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Evaluation and Response to Risk in International Accounting and Audit Systems: Framework and German Experiences

I. INTRODUCTION It is widely acknowledged that auditors play an important role in corporate governance. However, recent audit failures raised doubts as to whether they actually played a positive role in corporate governance. An unfortunate series of (suspected) audit failures started in Germany in the nineties of the last century and led to a massive re-regulation of both the audit profession and the statutory audit. In retrospect, they were small compared with the scandals that followed in the United States, which also led to a massive new regulation of the profession, namely the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley not only regulates audits and auditors in the United States, but extends to foreign companies and foreign audit companies as well. The underlying economic events that lead to these crises and the business risks which endanger the existence of a corporation are universally true. They arise from entrepreneurial activities, changing environments, and decisions taken all over the world. Therefore, it is widely accepted that, for instance, substantial risks which endanger the existence of a firm need to be identified in an early stage. What differs internationally, however, are the institutional mechanisms embedded in national corporate governance and market regulation to monitor these risks effectively and to bring about appropriate responses. As a result of corporate crises and audit failures, regulatory activities in both the United States and the EU aim to improve the statutory audit and corporate governance. Before further changing existing structures, an international assessment of arguments for and against certain elements of corporate governance may be of value. This paper presents arguments with respect to the evaluation and response to risk, placing an emphasis on German corporate governance. It will analyze aspects of responses to material risk from an individual point of view and review connected behavioral research in accounting and auditing. It will be argued that German corporate governance stresses internal reporting duties, some of which could serve as models for future international standards on auditing. Internal reporting duties reduce some effects that typically arise when information is disseminated to markets (e.g., self-fulfilling prophecies). They also facilitate a more open communication with monitoring parties because at least some of the heavy incentives to litigate which may lead corporations to use strategies of legal liability avoidance in their public reports (e.g., MD&A) are reduced. On the other hand, "cheap talk" reporting duties need to be legalized and put into compulsory form. II. RISK TYPES AND THE STATUTORY AUDIT A. Audit Risk and Audit Risk Approach The statutory audit shall detect material risks in the financial statements of a corporation, namely in the balance sheet, the income statement, and the accompanying notes. Material risks can be hidden in recognized assets and liabilities. Examples include overstatement of assets (e.g., real estates developed by the corporation or incorrectly capitalized costs for infrastructure), understatement of liabilities (e.g., provisions for compensations for damages), and earnings overstatement, which is certainly one of the most frequent types of error or fraud in accounting systems. Material risks can also arise out of underlying transactions, which should have been included in the balance sheet but were not as, e.g., provisions for losses. As recent examples show, consolidation rules for special purpose entities in group accounts hide risks even if the rules are correctly applied and the entities are not included in the consolidated accounts (group accounts). The auditor has the duty to discover these accounting risks within the limits of the standards of the duty of care. Given the great number of business transactions in modern corporations, the audit strategy plays an important part. …