External Auditors Business

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The Importance of External Auditors for the Successful Management of Business Firms

Abstract

Externally audited financial statements, contained in the voluminous Annual Reports of business corporations, have traditionally been the primary means of contact between company managements and various stakeholders like shareholders, bankers, investors, and regulatory authorities. Whilst the utility of external audits for such stakeholders has never been an issue of doubt, external audits and external auditors also play significant roles in the success of business firms and in the furtherance of their strategic objectives.

The external audit process has come under sharp scrutiny in the wake of Enron and other financial scandals. Recent legislative and regulatory changes, which have focussed on ensuring greater independence for external auditors and their separation from management, have been causal in redefining the scope of external audit and its potential to contribute to the success of business firms.

This dissertation uses primary and secondary research methods to explore the various ways in which external audits help managements to run their organisations successfully; taking account of the historical context; the evolution of the external audit function in modern times; and the likely impact of recent legislative and operational changes.

1.0 Introduction

Reliable financial information is vital for the very survival of the current social order. People and institutions, as diverse as bankers who need to decide upon granting of working capital credit, investors who need to decide upon acquisition or divestment of securities, foreign governments who need to decide upon granting access to their markets, or prospective suppliers who need to decide upon commencing trade relations, rely upon information provided by others. In many such cases, the objectives of suppliers of information are diverse from, if not counter to, those of information users. Embedded in this line of reasoning is acknowledgment of the collective need for autonomous and self determining auditors; individuals or firms with the specialised competence and integrity to assess the fairness of the information used by distanced people to know of the true state of affairs. (Kitchen, 1982)

High quality accounting and financial reporting helps the public to apportion their hard earned resources efficiently; to allot their restricted capital to the business of those goods and services, which offer the highest returns. Diplock (2002) states that financial resources flow towards industries and corporations, which appear through their financial statements, to be capable of making best use of resources. Given this phenomenon, inadequate reporting can often lead to concealment of waste and inefficiency, and by doing so not only prevent such resources from being allotted efficiently, but also result in substantial losses to trusting users of such financial statements.

“Investor confidence is fundamental to the successful operation of the world’s financial markets. When making decisions about capital allocation investors need to know that financial information they are given is credible and reliable The quality of audits and audit opinions on financial reports are crucial to achieving that. Independent auditors play a vital role in enhancing the reliability of financial information by attesting to the veracity of the financial statements” (Diplock, 2005)

An independent external auditor provides credibility to financial statements and empowers outsiders, for example trade creditors, bankers, stockholders, government and other interested third parties, to make business decisions, involving allocation of scarce resources, on the basis of the information contained in them. Audited financial statements are now the established means by which business corporations state their operating results and financial position. The word audit in this context, (i.e. when applied to financial statements), ensures that the balance sheet, statements of income and retained earnings, and statement of cash flows are accompanied by an audit report prepared by independent public accountants, expressing their professional opinion as to the fairness of the company’s financial statements.

Auditing is defined as obtaining and evaluating evidences regarding assertions about economic actions and events to ascertain the extent to which they correspond with the established criteria, and to communicating the result to the interested users. Thus, it encompasses investigation, attestation, and reporting on economic actions and events.” (Jaffrey, 2002)

Externally audited statements provide the most reliable indicator of company performance and enable the formation of an accurate assessment of the current position and performance. Apart from helping outsiders to decide on their approach towards business firms, they also enable managements to plan their future strategy.

Antle, (1984), notes that auditors have a strange and dual relationship with company managements. Whilst they are responsible to the shareholders of the company and are expected to protect their financial interests, they are appointed and remunerated by the Board of Directors. In addition to their auditing responsibilities, auditors have, for decades, rendered a range of other specialised services at the specific behest of company managements. The physical proximity of auditors to senior managers, their substantial knowledge and expertise in economic and financial matters, and long tenures as company auditors, often leads to the development of stable relationships between auditors and financial managers, CFOs, and CEOs; a logical fallout of this being their given responsibilities for providing other financial and counselling services.

Whilst this close and symbiotic relationship between management and auditors has changed beyond recognition in the last few years on the back of huge corporate scandals, incidents of acknowledged auditor error, radical legislative and regulatory changes, and led to the redefining of responsibilities, relationships, and work content, most entrepreneurs and managers are still more than forthcoming in acknowledging the various ways in which audits and auditors contribute to the growth of businesses. (Reynolds & Others, 2004) Their specialised knowledge and skills are at various times used for tax planning, management auditing, trouble shooting, inventory streamlining, creditor control, working capital optimisation, and exploration of new business opportunities.

