Audit in the Headlines (again)

So, once again, the audit profession has hit the headlines and, once again, for the wrong reasons!  The issue of audit quality has been an ongoing debate for several years and moreso in the last couple of years given the financial crisis and the fact that the auditors of banks have come under severe criticism for their handling of their audits of banks.

The Big 4 have presided over the auditing profession for years and there have been lots of calls for there to be a ‘break up’ of this dominant position the Big 4 hold to allow for more concentration of the audit profession; though time will inevitably tell if these attempts are going to be successful.

Auditing throughout the world has come under fire of late but is this criticism warranted, or are auditors simply the ones to blame when things go horribly wrong?

Auditors and the Financial Crisis

The role of the auditors in the financial crisis has been questioned very frequently.  Indeed, the Lords’ enquiry suggests that auditors directly contributed to the severity of the financial crisis.  In contrast, however, if you look at the Treasury Select Committee’s report in 2009, this concluded that there is little evidence to suggest that auditors failed in their duties.  PWC were lambasted by the Lords’ enquiry, notably for not making reference to the going concern warnings that were pivotal in the near demise of Northern Rock.  The enquiry cites a total breakdown in communication between the auditors and the banking regulators and suggests that whilst the Big 4 may well have “carried out their duties properly in the strict legal sense, we have to conclude that in the wider sense, they did not do so.”

In addition, the Lords’ enquiry rejected the idea of compulsory rotation and joint audits which was welcomed by the profession, particularly ACCA who said:

“ACCA believes would actually do little to increase market competition.”  (ACCA response to Lords’ Audit Enquiry).

The Lords have recommended that the use of restrictive covenants and audit liability be investigated by the Office of Fair Trading and ACCA believes that action in these areas could well go towards increasing opportunities for audit competition.  The profession itself is a fast-moving one and needs to seen to be “fit for purpose”.  The criticisms which the audit profession has recently received will certainly go to dilute the credibility of an audit.

The report itself highlights three main findings:

• The Big 4 auditors’ domination of the large firm audit market limits competition and choice.
• The breakdown of dialogue between bank auditors and regulators made the financial crisis worse.
• Audit standards are slipping.

It also makes the following recommendations:

• A detailed investigation of the large-firm audit market by the Office of Fair Trading, with a view to an inquiry by the Competition Commission so that all the interrelated issues surrounding concentration, competition and choice can be thoroughly examined in depth and in the round.
• Prudence should be reasserted as the guiding principle of audit.
• The new framework of banking supervision should provide for bank audit to contribute more to the transparency and stability of the financial system, in particular through two-way dialogue between auditors and supervisors about the financial health of banks.

IFRS

Lessons do need to be learned from the financial crisis and certainly the audit model needs to be evolved in order to meet changing market needs.  However, an area that has come under severe criticism – and not just in the lead up to, and during, the financial crisis – is the issue about IFRS which the Lords’ enquiry suggests is less prudent than current UK GAAP

IFRS has been frequently cited as the financial reporting framework which has brought about the financial crisis because of its ‘flawed’ nature and its effect on audit quality.  ACCA suggests that the Lords’ criticisms of IFRS are “misguided” and “could have serious implications internationally.”  Indeed, last year certain dissidents published an article in The Telegraph calling for IFRS to be withdrawn in the UK.

IFRS, like UK GAAP, requires general purpose financial statements to be prepared which present fairly the state of the financial position and performance of a company.  This overriding requirement is much the same as in UK GAAP which requires financial statements to be prepared which ‘give a true and fair view’.

The Lords’ enquiry makes recommendations that UK GAAP should continue and, whilst this may be the case for (potentially) the next couple of years, the enquiry does not appear to have considered that UK accounting standards on financial instruments are practically the same as in existing IFRS.  However, whilst there are ‘flaws’ in the standards governing financial instruments, these are in the process of being changed with the new standard on financial instruments planned for issuance in the second quarter of 2011 (IFRS 9: Financial Instruments).  Initially the draft IFRS 9 dealt only with financial assets, but financial liabilities were added to the standard in October 2010.  The areas relating to financial liabilities were mainly carried over from the existing IAS 39: Financial Instruments: Recognition and Measurement, though there have been changes made to the fair value option for financial liabilities to address the issue of own credit risk.

IFRS is also a financial reporting framework which is becoming more and more common throughout the world.  Here in the UK it has been mandatory for listed companies since 2005 and AIM-listed companies since 2007, so I am not entirely certain the dissidents who are calling for its withdrawal in the UK will get their wish.

An international-based framework is being proposed for the smaller end of the scale (notably medium-sized entities).  This is currently exposed for comment (until 30 April 2011) but the draft has been criticised; indeed the Lords’ enquiry suggests an international-based framework be limited in its application to smaller companies, though time will shortly tell where we are (proposed to be) going in the world of financial reporting and whether an international-based framework will be more widely rolled out in the UK or not.

FRSME is overly-complex in some areas; particularly in the area of deferred tax because of the way it is calculated under the IFRS regime (the ‘temporary difference’ approach as opposed to UK GAAP ‘timing difference’ approach).  There are other complications which should also be addressed before the draft is committed as a standard such as the issue of fixed asset revaluations and leasing, so we will have to wait until the comment period closes for issues of how this may affect us all in the future.

Non-Audit Services

Again, this is a debate which has been ongoing for years and seems to raise its head with a vengeance every now and again.  The Lords’ enquiry essentially recommends the prohibition of non-audit services to audit clients.  Clearly there will be firms out there who would be worried about such a prohibition, particularly smaller practices who may well provide, say, tax advisory services to their audit clients.

It would be futile to prohibit non-audit services to audit clients and this is something which I have frequently disagreed with since I started writing on auditing and financial reporting issues. There are many safeguards which firms can put in place to maintain objectivity and independence and it is extremely common for audit clients to request their auditors to perform tax work for them.  It would be unnecessarily costly to both the client and the audit firm if a separate firm was to be engaged to perform corporation tax work for an audit client.

Second (non-audit) partner reviews and external hot file reviews are examples of some of the adequate safeguards which can be put in place to ensure independence and objectivity are not impaired when undertaking non-audit work for audit clients.  Indeed, where firms are even involved in the accounts preparation work for audit clients, this can save time during the course of the audit as some audit evidence will already be in the possession of the audit firm.

Conclusion

Whilst lots of ‘anti-auditors’ will quite happily blame the profession for the financial crisis, I am not entirely certain this is necessarily true, but what is true is that lessons need to be learned from circumstances leading up to the financial crisis and, more notably, the audit model should be looked at to ensure that it does meet today’s market needs.  IFRS will probably continue to hit the headlines for many years to come, though I don’t hold out much hope that it will be withdrawn completely in the UK and, indeed, I suspect an international-based framework will be adopted soon in the UK though not in its current FRSME exposure draft form.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011).

Category: Audit