The Great Recession revealed one of the weakest links in Africa’s quest to build strong capital markets — bogus audited statements. After the fall of Lehman Brothers, the cascading dominoes spread around the world crippling markets and decimating companies. Despite the Wall Street-engineered financial avalanche, investors lost money in African equities largely because some audited statements were revealed to be patently deceptive.
Regulators failed markets
As investigations exposed all the myriad contributions to the market collapse, the asymmetries between the audited statements and what was happening in companies were mind-blowing. Regulators failed markets, as some public companies and auditing firms orchestrated monumental misdeeds, which continue to haunt the region. Yet since those epic letdowns, few bold regulatory reforms have been enacted in most African exchanges.
Kenya’s banking sector
From Nigeria to South Africa, retail investors are still below pre-Great Recession levels. They have defied assurances by market regulators that they offer fair products and services in the exchanges. Recent problems in Kenya’s banking sector have rekindled the necessity for regulators to push for tougher auditing reforms as well. When investors lack confidence in the books, they rarely invest, which deprives markets of liquidity.
Even the elite auditing firms, usually subsidiaries of the Big Four, have sold their professional “opinions” on companies, some of which have turned out to be extremely problematic. Notwithstanding, the regulators remain ineffective as Africa goes through cyclical boom and bust, where great companies emerge only to collapse in scandals.
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Investors are genuinely concerned that regulators are incapable of making sure that published financial statements of companies in their exchanges accurately reflect the true operating positions of the firms. As audit quality, auditor independence, and consistency in audit execution remain poor — alienating pension funds and major global investors in the process — ingenious regulatory reforms are urgently needed for Africa’s capital market to blossom.
Regulators must innovate
Regulators must innovate and create structures that correct inherent flaws which continue to stymie market efficiencies. But a reform must go beyond simply replicating processes in the SEC, NASDAQ, and NYSE; it must pioneer new ways to address problems in places with fledgling legal systems and criminal justice institutions.
This means establishing a regulatory system underpinned on the understanding that punishing a crime is less desirable than preventing it, especially when pensions of vulnerable citizens are risked on equities. Also, that system will ensure that auditing firms serving markets will experience adverse business impacts if their work with companies proves to be false in overstated income and falsified business growth.
New insurance companies
A key step will be for regulators to change the relationships that exist among auditors, public companies, and the exchanges. Specialty insurance companies may need to be created to protect investors from audit-fueled risks, as companies should be required to buy special insurance policies (audited statement insurance, as I call it) to compensate investors if their audited financials are found to be deceptive.
The premium charged by the insurer will track the risk profile of the auditor’s work. To reduce the insurance premiums, traded companies must cooperate and engage better with auditors. In situations where the present insurance companies cannot handle this type of risk, African governments and regulators should create opportunities for new insurance companies.
These companies should be built for the digital age, requiring public companies to link critical business data like trading and transaction volumes to insurers in real time to help them assess risks. Companies that fail to share such data may be asked to put money in an investor protection fund. For those that prefer buying insurance, they have incentives to lower premiums, which can only be achieved if they allow auditors unfettered access in their firms.
Not be allowed to hire auditors
In addition, African exchanges need to revamp the engagement process for how auditors are retained and compensated by traded companies. Public companies in Africa should not be allowed to hire their external auditors; the exchanges should do so for them. The auditors should be paid from a reserve fund carved out from the raised capital by the public companies.
This will fix the biggest flaw in the auditing model, where auditors are financially dependent on the companies they audit. Auditors must be first quality to be added into the pool, and then exchanges must ensure there is constant internal competition for jobs. This rivalry will keep auditing costs low while improving quality, since a high-quality audit will be expected to translate to lower insurance premiums, and vice versa.
Not delivering value
Auditors who continue to see the premiums of their audited companies rise will know they are not delivering value and will be systematically removed from the pool. Under this framework, the auditor has a clear incentive to innovate and do more than offer high-priced opinions, while the companies have responsibilities to reduce their insured premiums tied to audited statements by working with auditors to deliver reliable financial statements. The companies understand that investors will not just scrutinize their insurance expenses on audited statements but will also use the numbers while determining their financial valuations.
By strengthening corporate governance through auditing quality especially in public companies, African companies will last longer, and exchanges will be open to new capital as local and global investors put more confidence in their operations. Indeed, for all the mileages accumulated by African market regulators as they travel around the world promoting their markets, nothing could be more impactful than building trusted institutions where audited statements are reliable.
Havard Business Review