Geoffrey Townsend; Team LeaderMoscow, 11th November 2004

Russian Corporate Governance Roundtable Meeting (OECD / Tacis)

• Statutory Audit of Financial Statements;

• Who audits the auditor?

2

Introductory Comments

Professional Bodies

External Quality Assurance

Public Oversight

Summary

3

Introductory Comments

Caveat: - all views expressed are personal views.

They are not: - the views of the European Commission,- the views of the consortium partners.

4

Introductory CommentsWho are the users of financial statements?Views differ

broader definitions talk about stakeholders.

In this presentation, I shall use a narrower definition.

- Investors, by which I mean: current and future –

Minority ShareholdersLenders.

5

Introductory CommentsWhat Users want:• A flow of useful, current and accurate information from the management.• Most of that information is unaudited; i.e. will be taken on the trust of management. • A part of that information is annual final statements.• Audit is an external, independent verification of those financial statements.• Audited financial statements are usually too late for many investment decisions.• If there are no surprises, they reinforce trust in management.• If there are surprises, they reduce trust in management

6

Introductory Comments

History of Audit:

Audit has been a response to the possible problems arising from the division of management from ownership.

Originally, auditors were a committee of shareholders independent of management.

Increasingly, this task was transferred to outside experts; later this became a legal requirement.

7

Introductory CommentsHistory of the Audit profession:• Auditors began to form professional organisations, modelling themselves on medieval guilds.• These guilds represented the interest of their members, and simultaneously protected public interest.• Later, these guilds received legal privileges

1. Restriction of use of name2. Exclusive right to certain types of business – e.g. statutory audits.

• On the whole, the guilds worked well; but there were scandals. • Guilds have an inherent conflict of interest

– members interest vs. public interest.

8

Specific Problem of Audit Control - 1

“Normal” Contract Structure

Customer

Supplier

General– Normally subject to mutual agreement, i.e. freedom of

contract– Normally, assume parties are equal and knowledgeable; each

knows what he is doing; each protects himselfRole of state• Contract law framework• Court system (last step in dispute resolution)• Protect “weak” customers• Standards (simplification of contract)• Protect third parties

Goods/services Contract

Payment

9

Specific Problem of Audit Control - 2

Auditing

Enterprise

AuditorUserAuditor’s Report

Election of Auditors

ContractFee Payment

ServiceDeliveryFinancial

Statement

Lawsuit (??)

Triangular Problem– User not enterprise, but 3rd party – User not interested in audit technique, only in result– Appointment of auditor

• De jure – shareholder• De facto – management• Also users such as banks, not involved at all

Role of state and SRAAs SRAAs are “experts”; detail is very technical– Represent users’ interests – Set legal framework– Ethical guidelines– Legalize standards (codification of service)– Minimum quality– Set barrier to entry– Ensure auditors “up-to-date”– Force enterprise to appoint auditors– Police quality

10

Professional Bodies

Membership

Accountants?

Auditors?

Audit firms?

11

Professional Bodies

ActivitiesMembers’ interest:

– Lobbying– Training– Conferences– Publications

Public Interest:– Examinations (?)– CPE Monitoring– Compliance + Disciplinary– Inspection

12

Regulation and Discipline

Traditional “triggers”• Complaints• Scandals• Professional investigations• Government investigations• Legal Actions:

- civil,- criminal.

ProblemShutting the stable door after the horse has bolted.

13

Regulation and Discipline

Pre-emptive measures• Standards• Ethical code• Curriculum• Pre-qualification training

- theoretical

- practical• CPE monitoring

and – increasingly• inspections

14

External Quality Assurance

Two triangles or one rhombus?

Audit firm

Professional Organisation

Audit Assignment

Auditor

15

External Quality AssuranceInspect what?

• Procedures

• Independence

• Specific audit assignments.

Inspect whom?

• Firms

• Auditors

Inspect how often?

What to do with results of inspection?

16

Public Oversight

“Auditing too important to be left to auditors”.

“Chaps controlling chaps”.

Professional Organisations have a conflict of interest; they must represent interests of

• Members (who pay their subscriptions and complain)

• The Public (who only complain)

17

Public OversightIntrinsic problems

The topics are very technical

Meaningful inspection only possible by someone with at least the skills of the person being inspected.

Boredom risk

• Intrinsic boringness of subject

• Night-watchman syndrome

• Are results being taken seriously?

Source and remuneration of inspectors.

Parallel Problem (analogy)

How can independent director monitor management?

18

Public OversightHow it fits together

Accountants

Chief Accountant

Board

Audit

Users

Oversight

StandardSetting etc.

ProfessionalOrganizations

Audit firms

AuditEngagements

yardstick

yardstick

19

Public oversight of Professional Bodies

PublicRepresentative

Public InterestActivities

Professional Organisation

Members

Member InterestActivities

Oversight

20

Who should be the focusof quality assurance?

The problem:

There are very many small firms and only a few big ones.

This is not purely a Russian problem:

Auditors Audit firms

Germany (WP only) 12.194 2.178

UK (ICAEW only) 29.947 16.010

But: the focus of POBA in the UK is FTSE 350.

Big 4 – 97%!

21

SummaryAudit too important for auditors

Public oversight essential to improve perception of auditors.

Inspection of audit firms and audit engagements is an essential element.

Done well, inspection can help improve standards; focus on recommendations and follow-up rather then disqualification.

Thought must be given to the quality and training of inspectors

Inspectors’ remuneration will be an issue.

Prioritisation is important.

22

PrioritizationWho is to be inspected:

• Important to cover auditors of public interest companies.• But for smaller audit firms, inspection could be a real

help.What is to be inspected:

Personal view:• In addition to a general programme tailored to the size

of company inspected and complexity of clients.• I would suggest that MinFin publishes a lot of special

concerns on which there should be focus.e.g. Related Parties

Pocket auditors.

Presenter’s contact details

Geoffrey Townsend

tel: 937 – 29 – 51

e-mail: gtownsend@kpmg.ru