Audit Services

This article discusses audit services as they are related to an organization's financial reporting, finance operations, and enterprise risk. In large organizations, there are often three types of auditors and audit functions: internal, external (independent), and third party or consulting auditors. Auditing committees play an important role as liaisons between organizations and independent and external auditors. The current role of audit committees as overseeing compliance and governance issues is investigated—as is the changing role of the committee—as it moves toward the oversight of enterprise risk management. Enterprise risk assessment includes oversight of financial reporting compliance, but also encompasses a holistic approach to integrated risk within organizations. Risk assessment from the standpoint of finance is discussed in terms of an organization's entities, processes, and systems.

Keywords: Audit Committee; Certified Public Accountant (CPA); Enterprise Risk; External Auditor; Financial Restatement; Inherent Risk; Internal Audit; Managing risk; Materials Weakness; Objective Audit; Reassurance; Registrant; Residual Risk; Restatements; Risk Intelligent Enterprise; Sarbanes-Oxley; 404 Compliance

Overview

Auditing is often thought of in terms of complex oversight of a company's financial statements. However, auditing services vary widely depending upon the size and nature of the business contracting the service. For small businesses and firms, auditing services are most likely a relationship between the business and a CPA (certified public accountant). The CPA likely conducts a yearly audit (assistance with tax filing) and serves as an independent set of eyes and ears to check the work of the internal accounting department.

At large organizations, auditing of company financials and the associated risk can be extremely complex and costly and can involve relationships with multiple auditing-services firms. Financial disclosures and reports may be required on a quarterly basis and may be made available to employees, investors, and financial institutions to apprise customers of the financial health of an organization.

History of Auditing Services  

Auditing services have a long history of interaction in American business. The expansion of global markets and the growth of multinational companies have increased the complexity of financial management, reporting, and auditing in larger enterprises. As the accounting function grew in importance, organizations began to rely on outside auditors to help interpret fast-changing accounting rules, regulatory missives, and the overall pace at which finance functions were growing.

The notorious accounting scandals of the early 2000s (such as those involving Enron, Tyco, and Worldcom) were the impetus for passage of Sarbane-Oxley in 2002. However, as early as 1993, auditing failures were being documented. The estimated cost to investors was $88 billion from 1993 to 2000 (McNamee, Dwyer, Schmitt, & Lavelle, 2000).

In 2000, Arthur Levitt, chairman of the Securities and Exchange Commission (SEC), launched a personal crusade to expose what he considered “a massive conflict of interest between accountants' duties as auditors and the profits they earn as consultants to the same corporate clients" (McNamee, Dwyer, Schmitt, & Lavelle, 2000). By the year 2000, estimates put consulting revenues at 51% of the total revenues of many accounting firms. The big five accounting firms were well established as providers of accounting services for many of the largest corporations in the United States. The big five were Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers; all five were opposed to SEC intervention. The big five saw Levitt's action as potentially cutting the accounting firms "off" from new growth markets (consulting). That the big five accounting firms provided both accounting services and consulting services was not in itself problematic. However, it had become clear that these firms were signing up the same clients for accounting and consulting services, which created a conflict of interest.

“The trend [offering accounting and consulting] has convinced Levitt that auditors are relaxing their vigilance and growing cozier with management. And the SEC is developing evidence in at least two cases (Waste Management Inc.’s [WMI] $3.54 billion writedown of 1992-97 profits and the $55.8 million earnings restatement at high-flying software developer MicroStrategy Inc. [MSTR]) that accountants’ consulting work and financial ties to clients compromised their audits. Levitt’s solution was to split auditing and consulting. On June 27 [2000], the SEC voted unanimously to issue a proposed rule that would bar accountants from providing a range of consulting services to companies that they audit. Levitt also wants to beef up public oversight of accountants, all with an eye to send the profession back to its roots as vigorous guardians of investor interests. `When the public loses confidence in our markets, or when the reliability of the numbers is diminished, the whole system is jeopardized,’ said Levitt. `The sanctity of the numbers and of their reliability must be there’” (McNamee, Dwyer, Schmitt, & Lavelle, 2000).

Just two years after Levitt's call to action, the major accounting scandal involving Enron and its accounting firm Arthur Anderson became a watershed event in the way that auditing services were provided. Congressional intervention had stalled developments on Levitt's request for action in 2000. The big five accounting firms and their trade association (American Institute of CPAs) contributed millions of dollars in funds to election campaigns; they had hoped to retain the ability to provide both accounting and consulting services to the same clients. However, by 2002, Congress would become involved in crafting the landmark Sarbanes-Oxley law that was meant to restore investor confidence in corporate America.

