The collapse of Equity Funding had a far-reaching influence on business practices and institutions. Although it happened over 30 years ago, the lessons from Equity Funding are still meaningful and constructive nowadays. Auditors of Equity Funding failed to collect sufficient evidence, check internal control and substantiate computer system.
The audit premise----- understanding internal control system AUS 402.41 requires the auditor to obtain an understanding of internal control relevant to the audit. The effective internal control can provide “protection against human errors and reduce errors or irregularities’ (Leung et al, 2007), as well as provide reasonable assurance to auditors for relying on internal control to audit under limit of economic fee. In order to support an opinion on the financial statement, auditors need a sufficient knowledge of internal control, which includes design of policies and procedures of internal control, and then determine whether they are in operation in assessing audit risk and making audit plans. (Leung et al, 2007).
The internal control procedures can be eroded and invalidated resting with management override and collusion. As to EFCA, a considerable amount of personnel involved in collusion. This should have been detected by auditors if they assessed the control environment of the company, including the ethics and integrity of management and employees, and checked whether segregation of duties was carried out.
Unfortunately, the auditors of EFCA poorly understood the internal control procedures in EFCA, especially its computerized accounting system (Lee and Marc, 2002). There were glaring inconsistencies and irregularities in the inter-company accounts of EFCA and its subsidiaries. The auditors should have detected the lack of internal control if they reconcile the parent’s account with subsidiary’s accounts; and the computer fraud would not be hidden long had they kept update their technological skills and observed or gone through the data running process to make sure data are reliable.
Once the internal control system isn’t fully understood, the preliminary assessment of control risk is problematic. It was unpractical for auditors to make a judgment on control risk and design an appropriate audit strategy. The wrong judgment on control system and audit strategy may be the direct reason of failure of auditing in EFCA. The auditors wrongly trusted the effectiveness of control systems and relied on management. One of example was Haskins and Sells, the auditors of EFLIC, who total relied upon print-outs and similar data produced by EFLIC's computer (Lee et al, 2002).
In addition, the auditors also failed to test the effectiveness of the design an operation of internal control according to their judgment on control risk. The mainly test procedures base on audit evidence collection. ASA 330 requires the lower assessment of control risks, the more support the auditor should obtain. However, the auditors failed to obtain sufficient and competent evidence to support their judgment, which will be discussed in next section.
The audit basis----audit evidence collection
ASA 500.5 (ISA 500.2) requires that auditors collect and evaluate "sufficient and competent evidential matter" in the formation of an opinion on financial statements.
In areas where auditors find suspicious or involving material issues, they should collect more audit evidence. The cash-flow figures are hard to manipulate as auditors can check it by contrasting it with bank statements. However, as there are usually so many items in under assets, it the area the auditor should focus on and collect certain evidence. Like the account receivable in EF, a “25 million’s increase in California subsidiary’s account receivable” was cooked to solve the cash shortage problem. Had the auditors reconciled financial reports with legers and original document and re-performed a...