A Study on the Extents of the Responsibility of an External Auditor on Fraud

Introduction

This section of the study primarily focuses on the different researches and other literatures that focused on several aspects that will help with the progression of this study. With the topic mainly concerning on the extents of the responsibility of the external auditor on fraud and the wrong accounting practices and the illegal acts, through this appropriate conclusions and eventually recommendations can be made. The literatures presented will come from books, journals, and reports that are deemed to be helpful in the advancement of awareness concerning the subject.

 

Finance

Finance is a branch of economics concerned with providing funds to individuals, businesses, and governments. Finance allows these entities to use credit instead of cash to purchase goods and invest in projects. For example, an individual can borrow money from a bank to buy a home. An industrial firm can raise money through investors to build a new factory. Governments can issue bonds to raise money for projects (Fanelli & Medhora 2002). Finance plays an important role in the economy. As banks, credit unions, and other financial institutions provide credit, they help expand the economy by directing funds from savers to borrowers. For example, a bank acquires large amounts of money from the deposits of individual savers. The bank does not let this money sit idle but instead provides loans to borrowers who might then build a house or expand a business. The savings of millions of people percolate through many financial institutions, spurring economic growth. A wide variety of financial institutions have different roles in finance and the economy. Some institutions, such as banks, link lenders and borrowers. These institutions act as an intermediary among consumers, businesses, and governments by lending out deposits. Other institutions, such as stock exchanges, provide a market for existing securities, which include stocks and bonds. Stock exchanges encourage investment because they enable investors to sell their securities when the need arises (Fanelli & Medhora 2002)

 

Many aspects of finance are studied individually. Corporate finance centers on how businesses can best raise and spend their funds. Public finance focuses on the financial role of federal, state, and local governments. Public Finance is the field of economics concerned with how governments raise money, how that money is spent, and the effects of these activities on the economy and on society. Public finance studies how governments at all levels whether national, state, and local provide the public with desired services and how they secure the financial resources to pay for these services (Lutz 1936). Governments provide public goods, government-financed items and services such as roads, military forces, lighthouses, and street lights. Private citizens would not voluntarily pay for these services, and therefore businesses have no incentive to produce them. Public finance also enables governments to correct or offset undesirable side effects of a market economy. These side effects are called spillovers or externalities. For example, households and industries may generate pollution and release it into the environment without considering the adverse effect pollution has on others. If it costs less to pollute than not to, people and businesses have a financial incentive to continue polluting. Pollution is a spillover because it affects people who are not responsible for it. To correct a spillover, governments can encourage or restrict certain activities. For example, governments can sponsor recycling programs to encourage less pollution, pass laws that restrict pollution, or impose charges or taxes on activities that cause pollution. Public finance provides government programs that moderate the incomes of the wealthy and the poor. These programs include social security, welfare, and other social programs. For example, some elderly people or people with disabilities require financial assistance because they cannot work. Governments redistribute income by collecting taxes from their wealthier citizens to provide resources for their needy ones. The taxes fund programs that help support people with low incomes (Lutz 1936).

 

Financial System

A financial system usually performs its transmission role indirectly: original suppliers of funds generally differ from proximate suppliers. Exchanges of funds between original suppliers and ultimate users can be channeled through market transactions in securities, through intermediary borrowing and lending arrangements, or internally between corporate divisions. These three channels are henceforth referred to as a financial system’s three main types of governance mechanisms. The combination of governance mechanism and contract terms used to administer a given transaction is called a governance structure. Agents employ specific governance structures to administer individual transactions. Since agents strive to maximize the benefits they derive from transacting, the choices are driven by efficiency considerations, but this study interprets efficiency rather more broadly than do other contemporary studies. For, it recognizes that agents can have limited information and limited insight into how best to attain their desired ends and that such limitations can affect agents’ interpretations of efficiency. That is, agents attempt to choose efficient forms of governance structures, but their choices are limited by available information and available knowledge (Neave 1991). Hence, the form of a financial system is determined as an aggregate effect of choices which are efficient, but may not always be so in an objective sense. Nevertheless, if the financial environment did not change too rapidly, and if financial markets were sufficiently competitive, the continuing pursuit of improvements to existing practices could result in a system which was both intendedly and objectively efficient. In practice, the situation is rather more complex. A financial system is continuously adapting, and at any point in time some parts may operate efficiently in an objective sense while others are only intendedly efficient. Those parts which do operate efficiently in an objective sense can be analyzed using neoclassical financial theory, but those parts which are only intendedly efficient can be better understood using institutional analyses which postulate environmental uncertainty (Neave 1991).

