Nick Shepherd 24 Jan 2019 10:59am

Why audit changes will fail

Current approaches to audit change are solving the wrong problem and will not solve the problems of corporate accountability

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Caption: Governance frameworks are evolving too slowly to solve the widening gap

Whenever investors, regulators or the market place (or even the general pubic) are surprised by unexpected events in public and private entities, there is an automatic link back to the audit. Is this fair and reasonable? With the expansion of International Accounting Standards, it is no surprise that this problem is global? Carillion and Tesco in the UK; Toshiba in Japan, Wells Fargo in the US, Satyam Computer Services in India, Sino-Forest and Nortel in Canada; Steinhoff and VBS in South Africa. Are expectations too high in terms of the link between auditing and corporate accountability? Will the changes being proposed both by and for the profession solve the problems?

Sadly, the answer is probably “no.” "Those who cannot remember the past are condemned to repeat it" (attributed to George Santayana). We must quickly look back in history to realize that most corporate reporting and the supporting role of accounting and audit standards started after the great depression.

The outcry over investor losses and the collapse of the financial system required politicians to bring in legislated changes. This was the “sea change” event as the world shifted to the financial frameworks required to support the capital-intensive industrial revolution. The same started to happen with the governance issues in the late 1980’s that led to commissions such as Cadbury, Day and CoSo which started changes to corporate governance including auditor appointment, rotation and conflict-of-interest. This has been followed by other issues such as Enron leading to SOX and other “tinkering around the edges” yet the “nettle has not yet been grasped” that required by the current sea change of moving from an asset intensive world to an “asset light” or intangible based world.

Regulations and audit standards designed for a financially intensive economy will not work for the intellectual capital and knowledge-based economy. In effect the world has been changing over the last 40 years or so, but our governance frameworks have been evolving far too slowly to solve the widening gap.

The change must start with governance. The outdated rules contained in national legislation and regulations must expand the scope of audit and change the role of auditors. This might address comments such as “…recklessness, hubris and greed” – marks the failure not just of a model for providing public services but of the system by which the businesses we all rely on are kept financially honest” from the UK Parliamentary Committee investigating the collapse of Carillion? The system is not working. These changes might address issues such as the potential conflict of interest that auditors have by being paid by the company they audit?

Secondly the accounting profession must embrace the reality that focusing on financial capital as the foundation for materiality and audit scope is no longer acceptable when over 80% of a shareholder’s investment value is no longer on the balance sheet. If the profession is unable to embrace this scope, regulators must expand the role of audit to others who can address non-financial aspects of risk and the business model, as a determinant of both materiality and corporate sustainability.

Using an auditor’s statement to shareholders about “…relying on the opinion and representations of management” is a bit of a “cop out” as is pointing to the management discussion and analysis; both are valid and useful but do little to ensure that an audit is adding value? Some potential progress was being made in the revisions to the UK Companies Act but sadly the suggestions that made it in to the final legislation were limited. Maybe there remain too many influential voices in maintaining the status quo?

Recent articles of the use of data analytics are positive in terms of the process required of an audit but they will not address the foundational issues of the shift in the overall business model in the knowledge economy. Risk and systems of control must be changed for the new structural reality of multiple capitals that are both tangible and intangible.

Assessing the risk and sustainability of a going concern must reflect both the integrity of the financial capital employed but also the integrity of the overall business model that utilizes key “capitals” above and beyond financial capital.

Nick Shepherd is president of Eduvision a Council member at the UK based Maturity Institute where he leads their work on Integrated Reporting