AUDITORS AND CORPORATE GOVERNANCE

AUDITORS AND CORPORATE GOVERNANCE

By M. Iqbal Patel, F.C.A., Karachi

The recent series of corporate crises around the world holds many different lessons from peril of weak auditing to the risk of inadequate governance structure. But there is generally one lesson they all share in common; that is financial statements do not provide complete picture of soundness of the company. Consequently the Governments and the regulators throughout world have responded to some degree by tightening the accounting and auditing standards to enhance disclosures and oversight at public companies.

There regulatory development throughout the world has been that in United States the PCAOB adopted a negligence standard of liability that applies to the conduct of individual auditors who cause their audit firms to violate the securities laws or related rules. It also adopted an auditing standard on reporting on whether a previously reported material weakness in internal control, continues to exist as of a date specified by management.

Philippines Congress is considering legislation that, among other things, would require the audit partner to rotate every five years. The Government of South Africa proposed to require audit partners to rotate every four years with two years cooling off period. It has also introduced Companies Amendment Bill which contains regulatory framework for the auditing profession including the establishment of a new independent oversight body.

The Department of Trade and Industry of United Kingdom has published the document pursuant to Audit Quality Forum Report on the need for research into the perception of investors, brokers, advisers and audit committees of competition and choice in the audit market, and how and why changes of auditors occur. It has also undertaken project to develop simplified standards for small and medium sized entities.

The revised Code of Corporate Governance of Singapore expands the scope and power of audit committees to include ensuring the integrity of the company's financial statements, reviewing the effectiveness of internal control and making recommendations to the board regarding the engagement of the external auditor.

In Japan, the Financial Services Agency plans to submit the proposal to Parliament early next year which would allow the standards for internal controls over financial reporting to be implemented around the fiscal year ending March 2007/08. The new standards will require management to assess the effectiveness of internal control. over financial reporting, with independent auditors attesting to the accuracy of that assessment.

The Supervisory Board of the European Financial Reporting Advisory Group of European Union will organize a public forum in Brussels to discuss potential concerns regarding the consistent application of IFRS in EU. The aim is to gather feedback on whether there is a need for an increased number of interpretations of the international standards and if so, how such a need could be met. Moreover, unless European Parliament raises objection, the EC intends to adopt the agreed unanimously amended standard of IAS 39 relating to the Fair Value Option with retroactive to January 1, 2005.

Canada has issued corporate governance guidelines and disclosure requirements that includes that corporate boards comprise a majority of independent directors and chair and the board should conduct regular assessments of its own effectiveness as well as the effectiveness of each individual director and must disclose the attendance record for each director for all board meetings. The Canadian Public Accountability Board has released second public report on its inspections of 23 public accounting firms,' concluding that audits by those firms need significant improvements. Problems cited include lack of effective internal quality controls, accepting or retaining high risk clients, implementation problems of revised auditor independence rules and inadequate training on current accounting and auditing rules. France launched a French language website to promote knowledge and understanding of the international standards in the Francophone community.

But these tightened rules relating to audit, competition, professional liability, corporate governance, internal controls, international accounting and auditing standards and regulatory oversight take aim primarily at some of the more extreme problems of corporate malfeasance such as fraud and the falsification of accounts. The broader question is the regulators and the investors really monitoring the right indicators of long-term corporate health? Has remained largely unanswered as discussed here under:

The Security Exchange Commission of Pakistan (SECP) also motivated to improve the corporate culture in Pakistan and issued Code of Corporate Governance (CCG) through, amendment in the listing regulations of the Stock Exchanges. The Code inter alia other matters concerning structure and function of the corporate sector, includes matters relating to the audit. It requires that Board of Directors of every company to establish an Audit Committee comprising not less than three members, majority of them shall be from among the non-executive directors.

