Saturday, April 18, 2015

Auditor is a Watchdog in the Business Organization

At one time the audit was conducted primarily to inform management of irregularities and inefficiencies in the business. Due to which the world’s conception for the auditor was developed as bloodhound who is responsible to detect and prevent fraud and irregularities. Later on the concept was gradually changed as the auditor’s role as a watchdog more than the bloodhound due to inherent limitations of audit. The audit was intended only for a limited number of business which gradually was broadened to a wide range of business. The need for independent audits was generated by public ownership of business enterprises and by the requirements of the investors, investment specialists, stockholders and lenders demanded more reliable information. It is now well recognized that the audited financial statements are even intended for the use of third parties who have no contractual relationship with the auditor. The auditor's function has expanded from that of a watchdog for management to an independent evaluator of the adequacy of disclosures and fairness of results depicted by the financial statements issued by management to stockholders, creditors and others.
It is the responsibility of auditor to provide independent opinion on the truthfulness and fairness of the financial statements during the course of audit, the auditor may also provide the details (error and irregularities either intentional or unintentional). In case of any abnormal situation, the remedial action has to come from the owner of the entity. He has to discharge his responsibility by informing about the irregularity found in the normal course of audit.
Markets are only viewed as a safe and stable if investors can trust the activities of the auditors. Duty of the auditor is not to harm other person. As a professional accountant, the auditors must be sincere, systematic, honest, truthful, and tactful. An auditor has a professional knowledge and expertise in his field. The auditor owes the highest degree of care possible to his client and must deal with his client in the utmost good faith.
As part of private profession with a public mandate, the auditors face unique pressures and challenges that demand their careful attention and impeccable judgment. Audit profession is such type of profession that demands auditor to protect the public interest and trust, even under the weight of management’s pressure. The “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

Expectation Gap: Watchdog or Bloodhound
The extent to which an external auditor is responsible for a failure to detect fraud is probably the classical example of the gap between what an auditor sees as the auditor's responsibility and what company directors, shareholders and even the public expect of an auditor.
As per Nepal Standard on Auditing (NSA)-200 Objectives and General Principles Governing an Audit of Financial Statements “the objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with applicable financial reporting framework.”
As such, NSA addresses material misstatements of the accounts resulting from fraud, rather than the fraud itself. The implication, therefore, of NSA, is although the auditor should plan the audit with a reasonable expectation of detecting if fraud does not result a material misstatement, then the auditor will not necessarily have a duty to uncover it.
The role of auditor is sublimely unique. Audit is only the profession which actually intends to detect the material misstatement and convey with the management to adjust the financial statements and in other case issues a qualified opinion in contrast to the modern concept which states that the “customer is always right.” And then should emphasis other profession does not boost public confidence.
However, the public has big expectation with the auditor. Public assume that, the auditor shall know all about fraud and there shall not be any stone unturned regarding fraud.

Legal Precedent
The principle “Auditor is watchdog” is widely accepted in the world. This principle is originated form the court decision. Hence, it is very strong and legally backed principle.
More than 100 years have elapsed since the Court of Appeal in England delivered a landmark judgment in the Kingston Cotton Mills case. The facts were reasonably simple and not contended by the parties. The company’s managing director, who subsequently confessed the frauds he committed, had falsified its accounts. In particular, the quantities and value of the company’s stock had been falsified for many years but there were nothing on the face of the accounts to excite suspicion. It was suggested to the court that the auditor should not have relied solely on the representation of the managing director and should have further investigated the matter. In a unanimous judgment, the three Lord Justices reversed the decision of the lower court and found in favor of the auditor:
“It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion, or with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound. Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud, when there is nothing to arouse their suspicion ...So to hold would make the position of an auditor intolerable.”—Lord Justice Lopes Regarding Kingston Cotton Mills (1896)

In this famous judgment, Lord Justice Lopes, perhaps unintentionally, shaped the very ethos of the audit profession for the next century. In the watchdog mindset, the profession adopted a passive approach to an audit, together with an implicit presumption that the representations made by management could be, and indeed should be, relied upon. Yet, whatever the merits of this philosophy 100 years ago, the audit profession is increasingly seen as having failed to meet the public interest, particularly over the last few years. The flood of recent corporate failures and punishment to auditors irrefutably challenges to the flaws of the watchdog-driven audit philosophy. The auditor shall be honest and works as an active watchdog rather than sleepy dog. Unfortunately, for the profession, some blue –blooded auditors kept watching while the burglars   ran away with shareholders money in some high profile corporate scandals. Currently, many auditors play as a sleeping dog rather than active watchdog, based on this principle.

The need of the hour is, for the audit profession to rediscover its ethics and reinvent itself to capitalize on the emerging new frontiers. The theme of this judgment is to make auditor more ethical and loyal to the organization.
Auditors owe to their clients the highest duty of care possible – fiduciary duty. When the auditor breaches that duty, liability can result in financial reimbursement to the client for the losses sustained.
An auditor is not expected to be a bloodhound and detect every fraud and flaw in the company's books. Nor is an auditor exposed to indeterminate liability. To the contrary, the courts recognize the need to control the expansion of liability for negligent misstatement and economic losses. The development of proximity of relationship as a limitation on duty of care is to be welcomed by auditors.
Like a watch dog, auditor should protect the interest of those who appointed. Auditors are not servants, they are independent third parties with no financial interest. So, the auditor should not be in favor or interest of who appointed him but should be loyal to his profession and point out what is wrong and what is right. If auditor starts to become loyal to the person who appointed him, then it can be great chaos. In that case it refers that if auditor is concealing the tax liability of the company to preserve the interest of the shareholder it is alright but that is not ethically and professionally correct. But he will assume the servants of the company honest and he will rely on their statements. Further he can take a reasonable care. He should perform his duties with competence and due care. The attitude of watch dog will not reduce his responsibilities.