This article was first published in the June 2014 UK edition of Accounting and Business magazine.
There is a circularity about any debate on audit. The same arguments come round decade after decade; you could probably have found people arguing over expectation gaps a hundred years ago. And it is not helped by the obvious point that, for the mass of the population, audit issues do not come high on their scale of worries. This is dramatised on the cover of the latest research into audit, Improving Confidence in the Value of Audit.
It was carried out for the Financial Reporting Council (FRC) by YouGov and appears under the company’s generic cover design depicting a wildly mixed crowd of people representing a cross-section of society.
In one row a woman wearing a burka appears just along from a person with a gas mask. You would not expect any of this multitude to be carrying a placard saying ‘Down with complacent auditors’.
And the report bears this out. It finds that the people who know most about audit are happiest with how it currently works, while those who know the least, broadly politicians and regulators, have the least confidence. So, as the investment community might say: ‘No surprises!’
‘You would expect the people who are closest to the audit to be the ones who are the most confident,’ says Sue Almond, technical director at ACCA. ‘What we learned was broadly considered to be consistent with what we thought,’ says Marek Grabowski, the FRC’s director of audit policy.
It is the traditional problem. Audit takes place behind closed doors. Whenever detailed research has been carried out it has invariably reported that, all things considered, the process holds up well and largely does what the outside world would want it to do. But the outside world cannot see this with its own eyes. ‘Audit is a very opaque model,’ says Grabowski. ‘People have very little idea of what a particular audit does. There is a lack of transparency. Audits are tailored to particular circumstances. So you hear negative things when there is a problem. You hear all the bad things and you don’t hear the good things.’
The problems that this causes are apparent in the YouGov report. One investor said: ‘We still feel that the way the result of audit is reported to shareholders is poor and we still don’t get what we need in terms of the key aspects to help form an opinion…it is difficult for investors to assess the quality of the audit and where the information actually came from.’
This is why the FRC intends using the research as both a benchmark and a springboard for the future. It talks of measures to enhance a justifiable confidence in audit. The use of the word ‘justifiable’ is important. The FRC obviously wants to show how the quality of audit can improve specifically and can be seen to be improving. Given its confidential nature, this will always be difficult. But Grabowski sees this as unavoidable. ‘The public doesn’t give any professions “blind trust” anymore,’ he says. ‘So we are taking actions to enhance justifiable confidence.’
In the first year that auditors have been supposed to comment on key risks and materiality there are signs that change is under way. KPMG, for example, stuck comments into its audit report on jet engine maker Rolls-Royce that the company used an ‘acceptable but mildly optimistic’ estimate for a put option that produced lower liability estimates than it might otherwise have done. KPMG also pointed out that the company’s estimates and assumptions resulted in ‘mildly cautious profit recognition’. These are modest moves, but in the right direction.
But the fundamental illogicalities of the audit model will still cause problems. As another respondent to the research put it: ‘Politicians and regulators still have an expectation that audit does something it doesn’t do and this is the classic expectation gap that has been such an issue since 1884.’ And the fundamental sticking point of the auditor being employed by the company is not going to go away. ‘There is supposed to be a triangle of beneficiaries – the company, auditor and the shareholders,’ said one investor respondent to the survey, ‘but the triangle is increasingly missing shareholders as auditors and companies have got closer together.’
Having auditors employed and paid by companies doesn’t engender trust and encourages those who don’t understand the underlying process to say everything is wrong. The only defence, says Grabowski, is greater clarity. ‘Auditors need to demonstrate scepticism to prove that they are independent of the client and are helping users,’ he says. But the research report suggests there was ‘a feeling that the professionalisation of audit has created intelligent “box-tickers” rather than sceptical professionals’.
The financial crisis also muddied the audit waters. ‘All stakeholders,’ says the research report, ‘feel that the financial crisis highlighted shortfalls in auditor competencies in understanding the complex financial models being used by financial institutions.’
The circularity of the arguments over audit is set to continue. The hope is that, slowly and steadily, a greater commitment to explanations on all sides will lead to greater understanding. Certainly, the early signs of auditors starting to open up in their reports and talk more about how companies have dealt with risks, for example, will help. The FRC has a long task ahead, but an important one.
Robert Bruce is an accountancy commentator and journalist