FINANCIAL OVERSIGHT:Along with the credit crisis there have been a slew of financial scandals, and the auditors involved have come under fire. Is such fury justifiable? In some cases you would want the wisdom of Solomon and beyond to be able to penetrate a very carefully and cleverly constructed fraud.

AFTER EVERY major corporate scandal, the cry is heard: "Where were the auditors?" The standard retort of the auditors is that they are watchdogs, not bloodhounds. Now, with wave after wave of financial scandal breaking around the world, serious questions are once again being asked about the role of auditors.

For example, are auditors partly, or indeed largely, responsible for the losses incurred by investors in collapsed, nationalised or fraudulent companies? Or are people simply looking for a scapegoat for their own poor investment decisions?

Do investors overestimate the remit of an audit, or do conflicts of interest render the current auditing system worthless? Will we see more auditors hauled off in handcuffs like the two PricewaterhouseCoopers (PwC) audit partners in India in the wake of the Satyam scandal (dubbed "India's Enron"), or will accountancy firms continue to earn fat audit fees?

Investors burned by US Ponzi-scheme operator Bernie Madoff are already targeting their ire at global auditing firms. A growing number of investor lawsuits filed since Madoff was arrested in December have named national branches of PwC, Ernst & Young (E&Y), KPMG or BDO as co-defendants. These firms weren't responsible for auditing Madoff's business directly, but they audited the hedge funds that channelled money to him, and investors say they should have examined his books as well.

And it looks like Irish audit firms had better batten down the hatches and prepare themselves for litigation as well. According to recent reports, investors in Anglo Irish Bank are preparing to take legal action against the bank's auditors E&Y, and Irish Nationwide Building Society's auditors KPMG.

Irish audit firms are particularly exposed to litigation because of their unlimited liability status. "Other jurisdictions have brought in limited liability into partnerships, but we haven't yet brought it in here in Ireland," explains Bob Semple, risk partner with PwC Ireland.

Audit firms feel that they are being targeted because of their financial resources. "I think we will be targeted and we will be added on to actions because we have got deep pockets," says Duncan Wiggetts, lead counsel to the PwC assurance business in Europe. "If you look down the list of other defendants it's purely because no one's got a pocket at all, never mind a deep one.

"Clearly if there has been inappropriate auditing done, then audit firms will be held to judgment for those and will have to pay damages," he continues. "But I would be surprised if the audit firms are going to suffer too much because of the improvements that all audit firms have made over the last few years in actually identifying and looking at potential frauds."

Wiggetts also feels that there is a mismatch "between expectations of what an audit should have been doing, and the actual reality of what an audit actually constitutes".

He explains that when a large "household name" company is being audited, it would be impossible to check every invoice and every receipt within the short time allotted. Instead, sample checks are carried out and the auditors concentrate on the major transactions.

Auditors, therefore, rely "hugely" on management representation letters to fill in the gaps, he says. "We get management to sign off and confirm that they've told us everything material that we need to know about the company, and confirm that there's no other frauds other than what they've told us about in the course of the [audit]," he explains. "If there's any question mark in our minds regarding the integrity of the person signing that letter, we need to clear that up before we can move forward."

Semple points out that fraud is, by its nature, covert and concealed. "In some cases you would want the wisdom of Solomon and beyond to be able to penetrate a very carefully and cleverly constructed fraud," he says. He also points out that the "first line of defence" in terms of safeguarding the assets of the company (which includes detecting fraud) lies with the directors of the company.

Despite what many investors think, an audit doesn't provide a guarantee of the integrity of the company's financial statements (nor of its survival) but instead is an opinion on whether or not they present a true and fair view of the company's state of affairs based on the information provided to the auditors, and in accordance with accounting standards.

"A statutory audit is neither a guarantee against business failure nor an endorsement of the strategy pursued by company directors," Pat Costello, chief executive of the Institute of Chartered Accountants in Ireland, recently wrote in a letter to The Irish Times. "Successful audits are dependent on the quality of information provided by the audited entities."

Given the heavy reliance on management assurances, and the inherent difficulty in uncovering fraudulent activity, one could be forgiven for wondering just how worthwhile an audit actually is. After all, E&Y earned €2.2 million in audit fees from Anglo last year, signed off on the bank's accounts without qualification and is now being investigated by former comptroller and auditor general John Purcell in relation to its performance as auditor for the bank.

Costello pointed out that since 2004, the Office of the Director of Corporate Enforcement has reported that it has received more than 4,000 reports from auditors of suspected indictable offences committed by companies and company directors.

A number of weaknesses exist in the current audit system. Audits are generally carried out close to company reporting deadlines. This means if an auditor is concerned about something he or she discovers and is reluctant to sign off on the accounts without getting the matter investigated, the release of the company's results could be delayed, which would send out very damaging signals to the market. So there can be considerable pressure to sign off on accounts.

Broaching sensitive subjects with the company's board - for example, pointing out potential problems in the accounts - can also put a strain on the auditor-client relationship.

"It's a real moment of truth . . . where you do have to go to the board and explain that you see a difficulty," says Semple.

"The reaction of the board is one of those defining moments, because the good boards will say, 'Alright, explain, tell me, let me understand this, what do you have to do?' and they give you support. A much more difficult situation is if the board feels obliged to put you under pressure and say, 'Look, you're making a mountain out of a molehill, we're going to sign the accounts anyway and you have to give us a clean audit opinion.' "

So why would any auditor risk upsetting a client who pays them handsomely for their services each year? "Our reputation is absolutely vitally important to us," Semple says. If necessary they would walk away from a client, because their reputation is more important than collecting a fee, he says.

Wiggetts recalls a "very bad incident" about four years ago with a PwC client based in continental Europe who "refused to investigate an issue" uncovered by the auditors. "We literally sat from 6pm until 2am in the morning on the night before this company was due to announce its results," he recalls. "In the course of that evening, the audit partner was asked to consider how much audit fees he was throwing away for next year."

The partner was then asked to look at the faces of all the independent directors around the table who he would embarrass by refusing to sign off on the results, and to work out how much other business PwC would lose because of all the businesses they were connected to.

Despite the pressure, PwC stood its ground and this later proved to be the right call. Partly because of this incident, PwC is now putting considerable effort into educating directors (and its own audit teams) on their responsibilities in relation to detecting fraud, through the use of an innovative film, Risking it All.

However, the above example illustrates the difficult position that auditors can find themselves in, and it also begs the question as to whether auditors can be considered truly independent when they rely on the client for their income.

In an article in the Guardian late last year, UK accounting professor Prem Sikka listed many of the major banks that have been taken over or bailed out since the credit crunch struck, and pointed out that they all received clean audit opinions in 2007.

Although no one expects auditors to guarantee the survival of a company, he said, "many of the distressed companies have been on a diet of toxic debts, off balance sheet accounting, dubious asset values and questionable business models. Yet the auditors did not notice any of the red flags."

The current auditing model is broken and cannot be repaired, he argued. "The only effective way forward is for regulators to take direct responsibility for auditing banks and financial institutions," he stressed.

In an Irish context, handing over responsibility to the Financial Regulator might remove the problem of potential conflicts of interest. However, whether sufficient knowledge of the intricacies of finance and lending exists within the Regulator for it to take on this responsibility is highly questionable.