Features
18 Jul 2014 12:24pm

Measuring the value of audit

Accurately measuring audit quality was identified as a pressing issue for the profession at the first of a series of Value of Audit roundtables hosted by economia in association with KPMG

ATTENDEES AT THE ROUNDTABEL

Richard Cree, editor-in-chief, economia

Tony Cates, head of audit, KPMG UK

Mark Vaessen, global head of IFRS, KPMG

Melanie McLaren, executive director, FRC

Peter Montagnon, associate director, IBE

Robert Hodgkinson, executive director, technical, ICAEW

Will Pomroy, policy lead, governance and stewardship, NAPF

Robin Freestone, CFO, Pearson

Alan Ferguson, NED and audit committee chair

Paul Boyle, chief audit officer, Aviva

While Paul Boyle, chief audit officer at Aviva, welcomed recent improvements in audit (and recognised that there is always more that can be done), he added that the mere fact of having an audit at all was often enough to make sure executives behaved.

“The value of audit isn’t to be measured by the beauty and elegance of the financial statements that are produced,” he said. “It’s the unseen difference between the financial statements that are produced, and what would otherwise be produced without audit, due to a combination of simple errors and over-optimism in the absence of effective challenge, and in some cases, manipulation. That difference between what you see and what you would have seen otherwise, is important.”

Tony Cates, head of audit, KPMG UK, pointed out that this perspective highlighted the role audit has to play in building trust. “As a firm, we’ve been involved in the debate around restoring trust in business, which is really important. The public has lost trust in big business, in particular. And a big part of that debate is the trust in auditors, the profession, what auditors do and what broader things we bring to bear.”

Melanie McLaren, executive director at Financial Reporting Council (FRC) and the board member responsible for codes and standards, added that audit played a central role in fostering a strong environment for investment. “The FRC’s mission is to encourage high-quality corporate reporting and corporate governance, to foster investment. Obviously, the annual report and accounts is key. But we also believe that audit is a fundamental underpin of that model, and therefore is fundamental to capital markets. Our role is to make sure there’s justifiable confidence in audit.”

For his part, Peter Montagnon, associate director at the Institute of Business Ethics, agreed trust remains an issue. “It is deeply worrying to read in the Financial Times that 50% of Tory supporters think the government should crack down on big business. That’s half of Tory supporters and 72% of Labour supporters. UKIP and the Lib Dems are in the middle. There is a problem here, and we need to fix it. But I’m not sure how far audit is central to that, because audit has to do with the health of the capital market, rather than trust.”

Alan Ferguson, a serial non-executive director and chair of four audit committees (each of which employ a different one of the Big Four for their audit) added that the audit has definitely risen up the business agenda in recent years. Having been either a finance director or audit committee chairman for 16 years, he said he’d recently been contacted for the first time ever by an investor wanting to talk about audit. “Something’s stirring out there, which is interesting.”

Boyle highlighted the impact of recent developments in audit reporting, and the expanded audit report now required. “With what is now being proposed the UK is leading the world in terms of what the audit report says about the most important factors the auditor thought about.”

Highlighting KPMG’s audit report for Rolls-Royce, which has been acclaimed as a best-practice example of the new approach, Boyle added, “With Rolls-Royce, KPMG not only described the big issues it had to deal with in relation to that audit, it also described the conclusions it came to in relation to those issues. For the first time, ever, audit reports are actually worth reading, because they say something different and interesting.”

Cates admitted there had been a determined effort to make sure with Rolls-Royce (and two other pilot audits) that the firm “reported the stones we turned over, but also described what we’d found”.

These developments have already changed the nature of conversations in audit committees. This was hailed by Boyle as “probably the most significant development in auditing in years”.

Robert Hodgkinson, executive director, technical at ICAEW, pointed out that the profession’s ambition must be to build on this development. “It’s noticeable that there was a bit of market differentiation in what KPMG was looking to do, beyond what even the FRC was asking for. That’s interesting, and as a mechanism for innovation, it’s good. At a time of the biggest change in audit reporting, you decided to do something more, as opposed to saying ‘we’ve got enough to cope with’. It will be interesting to see whether you can maintain momentum and whether others will look to innovate in response, or whether that one surge of innovation will be enough to last for the next half-century.”

