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What Keep Auditors Awake At Night
Lee Kok Wai [Partner, Audit & Assurance]
Women looking afar

The audit profession has in recent years experienced unprecedented changes caused by a combination of factors — a more litigious environment, rapid changes in technology and regulations, and the struggle to recruit and retain talents.  It is not surprising that the profession finds itself grappling with these challenges and finding ways to overcome them.  As yet another year comes to an end, with auditors busy planning for the year end stock count and next year’s audit, it is timely to take a look at some of the key challenges the profession is facing today and how it can potentially address these challenges so that, hopefully, we may sleep better at night.

 

Fraud and Potential Litigation

Financial statements fraud in the corporate sector is nothing new. History will show a laundry list of mismanagement and corporate fraud committed by senior management personnel entrusted with running companies that have resulted in financial losses, or worse, the collapse of entire businesses.

The Global Financial Crisis in 2008 put a spotlight on the extent of financial fraud and the potential economic fallout following the closures of the affected companies. Suddenly, the role of auditors came into question with suggestions that auditors were not sufficiently rigorous in their audit of the financial statements of banks and other financial institutions which resulted in the failure to spot any warning signs of companies in financial trouble until it was too late.  Most companies which failed during the GFC did so without any warning.

While policymakers have responded to the fallout of the GFC as a result of public outcry for regulatory changes, cases of financial fraud have continued to rock the business world in recent years. The most recent case reported involves Rio Tinto – one of the world’s largest mining conglomerates.

According to an online report by the Financial Times, “Rio Tinto charged with fraud in US and fined in UK” on 18 October 2017, Rio Tinto and its two former senior executives were hit with fraud charges in the US and a fine in the UK for allegedly trying to hide a multibillion-dollar business failure by inflating the value of coal assets in Mozambique dating back to 2011. (1)

The US Securities and Exchange Commission said in the civil complaint filed in New York that Rio Tinto, its former chief executive, and its former chief financial officer had ignored proper accounting standards and misled investors in their valuation of coal deposits that the company had purchased for US$3.7 billion and later sold for just US$50 million, as well as allegedly breached disclosure obligations and corporate duties by hiding crucial information regarding the failed multibillion-dollar transaction from their board, auditors, and investors. (1)

While Rio Tinto’s auditors have not been implicated with the improprieties tied to the Mozambique coal business transaction, other auditors have not been so lucky.

In Singapore, for example, mainboard-listed digital media and software provider DMX Technologies Group filed a lawsuit in October 2017 claiming damages from its former auditor as a result of what DMX claimed was professional negligence. (2)

The lawsuit stems from contentious transactions executed by the former management that surfaced after the company appointed another auditor in 2014.2 According to DMX, once these transactions were excluded from the revenue and profits, cumulative losses of more than US$90 million were incurred and more than US$130 million in cash was drained from the company over the financial years 2010 to 2015. (2)

Meanwhile, in May 2017, Los Angeles County in California, USA filed a suit against a CPA firm, alleging that the firm defrauded the county by failing to detect the embezzlement of US$9 million committed by the firm’s client Chicana Service Action Center (CSAC).3 The complaint alleges that from 2009 to 2012, the auditor audited CSAC and failed to address the issues with CSAC’s inappropriate use of public money. (3)

Should auditors be liable for fraud and financial improprieties committed by their clients?

Clearly, auditors today are stuck between a rock and a hard place. On one hand, public perception and tighter regulations require auditors to do more and be more rigorous in vetting a client’s financial transactions. But on the other hand, auditors have to work within certain parameters including specific schedules, timelines, and fees; these parameters place limitations on what auditors can realistically achieve in the public expected role of detecting fraud.

Auditors are not fraud investigators – an auditor’s main objective is not to look for the occurrence of fraud but to assess a financial statement and express an opinion – which, unfortunately, seems to be at odds with public perception and expectation that auditors should act like law enforcement to seek and apprehend those committing financial fraud.

