Attribution of tax revenues to sub-sectors of general government, 2009

Some internal auditors often avoided financial auditing issues in past years. They took pride in their skills as operational auditors and reserved financial auditing tasks to their external audit firm. Those external auditors reviewed financial con-trols and records leading up to the issuance of annual financial statements along with their auditor’s reports on the fairness of those financial statements. Given their operational audit and internal controls skills, many internal auditors sup-ported their external auditors over the years. This arrangement began to change somewhat during the 1990s. The major public accounting firms up through about the year 2002—then called “the Big 5”—began to take responsibility for organiza-tional internal audit functions through what was called outsourcing. Through an

arrangement with the audit committee, many internal auditors at that time found themselves to be employees of their external audit firms continuing to perform internal audits but under the management of their external auditors.

These outsourcing arrangements offered advantages to some internal audi-tors. Reporting to a large external audit firm, many outsourced internal auditors found greater opportunities for access to continuing education or the possibility to make promotional career transfers to other organizations. Outsourcing somewhat changed the tone of many of these internal audit functions. The public accounting firms managing an internal audit group tended to focus the attention of their internal audit resources more on audits in support of financial controls rather than operational issues. Although not every internal audit function was outsourced, this trend continued through the late 1990s in many major corporations.

As the 1990s ended, businesses were faced with predictions of computer systems and other process-related disasters as part of the Y2K millennium change to the year 2000. Although the millennium arrived with no major prob-lems, the following year, 2001, brought with it some real disasters for U.S.

accountants, auditors, and business in general. The long-running stock market boom, fueled by “dot-com” Internet businesses, was shutting down with many companies failing and with growing ranks of unemployed professionals. Those same boom years spawned some businesses following new or very different models or approaches. One that received considerable attention and investor interest at that same time was Enron, an energy trading company. Starting as a gas pipeline company, Enron developed a business model based on buying and selling excess capacity first over their and competitor’s pipelines and then mov-ing on to excess capacity tradmov-ing in many other areas. For example, an electrical utility might have a power plant generating several millions of excess kilowatt hours of power during a period. Enron would arrange to buy the rights to that power and then sell it to a different power company who needed to get out of a capacity crunch. Enron would earn a commission on the transaction.

Enron’s trading concept was applied in many other markets such as tele-phone message capacity, oil tankers, water purification, and in many other areas. Enron quickly became a very large corporation and really got the attention of investors. Its business approach was aggressive, but it appeared to be profit-able. Then, in late 2001, it was discovered that Enron was not telling investors the true story about its financial condition. Enron was found to be using off-balance sheet accounting to hide some major debt balances. It had been transferring sig-nificant financial transactions to the books of unaffiliated partnership organiza-tions that did not have to be consolidated in Enron’s financial statements. Even worse, the off-balance sheet entities were paper-shuffling transactions orches-trated by Enron’s chief financial officer (CFO) who made massive personal prof-its from these bogus transactions. Such personal transactions had been prohibited by Enron’s Code of Conduct, but the CFO requested the board to for-mally exempt him from related code violations. Blessed by the external auditors, the board then approved these dicey off-balance sheet transactions. Once pub-licly discovered, Enron was forced to roll these side transactions back in to Enron’s consolidated financial statements and forcing a restatement of earnings.

Certain key lines of credit and other banking transactions were based on its

pledge to maintain certain financial health ratios. The restated earnings put Enron in violation of these agreements. What once had looked like a strong, healthy corporation, Enron was soon forced to declare bankruptcy.

Because Enron was a prominent company, there were many “how could this have happened?” questions raised in the press and by government authorities.

Another troubling question was, “where were the auditors?” Commentators felt that someone would have seen this catastrophe coming if they had only looked harder. The press at the time was filled with articles about Enron’s fraudulent accounting, the poor governance practices of Enron’s board, and the failure of its external auditors. The firm Arthur Andersen had served as Enron’s external audi-tors and had also assumed responsibility for its internal audit function through outsourcing. With rumors that the SEC would soon be on the way to investigate the evolving mess, Andersen directed its offices responsible for the Enron audit to

“clean up” all records from that audit. The result was a massive paper shredding exercise, giving the appearance of pure evidence destruction. The federal govern-ment moved quickly to indict Andersen for obstruction of justice because of this document shredding, and in June 2002, Andersen was convicted by a Texas jury of a felony, fined $500,000 and sentenced to five years’ probation. With the convic-tion, Andersen lost all public and professional trust and soon ceased to exist.