 

Financial systems perform most of their everyday operations so quickly and smoothly that their importance is not always well readily recognized. Few observers notice how easily a well functioning financial system performs its principal roles: effecting payments, facilitating the investment of accumulated wealth, making funds available to finance viable new projects, and providing risk management facilities (Neave 1998).   Yet, when a person begins to consider how important each of these functions is, the vital roles played by the financial system start to become apparent. When in addition a person realizes that the financial system can contribute to economic growth, the importance of its functioning becomes still more evident. The financial system effects payments by responding to the instructions of individuals, businesses and governments to transfer funds to other parties. When a traveler uses a credit card to obtain cash in a foreign country, or when a firm pays for imports from abroad, the financial system completes the transaction. The financial system also makes it possible for countries’ governments to deposit funds directly into individuals’ bank accounts. Indeed, the system makes it easy and cheap to transfer funds quickly between almost any two points in the world, usually in whatever currency the payer desires to use. The traveler appreciates this most acutely when communications are disrupted and the banking machines on which he/she is relying for his/her weekend expenditures do not dispense the cash he/she expected to obtain (Neave 1998).

 

Individuals who earn more than they spend, and businesses whose profits exceed their capital expenditures, are both classified as savers. There is also an obverse meaning: those who spend more than they earn are said to not save. When individuals save, they usually place some of their surplus funds in cash or non-interest-bearing deposits, some in return-bearing forms such as interest-bearing securities or deposits or other securities expected to yield a combination of dividend income and capital gains, In most developed countries, individuals’ savings are distributed among bank deposits, investments in pension and mutual funds, and marketable securities. The proportions held in each type of investment vary according to which types are available to the consumer, and according to the average returns each type yields. A financial system raises funds from lenders or investors, making them available to borrowers or other users. Lenders and other investors are called suppliers of funds, while borrowers and other users are known as demanders for funds (Neave 1998).  The funds may be used either to finance current expenditures, say on consumer goods, or capital expenditures, say on business plant and equipment. In either case, the transactions are measured using a system of accounts called the funds flow accounts or financial flow accounts. Instead of being used to raise new funds, some financial deals are struck with the principal purpose of dividing up and trading risks. Although risk management is often regarded as having emerged in the 1970s and 1980s, that view stems principally from observations of the very rapid growth of risk trading during those decades. Indeed, the idea of risk management has been familiar to at least some financiers for a much longer time (Neave 1998).

 

Financial systems vary in their capability to fund innovative or unfamiliar projects backed only by uncertain earnings or illiquid assets. In some economies, creative financiers know how to fund technologically innovative projects, and hence are able efficiently to allocate financial capital toward high risk or uncertain proposals. Other economies have relative few imaginative financiers capable of looking at such kinds of deals constructively as well as critically. Countries whose financial systems foster diverse financing arrangements normally do a better job of encouraging creative financiers. It follows that the more diverse the capabilities of a financial system, and the more its regulatory climate encourages responsible experimentation with new forms of financing, the more likely the economy will be able to maintain international competitiveness through updating its productive capacity (Neave 1998).

US Financial system

The structure of the financial system plays a role in influencing the performance of its economic function. The segregated structure that characterized the American financial system was associated with specific mission for the various financial sectors. For example:  securities firms and markets performed the function of channeling long-term financial investment into capital formation; the mission of the insurance industry was the assumption of risk for both individuals and companies a role that was vital to the operation of U.S. businesses. But its financial function like that of other institutional investors that manage pension funds, trust accounts, and other pools of savings for beneficiaries involved the investment of huge financial resources and thus entailed a major role in capital formation;  the traditional role of commercial banks was to use short-term deposits to provide working capital for businesses and loans to consumers;  thrifts were repositories for household savings used to finance long-term, fixed-rate mortgages for housing; and  credit unions used household savings for consumer lending (D’Arista 1994).  These missions tended to be defined and encouraged by limitations on the functions and portfolio strategies of the various types of institutions, which served to channel savings and credit to a given economic sector. It was argued that this structural strategy  helped to ensure adequate financing for all economic sectors and thus to promote balanced growth and economic stability that, at a minimum, it had a definite influence on the allocation of capital;  fostered a broader spectrum of opinion in the financial decision-making process by promoting the diversity and multiplicity of sources of finance;  prevented conflicts of interest and concentration which were also viewed as impediments to impartiality in credit decisions made by individual institutions;  required less regulation than would an integrated structure because there were fewer opportunities for integrated transactions such as the sale of a house, the provision of mortgage credit and insurance, and the issuance and underwriting of mortgage-backed securities and thus less need to police transactions to ensure that they were conducted at arm’s length and did not involve coercive tie-ins; and promoted a higher level of managerial competence in providing financial services (D’Arista 1994).     

