Auditing is defined by the American Accounting Association or AAA as “a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users” (cited in Turney et al p. 108). From that definition, it is evident that the auditing process consists of three elements: evidence collection and evaluation; comparison of collected evidence with established criteria and; results-sharing with interested parties. In obtaining evidence for auditing purposes, a systematic approach is taken. A well-planned, logical approach is vital so that important aspects of the process are not missed or bypassed. On the other hand, the rationale behind comparing assertions of a firm and control structure is to determine the authenticity of those assertions and whether they truly reflect its transactions.
Lastly, the most important aspect and end goal of the auditing process is to provide true and accurate information to interested parties, such as shareholders, creditors and investors, from which they will find basis in their future transactions and decisions involving the firm. The importance of the auditing process today, as defined above, cannot be argued against. It does not only ensure that firms keep track and control their financial activities, but it forms the rudimentary foundation of businesses and on a larger scale, the economy. Without the auditing process to ensure that the public put their trust on business entities and their activities, the economy will stagnate and perhaps eventually collapse.
THE HISTORY OF AUDITING PROCESS IN THE USA
To understand just how important the auditing process is, it is necessary to trace its origin to have some inkling on why it has gained so much prominence today. Historical accounts show that the auditing process did not originate in modern times, but was a product of early civilizations as far back as ancient Egypt, the Roman Empire and in the Middle Ages (Page 2000, p. 173). In the United States, however, the auditing process only started to flourish during the Industrial Revolution because of the explosion of business activities. It was the railroad companies that first heavily relied on the process to control and report costs and to keep operating expenses down. Furthermore, companies wanted to keep track of possibilities of fraud and determine the financial accountability of specific personnel. The participation of businesses in the stock market also added a new value for the auditing process and this was to keep investors abreast of the financial profiles of such companies (Byrnes et al 2012, p. 2).
It was only in 1929, however, that the process took on a compulsory character. In that year, the stock market crashed and among the changes brought by that event was the subsequent creation of the Securities and Exchange Commission by the Securities and Exchange Act of 1934. With the creation of SEC, the auditing process became an integral responsibility of publicly traded companies because of the requirement of submission of periodic financial reports. Public accounting firms were subsequently required to provide guarantees that reports were made using the generally accepted accounting principles (GAAP hereafter) (Byrnes et al 2012, p. 2). Nonetheless, the auditing process was generally backward and not very reliable in those times. Many aspects of the auditing process were conducted only in reaction to the happening of adverse events and much information were obtained only from management personnel rather than independently taken (Byrnes et al 2012, p. 2).
Even automated accounting, although already in existence in 1954, took flight only after Felix Kauffman published his book Electronic Data Processing and Auditing in 1961 and the Integrated Business Machine or IBM released its IBM 360 in 1963, which made computing more affordable. Nonetheless, the majority of auditors were still engaged in manual auditing until the Equity Funding scandal in 1973 and the Foreign Corrupt Practices Act (FCPA) was passed in 1977. In the first, Equity Funding committed fraud in falsely inflating its profits through the creation of bogus insurance policies, which constituted about 67% of the total balance in its ledger account. In the second, the law prohibited the bribing of foreign officials to obtain business. The consequence of both incidents was to strengthen the auditing process by shifting to computerized accounting and the imposition of more internal controls in the process.
These advances in the auditing system went through more refinement in the subsequent years, especially with advances in modern computing technologies (Byrnes et al 2012, p. 2). DISCUSSION: THE CRITICAL ROLE OF THE AUDITING PROCESS
In the early days, the audit process served valuable function to firms and private entities to ensure control of its finances and to keep tab of its own people’s financial transactions. Today, the auditing process has transcended firms’ private interests and into the sphere of public interest. It is no longer merely the business of companies or business entities, but of the public and today’s auditors are now playing a much larger role in society – the responsibility of providing true and accurate data of the finances of business entities upon which the public can truly rely on and upon which the economy of the nation depends upon. The absence of reliable data can, in the long run, cause the eventual collapse of the economy because the investing public will become untrusting and be forced either to hold back, which can result in economic stagnation, or to make erroneous decisions that do not promote economic advancement.
