The roles of external auditors in reporting fraud Essay

In Latin, the word audit means ‘to hear ‘ . One individual creates the Financial Statements, whilst the hearer ‘hears ‘ what they are stating, and passes his sentiment to them. External auditing ( EA ) is “ an scrutiny of the one-year fiscal study of an organisation by person independent ” . The intent of an EA, to show an sentiment on whether the information presented in the fiscal statements, reflect the fiscal place of the organisation at a given day of the month and reported to the clients or stockholders. For illustration, are inside informations of what the organisation owns and owes decently recorded in the balance sheet? Are net incomes or losingss decently assessed?

There are two types of external hearers, statutory audits which are compulsory by the jurisprudence and Non-statutory audit which is non mandatory by the jurisprudence. The EA study must includes different countries to demo a true and just value such as, traveling concern, consistence, prudence, fiting rule and collection rule. Besides, the International Federation of Accountants lays down cardinal rules as follows, independency, unity, objectiveness, confidentiality, proficient criterion, etc. External Hearers have responsibilities and rights related to the Company Act 1985 which was defined by ISA, CMA and Statutory jurisprudence which enable them to execute a good occupation.

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This paper is about the functions of external hearer to describe fiscal statements fraud. Number of corporate dirts in the universe has increased twelvemonth by twelvemonth like Enron, Tyco, and Parmalat. Researchers will discourse the instance of WordCom Company to foreground the chief issues.

Cardinal words: Fraud, External Audit and WordCom

The function of external Audited account

There are certain functions that the external hearers do in scrutinizing F.S of the company. These are as follows:

The primary function of external hearers is to show an sentiment on whether an entity ‘s fiscal statements are free of stuff misstatements.

Hearers merely want to do certain that company ‘s fiscal statements are true and just representation of its existent place.

Normally, external hearers review the entity ‘s information engineering control processs when measuring its overall internal controls.

They must besides look into any material issues raised by enquiries from professional or regulative governments, such as the local taxing authorization.

The independency of external hearers is important to a correct and thorough assessment of an entity ‘s fiscal controls and statements.

Literature Review

Many bookmans had discussed in their empirical surveies the external hearer duties in accounting dirts which result in make fulling chapter 11 of bankruptcy protection by those cooperate houses.

Recognition of gross and the hearer ‘s duty for observing fiscal statement fraud were most issues been discussed in the research by Intal & A ; Thuy ( 2002 ) titled “ Fiscal Statement Fraud ” . One of the most aims of the research is to place the grounds of why hearers have non detected fiscal statements fraud. Research workers are looking to suggesting solutions for bettering the audit procedure in these issues. Researchers approach a descriptive and explanatory research and it is a case-based survey. They make interviews with audit proficient board in 10 audits houses in Sweden and one Swedish professional accounting establishment. The found that the grounds which makes hearers have non discovered the fraud are: application of analytical reappraisal processs as “ sufficient audit grounds ; ” weaknesses in audit hazard theoretical account and hazard appraisal refering internal control ; and scrutinize failure in gross acknowledgment and related party dealing revelation.

Others like NEUMEISTER ( 2009 ) found that external hearer was responsible for fraud in ‘Bernard L. Madoff Investment Securities LLC ‘ . He added that Friehling & A ; Horowitz pleaded guilty for this alleged fraud as it was scrutinizing its client fiscal statements for 15 old ages. It failed to verify the discredited money director ‘s fiscal records. The house reported to AICPA that it did non performed audit since 1993. Therefore, the house licence had non been renewed for all that period. In add-on Christodoulou ( 2010 ) mentioned that KPMG was besides the hearer of Madoff. Although the tribunal held that KPMG found non guilty in the instance which it had sued by Madoff feeder fund, the house failed to set more attempt in accessing information necessary to guarantee investors were non cheated.

OJO ( 2006 ) agreed the position of NEUMEISTER ( 2009 ) and Christodoulou ( 2010 ) in their survey of ‘The Role of the External Auditor in Financial Regulation and Supervision ‘ in which the statutory hearer played function to avoid farther commercial dirts such as Enron. One of major job that happen in Enron was the balance sheet debt which resulted from following regulations because the accounting criterions did non authorise. The audit house had shredded paperss related to Enron, therefore it terminated the grounds that could take to deducted fraud which resulted to Enron dirt. This was besides considered as an offense against Andersen in the tribunal of jurisprudence.

