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The Auditors Role in the Bank Crisis
By Christy Kearney
Feb 16, 2010

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The Irish Bank crisis occurred largely without early warning from all the various experts entrusted with governing and overseeing the financial sector.

The Banks’ directors, the Financial regulator and the Banks’ Auditors were all silent until very late in the day.

Attention has focused on the dreadful performance of the Financial Regulator to-date, however, the role of the Auditor has not been considered in any detail.

Each bank had an Audit Committee, an Internal Audit department and the External Auditor looking out for the shareholders interest. Yet, no Auditor reported concerns to the shareholders until 2009.

Too late!

The courts have established in historic cases that the Auditor is a watchdog not a bloodhound. Yet in this case, one suspects that a blind dog would have stumbled on the problems.

Overall regulation

The regulation of the banking sector is entrusted to both Government and private regulation.
 
Private regulation is largely the responsibility of the Board of Directors and the external auditors.

It is well established that the Board of Directors has primary responsibility for Presenting Financial Statements that give a True and Fair View. They are also responsible for installing and monitoring internal controls that safeguard the Companies assets.

The Bank directors delegate this responsibility to a Sub-Committee, known as the Audit Committee, which deals with all the financial responsibilities of the Board.  In addition, each Bank has a well staffed Internal Audit department which monitors compliance with Internal Controls and Laws and Regulations.


The External Auditor

The external Auditor is engaged to report on the Financial Statements. The external auditor obtains sufficient and appropriate Audit evidence to enable him to report on the True and Fair view of the Financial Statements. The Audit Report is not a guarantee that the financial statements are materially correct; however the risk of an incorrect audit report should be reduced to an acceptable low level.

The Auditors’ reports on the Financial Statements confirmed that the Audit has been carried out in accordance with International Audit Standards.
In each Audit Report on the Irish Banks, the Auditor confirmed that there were no limitations of scope encountered when carrying out the Audit and the auditor received all the information and explanations he considered necessary.

Why did the Audit process fail to disclose the shortcomings of the Irish banking system?

The key question is whether the Audit was in fact carried out in accordance with prescribed Audit Standards.

There are a countless number of Audit Standards that prescribe audit procedures for various sections of the Audit process. It is worth while examining just a few of the more well known standards to consider if the Auditor should have been alerted to the signs that might have resulted in that early warning.

Understanding the entity and its Environment

“The auditor should obtain an understanding of the accounting and control systems taking into account the threat of management override of such controls at all times. The concentration of management powers in few hands obviously increases the risk of controls being over ridden by Management.”

This was definitely the case in a number of Irish Banks and Building Societies. Accordingly, the Auditor should have placed less reliance on the internal Controls of the Bank, and sought more extensive and externally sourced evidence.

Internal Controls
 
Standards highlight the importance of the Control Consciousness of Key Management and the Directors, which sets the tone for the control environment of the entity.

”The effectiveness of controls cannot rise above the Integrity and ethical values of the people who create, administer and monitor them.”

Did the Auditor consider this warning when designing his audit tests? 

There is a general acceptance that financial indiscipline was endemic in parts of the Irish Banking sector. Was the Auditor totally unaware of this?


Management Representations

Audit Standards clearly state that the Auditor should not rely on Management Representations alone, as sufficient Audit evidence to substantiate transactions or balances in the Financial Statements.

It is inconceivable that the Auditors would rely solely on letters from the Directors confirming their loan balances at the year end. Audit standards would require the Auditor to obtain supporting corroborating evidence that provide him with sufficient Audit evidence.

What Audit evidence did the Auditor obtain with regard to the completeness of Directors’ loans?

Fraud and Error

The responsibility for preventing and detecting fraud rests with the directors. However, the Auditor should plan and execute his audit so as to a reasonable expectation of detecting a material fraud. It is also acknowledged that the auditor would find it much more difficult to uncover a fraud rather than an innocent error.

The standard on Fraud and Error clearly identifies high risk factors that should alert the Auditor to be more skeptical when obtaining audit evidence.

“Information available indicates that the personal financial situation of management or those charged with governance is threatened by the entity’s financial performance arising from the following;

Significant financial interests in the company, or significant portion of their compensation being contingent on achieving aggressive targets for stock price, operating results, cash flow etc.

The directors and key management of the Irish Banks had an unhealthy financial involvement in their own Banks.  The Auditor should have been on high alert with regard to potential frauds (alleged) and errors.

Directors Loans

The Accounting Standard for Directors’ loans (Related Party Transactions) clearly states that all Directors transactions should be disclosed in the accounts. In addition, it states that the movement on the loans for the year should be disclosed. This should show the advances and repayments for the year.  (The companies’ acts do not permit non disclosure on the bases of loans being immaterial.)

It is hard to understand how the movement of significant sums of money relating to Directors’ loans around the Accounts year-end were not detected by the Auditor.

Did the auditor only concern himself with year end balances, rather than transactions throughout the year?

Did the auditor accept Management Representations as his only source of Audit evidence?

Did Management conceal the transactions so that the Auditor would not detect them?

Materiality

Audit standards state that an item is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the
Financial Statements.

Certain disclosures require greater precision than others, including Share Capital or statutory disclosures such as Directors loans.

It would be difficult to rely on the defense that the well publicized loans were immaterial in the overall context of the financial statements.

In addition, the disclosure of such loans would have warned of a much greater problem, the total lack of Financial Discipline at the very highest levels.

Conclusion

Many parties contributed to the crisis. Management, the Board of Directors, and the Financial Regulator all had major roles to play.
There is also a clear case for the Auditor to answer.  Shareholders, taxpayers, and the public are entitled to a detailed explanation as to why accountants of undoubted expertise failed to uncover critical non disclosures. The non disclosures in themselves did not cause the crisis, but proper disclosure would have alerted the public much earlier to the general management ethos that prevailed in the Banking Sector, and presumably have resulted in corrective action much sooner.

It is accepted that the auditor has a much more difficult role in detecting misstatements when fraud is involved. If this is proven to be the case, then let the responsibility fall on the fraudsters.

The most important outcome must be that changes must be made to ensure that such a tragedy never happens again.

There are certainly a number of changes to the Audit process that the author can suggest.

That is for another day!

Christy Kearney

The author lectures extensively on International Audit and Accounting Standards, having spent the early part of his career as an Auditor in a Big 4 practice.


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