Home > Risk > Can directors rely on external auditor to detect material errors in financial statements?

Can directors rely on external auditor to detect material errors in financial statements?

A recent court case in Australia came to an interesting conclusion. The Australian Securities and Investments Commission (ASIC) sued executives and non-executive members of the board of Centro, alleging that the company wrongly classified more than $2b of debt as non-current and failed to disclose a $2.8b debt guarantee.

The directors argued that they took reasonable steps and relied on the external auditor, who did not detect the errors. ASIC’s position was that “It is the duty of every director to read the financial statements carefully and consider whether what they disclose is consistent with the directors’ own knowledge of the company’s affairs.”

Although the judge found that there was no evidence of dishonesty by the directors, and that they relied on extensive advice, he found against the directors. He commented that the directors failed to apply their minds to the financial statements, otherwise they would have picked up the errors.

I wonder how many boards, and especially audit committee members, would need to intensify their review of the financial statements and questioning of both management and the external auditor to meet the standard in the ASIC argument above. How many rely on the external auditor without (a) questioning the quality of the external audit staff and approach, and (b) applying their own knowledge and understanding of the business and the financial condition of the company before approving the financial statements? Can they rely on the few directors with formal financial experience (financial experts)?

I hope that counsel at corporations around the world will look at this ruling and check to make sure their board is doing enough.

I welcome your comments.

  1. July 8, 2011 at 12:54 AM

    The several on-going projects to re-consider the scope and content of the standard “pass-fail” auditors’ report will bear — the two most detailed being those of the IAASB and the PCAOB, with comment periods ending in September. Both raise the possibility of higher levels of disclosure and transparency from management and boards — particularly audit committees or their equivalents — on which auditors might then provide their input — under either existing standards or new guidance.
    Such an approach has potential to relieve the legitimate questions involving the preferred or more appropriate sources for investor-oriented information, as well as the concern about consistency between company-sourced disclosures and auditor commentary.
    There are serious liability concerns, since as this case illustrates, responsibility is ultimately decided not by the standards-setters but by the court systems. But movement under what PCAOB chair James Doty calls a “holistic approach” is not possible without attention to this aspect.
    The issues are complex, but will be worthy of serious attention.

    • July 8, 2011 at 10:32 AM

      Directors globally should take this case seriously because they have to realize that they are responsible for moniroting and oversight their institutions. They can use external auditors as resources or check point for them or internal auditors to ensure all internal controls are effective as they should and more importantly directors should make sure that management team also responsible for design and implements all the appropriate controls in place to prevent, detect and correct all deficiencies within the system,

    • Norman Marks
      July 8, 2011 at 5:14 PM

      Jim, regardless of the form of auditor opinion, the question is how much reliance it is reasonable for the directors to place reliance on it. How knowledgeable do they have to be, and how penetrating should their analysis and review of the financials be?

  2. Frans Kersten
    July 8, 2011 at 2:11 AM

    Standard auditing procedures require the board to sign a letter of representation in which they declare to the financial auditor that the supplied all information of which they could think to be relevant to the auditor. Also, the auditor’s report clearly states that is the responsability of management to make the financial statements;the auditor will audit. However, the auditor should do enouugh work to gather sufficient evidence.

    • Norman Marks
      July 8, 2011 at 5:15 PM

      Frans, the directors have to sign off on the financial statements. The auditors are hired to check what management does. The question is how much more do directors have to do? How far do they need to go in assessing the quality of the external auditor’s work, and how penetrating do their own reviews have to be?

  3. David Yeomans
    July 8, 2011 at 2:40 AM

    The problem is that the letter of representations, matters of judgment coupled with the concept of materiality and focus on historical results. The test should be as ASIC says “consistent with knowledge of the company’s affairs”. It is not that the Directors shoudl go through the financial statement line by line as such but to be as knowledgeable about the company and its industry as possible. If the Directors delegate too much authority to management, so that they are unaware of significant transactions and activities, then the only source of defence is ensuring that the quality and independence of auditors is regularly assessed.

