January 6, 2013 1:18 pm

Pressure grows to bring auditors to account

Auditor©Getty

John Griffith-Jones, the former head of KPMG’s UK arm, gave a friendly warning to his old profession when he addressed a recent lunch for accountants in London.

As the guests basked in the splendour of the venue, the 18th-century Mansion House, he lamented that auditors were flirting with irrelevance by supplying information that was “less and less useful to the world at large”.

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Mr Griffith-Jones, now a senior UK regulator, is not alone in questioning the value investors derive from the obligation to use an auditor.

The profession’s failure to give warning of the financial crisis has increased long-simmering dissatisfaction with the auditors’ report, the formulaic paragraphs in a company’s annual accounts that say whether the auditor deems the figures reliable.

Some want the auditor to give a more detailed opinion, breaking away from the lifeless “pass or fail” pronouncements that did so little to alert shareholders to impending bank failures.

The allegations levelled in November against Autonomy, the UK software company bought by Hewlett-Packard in 2011, have given fresh momentum to this push for reform.

HP claims to have discovered “serious accounting improprieties, misrepresentation and disclosure failures” at Autonomy before the takeover, a charge denied by Mike Lynch, Autonomy’s founder and former chief executive.

A pioneer US audit to the buttoned-down template

When US companies started adding an auditor’s report to their financial statements more than a century ago, there was no formal template to follow. Accountants appear to have found the lack of guidance rather liberating, writes Adam Jones.

The pioneering auditors of United States Steel – Price Waterhouse, forefather of today’s PwC – gave investors an impressively thorough tour of their work in 1903, for instance.

Their detailed report declared that they had “verified cash and securities by actual inspection” and had also ensured that full provisions had been taken for doubtful receivables and all other ascertainable liabilities.

But it did not take long for the auditor’s report to start evolving into the buttoned-down, unspecific prose presented to today’s investors.

In less than two decades, the Federal Reserve had suggested that auditors use a brief, standardised formula, according to The Evolution of the United States Audit Report, an academic paper tracing the document’s history.

The reforms now being contemplated in the US and elsewhere could be seen as a revival of the more customised approach taken in the early days of the profession, according to Joseph Carcello, an accounting professor at the University of Tennessee.

“Over 100 years ago, when audit reports were in their infancy, they definitely did have more customisation to the specifics of the client and the circumstances. They were longer and said more,” he says.

The reports are now standardised templates that assert little more than that the financial statements are fairly presented, adds Prof Carcello, who is also an adviser to the Public Company Accounting Oversight Board, the US audit regulator.

The irony is that businesses have become much more complex over the last century but investors are actually told less than they were back in 1903, he observes.

If more information on Autonomy’s accounts had been revealed through auditor disclosure, investors might have been better prepared for the damaging spat, according to a senior figure at a leading institutional shareholder.

The pressure for change has led to a proposal for a beefed-up auditor’s report from the International Auditing and Assurance Standards Board, a technical body whose norms determine and influence the shape of audits around the world.

“People are asking for more information,” says Arnold Schilder, IAASB chairman, citing the crisis and the creeping complexity of financial statements as catalysts.

In addition to saying whether the financial statements are fairly presented, the IAASB envisages an auditor providing a commentary that highlights issues it deems important.

For consultation purposes, it produced a sample commentary that drew attention to several matters at a fictional company, such as the uncertainty surrounding environmental litigation.

It also disclosed that the company had come close to booking a goodwill impairment, declaring that the company’s valuation of its more esoteric financial assets was inherently uncertain too.

In addition, the commentary said how much audit work had been subcontracted to firms outside the auditor’s network.

This reflects concern that big auditors are not as seamlessly global as they like to appear – a doubt that underpins the US’s increasingly impatient demands to crack down on the Chinese affiliates of the big four accountancy groups.

Overall, this may be viewed as pretty bland stuff. Nonetheless, it would still constitute a departure from the audit profession’s traditional circumspection (although less so in France, where auditors already make extended disclosures). 

Those keen on introducing an auditor’s commentary include the Basel Committee on Banking Supervision and the investment managers BlackRock and Calpers, as well as the Chinese Institute of Certified Public Accountants.

The Council of Institutional Investors, a US body that represents pension funds, says a commentary, if done well, would allow shareholders to make a more informed vote when asked to re-elect auditors at annual meetings.

The response of the four biggest auditors – PwC, Deloitte, Ernst & Young and KPMG – to the plan was mixed. They made supportive noises but bridled at details.

Other respondents to the IAASB consultation were more hostile, citing fears that the commentary would undermine the principle that it is the role of management – and not the auditor – to provide original information to investors.

BP, the British oil and gas group, said the IAASB plan could drain resources and constrain discussions between management, the audit committee and the auditor.

Some fear yet more box-ticking. “My real concern is that we just replace one set of boilerplate words with another – and that the new set is longer,” says Eric Tracey, consultant partner at Governance for Owners, an investment manager.

The auditor’s report is by no means the only audit issue being examined in the wake of the financial crisis. The independence and scepticism of auditors has also come under the microscope, as has the dominance of the “Big Four” networks.

The IAASB’s work is also complicated by the fact that regulators around the world are not automatically bound by its rules.

Some, including the US Public Company Accounting Oversight Board, are working on their own changes to auditor reporting, which might diverge from the global template under development by the IAASB.

The UK, for instance, wants to keep the auditor relatively mute, relying on company audit committees instead to reveal extra information about the toing and froing that goes on between managers and auditors in the finalisation of accounts.

The hostility it has encountered from some quarters suggests the IAASB will have its work cut out trying to alter the status quo.

However, it has made reform of the auditor’s report its priority, with the aim of finalising new rules by mid-2014, leaving enough wiggle room to accommodate differing regional preferences. “People see the need for change,” says Mr Schilder.

The rise of boilerplate

Auditing through the ages: the rise of boilerplate

14th century: origins of modern audit visible in checks done by trustiest servant in English manor houses

1844: UK Joint Stock Companies Act includes provisions for auditor appointments amid railway mania

1900: Annual external audits become mandatory for all registered companies in UK

1903: Price Waterhouse issues pioneering, detailed auditor report for United States Steel

1974: The term “audit expectations gap” coined to describe confusion about audit’s purpose

1978: US commission unsuccessfully argues for move away from brief, boilerplate auditor reports

2012: IAASB proposes more detailed reporting by auditors globally in wake of financial crisis

Sources: Financial Reporting Council, Public Company Accounting Oversight Board

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