EXECUTIVE SUMMARY

After the recent financial crisis, this dissertation seeks to arouse debates on current auditing practices. It is noted that a considerable number of financial enterprises such as Lehman Brothers and non-financial firms such as Enron have filed for bankruptcy, shortly after receiving unqualified audit opinion. In addition, auditors have collected large amounts of money in audit and non-audit fees. These events (inter alia) raise questions about the credibility of external audits, auditor independence, relevance and quality of audit work, and the use of economic incentives for good audits. The dissertation begins by discussing why audits are accused of seeking self interest, especially since the market is dominated by the ‘Big four’ audit firms: PwC, KPMG, Deloitte, Ernst and Young. Secondly the dissertation discusses the criticisms related to the independence of audits. The challenges experienced by auditors in the contemporary business environment are also discussed before giving recommendation on how auditors’ relevance can be improved. It is concluded that auditors did what they supposed to do and amid all these, the financial crisis still happened. Auditing should not merely be binary but must offer more comprehensive, subjective and critical business critical insights into the audited entities. The shared goal of improving auditors’ contribution to prudential regulation can be attained and the relevance of auditors to the market will be improved through collaboration with key stakeholders in the market.

CHAPTER-1: INTRODUCTION

1.1 Motivation and Background

The audit profession has always come under severe criticism after major firms such as Enron have suffered financial bust. Since the recent financial crisis, auditors have been labelled as seeking self interests and useless by some quarters. The heightened scrutiny has certainly caused a stir in the corporate world, as a result, pressure has been mounting on the audit profession to evolve and transform so that it would be of benefit to society. This dissertation will discuss these criticisms against the audit profession and the response by the professionals. The business ethics and compliances are unavoidable aspects for maintaining standard corporate governance. Financial frauds in corporate world weaken markets as shareholders confidence is eroded. In this case, the role played by external auditors is very important. In a discussion paper written by ACCA; “auditors’ main responsibility is to form an opinion on whether the company’s financial statements give a true and fair view” (ACCA Paper F8, 2008, p.106).

1.2 Aims and Objectives

This dissertation aims to analyze the role of the auditor leading up to the financial crisis, by looking into the organizations that failed or were bailed out by government intervention and to judge whether the auditors fulfilled their required role. The dissertation will also try to point out how much, if any, blame can be put on auditors for the recent crisis, the current trend of auditors and some of the changes considered in audit since. The dissertation will to try to answer questions as to how major organizations, especially investment banks had their financial reports published a few months before, showing no sign of what was to come.

1.4 Organisation and structure of the dissertation

The dissertation is structured in a way that firstly; it will discuss the role of auditors in general using the relevant literature, discussing areas importance areas such as the importance of auditors and independence, transparency and the expectations gap, and then compare that to the role of auditors that were involved in financial meltdowns of large corporations which have had major repercussions globally and the most recent Financial Crisis of 2008 starting from Enron and Anderson then to Lehman Brothers and other current cases and trends of auditors. This is done by looking at the looming debate about audit and non-audit fees paid to audit firms and the diversification by audit firms into provision of non-audit services to clients. The main reason for this criticism, an opinion shared by the UK regulator, is that the UK market is dominated by the ‘Big four’ audit firms, PwC, KPMG, Deloitte, Ernst and Young. This domination raises legitimate concerns with regards to innovation and development in the theory and practice of auditing. ‘Independence and objectivity are at the heart of an auditor’s work, and without such principles auditors are useless, especially to investors (Hicks, 2011, para.2). In the past few decades, audit firms have been providing services other than audit, i.e., non audit services with fees generally higher than audit fees, which jeopardise auditor independence and objectivity, leading to strict measures being taken by the APB to improve auditor independence. The dissertation will also discuss how auditors’ role has changed from previous meltdowns and the changes proposed since the recent financial crisis. This paper will then offer recommendations on how auditors’ relevance can be improved before concluding by summing up the important finding of this paper.

1.5 Methodology

According to the nature of the topic, this dissertation will adopt a qualitative research methodology. Qualitative research is meant to develop explanations of social phenomenon; it is primarily concerned with answering questions such as “how” and “why”. Since the dissertation aims to analyze the role of the auditor leading up to the financial crisis, the research methodology that appeals to the achievement of this work was a study on literature in the auditing profession, particularly works written by authors from the UK and abroad: access to online databases, journal articles, discussion papers, and publications from regulatory authorities, newspaper articles and websites.