 

The history of the American financial system, and of corporate financial relationships within that system, reflects the interplay among financial frictions such as information and control costs of corporate finance; government policies such as bank and financial market regulations, tax policies, pension laws, bankruptcy laws; financial crises; and financial innovations. These influences together determine the menu of financial relationships available to corporations over time. With respect to the ability of the financial system to mitigate frictions due to problems of asymmetrical information and corporate control, the history of American institutional and regulatory change has seen moments of progress, as well as reversals. Three relatively successful cases the antebellum New England system, incipient universal banking in the 1920s, and the new financial capitalism are separated by periods that offered poorer menus of financial relationships. While over the very long run there may be a tendency for efficient financial relationships like universal banking to be allowed by government, over significant intervals government interventions have stood in the way of these beneficial relationships (Kaysen 1996). Thus, history has not been a process of steady or rapid convergence toward the most efficient set of relationships. Whether recent trends toward the expansion of the scale and scope of commercial bank operations will usher in a new, lasting era of true universal banking in the United States, and its accompanying benefits for the costs of corporate finance remains an open question. It is suspected that the road ahead will be as bumpy as that which has already been traversed. The future menu of relationships is hard to predict; institutional change is path dependent and subject to the un-forecastable influences of financial crises and government policy. Despite the potential for improvement in banking regulation brought by global competition, for example, the next financial crisis possibly a costly insolvency of a financial intermediary involved in complicated derivative transactions could reverse much of the progress that has been made in broadening banks’ involvement in nontraditional corporate finance. Just as important, government policies not directed toward financial markets or intermediaries like tax or health care policies may have important unforeseen consequences for corporate financing arrangements (Kaysen 1996).

 

International Financial system

The collapse of the Bretton Woods system of fixed exchange rates in the early 1970s marked the last major turning point in the evolution of global finance, ushering in the generalized non-system of exchange rate arrangements that survives today. However, at least as important in the development of international financial relations since then has been the enormous growth in the volume of international capital flows. In large part, this growth is attributable to the dismantling of the panoply of exchange controls introduced during the Bretton Woods era to facilitate exchange rate management by central banks under the auspices of the International Monetary Fund (IMF). Increased capital flows have been directed toward both advanced and developing economies alike. Major users of international funds include Australia, Britain, Canada, New Zealand and the United States, as well as the so-called emerging economies (Makin 2000).  The emerging economies are a culturally and geographically diverse group of international borrower countries whose membership presently includes Argentina, Brazil, Chile, Colombia, Hungary, the Czech Republic, India, Indonesia, Israel, Malaysia, Korea, Mexico, Pakistan, Peru, the Philippines, South Africa, Thailand, Turkey and Venezuela. The range of deregulatory initiatives affecting domestic and international financial transactions over recent decades include the abolition of capital and interest rate controls and the entry of foreign financial institutions to domestic markets. These measures combined with technological progress in telecommunications, greatly reduced transactions costs and widespread financial innovations have broken down barriers separating economies’ financial markets (Makin 2000). The domestic financial markets of many economies have therefore been increasingly internationalized in the wake of liberalizing policy initiatives implemented by governments around the world. Financial market liberalization in many advanced economies was virtually complete by the late 1980s. With the removal of previously stringent regulations over domestic and international financial transactions, institutional barriers impeding the movement of financial capital between many regions of the world have now largely disappeared. Accompanying the domestic deregulatory changes were tighter prudential arrangements in advanced economies aimed at strengthening the capitalization of banks and hence the stability of domestic financial systems. Such accompanying arrangements have been lacking in many emerging economies however and this has been a fundamental reason for recurrent financial crises in these economies (Makin 2000).

 

The effective functioning of the market economy depends on a number of conditions. One of them is monetary and financial stability that provides the environment for rational decision-making on savings and investments. The attention often goes to the opposite end: the absence of financial stability. Financial instability is a situation in which economic performance is potentially impaired by fluctuations in price of financial assets or in the ability of financial intermediaries to meet their contractual obligations. There are several reasons for the inherent instability of the international financial system. This includes wrong fundamentals (Makin 2000). Governments are continuously tempted for internal policy reasons to pursue an expansionary monetary and budgetary policy too far. Such excessive spending can lead to unsustainable public debts and to external borrowing beyond the financial capacity of the country. Another reason is international spill-over. The markets for exchange and for capital have become global markets under the influence of liberalization and new technology such as telecommunications. Over the past decade this trend has accelerated. A reason is more and more trading takes place between actors in different countries. This leads to a dense international network of interlocking claims and liabilities. So the degree of spill-over and contagion has increased too (Makin 2000).

 

 Furthermore a reason is market failures. Markets may react in a rather erratic way. Moreover, the gradual adaptation of the price of finance to changed circumstances often does not take place. This means that one gets a rather violent reaction once the retarded movement of adaptation starts. A reason is race to the bottom. Banks and other financial service providers tend to go for high margin market niches. This is part of the dynamics of the markets. However, high margins tend to go hand in hand with high risks. Now there is a lack of transparency as to the size and character of the total exposure of major players. So the sort of buffers needed is not always clearly understood. It means that the internal control of international financial providers is a problem.  Lastly a reason is lack of insight with prudential control. The control of public organizations on the exposure of market players has weaknesses as well. One is derived from the lack of basic information. Another one is the consequence of the increasing sophistication; the authorities of countries with small resources have much difficulty in coping with these intricacies (Makin 2000). Financial instability can lead to negative effects on the economy as a whole. For that reason, it is considered as a public bad. The main problem of financial instability is that it may deteriorate into a financial crisis. The anatomy of international financial crisis is now fairly well understood. The process often starts in one segment of the economy and then spreads out to other parts (Makin 2000).

