MT EXPERT: Why you need to audit your auditors

The auditor-management relationship has always been uncomfortable, but lately it's got more hands-on. Management needs to get involved, says Lawrence Reed.

by Lawrence Reed
Last Updated: 02 May 2014

The relationship between external auditors and management is entering a new era driven by regulatory change and increasing scrutiny from all stakeholders. We look at how that role has changed and what that means for management.

Auditors exist to tell shareholders that the account given to them about how their capital has been used can be trusted. And likewise, an independent, external audit is one of the few checks managers can rely on to tell them that year end accounts are a true and fair reflection of business performance to see off any unpleasant surprises.

Until the second half of the 20th century, audit was an increasingly regulated profession, secure in its position as the final word on accounts. In the 1970s audit firms began to compete openly, rapidly transforming from secure but fairly static professional firms into rapidly growing businesses, providing many additional (non-audit) services.

The growth of highly profitable consulting divisions meant that in competitive situations, firms were able to ‘low-ball’ (ie. understate) the audit fee in the expectation of high margin consultancy work. Audit became a loss-leader for the provision of consultancy services. This overt conflict of interest is now strongly discouraged and in hindsight, there is a view that this may have impacted negatively on audit quality.

Then came Enron, WorldCom and the collapse of Arthur Andersen. The credibility of the industry shattered. Many commentators have put these failures down to over-reliance by the audit firms on representations by management without independent verification.

At the same time, and partly in response to regulatory upheaval, the role of the non-executive director began to change from ornamental mouthpiece to protector of shareholder interests. A series of codes and guidance on corporate governance started to be introduced, each of which expanded the role of NEDs - Higgs on boards, Smith on audit committees, Turnbull on risk, the creation of the Financial Reporting Council, etc etc…

Quite possibly this reliance on NED governance is ultimately imperfect since they have the same legal responsibility as executives. They are explicitly responsible along with management for the company’s strategic leadership at the same time as being responsible for monitoring management. However, the UK is – with some justification – very attached to its unitary board system…so there has been a general agreement not to talk about it!

Part of the public policy response to the audit crisis was to give NEDs new responsibility for monitoring the external audit. For the past few years, NEDs have been charged with choosing the auditor and then ensuring that they remain objective and do a decent job. An irreversible culture change got underway in what many saw as an attempt to put the clock back using regulation. Management and the auditor were finally being prised apart.

The result is that now shareholders and other stakeholders (like management), are taking an active interest in how NEDs actually fulfil their audit-related responsibilities.   

The October 2013 Competition Commission remedy that shareholders must have an advisory vote on audit committee reports has had a dramatic effect – shareholders are already planning to hold audit committee chairman meetings, and audit committees are starting to look much harder at how they fulfil their responsibilities, not just whether they have been fulfilled.

If management want to maintain shareholder confidence, they should resist the temptation to see the audit committee’s work on auditors as pointless governance bureaucracy. They need to support their audit committees in whatever way will best demonstrate to shareholders that the board is mindful of their interests and properly supervising the audit appointment and process. And because of the tacit agreement to ignore the split-responsibility of the NED role, it needs to be made very obvious that NEDs are doing their work with complete independence from management.

Among the tools to do this is the annual ‘audit effectiveness review’. In the near future a large number of audit tenders are predicted, driven by regulation and the need to further demonstrate auditor independence. Our experience shows such tenders benefit from the early input of all stakeholders – including key management.

Our message for all management who might have an interest in the outcomes of a tender or the effectiveness of the audit is: get involved.

- Lawrence Reed MA FCA is a Senior Advisor with Independent Audit where he specialises in external audit effectiveness review and tender management.

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