This is not to say, however, that the auditing process is not equally important to the existence of business entities aside from its being a regulatory obligation. The importance of the audit process is illustrated in cases of voluntary demand for auditing by firms that are not imposed compulsory obligation to submit audited reports by regulatory bodies. In Canada, for example, the legal obligation to submit audited financial reports by large private corporations was scrapped in 1996, yet 73% of private companies continued to employ the services of external auditors. It has been suggested that this scenario was not confined to Canada alone, but happened also in other parts of the world even in unregulated sectors and in international business communities. Wallace (2004) attributed to this unwavering demand for audit on the agency and information hypotheses. In the first, the role of the auditing process is seen as a form of monitoring or stewardship where independent audit is a manifestation of corporate governance. In the latter, voluntary demand for auditing is rationalized by the need of firms to be perceived as legitimate and reputable. Legitimacy and reputability are advantageous in the long run to business entities because of favorable returns in the form of capital providers. It has been the experienced of entities in six countries that opted to obtain the services of the Big 5 auditors, the five largest accountancy firms in the world, to obtain the lower interest costs. These countries include the UK, Italy, Spain, France, Australia and Germany (Wallace 2005, pp. 271-274).
The larger role of the auditing process, however, is reserved to its noble function of informing the public. Even the nation’s courts acknowledge the critical role that the auditing process plays in societal progress. In Couch v United States 409 U.S. 322 (1973), the Court refused to endow the firm-auditor relationship with a privilege nature and protection under the Fourth and Fifth Amendments on the ground that disclosure of information relevant for tax purposes, in the hands of an auditor, was a legal obligation the violation of which exposed him to criminal and civil sanctions. The Court stressed that it was unlawful for an auditor to assist a firm in falsifying its financial records. In that case, the appellant attempted to seek protection under a privileged relationship akin to that of client-attorney relationship to stop the IRS from enforcing its summons directed to her director to produce all books, records and relevant documents pertaining to the tax liability of the former.
Similarly, in United States v Arthur Young & Co 465 U.S. 805 (1984), the Court held that there was no parallelism between a client-lawyer relationship and client-auditor relationship that could give rise to a privilege relationship in the latter. In the case of a lawyer, it is his duty to present his client in the most favorable light to the court, but an auditor does not have the same function. Rather, the role that an auditor plays, according to the Court, is to show the real and actual financial status of his client, a function that can be characterized as a “public responsibility transcending any employment relationship with the client, and owes allegiance to the corporation’s creditors and stockholders, as well as to the investing public” (United States v Arthur Young ; Co 465 U.S. 805 (1984).
The importance of the auditing process has never been more highlighted when at the turn of century a spate of corporate scandals rocked the business world and as a consequence of which Congress enacted a law that would impact greatly on the auditing process and on auditing firms. Two of these scandals involved WorldCom and Enron. In the WorldCom scandal, its CEO was able to amass a vast fortune in the 1990s using his stock holdings from the company to finance his personal ventures. When WorldCom’s stocks decline in value, however, he obtained loans and guarantees from the company with the help of the Board of Directors. He was subsequently convicted of fraud and conspiracy after the federal government investigated the company’s accounting practices (Anand 2011). On the other hand, Enron, which had gained the reputation of being “America’s most innovative company” in the 1990s, collapsed as it declared bankruptcy in 2001.
It was revealed that the management with the help of its auditing firm had masterminded the concealment of the debt-ridden company to make it appear that it was financially sound and remains at the top of the corporate ladder. The culprits, including its auditing firm were charged and found guilty resulting in, among others, the closure of the auditing firm (Pavel ; Encontro 2012, pp. 1-5). As can be gleaned from these cases, the auditing process play a very important role in that, if done properly and without connivance with the culprits, such fraudulent activities could not have been made. Realizing this, Congress passed the Sabarnes-Oxley Act for the purpose of restoring public confidence in financial reporting which promptly evaporated with the billions of dollars lost as a consequence of these scandals. Among the innovations brought about by the law is the requirement on auditing firms to report on the effectiveness, or lack of it, of firms’ internal controls. CONCLUSION
The auditing process plays a very important role in sustaining the stability of the nation’s economy aside from the role it plays in the internal monitoring by a company of its financial activities. This is because the public normally relies only on true and accurate financial reports of companies and their financial activities to become participatory actors in the expansion of these businesses. A perception that the auditing process is doctored and the auditing firm is in cahoots with their clients and their fraudulent activities will shatter their trust and confidence leading to erroneous decisions, which can spell disaster in the long run on the nation’s economy. Realizing the importance of the auditing process, Congress has enacted laws, among them the Sabarnes-Oxley Act, to ensure that the auditing process in protected from activities that can mar its image in the public eye.
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