Financial statements audit, a process whereby public accountants attest to whether the financial statements prepared by management give a true and fair view, is a business which generates fees for the multi-disciplinary firms of accountants. Public accountants who perform external auditing are expected to act on behalf of the investing public by providing reasonable assurance that management does not distort the true financial performance of the companies by cooking the books (sometimes referred to as managing earnings or aggressive/creative accounting).
There have been many occasions in the past where external auditors have failed in their duties to exercise independence and objectivity when reporting the results of their audit findings. Accounting scandals in the US over the last 30 years involving Equity Funding, Lincoln Savings and Loan, Phar-Mor and Enron, among others, are testaments that auditors could be captured and bullied by their clients into signing off on dubious financials and thereby colluding in misrepresenting audited financial statements.
At the heart of all these catastrophic audit failures is the lack of auditors' independence. One of the perennial dilemmas faced by auditors is that it is almost impossible to be independent of their clients (companies they audit or auditees) given that they are paid by the clients for the audit services, and sometimes non-audit services too.
Given that auditor independence is essential and yet elusive, how can the auditing fraternity convince the sceptical investing public that the so-called "independent" attest-and-assurance services which they provide are reliable and that a clean audit opinion provides a credible signal about the integrity of the financial statements?
To sustain the core audit business for the foreseeable future, it is crucial for auditors to demonstrate that their independence is not compromised. Or else, it makes a mockery of the requirement mandating a statutory audit of publicly owned companies when the investing public distrusts the audited earnings number.
In response to the recent unprecedented auditing crisis, the US government, through the Sarbanes Oxley Act of 2002, introduced a number of provisions to overcome the market's lack of confidence in the financial reporting process and to strengthen auditor independence. These include mandatory five-year lead audit partner and reviewing partner rotation, restrictions on providing non-audit services and establishing the Public Company Accounting Oversight Board (POB) as an independent watchdog over the auditors.
But sceptics question the effectiveness of these half-hearted, knee-jerk measures as they fail to address the fundamental problem, namely the endemic conflict of interest between auditors and audit clients. They argue that auditors who are hired, paid and fired by the audit clients are inclined not "to bite the hands that feed them". There is the inevitability that auditors meekly comply with management's wishes and debase themselves to acquiescent gatekeepers.
One vitriolic critic is an accounting professor from New York University. In an opinion piece that was published in the Wall Street Journal in March 2002, Joshua Ronen argues that the US Congress' response to the accounting crisis is inadequate as it does not eliminate the inherent conflict of interest. The auditor-client relationship remains too close for comfort. Ronen proposes that the responsibility for deciding on auditor employment and compensation should fall to an entity whose interests are essentially aligned with those of the investing public.
He advocates that instead of appointing and paying auditors, companies could purchase financial statement insurance that provides coverage to investors against losses suffered as a result of misrepresentation in financial reports. The insurance coverage that companies are able to obtain is publicised, along with the premiums paid for the coverage. The insurance carriers then appoint and pay the auditors who attest to the accuracy of the financial statements of the prospective insurance clients.
Those announcing higher limits of coverage and smaller premiums will distinguish themselves in the eyes of the investors as the companies with higher-quality financial statements. In contrast, those with smaller or no coverage or higher premiums will reveal themselves as those with lower-quality financial statements.
Every company will be eager to get higher coverage and smaller premiums lest it be identified as the latter. This proposed institutional arrangement removes the inherent conflict of interest facing the auditor by severing the agency relation between the firm's management and the auditor. A flight to quality financial statements ensues.
In Australia, PricewaterhouseCoopers established in 2002 an Audit Standards Oversight Board, comprising four members appointed outside the firm to enhance the perception of independence and meet market expectations. According to the Australian Financial Review, the board recently released a report that "described but did not test the firm's policies".
KPMG Australia has also appointed outsiders "with no commercial interest in the outcome" to review its audit practices as part of a campaign to lift the lid on "secret audit business". The reports prepared by Professor Keith Houghton (Australian National University/University of Melbourne) and Professor Ken Trotman (University of New South Wales) are titled Review of KPMG Australia's Processes and Policies in respect of Independence, Conflict Resolution and Quality Controls.
As the audit business stands today, the issue of independence remains a problem for even the most moral, honest auditors and threatens the usefulness of audited financial information. Needless to say, external auditors must be mindful at all times that their ultimate allegiance is to the investing public to detect significant misrepresentation in a company's financial misstatements and to zealously advocate their auditees to "tell it as it is".
Given that auditor independence and competency is directly unobservable to the Malaysian investing public at the moment, it can at least infer the degree of auditor independence from public disclosures of incidence of modified audit opinions, subsequent audit adjustments to the preliminary announcements of financial results and audit and non-audit fees paid to the incumbent auditors.
Definitely more can be done to allay the negative public perception on the real value of statutory audit and minimise auditor independence risk, in addition to the practice review programme introduced by the Malaysian Institute of Accountants early this year.
To the best of my knowledge, none of the leading firms of accountants in Malaysia have appointed credible outsiders to review their audit practices and promote transparency. As for companies buying and selling financial statement insurance, although it is too radical an idea to be implemented as yet, a sharp turn of events may make it a reality. Perhaps there is a trickle of truly premier Malaysian corporations with unquestionable ethics which dare to lead the way and enjoy lower insurance premium.

Joshua Ronen will speak at the Asia-Pacific Journal of Accounting and Economics Symposium to be held at Mutiara Hotel, Kuala Lumpur, from Jan 4 to 6, 2004. Wan Nordin Wan Hussin is deputy dean (development, research and postgraduate, Faculty of Accountancy, Universiti Utara Malaysia