Sunday, 25 July 2010

Cosy auditors

GOVERNANCE MATTERS

By SHIREEN MUHIUDEEN

ONE of the big questions we faced in the recent spate of annual general meetings (AGMs) is that whether companies should renew the contract or replace the audit firms. And, how does a company decide when appointing an auditor?

An auditor is supposed to be the company’s best friend, the sort that tells it what it needs – not wants – to hear, especially when the chips are down. But when listed companies in South-East Asia recently held their AGMs, these meetings exposed the annoying reality that the auditors of some of these companies have been unreliable friends.

To be sure, an auditor is in an unenviable position from the start. He is the company’s disciplinarian and so is there not only to ensure that the company complies with financial reporting standards and other best practices, but also to forewarn it of anything risky that might suddenly blow up.

These responsibilities have become even more complex in recent years, as there are now so many different industries and companies with complex structures; an audit firm needs to have sector specialists to manage the audit function effectively. One would presume that gone are the days when auditors should be able to just rubber-stamp a company’s finances.

Even so, we wonder how many auditors tell their client companies hard truths as well as red-flag their transgressions? Will they lose their clients if they push them too hard on tough issues? How far can they push their clients? Should they resign if clients stop taking their advice? From our experience, one thing is very clear: “There are auditors, and then, there are auditors.”

Recently, we reviewed a company that was supposedly recovering. We noted in our review that this company and all its subsidiaries after 10 years were still in the red as at Dec 31, 2009, and the board and management didn’t seem to know how to reverse that. We dug further and found that its share premium rose significantly over the decade because its fixed assets - primarily land for development - had been revalued.

What was very clear is that each time the land was developed and the properties sold, there were writedowns on the value of the assets. This suggested that the existing assets on its balance sheet were overvalued.

These seedy activities raise obvious questions:
● Where were its auditor’s red flags?;
● What was the auditor’s advise before the writedowns?; and
● Did the auditor assess the risk sufficiently before the company revalued the land or did he just bow to its wishes?

This company also cut deals with related parties, and every year for the last seven years wrote these transactions off, which cost it millions of dollars. These losses were too large and too often to be dismissed as occasional business risks.

To get some answers, we reviewed the composition of the company’s board of directors and audit committee. We zoomed in on the audit committee as the obvious source of the oversight. It has three members, or so-called independent directors, two of whom are in their 70s, and have been on it since 2000.

The third is an ex-politician who is well-connected.

While all three have had fairly successful careers, they seem to no longer be able to insist that the company desist its loss-making moves. That’s because these audit committee members must have been aware of all the company’s related-party transactions and write-offs for almost seven years.

We also compared the total audit fees paid. This company paid audit fees which were considerably lower than the average fees paid in the same sector. One wonders if the choice of the auditor was based primarily on fees and not on the best practices that the firm abides by.

We also wondered whether the audit committee discussed any of its real concerns with the external auditors. After all, the company’s annual report states that its board of directors and audit committee will meet every quarter “to acknowledge and monitor” its performance outcome, with “the counterbalance and revision” of the independent directors.

In the same report, this company also stated that it “believes in a good management system” and avowing that its directors and executives had “vision”, were responsible and had a “balance of power mechanism to ensure and monitor transparent management and equitable treatment for its shareholders.”

How can a company state all these when it is consistently losing money, does not have a single subsidiary that is profitable, indulges habitually in related-party transactions and then, consistently writes them off?

We can only wonder how its audit committee members and its other independent directors discharge their duties amid all of the above activities. For now, their profiles and records of attendance at meetings give us neither relief nor belief that they really are, as the annual report puts it, “adhering to the principles of the stock exchange for the optimal benefit of the Company”.

What is very clear to us is that the investment community should stand up and question companies that vote in auditors purely based on fees and cosy friendships.

Shireen Muhiudeen is managing director of Corston-Smith Asset Management in Malaysia, a fund management company that makes investment decisions based on corporate governance.

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