One of the defining features of the economic crisis is disclosure of high-level fraud on a breathtaking scale. Although the auditors’ traditional mantra (“it is not the purpose of audits to detect fraud”) is repeated at every opportunity, somehow those who rely on audits as a safeguard do not get the message.

The battle against public expectation has been waged since the beginning of auditing. Various attempts have been made to “educate” investors on what they should expect, but none has succeeded in persuading the public or the courts that the profession’s perception of audit scope is sustainable whenever a higher level of effectiveness is warranted. Anodyne, formulaic expressions in audit reports, carrying more hope than conviction, fill pages, but are read only by insomniacs seeking a cure. Much of that peripheral frippery is now being trimmed.

I received a box of golf balls with the Price Waterhouse logo

By no means all expectations of audit effectiveness are justified. In the throes of the BCCI debacle I received a box of golf balls with the Price Waterhouse logo after I wrote an article highlighting the absurdity of seeking to pin the Bank of England’s supervisory failures on BCCI’s auditors. Similarly unwarranted expectations were voiced when Equitable Life’s auditors, Ernst & Young, were misguidedly sued for not anticipating potential consequences of a dispute on guaranteed annuities that was resolved only when it finished up in the House of Lords.

 

“Auditability” pressures

Informed opinion is sensitive to the distinction between baseless exploitation of auditors as deep-pocket scapegoats, and auditing that is indefensibly sub-standard.  But with the expansion of global markets, the “auditability” of major enterprises becomes inversely proportional to the scale of their operations, and short-circuiting basic procedures inevitably follows.

Currently in the news is the fraud at Satyam, India’s outsourcing giant. Its founder and chairman has confessed publicly to orchestrating a scam over several years resulting in massive cash overstatements. How ironic that last September Satyam was given the Golden Peacock award by the World Council on Corporate Governance, and in 2007 its crooked chairman was named Ernst & Young Entrepreneur of the Year!

It is too early to comment on the Satyam audits, but following these admissions Price Waterhouse, the Indian arm of PwC, formally withdrew audit opinions previously issued. In a letter to Satyam, released by the Mumbai Stock Exchange, the auditors stated that they had “placed reliance on management controls over financial reporting” when signing off Satyam’s accounts. Whether or not this means they did not, independently, confirm bank balances inflated by some $1 billion is not known.

Either way, history shows that no matter how plausibly firms re-invent technical justifications for relying on the work of others, their neglect to perform the most obvious procedures lands them in the proverbial ordure – over and over again.

 

Missing the obvious

In one of many examples from my case-book, had auditors merely opened the company’s “private cash-book” they would have seen columns blatantly recording the finance director’s substantial personal expenditure and illicit “loans” to finance department personnel (mainly the FD’s relatives).  Instead they relied on “high-level IT systems reviews” in which the FD obligingly collaborated.

Executives of another cash-strapped company conspired to sit on millions of pounds of receipts from debtors instead of remitting them to the finance company that had discounted related invoices months earlier. The breach could have been discovered by comparing one of the balances listed on the finance company’s month-end reconciliation with the corresponding sales ledger balance. Instead, the auditors relied on analytical procedures framed on unchecked representations of one of the conspirators.

There is a common thread that threatens to mire the reputations of some major firms if a     systemic flaw, now embedded in their auditing culture, is not rooted out. Relying on high-level “management controls”, unsupported by basic transactional checks on company records, has never been justified. It is time to resurrect that thing called good old-fashioned auditing.

 

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