The Companies Act and its requirement for auditors


The Companies Act requires that all firms should be audited with the exception of small or dormant firms, this alone should emphasise how important the profession is. It is also clear that for such a dominant profession to be successful the public need to be able to place trust in auditors that they will carry out their role in an ethical and professional manner. Humphrey quotes Wallace in his article discussing the three hypotheses which Wallace believes leads to a demand for audit in society; they are the "stewardship hypothesis, information hypothesis and insurance hypothesis." [1] The stewardship hypothesis argues that auditing is demanded due to the agency theory concept where agency relationship occurs between the owner and managers. Jensen and Meckling describe an agency relationship as "a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interest of the principal." [2] The agent may act in a way that maximises their own wealth, that is, they will act in a self-serving manner. This is the argument developed by Watts and Zimmerman known as "positive accounting theory." [3] The information hypothesis argues that information asymmetry between the owner and the manager leads to a demand for auditing, as it is seen by society as a monitoring tool, which should ensure information asymmetry, and agency costs are reduced. The insurance hypothesis argues that shareholders would demand auditing so that if any fraud or misrepresentation of the financial statements occurs they will have a firm to sue for compensation. It is believed that auditing firms will have "deep pockets" and so would be a more likely choice to sue. The role of an auditor is described as "an expectation that auditing, as a professional service, should not only provide assurance for the credibility of financial statements but also enhance the integrity of the financial information and its usefulness in decision making by managers and other users." [4] The latter part of these is very important in the auditor's role in society as potential investors look to audited accounts to investigate a potential investment and decide whether it would be worthwhile.

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Auditor independence is the "cornerstone of auditing" without it the validity of the auditor's reports would come under a lot of scrutiny as well as the profession as a whole. Although in the eyes of the public they feel that as potential investor's auditors owe a duty of care to them, to ensure that the financial statements are free of fraud however case law doesn't always agree. In the case of Caparo plc v Dickman (1990) the House of Lords held that "auditor's duty is owed simply to the company and to its shareholders as a body" therefore auditors do not owe a duty of care to any potential investors or individual shareholders. This could be seen as a contradiction to what society would claim the role of an auditor is. Prior to the recent economic crisis the role of an auditor had shifted from fraud detention to a role described by Lord Justice Lopes as "a watchdog not a bloodhound." This means auditors duties became more about reporting on the truth and fairness of financial statements than the detection of fraud. However an expectations gap developed where the public perceived the auditors role to be detection of fraud and so when the economic crisis unfolded it caused widespread upheaval, with the public loosing confidence in the auditing profession. After a number of largely publicised corporate scandals such as Enron and Arthur Anderson and BBCI the validity of the auditor began to dwindle in the public's eyes. It was widely reported that the auditing company of Enron, Arthur Anderson was made aware of the fraud being carried out but decided to ignore it and not qualify the accounts. This was not a one off occurrence as auditing firms across the globe were being caught out on unqualified accounts. In an attempt to stifle criticism and appropriately respond to the public's demand for improved auditor performance the role of the auditor had to once again shifted back to one where there is a responsibility in the detention of fraud, however the role of reporting on the truth and fairness of financial accounts was still the main aspect of their job.

