Auditing for governmental accounting purposes. It was mainly involved

Auditing is the conduction of an
examination of several events to verify that those events are being managed and
documented in agreement with established guidelines, policies and procedures.
The auditing profession initially existed for governmental accounting purposes.
It was mainly involved with reporting instead of accounting procedures. It
wasn’t until the Industrial Revolution, that the auditing profession began
progressing into an area of fraud discovery and financial liability. As
businesses expanded immensely during this extent of time, company owners could
not directly manage all of their operations and had to hire managers. Those owners recognized an
expanding need to oversee managers’ financial tasks, both for accuracy
and for fraud
avoidance. In the years between the McKesson & Robbins scandal and the Enron and Worldcom scandals,
administrators made many changes to accounting and auditing policy in the
United States. One of these
numerous changes was that of the Sarbanes-Oxley Act of 2002 (“SOX”).

The auditing profession in the United States was subject to
self-regulation before
SOX was introduced.
Self-regulation is the fact of something such as an organization regulating itself without
interference from external bodies. According to the International Federation of Accountants (2011),
“Self-regulation with
public oversight and accountability would typically involve some form of
oversight being carried out by an independent agency (p.4).” Independent
agencies are important because audit requires bringing attention to the audit
profession challenges, weaknesses, and risks. Zeff (2003) discussed the need
for self-regulation as follows:

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From the earliest days of the
profession, accounting firms rendered consulting services. By the 1910s, they
included the installation of factory cost systems, studies of organizational
efficiency, investigations in connection with possible investments in other businesses, and an
array of other services to management, which, as Carey writes, were often rendered in conjunction
with audits (Carey 1969, 146). But accounting, auditing, and taxation
constituted the solid core of the firms services. In 1922, the American
Institute of Accountants, now known as the American Institute of Certified Public Accountants
(AICPA), banned certain forms of self-promotion by accounting firms. The
following year, A. C.
Ernst and two of his partners in Ernst & Ernst, by then a national firm,
were accused of violating the Institutes rules against soliciting and
advertising, and all three promptly resigned their Institute membership. Even
after his firm no longer engaged in those practices, A. C. Ernst never rejoined
the Institute (Carey 1969, 233-234). Federal agencies sought the advice of the organized
accounting profession because of its growing reputation. In 1917, at the
request of the Federal Trade Commission (FTC) and the Federal Reserve
Board, the Institute
supplied a technical memorandum for publication by the Board as a bulletin
on auditing procedures.
The FTC sought to promote uniform accounting, while the Board wanted to apprise
commercial bankers of the importance of securing audited financial statements
from their borrowers. Despite the title of the bulletin, Uniform Accounting, it
actually dealt with recommended auditing procedures and the format of the
balance sheet and profit and loss statement. This represented the first authoritative guidance
on auditing procedures published in the U.S. In 1929, at the request of the Federal Reserve
Board, the memorandum
was revised by the Institute and published anew (Carey 1969, 129-135, 159-160;
Previts and Merino 1998, 229-234, 250-251; Zeff 1972, 113-115, 118-119). Audit
work developed apace in the 1920s, as an increasing number of listed companies
issued audited financial statements. By 1926, more than 90 percent of industrial companies listed on the New
York Exchange were audited (May 1926, 322), even though the Exchange did not require audited
statements by newly listed
companies until 1933 (Rappaport 1963, 39-40). Yet the Exchange had informally encouraged
companies to publish audited
financial statements for some years before then (Staub 1942, 14-15). (p.191)

 Reporting by the professional
accountancy organizations to an independent agency in the dismissal of its
responsibility, and oversight tasks exercised by that agency, enhance and add
substance to self-regulation. The early implementation of regulation amongst
the auditing profession made it easier to adopt SOX.

