Auditors Role in Corporate Governance
A Discussant response to Prof. TJ Wong’s paper
By Philip TN Koh , FCIS
Adjunct Professor , Deakins University
Advocate & Solicitor, High Court Malaya
Partner, Lee Hishammuddin
philip.koh@leehishammuddin.com.my
1.0 The paper augments our understanding of role of Auditors in Corporate
Governance (CG) in East Asia.
It helpfully points out East Asia’s CG (at least pre 97/98 crisis) suffers from
following deficiencies:
1. The typical concentrated ownership structures;
2. Controlling shareholders further leveraged their control through stock
pyramids and cross shareholdings;
3. Weaknesses of alternate monitoring mechanisms like independent directors
(lack of supply and confined to local);1
4. Transactions are relation based and often in weak normative legal
environment;
5. There is also underdevelopment of domestic accounting profession.
We may also add that the interventionist mode of governmental shareholding also
adds to the erosion of independence both in Board rooms and also external
professionals who ought to have acted as monitors but in fact does a poor and weak
job of this function.
1.In this respect the inclusion of foreign directors in the recent listed Maxis Board constitute an
interesting signal to Global investors of Maxis desire to present good governance as part of their
branding and thereby summoning a higher premium inn their equity pricing. Cf that of Competitor TRI
/ Celcom where almost equivalent subscriber base but much lower share pricing in KLSE.
1
2.0 However it is also equally of interest to note that the paper writer draws our
attention to the following:
1. The external audit market is more developed in consequence of
compulsory statutory audit requirement for public listed companies;
2. The application of internationally audit standards and practice as been
gained impetus in most domestic jurisdictions in East Asia.
In Malaysia we have a Co –regulatory framework where a mixture of self
regulatory disciplinary processes sit along side a plethora of legislation
3. The framework is posited for effective monitoring of accounting
professionalism and engendering of independence.
However the acute issue is whether the auditor can be an effective monitoring agent
given that in East Asia Agency conflicts is predominantly between controlling owners
and minority.2
Hitherto there has been a limited study in emergent markets as to whether Auditors
fulfill any quality assurance roles in mitigating the classic agency problems that
characterized a situation where a management is dominated by concentrated
shareholdings and family founder (s).
4.0 Prof Wong and his colleagues is to be congratulated for filling up this gap in
scholarly literature and also in breaking ground in backing his findings with
empirical analysis and findings.
Not being a finance economist or academic laboring in this field my remarks
is offered from the perspective of a practitioner and adviser to Boards. It will
be in the main purposively provocative.
2
Shleifer & Vishny , A survey of Corporate Governance Journal of Finance Vol. LII No 2
1997.Also the vexed issue of Governmental intervention : See A Shleifer & RW Vishny , The
Grabbing Hand : Government Pathologies and Their Cures Harvard ( 1998) .
2
5.0 The paper asks the all too painful and poignant question:
“Why on the onset of the Asian Financial crisis, many external auditors had issued
clean auditing opinions to firms that went bankrupt within a few months after the
completion of the audits?” This question like an incubus hovers over deliberations of
C G in East Asia and in some ways is left unanswered in the paper.
6.0 It is therefore not without some irony that the paper concludes “the overall results
suggest that external auditors do perform a governance role inn East Asia.” The
cynic might demur on this but Prof Wong’s empirical work in this area appears to
support in part his thesis.
7.0 Less we go into a self-congratulatory mode it is important to point out that the
study has its limits:
1. It sets out to test whether external auditors mitigate agency conflicts when
making audit pricing and opinion decisions;
2. It tentatively demonstrated East Asia corporations are more likely to hire “Big
Five” when their ownership structures indicate agency conflicts; however no
data is provided for corporate failures which in part is contributed by negligent
or weak auditing;
3. Big Five charges a higher fee premium and resists lower audit modification
thresholds for auditors with larger agency problems. This does not necessarily
mean that lower fee premiums means weaker monitoring and professionalism
by Non Big Five accounting firms.
8.0 The study also does not state how effective the auditors ‘performance
of their duties has been in the discharge of the monitoring function.
The crucial governance role dispensed by auditors in an advance
capitalist society cannot be overstated.
The debate on this has been focused from the issue of auditor’s
independence.
3
It is obvious that the auditor’s contribution to the effective governance
of corporations is a direct correlation to his/her independence. Any
impairment of an auditors ‘independence will have disastrous impact
on the truth-value and veracity of financial information.
