The ability to get a more accurate handle on how to measure audit quality was identified as one of the most pressing issues facing the profession at the first of a series of Value of Audit roundtables hosted by economia, in association with KPMG
While participant Paul Boyle, chief audit officer at Aviva, welcomed recent improvements in audit (recognising there is always more than can be done), he said that the mere fact of having an audit was often enough to make executives behave.
“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 often the unseen difference between the financial statements that are produced, and what would otherwise be produced, in the absence of audit, due to simple errors, over-optimism in the absence of effective challenge and possibly, in some cases, manipulation. That difference between what you see and what you would have otherwise seen, is important.”
Tony Cates, head of audit, KPMG UK, agreed, pointing out that this perspective highlighted the role audit has to play in building trust. “As a firm, we’ve been involved in the whole debate around restoring trust in business, which is 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 could bring to bear.”
Melanie McLaren, executive director at Financial Reporting Council (FRC) and the board member responsible for codes and standards, added that audit plays a central role in fostering a positive investment environment. “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. We also believe that audit is a fundamental underpin of that model, and is fundamental to capital markets. Our role is to make sure that there’s justifiable confidence in audit.”
Tony Cates, KPMG
The public has lost trust in big business. And a big part of that debate is the trust in auditors, the profession
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 all Tory supporters, and its 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 he was less certain what role audit played in this. “I’m not sure how far audit is central to this, because audit has to do with the health of the capital markets, rather than trust.”
Alan Ferguson, a serial non-executive director and chair of four audit committees (which between them employ all of the Big Four for audit) added that audit quality has risen up the agenda in recent years. Having been a finance director and audit committee chairman for 16 years he reporting recently being contacted by an investor to discuss an audit. “A couple of weeks ago I had my first ever shareholder meeting where a shareholder wanted to come and talk to me about audit. Something’s stirring out there, which is interesting.”
Boyle pointed to the impact of recent developments in audit reporting, and the expanded audit report required by new FRC rules. “With what is now proposed the UK is a leader in terms of what the audit report says about the most important factors the auditor thought about.”
Boyle referenced KPMG’s audit report for Rolls Royce, which has been acclaimed as a best-practice example of this new approach. With Rolls Royce, KPMG not only described the big issues it had to deal with in relation to that audit, it also described the particular 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,” he said.
Cates admitted that there had been a determined effort to make sure with Rolls Royce (and two other pilots) that the firm not only reported the stones turned over, but also described what had been found. The fact that auditors will have to write reports like this agreed the group has changed the nature of the conversations in audit committees, a development 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 should 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 doing. That’s interesting, and as a mechanism for innovation, it’s good. At a time of the biggest change in audit reporting, we decided to do something more, as opposed to saying ‘we’ve got enough to cope with’. I think it will be interesting to see whether you can maintain momentum and whether others will look to innovate in response, or whether this one surge of innovation will be enough for the next half-century.”
Ferguson agreed that the challenge is to keep things interesting. “Because you do it once, next year it will be something similar, that’s the reality of these things.” Ferguson was also concerned about cross over with other reports. “We also have to think about the audit committee report. I’ve spent a lot of time on it and there’s a danger of overlap. Companies and auditors have to work hard to try to differentiate. But I’m hoping shareholders are genuinely going to read it.”
Robin Freestone, CFO at Pearson and chairman of the 100 Group, also saw issues with maintaining interest. “The differentiation of audit reports is something to be welcomed,” he said. “And it will be interesting to see where the debate goes. There’s a debate to be had around materiality. When a very large company talks about plus or minus £100m in their accounts, that’s an issue. So, there are further debates to come. I also worry that differentiation in year one is easier than differentiation in year five, when this becomes a bit more boilerplate and we converge in the same space. It might not be so well differentiated in a few years’ time. It is really difficult to assess quality, other than by the quality of the audit report at the end of the process, even when one’s being audited, let alone as an independent reader of a set of financial results.”
Ferguson concurred, adding that the debates so far on issues such as reporting standards audit market competition had forced the profession inward.
“The goal of having one global standard has made everybody introspective, and I’m not sure it really moved the needle other than in a slightly negative sense. And the competition debate, so far, has also made the profession introspective, because everybody is asking what it means for them. There’s an awful lot of game theories in terms of plotting and who is going to go out to tender.”
Montagnon suggested the debate on IFRS had led auditors to seek to use the standards defensively. “I’ve been around these issues for some time and I would agree we are in a better place 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. That was bad. 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 more interesting, when it comes to rotation. Through this process, it should be possible for shareholders get to know a more about what they’re buying.”
But for Robin Freestone, CFO at Pearson, the idea of mandatory rotation remains problematic. “I have strong views on rotation. This is not a 100 Group comment, but I have always felt there was a danger rotation would have precisely the inverse effects it was designed to achieve. Rotation has a fantastic effect, from a perception point of view. While that was the problem that some were trying to solve, in terms of whole new audit teams turning up every five years, or whatever it turns out to be, I don’t think it will stimulate quality. And I don’t think we’re going to see the cost come down, in fact costs will go up. And we’re going to have more limited choice than we’ve had. As a result you will see greater concentration of the Big Four down into the FTSE 350 and below. All of those four things are bad and yet I suspect we’re going to see all of them go, in some degree, in the wrong direction.”
