Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory & buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

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Friday, 1 June 2012

8 reasons why audits fail

Another week, another corporate collapse…and more predictable finger-pointing at the auditors. The corporate in question this time was Hastie Group in Australia, and the auditor was Deloitte.

Accounting irregularities were picked up, but they turned out to be more material than first realised and the group collapsed under a tsunami of $500m of debt.

As someone who has undertaken listed company audits and forensic audits, I know a bit about the difference between the two, and particularly, why listed corporate audits fail to pick up material errors and fraud.

Here are just 8 of those reasons:

1)      The great Expectation Gap

There is a perception that auditors test every transaction. They don’t, they test samples. Internal auditors may test controls and transactions in more detail, but external auditors don’t. They don’t have the time.

2)      Collusion

Auditors can test internal controls to death, but if staff members of companies are involved in collusion there is often very little an auditor can do to detect this. An example is where the payroll clerk is cahoots with someone from the payables team. I’ve witnessed audits where there have been 25 non-existent staff on the client’s payroll. If tracks are covered well, very hard to detect.

3)      Complexity

We live in an increasingly complex world with increasingly complex derivative transactions. Enron is a good example of derivatives causing a lack of transparency. The subprime crisis is another, where parcels of toxic debt were chopped up, re-mixed and sold on – no-one had a Scooby what was going on by the time the financial products reached the end of the chain.

4)      Time constraints

Audit firms run businesses like any other. They can only afford to spend so much time on an audit – sometimes they may even detect problems but not have the resources to follow them up (or the accounts filing deadline beats them, particularly if the company does not assist).

5)      Conflicts of interest

Auditors are sometimes accused of being too cosy with their clients and thus being unable to qualify accounts. Some have argued that there need to be more opinions that an auditor can give – auditors copped a lot of grief for issuing clean opinions on banks that subsequently collapsed, but when was the last time an audit firm qualified an opinion on a major bank? It virtually never happens – the auditors would be “judge, jury and executioner” if they qualified a bank's annual report (Economia magazine, 2012).

6)      Cost

      Audit firms can’t always use specialists (or sometimes even appropriately qualified staff) due to budget constraints. Unfortunate, but true.

7)      Incompetence

      Step forward PwC for their role in the Centro collapse. Centro notoriously presented current debt (due to be repaid in less than one year) as long-term debt and the whole sorry group went up in smoke. Is it harsh to label the auditors incompetent? In this instance, no – allowing the misclassification of debt is Mickey Mouse auditing…and if auditors aren’t insisting on correct presentation of accounts, what are their fees actually for? The audit Partner won no friends for reportedly blaming his junior staff for the error. Wrong again: the Partner signs the accounts and is the responsible individual. Period.

8)      Wilful ignorance (aka 'phantom ticking')

Audit fieldwork is often done by junior staff who aren’t qualified accountants. Junior staff may not have the confidence to flag or query issues with clients and thus re-select their samples or falsify audit schedules for an easy life. Might not happen often, but the truth is, it does happen sometimes.

Auditors are watchdogs not bloodhounds, and mostly they do a very fine job. And companies must shoulder their share of the burden too. An auditor’s role is not to detect fraud; ultimately it is to ensure that financial statements are materially free from error. Most of the time, they achieve that, and auditors fulfil their necessary role in the financial system.