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Practice governance: guarding against familiarity and misplaced trust

Practice governance: guarding against familiarity and misplaced trust

As South Africa continues to fight its way through the economic challenges posed by COVID-19, it is important that the financial market system is seen to be stable and trustworthy in order to attract investments. Providers of capital need to have confidence in the quality and reliability of the financial information produced by entities. The auditing function is crucial in ensuring that there is trust in the financial markets and confidence in the quality and reliability of the financial information produced, writes Thandokuhle Myoli, SAICA Project Director for Audit & Assurance.

The recent corporate failures have eroded trust and confidence in South Africa’s financial reporting system. While these failures may not have been caused by the auditors, the question often asked is, “where were the auditors?” This question reflects the public’s perception about the importance of the auditing profession.

The Auditing Profession

A profession may be described as an occupation whose practitioners must master a specialised body of knowledge, satisfy formal admission requirements, adhere to a code of ethics, and serve the public. The element of public interest is what distinguishes a profession from a business, and once professionals accept this public duty, society grants professionals the right to perform certain exclusive services. For example, only licensed medical practitioners may prescribe medication provided that they accept the public expectation to heal the sick; only registered legal practitioners may practice law provided that they accept the public expectation to promote justice and; only registered auditors may sign auditor’s reports provided that they accept the public expectation to enhance the credibility of financial information.

In this regard, criticism of the auditing profession by the public should not be an unjust attack. Rather, it is an ongoing dialogue between the public and the profession on how their needs and expectations from auditors are evolving with time. The impact of advancements in technology, a complex business environment and expanding stakeholder groups that use the auditor’s report add fuel to the fire.

SAICA, as part of its Audit Reform project, consulted with various stakeholders to understand some of the causes of the reputational crisis in the auditing profession. Various stakeholders cited the issues of the auditor’s over-familiarity with the entity and misplaced trust in those responsible for the management of the audited entity as possible causes. This is deeply concerning given that independence is the cornerstone of the profession.  Former US Supreme Court Justice, Warren Burger, once stated, “Public faith in the reliability of a corporation’s financial statements depends upon the public perception of the outside auditor as an independent professional. If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.”

Independence, however, is an unobservable state of mind and mental attitude that is impossible to measure and regulate. Independence requires that the auditor must always remain objective, impartial, without bias and should not be affected by self-interest. The following are some of the issues that could possibly cloud an auditor’s independence:

(a) Providing non-assurance services to audit clients

Provision of non-audit related services to audit clients may impair the independence of the auditor. Firstly, the revenue from the non-assurance services may potentially create a conflict of interest. Secondly, assurance and advisory services require different mindsets. Assurance services require that the auditor applies professional scepticism and act in the best interests of the public while advisory services require that the advisor becomes an ally of management and act in a way that promotes the interests of the entity. Whether both these mindsets can co-exist is a matter of contention. Some proponents argue that such advisory services improve audit quality by giving the auditors a better understanding of the client’s operations. Others argue that the provision advisory service could erode the auditor’s independence in appearance, which is defined in the SAICA Code of Professional Conduct (Revised November 2020) as, “the avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that a firm’s, or an audit or assurance team member’s, integrity, objectivity or professional scepticism has been compromised.”

In this regard, it is interesting to note that on 15 February 2021, KPMG announced their decision to cease performing non-audit related services to its JSE-listed audit clients with effect from 31 March 2021. One of the reasons given was to seek to improve the perception of auditor independence and protect the interests of the public.

(b) Audit clients appointing and paying their own auditors

In South Africa, apart from public sector audits, auditors are appointed and paid by the same entities whose financial statements they audit. Significant audit fees from audit clients may result in situations where these entities wield significant economic power over their auditors. Firms may have safeguards for ensuring that no single audit client represents a significant portion of the firm’s total revenue, however, the importance of a single client to an individual partner may be too significant. This will have even greater impact for audit firms that incentivise partners based on client profiles. This may create strong incentives for the partners to maintain good relationships with large and financially rewarding clients.

In addition, the current model could potentially lead to pricing inconsistencies in the audit market as auditors may use pricing to outbid competitors. This could have a detrimental effect to audit quality. It is evident that there is a need to conduct research on the current fee model to establish whether it is conducive to create the required level of independence for the auditor.

(c) Audit staff accepting jobs from audit clients

The luring of former auditors to occupy key financial positions, including audit committee positions in audited entities has been raised as one of the causes of familiarity and misplaced trust by the auditors. This could affect the independence of the auditors as audit staff would be more preoccupied with impressing potential employers rather than applying professional scepticism. Furthermore, where a former auditor now occupies a key financial position at a client, the auditor may not apply the necessary professional scepticism due to familiarity with a former colleague. The impact of alumni relations may impair the independence of the auditor and should be monitored closely by the firms.

In Concluding

The risks of familiarity highlighted above increase the need for strong oversight functions at both overall firm level as well as at audit engagement level. Guidance may be drawn from the principles of King IV Code on Corporate Governance which has as one of its principles that, “the governing body should comprise the appropriate balance of knowledge, skills, experience, diversity and independence for it to discharge its governance role and responsibilities objectively and effectively.”

In addition, the new Quality Management standards that have been approved for adoption in South Africa by the Independent Regulatory Board for Auditors (IRBA) will compel firms to review their current processes and procedures that relate to how audit quality is managed at both firm and engagement level, including the important role of engagement quality reviewers.

In considering the need to make changes required to enhance independence, auditors should always have in the forefront of their minds, the primary reason for the existence of the profession: serving the public interest.