Auditing After Enron or Financial Services

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Table of Contents

Introduction
Ethics in Accounting: The Auditing Function
Structural Origins of Conflicts of Interest
Conclusion
Work Cited

Introduction

Inaccurate and ineffective financial accounting and auditing are detrimental to the success of organizations. They can cause a decline in the value of shares, the collapse of the financial market, and the loss of investor’s faith and support. Several decades ago, investor confidence was destabilized by the financial scandals that were reported in various organizations: Enron, Arthur Andersen, and WorldCom among others. At the time, the corporations used to engage both internal and external auditors to check their accounts for compliance. They conducted their audits in compliance with the Code of Professional Conduct as provided by the American Institute of Certified Public Accountants.

The violation of the code of ethics by auditing companies compromised their reputation and the integrity of financial markets, leading to the collapse of their organizations. In their article, Duska and Duska discuss the issue of ethics in auditing. They explore the aftermath of the financial scandals and the mitigation measures implemented. Collin Boyd weighs in on the issue by discussing the structural origins of conflicts of interest that compelled the Big Five accounting firms to violate professional accounting ethics for selfish financial gains that had severe consequences.

Ethics in Accounting: The Auditing Function

According to the authors, auditors play an important role in financial markets; they facilitate the proper functioning of the economy (Arnold et al. 339). The auditor’s primary role is to ensure that a company’s financial estimates are based on legitimate and reasonable formulas that are applied consistently over time. In that regard, auditing the financial statements of public companies is among the most important roles of auditors. This function has existed for centuries.

However, it recently came under more scrutiny after the financial scandal involving two big corporations, Enron and Arthur Andersen. This incident revealed how auditing firms violate professional accounting ethics to benefit financially and help organizations misrepresent their financial performances to investors and other stakeholders. Auditors need to have integrity and honesty, be independent of any form of influence, and work without any conflict of interest. These factors create trust, which is a core component of the financial auditing process.

Trust

The authors explore the issue of trust as a key component of ethical accounting and auditing functions. They note that companies engage in unethical accounting practices to benefit financially. For example, Enron misrepresented its financial statements to raise the company’s stock price to use it as collateral for loans that would be used to pay their bad debts. If all companies around the globe embraced such unethical behaviors, trust in business deals involving finances would erode, markets would develop inefficiency, and misrepresentation of financial statements would become impossible (Arnold et al. 340). Trust is an important aspect of accounting. However, the appearance of being trustworthy is as important because skepticism is an essential factor in the protection of stakeholders’ interests.

Responsibilities

The auditor has a special responsibility to the public; he or she should ensure fairness and transparency in presenting the status of the financial statements of organizations. In that regard, the relationships between auditors and their clients are more special than those in other careers. As a “public watchdog,” an auditor should ensure that they maintain independence, avoid the influence of their client, and assume the role of a disinterested party that has to fulfill important public obligations.

The auditing process is a challenging task because of the conflict of interest, emanating from their responsibility to the client and the public. The auditor’s primary responsibility is to protect the interests of the public and not those of the client. The public obligations bestowed on these individuals render them disinterested analysts who should present fair reports regarding the exact status of a company’s financial statements (Arnold et al. 341). They need to recognize that they have a fiduciary duty to the public, which erodes trust whenever compromised.

The dilemmas that arise due to auditors’ responsibility to the public and the client present challenges that could lead to unethical practices. Therefore, they must be fully aware of their basic responsibilities. They should be proficient, independent, professional, engage in planned and supervised fieldwork, possess a thorough understanding of the audited organization’s structure, and be truthful (Arnold et al. 342).

The Cohen Report defined the main role of an independent auditor as acting as the intermediary between an organization’s financial statements and the users of the information in the documents. The report reiterated the auditor’s primary responsibility is protecting the public’s interests and not those of the client.

Independence

The authors also discuss the issue of independence and its importance in the auditing process. The AICPA requires that an auditor be given independence in fact and independent in appearance. The latter is accorded to all accountants for them to provide the most accurate information to stakeholders and anyone else in need of the data. According to the Independence Standards Board (ISB), auditor independence means freedom from the influence of factors and pressures that could compromise the ability to make unbiased decisions. Bodies that set auditing standards to identify the relationships and activities that could compromise auditing processes.