John Coffee Jr. puts it trenchantly:
“Corporate governance depends upon “gatekeepers“ to protect the interest of
investors and shareholders by monitoring the behavior of corporate insiders and
by reporting the financial results of corporate performance in accurate and
unbiased fashion that permits objective valuation of the firm,” Coffee Jr. warned
that if auditors did not discharge its watch dog function then” it is reasonable that
market efficiency would be lower, the cost of capital higher, and the structure of
corporate governance imperiled.”3
Another observer stresses that, “Without accountants to ensure the quality and
integrity of financial information, the markets for capital would be far less
efficient, the cost of capital would be higher, and our standard of living would be
lower.”4
In a US Supreme Court case involving Arthur Young a Supreme Court Justice
emphasized that the requirement to present externally financial statements stems
from the need, “to obviate the fear of loss from reliance on inaccurate
information, thereby encouraging public investments in the Nation’s industries.”5
3
John Coffee, Jr . “ the Acquiescent Gate keeper : Reputational intermediaries, Auditor Independence
and the Governance of Accounting,” ( Working paper , Columbia Law Scholl , 2001 ) 2.
4
Steve Walmann , “ The Future of Accounting and Disclosure in an Evolving world : The Need for
Dramatic Change “ ( 1993) 9 ( 3) Accounting Horizons 81.
5
Cited by Walter Schutetze , “ A Mountain or a Molehill ? “ ( 1994) 8(1) Accounting Horizons 69 ,
70 .
4
In the wake of the Enron and World Com debacle it is clear that when the myth of
auditors independence was badly shaken investors fled the markets causing severe
losses.6
Indeed where there is a concomitant lack of confidence in financial markets there
will be fear and reluctance to invest and thus leading to deterioration of an
economy. The accuracy of security prices relies on the provision of and the
efficient dissemination of information such that it becomes reflected in security
pricing and the pricing of their associated risk.”7
9.0 The Threats to Independence
The issue of independence is a complex one. As a Concept it has many inter-
related layers. It speaks of an ability to act impartially and provide an unbiased
report of a client’s financial health.
In an older work it is defined as
“independence is an abstract concept, and it is difficult to define either generally
or in its peculiar application to the public accountant. Essentially it is a state if
mind. It is partly synonymous with honesty, integrity, courage, and character. It
means, in its simplest terms, that the certified public accountant will tell the truth
as he sees it, and will permit no influence, financial or sentimental, to turn him
from that course.”8
The founder of Arthur Andersen was quoted in 1914 to have said when
approached by a client to sign off on a matter that, “There is not enough money in
the whole of Chicago that will cause me to sign off on a dubious
6
It was reported that following Enron revised financials USD 5 billion was wiped out from the
Enron Stock in 5 days .
7
Eugene Fama , “ efficient Capital markets : A review of theory and Empirical Work “( 197) 25
Journal of Finance 383; Marcel Kahan, “ Securities Law and The Social Costs of Inaccurate Stock
Prices ( 1992) 41 Duke Law Journal 977, 979.
8
John Carey , Professional Ethics of Public Accountants ( 1946).
5
transaction .” Clearly this stance has been eroded by the pressure of client
proximity, the incessant drive for firm’s profitability and the need for increasing
and or maintaining of billings and collections.
The Collapse of Enron has raised acute questions in respect to pressure brought to
bear on audit firms in relation to proximity to client and also conflicts engendered
by provision of non–audit services to client. In the setting up of the Special
purpose vehicles AA was consulted and it does appear that this can have an
impact impugning independence when AA performed their audit services .Also
evident as lesson is that within a large firm there can is free rider on the
reputational integrity of the so called Big Five. John Coffee Jr. has drawn
attention that a firm that has a well established reputation may be deterred in
damaging its reputation integrity has this will entail costs . However this
disincentive does not necessarily extend to all individuals within the firm. Other
commentators has also noted that the role of reputation in engendering certainties
regarding proper accounting treatment but also observed that this must be
accompanied by a thriving accounting market that is certain. Indeed where
markets are noisy and uncertain the role of reputation as a deterrent against lack of
independence is weakened and may be compromised. David Flint emphasized that
this conflict extends to auditors taking a “ free ride ”on the reputation of the
profession as a whole; he cautions that all auditors have a collective interests in
preserving the reputation of auditing if the utility of the profession is to continue.
We may add not just the utility but the very credibility and legitimacy of the
profession’s continued existence can be challenged if the erosion of trust and
confidence continues unabated.9 If the Market no longer believes in the truth-
value of audit then the audit exercise will be rendered meaningless. In such a
situation the caustic comment of GB Shaw that professions are a conspiracy
against the public will sadly be vindicated.
