The present day corporate world is well aware of the increasing cases of accounting fraud. Governments and regulatory bodies are finding themselves in embarrassing situations after corporation’s collapse, even after receiving a clean bill of financial health from their auditors, a landmark case being that of Enron. These incidences have led to the accounting regulatory bodies, securities regulatory bodies and other government institutions mandated with the regulation of the accounting profession to demand that auditors are accountable for their actions or omissions in the performance of their duties. In the case study below however, there is a conflict of the law between two countries with regard to the responsibilities and obligations of the auditor, almost boiling down to a diplomatic row.
The administrative judge in the case pitting the SEC and the china affiliates of the big four auditing firms, Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Ltd, after sec struggled for years to obtain information from these auditing firms, barred the auditors for six months, pending the hearing of the case. In this landmark ruling, the auditors are barred from operations, after they failed to provide information required for review by the Securities exchange commission for suspicions of accounting fraud in these Chinese based companies (Alan Katz, 2014).
Country Specific Legal Requirements
The audit firms argued that they are caught in the middle of differing regulations between the United States and the people’s republic of China. According to the US SEC regulations, all accounting firms are expected and required to turn over all information that is required by the SEC for their internal investigations, while the Chinese regulations demand that no information regarding a company domiciled in the country can be provided to another party, especially another country, due to the policy of protection of state secrets, and therefore the auditors were unable to provide this information.
Discussions between the two countries have been ongoing so as to arrive at an amicable solution on this issue, but this is not finalized as yet. The bigger picture in this case study is that in the event that SEC upholds the decision of the administrative judge, then it may be necessary for over two hundred companies of Chinese origin may have to look for other auditors, while US companies that have operations in China may be forced to look for auditors to check their units in China, which means that the decision to be made must be very well thought out.
Focus on financial statements
An auditing exercise involves an independent examination of the company’s financial statements with a view to forming an opinion as to whether the financial statements of the company give a true and fair view of the financial position of the company as at that position, as well as the results obtained in the given period.
In forming this opinion, the auditors should design tests and procedures that will assist them to obtain sufficient evidence on the financial statements. One of the ways of obtaining this evidence is going through the individual accounts to see if there is any extraordinary transactions that have been recorded and investigating the same. It may also involve their performance of an analytical review that compares previous rears results of individual or group accounts to the current year’s results, which gives the auditor an idea of where he may need to do more procedures.
The auditor expresses his opinion on the financial statements as a whole. These sets of financial statements include the statements of financial position, the statement of comprehensive income, the statement of changes in equity, as well as the statement of cash flows. These financials help the auditor to ensure that they are able to advise the client on the many areas in the business where they may need to improve or make changes.
Impact on accounting fraud on statements/ accounts and statements at large
Accounting fraud, which in most cases is perpetrated with the knowledge of the auditor, has the effect of distorting the financial statements, through misrepresentations. Smart and treacherous auditors have in the past been involved in manipulation of their client’s financial statements with the aim of assisting them to look either profitable, or less profitable to avoid taxes, depending on the requirements of the clients. One of the main methods of reducing tax liabilities that has been frequently employed by auditors is writing down inventories, debtors etc, so as to expense the same and reduce the clients tax liabilities. Others are involved in non recognition of income, or even recognizing income where a sale has not yet been made, as per the applicable accounting conventions. All these malpractices have the impact of distorting the financial statements.
Impact on Sec Regulations
SEC regulations demand that financial statements must be prepared within the framework of the applicable financial reporting standards and those auditors must perform their procedures and tests as per the requirements of the auditing standards. Sec requirements also demand that auditors must furnish the commission with the relevant information regarding their audit; especially in the event that the commission feels that accounting fraud is being propagated in the company.
This is the requirement that has led to the barring of the Chinese domiciled accounting firms from operations for their failure to furnish the commission with the required information, leading to a standoff between the two countries which need to be resolved before it escalates.
Impact on company, future financials, stakeholders and company
Accounting fraud has far reaching impacts on the company and its stakeholders. The company not only pays the wrong taxes, but may also get into problems with the revenue collection institutions if an in-depth audit is carried out and reveals these malpractices. In some cases, some companies have been heavily fined for non disclosure of revenues or overstatement of the expenditure.
On the impact of future financial statements, it’s natural that financial statements that have been constructed using balances that are misstated are likely to be misleading as well (Cagan, 2001). If for instance the balance sheet opening balances are misstated, it follows that if these misstatements are not corrected, then any future financials will also not be accurate, and therefore the company will not be able to know the exact performance for the period.
Stakeholders of the company who include shareholders, creditors, customers, government and even the general public may make misinformed decisions based on these financial statements which may at times lead to huge losses. Imagine buying stock in a company that purports to be profit making when actually it’s in a loss making position?
Creditors on the other hand may be misled to continue to advance credit whereas the company is already overstretched and unable to service additional credit, yet they do not realize this because of the financial statements being doctored.
In the event that the public gets information that a company has been engaging in creative accounting, then they are likely to develop a negative opinion of the company, in some cases even shunning the products of the company as well as the stocks of the company, and therefore the company may suffer long-term business losses as well as company value as a result of accounting fraud (Anonymous, 2002).
The above case study highlights the role of the auditors not only with regard to their clients but also concerning their obligations to the regulators of their work. It’s evident that different countries make different demands of the auditor, but all in all, the auditors are expected to perform their duties with utmost professionalism and competence as well as good faith.
It’s also notable that in deciding on what decision to make concerning the barring of the concerned auditors from operating in the US, the securities exchange commission must be guided by utmost wisdom and understanding of the bigger picture, since their decision will have far reaching consequences not only on the accounting profession as a whole, but also on the diplomatic relations of these two economic giants.
Anonymous (2002) Finance and economics: The Enron down under; Australian insurance .The Economist London, 363 (8274), 74-75
Cagan, P (2001) HIH Cases study. Retrieved on 12 May 2006 from www.erisk.com
Alan Katz (2014) China Auditors Appeal U.S. Ban as Ruling Endangers Diplomacy. Washington D.C
Francine Mckenna (2013) Auditor Independence, Professional Skepticism, Auditors' Fraud Obligations: Case Studies and Examples. Presented At the Georgia Southern Fraud and Forensic Accounting Conference
Williams, T (1999) The rise, the fall and the flight of Brierley Investments. Auckland, Bateman