CHAPTER-2: LITERATURE REVIEW

2.1 Background

When auditors are planning their work, they aim to gather and assess audit evidence so as to form an opinion on the financial statements; during this exercise auditors should carefully consider the risk of material misstatement in financial statements as a result of fraud or error (AUASB, 2008, p. 16). Auditors responsible plan their audits so as to obtain a sensible level of certainty on the existence or nonexistence of material misstatement in the financial statements as a result of fraud and error. Ideally, financial statements are prepared and presented by firms to reflect their heritage. The auditor of these statements has two alternatives: either to give a qualified or non-qualified opinion, or to withdraw from the audit. The auditor must responsibly abide by the auditing standards and should detect any distortions in the financial statements; this is by obtaining reasonable assurance that the materiality of misstatements was or was not observed. On the other hand, the management is responsible for the preparation and presentation of financial statements in accordance to the laid down accounting standards and to provide direction in the prevention and detection of anomalies in the organization and ensuring that the internal control system is functioning properly (Haddrill, 2010, p. 10). The global economy was hit by the global financial and economic recession that affected the financial institutions, enterprises and government budgets.  In such periods auditors have come to face daunting tasks, especially those relating to estimation of risks that are more uncertain and unstable. As a result, auditor liability is significantly augmented in such situations and their credibility called to question.

2.2 The role of external audits

The auditing process of a company involves the verifications of financial and accounting information revealed by an organization. Financial information or financial statements are disclosed by the publicly listed companies for investors and other external users. These financial statements are verified by auditors to measure their accuracy, reliability, transparency and validity before publishing. The responsibilities of auditor include several duties that must be met by them. Firstly, they must verify that the organization has maintained proper accounting records. Secondly, they must tally historical accounting record and financial statements. Thirdly, they must verify that whether the organisation has followed proper legal regulations for disclosing the financial report. Finally, “auditors encourage or assist managers and other internal stakeholders in developing or improving one or more of an organization’s performance management systems or the managing for results processes that depend on them” (Auditor Roles, 2010, p. 15). The financial crisis of 2008 revealed many issues and negligence of many organisations and the regulatory bodies. Many critics have claimed that auditors’ silence and negligence was the one of the major reason for financial crisis of 2008. The collapse of Lehman Brothers was a massive shock for the US economy. The US bank used the ‘repo 105’ that misled the entire market. “Unlike typical repo transactions, Lehman treated Repo 105 transactions as sales for accounting purposes” (Schapiro, 2010, p.6). The banks during the financial crisis failed to identify and to take necessary steps in reducing the liquidity risks. Moreover, many banks hide their poor conditions by disclosing false financial statements. In this case, the auditing firm of Lehman Brother was aware of this fact. The Ernst & Young were the auditors of Lehman’s accounting information and they helped the bank to hide $50bn debt for the market. However, this auditing firm was charged against this professional negligence by regulatory bodies of US (Inman, 2010, p.22). This silence of the auditing firms encouraged the companies to take unnecessary risk through various complex financial instruments like repo 105. In this case, the external financial auditors play a very important role. “The auditors’ main responsibility is to form an opinion on whether the company’s financial statements give a true and fair view” (ACCA Paper F8, 2010, p.106). A useful definition of fraud according to IAS 240, “An intentional act by one or more employees among management, those charged with governance employees or third parties, involving the use of deception to obtain an unjust or illegal advantage” (Gray and Mason, 2008, p.645). The financial auditors are responsible for conducting auditing process to assess the validity and reliability of financial activities and financial statements of organisations.

2.3 Self interest and domination of the ‘big-four’

The audit profession is accused of seeking self interest. The main reason for this criticism, an opinion shared by the UK regulator, is that the UK market is dominated by the ‘Big 4’ audit firms, PwC, KPMG, Deloitte, Ernst and Young. This domination raises legitimate concerns with regards to innovation and developments in the theory and practice of auditing. The Auditing Practise Board (APB) which sets standards on the applicability of the IAS in the UK has a number of its members that are at present or formerly associated with one of the Big 4. This is why the critics believe that auditors act in their own interests with standards and issues regulatory issues. It is argued that APB does not consider small auditing firms when dealing with IAS as well as in other important audit issues (Gray & Manson, 2008, p. 642). In addition, the argument for self interestedness in the auditing profession is where directors are accused of misusing the going concern concept, and auditors have signed off audit reports of deteriorating firms, against ISA 570. They knew that the government would bail these firms out with tax payers’ money, hence misleading the public and investors blowing up to the crisis. The going concern concept, as explained in Gray and Manson (2008, p. 643), requires that financial statements be prepared on the basis that the company is to continue in operational existence for the foreseeable future. For instance, Lord Lawson boldly criticised John Connolly, a senior member of Deloitte & Touché, for signing off Royal Bank of Scotland’s audit reports a few months before it went belly up (Christodoulou, M, 2010, para.2). Another example is the collapse of Lehman Brothers, who paid audit fees of $150m from 2001 to 2008 to Ernst and Young. Lehman Brothers was swept down by the recent financial crisis and Ernst &Young came under heavy scrutiny, they later sued.

