UAS : Etika bisnis & Profesi

Nama : Imaculada Maia Nahak

Nim : 17013006

Chapter Seven

The Auditing Function

"In January 2007, " KPMG and New Century ’ s own accountants

stunned the company ’ s board by revealing that the lender had
incorrectly calculated the reserves for troubled home loans. That
mistake was likely to cost New Century $300 million, wiping out profi
ts from the second half of 2006. "A week later, New Century announced
it would restate fi nancials from the fi rst three quarters of 2006. " The
market reaction to New Century ’ s announcement was swift, and its
stock price dropped signifi cantly at the news.
This declaration placed additional fi nancial pressure on the beleaguered
mortgage lender, and on March 8, New Century stated that it had
stopped accepting new loan applications. New York Stock Exchange
delisted New Century Financial Corporation, and on April 2, only 2
months after the restatement announcement, New Century fi led for
bankruptcy protection. New Century ’ s growth trajectory mirrored the
growth of the subprime loan industry in the United States. New Century
retained KPMG as the company ’ s auditor from its inception in 1995
until April 2007 when KPMG resigned.
KPMG had several different engagement partners, with varying degrees
of experience in the mortgage industry, heading the New Century
account over the years. New Century ’ s loan purchase agreement
required them to repurchase the loans if they suffered an early payment
default, it was found that New Century had misrepresented their
loans, or if there was borrower fraud. The problem, according to the
examiner ’ s report, was that New Century calculated the repurchase
reserve incorrectly.

Century had engaged in earnings management or manipulation, or

that
" Had KPMG conducted its audits and reviews prudently and in
accordance with professional standards, the misstatements included in
New Century ’ s fi nancial statements would have been detected long
before February 2007. The engagement team ’ s lack of experience was
compounded by the fact that New Century ’ s accounting function was
weak and led by a domineering and diffi cult controller.

Century
Although KPMG may not have created New Century ’ s
problems, many claim that it turned a blind eye to what could be
considered reckless and irresponsible business practices. More
egregiously, KPMG continued to do so even when its own experts
challenged New Century ’ s accounting practices.
The case of KPMG and New Century is only one example of the serious
ethical pressures in the accounting profession today – risks and dangers
to the integrity of the accounting practice created by confl icts of interest
and the necessity to survive in a competitive market. "If accounting is
the language of business, it is the auditor ’ s job to ensure that the
language is used properly to communicate relevant information
accurately – " to see whether the company ’ s estimates are based on
formulas that seem reasonable in the light of whatever evidence is
available and that formulas chosen are applied consistently from year to
year. " " 12 The lawsuits fi led against KPMG in the matter of New
Century Financial allege that the audit team failed to fulfi ll this
obligation.

 I The Ethics of Public Accounting

Auditing the fi nancial statements of publicly owned companies is not

the only role of an accountant, but in the current economic system, it is
certainly one of the most important.
Indeed independence is at integrity ’ s very core. And, for more than a
century, the responsibility for the independent oversight of corporate fi
nancial statements has fallen to America ’ s public accounting
profession. It is the auditor ’ s stamp on a fi nancial statement that gives
it its validity, its respect, and its acceptability by investors. And only if
the auditor ’ s work is comprehensive, skeptical, inquisitive, and
rigorous, can we have confi dence that fi nancial statements speak the
truth.
«As Bogle notes, a free market economy needs to base transactions and
decisions on truthful and accurate information. » In market
transactions, a company ’ s fi nancial status is vital information on
which a decision to purchase is based. The role of the auditor is to attest
to the accuracy of the company ’ s fi nancial picture presented to
whatever user needs to make a decision on the basis of that picture. This
function and responsibility is not new.
It has recently come to the public ’ s attention, however, with the
eruption of the numerous accounting scandals that shocked
investors, regulators, and politicians in 2002. Further, to ensure that an
accurate picture has been presented, it is essential that the auditor ’ s
integrity and honesty is not jeopardized by the presence of undue infl
uence. To bolster integrity and honesty, the auditor must have as much
independence as possible. Those who need to make decisions about a
company based on true and accurate information must be able to trust
the accountant ’ s pictures if the market is to function effi -ciently.

