AUDITOR ROTATION FOR SMEs - A REVOLUTIONERY IDEA
The quality of auditor judgment may be influenced by who hires, fires, and compensates the auditor. Management often has a great deal of influence over hiring the auditor. Management may use its contracting power to try to influence the conduct and outcome of an audit, undermining the objectivity and judgment of the auditors, as their personal self-interest may be served by keeping management happy. Recent audit scandals have focused public attention on the relationship between management and the auditor.
Beyond the audit firm, there are a number of professional, regulatory, and other institutional forces that provide guidance on acceptable auditor judgment and conduct, and reinforce society's desire for ethical auditor judgment. Specifically, ethical conduct by an auditor is supported through a code of conduct, rules regarding auditor independence, auditing standards, quality control standards, and external inspection of audit engagements.
Auditors throughout the world must follow a code of conduct that defines unacceptable ethical behavior. The International Federation of Accountants (IFAC) requires that all member bodies adopt, except where prohibited by local law, the in¬tent of the provisions of its "Code of Ethics for Professional Accountants."
In terms of this "Code of Ethics for Professional Accountants" auditors are expected to maintain independence from their clients. An auditor must be concerned with both independence in fact and independence in appearance. Independence in appearance means that an auditor should do nothing that creates a perception that he or she has a vested interest in the outcome of an audit.
The perception that an auditor is not independent, or has a potential conflict of in¬terest in providing audit services of the highest quality, undermines the value of those services even if the auditor is completely unbiased and objective. An auditor who does not possess independence in fact may be tempted to bias the execution of the audit, which could manifest itself in poor decisions related to the gathering and evaluation of evidence or the nature and extent of disclosures in the financial statements.
The "Code of Ethics for Professional Accountants" sets out the types of threats to independence. One of these threats is the “Familiarity Threat” which arises when an auditor becomes too close to a client. It is this ever present “Familiarity Threat” that is at the root of the problem of independence. How is one able to be absolutely certain that an auditor is acting independently? How can the public between the time of the commencement of the audit and the receipt of the audited annual financial statements be aware of the differences of opinion and the nuances of interpretation that might have existed between the auditor and his/her client and what compromises were made? Does one, can one know whether the auditor’s independence has been dented and bruised somewhere along the line?
So perhaps there is something fundamentally wrong with a system which keeps stressing the need for independence but which does not provide a framework within which independence can be seen to be operating. The law, the rules the accounting practices which comprise the system fail possibly because the human element is to a large extent neglected.
And here one comes to the crux of the matter, the auditor client relationship. In most instances small audit clients have remained with the same firm of auditors for many years. Auditors, friendly souls that they are, often fraternise socially with the directors and the senior personnel of a company. The lower echelons of audit trainees likewise fraternise with the office administrative staff.
These indefinite and long standing appointments as auditors, these intimate almost incestuous relationships between personnel of auditing firms and the clients are barriers to complete freedom of action and to absolute independence.
So then one can ask, what is the remedy? How does one tackle a human relationship problem in the arid field of auditing? A suggested remedy is simple, but revolutionary, rotation of auditors for small audit clients. This concept seems to be well worth considering in striving for a client auditor relationship through which the independence of an auditor is not only possible but and this is most important, is seen to be possible. The suggestion is that audit engagement practitioners rotate between clients on five to seven year cycle, thus overcoming the entrenchment and continuity aspects of the present system. National governments would do well to consider this pioneering rotation concept as a long terms objective.
Rotation, say the critics is not practical when it applies to one man and too small to medium size companies. The close relationship which exists between this type of client and the auditor, who not only audits the books and prepares the final accounts but who also acts as a confidante in a wide field is of a valuable nature, it is claimed.
There is merit in this argument but it is precisely this warm relationship in the professional field that can lend itself to abuse. In any event the notion of rotation does not preclude anyone from continuing to seek advice of a favourite or long standing consultant.
Tied up with this aspect is the whole question of mandatory audits for small audit clients. It is necessary, to ask once again, is it necessary to audit the financial statements of a small audit client?
These small, closely-held companies enjoy the privilege of trading with limited liability in accordance with the provisions of Corporations Law. This means that if the company fails or causes damage, the shareholders only lose the sum of money they invested. The property rights of those damaged by companies have been removed to the benefit of a select group of property owners.
