It needs to be said at the outset that the Global Financial Crisis (GFC) has been used as an opportunity to reopen the doors to age-old debates in accounting and auditing. European and American regulators have used this as an excuse to open up the evergreen discussions surrounding audit regulation and audit reporting.
Some readers may remember the issues of audit firm rotation, varying periods of partner rotation, and greater restrictions on non-audit services being offered by firms being raised following the collapse of HIH and One.Tel among other entities. These suggestions are being resurrected with the GFC as the backdrop.
Another discussion that is being promoted for debate internationally relates to the audit report and its format. One of the consistent thorns in the side of the accounting profession is the low level of understanding amongst the broader community about the role of auditors and the meaning of the audit report. This is typically referred to as the ‘expectation gap’ in the area of financial reporting and audit. It is the difference between the expectation a user may hold about the work of an auditor and what is actually done.
Leaders in audit standard-setting globally have decided to tackle the issue and earlier this year issued a discussion paper that provided a conceptual discussion about possible changes to the audit reports structure that might add value to users of the audit report.
Opinion first
One concept floated within a discussion paper issued by the International Federation of Accountants this year is for the deckchairs to be rearranged just a little by making the audit opinion the first thing that the reader sees before the explanation of the various processes and procedures the auditor and their engagement team had to follow in order to get sufficient appropriate audit evidence to support their view. This might be seen as useful. The key issue worrying investors may be whether the auditors found a problem. If the auditors have given a clean opinion – or what appears a clean opinion – then it all should be fine in their eyes.
Moving the audit opinion from the back to the front, however, also means that it is less likely that people run their eye over the various audit processes and procedures that feature in the audit report today. Those paragraphs related to the scope of audit are just as critical – if not more critical – than the audit opinion itself. The scope provides some additional information to let the beneficiaries of the audit work to get some idea of what the audit engagement team has had to do in order to reach its opinion. Other pieces of valuable information such as material that auditors want to highlight through emphasis paragraphs could end up being ignored if the audit opinion is moved up to the front.
Not a suitable approach
This type of thinking is actually reminiscent of the type of thought process that exists in a newsroom where the headline items are written up in the front end of a story in order to make sure key facts are up the front of the yarn in case somebody has to cut the copy for any purpose. An audit should not be likened to a piece of journalism or writing where the ‘headline item’ truly needs to be in the front. Applying the journalistic notion of an ‘inverted pyramid’ to an audit report may please those who do not wish to be bothered by the details of audit methodology or emphases of matter in their quest to get the confirmation that things are good, bad or indifferent. But those details are important. They set down some of the core ideas about the scope of the audit so that the audit opinion is accompanied by some material that explains the process of audit.
Scope matters
Understanding a little about the scope of an audit is important for the reader. Knowing that auditors do not look at every transaction is important. It should be acknowledged here that sampling technique plays a large part in the selection of transactions but there are few people outside the profession who would understand the significance of sampling technique. ‘Where were the auditors?’ is often the questioned asked by some commentators and shareholders. The truth of the matter may well be that auditors were doing everything they are required to do under the auditing standards but the samples they looked at and the procedures they adopted may not have picked up some critical information. Some hints about this already exist in the audit reports published today.
Media commentators will at times assume auditors look at everything when covering a corporate collapse. This leads to frustration within the profession because no auditor can disclose what work they have done on an audit engagement nor can they defend themselves in the public domain about allegations related to a specific entity’s audit. Media commentators need to be provided training by accountants so that criticisms of the profession are based on relevant and comprehensive information.
Commentary limitations
Reflect for a moment on the consequences of a suggestion that auditors should comment on whether they believe a client’s accounting treatments are aggressive.
The audit report provides information about whether the client has complied with accounting standards. The subjective analysis that would be published in that situation would only muddy the waters. The treatment used for a specific transaction will comply or fall short of compliance. Whether a treatment is aggressive or conservative is a matter for professional judgment. Additional commentary of this type would end up being a commentary on the entity’s management and its judgement rather than whether the financial statements are presented in manner that is compliant with the Corporations Act 2001 obligations of an entity, which, of course, includes compliance with accounting standards.
Commenting on the client’s business model and the entity’s business risks is also rather questionable. Some observers would like to see auditors provide an analysis that highlights risky areas in the audit report. What is wrong with this picture? It is the board of directors of the entity and senior management that are responsible for the governance and performance of the business, not the auditor. It is that group of individuals rather than the auditors who would need to communicate in a broad sense about the strategy of the entity and the economic environment in which the directors and managers see the entity operating.
An auditor’s analysis of the business model of an entity or business risks of an entity might be great for the voyeurs wanting to see evidence of conflict between the auditors and a client. While auditors are engaged in discussions with management over an extended period it is for management to talk about their business model and the risks they are entering into on behalf of the shareholders of the entity in question. Auditors editorialising in this space would merely draw attention away from those that are truly responsible for the running of the business. Just because accounting firms have expert knowledge in industries that they leverage in all of the work they do with clients does not mean it is sensible for auditors to opine on a particular business model. It is not a question of a lack of capacity or knowledge. It is just inappropriate.
Is a broader report desirable?
Another issue that ought to be debated more openly is whether there are some elements of the auditor’s letter to management that contain material that could be used if the concept of an expanded audit report ever went ahead.
Some accountants think it could work if text is reworked into a suitable form for an audit report. Others are far more reluctant to even consider this as a possibility given that the auditor’s letter to management is an opportunity for the auditor to be frank about the manner in which the company’s internal controls are maintained, for example. It is important to note that while no regulator appears to have suggested this, testing the notion of using the auditor’s letter to management gives us some idea of how many people would be prepared to expand the audit report in the first instance if it meant talking about things that may be wrong with systems or accounting in the auditor’s point of view.
Added risk
If standard-setters and regulators were to make audit reporting much broader in scope than it is today we all need to seriously consider audit risk and litigation risk. This is especially true in the context of integrated reporting and broadening the scope of reports produced by entities.
Put yourself in the shoes of an auditor that chooses to highlight a particular factor in a company’s accounts and something like a run on that company’s shares was to happen following the annual report being published. The company may have grounds to sue the audit firm for precipitating a market movement based on an opinion about the company’s aggressiveness in accounting or poor business model, for instance. How quickly would comments about entity operations from auditors become bland and innocuous because of the perceived risk of a law suit?
If liquidators of a company come across information that should have been disclosed by an auditor – and the liquidator has reason to believe that the auditors had access to this information – then the auditor can be taken to task for negligence.
Care needs to be taken that any suggestion to change the scope of audit reports is accompanied by recommendations for law reform so that auditors get protection of some description. The first question that needs to be asked, however, is whether such expansion is essential given that the accounts and reports produced by an entity belong to the entity and not the auditors.