The concept of audit committee has its origin in the report of Cadbury Committee which was set up in May, 1991 by the Financial Reporting Council, by the London Stock Exchange and the accountancy profession to address the financial aspects of corporate governance. The New York Stock Exchange had required in 1978 to all listed companies to have audit committees composed solely of independent directors. The American Tread way Commission in its report in 1987 concluded that audit committees had a critical role to play in ensuring the integrity of US company financial reports.

While experience of audit committees in Pakistan is shorter, but it is not encouraging because it is observed that these committees appears to have been set up mainly to meet listing requirements The names of the members of an audit committee disclosed in one of the company's accounts are four Board members including two of them are mother and daughter. What a joke is with the Code. Generally it is observed from the annual account of the companies that there is a trend that these committees are not true representatives but are represented by the board of directors themselves. Such committees neither prove their worth nor their value to their business nor they offer added assurance to the shareholders that appropriate measures to safeguard the company's assets are determined by the board and that the auditors who act on their behalf are in a position to safeguard their interests. Unless the membership on the committees is confined to the independent non-executive directors of the company, the object set by the CCG to set up such committees, would be defeated.

Further in respect of compliance with the CCG, all the listed companies are required to publish and circulate a statement along with their annual accounts the status of their compliance with the best practices of corporate governance as prescribed in the Code. This exercise is in futile. Because as it is observed in one of the company that such statement contained different assertions at one place it is mentioned that the company has one executive director and on the other two. Similarly in case of household spouse/daughter of the sponsors inducted as director, their attendance at the board meeting is recorded in the director's report. All these recordings are pointer of possible inaccuracies and calls for to strengthen the process of monitoring by the regulators.

Further the format of the Statement has been prescribed which generally is signed by the chairman/CEO of the company just filling in the blanks. In fact the Statement should be beyond the strict terms of the Code and it should be left on the Board to decide the terms in which they wish to make statement of compliance of the Code dealing with the matters which they have complied with and deliberating with those areas which are not complied with by them and stating the reasons for departure.

Further that the statement of compliance with the best practices of corporate governance is subject to review by the auditors before publication. The auditors generally give a stereotype review report making the Board responsible for the compliance of the Code. The review specifically states that they have not carried out any special review of the internal control system to enable them to express an opinion as to whether the Boards statement on internal control covers all controls and the effectiveness of such internal controls. Such review by the statutory auditor on compliance of the Code does not safeguard the interest of the shareholders. The review, in fact, should cover only those parts of the compliance statement which relate to provisions of the Code where compliance can objectively be verified. The auditors should not be required to report formally on a satisfactory conclusion to the review of the Board but if they identify an area of non-compliances which is not properly disclosed, they should draw attention of the shareholders to it in their review.

It is recommended that SEC may seek guidance from ICAP accordingly to make the auditors review effective. A voluntary option worth consideration is notion of a separate corporate audit whereby the auditor should act as a line of defence for SEC providing independent assessment of compliance with CCG and the provisions of the Company Ordinance, 1984 as a whole by the companies provided the investors agreed, that such audit worth the money they spent on it.

The auditors are duty bound to exercise a reasonable care and diligence in performance of their functions; but their primary responsibility is to provide reasonable assurance for reliance on financial reporting by the directors of the company. However, the regulator is to ensure that transparency and fairness exists in dealings between the constituents of the corporate environment. To quote an instance the US SEC charged Mr. Conaway and Mr. MacDonald the Chief Executive and the CFO respectively of the company for making material false statement misleading the investors about the company's liquidity and related matters in its quarterly report ended on October 31, 2001. It accused CFO because he did not adequately disclose the reasons for a massive inventory build up in the report. The SECs inquiry revealed that a significant portion of the inventory came from officers reckless and unilateral purchases of $ 850 million of excess inventory. But the report attributed this buildup to a seasonal inventory fluctuation and actions taken to improve overall stock position.