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The position of the auditor and the auditing profession has been strengthened by the introduction of The Companies (Audit, Investigations and Community Enterprise) Act in 2004. Making it an offence for directors and other employees to withhold any information that the auditors require from them has made the auditor's position stronger. The act also widened the scope by making it clear that employees came within its scope as well as company officers. Fearnley & Beattie discuss how following the collapse of Enron, the UK government set up the Co-ordinating Group on Audit and Accounting Issues (CGAA). [5] This high level group of regulators and ministers were responsible for leading the review of the regulatory framework, including the key area of auditor independence. Tony Bromwell refers to recent changes that have strengthened the role of audit in society and highlights how its correct functionality is crucial in society. Recent changes that are found in the UK Companies Act 2006 include, for example, requirements for example a business review for medium and large companies. [6] There are now additional auditor independence requirements from the International Federation of Accountants, which has a unequivocal knock-on effect on the ethical standards issued by the Auditing Practices Board in the UK. This is due to amendments being made to the International Financial Reporting Standards and therefore UK accounting standards, being aligned with US accounting standards. There has been a reworking of international standards on auditing and so therefore on UK auditing standards also as part of a project of clarity that seems to be resulting in a more black and white approach. The demise of Andersen after the Enron scandal meant the 'Big 5' accounting firms became the 'Big 4.' Increased concentration in an industry means there is more competition amongst auditing firms and less choice for clients. Due to audit being a crucial role in the functionality of businesses, an enquiry was launched in February 2002 by the Treasury Select Committee with the view to examine the arrangements for financial regulation of public limited companies in the UK. In July 2002 their report was subsequently published and it was recommended that the Government refer the operations of the 'Big 4' accounting firms to the Competition Commission (CC). The CGAA's interim report, recommended that the DTI and HMT should discuss with the OFT whether there are any competition implications of the high concentration in the market for audit and accountancy services. It is vital that a profession such as auditing possesses healthy levels of competition. Despite the European Commission declaring the merger of Andersen and Deloitte to be compatible with the common market, its investigation left open the question whether or not the transaction led to a situation of oligopolistic dominance. Public concern has been expressed about the provision of audit and accountancy services and much of this concern is centred on the level of auditor independence and corporate governance issues. The Accountancy Foundation Review Board, which was at the time responsible for the independent oversight of the UK accountancy professional bodies, took the leading role in this review.

The importance of the role of audit is seen again in the European Commission proposals for simplifying company law, accounting and auditing. These seek to enhance and strengthen the auditing profession. This work is referred to as the European Commission Consultation On The Simplification of EU Company Law and Accounting and Audit Regulation. [7] This was discussed in the media in July 2007 and the proposals are expected to come into force in 2012. The Consultative Committee of Accountancy Bodies (CCAB) is revising its ethical framework on statutory audit independence whilst the Government is conducting an ongoing review of the regulatory framework covering the accountancy and audit professions. Clearly, large amounts of capital and time are being invested which highlights the importance of the auditing profession in society. Each time new legislation is passed and amended the profession is being made stronger and more resilient to auditors being able to find loopholes.

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As noted above, the audit and accountancy market is currently undergoing a period of substantial change following the collapse of Andersens and the subsequent fall in confidence in auditing standards. The regulatory environment is in the process of change with a view to restoring confidence in audit independence and its standards. Where the reviews into corporate governance and regulatory issues result in proposals for new regulations, the OFT will advise, via regulatory impact assessments and otherwise, on the competition implications of proposed regulatory changes. Despite the aforementioned regulation and legislation, white-collar crimes and auditing failures continue to take place all around the world. This further harms the confidence levels of the public in the auditing profession and will prove very difficult to restore. Each time a new scandal emerges tough questions will inevitably be asked to those in authority, namely in relation to how it was allowed to happen, yet again. Whilst it is accepted that the frequency of corporate auditing scandals is indeed diminishing, much still needs to be done to reassure the public that auditors are working in the best interests of the company and for all those to which they owe a duty of care. Recent scandals include that of the declared falsified accounts of Satyam Computer Services in India in 2009. PriceWaterhouseCoopers failed to audit correctly, allowing exaggerated cash balances, overstating debt and understating liabilities to remain unnoticed meaning the accounts were incorrect by $1.54billion. [8] In Ireland in 2008 there was the Anglo Irish Bank hidden loans scandal, which has been described as Ireland's version of Enron. Ernst & Young gave the bank a clean bill of health for eight years. After stepping down in December 2008, recent headline news in March 2010 indicates that the former Chairman of Anglo Irish bank, Sean Fitzpatrick, has now been arrested in relation to his concealing of the €87 million in loans [9] . The Chief Executive of the Financial Regulator stated, "A lay person would expect that issues of this nature and this magnitude would have been picked up." by the external independent auditor. Even after receiving professional legal advice, Ernst & Young consistently declined to appear before a parliamentary committee. This highlights how much still has to be done in order to restore public confidence in the auditing profession. Further education of auditors may be required to remind them of the serious implications that will result if they do not do their jobs correctly.