The fundamental problem with auditing

by Malcolm Simister

Often criticised, auditors are in an unenviable position due to the structure of their engagement which is enshrined in law. The trouble is, no one has come up with a better structure.

Auditors’ engagement is a three-way thing: the company engages the auditors to report to the shareholders. The shareholders don’t engage the auditor directly (although they do ratify their appointment at the annual general meeting (AGM)) and nor do they have much, if any, contact with them except when receiving their report at the AGM – for those shareholders who show up.

Almost all auditors’ interaction is with the company’s employees and, to a lesser extent, its directors. Because of that and, importantly, because it’s those people who pay and, in reality, engage the auditors it’s natural for auditors to pay a lot of attention to them.

So, while auditors have a legal responsibility to the shareholders, it’s the company’s management and directors who call the shots and it can be a case of, ‘He who pays the piper calls the tune’. Management and directors often have every incentive (literally) to maximise profit and in doing so sometimes bend the rules. That can benefit shareholders too, of course, but sometimes it doesn’t. And it’s not just the current shareholders who may be duped but future and potential investors too – ‘the market’ – and that makes it even more important that auditors do their job properly.

Perhaps because of the close auditor-management-director relationship and knowing who pays and engages them, auditors are sometimes compliant in rule bending and there is plenty of scope for it as accounting is often not clear-cut and grey areas abound.

Take British supermarket business Tesco’s annual report in 2014, audited by a ‘Big 4’ audit firm. It was found that the profit was overstated by £326m (approximately Au$625m) due to the immediate recognition of revenue that should have been deferred and recognised over several years. The company’s stock market value tumbled by £2 billion in one day. Tesco suspended eight directors and three executives (two not in finance) and the Serious Fraud Office charged the latter with fraud, abuse of position and false accounting. The charges were not proved but the executives endured long legal cases, one suffered a heart attack and the situation wasn’t finalised until 2020. The company paid more than £200m in fines and compensation.

Two questions arise: 1) Would auditors act differently if their engagement was independent of the company’s management and directors, and 2) Is there a better way to engage auditors?

The answer to the first question is ‘maybe’, but close interaction between auditors, management and directors is inevitable and stiff penalties already apply to improper auditor compliance with rule bending.

Many people have thought about Question 2 and no one has found a workable, acceptable and better way such as Government-appointed auditors, set fees and fixed audit engagement terms. All have their pros and cons but none has yet gained wide acceptance.

So, mis-quoting Sir Winston Churchill, is the current audit structure the worst system ever invented, apart from all the others? Expect accounting scandals to continue from time-to-time but remember that non-finance executives can be charged and potentially go to jail for accounting irregularities!

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