Keeping audits in order

Many, if not all, audit firms stand by their system of quality controls. Can the quality controls of audit firms stand against the pressure from the client or even internal challenges such as talent shortage? — gunnar3000/123RF

US$78BIL (RM373.79bil) is no small change — it’s close to Malaysia’s annual national budget.

Yet, an auditor could sign off on financial statements for not just one, but two years, in a row when revenue was inflated for bond issuances by property developer China Evergrande. How did that happen?

Were there extraneous circumstances that led to PwC signing off on the statements for the financial years ended Dec 31, 2019 (FY2019) and FY2020, the statements from which bonds were issued?

Both are now under investigation, with all sorts of speculation given the scale of the fraud and with China Evergrande US$300bil in default.

There is no proof that PwC, which has been the developer’s auditor since 2008, even before China Evergrande’s 2009 Hong Kong IPO, was anything but professional. PwC resigned in January 2023 as the company’s auditor after audit-related disagreements over the financial statement for FY2021, according to China Evergrande.

On PwC’s part, the auditor noted that it did not receive information on certain material matters related to the company’s consolidated statements for FY2021, the year of the default.

PwC did not flag any material matters in FY2019 and FY2020 in the independent auditor’s report section of the annual report. China Evergrande only published FY2021 and FY2022 annual reports last August.

The company was ordered into liquidation in January by a Hong Kong court but because most of the assets are held in mainland China, the courts there will have discretion over how to proceed based on a 2021 agreement. It’s an agonising wait for domestic creditors while foreign ones can basically write off whatever is owed them.

Although not often reported on, the complex relationships between the board, management and auditors play a crucial role in preventing accounting fraud. There is no way of knowing what is discussed or what action is taken to prevent fraud or if a blind eye is turned towards creative accounting practices.

Of course, there are rules on corporate governance but despite that - even when regulators are rigorous in their enforcement - there is still an Enron, the biggest audit failure of them all.

Independent directors play a crucial check-and-balance role in a listed company but that does not seem to have been really effective, not in the case of China Evergrande or in many cases here in Malaysia, with the likes of Serba Dinamik, Transmile Group and of course, 1MDB.

Do cosy boardroom relationshipships play a role? Devanesan Evanson, the former CEO of MSWG, says a good independent director will know when and where to draw the line.

“It is a tough act but necessary for good governance”.

In South-East Asia, where family-owned or -controlled companies predominate even after an IPO, the recourse is always the codes on corporate governance. In Malaysia, under listing requirements, at least a third of the board must comprise independent directors. For large companies, it is at least 50%.

Devanesan acknowledges that it is a challenge to counter families with controlling stakes as they can appoint or remove directors. “There is a risk that independent directors may become subservient to these domineering families,” he points out.

Institutional Investors Council (IIC) believes that when competing interests and priorities come into play, navigating between the board, management and auditors requires a “delicate balancing act”.

Taking the example of FGV Holdings, it says institutional investors and external fund managers have leveraged their shareholding stakes to push for significant change. “As institutional investors, we must strike a fine balance between supporting management’s strategic vision and holding them accountable,” it says.

Rather than taking a dim view of relationships, the IIC believes that these relationships shape the dynamics between the board, management and auditors to form the bedrock of effective governance.

“Trust, communication and mutual respect are essential to build strong relationships and foster collaboration. Board members must navigate these relationships with integrity, professionalism and a commitment to ethical conduct.

“By fostering open dialogue, constructive debate and collective decision-making, boards can cultivate a culture of accountability and transparency that underpins effective governance,” it adds.

For the most part, the public cannot tell whether there is trust, communication and mutual respect, and one can only speculate as to how much pressure independent auditors face when they go through financial statements of clients.

Do the Big Four firms handle the pressure better than the middling ones or smaller outfits? Have they done their utmost to ensure financial reporting of the highest standards and the protection of investors?

It is important to understand how these auditors get reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error.

Many, if not all, audit firms stand by their system of quality controls. For the most part, it works but then how does a massive accounting fraud on the scale of China Evergrande go undetected?

Can the quality controls of audit firms stand against the pressure from the client or even internal challenges such as talent shortage?

It seems a long way to go if accounting fraud of such scale continues.

This article first appeared in Star Biz7 weekly edition.

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