An article from 2002 described the shift in political thinking in the following statement:

"Now, with both Congress and the FBI investigating Enron's close relationship with Arthur Andersen, the SEC is tackling the [Levitt] issue again. Enron's critics say because Arthur Andersen also provided $27 million worth of consulting services to Enron, the auditor failed to properly review the company's financial statements, allowing Enron to overstate its earnings by nearly $600 million. The SEC, now headed by Harvey Pitt, has proposed creating a watchdog panel that would oversee the accounting industry" (Center for Responsive Politics, 2002).

The issues of financial disclosure, compliance, and reporting in corporations have been profoundly affected by the passage of Sarbanes-Oxley. Auditing services also made course corrections in response to compliance and regulatory mandates. The distribution of auditing services and duties between internal, external, and consulting auditors are discussed in detail in this article. The role of audit committees related to the oversight of compliance and enterprise risk is also detailed within the context of Sarbanes-Oxley and beyond.

Applications

Trends in Auditing Services  

Years after the passage of SarbOx legislation, companies are still struggling to meet the requirements of the most costly (in terms of people and dollars) mandate: Section 404. Section 404 requires the auditing and testing of internal controls related to financial reporting and the generation of an internal audit report. Compliance with SarbOx 404 is proving to be costly when deficiencies in internal controls are found. These annual tests, "stipulated by Section 404 of the Sarbanes-Oxley Act, require external auditors to thoroughly test the adequacy of clients' key controls over financial reporting" (Banham, 2006). When deficiencies are found to exist in processes or controls, the cost can be enormous in terms of company share price or reputation. One such example is the case of Genlyte Group Inc., a Louisville, Kentucky lighting manufacturer.

"The auditors uncovered several deficiencies in the financial controls at Genlyte, including material weaknesses in three of the company's financial-statement accounts. The failing grade meant [that because of] the $1.2 billion (in revenues) Genlyte had to disclose the problems to the Securities and Exchange Commission. In the aftermath, the company's share price fell 9 percent. Recalls [CFO] Bill Ferko: `The Sarbox standards of evidence were more rigorous than we'd expected’” (Banham, 2006).

In the case of Genlyte, the company finance team had worked diligently with their external auditors at PricewaterhouseCoopers (PwC) for more than one year to ensure that the company was going to pass its audit. Still, when PwC sent its representative to review Genlyte's controls, the deficiencies described above were found. CFO Ferko decided not to take any chances, and instead contracted with yet another third party to conduct a pre-audit. Ferko actually hired Genlyte's former independent auditor, Ernst & Young, to conduct the pre-audit. The reliance on third-party consultants has become familiar in many companies that do not want to take chances with SarbOx 404 compliance.

Third Party Consultants  

“ Typically, the third-party consultants come from the Big Four accountancies, second-tier firms like BDO Seidman and Grant Thornton, or business-process specialists such as Protiviti Inc. or Paisley Consulting. And there appears to be no shortage of work, either. In a survey of public-company executives conducted by CFO magazine earlier this year nearly 60% of managers said they had hired third-party consultants to help with Section 404 certification” (Banham, 2006).

There are a number of reasons cited by CFOs and managers as to why third-party consultants are worth the extra dollars they cost in meeting compliance mandates.

• Many companies need help documenting and testing internal controls because the task is daunting and there are not enough internal resources to complete the task.
• Finance chiefs say that they are not getting the answers they need from external auditors—external auditors are "spooked" by the auditor-independence provision of SarbOx.
• Consultants help document workflow and provide advice on processes and documentation.
• Legally, independent auditors are not allowed to provide internal-controls consulting to audit clients.
• External auditors do not want companies testing their own internal controls; they want third-party auditors to do it.

Auditing Practices  

Before the passage of SarbOx legislation, many auditors saw themselves as business advisors to companies. Auditors would offer advice on accounting transactions and new ventures; auditors really knew the core business of their clients because they were involved in operational processes. The nearly "real-time" advice that auditors gave to clients enabled organizations to consult with them regarding complex accounting transactions.

