Financial oversight weaknesses have prompted regulatory tightening worldwide, and the companies that review books are coming under scrutiny.
Persuading auditors to be more accountable
Financial oversight weaknesses have prompted regulatory tightening worldwide, and the companies that review books are coming under scrutiny. The most pressing issues are being discussed in Abu Dhabi this week as officials from 33 countries hold the plenary meeting of the International Forum of Independent Audit Regulators.
On Sunday, the Dubai Financial Services Authority (DFSA) announced a raft of corporate governance changes and fines for the jewellery retailer Damas International after an investigation into "unauthorised transactions" by executives at the company. The DFSA ordered Damas to dismiss Ernst and Young as its external auditor and hire a new firm within 30 days. So far, the regulator has declined to give details as to why it made this decision. Ernst and Young, for its part, said it "fully" stood by its financial statements for Damas and that it had not been informed by the DFSA about the decision.
Ernst and Young has been in the headlines in the US lately after a report about the 2008 collapse of Lehman Brothers said the auditor had signed off on questionable accounting that allowed Lehman to hide US$50 billion (Dh183.66bn) of troubled assets to make its debt levels seem lower. Ernst and Young also stood by its work for Lehman. Last week, Saudi Arabia's Capital Market Authority cancelled the company's Saudi securities business licence after "several violations of the kingdom's capital market law and implementing regulations".
Ernst and Young said it respected the Saudi authority's decision and that the loss of the licence would have no impact on its other operations in the country. Binod Shankar, a chartered financial analyst and managing director of the Genesis Institute, said "Lehman and Damas are two recent cases which have brought the auditor into the limelight" but that the public misunderstood the responsibilities of audit firms.
"The job of an auditor is very clear. He can give only reasonable assurance that there are no material errors," Mr Shankar says. Audit firms cannot be held responsible for finding every instance of fraud, especially if the fraud is complex and well disguised, he says. "Auditors don't get that much access to information as you'd think, typically in a large audit," he says. "They have a limited time, hence they use random samples and test the controls. Hence to ask the auditor to also issue a no-fraud guarantee would make his job very risky and almost impossible."
The difference would be if the auditor found something inappropriate and did not investigate further. If this happened, the auditor could be subject to civil and criminal legal action, he says. Andrew Tarbuck, a corporate partner at the international law firm Latham and Watkins in Dubai, says an auditor should clearly be independent of the board of directors and communicate whether the company's internal audit procedures are correct.
But the situation becomes more complicated when it comes to determining whether an auditor should be responsible for detecting all violations of laws and regulations, he says. "Certainly they should know the law as it pertains to the conduct of the audit and the necessary financial information to be disclosed and a responsibility to alert the directors if they believe that the company is doing, or not doing, something in breach of the law or regulation," Mr Tarbuck says. "At that point, it is up to the board to consider whether it needs to consult its lawyers. It is fair to say that auditors should be able to spot the more obvious legal issues and should alert the company, and if there is something that does not 'add up', again, they should revert to the board. But, on occasion, breaches of the law can be hard to spot by non-legal eyes, and it would be difficult to make the auditors bear full responsibility for missing something."
What is clear is that if auditors do not do their job properly, there can be disastrous consequences, as was shown in Enron's collapse in 2001. The scandal led to executives being sent to prison. It also led to the passage in Congress of the Sarbanes-Oxley Act, which tightened management and auditing accountability. Shareholders of Enron lost $74bn but recovered some of the money in lawsuits in the years afterward.
Paul Koster, the chief executive of the DFSA, made it clear at a breakfast briefing with the region's top auditors last week that "audit quality" was among his top priorities. The DFSA is also "stepping up" its relationship with the Emirates Securities and Commodities Authority (ESCA) and the Central Bank. The DFSA has oversight responsibilities for auditors of companies listed on the NASDAQ Dubai but plans to expand this role to cover all auditors of companies in the Dubai International Financial Centre. The country's other larger regulators are also increasing scrutiny of auditors.
Mr Koster's experience early in his career as an accountant at Arthur Andersen, the audit company that fell apart after being found guilty of criminal charges relating to its handling of Enron's books, is likely to provide a deep understanding of the systemic issues at audit firms. He believes, in fact, that the entire system should be shaken up so that companies no longer directly pay auditors to examine their financial statements. One measure, he suggests, is to create a central trust to collect money from companies and then independently hire auditors.
"It's a really contentious issue," he said last week. In a speech in January, Mr Koster pointed out that with each high-profile incident - including the Bernard Madoff Ponzi scandal and the falsified accounts at Satyam Computer Services in India - the need for reform increases. With the audit industry "at a critical juncture", Mr Koster called on companies to have an unrestricted dialogue about the future of monitoring financial disclosures.
"Auditors, credit rating agencies, lawyers and boards all play a critical and pivotal role in protecting, maintaining the trust and confidence in the financial markets," he said in the speech. "All reputational intermediaries have failed in one way or another. No one escapes some form of blame, but it is exactly that failure that makes us face this singular historic moment in the audit profession and at other governance levels."