Ethics and Audit Risks of Auditing Fraudulent Financial Statements

According to section 110 of Responsibility and Functions of the independent Auditors states that “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statement is free of material misstatements, whether caused by error of fraud”. This section clearly provides guidelines and sets standards for auditors that enables them to accomplish responsibilities directed to them in relation to detecting frauds in auditing financial statements that are generally accepted auditing standards (GAAS) as well as show actions that were taken upon auditors who violate generally accepted accounting standards for WorldCom, Enron, Tyco, Waste Management, Telecommunication and Dot-com companies.

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Enron

Since the world scandal of Enron in March 2002, audit committees and national stock exchange have listing requirements for all public companies. These requirements are incorporated in the Blue ribbon committee (BRB) in order to improve the effectiveness of Corporate Audit Committees recommendations. The audit committee must be informed about all financial and operational endeavors of the company; therefore it should receive sufficient and timely information regarding company’s statements. If in any case the audit committee meeting does not agree with the regular board meetings, then the auditing committee must receive written information in relation to the conflicting schedule well in advance of the meeting. Auditing committee’s responsibility is to ask questions about property of the company’s financial reporting process and effectiveness of internal control system. The task of the committees is to keep up to date with the financial reporting developments affecting the running of the company (Smartpros, 2002).

To effectively accomplish the auditing responsibilities, the auditor needs to be positioned between senior management and the external auditors, this allows the auditing committee to assess all the financial statements and able to question the management about financial reporting matters and be able to be in a position to suggest improvements in the internal control systems. The responsibilities of the committee are to plan annual agendas, define company’s missions, responsibilities and in addition to that document finding and conclusions. Failure to comply to review and evaluate the financial statements by auditing committee in accordance with generally accepted accounting principles leads to malfeasance. Review of Enron’s annual proxy statements of March 27, 2001 revealed that the financial reports complied with the final disclosures rules on audit committee but when we look at the factors than indicative of financial reporting risks by Enron indicated that auditing committee would have minimized the losses of suffered by this company by recognizing well in advance warning signs that led to the fraudulent reporting (Smartpros, 2002).

The auditors would have watched for the following warning signals in order to minimize the class-suits of Enron; The over-optimism news bulletins in respect to Enron earnings and instead analyze annual reports and interim earnings to prevent future increased cases of managing earnings. b).Enron industry accounting practices were did not comply with revenue recognition opportunities to increase earnings. Auditing committees would have accessed monumental accounting policies that relates to industry policies specifically from financial reporting data base and take up irresponsibility to review the information with both internal and external auditors. c). The rapid growth of Enron, The auditing committees would have investigated the cause of the rapid growth in relation to both top-line and bottom-line double digits annual growth rates and also investigate the significant increases that occurred yearly in comparison to the past performances. d). Conflicts of interest and substantial contracts that affect financial statements. Enron frequently made related-party transactions and failed to enforce corporate code of conduct. The auditors should have determined the management’s intention to disclose such contracts activities and convey hoe its company approaches conflict of interest situations and monitors that it complies with the codes. The auditing committee should have conducted a special investigation to look into the matter and retain its independent counsel. Audit committee members should adapt to the potential of fraudulent reporting. As we have seen in Enron, the auditing committee did not employ its full authority in minimizing the potential for class action suits therefore failure of the committees to question management lead to the malfeasance and therefore the auditing committee and the board were held liable for failure to know what they were responsible for recognizing the mistakes and not acting on them (Smartpros, 2002) (Barret, 2004, p. 150).

David B. Duncan who was the auditor at the Arthur Andersen firm agreed to an injunction by the Securities and Exchange Commission to settle charges that he broke securities laws regarding signing false and misleading audit reports. Duncan agreed to settle civil injunctive action charging him with violating the antifraud provisions of federal securities laws, and the commission permanently suspended him form appearing or practicing before the SEC as am accountant or auditor. SEC said that Duncan failed to exercise due profession care and the necessary skepticism required under GAAS. Also he did not make sure that audit team certain transactions which took place such as “prepays” were prepared according to GAAS and also failed to ensure that Enron property presented and disclosed the transactions in its financial statements (WebCPA, 2008).

