Ethics in Auditing Dissertation

Abstract

Accounting auditing is at the center of concern about ethical financial reporting. Due to infamous cases of the fraud committed by Enron, Worldcom and other corporations, which is actually seen by some as a major threat to the economy of the United States (Doost & Fishman, 2004), poor ethical practice can lead to investor disaffection and possible desertion of the securities market. From the critical perspective, no profession can long ignore its own ethical standards and expect to avoid problem like the Arthur Andersen-Enron debacle that is why issues of ethics in auditing are particularly important to address, assess and analyze. This dissertation paper aims to discuss major ideas of ethics in auditing, accounting and financial reporting, analyze the basic implication of Sarbanes-Oxley Act (SOX), and emphasize the need for development of ethical standards in auditing and financial reporting.

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Introduction: Ethics in Auditing as a part of Business Ethics

Business ethics is all too often trotted out only when needed and never mentioned if not needed, yet ethics is central to the practice of commerce and is certainly nearly as old. It should be pointed out that while ethics is as old as the practice of commerce itself so is the lack of ethics. Economic hardships might be blamed but fraud exists in abundance even during economic boom times. In fact fraud tends to increase during economic boom times as witnessed by the dot-Com boom of the late 1990’s. What drives this phenomenon? Fraud and its antecedents are rooted in values and the family’s role as a socializing force (Birchfield, 2004). Society and its tolerance of unethical behavior is also a factor. It is not simply a matter of poor family values, ineffective socialization or societal ambivalence that fuels fraud, but rather a willingness to allow some “corner-cutting” when it comes to accumulating wealth and position. Few would vigorously condemn the occasional white lie, yet it is this attitude of nonchalance that can lead to greater problems. Enterprise wide ethics is a challenge but it is its own reward, as well. Birchfield (2004) points out that ethics as an endeavor can be promoted, instilled and fully integrated into business practices at all levels. It does not follow that ethics not fully developed as a concept in familial socialization cannot be spawned in the halls of the enterprise.

To be sure some degree of coercion must accompany the installation of ethical practice in the enterprise, but it is still better to codify boundaries of behavior than to foster a laissez-faire corporate culture such as existed at Enron. Auditing ethical standards are not inimical, in this country or abroad, to the process of instilling an ethical enterprise wide environment (Grant, 2004). Good ethical practice can generate sound business process and this should lead to positive growth and profit. The good news is that ethical practice need not be hard to achieve. Ethics can be built into a corporation’s processes and culture provided that senior management is onboard with the goals and the costs that ethical practice entails. If the company’s leadership is uncertain about how to setup an enterprise wide ethical infrastructure, then a Chief Ethical Compliance Officer (CECO) might be in order (Daigneault, 2002). It may be advisable for the enterprise to create the CECO position anyway as a demonstration of overall commitment to ethical practice and to assure that day to day operations are conducted in accordance to an ethical code of conduct. Such a position may be particularly needed in a widely diversified enterprise.

Regardless of the above, one profession in need of an ethics transfusion is the accounting profession. This fact is all the more apparent due to the avalanche of accounting fraud cases in the last five years. 

Accounting is a great profession in need of a revival in thought, purpose, and direction (Bunting, 2005). Only by proactively embracing such a revival can the profession look to future growth and a return to the top echelons of respectability. For a profession that once was the embodiment of the highest ethical and moral standards this statement is a far reaching indictment of all that has and can go wrong. No profession can long ignore its own ethical standards and expect to avoid problem like the Arthur Andersen-Enron debacle. Corporate culture can be significantly influenced by the accounting auditing profession as managers seek guidance from their internal auditor’s on various provisions of Sarbanes-Oxley Act (SOX) and an ethical corporate culture can also greatly reduce financial misreporting (Castellano, Rosenzweig & Roehm, 2004). Certified Public Accountants (CPA) should be in the vanguard of the new era of ethical practice at the enterprise level.

