These are (to borrow from the old Chinese proverb) “interesting times” for the audit profession. More than one voice is calling on it to confront deep and searching questions about the part it might have played in sustaining the corporate culture which led to the current financial crisis, questions which go to the very nature and purpose of audit work.
The Financial Services Authority (FSA) (in conjunction with the Financial Reporting Council) has recently issued a discussion paper seeking views on how the contribution auditors make to “prudential regulation” might be enhanced. Probably the most striking “charge” in a wide-ranging paper is that auditors are accused of being too concerned with collating and accepting evidence to support management’s assertions, thereby demonstrating what the FSA calls a “worrying lack of scepticism.” Further, the FSA has intimated that greater regulatory supervision is likely if what it regards as a general failure on the part of auditors to blow the whistle on accounting irregularities continues. The paper concludes by asking for input from interested parties so that auditors are better able to meet the FSA’s expectations, as well as those of society at large. The publication of the FSA’s paper coincides with various findings of the FRC’s Audit Inspection Unit which, it says, highlight failures by auditors to challenge management assumptions, particularly when it comes to internal asset valuation. If that were not enough, the Auditing Practices Board (APB) and the House of Lords Economic Affairs Committee have also queried whether auditors are applying the “correct” level of scepticism, saying that, in view of the problems affecting the banking industry, it is now time to look at how audits are carried out.
What are we to make of these developments?
For starters, from the tone of a lot of what has been said one could be forgiven for thinking that the causes of the economic crisis had their roots in systemic failure on the part of auditors (rather than the management of the institutions they audited), as a consequence of which relevant “stakeholders”, identified as being directors, managers, regulators, creditors, lenders and employees, have all been let down. Indeed, having opined that the audit process had failed to highlight developing problems in the banking sector, the House of Commons Treasury Committee came pretty close to questioning the value of audit generally.
The role of statutory audit
It appears that there might be scope for a process of educating (or re-educating) a sceptical public about the role and purpose of a statutory audit. It is not difficult to detect a mis-match between the public perception of what auditors do (or should do), and the role that the law expects them to perform.
The purpose of a statutory audit is clearly enshrined in both case law and the relevant legislative framework. An audit is intended to provide an independent opinion to the company’s shareholders of the truth and fairness of the Financial Statements which were prepared by the company’s directors. Absent exceptional circumstances from which it can be inferred the auditors assumed a wider duty of responsibility, they owe a legal duty to no other person and for no other purpose.
Now, in the real world, the directors, managers, regulators, creditors and lenders of the company whose accounts are being audited will naturally have an interest in what the auditors conclude and, accordingly, may have “expectations” (a word which appears a lot in the FSA’s paper) of the auditors. However, if the role and purpose of an audit were to be extended to fulfil those expectations, this could entail a fundamental change in what auditors have traditionally been asked to deliver.
Up until now, it has not been seen to be the role of auditors to ensure that the companies they are auditing are meeting the expectations of the companies’ stakeholders. This has usually been regarded as a matter for the directors. Moreover, over the years the law (both statute and common law) has come to impose increasing duties and obligations on the directors, and it cannot be stressed enough that the primary responsibility for preparing Financial Statements which give a true and fair view rests with directors and management. The auditor’s duty is to audit the Financial Statements in accordance with applicable law and auditing standards.
A wider role?
There have also been suggestions that auditors should be required to scrutinise and comment on business models and, in the case of banks and other financial institutions, instruments of the companies they audit, as well as what the directors of those companies do to manage systemic financial risk. Expectations are clearly very high.
However, the consequences of moving in this direction would be many and considerable. Requiring auditors to cover off all these areas (with the inevitable expansion of the information-gathering exercise necessary) would almost certainly slow down the audit process, with the inevitable costs consequences for the company being audited. Moreover, query whether auditors currently have the necessary experience and expertise to audit, for example, complex instruments of the kind created by banks and other financial institutions. Different skill sets would have to be developed, not something which can happen overnight.
Whilst there is plainly a legitimate public interest in ensuring high quality audits, currently at the heart of a statutory audit is a contractual arrangement between shareholders, directors and auditors. Auditors have (like other professionals) developed risk management techniques designed to ensure that they do not incur a legal liability to those whose interests they are not paid to protect and for whom their work was not carried out. Extending legal responsibility to regulators, lenders and creditors (for example) would involve imposing a scope of duty on auditors which, in the breadth of people to whom it is owed, would be unique amongst professionals.
Again, this would no doubt have an effect on audit costs, and would be likely to re-ignite the debate which has raged for years about the extent to which (and on what terms) auditors should be able to limit their liability.
Moreover, it is important not to gloss over the fact that the expectations of say, creditors, directors and employees in terms of what the audit should deliver may be different and, in some instances, may come into conflict with each other. For the audit to attempt to be “all things to all men” might actually diminish its value.
A word about scepticism. The professional guidance, most notably ISA 240, requires auditors to plan and perform an audit with an attitude of professional scepticism recognising that circumstances may exist that cause financial statements to be materially mis-stated. Indeed, members of the audit profession have recently said in the press that they pride themselves on the fact that professional scepticism is part of their DNA. And, of course, as the Auditing Practices Board has recognised, scepticism can be taken too far.
Challenging everything management does or says would no doubt slow down the publication of financial statements, as well as potentially resulting in unnecessary costs being incurred. Furthermore, as the APB has also emphasised, it is the responsibility of management and companies’ Audit Committees to ensure that the corporate culture and environment is one which encourages open dialogue with auditors at all levels.
In recent years, a lot of work has been done to enhance public confidence in the quality of audits. These include the more widespread adoption of International Standards on Quality Control and International Standards on Auditing. Moreover, there are plenty of incentives for auditors to carry out their duties correctly, including reputation, the fear of litigation (and claims, whether meritorious or speculative, arising out of audits continue to abound) and disciplinary complaints.
No doubt the audit profession will not wish to come across as unduly defensive in its response to the paper the FSA has issued. However, there is much that can – and no doubt will – be said (and rightly too) in response to some of the more sweeping comments which have been made. We will be responding to the Discussion Papers. For those that also want to make their views known, the response deadlines are 29 September for the FSA/FRC Discussion Paper, and 31 October for that issued by the APB.