Furthermore, whilst recent years have seen the emergence of significant distancing between clients and external auditors, the intense involvement of auditors in the businesses of their clients has never been denied, even if it has been a cause of occasional concern to investors and shareholders.

The research intends to explore the complex relationship that exists between managements and external auditors, with particular attention to the contribution of external auditors to the success of companies. The ensuing portions of the dissertation contain a detailed literature review, the research objective, and the research question, followed by a description of the adopted methodology, sections on data, findings, analysis and discussion, conclusions, recommendations, and the reflections of my research on the conduct of the dissertation.

The topic is contentious, especially in light of the now altered relationship between managements and external auditors, and the research hopes an objective and carefully conducted dissertation will prove to be useful to people in academics, business, finance, and auditing.

2.0. Literature Review

Auditors, even as they report to shareholders, enjoy relationships of mutual trust and confidence with managements. Simunic (1984) states that despite being appointed and having their remunerations decided every year by corporate managements, most auditors are distinguished by a fierce independence and a deep sense of commitment to shareholders. These traits, as well as their extensive knowledge, skills, exposure, and experience, enable them to stand out as exceptional professionals, able to contribute significantly to the interests of society and the economy. Most business corporations think of their auditors as business confidantes; people who can be trusted to look at business issues objectively, harness their extraordinary skills for the benefit of their clients, and provide mature and responsible insight and advice. (Simunic, 1984)

A literature review on the contribution of external auditors to successful company management needs to necessarily commence with the evolution of the special and strange relationship between company managements and auditors. This review begins with the tracing of the evolution of the audit function with special reference to the UK; it thereafter takes up the functions of auditors, their roles and responsibilities in the functioning of business corporations and society, the concept of agency in client and auditor relationships, the various ways in which auditor contributions can impact the success of business corporations, the impact of recent developments like the occurrence of major corporate collapses and legislative and regulatory changes on their functioning, and the changing dynamic of their relationships with corporate managements.

The researcher has depended upon the information available in the public domain, books, journal and magazine articles, professional institute and audit firm websites, and other accessible and relevant sources, all of which are elaborated in the references section at the end of the dissertation.

The information accessed during the review of literature has led to the development of the research objective and the formulation of the research question.

2.1. Evolution of Auditing in the UK

The audit function in the UK has evolved over centuries. Baker and Collins, (2005) state that the genesis of the modern audit function in England was discernible in medieval times in the substantiation of civic accounts such as Exchequer accounts, borough or municipality accounts and the accounts of public bodies, as well as in the authentication processes of tradesmen, merchants, landed gentry, and the upper class, for business endeavours, manors and estates. With agents or managers being progressively involved in the task of protection or administration of the assets of others, questions arose over issues of trust, integrity and competence, and consequently to the need for audit. The growth of the economy of the UK in the 19th century led to significant developments in financial reporting, and to the transformation of capital markets through investment, and the growth and expansion of banks. Such developments led to the separation of ownership and control within companies, which in turn led to the development of audits as a means of protecting the interests of shareholders.

It was however only with the enactment of the Companies Act in 1900 that a general legal obligation for annual audits was imposed on registered companies. (Kitchen, 1982) It is however relevant at this stage to note that there is little historical basis for the current sine qua non regarding the necessity of auditors to be totally independent of management. Watts and Zimmerman (1983) state that audits of merchant guilds were in fact conducted by committees of guild members. In the 1800s, responsibilities for company audits were commonly assumed by individual shareholders, whose independence from the managers, (who ran the companies), was not really an issue. The increasing complexity of business however progressively led shareholders, who undertook the conduct of audits, to find experts with adequate skills and responsibilities for executing these functions. More often than not it used to be the company managements who were entrusted with the task of locating these auditors, a practice that continues to the present day, and constitutes the root cause behind the complex and often contradictory relationship between shareholders, management, and auditors. (Baker & Collins, 2005)

2.2. Function and Role of Auditors

Audited financial statements constitute internationally accepted means and methods through which business corporations report their operating results and financial positions. Pollitt (1999) states that the word audit, (in the context of financial statements), refers to the balance sheet, statements of income and retained earnings, and statements of cash flows. These documents, on the completion of audit, are accompanied by an audit report prepared by independent qualified and recognised accountants, expressing their professional opinion on the fairness of the company’s financial statements. The contribution of the independent auditor is to give credibility to financial statements. The goal is to determine whether the preparation of these statements is in conformity with recognised accounting standards, e.g. IAS, IFRS or GAAP. Financial statement audits are normally performed by firms of chartered accountants or certified public accountants; users of auditors’ reports include trade creditors, management, investors, bankers, financial analysts and government agencies.

