Corporate Governance: Who Audits The Auditors? The case for an audit committee.

The manner and method by which auditors interact and report to company’s board of directors and shareholders is key area of corporate governance. Unless shareholders unanimously agree otherwise, every company in New Zealand must have its annual financial statements audited. In reality, probably less than five percent of them are audited because of the ownership structure of most New Zealand companies. For companies that are audited the functions, reporting lines and outcomes associated with the process and the auditors’ opinion are vitally important.

Despite impressions and its rash of corporate client collapses, international accounting consultancy Arthur Andersen is not the only audit firm that fails to detect fraud, allows misrepresentation or sanctions over zealous and aggressive accounting and reporting practices. In the United States all the other global auditing firms are currently facing at least one formal Securities Exchange Commission or Justice Department investigation.

Concerned US observers, including congressmen and the prestigious Conference Board are calling for an overhaul of the regulatory framework that governs auditor function and liability. The Conference Board recently launched The Blue Ribbon Commission on Public Trust and Private Enterprise, headed by former SEC chairman Arthur Levitt, to report on appropriate disclosure requirements, stock option structures and auditor and director responsibility.

New Zealand’s Business Roundtable, our nearest equivalent of the Conference Board, has yet to comment specifically on such matters or undertake any similar initiative. On the face of it, such study would both benefit Roundtable members and also the New Zealand business sector and capital markets.

Until the regulatory authorities, the New Zealand Stock Exchange or The Institute of Chartered Accountants of New Zealand – the auditors’ governing body – formulate and implement more relevant and robust audit oversight regime, the onus falls on company directors to be ever vigilant and thorough.

Managing the directors’ audit risk
Boards disconnected from the core and underlying business fundamentals of their failed companies was common factor in the spate of recent corporate collapses. It can, in part, be addressed by properly functioning, well managed and structured external audit process that involves either all or part of the board receiving reports and advice from the external auditors regardless of management’s interpretation of events. lack of any independent verification or external validation of management board reporting seems to be key common factor in nearly all the recent high profile collapses.

The Australian Institute of Company Directors has recently added forensic accounting course to its programme of continuing education. The objective is to provide directors with the questions they should ask to ensure that accounts are properly presented to disclose the company’s performance.

One respected company director recently observed that: “Outside of totally trustworthy CEO and senior management team the best insurance policy board can have against material misstatement or adverse accounting surprises is to have an appropriately constituted and well functioning audit committee.”

Our own Institute of Directors (IOD) advocates and encourages establishing audit committees as best practice, particularly for companies listed on the Stock Exchange and with widely held ownership.

The IOD defines an audit committee as “a committee of the board whose principal function is to assist the board in producing accurate financial statements in compliance with all applicable legal requirements and accounting standards”.

An audit committee is expected to:
* oversee, review and enhance the company’s external financial reporting procedures; and
* monitor and enhance the company’s internal financial systems and controls.

The IOD outlines details on establishment procedure, membership composition and terms of reference for operation and functioning of the committee. These include the committee’s objectives, membership composition, authority, responsibilities, decision making and reporting procedures and the need for ongoing review of the audit committee and the development of its role.

Beyond the audit committee directors should ensure that they fully understand both the appointment and the basis of engaging an auditor. Appointing or reviewing the appointment of an auditor goes well beyond telephone call and couple of meetings.

In the present environment all directors should be aware of and understand the key matters attaching to the company’s audit process and the auditor. These include the exact basis of engagement, the agreed scope and nature of the audit process, the general audit and materiality approach of the auditor and the proposed audit testing and sampling methods and techniques of the auditor. Directors should also know and understand how the auditor will ensure the quality control and integrity of its audit processes.

As part of their defence Enron’s directors argued that they relied on Arthur Andersen to guarantee the quality control of their audit. Unfortunately Arthur Andersen’s quality control procedure was fundamentally flawed by allowing the Enron Relationship Account Partner, not an independent or specialist technical partner, to resolve any technical matters of dispute or uncertainty that arose between Arthur Andersen and Enron. No independent existed to decide if it was an apple, an orange or indeed rotten or digestible.

Effective audit committees must be properly resourced, comprise members with professional experience, qualifications and independence from management and meet regularly, at least twice year, with the external auditors and without management present.

External auditors exist to test and verify the accuracy and presentation of the financial statements. They should also report back to the board on the adequacy or otherwise of internal systems and controls. An effective audit committee can be valuable in receiving, evaluating and discussing these findings with the auditor.

While in many of the recent collapses the competence and diligence of the external auditor can be questioned, we should also question the competence, diligence and integrity of the audit committees and the boards as whole. The auditor is “watch dog” not “bloodhound”. Directors as bloodhounds are the stewards of the company acting on behalf of shareholders, not the auditor.

Auditors – all care no responsibility
Last, but certainly not least, directors should be aware of the trend by auditors to limit their audit liability. Until recently directors, shareholders and other interested stakeholders such as bankers and creditors assumed that auditors could be held liable for negligence in conducting an audit in the event of loss.

Now, auditors are trying to limit their risk exposure. Whether in law, commercial reality or reputation they can actually do this is debatable and yet to be tested. What is not debatable, is the onus of responsibility and accountability this places on directors to ensure the accuracy and “truth and fairness” of the financial statements.

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