There’s more to audit than gathering evidence about areas of uncertainty. Meaningful scrutiny of management decisions calls for bolder auditors, suggests Jane Fuller
This article was first published in the January 2020 UK edition of Accounting and Business magazine.
One of the challenges laid down in Sir Donald Brydon’s UK review of the quality and effectiveness of audit was for contributors to provide views on ‘models for published auditor reporting that may provide more meaningful insight and narrative’.
Extended auditor’s reports have been around since 2014. The big advance has been in commentary on difficult judgments, provided under the heading ‘key audit matters’. These disclosures have actually given users of accounts meaningful insight into potential trouble. At Thomas Cook, for instance, referring to the going concern basis for the 2018 accounts, EY pointed out that this was dependent upon the group’s ‘continued access to bank borrowing facilities’ and its ability to operate within covenants that had already had to be reset.
But apart from KPMG’s limited foray into providing judgment on management’s approach – optimistic or cautious – there has been little innovation. Auditors have busied themselves by gathering evidence about areas of uncertainty, while ducking qualification of accounts and emphasis on serious matters. In theory, the disclosure approach is fine – investors are supposed to be an expert audience. But in practice it is not enough. Those relying on the accounts include suppliers, who are naïve creditors, and the not-so-financially literate politicians who investigate high-profile bankruptcies.
So what might a model to aid judgment look like? One solution is to learn from the credit rating agencies, whose ratios take in leverage, interest cover, profit margins and sales volatility. Auditors could use similar fact-based analysis to grade the financial strength of a company. Where forecast cashflows – sensitive to variations in key assumptions – are used in valuations, a range of outcomes could be displayed, like a Bank of England fan chart.
We all have our pet ‘red flags’, but they do overlap in a way that could guide our agents, the auditors. Mine are: net debt-to-EBITDA ratios above four times; interest cover below three times; weak cash conversion of operating profits; ballooning working capital; large long-term liabilities; management taking liberties with adjusted profit numbers. On the income side: sales are vanity, profits are sanity and cash is reality; on the balance sheet, asset values can be flaky while liabilities are stubborn.
Lessons can be learnt from the prudential regulation of banks, where goodwill is not regarded as a sound component of loss-absorbing capital. Other straws in the wind include the fact that providers of credit now rank alongside shareholders as primary users of accounts.
To demonstrate their public interest role, independent auditors need to be bolder, not only in their challenges of management judgments but in drawing attention to any weaknesses. The public does not care about successful companies, only about the ones that go bust.
Jane Fuller is a fellow of CFA Society of the UK and co-director of the Centre for the Study of Financial Innovation.
"Auditors have busied themselves gathering evidence about areas of uncertainty, while ducking emphasis on serious matters"