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Governance Q&A: The importance of an independent auditor

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My board chair wants to change audit firms to one where a friend of hers is a partner. If their quote is reasonable, is that ethically OK?

I am assuming you are referring to the financial audit, since you likely would have specified any other kind of audit, such as a legal or ethics one.

Any good financial professional qualified to conduct audits will avoid situations where their independence will come into question. CAs (Chartered Accountants) and CGAs (Chartered General Accountants) both have many resources available to them to help them confirm their independence from their national and provincial bodies. Laws vary by province, and audit firms have their own standards of conduct. Due to the range and complexity of these standards, the onus is on the auditor to ensure compliance.

As a board member, you have a number of roles, and it is within these roles that the ethical onus is yours. You will:

  1. Determine the process by which an auditor will be chosen, and possibly directly participate in the process.
  2. Approve or amend the recommendation that comes to the board.
  3. Be party to recommending that choice to the members at the Annual General Meeting.
  4. Oversee the audit scope, and timing, and deal with auditor questions during the audit.
  5. Receive, review and approve the draft Statements and auditor comments.
  6. Carefully review and deal with any management letter.
  7. Determine the chair's role throughout the process.

I will go through the process briefly. Your chief areas of concern will be items 1 and 7.

1. Selection process

First of all, you should consider several different firms. If the work has been good, the existing auditor should be included in the consideration. While it is wise practice to review the auditor selection periodically — perhaps every five years — you need a good reason to change. The first year or two with a new auditor involves a lot of extra work for the treasurer, staff and auditor.

If the board has established an audit committee (something I highly recommend), the process of selecting a new auditor may already have been delegated to that committee. If not, you may have to set up a task force reporting to the board, or have the whole board involved. I will call it a committee for the rest of this column.

No staff should sit on the audit committee, and neither should any board member who is directly involved with financial management. You can bring in outside volunteers, particularly if your board lacks audit oversight skills. If you have financial skills, let the chair or board know of your interest in being part of this committee.

The audit committee will seek out other recommendation for whom to consider, and set up a system to review the results of requests for a quote. A shortlist of candidates can be interviewed. You should confirm with all of them that they have sufficient independence to conduct the audit. A 20-page booklet called Guidance for Audit Committees: Discussing Auditor Independence Matters is available for free download from the CICA. It is aimed at for-profit organizations, but public confidence in financial statements is important in all sectors.

The audit firm where the chair's friend works would consider the level of "familiarity risk", a threat that arises from an auditor being influenced by a close relationship with an auditee. The auditor would have to consider whether the risk was significant enough to decline the assignment, or just require disclosure. The auditor would also need to consider any relationship with the organization. As a friend of the chair, perhaps they made a major gift and consider that equivalent to having a financial interest.

The committee should ask all candidates about their independence, and consider whether a reasonable observer would conclude that the auditor is free of influences that could impair objectivity.

2. Approve or amend the recommendation that comes to the board

You need to understand the basis for the committee's recommendation of the auditor and the auditor's compensation. Has that group done due diligence in its selection? Are you satisfied the organization will receive quality work on time and for good value? Clearly that requires consideration of more than one firm.

3. Be party to recommending that choice to the members at the Annual General Meeting

Auditors should not be changed without member approval except in extreme circumstances such as the audit firm being unable to perform the audit at all, or significant concerns about the audit firm's performance that have come to light after an AGM. Such a change needs to be justified to the members at the next AGM.

4. Oversee the audit scope and timing and deal with auditor questions during the audit

The committee will approve the auditor's engagement letter. And although audited statements may look the same year after year, auditors need to know about changes and issues that may affect liability, reporting requirements and quite a few other things. If a prior management letter raised concerns, they have to check into those. An audit committee can also advise of some area of concern they would particularly like checked. And right now auditing standards are changing, with options that nonprofits have to consider.

In other words, while the staff can deal with scheduling the auditor, making records available and such, oversight is not just a matter of hiring someone and giving them a deadline. The board, through its audit committee, can influence the nature (not the findings) of the audit and how its results are reported.

5. Receive, review and approve the draft statements

Ask questions to make sure you understand the draft. If significant concerns are raised, or there are major options in how to report a particular item, ask the auditor to explain them to the board. Schedule receipt of the draft far enough ahead of AGM or annual report timing to be able to get clarifications and amend how details are presented. You seek not only accuracy but also accountability to members, which requires a meaningful presentation of the numbers.

6. Carefully review and deal with any management letter

Make sure the auditor is asked directly whether there is a management letter; I have seen staff hide such letters from the board. If concerns are raised, ensure that its recommendations are dealt with before the next audit, and much more quickly if serious weaknesses in financial controls are noted.

7. Determine the chair's role throughout the process

Your inquiry did not reveal how close a friendship is involved or the size of the firm in question. Both could affect how much the chair needs to distance herself to avoid a real or perceived conflict of interest.

I think there is no question that the chair would have to fully remove herself from any involvement with the selection. The chair would not sit on the committee or be involved in any discussions about the selection, and would leave the room when the committee makes its recommendation to the board. Anything less risks a perception of unfairness. The process involved in declaring a conflict of interest should be set out in a conflict of interest policy.

As noted in Item 4, the board and therefore certainly the board chair is in a position to exert direct and significant influence over the engagement and the approval of the statements. The chair will have to take care not to be seen as letting a friendship affect that role. The board may prefer that the chair stay off the committee throughout the audit, and perhaps even declare a conflict at any time the audit is on the board agenda.

However, it is difficult for a chair not to be seen by the members as involved in the selection and statements. A close friendship with the auditor conducting the audit seems problematic, creating a situation not worth the trouble. A more casual relationship, and/or the use of another auditor from the same firm, is unlikely to raise eyebrows and so the board can be more relaxed. Each situation has to be considered individually.

In summary, it would be inappropriate for the auditor selection to be changed without a competitive process that ensures wise use of organizational resources. You certainly cannot justify spending extra, causing additional staff and volunteer work, or getting lower value just to benefit a friend. And the closer the friendship and the more involved the friend would be, the more uninvolved the chair needs to be.

Since 1992, Jane Garthson has dedicated her consulting and training business to creating better futures for our communities and organizations through values-based leadership. She is a respected international voice on governance, strategic thinking and ethics. Jane can be reached at jane@garthsonleadership.ca.

To submit a dilemma for a future column, or to comment on a previous one, please contact editor@charityvillage.com. For paid professional advice about an urgent or complex situation, contact Jane directly.

Disclaimer: This article is for information purposes only. It is not intended to be legal advice. You should not act or abstain from acting based upon such information without first consulting a legal professional.

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ngina@accamail.com ngina@accamail.com
When I read the first sentence I see familiarity threat to auditor's independence. Any move that may affect the independence of an auditor should be highly discouraged.

A familiarity threat occurs when, due to a long or close relationship with a client or employer, the auditor may become too sympathetic to their interests or too accepting of the clients work. hence affect the deliverable expected after the audit exercise is over.

Remember Why we need to engage an auditor in the first place??
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