BY SHADRACK MUYESU
Collapsing financial institutions have brought into critical focus the mandate of external auditors. Indeed not less has been the blame laid at their doorstep that the Institute of Certified Public Accountants of Kenya (ICPAK) has come out to ‘blame’ the supposed shortcomings on the external audit legal regime.
But just how far should external auditors go? The International Auditing Standards (IAS) has it that an external auditor audits an institution’s financial statements with a view of ascertaining its financial health. The auditor’s opinion on financial statements deals with whether the financial statements are properly prepared in accordance to the supervening financial framework. These standards sum up what ICPAK relied on in pointing out that “external auditors are just that, external auditors. They are not part of internal control and not a substitute for good corporate governance. At best external auditors spend a limited number of days or weeks focused on key financial information and financial statement presentation.”
The truth of this perspective raises a few serious issues, which, indifference to has rendered external audit a futility ab initio. Foremost, while providing overall guidelines, IAS affords individual jurisdictions, the jurisdiction to determine their own audit standards. Said, ICPAK has its own guidelines, which curiously, only its affiliates are privy to. Whether an auditor’s mandate ends with a critical assessment of financial books or whether it extends to a mandatory professional skepticism would be important determinants of their liability. Equally important is the liability of external auditors and the proper punishment thereof. Lacking on information, it is difficult to supervise external auditors and their regulator.
Yet this is only the smaller of the problems. The real issue is that the entire regime of external auditing is built on disturbing conflict of interest.
Accountancy is dominated by a handful of large firms, which rely on another handful of long-term clientele for their business. Competition is heavy and the need to keep these clients ever more critical. Where institutions appoint and pay their external auditors, it is entirely illogical that an auditor consistently paints a gruesome picture of the institution’s finances. This position is compounded by the fact that a considerable amount of the regulator’s senior staff often are the employees of these audit firms, imputing a conflict of interest on their part that often leads them to be biased.
Generally, shareholders appoint a Board of Directors and conscript the external auditors. The board appoints management and forms an Audit Committee, which mandatorily includes members of the board. It is management that appoints internal auditors who are then supervised by the audit committee. While the internal auditors are expected to cooperate with the external auditors who rely on their reports, they hardly work freely when the board, through the audit committee, wilds a power of fire over them.
The novelty of this system is that it will work ‘perfectly’ where the shareholders are not part of the management. Unfortunately, this is hardly the case with Kenya. Not only do shareholders run their businesses, they are active participants in audit committee. As such, they will go at length to paint a rosy picture of the business’ finances by controlling both limbs of audit.
The likelihood of this interference increases proportionately to a growth in the size of the business, and for a simple reason. While systemic auditing is meant to safeguard an institution’s liquidity, a slight skepticism in the firm’s finances or an indictment of the management shakes investor confidence with dire consequences on the institution’s share value. Where problems are noted therefore, firms often choose to ignore them (when ‘negligible’) or address them quietly. The result is what was witnessed with Imperial Bank, Dubai Bank, National Bank et al. Simply, privates are more susceptible to a financial meltdown due to shareholder interference and the window the law offers them against publishing their audited statements.
Conflicted regulators are the main reason why external auditors often go unpunished for bungled audits. Indeed, the IAS has succeeded in creating a weak regime that it, through its national agencies, supervises. The entire accounting industry has been colonized by a cabal of large firms whose protection by the regulators has made it impregnable by government or even newer, better firms.
To cite a few, PricewaterhouseCoopers (PwC) thrives even after a series of gaffes that should have otherwise seen it exit the market. Among them is the Tesco scandal where Tesco, a UK supermarket chain suffered multiple troubles on the discovery that it had overestimated profits by over £263 million and the Barclays debacle which necessitated Barclays Bank, a client, pay a heavy fine for its failure to properly protect a client’s assets worth £16.5billion. Not only so, PwC has recently been fined £260m with an additional order to pay £750, 000 in legal fees for its failure to spot a deep hole in a client’s (Cattle) books leading to a loss of £96.5m that year and eventual collapse. This is in addition to another vast sum they paid in a class action brought by Tyco International in 2007. An accountancy that audits 39 companies of the FTSE 100, it was also in 2014, accused by British Law makers of selling tax avoidance on an ‘industrial scale’ by having clients sign management representation letters before issuing the audit reports- a scheme that “was so horribly watertight that even opening a sluice gate wouldn’t let a trickle out!”
In the Cattle case, PwC had been hired to spot an error, which another accountancy bigwig, Big Four, had missed. Big Four has been slapped with a £3m fine and an additional order to pay costs.
From its failure to notice any problems at scandal ridden organizations such as Quindell, FIFA, and a number of bad banks and insurance firms to accusations of signing off accounts funded by drug lords and terrorists, Deloitte is not absent of blemish either. Their reluctance, alongside PricewaterhouseCoopers, KPMG and Ernst & Young to raise their standards in auditing Britain’s biggest lenders has also been a big concern for British lawmakers and the regulatory agency Financial Reporting Council (FRC)
Locally, the Haco scandal, where managers crafted a pre-invoicing scheme that helped them shore up profits and the de facto collapse of Uchumi when its auditors, PwC had given it a clean bill of health come to mind. Deloitte similarly blessed Mumias Sugar, CMC Holdings, Tuskys Supermarkets and Dubai Bank’s books only for these firms to momentarily collapse under a weight of losses while Ernst & Young takes credit for the financial irregularities at East African Portland Cement.
The mentioned fines seem like decent deterrents until one considers the losses involved. In the Cattle case for instance, a fine of £3m against an error of £260m is actually a slap on the wrist. (Meanwhile, there are no punishments in Kenya)
The bitter truth is that the industry’s captains have a powerful motive to maintain the status quo in crisis-era auditing. The big auditing firms have such a strong grip on the system that there is virtually no room for maneuver. The international regime remains acutely aware of the consequences of the Enron scandal (which felled Arthur Andersen).
They will do anything to avoid the implosion of another auditor. Similarly, while guidelines exist, the wave of interrelation between auditors and corporate governance structures means that their full potential may never be achieved. Take for instance principle 1 and 2 of the IAS, which requires auditors to be independent and exercise professional skepticism. As long as external auditors remain on the payroll of active shareholders and the employees of regulators, it will be difficult to demonstrate this impartiality. Similarly, as long as their application to the substance and format of the internal auditors’ reports remains the principle definition of their duty, professional skepticisms will continue to exist as an option and not as a mandatory extension of their mandate.
It is the opinion of this work that this mandate should be raised to a forensic audit. But this is only possible where the general corporate governance structure highlighted above is revised and where the audit firms limit themselves to limited clients within a lengthy one-off period and not the multiple long term clients that resign them to “spend a limited number of days or weeks focused on key financial information and financial statement presentation.”
