The Role of External Auditors in Companies - Assignment Example

External Auditors Outline 1. Introduction 2. What is the work or function of an external auditor? 3. Is the role of the auditor limited to that of a black box? 4. What business models are used by finance directors that may not be challenged by external auditors? What is meant by raising strategic issues with finance directors? 4.1 Why the models should be challenged? Why raise strategic issues? Is there basis in law to challenge the business models? How about raising strategic issues? 4.2 Should auditors be doing something else other than what the law presently requires? 5. Proposed changes and Auditor's Independence 6. What other modes could be used to strengthen corporate governance? 7. Conclusion 1. Introduction What is the work of an external auditor in UK companies under the present laws and regulations? Can external auditors not challenge the work of finance directors? Should they be doing something else? Answers to these and other questions will be discussed in this paper, which critically evaluates the issues raised in a statement made by Professor Michael Power (2009), quoted as follows: It may not be reasonable to expect that auditors would be challenging business models directly and raising strategic issues with finance directors, that is not their job and if we want it to be their job then things would have to change quite substantially… The direction of my comment is that we might be expecting too much from this black box [External Audit] in terms of what it actually delivers. 2. What is the work or function of an external auditor? The Companies Act of 2006 (The National Archive, n.d.) requires auditors to have reports of their audits of the clients' accounts. Such reports should contain an auditor's opinion on the annual accounts of the client. They should provide a true and fair view of the state of affairs at the end of the financial year and of the profit and loss for the financial year as a whole. In the accomplishment of his or her purpose to express and offer an opinion on the financial statements, the auditor has the general right to information from the company's account books and other information under the law. Based on this, unless the law is changed to allow the external auditor to challenge the finance director's use of models and raise strategic issues, there is no clear basis for the auditor to do the same. If viewed in a wider context, the external auditor is part of the pillars of corporate governance. Lutzenberger (2010), in explaining the external auditor’s role in corporate governance, noted that the four pillars of corporate governance include the board of directors, internal auditors, management, and external auditors. But what is corporate governance? It can simply be viewed as a guide to meeting goals and objectives by a corporation or company. The concept includes sets of activities, rules, processes, and guidelines which the board of directors can ask to have produced as the company utilizes resources, both human and financial, in the attainment of corporate goals (Financial Reporting Council, 2010). It is based on the truism that accountability in the management of resources is demanded by stakeholders, including whether goals are being met by the board. Stakeholders here may refer to stockholders, the creditors, the government, and the public. Since the company is now in the hands of management, there should be a way to hold them accountable, and such is governed by law. In the UK, the Combined Code of 2006 was subsequently replaced by the UK Corporate Governance Code of 2010 (Financial Reporting Council, 2010). The code defines the parameters of what can and cannot be done by those who would run companies for firms as defined in the law. It must be noted, however, that under the code, principles other than accountability are enshrined in the law. These are leadership, effectiveness, remuneration, and relations with shareholders. Before accountability, there must be leadership and effectiveness in the order of things. Section A of the Main Principles of the code requires companies to be led by an effective board which has collective responsibility for the long-term success of the enterprise (Financial Reporting Council, 2010). The provision fixes clearly who should be responsible for the long-term success of the company. If the board has the primary responsibility, how then does the work of the auditor play a part? Under effectiveness, the UK code mandates that the board and its committees to have an appropriate balance of skill, experience, and knowledge of the business organization for the effective discharge of their respective duties and responsibilities (Financial Reporting Council, 2010). Given the first two principles of corporate governance--leadership and effectiveness--the work of the auditor is not yet discussed. It is in the third set of principles of the code, which focuses on accountability, that the external auditor is mentioned as the “company's auditor.” The need for the auditor must be carefully read from the set of principles of accountability, which, among other things, requires the board to have an arrangement for its members to apply “corporate reporting and risk management and internal control principles and for maintaining an appropriate relationship" (Financial Reporting Council, 2010). This arrangement should be both formal and transparent. In other