WorldCom

WorldCom was accused of manipulating its books of account in the following areas; a). It charged income and classification of assets in connection with acquisition. b). its accounting for line costs. In recording its closing acquisition, WorldCom did not record its expenses properly at the time of acquisition therefore inflating earnings in later periods when the expenses actually incurred and that should have been recorded. On the other hand, WorldCom took huge and unjustified charges to its income statements thereby creating inflated merge reserves that later on tapped into to boost reported earnings that could not have lead Wall Street to suspect anything. The line costs in question which were inflated were fixed monthly payments for the use of networks or lines regardless of whether its company or the customers used the lines or not. Which was WorldCom’s biggest expense at the moment but it could not disclose. What really drained it down was that the network demand did not grow as WorldCom expected and it found itself with a substantial line costs for leased networks that were not generating sufficient revenue. (Hecht, 2003) (Australian Broadcasting Corporation, 2002).

The problem

Under the GAAP, it was required that line cost be reported as expenses but WorldCom accounting department masked this by making journal entries crediting line cost expenses accounts and made corresponding reductions here and there in various reserve accounts so that it could make it general ledger accounts balance. Came 200, WorldCom changes it’s tactics of reporting line costs to its revenues by reclassifying the line costs expenses as capital expenditure that were subjected to depreciation over a period of time. Later in 2002, internal auditors discovered the accounting fraud a WorldCom’s stock priced dropped drastically. Linking form the evidence, Andersen who were the auditing accounting firm were held responsible because they failed to verify WorldCom’s treatment of reserves or line costs and instead relied upon managements representations. Andersen auditing firm did not seek other supporting documents for various adjustments that took place and journal entries as well or would have reviewed general ledgers that would have enabled it discover the misappropriation. The court ruled that Andersen would have discovered that WorldCom had no documents in the process of auditing that supported their many significant adjustments in their financial statements (Hecht, 2003) (Cheng, 2003 ).

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Court ruling

The courts final judgment, Andersen revealed that WorldCom’s senior management admitted to auditors how it had lied to its auditors by concealing the falsification of the WorldCom books from the auditors. The courts alleged that Andersen would have unmasked the fraud if it had conducted the required review of the books before issuing its auditing opinions in connection with WorldCom’s annual financial statements. The Andersen’s audit opinions included in the WorldCom’s end year financial statements materially misrepresented the company’s financial condition that misleads the people (Hecht, 2008).

SEC disciplinary action

SEC settles action against Arthur Andersen LLP partners, Melvin Dick and Kenneth Avery partners who at the time served on the WorldCom inc. for the year ended December 31, 2001. SEC found that during the 2001 auditing period, Andersen christened WorldCom as “Maximum Risks” client and in conjunction Dick and Avery were very much aware of the several factors that led to the increase of the fraud at WorldCom and failed to plan and execute audit procedures to take this risks into account as required under Generally Accepted Auditing Standards (GAAS). SEC found that Dick and Avery failed to execute certain audit procedures in the critical audit areas such as valuating WorldCom’s Property, Plant and Equipment and line costs accounts where the company’s management posted its fraudulent accounting entries (Security Law, 2008).

Dick and Avery failed to implement fundamental audit steps required by GAAS thereby failing to exercise professional care and professional skepticism in the planning and performance of the audit and be able to gather sufficient evidential matter to afford a reasonable basis for Andersen’s opinion relating to WorldCom’s financial statements. It failed to audit procedures applied in the most critical audit areas or even change the procedures employed to obtain more persuasive evidence in relation to the significant risks of material misstatements that dwelled at WorldCom. It should have planned and performed the audit to obtain reasonable assurance about whether the financial statements reported were free of material misstatements, either caused by error or fraud. And afterwards issue an audit report that accurately states that the audit procedure was conducted in accordance with GAAS and that WorldCom’s financial statements conformed to the GAAS. Based on the court finding, the commission ruled out that Dick and Avery were involved in improper professional conduct within the meaning of Rule 102(e) (1) (ii) (Security Law, 2008).

