Auditors are engaged as protectors of society and are expected to be independent of the company. Yet it is the company who appoint and remunerate the protectors. Only by changing who pays the auditor will real audit reform take place in the public interest.
A 2020 report into the audit profession’s deficiencies by former London Stock Exchange chair Sir Donald Brydon says the audit profession has lost its way. This report was commissioned by the former Prime Minister of the United Kingdom, Theresa May, and provides an independent review of the quality and effectiveness of the audit.
Sir Donald Brydon tells us that auditors have lost their way regarding their application of the rules of evidence, due care, disclosure and independence.
Through no fault of their own, auditors find themselves in a situation that has become untenable, and relevant audit reform is desperately needed not only for society but also for the auditor.
Society needs protection but so do auditors. In theory, auditors should not risk the reputational capital built up over decades to be the subject of incessant claims of impropriety. It makes no sense. To believe that the auditor is a ‘criminal’, a person who assists clients in falsifying their accounting numbers, beggars’ belief. This would mean that the auditing profession is rife with crooks − a conclusion that anyone who has worked with auditors knows is untrue.
So, why do auditors fail? Consider the relationship between Enron and Arthur Andersen & Co, its auditor. Both for Enron and its senior management, a policy of inflating its financial results made at least short-term sense because it enabled them to make acquisitions, avoid bankruptcy and exploit stock options worth billions of dollars. For Arthur Andersen, however, the trade-off was vastly different. Enron was a valuable client that it saw as potentially worth as much as $100 million a year in revenues.
In the famous case Re Kingston Cotton Mills Co (1896), Lord Justice Lopes stated as follows: ‘He [the auditor] is a watchdog, not a bloodhound.’ Thus, the key mystery becomes: why did the watchdogs not bark in the night when massive fraud had taken place at Enron? I believe that Arthur Andersen developed what I would call ‘financial reporting myopia’, which is a catchy disease that results from a watchdog being paid by the person trying to open the gate. That the auditor failed is not surprising.
When the Queen of England visited the London Stock Exchange in 2008, she asked: ‘If these things are so large [accounting scandals], how come everyone missed it?’ If the Queen had asked me, my answer would have been: ‘It is self-evident, Your Highness – no one saw this coming.’
What was it that no one saw coming? This leads me to ask the question in 2021, 15 years after the enactment of the all-encompassing legislation that was supposed to solve the ‘auditing problem’ which was signed on 12 January 2006 when President Thabo Mbeki signed into law the Auditing Profession Act 26 of 2005, a response to the accounting scandals that had begun to erode confidence in South African business. What does one make of these seemingly endless ‘calls for views’ to establish what reforms need to be pursued and implemented? This article is in response to one of these calls. As I once said on 702 radio, ‘the next Steinhoff is around the corner’. Yes, I can guarantee that it is. At the epicentre of the audit ‘problem’ is a corporate reporting ecosystem that has failed to deliver substantive reform that serves the public interest. Every accounting scandal since the enactment of the Auditing Profession Act 26 of 2005 is a potent reminder of this failure to deliver. Let us see – Steinhoff, Tongaat Hulett, Gupta-owned companies, VBS Bank, McKinsey & Company, SAP, Eskom, Sharemax, EOH, construction companies (World Cup 2010), Bosasa, Gold Fields, Sasol, ANN7, Multichoice, SABC and the new age, and MMM Global.
I entered the auditing profession on 23 January 1984. Over the years every aspect in the audit environment has been tinkered with − a few more standards here, a bit more oversight there, some additional independence and competition arrangements, a tweak of the professional training curriculum, and a shopping list of extra items that auditors should tick off.
I believe Sir Donald Brydon’s report is much of the same. I believe none of the proposed reforms recommended by Sir Donald Brydon addresses any of the auditing profession’s fundamental problems. Professor Niamh Brennan of the University College Dublin explains that the real problem is not corruption but unconscious bias, which in my opinion is another term for ‘financial reporting myopia’. Unconscious bias is a deeper, more harmful, but subtle problem within auditing.
I am reminded of William Shakespeare’s insightful words in Hamlet: To die, to sleep – to sleep, perchance to dream – ay, there’s the rub …’ But what does ‘there’s the rub’ mean? By ‘rub’ William Shakespeare meant a difficulty, obstacle, or objection. A rub is some fault in the surface of a bowling green that stops a lawn bowl or diverts it from its intended direction.
What is the auditing profession’s ‘rub’, then? The auditor has an ethical dilemma: an auditor who suspects questionable accounting must choose, unconsciously, between potentially harming his/her client and him-/herself by challenging a client’s financial statements or harming faceless investors by failing to object to the skewed artificial accounting numbers. Auditors are engaged as protectors of society and are expected to be independent of the company they audit.
Yet it is the company who appoint and remunerate the protectors. The auditor is dependent on the company to pay his/her audit fee. Given this tension, auditors unconsciously lean toward approving the dubious accounting numbers. Imagine an investor who reads a ‘clean’ audit report containing the disclosure that the auditor receives R60 million in annual fees from the audited client. How much should the investor adjust the client’s earnings per share? The auditor’s rub reflects the enduring and well-known payment principle established in the 17th century: ‘Who pays the fiddler, calls the tune.’ Until this ‘rub’ is removed from the auditor’s ‘attire’, there will always be accusations of impropriety.
Investor confidence in a client’s financial results will be greatly enhanced by changing who pays the fiddler. This ‘rub’ places the auditor, a fallible human being, at a disadvantage, and the audit has not yet begun. Unconscious bias cannot be deterred by the constant change to the standards and codes of professional conduct and threats of substantial fines. Rooting out unconscious bias will require more fundamental changes to the way auditing firms and their clients operate.
If the stakeholders and role players in the financial reporting ecosystem are interested in restoring trust in the auditing profession, they will have to go beyond the provisions of the Auditing Profession Act 26 of 2005. There will have to be recognition of the existence of unconscious bias and temper its effects. Only by changing who pays the fiddler can a different tune be called, one with the best chance of providing a strong foundation for the rejuvenation of trust in companies’ financial statements and corporate governance in which all South Africans have a financial stake.
AUTHOR | Dr Steven Ronald Firer, Technical Officer at Nexia SAB & T and Research Fellow in the School of Accountancy, University of the Free State