According to the UK auditing standards, “auditor’s procedures necessarily involve a consideration of the entity’s ability to continue in operational existence for the foreseeable future. In turn that necessitates consideration of both the current and the possible future circumstances of the business and the environment in which it operates” (Auditing Practices Board, 2004a, p.8). Thus, the manner in which auditors constructed audits in their interest that some of the major banks were a going concern, yet the banks were on the verge of collapse is open to conjecture. On January 28^th 2008, Lehman Brothers received an unqualified audit opinion on its financial statements, accompanied by a green light on the health of its quarterly accounts on July 10^th, 2008. Nonetheless, in the dawn of August 2008 the company was in severe financial problems and was forced to file for bankruptcy on September 14^th, 2008. On January 28^th 2008, Bear Stearns, one of the largest investment banks in America, received an unqualified audit opinion. However, by the 10^th of March the company was all over the news for its financial problems and it was sold to JP Morgan (US Securities Exchange Commission, 2008).

2.4 Auditors’ Independence

The independence of audits has become questionable, especially after the financial crisis. ‘Independence and objectivity are at the heart of an auditor’s work, and without such principles audits are useless, especially to investors (Hicks, 2011, para.3). In the past few decades, audit firms have been providing services other than audit with non audit fees generally higher than audit fees, which jeopardise auditor independence and objectivity, leading to strict measures being taken by the APB to improve auditor’s independence (Auditing Practices Board, 2004a, p. 19). Gray and Manson (2008, p. 641), suggest that the role of auditors has changed from acting in the interests of investors to simply adding credibility to financial statements. Inasmuch as the figures for non audit fees have significantly reduced, because of stricter rules on independence, it still forms a significant part of the earnings of audit firms.

Ernest & Young even issued a document stating that they will customize their activities to suit clients’ needs. This backs the criticism on auditors’ independence (Gray &Manson, 2008, p. 650). In a document by ACCA, a major accounting firm in the UK was reported to have received £30.7m of professional fees over five years; apparently only £1.75m was for audit services (ACCA, 2010, p. 17). In 2010, BP paid Ernest &Young £11m for “other services” (Christodoulou, 2010, para.3).

The 2008 regulations were created to work in parallel with the Auditing Practices Board’s (APB’s) Ethical Standards to ensure that auditors maintain their independence. On 17 December 2010, the review by APB was completed, which has led to the proposition by the Government to revise the classification in the auditing regulations. The House of Commons Treasury Select Committee in its report “The Banking Crisis: Reforming Corporate Governance and Pay in the City also added their recommendations to the review raising  concerns about the fees paid to auditors by clients that they audit for non-audit services offered at the eve of the financial crisis.

The reviewed Ethical Standards require auditors to carefully analyse threats to their independence (this includes the provision of non-audit services) and to take measures that are necessary for safeguarding compromise of their independence.  This implies that in some cases, the auditor is required to refuse to provide some non-audit services or even to turn down the audit appointment, in order to comply with the Ethical Standards. The UK Government also amended the 2008 regulations so as to compel companies to disclosure of fees for non-audit services to associated parties of this nature. It does not intend to make proposals for such amendments. Therefore, the APB’s Ethical Standards have provision for disclosure of important services of this nature to the audit committee (BIS, 2011, p. 3).

2.5 Concerns on the role of audit and transparency

A report tabled by the House of Commons Treasury’s titled “Banking Crisis: Reforming Corporate Governance and Pay in the City” questions the role of audit. In the report, The House of Commons Treasury is “… perturbed that the process results in “tunnel vision”, where the big picture that shareholders want to see is lost in a sea of detail and regulatory disclosures” (Accounting web, (n.d), para.3).  Transparency is another major issue in the contemporary auditing profession. Although financial statements are published on a regular basis it does not tell the whole story. Issues such as the relationship between the auditor and their clients, the communication between board members, auditors and audit committees, and whether the auditors exercise their rights to be independent and objective by carrying out adequate research and tests on the financial statements are not communicate fully. As researched by Venuti et al., (2002, p.4), in the collapse of Enron Corporation, auditors failed to include a going-concern paragraph in its report on the corporation’s financial statements. The case would have been very different in deed. However, auditors’ role is not to predict the future. For that case, failure to issue a going-concern opinion is insufficient evidence of failure of audits, and the mere provision of a going concern opinion does not in itself guarantee assurance.

Auditing standards also require auditors to “perform audit procedures designed to obtain sufficient appropriate audit evidence that all events up to the date of the auditor’s report that may require adjustment of, or disclosure in, the financial statements have been identified“ (Auditing Practices Board, 2004b, p. 3).

In response to the questionability of auditors’ independence and objectivity, finance leaders and committees have suggested that the auditing profession needs to not only to evolve but must transform. This view is shared by Professor Michael Power of the London School of Economics and Jonathan Hayward of Independent Audit. Priddy is in favour of change but highlight there are challenges facing the changes; he posits that auditors acted in the way they were supposed but they should accept changes, changes that are substantial for the profession (Priddy, 2010).

