Financial scandals – Have auditors succumbed to greed?

Financial scandals – Have auditors succumbed to greed?

Slide 1:

Thank you Mr Gonzalez, for that wonderful introduction.
My name is Pengiran Izam and I am here to talk about Financial Scandals.

Slide 2:

In overview, today I will talk about defining the question at hand. I will then go straight to the bottom line. And then I will conclude with a little idea on where the way forward for the profession may be.

Slide 3:

•So to begin … Scandals arise where there are mistruths. •This may be management misrepresenting to the shareholders. Or management teams misrepresenting to the auditors.

•Butthe real scandals are … when auditors are complicit with the outright deception.

•But you know … I could not help but thinking … when I was preparing for this presentation, I felt that the title of this topic already seems as if it is pre-judging the auditors.

•And so, I beg you the audience, that through all of this discussion, we should also be wary that for every one publicly disclosed financial scandal, there are an undisclosed number of scandals and frauds that were uncovered or prevented through the work that auditors do.

•As Mr Chen Voon Hann, Council Member of MIA Malaysia said over dinner last night: Every day there are hundreds if not thousands of audit opinions being issued around the world. Yet we seem to characterise the entire audit profession based on the rare few audit failures that are publicised.

•In Manufacturing this is not the case. We do not write off an entire production run because a few items failed quality control. Yet this seems to be a “normal development” in the professional services world.

•And so, with this in mind, On my next slide, I want to share with you some details of the last three major accounting scandals.

Slide 4:

•Just to share with you, in no particular order, I went to Wikipedia’s article on “Accounting Scandals” and picked out three of the most recent scandals. As Dr Ernest Kan, President ICPAS and Partner Deloitte Singapore mentioned in this morning’s Plenary session:

•The first is about Satyam Computer Services which is now called Mahindra Satyam [click]. Satyam was accused of falsifying their accounts and their auditors were accused of complicity in the fraud and of knowingly issuing clean audit opinions when they should not have. Earlier this year, their auditors explained that the firms reliance on potentially false information provided by the management of Satyam may have rendered its audit reports “inaccurate and unreliable”.

•Bernie Madoff’s ponzi “Pyramid” scheme. The firm Friehling & Horowitz was the auditor of Bernie Madoff’s investment firm. The only partner in this firm has plead guilty to counts of filing false audit reports.

•AIG’s downgrade in credit rating resulted in it having to post additional collateral with its trading counter-parties. AIG was the largest government bailout of a private company of all time. Some may argue that AIG did not have any business dealing in esoteric financial derivatives. A cynic might say that the speculation of CDO’s and CDS’s that brought ruin to the company inflated the business results during the asset bubble, which benefited management at the detriment of the shareholders.

•In one of these cases we can see that disaster comes when auditors who are entrusted with a responsibility to issue an opinion had their independence compromised.

•Interestingly … in all three cases, there is evidence that on the bursting of the asset price bubble and the end of the “madness of crowds”, dangerous and risky decisions made by management caught up in the crazy bull market are now showing up in the light of day. Like they say … In the end … Truth will prevail.

Slide 5

•And Economic Theory gives us a way to explain the relationships and actions of these parties … It’s the “Principal-Agent Theory”.

•Which brings us to the 3-way triangle of the Principal, Agent and the trusted 3rd party.

•Here, it is the Shareholders who are the Principals. The providers of finance, it is the Shareholder’s interests that the Auditors must protect.

•The Management are the Agents. As delegates of the Principals, it is the safe custody and management of the Shareholder’s investments that the Management must protect.

•And finally, the Auditors are a trusted 3rd party. Here, although Auditors are appointed by Management, their reports are made to the Shareholders.

•Which brings us to the next topic. In this love-triangle relationship of Principal-Agent and Trusted 3rd Party … How does it happen that the Trusted 3rd party fail in their duties?

Slide 6:

•And so now, we come to the topic … of Greed.

•Greed is defined as the excessive desire for Money, Wealth, Power.

•And history tells us that there WERE auditors who have been so consumed by Greed that they have forgotten their primary roles.

•And this is to act as trusted third parties to their shareholders providing assurances on the results of the businesses, management’s custodianship of the assets and the true and fair reporting of the business.

•Because, just as the Honourable Minister of Finance II mentioned in his keynote address, the route out of this perfect storm financial crisis will be through greater emphasis on TRANSPARENCY, the core ingredient for business confidence.

Slide 7:

•So have auditors lost their independence? Have advisors bitten off more than they can chew?

•The IFAC Code of Ethics give us 5 key risks to independence:

Slide 8

•[Pause for busy slide]

•Firstly, Auditors are rational beings. It is a difficult choice to make, between taking the “high road”, sticking to maximum compliance but potentially losing a client, or being “sympathetic” to management and to maintain the relationship. This is especially a risk where auditors are financially interested to maintain lucrative non-audit work. In the past, some saw audit as a way to develop client relationships that can lead to more value-add sell on work such as systems implementation, financial advisory and management consulting.

•Secondly, where Auditors perform significant non-audit work for clients, there is a risk that in issuing their opinion, the Auditors may have to make reference or rely on their own work. For example, an audit firm may have to opine on the sufficiency and appropriateness of a system of internal controls that it helped to develop, or it may have to opine on the appropriateness of tax treatments that the firm itself developed.