10.0 So the role of Auditors in respect to CG is a direct corollary to its
ability to discharge its’ duties with independence. This independence is
9
B. Mayhew ,J. Schatzberg and G Sevcik , “ the effect of Accounting Uncertainty and Auditor
Reputation on Auditor Independence “ ( Working paper , University of Wisconsin at Madison ,
2000); John Coffee Jr. , supra
6
not just a function of the fee payable for the auditors services but
contains various elements:
1. There can be operational independence where the very inherent capacity of the
audit process is independent and there can be organizational independence. 10
2. Independence has a three dimensional character: programming independence
and, investigative independence and reporting independence. This entire
dimension has to work alongside the management seeking a collaborative
relationship and yet ensuring that there is freedom from interference or friction
or undue deference to the office of the CEO and management.11
3. The role of auditors to independently attests to accounts prepared by clients
being in compliance with accounting standards and presenting a “true and fair
“view” of the financial performance and condition of the firm as going
concern is the touch stone and foundation of the continued viability of auditors
as a profession. This is in part a perception issue. As Justice Burger of the US
Supreme Court puts it “the public path in the reliability of a corporation ‘s
financial statement depends upon the public perception of the outside auditor
as an independent professional if investor is were to view the auditor as an
advocate for the corporate client, the value of the audit function itself might be
lost.”12
4. Most significantly auditing and relevance of its independence to CG analysis
can be seen in the seminal work done by Jensen & Meckling using agency
13
theory. Jensen Meckling models relationship between principal and agent
and the audit problem as an expression of this issue manager who controls the
firm is a agent of shareholders ;but in accordance to classical economics
theory the agent and principals are also self-interested individuals bent in
10
See Michael Powers , The Audit society : Rituals of Verification ( 1997) 131 –134
11
RK Mautz and Hussein Sharaf, the Philosophy of Auditing, Monograph No .6 (1961) 204.
12
Cited by A. Briloff, “ Accountancy and Society: A Covenant Desecrated “ (1990) 1 Critical
Perspectives on Accounting
13
MC Jensen & Meckling , “ Theory of the Firm : Managerial Behavior , Agency Costs and
Ownership Structure” ( 1976) 3 Journal of Financial Economics 305; see also Oliver Hart Firms
Contracts & Financial Structure Oxford( 1995) .
7
pursuit of self-interest and when there is a misalignment of the self-interest
there is engendered agency costs which in essence is the governance issue. Ira
Milstein, the doyen lawyer of CG has written about the essential conundrum
of CG is the misalignment between self interest of a firms ‘agents with that of
the principal. Good CG is to nurture alignment of this interest with that of the
interest of the company and the public. In essence there is information
asymmetry between agent and principal. This occurs when the Board and
Audit committees fail to perform their roles adequately. Accounting
information can also be buried in a morass of details and complex footnotes.
Again Enron can be illustrative. In the audit Committee there was even a
Professor of accounting from Stanford. It took an outside academic , Professor
Carmichael from Baruch College, N.Y. to express unease over the accounting
treatment of the SPVs. Ultimately a middle ranking employee/officer (Ms.
Watkins) brought the house of cards that was Enron down. Therefore auditors
who are meant to be a solution to the agency costs can itself be the problem as
auditors are also rational self interested agents and to that extent may have
more incentive to sidled to management for potential future economic benefit
and thereby rendering themselves to be willing conformist to management’s
wishes.
5. The auditor as a Public steward owes duty to the Public at large.
11.0 One writer puts it well “ a Public accountant acknowledges no master but the
public, and this differs from the book keeper, whose acts and statements are
dictated by his employers. A Public accountant’s certificate, though addressed
to the President or directors, is virtually made to the public, who actually or
prospectively stockholders He should have ability, varied experience, and
undoubted integrity.”14
In a milieu where disclosure based regime has replaced the blue-sky merit based
approach this observation is a fortiori apposite.
14
Andrew Barr , “ the Independent accountant and The SEC “ ( 1959) Journal of Accountancy 32
8
Professor Briloff even goes further to argue that auditors have a covenant with society
to perform services which albeit involving “signing, delivering or issuing or causing
to be signed, delivering or issued, financial statements, opinions and reports’ thereby
owing a unique responsibility to society as a whole to assure full fair, open and timely
disclosure regarding governance and accountability of the corporate enterprise.” 15
From this view post Enron and World Com signify a broken covenant between
profession and public.