2.6 Expectations gap and the going concern concept

The discussion above leads us to the controversial topic of the ‘expectations gap’. Investors expect auditors to audit firms independently and objectively with the purpose of best serving their interests.  Auditors are expected to abide by laws and standards went conducting an audit but also a moral obligation, not lawful, to society as a whole. The financial crisis has fuelled this agenda to new heights and the role of auditors has become even more questionable. Auditors, on the other hand, argue that their role is not to detect fraud but to give a ‘true and fair view’ of the company. According to Lord Lawson, audit reports of failing companies shortly before the financial crisis did not reflect the ‘threat to insolvency’ hence misleading investors and misusing the going concern guidance (Christodoulou, 2010, p. 3).

The financial crisis has raised some old and new questions regarding auditing practices. Conservatives have often argued that that external audit adds value and credibility to financial statements. This claim is based on the notion that auditors are privy to ‘inside’ information and is therefore able to restrain management’s enthusiasm and report superior information. This claim however is difficult to prove, especially by looking at what the current financial crisis has taught us. From the crisis, it is clear that market and other stakeholders were not reassured by unqualified audit reports issued by major auditing firms. In 2006, the financial statements of Northern Rock, one of the largest mortgage providers in the UK, carried an unqualified audit opinion. However, in July 2007, the bank’s interim accounts received a positive feedback from its reporting accountants. Nevertheless, the bank was on a run during August and September.

Generally, little is known about the credibility that is added to financial statements and at whose behest, particularly because audit evidence is not made “public”. But confidence in auditing has been eroded and this has persuaded users of accounting information to pay no attention to audit assurances (UK House of Commons Treasury Committee, 2008).

2.7 The role of Statutory Audit and the expectations gap

In substance, auditors are supposed to provide an independent opinion as to whether financial statements are a true and fair representation of a firm and are in accordance with increasingly meticulous and prescriptive accounting standards. Ideally, it is the responsibility of directors to ensure that financial statements are prepared to reflect;

• Appropriate and consistent application of accounting policies;
• And judgments made from financial statements are highly subjective, reasonable and prudent (FSA and FRC, March 2010, p. 45).

When an investor inquires about how the company accounts look like would if they were prepared by Auditors, then they should know that they would of course be different.  But accounts prepared by the auditor wouldn’t be independently audited.  The question is who would audit the auditors’ assumptions and critical judgements? In this case, auditors will have assumed the role of management.   Back to fundamentals, the existence of an audit is precisely to remain independent and objective.  If an Audit didn’t exist in the first place, then it would have to be invented anyway (Giang, 2010, p.6).

Nevertheless, the substance of a statutory audit opinion has remained unscathed for over a century, while the market is increasingly changing.   It cannot be clearer that markets have become increasingly complex and that stakeholders’ demands have not only increased but have become more sophisticated.  This is a time whereby the need for real assurance has never been greater.  On the contrary, the audit profession has been using 20^th century tactics against 21^st century market demands and risks. Auditors are expected to do more, and they can do more, nevertheless these expectations have to be realistic (Giang, 2010, p. 8).  It is rather naïve to imagine that an individual audit of entities’ financial statements would have identified the looming global financial crisis and its impacts. If this was so then we would to be where we are today (Izza, 2010, p.16). The financial catastrophe came as a result of complex and multiple factors over a long period of time. In fact, most of the big collapses were as a result of bad managerial decisions and not about fraud or even misappropriation of assets. Failure to appreciate the assumed risks at board level and static business models among other factors slowly mounted the crisis (Izza, 2010, p.16).  But none of these factors were picked up by conventional accounting until after the crisis. And this is one of the reasons why auditors did not do much to contribute to the anticipation and mitigation of the crisis (Financial Services Authority, 2010, p. 12).

As a result, the “expectation gap” has become bigger (Giang, 2010, p. 6).  Time has come for auditors to acknowledge this gap; they have to admit that this gap is not going away and even of more importance embrace it as an opportunity to make radically constructive changes. But the expectations gap is mistakably assumed to refer only to the role of auditors yet more broadly it includes the role of: non-executive directors, audit and risk committees, and internal audit.  All these form the reporting framework responsible for corporate governance. If auditors cooperate with other market participants including those in charge of corporate governance, the expectations gap can be narrowed as a result of an expanded scope of their work. Auditors have got the skill set and wherewithal to close this gap. As a matter of fact, auditors are well placed in a unique and privileged position to positively contribute to the financial stability of markets and it would be farce not to seize this timely opportunity (Hassink, 2009, p. 86).

The quality of audits and the people attracted to the profession is a public concern.
A study by ICAEW has indicated that 84 percent of the FTSE 100 boards consist of an Institute member, and most of the other members serve in key roles in the financial sector, including the audit regulatory body.   Most of the surveys conducted in the market generally support the need for audits and have expressed confidence in audits.  Some of these studies including:

• A study by the University of Maastricht in 2009 (after the financial crisis) indicated that “auditors’ work is valuable as it increases the confidence in and reliance on financial statements.”
• In a recent review by the Audit Inspection Unit,  the government body responsible for reviewing auditors, concluded that audit quality in the United Kingdom was “fundamentally sound”
• The Treasury Select Committee and FSA have also recognised the value of auditors work amid the constraints they operate in.

