The Illusion of Control at the Heart of Auditing

The first half of the 2000s featured some of the most spectacular management and accounting scandals of all time. Enron. WorldCom. Freddie Mac. AIG. Parmalat. Canadians can take perverse pride in one of the most brazen of them all: the “self-righteous and aggressive looting” of Toronto’s Hollinger International by former executives under the blind eyes of the board’s audit committee. For four years while this happened, no one among the audit committee members had the financial expertise to properly fulfil their role as monitors. The dilettante overseers were so out to lunch that one wag at the time wondered, “Was Paris Hilton on the Hollinger audit committee?”

Something good came out of this inglorious era of accounting scandals. In Canada, the U.S. and Europe, tough new rules for auditors were drawn up, backed by new independent regulators. Accounting firms could no longer ignore the obvious—that their culture and “customer is king” attitude did not match their professed standards—and set about to improve matters. 

The lesson seems to have been learned. Accounting experts Bertrand Malsch, PricewaterhouseCoopers/Tom O'Neill Fellow of Accounting at Smith School of Business, and Oriane Couchoux, an assistant professor at Sprott School of Business ('HEC Montreal and a Smith PhD graduate' — at publication), note that audits are now more rigorous, and not only because of rules limiting potential conflicts of interest.

Auditors appear to have toughened their standards and beefed up internal controls, Malsch and Couchoux write in an essay for the Financial Reporting Council in the U.K. Recent studies point to a “positive cultural inflection at the top of the firms,” supported by new types of quality controls and accountability mechanisms. Their research in Canada highlights a similar cultural shift triggered by a renewed emphasis on technical skills and quality in the processes of evaluation and promotion.

Unfortunately, the same cannot be said for audit committees of corporate boards. These committees have three roles: the monitoring of external financial statements, external auditors and internal controls. They vary in size, independence, monitoring effectiveness and competencies, and it is not at all clear whether they improve the quality of financial reporting.

A teetering three-legged stool

Malsch and Couchoux liken audit quality to a three-legged stool involving auditors, management and audit committees. They say audit committees are not holding up their end. Based on interviews with a number of audit committee members of publicly-listed Canadian companies, they believe that problems mostly relate to how committee members perceive their role.

For one, a significant portion of the people they interviewed don’t believe they have the financial and accounting know-how to deal with the complexity of current financial reporting and audit processes. As a result, they take their lead from management and the external auditor, the two parties whom they see as having the responsibility to deliver a high-quality audit. They’re skeptical they would have much impact on the quality of the end result.

According to Malsch and Couchoux, audit committee members are also reluctant to sign off on the higher audit fees that would result from additional inspection requirements and recommendations.

The researchers feel these views reveal a short-sighted perspective and send the wrong signal to the auditors doing the heavy lifting. “Audit partners are unlikely to establish meaningful communications with audit committee members if the latter do not feel concerned by inspection processes and disengage from the technical substance of auditing,” Malsch and Couchoux write.

The lack of shared accountability between audit committee members and auditors can be frustrating for audit teams, “especially when the client is directly and partially responsible for some of the quality deficiencies identified in the inspection reports.”

So what’s to be done? The easiest route is to simply accept these shortcomings and manage expectations of what audit committees bring to the table. This pragmatic option might help avoid the illusion of control and expertise, but it does nothing to improve audit quality.

The researchers would prefer audit regulators—the Canadian Public Accountability Board (CPAB) in Canada—to provide more specific guidelines for how audit committee members should perform their monitoring role. The CPAB should also focus on both the auditor and the client (largely the audit committee) when identifying audit deficiencies and not focus only on the auditor. Doing so, they write, would generate a stronger sense of shared responsibility.

Malsch, who is also director of the CPA Ontario Centre for Corporate Reporting and Professionalism at Smith, says the vast majority of audit committees in Canadian publicly-listed companies “act in good faith and do a good job.”

“We are more concerned by the expectation gap that exists between what audit committees can realistically achieve and the promises of regulation,” he says. “Getting the audit process right is a shared responsibility that needs to be acknowledged in the development of regulations and best practices in governance.”