It is clear that Enron and World Com has sounded the death knell to the so called
growth of MDPs (Multi Disciplinary Practice) as Audit firms continued apace to sever
their audit work from their other services.
Other pressures on independence that has been noteworthy is the audit fee and the
practice of low balling (i.e. gaining a client by under quoting) and employment
relationship.
Recent pundits have even gone so far as categorically stating that the nature of
auditing has now changed so much that, “ the auditor can no longer be independent
because auditing is no longer an independent discipline.”16
The association of value added opportunities by proving and cross selling Non Audit
services (NAS) has been debated. There has been mixed results in various studies and
thereby difficult to draw policy prognostications
Whether there is evidence of the factual impairment of independence damage to
independence in appearance has been documented. In the Bolkiah vs. KPMG (a firm)
case decided by the House of Lords the Law Lords was unequivocal that to establish
a credible Chinese wall between investigative services and reporting services there
must be clear evidence of institutionalized secrecy arrangements and not merely ad
hoc arrangements within a department between colleagues who work together. 17
15
Briloff “ Accountancy and Society : A Covenant Desecrated ( 1990) 9 92) Critical Perspectives on
Accounting 217 , 223.
,
16
PJ Beck , TJ Frecka & I Solomon . “ A Model of Market for MAS and Audit services : Knowledge
Spilovers and Auditor 0-Auditee Bonding “ ( 1988) 7 Journal of Accounting Literature 50.
17
See [1999] 2 AC 222; Young v. Robson Rhodes [ 1999] 3 All ER 524.; Halewood v. Addlesshaw
Booth & Co [ 2000] Lloyd’s rep . P.N. 298.
9
Whilst it may be true that Auditors independence is not an absolute construct. For
example it is cogently urged that,
“Audit Independence require not only freedom of investigation and freedom in
reporting, but also the absolute independence of the auditor in the sense of absence of
previous or present involvement in the subject of the audit, absence of interest in the
outcome or its consequences, and absence of bias or susceptibility to influence by
consideration be extraneous ton the matter at issue /… absolute independence is,
however a theoretical concept. It is an ideal to be strived for; but the actuality is a
compromise. Auditors cannot be made completely asceptic …” 18
Indeed whilst all of us ought to be saints we aren’t.19 .
Concluding Reflections
This leads us to some concluding reflections as to extent can the burden of regulating
independence be placed upon the profession or expanding notions of negligence
giving rise to liabilities.
In one leading text on Professional negligence is found this words:
“Professional negligence remains an expanding domain. This is a product of many
factors. Predominant is the pervasive role of professionals in a services dominated
economy. Also feature large is the blame culture of our age. Professionals are
perceived as having deep pockets, if not broad shoulders .A perennial problem for the
Courts is to devise an appropriate polity which does not impose impossibly
burdensome and uninsurable potential liability and yet satisfies perceptions of
fairness.”20
18
David Flint , “ Social and Ethical Issues in Auditing “ in A Hopworth , M Bromwich and J Shaw (
eds.) Auditing Research in Issues and Opportunities ( 1982).
19
Graham Green , The Power and the Glory.
20
Preface to Jackson & Powell o Professional Negligence , The Common Law Library 5 th Ed. (
2002).
10
The governance role of auditors has been heightened and quickened in wake of major
corporate failures. Though some of the reaction is symptomatic of seeking a scape
goat for corporate ills it cannot be denied that the challenge of accounting profession
is to retrieve from within the resources of his/her profession the virtues that first
imbued its’ positioning in societal perception.
The regulatory reforms that attended to rectifying the CG crisis has not spared the
accountant.
After the wake of BCCI the Bingham Report resolved to impose a whistle blowing
duty on auditors of institutions across financial services in U.K. Closer home our
Bafia also imposed such a duty. The Revised KLSE Listing Requirements also set
forth various rights to promote and make effective the elusive quest for independence
at Board levels and also Committees work.
Indeed in an English Court of Appeal recent decision Sasea Finance Ltd v. KPMG21
has held that it was the auditor’s duty to report to the company management the fraud
of a senior employee as soon as the auditor discovered it or should reasonably
discovered it.
