Auditing firms need an overhaul
There has been a rise in the number of global corporate scandals, which has led to huge financial losses and increasing calls for the greater independence of auditors and a better understanding of their role.
Most of these scandals have involved a failure of corporate governance and auditing processes, and accountancy procedures that have been compromised.
One of the most infamous international scandals was that of Enron, the quick rise and rapid fall of an esteemed giant in the energy sector.
Arthur Andersen LLP, the external auditors, also became the financial consultants to the firm, which was in conflict with their auditing role and led to a failure to give a true and fair opinion on Enron’s operations. The scandal led to the fall of Enron and, subsequently, of Arthur Andersen.
It also led to accounting and auditing procedures being reviewed to mitigate against the chances of that happening again.
African countries have also faced their share of “Enron scandals”, with accountants and auditors who have exposed stakeholders to huge financial losses.
Steinhoff is a recent one. This exposed the gaps in the balance of power in the company’s structure. The role of auditors, as an independent body that ought to review records and check compliance with accounting processes, has again been at the root of it. Investigations have exposed the deliberate misrepresentation of financial data by top management.
South Africa has experienced several other cases in which corporate governance has been compromised by suspect auditing. For instance, the Gupta scandal has seen KPMG’s role as external auditor being questioned as it failed to identify cases of fraud during its auditing of companies owned by the family.
The Satyam scandal, one of the worst financial scandals in India’s corporate history, exposed gross accounting malpractices, involving 7 561 fake invoices and 13 000 ghost workers. This led to fraud of about $1.7-billion. According to the findings in the report released by the Securities and Exchange Board of India, PwC failed to check financial records and relied on management’s submissions in drawing up their “independent” opinion.
PwC was banned from auditing in India for two years. Furthermore, Satyam’s former chairperson was found guilty of collusion in inflating the company’s reported gains, of falsifying accounts and income tax returns and of fabricating invoices, earning him seven years in jail.
Similar cases have been reported in Nigeria, with Cadbury Nigeria’s management overstating the company’s financial position for several years, to the tune of between 13-billion naira ($36-million) and $42-million, to achieve its ambitious growth target.
The root cause of what compromises the governance structures of an organisation must be assessed to solve the rising number of scandals.
In the case of Enron, it was the result of the directors wanting to maximise wealth quickly without taking into consideration other factors that were critical in making business decisions. This led them to involve Arthur Andersen as both their consultants and auditors, which meant Arthur Andersen could not be objective about Enron’s financial position. Equally, it was Arthur Andersen’s desire to maximise earnings that led it to undertake two conflicting roles, which compromised its independence.
Businesses tend to view taxation as a major drain on their cash flow, and most companies try to find ways to avoid paying tax, which has also led to huge financial scandals. This also compromises their corporate governance practices. For instance, Satyam overstated its number of employees to declare more operating costs in its financial reports, reducing profits and translating into less tax paid.
The current model of business adopted by most companies is to set targets for the top management to meet. Failure to do this often involves disciplinary action such as the termination of contracts.
Some of these targets do not take into consideration the prevailing business environment so, to meet them, senior managers collude with other actors, including auditors, to misrepresent financial data. This was highlighted by the Cadbury Nigeria scandal, where the push for unrealisable targets meant that management colluded to overstate financial information to satisfy shareholder expectations and to safeguard their contracts.
Considering the nature of their work and the critical role that auditors play, the compensation offered should be equitable to enable them to carry out thorough and detailed reviews of an organisation’s operations. Reducing remuneration discourages lengthy, in-depth reviews, resulting in shallow exercises that rely on management reports and explanations without verifying them.
Besides disciplinary action, some practical considerations could be adopted to curb financial scandals.
Verifying the integrity of appointees to boards of directors is very important. The board fulfils a critical role as an intermediary between the shareholders and the company’s management. To be effective, there must be the right mix of people, including board members who understand financial accounting and auditing processes. This will make for an informed debate on the findings from the audit processes.
Long-standing auditors are prone to becoming compromised, especially when it comes to objectivity, particularly when a company’s management is unchanged for a long time. Their relationship evolves into mutual trust and often lacks professionalism. Businesses must set up mechanisms that allow them to change their auditors regularly.
A company’s board of directors and audit committee should be independent of each other, and the committee should be small and its members financial experts.
To ensure its effectiveness in monitoring and evaluating the auditor’s performance, the composition of the audit committee also needs to be reviewed regularly.
To ensure sound corporate governance, the board should introduce internal audits in an organisation. This would provide regular checks and would detect any impropriety.
The ability of auditors and accountants to bend the rules to satisfy the need for profit also needs more checking. In poor countries, corporate greed and continued illicit financial flows (IFF) to tax havens and secrecy jurisdictions undermine tax collection.
Furthermore, some professional services encourage tax planning behaviour that erodes the tax base of developing countries and weakens their structures, laws, policies and institutions.
Governments need to tighten up their legislation to be able to punish transgressors effectively, to implement the recommendations of the High Level Report on IFFs, and to heed the global call for a broad definition and approach to IFFs, which includes tax avoidance.
Corporate governance and its ethics and standards must be upheld to ensure companies pay their fair share of taxes. This includes an organisation’s policies and procedures to safeguard the interests of internal and external stakeholders. This practice is mainly to promote integrity, transparency and accountability in commercial operations.
Corporate governance can be manifested through the board of directors and auditing. The audit function is critical because it provides oversight on the others and affects all stakeholders. The audit process ensures that financial and other operations follow the International Financial Reporting Standards or other widely accepted external guidelines.
The reports published after an audit act as a key decision-making tool for shareholders, governments, investors, banks and the public. This means auditors have a duty of care to users of their reports, and any breach of this trust lends itself to negligence.
Between the audit process and corporate governance structures, there are professional accountants who must accurately record and file the financial operations of the organisation.
Accountants and auditors must protect the interests of shareholders, introduce measures to ensure accountability and transparency, and conduct periodic risk assessments.
The principle of independence, as stipulated in the Code of Ethics for Professional Accountants, must be observed between auditors and the users of their reports. This means that there should be a separation of functions in an organisation so that auditors are not exposed to situations in which they may fail to give an honest and independent opinion.
This separation of duties plays a critical role in building stakeholder confidence. Auditors serve as one of the primary protectors of corporate governance in any organisation, as in most cases they are in a position to detect and stop instances of abuse.
Jared Maranga leads the tax and investment programme at Tax Justice Network Africa