 

 

Accounting and Bookkeeping

Accounting and bookkeeping is the process of identifying, measuring, recording, and communicating economic information about an organization or other entity, in order to permit informed judgments by users of the information. Bookkeeping encompasses the record-keeping aspect of accounting and therefore provides much of the data to which accounting principles are applied in the preparation of financial statements and other financial information. Personal record keeping often uses a simple single-entry system, in which amounts are recorded in column form (Heely & Nersesian 1993).  Such entries include the date of the transaction, its nature, and the amount of money involved. Record keeping of organizations, however, is based on a double-entry system, whereby each transaction is recorded on the basis of its dual impact on the organization’s financial position or operating results or both. Information relating to the financial position of an enterprise is presented in a balance sheet, while disclosures about operating results are displayed in an income statement. Data relating to an organization’s liquidity and changes in its financial structure are shown in a statement of changes in financial position. Such financial statements are prepared to provide information about past performance, which in turn becomes a basis for readers to try to project what might happen in the future (Heely & Nersesian 1993).

 

Bookkeeping, which is a vital part of all accounting systems, was in the mid-20th century increasingly carried out by machines. The widespread use of computers broadened the scope of bookkeeping, and the term data processing now frequently encompasses bookkeeping (Heely & Nersesian 1993). Accounting information can be classified into two categories: financial accounting or public information and managerial accounting or private information. Financial accounting includes information disseminated to parties that are not part of the enterprise proper stockholders, creditors, customers, suppliers, regulatory commissions, financial analysts, and trade associations; although the information is also of interest to the company’s officers and managers (Droms 1997). Such information relates to the financial position, liquidity which is the ability to convert to cash, and profitability of an enterprise. Managerial accounting deals with cost-profit-volume relationships, efficiency and productivity, planning and control, pricing decisions, capital budgeting, and similar matters. This information is not generally disseminated outside the company. Whereas the general-purpose financial statements of financial accounting are assumed to meet basic information needs of most external users, managerial accounting provides a wide variety of specialized reports for division managers, department heads, project directors, section supervisors, and other managers (Droms 1997).

 

Of the various specialized areas of accounting that exist, the three most important are auditing, income taxation, and non-business organizations. Auditing is the examination, by an independent accountant, of the financial data, accounting records, business documents, and other pertinent documents of an organization in order to attest to the accuracy of its financial statements. Large private and public enterprises sometimes also maintain an internal audit staff to conduct audit like examinations, including some that are more concerned with operating efficiency and managerial effectiveness than with the accuracy of the accounting data. The second specialized area of accounting is income taxation. Preparing an income-tax form entails collecting information and presenting data in a coherent manner; therefore, both individuals and businesses frequently hire accountants to determine their taxes. Tax rules, however, are not identical with accounting theory and practices. Tax regulations are based on laws that are enacted by legislative bodies, interpreted by the courts, and enforced by designated administrative bodies (Kirkegaard 1997). Much of the information required in figuring taxes, however, is also needed in accounting, and many techniques of computing are common to both areas. A third area of specialization is accounting for non-business organizations, such as universities, hospitals, churches, trade and professional associations, and government agencies. These organizations differ from business enterprises in that they receive resources on some non-reciprocating basis, they do not have a profit orientation, and they have no defined ownership interests as such. As a result, these organizations call for differences in record keeping, in accounting measurements, and in the format of their financial statements (Kirkegaard 1997).

 

Traditionally, the function of financial reporting was to provide proprietors with information about the companies that they owned and operated. Once the delegation of managerial responsibilities to hired personnel became a common practice, financial reporting began to focus on stewardship, that is, on the managers’ accountability to the owners. Its purpose then was to document how effectively the owners’ assets were managed, in terms of both capital preservation and profit generation. After businesses were commonly organized as corporations, the appearance of large multinational corporations and the widespread employment of professional managers by absentee owners brought about a change in the focus of financial reporting (Riahi-Belkaoui 1999).  Although the stewardship orientation has not become obsolete, financial reporting in the mid-20th century is somewhat more geared toward the needs of investors. Because both individual and institutional investors view ownership of corporate stock as only one of various investment alternatives, they seek much more future-oriented information than was supplied under the traditional stewardship concept. As investors relied more on the potential of financial statements to predict the results of investment and disinvestment decisions, accounting became more sensitive to their needs. One important result was an expansion of the information supplied in financial statements (Riahi-Belkaoui 1999).