For the privilege of limited liability small, closely-held companies must ‘pay’ by making information available to its stakeholders in a responsible, transparent and unbiased manner. Gone are the days that a company is only accountable to its shareholders. No company is an island. It is part of a complex infrastructure and as a corporate citizen, is accountable to the community, employees and others.
The owners and directors of small, closely-held company’s limited liability companies must be made accountable in law for their actions. The law should ensure that external stakeholders, such as shareholders, minorities, employees, creditors, suppliers, consumers and the general public, are protected.
Whilst auditors carrying out a statutory audit of financial statements are accountable and report to the shareholders of a company only, there may be other stakeholders who believe that an independent audit provides some means of ensuring that the company’s responsibilities to them are being met; in effect that it serves their interests too. Stakeholders such as creditors, lenders, credit agencies, customers, and employees may claim an interest in the audit.
Today's legal structures allow small, closely-held companies to raise astronomical amounts of finance from the public in the time it takes to bat an eyelid and to employ these resources as they see fit behind a wall of secrecy and freedom from legal accountability. It is time to end the illusion that an audit has no value.
This revolutionary concept of audit practitioner rotation for small companies, in combination with the external inspection of audit engagements by National governments will change the small audit client practitioner from a benign fraternising and lax practitioner into a delving, hard-nosed and ruthless inquisitor. This is what the public want. This is the kind of protection the banks and other creditors are searching for in these hard times.
The audit of a small, closely-held company is nothing more than a necessary evil is a fallacy. In these hard times many causes of business failure, such as inadequate cash flow management or weaknesses in controls, may be identified and reported earlier as a result of the audit. Auditors are required to have a sound knowledge of the audited company and the business environment in which it operates. They can, therefore, offer advice on a range of issues including the potential for savings or additional profit. Auditors are required to consider the way the directors control their business. Poor or unreliable controls can reduce business efficiency and allow errors and fraud to go undetected.
An independent audit is therefore crucial, it gives credibility to the financial statements in a way that cannot be achieved by any other means and has a clear economic value for the small company. However, an audit of a small, closely-held company needs a major revolutionary change in manner in which the auditors of small, closely-held companies are appointed to establish wherein an auditor of a small, closely-held company can act entirely independent and can be seen to act. Otherwise the illusion will become a reality that an audit of a small, closely-held company has no value.
Beyond the audit firm, there are a number of professional, regulatory, and other institutional forces that provide guidance on acceptable auditor judgment and conduct, and reinforce society's desire for ethical auditor judgment. Specifically, ethical conduct by an auditor is supported through a code of conduct, rules regarding auditor independence, auditing standards, quality control standards, and external inspection of audit engagements.
Auditors throughout the world must follow a code of conduct that defines unacceptable ethical behavior. The International Federation of Accountants (IFAC) requires that all member bodies adopt, except where prohibited by local law, the in¬tent of the provisions of its "Code of Ethics for Professional Accountants."
In terms of this "Code of Ethics for Professional Accountants" auditors are expected to maintain independence from their clients. An auditor must be concerned with both independence in fact and independence in appearance. Independence in appearance means that an auditor should do nothing that creates a perception that he or she has a vested interest in the outcome of an audit.
The perception that an auditor is not independent, or has a potential conflict of in¬terest in providing audit services of the highest quality, undermines the value of those services even if the auditor is completely unbiased and objective. An auditor who does not possess independence in fact may be tempted to bias the execution of the audit, which could manifest itself in poor decisions related to the gathering and evaluation of evidence or the nature and extent of disclosures in the financial statements.
The "Code of Ethics for Professional Accountants" sets out the types of threats to independence. One of these threats is the “Familiarity Threat” which arises when an auditor becomes too close to a client. It is this ever present “Familiarity Threat” that is at the root of the problem of independence. How is one able to be absolutely certain that an auditor is acting independently? How can the public between the time of the commencement of the audit and the receipt of the audited annual financial statements be aware of the differences of opinion and the nuances of interpretation that might have existed between the auditor and his/her client and what compromises were made? Does one, can one know whether the auditor’s independence has been dented and bruised somewhere along the line?