Modern State of Accounting Audit Practice: Ethical Implications
Financial Reporting and Audit under Regulation of Sarbanes-Oxley Act

Accounting auditing is at the center of concern about ethical financial reporting. The problems created by the fraud surrounding Enron, Worldcom and other corporations is seen by some as a major threat to the economy of the United States (Doost & Fishman, 2004). Poor ethical practice can only lead to investor disaffection and possible desertion of the securities market. Only by restoring confidence in financial reporting can investor distrust be alleviated. One way to reduce this threat of investor disaffection is to combine enterprise risk management (ERM) with internal auditing to create ERM-based auditing (Matyjewicz & D’Arcangelo, 2004). ERM-based auditing includes (a) establishing and communicating the enterprise’s objectives, (b) determining the risk appetite of the enterprise, (c) establishing an appropriate risk management framework, (d) identifying risks, (e) assessing the probability of the risk occurring, (f) selecting the most effective way to deal with the risk, and (g) conducting control and response activities (Matyjewicz & D’Arcangelo, 2004). ERM based auditing therefore should help to strengthen internal auditing standards throughout the enterprise. Such an effect on internal auditing would be consistent with the requirements of the Sarbanes-Oxley act (SOX) and the stated objectives of various stock exchanges, such as the New York Stock Exchange, who now require all organizations to have an internal audit function (McElveen, 2002).

The first audit report should establish the areas demanding management action and following review, a follow up process should be set up that assures that required actions are implemented (De La Rosa, 2005). There needs to be a link between the findings of the audit and ERM processes if effective ERM based auditing is to occur. The audit report should include (a) the objectives and scope of the audit, (b) conclusions and scores presented in a tabular format, (c) recommendations, and (d) action plans (De La Rosa). The auditor must take primary responsibility for formulating an audit report that is comprehensive and easy to follow. An ERM map can be used to (a) detail the uncovered weaknesses, (b) their probability of occurrence, (c) severity, and (d) degree of financial impact on the enterprise (De La Rosa). The final audit assessment is critical as it is the foundation of the corrective action plan. The auditor should be careful to document management’s interventions to correct the issues uncovered in the audit for future reference. Success or failure of the audit is directly tied to the partnership forged between the auditor and the senior management of the enterprise.

Auditing controls can exert considerable influence over the enterprise in ways that can substantially improve an understanding of accounting processes. Revenue recognition is one such accounting issue that demands careful scrutiny. SOX focuses on accurate revenue recognition, which is a key element in assuring financial reporting integrity through internal audit controls (Bean & Chambliss, 2003). 

Revenue drivers have traditionally included earnings realizations and accruals versus matching revenues and expenses in the same period in which they occur. Such old school revenue drivers do not fare well in the more complex business climate of today nor do they stand up to the test of viability across multiple industries (Bean & Chambliss, 2003). It is necessary to carefully define revenues consistent with generally accepted accounting principles (GAAP) and to control the reporting of those revenues. Internal auditors should review revenue reporting practices for the enterprise consistent with SOX requirements. These reviews should (a) analyze management’s objective achievement through pre-audit narratives, (b) examine internal control from the top down using questionnaires and interviews, and (c) observe the strategic planning process from multiple perspectives (Bean & Chambliss, 2003). ERM based auditing can substantially affect financial reporting integrity. It is the belief among many that over the next few years that the net effects of SOX will be reliable and accurate financial reporting through improved audit practice. The realization of this desirable goal must encompass strong audit controls.

Not surprisingly the SOX has had an extensive impact on auditing practices. Behavioral changes are rapidly emerging in the wake of SOX. One of these changes includes greater board of director independence and increased audit committees authority (Mullan, 2003). A board of directors independent of management can provide more effective oversight and serve as a natural foil for an irresponsible management team. The audit committee of the board of directors has increased significance under SOX, as well. This committee has increased importance under SOX and plays a central role in overseeing both the internal and external audit practice of the enterprise. Other behavioral changes encompass such areas as the reinvention of ethical business practices (Mullan, 2003). SOX not only encourages ethical business practices but it also demands it by the force of its various sections, not the least of which is section 302 requiring the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) to certify the accuracy and completeness of the financial statement.

