Auditors - Influenced or Influencers?
"The auditor is a watchdog and not a bloodhound."
- Lord Justice Topes
By definition, an audit is considered to be an independent assessment of the manner in which a company's financial statements are prepared and presented to and by its management; this task is mainly performed by skilled, independent and experienced persons known as auditors.
In recent times, in light of the current economic climate, especially in relation to financial institutions and the practices they employed, serious questions are arising regarding the actual competence and independence of these auditors, and indeed whether they are influenced by the organisations who are engaging their auditing services.
Can one really determine if auditors are influenced by an organisation or an influencer of an organisation without understanding possible associated externalities? I mean, it's very easy to single out auditors in anger, as the sole reason for many failed companies. But is it really that simple? Is it really a failure of the audit process, or are we looking for a scapegoat when things go wrong?
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In accessing this claim, this report will look firstly at the two different types of auditor and the role of the auditor, followed by examples of international and domestic companies, namely Enron, Lehman Brothers, Greencore Ltd and Anglo Irish Bank, in which the auditor's role was questioned.
But is the role of an auditor truly black and white. To examine this we consider some of the internal difficulties or limitations on the work of an auditor such as the concept of "true and fair" view and materiality, the flexibility and rigidity of accounting and the human element.
Following that we examine external issues which have a huge impact both on the role of the individual auditor and the audit firms themselves; independence, its perception and the policies implemented to ensure independence; and the question of liability in the role of the Auditor.
Finally we conclude with observations of failings of the Audit process, its limitations and issues and recommendations.
It is important to recognise from the outset that when people speak of auditors in the current market context, one automatically assumes they are speaking of one of the 'Big Four' - the four largest international accountancy firms, namely PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, which handle the vast majority of audits for publicly traded companies as well as many private companies,. However, it is important to remember that for the purpose of financial auditing, there are two types of auditors; external and internal. And while both professions have shared interests regarding the efficiency of internal financial controls, and both adhere to codes of ethics and standards as determined by their respective associations, there is a large distinction between the scope of their work and their objectives and their relationship to the organisation.
External auditors are independent of the organisation, to provide an annual assessment and evaluation of their clients' financial statements. Their approach is to assess whether the financial statements fit generally accepted accounting principles, impartially represent the organisation's financial position, accurately represent the organisations results over a given time period, and whether they have been materially affected. Their objectives are set predominantly by law and their client, the Board of Directors. External auditors may also be engaged to perform non-audit professional services such as consultancy work.
Internal auditors are part of the organisation. They are company hired employees whose scope of work is all-inclusive; they continually assess and evaluate the company's internal controls and processes, and while primarily related to financial reporting, the assessment does include both financial and non-financial aspects of the organisation. This effort helps an organisation achieve its objectives, whilst improving operations, risk management and internal controls and thereby mitigating the possibility of fraud. And while internal auditors are not independent of an organisation per se, they are expected to report directly to the Board of Directors or a sub-committee as determined by the Board of Directors and not to management, in order to prevent the possibility of favoured evaluations.
So why is there such a furor over the role of the auditor at the moment? Well this is primarily due to the number of high profile cases in recent times where auditors failed to identify problems.
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In 2001, Enron which was considered one of the world's leading electricity, natural gas and communications company, with claimed revenues of $101bn in 2000, collapsed. Enron's downfall occurred after it was revealed that much of its profits and revenue were the result of deals with special purpose entities. Enron created off-shore entities, which allow for the planning and avoidance of tax, allowing management the full freedom of currency movement and anonymity to hide losses. The result was that many of Enron's debts and the losses were not reported in its financial statements and therefore the company was made look more profitable than it was. Arthur Andersen, the auditors, were convicted for obstruction of justice over its handling of the audit of Enron and forced to stop auditing public companies. This prosecution resultantly highlighted its flawed audits of other companies, most notably WorldCom, whose subsequent bankruptcy became the biggest in US history, but now surpassed by the Lehman Brothers collapse. And while the charge was later overturned, the damage caused by the scandal prevented Arthur Andersen returning as a viable business.
More recently, the collapse of Lehman Brothers in 2008 sparked a financial crisis which shook the banking industry on a global level. After burdening itself with tens of billions of troubled assets, mainly due to the subprime mortgage crisis, which couldn't be sold easily, Lehman concealed its debt and risky financial position through use of temporary, off-balance sheet transactions to the value of $50bn, known as Repo 105, which flattered the bank's financial position. Repo 105 was a form of repurchase agreement which allowed the sale of "toxic" securities at the end of a quarter, thus wiping them off its balance sheet and then quickly buying them back again. The examiner in charge of the investigation into the collapse of Lehman Brothers apportions the blame to both the senior management for "actionable balance sheet manipulation" and the auditors, Ernst & Young "for among other things its failure to question and challenge improper or inadequate disclosure in those financial statements".