At about the same time, the telecommunications firm WorldCom disclosed that it had inflated its reported profits by at least $9 billion during the previous three years, forcing WorldCom to declare bankruptcy. Another telecommunica-tions company, Global Crossing, also failed during this same time period when its shaky accounting became public. The cable television company Adelphia failed when it was revealed that its top management, the founding family, was using company funds as a personal piggy bank, and the CEO of the major con-glomerate Tyco was both indicted and fired because of major questionable finan-cial transactions and personal greed. Only a few examples are mentioned here;

in late 2001 and through the following year, 2002, many large corporations were accused of fraud, poor corporate governance policies, or very sloppy accounting procedures. Exhibit 3.1 highlights some of these financial failures. The press, the SEC, and members of Congress all declared that auditing and corporate gover-nance practices needed to be fixed.

These financial failures helped to introduce some major changes to what had been well-established financial auditing standards and practices. They caused government regulators as well as the investment community to question and then reform the financial auditing standards setting process and a wide range of public accounting firm practices. Many organizations’ CEOs and CFOs were character-ized as being more interested in personal gain than in serving shareholders, audit committees were often characterized as not being sufficiently involved in organi-zational transactions, and external auditors and their professional organization, the American Institute of Certified Public Accountants (AICPA) received major criticism. Outsourced internal auditors caught this criticism as well; they were viewed as being tied too closely to their external audit firm owners. Many other previously accepted practices, such as the self-regulation of public accounting firms, were seriously questioned. By self-regulation, we refer to the AICPA’s peer review process, where public accounting firm A would be given the responsibility

to review standards and practices for firm B. Knowing that firm B might be assigned to come back and review A a few years into the future, few firms ever found that much critical to say about their peers.

These financial scandals caused many changes with the passage in 2002 of the Sarbanes-Oxley Act (SOA) as the most significant event. SOA establishes regula-tory rules for public accounting firms, financial auditing standards, and corporate governance. Through SOA, the public accounting profession has been trans-formed, the AICPA’s Auditing Standards Board (ASB) has lost its authority for setting auditing standards, and the rules have changed for corporate senior exec-utives, boards of directors, and their audit committees. A new entity, the Public Corporation Accounting Overview Board (PCAOB) has been established, as part of SOA and under the SEC to set public accounting auditing standards and to oversee individual public accounting firms. Although not directly covered in the legislation, SOA also has very much affected internal auditors as well.

This chapter discusses this very significant public accounting standards set-ting and corporate governance legislation, the Sarbanes-Oxley Act (SOA), with an emphasis on its aspects that are most important to internal auditors. SOA and the PCAOB represent the most major change to public accounting, financial report-ing, and corporate governance rules since the SEC was launched in the 1930s.

SOA represents the most important set of new rules for auditing and internal auditing today. The effective internal auditor should have a good understanding of these new rules and how they apply to today’s practice of internal auditing.

EXHIBIT 3.1

Early Twenty-first Century U.S. Financial Scandals

The following represent some, but not all, of the accounting scandals that took place in the United States in the period around early 2004. This list represents allegations reported in the financial press and situations where earnings restatements were necessary.

Company What Happened

Adelphia Communications Organizational funds used by founding family officers as a personal “piggy bank.”

Enron Corporation Massive accounting fraud discovered through improper off-balance sheet accounting.

Fine Host Corporation CFO resigned because of financial fraud.

HealthSouth Earnings fraudulently misstated over many years to satisfy analyst expectations.

Homestore.Com Bogus sales reported to boost reported results.

ImClone Systems CEO and founder engaged in massive insider trading based on advance knowledge of regulatory ruling.

Parmalat At least $14 billion in fictitious cash reported for this Italian dairy products corporation.

Tyco Accounting fraud coupled with the CEO using corporate

funds for personal gain.

WorldCom $3.8 billion in overstated earnings.

Xerox Masked billions of losses through “creative accounting.”

3.2 “WHERE WERE THE AUDITORS?” STANDARDS FAILURE