The fact is auditors have not been criticised in substance, instead they are being criticised for not doing something different, i.e. they have not been able to adapt to the ever changing market environment (HM Treasury, 2010, p. 14).

CHAPTER-3: FINDINGS AND DISCUSSION

3.1 Change is as good as rest

Auditors believe that they have to be close to their clients in order to conduct a competent audit. They have also responded to the lack of independence by accepting the principle of rotation, having a second auditor checking decisions and the procedure of rigorous quality control. There has always been criticism towards auditing practise. However, the financial crisis has brought the debate of audit to the forefront.

ACCA global believes that the role of auditing should be expanded to include risk management, controls, business modelling and financial management to improve the transparency in auditing that is being called out in these difficult times. Gray and Mason (2008, p. 642) argued that auditing regulatory bodies should include non- accountants as members to enhance public confidence. Auditors can also assist affected local companies, especially if one company goes under (ACCA, 2010). Pertinent questions on the value of audit to society have been raised lately. Research into the value of audit carried out by FRC, Ipsos, Mori, University of Maastricht, and ICGN indicate that audit has a vital role in serving the society. The profession has accepted that it has to make changes in order to tackle the issues and to silence its critics and in doing so public interest has to be at the vanguard of any potential changes (Izza, 2010, p.16).

Inasmuch as the auditing profession is gracefully evolving, auditors are not willing or ready to make radical changes. Michel Barnier has suggested a number of changes that should be implemented in the auditing profession. These changes include; putting a cap on total market share of large firms, conducting joint audits (one of the Big 4 with another firm), and having wide choice of firms.  In addition, improving independence can be done by restricting audit and non audit work, rotation of auditors, regular competitive tendering and a greater role for companies audit committees in selecting audit firms are too radical (Tait, & Jones, A, 2011).

John Connolly of Deloitte wrote a letter to the Prime Minister expressing his concern over potential radical changes proposed by Michel Barnier and asked him to ‘lead the debate’ against the heavy handed proposals. Steve Maslin, who won the Accountancy Age Personality Award, has continuously backed auditors in these troubled times but admits a need for change. His proposal includes; improvement in communication between auditors and audit committees, as well as opening communication line to investors to allow them to access the information they need without undermining auditors’ ability. Steve Maslin posited that audit makes companies account for their statements and that it comforts shareholders. Steve also argues that auditing has important ‘by-products’ such as deterring of fraud, ensures that companies are disciplined and comforting of shareholders on the basis of going concern. Fraud according to IAS 240, is defined as “An intentional act by one or more employees among management, those charged with governance employees or third parties, involving the use of deception to obtain an unjust or illegal advantage” (Gray and Mason, 2008, p.645). Auditors are responsible for conducting auditing process to assess the validity and reliability of financial activities and financial statements of organisations. In this respect, auditors’ negligence may produce very serious issues like a financial crisis. Many critics believe that due to the auditors’ negligence, the financial crisis of 2008 was exacerbated.

In defence, auditors argue that the financial crisis came as a surprise and they were ill prepared to make opinions about the occurrence of the financial distress. This argument is difficult to back up. Ferguson (2008) argues that financial capitalism has for a long time been in ascendancy and has significantly contributed to the banking crises in various countries including Latin America (Collyns & Kincaid, 2003), Sweden and Japan (Basel Committee on Banking Supervision. 2004). In the UK, the collapse of Bank of Credit and Commerce International (BCCI) was historical as it was the biggest banking failure of the 21^st century (Arnold & Sikka, 2001). The US also experienced a financial crisis earlier on (Lowy, 1991). In addition, the US Office of Federal Housing Enterprise Oversight (2006) indicated that Fannie Mae has a history of accounting and auditing issues. These scenarios among others have highlighted issues on corporate earning, capital shifting, disproportionate leverage and demises of traditional auditing technologies. In spite of all these, regulators have paid little (if any) attention to ever changing capitalists markets and other emerging issues (Sikka et al., 2007). It would be of great significance to look at the lessons that the recent crisis and changes in the context capitalism have taught us.

In a publication titled ‘the Audit Quality Framework (February 2008)’, the Financial Reporting Council emphasized the need for improving audit quality. After extensive consultation on promoting of audit quality, the recent framework is intended to complement existing regulations and guidelines for the promotion of audit quality through the following key drivers:

• “The culture within an audit firm;
• The skills and personal qualities of audit partners and staff”;
• The effectiveness of the audit process”;
• The reliability and usefulness of audit reporting; and”
• Factors outside the control of auditors affecting audit quality” (Financial Reporting Council, 2008, p.5).