 

The proliferation of footnotes to financial statements is a particularly visible example. Such footnotes disclose information that is not already included in the body of the financial statement. One footnote usually identifies the accounting methods adopted when acceptable alternative methods also exist, or when the unique nature of the company’s business justifies an otherwise unconventional approach (Riahi-Belkaoui 1999).  Footnotes also disclose information about lease commitments, contingent liabilities, pension plans, stock options, and foreign currency translation, as well as details about long-term debt. A company having a widely distributed ownership usually includes among its footnotes the income it earned in each quarter, quarterly stock market prices of its outstanding shares of common stock, and information about the relative sales and profit contribution of its different industry segments (Riahi-Belkaoui 1999).

 

Until 1973, accounting principles in the United States had traditionally been established by certified public accountants. Such persons are accountants licensed by their state governments on the basis of educational background, a rigorous certification examination, and, in some jurisdictions, relevant field experience. In 1973, the seven-member Financial Accounting Standards Board was created as an independent standard-setting organization. Regulations for auditors are promulgated by the American Institute of Certified Public Accountants. United States companies whose stocks or bonds are traded by the general public must conform to rules set by the Securities and Exchange Commission, a federal government agency. Tax laws and regulations are administered at the federal level by the Internal Revenue Service and at the local level by state and municipal government agencies. The United States has no standard-setting body for managerial accounting (West 2003).  From 1971 to 1980, however, the federal Cost Accounting Standards Board established accounting rules for contracts with parties that sell goods and services to the government. The nongovernmental Institute of Management Accounting, although not active in issuing technical standards, does administer a program qualifying candidates for a certificate in management accounting (CMA). The Institute of Internal Auditors has a program enabling an accountant to be designated a certified internal auditor (CIA). Accounting has a well-defined body of knowledge and rather definitive procedures. Nevertheless, standard setters continue to refine existing techniques and develop new approaches. Such activity is needed in part because of innovative business practices, newly enacted laws, and socioeconomic changes. Better insights, new concepts, and enhanced perceptions have also influenced the development of accounting theory and practices (West 2003).

 

Ethics of accounting

Accountants find themselves performing tasks daily in an environment governed by a complex set of rules, principles, and practices. In performing their tasks they are asked to take a certain role. A role is best described as follows. The concept of a role is one which enters in the sociologist’s account of a social interaction. It is needed in describing the repeatable patterns of social relations which are not mere physical facts and which are structured partly by the rules of acceptable behavior in the society in question. In performing their roles, accountants face formal or legal rules of behavior but also moral elements created by specific situations. By accepting certain roles, accountants accept at the same time the resulting obligations and moral responsibilities of roles (Riahi-Belkaoui 1992).  By ethics, it is meant the concern with the moral judgments involved in making moral decisions about what is morally wrong and right or morally good and bad. These assumes the existence of moral standards that affect human well being are not established or changed by decisions of authoritative bodies, are intended to override the self-interest, and are based on impartial considerations. Various categories of ethical perspectives or modes of ethical thinking are applicable to accounting. They are reviewed next before a discussion of the implementation, teaching, and research of ethics in accounting (Riahi-Belkaoui 1992).

 

One way of implementing ethics in accounting is to use the deontological view of ethics and use a code of ethics for each of the professions of accounting. Each of the main accounting professions in the United States has in fact a code of ethics.  In 1988 the AICPA issued a new code of professional conduct that has a more positive tone than the previous one. It contains Principles of Professional Conducts that are enforceable through the Rules of Performance and Behavior and through the interpretation of the various senior-level committees of the AICPA: Ethics, Accounting and Auditing, Accounting and Review Services, Taxes, and Management Advisory Services (Riahi-Belkaoui 1992).  The Principles cover the following areas. First Responsibilities of Members wherein in carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities.  Second the public interest. Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.  Third Integrity which is to maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.  Fourth objectivity and independence wherein a member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and the other attestation services.  Fifth Due Care wherein a member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability.  Sixth is scope and nature of services wherein a member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and the nature to be provided (Riahi-Belkaoui 1992).

 

Accountants already know that the best way to evaluate the integrity of the financial information being communicated, both within the organization and to parties outside of it, is to understand and evaluate the accounting system used to convey this information. A parallel may be found in the realm of ethics. To understand an ethical dilemma and to analyze the potential resolution of a specific problem, one should seek to evaluate the strength of the particular ethical system in use. Two ethical systems in particular have dominated the way that humankind thinks about ethics this two are Utilitarinism and Deontologism. Balance is a concept close to the heart of every accountant. One of the first things they learn is to balance assets against liabilities and owners’ equities. Utilitarianism can be best understood as a system of ethical balance. Here the desire is to find the balance of good consequences as opposed to bad consequences (Cottell Jr. & Perlin 1990). The utilitarian perspective about ethics claims that we should take those actions that lead to the greatest balance of good versus bad consequences. Utilitarianism manifests itself in two major forms. The stronger of the two is so-called act-utilitarianism. Under this system, the moral agent considers the consequences of only the action under consideration. The second system is called rule-utilitarianism. Here the moral agent considers a set of rules by which life should be lived. The basis of accepting or rejecting a rule is whether the consequences of everyone following the rule will result in the maximum probable good consequences. Rule-utilitarianism may be regarded as a weaker form of utilitarianism than act-utilitarianism. A rule-utilitarian, when confronted with a situation in which he/she believes that abiding by the rule will not in the present case be most beneficial, will simply modify the rule. Ultimately, this would end logically in one rule, particularly maximize probable benefit, which is the position of the act-utilitarian (Cottell Jr. & Perlin 1990).

