The Australian Institute of Company Directors (AICD) has recommended companies undertake robust reviews of their external auditors every five years to instil investor confidence and avoid accounting misconduct.
These sentiments are something Directors’ and Officers’ (D&O) insurance underwriters have been encouraging for years when reviewing company risk profiles. Implementing a review or even having a fresh set of eyes has always been considered good financial management, usually indicating financials have undergone regular health checks. This article takes a closer look at the recommendations and why they matter when it comes to insurance coverage.
Key areas of concern for underwriters
The routine would promote a strong culture focused on audit quality, effective supervision, review of audits and accountability of partners, managers and staff for audit quality and finding the effective root cause of problems. Most negative findings tend to relate to auditing asset values and impairment of non-financial assets and the audit of revenue. These are some of the key factors underwriters examine when assessing risk so it is important that these figures are accurate in the auditing process. When the auditing process is careless, it can cast doubt over other factors such as company liquidity, the ability to meet short term obligations, debt levels and serviceability, as well operating cash. This can be disconcerting, as a key concern for underwriters is insured solvency, and once aspects of the financial reporting are questioned it can be hard to find solace in the rest of the reporting.
The AICD also examined whether Internal Audit Committees should closely monitor whether their auditors are also performing non-audit work and consider how amenable they are to questioning. Underwriters echo such sentiments with non-audit work seen as having the potential to generate conflict and impact independence. This is not to say such work demonstrates a lack of independence, but the provision of such work tends to put underwriters on higher alert. Financials are the backbone of the D&O underwriting process, so where doubt is cast on the integrity of accounts, underwriters tend to take a more “glass half empty” approach.
Implications for company directors
Ultimately, company directors in Australia cannot afford to be complacent. The global spotlight has been on audit quality in countries such as the USA and Canada with more rigorous regulations being established in those jurisdictions.
It should also be stressed that ASIC has started to disseminate its findings on a consistent basis with Internal Audit Committees, especially with the growing global focus on audit quality. Last year ASIC made it clear it would go directly to company directors when auditors have made significant errors in addition to its annual audit quality reports.
The AICD has contended the five-yearly reviews would mean extra work for Internal Audit Committees, however, the financial market is starting to develop expectations that companies must have strict guidelines in their auditor selection process.
To assist, the AICD has provided step-by-step guidance for audit committees requiring the committee to complete a wide-ranging review of their external audit firms every five years by consulting the auditors and company management. The review would outline whether providers were retained without conditions, retained with some changes, or whether the work should go to public tender.
Measures will incorporate the following:
- Internal Audit Committees must consider who their auditors were, how long they have provided the service, their firm’s transparency reports, and whether audits were done on time and how they were taken
- The committee would need to review how upfront the auditor was in addressing difficult situations, (as this is a strong indication of their independence), and whether they adequately challenged estimates and accounting policy choices. It should also be stressed, D&O underwriters place a considerable amount of importance on whether or not an auditor provides a qualified or unqualified opinion. If an auditor has a proven track record of meticulousness and questioning Management on accounts with solid reasoning, an unqualified opinion carries significantly more goodwill in the eyes of underwriters
- They should also review the quality of the teams on the job, looking at their background and expertise and how audit partners were overseeing juniors
- Feedback should also be given by the Internal Auditor to the Board, and external auditors should address questions concerning their independence and any issues raised by regulators
The AICD has said that mandatory auditor changes would not fix the issue, given how small the market is, however stringent and detailed reviews would assist. Australian audit firm placements are very long in comparison to other countries; however, transparency can be significantly improved by rotating lead partners on audits and not the firms themselves.
Overall, the measures are a step towards improving auditor effectiveness, and they will no doubt provide an added safeguard for underwriters when assessing a client’s internal and external audit practices This will in due course help pave the way to more favourable terms and conditions for D&O insurance, especially as momentum starts to carry with companies taking up the new guidance.
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Client Manager – Professional & Executive Risks