Illustration: John Spooner.
HEADLINES such as Hastie Group collapses with $20 million accounting irregularities, Banksia's auditors sign off on accounts weeks before a $660 million collapse, and an auditor signs off on billions of dollars of accounting errors in Centro, epitomise a deeper problem at play: a conflict of interest.
The real or perceived conflict is that auditors get paid by the company that they have been hired to independently audit. It is a flawed system because it puts auditors in the invidious position of being torn between getting paid by retaining the audit job - which is code for keeping the client happy - and suffering the ignominy of being sued for complacency if a company blows up.
It is a similar conflict facing credit ratings agencies, which caused untold problems during the GFC when they issued AAA ratings to complex derivatives worth trillions of dollars that turned out to be junk and eventually blew up the financial system. The agencies were paid by the issuers of the products.
It is a problem that manifested itself in the latest audit inspection report from the corporate regulator, ASIC, which was scathing in its assessment of auditors. The report found that from inspections of 20 audit firms over the past 18 months, audit quality went backwards.
ASIC cites a glaring example of a conflict, which it preferred to describe as ''threats to perceived independence'', where a partner in a national accounting firm challenged the accounting treatment of one of its listed clients, which created tensions with the chief financial officer. The accounting firm replaced the partner. But at the end of the day, companies don't fail because of an audit oversight. They fail because management have done the wrong thing, either due to incompetence or fraud.
ASIC boils the problem down to a lack of professional scepticism from some auditors when it came to conducting external audits on a company. ASIC said where disclosure deficiencies were identified ''it often appeared that the auditor was willing to agree with the audited entity's disclosures rather than challenge them.'' This could be a combination of wanting to keep the client happy and laziness on the auditor's part.
All up, ASIC found that in 18 per cent of the key areas it reviewed, auditors did not obtain sufficient ''appropriate audit evidence, exercise sufficient scepticism, or otherwise comply with auditing standards''.
In the 18-month period to December 31, 2010, ASIC noted similar findings in 14 per cent of the key audit areas reviewed, which is a concerning trend given the latest period under review was post-GFC when most companies had cleaned up their balance sheets. Indeed during the GFC listed companies raised a combined $100 billion in fresh equity to strengthen their balance sheets after debt blowouts and massive write-downs.
It is a similar trend facing other countries, which could be due to accounting firms or companies trying to cut costs and therefore becoming mechanical and process driven and pushing some of the work to junior auditors.
ASIC found deficiencies in the assessment of impairment of assets and the measurement of assets and liabilities at fair value. ''In many audit files, auditors had not obtained sufficient appropriate audit evidence to support the values of assets and liabilities in the financial report.'' It found shortcomings in how auditors tested a company's impairment model and assumptions or the accuracy of the source data put forward by the company.
Unfortunately ASIC's suggestion to send ''clear, consistent messages from firm leadership, partners and managers that professional scepticism and audit quality must not be compromised to meet deadlines and budgets, to support a particular outcome desired by management, or to protect fees'' doesn't address the root of the problem.
Audit fees are the cornerstone of accounting firms and they get a lot of referrals from other parts of their business. They are also conscious of their own bottom line, which means in some cases they will put juniors on the job.
All of this goes a long way to explaining why ASIC's inspection found shortcomings with the adequacy of some audit procedures in terms of assessing whether a company's ''going concern'' assumption was appropriate or the company's audited budgeting and cash flow forecasting was reasonable and that the auditor was able to rely on management's key assumptions about the budget and forecast.
Countries around the world are trying to grapple with the issue of the relationship between auditors and companies. Auditors are considered vital gatekeepers to the financial system. Their external audit and sign-off is used by analysts, investment banks and shareholders to make important decisions on the financial stability of a company. If this is open to question then it tests the integrity of the system.
The report into auditors is a step in the right direction, but to eliminate any perceived conflict of interest, one option would be for the regulator to appoint an auditor rather than the company. Companies pay fees to the regulator out of a pool of fees and the regulator then pays the auditor.