Question

Given that financial fraud occurs even with the presence of outside auditors, what steps do companies need to take in order to make sure that their financial statements remain accurate and trustworthy? How can a company better support the role of an outside auditor?

Answer 1

A: Of late, financial frauds are on the rise and this is because of management control wresting in the hands of the owners/shareholders either directly or indirectly. The credibility and reputation of external/outside auditors and credit rating agencies have taken a beating as they are found wanting by sitting on the fence and should have been doing their jobs with utmost transparency and ethics and calling out any frauds and blowing the whistle to the board of directors in the event the management is involved in the fraud or is abetting it or even if ignoring malpractices and refusing to take cognizance and action.

Some of the steps that companies need to take in order to make sure that their financial statements remain accurate and trustworthy are:

1. Divest management control from the company owners - owners should not play an active role in the operations and owners and their families cannot hold management positions in the company.

2. Have a whistle blower protection policy in place to protect the interests of the company by encouraging an organizational culture transparency and honesty from top to bottom levels.

3. Clearly defined reporting structure for external auditors wherein their first line of reporting will be only to the CFO - Chief Financial Officer or Director, Finance of the company for streamlining purposes and if the CFO / Director, Finance fails to check malpractices or is involved or is on leave/unavailable then reporting should be directly to the CEO or M.D. of the company. External auditors should not report to anyone else in the company to ensure direct management control and bypassing any politics or vested interests in the company.

4. An external ombudsman must be appointed by the company to hear and resolve any complaints from external stakeholders pertaining to financial issues from shareholders issues, customer complaints, complaints from bankers, creditors, suppliers, vendors, franchisees, etc. This will aid and support transparency by putting in checks and balances on any company malpractices being brought to light immediately for the company management to take corrective action. The external ombudsman is directly reporting to the company CEO or MD and will have the full support of the top management.

5. External auditor reports must be verified and submitted to the board of directors on a periodical basis to ensure accountability of the management.

6. External auditors must be appointed on a fixed-term contract basis and they must be changed every three years to ensure there is no nepotism or corruption by the management in their appointment to mitigate the risk of manipulation of financial statements at the behest of the management.

7. The management must ensure that there is a clear corporate governance policy and practice in place which is transparent and accountable to the owners / board of directors.

8. The CEO / MD of the company must be on a fixed term basis to ensure controls and checks on management conduct to ensure there is no free run over the company.

9. External auditors statements must also be audited at random to ensure compliance and accountability.

10. External auditors cannot be employees, ex employees, relatives or friends of employees of the company or its management.

The company can ensure support to an external auditor is supported by a few very simple and straightforward measures:

1. The external auditors can directly approach and report to the company board of directors / owners in the event of any suspicious conduct on the part of the CEO / CFO of the company to either manipulate, abet or cover up any financial irregularities.

2. The external auditors reports must be submitted to the board of directors for verification purposes to ensure accountability on the management.

3. The external auditors should be appointed and terminated by the board of directors directly so that the management cannot interfere, obstruct or pressure them to participate in any financial statement manipulations. The external auditors must report to the management only for audit activities but they report administratively to the board of directors / shareholders / owners and not to the management.

4. External auditors must be given authority by the board of directors / owners to recommend immediate suspension of any operational activities or staff irrespective of position or tenure, if any irregularities are witnessed and recommend immediate investigation.