The Role of the Independent Auditor as a Pillar of Good Corporate Governance

INTRODUCTION

China’s Ministry of Finance on 13th September 2024 imposed severe penalties on PricewaterhouseCoopers China (PWC China) for financial reporting misconduct involving Hengda Real Estate, a subsidiary of Evergrande Group, PWC’S audit client. PWC China was issued a $62 million fine and a six-month operational suspension for its role in window-dressing Evergrande’s financial statements for the years 2018 – 2020.

In most corporate failures, poor audit practices have consistently stood out as a key contributory factor, from the various corporate scandals that rocked the United Kingdom in the early 1990s, to Enron’s bankruptcy in the United States in 2001, and now the Evergrande crises in China. External auditors have been frequently identified for their role in aiding and abetting financial reporting malpractices.

Nigeria has experienced its share of corporate failures, ranging from the Cadbury Scandal of 2006 to the banking sector crises which plagued the nation between 2008 through 2011, and more recently, the Oando financial management crises. A common factor in many of these failures has been poor financial reporting and inefficient auditing. This highlights the essence of the external auditor in safeguarding the financial health of companies, bolstering the integrity of the stock exchange, and maintaining economic stability.

In a bid to strengthen Nigeria’s corporate eco-system, several regulations and sectoral codes have introduced provisions aimed at enhancing auditor independence. Accordingly, this article explores the role of auditor independence as a hallmark of good corporate governance.

ROLE OF THE EXTERNAL AUDITOR

• Review of Internal Control Systems: It is the responsibility of the external auditor to review the internal control systems within the audited company. This involves an appraisal of the corporate culture, board structure and management oversight, including adopted systems and procedures for the safeguard of the company’s assets and finances. The auditor conducts a careful assessment of the risk management policies, as well as the information and communication framework of the company, vis-a-vis the effectiveness of the company’s administrative, physical and technical control measures.
• Audit of the Financial Statements: Another fundamental duty of the external auditor is auditing of the company’s financial statements. This activity involves the evaluation of the appropriateness of the accounting policies utilized by the company. The financial statements are critically scrutinized for any material misstatements or concealments.Upon conclusion of the audit exercise, the auditor issues an opinion in his report. Depending on the facts, circumstances and outcome of the audit, the auditor’s opinion may take any of the following four forms:

1. Unqualified opinion – also known as a clean opinion, it indicates that the financial statements of the company under review is a fair representation of the affairs of the company and have been properly prepared in accordance with applicable accounting standards. It is a positive opinion and is issued where the auditor has no reservations or concerns about the financial statements.
2. Qualified opinion – This is an opinion stating that the financial statements of the company fairly represent the company’s financial position, except for a particular matter of concern.
3. Adverse opinion – This is essentially a bad report expressing that the financial statements are unreliable. It is issued in instances where there has been fraud or other illegality, non-compliance with applicable standards, and weak internal controls.
4. Disclaimer of opinion – issued where the auditor is unable to form an opinion on the financial statements. This to a number of reasons such as unavailability of information, lack of auditor independence, and so on.

NEED FOR AUDITOR INDEPENDENCE

The law mandates company directors to prepare financial statements annually. These financial statements serve both regulatory and business functions. From a regulatory perspective, financial statements are statutorily required for record purposes, evidencing that a company is a going concern while also determining the company’s tax liabilities. On the business side, financial statements assist investors and creditors in assessing a company’s viability and creditworthiness. It is not uncommon for directors to adopt accounting policies aimed at achieving certain objectives. For instance, profits may be concealed and losses exaggerated, so as to reduce tax obligations. On the other hand, directors may inflate profits in order to attract investors.

The need to check, vet and scrutinize the financial statements prepared by the directors necessitated the statutory duty of auditors to examine the statements of financial position, profit and loss account, and other components of the financial statements and form an independent opinion on the veracity thereof.

The auditor’s role requires independence and objectivity in order to ensure that their work is free from the influence of company directors. The auditor is expected to remain independent throughout his tenure as auditor. This is why individuals with close ties to the company such as officers of the company, employees, shareholders, secretaries or spouses of shareholders or officers of the company are not permitted to be appointed as auditor for that company. An auditor must not be unduly attached to a company in such a manner as to impair his independence, and all insiders, officers and directors of the company are prohibited from influencing the auditor in any manner.

