Auditing Literature Review 2250 words

  1. LITERATURE REVIEW

 

2.1 THEORETICAL FRAMEWORK

 

Auditing is a systematic process for obtaining and assessing evidence regarding assertions of one kind or another in accordance with established criteria, (Lyke, 2002) This is so as to determine the degree of correspondence of the financial statements to the accounting standards and to attest the truth and fairness of these financial statements. An audit is carried out by a qualified person known as an auditor whose responsibility is to carry out the auditing process and form an opinion as to whether the financial statements are prepared according to the accounting standards, the Generally Accepted Auditing Standards, (GAAP), and to form an opinion as to the truth and fairness of these financial statements. Auditors are regulated by government bodies and other professional organizations such as the Securities and Exchange Commission, (SEC). According to the Companies Act of 1985, not all companies are required to be audited. Small companies are generally exempt from being audited. The criteria below explain the requirements attained in order for a business to be liable for audit.

  1. i) Companies with a turnover of not more than 5.6 million and a balance sheet total of not more than £2.8 million may be exempt from statutory audit, (Smullen et al, 2008)
  2. ii) Companies with a turnover of £1 million and a balance sheet total of not more than £1.4 million do not need an auditor report. (Smullen et al, 2008)

iii) Companies with a turnover of £1 million and £5.6 million need an accountant’s audit exemption report. (Smullen et al, 2008)

In performing his duties an auditor is supposed to be independent in fact and judgment. An auditor’s independence is often defined as the probability that the auditor will report a discovered breach in the financial reports, (Watts and Zimmerman; 1983, 1986)

An auditor’s main duty is to perform a range of duties know as audit services. Audit services can be defined as Non- audit services generally refer to all other services which an auditor provides beyond their related audit services such as tax advisory, management consultancy amongst others to its clients other than the traditional audit framework. There is no certain classification structure in which non-audit services are classified; as such most researchers have utilized diverse classification of non-audit services while trying to evaluate the concept of non-audit services. Non audit services have been defined from many angles by various boards and institutions. The Auditing Practices Boards (APB) Ethical Standards define non-audit services as any engagements which an audit firm provides professional services to an audit client other than the audit of its financial statements and other duties such as the audit of the clients internal control in compliance with the procedural and reporting requirements of the regulatory bodies. (Auditing Practice Board, 2004) Purcell and Lifison (2003) defined non-audit services as traditional CPA works which includes assurance, investment assurance, commerce registration and accounting affairs as well as, tax advisory service, management advisory service, finance, investment advisory service, and information technology advisory service, (Lifison et al,2003).

 

2.2 EMPIRICAL LITERATURE REVIEW

A number of studies have been made regarding the provision of non-audit services by auditors, the range of non-audit services they can provide, the fee they are entitled to receive for these services and how they manage to keep their independence when carrying out these services alongside their traditional audit services of the financial statements of their client. These were propagated as a result of the collapse of one of the big four companies; Enron in the year 2001. Despite the evidence provided against the provision of non-audit services, cases like the Enron debacle which happened in 2001 are still evident. For example the global financial crisis serve as a test of the regulations and procedures put in place following the Enron debacle and other accounting scandals. The big question still remains as to whether auditors can remain independent while providing both audit and non-audit services. This section reviews theories which have been suggested by researchers since the collapse of Enron in 2001, how non-audit services have changed since then, how much non-audit fee measures up to audit fee and what regulations have been set up by the Board of Ethical Standard.  Interesting studies emphasizing reforms to non-audit services after the Enron collapse can be examined thus.

According to Rezaee financial statements fraud has recently received considerable attention from the business community; accounting profession; academicians; and regulators, (Rezaee, 2005: p277). There have been significant changes in internal auditing following the accounting scandals at Enron and WorldCom, (Carcello et al, 2005). In a study by Carcello et al using data from 271 mid-sized US publicly traded companies, they find that internal audit budgets, staffing levels, meetings with the audit committee and meeting lengths increased significantly during this time. Using regression analysis, Carcello et al. provide further evidence of: (1) larger budget increases among smaller firms; (2) larger budget and staff increases in companies with greater financial resources (i.e., stronger operating cash flows) or with greater liquidity risk (i.e., lower current ratios); and (3) industry differences in the change in internal auditing, (Carcello et al, 2005: p.117).

