Perspectives

January 2004

Auditors as Leaders

By Mary Ellen Oliverio

Key executives of many companies involved in the ongoing financial scandals have made public statements identifying their external auditor as an influential advisor and claiming to be uninformed of key accounting matters. Those statements don’t answer obvious questions about the effectiveness of the external auditor in adhering to the professional standards of the Auditing Standards Board.

This professional guidance clearly identifies the role of the auditor in ensuring that management understands its responsibilities.

Why, then, do the words “auditor leadership” sound like an oxymoron? The auditor’s objective in performing an ordinary audit of financial statements is, according to the AICPA, “the expression of an opinion on the fairness with which [a company] present[s], in all material respects, financial position, results of operations, and cash flow in conformity with generally accepted accounting principles.” That objective is straightforward and does not seem to directly reflect the need for leadership. But a closer look at the environment in which the auditor functions and what the auditor is expected to accomplish reveals considerable leadership responsibilities.

The auditor has an overriding responsibility to serve the public interest and is committed to providing credibility to the financial statements. The auditor must also be certain that management understands its responsibilities. I propose the following operational qualifications for “auditor leadership” to be exhibited by an engagement partner:

• The ability to compel both the client and all audit team members to fulfill their responsibility to the public interest when financial statements are audited.
• The ability to convince the client that it is advantageous to present fairly the financial information included in financial statements.
• Skill in communicating the responsibility that the client assumes for the financial statements.
• The ability to maintain a sense of due professional care among all members of the audit team and all specialists that participate in the audit.
• Skill in communicating to the audit committee—or its equivalent group—its importance in assessing the quality of the entity’s financial reporting.
• The ability to support the recommended treatment for questionable transactions and for adjustments resulting from substantive auditing procedures.

The foregoing are clearly stated or implied in professional guidance for audit engagements. This professional guidance, crafted over many years of serious commitment on the part of practitioners, is impressive. The failure is often in the implementation of that guidance.

Leadership in the Initial Meeting

External auditors, in their initial encounters after accepting an audit engagement, should clearly communicate the client’s responsibilities in relation to the financial statements that are to be audited. According to the AICPA’s Professional Standards (AU110.03), key executives must be informed that:

The financial statements are management’s responsibility … Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, record, process, summarize, and report transactions … consistent with management’s assertions embodied in the financial statements. … Thus, the fair presentation of financial statements in conformity with generally accepted accounting principles is management’s responsibility.

Assurance of Acceptance of Responsibility

External auditors expect that a client’s leaders accept the stated responsibility. Such auditors remain attentive in all interactions with key executives to assure themselves that the client has internalized its responsibility in both attitude and actions. For example, further discussion is needed if a CEO says something like: “We are paying you because you are accountants as well as auditors. I’m not an accountant. You know what you are doing. Whatever you think should be done is what you should do. We delegate responsibility to you.”

The audit partner who hears such a comment, or learns of such a comment from the onsite senior or manager, should recognize that further conversation with key executives is in order. In that discussion, the audit partner should point out that the auditor’s public interest responsibility is not unlike the client’s own interest in ensuring the public receives fair disclosure of financial information.

Leadership in Initial Planning

The auditor must set the tone for competent performance at the initial planning session. Although the audit team members may be experienced and know what is required, the audit partner, acting as a leader, should reinforce, teach, and encourage all team members to maintain high standards for every aspect of what they will be doing.

Professional skepticism is possibly the key quality of due professional care. It requires that no assumptions about the honesty or dishonesty of management are made. This attitude leads to an objective challenge of the sufficiency and the competency of the evidence obtained.

There should be a good-faith, professional effort to maintain an audit risk of no more than 5%, which means the auditor should design and complete the audit with 95% assurance that the conclusions would agree with a replication of the same audit by another team.

Sharing Information

Auditors should understand their clients’ businesses and industries and know the risks a client faces, as well as what those risks impose on the audit team as the work progresses.

