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Royal Bank Column – Auditors and corporate governance

By Alex Tawanda Magaisa

THE function and role of auditors has come under increasing scrutiny in light of the major corporate collapses across the world. The crisis in Zimbabwe’s banking industry has also hig

hlighted shortcomings and problems arising between auditors and public companies.


This article seeks to highlight pertinent issues arising and argues that the role and performance of auditors could be improved to make positive impact on the quality of corporate governance in Zimbabwe. The failure of the profession to modernise and create positive impressions may lead to the demise of their traditional role as useful watchdogs on behalf of stakeholders.


Role of auditors


Shareholders need to receive regular reports in respect of the financial aspects of the company in which they have invested their funds. The Companies Act provides that shareholders at a general meeting appoint an auditor. The primary duty of the auditor is to investigate and form an opinion on the adequacy of the company’s accounting records and returns and correspondence between the company’s records and its accounts. In his report to shareholders, the auditor must indicate whether in his opinion the company’s accounts give a true and fair view of the company’s financial position.


The auditor must use his professional skill and judgement to give an independent report on the reliability of the company’s accounts. That report is part of the company’s accounts and must be read in the general meeting and is open to free inspection by shareholders. In a nutshell, the legal provisions establish a relationship between auditors and shareholders on which shareholders are entitled to rely for the protection of their interests.


They can for example dismiss directors when they realise that according to the auditor, the affairs of the company are not being properly conducted. The auditors also provide an essential service by giving access to information to the market. This account would be so perfect if it reflected the reality on the ground. Unfortunately it is not always so and auditors have come under the spotlight for their role in the corporate scandals and collapses.


Areas of concern


The question that immediately arises is what would happen where an auditor fails to perform his duties as required by the law. We are concerned here with a situation where the auditor has been negligent in the performance of his audit duties. The law of delict is very clear that to establish liability for negligence, a duty of care must be owed to the claimant.


The law also recognises that a duty of care can arise where the claimant relies on information supplied by another to his financial detriment. The legal niceties of that part of the law are beyond the scope of this article.

However leading cases in major jurisdictions have held that auditors do not owe a duty of care to shareholders or potential investors of a public company who suffer financial loss by relying on the accuracy of the auditors’ reports. In a line of cases that appear to shield auditors from liability, the courts have stated that the purpose of the audit reports is to enable shareholders to exercise informed control over the company’s affairs but not to enable existing or potential shareholders to buy shares with a view to profit.


The courts appear to have taken this rather unsatisfactory position on the basis that holding auditors liable to such claims would expose auditors to potentially indeterminate liability to an indeterminate class of claimants. This could affect the viability of auditing firms and if the firms insure themselves against financial ruin, it might affect the viability of the insurance industry or worse still auditors would simply increase the cost of their services to companies. Ultimately therefore, it is the consumers who would be hit hard as the companies will transfer their increased costs to the end users.


Despite these arguments, the legal position has been criticised for its unrealistic stance regarding the use of company accounts by small, unsophisticated investors who lack resources to access information about the company’s finances and therefore reasonably rely on the audited accounts. The reality is that the market traditionally responds to company results and investors and shareholders rely on auditors certification of the accuracy of financial reporting to make their decisions.


The argument is that surely when an auditor is careless and negligent he should be held accountable to those who suffer loss by relying on his actions. While the company could recover at present shareholder remedies against negligent auditors are very difficult to sustain. This has the potential of diminishing the auditor’s accountability to shareholders to which he should be primarily beholden.


Conflict of interest


Auditors work closely with the directors, management and junior company officials for purposes of carrying out their audit function and are paid by the company.


After 10 or so years auditing the same company, a special cordial relationship between the auditor and the management of the company is established and this has the potential of diminishing the independence and objectivity of the auditor. At the same time he ideally performs an antagonistic role against the management, as his duty is to check if the management are acting properly and in terms of the law. Simultaneously it has become very common for the accounting firms to perform both audit and non-audit functions for the company. Thus in addition they perform a wide range of consultancy services for which they are paid handsomely by the company. In fact it is also possible in some remote cases that the firms prepare the company accounts which they subsequently audit.