An oft discussed issue of recent times, (especially in the wake of Enron, Parmalat, and other scandals), relates to the role of the auditor in detecting fraud. Bush, (2005), states that the issue requires an understanding of the role of the auditor. Auditors are outside accountants engaged by the board to review the financial statements prepared by employees of a company. Their main job is to judge the accuracy of the financial statements and report to the shareholders. To do this, auditors usually examine some typical transactions and review internal controls, accounting procedures, and financial reporting systems. An audit is a spot check of information, not an exhaustive review of all financial transactions. Furthermore, auditors are charged with determining the accuracy of the financial statements only “in all material respects.” (Pollitt, 1999) A clean bill of health from an auditor means that the auditor is convinced that the finance ial statements do not misrepresent the company’s financial position in any significant way; it does not also guarantee 100 percent accuracy. As professionals, auditors express detached judgements. They state, for example, that proper accounting principles appear to have been applied consistently by management and that standard auditing procedures deemed applicable under particular circumstances have revealed nothing which would cause them to question the fairness of the resultant statements.

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Auditors are not charged specifically with uncovering fraud, though they are expected to take all reasonable care and investigate further, if they have reason to feel its possibility, and report accordingly to the shareholders. Since they rely heavily on management to provide information and documentation, small-scale fraud is extremely difficult for auditors to detect, particularly if it is perpetuated by more than one key staff person within the organisation. (Bush, 2005)

2.3. The Complexity of the Agency Concept and Independence in Appointment of Auditors

Antle (2002), whilst explaining the complex three way relationship between shareholders, the Board of Directors, (BOD) and auditors, argues that whilst study of financial statements undoubtedly constitutes the primary mechanism for shareholders to monitor the performance of directors, the separation of ownership and control in business organisations can lead to problems because of information asymmetries and differing motives; thus causing tensions in shareholder-director relationships. Shareholders, with their limited access to information about company operations may feel that they may not be getting the information they need to make informed decisions, or that the information available in the financial statements is biased and does not lead to objective decision making. In such circumstances the benefits of an audit easily outweighs its costs and justifies the appointment of auditors. Under section 235 of the Companies Act 1985, auditors are appointed by the BOD and report to the shareholders of the company. They provide an independent report to the shareholders on the truth and fairness of the financial statements that are prepared by the board of directors; auditors, (as confirmed by the Caparo case), are directly accountable for the auditing of prepared accounts and hence owe a duty of care to the company’s existing shareholders as a body. (Aaron & Slemrod, 2004)

Whilst the issue is prima facie simple, with the auditor helping to address a simple agency conflict between shareholders and directors, it assumes complex overtones because of the relationship of auditors with various other personas, namely the directors and other stakeholders like bankers. Reynolds, Deis and Francis (2004) argue that as both the BOD and auditors are agents of the shareholders, and work in much closer proximity with each other than with the physically distanced principals, e.g. the shareholders, serious concerns are bound to arise regarding the management-auditor relationship, as well as whether other institutions need to be created to audit the auditor.

An audit also necessarily needs extremely close cooperation between auditors and the management, especially the CFO and the finance team, a phenomenon that can lead to substantial extra-audit interaction between them about company and business matters. This interaction has historically been the major cause behind the ever increasing involvement between the management and auditors, as well as the substantial amount of extra-audit service assignments undertaken by auditors in diverse areas like tax management and planning, asset verification, inventory planning, payables rationalisation, internal audit, and a host of other operational variables. (Antle, 2002)

At the time of the Enron collapse there was very little difference between the fees received by Arthur Anderson for audit and for other services. Whilst the desire of managements to obtain other specialist services from auditors could very well have been caused by their perception of the skill sets at the disposal of auditors, such situations were bound to lead to flash points, the questioning of the perceived and actual independence of auditors, and the demand for tougher controls and standards regarding auditor independence. (Reynolds & Others, 2004)

Such inherent conflicts and contradictions have heightened the need for external auditor independence and led to a slew of regulatory and legal changes.

