Auditing- Auditor's Independence

Independent auditing is an essential feature of efficient capital markets and regulators have long been concerned with potential threats to auditor independence. In the wake of the Enron bankruptcy, concerns about auditor independence have prompted Congress to enact legislation that bans most auditor-provided non-audit services. Regulators' concerns about non audit services are based on the assumption that auditors are willing to sacrifice their independence in exchange for retaining clients that pay large non-audit fees. A problem with this assumption, however, is that it ignores auditors' expected costs of compromising their independence. In particular, loss of reputation and litigation costs is likely to provide strong incentives for auditors to maintain their independence.
            The independence of an audit is impossible for anyone on the outside of the process to assess. This creates problems in a world where there is a belief, mistaken or not, that a process that cannot be seen must be flawed. What no one can know is how far the company is under pressure from the auditor over some accounting treatment or other or how far the company is trying to intimidate the auditor with the threat of sacking. You can take into account anecdotal evidence.

 I heard recently about what had happened at a highly respected FTSE 100 company several years ago. There was a conflict between the finance director and the chief executive over a significant and material item of accounting treatment. The lead audit partner backed the finance director. A meeting ensued during which, as one observer put it, the audit partner was subjected to "a stream of obscenities and profanities" from the chief executive. The audit partner stuck to his guns. The figures went out in the form that the finance director and the audit partner decreed. But the firm later lost the audit. That is a good example of the sort of thing that critics of the audit system insist cannot occur.
 It is always suggested that if the audit is at stake, the auditor will always back down. Undoubtedly it does happen. But human nature prefers to be awkward rather than compliant. Auditors are more likely to be ornery than subservient.
The example also fits well with the findings of the only recent research into the process. Last year's book* by Vivien Beattie, Stella Fearnley and Richard Brandt filled in many of the gaps in our knowledge.  "A key problem for both regulators and standard setters is that the audit process itself is unobservable," they said. "Only the participants in the process, the auditors and the company management, know how decisions are reached."
        The importance of this is that it makes it very hard for those on the outside to create some sort of regulatory framework that will somehow limit the possibility of any loss of independence at the heart of the audit process.
        Certainly the researchers' findings suggested that tightening rules could change the culture but that the central issue of human nature would always remain. For them the two key areas are very simple. "What you have to worry about," said Stella Fearnley, reader in accounting at Portsmouth Business School, "is the intimidation of the auditor and the auditor's fear of losing a client."
      To counter the current feeling is that audit committees will have a greater part to play. Audit committees have the ability to stand in the middle, detect such threats and then do something about counteracting them. However, Mrs Fearnley counsels against too much reliance on audit committees. "They don't always support the auditor," she suggested this week.
        "If there is a bid for the company coming in and they are trying to bump up the share price in an effort to prevent the bid, then the non-executive directors will feel they need to support the executive directors rather than the auditors in such a situation because if the bid went through, the non-executive directors would be dumped as well."
        It is a complex world and rules don't fit all the eventualities. Where people should be concentrating is on what Mrs Fearnley and her co-authors see as the greatest threat to auditor independence: intimidation. We are back to bullies. And it is no surprise that, as the background and the detail unfolds, the biggest corporate collapses on the current American scene have been characterised by bullying behaviour from the executive directors. This is exactly what the UK went through just over a decade ago with Robert Maxwell and Asil Nadir among others.
 If this is where the real threat to audit independence lies, it is worth looking at ways to combat it. One method is exactly what has been happening over the past decade in the UK in the tightening of the corporate governance culture to squeeze such people out of overall power. The other is to concentrate on the detail, to which the full force of the law must be attached.
       Al Capone, the Chicago gangster, never went to prison for any shootings. ( I met a retired policeman in Chicago this summer who is still trying to sort out who precisely did what in the St Valentine's Day Massacre.) Capone was finally put away for tax evasion.
        Probably the most important new move to shore up auditor independence lies in the new draft company’s bill published last month. It contains, in clause 108 (6), under the duty of company directors to volunteer information to auditors, the stricture that if a director "knowingly or recklessly makes to an auditor of the company a statement (whether written or oral) that is misleading, false, or deceptive in a material particular", the person is guilty of a criminal offence. Imprisonment or a fine would follow conviction.
This is the key to future efforts at backing up the independence of auditors. There has been an offence of misleading auditors on the statute books for years. But although it provides an easy route to an open-and-shut case the lack of any deterrent penalty meant that prosecutors tended to ignore it. It was said that those responsible for the Polly Peck scandal could have been prosecuted very simply by this means. It was, supposedly, a matter of one memo as evidence and the case would have been over. But the sight of a corporate scandal being dealt with via the equivalent of community service was never going to be a sensible one.
      Assuming the proposed company’s bill reaches the statute book, the auditing profession will have a very powerful threat to back up their independence.

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