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Auditors’ would not bark

September 30, 2002

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NOBODY ever gives confidence much thought until it is gone. The industry has manifestly broken the vow of trust to safeguard stakeholders’ interests.

The enormity of corporate meltdowns suggests that auditors’ would not bark even when the management whisked off the entire stock of biscuits.

In becoming an industry, the profession has turned their back on their raison d’etre— integrity, and swapped it with profit motive. Stephen L. Carter defined integrity thus: “Integrity requires three steps: (1) discerning what is right and what is wrong; (2) acting on what you have discerned, even at personal cost; and (3) saying openly that you are acting on your understanding of right from wrong.” It’s your judgment and your integrity and the duty of care that you apply to your job that are critical.” The scams show that because of profit motive the profession is dripped dry from integrity to its bones.

The conflict of interest situation carries grave consequences other than being comfy with management and attesting accounting trickery. Which, as maintained by the US Securities and Exchange Commission in a court filing against one of the Big Four, is that the financial statements certified in a conflict of interest situation “cannot be considered to be independently audited financial statements, as required by the law.” Widespread conflict of interest situations, therefore, raises, as it must, questions of public concern: should exclusive franchise for audit allowed to them be continued? or, should the industry be allowed to self-regulate?

The profession’s constituency is gripped with fear. What hasn’t been and couldn’t be unearthed due to enormity is frightening and even half suggestion about continuation of self-regulation makes the constituency twitch. Dow Jones’ index’s rise in the US by 489 points in one day on the word only that the US Congress had agreed for an oversight board indicate investors’ mood. The industry’s feathers need to be ruffled with a firm hand like all other industries; independent assurance about auditors’ ironclad and unequivocal fidelity is essential.

Consultancy relationship is said to be the prime source for this epidemic. Brand Finance plc survey of 292 London equity analysts revealed that over 90 percent of the analysts believe that enormity of fees for other services as compared to audit fee poses very serious problem of conflict of interest. (Motorola, Gap and Raytheon paid their auditors more than ten times as much for consulting as for auditing).” Sir Howard Davies, chairman, UK Financial Services Authority, said: “Concerns have grown about the dangers of auditors colluding in bad accounting practices because they are earning large consultancy fees.”

The proof of the pudding is in eating it. The mountain of muck revealed by Enron, Global Crossing, Tyco International, Xerox, Rite Aid, Adelphie, Worldcom, Qwest, Peregrine Systems, and GE, IBM, Bristol Myers, Merck Sharpe, Halliburton and Elan, an Irish pharmaceutical company, show the profession to be in cahoots with management on a very grand scale. The US government’s court filing against Xerox stated “Xerox committed fraud in boosting its profits by billions of dollars through accounting chicanery.”

“Most of Xerox’s accounting violated generally accepted accounting principles (GAAP)”, and it “used it’s accounting to burnish and distort operating results rather than to describe them accurately. The accounting function was just another revenue source and profit opportunity,” said SEC’s Director of Enforcement. Self-regulation is a sham; it tantamounts to convincing residents not to lock the doors at night, nor to put police on street and then burgle the house(s).

Weiss Ratings, in a recent study, entitled “The Worsening Crisis of Confidence on Wall Street: The Role of Auditing Firms” observed that out of 228 companies audited by the Big Five, 194 went bust in a year and that the audit firms gave a clean bill of health to fully 94 per cent of the public companies that were subsequently cited for serious irregularities and companies total peak market value of $1.8 trillion dropped to $927 billion and the shareholders suffered an aggregate loss of almost $1.3 trillion.”

Other than consultancy relationship, who appoints auditors also has a significant behavioural implication. Favours have to be returned to those who provide business. It’s almost an either or situation, be comfy with clients or lose business. (Watchtowers for monitoring auditor independence ought to have been, therefore, erected on the day the management started obtaining shareholders’ blanket mandate to appoint statutory auditors and fix their remuneration.)

Arthur Levitt, immediate past chairman of the US SEC and crusader against Professions’ terminal illness of conflict of interest said accounting firms could not be trusted to regulate themselves: “I don’t think the accountants can do it on their own. I think they’ve been insensitive to the importance of the public interest.”

Whether to let the profession self-regulate itself is simple to decide. Would anybody allow self-policing to an association of individuals who have proven potentiality to commit social ill of very serious nature, which if committed, would alarmingly destabilise the society? No prizes for guessing which it would be.

The US has done away with self-regulation and severely tightened corporate regulations. A new independent oversight board of nine people, six of whom would have no connection with the accountancy profession, has been set up for the accounting industry. The auditing standards would now be set by the board rather than by professions trade body, the American Institute of CPAs. The board would punish miscreant auditors, as well as investigate and discipline them. The law has imposed outright ban on nine kinds of non-audit services, including building financial-information systems, legal services and investment banking and provides that any non-audit work must be approved first by the company’s audit committee. (Large corporations, e.g., Walt Disney, Unilever and Citigroup have announced that they will not give any consulting work to their auditors. PwC has already sold its consulting business to IBM.) To assure its independence, the law makes provision for mandatory funding from audit firms and companies. Another significant US proposal is that reliance on prior audit shall no longer be permissible.