 

 Most accountants are already familiar with a system that acts very much like utilitarianism: cost/benefit analysis. In the cost/benefit system the accountant/manager attempts to balance the probable costs of taking a particular course of action with the probable benefits to be derived. Most accountants realize that cost/benefit analysis becomes more and stickier as the analysis moves away from measurability in terms of dollars. Measurement of benefits has been particularly problematic (Cottell Jr. & Perlin 1990). Critics of utilitarianism have pointed out many flaws. One is the apparent ability of utilitarianism to justify the imposition of great suffering on a few people as long as benefit is derived by many people. A second, more practical criticism centers around the difficulty of defining the probable benefits, called utility, and somehow summing them. Great disagreement may be generated over which consequences are in fact good, which consequences should receive greater or lesser weight, and what probability should be assigned to different future consequences. Modern critics of utilitarianism also note that ultimately utilitarianism must seek non-utilitarian answers on assigning boundaries and values around the measurement of activities and values associated with the calculation of utilitarian systems. All these matters serve to cause what appears to be an exceptionally practical system to become less and less practical (Cottell Jr. & Perlin 1990).

 

The second major system of ethics found in modern society is deontologism. The term stems from the Greek word deon, which means duty. In contrast with the utilitarian ethical system, deontologism holds that right action is independent of consequences. Deontological theories focus instead upon the correctness of the action itself. The assumption is that there are duties, rules, and principles that are inherently valuable and should never be violated. People respect the law, for example, because it is correct to do so, not because it smooths the way in which the courts or the police operate (Riahi-Belkaoui 1992). Deontological theory is anti-utilitarian: it states that an action is morally correct if it is rooted in a true moral principle. A moral person has a duty to take the right action regardless of consequences. One should take that action that he or she would wish everyone to take in all circumstances, irrespective of the consequences of the single, individual action (Riahi-Belkaoui 1992).Deontological ethics as an approach to resolving moral issues is also known as rule-based morality. The approach considers an action as morally right if it conforms with a proper moral rule. An action that violates the rule but results in beneficial actions is still considered wrong. The sources of the rule could be either theological in the sense that the actions are stipulated as moral by a religion, or societal in the sense that they are the result of a social consensus as to whether they are right or wrong. Because of the limitations of these two sources, criteria have been adopted based on either the consequences of adopting a particular set of moral rules, or our supposed faculty of moral intuition (Cottell Jr. & Perlin 1990).  First, this rule consequentialism differs from the act consequentialism adopted by utilitarianism because it states that, in effect, the rightness of a particular action lies in its conformity with the proper moral rule; the properness of the moral rule, in turn is based on the value of the consequences of it being followed. Second, the intuitionist approach holds that our special faculty of moral intuition tells us which actions have the inherent properties of being morally right. Rule-based moralists can accommodate most of the weaknesses of utilitarianism. The weaknesses correspond to the strengths of utilitarianism (Cottell Jr. & Perlin 1990).

 

Auditing

Audit is the inspection and verification of the accuracy of financial records and statements. Private businesses and all levels of government conduct internal audits of accounting records and procedures. Internal audits are conducted by a company’s own personnel to uncover bookkeeping errors and also to check the honesty of employees. In large companies, internal auditing is an ongoing procedure. A company that trades stock on a registered stock exchange or is preparing to issue new shares of stock must submit to an external audit. These companies are known as publicly traded companies. An external audit is used to give the public a true statement of a company’s financial position. It is made at least once a year by public accountants who are not regular employees of the company. The auditors make sure that the company has followed proper accounting procedures in its financial records and statements. They compare the current financial statements with those of the previous year to determine whether the statements are calculated consistently. If they are not, they present a distorted picture of the company’s financial position. The auditors also inspect real estate, buildings, and other assets to see if their value is overstated. Debts and other liabilities are checked to see if they have been understated (Hollingsworth & White 1999). When the auditors are satisfied that the company’s accounts are in order, they issue a statement certifying that they believe the company’s balance sheet, income statement, and records fairly reflect the company’s financial condition. The audit statement is then made public in the company’s annual report. Accounting firms that perform external audits came under close scrutiny by the United States government in 2001 in the wake of major scandals involving accounting and bookkeeping fraud at several major corporations. To remedy the problems, the U.S. Congress in 2002 passed a law that brought accounting firms under the strict supervision of the Securities and Exchange Commission (SEC) and its newly formed Public Company Accounting Oversight Board. Among other measures, chief executive officers (CEOs) and chief financial officers (CFOs) of publicly traded companies were required to sign statements affirming the accuracy of their firm’s financial reports or face prison terms for knowingly and willfully falsifying those reports (Hollingsworth & White 1999).

