Management Integrity: The Lynchpin of a GAAS Audit

Article excerpt

What we have done once, we are likely to do again; that is, acts tend to recur. Acts repeated form habits; and habits crystallize into character, which is the cause of subsequent acts.

- Aaron Schuyler, Systems of Ethics, Jenning & Pye, 1902, p. 11

Management's integrity is a key element in the efficacy of an audit conducted in accordance with generally accepted auditing standards (GAAS) as practiced in the United States. When management's integrity is in question, the underpinning of a GAAS audit may be destroyed. This can occur because a GAAS audit does not contemplate an examination of the accounting for every economic event affecting the enterprise. Instead, the performance of a GAAS audit involves the use of verification and evaluation techniques and other procedures that focus on a limited number of transactions, as well as financial ratios and analytics, rather than doing the more extensive verification generally associated with a fraud or internal audit. Moreover, an enterprise's financial statements are management's representations, and the embodied assertions that are tested in a GAAS audit are management's assertions. Management's integrity is the critical element in determining if an independent auditor can rely on the many oral and written representations made by management during the auditing process. An independent auditor must decide whether to accept or reject management's explanation of nonroutine transactions - matters requiring the application of judgment and, in some instances, representations concerning future actions. These situations often represent the greatest risk areas in an audit.

Accordingly, an independent auditor's assessment of management's integrity becomes one of the most important exercises of judgment that one must make in the performance of a GAAS audit. As stated in Montgomery's Auditing: "The assertions of management that are embodied in a set of financial statements are the subject matter of an audit of those statements" (O'Reilly et al., Wiley, 2001). Failing to make a critical assessment of management's integrity - or worse, proceeding with an audit in the face of evidence calling management's integrity into serious question without performing sufficient additional audit procedures - can result in a consequent impairment of the audit's effectiveness, putting the independent auditor at the risk of ethical sanction and legal liability.

Moreover, GAAS states that management integrity concerns can, in certain instances, cause the independent auditor to reach the conclusion that the risk of management misrepresentation in the financial statements is so great that a GAAS audit cannot be performed and that the independent auditor may need to withdraw from the engagement.

What Is Management Integrity?

Management integrity is the essential concern articulated in the professional standards and the internal control and risk guidance from the Committee of Sponsoring Organizations of the Treadway Commission (COSO). COSO defines integrity as: 'The quality or state of being of sound moral principle; uprightness, honesty and sincerity; the desire to do the right thing, to profess and live up to a set of values and expectations." Another similar definition is found in Management Ethics: Integrìty at Work, by Joseph A. Petrick and John F. Quinn (Sage Publications, 1997): "Management integrity is the individual process of repeated alignment of moral awareness, judgment, character, and conduct that demonstrates balanced judgment and promotes sustained moral development at all levels of managerial practice."

Who Is Management?

The FASB Accounting Standards Codification, in its master glossary, defines "management" as including those individuals who are responsible for setting the objectives and policy for an enterprise and having the authority to make the decisions necessary to achieve those objectives. Management would include the principal owners, the board of directors, the chief executive and operating officers, officers in charge of principal business functions, and any other person who performs similar policy-making functions. …