"Some auditors have taken the position that continuous dialogue with registrants on accounting issues runs counter to the Securities and Exchange Commission's position that an accounting firm cannot be deemed independent with regard to auditing financial statements of a client if it has participated closely in maintenance of basic accounting records and preparation of financial statements, or if the firm performs other accounting services through which it participates with management in operational decisions" (Spinella, 2006).

Contracting of third-party auditors is a trend that is likely to continue. Organizations and their respective external auditors feel better having an objective third party to test controls, advise on processes and documentation, and alleviate fears about auditor-client independence. There is no question that organizations regard objective third-party advice to be valuable, and many are turning toward audit committees to provide oversight as well.

Audit Committees  

“In no small part, audit committees help to create the right environment for confident investing around the world. They do this by playing a substantial and growing role in matters of financial responsibility and accountability to shareholders, regulators and the business and government communities at large” (Lloyd, 2007).

Reasons for Increased Auditor Dependence  

Meeting financial reporting, testing, and compliance in the post SarbOx era has been tough on CFOs. The following points illustrate why companies are so anxious to disperse compliance risk by seeking advice of third-party auditors and audit committees (Banham, 2006).

• A material weakness (defined as a deficiency in an internal control) can result in a 4% drop in share price for a company.
• Sixty percent of finance chiefs at companies who reported materials weakness were replaced within 6 months.

Even with the dire consequences of bungled compliance and reporting, many companies feel like they have SarbOx 404 compliance under control.

“With Sarbanes-Oxley Act Section 404 compliance processes widely in place, many audit committees are refocusing on the issues they view as critical to the integrity of the company’s financial reporting process. Oversight of internal controls remains a top issue, as does risk management. But many audit committees have identified accounting judgments and estimates as their top priority, and they’re looking to the CFO to help them better understand this increasingly complex area of oversight” (Daly, 2007). Because of the failures and extreme costs of Section 404, a 2011 article called for Congress to amend the section to require the opinions of CEOs, CFOs, and external auditors on “the effectiveness of risk management processes” (Leech & Leech, 2011). The authors argue that “this legislative change will result in significantly more reliable financial statements, [will] reduce long-term Section 404 compliance costs, [will] better align with the new global regulatory focus on risk management and risk oversight and, most importantly, [will] restore global confidence in US corporate governance and capital markets” (Leech & Leech, 2011).

Auditor Responsibility  

Audit committee members are increasingly under pressure from responsibilities that are cited under section 204 of SarbOx. Some of the responsibilities include the following (Daly, 2007):

• The audit committee must review all critical accounting policies and practices with external auditor.
• The audit committee must review major issues and changes regarding accounting principals and financial presentations—per NY Stock Exchange listing standards (Sec. 303A, 07(c)).
• The audit committee must review analyses of management or external auditor regarding significant issues and judgments related to financial statements, including alternative GAAP methods.
• The audit committee has an obligation to exercise "duty of care," which requires staying informed of company matters, asking probing questions, and being actively engaged.

Management Accountability  

Because of their increased responsibilities, audit committees are demanding more accountability from management, especially the CFO and external auditors. Generally, audit committees are only somewhat satisfied that they are getting the information they need from management and auditors to fulfill their responsibilities. The rise in the number of financial restatements is driving audit committees to demand more and better information from management and external auditors.

As Daly reports, “Whatever the actual cause of restatements, the growing intolerance—by investors, regulators, and others—for management miscues has put a premium on `getting the numbers right’” (Daly, 2007).

Committee members acknowledge that their responsibility is to take a “deep dive” into vital issues regarding accounting. Audit committees are relying most heavily on CFOs to provide a greater level of understanding of critical accounting issues. While there are many points that CFOs can help audit committee members understand, the biggest opportunity is to increase the depth and frequency of communication between the CFO and the committee. It is critical that the CFO and the audit committee speak the same language, understand critical issues, and devote appropriate time to discussion of key points.

Auditing Risk  

Mazur reports that “Audit committee chairs are becoming more aware of risk as recent events have rocked the corporate world. When asked how they felt about the personal settlements by company directors in certain high profile cases, more than half polled said they were concerned. In addition, a vast majority (83 percent) noted that their risk as an audit committee chair has increased since the Sarbanes-Oxley Act was passed. Still, even with this growing concern, a majority of respondents did not believe it was either easier or harder to recruit audit committee members” (Mazur, 2007).

One cannot overstate the impact that the passage of Sarbanes-Oxley legislation has had on auditing services and corporate auditing committees. However, there is a growing call for audit committees to focus on broader risk management issues and their potential impact of the financial health of organizations. Audit committees will also benefit greatly from recruiting a younger and more diverse membership.