 

Although auditing can be traced back to before the rise of the Roman Empire, in Britain it was only in 1900 that every company was required to have its balance sheet and underlying accounting books and records audited. The object of the exercise was to provide an audit report for the shareholders of the company which attested to the truth and correctness of the balance sheet. If the directors did not permit the proper performance of an audit or if an audit report was unfavorable, the shareholders had the legal right to call the directors to account for their stewardship of the company and if necessary to have them replaced by new directors willing to accept the responsibilities of running the company in the interests of the shareholders. These arrangements are still in force today although they have been augmented in a number of important ways. From 1948 only suitably qualified accountants could act as auditors and from that time they were called upon to audit both balance sheet and profit and loss account, and where appropriate consolidated accounts. In the 1948 Act the auditor was required to report on the truth and fairness of a company’s profitability for the financial year in question and its financial position at the end of that year (Roslender 1992).  Disclosure requirements have become more extensive in the post-war period and in 1981 the form and content of the financial statements to be audited was prescribed. The same Act saw the auditor being required to review the directors’ report as well as any company transactions in its own shares. The scale and complexity of business operations has certainly kept pace with the enhanced statutory role of the auditor but the objective of being able to provide an annual audit report to the shareholders remains unchanged. As a result the performance of an audit of even the most modest business enterprise is much more demanding than it was at the beginning of the century when the statutory provision was introduced. It takes much more time to complete, the number of financial items is normally much larger and their value far greater (Roslender 1992).

 

In many cases the term auditor is best understood in a collective sense since it would be unrealistic to expect an individual to be able to perform the work which now constitutes an audit within acceptable time parameters. Consequently the audit of most companies other than the smallest ones is achieved by employing a number of divisions of labor. In most cases there is a division of labor in a temporal sense between the interim, year-end and final review audits. The former normally takes place three-quarters of the way through the financial year and in the main involves the auditor in work designed to assess the efficiency of the system of internal control which the client operates. In the case of an on-going audit the auditor should already have a knowledge of the systems in operation and have formed an opinion as to their effectiveness. The interim audit provides an opportunity to determine whether the system is still working efficiently (Roslender 1992).  As the term suggests, the year-end audit takes place at the end of the company’s financial year and is normally more concerned with the verification of the company’s balance sheet items rather than their systems. If there was some concern with the latter at the interim stage the year-end audit also provides an opportunity for further enquiry. The third audit should not really be a time-consuming exercise, being concerned with completing the audit for the year. It might involve adjustments to financial statements or resolving matters of concern to the auditor. The outcome will hopefully be the signing of an unqualified audit report which will be attached to the financial statements which the company will publish and make available to shareholders. In the largest companies it may be necessary to adopt what is known as a continuous audit approach where there are a series of interim audits throughout the year or where there is auditor presence in the organization on a continuing basis in order to complete the scale of audit work involved (Roslender 1992).

 

When the accounting process has been completed, an external audit evaluates and reports on the accuracy of the account. This is the second stage, and a separate stage, in the process to hold to account those responsible for the management of an organization’s finances. In the private sector, there is a legal requirement, under the Companies Acts, for the accounts of most companies to be audited by an independent auditor. The auditor must report to members his/her opinion as to whether proper books of account have been kept by the company and whether the company’s balance sheet and profit and loss account are in agreement with the books of account (Hollingsworth & White 1999).The auditor must also consider whether the information given in the director’s report is consistent with the accounts. If the auditor is not satisfied that the accounts comply with the Companies Acts or show a true and fair view of the state of affairs of a company then the auditor has a number of options. If appropriate amendments are not made to the accounts, or if certain information is not available, the auditor may give a qualified opinion on the accounts; as well as qualifying the opinion in his/her report to members, he/she may also report to a regulator; or he/she may be required to report to a regulator whether he/she qualifies his/she opinion or not (Hollingsworth & White 1999).

 

Audit is used to serve two purposes in both the public and private sectors. First, it can act as a tool of management: this is internal audit. Internal audit has been described as an independent appraisal function within an organization for the review of activities as a service to all levels of management. It is a control which measures, evaluates and reports upon the effectiveness of internal controls, financial and other, as a contribution to the efficient use of resources within an organization. Secondly, audit can be used as a form of external review, conducted by an independent auditor in order to hold the organization and its management to account. This is external audit (Hollingsworth & White 1999). Although the two types of audit serve different purposes and different audiences, they are linked. The purpose of internal audit is to improve value for money, avoid and detect fraud, and check and improve the financial systems. These are not dissimilar from the functions of external auditors, and clearly there is a degree of overlap. This allows the external auditor to rely on the work of the internal auditor if he is satisfied that the internal audit findings are accurate. Therefore, the closer the fit between the internal and external processes the more efficient and effective the latter is likely to be (Hollingsworth & White 1999).