2.4. External Auditor Benefits for Company Managements.

Francis, Matthew and Sparks (1999) state that in addition to their extensive skills in areas of accounts finance, tax, regulatory requirements, business issue and economics, auditors are trained to question accepted policies and routines and to test assumptions. They are able to look at organisations in totality and form comparisons with the management of similar companies in similar or divers settings or industries. Unconstrained by the blinders of departmentalisation, which often act against objectivity and logical decision making within companies, they are able to gather an organisation wide, cross-functional picture and spot areas of weakness and concern. Very clearly it follows that external auditors can often provide top management with a broad overview of operations can help in making informed decisions.

Most organisations, because of their multidisciplinary nature and strategic corporate objectives, look at finance and accounts as departments meant to provide standardised support to management actions rather than for undertaking specialised financial, tax or accounting assignments. Again the routine nature of work and the low turnover amongst accounting staff leads to in-house accounting skills, which, though sufficient for day to day working, are often inadequate for specialised work. CFOs and CEOs, long aware of the inherent shortage of sophisticated financial and accounting skills in in-house staff, have made use of external services whenever sophisticated services have been required, rather than incur the wasteful and self defeating expenditure involved in maintaining a bench of highly paid and mostly under utilised experts. (Geiger & Rama, 2003)

With members of the team of external auditors available in the premises for a quite a few months each year, their utilisation for services outside the ability of internal staff was a fait accompli. In fact, whilst there has been much debate during the last few years on the disadvantages of obtaining internal audit services from external auditors, the main rationale behind this decision was the inadequacy of internal staff to undertake such functions, especially in comparison with those of the external auditing team. (Asthana & Others, 2004) For many years, companies have outsourced commodity-type services including food, security, and janitorial services. This trend has naturally extended to other areas like payroll, tax, legal services, data processing, and internal audit. In fact the practice of giving internal auditing responsibilities to external auditors became popular because of its win-win nature; it offered a number of potential benefits to the management even as it created additional revenues for audit firms. Internal audit outsourcing reduced overlapping positions and audit effort by creating more flexibility in increasing and decreasing workloads. Whilst the wide range of expertise available from large firms was far too expensive for companies to maintain internally, outsourcing also allowed companies to replace “fixed” cost employees with “variable” fees for services.

In the area of tax services, companies have traditionally used the services of external auditors for tax planning and management. With all publicly listed firms requiring to have audits, and all privately held businesses of consequence acquiring them, firms conducting audits came to historically enjoy two significant advantages compared to other accounting firms; first the knowledge gained about the business of clients business during the course of audit, and second, strong working relationships with CFOs, who were key to the selection of tax providers. (Plesko, 2004)

Compared to non-accounting providers of tax services, specifically law firms, accounting firms also enjoy advantages in designing corporate tax plans, which aim to reduce the actual taxes paid in a manner that translates into reduced tax expense (and increased earnings) in the financial statements. Since net earnings and earnings per share are viewed by CFOs as the most important determinants of share prices (Graham & Others, al., 2005), the ability to reduce taxes for financial accounting purposes is often critical to the selection of tax planning strategies. It also needs to be noted that the financial reporting perspective of accountants has largely shaped corporate tax planning. Accountants have been instrumental in positioning tax departments as corporate profit centres, where reducing effective tax rates is seen as a means of enhancing accounting earnings. (Plesko, 2004) This synergy meshes nicely with the managerial goal of enhancing shareholder value, since earnings form a key component in valuation. (Geiger & Rama, 2003) Accounting firms also enjoy advantages in providing tax services that require number crunching, something law firms typically do not do, as well as tax services that require coordination across offices in different countries.

In addition to providing internal audit and tax services, external auditors are able to help company managements in various other ways. Companies are able to take advantage of the knowledge of external auditors in matters relating to accounting standards. The constant evolution of accounting standards in recent years and the need to harmonise accounting statements of different countries for firms with international operations often places enormous challenges before in-house accounting staff; in such circumstances the experience and knowledge of large audit firms in this area is often invaluable. (Graham & Others, 2005) Another area of benefit arises from the knowledge of external auditors with the compliance requirements of the Companies Act. Whilst external legal services and large law firms are also able to provide this service, companies, especially those which are smaller, often find it convenient to sound out external auditors on the various compliance issues required by Company Law. (Graham & Others, 2005)

Business experts are however divided on the issue of using auditors as business advisors. Graham and others (2005) state that whilst smaller businesses often use their external auditors as business advisers, this demand appears to reduce in larger and more complex organisations. In fact many operational managers feel the advice tendered by external auditors to be narrow, restricted by financial and tax considerations, and lacking with regard to the larger demands of the market and the socio-economic environment.