Sheely ( 2000 ) besides realized in ‘A Simple Recipe for Cooking the Books ‘ audit failure in tax write-off fraud as in instance of WorldCom although there were qui vives about the company ‘s fiscal place. When bills were paid, they were decently coded to an operating disbursal history. The audit house Arthur Andersen ‘s staffs were followed an bill through the histories collectible system and could non happen any fraud. This fraud occurred by reclassified the line-cost as capital outgos. For illustration, $ 500 million in undocumented computing machine disbursals were logged as a capital outgo. However, the internal hearers discovered that $ 2 billion of the company ‘s disbursals had been spent on capital outgos during the first three quarters of 2001 had ne’er been authorized for capital disbursement.

Furthermore, Sheldon and Reena ( 2007 ) mentioned that the authorities besides plays in cut downing or extinguishing frauds. However the propose of external audit is to attest that the fiscal statement reflect the true and just position. First, they discussed the function of external hearer in tax write-off fraud from an accounting dirt instance in Turkey. The Imar bank instance was collapsed although this bank was in list of administrative ability for about 10 old ages. The prostration of the bank was chiefly due to IT- related fraud which occurred in two ways. The records of the bank had been deleted and so, it had dual record-keeping system where the original records kept at the bank and the bogus one sent to the Banking Regulation and Supervision Authority. The hearer failed to prove the system which consequences to deceitful activity. Second, they discussed the function of authorities in make up one’s minding the appropriate criterions to be used and that the external hearer should be authorized by BRSA before scrutinizing the Bankss.

On other manus, Agrawal and Chadha ( 2005 ) focused in their survey about “ Corporate Administration and Accounting Scandals ” aimed to analyze whether certain corporate administration mechanisms are related to the chance of a company repeating its net incomes. The writers choose a sample size of 318 US public companies including those which restated their net incomes, such as Adelphia, Gateway and Xerox and non-restating houses. The research workers through empirical observation investigate the relation between the likeliness of restatement and independency of boards and audit commissions. Besides, they discuss about fiscal expertness of boards and audit commissions. In the last subdivision research workers discuss other administration mechanisms. They found that several cardinal administration features are basically unrelated to the chance of a company repeating net incomes including the independency of boards and audit commissions and the extent to which outside hearers provide non audit services to a house. Besides they found the usage of Arthur Andersen or another large 5 ( antecedently ) audit house is besides unrelated to this chance. Researchers besides found that the chance of restatement is significantly lower in companies whose boards or audit commissions include an independent fiscal expert.

Finally, Stirbu et Al ( 2009 ) in “ Fraud and mistake: Hearers ‘ duty degrees ” aimed to place the perceptual experiences of users about fiscal study on the extent of fraud in Romania and to place stockholders perceptual experience of the duties in describing fraud and the public presentation of hearer processs. The inquiry of the research was “ Are hearers responsible for observing fraud in the companies they inspect? ” The sample of the research was 451 hearers. On-line questionnaires were sent by electronic mail and merely 378 hearers were responded. Researchers found an outlook spread between respondents and present statutory demands with regard to fraud coverage and sensing.

The direction squad is the 1 who should detect the fraud at first topographic point. However, External hearers play one of the most of import function in cooperate dirt because of their failure to take some necessity stairss, such as following ethical codification of behavior. But they should non be blamed entirely as authorities has besides duties in bar these frauds. If it non has suited processs for naming hearers every bit good as for penalties, the figure of accounting dirts will be more.

WorldCom Scandal


WorldCom ( WCom ) was the 2nd largest long distance telecommunication company in USA. It besides was the largest cyberspace web in the universe with around 60,000 employees over 65 states worldwide. The company grew through amalgamation and acquisition. It foremost merge was with MCI Inc which cost $ 37 billion doing the largest amalgamation in US. It acquired over 60 companies within 15 old ages.

On July 2002, it filed chapter 11 to seek bankruptcy protection. The appraisal of corporate fraud dirt was $ 11 billion.