 II Trust

First, trust in business dealings that require information about fi nancial

status would be eroded. Chaos would ensue, because fi nancial markets
cannot operate without trust. Cooperation is vital, and trust is a
precondition of cooperation. If misrepresentation became a universal
practice, trust and, consequently, cooperation would be impossible.
Second, universalizing misrepresentation, besides leading to
mistrust, chaos, and ineffi ciencies in the market, would make the act of
misrepresentation impossible. Because no one would trust another ’ s
word, and misrepresentation can occur only if the person lied to trusts
the person lying. Prudent people do not trust known liars. Thus, if
everyone lied, no one would trust another, and it would be impossible to
lie.
Universalized lying, therefore, makes lying impossible. Once we
recognize that certain people are unreliable or untrustworthy, it becomes
impossible for them to misrepresent things to us, because we don ’ t
believe a word they ’ re saying. Liars are free riders. Liars want an
unfair advantage.
They don ’ t want others to lie – to act like the liars are acting. They
want others to tell the truth and be trusting so that the liars can lie to
those trusting people. Liars want the world to work one way for them
and differently for all others. In short, liars want a double standard.
Such a selfi sh, self - serving attitude is the antithesis of ethical. If
misrepresentation of an organization ’ s fi nancial situation were
universal, auditing would become a useless function. The attitude
precludes telling the public what a company ’ s fi nancial condition
really is. Firms with this attitude just guarantee that the presentation
won ’ t be subject to charges of illegal behavior.

 III The Auditor ’ s Responsibility to the Public

« The auditor does not have the same relationship to his client that a
private attorney does who 1 has a role as a confi dential advisor and
advocate, a loyal representative whose duty it is to present the client ’
s case in the most
By certifying the public reports that collectively depict a corporation ’ s
fi nancial status, the independent auditor assumes a public responsibility
transcending any employment relationship with the client. The
independent public accountant performing this special function owes
ultimate allegiance to the corporation ’ s creditors and stockholders, as
well as to the investing public. This ‘ public watchdog ’ function
demands that the accountant maintain total independence from the client
at all times and requires complete fi delity to the public trust. To insulate
from disclosure a CPA ’ s interpretations of the client ’ s fi nancial
statements would be to ignore the signifi cance of the accountant ’ s role
as a disinterested analyst charged with public obligations.
«Given the sometimes opposing interests between the public and
clients, it is clear that auditors face confl icting loyalties. » Over
time, the evaluation of another accountant ’ s records has become a
necessary component of capitalist societies, particularly the part of
society that deals in money markets and offers publicly traded stocks
and securities. The role of verifi er falls to the public accountant – the
auditor.

 IV The Auditor ’ s Basic Responsibilities

We have seen that the auditor ’ s fi rst responsibility is to certify or attest

to the truth offinancial statements. But an auditor also has other
responsibilities. A document known as the Cohen Report contains a
comprehensive statement of an independent auditor ’ s
responsibilities. In 1974, the AICPA ’ s Commission on Auditor ’ s
Responsibilities was established to develop conclusions and
recommendations regarding the appropriate responsibilities of
independent auditors.
As we might expect, the report defi ned the independent auditor ’ s main
role as an intermediary between the client ’ s fi nancial statements and
the users of those statements, to whom the auditor is
accountable. Commission made it clear that the auditor ’ s primary
responsibility is to the public, not to the client. In most
cases, management accountants prepare the fi nancial statements, and it
is management – not the auditor – who is responsible for them. Auditors
are responsible for forming an opinion on whether the fi nancial
statements are presented in accord with appropriately utilized
accounting principles.
The traditional attest statement affi rms that the fi nancial statements
were « presented fairly in accordance with generally accepted
accounting principles. » .

« In the standard report of the auditor, he generally says that

financial statements
Rather, the responsibility of the auditors is to determine whether the
judgments of managers in the selection and application of accounting
principles was appropriate in the particular circumstance. Note that this
differs from Justice Burger ’ s opinion that the auditor attests to the «
fairness » of the picture. Still, the idea prevails that « fairly » presented
means that the report being audited will give a reasonable person an
accurate picture of an entity ’ s fi nancial status. GAAP
principles, however, can be used by artful dodgers to hide the real health
or sickness of a company.
Indeed, one accountant has suggested that accounting is an art, and a
truly profi cient artist can, by the skillful use of GAAP, make the same
company look to be a dizzying success or a miserable failure.

The evaluation of internal auditing control

Not only is the auditor responsible for attesting to the appropriateness of
the fi nancial statements, the commission said, but he or she is also
responsible for determining whether the internal auditing system and
controls are adequate. This necessarily leads to the conclusion that
auditors have an obligation to examine the internal workings of the
company ’ s accounting procedures and safeguards.

Responsibility to detect and report errors and irregularities

«The suit called PricewaterhouseCoopers ‘ the one independent entity
that was in a position to detect and expose ’ Allegheny ’ s ‘ fi nancial
manipulations. Yet the system ’ s fi nancial statements audited by the fi
rm ‘ consistently depicted a business conglomerate in sound fi nancial
condition, ’ even after Allegheny ’ s senior offi cials were fi red in
1998. A spokesman for PricewaterhouseCoopers, Steven Silber, said, ‘
We believe this lawsuit to be totally without merit. We intend to defend
ourselves vigorously and we ’ re fully confi dent that we will prevail.
Accounting fi rms are considered to be deep pockets and lawsuits
happen to auditors with great frequency. The responsibility to report
errors and irregularities is one of the most serious – and confusing – to
an auditor. » In the fi rst place, it seems to run counter to the accountant
’ s responsibility of confi dentiality that we examined in Chapter 6 .

