Blurred lines in auditing


3 minute read

Audit committees oversee companies’ financial reporting and audit processes, internal controls and compliance with laws and regulations.

But how does audit committee membership affect audit quality? A paper co-authored by Dr Madhukar Singh from The Australian National University (ANU), Professor Divesh S. Sharma of Kennesaw State University, and Professor Arvind Patel of the University of the South Pacific, provides new evidence in this regard.

The paper, entitled Do Alma Mater Ties Between the Auditor and the Audit Committee Affect Audit Quality?, was published by internationally renowned journal Contemporary Accounting Research, and reveals that audit committees including retired audit partners favour partners’ former employers when purchasing non-audit services.

The study employs a sample of firms from New Zealand which, like Australia, has a saturated audit market experiencing a large annual influx of accounting graduates looking for work, that are accommodated by audit partners being enticed into early retirement.

 “There’s a history of audit firms having written contracts that partners have to retire young – by the age of 55–58, and they’ve got these non-compete clauses to prevent them entering another audit firm. As part of their leaving, they may have agreed on a payout, which is usually lifelong,” says Madhukar.

Former audit partners are the most qualified group of individuals who can effectively supervise the financial reporting processes of companies. However, New Zealand (and Australian) laws and regulations do nothing to stop retired audit partners accepting positions on corporate audit committees, with conflicts of interest inevitably arising from partners’ vested interest in the financial health of their former employers.

“Audit firms need to constantly generate profits to be able to pay these ex-partners. When ex-partners sit on audit committees, they send more business to their alma maters, so the alma maters make more profits and their payments continue,” Madhukar explains.

Consistent with this, Madhukar and his colleagues find that audit committees comprising retired partners generate an average of 77 per cent more revenue for partners’ former employers than audit committees which do not have affiliated retired partners.

In the wake of corporate scandals, the United States has taken measures to prohibit these relationships. UK regulators are looking into how they can mitigate this issue by separating each firm into two distinct entities, one of which would focus on financial statements, and the other on non-audit services. Madhukar believes Australia will probably mirror this approach.

“EY is moving on having their consulting businesses listed on the stock exchange, so we’d be looking at a separate, public company. This means when partners of these firms become actors on the audit committee, they will be clearly disclosed,” he says.

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