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This article was first published in the September 2009 edition of Accounting and Business magazine. 

Today I walked through yet another shopping centre where staff outnumber customers. Discussion boards I frequent are full of debate about the property market, and most people I know are constantly anxious, wondering how long this slump will last.

The scale and severity of this crisis can probably only be compared with the early 1980s - or perhaps even the Great Depression of the 1930s.

Background to the crisis

Explanations range from the simplistic ('it's all the fault of greedy bankers') to the extremely complex, beyond the scope of this article, but most would agree on the following factors:

  • Low interest rates led to people borrowing more money than they could afford since property was 'certain' to increase in value.
  • A continuing upward trend in property values led to more properties being purchased as investments.
  • With the value of property 'guaranteed' to rise, banks relaxed their lending requirements.
  • First-time borrowers and low-income families had to borrow higher multiples of income to get onto the property ladder.
  • Home loans became securitised; lenders sold the rights to bundles of home loans as collaterised debt obligations (CDOs) on to other banks/investors, including sub-prime loans made to borrowers with poor credit ratings.
  • People felt wealthy so they spent more, leading to heavy personal debt.

This was all fine, as long as the housing market continued to rise; received wisdom was that if sub-prime borrowers had repayment problems, they or the banks could just sell the properties and realise their gains.

In 2007, prices across the US began to fall. Struggling homeowners discovered they couldn't sell for enough to clear their debts. Banks discovered the foreclosure process was expensive and didn't realise enough to pay off loans. Borrowers were unable to renegotiate their payment schedules as they didn't know to whom their debt had been sold.

The bursting of the real estate bubble has led to the following:

  • Banks realising that their investments in CDOs are overvalued, but they have no idea of their true value since they don't know the identity of the borrowers or their credit ratings.
  • Banks becoming less able and willing to lend money, as falling asset values mean they need to retain cash to bolster their reserves.
  • Insurance companies that had insured CDOs facing huge losses.
  • Falling house prices leading to fewer construction projects, leading to unemployment in the construction sector, with multiple effects on the wider economy.
  • Falling consumer confidence resulting in fewer purchases, especially of big-ticket items. For those who want to purchase, limited availability of finance makes it difficult.
  • Falling stock markets due to falling confidence (especially in banks) and investors converting funds to the safe haven of cash.
  • Increasing personal default as individuals who are overly leveraged struggle to pay their mortgages and credit card bills.

Professional guidance

Auditors of banks and other financial institutions will be most affected by the current problems; it will be very difficult to determine the value of many assets held, and they face scrutiny from regulators looking at banks' capital-adequacy ratios.

But most businesses will be affected to some extent. A reduction in consumer confidence will affect sales, a lack of availability of consumer credit will prevent closure of many deals, and companies will face problems raising money for their working capital and long-term needs.

Many professional bodies and regulators around the world have issued guidance on the implications of the crisis. For example, in January 2008 the UK Auditing Practices Board (APB) issued a bulletin, Audit Issues When Financial Markets are Difficult and Credit Facilities May be Restricted, and the International Auditing and Assurance Standards Board (IAASB) has issued two audit practice alerts - in October 2008 and January 2009. The first was Challenges in Auditing Fair Value Accounting Estimates in the Current Market Environment, followed by Audit Considerations in Respect of Going Concern in the Current Market Environment.

The APB guidance identifies issues that need to be considered throughout the audit process, whereas the IAASB alerts focus on the problems of auditing fair value, especially when markets are illiquid, and going concern. All of the bulletins emphasise that they contain no new guidance - ie. that existing auditing standards still apply - but that they provide expansion in some areas.

Practice management issues

The International Standard on Quality Control (ISQS) 1, and ISA 220, Quality Control, state that firms should only undertake engagements where they are competent to do so and have the appropriate capabilities and resources.

The APB bulletin points out that there is an obvious issue where the client has financial instruments whose fair value must be determined, so auditors of banks and other financial institutions must take particular care.

Valuation and disclosure requirements of financial instruments are complex, so audit firms should consider:

  • Enhanced training courses for audit staff;
  • Recruiting staff with experience in auditing banks etc; and
  • Retaining experts to assist in valuation, particularly in
    classes of assets that have become illiquid.