Internal auditors also see their roles changing with greater emphasis on internal control assessment and financial statement audits (Aldhizer, Cashell & Saylor, 2003). Section 404 of SOX requires management to provide a thorough and honest assessment of the internal control system of the enterprise. An interesting requirement of SOX is section 409, which requires that a current and rapid notice be issued by the enterprise concerning any material change in the financial position of the company. The auditor was never more important or more favorably positioned to affect extensive changes to the enterprise’s financial operations.

In the SOX age the internal auditing function has provided (a) business process analysis, (b) control testing, (c) risk management, (d) and forensic accounting. These valuable services underline how internal auditors have stepped up their services level to the modern enterprise. Auditing and ERM are a good fit for each other. The convergence of ERM and auditing has been brought about largely by the need to comply with SOX. The drive to achieve full SOX compliance has been intense as can be imagined. Some are concerned that the hyper attention given to SOX compliance may have distracted the internal auditor from their primary mission namely operational audits. Some displacement of effort may have taken place due largely to the complexity of SOX compliance activities. However, this shift of attention is not unusual since many new processes require a greater effort at the beginning of the implementation phase. What is of the greatest concern is the long-term effect of the new of SOX. Once the mechanisms of SOX compliance are mastered, internal auditors can offer more services in a broader spectrum such as comprehensive business analysis, risk management, and forensic accounting as mentioned above.

Expanded Role of AICPA

The American Institute of Certified Public Accountants (AICPA) has facilitated the shift from business as usual to greater emphasis on auditing by prohibiting accounting firms from providing management consulting services to those firms that they also provide audit services (Reinstein, 2005). This provision prevents auditing firms from offering services that might produce conflicts of interest between auditing integrity and the financial relationship of auditor and audited enterprise. This change in position by the AICPA is an example of how the accounting profession is changing and in effect auditing itself. This degree of self policing is necessary to assure that the interests of the public are put above any other consideration. Sound audit practice as required by SOX law and the AICPA rules has also engendered ERM as a means to detect fraud in the public sector (Collins, 2004). These developments have had positive influences on the enterprise and on the accounting profession as a whole. These changes were also needed given the fact that many practitioners and observers of the audit profession feel that auditors had lost their objectively and needed to recapture that objectivity quickly (Shafer, Ketchaud & Morris, 2004). The AICPA act of taking a proactive approach has served to help lead the accounting profession back to a degree of respectability.

To Auditing Ethics through Compliance to SOX

SOX has brought concerns about quality audit practice into the mainstream of total quality management. Financial reporting matters are of increased importance today given the trial of the malefactors from Enron, Skilling and Lay. Obviously there is a greater appetite to pursue and punish corporate fraud wrong doers. Sound and honest internal audit practices coupled with the need for arms-length external auditing practices have finally been recognized as necessary components of total quality management. No enterprise can claim that it is committed to quality management principles without also committing itself to financial integrity. SOX has brought about many changes both intended and unintended. All of these changes have served to redirect the attention of corporate governance onto the topic of audit and enterprise risk management (Yakhou & Dorweiler, 2005). The need for a new system of enterprise governance may have been met with the ideal solution the convergence of ERM and audit practices.