From an Irish context, accountants at the Scottish mineral water division of Greencore Ltd, Campsie Springs, uncovered fraud to the value of €21m in 2008. Over a three year period, the financial controller at the Scottish plant deliberately misstated the company's costs which saw the company take a €9m impairment charge in 2008, as well as a further €8m impairment charge in 2007 and €4m in 2006. A number of operating costs relating to general overheads, as well as transport, distribution and raw material costs were concealed by incorrectly offsetting them against items on the balance sheet. The money had been consequently held in a 'suspense' account. However, this deliberate concealment, which came to light during an internal audit review, was missed by two previous internal reviews and by two external audits conducted by PricewaterhouseCoopers, who received €1.8m in audit fees over the fraudulent three year period. Resultantly Greencore are pursuing PwC for compensation for their failure to notice the fraud.
In December 2008, Sean Fitzpatrick, chairman of Ireland's third largest bank, Anglo Irish Bank, disclosed that he had concealed €87 million in loans from the bank over an eight year period. Anglo's annual report displays the total loans given to directors, measured at a single point in time, namely 30th September. From 2000 to 2008, Sean Fitzpatrick transferred the loans to the Irish Nationwide Building Society prior to this date, thereby inhibiting the transparency of Anglo's loan book and causing "Loans to Directors" to be understated, and transferring them back after this date. While the internal audit committee, of which the current executive chairman Donal O'Connor was a member at the time failed to notice the irregularities as did Ernst & Young. This was only noticed following an investigation by the Financial Regulator into the loan book of Irish Nationwide Building Society. However this was not the only discrepancy at Anglo, its 2008 full-year figures showed a profit of €784m, and initially a bad debts provision of €379m which was later increased by an extra €500m. This showed a bank in a healthy position, however 6 months later, the profit of €784m had turned into a loss of €4.1bn and impaired loans increased from €2.5bn to €23bn. Where were the auditors when these figures were adopted?
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In the light of the number of major oversights incurred by auditors, what internal difficulties or limitations do they face in regard to conducting an audit?
The first limitation is the concept of "true and fair" view. The responsibility of external auditors is to audit the financial statements as required by company law and report whether, in their opinion, the financial statements present a "true and fair" view. But what is a "true and fair" view? The concept has been central to accounting and auditing practices for decades but the term itself is not defined by legislation or by the auditing profession.
The Statement of Auditing Standards 100 (SAS 100), Objective and General Principles Governing an Audit of Financial Statements explains that 'an audit in accordance with SASs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement.' But what is understood by "material"? According to SAS 220, Audit Materiality, 'a matter is material if knowledge of the matter would reasonably influence the economic decisions of users taken on the basis of the financial statements.' However, materiality is calculated based on rules of thumb for example 1-1.5% of sales. In the case of Enron, the company had to correct its accounts back to 1997; the correction was $51m and its reported profit was $105m, the adjustment resulted in a reduction of reported profit to $54m. $51m was deemed by the auditors to be immaterial based on the rules of thumb used.
A third limitation is the flexibility of accounting. Accounting is based on concepts and follows "generally accepted principles" but there can exist more than one principle for the treatment of any one item. For example, closing stock of a business may be valued using the FIFO, LIFO, average price, etc. methods, but the results are not comparable.
Another limitation is that financial information is rigid and backward looking. It does not take in to account non-monetary information such as intellectual capital held by the company, the degree of competition faced by the company, etc., which is vital information to those with an interest in the company. Coupled with this the fact that it does not provide timely information, it provides information in the form of statements usually for a period of one year, therefore the information is historical and only a 'post-mortem' analysis can be undertaken.
A final limitation is the human element. With pressure on employees of the organisation to continually perform due to the demands of management and the market there is a risk that employees may exploit ambiguities in the accounting rules, such as deliberately entering into or structuring transactions which may circumvent the rules, in order to meet markets expectations about earnings.
While those internal constraints which may inhibit an auditor's work have been identified, we'll now look at the external difficulties surrounding the implementation of an audit?
One of the areas for concern is surrounding the independence of the appointed auditor. Although the auditing market in Ireland is, for the most part, an environment in which small companies are audited by an variety of smaller audit firms, the accountancy market is generally considered an oligopoly, in which the market is dominated by the Big Four: PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu, and Ernst & Young, therefore there is very little choice for consumers. And due to the nature of oligopolies' there is very little differentiation present between the services provided. Resultantly all these firms provide additional services outside of auditing, known as nonaudit services (NAS). The number of nonaudit services provided by an auditor brings into question that auditors independence; at what stage does a firm lose its independence when providing several services? In Enron's case, Arthur Andersen was providing so many services that it was in fact auditing its own work.
