By Dr Steven Firer
For decades, the auditing profession has been troubled with high levels of litigation and accusations. The traditional argument is that the criticism of, and litigation against, auditors is due to the failure of auditors to meet society’s expectations.
It is essential to recognise that the legitimacy of the duties and standards adopted by auditors can never be isolated from the expectations of the various interest groups within society, who all rely upon the auditor’s services. This umbilical-cord relationship between the auditing profession and the various interest groups within society forms the basis for the increased scale and frequency of litigation against auditors. Auditors and society have entered into a social contract. It is not written, but is implied. The social contract (or as it is sometimes called, the community licence to operate) incorporates community norms and expectations about how an organisation should conduct its operations (including what information it produces).
A well-functioning economy relies on sound financial statements. Accounting by companies serves not only management but also the wider public interest, including financial stability. Statutory auditors play a pivotal role in this respect, as they are gatekeepers for the benefit of users of such financial statements. The quality of the auditors’ work should allow users to build trust and to decide whether to invest or to divest in companies. If users cannot trust financial statements, companies will no longer have access to the capital they need.
Shareholders and society have limited access to information about the operations of a company and may believe, therefore, that they are not getting the right information they need to make informed decisions, or that the information being provided by way of the financial statements is biased. As such, shareholders and society may lack trust in the directors and, in such a situation, the benefits of an audit in maintaining confidence and reinforcing trust are likely to be perceived as outweighing the costs.
Shareholders (society) do not have the expertise and skills to check whether agents (management) have met their responsibilities. Faced with such problems, they turn to expert auditors. Auditors are engaged as protector s of society and are expected to be independent of the directors who manage the operations of the business. Yet it is the directors who are allowed in terms of law to hire and remunerate the protectors. Auditors are not paid by those they are supposed to represent. The auditor is dependent on the directors to pay the audit fee.
By not being paid by the stakeholders they represent, legitimate questions arise about whether the auditors’ and stakeholders’ interests are aligned. The problem with this arrangement is when auditors refer to the company, which is controlled by the directors on a day-to-day basis, as the client. But if the system is to serve a modern economy, auditing must serve the investing public and treat it as the client. In simple terms, management uses shareholders’ (society) money to hire auditors to provide a stamp of approval on management’s reports on its own performance to society. Auditors are in an awkward position. They make their living pleasing management but their societal justification requires serving the public.
Auditors are human beings and make mistakes. The audit process is grounded in the judgment of fallible human beings, who are subject to errors and mistakes. At its core, auditing is a process of making professional judgments. This structural problem, a misalignment of incentives, is ignored by regulators, who impose rules and regulations as a safeguard against audit failure. Attention has been not been focused on the flaws in modern auditing. Regulation alone will not regain public trust and repair the perceived breach of the auditor’s social contract with society. Regulation can never improve the judgment of fallible human beings. Everyone has assumed that the professionalism of individual auditors would enable them to manage the inevitable pressures that arise as they work to provide top-grade service to their clients within the spirit of the standards of their firm and the profession.
The events of the past several years suggest that, for some auditors, those pressures have grown past the tipping point. Some audit partners have done their job and stood tough in the face of client pressures. Many have correctly understood the requirements of the profession and their firms, but some audit partners have lacked the fortitude to stand up to their clients, and some have misunderstood their client management role. What the failures of those individual audit partners have cost their firms, the profession, and the financial community is staggering.
The occasional scandal might be excused as an exception to the norm, but these past few years have seen a series of disasters. It is a different world, in which the pressures being brought to bear on the practice of auditing preclude the continued reliance solely on the professionalism of individual auditors, or on a new set of independence rules. The cost to the profession and to the financial markets is too great to justify reliance on a historical model that may be out of date.
An enduring and well-known payment principle was established in the 17th century: “Who pays the fiddler, calls the tune.” Investor confidence in a company’s reported financial results could be greatly enhanced by changing who calls the tune, and to do that, who pays the fiddler must change as well.
The Companies Act and the JSE have sought to change the relationship between the auditor and client by giving the audit committee of a company’s board of directors a more central role and relationship with the external auditors. This is a naive hope and will result in more dashed expectations. With all the talk of having the audit committee “hire” the auditor, no one has talked about how fee disputes will be settled, how scope questions will be answered, or how reporting and disclosure debates will be resolved.
Corporate audit committees will turn to management for help in resolving such critical questions. The audit committee is a company-centric body that must work closely with company management. More responsibility on the audit committee might result in a few more company hands on the fiddle, but the tune will substantively remain the same.
This needs to change. Shareholders and society need to call the tune because the audit is conducted for their benefit. Because shareholder interests coalesce in the stock exchanges, the exchanges themselves should hire and compensate the auditors who audit the listees’ financial statements. Such an arrangement would better align the interests of shareholders and auditors, enhance corporate governance, and bolster the confidence of the financial community.
Given the trauma our financial markets have suffered because of a variety of accounting scandals and audit failures, and given the ever-increasing complaints about how corporations are governed, it is imperative for the stock exchanges to adopt a more proactive role on behalf of investors who purchase the shares of companies they list and not just the role the JSE plays currently: a reactive role with a big stick attached.
Only by changing who pays the fiddler can a different tune be called, one that has the best chance of providing a strong foundation for the rejuvenation of trust in the financial statements and corporate governance of the companies in which most South Africans have a financial stake.
Visit Dr Steven Firer’s blog here.