Auditor independence is influenced by four concepts: safeguards, threats, independence risk, and the significance or effectiveness of risks and threats respectively (Arnold et al. 346). The independence of an auditor is evaluated using four principles. These are the assessment of the level of independence risk, determination of the acceptability of that risk level, evaluation of the benefits and costs, and appraisal of the opinions of interested parties (Arnold et al. 346). This framework was provided because total independence is an impossibility.

Structural Origins of Conflicts of Interest

In this article, the author argues that the reason for the collapse of Enron was primarily due to failures by the company’s audit firm, which was influenced by tensions emanating from conflicts of interest in the industry and the accounting profession. These ethical tensions had been building up for decades as the accounting profession went through its various growth and evolution phases (Arnold et al. 347). In the paper, the author argues that the industry’s ignorance of the conflicts of interest that arose due to the style of service delivery was problematic and led to the scandal. These conflicts compromised the judgments of accounting professionals because of the immense pressures they placed on their decision-making.

Evolution of Accounting Firms

One of the issues covered in the article is the unmonitored evolution of public accounting firms. The scope of most accounting firms was local, and a single office offered financial services to a town or city. Large firms existed as partnership ventures. The structure of the accounting profession became unstable in the 1960s when companies started going global. A change in the geographical scope of organizations compelled large accounting firms to adopt a similar strategy to keep up with their clients (Arnold et al. 348). In that regard, mergers between large companies or many smaller firms became common.

This led to the formation of the “Big Five” that dominate the industry (Arnold et al. 348). This change in structure led to the formation of five global accounting firms that controlled the accounting industry. The consolidation watered down the auditing function from a prestigious service to an additional activity that the firms offered to its clients. As a result, clients’ loyalty to the accounting firms waned, audit prices declined, and the concept of long-term relationships between auditors and clients disappeared. This instability led to the emergence of “opinion shopping,” a practice that involved looking for a firm that would represent information as per the request of the client (Arnold et al. 352). They took advantage of the flexibility of accounting standards to engage in unethical practices.

Conflicts of Interest

The participation in consulting and auditing services by accounting firms led to conflicts of interest. For example, Arthur Andersen provided both audit and consulting services to Enron, thus compromising the independence that auditors should possess (Arnold et al. 352). Firms did not want to compromise their consulting business, so they agreed to the demands of clients. Consulting services are the major source of revenue for accounting firms. Therefore, it is difficult for them to question their clients regarding questionable accounting practices for fear of losing them and the revenue. For instance, more than 50 percent of the fees paid to Andersen by Enron in 2000 accounted for consulting services (Arnold et al. 352). This conflict of interest led to unethical practices as Arthur Andersen sought to protect its revenues.

The Big Five

The creation of a few large accounting firms consolidated power and influenced the membership of accounting firms. As a result, the firms wielded great power that allowed them to control the institutes at will. Case studies of how this dominance prevented the institutes from eliminating any conflict of interest are provided. For example, the recommendations provided by the Auditing Practices Board (APB) in the United Kingdom were rejected because the big firms lobbied successfully against them because of their huge representation in accounting firms (Arnold et al. 353). This power has been used by the Big Five to prevent any form of federal regulation by becoming actively involved in political matters.

The Sarbanes-Oxley Act

The issue of the Sarbanes-Oxley Act was implemented after the collapse of Enron as a mitigation measure. The legislation was enacted to streamline the accounting profession by eliminating conflict of interest, mandating a compulsory rotation of audit leaders, and limiting the number of additional services an auditor can offer a client, in addition to the audit (Arnold et al. 354). Boyd is concerned that the Act disregarded the conflicts of interest that emanate from marketing-related functions. The scandal compelled three of the four remaining firms to lower the level of involvement in their consulting divisions.

However, Boyd is concerned that they could go back to their former activities in the future. The Act allows audit firms to offer some consulting services. This could lead to another scandal in the future because it is difficult to revert the accounting to a time when integrity and honesty were the dominant characteristics of the profession.

Conclusion

The reviewed articles discuss accounting from different perspectives. Duska and Duska approach it from the perspective of ethics while Boyd uses the structural evolution method. Conflicts of interest, the consolidation of power in the Big Five, and the need to keep clients are the major causes of unethical accounting practices. Mitigation measures were put in place after the scandal. However, critics have argued that a similar event could recur due to relaxed regulations in the accounting industry.

Work Cited

Arnold, Denis G., et al. Ethical Theory and Business. 9th ed., Pearson Education Limited, 2014.

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