Auditing: A Brief Synopsis Empire State College

Audit Beginnings The origin of auditing goes back to times scarcely less remote than that of accou ntingwhenever the advance of civilization brought about the necessity of one man being in-trusted to some extent with the property of another, the advisa bility of some kind of check upon the fidelity of the former would become apparent. As t old by accounting historian Richard Brown (1905, quoted in Mautz & Sharaf, 1961) . As far back as 4000 B.C. record-keeping systems were started by businesses and governments in the East to lessen their concerns about sufficiently accounting for receipts and disbursements and collecting taxes. The need for audits can be traced back to public finance systems in Babylonia, Greece, the Roman Empire, et c., all of which expanded a full system of checks and balances. These government s were worried about inept officials making bookkeeping errors, as well as corru pt officials who were motivated to commit fraud when they had a chance. Fraud ca ses throughout European history such as the South Sea bubble of the 18th century, and the tulip scandal provided the need for placing more control over managers. In the period of a few hundred years, the European systems of bookkeeping and au diting were launched to the United States. As business activities started to gro w in nature and complexity, an urgent need for a separate internal assurance uni t that would authenticate the accounting information used for decision-making by managers materialized. There was a need to verify the honesty and efficiency of employees. Around the turn of the 20th century, the internal business function primarily consisted of protection against payroll fraud and loss of assets, inte rnal audits scope was quickly extended to the substantiation of almost all financ ial transactions, gradually moving from an audit for management emphasis to an audi t of management approach (Reeve, 1986). For most of the twentieth century the public accounting industry remained pretty stable. Many public accountants were in public-practice firms that provided tax and accounting services to businesses and a small proportion of private individ uals with complex financial affairs. Most firms were local, with operations conc entrated in one office servicing one city. Accountants were perceived by the pub lic to have a reputation for ethical integrity. A short time before the Enron fi asco, a survey of attitudes within the business community done by the Canadian I nstitute of Chartered Accountants (CICA) revealed that accountants had the highe

st reputation for ethical integrity compared to other professional groups. (CICA 2001: 6) The severe contrast between the professions reputation pre- and post-En ron is notable. What was it that caused this change? The 1960s saw advances in the transportation and communications industries that let many businesses expand to the national level. As the accounting professions m ajor clients changed their geographical reach, it became inevitable that account ing firms also expanded from a local to a national level to reach their largest clients. The growth of national firms by a succession of mergers increased the c oncentration in the industry by merging national accounting firms into internati onal companies. These mergers first produced the Big Eight accounting firms, then the Big Six, followed by the Big Five. The collapse of the merger of KPMG and Ernst and Young in 1997 stopped further consolidation to a Big Four. The major change in public accounting in these decades was the surfacing of this small number of la rge global accounting firms that dominated the field. These varying mergers were probably one of a number of factors that reduced client loyalty in the 1970s an d 1980s. (Magill & Previts, 1991: 123.) Eventually clients began to shop around, putting intense pressure on audit prices, affecting profits. And with this we b egin to see the first small signs of conflicts of interest starting in the accou nting profession. LABOR PRESSURE Price began to be the only variable to the audit companies. Since labor is the m ain cost of auditing, one of the ways to reduce the cost would be to reduce the total labor-hours of an audit or else reduce the cost of a labor-hour. Therefore , expensive senior supervision began to decrease and recent grads were being use d, lowering the quality of audits. In the 1970s and 1980s, there was an increase in audit failures, evidenced by an increase in litigation against the major acc ounting firms which caused a sharp increase in malpractice insurance premiums. ( Griffin 1977; Wise 1994) But in the 80s the competition for audit clients began t o intensify. The reason: spin-off benefits that an audit could produce. If durin g the audit there were systems that were found deficient, then there would be an opportunity to sell consulting services to fix the clients problems. These servi ces could be priced at a high margin to off-set the low margin audit business. F irms are branching out into consulting practices and other non-traditional speci alties, as the one-time staple of audit services is being squeezed... (Conrod 199 4). This strategy produced a multitude of tension within the big accounting firm s that strained their ability to provide audit services that were independent of their commercial interests. WHAT HAPPENED TO AUDITNG? Table 1 shows revenues from the Big Sixs sources other than auditing back in 1990 . Audits share of Big Six revenues declined from 62% in 1982 to just under 50% las t year. (Jacob 1991: 191) Percentage of Revenues FIRM 1990 US Revenues Auditing Management Tax (Millions) Consulting Arthur Andersen $2,282 35% 44% 21% Ernst & Young $2,239 53% 22% 25% Deloitte & Touche $1,921 57% 20% 23% KMPG Peat Marwick $1,827 53% 20% 27% Coopers & Lybrand $1,400 56% 2 5% 19% Price Waterhouse $1,200 48% 24% 28% Table 1 - Sources of US Revenue for the Big Six Accounting Firms, 1990.