As a result of the Enron collapse, the U.S. Congress passed the Sarbanes-Oxley Act of 2002. This legislation imposed restrictions regarding the nonaudit services a firm can provide, which are deemed to impair an auditor's independence such as bookkeeping or other services relating to the clients financial statements, financial software system design and implementation, management functions, and legal services to name a few.
The Act also provides further provision to help maintain independence through:
Preapproval conditions: all services to be provided must be preapproved by the audit committee,
Rotation of partners: depending on their role in the appointment, audit partners are disallowed from auditing the same company for five to seven successive years, Auditor reports to audit committee, Conflicts of interest: if within a one-year period, key members of the management team were involved in the audit engagement, then the auditing of that client is prohibited, Improved financial disclosure: more comprehensive financial disclosure is required within the financial statements, Compensation: independence will become prejudiced if the provision of nonaudit services determines the audit partners compensation.
From an organisations point of view, because of the valuable information within financial statements for investors, unfavourable reports regarding the quality and independence of the auditors creates doubt around the accuracy of the organisations financial statements and can have a negative impact; for example, following the announcement of Andersen's indictment, the market reacted negatively to Andersen's clients but gained following their dismissal as auditors.
While the initial reaction of most European auditors to the Enron scandal was that it could not happen in Europe because the EU emphasis is in direct contrast to the rule-bound behaviours of US financial reporting, the EU is taking similar steps to the Sarbanes-Oxley Act, issuing a proposal that broadens the scope of the 8th Council Directive on Company Law. It specifies the duties of statutory auditors, their independence and ethics, the introduction requirements for external quality assurance by ensuring better public oversight over the audit profession and improved co-operation between oversight bodies in the EU.
While these legislative changes have tackled the issues around the maintenance of independence, there are still some concerns; should the rotation of Audit partners be reduced from seven years - in the case of Anglo Irish Bank the loans to Director's were hidden for eight years, in Greencore the concealment of costs occurred over a three year period; should audit firms be prohibited from auditing companies which have on their Board or in executive positions ex-employees - Donal O'Connor, current chairman of Anglo Irish Bank was senior partner with PricewaterhouseCoopers in Ireland from 1995 until 2007.
There has been a continual increase in the number of claims people are bringing against professional advisors in recent times; a recession usually brings with it an increase in legal action as people look harder at their finances. Auditors are not exempt and a substantial topic of concern is surrounding the area of liability. Following the decision of the Hedley Byrne case in 1963 which set a precedent for liability actions for negligent misinterpretation causing economic loss, many audit firms use engagement letters containing disclaimers in order to limit the liability by clarifying the scope of the duty of care understood; with regard to third parties to whom the duty of care is owed and with regard to the purpose of the audit report.
However, the view to limiting liability varies differently between countries and even organisations. The American Institute of Certified Public Accountants (AICPA) in the US released Ethics Interpretation 501-8 on Indemnification and Limitation of Liability Provisions and while it does not directly deal with the actuality of using limited liability clauses it does refer to specific regulatory industry guidance which does contain these restrictions. The reasoning for this is the perception that the inclusion of limited liability clauses can impair an auditor's objectivity such that their independence may be compromised and also cause deterioration in the quality of audit conducted, and indeed the insurance industry rigorously restrict their use in auditor engagement letters. The use of disclaimers by professional auditors can indicate at best, a lack of trust in the reliability of their work and, at worst a recognition that it is not reliable.
Within the EU, there are differing trains of thought on the issue, with EU member states varying widely on how they handle auditor liability and the increased audit risk due to growing markets and globalisation. In 2006, the EU issued an audit directive seeking to harmonise audit requirements throughout the EU and commissioned a London Economics International study. At this time five EU member countries limited auditor liability - Austria, Belgium, Germany, Greece and Slovenia, while the UK passed the Companies Act 2006 which allows auditors to limit their liability once the contract has received shareholder approval. Although the Act does not specify how the limitations are established, the Financial Reporting Council (FRC) recommends three methods in determining these amounts:
- proportionate share - caps auditors' liability based on the degree of their responsibility for the loss
- fair and reasonable amount - determined by the courts on an individual case
- agreed-upon cap - based on an agreed formula, expressed as a monetary value or a combination of both
If no agreement is reached regarding limiting the liability then unlimited liability will ensue.
