31 Oct 2014 10:49am

Value of audit: Toronto

The importance of the audit profession “sticking to the basics” and “doing the fundamentals well” was a major theme at the fourth economia Value of Audit roundtable in association with KPMG, which took place in Toronto earlier this month. Chaired by economia’s editor-in-chief, Richard Cree, and hosted by KPMG Canada, the discussion included input from senior local and international KPMG staff, as well as representatives of all the other major stakeholders in the audit debate, including CFOs and other directors, audit committee chairmen, investors and regulators

Strongly influenced by the risk-averse US market, the Canadian profession is more cautious than other markets that have hosted discussions (you can find all discussions here) and there was a less open reception for ideas such as expanded auditor reporting or offering assurance over forward-looking elements of the corporate report.

If the auditors start to get into areas they're not skilled, capable or trained to do, they're going to dilute the real value of the system, which is integrity of the financial statements

Head of audit for KPMG Canada, John Gordon, explained the local context, saying that while Canada may not have been at the heart of recent events, neither was it immune from the pressures that they have created: “While there are major trends or events that have led to discussions, like this, around the world, Canada wasn’t at the epicentre of them. But nor are we immune. Whether that’s the financial crisis or some responses to it, like audit reform in EU, we are hearing audit committees and management ask what it means. They are asking about the role of auditors, whether it could be broader, given the skills and experiences we have and the information we have access to.”

Former KPMG partner and audit committee chairman, Axel Thesberg, concurred: “Canada is unique. We’re close to the US and a lot of regulation is patterned off the US. But we approach issues and opportunities differently. We get regulators, firms and clients sitting together to talk through these questions. We ask what can the profession do in Canada to enhance financial reporting or audit. That has led to discussion on whether you can do much about the value of audit, unless you ask questions about the relevance of financial reporting.”

For Stan Magidson, president and CEO of the Institute of Corporate Directors, this “made in Canada” approach has led to a good corporate governance structure. “We have a healthy state of corporate governance, by global standards. I’m a believer that regulation for the sake of regulation is a result of the failure of capital markets to work effectively.”

Talk of extending the role of audit caused concerns, with many agreeing with Ian Bourne, board director and audit committee chairman for some of Canada’s largest organizations, who said: “I think the real value of audit is in ensuring the system has got the integrity and is functioning. My sense is that if the auditors start to get into areas they're not skilled, capable or trained to do, they're going to dilute the real value of the system, which is integrity of the financial statements.”

As chief accountant of the Ontario Securities Commission, Cameron McInnis was clear his priority was protecting investors: “My fundamental concern is making sure the system is reliable and that investors can rely on the audit report,” he said. “It’s interesting to hear talk about other activities auditors detracting or diluting the value of the audit, from an investor standpoint. Investors rely on the auditor as an important gatekeeper, to make sure financial statements are sound and that they can rely on the report. The further we get into other areas, I worry about detracting from that focus. It is such a fundamental piece of decision-making for investors. Sometimes there is too much focus on forward-looking information. This information is based on the historical aspects of the business, and making sure that information is valid, means you can build the forward-looking information.” Another investor representative present was Scott Lawrence, managing director and head of relationship investments, at the Toronto Office of the Canadian Pension Plan Investment Board. He concurred on the importance of the fundamentals of audited historical financial statements:

“Trust in the system and financial statements is absolutely essential. Investment decisions shouldn’t be made solely on forward-looking information. It’s easy to project all kinds of hockey stick financials. Those who ignore history are doomed to repeat it. If you don’t look back and see how a company generates cashflow, if you don't have trust in the systems, if it doesn’t hold together, you shouldn’t invest. Audit is an integral part of the financial system, so that we have financials that communicate information for investors to make critical decisions.”

Bourne was also vocal on the role played by audit committees. “The whole key to success here is that the audit committee needs to be an active participant in the system of checks and balances, the assessment of the quality of the audit. Part of this exercise of assessing the value of the audit is making sure we’re getting what we pay for, that we’re not getting stuff we don’t need or can’t use and that the people doing the work know what that they’re doing.”

Glen Fagan, vice-president at Canadian Public Accountability Board, agreed that audit committees are crucial: “We’re taking a more holistic approach to regulation. As part of the solution, we see audit committees having a big role to play. It is important audit committees have a good understanding of audit quality and what that means, and why they should be concerned about it.”