Tyco

In August 13, 2003, Washington D.C Securities and Exchange commission issued an Order instituting settled cease-and-desist proceedings and proceedings pursuant to Rule 102 (e) of the Commission’s Rules of Practice against the then CPA Richard P. Scalzo of the PricewaterhouseCoopers LLP (PwC) who were engaging partner for that firm’s audits of the financial statements of Tyco International Ltd of the fiscal years from 1997 to 2001. The commission of inquiry set up found that Scalzo recklessly breached the anti-fraud provisions of the federal securities laws and engaged in inappropriate professional conduct. Together with the institution of the administrative proceedings, and without conceding or denying the findings contained in that time, Scalzo agreed to the issuance of the Commission Order that required him to cease and desist from violations of the anti-fraud provisions and permanently implemented him from appearing or practicing as an accountant before the Commission (U.S Securities and Exchange Commission, 2003).

The Commission discovered that multiple and repeated notice were issued to Scalzo in respect to the integrity of Tyco senior management and that Scalzo was recklessly in the fact that it did not take appropriate audit steps of this process. at the end of the fiscal year September 30, 1998, facts availed were sufficient enough to obligate Scalzo, which did not subject its reports to generally accepted auditing standards (GAAS) to re-evaluate the risks assessment of the Tyco audits and to perform other additional audit procedures such as further auditing testing of certain items like executive benefits, executive compensation and other related party transactions. Scalzo did not at all take sufficient steps regarding these areas completely. Scalzo recklessly failed to conduct the audits in accordance with GAAS. The Commission Order therefore founded out that Scalzo was involved in professional misconduct. The Commission denied him the privilege of ever practicing before the Commission as an accountant (U.S Securities and Exchange Commission, 2003).

PwC issued an audit report that Tyco’s fiscal years from the year ended September 30, 1998 through Sept. 30, 2001 had successfully conducted an audit of Tyco’s financial statements in “accordance with auditing standards generally accepted in the United States of America.” PwC team worked as auditors for Tyco’s financial statements therefore making Scalzo reckless in not knowing that Tyco audits had not been done in accordance with GAAS. The Commission found that Scalzo recklessly altered the anti-fraud provisions of the federal securities laws and therefore ordered Scalzo to cease and desist from violations of the provisions. The public and investors rely entirely on auditors to present correct financial reports, when they fail to conduct diligent audits, they feel betrayed. Thomas C. Newkirk, Associate Director of enforcement at the Securities and Exchange Commission points out regarding this case that senior management of Tyco were looting the company and since Scalzo was confronted earlier with a number of warnings about signs management integrity. In this case, Scalzo was not sanctioned because he did not discover the looting; however, he was being charged because he did not take the warnings into action and investigate the case brought forward (U.S Securities and Exchange Commission, 2003).

Waste Management

The Securities and Exchange Commission brought a civil fraud complaint against Arthur Andersen against a Big five accounting firm stemming from failed audits at Waste Management Inc. which led to $1.43 billion restatements of earnings in 1998 the largest restatement ever in American history. The suit was aimed to prove to the other Big Five accounting firms that in egregious cases like in Waste Management, the entire firm will be held responsible if auditors certify misleading financial statements. SEC said that Andersen knows that Waste Management was overstating its profits throughout its financial period between early to mid-1990s and he repeatedly pleaded with the company to make changes which it failed to. But instead Waste Management made promises of future reforms which were not kept and refused to reduce exaggerated reported profits as the auditor recommended. Each year Andersen repeatedly pleaded with the company to make changes, certifying the company’s annual financial statements were not complying with generally accepted accounting principles (Floyd, 2001).