 V Independence

« Total independence » is the term that Burger uses. Obviously, an

external auditor should be independent from the client. We need to
examine whether total independence is a possibility or even a
necessity. Independence in fact is applicable to all accountants.
If the accountant ’ s function is to render accurate fi nancial
pictures, confl icts of interest that cause incorrect pictures do a
disservice to whoever is entitled to and in need of the accurate
picture. Whether independence in appearance must apply to all
accountants or only to independent auditors is an open question. Some
contend that independence in appearance is applicable only to
independent auditors. Arthur Levitt in concert with the AICPA.
Confi dence in the securities markets. » 26 It acknowledged that « he
various securities laws enacted by Congress and administered by the
SEC recognize that the integrity and credibility of the fi nancial
reporting process for public companies depends, in large part, on
auditors remaining independent from their audit clients. » .

John Bogle explains why eloquently

The ISB board defi ned auditor independence as « freedom from those
pressures and other factors that compromise, or can reason-ably be
expected to compromise, an auditor ’ s ability to make unbiased audit
decisions. » » 29 This, of course, does not mean freedom from all
pressures, only those that are « so signifi cant that they rise to a level
where they compromise, or can reasonably be expected to
compromise, the auditor ’ s ability to make audit decisions without
bias. 30 « Reasonably be expected » means based on rational beliefs of
well - informed investors and other users of fi nancial information. » 31
Although some auditors may be able to remain unbiased in such
situations, the rules apply to them as well, because « it is reasonable to
expect audit decisions to be biased in those circumstances.
32 Accordingly, noncompliance with those rules might not preclude a
particular auditor from being objective, but it would preclude the auditor
from claiming to be « independent » at least in appearance, if not in
reality. The absence of a rule dealing with a certain
relationship, therefore, does not mean that the relationship does not
jeopardize the auditor ’ s independence if the audit decision could
reasonably be expected to be compromised as a result. « Compliance
with the rules is a necessary, but not a suffi cient, condition for
independence. » The goal of independence, the report says, is « to
support user reliance on the fi nancial reporting process and to enhance
management effi ciency. »
Hence, independence is an instrumental good, while the goal is
management effi ciency. The ISB delineated four basic principles and
four concepts to use as guidelines to determine what interferes with or
aids independence. Threats to auditor independence are defi ned as «
sources of potential bias that may compromise, or may reasonably be
expected to compromise, an auditor ’ s ability to make unbiased audit
decisions.
In an article titled « Auditing and Ethical Sensitivity, » 36 Gordon Cohn
discusses several other factors that jeopardize auditor
independence. First, he considers the effect of family and fi nancial
relations on independence. Obviously, if the auditor is a relative of a
client or maintains fi nancial interests with a client, this could create a
confl ict of interest that affects the auditor ’ s independence. Hence, the
AICPA ’ s rule of independence prevents someone being an auditor
where such relationships exist.
Even if the auditor could overcome the confl ict of interest and his or
her evaluation and attestations were impeccably honest, the public
would be suspicious of the auditor ’ s fi ndings. As we have discussed
before, it is important to avoid even the appearance of a confl ict. But
there are other possible confl icts of interest that challenge the
auditor. Concerning lack of independence, it is important to recognize
that auditing fi rms have a strong stake in client retention and fi nancial
solvency, as was apparent in the New Century/KPMG case, among
others.
A claim can be made, therefore, that an « accountant ’ s dependence on
compensation from and gratitude to the client limits
independence. Having other fi nancial relationships with the client fi rm
also puts a strain on the auditor ’ s independence. » The practice of
opinion shopping indicates how far we are from actual
independence. Opinion shopping – the act of searching for an auditor
who will give a positive attestation, even if it is unwarranted – is simply
bad.
« Those fi ndings have been challenged, 40 however, on the grounds
that the AICPA ’ s defi nition of independence is ambiguous, and that
some cases in which an accounting fi rm ’ s integrity was compromised
are settled out of court and therefore not identifi ed.
  VI Independence Risk

After examining the threats to independence, the ISB report outlines «

controls that mitigate or eliminate threats to auditors
independence. Simply, risk to independence increases with the presence
of threats and decreases with the presence of safeguards. » 44 The report
also examines the signifi cance of threats and the effectiveness of
safeguards, noting, « The signifi cance of a threat to auditor
independence is the extent to which the threat increases independence
risk. Because there will always be some bias and interest, and because
no independence is absolute or total, it is necessary to assess the
different levels of risk. »
Recognizing that total independence is impossible, the report gives
auditors a framework in which to evaluate whether the amount of
independence they have will protect them from the risks that would
jeopardize their judgment or audit. There are four basic activities, called
principles, used to determine auditor independence. Assessing the level
of independence risk. Independence decision makers should assess the
level of independence risk by considering the types and signifi cance of
threats to auditor independence and the types and effectiveness of
safeguards.