So perhaps there is something fundamentally wrong with a system which keeps stressing the need for independence but which does not provide a framework within which independence can be seen to be operating. The law, the rules the accounting practices which comprise the system fail possibly because the human element is to a large extent neglected.
And here one comes to the crux of the matter, the auditor client relationship. In most instances small audit clients have remained with the same firm of auditors for many years. Auditors, friendly souls that they are, often fraternise socially with the directors and the senior personnel of a company. The lower echelons of audit trainees likewise fraternise with the office administrative staff.
These indefinite and long standing appointments as auditors, these intimate almost incestuous relationships between personnel of auditing firms and the clients are barriers to complete freedom of action and to absolute independence.
So then one can ask, what is the remedy? How does one tackle a human relationship problem in the arid field of auditing? A suggested remedy is simple, but revolutionary, rotation of auditors for small audit clients. This concept seems to be well worth considering in striving for a client auditor relationship through which the independence of an auditor is not only possible but and this is most important, is seen to be possible. The suggestion is that audit engagement practitioners rotate between clients on five to seven year cycle, thus overcoming the entrenchment and continuity aspects of the present system. National governments would do well to consider this pioneering rotation concept as a long terms objective.
Rotation, say the critics is not practical when it applies to one man and too small to medium size companies. The close relationship which exists between this type of client and the auditor, who not only audits the books and prepares the final accounts but who also acts as a confidante in a wide field is of a valuable nature, it is claimed.
There is merit in this argument but it is precisely this warm relationship in the professional field that can lend itself to abuse. In any event the notion of rotation does not preclude anyone from continuing to seek advice of a favourite or long standing consultant.
Tied up with this aspect is the whole question of mandatory audits for small audit clients. It is necessary, to ask once again, is it necessary to audit the financial statements of a small audit client?
These small, closely-held companies enjoy the privilege of trading with limited liability in accordance with the provisions of Corporations Law. This means that if the company fails or causes damage, the shareholders only lose the sum of money they invested. The property rights of those damaged by companies have been removed to the benefit of a select group of property owners.
For the privilege of limited liability small, closely-held companies must ‘pay’ by making information available to its stakeholders in a responsible, transparent and unbiased manner. Gone are the days that a company is only accountable to its shareholders. No company is an island. It is part of a complex infrastructure and as a corporate citizen, is accountable to the community, employees and others.
The owners and directors of small, closely-held company’s limited liability companies must be made accountable in law for their actions. The law should ensure that external stakeholders, such as shareholders, minorities, employees, creditors, suppliers, consumers and the general public, are protected.
Whilst auditors carrying out a statutory audit of financial statements are accountable and report to the shareholders of a company only, there may be other stakeholders who believe that an independent audit provides some means of ensuring that the company’s responsibilities to them are being met; in effect that it serves their interests too. Stakeholders such as creditors, lenders, credit agencies, customers, and employees may claim an interest in the audit.
Today's legal structures allow small, closely-held companies to raise astronomical amounts of finance from the public in the time it takes to bat an eyelid and to employ these resources as they see fit behind a wall of secrecy and freedom from legal accountability. It is time to end the illusion that an audit has no value.
This revolutionary concept of audit practitioner rotation for small companies, in combination with the external inspection of audit engagements by National governments will change the small audit client practitioner from a benign fraternising and lax practitioner into a delving, hard-nosed and ruthless inquisitor. This is what the public want. This is the kind of protection the banks and other creditors are searching for in these hard times.
The audit of a small, closely-held company is nothing more than a necessary evil is a fallacy. In these hard times many causes of business failure, such as inadequate cash flow management or weaknesses in controls, may be identified and reported earlier as a result of the audit. Auditors are required to have a sound knowledge of the audited company and the business environment in which it operates. They can, therefore, offer advice on a range of issues including the potential for savings or additional profit. Auditors are required to consider the way the directors control their business. Poor or unreliable controls can reduce business efficiency and allow errors and fraud to go undetected.
An independent audit is therefore crucial, it gives credibility to the financial statements in a way that cannot be achieved by any other means and has a clear economic value for the small company. However, an audit of a small, closely-held company needs a major revolutionary change in manner in which the auditors of small, closely-held companies are appointed to establish wherein an auditor of a small, closely-held company can act entirely independent and can be seen to act. Otherwise the illusion will become a reality that an audit of a small, closely-held company has no value.
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