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Richard H. Walker, the commissions director of enforcement said that Arthur Andersen and its partners failed to stand up against company’s management and therefore betraying their ultimate allegiance to Waste Management’s shareholders and the investing public, given the position held by these senior partners and the duration and gravity of the misconduct, it held the firm responsible for the false and misleading audit reports it submitted. SEC filed a civil suit complaint against the three auditors; Andersen and partners who were engaged in auditing the company’s financial statements. All the three partners admitted to the allegation and were fines $30,000 to $50,000 each and were barred from auditing public companies for a period of up to five years and the forth partner was banned from auditing for one year (Floyd, 2001) (Wall Street journal, 2002).

SEC said that in early 1994, while still auditing Waste Management’s 1993 results, Andersen identified $128 million in misstatements in relation to that years and previous periods and asked Waste Management to change its reports to remove those earnings that were misrepresented an action would have reduced reported profits by 12 percent. In addition to that SEC had found bad accounting practices that overstated the profits that Andersen did not quantify. When Waste Management refused to make changes, Andersen concluded that overcharged profit accounts were not material, a decision that was not quantified as audit opinion states that financial reports “present fairly, in all material respects,” of the company’s financial position. What Andersen concluded was that the total misstatements were huge and most of the overstatements reflected the previous years and that the misstatements of the financial period starting from 1993 were not big enough to be reflect that year’s profit. In his argument he said that older reports were viewed as immaterial relative to the retained earnings on the present company’s balance sheet. On SEC ruled out that Andersen was completely wrong to conclude that the amounts were not material because Andersen did not “diligently pursue” and check the other indications of overstated profit. In settling the SEC’s civil fraud suits, Mr. Allgyer, 56, was subjected to pay a $50,000 fine and was banned for five years from auditing public companies. Edward G. Maier, 54, partners on Waste Management audits was fined $40,000 and banned to for auditing public companies for three years. Walter, C. 45, who worked on the audits was fines $30,000 and banned to three years. And all agreed to conjunction against further violation of security laws (Floyd, 2001). Waste management also said that its auditor, Arthur Andersen LLP settled a suit that alleged professional malpractice by the accounting firm in relation to the alleged securities violation and therefore deserved to compensate the shareholders adequately (Coleman, 2001).

Dot.Com companies

The recent failures of dot-com companies during the past years have been attributed to malpractice lawsuits against their accountants and auditors because of the potential lenders and investors who have trusted upon the audited financial statements to guide them through decision making. It is claimed that dot-com fell because of the common law-negligence, fraud defined by Rule 10b-5 of the Securities Exchange Act of 1934. Dot-com booked profits and reported rapid increase of revenues in their financial statements. Dot-com capitalized costs as assets on the balance sheet rather than putting the costs as expenses on the profit and loss statements. It manipulated its accounting statements by reporting gross-up revenues as the entire price a customer pays at their site even though the company kept only as a small percentage of the sum reported. A contra deals or barter method involves booking revenues prior to sales. Dot-com exchanges advertising space on its website for advertising on another build brand recognition and use up excess advertising capacity without using cash thereby violating generally accepted accounting standards that require recording barter transactions at fair values. Dot-com treated these barter advertisings as sales thereby increasing revenues and expenses (Rabelo, 2003, p.1).

In Expenses method, Dot.com reduced expenses it incurred and reported a more favorable operating performance because they rarely report net profits. They tried to minimize direct expenses it incurred directly by reclassifying them as indirect thereby reducing direct expenses and increasing indirect ones. So, the companies break even at the gross profit level even though net losses are the same. Usually company’s record fulfillment costs such as warehousing, packaging and shipping products as cost of sales whereas dot.com classified them as marketing expenses which allowed them to hide operational expenses within hefty marketing costs that led to investors and lenders believing that the company was engaging in establishing brand awareness (Rabelo, 2003, p.1).