(Taken from Jacob 1991) Fighting between audit partners and consulting partners over internal power and about profit-sharing was the origin of the splitting away of Andersen Consulting from Arthur Andersen in 1989. This phenomenon of in-fighting was becoming commo n in all the Big Six companies. Consulting partners were becoming successful and didnt want to share their profits with the auditors. In turn the audit partners didnt want to share their power with the consultants. This was also happening at local firms. The auditing departments were losing their luster. Out of 20 local CPAs that were surveyed at 4 major firms, 18 participants said there was competit ion among their auditing and consulting partners. They also said it was becoming very uncomfortable once the profits stopped being split 1:1. Some stated the te nsion was thick enough to cut with a knife. (Dunn, 2011) Due to this and the fact that the business community was starting to see this as a conflict of interest, Anderson Consulting was formed as a separate division. The other big accounting firms eventually followed suit some time later. Althoug h this separate division was created; Arthur Anderson formed a new consulting un it internally creating competition between the two. This conflict of interest be came more apparent when in the year 2000 Arthur Anderson brought in $52 million from Enron in consulting and auditing fees. It came to the point where Anderson didnt want to defy its meal ticket. Instances of fraud were popping up, but gettin g ignored because the auditors didnt want to be fired sacrificing the millions th e consulting department was bringing in. Of course that wasnt the only reason fra ud occurred. According to Sherron Watkins, credited as being the Enron whistlebl ower, in an open interview cited the formula: Moral Hazard = People Doing Bad Things MH= f Likelihood of Urgency of Reward Being Successful Need/Greed Penalty , Likelihood of , Personal Being Caught Moral Ethic Component A : Risk Reward Personal Inclination of Success (Sherron Watkins 2011) The root of Enrons failure was blamed on the diffusion of responsibility, lack of open dialogue, rationalizing fraudulent behavior, and the outsourcing of the in ternal auditing department. These factors helped to breed the self-indulgent att itude of the workers. She herself was susceptible to the greed. At her interview she stated she first noticed minor fraudulent activity in 1996, which progresse d to a larger scale in 1998. When asked why she didnt report it then, her excuse was the pressure of management to continue to be innovative and the pressure of being ranked every six months. Then as her income grew it became maybe theyll lis ten when shes VP. Then maybe she would tell them after her second child was born, then maybe after the car was paid, or after the house was paid for. It seemed l ike she was waiting for her financial goals to be met before she broke her silen ce. Everyone was starting to make so much money the local car dealerships would bring their automobiles right to the Enron parking lot during bonus time. Their Board of Directors was making over $300,000 a year. By 2001 half of the income w as cooked. (Sherron Watkins 2011) Probability Component B: Component C

Now What?? Tragedies like those at Enron, WorldCom, Health South, Tyco, AIG and the like we re the main reason for the implementation of the Sarbanes-Oxley Act. But when En ron blew up, the senators who first looked at legislation for a new oversight bo ard--Christopher Dodd (D-Conn.), Jon S. Corzine (D-N.J.) and Richard Durbin (D-I ll.)--used a prior SEC draft that was previously shot down. But nobody thinks Sa rbanes-Oxley will be an instant fix. Sarbanes-Oxley developed the Public Company Accounting Oversight Board, a private, nonprofit corporation, to ensure that fi nancial statements are audited according to independent standards. Sarbanes Oxle y Act seeks to make companies more transparent and vigilant by requiring the rep orting of all their operational risks as well as the internal controls put in pl ace to monitor them. Any material change in the monitoring of risks has to be re ported to the shareholders in real time. Sarbanes-Oxley also holds chief executi ves and chief financial officers directly responsible for the accuracy of financ ial statements. Penalties run up to $5 million in fines, a 20-year jail term or both. The law seeks to rule out conflicts that would make securities analysts le ss than objective and gives board audit committees--rather than CEOs or chief fi nancial officers--full control of auditors. It s impossible for legislators to m andate integrity. Just as lawmakers can t stop crooks from robbing banks or sell ing drugs, they can t stop them from ripping off investors in the stock market. But you can try to set up consequences and require doubled-up efforts. Then there s the ongoing restructuring of the accounting industry to separate th e auditing and consulting functions. Certainly compliance costs are increa sing, perhaps doubling, to get control systems fixed, add compliance executives and compensate board audit committees now doing more work. But its said there s h ardly a comparison between the $63 billion lost by Enron common stockholders alo ne and, say, even a tripling of audit fees to $3.6 billion. Interes tingly enough Rep. Michael G. Oxley (R-Ohio) wasn t even added to the bill until a last-minute concession by House Republicans after the WorldCom scandal broke and the public began to turn in favor of the Democrats as the November 2002 elec tions were approaching. No matter what form conflicts take, they are sometimes d ifficult to resolve. The financial costs associated with audit conflicts can be enormous; and a significant toll may also be taken in other ways, such as in low morale, job switching, and reduced effectiveness within the internal audit depa rtment. (Fass 2003) The summary highlights of the most important Sarbanes-Oxley sections for complia nce are listed below. SOX Section 302 - Corporate Responsibility for Financial Reports Periodic statutory financial reports are to include certifications that: The signing officers have reviewed the report The report does not contain any material untrue statements or material omission or be considered misleading The financial statements and related information fairly present the financial co ndition and the results in all material respects The signing officers are responsible for internal controls and have evaluated th ese internal controls within the previous ninety days and have reported on their findings A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities Any significant changes in internal controls or related factors that could have a negative impact on the internal controls Organizations may not attempt to avoid these requirements by reincorporating the ir activities or transferring their activities outside of the United States SOX Section 404- Management Assessment of Internal Controls Requires each annual report of a public company to include a report by managemen t on the company s internal control over financial reporting. This report should

