AUDIT NOTES
What is Audit Theory?
Audit theory refers to the foundational principles, concepts, and assumptions that
guide the practice of auditing. It explains why auditing is necessary, how it should be
conducted, and what objectives it aims to achieve.
Key Concepts in Audit Theory:
1. Agency Theory
Explains the relationship between principals (e.g., shareholders) and agents (e.g.,
company management).
Auditing helps ensure that managers act in the best interest of owners.
2. Information Theory
Emphasizes the auditor’s role in reducing information risk by providing reliable and
credible financial information.
3. Insurance Hypothesis
Suggests that an audit provides assurance that can reduce potential financial losses for
users of financial statements.
4. Lending Credibility Theory
Suggests that audited financial statements are more credible and trustworthy to
external users, like investors or lenders.
5. Audit Risk Model
Breaks down the risk that an auditor gives an inappropriate opinion. It includes:
Inherent risk
Control risk
Detection risk
Top 5 Auditing Firms in the World (a.k.a. The Big 4 + 1)
These firms dominate the global auditing and accounting industry:
Rank Firm Name HeadquartersNotes
1 Deloitte New York, USA Largest by revenue; offers audit, tax, consulting,
and advisory services.
2 PwC (PricewaterhouseCoopers) London, UK Known for its strong presence in
auditing and business consulting.
3 EY (Ernst & Young) London, UK Focuses on assurance, tax, transaction, and
advisory services.
4 KPMG Amstelveen, Netherlands Known for strong auditing and tax services.
5 BDO Global Zaventem, Belgium Largest mid-tier firm; growing fast in
international markets.
> In the Philippines, top firms also include SGV & Co. (a member firm of EY) and R.G.
Manabat & Co. (a member of KPMG).
✅ Why Auditor Independence Matters:
Auditors are the public’s safeguard — their job is to verify a company’s financial
honesty, not to please management.
• An independent audit is to lend credibility to the financial statements prepared by
an entity.
• Auditor provides increased assurance to users that the financial statements are
reliable
If an auditor is financially dependent on the client, their judgment can become biased.
Independence ensures objectivity, reliability, and trust in the financial system.
In Enron’s case, Arthur Andersen’s failure enabled years of deception and contributed to
billions in losses and the collapse of a major public company.
In business, auditor independence is critical because:
Investors, lenders, regulators, and the public rely on unbiased financial reports to make
decisions.
Without independence, fraud can grow unchecked.
Confidence in financial markets depends on trustworthy auditing.
🔹 The Sarbanes-Oxley Act of 2002 (SOX)
In response to Enron and other scandals (like WorldCom), the U.S. passed the Sarbanes-
Oxley Act, which:
Requires CEOs and CFOs to certify financial statements
Imposes stricter internal controls and audit requirements
Limits the non-audit services that auditors can provide to clients
Establishes the Public Company Accounting Oversight Board (PCAOB) to regulate
auditors
ENRON CORPORATION SCANDAL
Enron Corporation
is energy trader and supplier
> named "America's Most Innovative Company" by Fortune for 6 consecutive years prior to
scandal.
• Electronic Tradidnt website (EOL)
•Enron BroadBand services
> considered as the riches company jn the world in the late 90s.
> 7th largest Public Company/Corporation in the US valued at US $70B.
History
1982
merged of two companies
1. Houstan Natural Gas Corporation
> Ceo is kenneth lay (Ken Lay)
2. InterNorth Inc.
These two merged and called Enron Corporation and rebranded as a trader and supplier of
energy.
1990
Ceo Ken Lay hires Jeff Skilling (one of the partners of mac and see consultancy)
1992
Jeff Skilling known for management consultant proposes ' Mark to market method ' which is
approved by SEC.
normally when clients buy land on historical cost ( magkano mo talaga nabili ganon mo rin
irerecord)
MARK TO MARKET ACCOUNTING is a method where the price is appraised and recorded at
the value today.
ex. buy land 10 yrs back and update at fair value, the price will change. (mag aadjust yung value
ng mga property, assets sa today's value in the market)
Mark to market method is both a positive and a negative (can be use for pandaraya)
• In 1992, the stock price to be an owner of Enron Corporation is $10 per share but because
of the 'mark to market accounting' the $10 rocketed to $85 in (2000) which attracts lot of
investors.
1998
Andrew Fastow promoted to CFO and spearhead the creation of Network of companies that
hides Enron's Losses. (hides losses utang and hindi nag aappear sa FS ang losses, pagkaka utang
and other unsuccessful activities)
in reality, the company is baon sa utang and the sister company ang sumasalo sa utang (sa sister
company nag a-appear ang mga losses and debts
showing that Enron Corporation is only earning and don't incur any losses and debt.
