The Impact of Sarbanes Oxley on Auditing Essay

The Impact of Sarbanes Oxley on AuditingIntroduction            The 107th Congress (2002, 116 STAT. 747) defined the term audit as “an examination of the financial statements of any issuer by an independent public accounting firm in accordance with the rules of the Board or the Commission (or, for the period preceding the adoption of applicable rules of the Board under section 103, in accordance with then-applicable generally accepted auditing and related standards for such purposes), for the purpose of expressing an opinion on such statements.” The Sarbanes-Oxley Act of 2002 was created to address the high rate of failure by publicized businesses, restatement of financial statements and the corporate improprieties. The act requires the management to be responsible for the ensuring adequate internal control measures are in operation within the organization. The auditors should report about the effectiveness of the internal controls during the annual audit reporting (McConnell, and Banks, pp. 1).

            The Sarbanes-Oxley audit laws have brought about many changes to both the auditors and their clients. Auditors will be required to certify the system of internal controls of any company according to the new laws. Some common audit strategies will be abolished after the implementation of the law. The implementation of these new rules will create additional costs to the management (McConnell and Banks, pp. 1-7).  According to Small, Ionici and Hong Zhu, (2007, pp. 1) “the objective of the law was to make financial reporting more transparent and executives more accountable, changes that were ultimately planned to restore investors’ confidence in financial markets and enhance corporate governance.

“The various accounting scandalsEnron scandalThe Enron Scandal was disclosed in 2001. It involved the Enron Corporation of US. The headquarters of the company are located in Houston, Texas and is involved in the provision of energy. The scandal led to the bankruptcy of the company as well as the dissolution of Arthur Anderson, an auditing firm. Arthur Anderson was one of the largest auditing and accounting firms in the country before the scandal happened. It is one of the largest audit failures in the history of American auditing (Fezler and Lashinsky, para. 1-12).            Kenneth Lay founded the company bin 1985 as a merger between Houston Natural Gas and the InterNorth Company.

During the presidency of Jeffrey Skilling the employees used loopholes in accounting, special purpose entities as well as preparation of poor financial reports. The staff of the company was involved in activities of hiding billions of debts from deals and projects which failed. Andrew Fastow, the Chief Financial Officer of the company by then, among other executives misled the board of directors as well as the audit committee about taking high risks in accounting. They pressured Arthur Anderson to ignore the high risk activities conducted by the company (Healy, and Palepu, pp. 13).            In 2000 the price of stock for the Enron was US $90 per share but during the following year the shares were traded at less than $1 billion. The shareholders lost almost $11 billion in the scandal. Securities and Exchange Commission of the United States started investigating the scandal.

Dynergy Inc proposed purchasing the company and Enron had no option but to file for bankruptcy in 2001. Most of the executives of the company were arraigned in court and sentenced to court. The US District Court ruled that Arthur Anderson was guilty of professional offences and misconduct but the company became bankrupt before the ruling was made. The employees and shareholders of the company lost most of their benefits and after the lawsuit a few returns, pensions and stock prices were recovered (Fezler and Lashinsky, para.

1-12).WorldComWorldCom was a telecommunications company based in US and had its headquarters based in Clinton, Mississippi and moved to Virginia afterwards. The company was established in 1983 as Long Distance Discount services, Inc. (LDDS) in Hattiesburg, Mississippi. WorldCom Company emerged as a merger of several companies.

The company was affected by financial scandals in the early 2000s and was afterwards declared bankrupt. Verizon Communications purchased WorldCom after it collapsed. WorldCom dominated the US telecommunications market for a long period of time. It was the second largest company in the industry after AT&T.

the company expanded its operations by acquiring many other small companies, for example, MCI Communications, Tier 1 ISP UUNET (Jeter, pp. 128).            In 2000 WorldCom encountered accounting scandals. Bernard Ebbers, the CEO of the company borrowed excess loans from the company to finance his businesses. In 2001 he persuaded the board of directors to provide him with loan in excess of $400 million to fund his margin calls.

The strategy to repay the loan failed an Ebbers was ousted as the president of the company and John Sidgmore replaced him in 2002. The company was involved in another scandal in 1999 where the management adopted poor accounting practices. During this period Ebbers was the president of the company while Scott Sullivan was the chief finance officer. David Myers was the acting financial controller while Buford Yates was the Director of General Accounting. To conceal the declining financial status of the company; these directors used fraudulent accounting methods.

They provided false information about the increasing financial growth of the company as well as high profitability to raise the stock price of the shares of the company (Malik, pp. 291).            The fraud was done by reporting low line costs. The finance officers capitalized these expenses instead of expensing them properly on the balance sheet. The revenues were inflated by the use of revenue accounts which had not been allocated. In 2002 a team of internal auditors secretly worked by investigating the fraudulence of $3.8 billion from the company.