2. 5. Changing Relationships between Auditors and Managements

Relationships between company managements and financial auditors have undergone a sea change since the enactment of the Sarbanes Oxley Act (SOA) in the United States and the introduction of the Combined Common Code in the UK. Cautiousness on both sides has led to the closing of areas of mutually beneficial contact; the increased intensity and sharply increasing costs of audit leading to a further distancing in the relationship. Griffin and Lont (2005) state that this new dynamic in long established and stable relationships is a natural consequence of recent changes in legislation and regulatory guidelines, which have not only led both managements and auditors to be more rigid in the interpretation of such changes, but also to decisions to maintain arm’s length relationships in the interests of auditor independence. Defond and others (2004) state that whereas some years ago it was very common for senior financial executives to have an open, candid, direct relationship with the senior partners of Big Four auditing firms, explain concerns about accounting and business exposures, and discuss alternative accountings, such an approach is unthinkable in today’s circumstances.

Apart from cautiousness, distancing between managements and auditors has also occurred, as Frankel and others (2004) state, due to the decisions of audit committees to expressly prohibit CFOs and other executives from discussing non-auditing matters with their auditing partners for fear of running afoul of the mandate for auditor independence. With the dissolution of Arthur Anderson fresh in the minds of all audit firms, significant increases in audit fees have occurred due to the decisions of auditors to make audits more rigorous along with their reluctance to rely overmuch on existing internal controls.

The distancing is further evidenced by a dramatic decline in the amount of tax services provided by audit firms during the period 2001-2004. (Omer & Others, 2005) Furthermore, the increase in the amount of tax work that accounting firms are now performing for non-audit clients indicates a large scale shift of tax work among accounting firms. Bankman (2004) states that whereas S&P 500 companies, on average, paid their auditors more or less the same fees for audit and tax work (i.e., the combination of tax compliance, tax advice and tax consulting), in 2001, these companies were paying twice as much for audit work as tax work just 2 years later. By 2004, the average S&P 500 firm was paying its auditor four times more for audit than for tax. This striking shift occurred because whilst audit clients were paying more for audit work, they were also spending far less for tax services from their auditor. (Omer & Others, 2005) However, the fact that the total tax practice of the largest accounting firms (from both audit and non-audit clients) has held steady during this period, indicates (a) the occurrence of a shift among the providers of tax service rather than a general decline in tax services and (b) the confidence of most companies in the tax skills of audit firms. (Omer & Others, 2005)

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2.6. Crystallisation of Research Objective

Information available from the literature review suggests that external auditors have not only enjoyed steady and contributory relationships with BODs and corporate managements, but have also been able to contribute substantially towards the fulfillment of corporate objectives. At this stage it is also necessary to note that whilst external audits have helped companies to assess and improve their performance, obtain the trust of stakeholders, engage with outsiders, ensure the effective functioning of internal control systems, and comply with the provisions of the Companies Act and other regulatory requirements, external auditors have also assisted managements to achieve business success in many other ways; in all probability such benefits, in the absence of external auditors, would have been difficult to obtain, unduly expensive, and possibly never availed.

Whilst few people have, if ever, rebutted the significance of the contributions made by external auditors towards the success of corporate managements, the close relationships between BODs and auditors have also been a source of constant shareholder unease, mostly because of the potentially harmful consequences of such relationships on auditor independence, and consequently on the fairness of audited statements. Matters over the issue came to a head after the spate of Enron type scandals in the early 2000s, triggering off regulatory and legislative changes aimed at distancing external auditors from management. Whilst such changes, which included the disassociation of external auditors from the internal audit function, reduction of their other assignments, and the creation of arm’s length between BODs and auditors at the instance of audit committees, furthered the cause of auditor independence, they also divested the management of access to a valuable source of assistance from experts with significant knowledge of company operations.

This dissertation proposes to study the various ways in which external auditors can help the management; their contribution to company success; and the likely fallout of recent legislative and regulatory changes on the effectiveness of companies.

2.7. Formulation of Research Question

In light of the information made available during the course of the literature review and the formulation of the research objective, the research hypothesis is stated as “external audit can make a significant contribution to the successful management of a company.”