There was less certainty as to what we mean by audit quality and how it is measured. For many, this remains a continuing difficulty and something the profession has struggled with. Fagan claimed he hadn’t ever seen “a really good definition of audit quality”, while Karyn Brooks, board director at Financial Executives International Canada and former VP finance at Bell Canada, denied there was any single measure. “I don't think there is a real measure of audit quality,” she said. “You get a different answer, depending who you ask. If you ask the management or if you asked the chairman, you’re going to get a different answer about the quality of the audit and who is accountable for it.”

Bourne added that audit committees weren’t good at assessing quality. “It’s partly because in many cases audit committees are only now starting to figure out what an audit firm does. They’ve never thought about it. They look at the fee structure, which is usually negotiated with management. Now we’re at a point where audit committees have to satisfy themselves they’re paying an appropriate amount for what they’re getting and that they’ve got a basis for approving it. Which comes back to is the question of whether the audit plan is properly structured in the first place. Does it display an understanding of the business, are the auditors looking in the right places? If the plan’s okay, did they follow it and react to changes?”

McInnis raised the difference between the quality of any specific audit and the wider concept of audit quality: “Talk about audit quality gives me a headache, because it’s been discussed for so long. Is audit quality the same as a quality audit? A quality audit is fundamental for investors to rely on a set of financial statements. But audit quality means something beyond that.”

On the upside, McInnis added that we’re getting better at measuring audit quality globally. “Oversight bodies are doing a good job of figuring it out more consistently. It’s back to standard setting and execution. Are the standards clear and robust enough, so that auditors can apply them appropriately? Are they executing well?”

Magidson agreed with Bourne’s point on sticking to a plan: “I like Ian’s focus on getting the right audit plan for a business and holding people accountable for delivery of that plan. There is clearly a role for audit committees to get the right outcomes. But I don't think audit committees should be expected to take responsibility for ensuring audit quality in general is enhanced. Directors have a full-time vocation looking after their business. But if each audit committee does what it needs to do to get a good quality audit outcome, the macro effect is cumulative.”

One obvious answer to the question of how we measure audit quality is the annual reviews of oversight bodies. But as Brooks suggested one problem here is that they often appear to focus on the negative. “Once it’s issued, the audience focuses on the negative. It’s not a balanced view.”

Bourne, who assists in the CPAB review, disagreed, explaining that while the nuance in the report might be lost on some, the report included specific wording as to the positive state of the audit market in Canada. “We actually say the standard of auditing in Canada is OK. That’s a very important statement, and is not said lightly. There are negatives picked out, but the core message is ‘you can count on the audit function’.”

The group dismissed the notion that audit quality would be enhanced by recent EU reforms and increased pressure for more frequent tendering, or mandatory rotation. Lawrence explained: “I would say it’s a nice academic and theoretical idea to rotate firms. But there are alternative solutions to changing firms. Additional review, professional standards and training and increasing the sophistication by which systems are reviewed, there are a whole lot of other things that I think investors worry about more, in terms of quality of audit, than independence. It’s a bit of a red herring. It’s easy to talk about changing auditors, it’s easily fixed, but I don’t think it addresses the root of what investors worry about.”

Fagan expressed concern that the outcome may be worse: “I’m concerned about simplistic solutions being proposed to complex problems. It's only a matter of time before there is going to be a failure that occurs just because you’ve changed auditors, and that’s going to send people scuttering around.”
This led back to the idea that improved quality could come from an extended report. Recent changes to the UK standards, were explained by Mark Vaessen, global head of IFRS at KPMG: “The requirement in the UK is that auditors have to talk about the significant risk areas you see for your audit, and how you have addressed them, in terms of procedures, and the details. KPMG has gone further with a pilot with some clients, including Rolls Royce, where we also report findings. And the investor community has responded positively.”

Bourne wasn’t keen on the idea. “The transparency of what went into the audit is important. But if we’re talking about more than that, all of a sudden the burden on the company and auditors becomes significant. The liability side of this is something most of us underestimate until we're in the middle of a lawsuit.”