 

Financial auditing practice has a much longer history than many of the other developments that can be considered and the large firms of accountants, in which many financial auditors work have become influential advisory institutions throughout the world.  Thus financial auditing has provided the model which has influenced the design of auditing practice in many other fields. Although environmental, medical, or value for money audits are conceived as distinct from financial auditing, the latter continues to exert its normative influence as a centre of gravity for debate and discussion. And it is in the context of financial auditing that the dependency of acts of verification on judgment and negotiation is most apparent. The power of the financial auditing model lies in its benchmarking potential for other audit practices. In part this potential is realized indirectly through the work of accountant advisors, for whom the financial auditing model is a fundamental component of their expertise and whose advice in areas of control is shaped by it. But the influence can also be direct as entities such as hospital trusts, privatized industries, charities, and many other organizations become subject to an intensification of financial control and reporting requirements. This is an expanding domain, not just of neutral checking but also of judgment and of an evaluation of the fundamental purposes of organizations. Paradoxically, given the influential role of the financial auditing model suggested above, its status as a practice is unclear. What do audits produce and how are they effective? Financial auditing is subject to expectations and demands which are, justifiably or otherwise, often disappointed. Nevertheless, the official procedural knowledge base of auditing has evolved in response to scandals and corporate failures in such a way that the essential puzzle of what audits produces their effectiveness remains hidden from view as an article of faith. Finally despite, and probably because of, this puzzle it is argued that financial auditing maintains itself as an institutionally credible system of knowledge. Notwithstanding crisis and scandal it satisfies the aspirations and demands of a variety of regulatory programs. Particular audits may fail but the system as such cannot. The possibility of effective auditing is necessarily presupposed by regulatory intentions.

 

Traditionally, auditing has applied itself to the domain of finance, but organizations are increasingly finding value from internal audits that monitor other aspects of their activity. Environmental and social audits, for example, have been championed by firms in response to the ethical concerns of both shareholders and the public in relation to the company’s impact upon the locality. Financial auditing is growing in importance too, partly in response to recent major scandals such as the collapse of banks, and also in order to monitor the increasingly complex demands being made upon accountants (Vernon 2002). However, auditing remains something of a mystery to those outside of the profession, and has become more specialized as accounting has become more sophisticated. For example, while best practice has evolved certain tools for analytical review or establishing audit trails, an element of subjective judgment remains as auditors decide what evidence to include. Further, rules of thumb can never be ruled out. Audit risk has developed as an issue too, as the models for reducing the probability of mistakes being made on sampling, for example, become more subtle. In countries such as Canada these have changed dramatically. Here, a Bayesian approach was introduced in 1980. Auditors recognize the limitations of their science. They are not held responsible for detecting fraud, for example. Auditing provides a degree of assurance, but not insurance, as to the financial position of the firm (Vernon 2002).

 

American Institute of Certified Public Accountants

The American Institute of Certified Public Accountants (AICPA) is the professional organization of practicing certified public accountants. The Institute, which was founded in 1887, provides technical advice and guidance to its members and such government bodies as the Securities and Exchange Commission. It issues many influential publications in the areas of accounting, auditing, and taxation (Hussey 1999). The public accounting profession, through the leadership of the American Institute of Certified Public Accountants, has responded to the changing world of business and the implications for this profession. A committee charged with studying assurance services provided a report that enlarges significantly the types of services public accountants are qualified to handle. The challenges that face practitioners are to venture into relatively new areas and add value to the words and practices of clients. The American Institute of Certified Public Accountants (AICPA) in early 1998 issued a publication titled Implementing Ethics Strategies within Organizations, which serves as a guide to organizations wanting practical operating principles and information about appropriate approaches for organizing corporate ethics programs (Calhoun, Oliverio & Wolitzer 1999). More and more, organizations and the public worldwide recognize that business ethics and corporate social responsibility are important concerns. Many individuals and groups from employees to consumers, from shareholder coalitions to neighborhood associations are demanding more than profit maximization from business corporations and their leaders, and honesty from not-for-profit organizations. Governments, both through increased attention to corruption and incentive schemes, have encouraged organizations to address ethics specifically. Organizations are being challenged to review their current approaches to ethics and to explore new models and techniques to meet rising stakeholder expectations. The AICPA has a number of additional publications relevant to the topic of ethics. The Institute for Management Accountants (IMA) and the Institute of Internal Auditors (IIA) give attention to ethics through publishing studies and practical guides, plus providing seminars and conferences on ethical topics (Calhoun, Oliverio & Wolitzer 1999).

 

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