Due professional care in cases of high engagement risk

CPA Journal, The, Dec 2002 by Venuti, Elizabeth, Holtzman, Mark P, Basile, Anthony

Surveying a perilous environment

In Brief

Audit lessons from Andersen and Enron

The Enron-Andersen debacle makes for a case study on exercising due professsional care on high-risk audit engagements. Auditing issues that the lawon case highlights include going-concern assessments: related-party disclosures; subsequent discover of facts; auditor independence: audit documentation: and loss contingency disclosures. The authors examine these high-risk areas and discuss how auditors can avoid audit failures by due professional application of auditing .standards.

he media scrutiny of the Enron-- Andersen case has obscured relevant auditing and accounting issues. Although apparent loopholes in the application of accounting standards may have enhanced Enron's ability to manipulate earnings, shortcomings in and the application of auditing standards may have reduced the effectiveness of Andersen's audit.

Many of Enron's complex, relatedparty transactions involved off-balance sheet financing arrangements guaranteed by Enron's stock. Additionally, the company's stock price depended on earnings growth and continued access to capital. Combined, these circumstances created a high-risk environment from an audit perspective. "Going Concern" Issues SAS 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, requires the auditor to evaluate conditions or events discovered during the engagement that raise questions about the validity of the going-concern assumption. The auditor is not required to design specific audit procedures to identify such conditions and events. Instead, when evaluating the results of the overall audit, the auditor should consider whether certain conditions or events discovered during the course of the audit contradict the going-concern assumption. The projection of the going-concern concept is defined as not exceeding one year beyond the date of the audited financial statements. The current standard places the responsibility for identifying any exceptions to the going-concern assumption with the auditor.

Because a going-concern opinion may cause stockholders and creditors to lose confidence in the company and ratings agencies to downgrade the debt, leading to an inability to obtain new capital and an increase in the cost of existing capital, auditors are extremely cautious in giving such opinions. Because Enron had debt guarantees tied to its credit rating, a goingconcern opinion could have sealed the company's fate even sooner.

If Andersen had included a goingconcern paragraph in its opinion on Enron's 2000 financial statements, its fate might have been very different. Auditors, however, cannot predict the future. Failure to issue a going-concern opinion is not sufficient evidence of an audit failure, and the absence of a going-concern qualification should not be viewed as providing assurance. Post-SAS 59 research shows that 40% to 50% of failed companies do not receive going-concern qualifications in the year immediately preceding bankruptcy. Of three recent high-profile bankruptcy filings-Enron, K-Mart, and Global Crossing-none received a going-concern opinion.

The Auditing Standards Board (ASB) has revisited the going-concern issue. The original standard, SAS 34, The Auditor's Considerations When a Question Arises About an Entity's Continued Existence (1981), was superseded by SAS 59 in 1988. While the current audit guidance for considering the going-concern assumption is widely acknowledged to be problematic, neither the ASB nor FASB has addressed this item.

SAS 96, Auditing Documentation, would augment the documentation requirements of SAS 59 by requiring an auditor to document the conditions or events that lead it to believe there is substantial doubt about a company's ability to continue as a going concern. The documentation must also describe the work the auditor performed to evaluate management's plans. The auditor should document its conclusion as to whether there is substantial doubt about the company's ability to continue as a going concern for a reasonable period of time, as well as how that conclusion will affect the financial statements, disclosures, and audit report.

In its final report, the Panel on Audit Effectiveness recommended that "the ASB provide expanded guidance and specific examples of the auditing procedures to be performed and the audit evidence to be obtained when considering management's plans for mitigating the adverse effects of conditions and events that raised the auditor's substantial doubt about the entity's ability to continue as a going concern" and that audit firms provide specific guidance and practice aids for considering management's plans. Their most controversial recommendation was that the FASB codify a definition of the going-concern concept. The panel's opinion was that management has the responsibility to evaluate and report on the entity's ability to remain a going concern, similar to International Accounting Standard (IAS) 1-a recommendation that shifts the focus from an auditing issue to an accounting issue, and is in direct conflict with the auditor's present responsibilities.