Magidson concurred: “I would be careful seeking an expansion of reporting by auditors, precisely for the liability reason. If you’re going to move into this area, it seems to me you would want the benefit of disclaimers and safe harbours.”

Thesberg was concerned what this expanded report was meant to achieve. “This question of using the auditor to communicate something about the company is indicative of companies not communicating themselves. It’s the job of the company to explain to investors their financial position and risks. To use the auditor as a surrogate for information you’re failing to get out is misguided.”

McInnis was less concerned than others by this expansion: “When the expanded audit report started to be discussed, I was sceptical of what it would produce. Now I’m more open-minded. My scepticism was whether this was just going to produce more information investors will have to sift through and add to concerns about too much information. Does anyone really need to know this information about the areas of the audit? But I’m open-minded and wait for the outcomes of how stakeholders react. But I haven’t fully drunk the Kool-Aid.”

Larry Bradley, global head of audit at KPMG International, agreed that the debate is just beginning and cited the example of the recent Tesco in the UK: “The media initially questioned the audit. They looked at the audit report and it came out that the auditors had warned about this. Then people took management to task. In reality, when you read the report, it was just a key audit matter and a description of the fact that auditors focused on this. At the end of the day, it was a clean opinion. But what was reported was that the auditors warned about the situation.”

Magidson raised the question as to how expanded reporting has been received in the US. “If auditors are more engaged in commenting on the situation, your exposure will increase, without some safe harbour disclaimers. We have some litigation here and some of us around the table know about that, but not to the same extent as the US.”

Bradley agreed that it has been met with “trepidation and a significant amount of caution” in the US. “We’ve commented publicly on the PCAOB release on enhanced auditor reports. The PCAOB release was talking about a description of the key audit matters and audit procedures, not moving into a detailed description of findings. Even so, one of our concerns was over the extent to which we are articulating something that should be articulated by management. Is that indicative of a deficiency in reporting? In the US, the SEC has a requirement that in the annual report, management has a responsibility to describe risks. Our proposal is that we should report on management’s report, and providing our assurance or an attestation on what managements is reporting, as opposed to articulating our own view”.

Brooks expressed dismay that over her 40-year career there has been little movement in solving the “expectation gap” as to what audit can do. “It strikes me as astonishing that 40 years on, we’re still talking about the expectation gap when it comes to audit. This is a fundamental issue, because if you don’t solve it all these other things are not going to solve it. Expanding the audit report isn’t going to solve the expectation gap.”

McInnis countered by saying that what’s more interesting now is the debate about the information gap. “Investors want more information, and that’s something that happened before the financial crisis, and which became a focus after it. What do investors need to know about the audit? There’s been movement in that direction and we’ll have to see what the outcome is and how capital markets respond to this information provided about audit.”

For Thesburg, the answer lies in providing assurance. “What’s key is the linkage between assurance, audit and the information a company provides. The profession needs to work with those who are providing information to stakeholders and figure the appropriate assurance model. I recognise the liability concerns and what you can and can’t say. But investors are looking for more information about risks, uncertainties and measurement uncertainties. We need to find a way to build assurance into that, and then make sure people understand what’s assured, and what’s not, and what level of assurance is, without adding a lot of cost.”

Lawrence added that investors’ primary concern is to make sure that confidence in the primary audit function, namely testifying to the quality of the financials, remains paramount. “You should make sure that you invest all of those resources to make sure that that promise has been delivered against, and not watered down by other things. Additional information is useful for investors. The more the better, we can’t get enough. But it should be of paramount importance to stay focused on the core of what we’re asking auditors to do.”

Vaessen added that improvements in the reporting model could be helpful and might address the information gap. “Whether it’s the disclosure initiative to get rid of clutter, or integrated reporting, I think we should have further debate about it.”

Bradley concluded by pointing out that the profession is at an “inflection point” with respect to the future. “We have an increase in sophistication of international regulators coming together. We have a debate with respect to enhanced audit that is not going to go away. And we have the advent of mandatory rotation in the EU, which is a global phenomenon. All of these events coming together within a few years mean there will be changes. We’d much rather compete on quality. If we’re competing on quality, it means we’re not competing solely on cost. Competing on cost means there’s a race to the bottom. That’s the last place I want to go.” 

Richard Cree Richard Cree is editor-in-chief at economia


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