Staffs involved in dirt

The followers is a list of WorldCom executives and other employees who implicated in the accounting fraud:

Bernard Ebbers – former CEO found guilty of all charges and convicted of fraud, confederacy and filing false paperss with regulators.

Scott Sullivan – former CFO was indicted on charges of securities fraud, confederacy, and false statements to the SEC.

David Myers – former accountant was charged with securities fraud, confederacy, and false statements to the SEC.

Buford Yates Jr. – former accounting manager pleaded guilty to charges of securities fraud and confederacy.

Betty Vinson & A ; Troy Normand – former accounting directors pleaded guilty to charges of confederacy to perpetrate securities fraud.

Causes of dirt

There was several grounds lead to corporate dirt as illustrated below:

Excessive projection. The WorldCom acquired many other companies at really high monetary value in hope that the growing rate will be continued.

Expecting high demand. The house was anticipating that the demand for cyberspace services will be leaped to flip high.

Over built the capacity. Merely 10 % of its fiber optic-cable is presently used.

Excessive purchase. The company ‘s boards of managers were non paying attending to how the company was run.

Analysis of Scandal

There were two major ways WCom had committed fraud which it occurred between 1999 and 2002. However the figures below are related to 1st one-fourth 2001 boulder clay 1st one-fourth 2002. One of these was underreporting the disbursals by capitalising them in balance sheet as an investing. The tabular array below explains how the improperly reported line cost affected on net income before involvement and revenue enhancement. It can be noticed that after restatement these costs into proper class, alternatively of acquiring net income around $ 2.6 billion the company suffer losingss of $ 1.2 billion between the period of 1st one-fourth 2001 and 1st one-fourth 2002.

The other signifier of fraud was exaggerating company ‘s gross. WCom was entering net incomes from service provided to its subordinates as gross. In add-on, direction charge which was provided to the subordinates recorded as income.

Auditor Responsibility

Arthur Andersen ( the hearer ) did non changed its audit processs irrespective of cognizing that the line cost was one of the points where WCom could perpetrate fraud. Furthermore, Anderson ranked WCom as a high hazard company because it was refering about its portion monetary value. However it did nil to alter this state of affairs.

Anderson besides ignored the qui vive about WCom ‘s fiscal place. It ignored ratio indexs, such as net income border, debt/equity rations and so on which most of them were giving consequence below the bench grade.

The house was seeking to acquire a good feeling from its client in hope to hold more concern from the client. Therefore, Anderson did non seek to take action when it was prevented to entree the client ‘s leger. Therefore, it failed to take safe guard processs for such struggle.

Lessons learned from the dirt

There are certain lessons can be learned from the above instance for different points of position.

The investors should non depend merely on company ‘s fiscal statements in make up one’s minding of whether it is worthy for their investings. They should besides seek for 2nd professional sentiment.

The investors should diversify their investings widely and non to maintain them in one basket.

The company should name more independent managers to take attention of public involvement, therefore avoiding forces involvement.

The authorities has to selected appropriate criterions and to follow tormenting penalty against those who breach the regulations.

Decisions and Recommendations

Arthur Andersen scrutinizing house which audited WorldCom Company failed to observe the fraud. It is clear now the Audit house ignored some issues to happen out fiscal fraud. We believe that the chief ground of why audit have non detected fraud were “ application of analytical reappraisal processs, hazard appraisal refering internal control ” . Intal & A ; Thuy ( 2002 ) had analyzed this ground in their thesis.

In WCom, five factors of fraud had been passed bit by bit which are cooks, formulas, inducements, monitoring and end consequences or called as offense and this because of failure of external audit as we mentioned supra. In this paper we listed some analytical reappraisal of WCom dirt back uping our position with figures. We found that the grounds of why hearer had non stopped the fraud in early clip including Ignore ratio indexs, such as net income border, debt/equity rations. Harmonizing to our reappraisal, we suggested some recommendations to both stockholders and audit house to forestall fraud as followers:

Stockholders should name different audit houses for different services, for illustrations scrutinizing of fiscal statements and audiences.

Stockholders should name qualified audit commission with high degree of experience and honestness.

Company should alter its hearer on a regular basis ( every five old ages ) to avoid the struggle of involvement between the audit house and its client.

Audited account houses should develop the processs of audit to observe staff members who suspected their purpose to make fraud.


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