A single step can help improve the governance and accountability of state-owned enterprises (SOEs): let a third party, and not the SOEs, appoint their external auditors and also deal with related matters such as audit fee and removal.

The rationale is simple. It will enhance the independence of the external auditors who will be able to do a more thorough job and be more willing to report issues regardless of how SOE’s management may react. This will put pressure on the SOEs, which will lead to more representative financial statements and fewer wrongdoings.

The global body for the accounting profession, the International Federation of Accountants (IFAC), recognises that independence is the cornerstone of auditing. But think about it. Can you really be independent of the entity that appoints and removes you, determines your fee, and gives you other profitable business? The short answer is not really. That’s why for many years, some observers in the developed world have been advocating that auditors be appointed by a third party, such as a stock exchange. SOEs in Pakistan make a special case that needs this unconventional approach.

Can you really be independent of the entity that appoints and removes you, determines your fee and gives you other profitable business?

There are more than 200 SOEs incorporated by the federal government including their subsidiaries, trusts, and funds. According to a triage report (March 2021) by the Ministry of Finance, the aggregate revenue of the SOEs in 2018-19 was approximately Rs4 trillion with a staggering aggregate loss of Rs143 billion. Employing around 450,000 Pakistanis, these SOEs operate in different sectors such as financial services, power generation and distribution, and energy.

It is well known that the loss-making SOEs have been bleeding Pakistan dry with the ordinary Pakistanis having to bear the cost of their poor performance. No wonder that the term SOE appears nearly 50 times in the IMF’s latest country review (April 2021) which requires Pakistan to “bolster the governance, transparency, and efficiency of the vast SOE sector”.

Because many SOEs are poorly governed and running losses, they are likely to have something to hide in their financial statements for which they need “cooperation” by the external auditors. On the other hand, the external audit is meant to bring credibility to a company’s financial statements for its stakeholders that include shareholders, lenders, employees and tax authorities.

A report by the International Monetary Fund (Fiscal Monitor, April 2020) claims that data from about a million SOEs from across 109 countries shows that “profits and labour productivity are lower in SOEs than in private firms”. Regarding the audit, the report suggests, “SOE financial statements should be audited by the national audit office or private audit firms approved by the national audit office”.

Independence is the main reason why these SOEs fear the Auditor General of Pakistan (AGP). However, AGP conducts regulatory audits using the standards by the International Organisation of Supreme Audit Institutions. This is different from the audit of the financial statements in accordance with IFAC’s International Standards on Auditing. Under section 247 of the Companies Act, 2017 the external audit for a company with a paid-up capital of Rs3 million or more can only be performed by a firm of chartered accountants.

Where a company fails to appoint its auditor in time, SECP is empowered to appoint its auditor under section 246 of the Companies Act, 2017. This is a wide power over any company and not confined to an SOE registered under the Act. Using this as a precedent, to implement the appointment of an SOE auditor by a third party, SECP could set up a standing committee of subject matter experts that would appoint SOE auditors under custom-made regulations.

The committee would of course have to be independent of the audit firms and the SOEs. It may include those who understand audit and SOEs but are no longer associated with them, such as former Chief Financial Officers and auditors and other relevant professionals such as corporate lawyers. The fee must be appropriate with respect to the audit work and certainly not low. To avoid conflict of interest, the audit firm should be barred from providing any other service to the SOE.

The general selection criteria would remain the same, such as the audit firm’s sector expertise, available resources, reputation, and so on. The pool of auditors, about 100 firms registered with the Audit Oversight Board that are permitted to undertake these audits, need not change either. However, implementation would require some amendments to the relevant laws, such as the Companies Act, 2017, the Public Sector Companies Corporate Governance Rules, 2013, and the draft SOE bill.

The cynics may argue that SOEs suffer from many ills and a rigorous audit of financial statements alone cannot cure them. Indeed, making the auditor truly independent is not a silver bullet for all that ails the SOEs but it is surely a substantial improvement over the status quo and isn’t that worth it?

The writer is former CEO at the Audit Oversight Board, Executive Director at the Securities and Exchange Commission and content director at CFA Institute (London)

Published in Dawn, The Business and Finance Weekly, May 31st, 2021