Post Caparo decisions see judges grappling with the intractable balance between
fairness to injured parties and limits to awarding economic loss compensation.22
It is also noteworthy that judicial notice has been taken in respect to auditing
standards so that deviation from the same could be evidential of breach of duty.23
In respect to claims against audits for failure to detect or report fraud three main
issues has arisen for consideration:
(1) If auditors’ role is watchdog can he plead that the fraud is caused or
contributed by the officers. A fair perspective on this must be that proper
21
[ 2000] 1 All ER 676
22
Morgan Crucible Co.Plc v.Hill Samuel & Co Ltd [1991] Ch.295n; BCCI v. Price Waterhouse ( No
2) [ 1998] PNLR 564; Poss Fund Custodian Trustee Ltd v . Diamond [ 1996] 1 WLR 1351 (
prospectus liability; Barings plc v Coopers & Lybrand [ 1997] PNLR 179
23
Lloyd Cheynam v. Littllejohn [ 1987] BCLC 303, 313;Pacific Acceptance Corporation Ltd v.
Forsyth 9 1970) 92 W.N. ( NSW ) 29.
11
accounting and setting up of internal control systems is the primary
responsibility of management and the directors.
(2) Is it possible to separate Company from those who controls it so that the
company is also the victim rather than wrongdoer. If it is a one-man company
perpetrated the fraud any claim by it against the auditor if the fraud is
attributable to his own misconduct or negligent omission would fail in larger
conglomerates it is difficult to ascertain causation issues.
(3) If it is proper to take into account fraud of company’s officers can the
defendant do by way of action of contributory negligence or by way of
contribution proceedings or both? Care need to be taken that there is no double
counting extant case authority do not favor contribution proceedings.24
Another interesting development is the advent of forms of statutory derivative actions.
Under Securities Commission Act25 the SC can now claim against any officers and/or
agents, which if they considered had conducted themselves misfeasantly resulting in
damages and losses against the company. In Australia Deloittes & Haskins was
subject of such a claim by ASIC in the so-called Adsteam case. In analogous
Australian legislative provision .26
Professor MA Eisenberg has pointed out the critical importance in corporate
governance issue is the ability of Board ‘s role to monitor management. In respect to
flow of accounting information Eisensberg was prescient in pointing out that in “
theory , a satisfactory degree of objectivity and comparability is achieved through
institutional means – the central role given to independent accountants . In practice
the theory does not hold up , due to a series of institutional failures .27
H e stressed that :
24
See Jackson & Powell , supra para 15-148 ; Daniels v Anderson ( 1995) 16 ACSR 607; Dairy
Containers Ltd v. NZI bank Ltd [ 1994] 2 NZLR 30 ; Duke Group Ltd v Pilmer ( 1999) 31 ACSR
213
25
S 155 of SCA Act .
26
ASC v Deloitte Touche Tohmatsu 21 ACSR( 1996) 331
27
MA Eisenberg, Legal Models of Management Structure in the Modern Corporation : Officers ,
Directors , and Accountants California Law Review Vol .63 : 375 , 416ff.
12
Firstly, responsibility for selecting accounting principles has been placed with
management rather than the accountants;
Second, management has been given enormous discretion in selecting among
competing accounting principles and
Finally, the accountants have been dependent upon management for their selection,
tenure, and dismissal .
Eisenberg made the call for restructuring of accountant’s role in 1975. Some gains has
been made but it looks like not enough .
There is now calls for further reform :
1. In Australia the Ramsay Report made key recommendations for ensuring
accounting firms independence from audit Clients. It also suggested
amendments to corporation laws dealing with financial relationship between
auditors and clients and regulation of non audit services .One of its chief
recommendations is the establishment of an Auditor Independence
Supervisory Board ( AISB ) that is not controlled by the accounting
profession .
2. In UK and US the impetus for reforms will be intensified as fresh calls for
accountability arises.
When we talk about role of accountants in governance reform we must palce some
limits to the subject matter at hand .
From perspective of reform of structures Eisenberg has a poignant closure to his
article :
“ In dealing with questions of organizational structures, it is always necessary to
keep in mind the limits on the subject’s importance . … in 1904 Franz Klein
referred to a concept he called “ the truth of form,” meaning that certain forces are
13
active in any given corporation , and that corporate organizational structure will in
the end conform to those prevailing forces There is much bite to this concept , and it
will be self deception to believe that great changes in organizational structures
will necessarily produce great changes in the way a given organization actually
functions , let alone great changes in the general structure of society . There is an
iron paradox which governs corporate affairs , and no amount of restructuring can
avoid its force: Only those who are involved in an enterprise full time have sufficient
knowledge to direct an enterprise . which those who are not involved full time can
be trusted to monitor those who directs.”28
As imperfect monitors that we are all we nevertheless work towards strengthening
the lacuna in our rules and the ethos of which we practice in .
We recognize that even in small gains we may win a partial victory in stemming the
tide of infectious greed and restoring trust in the market .
28
MA Eisenbserg , supra, 459 .
14