Introduction
The financial statements of organization are the measure of its performance. The financial health of an organization can be judged from its financial statements. That is the reason why the statements should represent a true and fair view of its position. Often people at key positions are encouraged to falsify accounts to meet short term needs such higher earnings per share or profit after tax. Sometimes people engage in such activities to conceal the actual position of the organization and make it look profitable in the eyes of investors. It is not just big organizations but the small ones are also tempted to employ such techniques, like understating revenue, underreporting liabilities, overstating revenue, misuse of reserves and other techniques. It is not just the organization which can be sued but also the people involved in the development of such scam. That also includes the auditor of the organization. If it can be proved that the auditor could have found out the fraud in the normal course of events which he failed to do so he can be charged with professional misconduct and can be tried against. According to Lord Denning, an auditor “must come to (his task) with an inquiring mind – not suspicious of dishonesty, I agree – but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none” (Formento v. Seldson Fountain Pen Co., [1958] 1 WLR 45). (Morgan 2000)
A limited company must have one director who should be human and a public limited organization should have at least two directors. Shareholders appoint directors in the annual general meeting also known as AGM and in extreme scenarios are appointed in the extra ordinary general meeting (EGM). A resolution for the same has to be passed in the meeting. The resolution passes if the majority votes in the favor of the resolution. The other directors can fill in the vacancy which arises out of an emergency situation. The vacancy is later confirmed by the shareholders in the general meeting. The death of a director who represented institutional shareholders is an example of such a scenario.
Duties and Responsibilities
A company is not a real entity. It is an entity which is created by law and has perpetual succession. This implies that the organization goes on forever till it is put to an end by law or in other words wound up by the court. The company acts through the directors. The directors are the agents as well as the owner of the organization. The duties and the responsibilities of the directors are as follows:
- Directors have to ensure that the organization does not anything which is outside the scope of the objectives mentioned in the memorandum. The memorandum is the bible which the organization has to follow.
- The directors have to do what is best for the organization as a whole. They have to act in the best interests of the organization and have to overlook their personal well being over the organization’s well being.
- One of the most important roles of the directors is to maximize the wealth of the shareholders. Maximization of wealth is a bigger concept than maximization of profit. They have to decide upon the retention and the division of profits as dividends.
- As stated before the organizations acts through the directors of the organization. The directors are responsible for the functioning of the organization. They are responsible for forming the strategies of the organization for e.g. pricing policies, global expansion, etc.
The Auditor
An auditor is appointed by the shareholders in the annual general meeting like the directors and continues to hold office till the conclusion of the next annual general meeting. The auditor is responsible for certifying the financial statements of the organization. The auditor must make sure that the financial statements have been prepared in the proper way and that they state the true and fair position of the organization. However, time and again the directors and the auditors have been found responsible for forging the accounts of an organization.
An organization involves in such scams when it fails to account a chunk of its income. In the light of such scams it becomes the duty of the auditor to be independent in the performance of attest function. It has been held, in observations relied on by the Supreme Court of India, “The auditor must exercise such reasonable care as would satisfy a man that the accounts are genuine, assuming that there is nothing to arouse his suspicion and if he does that he fulfils his duty; if his suspicion is aroused, his duty is to 'probe the thing to the bottom'” ( ICAI v. P.K. Mukherji, AIR 1968 SC 1104). (Indian Kanoon 1952)
Auditor’s Responsibility
The auditor of a regulated entity generally has special reporting responsibilities in addition to the responsibility to report on financial statements. These special reporting responsibilities take two forms:
- The auditor has to report on the matters specified by the regulator or the legislation. Generally such report is made on an annual basis. The auditor is required to carry out appropriate procedures sufficient to form an opinion on the matters concerned. Apart from the above the auditor might be required to perform audits in special or extraordinary scenarios. The procedures performed under such scenarios can be different from those mentioned earlier. However, these are functions performed with a view expressing their opinion on the financial statements of an organization.
- Certain pieces of information have to be disclosed by the auditors statutorily. The auditors have to state in their report if the transactions of the organization have been conducted in ways which are not prejudicial to the interests of the company.
- The auditors also have to make sure that the books of accounts have been prepared in the right way as in all the accounting standards have been followed and no material information has been concealed. If information which has been concealed has material impact on the financial statements, the auditor has to quantify the impact of such information and qualify his report accordingly.
Threats to Independence
Some of the major factors which impair the perception of independence of an auditor are as follows:
- Management Advisory Services.
- Size of the audit firm.
- Tough competition in the auditing services market.
- Tenure of the audit service.
