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“Audit reality”

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5 April 2017 – Speech by Paul M. Koster, Chairman of European Investors and Chief Executive of the Dutch Investors’ Association VEB, at the IFIAR Tokyo Plenary Week:

Today, ladies and gentlemen, I like to talk about audit quality and audit quality, in particular, in relation to shareholders, a group that I represent. Regulators over the last decade have greatly impacted the discussion about audit quality and, for that, shareholders are certainly grateful. Audit quality is challenged in today’s digitalized and complex environment. Audits need to reflect that new environment and shareholders expect that. They want to trust financials and rely on adherence to the law.

Shareholders (companies for that matter) need more protection and audits have disappointed shareholders in this respect regularly, to put it mildly. I will come to that in a moment.

Audit Committees and Supervisory Boards, as well, have fallen short in their role of supervision and control of the company. A far more pro-active role is needed from, in particular, the Audit Committees to extract more value from audits and to strengthen the ultimate control function by the supervisory board. Both bodies need to adjust their role to the new environment.

The business environment, as said, is greatly affected by on-going digitalization and this is bringing a new level of transparency that will expose more transgressions and violations at companies. Violations that have gone unnoticed so far.

Audit quality obviously starts with the auditors. Their work has been at times disappointing. Even the largest corporations have fallen victim over the past couple of years to belated discovery of fraud, corruption and accounting errors. The companies underscore the seriousness of this issue and all at the expense of the shareholders. And in the worst cases, to the continuity of the company. Wells Fargo, Toshiba, Petrobras, Tesco, Walmart, British Telecom, WV, Rolls Royce, Rabo Bank and Samsung have all faced serious fraud, corruption or other charges and tremendous value loss as a result of settlement cost, penalties and explosive legal costs. Each case offers a lot of lessons for auditors, audit committees and boards in general.

Unfortunately, we cannot expect this trend of painful and costly discoveries to abate very soon. Many governments like China, India, Korea, and Brazil are fighting corruption and tax evasion and tax-fraud with enhanced exchange of information among them, and with great vigor.

The Panama Papers revealed heretofore-unknown connections, transactions and obfuscation on a scale that stunned many and with dramatic consequences for companies and persons mentioned in those Papers. This, in short, is a problem that is not going away soon. There is in today’s world a new level of wider and deeper scrutiny based on what I call “glaring transparency”, a transparency level that is growing on the back of digitalization. Companies need to be more vigilant in this digitalized environment to protect their assets. “Where were the auditors?” is the standard question when an incident occurs.

The standard response is “it is management who is responsible to stop fraud and corruption from occurring”.

Then, the second line of defense is “a properly designed and executed audit may not detect fraud and corruption especially in instances where there is collusion, fabrication of documents and override of controls”.

The third line of defense is “detection of fraud is by law not in our scope”.

Quite frankly, these defensive arguments are worn out and do not help at all to give investors any comfort. On the contrary, the growing list of incidents as highlighted continues to erode confidence in the market and, in particular, confidence in the quality and true value of audits.

Let me illustrate this with an example.

Deutsche Bank settled with the DOJ in December 2016 for $7.2 billion regarding the sale of toxic securities to their clients. Then, in February 2017, it paid $630 million to settle probes into market manipulation of Russian trades. Worse, Deutsche Bank had to take an additional charge of $1.6 billion in legal bills. This is an incredible total of $9.4 billion. Shareholders were asked by management last month for the third time in three years to shore up Deutsche Bank’s capital–this time by $8.5 billion. This does not even cover the losses of $9.4billion as a result of these serious transgressions.

So, shareholders are expected to pay up (and preferably shut up) and trust that this kind of egregious behavior will not be repeated. This is where I wonder what steps the Audit Committee at Deutsche Bank has taken to fortify their monitoring controls and which kind of demands have they brought to management–and to the AUDITOR–in regard to the risk management system and internal controls.

How are we going to stop this from happening again? Can shareholders rely on better and stronger controls and sharper auditors? Will transgressions be spotted earlier?

The IFIAR Plenary Paper highlights relevant questions pertinent to this situation. Clearly, the cost associated with penalties and legal bills and compensation to claimants and–let’s not forget the resulting huge cost to shareholders–warrant a far stronger focus in the audit approach on fraud and corruption discovery. Only recently, Rolls Royce had to pay £670 million to settle claims for corruption practices that lasted an unbelievable 28 years. The judge who ruled in this case said the “the gravity and duration of this corruption was such that he had contemplated to let the company go under”. Shareholders are stunned to discover that corruption could go on for 28 years at a U.K. blue chip company.

My message today to you is that we need more involvement from audit committees in protecting the company and improving the audits. The audit committee should be pro-active in:

· Garnering information independently that will help the audit committee in better judging the audit scope
· Ask auditors direct questions with respect to their suggested audit approach
· Ask auditors to explain the provisional key audit matters and agree on these “special attention” areas for the year
· Also, a clear understanding should be reached before the audit starts, of regular up-dates on the audit scope and a discussion about planned-time allotted by the audit partner and when this should be adjusted given developments during the audit
· This interactive process in no way mitigates the ultimate responsibility of the auditor for the audit and sign-off. It specifically helps to strengthen the audit process.
· Finally, the audit committee should disclose in its annual report statement if extra audit fees were incurred. And, importantly, a clarification and description of WHY extra fees were incurred should also be included.

This is all aimed at improving the audit quality and giving shareholders more comfort that the company they invest in is indeed pro-active and alert towards mitigating the risks of frauds, corruption and accounting scandals.

Thank you

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