There are, however, countervailing risks: confidence in the audit of listed companies is at a low ebb. If stakeholder concerns are not addressed, trust in audit; which is vital for its legitimacy; could be severely damaged. There are a number of immediate issues related to the scope of audit that need to be addressed. These include its role in narrative reporting, going concern and viability, capital maintenance, and fraud. These are discussed below.
The future of audit links to the future of reporting
The future of audit cannot be viewed separately from the future of reporting. It is the financial statements which are subject to audit, so if there is not confidence in content of the former, it is very unlikely that assurance on them will be highly regarded. For most large businesses, the vast majority of their value lies in their intangibles; be it their brands, customer relationships, other forms of intellectual property and their corporate culture. However, where these are internally generated, they are generally very inadequately represented in the financial statements and often only fairly patchily so in narrative reporting.
Focusing the assurance process on either targeted, high priority, parts of narrative reporting or, alternatively, strengthening narrative reporting in its entirety, could provide users of corporate reports with higher quality information on the value drivers of the business. Requiring assurance generally on narrative reporting that has been strengthened or on certain specific parts of it could provide users of corporate reports with more and higher quality information on the value drivers of the business.
This might include disclosures related to corporate culture, intangibles, climate change and sustainability more generally as well as the principal KPIs used in the business, including alternative performance measures.
The detail provided in viability statements should also be improved, especially as regards ensuring the reporting period is adequate. Requiring assurance on the statements would help achieve these goals. Directors are responsible for running their businesses, but on matters of going concern and future viability we do believe effective auditing can reduce future failures. Auditors are uniquely positioned to provide early warning systems and ‘red flags’ which, if acted upon, will allow those running the business to take corrective action.
Review needed before a UK Sarbanes-Oxley
There seems to be a groundswell of opinion in favour of a UK version of Sarbanes-Oxley but, prior to the introduction of any proposed measures in the UK, we require a thorough assessment of the expected costs and benefits. Sarbanes-Oxley did not, for example, stop the US being significantly impacted by the global financial crisis in 2008.
There seem also to be mixed views with respect to the merits of auditing management’s statements on financial controls. We do, though, support management and the board being expected to confirm that, in their opinion, the necessary internal controls are in place and working effectively.
Sort out the capital maintenance controversy
In recent years there has been much controversy around capital maintenance issues. The issues are complex but it is now time for them to be resolved. If the current system is to be retained, the level of distributable reserves should be disclosed and subject to audit with a clear reminder that a distributions may only be made if there are sufficient reserves. Thought, however, should also be given to whether an alternative system might better address the underlying issue of when limits should be placed on dividend distributions, and possibly also share buy-backs, in the interests of other stakeholders.
Detection of fraud
We consider that the auditor’s responsibilities in relation to the detection of fraud are reasonably clearly set out. It would be helpful, however, to review on how they are being fulfilled in practice and whether there is a ‘delivery gap’ and, if so, how to close it.
Any extension of responsibilities should be left to discussions with investors; in particular on their willingness to bear the likely extra cost of seeking out frauds which, though substantial, fell below the normal level of financial statement materiality. The normal level of materiality is, admittedly, fairly high in absolute terms for our largest companies. Alternatively, internal auditors could increase their surveillance in this area.
Charting the way ahead
Though extensive, issues around the scope of audit are just one sub-group of those to be tackled if we are to create a modern, vibrant and competitive audit market.
Others include how auditors can best report their findings in a concise and insightful way, defining to whom auditors should be responsible, creating a respected new audit regulator with a proportionate approach to its work, introducing a fair system of audit liability, and market reforms as proposed by the CMA including the introduction of joint audit in the FTSE350.
How well we address these will determine the most crucial issue of all: our ability to retain current senior auditors in the profession and, above all, to recruit the most talented young accountants to be tomorrow’s leading auditors.
David Herbinet is UK head of PIE and global head of audit at Mazars