Audit Committees That Fail Their Auditors
A danger sign warning of an unstable cliff stands on a cliff edge. (Photographer: Chris Ratcliffe/Bloomberg)

Audit Committees That Fail Their Auditors

BloombergQuintOpinion

Much attention has recently been focussed on auditors for allegedly conniving with managements, for alleged negligence and for resigning from their office without believable explanations.

When an auditor fails, indeed, before he fails, it is the audit committee that has failed. The committee has failed because they approved financial statements that they never should have. There is a significance to the auditor being required to issue his report after the committee and the board have approved the financial statements: they are primarily responsible for them.

Six Questions To Ask The Audit Committee

  • Why did the board approve financial statements containing material deficiencies?

  • Why did the directors not challenge the overvaluation of assets, the underestimation of asset impairment provisions, the understating or omission of liabilities, the use of aggressive assumptions and estimates to justify aggressive business practices?

  • Did the committee and board focus excessively on the revenue statement and not on the financial position? Did the committee discuss business performance rather than examine the financials in the context of that performance?

  • Why did the audit committee not draw the auditor’s attention to aggressive business practices and support him if he challenged their equally aggressive accounting treatment?

  • Did the committee make clear to the auditor that they expected a conservative approach from him? Or did they, instead, become advocates or apologists for management’s position on aggressive accounting practices?

  • Did the committee create a culture where the auditor felt safe behind their protection or did they give the auditor the impression that he was alone in a battle against the management and the board of directors?

10 Best Practices To Adopt

The committee must ‘own’ the relationship between an auditor and the company. There are many practices for an audit committee and, especially, its chairperson, to create an environment conducive to an effective audit:

1. Private conversations between the chair and the audit partner regularly, to create a bond between them and confidence in each other’s support.

The auditor should feel that he can confide his concerns in the chair and that these will then be taken to logical conclusions. 

2. Private meetings of the committee and the auditors at which the auditor is invited to raise concerns that he would hesitate to, in an open meeting. Say, a concern or a hunch for which the auditor lacks evidence or because it is subjective. This could include matters such as leadership style of the CEO, morale in the organisation and integrity of top management.

3. A relationship between the chair and the CFO by which the latter can candidly share with the former his concerns about business practices. It is then the responsibility of the chair, if satisfied with these concerns, to convey them appropriately to the auditor so that they can be addressed in the audit.

4. The chair keeping the audit partner informed of significant developments in the board or the business that could have a current or future impact on the financials.

5. The committee making clear to senior management in committee meeting, in the auditor’s presence, that it expects conservative or reasonable assumptions and policies in the drawing-up of the financial statements and that is expects full co-operation with the auditor.

6. The committee carefully evaluating the impact on the financials of business strategy, plans, practices, policies, instruments and transactions and giving the auditor a proper focus for his work.

7. Asking the auditor probing questions about the quality of the evidence he is provided, the conservatism and quality of accounting management, the culture in the finance function, the quality of explanations provided to him, adequacy of time for his work, the quality of the other governance functions such as internal audit, compliance, secretarial and whistle-blowing. Making clear to management that it is concerned with these matters.

8. Making it apparent to the auditor that the audit committee is not beholden to management or the controlling shareholder by the way its members conduct themselves.

9. Rigorously questioning management on all major assumptions, estimates, forecasts, valuations and promises of setting things right. The committee needs to be fully satisfied that, if a matter is to be carried forward for future action, management is genuinely committed to it and that they have the resources and competence to act within the agreed timeframe. When there is a failure to deliver on these, it is primarily the board’s fault for having depended on the promises.

10. Conveying to the full board all significant concerns about the financials so that they are as responsible for compromises as are the committee (and the auditors).

The committee must allow the auditor full voice in its meetings and must never create the impression that they are the final defence (of management views) that the auditor must conquer.

The committee’s and the independent director’s safety lies in an effective audit. The auditor is their protector and they, equally, his.

The committee’s effectiveness will be impaired if any member is perceived as not clearly independent of management or controlling shareholder influence. In such a case, it is for the committee chair to go out of his/her way to clearly signal that the committee wants an effective audit, and expects financial statements that are true and fair. That signal is given not by mere words but by conduct inside and outside of meetings.

It is the committee’s job to ensure that the audit team has the competence to assess management arguments and complex business practices. It is their responsibility to ask for the auditor to be changed if he does not inspire in them confidence of his independence and competence. It is not enough for them to appoint a prominent firm as auditor and then to sit-back; they need to be actively involved in ensuring a good audit. The audit committee must be held responsible for a failed audit.

The chair is the most important individual in the committee, and he must give it the leadership for it to be effective; which alone can ensure an effective audit. On this individual rests the safety of the company and its auditors. Is it time for the auditors to be given a veto over who can chair the audit committee they get protection and direction from?

Nawshir Mirza is a professional independent director, and serves on the boards of a number of large Indian companies.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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