No guarantee that audits will catch fishy business
AS LONG as there is money to be made, dishonest businessmen will try every conceivable means to manipulate financial statements to give a false impression of their company's health.
There are many ways to deceive investors, the end-consumer of financial statements. They range from relatively mild "window-dressing" techniques to mask falling revenues or excessive expenses, to outright fraud by faking receipts and documents.
Every year, a listed company's financials are subject to review by an external auditor. This is to give the investing public additional assurance that a company's financial statements are reliable.
An audit is a costly and time-consuming process. Audit fees can run from the tens of thousands of dollars for a small private company to the hundreds of thousands for a larger listed company, to millions of dollars for the bigger listed firms reporting billions of dollars in revenue.
Auditors, for example, might have to spend time interviewing management, visiting company store outlets, counting inventory and checking bank statements to verify claims.
In practice, however, it is impossible to check every statement, receipt, voucher or bill. And auditors do not do that - they go through a sample of source documents, rather than every one.
If auditors are given well-forged documents to pore over, as they have in past scandals, nothing may smell fishy.
The profession is also susceptible to conflicts of interest. Sure, auditors have reputations to keep and are not likely to shy away from pointing out fraudulent practices just for the sake of some fees.
Regulators have tried ways to increase auditor independence. One of the most contentious is the institution of mandatory audit rotation.
Supporters of the rule argue that it will allow a fresh set of eyes to spot issues, and avoid the risk of an incumbent audit firm losing objectivity by being too close to the audited company.
The knowledge that a new audit firm will take over the audit will cause the incumbent firm to be more careful with its work to avoid being embarrassed, goes the argument.
A few months ago, the European Parliament voted in favour of rules to force European-listed companies to appoint new auditors every 10 years. However, a similar effort in the United States failed to gain traction.
Over here, the Monetary Authority of Singapore (MAS) put out rules in 2002 to require local banks to change auditors every five years. But it suspended those rules in 2008 amid the global financial crisis to avoid market disruption.
Some audit firms are against being compulsorily rotated. An Ernst & Young report last year argued that audit firms can best perform when they have a long-term working relationship with the company.
They can better understand their clients' business, which could be in a specialised industry. Changing auditors for companies with complex global operations can be costly and inefficient if the existing audit firm has already established a network.
By staying on for longer, auditors can gain their clients' respect and trust to better resolve issues with management, Ernst & Young argued.
It is also important to note that, contrary to popular belief, auditors stress that their job is not to detect fraud.
As they remind investors in every report, their responsibility is to express an opinion on whether the financial statements are free from material misstatement.
It is the management's responsibility to prepare financial statements to give a true and fair view, in accordance with laws and regulations.
Auditors also point out that it is the management's responsibility to have a system of internal controls to protect assets against unauthorised use.
Auditors are, however, required to obtain an understanding of a company's internal controls, when identifying and assessing the risks of material misstatement.
Unstated, perhaps, is the age-old dictum of caveat emptor: Let the buyer beware.
Ultimately, the onus is on investors to read through the disclosures given by a company in its financial statements and annual reports, and to make their own judgment on whether the company can be trusted.
Falling profits, pressure to meet investor expectations, lucrative management stock options, combined with a complicated business model, are just some of the conditions under which fraud could occur.
Let the investor beware.
THE BUSINESS TIMES