Auditing at the Crossroads

Mauritius would only be consolidating its reputation if, seeing the multiple auditing failures in different jurisdictions, it worked cooperatively with auditors to strengthen the latter’s hands free from the clutches of managements and influential shareholders

When I joined the Bank of Mauritius in 1967, I often overheard conversations about companies “cooking up their books”. Being then untutored in accounting, I wondered how they did such a thing. Later, when studying the practice of bank lending, I came across several cases precedent in which companies were seen to have been “window-dressing their accounting books”, i.e., they were painting a rosier picture of their financial condition than it was actually the case. In those days, in Mauritius at least, it was on a voluntary basis that companies engaged external auditors to express an opinion on the correctness of their accounts. Even today, it is not mandatory for all companies, except for certain large companies, including Public Interest Entities, to have themselves audited.

It all began in the 1850s. British lenders were putting large amounts of funds into American railway companies. The latter appeared to have a huge appetite for those funds. It is in this context that the British lenders decided to appoint chartered accountants to investigate every aspect of the railways’ businesses. The point was to ensure that the money they were injecting into the companies was safe and used for the purpose for which it was given and not being diverted away to other wasteful purposes. Aggressive accounting could hide the biggest sores about companies’ real state of health. The chartered accountants were sent there to ensure that the railway companies’ books added up. This is how the audit business started off.

This primitive form of railway auditing evolved into complex auditing processes after the advent of the Joint Stock Company. Hundreds of auditors are today registered with the Financial Reporting Council of Mauritius, many of them being part of bigger audit firms. The world over, it is the few bigger audit firms that dominate audit business with annual earnings by way of audit fees exceeding $50 billion.

Global Audit Firms

Such global audit firms are controlled essentially by their branches in the US and Britain. They have established networks of branches operating in virtually all countries of the world. They used to be referred to as the “Big Five” until Arthur Andersen, one of them, saw its reputation severely mauled by one of the world’s biggest financial scandals in 2001-02 involving two of its clients, Enron and WorldCom.

In the case of Enron, an energy giant, the company’s executives had used accounting loopholes, special purpose entities, and poor financial reporting, to hide billions of dollars in debt from failed deals and projects. Andersen was pressured into ignoring those issues. No doubt, this case was cited as the “biggest audit failure”. It was in this context that we saw the dissolution of Andersen, and American regulators coming up with the Sarbanes-Oxley Act in 2002 to try to banish, among others, audit firms finding themselves in situations of conflict of interest by offering multiple services to firms they worked at.

The financial scandal was not less in the case of WorldCom (2002), a telecoms company. The CEO had inflated assets by $11 billion as well as revenues by using fake invoices. Once the accounting fraud was laid bare, the company had no choice than to go bankrupt. Andersen was also the auditor of this company and that did not help it avoiding its dissolution.

The world’s audit business is therefore now dominated by the “Big Four”, Deloitte, Ernst &Young (EY), PriceWaterhouse Coopers (PWC) and KPMG. All of them are present in Mauritius.

A string of accounting scandals

The question one may ask is whether after chastening Andersen in the wake of the Enron and WorldCom financial scandals, accounting scandals have diminished and the audit profession can look forward to a less fraud-ridden corporate world. This is not so.

The international economic crisis of 2007-08 saw numerous firms go down or be salvaged, in the event they were systemically important, by government injection of funds into them. All of these had either misstated their correct financial exposures or concealed material facts from their auditors to obtain a clean opinion from the latter about their financial condition when the contrary was true. Consequently, auditors failed to raise the alarm where they should have done so.