words, it is needed for the board to present a balanced and understandable assessment of the company's position and prospects or corporate reporting that the members require. Thus, annual reports containing, among other things, the financial reports for the most recent fiscal or financial year are given to shareholders at least yearly. It may then be noted that it is by legislation that the work of external auditors was added to the critical layers or pillars of corporate governance. The need for the auditor to maintain an appropriate relationship with the board is a choice to be made by the board. If the board chooses to have good and independent auditor, this is also the function of its audit committee, formed from the board, which normally should be dominated in number by non-executive members. It is, therefore, required in the Companies Act of 2006 that auditors be a part of corporate governance, whether the board of any company likes it or not. If corporate governance is removed, it would be very hard for stockholders to leave their trust to management as represented by the board of directors, whose members were elected or appointed into office by shareholders. Conduct of business would be a game without rules. Without corporate governance, the limits of the power of management would be unclear. Although it may be argued that the board should be held responsible to the shareholders first and that a certain amount of trust can be afforded them, the work of the auditor lends credibility to the financial information for many groups of users, which are, at the same time, the stakeholders. From the evolution of auditing practice and theory, and based on the provisions of the Companies Act of 2006, it is the board that is primarily responsible to shareholders, as they receive their elected appointments from the shareholders who have made investments in the company. Auditors help the shareholders and the public to be confident that the company's reports are free from material misstatement and are true and fair reports of what is being audited (Whittington & Pany, 1995; Lutzenberger, 2010). Although it is part of the pillars of corporate governance that the reports of the company must be accurate, true, and reliable and fairly reflect the company's status, the auditors are still not primarily responsible for fraud. Although company auditors should promote corporate governance in their opinions on whether the financial statements are true and fair reflections of the company's status, their work is not mainly intended to find fraud. If, in the course of an external audit, the auditors find practices which may appear to be fraudulent, they should direct the issue to management. Management may then choose to correct or continue with the fraud. If the auditors observe continuation of the fraud, withdrawal from the engagement should be seriously considered. Continuing with the engagement would be a violation of the code of ethics for auditors (Mead & Sagar, 2006). Should the auditor find that the models used by the finance director are not reflective of the market, such could actually constitute fraud; in this case, the auditor should be advised to qualify the opinion, issue an adverse one, or terminate the audit engagement if the auditor would not be able to express an opinion. Since the nature of the work of the auditor is to express an opinion on what the company reports, based on what has happened to the company, it would basically be out of the auditor's power to question models used by the finance director, unless the models would present an estimate of the fair values of certain items in the statement of financial position (Epstein & Jermakowicz, 2010), which are made part of the IFRS. However, it would be difficult to conclude or infer fraud regarding the eventual result of an estimate of the values, unless things are verifiable at the time that the auditor makes an examination of the financial statements. Fraud investigation is not the inherent and primary role of external auditor (Whittington, & Pany, 1995). It is important that this is understood, so that the role of external auditor may be exposed in a more accurate light. It is the internal auditor, under the power of the audit committee, who will be held primarily responsible for fraud. In the US, Enron and WorldCom were found to have had fraudulent practices. To assess who should bear most of the blame in those cases--the external or internal auditor--it is necessary to understand their functions. If the internal controls are weak, the internal auditor would be unable to perform his or her functions well. As a result, the examination by the external auditor will be seriously affected. With regard to raising strategic issues with the management, there is no logical and legal basis to do so based on the present function and duties of the auditor. To force them into that situation would amount to substituting their judgement for that of the board of directors, who should be responsible first and foremost for the long-term success of the company. 