How The Sarbanes-Oxley Act Will Impact The Audit Function

Before the Enron-Arthur Anderson scandal, auditors were generally viewed as independent and trustworthy professionals. They protected the interests of the individual investor by ensuring that corporations presented financial statements that accurately reflected the financial results of operations. The auditor was trusted to present the facts as he saw it, regardless of the implications. When events such as the academy awards used the services of a CPA, it was done not because the counting of ballots was a technically difficult task, but because people believed CPA's could be trusted. The recent problems encountered by many of the nations top accounting firms "has taken something important from all accountants: the assurance that practicing or teaching others to practice accounting is an honorable way to spend one's life (Williams 2003)."

The traditional audit involved many time consuming practices that increased the likelihood of detecting fraud, such as site visits to multiple locations, observation of assets, and random sampling of non-material levels. Also, the audit was closely supervised by senior partners who thought their firm's integrity was at stake at every engagement. However, as the revenues from consulting services grew, the audit function became merely a part of a package which accounting firms offered in conjunction with the more lucrative consulting services. As the financial rewards from audits diminished so did the scope and depth of procedures performed. Audits, in recent years, have been reduced to computer based test controls and statistical modeling. Another development is that junior accountants are often assigned the crucial oversight roles that were traditionally filled by senior partners who are now too busy selling to prospective clients (Frieswick, 2003).

While many view the Arthur Anderson scandal as the classic case of the deterioration of the audit function, there are other cases which demonstrate the predictability and inadequacy of the audit processes employed by many of the top accounting firms. One such case involves healthcare provider HealthSouth Corporation. HealthSouth and its former CEO Richard Scrushy orchestrated a scheme to overstate their earnings in order to meet the earnings estimates of financial analysts. Between 1999 and 2002 the company overstated income by $1.4 billion. This was done by making false journal entries that overstated the amount of third party insurance reimbursement, and by decreasing expenses. HealthSouth was able to avoid detection by its auditors Ernst & Young LLP by using the auditor's own process against it. Executives increased earnings not by booking revenues directly which auditors would have almost certainly have found, but by reducing a revenue-allowance account which was netted against revenues. These amounts were based on estimates, had very little paper trail, and was difficult to verify. HealthSouth executives also knew that Ernst &Young did not question fixed assets additions below a certain dollar amount, so random entries were made to its balance sheet for fictitious assets worth less than that threshold amount. Senior accounting personnel also created false documents to support these false purchases. This allowed the company to overstate fixed assets by $800 million (Frieswick, 2003).

There have been numerous attempts over the years to improve the audit process. Studies conduced by the Treadway Commission in 1987, the Jenkins Committee in 1994, and the Panel on Audit Effectiveness of the Public Oversight Board (POB) in 2000, issued reports recommending changes in audit procedures. The 2000 POB study, considered the most comprehensive study of the profession ever done, recommended the use of forensic techniques in every audit, and suggested the insertion of the element of surprise into audits. The study also advised auditors to assume the possibility of dishonesty at various levels of management including, collusion, override of internal control, and falsification of documents. The American Institute of Certified Public Accountants (AICPA) always vowed to enact sweeping changes after each of advisory, however, the AICPA's recommendations always fell short of advising its members to view client financial statements skeptically, and conduct audits accordingly (Frieswick, 2003).

After the flood of financial scandals, congress felt it had to move quickly to restore confidence in the financial markets. The result was the Sarbanes-Oxley Act of 2002, the most significant federal legislation in the securities area since the 1930's. The new law places significant burdens on auditors and executives who are required to make specific certifications and representations about the internal controls of public companies. The Act requires auditors to test the scope of a firm's internal control procedures and present its findings in its annual audit report. This audit report must include an evaluation of whether the internal controls provide a system of maintaining records that accurately reflect the firm's transactions, and reasonable assurance that transactions are recorded in accordance with GAAP principles. The audit report must also give a description of any material noncompliance, and any material weaknesses in the internal controls. The Act also requires the CFO and CEO of the company being audited to certify that they are responsible for establishing and maintaining internal controls; have designed the internal controls to enable them to obtain all material financial information; have evaluated the effectiveness of internal controls; and have presented their conclusions about the effectiveness of the internal controls in the report (Bloch, 2003). If an auditor is asked by a client to be involved in its evaluation of internal controls, the auditor should make sure that nothing is done to impair the appearance of objectivity and independence. The auditor may help in the gathering and preparation information as long as management directs the entire process, and is responsible for documenting controls. In order to ensure a consistent and comprehensive companywide process, auditors are recommending that their clients establish project teams that report directly to the CEO or CFO (McConnell, Banks, 2003).

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As a result of the Sarbanes-Oxley Act, a variety of methods used by auditors in the past to enhance audit efficiency and effectiveness will no longer be acceptable for integrated audits of public companies. Auditors sometimes used cycle rotation to test controls, this involved testing of controls in several areas of a firm's transaction cycles while doing a transaction walk-through to confirm the absence of control changes in the remaining cycles. This practice will no longer be acceptable in public company audits,