Auditors under the blowtorch

The collapse of rural financier Banksia has highlighted the critical role of auditors. Now a new rule is likely to radically change the industry, putting greater responsibility on auditors' shoulders. That will help investors, but at a price.

Auditors around the world are facing an enormous shake-up, one likely to increase transparency. With a wave of corporate disasters in the wake of the global financial crisis, the global rule setter for auditors, the International Auditing and Assurance Standards Board, has proposed changes that will have auditors providing more information about what’s in a company’s accounts.

That’s good news for investors who want auditors’ expert opinions. The downside is that we can expect this will generate litigation. Lawyers will be the biggest winners. And if it goes through, audit fees will go through the roof. Transparency has a price.

Still, accounting and audit regulators say things need to change. For good reason too. Time and time again, we have seen fault lines in the basic audit model. The accounting giant Andersen went out of business in 2002 because of its collusion with accounting fraud at Enron. That was supposed to be the wake-up call for auditors. Tell that to the accountants who signed off on accounts of Banksia that found "no significant changes in the state of affairs" during the year. The non-bank lender collapsed four weeks later, leaving thousands of households in regional Victoria, South Australia and New South Wales at risk of losing their nest eggs and retirement savings. Investigations are now under way as to whether it ran an illegal banking business.

The audit model is not broken as most audits are fine but let’s not kid ourselves, they’re not ironclad guarantees.

Auditors claim they have been struggling with the so-called "expectation gap” of what the public thinks auditors do and what they are actually allowed to do. Truth be told, auditors are not required to go through every single number, dotting every 'i' and crossing every 't'. Also, they can only work with what companies give them. But that raises an obvious question: if no one knows what the auditors are supposed to be doing, what the hell are they signing off on every year and how relevant is it to shareholders?

The Institute of Chartered Accountants in Australia acknowledges work needs to be done to bolster professional scepticism among Australia’s auditors with ICAA research showing only a handful of firms focus on it.

With companies going under like nine-pins in the financial crisis and under pressure from investors, the IAASB has proposed auditors put additional information into their reports as "auditor commentary” to highlight matters that they believe are likely to be most important to help investors understand the audited financial statements. The proposed changes would include a conclusion by the auditor on the appropriateness of management’s use of the going-concern assumption. Auditors would also have to identify material inconsistencies between the audited financial statements and other information. And they would be allowed to pass comment – and judgement – on assertions by management and directors.

At the moment, auditors are only required to give comment around an "emphasis of matter” which is really providing a pointer to what’s happening in the accounts. For example: "In note, 5 the directors have disclosed they have significant funding that’s up for renewal within the next 12 months”. Ho-hum.

However, this changes everything. Auditors would write up issues that might have been raised in the audit committee but which, until now, never found their way into the accounts. It will provide more information on a company for investors.

The board is putting out a draft of new audit standards that will apply worldwide around the middle of next year with a view to issuing the standard next year. It would become applicable in 2015. The new rule would apply to what’s termed as "public interest entities” which would, at minimum include listed companies but could also extend to large non-profits and possibly, in some circumstances, SMEs.

The board has been seeking comments. While investors would welcome the greater transparency, many practitioners are less than enthusiastic as they would see it making their jobs riskier. Recently, its chairman Arnold Schilder and technical officer James Gunn were here holding round tables with auditors, accounting bodies, investor groups, chief financial officers and audit committee chairmen. Opinions were divided. Investors were in favour of it and some audit firms said they wanted to expand the scope of their work. But the CFO peak body, the Group of 100, attacked the changes. In its submission, it said the idea was misguided and encroached on the responsibilities of directors and management. The ICAA said it "stretches the traditional role of the audit function unnecessarily”.

If it’s adopted, it will create a very different audit report, one that will go some way to fixing the model. But it will come at a price.

The big concern might be the risk of legal liability. Audit firms passing comments about a company’s accounts are vulnerable to litigation when, for example, a company’s share price tanks following the auditor’s disclosures. This could be a gold mine for lawyers.

Merran Kelsall, chairman of the Australian Auditing and Assurance Standards Board and a member of the international board, acknowledges the legal risk is there but implies things have to change.

"You can take that view and clearly many are. I suppose the contrary view is that investors are seeking more information and if they better understand both the audit process and the decisions that are being made by the auditors and indeed by preparers that there is a more informed debate and less of a black hole around the whole audit process," Kelsall says.

"We can’t keep saying this is the standard structure of the reporting of an audit and we understand what we’re doing therefore just cop it. It’s very important to maintain the relevance of audit and maintaining that is a real lynchpin of confidence in capital markets.”

Given auditors’ inability to learn from Enron, and given the pressure now coming from the investment community, the international board might have to do the courageous thing and make the change.

Still, investors wanting a more comprehensive audit process with more commentary will have to consider one other thing: if auditors are doing more work and taking on more risk, they will have to raise their audit fees. At the same time, lawyers will be cashing in. Greater transparency might be good for investors but there will be no free lunch. Accountants are like that.

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