3.2 The relevance of audit today

A defining moment has come for the audit profession to embrace change, at a juncture whereby the value of an audit has come under increased scrutiny and criticism.  Auditors are at the crossroads.  The Treasury Select Committee has questioned the significance of conducting extensive and all the time more elaborate audits, when individual audits have been unsuccessful-they have not identified exorbitant and systemic risks which almost sank the Global banking system. More recently, the FSA and FRC issued a discussion paper on the contribution of Auditors to prudential regulation ((FSA and FRC, March 2010, p. 15).  The discussion paper highlighted, amongst a myriad of issues, the need for auditors to challenge management more and queried whether the auditor had been satisfactorily unconvinced.  Some observers have even called out for the abolishment of external audit, but there is even more in the pipeline. This autumn, the European Commission will be launching a Green Paper that will be discussing the role of auditors.  Commissioner Michel Barnier expressed that, though the role of key economic and financial entities had been scrutinized, the role of auditors had not been called into question.  In the UK, there is going to be a Vickers review (Forsyth, 2011, para.3). It is apparent that regulatory bodies are not going to bury their heads in the sand, the system failed and therefore no aspect of the global financial market will ever be the same again. The financial crisis exposed deep-seated weaknesses in the prudential regulation and supervision (micro and macro) of financial institutions (Christodoulou, 2009, p.1).  Change is a must. The audit profession must get hold of this opportunity to implement positive changes to maximise the value of audit and its significant role in protecting the financial system (Christodoulou, 2009, p.1). However, if the audit profession continues to respond in the same it has done in the past, there is real risk that it will become irrelevant to an increasingly challenging and dynamic market (Timmins, 2011, p.3).  The crisis has taught us the importance of reliability and veracity of audits, the need for real assurance on the inherently backward looking financial statements. The earlier the choices are made today; the better will be the future perception on the value of audits.  This is challenging and audit professions must look forward to these changes, they will have to be confident (Inman, 2010, p. 23).

3.3 The changing audit environment
In order to move forward, it is imperative to understand the environment within which auditors operate.  This dissertation will discuss three major themes with regards to the changing audit environment.

FIRSTLY, the environment within which auditors operate is highly litigious, where the delicate balance of risk and reward has created a world of caveats.  The auditor invariably carries the risk of being sued as a result of corporate failure or financial loss suffered as a result of failed audits. This is the characteristic “deep pocket” focussed litigation which disregards the balance of responsibility between auditor and management.  Actually it is unfair, and is a subject of much debate and lobbying in the profession (Hegarty, Gielen, & Barros, 2004, p. 32).

SECONDLY, the audit profession has experienced a cultural challenge.  However, the response to past corporate failures has remained invariant.  Auditors’ independence has been controversial, their objectivity criticised, and ethical behaviour called into question.  The profession ought to appreciate and embrace the need for scrutiny and regulation.  Nonetheless, the continued tightening of the same screws is not going to yield results.  We cannot do things in the same way and expect change.  Now this takes us back to an earlier observation made in the FRC/FSA discussion paper where auditors’ professional conduct has been called into doubt.  Quite frankly, it is unacceptable to leave the issue unabated. Auditors’ professional scepticism is a central part of their profession and remains one of their core distinctions and strengths (Sanderson, 2010, p.29). We may not be sure of the number of external quality control reviews that are undertaken by the big four audit firms, but the fact remains that the profession ought to conduct itself with more responsibility. However, folks outside the audit profession have continued to hold the ‘we don’t trust you’ attitude towards auditors. This is where the danger lies in this premise from which this debate is positioned. In such an environment where criticism towards the profession is mounting, it is not surprising that some of the sharper criticisms of auditors have accused them of being mere box tickers and observance officers.  Such negative criticism could rebuff talented people from joining or even remaining the profession.   Consequently, everyone will lose (ACCA, 2008, p. 143).

THIRDLY, a very simple but important point – financial institutions are unique.  They have their own regulations and are the heartbeat of any successfully operated domestic and global market.  Most people have argued that financial institutions have developed into big and complex entities from both product and system point of view.  This is why it is hard and complex to regulate and even harder to audit such institutions. The discussion paper presented by FRC/FSA posits that disclosures of major financial institutions are “by their nature, somewhat opaque” (KPMG, 2010, para.11).  Big international banks are customarily managed on a very dissimilar basis from the way they are legally structured.   Most of them have several legal entities located in a number of countries with many offshore centres.  Therefore, it is only legal entities that really exist. As Mervyn King put it, “major financial institutions live globally and die nationally”, something that we have all painfully experienced with the death of Lehman Brothers. Self-governing legal systems across the globe were never designed to accommodate the enormity and complexity of giant financial institutions which, fairly logical, arbitrage the legal, tax and capital environment to pursue profit and capital efficiency.  Consequently giant financial institutions engage in countless intercompany transactions, each carrying an aspect of legal significance, which for some of these entities account for higher volumes than any peripheral counterparty. In order for financial institutions to be regulated and audited more successfully, a higher level of convergence has to be attained between the way they are structured, and the way these institutions conduct their risk taking activities.   Currently, “living wills” proposals are being written to come up with comprehensive revitalization and resolution plans for institutions so as to provide the required framework that will simplify structures of financial institutions and foster accountability.

