From Enron to Lehman Brothers:

Implications for the audit profession

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Over the last 50 years, we have witnessed fundamental changes to the role of the auditor. Influenced by critical events (eg court decisions, corporate failures, economic melt-downs), audit responsibility has evolved from straight-forward error and fraud detection to the provision of more value-added services for clients and regulators; services that include, among others, reporting on internal control deficiencies, identifying business risks and even providing guidance on these risks.

As a result, auditors are now not only expected to be fluent in accounting and reporting standards and requirements, but also in a variety topics ranging from the technological to the legal aspects of business and finance. And, while demand for oversight is nothing new, the pressure on the audit function is increasing, largely as a result of what many regulators, politicians and investors perceive as recent, audit-related corporate failures.

So, where next for the audit profession?

The risks of over-regulation
History shows that regulation drives evolution when it comes to the role of the auditor. Although corporate failures like Enron and WorldCom have been few and far between (and in reality resulted more from significant underlying issues – ie fraud and collusion – than from their auditors’ perceived malpractice) they have nonetheless been viewed as some of the most pervasive and expensive failures of the century. The knock-on effect has been extensive reform in audit oversight.

What began with the introduction of the Sarbanes Oxley Act and the creation of the Public Company Accounting Oversight Board in 2002 has consistently evolved through to present day. Unfortunately, it looks as though these initiatives have done very little to prevent the subsequent failures that have occurred throughout the most recent economic crisis.

Therefore, governments and regulators are once again focusing their attention on this profession and are more closely examining the systemic risk associated with the role of the auditor.

Interestingly, however, one unintended consequence of this renewed scrutiny seems to be increased competition and retaliation between global financial centres. Newly created standards of excellence for regulatory frameworks, which have been designed to manage audit risk and prevent future audit-related failures, will, in practice, restrict auditors from providing audit services to clients that are registered and listed in foreign jurisdictions. Under the “third-country auditor” reforms being put forward by the US, EU and Japanese regulators, any foreign audit firm, or auditor wishing to perform an audit function for regulated entities, will be required to register with and adhere to all regulatory reforms and practices in each respective jurisdiction – a different set of rules for each country.

International response to the proposal of these reforms has been far from ideal as it has, unhelpfully, perpetuated further retaliation by other regulators (eg “If you won’t let my auditors audit in your country, I won’t let your auditors audit in mine.”) If left unchecked, this ‘tit for tat’ mentality may eventually lead to the fragmentation of global audit networks, which would have disastrous consequences for corporate governance overall and for the audit profession in particular.

Another risk posed by over-regulation is as a consequence of the unremitting demand for ever more information at greater speed. Financial and corporate transactions have become more voluminous and more complex and the level of detail mandated by filing requirements has also increased. Auditors, therefore, have less time to understand, evaluate and, ultimately, audit the financial information. As a result, audit quality may be affected and this may, in turn, contribute to future corporate failures.

That said, external developments may help make this situation more manageable. In the wake of the global financial crisis and in response to the limited information on complex financial transactions available pre-crisis, new regulations, such as the Restoring American Stability Act 2010, will require companies to become more transparent and to make information on complex business transactions publicly available. This step is expected to relieve some of the burden that auditors face today and enable these firms to focus less on deciphering transactions and more on their core role of auditing financial information.

While it may be tempting to make the auditor a scapegoat for the recent financial markets crisis, all parties involved (regulators, governments, corporations) share in the responsibility for these events. All parties are also, therefore, responsible for developing the solutions needed to prevent a similar crisis from happening in the future. If regulation is undertaken for its own sake, we may see knee-jerk reinforcement of outdated elements without the necessary reflection to ensure all regulation is fit for modern purpose. It is my hope that auditors and regulators will work together to find proportionate responses to address the short comings of current regulation, oversight measures and audit assurance.

These sentiments apply both globally and locally and we are already seeing positive steps being taken right here in the Cayman Islands.

Cayman specific
As the Cayman Islands have evolved into a leading financial services centre the need to ensure compliance with global standards and expectations for auditor oversight has become ever more critical. As a domicile of choice for hedge funds, with more auditors per capita than most other developed countries and with more than its fair share of scrutiny by the financial superpowers of the world, the Cayman Islands have not stood still.