Competence could also be an issue for most other audits. There are few, if any, recession-proof industries and most clients are likely to face declining sales or operating difficulties as a result of the crisis and its impact on consumer confidence. For some clients, the impact will cause potential going-concern problems, increasing the risk of material misstatement at the overall entity level. ISA 330, The Auditor's Responses to Assessed Risks, includes assigning more experienced staff and emphasising the need for professional scepticism in its list of appropriate responses.

Audit firms may find they have insufficient staff with the levels of skill and experience required to audit the increased number of risky clients.

Increased fees

ISA 330 states that increased supervision is an appropriate overall response, and the APB bulletin says the audit engagement partner should consider being involved in the audit. This, combined with the higher level staff required, the increased time commitment that risky clients require, and the use of experts, means higher audit fees should be charged to cover increased costs. Firms' overheads are also likely to increase due to increased insurance costs resulting from expected legal actions against auditors.

As increased fees will not be particularly welcome, clients with financial difficulties may delay paying them. This leads to a potential breach of the ACCA's Rules of Professional Conduct, which say that overdue fees can lead to a self-interest threat - the firm may be tempted to give an unqualified report in order to recover fees from the previous year. Outstanding fees could also be interpreted as a loan to the client, also in breach of the Rules.

Firms therefore need to put pressure on clients to pay but, if a client later goes out of business, the firm may be accused of using confidential information about a client's pending insolvency for its own benefit and to the detriment of the other creditors. Firms may want to take legal advice before aggressively pursuing outstanding fees from clients whom they suspect to be facing serious difficulties.

Advocacy threat

Banks may require companies to submit forecasts on which assurance firms have expressed an opinion before granting/renewing finance. Firms will be aware of the importance of this finance, and there is a danger they may so strongly advocate their client's position they lose their objectivity.

Obvious safeguards are concurring reviews and having the work performed by staff that have no other contact with that client.

Quality control

To prevent legal actions, or defend themselves against them, it's critical to have sound quality control procedures.

Adequate audit documentation is also key: firms need to be able to justify how they reached decisions with respect to, for example, going concern.

ISA 220 requires engagement quality control reviews ('hot' reviews) to be undertaken for listed clients and all other clients where they are thought to be necessary. This is usually taken to mean risky clients, and there are a lot more of those at the moment. (Time spent on more hot reviews again increases a firms' overheads).


With an increasing number of firms in financial difficulty, firms need to ensure their 'Chinese walls' are sufficiently robust. It could well be the case that an audit client (A) experiencing financial difficulties owes money to another audit client (B), and that defaulting on the debt could cause B to face financial problems. The audit team of B may be unaware of A's difficulties and may be planning to give an unmodified report, but the audit team of B may realise this report is potentially inappropriate. Team B is precluded under the rules on confidentiality from informing team A of B's financial difficulties.

There is also a risk that the insolvency department's clients may owe money to the audit department's clients.

Staff should be reminded of the importance of confidentiality, and controls over the security of files - both paper and electronic - should be reviewed. Firms should consider segregating and restricting access to the insolvency department.

Engagement letters

Firms should consider sending an updated engagement letter to long-standing clients to reiterate the extent of their responsibility.

Liability and disclaimers

Auditors who act reasonably and follow auditing standards should not be found to be negligent, but in the current climate auditors may wish to increase the use of disclaimer clauses in their audit reports. ACCA's position, outlined in Technical Factsheet 84 (updated in September 2008): The Use of Disclaimers in Audit Reports, is that the use of disclaimers is unnecessary and the best defence is to do a good job.

Inevitably, banks will be scrutinising financial statements and audit reports more closely in the months to come. If there is a risk firms may be deemed to have knowledge of the specific bank and use to which they will put the information, they may wish to add a disclaimer clause to their audit reports.

Next time: Risk assessment, including going concern issues. Part three will cover substantive procedures, including audit of fair value review stage, reporting issues and communication with those charged with governance.

Connie Richardson, auditing and accounting lecturer, Kaplan Financial in Singapore