Lesson 3 of 23
There are a number of accounting guidelines and standards known as the Generally Accepted Auditing Standards (GAAS). They give auditors the framework for planning and reporting an audit outcome. In 1972, the American Institute of Certified Public Accountants (AICPA) developed it. AICPA member auditors are currently required to adhere to 10 standards known as GAAS. Any audit or auditing technique used by auditors must follow GAAS.
Although the AICPA is an American organization, audit members come from many different nations.
They adhere to GAAS since it is required by the AICPA's code of professional conduct. We can assert that GAAS offers an international framework for auditing. It makes it easier for auditors to utilise it as a model for their auditing procedures. Further, norms are followed based on the country of audit, industry, and the audit body of that country.
According to the AICPA, an independent auditor must plan, conduct, and report the results of an audit in accordance with GAAS. These standards provide a scale to measure the quality of the audit and its objectives.
Auditors need to follow procedures to do the audit. These procedures must be done so that they comply with auditing standards.
According to GAAS, the 10 standards fall into three categories, general, field reporting and reporting standards.
This is the framework for an audit firm to ensure that its clients meet auditing standards
One of the foremost cases in which an auditing firm did not call out a client that was flouting GAAS is of the accounting firm Arthur Anderson and its client Enron.
GAAS standards are clear in terms of what standards must be met during an audit cycle, starting with the tests that must be conducted, and the extent and level at which these tests must be conducted. Auditors are also expected to function independently with no other business interest in their client.
Enron started a trading business to offset large debts it had incurred during a merger with Houston Natural Gas and Internorth. It traded in energy derivatives, with two executives Jeffery Skilling and Andrew Fastow to head and manage it.
Skilling used the mark-to-market technique in accounting for the energy trading business. In this method, outstanding derivatives and energy-related contracts in the balance sheet in a quarter must be adjusted for fair market value. The unrealized gains or losses must be booked for that period. Gas commodities' fair market values were difficult to ascertain, so the company could manipulate and assign values to it to show reduced debt in the balance sheet.
Fastow also used special purpose entities or SPEs for better ratings. SPEs allow partnerships with third parties and an increase in Return on Assets (ROA) and leverage without reporting debt in their financial statements. These entities are supposed to be evaluated by the auditor and termed risky or worthy. Fastow managed to hide the debt using these SPEs. Arthur Anderson failed to report these risky measures since they were earning non-audit fees, through consulting for Enron.
The legal documents against Anderson's personnel clearly show that auditor after auditor who was responsible for ensuring Enron followed the various accounting and financial reporting standards failed to do so. They ignored the red flags and signs of trouble. Their licenses were revoked or suspended for improper professional conduct. Anderson was found guilty of obstructing justice, and not following audit standards and procedures.
As a result of this debacle, companies that had used Arthur Anderson previously had to appoint new oversight committees and auditors to go over their past financial reports to verify their veracity.
The Government passed the Sarbanes Oxley Act, which has provisions that impact corporate governance, risk management, auditing, and financial reporting of public companies. It also has provisions to deter and punish companies that indulge in corporate accounting fraud and corruption.
It states that companies must reevaluate their internal audit procedures that must meet or exceed auditor standards. CEOs and CFOs are expected to know the company's financial workings and ensure that no fraud is occurring. They increased the net on the types of transactions that were to be reported, failing which large penalties would be imposed.
GAAS is an important code of accounting standards. Audit firms and their clients gain by following these standards. In case of gaps, they can evaluate how to fill them. Shareholders benefit since they can assess the true value of the business. If these standards are not maintained and followed, it will adversely impact the firm or in some cases end them. Conversely, following these standards allows companies to improve their processes and operations.