The research questions are as under:

  • What are the ways in which external audit contributes to the success of corporate management?
  • Can such avenues of aiding managements to successfully run companies continue in the wake of recent changes distancing external auditors from company managements?

3.0 Methodology

The methodology for researching this dissertation is based upon the framing of the research objective, the research hypothesis, and research questions on the basis of the information accessed during the course of the literature review, followed by obtaining of data through an appropriate and carefully selected method.

In dissertation assignments, methodology basically involves the formulation of a route path by deciding first between the adoption of quantitative or qualitative research methods and second on obtaining of data from primary and/or secondary sources.

Quantitative methods, being more suitable for research assignments that need information to be collected on a wide scale from extensive respondent populations, are clearly not appropriate for the purposes of this dissertation. Taking account of the complexity of the issue being investigated, the interpretative nature of information to be analysed, the need to obtain information from carefully selected sources and to answer questions of a “how” and why “nature”, the purpose of this study will be better served by adopting qualitative methods. (Crano & Brewer, 2002)

Whilst substantial secondary information has been accessed for this dissertation, (as is evidenced, both from the material detailed in the references section and from the contents of the literature review), obtaining of primary information will enable such information to be corroborated, facilitate the testing of the hypothesis and answering of the research questions.

Primary information in qualitative research can be obtained directly from selected respondents, as well as from information available in the form of websites of relevant institutions, interviews given by experts, and research studies conducted by other researchers. (Harrison, 2001) For the purpose of this dissertation primary information has been obtained through detailed and carefully designed interviews with two industry experts, one from the auditing fraternity and the other an active financial manager. In addition to information from these two respondents, the data available from a recent research study conducted by a British university on a comparatively similar subject has also been accessed, studied and analysed.

The following sections deals in greater detail with the sources of primary information, the collection of data, and the recording, analysis and discussion of findings, which in turn lead to conclusions and recommendations.

4.0. Data and Findings

4.1. Data

As elaborated in the previous section, substantial primary and secondary information has been accessed during the literature review in the form of books, journal and magazine articles, in electronic and physical form. Data bases have been especially useful in providing information from older publications, which otherwise would have been difficult to obtain. Whilst the information accessed during the literature review has helped in creating a basic knowledge platform and facilitated the identification of central issues, the methodology depends upon obtaining primary information for testing the hypothesis and answering the research questions.

Primary information for this dissertation has been obtained from three distinct sources, two telephonic interviews with professionals and the use of a survey conducted recently by the University of Greenwich.

1st Information Source:

The first interview consists of a 90 minute session with a 45 year old Chartered Accountant with 20 years of experience, of which 5 were spent in employment with a then big 5 firm and the later 15 in accounting practice. The respondent operates from Edgware in North London, has a staff of 11, of whom 3 are qualified accountants, and an accounting and auditing practice with more than 250 clients. Whilst the majority of his clients have small to medium businesses, he also provides taxation and internal audit services to a few companies listed on the LSE. The respondent has been briefed in detail about the purpose of the interview and has asked for his identity, as well as the identity of his firm to be kept confidential. Whilst the name of the respondent has been mentioned in the introductory data to the interview, confidentiality of identity will need to be maintained.

The complete transcript of the interview is provided in Appendix 1.

2nd Information Source:

The second interview is with a 56 year old finance professional, an MBA, not a Chartered Accountant, with more than 25 years of experience in senior positions with major international banks and industry. As the CFO of a LSE listed company with its offices at the dockyard, the respondent is responsible for dealing with external auditors, internal auditors, tax practitioners, legal professionals, and other advisers. The respondent has been briefed in detail about the purpose of the interview and would like his personal information to be kept confidential. The respondent’s name is detailed in the run-up to the interview transcript as a matter of record. The complete transcript of the interview is provided in Appendix 2.

3rd Information Source:

Apart from these two interviews, the dissertation uses the findings of a 2005 study conducted by Julian Spencer Wood of the university of Greenwich entitled “More than just audit: Indicators of extended values of the external auditor to finance managers” The study is based on an extensive survey of more than 60 finance managers on their relationship and experiences with external auditors, as well as the ways in which they were benefited from the conduct of external audit. The study is available in Appendix 3.

Apart from the above sources, information and findings accessed in the course of the literature review also contributes to the findings, analysis, and discussion.

It needs to be noted that with both interviews being on the same subject and that too with finance professionals, the incidence of repetition of questions could not be avoided. With questions being open ended and conversational, the researcher has had to club together some answers and delete repetitions in the interest of conciseness.