Audit partners, thinking as leaders, must realize that team members that are uninformed about the environment in which they are working are unlikely to perform well. Therefore, the audit partner should not consider it a waste of time to instruct the audit team—even though some team members may have been on prior audits—about the client during the initial stages of an audit. The audit partner, as a leader, should provide information including the following:

• The status of the client’s business, including updates from the previous year if it is a continuing engagement. The audit partner should also provide information regarding the nature of the client’s business.
• The current state of the client’s industry and the extent to which changes in external and internal factors affect the clients risk.
• Observations about the client’s business that are central to the team’s understanding of the tasks they are to perform.
• Continuing and new risks related to the client’s business or industry. Matters such as a complex organizational structure, related-party transactions, and new regulations may be the basis for identified risks.
• An overview of what is to be expected in relation to the audit, including the level of client cooperation and the quality of the client’s internal controls.

The audit partner should also ensure the audit team’s independence from the client. If the audit firm is also engaged in nonaudit services, such services must be reviewed and a strategy for their completion designed so as to not impact the independence of the audit team, in fact or appearance.

Leadership During the Audit

Because audit partners are generally involved in more than one audit at a time, a considerable amount of delegation is expected on any audit. No audit partner, however, should relinquish the overall responsibility for the audit. The audit partner must remain fully aware of what is happening and know when reality differs from expectations.

Audit partners must ensure that all audit team members understand their responsibility for immediate feedback to their supervisors, seniors, and managers, about troublesome events and observations encountered as they perform audit tasks. One audit partner’s comments in the initial orientation to a continuing audit, on which many team members had served during the prior year:

We are fortunate to have such a knowledgeable team for this year’s audit. As you recall, last year we were surprised that one key assumption and the related expectations going into the audit were soon revealed to be wrong. The two staff auditors who first alerted the manager and me to the variance were reflecting the kind of initiative and immediate feedback that we prize.

I’ve given you an update based on the key manager’s and my observations and inquiries of executives. However, all of us must be alert to variations between what we are saying here and what we actually discover as we proceed with the strategy for this audit. Remember, all judgments are tentative and are open to revision as we move ahead with our audit programs.

This type of feedback from seniors and managers informs an audit partner about the effectiveness of the initial orientation to an audit. The questions raised, the concerns of the team members, and the problems encountered in fulfilling the requirements of an audit program must all be assessed by the audit partner. Understanding the overall framework of the client’s financial reporting system and the output of that system enhances the competency with which each team member performs assigned tasks.

Leadership in the Concluding Tasks

As the end of the audit is contemplated, the audit team should determine the adequacy of what it has done. The effectiveness of the audit strategy that guided the performance of an audit requires careful assessment.

The AICPA’s professional guidance states the need to evaluate audit findings as follows:

In evaluating whether the financial statements are presented fairly, in all material respects, in conformity with generally accepted accounting principles, the auditor should aggregate misstatements that the entity has not corrected in a way that enables him or her to consider whether, in relation to individual amounts, subtotals, or totals in the financial statements, they materially misstate the financial statements taken as whole.

The auditor is also required to complete analytical procedures in the review stage of an audit:

The objective of analytical procedures used in the overall review stage of the audit is to assist the auditor in assessing the conclusions reached and in the evaluation of the overall financial statement presentation.

Communicating with the Audit Committee

Auditors are expected to communicate certain matters to the audit committee, or when the client has no audit committee, the group that assumes responsibilities comparable to those of an audit committee. Such matters include fraud, illegal acts, reportable conditions, and material weaknesses in internal control.

There are other matters that are specified in professional guidance that are to be communicated to the audit committee, or comparable group. This communication considered “incidental” to the audit may take place at a time selected by the audit partner. Matters that are to be communicated include the following:

• The auditor’s responsibility in performing an audit;
• The client’s significant accounting policies;
• Management’s judgment, reflected in financial presentations;
• Audit adjustments;
• The auditor’s judgment about the quality of the entity’s accounting principles;
• Other information in documents containing audited financial statements;
• Disagreements with management;
• Consultation with other accounts;
• Major issues discussed with management prior to retention; and
• Difficulties encountered in performing the audit.

Guidance Requires Professional Judgment

During its evolution over the past decades, professional guidance for auditing has been a responsibility of the profession. Now, however, the Public Company Accounting Oversight Board has announced that it will be responsible for auditing standards for publicly owned companies reporting to the SEC.

Because of variations in entities, auditing guidance inevitably requires professional judgment in implementation. Yet, the range for professional judgment is clearly described in standards and related statements. As the alleged audit failures are disclosed in the business press, it appears that the problem is not that the guidance is insufficient; it appears that the implementation has lacked the professional judgment expected of independent auditors.

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