Understanding the value of the audit

Aug 01, 2018
With a stream of negative news, the outlook for auditors can appear bleak at times. However, we should never lose sight of the value in the audit process.

Accountants and auditors are faced with a bleak outlook. There is a constant narrative telling us that accountants and auditors are not relevant anymore; reports that investors don’t care about the parts of the annual report governed by IFRS and audited by professional experts; reports that all accountants will be unemployed in a short number of years, made redundant by blockchain, which in turn makes the auditor redundant because who needs an auditor when blockchain is verified in real-time?

Then there are the articles criticising audits and auditors. When there are large corporate failures, the question inevitably arises: where were the auditors and the audit regulators? The Financial Reporting Council (FRC) recently published its latest inspection reports and noted a decline in audit quality. A recent International Forum of Independent Audit Regulators (IFIAR) survey reported mixed results across countries and stated that firms need to continue their efforts to strengthen their systems of quality control and drive consistent execution of high-quality audits across the world. A record fine of $625 million was imposed on one firm after a judge concluded that it had failed in a number of audits of a failed bank. Other high-profile investigations are ongoing and widely publicised across the globe.

So, should all accountants and auditors frantically retrain in another profession? Or, alternatively, should all stakeholders take a moment to consider the value contained in a set of audited financial statements?

The expectation gap

All auditors know about the expectation gap. While some stakeholders believe that an audit is verification that everything is 100% correct, auditors know that an audit provides reasonable assurance that the financial statements present a true and fair view. An audit is not designed to pick up every fraud. An audit uses the concept of materiality – if an error would not influence an investor’s decision, it is not adjusted typically. In addition, an auditor relies on information presented to him or her by the directors. Clearly, an auditor challenges the information but the directors are the ones who understand their entity best.

Technology developments are coming hard and fast. Entities are becoming more complex and are investing in their IT systems to produce vast amounts of information. Their auditors are following suit, developing tools that can analyse this information and improve the efficiency of the audit. These developments are positive, enabling auditors to analyse larger samples, find outliers faster and focus their efforts accordingly. However, with sound bites and headlines now stating that auditors can test 100% of transactions, does this worsen the expectation gap?

If an auditor is testing 100% of the data, then surely it is total verification as opposed to reasonable assurance?

Relevance of historical information

We are told that investors only focus on the unaudited parts of the annual report – the forward-looking information, the viability statement and the corporate social responsibility reports. This makes perfect sense to me. An investor wants to predict how the share price will move in the future in order to help them decide on the best time to sell and make a profit. And often, investors are becoming more socially and ethically conscious and want to know that their money is being put to good use by the companies they invest in.

But, all of the predictions are based on the presumption that the current share price is correct. Moreover, that share price is only correct if the underlying financial information is calculated consistently with other companies (as governed by IFRS or the appropriate accounting framework) and is materially correct.

Who is really responsible?

So, whose role is it to give investors the comfort they need that the underlying financial information is correct and therefore, that their investments properly valued?
The directors are ultimately responsible for the running of the company and for the financial information released. It is up to them to make wise choices that keep the company afloat and to present all the information an investor – and indeed, an auditor – might need to reach their conclusions.

Audit committees, where they exist, have clear responsibilities to monitor the entity’s financial reporting and internal quality control and internal audit. They are also responsible for recommending an appropriate auditor, ensuring they are independent, monitoring the statutory audit and informing the directors of the outcome.

The auditor’s job is to conclude that the financial statements present a true and fair view. There are extensive rules and requirements that guide how they must do this. They must take the information, which has been prepared by the entity, as overseen by the audit committee and directors, and gather third-party evidence to verify that information to the greatest extent possible. Where estimates are used and cannot be verified, the auditor must make sure that the estimates are reasonable. Is there supporting evidence for the assumptions? Is there contradictory evidence? Is it within a reasonable range? Has the entity historically been good at estimating? Is the information used in developing the estimate correct?

The audit regulator is next in the chain. He or she is primarily responsible for checking that firms have appropriate policies and controls in place, and that those policies and controls are applied properly and consistently to a sample of audits. Many regulators also use thematic reviews to promote best practice in an anonymised way.

So there are several building blocks in the process, all stacked on a foundation of solid financial reporting and auditing standards. If any of those blocks are not solid, however, the tower of comfort will fall.

Reputation is everything

Investors and other stakeholders need to have confidence in the opinions of an auditor and in the financial statements. Directors need to ensure that the financial statements are properly prepared and give a true and fair view. Auditors need to ensure that high-quality audit services are provided. All stakeholders have a responsibility to continue efforts to close the expectation gap and ensure that an audit opinion is understood correctly.

Audit firms survive on their reputation. Reputational damage, which can ultimately cost even more than record financial penalties, can be fatal to the survival of an audit firm. This is a risk to the market as it could result in higher concentration levels. We all recall the collapse of Arthur Andersen in 2002, which served only to reduce the number of large players offering audit services. The phrase ‘Titanic Three’ has already been coined, but it would not be a positive development in the market if it became a reality.

Competition

Most stakeholders would agree that increased competition in the market would be positive and this was one of the aims of the EU Audit Reform Legislation, which came into effect in 2016. Evidence shows that this has not been achieved to date, however. Indeed, the trend has been to the opposite.

The suggestion that the Big Four must become audit-only service providers is an interesting one. European law already largely prevents auditors from carrying out non-audit services for their audit clients, yet there are many benefits to having multidisciplinary firms carry out audits. Audit teams now comprise auditors, often from several offices, and specialists from a range of disciplines including IT, tax, valuation and pensions. These specialisms are critical to an effective audit and often, such specialists spend part of their time providing non-audit services in order to be economically viable. Would reducing the availability of such specialists really result in an improved audit?

European law also requires auditors to rotate regularly. We increasingly hear reports from entities that they cannot identify two audit firms who are independent and willing to tender for an audit. We also hear from non-Big Four audit firms that they are not invited to tender or cannot afford to tender, as the demands in a tender are too high. One audit firm in the UK publicly announced a strategic decision not to tender for the largest audits because the costs are too high. This aspect of competition requires investigation. How can audit committees get the information they need to be able to make their recommendations on appointing the auditor without driving the cost of tendering so high that only the largest firms have the capacity to engage in the process? The costs include the final document, which is usually a high-quality and well-designed product, but there is also an extensive time commitment involved in preparing and in getting to know the client in order to prepare.

Is change on the horizon?

The world of audit and audit regulation is being heavily scrutinised. The Competition & Markets Authority in the UK is reportedly meeting with the large audit firms amid intense pressure to look at the audit market and ways to increase competition. The UK Government has launched an independent review into the FRC. The Public Company Accounting Oversight Board (PCAOB) has a new board and is reviewing how it operates, while record fines are being handed out to audit firms.

So what does the future hold? Certainly, the conclusions of the reviews conducted by the FRC and PCAOB will be of interest to stakeholders around the globe – particularly in Ireland, given our close links with both countries. Socrates said that the secret of change is to focus all of your energy not on fighting the old, but on building the new.
For many people, the world of accounting and audit has transformed during their careers and is continuing to evolve. Penalising failure is important, of course, but less so than working to ensure that the problems of today are designed out of the system in the future.

Lisa Campbell FCA is Head of Statutory Reporting Quality at IAASA.