4.2. Findings

Primary and secondary information for the dissertation has arisen from a broad reading of material available in the public domain on the evolution of external audit, the importance of external audit for businesses, the services provided by external auditors, and the effect of recent changes in legislation and regulatory guidelines on the scope of external audit as well as in relations between auditors and clients.

In addition to study of available literature, primary information has also been obtained from 121 interviews with two senior finance and auditing professionals, and from an extensive survey on the impressions of finance managers on the direct and lateral benefits of external audit.

For ease of presentation the findings are bulleted as under:

  • External audit has evolved over the last few centuries in response to the separation of ownership and management to ensure that the work of agents, i.e. managements, happens in accordance with the objectives of the owners.
  • Whilst auditors are primarily responsible for assessing the fairness of operational and financial statements prepared by managements, their physical proximity to managements and distancing from shareholders has led to the development of strong and stable management-auditor relationships, a phenomenon that continues to cause unease in the eyes of shareholders because of the potential of such relationships to affect the fairness of audited financial statements.
  • Externally audited financial statements go a long way towards building trust and confidence of external users of these documents. Their reliability empowers managements to engage with the social, economic, political, and business environments and leverage them for the successful management of the company in various areas, e.g. in raising finances, recruiting talent, sales, and purchases
  • Apart from such management advantages external audits improve the working of businesses through providing a framework for high quality internal controls, reduction of fraud and other financial malpractices, and the quantification and dissemination of correct operational and financial information, thus improving the competitive advantage of companies. Audited figures provide the basis for performance measurement and performance improvement.
  • The working of company finance functions improved because of external auditor assistance in areas like application of accounting standards, assurance on compliance with the requirements of the Companies Act, and the optimisation of internal controls. Auditors also help managements by providing advice on difficult business issues and resolving interdepartmental conflicts on needs and responsibilities of providing information
  • External auditors have been especially useful in the initiation and assimilation of computers and data processing in finance and accounting functions by facilitating information absorption, providing for effective checks and balances and controls, as well as through the formulation of adequate audit trails.
  • The legislative and regulatory changes, which occurred in the wake of the corporate scandals of the 1990s and the early 2000s, whilst aiming to enhance the independence of external auditors by reducing their involvement with company managements, led to an increased role for audit committees and the internal audit function. The obligation to maintain arm’s length between auditors and management has also led to a reduction of external auditor involvement in provision of services like tax and other finance oriented assignments; these being external auditor services that were extremely common in previous days.
  • Audit fees have gone up significantly during the last five years, in quantum as well as in comparison with fees for other services like taxation, and legal advice.

6.0 Analysis and Discussion

The relationships that exist between auditors, shareholders, and managements are at once complex, paradoxical, and contradictory. Arising out of the interplay of various social and economic forces and circumstances, the evolution of these relationships has been instrumental, not only to the growth and importance of auditing but also in shaping the way in which external auditing has developed over the years.

Nobody in the business, financial, or economic fraternity doubts the importance of independence for external auditors. Expressing an independent and expert opinion on the fairness of financial statements is the most important and valuable service rendered by the public accounting profession. However, notwithstanding the importance of auditor independence, audited statements also command respect because of the quality of work associated with the work of external auditors, governed as it is by intensive training, strict regulation of auditing procedures and conventions, and accountability to professional societies. This phenomenon seems to have escaped observers. Although the issue of competence of auditors has not really emerged in the material accessed for this dissertation, it is doubtful if audited statements would command as much respect as they do today if there were doubts about the competence of auditors, irrespective of the degree of independence enjoyed by auditors. Paradoxically, auditor competence is rarely subject to questioning even as the smallest whiff of fraud in a company is adequate to stoke debate on loss of independence of auditors or the compromising of their ethics.

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The success of a company depends upon the figures that come out in audited financial statements. Transparency of reporting and accuracy in computation of results have led to externally audited reports becoming performance bell weathers, making them the most accepted means of gauging performance and the base for all performance improvement strategies.

Despite the constant public unease on the closeness of auditors and managements, the imperatives of business growth proved to be too strong for such apprehensions, proving to be causal in the development of proximity between auditors and managements, even as they distanced shareholders from auditors and management, and led to increased sophistication of accounting, auditing and reporting techniques and procedures.