In 2008, the EU Commission recommended its member states to limit auditor liability similar to the Companies Act but differs in that it suggests four options in determining the liability limitations: an EU wide single monetary cap, a cap based on company size, a cap based on audit fees or proportionate liability, but as yet outside of the six countries identified earlier, no other EU country has implemented this recommendation.
Auditors in the Republic of Ireland continue to operate under 'joint and several liability' which means that all partners of an auditing firm, regardless of whether they were involved in the audit or not, are liable on a 'joint and several' basis for each and every claim taken against the firm; under section 200 of the Companies Act, 1963 auditors and companies are not allowed to limit auditors' liability through contractual means. The failing in this approach is that it does not take into consideration the level of responsibility of the auditor; thereby meaning that a small oversight could result in the firm being responsible for a loss which was the result of intentional wrongdoing by a company's directors/employees.
The London Economics study found that EU firms face huge potential losses due to litigation but the liability is manageable if the firm can obtain sufficient insurance cover; yet since the 1990's firms ability to purchase adequate cover has deteriorated resulting in the then Big Five to create captive insurance companies into which they pooled their premiums to provide sufficient cover, but these companies are no longer able to provide ample cover for the number of recent claims. In 2008, the six largest accountancy firms advised that they had 27 outstanding legal actions pending with over $1bn been claimed in each case, with seven of those pleading in excess of $10bn.
Can one definitively determine if Auditors are Influenced or Influencers? Or are we, in the middle of a recession which heralded the end of the good times for many people, looking for someone to blame for now having to tighten our belts and change the lifestyle we were once used to.
But there are grey areas and external factors which can create difficulties for an auditor, and coupled with confusion around the scope their work can impact on the result of an Auditor's report.
One such area is that in which we initially identified that both external and internal auditors report to the Board of Directors. Could this cause a conflict of interest whereby the Board is in fact the puppet master, subtlety pulling strings of both groups to achieve their goal? The concept of 'fraud' is based around concealment and Auditors can only work with the information they are given.
Or can a company providing Auditors with canteen facilities or other facilities which would naturally be provided to external consultants on the company's payroll be deemed to impair the Auditors independence? Could external auditors be appointed by the relevant Stock Exchange or Companies Office, who in turn charge the company to prevent these possibilities?
An audit is generally undertaken at year end and provides a snapshot of the company's finances at that point in time. Could it be more beneficial if smaller audits were undertaken at regular intervals such as quarterly audits, which would allow auditors to look more closely at potential issues and accounting practices due to the reduced quantity of data?
Accounting is based on concepts and follows "generally accepted principles". More than one principle can exist for the treatment of an item depending on the auditors understanding of the principle and how it should be treated and indeed an accountant's own training could determine how it is treated. The lack of clear rules allows not only for the accidental misunderstanding and misinterpretation of principles but also allows the possibility of intentional misinterpretation. Is there a requirement to tighten these principles or apply stricter rules of thumb?
While these areas outline shortcomings in the area of auditing, I do believe that auditors are influenced and not influencers. But not for the reasons I originally thought of, prior to undertaking this work.
Initially, I believed that auditors were bowing to pressures from the company or Board of Directors to show the company's financial statements in good light and not highlight any issue which may negatively impact on the company's performance.
However, I am off the opinion now that perhaps auditors are influenced not by companies or Boards of Directors but with regards to their own self preservation. Because auditor's reports are only reasonable assurance of the accuracy of a company's financial statements, unlimited liability has become the stakeholders 'insurance' against a challenging report, along with the perception that audit firms are cash rich and a source for financial gain. With the six largest accountancy firms having 27 outstanding legal actions pending for over $1bn each, and seven of those in excess of $10bn. The possibility of a Big Four firm collapsing due to a liability claim is very real. Audit fees do not incorporate sufficiently into their calculation the audit risk and as per the London Economics study, liability insurance is proving costly and inadequate with available commercial insurance only covering less than 5% of some of the large claims faced by some firms.
In the examples outlined earlier, Enron; could Arthur Andersen afford to lose what was at the time, a blue chip client or indeed risk litigation proceedings which would have impacted on their reputation. Lehman Brothers; would Ernst & Young have brought about the downfall of Lehman more rapidly had they challenged the improper disclosure of the financial statements and in turn risked litigation. Greencore: an audit failing in which the financial controller was able to conceal cost misstatements and Anglo Irish Bank in which the audit process was manipulated and loans concealed.
In many of the recent scandals, of those which were not due to failings of the audit process, one can identify the influencing factor of self preservation and one feels that a change to laws on liability based on a proportionate share approach need to be implemented.