Issues

The Changing Focus of Audit Committees  

A 2006 Ernst & Young survey indicated some interesting facts about corporate audit committees. The top four reported risk issues were

• regulation and compliance.
• merger and acquisitions/divestitures.
• information technology.
• market dynamics.

Ironically, the same survey indicated that only 18% of respondents had established a risk committee. The majority of respondents indicated that their audit committees had the following standing committees—as required by their corporate boards (Koppes, 2007):

• compensation committee
• corporate governance committee
• nomination committee

Audit committees have long provided oversight and guidance to corporations, but with the passage of Sarbanes-Oxley legislation, the scope of responsibilities and the visibility of the audit committee have increased greatly. Global investor confidence relies on the work that audit committees do in an expanding landscape. Multinational corporations have an obligation to diversify their audit committees to look more like their customers and markets (younger and more diverse). An Ernst & Young survey in 2006 reported that more than 91% of audit committee members were age 50 years or older, more than one-half were between the ages of 61 and 70, and only 42% were employed full-time. "In response to the hot-house growth of global business, now—more than ever—it is time to think beyond the traditional resume when looking to strengthen the audit committee composition" (Lloyd, 2007).

Recommendations for changing the composition of the audit committee include the recruiting of younger members, global candidates, entrepreneurs, members with legal experience, women, and other diverse populations. Recruiting the correct committee mix is just one aspect of assembling a world-class auditing committee. Supporting audit committee members with in-house and continuing education is critical, according to a poll by the Audit Committee Institute. SEC reporting requirements make up just one example of the complex regulations that audit committee members are required to understand. Continuing education initiatives should include the following participants: management, internal and external auditors, corporate counsel, and outside experts—all of whom can help to educate committee members. On-boarding (new member orientation) is crucial for member success and retention (Daley, 2006).

Refocusing the Auditing Committee Agenda  

As organizations work toward the creation of more diverse auditing committees, there should also be a focus on more enterprise risk management. An Ernst & Young survey from 2006 reported that respondents thought that compliance issue distracted audit committee members from "other" critical risk issues. The majority of respondents to the Ernst & Young survey reported that only 20% of the typical audit committee agenda was devoted to risk. Risk management is uncharted territory for most audit committees, and committee chairs are aware that the topic of enterprise risk management must play a much larger role on audit committee agendas.

Enterprise Risk Management  

Lloyd states that “Whether scrutinizing financial statements or exploring the possible risk from a cross-border transaction, the work of audit committees is vital to the future success of the companies they serve, particularly as the competition for global market share intensifies” (Lloyd, 2007).

The experience that many companies have in managing financial risk through SarbOx regulations can be transferred to other risk management areas.

SarbOx disclosure has raised the expectations of stakeholders who want transparency in all areas of business reporting. Stakeholders are paying attention to how companies conduct their businesses, and their perception of an organization is critical (Nabel, 2007).

Enterprise risk management (ERM) can be defined as an organization's planned efforts to identify the myriad risks that exist as an organization conducts its business operations. Some common business risks include credit risks, market risks, product risks, and risks to reputation or brand. Managing enterprise risk is not about eliminating all risks—an impossible task. Instead, "Risk Intelligent Enterprises" (Deloitte, 2007) modify their overall strategic plans to include risks assessment and management.

Steps for Dealing with Risk  

The most effective steps for dealing with the inevitable risks of doing business are the following (Sammer, 2006):

• Understand key risks in an organization; this should be a comprehensive list.
• Measure the tolerance for the identified risk.
• Develop a process to manage the risk.
• Continuously update the risk profile.

It is critical to remember that some risk is inevitable and will occur. The ERM approach is designed to make risk more predictable and less volatile when it does occur. Organizations that understand key risks and have shared information with other functional areas will be better prepared to deal with risk. The more decentralized that business units are, and the more easily information flows through a company, will determine how quickly risk can be managed.

The faster pace of business has increased risk for many companies. Identifying stakeholders, their interests, and the "what ifs" of risk is an absolute necessity in managing enterprise-wide risk. Mapping out risks and the interdependencies and potential effects is really the key to ERM, but the assessment of risk impact is also a mission- critical part of the process.

"Many companies base their risk management program on the probability of certain negative events occurring. This approach is especially well-established in the internal audit profession and in the financial services and energy industries. Unfortunately, probability-based risk assessments do not always suffice. As a recent Deloitte Research study noted, major-value losses are often high-impact, low-likelihood events.