Telecommunication

Securities and Exchange Commission filed a microcap fraud complaints against DCI Telecommunication, Inc. its Chief Executive Officer, Joseph J. Murphy and Russell B. Hintz and it auditors at the time. The complainant filed against telecom’s inaccurate financial statements. The Commission’s complaint filed in New York district court alleged that between March 1995 and June 1999, DCI improperly accounted for seven acquisitions and grossly overstated a purported $15 million contract and a $5 million promissory note. Due to this improper accounting financial statements of Forms 10-k and 10-Q were inaccurate and misleading that later victimized investors and the public into believing that DCI was a vibrant, high-growth telecommunication company, as well as the owners of the other small businesses who sold their companies to DCI in exchange for near-worthless DCI stock (U.S Securities and Exchange Commission, online, 2000) (United States, Department of justice, Federal Bureau of Investigation, 1994).

The Commission instituted and settled administrative proceedings against the telecommunication auditor Schnitzer & Kondub. The commission denied the accountants and the auditors the privilege of practicing before the commission as accountants or auditors with the right to apply for reinstatement after 5 years (U.S Securities and Exchange Commission, online, 2000) (Brown, 2005. p.6).

Fraud and responsibility of the Government Audit committee

The purpose of the set up government audit committee is to take active role in prevention, deterrence and detection of fraud and encourage government organizations to establish an effective ethics and compliance program. The government audit committee should constantly check the management and auditors to ensure that the established organizations has set up appropriate anti-fraud programs and controls to clearly identify potential fraud and quick investigation of any fraud allegations detected. The committees other responsibility is to ensure that appropriate action is taken against known violators of generally accepted accounting standards. The responsibility of Government Audit Committee include; a). Checking whether internal control system within the organization is effective). Monitoring all financial reporting process. c). reporting findings to the legislative body or any other formed independent governing body d). Making sure that government auditors and public accounting organizations engaged to perform government audits. Over the accounting years, fraud has been seen as a catastrophic risk to financial organizations and if is not early identified with and monitored, the results are very devastating to the company’s financial position, it’s reputation, lowers citizen’s level of confidence and it jeopardizes the success of the company in achieving its goals and objectives. The government set up body reduces the risks of fraud. Government organization elects officials body and management which are confined to a code of ethics. An audit committee helps the governing body in providing guidance necessary to create a culture of healthy and integrity in deterring, prevention and detecting fraud thereby gaining citizens and investor’s confidence (AICPA, online, 2004).

Ethical framework includes:

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  1. Code of ethics that is established within the organization that defines core values and that clearly states accepted and unaccepted behaviors
  2. Providing a training program for its organization code of ethics that includes sessions for new hires, management and newly elected officials on understanding code of ethics and also they should not leave behind the regular staff and officials.
  3. The ethical framework should adequately provide clear channel of communication for employees and other people to obtain advice when facing difficult ethical decision and the reporting of known or any suspicious unlawful activities against the government organization.
  4. Provide a system to monitor compliance with the code of ethics (AICPA, online, 2004).

Establishment of Anti-fraud programs and internal control watchdog

Audit committee should make sure that government organization forms an anti-fraud programs and internal controls to help prevent and detect fraud. To meet these responsibilities the audit committee should ensure that the government organization has: a). appointed a senior level member of the government organization to manage fraud risks b). It establishes policies and procedures that identify, evaluate and mitigate the organization’s fraud risk exposure c). Create a system that monitors that the organization complies with policies and procedures and controls. d). establish a clear communication channel that reports potential fraudulent activities. The communication lines established should include hot-lines, suggestion boxes or tracking reports. e). It should develop a process for investigating unlawful activities against the organization prior to the violation to minimize the losses suffered by the company and investing public. When fraud is discovered, the government audit committee should make sure that a certain process is put in place to receive periodic reports describing the nature, status and eventual disposition of anti-fraud investigations (AICPA, online, 2004).

