The current Audit structure for Banks and Insurance companies is inherently faulty & cannot be allowed to continue. In the case of Banks and Insurance Companies, the Auditors impact over the last few years has been at best neutral, or at worst seriously lacking when it came to acting in the Public Interest.
It is proposed that the audit of banks and insurance companies be subject to greater regulation, as the fallout from their failure or wrongdoings is significantly more damaging to the Public interest. If these Audits are of such national importance, then the state should play a greater role in their regulation.
The Current Audit system may be the best option for Private companies and public companies that do not require State support in the event of their failure. However, there are certain companies that when they reach a critical mass, they cannot be allowed to fail. The Irish Banks and insurance companies would meet these criteria. President Obama has identified this problem in the US and is currently attempting to resolve the issue in connection with the big banks.
What is wrong with the current Audit process?
The Directors effectively appoint the auditor, set his fees, & dismiss him when required. For the Banks, the Audit fee together with regular Consultancy fees can make the Auditor financially dependent on his Audit client. “He, who pays the piper, plays the tune”. The Auditors Independence is seriously undermined by this financial dependence & by the power the Directors exercise over their appointment and fees; notwithstanding it is the Auditors role to report on the same directors.
In addition, there is no time limit on his term of office. There is no incentive for the Directors to change Auditors as they will have built up a relationship with the Auditor and will come to know what to expect from the audit. This relationship built up over the years can be the biggest single threat to Objectivity when the Auditor has to face serious challenges.
The Directors can also use the Auditor to do other assignments for the Bank, which will be the subject of Audit examination later. The Auditor is reporting on his own work. The auditor may carry out due diligence work on new acquisitions to ascertain if the accounting records of the new business are correct. Any errors that are not uncovered in this report will invariably come to light in subsequent periods. It is not in the Directors or Auditors interest to highlight these errors. Accordingly, these errors may not be disclosed separately in subsequent financial reports.
The Auditors primary duty is to the Bank,, and there is a conflict of interest when it comes to matters in the “Public Interest”. The auditors of one bank may discover matters in transactions with other banks and Building Societies, which should be reported in the public interest, but cannot disclose the matter without breaching client confidentiality. The Companies Acts currently does not adequately address these threats to the Auditor’s Independence. It allows the Auditor to have a financial interest in his client, have business relationships with the client & imposes no time limit to his tenure of office.
Changes proposed
There are a number of changes which will immediately improve the current status quo and can be achieved without cost to the Taxpayer. The following changes can be achieved by a special resolution at the forthcoming Bank AGMs
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Mandatory Rotation of the Auditor
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Auditor Appointment & power to agree fees
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Cap on Total fees and Consultancy fees.
Mandatory Rotation & cooling off period for the Audit Firm.
Bank Auditors should be appointed for 3 years and subsequently not be allowed to carry out this audit for a further six years.
Most Bank Auditors are in office longer than Sir Alex Ferguson. Relationships are built up between the Auditor and Directors over a long period of time. The client is often a career opportunity for the young auditor and a directorship for the not so young partner, who is eager not to upset his possible future employer. The Auditor relies heavily on his client’s assistance to carry out the audit efficiently, and will be reluctant to estrange his client. The longstanding Auditor’s Approach invariably gets complacent. Last year’s file is followed slavishly by staff. The element of surprise & fear of the Auditor is rapidly eroded, as the client knows exactly what areas the auditor looks at each year. Contrast this to the visit of the Revenue Auditor or US internal auditor arriving at the Irish location.
Audit Firm rotation will allow the Auditor to consider issues more objectively, without the need to consider the consequences of losing his position. Audit clients will not have the time to build up personal relationships with the Auditor and will not develop an insight into audit practices of the Auditor.
The Audit & the Bank Industry will oppose Audit Rotation on the basis that it will result in additional costs for the client and result in a loss of expertise on the part of the auditor. In addition, they will point to the requirement that the Engagement Partner must be rotated every five years.
Unfortunately, the Chinese walls do not work and the prevailing system has and will prove much more expensive in the long run.
Appointment of the Bank Auditor
The Financial Regulator should approve the Appointment of the Auditor, with the discretion to overrule the shareholders appointment in the public interest.
The Financial Regulator should approve the Auditors fees. Like a Taxing Master in the Courts, he should be in a position to set a Fair & Reasonable fee for the work. This should eliminate the use of the Audit as a Lost Leader in order to get additional work.
Cap on fees for each Audit
The Total fees from the Audit Client should be strictly limited to a maximum of 5% of the Engagement Partners gross fees. Currently, there is a figure of 10% which activates extra Chinese wall type controls. Unfortunately, these “virtual walls” are ineffective. Ideally non Audit work should be prohibited. However, it may be more helpful to place a Cap on the Non Audit fees. This can be achieved by making the cap a % of the Audit fees. The Financial Audit is the only Audit, whereby the Auditor can also work as a consultant for the same company.
All the foregoing proposals can be implemented for each bank now under the effective control of the state, by passing a resolution at the upcoming Annual General Meetings.
Major Structural Changes
The following changes would require Government legislation but the benefits would far exceed their cost.
At present, the Auditors duty is primarily to the Company he audits. While Confidentiality is required, there are certain matters that should be above this duty, when matters in the Public Interest arise. The Bank Auditor should have a much stronger reporting line to the Financial Regulator, whereby a much broader range of matters should be reported to the Regulator.
Internal Audit Department
There are significant resources committed to the Internal Audit department in the banks. At present, the internal Audit Department is part of Management and the effectiveness of his role is seriously reduced as a result. It has been shown clearly in the Dirt Tax debacle that the Internal Auditor is powerless against Management’s commercial interests. An Independent Internal Auditor would greatly enhance the effectiveness of the Internal Controls within the Banks.
The Companies acts should formally set out strict parameters for the Internal Auditor regarding his independence, scope of work and reporting procedures.
Conclusion
The improvements proposed for the Auditors of Banks and Insurance companies could not be applied to Private Companies. The cost and the restrictions proposed would greatly outweigh the benefits achieved by Private Companies. To date, the costs of Audit failures in such companies has been borne by the shareholders and Auditors where they have been found to be negligent. The state has not had to carry the loss of such failures.
We need to act promptly and unilaterally. We should not wait for Europe to act as we alone will have to pay for the costs of failure. Supporters of Sir Alex will point to his success, but then again, “he always told it like it was”. Not so the Bank Auditor.