3. Is the role of the auditor limited to that of a black box? The external audit is referred as a "black box" by Professor Michael Power (2009). He might mean that the role of the external auditor is to preserve what has been recorded, as in the purpose of black box on an airplane. A black box is meant to preserve the communications made by relevant people in the aircraft while the plane travels. Its purpose is to record events that occur or facts and should involve no opinion. Although the work of the auditor is to express an opinion on the financial statements and whether they present a true and fair view, such an opinion must be: an informed opinion in relation to facts from his or her examination, with access to important records; legally compellable; and in relation to given reporting standards. The professor was, in fact, defending the external auditors by stating that they cannot be faulted for what they are not responsible for in the first place. Professor Power implied in his statement that little can be expected from the external audit other than to keep a record, similar to the purpose of a black box. 4. What business models are used by finance directors that may not be challenged by external auditors? What is meant by raising strategic issues with finance directors? These models may be referring to valuation models, which should basically include the preparation of cash flows using the cost of capital. The description is quoted as follows: “challenging business models directly and raising strategic issues with finance directors”. To challenge business models may refer to all kinds of models used by finance directors. To raise strategic issues would be imposed on the management prerogative. Finance models may involve the use of valuation models, such as the economic value added (EVA), the market value added (MAV), the discounted free cash flow method (DFCF), the dividend discount model (DDM), and other models (Kelleher, 2010). It should be noted that these models may entail the use of estimates that the auditor is expected to know as well. To raise strategic issues would be essentially to mind how the company should be managed. This is discretion solely on the part of the management, and to involve the external auditor in raising issues would be to require them to become good strategic managers as well. That would require a higher qualification than present external auditors have. 4.1 Why should the models be challenged? Why raise strategic issues? Is there basis in law to challenge the business models? How about raising strategic issues? The context of the statement on the need to challenge models used by finance directors implies a proposal to increase the responsibility of the auditors beyond their present work. Checking the work of the finance director, who is an executive director, is proposed. Challenging the model used by finance director would mean requiring auditors to express an opinion, whether or not they are reliable and can be used for decision making. The intention appears good but one effect is to pass on the responsibility of management to the external auditor, and that would involve creating a responsibility for the auditor that is beyond consideration. Existing laws separate the work of the audit committee in corporations from that of the executive directors. One of the executive directors is the CFO; therefore, to allow an external auditor to check on the work of finance directors as to the latter's use of finance models might be interpreted as minding as how the finance officials are made responsible to the investors. However, it may be observed that one of the requirements for the audit committee, which functions as a non-executive committee, is for the "board to satisfy itself that at least one member of the audit committee has recent and relevant financial experience” (Financial Reporting Council, 2010; Morris, MacKay & Oates, 2009). This relevant financial experience requires an understanding of the various finance models, so that it can at least challenge the models being used or applied by a finance director in business. Requiring the auditor to evaluate the models by finance directors would not be inherently bad, because the same would involve an estimate of the cost of capital. However, the said cost of capital is difficult to estimate, and its accuracy cannot be fully established (Brigham & Houston, 2002). If, however, the auditor is not allowed to check on the model, what would be basis for making an opinion on whether the financial statements represent a “true and fair” value of what is reported in the financial statements? This researcher however, takes the position that requiring auditors to evaluate the models may alter the program to expect or force the auditor to be better than the finance directors. The job of an auditor is to express an opinion and not to become guarantor or insurer of the financial performance of the company. An imaginary line may be perceived that the work of an auditor is backward looking but that of the finance auditor is forward looking. The audit is a risk reduction mechanism that helps decision makers by providing them with more reliable and objective information. Auditors simply examine what has been done by the accountant for the purpose of enhancing the value of the accounting information for users. Although an audit may be a way of reducing value-reducing actions by agents or managers under the agency theory (Department for Business, Innovation, and Skills, 2010), it can only do so to a certain extent. 