Many
cases shaped the auditing profession to what
it is today. From McKesson
& Robbins to Enron and WorldCom, they each played a major part in developing SOX. In 1937, McKesson & Robbins recorded total assets of $87
million. It was
later detected that this
$87 million was comprised of
$10 million in
nonexistent inventory and
$9 million in phony
receivables. The fraud was executed by the c-suite executives of McKesson &
Robbins and involved fabricated purchases from and sales to counterfeit
Canadian companies, which were indeed just vacant offices staffed by
secretaries who forwarded mail. The widely known McKesson & Robbins fraud
triggered the auditing profession to endorse two auditing standards that are
adhered to today. Cengage (1999) described the two standards as follows:

1. The physical existence of
inventory must be confirmed through direct observation. This simple procedure
applied in the McKesson & Robbins case would have revealed that the
reported purchases from the Canadian suppliers were phony.

2. The existence and accuracy of
reported receivables must be independently confirmed by contacting a sample of
the parties who allegedly owe the money. Sixty-two years after the original
McKesson & Robbins scandal, this simple procedure, applied by a staff
auditor at Deloitte & Touche, uncovered the modern-day McKesson HBOC fraud.

The accounting scandal of McKesson & Robbins was only
the beginning of many issues to be uncovered within the auditing profession.
The cases that changed the auditing profession took place some thirty years
later.

The case of Enron played a valuable
part in illustrating what the auditor-client relationship should not be. It is
the main accounting scandal that gave way to the implementation of SOX. Arthur
Andersen LLP (“Andersen”) was Enron’s, a corporation during the 1990s that
swapped its business from operation of natural gas pipelines to an energy
conglomerate, auditor. They audited Enron’s publicly filed financial statements
and provided internal audit and consulting services to it. In 2000, Enron began
to suffer financially and continued to diminish in 2001. Enron was headed by
global managing partner David Duncan (“Duncan”). On August 14, 2001, Jeffrey
Skilling, Enron’s CEO, surprisingly resigned. Within days of his resignation,
Sherron Watkins, a senior accountant at Enron, informed Kenneth Lay, Enron’s
new CEO, Duncan, and Michael Odom, an Andersen partner who supervised Duncan,
of the potential accounting problems facing Enron.

A key accounting problem involved
Enron’s use of special-purpose entities (“SPEs”) used to engage in “off-balance-sheet”
activities. Andersen’s engagement team had allowed Enron to “aggregate”
the SPEs for accounting purposes so that they showed a positive return, an
infraction of generally accepted accounting principles. On August 28, 2001, the
SEC opened an informal investigation. On October 8, Andersen retained outside
counsel to represent it in any litigation that might emerge from the Enron
matter. On October 10, Odom spoke at a general training meeting stating that if
all documentation is destroyed in the normal course of business, then it is
acceptable. Odom was informed by Enron’s lawyer that each engagement file
should contain only information compatible with the work completed.

On October 16, Enron announced its
third quarter results, disclosing $1.01 billion charge to earnings. The
following day, the SEC sent a letter to Enron about the investigation against
them and they forwarded it to Andersen. A meeting was called with Enron’s
crisis response team to make sure everyone was complying with the document
retention policy.  On October 30, the SEC
opened a formal investigation and petitioned for accounting documents from
Enron. As a result, Andersen continued to destroy documents. On November 8,
Enron restated its earnings and assets. The SEC also subpoenaed Enron and
Andersen for its records. In March 2002, Andersen was indicted on one count of
breaching witness tampering provisions 18 U.S.C. § §1512(b)(2)(A) and (B). The
indictment alleged that Andersen knowingly, intentionally, and corruptly
persuaded Andersen’s employees, with intent to cause them to withhold documents
from, and alter documents for use in, an official proceeding.

The case of WorldCom, a
telecommunications company, turned out to be one of the largest accounting scandals
in United States history. An internal audit of the company found that improper
accounting practices were employed. More than $3.8 billion in expenses were
reported as capital investments over five quarters. Tran (2002) stated,
“WorldCom’s chief executive, John Sidgmore, blamed the company’s former
chief financial officer, Scott Sullivan, and the former controller, David
Myers. The two were fired for claiming $3.8bn in regular expenses as capital
investment in 2001.” Also, as another client of Anderson, they began to
feel the pressure. Anderson audited
the company’s 2001 financial statements and reviewed their books in the first quarter of 2002. Andersen
accused Mr. Sullivan of withholding material information from them. According
to Tran, “The deputy US attorney general, Larry Thompson
(“Thompson”), said: We have to ask where the professionals were, the accountants and the
lawyers.” Two major accounting scandals have happened before
WorldCom. The question posed by Thompson was a valid one to ask. Why were there
no accountants who caught the fraud from the beginning?

