Several catastrophic accounting failures have occurred over the last few years. Although the details of each failure is different, each case stems from attempts to manage earnings and thus all of these failures have common elements. One of the elements
identified in these earnings management meltdowns is the auditor's calculated risk. Explain what is meant by the term "the auditor's calculated risk".
The financial statements of an enterprise may be viewed as a negotiated settlement between the client management and the independent auditor. Management has many incentives to portray the company in the best light possible through the financial statements. The independent auditing firm wishes to preserve its reputation and to avoid investor lawsuits. Accordingly, the auditor has a strong incentive to reject any accounting treatment that appears overly optimistic. Much discussion may ensue regarding a questionable accounting practice before management and the auditor reach an agreement and the auditor signs the audit opinion and releases the audited statements to the public.
The auditor is faced in these situations with the choice of continuing to serve the audit client or withdrawing from the engagement. Withdrawing from the engagement results in the loss of significant amounts of revenue. Alternatively, continuing to serve the client when the client's actions result in an accounting scandal can result in lawsuits, loss of reputation, loss of clients, and even the demise of the accounting firm. The auditor's decision to sign the audit opinion thus is always a calculated risk for the auditor. Independent auditors should not underestimate the magnitude of this risk and the devastating effects that can result from signing an audit report in error.
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