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FEBRUARY 2021 Download this Article
Audit quality refers to the probability of detecting and reporting a breach in the financial processes followed by a firm. By that definition, failure to detect or failure to report the detection reflects the poor quality of audits.
The bottom line to the argument is the inability of the auditors to provide clean account books, especially for those firms which have committed fraud. The role of the auditor vis-à-vis their client firms had been in question every time there is headline-grabbing news.
The core challenge in the audit profession is the independence of the auditors in providing a balanced judgment by the firm’s accounting treatments.
Two benchmarks for accounting judgment are the concepts of materiality and fairness. The practice of audit as a profession needs to present a balanced judgment about the materiality of the client firm with fairness to the investors. Any artificial deviation in that judgment will bring conflict of interest.
It is like paying hefty to the policeman directly to get an official character certificate.
The role of the auditor is somewhat semi-judicial, with responsibility and accountability for upholding the TRUTH of the financial statement beyond the pleasure of the firm’s management and profit-seeking investors.
The ground reality had proved otherwise. It is also understood that large firms which have been embroiled in fraud had hired the big five audit firms for both audits and consulting. The most infamous one being Enron.
After the Enron crisis, the SOX Act of 2002 had a positive impact on the practice of audit and the processes followed by the auditors. Still, a lot more needs to be done, and we continue to see frauds.
Although it looks otherwise, the auditors were toothless. They were neither able to challenge the financial results of the firms nor their risky financial model.
The practice of audit is just to assure that financial transactions are recorded as per standards even though it meant recording (colossal) losses. It was not their responsibility to get underneath the skin of the business.
The business model of the auditing firms and their fee relationship with firms, conflict-of-interest is natural.
For a long time, auditing standards had been following a boilerplate process of disclosures and declarations in the financial reports.
These declarations have been overly generic, more customary; hence it reveals all that is necessary from an advantage point of view of the management. This is how auditors had posed a risk due to information asymmetry.
If history is the record, all major corporate frauds and manipulations, the toothless role of auditors appear familiar. While there is no incentive for auditors to be principle-based or rule-based, there are discrete incentives to be a client-oriented auditor.
On the other hand, - the audit firm’s revenue is based on audit and non-audit services rendered to the same client. The services are just not restricted to one area of account audits.
The auditors hence attempt to get more business and service fee from the client in return for handling managed earnings. Moreover, if one reviews the business model of the auditing firms and the fee relationship in the financial system, conflict-of-interest is natural.
It is like paying the policeman directly to get an official character certificate. It is too easy to influence and manipulate the situation, especially if the policeman wishes for repeat business from the client. If his livelihood depends on that fee, then there is a clear and provoking incentive to promote conflict-of-interest.
As discussed earlier, it is the ability to detect and report a breach in the accounting system without the consequence of losing the client’s business opportunity.
The auditor’s independence holds the key to the success of the profession of audit and the market risk as a whole. Therefore, the business model in which the auditors survive as a profitable profession along with integrity and independence is a MUST.
In the UK, the select committee has found that the FTSE 100 companies have not changed their auditors for decades, and 99% of the FTSE 100 companies had only those big four audit firms.
As a remedy, if the audit services are nationalized, paid by a shared pool of corporate taxes, the audit services will be independent, and integrity will be assured with higher probability. Any system-wide conflict-of-interest will be eliminated.
The firms will be more secured, and the shareholders will be protected even more.
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