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The risks auditors face


Q1. Discuss the risks auditors face when considering management earnings management practices?

            To Nelson (2009, p22), the extent to which earnings in the company are manipulated has long been of interest to researchers, legislators, analysts, and other investment professionals. Earnings management occurs when auditors or the management use financial reports to mislead some stakeholders about the underlying performance of the company or influence the contractual outcomes, which depend on the financial results. It is crucial to note that, earnings management is a manipulation of the firm’s earning, which may put the company and its auditors in risk. Although earning management may create a good image of how the company is prospering and making profits, the auditors may face the risk in their operational activities when the company collapses and makes losses that cannot be manipulated. The information provided may ruin the company’s image and reputation and discourages many investors in the future. It is important to note that, the stock market usually relies on the information provided by the auditors.  This means that investors may invest more when auditors create figures that shows the company is making profits.  Despite meeting the expectations of investors, the company may encounter higher losses, which would deteriorate the stability of the company.

            According to Satava, Caldwell & Richards (2006, p274), it is an established duty of the auditors to protect the shareholders’ interests and the management of the company. Due to the importance and increasing role placed on protecting the shareholders’ interests, auditors are placed on the risk of giving information that encourages investors to invest more. For instance, if the company did not perform as intended in the prior year, the auditors may bring in some of the expenses that the company had to meet. In so doing, shareholders may be prevented from stress that emerge when a company collapses. In most cases, companies engang in such practices only if that is their last option and choice. It is important to note that, most shareholders and investors want to know the forecast the financial side of the company before they invest or become part of the company. Investors and shareholders invest in successful and profitable firms. With this in mind, auditors face the risk of making the financial analyzes look good and strong to the shareholders and investors. Auditors opt for earning management and practices because they want to stay in their profession and they expect their company to have a good reputation of succeeding in the marketplace.

            The auditors face the risk of considering earning management when the company does not have to show its earnings and operations to the government or stakeholders. In such cases, the company may force its auditors us this tool to attain its goals and performance plan. The company may opt for this plan if they want to avoid paying tax to the government. Despite the reasons that make the company and its auditors to engage in such activities, it is crucial to note that earning management may affect the company’s image and reputation. Enron Company is the most popular example of a company that disclosed its financial practices, and eventually the company ruined its image and reputation (Maijoor & Vanstraelen 2012, p115).

Q2. List and explain the top 10 audit deficiencies.

            During the period of 1987-1997, an analysis of the top 10 audit deficiencies was conducted (Carcello, Bedard & Hermanson 2009, p69). Initially, the research involved 56 cases. Nevertheless, 11 of these cases involved a bogus audit while the remaining 45 cases were alleged deficiencies by the SEC. All of these were from public companies, most which engaged in fraud accounts. Only a few of the public companies engaged in stealing or misappropriation of assets. The top 10 alleged deficiencies as claimed by the SEC are listed in the table below.

Top Ten Deficiencies claimed by the SEC from 1987 to 1997

Problem areasPercentage (Number of cases)
Gathering sufficient Audit evidence80% (36 cases)
Exercising due professional care71% (32)
Demonstrating a high level of professional skepticism60% (27)
Interpreting or applying the requirements of GAAP49% (22)
Designing audit programs and planning engagements (Inherent risk issues, nonroutine transactions).44% (20)
Using inquiry as the form of evidence (relying too much on the method)40% (18)
Obtaining adequate facts and evidence related to the assessment of significant management estimates ( Failing to gather adequate evidence)36% (16)
Confirming accounts receivable29% (13)
Disclosing/recognizing key related parties27% (12)
Relying too much on internal control (relying too much/ failing to react to detected control weaknesses)24% (11)

As noted by Beasley, Carcello, and Hermanson, 2001, Top 10 Audit Deficiencies, Retrieved from http://www.journalofaccountancy.com/Issues/2001/Apr/Top10AuditDeficiencies.htm

            As shown in the above table, the most common problem was the auditor failure to gather adequate audit evidence that amounts to 80% and 36 cases. Most of these cases involved insufficient evidence in areas such as management representations, asset ownership, and asset valuation. In over 50% of these cases, the SEC claimed that auditors failed to utilize or else apply GAAP pronouncements or utilized them incorrectly.In response to this, the SEC alleged that one way companies can deal with this issue is to expand their knowledge on accounting through training. In 44 of these cases, the SEC alleged that the auditors failed to assess the inherent risk and alter the audit program accordingly. In this regard, the best approach for a firm to fix this deficiency is to advocate for more involvement of audit firm executives, managers, and partners in planning the engagement of assessing audit program. Other noted audit programs included failure to exercise a high level of professional skepticism,  and failure to recognize transactions. Another common deficiency in 27% of cases was deficient in confirming the received accounts and problems in receiving and sending confirmation requests such as failing to confirm the confirmation received via tax. In such cases, the auditor was unaware of the party involved in the transaction or lacked adequate evidence of the transaction involved.  

            Based on deficiencies found, there are a number of solutions that SEC found. AS mentioned, the three most common deficiencies affecting most auditors were failure to gather adequate information, lack of competent evidence of transactions taking place, and lack of professional skepticism. In most cases, the best remedy so such issues is for auditors to design and execute quality control system that creates a culture that encourages the audit team to maintain an acceptable level of performance. It is also important to encourage the audit team to maintain a high level of professionalism that protects the public interests and promote strong capital markets (Spalding 2012, p10).

Q3. Why would they be supporting a principle based system? Explain and discuss.