Whether rightly or wrongly, more auditors are being held accountable for fraud that has gone undetected. One of the cornerstones of auditing is that auditors should not accept the client’s word as evidence; auditors are required to compare information and evidence presented by management to those obtained independently from external sources, for example, confirmations of balances with banks, customers, and suppliers. But if there is collusion between the client and these external parties, how do auditors uncover that level of fraud?  A comprehensive and well-planned fraud can take years to unravel and more often than not, they are detected by whistle blowers who are insiders within the company.  Fraud is rarely detected by auditors.

Being associated with a company that has committed financial fraud can be damaging to an auditor and worse when litigation is brought against the auditor for not detecting the fraud.

As such, it is critical for auditors to manage this type of risk well. While there is no fool proof way to prevent this, the risk can be reduced through a combination of processes and procedures.  This starts from knowing a client well before acceptance to assessing the culture and attitude of management towards risks and how management are incentivised to meet performance, among others.

 

Finding Quality Clients

At a time when auditors are being held to a higher standard and accountability, the quality of clients has never been more important. Naturally, every firm wants to have quality clients.  These are generally defined as those companies operating in growing industries and operating profitably, with competent and reputable management teams, and do not have a history of corporate scandal.  But in reality, where there is constant pressures to grow fees and build the business, firms may be put into the compromised position of accepting clients that they may have otherwise declined.

The challenge is to find that equilibrium where a firm can grow the business while maintaining clients which meet the required risk quality.

 

Crystal Ball

Auditing is a business of attesting historical financial information – verifying financial statements prepared by the management and report whether these financial statements are presented in accordance with accounting standards or otherwise.

If the company’s business is flourishing, the audit process is generally less challenging.  This is so because there will be less audit issues such as impairment of assets, whether the company has any going concern problem, or whether intangibles such as goodwill or intellectual properties are impaired. But if a company is struggling financially, it is often challenging for auditors who then have to consider if adjustments are required relating to issues mentioned above.  This is especially difficult when the issues require professional judgement by both the management and the auditors.  Such professional judgements generally involve the assessment of profit forecasts and possible outcome of future events, for example, whether a customer can pay its debts.  A crystal ball should have been a standard issue to all new auditors!

In the absence of the ability to predict the future, auditors have in recent years relied on industry practices as a benchmark when it comes to areas of professional judgement.  For example, during the recent crisis affecting the oil and gas industry, both companies and auditors have looked at the industry’s trend in making impairment for its assets, both globally and locally.  While this may be accused as following the herd, it would be hard to argue that a company does not require impairment when the industry leaders are doing precisely that.

 

Technology – Friend or Foe?

Where once a future in which robots and artificial intelligence replacing humans was the realm of science fiction movies, the pervasiveness of technology impacting on our lives is a reality today.

Take driverless cars, for example. Would you have imagined a decade ago that we would be seeing driverless cars on the road today? According to David Galland, Partner at Garret/Galland Research, there will be 10 million self-driving cars on the road by 2020 and by 2030 one in four cars will be self-driving.4 Not only will self-driving cars impact us as consumers but it will also impact businesses. The technology will be a boon for logistic companies which will benefit from reduced costs of transportation, but may potentially put thousands of drivers out of jobs.

Similarly, we are also seeing technology’s impact on the accounting profession. For example, data analytics, big data, and artificial intelligence are expected to change, if not replace the role of accountants and auditors.  There have been predictions that auditors may not be required since these tools will be able to identify and highlight anomalies and red flags in financial transactions.  Such news is obviously brushed off by a profession which has seen its fair share of technology changes over the decades.  If we had survived the transition from 14 columns working paper and calculators to spreadsheets and paperless audit working paper, surely we can survive this? But then again, the taxi business said the same thing about Uber and Grab.  Hence, we should not throw caution to the wind lest we are proven wrong.

There are a few factors which work in the profession’s favour in this area.  The accounting profession has in the past showed its willingness to embrace technology.  In addition, its relatively young workforce is technologically savvy and has been able to use technology to its benefit.  As it is, we have seen an increased use of software tools to perform routine monotonous audit procedures and data analysis.  This will allow auditors to spend more time on areas which require assessment of information generated and the exercise of their professional judgement. Cloud computing, paperless audit, sharing of files, and many other audit tools have allowed firms to provide what is demanded by its young workforce — such as flexible working hours and working away from office.  These technology tools have also enabled clients to work remotely with audit teams, making cross border assignments more cost efficient and effective. So long as we continue to adapt successfully to technology changes, we should be able to capitalise on the advancement in technology and remain relevant to the business community. As they say, adapt or perish. In fact, for a profession which has continuously faced high staff attrition rates, advancement in technology is definitely a friend rather than a foe.