contain: A statement of management s responsibility for establishing and maintaining adeq uate internal control over financial reporting for the company A statement identifying the framework used by management to evaluate the effecti veness of internal control Management s assessment of the effectiveness of internal control as of the end o f the company s most recent fiscal year Disclosure of material weaknesses (A material weakness is a significant deficien cy or combination of significant deficiencies that result in more than a remote likelihood that a material misstatement will not be prevented or detected.) A statement that its auditor has issued an attestation report on management s as sessment SOX 404 also requires the company s auditor to attest to, and report on, managem ent s assessment of the effectiveness of the company s internal control over fin ancial reporting. SOX Section 409 - Real Time Issuer Disclosures Companies are required to disclose on a almost real-time basis information conce rning material changes in its financial condition or operations. SOX Section 902 - Attempts & Conspiracies to Commit Fraud Offenses It is a crime for any person to corruptly alter, destroy, mutilate, or conceal a ny document with the intent to impair the object s integrity or availability for use in an official proceeding. SOX Section 906 - Corporate Responsibility for Financial Reports Section 906 addresses criminal penalties for certifying a misleading or fraudule nt financial report. Under SOX 906, penalties can be upwards of $5 million in fi nes and 20 years in prison. Life After SOX Survey results indicate that most CPAs welcome the changes brought on by SOX. Ini tially the increased workload put a severe strain on the accounting departments. All of the participants stated their stress level was amplified, especially the first two years after. The training they received significantly changed with et hics and internal controls concentrated on. Some say the work environment has al so changed so as to be more conducive to open communication. (Dunn 2011) While i nvestor confidence in audits has increased since 2001, the accounting community still has a lot of work to do. The public is still leery when it comes to invest ing. More people have had to become more knowledgeable when it comes to financia l statements. SOX also helped restore some investor confidence in capital market s with federal securities enforcement being strengthened. The image of the accou nting regulators has even improved. Back during Enron times, Sherron Watkins fel t the SEC had a poor track record of listening to whistleblowers, most notably i ts communication with Harry Markopolos of Bernie Madoff fame. He reported the fra ud ten years before Madoffs arrest. She prefers still for whistleblowers not to g o straight to the SEC, but to put their proof on WikiLeaks. (Sherron Watkins, 20 11) While progress is still being made, a lot can still be done to change invest or and whistleblower perceptions.

REFERENCES Canadian Institute of Chartered Accountants, 2001. Protecting The Public Interes t: The Role of the Chartered Accountancy Profession. A Report Prepared by Kroll Associates, August. Available at http://www.cica.ca/index.cfm/ci_id/7760/la_id/1 .htm Conrod, M. 1994. The Bottom Line Top 30 Accounting Firms. The Bottom Line (Canada) Apr: 1 Donaldson, W.H.-Chairman (2005, April 21) Testimony Concerning the Impact of Sar banes-Oxley Act. Testimony before the House Committee on Financial Services, US Securities and Exchange Commission. Available at http://www.sec.gov/news/testimo ny/ts042105whd.htm Dunn, J. (April 2011) Survey on Internal Differences Among CPAs Before & After SO X (template provided) Fass, A. 2003. Reforming the Boardroom: One Year Later, The Impact of Sarbanes-O xley. Available at http://www.forbes.com/2003/07/22/cz_af_0722sarbanes.html Griffin, C. H. 1977. The Beleaguered Accountants: a Defendant s Viewpoint. Journal of Accountancy 143(1): 81-85 Jacob, R. 1991. Can You Trust That Audit? Fortune Magazine November 18: 191-198 Magill, H.T., & G.J. Previts 1991. CPA Professional Responsibilities: An Introdu cton. Cincinnati: South-Western Publishing Mautz, R.K. and H.A. Sharaf, The Philosophy of Auditing (Sarasota, FL: American Accounting Association, 1961) Reeve, John T, Internal Auditing, pp. 8-1 to 8-39. In Cashin, J.A., Neuwirth, P. D., and Levy, J.F.(eds.), Cashins Handbook for Auditors, 2nd Ed. (Englewood Cliffs , NJ: Prentice Hall, 1986) Watkins, S. (2011, April 7) Leadership Lessons From Enron: Tales From the Enron Whistleblower. Address at the Montante Cultural Center, Canisius College, Buffal o, NY (slides attached) Wise, R. 1994 Litigation support risky for US accountants. Bottom Line (Canada) Ju

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