The board of directors and the audit committee were informed of the fraud. To solve the problem Sullivan was retrenched while Myers resigned. Arthur Anderson, the external auditor of the WorldCom by then, acted by withdrawing its audit opinion for 2001.

On 26th June, 2002 the Securities and Exchange Commission of US started investigating the fraudulence activities of the executives of the company. The commission found out that the assets of the company had been inflated by approximate $11 billion (Malik, pp. 219-238).            WorldCom filed for Chapter 11 bankruptcy protection on 21st July 2002. This was the largest bankruptcy filing in the history of United States. The executives of the company were arraigned at the US Federal Bankruptcy Judge Arthur J. Gonzalez. The company was converted into the MCI; Inc.

it relocated its headquarters from Clinton, Mississippi to Dulles, Virginia in 2003. WorldCom paid the Securities and Exchange Commission of US an amount of $750 million under the agreement for bankruptcy reorganization. This was the amount which had been budgeted to be paid to the wronged investors of the former company (Jeter, pp. 123).TycoTyco International Ltd is a Switzerland company that diversifies in the manufacture of different products and operates globally. In the United States the company has its headquarters located in Princeton, New Jersey.

The company operates five lines of business segments: ADT Worldwide, Fire Protection Services, Safety Products, Flow Control and Electrical and Metal Products. In 2007 the company was divided into three separate companies: Covidien Ltd, Tyco Electronics and Tyco Engineered Products & Services. Tyco was established by Arthur J. Rosenberg in 1960 (Tyco International, Ltd. Pp. 1-20).            The corporate scandal of 2002 involved Dennis Kozlowski, the former Chairman and CEO of the company and Mark H.

Swartz, the chief financial officer. More than $150 million were lost from the company during the scandal. In defense to the allegations leveled against them, the two executives claimed that the board of directors had authorized the transactions as compensation.

After a long court process, Kozlowski and Swartz were sentenced for a minimum of eight years and four months to a maximum of 25 years. 2007 Tyco agreed before the New Hampshire Federal District Court Judge to repay $75 million to the shareholders of the company (Tyco International, Ltd. Pp. 1-20).AdelphiaAdelphia Communications Corporation was the largest cable providing company based in US but went bankrupt in 2002. The headquarters the company were located in Coudersport, Pennsylvania.

Internal corruption affected the accounting and auditing systems of the company causing huge losses to the company. John Rigas established the company in 1952 in Coudersport. After the bankruptcy of the company the assets of the company were purchased by Time Warner Cable and Comcast in 2006. The business for long-distance telephone was acquired by Pioneer Telephone for approximately $1.2 million. More than 110,000 customers were sold to the Pioneer Telephone. Creditors of the company lost about $150 million dollars (Smith and Walter, pp. 323).

            The scandal of the company involved $2.3 billion in off-balance-sheet debt. Rigas used complex systems for managing the funds of the company and spread money to several family businesses. He also did financial malpractices by allowing the family entities to steal more than $100 million from the company. Michael Mulcahey, the former assistant treasurer, was blamed for all the financial problems facing the company. John Rigas and Timothy Rigas were charged of criminal offences and sentenced for 15 years (John) and 20 years (Timothy). Another son to Rigas, Michael, was accused of fraudulence in 2005.

He was the former executive deputy president for operations in the company and was found guilty of wire fraudulence. Most of the officers arraigned in court were members from Rigas family. The company had given most of the executive posts to family members and this affected the ability of the auditors of the company carry out their work efficiently (Smith and Walter, pp. 321).How these cases propel the US government to pass the Sarbanes lawThe US government reacted to the financial scandals by establishing the Sarbanes-Oxley laws to protect the interest of the stakeholders who were being affected by the increasing frauds in the country.

The systems of internal controls in companies were becoming weak and the auditing activities were presenting financial information which never indicated the true and fair value of the financial state of the companies. The executives (management) could conduct fraudulence activities since they were under no legal obligation to protect the interest of the shareholders of the companies they were working with (McConnell and Banks, pp. 1-7).            The establishment of the new laws would ensure that the management was responsible and that the systems of internal controls were operational. In 2002 major companies were experiencing bankruptcy due to poor financial management and lack of adequate internal controls. The professionals in accounting and auditing had misused their mandate and this resulted into large-scale business losses.

In the history of US, the country experienced the largest bankruptcy filings from WorldCom and Enron. May lawsuits had been placed by the stakeholders of various companies concerning poor financial and auditing practices. Huge losses were being reported by several companies leading to a major concern by the Federal government (McConnell and Banks, pp. 1-7).            The scandals involving Adelphia caused the federal government establish laws to protect the independence of the auditors. The company collapsed due to over reliance on family members.

Most of the executive activities were being conducted by the people from the Rigas family. This strategy affected the independence of the auditors. The application of internal controls was affected since the management had no power to establish strong internal control systems. To ensure that auditors are accurate and carry out their work efficiently; the federal government required the auditors’ independence be given priority. The Sarbanes-Oxley laws required that the auditor be independent so that he can establish the effectiveness of internal controls (McConnell and Banks, pp. 1-7; Smith and Walter, pp.