FACTORS THAT THREATEN AUDITOR INDEPENDENCE AND OBJECTIVITY

1. Self-interest threat: Here, the auditor’s independence is jeopardized by the financial and other benefits he stands to gain from the company he is auditing.
2. Self-review threat: This arises where auditors review work that has been done by them or related parties. The chances of bias are high, thereby reducing objectivity.
3. Advocacy threat: Threats that arise as a result of auditors or others in their firm advocating for or against a company under audit instead of acting as an unbiased assessor of the company’s financial statements. This threat may be present where the auditors do other non-audit work for the company they are auditing.
4. Familiarity threat: Threats that arise as a result of close relationships between the auditor and company under audit. Long-standing professional or personal relationships are instances of familiarity threats.
5. Intimidation threat: Overt or covert coercion of the auditors by the directors and other interested parties. Such threat may arise where an audit firm is threatened with disengagement for not adopting certain strategies or giving certain opinions.

SAFEGUARDS FOR EXTERNAL AUDITOR’S INDEPENDENCE

Constitution of a Formidable Audit Committee

An audit committee is both a core corporate governance recommendation and a statutorily required obligation for all companies. It is crucial for the audit committee to be formidably composed with members sufficiently equipped with requisite skill, experience and financial literacy.

The audit committee can either be a statutory audit committee, as prescribed by statute, composed of both non-executive directors and company members or board audit committee, as recommended by applicable codes of corporate governance and composed solely of non-executive directors. While the board and statutory audit committees may exist independently or jointly, the committee’s core mandate includes reviewing, monitoring, and enhancing the independence of the external auditor.

Implementation of Audit Firm and Audit Partner Rotation

Audit firm rotation and audit partner rotation is a key safeguard necessary for eliminating the familiarity threat. Audit firm rotation is the practice of periodically changing a company’s external auditors in order to enhance and sustain auditor independence.

Audit partner rotation is the practice whereby the audit firm changes its lead audit partner deployed to an audit client after a specific period of time. The FRCN Audit Regulations 2020 provides that audit firms shall disengage after continuous service to a public interest company for ten years while a joint audit arrangement shall not exceed fifteen years.

For audit partner rotation, a maximum period of five years is stipulated for audit firms to rotate the Engagement Partners assigned to undertake the external audit of the public interest companies.

Compliance with Regulations Governing Engagement of Auditors for Non-Audit Work

After the Enron collapse in the United States, it was discovered that part of the threats to auditor independence was due to the fact that, in addition to audit work, auditors were rendering non-audit services to their audit clients, thereby impairing auditor independence. To address this issue, audit firms were prohibited from providing non-audit work to their audit clients, Asides tax consultancy services, all other non-audit services such as book-keeping, brokerage, valuation, accounting, actuarial services, and many more were prohibited for audit firms.

In Nigeria, Rule 3 of the Financial Reporting Council of Nigeria (FRCN) Rules recognizes that potential threats to the audit firm’s independence and objectivity frequently arise when an audit firm and/or its related entity also provides non-audit services to their audit clients. Non-audit services should not exceed 80% of the total fees paid by the audit client to the audit firm. As stipulated by the FRCN Audit Regulations 2020, where an audit firm is engaged by its audit client for non-audit work, it must comply with the guidelines provided by the International Ethical Standards Board for Accountants (IESBA)’s Code of Ethics for Professional Accountants as well as the International Independence Standards.

Appointment of a Competent Company Secretary

The company secretary is the chief compliance officer of the company. The company secretary is responsible for the provision of independent guidance and support at the highest level of decision making in the company. It is not just about appointing a company secretary; the board of directors are additionally charged with the task of properly empowering the secretary, to enable the company secretary perform their duties adequately. Where the company secretary is an employee of the company, the company secretary should be a member of senior management functionally answerable to the board through the chairman, and administratively answerable to the MD/CEO.

The company secretary’s responsibility includes the provision of a central source of guidance and advice to the board and the company on matters of ethics, conflict of interest and good corporate governance. This undoubtedly includes advising the company on best practices and regulations regarding the independence of the external auditor.

CONCLUSION

The issue of auditor independence stands out as a major factor in Evergrande’s collapse and the ripple effects are far reaching and expected to continue, ranging from huge financial losses, loss of jobs, loss of investor confidence, reputational damage, and stiff sanctions against both the auditor and the audit client.

In the administrative penalty decision issued by China’s Ministry of Finance against PWC, the Ministry noted that PWC failed to point out major misstatements in Evergrande’s Financial Statements, as well as issuing inappropriate audit opinions and false audit reports. The problems identified in PWC’s audit of Evergrande, according to the Ministry of Finance were firstly, poor design and implementation of audit procedures, secondly; loss of auditor independence, as well as concealment of Evergrande’s misstatements and accounting errors.

The auditor’s professional opinion on a company’s financial statements has far reaching impacts on that company, the stock market, and the broader economy, as the investing public places huge reliance on these opinions in making financial decisions. The need for the safeguard of auditor’s independence cannot therefore be treated with levity. Being a corporate governance issue itself, organizations must imbibe and entrench good corporate governance practices to ensure that auditor independence is not eroded.