If senior management is biased toward mitigating high-impact, high-likelihood events, [an] internal audit should draw attention to and advocate for resources to address other events relevant to the business that could have a high negative impact if they do occur. Simply stated, if a risk is relevant to the business and is extremely high impact, it should be addressed, regardless of probability. This is particularly true of risks associated with value creation as they have higher uncertainty (such as the development and launch of new products)" (Deloitte, 2007).

Conclusion

Companies have been relying on external auditors to help meet Sarbanes-Oxley compliance mandates. Client-external auditor relationships are under scrutiny because of a renewed focus on objectivity and transparency in financial disclosure. Relationships with consulting (third-party) auditors provide companies with an additional set of objective (nonbiased) eyes for assessing business processes and internal controls. Financial restatements (reissuance of past financial statements) have become commonplace. Restatements can be costly for a company in terms of reputation and negative affects on stock prices. Company executives, anxious to avoid having to file a financial restatement, are relying on third-party auditors to serve as an additional line of defense in the process.

Auditing committees play an important role in managing relationships between independent auditors and management. They also provide objective oversight and guidance to an organization on a number of issues. The responsibilities of the audit committee continue to increase as accounting rules and regulations become more complex. Companies are reshaping the look of their audit committees by recruiting a younger and more diverse demographic mix. Audit committee members are spending more time per year in their oversight duties and will benefit from company-sponsored training and education. Audit committees will shift their focus from financial compliance to overall risk management in organizations. Enterprise risk management will include financial oversight, but that is only one aspect of a company's overall risk. Enterprise risk management is most effective when integrated into an organization's strategic plan—the overall goal being to help the organization achieve business objectives and improve business performance while planning and managing company-wide risk.

Terms & Concepts

Audit Committee: The committee established to monitor oversight of an institution's financial reporting process and enterprise risk.

Certified Public Accountant (CPA): Refers to individuals (accountants) in the United States who have successfully passed the Uniform Certified Public Accountant Examination and other requirements for CPA status. In most U.S. states, only licensed CPAs are allowed to contribute to the public attestation, including auditing opinions on financial statements.

Enterprise Risk: A management strategy focused on risk that includes static planning, operations management, and internal controls. This approach is adapting to satisfy the various needs of stakeholders who wish to comprehend the wide array of risks faced by complicated organizations to make sure that they are managed appropriately.

External Auditor: In the United States, CPAs are the only nongovernmental external-auditing entity allowed to conduct audits and attestations regarding an organization’s financial statements and submit public audit reports for review. This person is independent of the company that they are auditing.

Financial Restatement: The reissuance of a past financial statement because of some error or omission in reporting.

Inherent Risk: Inherent risk identifies the risk that already exists before one acts on it. In other words, this is the risk your company faces without any action you might take to change the probability or the effects of the risk.

Materials Weakness: Materials weakness refers to a situation where a company’s internal controls—established to avoid major financial statement irregularities—prove ineffective. If a failure of an internal control is considered a material weakness, it could result in a major material mistake in the company financial statements.

Restatements: Correction of a previously issued financial statement, usually because of an accounting irregularity or misrepresentation.

Registrant: A client or company that has established a relationship with an auditor for oversight of financial statements and reporting.

Residual Risk: The risk that remains after a company has tried to address the inherent risk. Residual risk is also referred to as “vulnerability” or “exposure.”

404 Compliance: Section 404 of the Sarbanes-Oxley Act of 2002 necessitates that publicly traded companies implement and uphold internal controls for the financial reporting process. ..ST. -Bibliography

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Deloitte (2007) The risk intelligent chief audit officer. Retrieved August 21, 2007, from http://www.deloitte.com/dtt/cda/doc/content/dtt_ERS_CAE031907.pdf

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Suggested Reading

Jackson, B., & Goodridge, E. (2005). New auditor? You're not the only one. American Banker, 170, 1-5. Retrieved August 21, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=16788713&site=ehost-live

Koppes, R. (2007). The growing role of the nominating/corporate governance committee. Corporate Governance Advisor, 15, 7-8. Retrieved August 21, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25039018&site=ehost-live

Landsberg, R. (2007). Understanding the role of a corporate compensation committee. Journal of Financial Service Professionals, 61, 22-23. Retrieved August 21, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25575972&site=ehost-live