Analysing

Audit failures
Mamode Faraaz Sooklall
Middlesex University
Business School
sfaraaz@yahoo.com
Muhammad Eershad Guness
Middlesex University
Business School
MG1031@live.mdx.ac.uk
March 27, 2016

The audit profession has failed in the 21 st century and thus is losing
importance in society. Critically examine this statement and analyse the
reasons for audit failures.

Abstract
Auditors often view themselves as enhancers of financial statements with an aim to provide
an objective view about the truth and fairness of reported financial information. This paper
seeks to critically examine the claim that the audit profession has failed in the 21st century
and analyses the reasons for such failure. It also attempts to shed some light upon the
various benefits this noble profession brings to society, more specifically to the corporate
world.

Keywords: Audit, failures, scandals, benefits, importance

Introduction
Since the very dawn of mankind, auditing has established its place as a long established
profession to serve the needs of society when it comes to providing detailed and meaningful
financial information to end user needs. Put simply, capital is the engine of the business
world and information is the oil that powers the engine. Auditors have since long observed
an ostensible role of assuring society that the right oil is being spilled to keep moving the
turbines. Nevertheless, with the spectacular pace at which corporate scandals have vented
across the globe, the importance of the audit profession has been brought under substantial
public scrutiny questioning the existence of auditing as a panacea for the smooth running of
the corporate world. This in turn led to various scholars probing into cause of audit failures
through empirical evidences.

Research design and methodology

This working paper has been generated on the basis of documentary research method. It
involves accumulation of research data from a plethora of sources based on historical
analysis by reputed scholars and researchers. Auditing is undoubtedly an area of great
interest to scholars and hence as a preliminary point, google scholar proved to be an
important source of information to help shape this research. Accounting journals not limited
to the International Accounting Standard Board and the Financial Reporting Council were
vital in enhancing this paper through empirical evidences. Finally, the publications of the
International Federation of Accountants provided the necessary ingredients to help
conclude this research.

Auditing: Conceptual definition and evolution

Auditing traces its roots to the Mesopotamian era around 3500-3200 BC. The Egyptians had
their fiscal documents recorded by two officials while another officer would conduct an
independent check of the figures. The Greeks would appoint officials to scrutinise public
officials accounts when they leave office. The Romans in turn implemented the concept of
segregation of duties by distinguishing between who should authorize payments and who
should effect payments. Later, in the beginning of the 12th century, crown revenues were
thoroughly investigated by trusted officers in the UK.
However, with the extensive development of the business world in the late 18th century
following the industrial revolution, there has been strong needs for a proper framework to
define auditing to enable auditors achieve their objectives. The world audit is derived from
the Latin word Audire which means to hear. The IAASB defines auditing as the objective
of an audit is to provide an opinion as to whether the accounts have been prepared in
accordance with appropriate standards and provide a true and fair view of the financial
status of the company. Similarly, Mautz (1964) defines auditing as an independent check
of the books of accounts to ascertain the reliability and accuracy of financial statements.

Analysing the failures of auditing through empirical evidence

In the wake of a myriad of corporate scandals in the 2000s including Enron and WorldCom,
the audit profession became heavily under public scrutiny. The audit profession was
gradually regaining public confidence when the 2008/2009 financial crisis proved to be a
blatant metaphoric reminder of how the audit profession can fail lamentably. With $11
trillion in household wealth lost as reported by the Financial Crisis Inquiry Commission, the
auditors have been dubbed as the watchdog that failed to bark by various stakeholders
and investors. Indeed there is an overwhelming plethora of plausible reasons that accounts
for these audit failures.
It is indubitable that the problem of independency often referred to independent threat
accounts for the major audit failures in the corporate history. Being a business in the private
sector, all audit firms seeks to maximize profits which is their main objective. They are
tempted to give an unqualified report despite the financial statements requires
qualifications due to fear of losing the audit contract to rival firm. In this process, they turn a
blind eye to potential areas of material misstatements arising from fraud and errors. For
instance, in the case of Enron, the auditors Arthur Andersen conspired with directors to
understate total debts by writing off $8.5 billion of debts from consolidated financial
statements. Andersen billed Enron around $1.3 million to agree to remain silent on the
gearing position of the company.
The existence of conflict of interest also referred to as self-interest threat, also provides a
basis for audit failures. Taking the Enron example again, it was found that apart from the
audit fee that Andersen billed Enron; the auditors were also regularly providing non-audit
services in terms of consultancy. Arthur Andersen earned more than $25 million in
consultancy fees in 2000 from Enron alone. This immediately questions the level of
independence and integrity of the auditors in providing a true and fair view of the financial

