Auditing and economic markets - (15.02.02)

Since the collapse of Enron there has been much debate of how far firms of auditors are responsible for what in effect is really an economic failure of a company. The role of auditors is to provide shareholders with information on how likely such an economic collapse is, not to prevent it themselves. It is perhaps of equal importance to maintain the independence of non-executive directors and to ensure they have access to the information required to make a judgement about the management of a firm on a day-to-day basis rather than once a year. As the Chartered Institute of Management Accountants pointed out this week, it is the primary responsibility of company directors to protect shareholders interests rather than auditors, who are there merely to try and ensure transparency.

In principle there are three types of market for financial information of a company that require it for efficient economic operation - The stock market, the executive job market and the free market (through the competition regulation authorities). The focus of auditors at the current time focuses exclusively on the stock market and hardly touches the other two.'s recommendation to resolve this would therefore require an independent statutory audit of major companies only measuring executive performance and competition issues in the public interest.

Much of the focus on the audit firms so far has been on splitting the firms into seperate audit and consultancy businesses. This would seem unlikely to make much difference on the whole to audit operations and effectiveness. Mid-sized firms seem most to be at risk from undesirable accounting policies from an economic information point of view. Evidence for this can be seen that firms audited by PricewaterhouseCoopers have had decisions held against them by the UK Financial Reporting Review Panel more times than firms audited by other top ten audit firms put together (source: Company Reporting). PWC's dominance of audit fee rather than consultancy income in these mid sized plc's is no coincidence in this statistic. Instead a maximum audit term of 3 years with any one single audit firm should become a stock exchange listing rule. Similarly rules should specifically forbid the statutory auditor also carrying out internal audit work for that firm, although other consultancy such as taxation work should not be restricted.

More important to this would be enhanced shareholder control over firms. Perhaps it is time to remove shareholder control from city institutions and pension fund managers to the indirect shareholders of a firm, those future pensioners who are paying into these funds. If devolved shareholder control could be attributed to these indirect shareholders and the city institutions were legally obliged to act on their collective wishes then corporate control would vastly improve, particularly in terms of non-executive performance and top executive renumeration. Direct shareholder voting over pay and political donations should be considered as a priority.

Another proposal of is to create two varieties of non-executive directors, who should be equally balanced on company boards. The first type as now would be recommended by the executive directors of the firm, the second type being elected by shareholders for fixed 3 year terms.

Other new rules to be recommended are to prevent auditors accepting jobs with firms they have audited for a minimum of 3 years. Accounting standards should also contain more specific standard practice rules where extensive disclosure is required and evaluated in the accounts if these are not met. The excuse often used that the standard is not meaningful to a particular business may often be valid, but providing the information for others to also reach this judgement would back this up.

Perhaps most importantly annual reports should automatically include the presentations that firms make to city analysts when they release their results. These invariably provide a much better picture of a company than an audited annual report ever will. The best practice companies already make these presentations availble in the investor relations sections of their web sites.