Opinion
28 Aug 2019 03:24pm

Why audits are not meeting investor expectations

Corporate failures such as Carillion and Patisserie Valerie demonstrate unequivocally that audits are not meeting investor expectations

Carillion 630
Caption: Corporate failures are part of the business cycle

Audits cannot, and should not, be expected to predict corporate insolvency or occurrence of fraud. However, there needs to be an evaluation of whether audits are abiding by standards of ethics, professional skepticism, and due diligence, which prompts the important question: is current audit practice putting investors first?

Nevertheless, the fact that auditors are not required to predict corporate failure or explicitly detect fraudulent activity has led to a buildup of complacency in audits, whereby red flags are ignored altogether. Consequently, the audit industry’s focus has shifted to improve audit efficiency over audit quality.

Corporate failures are part and parcel of the business cycle; they play an important role in alerting industries to the importance of change for survival, and the relative urgency of this fact itself. One example is the retail industry needing to shift fast to meet a tech-savvy consumer base. The innovators and laggards are rising and falling with unprecedented speed as the onward march of technology is forcing companies to adapt to the consumption requirements of their customers. Unfortunately, the oligopolistic audit industry is not exposed to such competitive, market-based and ‘self-correcting’ dynamics. This leaves little incentive to improve the audit product to keep up with the changes of its users.

Inadequate corporate reporting is a symptom of poor audit quality. In the case of Carillion, the management team was using its suppliers to manage liquidity issues by using reverse factoring transactions (where suppliers agree delayed payment but can discount it using creditors’ banks). There is no explicit accounting requirement to disclose reverse factoring transactions, so this information was included in operating cash flows. In Carillion’s 2016 annual report, the balance of trade and other payables on the balance sheet increased from £1,714m in 2015 to £2,090m in 2016.

In the 2016 cash flow statement, this was included in operating activity, resulting in net positive operating cash flows of £73.3m and a reduction in net financing activities by £84.4m. However, in actual terms this was simply borrowing from suppliers to manage a liquidity shortfall. Technically, it could be argued that such treatment was compliant with accounting standards but economically, it was a misstatement. The auditor should have brought this transaction to the attention of investors by stating that if such an adjustment was considered to be ‘financing’, then operating cash flows would have been lower, and borrowing would have been higher, by approximately £376m. Another interesting observation in the 2016 financial statement is that the audited net operating cash flows for both 2016 and 2015 yearend was exactly £73.3m.

The case of Carillion illustrates why audit quality is the single most important issue which requires comprehensive and drastic improvement, covering all aspects relating to ethics, professionalism, the audit process, the audit product and how the industry is regulated. A high-quality audit is one that diminishes the ability of a management team to obscure the economic reality, and one which ensures the timely communication of information which could become significant if the future state turns out to be different to reporting date expectations.

The Quality and Effectiveness of Audit: Independent Review, carried out by Sir Donald Brydon, will be keenly awaited by the global audit industry and we look forward to the submission of the findings by the end of 2019. CFA Institute will also be submitting its response to the independent review to emphasise the need for more proactive involvement of the audit regulator.

A disruption in the audit industry is somewhat necessary if the impending, additional challenges are to be addressed. This is due, in part, to the significant socio-economic, political and regulatory changes we have seen since the financial crisis, and they will impact future corporate reporting - either directly or indirectly.

In addition, the introduction of new accounting standards has added complexity to financial reporting and demands more judgement, assumptions and interpretations from management teams. The audit industry therefore needs to undergo drastic change by embracing the use of technology to automate basic verification work and increase the use of data analytics. The remorseless logic of technologically-induced change across professional and financial services firms is already underway, and our own research, Investment Professional of the Future: Changing Roles, Skills and Organizational Cultures, suggests that 43% of investment professionals think the role they perform today will be substantially different within the next decade.

Within accountancy firms, technological advances will also enable the expansion of audit coverage of transactions which are currently audited on a sample basis. Consequently, this will also increase the scope and responsibilities of auditors which will to some extent address the complacency factor. Embracing the automation of certain tasks will enable auditors to spend more time on complex and analytical aspects which are important to investors.

The audit report also needs to shift from providing a binary opinion to a more graduated audit opinion, especially where complex and forward-looking datasets are concerned because they are subjective by nature. An audit report including a better-adjusted, graduated opinion will enable auditors to communicate with investors in a more informed manner through enhanced transparency, comparability and by drawing attention to risks which may be not clear in the financial statements.

Finally, there needs to be a forum where regulators, investors and auditors can exchange views and discuss emerging risks. Policymakers alone cannot set rules to cover all future products and transactions. A proactive and forward-looking forum which facilitates communication between regulators, investors, and auditors these will create a virtuous cycle whereby expectations and risks are discussed and agreed upon in a timely manner. This will allow regulators to set the benchmark and take rigorous action to ensure high quality audit standards are consistently maintained. This in turn will enhance usability for investors.

Kazim Razvi is director of Financial Reporting Policy at CFA Institute

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