Monday 11 December 2017

We have to train financial watchdogs to bark more

It's time to open up the auditing market and look at how long auditors stay in office, writes Paul Raleigh

THE auditor is "a watchdog not a bloodhound", said Lord Justice Lopes in 1876 in the famous Kingston Cotton Mills case when he found the auditor, one Mr Pilkington, not guilty of negligence.

He probably didn't realise at the time just how fundamental these words would become to the culture of auditing. This case established the principle that auditors need not approach their work as detectives, and, in the absence of suspicious circumstances, they can assume that management have acted honestly and responsibly and their representations can be relied on.

The legitimate question for the shareholders and pension funds who lost millions in the collapse of our banks, and indeed for the general public who now have to foot the bailout bill, is: where were the watchdogs? Why did no one bark when there was clearly such reckless lending and when internal procedures and controls were either completely ignored or were totally inadequate?

The audit profession must now acknowledge the scale of the issues facing them and in particular the loss of public confidence in their work. People need to understand when and how the auditor barks. If there are shortcomings, they need to be clearly addressed for the future.

The auditor's main duty is to independently verify the financial statements of a company, express an opinion on whether or not they show a true and fair view, and confirm whether proper books and records were kept. To do this, auditors will extensively review internal controls and procedures to see if they can be relied on: the "suspicious circumstances" test. Given the complicated and international nature of public companies, the job is usually very complex, and much more needs to be done to explain the limitations and risks inherent in an audit to the investing public.

However, it is not only the public who are confused. Regulators across the globe have been debating the structure and approach of auditing since the financial crisis erupted. The European Commission has produced a Green Paper on the matter, and is considering making sweeping changes governing how auditors are appointed, how long they can serve and the number of public-interest audits they can undertake.

There is a real concern that far too many public company audits are undertaken by the four largest accounting firms, known as the Big Four. In the UK, the House of Lords recently described the situation of the Big Four firms as an oligopoly, and called for an investigation by the Office of Fair Trading (OFT). In fact, the OFT has decided that competition concerns in the UK are serious enough to warrant potential regulatory intervention. The regulators are concerned by the systemic risk and consequences if another firm were to collapse, as Andersens did following the Enron scandal.

The chairman of the PCAOB (the accounting oversight body in the US) called last month for a review of the structural foundation for auditing in the best interests of investors and the profession itself. James Doty commented that "too often inspectors find that auditors have failed to exercise the required scepticism and have accepted evidence that is less than persuasive -- indeed the examples are galling in their simplicity", before going on to highlight cases that would certainly not instill confidence in the work of auditors.

The key issue emerging is that of independence. The audit can only have value to the shareholder when the auditor carries out his work with a healthy dose of scepticism and complete independence. These attributes need to be engrained into the culture of the auditing profession, and as regards listed companies, I believe three changes need to be made to the structure of auditing.

Firstly, the market needs to open up. Similar to the situation that prevailed for too long on the boards of Irish companies, when we had too few people on too many boards, we now have too few audit firms doing too many public company audits. All of the companies on the main listing of the Irish Stock Exchange are audited by just four firms. Learning from past lessons in our boardrooms, we know that this can create an unhealthy environment where independence and scepticism is compromised by familiarity.

Secondly, we need to take a close look at the length of time an auditor can remain in office. Recent research carried out in the UK showed that the average time auditors stay in office is 25 years. It has to be increasingly difficult to remain independent with the passage of time, as you become more familiar with a client's finance team (some of whom might be ex-employees) and systems. While audit firms must rotate audit partners every five years, who wants to be the partner to lose an audit client who has been with the firm for 20 years? As there can be a significant cost in changing auditors, the term should be set at a reasonable period. The fundamental principle is that the appointment is not permanent and another firm will come in after your term to review and put a fresh set of eyes on the numbers.

Lastly, the issue of auditors providing non-audit services needs to be reviewed. For listed clients, the client is clearly the shareholder and not management. The auditor should not be, or be seen to be, involved in any management decisions, and should focus exclusively on the audit. A review of the financial statements for listed companies clearly shows the extent to which audit firms benefit from non-audit services. It is difficult enough for an audit partner to take a stand against a finance director where audit fees are at risk, but what if that stand is also going to jeopardise millions in non-audit fees? The fact that non-audit services are generally more profitable than audit work, creates an incentive for audit firms to under-price audit fees in order to win the more lucrative and profitable specialist services in tax and corporate finance. Apart from the risk that this practice could compromise audit quality, non-audit work, even with mile-high Chinese walls, brings the audit firm closer to assisting management in business decisions.

These changes would send out a clear message that the audit profession is focused on producing high-quality independent audits, and would help restore the confidence of the investor community.

I'll finish with a personal story on watchdogs. It was the promise from my daughters that the two Jack Russells they so eagerly wanted would make excellent watchdogs that finally persuaded me to relent and get them. I now know the most an intruder is likely to get is a good lick, definitely not a bark, and they're certainly smart enough to know not to bite the hand that feeds them.

Paul Raleigh is managing partner at Grant Thornton

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