The importance of keeping audits truly independent

A COUPLE of weeks ago, I raised the question as to whether the statutory audit of limited companies' financial statements should be provided independently from other accounting services. I suggested that the major accounting firms are in danger of treating statutory audit services as a "loss leader" to attract other business in the long term. The need to build relationships with big businesses generally (and the government bodies which regulate them and who are the other major source of non-audit work) places downward pressure on the audit fee, leading to cost-cutting and depreciation in value of the statutory audit to an accounting firm's overall business model. The "best and brightest" may only be attracted to audit as a training facility and not as a long-term career.

This has implications for the quality of audit. I am aware that all major jurisdictions, including Singapore, have audit quality standards that are rigorously enforced by professional bodies. All major audit firms have internal standards that often go beyond the public ones. However, when the regulatory body in the United Kingdom states that the standard of audit generally within the Big Four accounting firms for the FTSE 350 requires significant improvement in 27 per cent of cases (and 50 per cent in one firm), there has to be cause for concern - investors are being shortchanged.

There is one significant difference between the provision of statutory audit to any business and the provision of all other accounting and advisory services. The statutory audit is a contract between the shareholders and the auditors. All other services are contracts between the management of the business (representing the shareholders) and the service providers. Before the auditors report the results of their audit to the shareholders, any concerns arising are discussed with management. If the auditors are already providing other services to the company, or are ambitious to do so, there is a clear conflict of interest for the audit partner. Where his concerns may have a material effect on the financial statements, there is perceived, or actual, pressure to downplay them in the interests of other, or future business. When the audit fee is lower than it should be, and the prospect of other fees is enticing, this pressure is enhanced.

I am not being alarmist and I am not accusing any audit partner anywhere of lowering their standards. I am just pointing out a financial truth. I was brought up to regard independence as the cornerstone of audit impartiality and it was drummed into me that independence is a state of mind, not a set of rules. Mankind is venal and if a decision may lead to loss of income, it is a hard one to take. Auditors should never be put in this position, otherwise standards slip and the public's faith in audit is weakened.

Audit failures in recent history are divided between those of quality failure and those of independence failure. In Singapore, we have had several quality problems, the headline cases being Haw Par, Pan-El and Barings Futures decades ago. Quality of audit is already addressed by the local profession and the regulators and it is not an issue on its own. If it becomes an issue in the future, you can be assured that the proper sanctions will be applied. The regulations are as tough as anywhere in the world.

Independence failure is something else and because it involves the auditor's personality, it is a very grey area (suitable description for an accounting scenario). The most obvious example in recent history is Enron, audited by Arthur Andersen, then the world's largest accounting firm. By their own admission, they connived with management to keep certain matters out of the financial statements, where a truly independent auditor would have insisted on full disclosure. It does not matter that the "Special Purpose Vehicles" were designed to (just about) comply with the then accounting standards - the shareholders were deceived. The auditors then admitted their failures through the stupidity of trying to shred evidence of their collusion with management. The whole firm was destroyed as a result of greed for non-audit fees. This is the worst example of what I am trying to convey - that auditors must be, and be seen to be utterly independent of management.

ENSURING TRANSPARENCY

We have all suffered from the cosiness of big business, their advisers and politicians this century. The financial crisis of 2008 (ongoing) was a result of well-meaning politicians (Bill Clinton take a bow) trying to assuage their guilt at destroying jobs in their own country in the interest of globalisation by providing cheap housing to the jobless. Which would have been fine if real estate values in the US (and the UK) kept rising. As we know, enter the most venal of all people - bankers - who packaged the infamous mortgage-backed securities, got them AAA-listed by their rating poodles, wound them into derivatives (at vast paper values) and sold them round the world, even sucking local banks into selling them in HDB estates as safe investments.

I acknowledge that I am on the verge of a rant, but there is a point to it. We have suffered enormously from the shenanigans and egos of business and politicians in our (capitalist) society, but it is a whole lot better than the socialist alternatives. The model is good, but there have to be real checks and balances. Singapore is a shining example of what independence of thought can mean in the current capitalist world.

Back to audit. An expert audit, conducted in an environment of guaranteed independence and properly remunerated, is still the best way of showing up the faults of our current way of doing business. Training people to be able to do this job is very expensive and keeping them from alternative careers requires not just job satisfaction, but competitive salaries. Modern major accounting firms have the resources to sustain an audit business but cannot fulfil the independence role, because audit has been relegated to a sales opportunity. Audit clients are happy because their fees are contained. No business, anywhere, has enjoyed being audited and treat their auditors as unwanted guests. Auditors only put up with this today because they believe that the relationships they establish with their client, with their client's contacts/board members and with the regulators will result in future income. The movers and shakers in all jurisdictions know each other and are leery of anyone who rocks the boat.

Audit is a profession that has been unjustly denigrated. It is poorly paid, but should be seen as a vital source of independent information on the conduct of our capitalist business model. I am not convinced that it can be carried out properly within global businesses unless it is separated financially.

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