  4. Keith Ouellette
    July 8, 2011 at 3:33 AM

    Fortunately, setting legal precedence is not extended to other countries in the U.S. courts today, but I expect it to go global in future like everything else these days. The World Web makes all of this possible . . . research is much easier than in the past.

    To protect themselves, the Board will have to become more “diversified” with strong representation in each of the major functions of an organization. The CFO is too close to the business operation to remain impartial long-term and their mental decision-making process may result in “justifying” a financial reporting change. These changes should be discussed at the Board level.

    I would recommend one inside and one outside representation in all major disciplines, including Finance, Legal/Compliance and Risk Management if segregated.

    • Norman Marks
      July 8, 2011 at 5:16 PM

      The question then becomes, if the board includes one or more directors with great financial expertise, whether the board can rely on that person’s review.

  5. Ck6
    July 8, 2011 at 5:57 AM

    No external auditor is the financial manager of a firm. His job is to assure ownership that the books and records are being kept in accordance with prescribed norms. Therefore, I believe the issue is internal rather than external. $4 billion in errors on any company’s balance sheet should have been discovered by a relatively low accounting manager and discussed with the CFO. This shows poor communication and a weak risk management framework.

    Did the auditor make a mistake by not pursuing an investigation? Probably, but the CFO is the party at fault allowing the mistake in the first place.

  6. Sally March
    July 11, 2011 at 12:27 AM

    This is very interesting, particularly as I am currently working alongside one of the big firms. A partner told me that he fears that audit firms are becoming irrelevant as no one really relies on their reports anymore.

  7. Norman Marks
    July 11, 2011 at 2:35 PM

    Just to be clear, this discussion is about detecting material errors or omissions in the financial statements only.

  8. July 14, 2011 at 12:05 PM

    Good topic. What role does the negotiation of audit scope and fees play? Like many other costs, audit fees have come under pressure. There can be pressure to staff audits with too many junior staff with too few experienced auditors directing strategy, coaching junior auditors, or encouraging critical thinking. This case should signal to Board members that they should take a more active role in understanding issues, posing tough questions – to everyone, Management and Auditors. This interchange is ultimately good for everyone. I suggest the Board should similarly consider their role in compliance, operations, and non-financial reporting (Sustainability, etc.).

  9. Norman Marks
    July 25, 2011 at 6:15 AM

    I have worked with external audit teams that had one or more of the following issues:
    – A lack of knowledge of the company and its business
    – A lack of knowledge of the industry
    – A lack of technical knowledge in matters relating to the industry
    – A terrible attitude, where they wouldn’t listen but always acted as if they knew best
    – Significant turnover
    – Poor managers who failed to guide and supervise staff or review workpapers properly. There was one instance where they ‘dinged’ my IA team for SOX workpapers; I reviewed their’s, and they were far worse.
    – An inability to direct and control the actions of affiliates overseas, resulting in poor coordination and substandard work
    – A reticence to call the tough shots. It fell to me at one company to tell the Audit Committee that not a single person involved in preparing the financial statements, up to and including the CFO, was a CPA or similar

    • Ck6
      July 25, 2011 at 7:07 AM

      These are generally the issues and have been for a very long time. Each year my staff and I go over the same basic set of questions during our review of the external audit for the Board. (Yes this is an ERM function.) While a CFO with a CPA does have its disadvantages, the chief accounting person (CAO or equivalent or external accountant) does need the certification.

      The “inability to direct and control the actions of affiliates overseas, resulting in poor coordination and substandard work” is very critical for multi-domicile organizations. In order to ensure consistent audit work, the customer has to be as involved with the foreign audit as he is with the major portion of the work in addition to holding the audit firm responsible for the entirety of the work.

  10. Norman Marks
    July 25, 2011 at 6:20 AM

    Key for me are these points:
    1. Have the directors satisfied themselves that the external auditors’ work was of high quality? This includes reviewing staffing, budget, approach, and independence (among other things).
    2. Have the directors obtained a reasonable level of knowledge and understanding of the business and industry; the organization’s performance and financial condition; and the related accounting and reporting?
    3. Have the directors applied that knowledge and asked appropriate questions of management and auditors to satisfy themselves of the integrity of the filings with the regulators?

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