• Sep 2010
• 
• about asa
• 
• advertise
• 
• subscribe
• 
• Xl Magazine
• 
• contact us
• 
• search

The Role of the Auditor and the Companies Act

Globally, the role of the auditor is once again in the spotlight. And the promulgation of the Companies Act 2008 (The Act) and the publication for comment of the Draft Company Regulations 2010 have added fuel to the heated debate in the South African context.

Every time there is a financial crisis or a large corporate entity collapses, questions such as the following inevitably arise:

• Why didn't the auditors detect what was going on?
• Who was responsible for the financial statements we received before the true state of affairs was presented?
• What precisely do we expect the auditors to do in such circumstances?
• If audits don't always “catch” the fraud or misrepresentation contained in the financial statements, what then is the value of the audit process?
• Is it necessary for all entities to be audited?
• Is the cost of having the financial statements audited justified?
• Does the fact that an auditor renders “non-audit” services to an entity affect the validity of the audit process?
• If the role of the auditor is minimised, who will be responsible for misleading statements contained in the financial statements? (fn1)

As far back as 1932 (fn2) it was recognised and emphasised that “the accounts of a corporation carrying on a complex modern business are not, and cannot be, statements of absolute fact. They are necessarily based largely on conventions, on estimates and opinions”.

A distinction can also be drawn between two broad categories of financial statements:

• those that are presented in a prospectus, placement memorandum, business plan, interim results, or even a loan application – where the intention is to induce a third party to commit funds to the business venture carried on or to be carried on by the company; and
• the annual financial statements in which the directors report to the shareholders on their administration of the affairs of the company for the financial year and the profit and loss for the period.

The purpose to which these financial statements are put may differ, but both have enhanced credibility if they are presented as having been subject to an “audit” – defined by the Auditing Profession Act 2005 to mean:

“the examination of, in accordance with prescribed or applicable auditing standards:
a. financial statements with the objective of expressing an opinion as to their fairness or compliance with an identified financial reporting framework and any applicable statutory enactments; or
b. financial and other information, prepared in accordance with suitable criteria, with the objective of expressing an opinion on the financial and other information”.

The most critical element in this definition is that the examination of the financial statements or other information results in the auditor “expressing an opinion” on “the fairness, or compliance” of the financial statements with certain criteria. An auditor does not give a guarantee “that the financial statements are free from material misstatement, because absolute assurance is not attainable. Further, an audit opinion does not give assurance about the future viability of the entity nor the efficiency or effectiveness with which management has conducted the affairs of the entity” (fn3). Accordingly, an auditor conducting an audit in accordance with the International Standards on Auditing obtains “reasonable assurance” that the financial statements taken as a whole are free from material misstatement whether due to fraud or error (fn4), and that the audit of the financial statements does not relieve management or those charged with governance of their responsibilities (fn5).

The problem for auditors is that, in this day and age, the general public probably have a higher expectation than “reasonable assurance” from audited financial statements - especially when a business collapses within months of the presentation of a set of financial statements (fn5a) in which the auditors have expressed that they have evaluated the company on a “going concern basis” and have not alerted investors or shareholders to potential shortcomings.

John & Lee Hendrikse (fn6) identify other reasons why businesses and investors may value an audit:
• improved controls and the reduction of the risk of fraud; (fn7)
• more accurate information leads to better decision-making;
• an audit requires the auditor to develop an in-depth understanding of a company's business, its industry sector, its organisational structure and the quality of its control environment; and
• the experience and understanding of the auditor, combined with objectivity, provides the auditor with an excellent basis for adding value by helping his/her clients build stronger businesses.

The last two points, perhaps more than any other, have led to the growth of non-audit services provided by auditors to his/her clients. Also, as the Hendrikses point out, the auditors are often the only outside professionals that many small businesses engage, and so the auditors can be the only people in a position to provide the support these businesses need.

How has the Act addressed the issues raised so far?
First, the Act recognises the status of the Auditing Profession Act, that is one of seven acts which will overrule the Companies Act if there is an inconsistency between the wording of the two acts, which cannot be resolved by attempting to comply with one Act without contravening the other (fn8).

Second, the Companies Act recognises the valuable role that an audit does play by requiring all public companies and certain private companies to have their annual financial statements subject to an audit. The category of private companies that must be audited is to be determined by regulation proclaimed by the Minister of Trade and Industry having regard to a number of factors. The Draft Regulations have raised concerns among some quarters in the auditing profession that the bar has been set at a level which means that most private companies will not need to be audited. This has at least two consequences –

• the financial statements of these companies will no longer contain even a “reasonable level of assurance” whether the financial statements are free from material error; and
• many small to medium sized auditing practices, which serve the majority of this market, will find their clients “walking out the door”, effectively destroying their audit division!
Submissions from the public on the Draft Regulations closed at the end of February, and the public hearings and the response of the Minister to the submissions must still take place – so we can expect some lively debate going forward.

