Auditors today carry greater weight and expectations compared with the past and here in the Middle East, which contains some of the fastest-growing and swiftly recovering economies, it is important to keep abreast of evolving international audit standards and how we can adopt them.
Our leaders have signalled its significance. Recently Sheikh Nahyan bin Mubarak, the UAE Minister of Higher Education and Scientific Research, referred to the importance of the highest standards for the nation's accounting profession.
The profession has emerged from its latest crisis battered and bruised. In the time-honoured tradition of reform following public crisis, the reforms implemented by legislators and professional organisations, such as auditor rotation and prohibition of certain activities for accountants and external supervision, are important steps towards restoring confidence.
But just as we feel that confidence is restored, we see another crisis. Major corporate collapses such as Enron, WorldCom, Parmalat, Satyam and Lehman Brothers have one thing in common: accusations that the auditors were either complicit, negligent or both.
There are lessons for all of us from these corporate failures.
The EU Green Paper on Audit Policy: Lessons from the Crisis also acknowledges that robust audit is key to re-establishing trust and market confidence; contributing to investor protection and reducing the cost of capital for companies. Can we do more to increase (if not restore) the confidence? My answer is: Yes, in a number of ways, we can.
The first of these is independence. The debate surrounding the role of external auditors focuses in particular on auditor independence. The concept of independence is not the easiest to define. The definition which I like the most is the ability to resist client pressure.
In the absence of an active regulator or a professional association, most audit firms are required to use their own judgements when dealing with independence issues. Another important area where independence plays a critical role is that of initial public offerings (IPOs) and the role of auditors.
This flows as a subset from the issue of independence. Global markets will return to an increase in IPOs, particularly here in the GCC, where more family businesses are either going public or preparing to go public. Here an important question arises: what role should an auditor play when a client is preparing to go public? We have witnessed at times how auditors have become an important and reliable partner in the journey of a client from a family business to a public entity.
Enron and WorldCom are glaring examples where the auditor grew with the companies and could not detach themselves from that growth.
Where should the engagement partner detach himself from the process and an independent partner be introduced? Or should a different audit firm be introduced? I see a greater role for a professional body or a regulator to issue some guidelines with respect to the role of auditor in public offerings.
A further issue of independence arises with the question: who should be appointing the auditors? Is it the chief executive, chief financial officer or the board?
In the past, I have been an advocate for forming a trust fund for appointment of auditors. Another option is that the board takes the leading role with the chief executive and chief financial officer providing support without being the ultimate decision-maker.
They are involved with day-to-day handling of the auditor, while the board is in a more appropriate position to appoint an "independent" auditor.
There is an interesting debate in various jurisdictions over rotation of auditors. Countries such as Italy, Brazil, Malaysia, Singapore and South Korea already have an audit rotation system in place.
Italy has a statutory requirement for audit firm rotation every nine years. In Brazil, companies have been made to change auditing firms every three years. In Singapore, banks are required to change audit firms every five years, but there is no requirement on listed companies.
In 2003, Korea adopted the mandatory rotation rule and required listed firms to rotate their auditors every six years commencing in 2006. A debate centres on whether it is better to rotate the audit partner or rotate the firm? What should be the rotation period: three years, five years or perhaps seven years? I am of the view that rotation of the audit partner every seven years appears reasonable, based on the cost associated in terms of acquiring the knowledge base.
One way to restore confidence in audit is to have in place a universal set of standards. To this end, the International Forum of Independent Audit Regulators (IFIAR) recently issued in draft form its core principles on audit oversight.
Although these are not mandatory for IFIAR members, the Dubai Financial Services Authority (DFSA) is pleased to announce that we shall be adopting these principles in their totality, as we strongly believe they will prove to be a strong foundation.
Last year and this year, the DFSA conducted on-site assessments for all 16 registered audit firms. These covered 47 audit engagement files and 27 audit partners.This was not an easy task. Our approach to on-site supervision was purely intended to increase the audit quality of the firms involved and not to finger-point the issues.
However, I do feel it appropriate to share a few instances from our first-hand experience with the firms involved.
On one particular file, we identified a significant balance that was classified as cash and cash equivalents, which represented an amount transferred to a related entity that in turn was placed with a third party bank. However, although the amount was held in a bank, it was not held in a ring-fenced bank account in the name of the audit client.
Cash equivalents are defined in IAS 7 as "short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value".
As the amount is controlled by a related entity there is a risk that it is not readily convertible into cash. This had not been adequately considered and documented by the audit team.
On another file, no audit work had been done on the revenue that represented more than 90 per cent of the total revenue other than obtaining a management representation. There was no other evidence on the working paper file.
The audit partner had discussed this matter with the client and was satisfied with the outcome. There was no documentary evidence to substantiate this discussion.
The DFSA also noted that the initial draft audit report had a qualification which was later removed. There was no audit trail for the consideration for a clean audit opinion. Finally, the revenue transaction that was booked in the first year was subsequently reversed in the second.
We expect auditors to recognise the often complex financial transactions on which they have to opine. Auditors should obtain confirmations of critical balance sheet items. The auditors have to avoid being over-confident of their own judgements.
Auditors should certainly avoid anchoring their judgement and that of the client, and should clearly investigate all current and historic data and information relating to a critical balance sheet/profit and loss item, not simply focusing solely on recent data.
These are only a few examples that could easily have been avoided had the firm acted with a greater professional scepticism.
In my view, following international standards on auditing is very important in improving the quality of audit. In conclusion, we do not expect to find magical solutions to the problems that the profession faces in just two days.
But by coming together in such numbers and from across the Gulf, we shall certainly be making an informed start towards finding solutions.
These are excerpts from a speech to be delivered to the Regional Audit Seminar in Dubai today by Paul M Koster, the chief executive of the Dubai Financial Services Authority