4.2 Should auditors be doing something other than what the law presently requires? Whether auditors should be doing something else is an issue that should be decided on the basis of whether there is a law authorizing them to do so and whether they are capable of doing it. Professor Power's argument that there is a lack of a legal basis to demand that auditors challenge business models and raise strategic issues with finance directors is supported by Jonathan Hayward of Independent Audit. Hayward points to the lack of evidence to suggest that these auditors have failed to do what they are required under existing law (Priddy, n.d.). Concern regarding the competence of auditors to do such additional, the cost involved, as well as the exposure of auditors and others to liability risks are critical (Priddy, n.d.) if auditor’s work is extended. To question CFOs, who are among the most highly compensated directors in companies, would indeed be a risky action. Additional cost may affect the competitiveness of UK companies in relation to companies in other parts of the world. 5. Proposed changes and auditor independence It can also be argued that auditors may choose to challenge models and raise strategic issues, or they may not do so because of the issue of independence. Thus, it can be argued that auditors would be less likely to issue a clean opinion, because they simply have to earn a living from clients (Department for Business, Innovation, and Skills, 2010). This may explain the fact that part of the principles of corporate governance focuses on remuneration. The nature of the function of the auditor should not be detached from the real economic world. Auditors must be able to earn their living from their clients, and they are expected to be independent from their clients. The total level of remuneration for auditors was observed to unavoidably affect the latter's independence and judgment (Ball, 2009). Under the UK code, auditors are required to be hired by management through the audit committee of the board of directors, which normally consists of non-executive directors (Financial Reporting Council, 2010). It would be hard to fully expect that the auditor would stand up to “management, particularly when results are poor” (Power, n.d., cited in Department for Business, Innovation, and Skills, 2010). That clients would be shopping for auditors (Lennox, 2000) to issue what is favourable to them is expected. This is, however, contradicted by the experience of low switching rates of auditors in the UK (Department for Business, Innovation, and Skills, 2010). Users of financial information, although audited by external auditors, should be able to view the latter's work with some sense of realism, recognizing that auditors are not absolute truth-tellers. The chance that the auditors may be biased toward issuing a clean opinion because of the nature of their relationship with the client should be understood and accepted. There is evidence indicating that auditors are more likely to issue an unqualified report before a bankruptcy filing while the auditor-client relationship is still in an early stage (Geiger & Raghundan, 2002, cited in Department for Business, Innovation, and Skills, 2010). Under the present structure, auditors cannot own stock in the companies they are auditing or they will be deemed to have lost their independence, and entering into an audit engagement is not allowed. Their position of independence is even stricter as far as determining the independence requirement of non-executive directors, who normally form part of the audit committee. For the auditor to act as a challenger of models is therefore not appropriate. 6. What other modes could be used to strengthen corporate governance? There are other modes may be used as substitutes or as additional support for the audit work, if proposals are made to expand the present jobs. Less cost may come from these alternatives. The adoption and fine-tuning of accounting standards is one method. Enhancement of the standard for the need, for example, to increase disclosure requirements (including models used in the determination of fair values as required and allowed in accounting reporting standards), may cost the business less. This would have the effect of having other advisers who are competent enough to evaluate the risks involved in investments, rather than expecting the external auditor to challenge the same. Another method that could be implemented is dispersed ownership among audit committees and risk management committees (Carcello & Neal, 2003) from the companies. This decision is within the power of the board of directors of the companies, who are, first and foremost, responsible for corporate governance. Dispersed ownership would increase the presence of professional and non-executive directors who would objectively consider the wider interest of the majority of the owners. Rather than putting all of the responsibility on auditors to perform in an area in which they may not be competent, considering audit as one part of a system of activities for corporate governance and regulation may be a better option for policy makers (Leuz, Nanda, & Wysocki, 2003). If there are other modes of assurance, does that mean that the external audit should be excused from performing its unique role? Of course, the answer is no. Auditors were found to have not failed their duty under present laws (Priddy, n.d.). Hence they still deemed to be performing or delivering value in terms of reduced risks. Systemic risks do exist and they cannot be eliminated by an external audit. Even the most competent management cannot assure that it would be able to anticipate all dangers and manage all risks in business. The external audit may be