The Act does however give a company the right to decide voluntarily (usually by inserting such a requirement in the company's memorandum of incorporation) that the company's annual financial statements should be audited, and furthermore provides that a substantial number of companies may still need to have their accounts subjected to a review. A “review” is said to provide a moderate level of assurance that the information subject to review is free from material misstatement, which is expressed in the form of negative assurance. This level of assurance may satisfy the needs of many users of financial statements – especially since, as we have seen, an audit is also not an absolute guarantee of the correctness of the financial statements, and because of the liability imposed on those who participate in the preparation, approval, dissemination and publication of false or misleading financial statements.

The Act and the Draft Regulations also envisage that a far wider range of accountants may conduct a review compared to an audit. An audit can only be performed by a “registered auditor” being an auditor or firm registered with the Independent Regulatory Board for Auditors.

On the other hand a review as contemplated in the Act can be performed by an “independent accounting professional”, which includes a member in good standing with a professional body that is a member of the International Federation of Accountants.

The loss of the auditors will be the gain of these other accounting professionals and to the casual bystander, such as Companies Act Online. It will be interesting to watch how this differentiation plays out in practice.

A third issue dealt with in the Act is the liability imposed on persons that participate in the preparation, approval, dissemination or publication of any financial statements, including Annual Financial Statements, knowing that those statements do not comply with the requirements of the Act or which are materially false or misleading.

This would include the directors of the company and could reduce the necessity for audited financial statements, for example, where a company is approaching a financial institution for credit. The financial institution should be able to rely on the ipse dixit of the directors themselves, plus any management that were involved in the preparation of the financial statements used to support the application, because they'd be personally liable for any misstatement contained in the financial statements.

Section 214 of the Act provides that a person is a party to the preparation of a document … if:

• the document includes or is otherwise based on a scheme, structure or form of words or numbers, devised, prepared or recommended by that person; and
• the scheme or structure or form of words is of such a nature that the person knew or ought reasonably to have known, that its inclusion or other use in connection with the preparation of the document would cause it to be false or misleading.

The Act also defines what is meant by “knew or ought reasonably to have known” by defining “knowing”, “knowingly” or “knows”, when used with respect to a person, and in relation to a particular matter, to mean that the person either –

• “had actual knowledge of that matter;
• was in a position in which the person ought to have –
• had actual knowledge;
• investigated the matter to an extent that would have provided the person with actual knowledge; or
• taken other measures which, if taken, would reasonably be expected to have provided the person with actual knowledge of the matter”.

Accordingly, where a person did not have actual knowledge his/her conduct will be objectively measured to ascertain whether his/her actions or omissions in the circumstances would have resulted in his/her having actual knowledge.

The application of these sections by the Court to persons that audit or review financial statements that turn out to contain false or misleading information is likely to be highly debated and will no doubt be tested in the Courts more than once in the future. What steps were actually taken or ought reasonably to have been taken in that process will have to be assessed to determine whether the conduct of the auditor or reviewer was reasonable in the circumstances. Weighed against this will also be the type of opinion and the actual words used in expressing that opinion on the financial statements, and whether this was sufficient to alert the “misled” user of the financial statements of the role of the auditor or reviewer in the preparation of the financial statements.
Fourth, another complex issue regarding the role of the auditor pertains to so-called “non-audit” work, which the company engages the auditor to perform – and which has always been a question left to the auditor in assessing his or her independence, but which was thrown into prominence by the actions of the now defunct Arthur Andersen in the Enron saga. The growth of non-audit work performed by auditors is attributable to a number of factors (skill, knowledge of the company's affairs, access, indifference or lack of foresight from competing professionals, such as the legal fraternity, to provide the service and so on) but has definitely put the auditor into a potentially difficult position. The Act follows the pattern established by the Corporate Laws Amendment Act 2006 of requiring the audit committee (fn9) to determine what non-audit work the auditor may perform for the company or which non-audit work the auditor is prohibited from performing, and also requiring the prior approval of the audit committee for any “ad hoc” non-audit work to be provided by the auditor to the company.

Since the Act now envisages that the audit committee must be elected by the shareholders at the annual general meeting of the company (fn10), presumably the shareholders would be able to express their approval or otherwise regarding any decision taken by the audit committee in determining the parameters for the performance of non-audit services by the auditor.

