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Corporate Governance: Do non-audit services create a conflict of interest?

There are some issues in corporate governance that seem
impossible to pin down. One of these is the question of whether the provision of
non-audit services to a client alongside the traditional audit creates enormous
conflict of interest. Or whether the conflicts can be managed. Or whether they
exist at all.

On the surface, it is a very simple issue, ­ which is why the Treasury Select
Committee, for example, keeps returning to it. It is something it thinks it can
get to grips with easily. But every time it tries, the whole thing eludes it
once more.

The argument goes back years and grew from simple beginnings. Audit teams
descended on the client to carry out the audit and at the end of the process
they provided a management letter that pointed out problems in internal
controls, or some other weak area of financial or operational management spotted
by chance, and thought management ought to rectify.

Some of these problems management could easily rectify itself. But no! The
logical thing was to send in a team from the audit firm, which by now knew the
place and its systems inside out, to do the job as a one-off for the client. And
everyone goes home happy: the audit firm earns an extra fee, the finance
director and his team can boast a clean bill of health and a problem is dealt
with swiftly.

That worked when companies and audit firms were more modest in both scale and
complexity. It is very different now. The provision of non-audit services has
had a bit of a cloud over it worldwide. And to be fair, the large audit firms
have tended to cut corners at times, overplay the extent to which they are
blameless and have effective Chinese walls in place.

But corporate governance has changed much of that culture. Look at the annual
report of any serious company and you find a note along the lines of,
“Assignments awarded to the auditors are subject to controls by management and
have been agreed by the audit committee, so that auditor independence is not com
promised.”

Regulators and politicians tend to make an enormous fuss about it. What is
often ignored, though, is that investors, shareholders, audit committees and all
the real owners of companies tend not to worry too much about it at all. As long
as it all works and they have an assurance that all is well ­ and independent ­
they tend to be happy with the arrangement. All of which makes regulators and
politicians even more furious.

Hence the most recent fury from the Treasury Select Committee which, though
there appeared to be little evidence from the deliberations that supported it,
announced in May 2009 that it strongly believed “investor confidence and trust
in audit would be enhanced by a prohibition on audit firms conducting non-audit
work for the same company.” The committee suggested that the Financial Reporting
Council (FRC) should consult on this issue as soon as possible. So it did. And
now the responses are in. We all wait to see what the FRC is to do. But in the
meantime, a really heavyweight response and survey has made the argument plain.

The Institute of Chartered Accountants of Scotland put together a working
group of finance directors, academics, non-executive directors and auditors.
This included people from BP, the Association of British Insurers and fund
manager Hermes ­ all big-hitters. More importantly, the working group conducted
a survey among finance directors and the chairs of audit committees. These
people are, after all, the ones who, according to the politicians, would be the
most likely to say that the current system is an outrage.

So what did they say? “There is no appetite among investors and corporate
entities for introducing a complete prohibition on auditors providing non-audit
services to their listed audit clients. No respondent to the survey of audit
committee chairs and finance directors supported such a move. Likewise, none of
the investors consulted supported such a move.”

What it did suggest was greater transparency and changes to the existing
regulations. At present, for example, the figure for the audit of subsidiaries
has to appear under ‘other services’, which hardly adds clarity to the argument.
Financial Director was recently contacted by an accounting student
querying the very same thing.

In the end, as the working party makes clear, it comes down to what
politicians think, rather than what actually happens. The worry about investor
confidence in the independence of auditors, it suggests, is “a perception issue
and not reflective of the actual position.” But as the most recent Treasury
Select Committee hearing in early February revealed, the politicians are a long
way off losing their appetite for barking furiously up the wrong tree.

Robert Bruce is a leading commentator on accountancy issues

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