Assignment 1: Phar-Mor Inc
By: Rich Allen
Date: July 18th, 2013
Prof: M. TeKare
1a). A company would want to hire a member of its external audit for a number of reasons. The external auditor would have extensive knowledge of how the company works due to analyzing statements and performing many audit procedures and tests on the company and therefore would reduce time in order to become effective as an employee. The company would know the former auditor personally and have a good idea of how they would fit in with the existing staff. The former auditor could prepare working papers and assist with the auditors to reduce the time and cost of the audit. However, the former external auditor would know what the existing auditors would examine when conducting an audit. This also could lead to the company committing fraud or using creative accounting to misstate numbers on the financial statements. For example, in Phar-Mor, the company knew that the auditors would spend a lot of time looking at inventory due to Phar-Mor being in a retail industry. The external auditor now working for Phar-Mor could inform management of the tests that the auditors would perform on inventory and therefore would give an idea to management to how they could inflate the inventory numbers.
1b). If the client has hired former auditors, it would affect the independence of the existing auditors. The main factor that would threaten independence in this case would be the familiarity threat, which occurs when it is difficult to behave with professional scepticism during the engagement due to a belief that one knows the client well. If the former auditors and existing auditors worked for the same firm, it is very likely that they had worked together quite a bit in the past and could be friends or at least business associates. This could lead to the existing auditors being less inquisitive and more satisfied with explanations when conducting the audit and could lead, either intentionally or unintentionally, to the auditors overlooking fraud or error. The appearance of independence is paramount for external audits. Even if the external auditor and the former external auditor never worked together at the accounting firm, independence has to be both in fact and in appearance and therefore the appearance of independence would fail in this case as well.
1c). Sarbanes-Oxley of 2002 had a significant affect on the way that public companies are allowed to hire members of its external audit team. Section 201 of the act, specifies that no external auditor that is working on a company is allowed to be involved in any non-audit services performed on the company such as tax returns, bookkeeping, valuation/appraisal reports and internal audit outsourcing services. All these services violate the self-review threat of independence because it would mean that external auditors are auditing their own work. Independence in auditing was a very important issue that the Sarbanes-Oxley Act set to out to change. For example in Par-Mor, an auditor left Coopers and was hired by Phar-Mor. After the Sarbanes-Oxley Act, this would no longer be allowed as Coopers would have failed the test of independence due to the familiarity if its’ auditors with the client.
1d). It is not appropriate for auditors to blindly trust executives of a client even though valuable information can be obtained and discussions must be conducted with executives. The auditors must maintain professional skepticism during the entire engagement. The auditor must also maintain an objective mind. For example, the client may be very nice and helpful but at the same time could be doctoring invoices or intentionally misstating financial statements. This is why sources of evidence that come directly from management are the least reliable source of evidence and that is why third party confirmations and other sources of external evidence are used heavily and are crucial to...
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