Role of the External Auditor in Corporate Governance

The Role of the External Auditor in Corporate Governance

The external auditor has long played an important role in the corporate governance function. However, before we begin our analysis on how the external auditor plays this role and its importance, we must first examine the responsibilities and duties of such an auditor. Similarly, we need to clearly define what corporate governance is before we discuss in detail the role that auditors play in it.

1. Introduction

1.1 The External Auditor

External auditors are employees of a public accounting firm which has been engaged to conduct the audit of a particular company's financial statements (audit client). The external auditor's responsibility is to provide assurance to the general public regarding the truth and fairness of the information presented in the audit client's financial statements.

Since the public relies heavily upon an audit opinion published by a public accounting firm to make investment decisions, it is imperative that they view accounting firms as being independent, objective and free from the influence of the audit client or any other parties. Indeed, some authors have gone as far as to say that this assurance is the basis of the world's capital markets.

1.2 Corporate Governance in Singapore

In the company-owner relationship, corporate governance is essentially practices and regulations that are implemented to solve the conflict of interest between a company's directors (management) and its shareholders (owners). The need for corporate governance arises from the agency problem between the principal (shareholders) and the agent (management). The shareholders of a company place their trust and their investment in the custody of the management in the hope that the company will turn in profits to reward their investments. However, management's aim will be more aligned towards self profit rather than the advancement of the company's interests. Hence this conflict of interest and lack of goal congruence between the shareholders and management give rise to the agency problem, thereby requiring the implementation of corporate governance mechanisms. In the capital markets, this information asymmetry is amplified and the corporation is even more of a "black box" to its owners who are not involved in its operations.

In Singapore, the Council on Corporate Disclosure and Governance (CCDG) was set up on August 16th 2002 . This CCDG was set up to complement the Ministry of Finance's Corporate Governance Committee .

1.3 The External Auditor in the Corporate Governance Framework

The presence of an agency problem between the management of a company and the shareholders is attributable to the information asymmetry between the two parties. It is due to this lack of information obtainable on the part of the shareholders that the management is able to commit fraudulent behaviour without their knowledge.

Hence, it is the role of the external auditor to act as a mediator of information and as a 'corporate watchdog' in order to bridge this asymmetry of information and prevent or report any fraudulent management behaviour. In light of the new auditor independence rules recently put in place, we will now examine how these regulations will affect the role of the external auditor in corporate governance and whether these rules will actually achieve their intended aim of increasing auditor independence and boosting investor confidence in both the audit profession and in the reliability of financial statements.

1.4 Auditing Standards in Singapore

The main legislation governing auditing in Singapore is the Companies Act. However, there are also other important regulations like the rules on auditor independence found in the Code of Professional Conduct and Ethics, now contained in Part IV of the Accountants (Public Accountants) Rules 2004 of the Accountants Act 2004. This act, previously regulated by the Institute of Certified Public Accountants of Singapore (ICPAS), is now handled by the Accounting and Corporate Regulatory Authority (ACRA), established in April 1, 2004.

This Code of Professional Conduct and Ethics was first issued in 1989 and contained in the Fundamental Principles were integrity, objectivity, and freedom from conflicts of interest. However, a public accountant before the 2004 change was only barred "from accepting an audit appointment if he or his immediate family held a significant beneficial interest in the shares of the company; of if he had a direct or indirect material financial interest in the company; or if he had been an officer or employee of the company for the 12-month period immediately preceding the appointment, or a partner of a company officer, or employed by a company officer." . So what had spurred on the recommendation for change in the independence rules?

2. Cause for Change in Auditor Independence Rules

In the recent years, there have been many high profile corporate failures that had a very large impact on the accounting profession. One such example is the Enron debacle which led to the demise of the accounting firm, Arthur Anderson, then part of the Big 5. This has caused the relationship between auditors and their clients to be heavily scrutinised. Over the years, in a bid to diversify their business to prevent their market from shrinking further , accounting firms now provide many non-auditing services for their clients and this has raised the question pertaining to the lack of independence of the external auditors. This close relationship may cause corporate disclosure to be less credible as auditors are not as independent as they used to be and may pass prejudiced judgements. There may be also an increase in the lack of transparency as the auditor may be more inclined to "turn a blind eye" in a bid to hold on to that extra revenue. For many countries, this meant regulations need to be changed to become stricter, leading to Singapore coming up with the new auditor independence requirements.

3. The New Auditor Independence Rules

The change was brought about by the recommendations of the Disclosure and Accounting Standards Committee (DASC), established in December, 1999. The new rules were much more numerous and more wide-ranging. They were based on the Code, as well as auditor independence rules of professional bodies and other regulatory agencies in Australia, the UK, and the US.

To ensure that these requirements are kept up to date and complied with, the Auditor Independence Committee (AIC) was set up in December 2001. The AIC