2000
Enron enter to a partnership deal to a blockbuster company who's involved to video on
demand services.
enron role is to provide connection or bandwidth to blockbuster co.
but the deal is unsuccessful (nalugi and hindi nag materialized) and this unsuccessful activity is
hinide (hindi pinaalam) sa mga investors and current shareholders.
tinapon ang failure activity records sa sister company.
>hindi nag appear ang unsuccessful activity sa enron corporation record but to sister company.
(because if disclosed many investors will back out)
2001
All fraudulent activities were discovered and the company collapsed. Enron Company
Bankruptcy.
from $90.75 to 0.26 cents of stock price (low in demand and investors pulled out)
•some people involved is nakapag cash out ng money before the bankruptcy.
People Involved
• management/executive
• independent auditor
INDEPENDENT AUDITOR role is to check if the financial statement of the company is
fairly presented.
financial statement shows the performance of the company and has enough cash flow to attract
more investors and has readers (managers, board, investors, creditors) m who will create
important economic decisions for the company.
Management/Executive involved
1. CEO, Kenneth Lay
2. Jeff Skilling
3. CFO, Andrew Fastow
Independent Auditor (external auditor)
1. Arthur Andersen ( which is originally one of the Big 5 auditing firm in the world but later
excluded -- KPMG, ... )
Collapse
1. Fiduciary failure (based on trust and confidence)
- BOD failed to safeguard Enron shareholders
- BOD witnessed numerous indications of questionable practices by Enron Management over
several years but chose to IGNORE them.
>lost of trust and confidence given by the shareholders to board of directors who’s role are not
executed properly.
Board of directors Role
> is to engage or represent in contracts and business transaction.
> role to set salary in compensation of CEO, CFO to not be excessive but just and equitable
only.
> trusted to watch the activities of CEO, CFO and put the corporation in good state where the
shareholders will be happy and to ensure their wealth.
2. High Risk accounting
> From traditional historical value accounting to Mark-to-Market Accounting (M2M) that
adjust value to current market value according to demand in the market.
^^ Enron Corporation recorded expected revenue as actual revenue (record projected income –
meaning example if may invesment sa planta kahit hindi pa na kita (no actual income incurred)
nirerecord na agad ang projected income) to show that corporation has excellent company
performance to attract potential investors.
[Link] Undisclosed off-the-books activity
> Window-dressing of the financial statements
>Creation of network companies that hide Enron’s losses through CFO, Andrew Festow
Window dressing – pinapaganda ang FS contents like not recording of debts to show only the
good things to attractt investors.
>The BOD approved excessive compensation for company executive (even if not just and
equitable)
>The bod failed to monitor the ff:
• cumulative cash drain by Enron’s 2000 annual bonus and performance units plan (because
executives know that the corporation will get bankrupt)
• Abuse of CEO Kenneth Lay of a company-financed-multi-million dollar, personal credit line.
3. Lack of Independence
> The BOD allowed their EXTERNAL/independent auditor Arthur Andersen to provide
internal audit and consulting services.
(internal audit should only be done hy the employees or in the management NOT THE
EXTERNAL AUDIT ) this shows unfair and biased.
>Arthur Andersen legal counsel tells auditors to destroy Enron files, except for Enron’s most
basic documents.(destroyed evidences)
Significant impacts
The collapse of Enron led to:
> 4,500 employees losing their jobs
>Investors losing some US $60B within a few days
> Obliteration of the company’s employees’ pension fund
> Citizens’ loss of trust in the American Economic System
>Losses in the financial market that amounted to the worst stock value loss in peaceful times
> Passing of the Sarbanes-Oxley Act of 2002
( audit work will be checked by another … and the FS will all be signed by CEO, CFO….. and
management should be in charge for internal control to avoid mistakes)
>Auditing firm Arthur Andersen lost its accreditation ( the firm surrendered its CPA license
on Aug 31, 2022 and 85,000 employees lost their jobs) ---- naubusan ng clients due to lost of
public interest and trust, no one wants to invest due to Arthur reputation.
Identified leadership issues
> failure of the Board (BOD) of their duties and responsibilities
> agency problem
> moral/ethical issues
> Conspiracy/Connivance
The Enron Scandal – A Summary
Enron Corporation was once one of the biggest energy companies in the U.S. It was praised for
innovation and fast growth. But behind the scenes, Enron was hiding billions of pesos in debt
through tricky accounting methods.
They used mark-to-market accounting to record profits that didn’t exist yet, and created fake
companies called SPEs (Special Purpose Entities) to hide losses and make their financial reports
look better than they actually were.
