The problematic regime of external auditing

As long as external auditors remain on the payroll of active shareholders, it will be difficult to exact impartiality from them… their mandate ought to be raised to a forensic audit

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By Shadrack Muyesu

Collapsing financial institutions have brought into focus the role and mandate of external auditors. Indeed, so much 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, our indifference to which 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. That said, ICPAK has its own guidelines to which, curiously only its affiliates are privy. 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 – yet it is information to this end that ICPAK keeps secret. 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.

But 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 that rely on another handful of long-term clientele for their business. Competition is heavy and the need to keep these clients is 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’s 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, wields 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 to any lengths to paint a rosy picture of the business’ finances by controlling both limbs of audit.

The likelihood of this interference increases proportionately to an increase 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 Dubai, Imperial and Chase Banks. Simply, private entities are more susceptible to a financial meltdown due to shareholder interference and the window the law offers them against publishing their audited statements.

Colonised by a cabal of firms

Conflicted regulators are the main reason 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 colonised 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 thrives even after a series of gaffes that should have otherwise seen it exit the market.  Among them is the Tesco scandal where Tesco suffered multiple troubles on the discovery that it had overestimated profits by over £263million (Sh32 billion), and the Barclays debacle which necessitated Barclays, a client, pay a heavy fine for its failure to properly protect a client’s assets worth £16.5 billion (Sh2 trillion). Not only so; PwC has recently been fined £260m (Sh32.3 billion) with an additional order to pay £750,000 (Sh93 million) in legal fees for its failure to spot a deep hole in a client’s (Cattle) books, leading to a loss of £96.5m (Sh12 billion) that year, and its eventual collapse. This is in addition to another vast sum they paid in a class action by brought by Tyco in 2007.

An accountancy firm that audits 39 companies of the FTSE 100, it was also, in 2014, accused by British lawmakers 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 that another accountancy bigwig, Big Four, had missed. Big Four has been slapped with a £3m (Sh373 million) fine and an additional order to pay costs.

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