Should external auditors provide “Other Professional Services”?

The ultimate responsibility for financial statements may lie with corporate managers, but by any measure, the audit firms have failed miserably in their role as financial watchdogs. And with their profession about to undergo a major overhaul, they have been a very quiet voice in the reform debate. There's a void of leadership in the audit industry. The firms are all in defensive mode.

For corporate executives, that defensive mode already means tougher, more-expensive audits and less wiggle room when it comes to the interpretation of accounting rules. It may go a long way toward fostering a more independent and adversarial role for auditors of public companies. It's a very different environment from nine months ago. Instead of focusing on whittling down fees, senior executives are challenging to make sure auditors are doing an adequate job.

In the past two decades, the accounting firms have ventured far beyond their humble roots. While they have always provided some degree of non-audit services to clients, the opportunities for new business have exploded in the past 20 years. With the spread of information technology, the biggest auditors became designers and implementers of IT systems. They expanded their tax, legal, and investment advisory services, and branched out into all manner of management consulting work. A survey in US found that 72 percent of the $5.7 billion in fees paid by 1,200 public companies to their auditors in 2000 was for non-audit services.

In the broader offering of professional services by the audit firms, the actual audit has arguably become a loss leader to land more lucrative consulting contracts. Some firms used to refer to audits as a commodity. No one believes that now. Even if there's a wall between the consultants who might design and implement a system and those who audit the statements, appearances matter.

The new laws lists eight distinct services that firms will no longer be allowed to provide to their audit clients. It also requires that corporate audit committees pre-approve all services provided by auditors to the company.

Investors have already been attempting to reduce the ties between public companies and their auditors. Many companies are paying extra attention to their relationships with auditors these days. In some cases, the auditor has a base of knowledge that gives it an advantage over other providers. It puts them in a position to make better assumptions or to poke holes in our assumptions. The new restrictions, however, will likely force companies to find another firm to perform other professional work. It's been convenient to do one-stop shopping. Now it's just going to be a little less convenient.

A notable exception to the new service restrictions is tax work – the assumption being that issues of tax are so intertwined with accounting and financial reporting that separating the two could jeopardize the quality of audits. Other non-audit services, however, are also essential to the audit work. To perform good audits, more skills are needed than just forensic accounting. Specifically, general accounting skills, tax planning, risk management, and security analysis are all vital competencies for auditors to possess. All these elements are embedded in the financial statements. If we legislate against providing these services, we could end up with poorer audits.

The new restrictions on the provision of non-audit services don't resolve all conflicts of interest. The fact that clients foot the bill for their audits and can readily take their business elsewhere creates a basic conflict to begin with. But the new ground rules will at least reduce the appearance of conflicts of interest. If we're going to rebuild trust in financial reporting, these things are needed.

Corporate executives are now realizing that the credibility of their financial disclosures can be more important than the financials themselves. That should result in less pressure on auditors from executives trying to make their numbers. It also may improve the compensation auditors receive to conduct their work.

Of the parade of participants in the Enron hearings, none generated more outrage than the document-shredding Andersen auditors. Greed and corruption may be no more acceptable in corporate executives than in anyone else, but the auditors have borne a particularly large share of the public opprobrium from Enron and other corporate accounting scandals.

The audit industry shares much of the blame for the loss of confidence in the capital markets. Accounting firms must never forget that their work serves the interests of shareholders, not just the company that writes the check. The reform debate has to shift to broader considerations of corporate reporting rather than just the failings of auditors. If we're going to move toward a new auditing framework, we need to consider all the pieces of the puzzle.

International Accounting Standards (IAS), long considered the best and most accounting standards in the world, may be the most important piece of that puzzle. Growing numbers of financial accounting experts believe that IAS itself may be part of the problem. As financial transactions have become more complicated, so too has the accounting for them. Over the last 10 years, IAS has evolved into complex detailed rules that encourage financial engineering rather than transparency. The highly politicized nature of the standards-setting process, wherein businesses lobby politicians to exert pressure on the Board, is a large part of the problem. IAS has enabled companies to comply with the accounting standards and yet violate basic principles of transparency and risk disclosure.

Given the ground rules, auditors are not wholly to blame for helping finance chiefs negotiate their way through them. But the situation has fostered a culture of gamesmanship in which auditors help their clients engineer transactions to achieve their accounting objectives. Enron is a case in point. Andersen received millions of dollars for helping to structure Enron's labyrinthine network of off-balance-sheet entities. It clearly bears responsibility for not investigating what transactions the company was conducting in the entities more thoroughly, but at the end of the day, accounting rules may not have been broken.

The solution is principles. Rather than focusing on whether or not the accounting complies with rules, executives and auditors should be evaluating whether or not it portrays the underlying economics of a transaction. It's a lot harder to bend a principle than to bend a rule. Integrity and adherence to principles are the only things that will restore confidence in the audit community and in financial disclosures. The auditors have to be willing to take a position on principle.

The give-and-take between public companies and their auditors in the reporting of financial results won't disappear with the passage of a reform package. Accounting involves interpretation, and judgment will continue to play a part in how financial results are presented. The two objectives will always create points of contention with auditors.

More than likely, the arguments will be a lot more vigorous going forward.

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Rahim Panjwani completed his articleship from KPMG Taseer Hadi Khalid & Co. and qualified for ACA in 2000. In addition to being an ACA, Rahim is a qualified APA from PIPFA (1998) and CIA from the IIA (2001). He has also successfully completed a training course on Management Auditing from London School of Economics. His past work experience includes working with Hongkong Shanghai Bank and Serena Hotels. Presently, Rahim is engaged with The Aga Khan University – Funds Management & Corporate Affairs Department. He is a regular contributor of articles in Dawn, Business Recorder and News.