Ferguson agreed there is a challenge to keep it interesting. “Because next year you know it will be something similar, that’s the reality of these things,” he said.

Ferguson was also concerned about crossover with other reports. “We have to think about the audit committee report. I’ve personally spent a huge amount of time on it and there’s a danger of overlap. Companies and auditors have to work hard to try to differentiate that. But I’m hoping shareholders are genuinely going to read it.”

The audit competition debate, so far, has made the profession quite introspective, because everybody is asking what it means to them

ALAN FERGUSON

Robin Freestone, CFO at Pearson, also saw potential issues with maintaining interest. “The differentiation of audit reports is something to be welcomed,” he said. “It will be interesting to see where it goes. There’s a debate to be had around materiality. When a company can talk about plus or minus £100m in their accounts, that’s an issue. So, there are further debates to come. I also worry that the differentiation in year one is easier than it is in year five, as over time this might become a more boilerplate and we converge in the same space, which means it isn’t so well differentiated. And it remains difficult to assess audit quality, other than by the quality of the audit report at the end of the process. That’s true even when one’s being audited, let alone as an independent reader of a set of financial results.”

Ferguson agreed, adding that the debates so far on issues such as reporting standards and competition in the audit market had forced the profession to be inward-focused. “That goal of one global standard made everybody rather introspective, and I’m not sure it’s really moved the needle in any sense, other than in a slightly negative sense. And the audit competition debate, so far, has made the profession quite introspective, because everybody is asking what it means to them. There’s an awful lot of game theories in terms of plotting and who is going to go out to tender.”

For Montagnon, the debate on IFRS has led auditors to seek to use the standards for other purposes. “I’m an outside observer, but I’ve been around the issue for some time and I agree we are in a better place now than when everybody was pushing IFRS and it seemed, to shareholders and investors, that audit firms were using this to promote standards that would limit their liability. In a way, the failure of convergence has created an opportunity for more discussion around the way in which decisions have been made. We can do this in a way that opens up the debate with shareholders, and opens up our understanding of differentiation, and makes the choice [of auditor] more interesting, when it comes to rotation. Through this process, it should be possible for shareholders to get to know a bit more about what they’re buying.”

But for Freestone the idea that this discussion might lead to mandatory rotation is problematic. “I have strong views on rotation. This is not a 100 Group comment, but I have always felt there was a severe danger that mandatory rotation would have precisely the inverse effects of what it was designed to achieve. That danger is still there. Rotation has a fantastic effect, from a perception point of view. And while that was one problem that was trying to be solved, in terms of whole new audit teams turning up every five years, or whatever it turns out to be, I don’t think that will stimulate quality. And I don’t think we’re going to see costs come down, in fact we’ll see them go up. And we’re going to have more limited choice than we’ve had in the past. As a result you’ll see greater concentration of the Big Four further down into the FTSE 350. All of this is bad and yet I suspect this is the direction we’re heading in.”

For the FRC, McLaren was clear that they had never been in favour of mandatory rotation. “We focus, first and foremost, on quality and things that improve quality, but we’re realistic. The fact is that the audit market is very concentrated, and we’ve never been persuaded that in a market where you have limited choice, to take away the choice of the current incumbent and limit your choice further was going to help. But we do need a mechanism for dealing with the perception that the longer the tenure of the audit, if you’re not testing it regularly, the more cosy the relationship becomes. That is why we alighted on re-tendering and we’re pleased re-tendering has been swept up into the European solution with essentially a 22-year backstop, that you must rotate after a period of time.”

For Will Pomroy, policy lead on governance and stewardship at NAPF, this still presented some problems for investors, who had alighted on the idea of rotation partly to address perceived issues of cosiness and a lack of independence. “Investors were blamed as corporations for the financial crisis and they were to blame, to some extent. One of the things they’ve looked at is the regulatory system, and regulation of the financial markets and the confidence in them. One of the perceived problems was how are they ensuring independence is maintained and that auditors are serving their interests? A quick fix that some people fell on was mandatory rotation, because they didn’t have confidence in the audit market to ensure tendering, on its own, would be enough. There was an assumption that tendering would result in going through the motions and not a great deal of change.”

