PracticeAccounting FirmsWinning back reputations

Winning back reputations

Recent accounting problems have reignited the longstanding 'expectation gap' debate between investors and company external auditors. In response to investor concerns following Enron, the current stance of the accountancy profession is to reaffirm its faith in the basic soundness of UK corporate governance structures, and to maintain that no radical changes are required.

In taking this approach the profession has sidestepped the issue at the heart of investor disquiet – auditor independence.

The purpose of external audit is to ensure objectivity in financial reporting.

Institutional investors are generally long-term players seeking steady sustainable growth, and accordingly do not favour ‘aggressive’ accounting policies which may lead to future reversals of current earnings growth.

In general, lack of objective reporting leads to market misperceptions and distortions, unexpected corporate crises or, at worst, corporate failure.

The framework for internal audit should recognise that the process is potentially confrontational in nature; company boards are judged and remunerated by reference to reported earnings per share and gearing levels. Consequently, finance directors are often under extreme pressure for ‘aggressive’ accounting information.

The threat to accounting objectivity notwithstanding, the professional affiliations of the finance directors concerned, is plain to see. Indeed, a recent survey commissioned by Accountancy Age revealed that almost one in three of the finance directors surveyed were unable to be objective about their company accounts. ‘You don’t upset those who pay your wages,’ said one. Faced with this unpromising scenario, investors need to be confident the external audit system operates in an environment conducive to objectivity.

In particular directors should not be capable of exerting influence over the external auditor’s firm. Ideally, investors would require external auditors to demonstrate an objective stance similar to that of the taxation authorities. In order to achieve this it is essential for the external audit firm’s relationship with the client company to be governed by the shareholders rather than the company’s directors.

Currently, company directors have economic influence over external auditors by virtue of their ability to control their appointment and remuneration.

The increasing importance given to audit committees of non-executive directors has gone some way towards the reduction of executive director influence in this area. Many commentators favour further enhancement of the role of the non-executive directors whereby the audit committee would assume overall powers for appointment and remuneration of external auditors.

This approach appears attractive, in that non-executives supposedly would bring required degree of objectivity and independence to the external audit process. However, as shown by the commissioning of the Higgs review currently in progress, doubts remain as to whether non-executive directors are truly free from influence from the companies they serve.

More fundamentally, additional involvement of the non-executive directors in the audit process raises difficult questions regarding the ‘unitary’ nature of UK company boards. It is generally accepted that UK boards of directors are collectively responsible for overall company performance, and are not partitioned into ‘supervisory’ and ‘operating’ elements, as in certain overseas countries. Given this collective responsibility, it could be argued that any non-executive director, however appointed, has an inherent conflict of interest when dealing with external audit issues.

Further reservations arise with regard to the available relevant expertise within the non-executive team; non-executives are drawn from a wide variety of backgrounds, financial and non-financial.

The foregoing comments are not intended to denigrate the role of non-executive directors, but merely to highlight their limitations with regard to external auditor independence. External auditor appointment and remuneration issues accordingly should be reserved for direct shareholder action, by means of suitably convened shareholder panels, to the exclusion of the company board.

It is commonplace for firms acting as external auditors to provide non-audit services to the same client company. This practice reflects the common accountancy skills base that underlies audit and non-audit work.

However, other than minor synergies and administrative convenience, there is no substantive logic in this dual role; external audit comprises a critical review of the performance of the directors, under the instruction of the investors, whereas non-audit work is undertaken in collaboration with and under the express instructions of the directors. In many cases the fee value and profitability of non-audit work greatly exceeds the corresponding audit figures.

The ability of the directors to control the level of non-audit-work allocated to the external auditor’s firm gives rise to a clear threat to the external auditor’s objectivity. Such a threat can only be removed by the prohibition of the supply of non-audit services to audit clients.

Mandatory rotation of either audit firms or partners is often proposed as a means of improving perceptions of auditor independence. Auditor rotation procedures have proved ineffective and do little to tackle the fundamental independence issues referred to previously.

The legacy of recent accounting scandals is a credibility problem for the external auditors. Investors need to be assured that external auditors are free from any extraneous factors that may compromise their objectivity when confronted with difficult audit situations.

Until the accountancy bodies address the above issues the external audit credibility problem will recur, and will obscure the general technical excellence of UK accounting. Failure of the profession to embrace change may also inhibit rational debate on other major current audit issues, such as responsibility for the detection of fraud, liability capping and regulatory reforms.

  • David Spencer is a senior lecturer in corporate finance at the University of Central Lancashire.

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