Recently, the audit profession in the Cayman Islands has experienced an increase in regulations through both the introduction of the revised accountancy law and the revitalisation of the Cayman Island Society of Professional Accountants’ role in governance of the profession. The majority of local audit firms locally are subject to their firm’s own global peer reviews and assessments on an annual basis.

To establish a standard accepted level of practice for all audit practitioners and consistency in audit quality across all audit firms in the Cayman Islands, CISPA and the Cayman Islands Monetary Authority need to consider various ways to effectively implement globally accepted peer review and independent inspection procedures. Engaging an independent organisation to review and assess the quality of risk management and audit procedures being applied in practice by all audit firms registered in the Cayman Islands would help ensure that the process is fair to all and that no bias is taken against the firms subject to review.

There is no question that a consistently high standard of audit quality is integral to the maintenance and survival of the Cayman Islands as a bona-fide leading financial services centre. In this regard, the Cayman Islands are fortunate to have CISPA as a major proponent for the improvement of the islands’ regulatory and supervisory infrastructures. To their credit, CISPA is currently an associate member of the International Federation of Accountants and are in the process of pursuing full membership.

As a condition of full membership, CISPA is obliged to ensure that the appropriate infrastructure is in place to meet the stringent IFAC requirements for independent review, supervision and disciplinary action of the profession. Full membership and the associated credibility would further bolster the Cayman Islands’ and its auditors’ efforts to be viewed as equals when compared to other leading jurisdictions, such as the US and the EU.

In addition, the Cayman Islands has collaborated with a number of high profile organisations such as the IMF and OECD to address and implement other global standards on due diligence and transparency. It would seem to be a case of natural progression for the Cayman Islands’ regulator to join the International Forum of Independent Audit Regulators – which brings together a number of the world’s financial regulatory bodies (excluding the US) to share knowledge in relation to independent audit oversight and increase collaboration in regulatory activity – and similar collaborative affiliations to ensure that their views on audit oversight and quality are expressed and used to shape the future of global oversight.

Responding to the pressure
So, how are audit firms responding to the regulatory changes at both global and local levels?

The viability of any audit firm is directly linked to the strength of its reputation. As audit failures have occurred, audit firms have wisely taken corrective action to mitigate negative publicity and other potential repercussions. After the collapse of a number of large public companies in the early 2000s (Enron, WorldCom, Parmalat to name a few), and as a result of the ensuing lack of confidence and increased litigation related to the work of auditors, most of the large accounting firms decided, with some urging from regulators, to change their business structures.

Fundamentally, most separated their consulting from their audit practices and put in new safeguards to monitor and ensure better independence and audit quality. From then on, audit firms have avoided the gray areas of practice and refocused efforts on their core lines of business and adherence to independence rules. In addition, the largest audit firms around the world have reportedly increased their operating budgets for risk mitigation practices, procedure and risk management tools. These changes have held them in good stead throughout the recent financial market turmoil, but the evolution continues.

To remain competitive and maintain market share, while at the same time manage the constraints on time and other resources new regulation and increasingly complex information bring, audit firms are exploring new ways of increasing efficiency and reducing cost without comprising quality. Recently, we have seen firms embrace technological advancements, such as the use of fully integrated electronic audit tools, as one way to meet this challenge. We have also seen a significant increase in training and the implementation of accreditation requirements within audit firms, both of which support auditors in the conduct of an effective audit.

Finally, as a next step in its continued evolution, firms are even pondering a change to the very nature of an audit. Recent comments expressed by the leaders of major accounting firms seem to suggest that in the future we may see a shift away from the typical binary audit report and a move towards an overall assurance report, which may even be issued in conjunction with others (eg rating agencies, boards and management of audit clients, etc).

The evolution will continue
No matter the shape of new regulations to come, both on local and global levels, and no matter the new demands audit firms face when critical events change the landscape, there is no doubt that the audit profession will continue to adapt, evolve and maintain its status as one of the most reliable and necessary players in the global marketplace.

The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.

Endnotes  

  1. Source: Journal of Modern Accounting and Auditing, ISSN1548-6583, USA ‘The evolution of auditing: Analysis of historical development’, Vol.4, No.12 (Serial No.43), December 2008.
  2. John Griffith-Jones, Joint Chairman of KPMG Europe LLP. “Address”. Institute of Chartered Accountants in England and Wales (ICAEW). London, England. 16 June 2010. Available at: http://rd.kpmg.co.uk/search.asp.
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