Top executives like Jeffrey Skilling (CEO), Kenneth Lay (Founder), and Andrew Fastow (CFO)
were all deeply involved in the fraud. They made millions while misleading investors,
employees, and the public.
Their auditor, Arthur Andersen, didn’t do its job of checking the company’s books properly. In
fact, they helped cover it up and even destroyed evidence.
In 2001, the truth came out. Enron declared bankruptcy. Thousands of employees lost their jobs
and life savings. Investors lost billions. Arthur Andersen also collapsed.
The scandal led to big changes in law, especially the Sarbanes-Oxley Act of 2002, which aimed
to make companies and auditors more honest and accountable.
1ST LESSON in audit
1. AUDITOR HOLDS 50% OF THE SHARES OF THE COMPANY HE CONDUCTS AN
AUDIT
Answer:
Not independent.
The auditor has a direct financial interest in the company. Holding 50% of the shares creates a
self-interest threat and violates the requirement to be independent in both mind and appearance.
The auditor may influence decisions and cannot remain objective.
2. AUDITOR PROVIDES BOOKKEEPING SERVICES TO THE SAME CLIENT IT AUDITS
Answer:
Not independent (in most cases).
This creates a self-review threat, as the auditor would be auditing their own work. While some
exceptions exist for small, non-public entities (with proper safeguards and client responsibility),
in general, providing bookkeeping services impairs independence
3. AUDITOR AUDITS A COMPANY WHERE HE USED TO BE A CHIEF FINANCIAL
OFFICER A YEAR AGO
Answer:
Not independent.
If less than two years have passed since the auditor held a key management position (e.g., CFO),
independence is impaired. This is due to self-review and familiarity threats. A cooling-off period
of at least two years is required by ethical standards for public interest entities.
4. AUDITOR CONDUCTS AN AUDIT WHERE HIS BROTHER IS THE CHIEF EXECUTIVE
OFFICER
Answer:
Not independent.
Having a close family member (such as a brother) in a key management role (e.g., CEO) creates
a strong familiarity and self-interest threat. This violates the ethical principles of objectivity and
independence, and the auditor must not accept or continue the engagement.
1. Independence in Fact
Independence in fact refers to the actual mental attitude of the auditor. It means the auditor
must be truly objective, honest, and free from any influence—whether financial, personal, or
professional—that could affect their judgment.
It is the true independence of the auditor’s thoughts, actions, and decisions.
The auditor must not let relationships or personal interests affect how they conduct or report
the audit.
For example, if an auditor has no financial ties to the client and performs the audit solely based
on facts and evidence, then they are independent in fact.
This is essential for the quality and reliability of the audit itself.
In short, independence in fact is about what is real and internal—the auditor must actually be
objective and unbiased.
2. Independence in Appearance
Independence in appearance refers to how the auditor’s independence is perceived by
outsiders—such as investors, regulators, and the public.
Even if the auditor is truly independent (in fact), if their actions appear biased or conflicted,
their credibility may be questioned.
For example, if an auditor’s close family member works for the client, or the auditor attends
social events hosted by the client, this might create a perception of bias, even if none exists.
Stakeholders need to trust the audit report, and that trust can be damaged if the auditor’s
independence is in doubt—even just in appearance.
This is especially important in maintaining public confidence in financial reporting and the
audit profession.
In short, independence in appearance is about what is seen and perceived—the auditor must
avoid situations that might look like a conflict of interest.
Audit Assignment
ENRON CORPORATION SCANDAL
Enron Corporation was founded in 1985 after a merger between Houston Natural Gas
Corporation and InterNorth Inc. It started out as an energy company but later transformed into a
massive trading and investment firm, dealing with electricity, natural gas, broadband, and even
weather derivatives.
1. How was the fraud done?
The fraud at Enron was executed through a combination of unethical accounting practices and
corporate deception:
A. Mark-to-Market (M2M) Accounting: Enron recorded projected future income
from long-term contracts as if it were current revenue. This artificially inflated
earnings, making the company appear more profitable than it really was.
B. Use of Special Purpose Entities (SPEs): CFO Andrew Fastow created
hundreds of off-the-books entities (like LJM1, LJM2, and Chewco) to hide
Enron’s losses and debts. These made Enron’s financial statements look stronger
by moving liabilities off the balance sheet.
C. Concealing Failed Ventures: Unsuccessful deals, such as the video-on-demand
project with Blockbuster, were hidden in these SPEs instead of being reported to
shareholders.
D. Stock Price Manipulation: The inflated earnings boosted the stock price.
Executives, who were paid based on performance and stock value, profited while
the actual financial condition of the company was deteriorating.
2. Who were the people involved?
Management/Executives:
Kenneth Lay – Enron’s founder and former CEO/Chairman. He encouraged aggressive growth
and ignored red flags, enabling unethical behavior.