3.4 The Quality of Audits in the Financial Sector

Most of the studies on the causes of the crisis have emphasized on issues like excessive leveraging, poor business models and risk management strategies, weak regulatory framework and oversight, and lack of competition. Therefore, this crisis is not in any way comparable to previous crises since the dawn of this century, where fraudulent accounting and poor audits were major contributors. However, the shortcomings have been identified in audits of the big four firms. Inasmuch as auditing or accounting was not main causes of the crisis, it resulted in the establishment of independent watch committees to oversee auditing practices in many countries. In 2009, AFM identified shortcomings in 11 of the audits performed by these firms. This crisis can be associated to the bursting of the dotcom bubble. Most of the shortcomings were related to insufficient audit evidence, especially on financial assets. A major issue highlighted was that external auditors failed to sufficiently apply the required professional scepticism. Professional scepticism is where amongst various issues, the auditor is required to critically assess the value of evidence that does not agree with, or raises questions regarding, the reliability of information and supporting documents obtained from client management. Besides professional scepticism, there were important findings regarding auditing of:

ü  valuation of financial assets;

ü  disclosures on uncertainties especially on creative accounting (fair value principle);

ü  Documentation; and

ü  Role of the group auditor.

The issues highlighted above are consistent with empirical studies by Huizinga and Laeven (2010, p. 16)  which indicate that write-downs of complex financial instruments on banks’ balance sheets were rather lagged relative to plummeting credit indices and share prices. Another study by Vyas (2009) agrees with that of Huizinga and Laeven (2010, p. 16). Globally, the mandate of auditors of financial institutions is not restricted to the provision of assurance on the financial statements. Quite often, the auditor has also a role regarding the banking regulator. For example, in the EU the auditor is required to alert the relevant authorities when they become aware of facts that might have a destructive effect on the financial health of an entity. With regard to this role, the European Commission has lately admitted that this requirement has not been effectively implemented.

3.5 The Regulatory Response

A number of regulatory responses that have an impact on auditing have been proposed in most countries.  These responses can be well understood by looking at specific effects of the increasing attention for accounting and auditing professions, particularly from regulators of financial institutions and governments.

There have been calls for accountants to reduce the use of fair values and the need for accounting standards to give more attention to prudential objectives. Hence, increasing the value of financial statements for regulators of financial institutions would be boosted. On the auditing side calls have been expressed to broaden the role of auditors, especially with regard to the risks management, controls, and scrutiny of financial institutions. The primary objective of financial reporting is, and ought to be, providing credibility and transparency on financial performance of an entity to investors and the general public. Without credibility, investors’ confidence in financial reporting will be lost. Nevertheless, while credibility and transparency serve the prudential objective, an exceptional case is where the financial condition of a financial institution is are very poor. A disclosure on such might initiate a panic run. This might cause a stand-off to the auditor since, transparency and prudential objectives are mixed in financial reporting. A study by Skinner (2008) on the financial crisis in Japan in the 90s is a good explanation of this risk. During that crisis, a number of changes in accounting standards were motivated by prudential aspirations. Accounting changes allowed financial institutions to superficially increase their regulatory capital and to hide their enormously poor financial position. Such banks delayed their restructuring, and had high incentives to continue giving credit to struggling companies. This practice has had a long lasting systematic negative impact on the Japanese economy, even prolonging the Japanese financial crisis.

With regard to the call for auditors to broaden their roles to cover risks management, controls, and scrutiny of financial institutions; auditing of firms will be a tall order and auditors will still have a way to escape. In order for audits to be reliable it is fundamental that they should contribute to transparency, both in good and bad times. Therefore, an auditor should at least strive for transparency, even when it touches on the client’s viability. The evidence that failures of financial institutions have been witnessed without going concern opinions confirms that auditors are deliberately reluctant to openly report serious financial problems of their clients. Regulatory proposals that will witness the sharing of important information with prudential regulators and the supervisory board, but not with investors, can go a long way in enhancing the relevance and reliability of financial statements.

CHAPTER-4: RECOMMENDATIONS

This dissertation has outlined a few of the challenges experienced by auditors in the contemporary business environment. But the question remains, how can auditors’ relevance be improved?  Three ideas that could see better use of auditing skills (that are at present trapped and under-used) are presented with an aim of ensuring that auditors provide real assurance.