The SEC released a « Revision of the Commission ’ s Auditor

Independence
«Requirements, » effective February 5, 2001, which prohibits certain
nonaudit services that impair auditors ’ independence. The
release, which met with resistance from the accounting profession, was
deemed necessary by Levitt of the SEC and those sympathetic with his
position. Because that position seems prophetic in the light of
subsequent events, it is worth reviewing Bogle ’ s defense of the SEC ’ s
recommendations. So I come down with a fi rm endorsement of the
substance of the proposed SEC rule, which would in effect bar such
relationships.
«Or ‘ affi liate of the audit client ’ and so on. » Still, there are objections
Bogle sees as invalid and without merit.
« The SEC requires the fi ling of audited fi nancial statements to obviate
the fear of loss from reliance on inaccurate information, thereby
encouraging public investment in the Nation ’ s industries.

Public faith in the reliability of a corporation ’ s financial statements

depends on the public perception of the outside auditor as an
independent professional.
The accounting profession has long embraced the need for the
appearance of independence. Witnesses at the Commission ’ s hearings
on the auditor independence rule strongly endorsed the need for auditors
to maintain the appearance of independence from audit clients. «.

Public confi dence would be impaired by evidence that independence

was actually lacking, and it might also be impaired by the existence of
circumstances which reasonable people might believe likely to
influence independence .
« Financial statements are at the very heart of our capital markets. » On
January 28, 2003, in response to the act, the SEC adopted amendments
to strengthen requirements on requiring auditor
independence. «Finally, Rule 2 - 10 prohibits certain specifi c
relationships, including fi nancial relationships, employment
relationships, business relationships, relationships in which the audit fi
rm performs nonaudit services to the client. » 2 - 10 also includes
requirements regarding partner rotation and audit committee
administration of the engagement.
The reasons to avoid even the appearance of a confl ict of
interest, which might affect auditor independence, are
obvious. Representations made by accountants who have – even appear
to have – confl icting interests do not inspire such faith.

 VII Professional Skepticism

Independence is crucial because it is the auditor ’ s responsibility to

maintain professional skepticism. Due professional care imposes a
responsibility upon each professional within an independent auditor ’ s
organization to observe the standards of fi eld work and reporting.
Due professional care requires the auditor to exercise professional
skepticism . Professional skepticism is an attitude that includes a
questioning mind and a critical assessment of audit evidence. The
auditor uses the knowledge, skill, and ability called for by the profession
of public accounting to diligently perform, in good faith and with
integrity, the gathering and objective evaluation of
evidence. 82, approved by PCAOB as AU 230.07 provides further
clarifi cation of auditors ’ obligations.
An auditor may not detect a material irregularity, for example, because
generally accepted auditing standards do not require the authentication
of documents, or there may be collusion and concealment. To be
appropriately skeptical, the auditor must consider factors that infl uence
audit risk, especially the internal control structure. « The auditor ’ s
understanding of the internal control structure should either heighten or
mitigate the auditor ’ s concern about the risk of material
misstatements. » « Higher risk will also ordinarily cause the auditor to
exercise a heightened degree of professional skepticism in conducting
the audit.

The following paragraph summarizes the responsibility of

maintaining professional skepticism
In exercising professional skepticism, the auditor should not be satisfi
ed with less than persuasive evidence because of a belief that
management is honest.

 VIII Reasonable Assurance

It includes the following stipulations

The exercise of due professional care allows the auditor to obtain
reasonable assurance about whether the fi nancial statements are free of
material misstatement, whether caused by error or fraud, or whether any
material weaknesses exist as of the date of management ’ s
assessment. Absolute assurance is not attainable because of the nature of
audit evidence and the characteristics of fraud. Although not absolute
assurance, reasonable assurance is a high level of assurance. The nature
of most evidence derives, in part, from the concept of selective testing
of the data being audited, which involves judgment regarding both the
areas to be tested and the nature, timing, and extent of the tests to be
performed.
In addition, judgment is required in interpreting the results of audit
testing and evaluating audit evidence. Even with good faith and
integrity, mistakes and errors in judgment can be made . As a
professional, the auditor has a duty to the public that he or she freely
embraced in becoming a public accountant. This concludes our
discussion of the function and responsibilities of the auditor.