With respect to the relationship between the audit fee and non-audit services, valuable studies pertaining to non-audit services and its relationship with the audit fee has been studied by a number of researchers. Simunic (1984) contends that the clientele demand of audit services affects the provision of non-audit services by accounting firms on audit fee. Similarly, Abdel-khalik ( 1990) suggested that the audit and non-audit fee are positively related. In addition, Barkess & Simnett (1994), and Firth (1997a) also indicate the significant correlation between audit fee and non-audit services fee.

Also, in response to this wave of corporate scandals, the US congress in 2002 passed the Sarbanes Oxley (SOX) Act. It was promulgated into law by President George W. Bush in 2002, (Carcello et al, 2005). The SOX has brought significant changes in several elements of corporate governance and financial reporting for public companies particularly by significantly improving internal controls of a company. (Carcello, 2005).

In addition, audit committees are now expected to be more independent and audit firms are expected to keep the provision of non-audit services to audit clients at a minimum level to ensure that they do not form strong bonds with the client that may have an impact on their independence, (Chadha et al, 2005; Grant et al, 2007). As a result certain consulting services, internal audit outsourcing, and other activities routinely provided to clients in the past are now deemed illegal under the SOX rules when performed by the audit firm, (Chadha et al, 2005; Grant et al, 2007).

The SOX also created the Public Company Accounting Oversight Board (PCAOB) to oversee the activities of accounting firms and accounting firms are required to be registered with this board, (Carcello e al, 2005; McCarthy et al 2005).

In addition to the rules, the U.S stock markets also responded to the corporate scandals by adopting additional set of rules for companies wishing to list their securities in the U.S. for example, in November 2003 the New York Stock Exchange (NYSE) and the NASDAQ stock exchange issued a number of new regulations for companies that want to list in the exchange, (Chadha et al, 2005). The American Stock Exchange (AMEX) followed suit in December 2003 with similar rules, (Chadha et al, 2005).

Also, in response to the scandals, rules based accounting standards have been complemented with principles-based accounting standards. The FASB and the SEC in recognition of the fact that rules-based standards have a number of bright-lines decided to complement rules-based standards with principles based standards so as to reduce the loopholes that preparers of financial statements may use to manipulate investors, (Lee, 2003; Williams, 2005; Schipper, 2006). The Security and Exchange Community (SEC) holds that “moving to a principles-based system is desirable, because such a system allows (or requires) the appropriate exercise of professional judgment”. The financial accounting Standards Board has already developed a ‘proposal for the principle-based approach to the US setting (Lee, 2003; Williams, 2005; Schipper, 2006).’

Moreover, the International Accounting Standards Boards as well as the Financial Accounting Standards Board have been working towards a common conceptual framework and have been issuing new accounting standards reducing the bright-lines in the old standards so as to ensure that financial statements present fairly. (Epstein et al, 2007).

Companies announcing higher limits of coverage and smaller premiums would distinguish themselves in the eyes of the investors as companies with higher quality financial statements (Jain et al, 2006). On the other hand, companies with little or no coverage as well as higher premiums would be considered by investors as companies with lower quality financial statements, (Jain et al, 2006). This would instill discipline on each company’s management in that they would be motivated to avoid this characterization, (Jain et al, 2006).

A few studies have been carried out on how effective SOX and other responses to the accounting scandals could be effective in mitigating Enron-like type of scandals. In particular, the only study that the researcher came across was the study by Jain et al., which investigated the trends and determinants of market liquidity in the pre-SOX period particularly when the wave of financial scandals was reported as well as the post-SOX period when the SEC rules relating to the implementation of the SOX were issued. The study provides evidence that there are wider spreads, lower depths and higher adverse selection of component spreads in the period surrounding the reported financial scandals implying that liquidity measures deteriorated as a result of those scandals, (Jain et al, 2006). They also provide evidence that liquidity measures witnessed an improvement following the implementation of the SOX Act in 2002, (Jain et al, 2006). Following from these findings Jain et al., conclude that the observed improvements in the market liquidity in the post-SOX period is positively correlated with the quality of financial results, several firm-specific variable such as firm size, market factors such as price volatility, volume as well as microeconomic events such as the NYSE Open Book, (Jain et al, 2006). In addition to the above findings, Jain et al. also observe that the improvement in liquidity measures were more pronounced for companies that were closer to compliance that for those that were far from compliance with the provisions of the SOX. From the above literature it can be observed that less attention on how the responses (in particular the SOX implementation) are effective in mitigating Enron-like accounting scandals in future. Much of the literature has been documenting the causes of, consequences of and responses to the scandal with little attention toward how effective these responses could be. Even the few (e.g., Jain et al., 2006) that were carried out were on companies that are based in the US with no attention to European-based companies that are listed in the US and therefore required to comply with SOX.

