By Mak Yuen Teen
First published in Business Times, June 25, 2013
Who watches the watchers? Given that auditors are supposed to look after the interests of shareholders, investors’ lack of trust in financial statements is a real cause for concern. – FILE PHOTO
THE report “Investors less trustful of financial statements: survey” (BT, June 13) mentions that investors continue to see external assurance as the main counterbalance to declining trust in financial statements. This is not surprising because there is simply no other viable alternative at the moment. Unfortunately, there is little doubt that trust in external assurance is being eroded.
A recent position paper submitted to European Union regulators by a group of long-term institutional investors managing 1.66 trillion euros (S$2.8 billion) highlighted their worries about external auditors, cast doubts on current safeguards to ensure their independence, and supported tougher measures to enhance independence. Given that auditors are supposed to look after the interests of shareholders, this lack of trust by influential investors is a real cause for concern.
All is not well in the house of audit, and a number of fundamental issues need to be addressed.
The issue of mandatory audit firm rotation has been debated extensively from time to time, and has recently resurfaced. Although audit partner rotation has been introduced to improve audit quality, this may not be effective because of unwillingness to challenge the judgments of fellow partners within the same firm and potentially exposes their firm to legal liability.
If you rotate a firm rather than just partners within a firm, you are more likely to have real scrutiny of the work of the preceding auditor. Although mandatory rotation of audit firms is likely to increase the cost of audits and potentially reduces audit quality if done too frequently, statistics reported in the UK show that the lack of rules on audit firm rotation has led to FTSE100 firms retaining the same audit firm for 48 years on average, with some having the same audit firm for more than 100 years.
It is true that research does not seem to suggest that longer tenure of auditors harms audit quality, but surely it cannot be healthy for a company to have the same auditor for 50 years because that looks more like a good marriage than an arms-length auditor-auditee relationship.
The research evidence also needs to be viewed with caution. For example, some studies suggest that newer auditors are more likely to miss fraud in financial statements. However, it is relatively common for auditors to miss fraud – and auditors constantly remind us that detecting fraud is not really their job anyway! Other studies have found that the quality of financial statements is better where auditors have longer tenure.
An alternative explanation is that auditors generally stay for as long as they can with a client, and bail out when they smell something fishy. Perhaps the newer auditors are just picking up the audits when the previous auditors no longer feel comfortable with the clients.
A Yale University paper representing academic and practitioner perspectives argues that audit firm rotation may not improve audit quality because audit committees are not really independent, and management has too much influence over auditor selection. This seems to be an argument for reducing management’s influence over auditor selection, than against audit firm rotation per se.
It would seem that some kind of middle ground between continuity and change needs to be struck. I can fully understand why the EU is considering rules on mandatory periodic re-tendering of audits and a finite maximum tenure.
In the meantime, it would be useful to require the tenure of the auditors to be disclosed when they are proposed for re-appointment at shareholder meetings. If the date of first appointment of directors is expected to be disclosed, why not for auditors?
When shareholders learn that a company has had the same auditor since Singapore gained its independence, they may start asking tougher questions about auditor independence when the auditor is put up for re-appointment.
After the Enron and WorldCom scandals, regulators in the US and globally introduced tougher rules on auditor independence, including restrictions on the provision of certain types of non-audit services by external auditors. However, as old threats are suppressed, new threats may have emerged as accounting firms continue to grow their non-audit services.
Today, all the Big 4 firms, and some of the second-tier firms, already have global revenues from non-audit services exceeding audit services, with non-audit services growing faster than audit services. Some provide services that are far removed from accounting (such as human resource or executive compensation).
I was shocked to read in the news recently that one of the major accounting firms even has a unit in the US whose main function is to lobby on behalf of clients, and even more shocked that it was not the only one!
I believe that the business model of many accounting firms today leaves them vulnerable to losing their independence. Audits may become no more than “door openers” to auditors or their network firms providing more lucrative non-audit services – and that is a real worry.
The growth in non-audit services may also affect the values of accounting firms. If a bank has a big investment banking business, the investment banking business is probably going to drive the values of the bank. In the same way, as non-audit services become more important, one must wonder what is going to happen to the values of the accounting firms.
A potentially serious threat to audit quality is the self-review threat created by the provision of valuation services by the auditors or their network firms, either in the parent company or in the subsidiaries. Increasingly, financial statements are affected by valuations.
In my conversations with some auditors and ex-auditors, it seems that it is not unheard of for network firms to be involved in valuations at the parent or group entities’ level.
In Singapore, the Code of Professional Conduct and Ethics for Public Accountants and Accounting Entities disallows external auditors from performing valuations that are “material” to the financial statements and with a “significant degree of subjectivity”.
What is material and subjective is itself highly subjective. This requirement is similar to those in countries such as Canada, Australia and the UK for non-public interest entities. For public interest entities, including listed companies, the rules in these countries tend to be more stringent – any valuation services that will have a material effect separately or in the aggregate on the financial statements are prohibited, and there is no “subjectivity” criterion.
In New Zealand, regardless of the type of entity being audited, any valuation relating to “matters material to the financial statements” cannot be provided unless the auditor withdraws from the audit engagement. We should consider aligning our rules on auditors and their network firms providing valuation services to those in other advanced economies.
We should also align to these countries in the disclosure of audit fees and non-audit fees paid to the parent company auditor and all its network firms, and the nature of non-audit services provided. As I pointed out in a recent commentary, there is much to be desired in the current disclosures by most Singapore companies when it comes to such matters.
The audit profession needs to recognise that the erosion in trust is real, and do something about it. I wish that the audit profession would be more enlightened and embrace tougher rules on disclosures of audit and non-audit fees, disclosure of their tenure, and the provision of services such as valuation services – particularly for a profession which should be the sultans of transparency.
The regulators should continue to review the rules governing professional conduct and ethics of public accountants and accounting entities, and maintain their vigilance over the profession. There is presently no viable alternative to external assurance to maintaining trust in financial statements, and we need to do our utmost to maintain trust in external assurance.
The writer is associate professor of accounting at the NUS Business School, where he teaches corporate governance and ethics
