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Investing in companies that are well managed, strong and sustainable is central to the purpose of any asset management business. One of the key checks and balances in the investment process is the auditing of company accounts. However, to have trust in the information a company provides, shareholders must be satisfied independent audits will identify and raise any accounting discrepancies.
In recent years, question marks over audit quality, accountability and auditor rotation have emerged, especially following the collapse of Carillion and Patisserie Valerie – as well as numerous accounting issues at less high-profile companies.
The 2016 revisions to auditing and ethical standards1 to some extent improved audit quality and reduced conflicts of interests, while reviews by the Financial Reporting Council (FRC) and Competition and Markets Authority were also welcome. However, the March 11 announcement by UK business secretary that the FRC will be replaced by the Audit, Reporting and Governance Authority – a new regulator with “a new mandate, new leadership and strong statutory powers”2 – speaks volumes about the urgent need for change.
The highest priority of ongoing probes into the sector and the new regulator should be to improve audit quality. This does not just relate to the auditors but to audit committees. Shareholders should be confident the issues auditors highlight, such as exceptions and significant changes, are addressed rather than repeated in audit committee reports. Audit committees must do better at disclosing how they have satisfied themselves on the quality of the audit, assessing the audit process, the governance around that and audit committee competency itself.
A good audit committee will understand the business, challenge management and even raise issues with the auditor. If auditors are wary of disclosing information that is not strictly disclosable, audit committees should take on that responsibility.
Auditors, meanwhile, should do more to consider risks relating to the future viability of a company than is provided under the standard ‘going concern’ approach and raise a list of issues for shareholder awareness. While fair value accounting requires more judgement due to the difficulties in valuing and auditing certain assets and liabilities, it is concerning a recurring theme in FRC’s Audit Quality Reviews (AQR) is a lack of professional scepticism and challenge to management among auditors.
The chief executive of Grant Thornton, auditor of Patisserie Valerie, advised the Business, Energy and Industrial Strategy Committee that “audit fundamentally gives a reasonable opinion on historic information, and doesn't look for fraud.”3 He added there is a “clear expectation gap” between what the public thinks an auditor does, and the reality.
This poses two questions. Firstly, were there any red flags Grant Thornton could have identified if its mandate was broader? Secondly, are there issues with management information that are preventing executives and the audit committee from having a clear understanding of a company’s true performance? Accounting treatment has become so complex it can obscure the truth: without good management information, processes and oversight there is additional risk.
Technology will be an increasingly important factor in helping improve audit quality. Intelligent algorithms in a real-time audit environment will help management and accountants better identify discrepancies. This should be a consideration when choosing auditors.
Additionally, audit firms should review their culture and diversity. More diversity within audit teams and encouragement for new members to challenge responses and raise issues should broaden viewpoints and help to improve overall quality.
Lengthy tenure is potentially a reason for poor audits, if relationships with companies become too close. In the case of Carillion, its auditors had served for 18 years. A change in auditor can provide fresh perspectives. Although this may seem obvious, it is surprising this is not the general view in the US, where numerous companies have retained the same audit firms for decades. In some markets, the auditor’s tenure is not even disclosed.
Rotation helps address the perception auditors are not raising issues with management for fear of losing a client. The commercial relationship will be less of an issue for auditors of EU companies if they know they will be rotated off sooner or later.
Accountability and competition
Regulators have not been tough enough on companies and auditors for accounting oversights. Fines need to be larger and more consistent. It is positive to see shareholders increasingly vote against audit committee members and auditors when material problems have been identified. Where directors and audit partners are responsible for significant failures, shareholders should challenge their appointments as directors or audit partners at other companies.
Our biggest concern is not the lack of competition in audit. In fact, the auditor tender and rotation requirements in the European Union have resulted in audit committees being forced to review several audit firms. However, it appears most audit committees and boards of large companies consider it too much of a risk to appoint a mid-tier auditor. This perception must change, and investors should do more to challenge companies on auditor selection. There should certainly be more onus on audit committees to explain the tender/rotation and auditor selection process. It may be beneficial for mid-tier firms to do specialist parts of the audit. That way, companies can build up a relationship with them and assess whether they can perform the full audit in due course.
Another option is joint audits, whereby each auditor undertakes a live review of the other’s work before arriving at a joint opinion on accounts. This appears to work well in France and would provide an opportunity for smaller firms to be part of larger company audits.
These options could increase costs, but this should not discourage companies from appointing a mid-tier firm if they believe it will produce better quality audits. If the costs are significantly higher, companies could solicit shareholder views in the same way they do when proposing changes to executive remuneration. Finally, when companies change auditors, there should be a transition arrangement to allow the outgoing auditors to share knowledge with the new auditors to help them get up to speed on key issues.
While the proposed remedy of a market share cap would result in more firms auditing FTSE 350 companies, this is not the answer to raising auditor quality. Nor are suggestions shareholders should be involved in selecting auditors or being on audit committees. This is not practical and will create more problems than it solves.
The measures outlined above would be far more effective in raising audit standards. It is long overdue.