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Wither independent audit?

The limited liability company was one of the most significant inventions of the nineteenth century. The state permitted the incorporation of corporate entities, with many of the legal rights of a person, whilst limiting the liability of their owners for the companies’ debts. Elegantly simple, the limited liability company proved amazingly successful. Unfortunately, the idea was so successful that today the notion has become confused and immensely complex. The entire concept needs reinventing.

But one aspect has remained constant: the requirement for an independent audit of the financial accounts that the directors provide for their shareholders. Initially, auditors were drawn from the shareholders, but by the later 19th century, they were supported by an emerging audit profession. In those days, accounting firms were small, the number of partners limited.

A hundred years later, however, throughout the economically advanced world, the audit of public companies had become the preserve of the ‘big five’ accounting firms. Listed companies and stock markets preferred the assurance of a well-known audit firm on its accounts.

But the collapse of the American energy company Enron raised some fundamental questions about their auditors, Arthur Andersen. The firm’s fees for consultancy and other non-audit work were larger than the audit fee, which some thought might be a loss-leader for consultancy work. Andersen trained accountants also held key financial positions in the company. Moreover, Andersen partners had chosen to overlook some vital questions about Enron’s financial processes. Faced with these issues, and problems with other clients that had collapsed, including WorldCom and Waste Management, the firm of Arthur Andersen failed: and the big five became the even bigger four.

Today the global market for the audit of public companies is dominated by these four accounting firms. They are major businesses in their own right, offering products and solutions, their partners judged by fee generation, market share, and profit performance. Recently some have been criticised them for advising clients on legal, but morally-questionable, tax avoidance schemes.

Of course, others have drawn attention to the oligopoly of firms doing public company audits. Some suggest a periodic, statutory change of auditor. Others call for second-tier accountancy firms to be more involved. The United Sates responded to the Enron challenge with the Sarbanes Oxley Act (SOX), which set out to regulate the audit profession.

“Why do auditors report to the directors of the company they have audited?”

But a more fundamental question needs to be asked: why do auditors report to the directors of the company they have audited? The classical response is that auditors report to shareholders not to directors. But this ignores the de facto reality of the public company today, with its diverse shareholder base of index-funds run by computer programs, private equity investors, and hedge funds with little interest in governance. The reality is that auditors report to the board, through the board’s audit committee. The directors approve the auditor’s fees, determine their continuity, and provide them with non-audit business.

A more fundamental re-think is needed, one that re-examines the original concept of the corporation. Auditors could report directly to the financial regulators, not to the directors of the companies they audit. In this model, the auditors would deal with the regulators, discuss their audit findings and provide their audit report. The regulators would agree the fees, and re-appoint or replace them.

Of course, the directors and the shareholders would be kept informed. The costs of the audit would be paid by the company, as now. The regulators already exist to manage such a relationship: although, of course, their resources would need developing.

Such changes would end cosy relationships between directors and auditors. Independent and professional supervision would improve audit practices. The independence of audit would revert to the original notion.

Such a proposal will undoubtedly be rejected by both auditors and business. Too many vested interests are involved. A new mind set would be needed. Such changes would have to be imposed statutorily. But, as in the 19th century, it is the state that permits companies to incorporate, limiting shareholders’ liability for corporate debt. The state lays down company laws and regulations, including audit requirements, to protect the interests of investors, creditors and other stakeholders. What the state provides, the state can change.

Featured image credit: Business: Analyzing electronic document, © shironosov, via iStockPhoto.

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