 

Keeping Pace with Change

To keep up with the rapidly evolving global business environment and needs of financial statement users, accounting standards have evolved rapidly.  This can be seen from the slew of changes in accounting standards in recent years. As auditors, we have to stay abreast with these changes, both to ensure that we remain competent in our role as well as to advise and assist clients who may require guidance on the effect of these changes.

While changes in accounting standards are necessary and important to keep up with the needs of the financial statements users, there is a real cost to accountants and auditors to keep up with these changes. The speed at which new accounting standards are being introduced means firms need to keep up through the constant trainings of its people. This means firms need to be prepared to consistently invest to keep up with the changes or face the threat of being left behind.

 

Audit Exemption

The gradual deregulation of reporting requirements has resulted in the exemption of certain categories of companies from auditing their financial statements. The implementation of the Companies Act 2016 has provided for such an exemption in Malaysia, though the present exemption applies mainly to smaller companies.  If the trend of audit exemption in more developed countries is an indication, we are likely to see more categories of companies being audit exempted in the future.  The audit exemption is expected to affect both small and large firms particularly in a relatively young economy like Malaysia.  We need to brace ourselves for this by looking beyond audit services to provide value added services to our clients.

 

Fight For Talent

The fact is audit is neither a glamorous nor a high profile profession. We may hear of kids wanting to grow up to be doctors or engineers or pilots, but never an auditor. The perception is that our profession has not changed in decades and is boring, offers no work-life balance, and requires long work hours. As a result, it is a challenge to attract and retain talents in the auditing industry.  For many who chose the auditing profession, it is not uncommon to hear from them that they take this as a stepping stone before they move to other roles.

How do we overcome this perception to attract new talent?

The reality is the accounting and auditing profession provides a stable career. Young adults who graduate with an accounting degree will find that it is easier to find a job compared to many other degree holders. Our profession offers job security and, if you can find an interest in it, quite a rewarding career.

The first few years in the career of an auditor can be daunting.  The auditor is expected to learn different skills and acquire a multitude of knowledge.  An auditor is likely to audit clients from different industries, using different systems, operating in different geographical areas, and working with people from different disciplines.  An auditor also works within tight reporting datelines, is required to be technically sound, and, because of the requirement to interact with management, possesses good communication skills.

It is precisely because of these demands that the auditing profession is an excellent training ground for young professionals.  Those who are able to excel in the profession are highly sought after by companies seeking accountants or finance managers.  The training also provides the auditor certain versatility as can be seen by former auditors who are leading companies in CEO and MD roles. 

The profession is going through huge challenges and sometimes these challenges can appear unsurmountable. The key factor is that we embrace and adapt to the changes proactively and at the same time make the profession appealing to the new generation of talents to continue to stay relevant for the profession to flourish.  I hope with that attitude, we do not have too many sleepless nights.  And if sleep eludes you, you would realise that it is darkest before the dawn.

 

 

(1) Financial Times, Rio Tinto charged with fraud in US and fined in UK, 18 October 2017.

https://www.ft.com/content/163f2e3c-b38a-11e7-a398-73d59db9e399?mhq5j=e7

 

(2) The Straits Times, DMX sues Deloitte & Touche for negligence, 7 October 2017.

http://www.straitstimes.com/business/dmx-sues-deloitte-touche-for-negligence

 

(3) Jurist.org, LA County sues CPA firm for alleged accounting fraud involving public funds, 29 May 2017.

http://www.jurist.org/paperchase/2017/05/la-county-sues-auditing-firm-for-alleged-fraud.php

 

(4) Forbes, 10 million self-driving cars will hit the road by 2020 – here's how to profit, 3 March 2017.

https://www.forbes.com/sites/oliviergarret/2017/03/03/10-million-self-driving-cars-will-hit-the-road-by-2020-heres-how-to-profit/#66dcb2bb7e50