We see today that accounting scandals continue much the same. A string of accounting scandals have taken place in different parts of the world since the financial crisis of 2007-08 but did not get publicized:

– 2009, failure of PWC to detect fraud at Colonial Bank;

– 2009, Satyam, an Indian technology firm, admitted having faked over $1 billion of cash on its books;

– 2010, a KPMG client, China Integrated Energy was found to have been dormant for months when it had claimed it was producing at full blast;

– 2011, in the case of Sino Forest, a client of EY, much of the timber the firm claimed to own did not actually exist; the latter two firms lost 95% of their value in the process;

– 2012, Hewlett-Packard wrote off 80% of its $10.3 billion purchase price of Autonomy, a software firm, on the fact that Autonomy had reckoned forecast subscriptions as current sales in its accounts;

– 2013, Olympus, a Japanese optical maker, another client of the ‘Big Four’, revealed that it had hidden billions of dollars in losses;

– June 2014, two KPMG auditors failed to scrutinize loan loss reserves at TierOne, another failed bank;

– 22nd September 2014, Tesco, a PWC client, lowered its profits forecast for the first half of 2014 by £250 million for having overstated suspect rebate income it would receive from suppliers of which PWC was aware when signing off its accounts but gave a clean audit opinion nevertheless.

– On 4th December 2014, a Spanish court disclosed that Bankia, a Spanish banking conglomerate formed in 2010 by the consolidation of 7 regional savings banks, had misstated its finances when it went public in 2011. North American exchanges have de-listed 100 Chinese firms in recent years because of accounting problems.

Can we encourage our audit firms to go deeper fearlessly?

In this kind of business environment, it is not surprising that audit firms, which are self-regulated, no longer want to be seen as fraud busters, a popular image they once carried about themselves. Faced with this amount of onslaught of corporate accounting failures, they have set their bar of accountability low enough making it impossible for them to fail in their jobs – which is to merely give an opinion whether financial statements meet the requirements of accounting standards. We should enhance our audit profession in Mauritius by liberating them from having to state the same platitudes year after year. Let them probe deeper and pay them for it.

As in the days of the British lending to American railway companies, can investors, company creditors and members of the public continue to seek comfort from the audit profession that their interests – getting a full picture of the firm — will be safeguarded by the audit firm in charge? It is imperative that investors at least trust the audited firms’ financial statements for their intrinsic worth in telling them that they are “comprehensive, true and correct” instead of being simply “true and fair” or compliant with accounting standards, leaving it to the company directors to assume responsibility for financial misstatement, fraud and error. This is because unless investors are assured by independent auditors at least that the company’s financial statements are not fraught with concealed, dishonest and deceitful company practices, they may lose the incentive to invest, something which has repercussions on the economic uptake.

So far, actions have been taken by the authorities in different places and by the accounting profession itself to make for auditor independence by preventing auditors from getting into situations of conflict. The Andersen case reflected how much auditors put their reputation on the line when giving little or shoddy attention to their job or simply acquiescing to unwarranted pressures from company executives. Several of them have ended up paying fines or reaching settlements with regulators to be able to carry on as it is very hard to prove intentional recklessness on their part in the carrying out of their duties. The final tool there is to give back the bite to auditors is to regulate them objectively rather than letting the self-regulation – which is the norm today — take the full burden. They may be required for example to give in their audit certificate a detailed summary of their activities and areas of focus during the audit. In the process, they would need to be fully shielded by the authorities to encourage them to fearlessly give their audit opinion without risking being sacked.

Companies in Mauritius have met with “accidents”, such as the one that happened at the Mauritius Commercial Bank in 2003 when the bank found out that upwards of Rs800 million of the bank’s funds could not be traced. Eleven years after this event today, the matter is still unresolved even after going through the Commercial Court and the Privy Council. This situation doesn’t throw us into bright light. Moody’s recently downgraded two of our principal banks for, among others, facing risky loan recovery situations. Why Moody’s and not the bank auditors instead, getting things right before it is too late and pre-empting the downgrade?

Auditors have often avoided blame, claiming, when the worm comes out from the can, that managements had concealed material facts from them, or that they’ve formed their opinion solely on a sample basis when explaining how year after year they have been giving a clean opinion and nothing untoward to report on the “basis of information supplied to us by the company”. That does not go proactively far enough. Mauritius would only be consolidating its reputation if, seeing the multiple auditing failures in different jurisdictions, it worked cooperatively with auditors to strengthen the latter’s hands free from the clutches of managements and influential shareholders of firms.

 

* Published in print edition on 19 December 2014

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