Why the audit function is so important to larger public companies

Why do large companies need auditors?

Author Frank McGivney

Date 20 April 2013

The company structure is the vehicle by which people with resources can invest in different enterprises in order to increase the long term value of these resources (share capital growth) and to obtain some short term income from their investment(annual dividends) .The company structure allows investors to risk some of their resources while availing of the protection of limited liability. This means that the extent of any loss they will incur is limited to their investment. If a company fails then their other  resources and assets will not be affected. This is a vital prerequisite in order to encourage investors to take the risks involved in putting money into any enterprise. Before the advent of the principal of limited liability the investor could lose all of their wealth if an enterprise failed. 

As companies have developed over the centuries there has been a separation of management from the ownership of companies. In the modern world companies are owned by a large number of investors (shareholders) and the company is run by the directors. This means that the people who run the company are different from those who own the company. This has lead to the development of the agency theory. Essentially the directors act as agents for the owners. The objective of directors should be to maximise the return to share holders both in terms of long term growth and in short term revenue, while also protecting the interests of other stake holders, while still operating the business in accordance with company law regulations and requirements. Agency theory contends that directors however will be motivated to maximise their own salary, benefits, bonus and share options. While also maximising the short term share price so as to reflect favourably on their own personal success in operating the business. However the pursuit of these objectives does not necessarily lead to decisions that are in the best interests of shareholders. This conflict of interest is the reason that auditing is so vitally important. Once one man is entrusted with the resources of another for the pursuit of wealth then given the nature of man it is vital that the fidelity of the controller of the resources is checked and verified.

In Ireland and the UK there has developed an option for smaller private companies to claim audit exemption. This is because in a lot of small companies the above separation of ownership and control does not occur because the owners are also the people who run the company. Therefore the need for an audit is diminished. Also it allows small companies to avoid the high costs of audits, However even within these companies there are published guidelines as to how their accounts should be produced so that they still have financial controls to protect other stakeholders such as creditors and the revenue commissioners.

 Of course in most cases auditors and mangers are on the same side as they attempt to protect the assets of a company and identify anyone who is trying to commit fraud. However they can diverge when it is the managers/directors who are the actual ones who are trying to commit fraud or enrich themselves at the expense of the shareholders of the business. At this stage they separate as the auditors are the ones who will attempt to identify any such malpractice or fraud. The effectiveness of external auditors to actually identify such misbehaviour has been justifiably called into question. Most fraud is identified by whistleblowers and by other parties rather than the external auditors. Currently a lot of work is been undertaking in the accountancy field to rectify this situation. Of particular concern in my opionion is the fact that the four big accountancy firms are the only ones who perform audits in public companies quoted on stock exchanges. Also companies don’t change their auditors regularly and therefore a relationship develops which is not consistent with the off hand nature that auditors should operate in. Some suggestions are that public companies will have to change their auditors regularly. It is also suggested that the firms of a size just below the big four accountancy firms should be allowed to develop to order  to compete for public company audits, There are market forces which are an obstacle to these firms growing to the size where they can compete for public company contracts and these need to be removed in my opinion in order to give more credibility to the profession

 The Cadbury report was produced because of Robert Maxwells Mirror group scandal and the BCCI scandals. In 1992 it stated that “The central issue is to ensure that an appropriate relationship exists between the auditors and the management whose financial statements they are auditing.”

Prior to 1844 in the UK and Ireland only the crown could issue Charters of Incorporation. Examples of such charters were The Honourable East India Company and the South Sea company. The south sea Company was the Enron of its day where false claims of potential profits lead to huge investments in the company. The business proposals proved to be fraudulent and the company collapsed leading to the ruination of many of the investors. The industrial revolution lead to a huge increase in the level of trade and manufacturing in the UK and  an Act of Parliament was passed in 1844 that allowed the incorporation of Joint stock Companies. This was followed in 1855 with the passing of the Limited liability Act which allowed for investors to quantify the risk of loss they were taking in their investments. This resulted in the divergence of ownership and control in large public companies as discussed above.

In 1900 the push towards accountability took a big step with an act that required the publication of a audited balance sheet and thus began the steps to the modern situation of producing full audited accounts by large public corporations in a way to ensure transparency and accuracy in the accounts and information presented to the public.

In Summary audits of large companies are necessary in order to protect the interests of all its stakeholders. These stakeholders include the owners of the business. The auditors function is to ensure the owners investment is safe and that the directors aren’t diverting the resources to their own gain. The auditor also protects creditors to ensure that the assets of the business are preserved to allow it to pay its debts. The auditors’ objectives are extremely complex in the modern business environment and hopefully all of the current developments will give confidence back to people in the work of the auditor.  

We specialise in producing audit exempt accounts for small and medium size companies in Ireland to the high standard required by the Companies acts 1963 to 2013 and accounting standards.
Frank McGivney & Co. Chartered Management Accountants Kells, Co Meath