There was an assumption that tendering would result in going through the motions and not a great deal of change

WILL POMROY

Montagnon agreed mandatory rotation is dangerous, but he said it was clear why investors might like the idea of it. “You’ve got to understand why they’ve got the wrong end of the stick. It’s because companies have had the same auditor for decades, and don’t show any indication of change, and there’s quite obviously a cosy relationship behind it.”

For Ferguson, having been a finance director and audit committee chairman, close relationships between the parties were important and he suggested a powerful analogy to describe the perfect relationship. “The audit committee chairman has more responsibility and a more clearly defined role these days. Which is good. But I have an analogy of the three points of a triangle: the finance director and the audit partner were an awful lot closer, and the audit committee chairman was somewhere over to one side. But it should be an equilateral triangle because I don’t think we can afford to have the triangle skewed either way. I don’t think the investment community or the Competition Commission want the finance director over at one side and the audit partner and audit committee chairman close together. That doesn’t work, either.”

For Pomroy that triangle should also consider shareholders. “What it alludes to is that we were a long way to one side, and the shareholders were skewed a long way from the other two. Some of the solutions on audit rotation will resolve a lot of the concerns. After all, 20 years is quite a long backstop and therefore the impacts on competition, having to rotate on a 20-year cycle should be manageable.”

What was clear throughout the discussion was the significant agreement that public trust in business and in audit, even by default, had broken down and that rebuilding it will take time. The policy approach to help resolve this breakdown and restore trust in financial reporting and capital markets has started to have a positive impact, with some movement in areas such as audit reporting. And yet, there was still a strong sense that there is much more that needs to be done to really get a grasp on what we mean by audit quality and what a good audit looks like. While most present were dismissive that mandatory rotation would mean higher quality audits, there was agreement that the standard policy approach to the issue of trust had been to talk about more transparency and greater competition in markets. As the FRC’s McLaren pointed out, it was important the profession avoided falling into the trap of making such “lazy policy” changes for the sake of achieving quick wins.

And yet the biggest question on the day remained how the role and scope of audit is defined to be of value to all parties. This gets back to having a more detailed understanding of how we measure audit quality and what expectations we place on auditors to be able to identify and understand any future risks facing the business. Is that achievable from a backward snapshot at last year’s numbers? Should auditors be required to offer assurance on wider elements, such as the viability of the business model over the longer term, or to identify any significant risks on the near horizon?

Ferguson spoke for many when he expressed the view that modern audit has lost some key elements from the traditional process. “In my day, I used to walk the floor and while we didn’t have the IT systems, we had to go and find a piece of paper. Now when I’m in as chairman of the audit committee I find the auditors all in a room, staring intently at a computer screen. I’ve no idea what they’re doing. It could be like my son doing his revision. I think audit quality is an area where there’s a long way to go to peel the onion a bit and where everybody would benefit.”

Freestone concurred. “Audit quality is something that we have to really pin down, in terms of working out how we measure it, because otherwise these debates are quite difficult. We can’t say we’re definitively moving forward. It becomes judgemental. I think we are moving forward and the quality of audit has got notably better over recent years in a more complex environment. But public trust is a more complex issue, because it can be so easily undermined by very small things.”

Pomroy added that investors are also concerned with quality: “Audit quality is what lay behind requests from investors to focus on rotation and tendering. But audit reporting that’s come into play this year has been welcomed by investors. We’ve referenced the Rolls-Royce report, but the majority of audit reports, while useful to the board still leave a ‘so-what?’ question, in many regards.”

The desire for the profession to work out the best future approach was expressed by Hodgkinson: “I think we need to work out how to have an auditing profession that is dynamic, in the sense there’s an engagement with the issues that businesses need to address, and that the wider public are interested in. And it would be good to see a dynamic for developing what auditing does that isn’t reliant upon crises. The history of auditing progresses by landmarks in terms of what we did in relation to the last crisis. There will still be crises, but it would be nice to anticipate some and have a process for engagement that builds trust.”

 


 

Richard Cree Richard Cree, editor-in-chief, economia


 

 

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