Supriyo (2007) argues that in order to prevent future fraud cases, IAS should produce high quality information which identifies and records all valid transactions, provide timely information that reflects and permits every classification and financial reporting, provide accurate measures for financial value transactions and record all transactions in the time and period which they occur. In WorldCom, Enron frauds and telecommunication, auditors and directors lacked independency in such a way that it allowed its customers to perform non-accounting activities such as actuarial services. The organizations also employed inappropriate accounting practices; for example Enron made elaborate use of special entities to hide liabilities through off-balance sheet accounting while WorldCom transferred transmission costs from current expense accounts to capital accounts thereby altering some operating expenses and reporting higher earnings (Supriyo, 2007, p.9) (ACPA, 2008, p.300) (RSMBird Cameron Partners, 2007, p.2) ( Larsen, 2005, p. 811).

In conclusion, the public, U.S corporations and the regulatory environment have employed efforts to fight fraud. The public and investors are demanding a greater watch dog form all parties involved in organizational governance. Audit committees are called upon to play a vital role in the prevention of fraud and take appropriate action to the perpetrators. Government auditors on the other hand can provide additional assistance to the already set up audit committees to enable them to better carry out their fiduciary responsibilities in fighting fraud and protecting public interest.

References

  1. AICPA Audit Committee Toolkit. (2004). Fraud and the Responsibilities of the Government Audit Committee.
  2. ACPA. (2008). Consideration of Fraud in a Financial statement Audit. Effective for audits of financial statements for periods beginning on or after, 2002, unless otherwise indicated, 1, 271-300
  3. Australian Broadcasting Corporation. (2002). Market brace for fall- out WorldCom scandal.
  4. Barrett, J. M. (2004). Enron: Corporate Fiasco and their Implications, p. 155- 168.
  5. Brown, S. (2005). Telecommunication Fraud Management. Waveroad securiT,  2005, 1-13.
  6. Coleman, C. (2001). Waste Management to Pay $457 Million To Settle Shareholders Class-Action Suit. Wall Street Journal, 2001.
  7. Cheng, E. (2003). WorldCom and Capitalism.
  8. Floyd, N. (2001). Accounting Firm to Pay a Gig Fine.
  9. Hecht, C. (2003). SEC Central, Who is Responsible? The Audit fails to discover a massive fraud-which accountant takes the blame?
  10. Larsen, P. E. (10th Ed.). (2005). Modern Accounting. McGraw-Hill higher Education.
  11. Rabelo, m. (2003). Effects of the dot-com decline on independent accounts and auditors. The CPA journal, 2003, 1-3
  12. Russell G. S. (1996). Prevention of Telecommunication Fraud. Australian Heads of Fraud Conference Perth, 1996, 1-32.
  13. RSMBird Cameron Partners. (2007). Independent Audit Report. 2007, 1-2.
  14. Securities Law Prof Blog. (2008). SEC Settles Disciplinary Proceedings Against Two WorldCom Auditors.
  15. Smartpros. (2002). Audit Committee Responsibilities: Lessons from Enron.
  16. Supriyo, B. (2007). Ethics, Fraud and Internal Control. College of Agriculture Banking,  2007, 1-49.
  17. U.S Securities and Exchange Commission. (2003). Former Tyco Auditor Permanently Barred from Practicing before the Commission. Web.
  18. U.S Securities and Exchange Commission. (2000). SEC Files Microcap Accounting Fraud Case Against DCI Telecommunication, Inc. and Two of its Officers, and Settled Related Proceedings Against Auditors. Litigation release no. 16609, 2000.
  19. United States, Department of justice, Federal Bureau of Investigation (1994). Telemarketing fraud, Economic Crimes unit, White-Collar Crimes Section, Criminal Investigation Division, Department of Justice, Washington.
  20. Wall Street journal. (2002). SEC, Citing Massive Fraud, sues Former Waste Management Officials.
  21. WebCPA. (2008). Enron Editor Agrees to SEC injunction.
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StudyCorgi. (2021, October 14). Ethics and Audit Risks of Auditing Fraudulent Financial Statements. Retrieved from https://studycorgi.com/ethics-and-audit-risks-of-auditing-fraudulent-financial-statements/

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