With the growth of business came complexities in accounting, tax, company law compliances and regulatory procedures, all of which caused greater involvement between managements and auditors. Whilst stricter and more demanding audit requirements nudged companies to improve their accounting and reporting abilities significantly, managements and auditors recognised numerous other areas in which they could work together to improve the effectiveness of managements as well as create revenues for external auditors.

The other services provided by external auditors have flowed from the strengths of their position as holders of detailed inside information, the skills at their disposal, and the benefits that managements could obtain by exploiting these skills to further their business objectives. It would be nothing short of churlish to assume otherwise; or to conclude that other external auditor services were undertaken and granted first because of closeness between managements and auditors and second because managements could use such decisions to influence auditor opinion on the fairness of accounts.

Whilst recent changes in legislation and regulatory guidelines have succeeded in distancing auditors from management by substantially reducing external auditor involvement in areas other than audit, such developments have also led to a number of complex and difficult challenges that need to be addressed.

These relate to the sudden shortfall in skills in areas of internal audit, taxation, company law compliance, financial scanning, preparation of feasibilities and banking proposals, due diligence studies, and M & A work; where skills of external auditors were regularly used. Whilst companies are trying to fill these gaps, either by outsourcing or creating in-house talent, both these solutions may prove to be far less efficient than the previous practice, the first because other agencies will not have the depth of company knowledge possessed by external auditors, and the second because of the time it will take, as well as because of the impracticality of developing specialised skills in non core areas.

6.0. Conclusions and Recommendations

With external auditors under the microscope since the days of Enron, WorldCom, and Parmalat, recent years have seen significant changes in their roles in the working of business corporations. Legislative and regulatory changes, although primarily aiming to reduce potential management influence on the conduct of external audit, have been causal in altering management- auditor relationships, reducing management access to auditor skills and competencies, and placing new and complex challenges before corporate managements.

Whilst the traditional role of auditors, as certifiers of the fairness of financial statements, continues as before albeit with much greater interface with audit committees, and with more distancing between them and company managements, their role as providers of other services has changed significantly.

Services like internal audit, tax management, filing of returns, conducting of specialised assignments for mergers, carrying out feasibility studies, and a host of other activities have been hit badly. Whilst internal audit has gone out of the realm of external auditors, their undertaking of other services can be decided only with the active involvement and agreement of the audit committee.

The institution of external audit has been instrumental in improving the efficiencies of businesses and in contributing to their success in many ways. By bringing about information transparency, objective reporting, internal control and reduction of fraud, external audits have helped empower managements to improve organisational efficiencies and further corporate objectives. Possibly the most significant contribution of external audit to the success of a company has been the provisioning of a uniform and indisputable means of performance management, enabling managements to assess, take stock, and push for further improvement in company performance.

Apart from internal benefits, external audits enable managements to gain the trust of employees and all external stakeholders, engage them appropriately, and leverage these relationships for furthering company objectives.

The distancing that has occurred because of measures to facilitate greater external auditor independence have led to (a) auditors becoming far more careful about internal controls, (b) the revamping of audit programmes, (c) greater stress on internal controls, (d) substantial increase in audit fees, and (e) far lesser management access to auditor skill sets and expertise.

With audit committees now shouldering much greater responsibilities for the effective conduct of external audit and maintenance of internal controls, they (the audit committees) will need to ensure that internal management benefits available until now from external audit are not eroded, even as alternate infrastructures are built up for internal audit, tax management, and compliance and assurance in matters of company law and other regulatory requirements. Made up of wholly independent directors, audit committees are inherently suited for coordinating internal and external audit functions with authority and credibility. They must ensure the maintenance of the best possible balance between external auditors and in-house service providers, and furthermore optimise on the usage of external auditor skills without compromising on their independence.

7.0. Reflections

At the time of the commencement of the dissertation case, the topic for the assignment appeared to be quite clear for the researcher, not needing more than some detailed research and responses from experts on the subject to arrive at appropriate findings. With the progress of the assignment the issue became far more complex, especially with the unravelling of the evolution of relationships between shareholders, managements, and external auditors.

The impressions gained from the developments of the last few years on the need for auditor independence being cut and dried, have also undergone a drastic reassessment in light of the realisation of the enormous economic and social ramifications that arise out of the external audit process, and the gross inadequacy of a one shoe fits all approach. It is difficult for a dissertation of this nature to perhaps do more than raise issues that are extremely pertinent but were otherwise obfuscated by media hype and expert over-discussion. This, hopefully this has been achieved.

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