just one part of the big puzzle to minimize systemic risk, and to expect the audit person or entity to accomplish everything is simply unrealistic as well. 7. Conclusion The bottom line should be whether the real or ultimate purpose of the external audit is attained. Anything can be accomplished in this world if the goal is doable and if the power of law can help in attaining the same. However, the business community exists in the economic world of business, in which companies need to have a net advantage after weighing the benefits and costs of requiring an external audit or further expanding its role. The requirement for an external audit is just part of the corporate governance that is meant to address the agency problem in business. There is nothing wrong with thinking or contemplating the best ways in which to protect investors as in expanding the work of auditors. However, additional job would mean increased knowledge and training and increased risk, which would require increased compensation. A better corporate governance is possible but with a less competitive cost position of UK companies when viewed in the global market in relation to foreign companies. To require auditors to challenge the models used by finance directors would amount to challenging management efficiency or management capability. If their assigned work is to make the information reliable, requiring auditors to determine inefficiency should remain the primarily responsibility of the board of directors, as enshrined in the UK Corporate Governance Code. The fact that the information may be made credible by the auditor's report should not be considered a guarantee for the protection of investors, because there are external risks that may not be addressed. Moreover, the auditor, who certifies certain historical facts, cannot necessarily predict the future with accuracy, although the information needs to have predictive value. The competence of the person making the prediction--using, as a basis, the information that passed the hands of an auditor--is also very important. However, this limitation of the historical information to predict the future should not be used as an excuse to not make the information more relevant. Although the future is uncertain and nobody can know perfectly what will happen, the auditor's work is a logical part of corporate governance, in that a statement that the accounts of the client are free of any material misstatement should provide a certain amount of assurance. The requirement of the present law is to express an opinion, not to substitute for the minds of those in management by challenging models used or raising strategic issues with finance directors. For the auditors to do the latter, they may simply need to be part of the board of directors, who should be responsible. However, then, that would entail actually removing them from the picture, and the UK Corporate Governance Code maintains that responsibility for corporate governance belongs to the board. With the board maintaining good relations with their shareholders by having a mutual understanding of the corporate objectives as required by the code, these parties should be more convinced that the directors are competent and trustworthy enough. External auditor is director surrenders the responsibility. References: Ball, Ray (2009) Market and political/regulatory perspectives on the recent accounting scandals Journal of Accounting Research Vol 47, No 2. Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management, London: Thomson South-Western Carcello and Neal (2003). Audit committee characteristics and auditor dismissals following “new” going-concern reports, The Accounting Review Vol 78, No.1, pp 95-117 Department for Business, Innovation and Skills (2010). Inquiry by the House of Lords Economic Affairs Committee on “Auditors: Market Concentration and Their Role”. Retrieved 28 March 2011 from Epstein & Jermakowicz (2010). WILEY Interpretation and Application of International Financial Reporting Standards. John Wiley and Sons Financial Reporting Council (2010). UK Corporate Governance Code. Retrieved 28 March 2011 Geiger and Radhunandan (2002). Auditor tenure and audit reporting failures Auditing: a journal of practice and theory. Vol 21, pp 66-68 Kelleher (2010). Equity Valuation for Analysts and Investors. McGraw-Hill Professional Leuz, Nanda and Wysocki (2003). Earnings management and investor protection: an international comparison Journal of Financial Economics. Vol 69, pp 504-529 Lutzenberger (2010). The Role of External Auditor in Corporate Governance. < http://www.ehow.com/about_6302822_role-external-auditor-corporate-governance.html> Mead & Sagar (2006). CIMA Learning System Fundamentals of Ethics, Corporate Governance and Business Law: New Syllabus. Butterworth-Heinemann Morris, MacKay and Oates (2009) Finance Director's Handbook. Butterworth-Heinemann Power, M. (2009). Evidence to the UK House of Commons Treasury Committee. Power, M. (n.d.). Memorandum to the House of Commons Treasury Committee on the banking crisis. Written evidence (Vol. II, HC 144-II) Priddy (n.d.). The Future Evolution of Audit. . Retrieved 28 March 2011http://www.accaglobal.com/pubs/af/audit/articles/evolutionofaudit.pdf The National Archive (n.d.). Companies Act of 2006. . Retrieved 28 March 2011 < www.legislation.gov.uk/ukpga/2006/46/pdfs/ukpga_20060046_en.pdf> Whittington & Pany (1995). Principles of Auditing. London: IRWIN Read More