Last, the Act does provide certain powers that will aid the auditor to carry out his or her function (fn11), including:

• the right of access at all times to the accounting records and all books and documents of the company;
• being entitled to require from the directors or prescribed officers of the company any information and explanations necessary for the performance of the auditor's duties;
• the right to attend any general shareholders meeting;
• the right to receive all notices of and other communications relating to any general shareholders meeting; and
• the right to be heard at any general shareholders meeting on any part of the business of the meeting that concerns the auditor's duties or functions.

An auditor may apply to Court for an order to enforce his/her right of access to the accounting records and to obtain information from the directors, and the Court may make any order that is just and reasonable to prevent frustration of the auditor's duties, and an order of costs personally against any director or prescribed officer whom the court has found to have wilfully and knowingly frustrated or attempted to frustrate the performance of the auditor's functions.

Auditors who use the right to attend general meetings of the shareholders must take care to avoid being “dragged into” squabbles between the shareholders, particularly if, by taking sides, the independence of the auditor can be challenged at a later stage.
We can conclude that though the Act does address some concerns about the role of auditors, it also gives rise to issues itself.

There is also no simple answer as to what role the auditor could or should play in respect of ensuring that directors faithfully administer the assets of the company for the benefit of all stakeholders.

And so we expect the debate on the role of the auditor to continue late into the night.

Footnotes
Fn1 - The above list is not exclusive – nor is it possible to answer everyone conclusively in this article. Our intention was to raise issues for consideration by both auditors and the users of financial statements within in the context of developments in the Companies Act 2008. We also have not addressed the role of the auditor in reporting material irregularities in terms of section 45 of the Auditing Profession Act.
Fn 2 - In a lecture entitled “The Accountant and the Investor” delivered at Northwestern University, Chicago, Illinois on 11 January 1932, under the auspices of the William a Vawter Foundation on Business Ethics – Published in The Ethical Problems of Modern Accountancy, Ronald Press Co (1933), pp26-54.
Fn3 - International Standards on Auditing - ISA 200, para 21.
Fn4 - ISA200, para 17.
Fn5 -  ISA200, para 33.
Fn5a- It is important to note that the Companies Act uses the term “financial statements” to refer to a set of accounting reports which is wider than “the annual financial statements”, and which would include for example “financial information in a circular, prospectus, the provisional announcement of results…”
Fn6 - “Business Governance Handbook – Principles and Practice”, p265.
Fn7 - The entire issue of risk management too is at the forefront of discussion in the wake of the financial crisis.
Fn8 -  Section 5(4) of the Companies Act 2008.
Fn9 -  If the company is not required to have an audit committee, then the board of directors should make this determination.
Fn10 - Section 94(2) of the Companies Act 2008.
Fn11 - Section 93 of the Companies Act 2008.

Graeme Fraser, BA LLB, LLM, HDip Tax, and Veldra Morris who is currently studying for her LLB degree, are joint owners of Companies Act Online which has been established to provide information and resources on the Companies Act 2008 (and related issues relevant to corporate stakeholders) through the medium of their website (www.companiesactonline.co.za), lectures and workshops (public and in-house), newsletters and specialist articles. Edwin Selbst CA(SA) assisted the authors in editing the initial draft.

You can earn verifiable CPD points from this article. Click here to get your free verifiable points.

• Print this article
• View more articles from the 'in practice' section.

Submit a comment
First Name:	*
Comment:	*
	Items with * are required.
Anti-Spam Policy
To complete your post please type in the words that you see in the image below. (Note: The image is case sensitive.)  Generate new Code

Comment(s)

• No comments have been made.

• CPD Verifiable Articles
• Budget Issues: Finance vs IT (15min)
• The Role of the Auditor and the Companies Act (30min)
• GAAP and Tax (15min)
• HR Matters
  The Impact of Anxiety (15min)

• Additional CPD Articles
• No items available

• Latest Comments
• i'm currently studying for a corporate law diploma and had to do an essay on the strenghts and weaknesses of business rescue. the article has been of great help since I didn't have enough time to do research due to my work overload and keeping my 18 month old boy happy. I got 82% on the essay. thanx a million
  read more
• I would like to be part of the learnership for accounting for next year i am available at any time convinient to you.
  read more
• A warranty on a repaired item becoming void if it is abused or if normal wear and tear is determined should apply to new items as well and not just repaired items
  read more
• Awesome article, this has been very helpful!
  read more
• The argument blaming directors of insider trading based on the fact that share prices traded lower after the directors hedged their shares does not hold water. Correlation does not automatically imply causation. A likely reason for the share performance drop is the signalling effect of the act of the director hedging their shares. This action would lead investors to be sceptical about the prospects of the shares and hence those shares would trade lower.
  read more

• Latest What to Watch