Auditor: A watchful guardian

The auditing profession should consider whether some elements of forensic audit be included in audit procedures

Large-scale frauds were reported almost in every decade from the time business became an important component of the social system. Risk management, including fraud risk management, is the primary responsibility of the board of directors. Audit plays an important role in deterring directors and employees from committing fraud. However, the audit procedures are insufficient for detecting fraud, particularly those that are committed by trusted employees, because the auditor’s role is not that of a detective. In 1896, in the Kingston Cotton Mill Company case in the UK, it was established that the auditor's role is that of a watchful guardian. 

In the Kingston Cotton Mill Company case, Justice Lopes observed: “An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful.” 

In the book titled The Principles of Auditing: A Practical Manual for Students and Practitioners, which was published in 1921, celebrated author F R M de Paula writes on the auditor’s responsibility for detecting fraud. He writes: “The objects of his appointment are to satisfy the shareholders that no fraud is being committed by either the directors or the employees…. It must not be thought that an auditor should adopt an attitude of suspicion during the conduct of his audit; in fact, he should endeavour to avoid creating a spirit of hostility and mistrust between himself and the directors and staff of the company."

Although detection of fraud is not the primary audit objective, evidence collected by the auditor in the course of audit might make him/her believe that that directors or employees might have committed fraud against the company. The Companies Act, 2013, stipulates that the auditor shall report to the Central government the fact that he/she believes that fraud involving or is expected to involve individually an amount of Rs 10 million or above is being or has been committed against the company by its officers or employees, if audit evidence makes him/her believe the same.

In order to serve shareholders better, the auditing profession is continuously improving the audit procedure, developing new tools and bringing transparency in reporting the audit findings. For example, in order to improve transparency, now auditors report key audit matters (KAM) in his/her report to shareholders. KAM are those matters which in the auditor’s professional judgement are of most significance in the audit of the financial statements of the current period. 

Auditing requires the ability to apply effectively both the science (auditing standards) and art of auditing (ability to smell wrongdoings, albeit, not that of a bloodhound, which smells the scent over great distances.). An auditor is effective if he/she is tactful in managing relationships with the directors, top management and other employees of the company, as an audit cannot be completed in an environment of hostility and suspicion. An auditor should be held responsible for professional negligence, if he/she fails to demonstrate, through his/her work, that he/she is master of applying the science and art of auditing.  

Auditing involves judgement. An important area where the auditor requires to form judgement is whether to accept management representations on contentious issues raised during the audit.  An auditor might err in judgement because he/she approaches her work with trust on directors and the management. He/she reduces the chance of error by evaluating audit risk at the commencement of the audit and approaches the work with scepticism. 

When we are cheated by a trusted individual, with hindsight, we feel that we could have been more careful. When enquiring into audit failures, the enquiring authority gets the benefit of hindsight and might hold the auditor guilty of professional negligence. Regulators should keep this in mind while deciding the quantum of penalty. 

Auditors will continue to play the role of a watchful guardian in times to come. However, the auditing profession should consider whether some elements of the forensic audit should be included in audit procedures, and shareholders should weigh the benefits of the same against the additional cost involved, which they will have to bear. 
 

The writer is director, Institute of Management Technology Ghaziabad

asish.bhattacharyya@gmail.com