Auditors should be open to new ways of guaranteeing their independence, including the possibility of being hired by stock exchanges or even institutional investors, according to one of the world’s foremost accounting experts.
VG Narayanan, an economist and Harvard Business School professor, said there is a ‘fundamental problem’ of independence in audit because auditors are paid by their clients to review financial statements.
He went on to compare the arrangement to participants in a legal case being able to select their own judges. ‘Even if all the judges are honest, it will not give us the perception of honesty,’ he added.
Narayanan’s stinging criticism of what is an audit structure universally used around the world came in a presentation at the 21st World Congress of Accountants in Mumbai.
The event, which has attracted 6,000 delegates from more than one hundred countries, explores in detail the public interest function of accountants.
'The fundamental basis on which the auditor-auditee relationship has been set up is not correct.’
Narayanan’s conflicts of interest claim is a long-running criticism of an audit structure in common use around the world. Policymakers and regulators have attempted to manage the issue in multiple ways.
For example, in 2014 the European Union introduced mandatory audit rotation as well as restrictions on the alternative services that could be bought from the same firm. The rules also imposed new duties on audit committees to scrutinise audit tenders.
In the UK, the government is moving to introduce mandatory ‘managed shared audit’ for public interest entities while the Big Four firms are currently working on a ‘operational split’ of their audit divisions from other functions. Audit committees face working under a new set of standards to be designed by regulators.
'Maybe auditors should be hired by the institutional shareholders. We have to focus on making ourselves a force for good'
Turning back to the auditor-client relationship, Narayanan said: ‘Why do we put up with this anywhere in the world. We put up with this system where the client pays the auditor and yet the auditor is supposed to exercise professional judgement.
‘It’s actually a miracle that the financial statements are this good because the fundamental basis on which the auditor-auditee relationship has been set up is not correct.’
Narayanan gave a nod to regulatory efforts to deal with the conflict, highlighting India’s introduction of mandatory audit rotation and other jurisdictions that have terms limits for engagement partners. He dubbed these ‘natural experiments’ to deal with the conflict of interest issue.
Another regulatory route could be auditors checking the work of other auditors. Narayanan offered the example of his experience as an articled clerk in Chennai where an outside auditor checked the calculations of his own firm.
‘Boy, did we take immense pride in our audit reports because we did not want a fellow professional to find mistakes in the work we had done,’ he said.
But Narayanan concluded his speech by focusing on alternative ways of ensuring auditor independence, insisting they need to be ‘embraced’ while auditors and accountants needed to be ‘flexible’. These methods focus on who hires the auditor for listed companies.
‘Maybe auditors should be hired by stock exchanges. Maybe they should be hired directly by the institutional shareholders. They should be open to all arrangements that improve integrity and perceived, and actual, independence of auditors.
‘If we do that, we have a very, very bright future. All we have to do is focus on our independence and integrity and making ourselves a force for good and attract the best and brightest.’