Another important response is the issuing of new accounting standards and compliance requirements by the International Accounting Standards Board and the Financial Accounting Standards Board as well as the move towards harmonization of International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS) with U.S Generally Accepted Accounting Principles (GAAP) by the IASB and the FASB, (Sellani et al, 2005; Ding et al, 2005, Ausbaugh, 2001). The EU also responded by issuing regulation 1606/2002 of July 19, 2002 requiring all EU listed companies to report accounting information as from 1st January 2005 in compliance with IAS/IFRS, (Haverals, 2007).

 

This study is aimed at breaching the literature gap by studying how auditing standards have since changed post Enron collapse in 2001. New audit regulations were provided for to govern audit practices. For example the SOX in particular have helped in mitigating financial statement fraud in a UK-based company that is required to comply with SOX. There has been increased debate on whether European-based companies too should comply with SOX.  Studies regarding the auditor’s independence with regard to its fee from non- audit and audit services have been examined and have shown that the auditor is likely to rely on the non-audit service fees as such this will impair his independence in carrying out his audit services.

 

 

 

 

 

 

REFERENCES

Agrawal A. and Chadha S;(2005) Corporate Governance and Accounting Scandals: The Journal of Law and Economics, vol. 48 pp371-406

 

Ampofo A., A., Sellani R., J. (2005). Examining the differences between United States Generally Accepted Accounting Principles (U.S.GAAP) and International Accounting Standards (IAS): implications for the harmonization of accounting standards. Accounting Forum. Vol. 29, Pp 219-231.

 

Auditing Practice Board, (APB), December 2004

 

Carcello, J. V., Hermanson, D. R.., Raghunandan, K. (2005) Changes in Internal Auditing During the Time of the Major US Accounting Scandals International Journal of Auditing, vol. 9 , No. 2 , 117–127.

 

Defond, M.L, Raghunandan K, Subramanyam, K. R. (2002) Do Non-audit Service Fees Impair Auditor Independence? Evidence from Going-concern Audit Opinions. USC Leventhal School of Accounting

 

Epstein B. J., Jermakowicz E. K. (2007) Interpretations and Application of International Financial Reporting Standards. Wiley and Sons Inc.

 

Gantt K, Generas G, and Lamberton B (2007) Sarbanes-Oxley, Accounting Scandals, and State Accountancy Boards Red Versus Blue State Reactions: the CPA journal

 

Lee T. A. (2006).  The FASB and Accounting for Economic Reality.  Accounting and the Public Interest, Vol 6, pp 1-23

 

Lyke, B (2002). Auditing and Its Regulators: Reforms after Enron. CRS Report for Congress

Purcell III, T. and Lifson, D. 2003. Tax services after Sarbanes-Oxley. Journal of Accountancy 96 (November):32-40.

Ravenscroft, S., Williams, P., F. (2005) Rules, Rogues, and Risk Assessors: Academic Responses to Enron and Other Accounting Scandals European Accounting Review, Vol. 14, No. 2, 363–372

 

Schipper, K. (2003).  Principles-Based Accounting Standards.  Accounting Horizons Vol. 17 No. 1 pp. 61-72.

 

Asbaugh H. (2001). Non-U.S firms’ Accounting Standard Choices. Journal of Accounting and Public Policy. Vol. 20. Pp 129-153.

 

Jensen M.C., Meckling W. H. (1976). Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure. Firms Organisations and contracts: A reader in Insustrial Organisation. Edited by Buckley P. J. and Michie J. Oxford.

 

Rezaee, Z. (2005). Causes, consequences, and deterrence of financial statement fraud. Critical perspectives on Accounting, vol. 16, pp. 277-298.

 

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