•Thirdly, where Auditors champion a client’s position to the point their objectivity is compromised. For example, there may be cases when a company’s auditors are called as expert witnesses in court to give evidence. Or situations where a company’s auditor has a business relationships with a client, to the extent of using that client’s products or services and benefiting from the audit relationship at a non-arms length basis.

•Fourthly, where Auditors may be seen to be “too cosy” with Management teams, and their Independence is called to question. An auditor cannot afford to be perceived to be too “sympathetic” with the interests of management.

•And Finally, where clients are “bullying” the auditors into wrong behaviours.

•I think that … based on these 5 threats … a consistent trend I see is the word of “Independence”. For how else can Auditors perform their function if they are not both Independent of mind and Independent in appearance?

Slide 9

•Independence is the key ingredient to preventing auditors from falling prey to Greed.

•And the current Independence requirements are getting tighter. If applied correctly, I would say that these requirements address the risk of audit failures stemming from Integrity and Objectivity.

•Both the newly revised IFAC Code of Ethics and in US, the Sarbanes Oxley regulations introduced in 2002 prohibit a listed company’s auditors from performing various non-audit services.

•So in the end, we should find that audit firms reposition themselves to selling only audit services to their audit client base. And their non-audit work is only marketed to non-audit clients, with rare exceptions. Thus addressing the risk of self-interest.

Slide 10

•So that is all well and good … But what happens when there is non-compliance. Who is going to be tough on Ethical guidelines, and give out the red card?

•The newly introduced ISQC1, the “International Standard on Quality Control” provides for audit firms to be policed through specially designed quality control procedures.

•These may include a “second review” of audit opinions by relevant qualified individuals or centralised “Quality Assurance” teams. Hopefully, this level of review will raise the necessary red cards and in general reduce the occurrences of audit failures.

•And to be honest with you … With all these levels of quality assurance and independence checks that have to be done, and the general higher level of audit work that must be completed … Yet at the same time auditors have to deal with higher expectations of the audit … And all while doing it on a lower budget than before.

•To be honest with you, I wonder what the trend is going to be for audits, and how the audit function will evolve.

Slide 11

•It is my opinion that audit will evolve in a market where there are two extreme future scenarios.

•Let me share with you, this is a photo of Fishing boats docked at a Ferry Wharf unloading their catch of the day.

•Where the product is homogeneous (i.e. All the same) and plentiful in supply, haggling and negotiations consume a lot of energy

Slide 12

•On the other hand, where the product is homogeneous but relatively restricted in supply, it is a “sellers market”. •

So where does the audit service lie? Homogeneous but plentiful like fish at the market? Or homogeneous but limited like diamonds at De Beers?

•Some might argue that because the service is so plentiful, that auditors must supplement their income with other non-audit services because of the buyer’s bargaining power in a homogeneous market.

•Conversely, one could argue that auditors must charge relatively high fees is because they must be duly compensated for abstaining from the lucrative market of non-audit services.

Slide 13

•So where will we end up?

•Before I share with you my answer … let me read out this is excerpt of a speech given by Michael Douglas in the 1987 movie called “Wall Street”. He’s using it to emphasize the point of misalignment of interests between shareholders and management.

•Quote begins: “The point is, ladies and gentleman, that greed — for lack of a better word — is good.  Greed is right.  Greed works.  Greed clarifies, cuts through, and captures the essence of the evolutionary spirit.  Greed, in all of its forms — greed for life, for money, for love, knowledge — has marked the upward surge of mankind.”

•Now in our case … the case of Auditors acting as a Trusted 3rd party to Principals in the Principal-Agent relationship … we can see that there can exist a misalignment that results in audit failures. And that misalignment stems from the self interest threat, where non-audit services are provided to audit clients.

•So, one might argue that the best path for Corporate Governance, is to totally eliminate any doubts on auditor’s Independence. And that is for auditors to forsake all their non-audit services.

Slide 14

•And this is what they are currently proposing in the UK. Some of our contemporaries in the UK, the Audit Practices Board, has published a consultation paper on the cross-selling of non-audit services to audit clients.

•So is the answer then for auditors to go back to basics, as Ms Christina Foo, Vice President MIA mentioned in this morning’s Plenary session?

•In between the two extremes … Positioning the audit service as a loss leader, Accepting some level of non-audit services versus Total prohibition of non-audit services and positioning audit as a premium “Diamond” service. Where will we end up?

•The reality is that the end state will probably be a compromise of somewhere in the middle.

Slide 15

•Because at the end of the day, what we have is an “Expectations Gap”.

•To sum up then, Ladies and Gentlemen … Society, the investment community, shareholders and management all have certain expectations of their professional advisors.

•In some cases, these are very valid and appropriate. In fact, many of these expectations and best practices of how auditors should address them are being codified in best practice standards and are adopted worldwide. To name a few these standards are The IFAC Code of Ethics and ISQ 1. the International Standard on Quality Control.

•To answer the original question … “Yes, in the past there may have been some cases where audit failures resulted from greed and self-interest. But we are learning from it and we are evolving, changing and developing ways to guard against future audit failures.”

•And when all is said and done, perhaps what remains is for the accounting profession worldwide and here in ASEAN is to continue to engage relevant stakeholders and help manage this expectations gap, through relevant fora like this AFA16 and our continued dealings with stakeholders wherever we come across them.

Slide 16

And with that … Ladies and Gentlemen … I thank you for the greatest gift you could have given me … I thank you for giving your attention during that brief presentation.

Thank you.