- Audit fees. (Samad & Shahrir 2006)
The Enron Scenario
Arthur & Anderson was the statutory auditor of Enron. In the year 2001 as per the financial statement of Enron the firm was paid a fee of $25 million for auditing services and another $27 million for Management Advisory Services. It was the organization’s sole auditor for 16 years. It was responsible for its internal audits and for rendering Management Advisory Services. As discussed earlier all the factors which compromise the independence of an auditor can be found in this case. The fees paid were exceptionally high. Both the organizations had been associated for a long time. Last but not the least, many of the employees of Arthur & Anderson later became employees at Enron. “Ben Gilsan, Jr. was treasurer of Enron until he was fired in October 2001, for benefiting personally from one of Enron’s complex SPE investments. He was a former accountant with Andersen and played a key role in accounting-related deceptions. He pleaded guilty to one count of conspiracy related to financial reporting deception.” (Cunningham & Harris 2006, p.32)
Did Arthur Anderson & Co Assist Enron?
The answer to this question would be yes. They were paid $5.7 million in from 1997 to 2001 to look after the transactions regarding LJM and Chewco. These were the main SPE’s connected with the Enron scandal.
These are the reasons which resulted in the firm compromising its independence and integrity. When Arthur & Anderson learnt about the financial distress of Enron it started destructing the documents. (PBS 2008)
Though it had a clear cut policy of document retention the senior partner connected with the audit of Enron destroyed them so that no evidence could be produced against the firm (Refer Figure.1, Appendix)
It was later convicted of obstruction of justice for destroying the relevant papers. In addition to this the firm was found guilty of “improper professional conduct” and was fined $7 million. It had clearly assisted Enron in inflating the revenue of the organization. (Thomson One 2009)
The Companies Act 2006
The main purpose of the Companies Act 2006 was to eradicate old and redundant procedures. The act was not brought into action with a view of bring radical changes. The act empowers the organization to send summarized financial statements instead of full financial statements to:
- Members of the organization
- Debenture Holders
- Any person who is entitled to receive notice of general meeting
- Any person who enjoys information rights under the provisions of the Companies Act
However while sending such financial statements the organization has to make sure that the financial statements comprise:
- Summarized form of the profit and loss/income statement
- Information in regards to recognized or proposed dividends
- Summarized form of the Balance Sheet
- Director’s remuneration details
The act was introduced with the aim of limiting the liability of the auditors. The Act provides for liability restriction by contract to ‘such amount as is fair and reasonable in all the circumstances’. (Bush, Fearnley & Sunder 2007)
However the audit firms would be held liable if found guilty of recklessly departing with the attest function. Further the audit report has to be signed by a named partner of the firm. In case the audit firm ceases to be the auditor of a listed company it has to state the reasons which led to the departure. (Collings 2008)
Impact on Audit Firms
The audit firms have to clearly state in their reports that the books of accounts have been prepared in accordance with the Companies Act 2006 and that they are in accordance with the United Kingdom Generally Accepted Accounting Practice. They also have to clearly state that the financial statements prepared give a true and fair view of the organization’s affairs.
Advantages of the Act
The act brings a provision where the auditor found guilty can be prosecuted under law. This will force the audit firms to depart with their audit functions with more care.
Disadvantages of the Act
There is no provision which allows the shareholders to sue for the drop in the prices of the shares. Also the act was introduced with the aim of limiting the liability of the auditors. Though the act has changed the reporting format, it is just not strong enough.
Reference
Morgan, J. (2000). Auditors: 'Watchdog OR Bloodhound'?. Available: http://www.rohanchambers.com/Courses/Auditing/auditors_watchdog_or_bloodhound.htm. Last accessed 17th March 2014.
PBS. (2008). Arthur Andersen LLP. Available: http://www.pbs.org/newshour/bb/business/enron/player6.html. Last accessed 17th March 2014.
Indian Kanoon. (1952). Commr. Of Income-Tax, Madras vs G.M. Dandekar Of M.K. Dandekar. Available: http://www.indiankanoon.org/doc/215059/?type=print. Last accessed Last accessed 17th March 2014.
Cunningham, G & Harris, J. (2006). ENRON AND ARTHUR ANDERSEN: THE CASE OF THE CROOKED E AND THE FALLEN A. Global Perspectives on Accounting Education. 3 (1), p32.
Bush, T; Fearnley, S & Sunder, S. (2007). Auditor Liability Reforms in the UK and the US: A Comparative Review . Available: http://depot.som.yale.edu/icf/papers/fileuploads/2575/original/07-33.pdf. Last accessed 17th March 2013.
Samad, A & Shahrir, D. (2006). Threats to Auditor Independence. The Malaysian Accountant. 3 (1), 2-10.
Thomson One. (2009). Lessons Learned from Enron and WorldCom. Available: http://www.cengage.com/resource_uploads/downloads/0324319835_132031.pdf. Last accessed 17th March 2013.
Collings, S. (2008). The Companies Act 2006 and the auditor. Available: http://www.accountingweb.co.uk/topic/practice/companies-act-2006-and-auditor-steve-collings. Last accessed 17th March 2013.
Appendix:
Figure.1: Source: http://www.accountancyage.com/aa/news/1786608/andersen-memo-houston-office-david-duncan#