statements. Analysts suggest that the reluctance of Andersen to qualify Enron accounts may
also have been due to fear of revenue loses.
Besides, the existence of expectancy gap also provides an impetus for audit failure. The
American Institute of Public Accountants (1992) defines the expectancy gap as the gap that
exists between what society expects auditors to do and what auditors are expected to do.
The job of auditors is to provide reasonable assurance as to the truth and fairness of the
company financial statements while society demand auditors an absolute level of assurance.
The existence of this gap implies that very often auditors are tempted to do the minimum
expected from them and thus they behave negligently and without due care in the process
of their audit. This can often be viewed when auditors wrap up the audit to finish ahead of
time and perform a relatively low and inadequate level of sample testing. For instance, in
the case of Belgrave Finance Ltd, the company sued the auditors in court for failure to carry
the audit work with reasonable care. By failing to analyze the liquidity and leverage level of
the company, Belgrave Finance Ltd suffered losses amounting to $5 million after being
unable to repay debts it borrowed from debenture holders.
Furthermore, lack of professional skepticism often leads to corporate failure. According to
ISA 200, professional skepticism requires the auditor to perform his audit using a critical
approach. The auditor should not undermine any risks of material misstatements due to
fraud and errors and should always question the integrity and honesty of directors. Auditors
are expected to critically investigate the reliability and accuracy of evidences obtained.
However, this professional skepticism is often lost with time due to familiarity with directors
after long years of audit relationships and this often lead in audit failures. In the case of the
Parmalat scandal, the failure of Grant Thornton to check the truthfulness of a fax sent by the
Bank of America led to extensive overstatement of the companys asset. Parmalat directors
provided auditors with a fax certifying the company has a staggering amount of Euro 3.6
billion as cash reserve, which later proved to be a fake document.
Moreover, the increased complexity of industries has meant that auditors need to evolve
and innovate to adapt themselves to the new risk management systems implemented by
companies. The banking, finance and investment industries are now heavily involved in
cross-border activities having a wide network of subsidiaries that are spread across the
globe like a spider web. This linkage of the financial system across national boundaries
makes it more complicated than ever to assign a reliable market value to securities and
derivatives such as mortgages and other debt obligations. Hence, the auditors are caught in
a nightmare when it comes to assessing the reliability and accuracy of figures provided in
financial statements. They then attempt to adopt the simple box-ticking method in the audit
process rather than formulating distinct and appropriate mechanisms to analyze the clients
business. This was the case for Goldman Sachs subsidiaries during the financial crisis of
2008/2009. The company structure was so complex that auditors did nothing more than
following the standard checklist of their audit process, which later failed to discover the
existence of toxic assets in group balance sheet.

In addition, the existence of prescriptive rules implemented by regulators has been an evil in
disguise. In fact, once rigid rules are implemented, accountant will find a way to bypass
them. For instance, the occurrence of the Enron scandal shock everyone because it was
prepared under the US GAAP, dubbed to be the best accounting regime that ever existed.
The more you have rules, the more interpretation can be derived. Hence, Enron hired
various accountants to interpret the rules according to the companys benefits to help hide
debts by creating special entities not consolidated in group accounts. Andersen played its
part in helping Enron to cook the books by relying on the ambiguity of the US GAAP to
protect itself in case of litigation. In the case of WorldCom, Andersen used the hazy
accounting standards to capitalize long flight costs thereby understating debts amounting to
$2.5 billion. Recently, PriceWaterhouseCoopers were accused of failing to unveil the $1
billion Satyam Corporation scandal in India where revenue and profits were artificially
inflated by misusing accounting standards. The main problem is that the more complex and
stiff are the standards, the less able are auditors to use their independent judgments or use
their creative mind to assess risk management systems. This eventually leads to frequent
audit failures.

The place of Audit in modern society

Despite the outburst of numerous scandals involving audit failures, it is undeniable that the
audit profession still holds its value in society due to the profuse benefits it brings to various
stakeholders. Firstly, an audit is still the most sought after monitoring mechanism to
regulate the agency relationship arising from information asymmetry. Principals who are the
shareholders of the company often lack trust on agents (directors) of the company.
Directors may pursue their own interest such as empire building at the expense of
maximizing shareholders wealth. In such a case, an audit helps to oversee that directors are
working towards the best interest of the company and thus align directors interest with
that of shareholders.
From the information hypothesis perspective, an audit is an important provider of financial
information. Investors require timely and reliable information to make informed decisions
about their investment. An audit provides the necessary assurance that the information
provided is free from material misstatements arising from errors or fraud. This allows
companies to have access to capital markets. In UK listed companies may be deprived access
to capital markets, without an audit. A research by Blackwell (1998) concluded that the
improved confidence in financial information being reported in turn helped to reduce the
cost of raising capital. Private companies seeking funds from banks benefitted from lower
borrowing cost in terms of interest when they had their accounts audited.
On the other hand, from the insurance perspective, directors seek to protect themselves
from expensive claims if ever the company fails. Management wishes to transfer all liability
on the shoulders of auditors when faced with bankruptcy. Hence, they view an audit as a

proper safeguard in period of crisis. Auditors are concerned about their reputation and are
thus expected to compensate for any corporate losses. This is often termed as the deeppockets effect which argues that auditors will always have greater ability to pay.
An audit also helps management in many other ways. It aids to provide an insight as to
where there is high risk of fraud and accordingly management can improve internal controls
of the business. It also seeks to ensure that directors have abided by all statutory duties and
accounts are in conformity with prescribed accounting standards. Even the tax authorities
are more assured that tax has been properly accounted for if the company provides audited
financial statements.

Conclusion
From our analysis, it is found that the various corporate scandals that have swept the globe
have undoubtedly warned that accounting figures are malleable. The rise in Big-Bath
accounting techniques and creation of cookie-jar reserves for earnings management have
meant that the audit profession is more than ever important in generating an efficient
financial market. As the quote says, we can observe a lot by watching, it is high time for
regulators to play their part by devising innovative regulatory controls to aid preparing final
accounts in a more transparent way but simultaneously allows auditors to use their
professional judgments to enhance the quality of their work. In short, it calls for the need to
draw an equilibrium line between statutory rules and self-regulation. But the question is
who shall draw that line and where the equilibrium lies? Time will undoubtedly reveal the
answer.

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Disclaimer
This working paper has been generated to enhance public awareness about the causes of
audit failures. However, the authors accept no responsibility or liability whatsoever with
regard to the materials in this paper.

Suggested Citation
Sooklall, Mamode Faraaz and Guness, Muhammad Eershad, The audit profession has failed
in the 21st century and thus is losing importance in society. Critically examine this
statement and analyse the reasons for audit failures. (March 27, 2016). Available at
SSRN: http://ssrn.com/abstract=2755176