321).How the Sarbanes affect the audit world and what the outlook is for the future in terms of audit            The new audit approach has discarded some auditing practices. In the past auditors did substantive procedures rather than testing the controls in the companies they are auditing or they could use the two strategies together.

They could also rotate the auditing approach by alternating the testing of controls with substantive procedures with other systems. The system of cycle rotation of the auditing procedures is no longer accepted when auditing the financial statements of the public companies. The auditors are now required to report the effectiveness of the management in implementing the internal controls in a company (McConnell and Banks, pp. 3).

            The use of preventive controls was also abolished by the new laws. Preventive controls ensure the transactions are authorized and recorded by the appropriate persons in the organization. The use of detective controls was encouraged by the new laws. These controls reveal the problems after fact and the main focus is on the amount of transactions checked. This system is only acceptable where the systems of internal controls are sufficient enough. The auditors have an obligation of conducting sufficient tests about the efficiency of internal controls before relying on the information from the internal auditors.

The auditors will have to conduct the testing of both preventive and detective controls (McConnell and Banks, pp. 3).            The internal auditors are required to ensure that the internal control systems are operational and that the management is efficient in the application of the controls. The external auditors can only rely on the internal control systems after acknowledging the efficiency of the internal auditors.

The independence of the internal auditors should be determined by the external auditors before using the internal information. More evidence about how effective the internal controls are will have to be conducted. Auditors will be required to carry out substantive procedures to determine how material the transactions are compared to the financial status of the company they are auditing. This is important even if the auditor will have realized no significant weakness in the system of internal controls (McConnell and Banks, pp. 3).

            The Sarbanes-Oxley laws would establish changes in the auditing activities as well as the management of the companies the audit. Auditors will be required to certify the efficiency of the internal controls in a company. The management of all companies in the country would finance all the costs of implementing the new rules brought about by the Act. There will be changes in the auditing process since the auditors will not only be required to express an opinion on the financial statements but will also be required to report on the efficiency of the internal control systems of the companies they are auditing (McConnell and Banks, pp. 1-7).            Auditors will be required to assess the internal control system and the effectiveness of the management to apply them.

This will be made possible by the use of the Public Company Accounting Oversight Board issues and adopts provided by the Sarbanes-Oxley Act. It will be the obligation of the auditor to involve the management in the identification, documentation and evaluation of significant internal controls. The auditors will also be required to advise the management of the companies they audit to assess how effective the internal controls are before the auditing period. The process will take a lot of time and the management need to prepare themselves early enough to ensure all aspects are captured. Appropriate evaluation of the business will be required to determine the business units to be included in the process of evaluating the internal controls. To avoid risking the objective of auditing, the auditors should not be involved in the process of evaluating the internal controls.

The conclusion about the effectiveness of the internal controls will not be assessed by the management. It is the responsibility of the auditor to determine how effective the internal controls of a company are (McConnell and Banks, pp. 1-7).ConclusionThe management of any company has a legal obligation to ensure all the accounting and auditing procedures are conducted according to the professional standards.

  The system of internal controls should be strong enough to ensure the financial statements reflect the true and fair value of the organizational transactions. After several auditing and accounting scandals affected big companies in US during the late 1990s and the early 2000s the Federal government established the Sarbanes-Oxley law to control the auditing practices. The increase in fraudulence in US by the financial accountants and auditors forced the federal government enact laws to ensure that the systems of internal controls were operating efficiently. The failure and bankruptcy of major companies in the countries caused a lot of concern about the effectiveness of the internal controls.

The emphasis of the new Sarbanes-Oxley laws is on the maintenance of internal control systems in an organization. The old system of accounting never emphasized on internal control systems. The management is required to ensure the efficiency of the internal control systems. The internal auditors should advice the management about the appropriate controls to ensure the financial statements meet the international standards.Work citedFezler, Donna and Lashinsky, Adam. THE ENRON SCANDAL.

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“The Fall of Enron” (PDF). Journal of Economic Perspectives. (Spring 2003); vol. 17 (2): 3.

<http://www-personal.umich.edu/~kathrynd/JEP.FallofEnron.pdf. Retrieved 2009-08-04.

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Malik, Om. Broadbandits. Wiley. 2003. ISBN 0-471-43405-1.McConnell, Donald k. and Banks, George Y.  “How Sarbanes-Oxley will change the Audit process.

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and Walter, Ingo. Governing the Modern Corporation: Capital Markets, Corporate Control and Economic Performance. Oxford University Press, 2006Tyco International, Ltd. Tyco International News, Reports, Presentations and Web casts. Tyco International, Ltd.

2004-2010. Retrieved 29th April 2010 from;<http://www.tyco.com/.>107th Congress “An Act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.” Public Law 107–204. July 30, 2002.<http://www.sec.gov/about/laws/soa2002.pdf.>