred that the threat of auditor’s independence arises from multiple factors ranging from internal to external. Auditors are faced with several risks while conducting audits and the failure of them to identify such risks would pose a threat to their independence. Moreover, organization should operated and engage within the confines of business jurisdiction and auditors should keep a blank eye on illegal and unethical activities of organizations. For analyzing the liquidity issue of company, auditors should place careful consideration of indicators of cash flow that will help in preventing such problems. Stringent policies must be initiated by different regulatory standards for addressing the failure to avert occurrence of such financial collapses. Organizations are also required to adhere to practices of good corporate governances. For auditors to discover such fraudulent activities, it is essential to detect the main indicators of occurrence of such frauds. For avoiding the collapse of such firms, it must be ensured by business international communities that ethical culture and high standards should be held by businesses.

References list:

Ahmed Haji, A., & Anifowose, M. (2016). Audit committee and integrated reporting practice: does internal assurance matter?. Managerial Auditing Journal, 31(8/9), 915-948.

Appelbaum, D., Kogan, A., & Vasarhelyi, M. A. (2017). Big Data and analytics in the modern audit engagement: Research needs. Auditing: A Journal of Practice & Theory, 36(4), 1-27.

Arens, A. A., Elder, R. J., Beasley, M. S., & Hogan, C. E. (2016). Auditing and assurance services. Pearson.

Azibi, J., Azibi, H., & Tondeur, H. (2017). Institutional Activism, Auditor’s Choice and Earning Management after the Enron Collapse: Evidence from France. International Business Research, 10(2), 154.

Byrnes, P. E., Al-Awadhi, C. A., Gullvist, B., Brown-Liburd, H., Teeter, C. R., Warren Jr, J. D., & Vasarhelyi, M. (2015). Evolution of auditing: From the traditional approach to the future audit. Audit Analytics, 71.

Caya, E. (2016). Make the most of assurance: assurance maps can enable internal audit to team with other assurance providers to visually convey how risk is managed. Internal Auditor, 73(4), 21-23

Chambers, A. D., & Odar, M. (2015). A new vision for internal audit. Managerial Auditing Journal, 30(1), 34-55.

Duncan, B., & Whittington, M. (2014, September). Compliance with standards, assurance and audit: does this equal security?. In Proceedings of the 7th International Conference on Security of Information and Networks (p. 77). ACM.

Knechel, W. R. (2016). Audit quality and regulation. International Journal of Auditing, 20(3), 215-223.

Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Taylor & Francis.

Leung, P., Coram, P., Cooper, B. J., & Richardson, P. (2014). Modern Auditing and Assurance Services 6e. Wiley.

Messier, W. F., Glover, S. M., & Prawitt, D. F. (2015). Auditing & Assurance Services: A Systematic Approach. Qing hua da xue chu ban she.

Parwada, J. T., Shen, J., Siaw, K., & Tan, E. K. (2015). The Value of Institutional Brokerage Relationships: Evidence From The Collapse of Lehman Brothers.

Schmidt, P., Steele, A. J., & Grabski, S. V. (2015). Cloud Computing: Governance and Audit Research Questions. Washburn University School of Business.

Sirois, L. P., Marmousez, S., & Simunic, D. A. (2016). Auditor size and audit quality revisited: The importance of audit technology. Comptabilité-Contrôle-Audit, 22(3), 111-144.

Waldron, M. (2016). The Future of Audit. CFA Institute Magazine, 27(3), 55-55.

William Jr, M., Glover, S., & Prawitt, D. (2016). Auditing and assurance services: A systematic approach. McGraw-Hill Education