Jeffrey Skilling – CEO in 2001 and the primary architect of Enron’s fraudulent practices,
especially mark-to-market accounting.
Andrew Fastow – CFO who created and personally profited from the SPEs, while using them to
manipulate the company’s financial appearance.
Board of Directors – Failed in their fiduciary duties by allowing obvious conflicts of interest,
such as Fastow’s dual roles with the SPEs, allowed excessive compensation, ignored red flags
and violated their fiduciary duties to shareholders.
Independent Auditor:
Arthur Andersen LLP – External auditor that failed to question fraudulent activities and even
destroyed audit evidence when the scandal was exposed.
3. The role of the auditor in the scandal, and what it should have done
Auditor: Arthur Andersen
Arthur Andersen committed several major failures in its role as Enron’s external auditor. It broke
auditor independence by serving both as auditor and consultant, receiving large consulting
fees that created a serious conflict of interest. The firm neglected clear red flags, such as
Enron’s questionable use of Special Purpose Entities (SPEs), unusual accounting practices, and
signs of financial manipulation. Andersen failed to detect or report these irregularities,
demonstrating gross negligence. Most critically, during the investigation, the firm engaged in
obstruction of justice by shredding key audit documents under legal advice, further
compromising its credibility and ultimately contributing to its downfall.
What the Auditor Should Have Done
1. Maintain Professional Independence
Andersen should not have accepted non-audit consulting work from Enron, as it created a
conflict of interest and compromised objectivity.
2. Challenge Unusual Accounting Practices
The firm should have thoroughly investigated and questioned Enron’s use of mark-to-market
accounting and Special Purpose Entities (SPEs), recognizing them as signs of potential fraud.
3. Report Irregularities
When management failed to address concerns, the auditor had a responsibility to report
suspicious or unethical practices to regulatory bodies such as the SEC.
4. Follow Ethical Standards
As auditors serve as gatekeepers of financial integrity, Andersen should have prioritized truth,
transparency, and public trust over client loyalty.
5. Provide Fair and Honest Assurance
The firm should have upheld its duty to deliver accurate, unbiased audit opinions that
stakeholders could rely on to make informed decisions.
4. Aftermath to the Public
1. Over 4,500 workers lost their jobs, and many lost their retirement savings that were
invested in Enron stock as part of pension plans.
2. Investors lost over $60 billion in market value within days as stock prices dropped from
$90.75 to $0.26.
3. Caused a massive loss of public trust in the financial markets and corporate reporting and
became one of the worst financial collapses in U.S history.
4. The U.S. Congress passed the Sarbanes-Oxley Act of 2002, introducing a stronger
internal controls, greater accountability for executives that made CEOs and CFOs
personally responsible for the accuracy of the financial reports, and prohibition of non-
audit services by auditors.
5. Arthur Andersen found guilty of obstruction of justice and surrendered its CPA license
in 2002. About 85,000 employees lost their jobs due to lost credibility and clients and the
firm’s reputation was permanently destroyed.
6. Importance of Auditor Independence
Auditor independence is not just a professional principle — it is the foundation of credibility,
objectivity, and trust in financial reporting. Independent auditors are meant to serve the public
interest, not the interests of corporate management.
1. Prevents Bias and Misrepresentation
Independent auditors are more likely to report financial misstatements and irregularities
honestly, rather than aligning their opinions with what management wants to present. Without
independence, the auditor becomes a partner in deception rather than a guardian of accuracy.
2. Strengthens Investor and Market Confidence
Investors depend on audited financial statements to assess a company’s performance and make
informed decisions. When auditors are compromised, this trust collapses — leading to massive
market losses.
3. Ensures Accountability and Oversight
Auditors serve as critical watchdogs over corporate financial reporting. True independence
enables them to hold executives accountable and prevent management from manipulating
earnings or hiding liabilities.
4. Avoids Conflicts of Interest
Independent auditors should not have financial ties or business incentives that could influence
their objectivity.
5. Upholds Legal and Ethical Standards
Auditor independence is required by law and enforced through standards such as the Sarbanes-
Oxley Act. Violating this duty can lead to legal consequences, loss of licensure, and public
disgrace.
6. Protects Employees, Creditors, and the Economy
A compromised audit doesn’t just affect shareholders — it puts employees, lenders, and the
broader economy at risk. When financial reports are misleading, everyone who relies on them is
misinformed, which can lead to widespread financial harm.
7. Supports Transparency and Good Governance
Independent audits contribute to a culture of transparency within organizations. They discourage
fraud and unethical behavior while promoting responsible corporate governance and financial
stewardship.