SOX compliance involves in part an evaluation of the enterprise’s ethical environment. However, auditing the ethnical environment creates some unique challenges for the internal auditor (Sinason, 2005). Guidelines for ethical environment auditing include (a) review the written code of ethics, (b) review board of director meeting minutes, (c) review the job description of the chief ethical compliance officer, (d) review the job descriptions of all management positions, (e) review the procedures for reporting ethical violations, (f) review ethical violations reports sent to senior managers, (g) review the code of ethics reinforcement and display strategy (Sinason, 2005). The above may seem an odd set of guidelines for an internal auditor to follow, but there are no specific rules for reviewing ethical practice. Some of the above guidelines, however, are appropriate if the objective is to gauge actual behavior versus stated policy. It is necessary to determine if the managers responsible for ethical compliance are if fact being evaluated on these activities. One way to determine this is to look at the job descriptions of those positions. If the job description does not include statements about ethical guidance, then it is likely the manager may receive good evaluations without meeting this key objective. It should be equally obvious that ethical violation procedures and reports are important activities in an ethical enterprise. A comprehensive internal audit should review all of these areas. However, it would be naive to believe that changes in corporate governance, the emergence of ERM and changes in audit practice brought about by SOX have solved all of the problems inherent in financial reporting. Big four audit accounting practice may not be where it needs to be in order to restore confidence in financial reporting completely.

Recent inspections by the Public Company Accounting Oversight Board (PCAOB) point to a lack of good communication within the audit departments of the big four firms concerning the need to be extra vigilant in complying with SOX. The audit issues surrounding the big four accounting firms have brought about a departure of 38% of audit clients to middle tier accounting firms (Nixon, 2005). 

Presumably the departure has been precipitated by concerns over SOX auditing requirements. Some of these departures were due in no small part to the increased work load SOX has created. What is needed is a vigorous promotion of enterprise wide values such as honesty, integrity, and devotion to serving the broader interests of the greater enterprise stakeholders. The emergence of responsible values along with ERM and renewed audit rigor has begun to change the enterprise landscape. Not only are accounting and auditor practices affected by SOX but information technology (IT) practices are effected as well. Security of Accounting information systems (AIS) and access controls have become major issues for IT operations as well. This is due to the opening up of the auditing perspective in reaction to SOX and ERM ranging from auditing standards for nonprofits and auditing techniques to improving security of financial management systems at all levels (Floch, 2004). The increased reliance of many enterprises on the Internet and security issues surrounding eCommerce activities and the accounting for such activities will be affected by SOX as well. Concern about fraud in financial reporting as affected IT control systems in far reaching ways. The application of Auditing Standards SAS 99 has forced a closer examination of AIS procedures and controls (Leinicke, Ostrosky, Rexroad, Baker & Beckman, 2005). Virtually every aspect of auditing has changes since SOX was introduced in 2002. These changes have served to bring the practice of auditing out of the back room and into the board room. Information technology (IT) management is also elevated in the era of SOX and ERM convergence (Brown & Nasuti, 2005). Security of IT information is essential for SOX compliance and ERM practice. The necessary security framework should integrate (a) IT structures, (b) IT processes, and (c) communications to create an enabling security focused organization (Brown & Nasuti, 2005).

Conclusion: Ethics in Auditing as a Pillar of Business

Ethics is a critical component of sound economic practice and cannot be relegated to the back seat of strategic thinking. Too many enterprises have relegated ethical thinking to a “use it only when needed” status. By no means is this misplacement of ethics only endemic in “for profit” businesses. All enterprises should consider the long range benefits the full integration of ethics into the strategic thinking process can affect. The question must be asked: By what means can ethical thinking be accomplished? Considering the focus over the last five years on accounting ethics, one way ethical thinking can be achieved, is by teaching accounting from a thoroughly ethical perspective (Esmond-Kiger, 2004). Such an approach includes more than simply teaching the dogma of Generally Accepted Accounting Principles (GAAP) or the catechism of moral behavior. What is needed is a humanistic and holistic approach to ethical education. Not humanistic from the stand point of situational ethics, but in the context of realistic human interaction. The prime directive must be do no harm and always place the well being of the investor above personal considerations. Universities must also make ethical education a completely seamless part of accounting school curricula. A major part of this movement toward high ethical standards is to teach Certified Public Accountants (CPAs) about serving the public interest first. It does reflect both the code of professional conduct of the Society of Certified Public Accountants and the tenants of the SOX law.

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