“There is no true number in accounting,” said Harvey Pitt, Chairman, the US SEC, “and if there were, auditors would be the last people to find it.” He wants to “shed light on the processes of calculation that lead to the numbers in the financial statements. According to the Economist, “he has already ordered auditors to identify the five assumptions that make the biggest difference, and to show how the numbers would look were different assumptions made.” In doing so, “he is on the right track”, added the Economist.

Skeptics may say that all scams taking place in the US suggested that the accounting industry there needed screwing up. But it isn’t indeed so and the position almost everywhere is similar; for instance, there were spectacular meltdowns of blue chip corporations in Australia and year 2000 is called there a year of corporate collapses.

The UK already had an independent board— Accounting Foundation- that regulates the accounting industry. Canada also has very recently established public accountability board (CPAB). It will review the country’s six major auditing firms each year and impose sanctions when companies fail to comply. The board has 11 members, seven of whom are from outside the accounting profession; “the new oversight body is not controlled by the (chartered accounting) profession,” said David Brown, head of the Ontario Securities Commission.

Oversight institutions should be ideally established in every country. Provable nexus between consulting relationship and loss of auditor independence does exist. For instance, the US SEC’s has recently imposed fine of $5.00 million, its largest fine for auditor independence, on one of the Big Four (the firm has accepted to pay the fine), which, as SEC said, showed that a consulting relationship compromised an auditor’s independence and led to a bad audit; or, one other of the Big Four firms admitting their lack of independence and consenting to a SEC’s final order directing them to comply with applicable auditor independence standards and guidelines; or, yet another of the Big Four being censured by SEC for violating auditor independence rules; or, David Cairns, former Sec Gen, IASB, observing in “IAS Survey 2000” that in several instances auditors awarded “clean bills of health” to companies even though the financial statements were not fully compliant with IASC standards.”

Instances of unbridled conflict of interest are available at penny a dozen. However, if the profession yet needs proof beyond such overwhelming evidence, then, it should itself pass through needle’s eye and prove its case as it is under French law, where the defendant is to prove his/her innocence,.

Long association between auditors and management is suspect and perceived to create a sort of ‘co-habitation’ arrangement. As pointed out by the Financial Times (FT) long association has made people nervous.” Sir Howard Davies of UK FSA said: “Concerns have grown about the dangers of auditors colluding in bad accounting practices because they have become too close to their clients.”

As its remedy, it is argued that auditors’ tenure be fixed for a maximum of 3-6 years. Recent survey by the FT of UK’s finance directors showed their majority to be emphatically in favour of rotation. Chris Dickson, executive counsel, Joint Disciplinary Scheme, said that auditors’ change leads to a ‘new broom’ approach. The knowledge that another accountancy firm must take over after a fixed period is likely to encourage a more searching and skeptical audit, if only to prevent costly embarrassment in the wake of the new broom.”

However, there are others who do not favour it, for instance, a UK FD termed mandatory rotation to be ‘draconian measure’ that “offers no guarantee that another Enron could not happen.” Gerry Acher, KPMG senior partner has said rotation would lead to ‘massive amount of disruption.

Human crafted remedies are rarely perfect. Rotation of auditors also is no panacea. Kieran Poynter, UK’s PWC’s senior partner, has termed it as ‘fatally flawed’ which would reduce the quality of audit and double audit cost as well.” Though not in response to it but still discussing rotation-related cost-increase issue, the Economist observed: “But higher prices are by no means most serious danger reform poses for auditors’ clients. For some companies, the real threat is that their accounts may be properly audited.” Roger Housechild, head, ICAEW’s audit and assurance faculty, said:”Instead of rotation of auditors, audit partner be rotated every four years to ensure a new viewpoint is introduced on a regular basis.” The “Economist”, however, has summed up the case for rotation thus:”The WorldCom scandal came to light only after another of the Big Five had been brought in to replace Andersen. Experience shows that the best form of peer review is a frequent change of reviewer”.

The FT has suggested “as a backstop to auditing, corporate regulators must monitor corporate accounts, with special emphasis on complex companies.” In the UK and Sri Lanka boards of independent members and statutory commissions respectively already exist for the purpose. Literature shows that due to UK board’s intervention published financial statements are drastically amended or altered by auditors, even by Big Five. This seems to be the ideal need of every country.

Situation in non-listed companies concerning quality of audit should be no better than that of listed companies.fff Erecting rules for corporate governance and guidelines to assure equally high quality of audit are no less pressing for non-listed companies as well.