FIRSTLY, it is important to broadly and objectively look at the effectiveness of financial institutions boards, the structure and effectiveness of monitoring authorities, and the quality of management of key financial institutions risks.  Auditors should work hand in hand with regulators, and those that are in charge of corporate governance, to design a common framework that will govern the creation of audit reports that are concise, reliable and effective.  From such a collaboration, a binding report could then be issued to audit committees and to regulators in line with the needs of stakeholders.  This very framework should be built on ethics, working against the risk of being too dictatorial and being litigated.  Essentially, audit reports need to express, without fear, what the auditors think in a brief, comprehensible and consistent manner. In fact, though debatable, there are merits of making such a report “public”. Actually, some of this practices are already in the market, a good example is the SoX regime in the US.  Nonetheless, what this dissertation is backing is far from a subjective and thematic approach that most believe to be mere box ticking and observing. For instance, auditors could work devotedly with stakeholders to design a report that more than contrarian and forward looking, but a report that will give a situational based view of risk (FRC, 2011, p.4). Key stakeholders such as investors, creditors and account depositors could do better with understanding the inherent risk in any financial institution-from liquidity risk through credit risk, systematic risk and operational risk which are the most challenging to quantify (Sukhraj, 2010, p.22).An independent voice raising comments on the risks of an institution is a valuable form of assurance that is likely to be gracefully welcomed by stakeholders (FSA, 2010, p.27).

SECONDLY, from a prudential point of view, auditors need to come out of the silos.   This is whereby Auditors and regulators together with those responsible for corporate governance will work much more as partners, breaking the notion that they (auditors) are under surveillance.  By combination the FSA prudential reporting with the intervallic insights of the audit, stakeholders can be sure to get what they need, comprehensive assurance (FSA, 2010, p.19). Furthermore, there is also need of developing an oversight team in charge of potential bubbles and auditors should be part of this team. In order to point out and mitigate the effects of systemic risks there is a crucial need to solve a complex set of puzzles.  The existing overlap between the audit process and regulatory compliance is patently obvious, and there is a colossal coincidence of interest in ensuring that the investment world is safe for both depositors and investors (FRC, 2011, p.3).  A very excellent move could provide a mechanism for this recommendation to happen would be the integration of the FSA into the Bank of England.

FINALLY, institutional changes need to be made to push for a broader, more concerted and subjective framework of financial reporting (FRC, 2011, p.6). Continuing to premise on the wide held public perspective that auditors “are not to be trusted” and tightening the same old screws, then the end result will be an ugly process of typical box tickers.  One gets only that which they can measure. Such a trend may imply that the role of external audit may as well be transferred to the government. The consequences of such an action are left to pondering.  The legal environment must also be radically reformed; this will help in re-balancing the risk-reward relationship of auditors’ work.  Legal reforms will ensure that there is proportional liability.  Inasmuch as this recommendation is subject to debate and some opponents are gnashing their teeth that this could cheer auditors to get away with murder. It is a fact that, auditors are professionals who are extremely aware of risk management together with its consequences.  One has to look at what conspired after a great firm like Arthur Andersons after its audit of Enron backfired. The industry has now been left with only big four firms and is severely berated for a lack of competition.  An even more grave concern is what may happen if the industry ends up with only three firms. There have been good and bad rewards for failure; some of the main characters of the crisis have moved on to other financial institutions and hedge funds and they continue to practice in the market.  On the other hand, rating agencies have remained unscathed.  The asymmetry of the risk reward relationship has also impaired auditors’ ability to provide comprehensive observations. This dissertation supposes that these three recommendations, as presented above would be of valuable significance to the evolving regulatory landscape which is now increasingly monitoring the financial system in multiple ways.  These perspectives are offered in a view that by operating alone the value of audits is diminished.

CHAPTER-5: CONCLUSION

Genuinely, it can be argued that (based on the existing framework and evidence), auditors did what we were required to do and amid all these, the financial crisis still happened. The issue here is that auditors, along with regulators and pundits, have to be open to partnership. This will help in the pointing out of risks and bubbles; a consensus is likely to be reached if ‘scapegoating’ is avoided. As a matter of fact, everyone must accept responsibility with the self-assured predicated blind wisdom on the classical belief that markets are seamlessly self correcting by nature.  In this sense auditors and other stakeholders were not sceptical enough. Consider a case of HSBC in 2006. The financial institution was accused of having too much capital and a low ROE. Just like other previous bubbles, those responsible only move in to connect the dots after the burst.  This crisis should make the corporate world and regulatory bodies to be wiser. As a matter of fact, not everyone was blind to the looming crisis, some few experts saw it coming, but they were not sure of the timing. Alan Greenspan in 1996 talked about irrational exuberance, a decade before the crisis occurred! At the height of this dissertation the question of how relevant is the audit in financial institutions was posed.   According to the researched evidence, the independence of audit is absolutely essential.  Nonetheless, if auditors want to be more significant they must not only evolve but should also keep up with the pace at which markets are changing. Auditors should not merely be binary and must start to offer more comprehensive, subjective and critical business critical insights into the entities they audit. The success of auditors should not only be defined by the absence of failure.  As a result, the shared goal of improving auditors’ contribution to prudential regulation will be attained and the relevance of auditors to the market will be improved. There is an irresistible urgency for all stakeholders to come together. The crisis has done a ‘good’ job of illuminating serious weaknesses of the financial system and has provided the market with an excellent opportunity to contribute in a comprehensive and much more important and relevant way than as it has been in the past.   There is confidence that auditing as a profession has the quality, the experience and wherewithal to grab this opportunity and play a major role in providing real 21^st century audit assurance.

 

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