The other instance relates that Mr. Rigby the Chairman and Mr. Bailey the Finance Director of software company AIT, were convicted under British Market Abuse Law and were given prison sentences by Jury Southwark Crown Court for issuing recklessly statement that AIT" s profit for the year ending March, 2002 would be in line with market expectation at 6.7 million pounds which subsequently proved incorrect. Hence they were accused that this statement was misleading, false or deceptive in a material particular which damaged the integrity of the stock market. Similarly former WorldCom Chief Executive Bernard Ebbs is facing 25 years in federal prison and finance Chief Scott too on the charge of overseeing the accounting fraud.

The stiff sentences mentioned above could be a wake-up-call for executives that send signals to senior executives that if you sit on information and mislead the investors and market, this offence could be Punishable with prison. In monitoring the compliance of the provisions of the Code or company law by the regulator should not consider the non-compliance act as an opportunity to generate revenues by way imposing fines. Because such defaults are not victimless crime. The efficient markets depend on investor's ability to rely on the information released by the company.

The statutory audit is one of the cornerstones of corporate governance. It provides an external and objective check on the way in which the financial statements have been prepared and presented. The basic statutory duty of the auditor is to report to the shareholders on whether the accounts give a true and fair view of the affairs of the company. The shareholders in particular and investors in general expect that the auditor must be objective and remain independent from the company management.

Although audit firms preserve reputation of independence; however, there may be a temptation to compromise on independence for financial consideration. Arthur Andersen is a classical example. One of the reasons why Andersen is accused of having turned blind eyes on Enron's creative accounting which resulted in collapse of energy giant, the biggest bankruptcy in US history, was for the phenomenal consulting fee of $27 million in addition to audit fee of $25 million it received last year. Similarly collapse of Parmalat in one of Europe's biggest corporate fraud scandal which also involves two auditing firms on charges of false auditing.

Besides above, the other corporate frauds also surfaced at WorldCom, $11 billion accounting fraud led the company into the bankruptcy. The other is the US brokerage Refco Inc. Furthermore the news that there will start of GM accounting probe which has sparked renewed talk about bankruptcy of this US auto giant.

Now a days well talk subject among the stakeholders is that like citizen of most developing countries tend to be attracted by foreign goods, accordingly the ICAP adopted more consistent approach and now has permitted the local audit firms to label with an identification of affiliation with a foreign firm with the name and style of their firms name probably under the perception that the label could become symbol of service or may be like a belief of Italians that if they assumed Roman dress and began to observe their customs and adopt their belief, they could once again become rulers of the known world. However, the issue has positive as well as negative, aspects. It will enhance competition among some and concern for most unfortunate.

Confronting with the identical situation, the Department of Trade and Industry of U.K. has issued a consultation document entitled Shareholders Involvement, Competition and Choice. The document has seriously considered the concept of joint audit, noting joint audit might on ad-hoc basis can cause insecurity directly impinging on judicial independence.

(f) Article 193 of the Constitution bestows a primary obligation on the President to provide adequate permanent' strength to every High Court to enable it to cope with its normal business so as to ensure expeditious disposal of cases. The strength has to be reviewed from time to time so that arrears do not accumulate and justice to litigants is not unduly delayed. The stark reality prevailing in all the four High Courts make it clear that the increase of business is not of a temporary character but is a permanent phenomenon and that the arrears have accumulated to a disturbing level. Therefore, it is imperative for the President not to resort to Article 197 but to increase the strength by making permanent appointments under Article 193.

The Supreme Court of Pakistan in PLJ 1996 SC 882 has expressed its resentment at the appointment of ad-hoc chief justices. It is a pity that successive governments have been "virtually playing with the courts", to use the words of Indian Justice E.S. Evnkataramiah, who vehemently criticized the use of Article 224 of the Indian Constitution by the President under similar circumstances.

What is needed is a complete and correct assessment of the requisite strengths of permanent judges for every High Court in terms of its work-load. If the situation so demands, the President must take immediate steps to provide an adequate strength of permanent judges to every High Court to cope with its normal business. He must also review such strength from time to time so that arrears may not accumulate and justice is dispensed expeditiously.

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