Compliance or Defiance: Auditors’ Role in Corporate Governance

Let's reminisce of our younger days; simply imagine your parents just pulled out the most aromatic, life-altering cookies from your oven and placed them on your counter. They then walk out of the kitchen and leave whilst the freshly baked smell is still wafting throughout the house. Inches away from sinking into a perfect plate of cookies, despite your parents having repeatedly warned that you cannot have a cookie until dessert, you think, “What’s the harm in taking one? Taking two even! They’re never going to find out”. 

Except in our financial markets, rather than a wide-eyed child yearning for a cookie, it is Fortune 500 global companies toying with billions of dollars while seemingly only being surveyed by their weary parents; auditors.

Auditors in Corporate Canada

Auditors possess an extensive role in corporate governance and citizenship. Their job entails ensuring businesses maintain adequate security measures against corporate corruption or fraud. The position of auditors in corporate Canada, such as the “Big Four”– Deloitte, Ernst & Young, KPMG and PwC –  is so vital that they are regulated by The Canadian Public Accountability Board (CPAB). 

In 2021, the CPAB launched an all-time high quantity of enforcement actions arising from inadequate 2020 firm investigations, in which the quality of audits were deemed inconsistent; leading to problem audits. The board declared the primary concern to be a lack of business rationale toward unusual transactions or contradictory evidence. Auditors were too frequently sweeping this evidence, such as irregular material transactions under the rug. This can be indicative of asset misappropriation and fraudulent financial reporting. 

From their findings, the CPAB flagged two of the Big Four firms for exceeding their problem audit targets. This is not the first time the Big Four have been recognized for violating accounting standards in recent years. In 2021, Deloitte employees were exposed for falsifying time stamps on audit work papers, and in 2022 over 1000 PwC employees were caught sharing training exam answers, including questions regarding ethics. 

But what’s the harm? Who cares if mom or dad never realizes you snuck an extra cookie or two? Why does it matter if our auditors don’t crack down on every last misstatement companies make? 

The answer dives into the ethical aptitude of our entire financial system itself.

A Lack of Corporate Governance  

Our society’s businesses are expected to conduct their operations with corporate governance. Defined as the method of guaranteeing a company remains accountable, transparent, and fair within each step of their business practices, the main objective of corporate governance is ensuring a firm’s management is continually acting in its stakeholders' best interest and handling the company’s finances efficiently.  

In a perfect world, companies would invariably hold themselves to these standards. Inevitably, our world is not perfect, making auditors essential in nurturing economic balance and safeguarding the best interests of external stakeholders (customers, creditors, investors, suppliers, and surrounding communities). Auditors aid in building confidence and trust in our financial markets. Their vetting of companies brings validity and integrity to the information millions trust on a daily basis when making critical, potentially life-changing decisions within their investments and finances. Decisions, which on a lower scale, can determine the fate of a college fund, down payment for a home, or financial independence.  

On a larger scale, the decisions influenced by audited financial statements can dictate mergers and acquisitions, stock valuation, and lending decisions – leaving ripples throughout entire industries.  

Suitably, a corporate world deficient in integrity and governance would entail disaster. When disaster does strike, it is the most vulnerable of external stakeholders who bear the brunt of the burden. Consider the 2008 financial crisis, which saw GDP plummet and millions of Americans lose their homes to foreclosure. This recession was swayed by corporate governance issues pioneered by internal stakeholders, including all-powerful CEOs, weak management control systems, focus on short-term financial performance goals, opaque disclosures, and meagre codes of ethics. The immoral decisions made by management, in tandem with a lack of adequate corporate governance, created an extreme distrust in financial institutions by the general public as they were left powerless, in despair.  

In examining recent trends, there is a lack of transparency, thoroughness, and long-term consideration in today’s modern corporate auditing industry, which implicates heavy ethical and financial consequences on internal and external shareholders alike.  

Without urgent change, accounting firms may face the same fate as their failed comrade, Arthur Andersen LLP, in 2002. The scandal entailed questionable accounting practices by energy mogul Enron Corporation, creating overstated profits, and the omission of evidence on the part of auditor, Arthur Andersen. This case saw the bankruptcy of Enron and the eventual dissolution of Arthur Andersen, once one of the most dominant accounting firms globally. This scandal influenced federal legislation in the United States, like the Sarbanes Oxley Act, as it was one of the country's most significant bankruptcy filings in history. The Act was swiftly passed to prevent auditors of publicly traded companies from providing business consulting services to their audit clients, reducing conflicts of interest.  

Tightening Up 

To avoid inciting another economic disaster or firm dissolution, it is evident that the Big Four need to tighten up their procedures, and regulatory boards —like the CPAB —must be more punitive with their findings. 

Many have called for a greater or complete entity separation between audit and consulting service lines within the Big Four firms, due to beliefs that consulting’s increased presence has hindered audit quality. Regulators are becoming worried that expanding into the more lucrative consulting business will prompt firms to be primarily consulting-focused rather than audit-focused. As a result, the audit practice and subsequent audit quality will be demoted in terms of importance to firms' upper management. This will lead the Big Four culture to deviate from an honest mindset serving the market to a profitable mindset rooted in client advocacy. Firms must strictly abide by the Sarbanes Oxley Act and prioritize their audit practices over the bottom line to provide high-calibre audits that don't breach independence threats.  

Further, the lack of transparency from the CPAB is a prevalent reflection of our country’s prioritization of corporations rather than the public’s best interest. Although the board found that two of the Big Four firms had violated CPAB regulation, they refrained from revealing the identity of these companies. The CPAB is in place to hold these firms accountable. Their role of enforcing accountability cannot be fulfilled when they continue to protect and shield firms from the public eye. As the issue spirals, the CPAB is now considering disclosing increased information regarding problematic audits and the names of the firms that conduct them. However, heavy resistance persists. The board is continuing to review feedback on this concept, as they know it will follow with serious pushback from the affected firms. 

So, what are the warning signs? What should our auditors look out for to mitigate corporate corruption and fraud? Easy identifiers include weak risk management processes, - which can stem from outsourced internal audit departments, stock option over-use, and the diffusion of responsibility where much of management is unaware of ongoing financial consequences. Continually approaching situations with a mindset of professional skepticism will aid our auditors in sniffing out deceitful information.  

Although we have seen improvements, such as stricter amendments in the CPA Code of Professional Conduct regarding auditor independence and misleading documents, repercussions for misconduct must be more severe to catalyze ethical progress. The Big Four continue to see growth year over year, so without a significant decline in business and client acquisition, they will remain stagnant in their lack-luster practices. This decline can come from regulators, like the CPAB, being more transparent and directly naming firms to deter new clients from top offenders. 

So, the next time you choose to sneak that extra cookie, just know your parent may still be peaking around the corner, and that compliance tastes much sweeter than defiance.