Tuesday, July 19, 2011

Essay on Auditing

Essay on Auditing

Mautz and Sharaf presented an interesting idea about the postulates of auditing. In their study, they stated that the postulates were the basis, the assumptions, and the starting point for building the auditing structure. My generalization about the postulates is as follows:

In my opinion, the postulates were valid in 1961. This was because Mautz and Sharaf carefully conducted a study and experimented about the nature and activities of auditing before they came up with the postulates. They were pioneering philosophers and experts in the auditing field. They did use their best judgment to arrive at the postulates that were best fitted to their existing environment and situation. Therefore, I believe the postulates were sufficient to support all audit theories and satisfied the needs of the auditing field at that time.

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I don't think that all the postulates are valid today. Some of them are still valid while some of them are not. The first postulate, which is "financial statements and financial data are verifiable", is still valid because there is a need of financial statements and financial data's audit. The Securities and Exchange Commission (SEC) requires public companies to have their financial statements examined by a registered public accounting firm annually. Financial statement users rely on the financial statements to measure the results of management's performance. They rely on auditors to assure them that the financial data in the statements is unbiased, the transactions have been properly accounted for, and all relevant information has been disclosed so that their informed decisions can be made. The auditors opinions give investors, creditors, and other users confidence in the accuracy of financial data. Today, financial statements and financial data are still verifiable through auditors expertise in technical accounting, auditing, and knowledge of business. Current audit practices and standards reflect belief in this postulate through the uses of audit programs. That is, the auditors have to gather audit evidence, assess risks, conduct analytical procedures, develop expectations about account balances, test account balances, and assess and test internal control to proof the reliability of financial statements.

The second postulate, which is "there is no necessary conflict of interest between the auditor and the management of the enterprise under audit", is not valid today. Recently, there are many cases that show the evidences of management's influences on auditors works. For example, Arthur Anderson audited Waste Management's 1993 financial statements. The engagement team proposed adjusting journal entries for $128 million misstatements, but Waste Management refused to record the adjusting journal entries and refused to correct the inappropriate accounting practices and other misstatements. Another example, the PricewaterhouseCoopers audit team for Tyco International recommended Tyco to disclose the existence of non-interest-bearing loans in the periodic reports. However, the management refused to make the disclosure and said that the loans were not material to Tyco's financial statements. A study conducted by Koh and Woo (2001) reported that the self-interests of auditors and managers are not expected to coincide, and an audit expectation gap between the two groups can be expected. These show that managements, especially big clients managements, tend to be less cooperative with the auditors and there is possibility of necessary conflict of interest between them. As a result, current audit practices and standards do not reflect belief in this postulate. The implication to current audit practice is that the invalidity of the postulate results in the change in audit practice and the establishment of the Sarbanes Oxley Act of 2002. Under the Act, the audit firm cannot perform non-audit service to its current audit client. The audit partner cannot perform audit to the same client more than five consecutive years. The Chief Executive Officer and Chief Financial Officer have to sign on the financial statements and personally take responsibility for them. The management of audit client cannot fraudulently influence, coerce, manipulate, or mislead any auditors. The audit firm cannot audit the company that has its senior management previously employed by the audit firm as an audit partner for that company.

The third postulate, "the financial statements and other information submitted for verification are free from collusive and other unusual irregularities", is certainly invalid. The Enron, Worldcom, Sunbeam, Waste Management, Polaroid, Tyco, and other fraudulent financial reporting cases can challenge this postulate. Certain items on a firm's financial statements appear to be vulnerable to fraud. Examples are the failure to record loss contingencies and asset writeoffs, the manipulation of acquisition reserves, the shifting of costs to improve current operating results, and the recognition of fictitious revenue. Therefore, current audit practices and standards do not reflect belief in this postulate. The implication to current audit practice is the adoption of the Statement on Auditing Standards No. 99 (SAS 99), Consideration of Fraud in a Financial Statement Audit. The SAS 99 changes audit practice. It requires auditors to increase professional skepticism and to maintain a questioning mind throughout the engagement. In planning and performing the audit, auditors must set aside their beliefs that management is honest, even though they may have many years of experience with management. The changes in audit practice also includes a required brainstorming session among the audit team members to discuss the potential for material misstatement due to fraud, an increased emphasis on inquiry as an audit procedure that increases the likelihood of fraud detection, and the expanded use of analytical procedures to gather information used to identify risks of the material misstatement due to fraud.

The fourth postulate, "the existence of a satisfactory system of internal control eliminates the probability of irregularities", is not valid because the existence of a good system of internal control does not guarantee its effectiveness. The internal control usually has inherent limitations that management can override controls. Therefore, the existence of a good internal control system does not eliminate the probability of irregularities. Current audit practices and standards do not reflect belief in this postulate. The implications to current audit practice is that the auditors always need to evaluate internal controls for each client because the internal controls affect the processing of material account transactions. The auditors are required to assess control risk for each relevant assertion for each important class of transactions and account balances as a basis for planning the audit. To reduce the control risk assessment below the high level, the auditor must obtain evidence that the control structure is a soundly designed and operating effectively. In addition, the auditor is required to perform substantive procedures, including tests of details or analytical procedures, for all material classes of transactions and account balances, although the auditor may use evidence about the operating effectiveness of controls to alter the nature, timing, and extent of substantive procedures in a financial statement audit.

The fifth postulate, "consistent application of generally accepted principles of accounting results in the fair presentation of financial position and the results of operations", is valid. This is because the Generally Accepted Accounting Principles (GAAP) is a common set of standards and procedures that are generally accepted and universally practice. Although GAAP have provoked both debate and criticism, most member of the financial community recognized them as the standard that over time have proven to be most useful. Most importantly, the SEC has affirmed its support for the GAAP and required its registrants to adhere to GAAP. Current audit practices and standards reflect belief in this postulate. According to the Generally Accepted Auditing Standards (GAAS), the auditors is required to state explicitly whether the financial statements are fairly presented in accordance with GAAP. If the auditors determine that the statements materially depart from GAAP, the auditors describe the deficiencies and the dollar effects of the departure from GAAP.

The sixth postulate, "in the absence of clear evidence to the contrary, what has held true in the past for the enterprise under examination will hold true in the future", is not valid. This is because there is a danger of relying too heavily on the previous audit work. For example, organization that had a strong control environment in one year may be significantly different in the next year under new management. Current audit practices and standards do not reflect belief in this postulate. According to GAAS, the auditors should exercise due professional care and professional skepticism in the performance of the engagement. The auditors must guard against overfamiliarity with a client. When planning for the audit programs, the auditors need to consider current environments such as client's current control structure, current market conditions, competitor actions, and current economic risk as well.

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