Clearly there is a potential of conflict of interest in that case. It may be that it is unethical in accordance with International Accounting Standards but as this is a self-regulatory system, the question is how effective is it in practice?

In any event, it is difficult to see the auditor being an effective watchdog over the company’ management on whose hand they rely for consumption.

It is hard to conceive how the dog could bite the hand that provides the food. How is it possible that many banks engaged in non-core and speculative investments without any concern being raised by auditors? The proliferation of special purpose vehicles (SPVs), more commonly known as asset-management companies, as arms of many banks ought to have raised some concern among auditors that no doubt should know about the problems raised in other countries.


Could they have been involved in the setting up of these special purpose vehicles? There are many questions that remain unanswered. Seen in this light the dual role of accounting firms compromises their duty to provide shareholders with accurate and independent information regarding the financial aspects of companies. There is need to re-consider this practice of providing of consultancy and audit functions by the same firm to a single company.


Standard of service


There are dominant accounting firms, which operate across the world as global networks. These big firms have presence in almost every country in the world. Local partners benefit from the exceptional brand name while the firm benefits by attracting multi-national clients through their picture of a globalised entity.


What is not often clear however is whether auditing standards are maintained uniformly in all markets. While there are international accounting standards to guide accountants and auditors, global accounting firms are accused of franchising their names without effecting quality control. In other words having a big brand name at the head of the notepaper is not a guarantee to quality as standards differ from one country to another.


It is necessary therefore to take measures, such as global training programmes, uniform codes of conduct as some global firms have done in order to reduce conflicts and to improve quality of service across the world.


Some analysts suggest that when a firm uses a global brand name it must also mean that the audit has been performed in terms of international standards. Any failures to meet those standards should be met with severe sanctions from the regulatory authorities.


Credit-rating


It is argued that the rapid growth of credit-rating firms has a negative effect on the role of auditors in corporate governance. Many individuals now seem to rely on credit rating thus paying little attention to the company’s actual accounts. They no longer monitor the company’s accounts and balance sheet thus diminishing the value of the auditor’s role in monitoring the authenticity of the company’s books. Therefore while a number of banks in Zimbabwe may have received five star ratings from credit-rating agencies, that should not be the end of the matter. It is still necessary to emphasise the traditionally recognised role of the auditors to ensure that the auditors perform their duty well. After all, auditors’ reports and not credit rating are what the law requires and that should not be diminished.


It may be that the market is turning to other indices because it now has less confidence in the credibility of the auditor’s work and for that reason auditors need to do more to regain public confidence. Similarly some reports by so called asset-management firms or market analysts have often been misleading. How for example did the scandal at ENG persist for the last few years without any financial or investment analyst noticing the wayward policies. Instead we saw, as we do with many up-coming companies, glowing reports and tales of their flamboyant lifestyles. Indeed some executives even scooped awards for excellence barely a year before being engulfed in the scandals that have exposed their managerial incapacities.

Therefore some of these markers can be misleading and that is why we should continue to focus on the statutorily recognised auditors and improve where there are shortcomings.


Conclusion


The scope of liability to shareholders and potential investors is very limited in terms of the common law and it may be necessary to re-think this area especially with regards to its impact on small unsophisticated investors. There has been a proposal to have a separate audit of the company’s internal control mechanisms on financial reporting so that any adverse report by the auditor will attract sanctions. This has the potential of strengthening internal control mechanisms and also improving the quality of audits by firms. Auditors will have to revert to their traditional role of being watchdogs for shareholders’ interests and avoid being compromised by management interests. They still have a crucial role to play in improving the quality of corporate governance in Zimbabwe and to do so they must come out of the protective shell and be more vigilant to maintain standards and thwart wayward tendencies among their peers.


Alex Tawanda Magaisa is Baker & McKenzie Lecturer in Corporate & Commercial Law at The University of Nottingham. He can be contacted at alexmagaisa@hotmail.com or alex.magaisa@nottingham.ac.uk

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