            Where it comes to accounting standards, there have been debates on whether the rules or principles are better. Some people argue that rules are better at governing accounting practices while others argue that the principles are better. To fully understand the article placed by PricewaterhouseCoopers on the importance of supporting the principles based accounting, it is crucial to understand the guidelines that govern the rule-based accounting standards. Although rule based accounting standards have advantages such as providing accurate applications and reduction of fraud risk, it includes a regimented approach where a company must conduct its transactions in accordance with the rule even if it is misleading. With this in mind, PricewaterhouseCoopers advert supported the principle based accounting system on the basis that it allows companies to consider the best approach to account and report their transaction. It also creates a strong platform for the company to defend its financial transactions and systems based on the principles that govern accounting. The major advantage of principle-based accounting is the fact it can be applied in numerous situations because it’s based on principles (Martin 2007, p5).

            A major concern arising from the U.S current business scandals is that the accounting standards have become rule-based. The accounting details are filled with specific details  that addresses many contingencies that emerge in the accounting field. As a result, this has made principles based system more complex in that it allows firms to structure transactions based on set principles. Despite many people criticizing the principle-based standards, it is undeniable that most accounting firm leaders are moving toward the principle-based standards in that this approach is more likely to enhance a true economic substance. The rule-based system is a problem because those who comply with rules they are not always sure about why they do what they do (Ali, 2013).   

            PricewaterhouseCoopers supports the principle-based accounting in that it offers a conceptual framework for accountants to follow instead of detailed documented rules. In the principle-based approach, one starts with understanding the key goals and objectives of good reporting and further provides adequate guidelines explaining the objectives with common examples. The principle based accounting system creates a strong platform for accountants to apply their professional judgment when assessing the transactions. This approach is different from the rule based system in that, the latter provide rules that every member should abide to without questioning or thinking about them. However, the principle based standards allows members to articulate what the detailed principles mean and how they enhance a smooth running of financial transactions.

            The use of the principle based standards may provide accurate accounting statements in that an increase of these principles reduces manipulation and chances of committing fraud.  Unlike rule-based system, principle-based standards are flexible to accommodate for future development of accounting in the marketplace. With this in mind, one would argue that principles based standards are easier to comply than rules. Lastly, the PricewaterhouseCoopers would be supporting the principle based system because it does not create a room where the auditors or else accountants can ask where in the rule does it say not to do a certain act. In this context, principle based system lays a strong platform where every individual can understand the importance of abiding to set principles governing accounting practices (Martin 2007, p5).

Q4. How should an auditor feel if a client collapses after a ‘clean’ audit report? Discuss

            In most cases, the auditors are faced with the challenge of whether to give a clean audit report or inappropriate information. To fully answer this question,  it is important to note that, if auditors compiled all financial transactions accurately and properly, then there would be transparency. However, human being nature demands the need to protect one’s image and reputation. With this aspect, many auditors are found with the urge to give wrong information about their auditing job and report. In this case, we shall discuss how an auditor should feel when he gives clean auditing data to his client. First, the auditor should feel good that he or she has compiled with the ethics of accounting. An auditor should understand that he has the continuing duty of maintaining professional competence and knowledge to ensure that the employer or client receive accurate services based on the current developments in legislation, practice, and techniques (Nelson 2009, p30).

            Secondly, the auditor should feel right giving the clean information as this dictates his professional behavior. Ethically, auditors are obliged to comply with relevant regulations and laws that help them avoid any action that does not sustain honesty and integrity. It is crucial to note that, honest is the core value of the code of ethics for auditors. Auditors have the obligation to adhere to standards of truthfulness, candidness, fairness, and honesty in their course of their duties and responsibilities. The conduct of the auditors should be to present accurate information as it is regardless the consequences. Giving the client the right information would be helpful, but the auditor could look for ways to show his or her competency. For instance, in the picture attached in the instruction, the auditor would have to give additional information of how he has improved in his skills and competence. Having been an Enron’s team that experienced tremendous loss because of poor auditing, there would be a need for the auditor to show how his skills are exceptional and why he should be considered for the job position. For instance, he would mention of how he has improved his skills through attending various seminars and conferences. He would also mention to have been among the few auditors that provided appropriate information to Enron’s financial performance (Maijoor & Vanstraelen 2012, p115).


Ali, A. 2013, “Events of Importance in External Auditing in Malaysia, 1957-1997a”, International Journal of Business and Social Science, vol. 4, no. 17.

Carcello, and Hermanson, 2001, Top 10 Audit Deficiencies,

Carcello, J.V., Bedard, J.C. & Hermanson, D.R. 2009, “Responses of the American Accounting Association’s Tracking Team to the Recommendations of the Advisory Committee on the Auditing Profession”, Accounting Horizons, vol. 23, no. 1, pp. 69-84.

Maijoor, S. & Vanstraelen, A. 2012, “”Research Opportunities in Auditing in the EU,” Revisited”, Auditing, vol. 31, no. 1, pp. 115-126.

Martin, R.D. 2007, “Through the Ethics Looking Glass: Another View of the World of Auditors and Ethics”, Journal of Business Ethics, vol. 70, no. 1, pp. 5.

Nelson, M.W. 2009, “A Model and Literature Review of Professional Skepticism in Auditing”, Auditing, vol. 28, no. 2, pp. 1-34.

Satava, D., Caldwell, C. & Richards, L. 2006, “Ethics and the Auditing Culture: Rethinking the Foundation of Accounting and Auditing”, Journal of Business Ethics, vol. 64, no. 3, pp. 271-284.

Spalding,Albert D.,,Jr 2012, “Auditing Due Diligence In Law And Ethics: The Ponzi “Feeder Fund” CASES”, Review of Business & Finance Case Studies, vol. 3, no. 1, pp. 1-12.

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