From these three cases, one should
understand the importance of auditing and the responsibilities that go along
with it. Auditors are held accountable for having relevant competence and capabilities
to execute the audit, complying with relevant ethical requirements, and
maintaining professional skepticism and exercising professional judgment
throughout the preparation and performance of the audit. The Public Company
Accounting Oversight Board (“PCAOB”) SAS No. 1, section 110 (1972),
detailed the responsibilities and functions of the independent auditor. They
are described as follows:

The auditor has a responsibility to
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement, whether caused by error
or fraud. Because of the nature of audit evidence and the characteristics of
fraud, the auditor is able to obtain reasonable, but not absolute, assurance
that material misstatements are detected. The auditor has no responsibility to
plan and perform the audit to obtain reasonable assurance that misstatements,
whether caused by errors or fraud, that are not material to the financial
statements are detected… The auditor’s responsibility is to express an
opinion on the financial statements.

Each auditor is held accountable to his profession, the
responsibility to adhere to the standards accepted by his fellow auditors.
Knowing this, each auditor should know the importance of their role.

SOX was created with the intent to address the confusion and animosity in the country over the bankruptcies of WorldCom and other accounting
scandals. The goals
of SOX are to complement
the clarity of financial information, redeclare auditor independence, and detail aspects
of corporate governance.
SOX assigned specific SEC oversight and altered the self-regulatory, peer
review environment in which accounting firms had conducted business. It decreed
that the SEC set up
the PCAOB which
would “establish auditing
and related attestation, quality control, ethics, and independence
standards and rules to be
used by registered
public accounting firms
in the preparation and
issuance of audit reports.” SOX held c-suite executives to a greater standard of
accountability, required
the use of independent audit committees, and enhanced auditor
independence.

Today, the auditing profession is in a continual state of growth. Auditors
are held to a higher standard so that accounting scandals are not as prevalent.
There are four things that stand out amongst the auditing profession today.
These four things are explained by Daniel Goelzer (2005), a board member of the PCAOB. The first is the refocus on auditing.

“The profession is beginning to again view auditing as its core business — not merely an adjunct to consulting. Many non-audit services have
been prohibited. For those that remain legal, audit committee pre-approval is
required, and audit committees are more reluctant to let their auditors perform significant non-audit services.”

Secondly, the impact of inspections.

“While there is a place for
enforcement proceedings and
a place for
liability to private
parties who are injured by bad auditing, in my
view, a well-thought-out inspection is more likely to improve the day-to-day quality
of auditing than
are those other, blunter
tools.”

Next, auditor risk aversion and client selectivity.

“Our inspections and published figures show that the major firms have “fired” some clients, particular those
that are riskier.
Firms also have
developed more sophisticated tools
for assessing client risk and using those assessments to tailor how
they audit.”

Last, but not least, Section 404 internal control
audits.

“The audits of internal control have added an important new
dimension to the auditor’s work. The auditor is required to have a more
complete understanding of the strengths and weaknesses of the client’s financial reporting
systems. Audit
committees are also being forced to learn more about those systems in order to assess significant
deficiencies that the auditor reports to them.”

The auditing profession will continue to develop to become
adaptive to the new pressures placed on the profession. Constant training and
development must be required for auditors to adapt to the changing culture of
auditing.

The
auditing profession has experienced many setbacks, but it is much stronger than
it was years ago. McKesson & Robbins, Enron, and WorldCom were included
amongst the many accounting scandals that led towards the implementation of
SOX. The implementation was a stride in the right direction for the auditing
profession. SOX helps to support audit quality and investor assurance. It also
enhances the audit effectiveness and efficiency, while also increasing the
reliability of financial reporting. Because the profession will continue to
grow, the auditing profession must continue to set regulations to push auditing
in the right direction. In the years to come, regulations will make it easier
for auditors to do their jobs.

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