McLaren was clear that the FRC had never been in favour of mandatory rotation. “We focus, first and foremost, on things that improve quality, but we’re realistic. The audit market is very concentrated, and we’ve never been persuaded that in a market where you’ve got limited choice, taking away the choice of the current incumbent and was going to help. That said, we need a mechanism for dealing with the perception or reality that the longer the tenure of the audit, if you’re not testing it regularly, the more cosy the relationship becomes. This is why we alighted on re-tendering and we’re pleased that has been swept up into the European solution with a 22-year backstop, that you must rotate after a period of time.”
Paul Boyle, Aviva
For the first time, ever, audit reports are actually worth reading, because they say something different and interesting
But Will Pomroy, policy lead on governance and stewardship at NAPF, said this still presented problems for some investors, who had picked up the idea of rotation to address perceived issues of independence. “Investors were partly blamed for the financial crisis and to some extent they were to blame. One of the things they’ve looked at is regulation of the financial markets and the confidence in them. One of the perceived problems was how to ensure independence is maintained and auditors are serving their interests? A number fell on mandatory rotation as a quick fix, because they didn’t have confidence in the audit market to ensure tendering on its own would be satisfactory. There was an assumption tendering would result in going through the motions and not a great deal of change.”
However for Montagnon mandatory rotation would indeed be dangerous, although he agreed it was clear why investors had got the “wrong end of the stick’ on this. “You’ve got to understand it’s because some companies have had the same auditor for decades, and don’t show any indication of change. There’s obviously a cosy relationship behind it.”
Ferguson, having been both a finance director and audit committee chairman, disagreed. He offered the analogy of a triangle to describe the relationship. “The audit committee chairman has more responsibility and a more clearly defined responsibility these days. Which is a good thing. 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 there. Ideally 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 one side and the audit partner and audit committee chairman close together over there. That doesn’t work, either.”
For Pomroy that triangle also had include 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 focusing on audit rotation will probably resolve a lot of the concerns and hopefully concerns around rotation should fall away. 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.”
Throughout the discussion it was repeatedly stated that public trust in business and, by default audit, had broken down and that the rebuilding process will take time. The policy approach to resolve this breakdown and restore trust in markets has started to have a positive impact, with movements in areas such as audit reporting. And yet, there was still a sense there is more than needs to be done to really get a grasp on what we mean by audit quality and what a good audit looks like.
There was also acceptance that a somewhat aimless call for “greater transparency” across all areas of public life and greater competition in markets has been the standard approach to restoring trust. But as the McLaren pointed out, it was important for the profession to avoid falling into this trap of making “lazy policy” for the sake of quick wins.
And yet the biggest question on the day remained how the role and scope of audit should be defined to be of maximum value. This requires more work on how audit quality is measured and what expectations we place on auditors to be able to identify future risks. Is it achievable from a backward snapshot look at the previous year’s accounts? Should auditors be required to also offer a broad assurance on wider elements, such as the viability of the business model over the longer term?
Ferguson was supported when he said that modern audit sometimes leaves him a little cold. “In my day, I used to walk the floor. While we didn’t have the IT systems, we had to go and find a piece of paper. Now as chairman of the audit committee I find the auditors all in a room, sitting, intently, on a computer. I’ve no idea what they’re doing. It could be like my son doing his revision. Audit quality is an area where there’s a way to go to peel the onion back a bit, where everybody would benefit.”
Freestone concurred. “Audit quality is something that we’ve got to really pin down, in terms of how we measure it, otherwise these debates are difficult. We can’t say we’re definitively moving forward, as it becomes judgemental. We are moving forward and the quality of audit has got better over recent years in a more complex environment. But the issue of public trust is more complex, because it is easily undermined by very small things.”
Pomroy agreed investors were also concerned: “Audit quality is what lay behind requests to focus on rotation and tendering. The reporting that’s come into play this year is important and welcome. We’ve referenced the Rolls Royce report, but the majority of audit reports, while useful to the board still leave a ‘so-what?’ question.”
The desire for the profession to work out the best future approach was expressed well by Hodgkinson: “I think we need to work out how we get an auditing profession that is dynamic, in the sense there’s an engagement with the issues businesses need to address, and which the public are interested in. 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’d be nice to anticipate some and have a process for engagement which builds trust.”
Attendees at the roundtable
Richard Cree, editor, economia
Tony Cates, head of audit, KPMG UK
Mark Vaessen, KPMG global head of IFRS
Melanie McLaren, executive director, codes & standards
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
For a full transcript of the conversation, click here. More from the Value of Audit Series will follow in coming weeks.
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