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Auditors and accountants behaving badly

The failure of auditors to properly appraise the value of goodwill has tarnished their own.

Auditors should be the last line of defence in detecting corporate accounting fraud, irregularities and unacceptable accounting practices. Sadly, accountants and auditors are hogging the headlines for all sorts of misdemeanours.

There are many areas of audit negligence, but one of the most damaging is the signing off on financial statements that overstate the company’s financial position. This includes inflating revenue, incorrectly accounting for profits from contracts, bringing future profits into the current period, not impairing intangible assets, and failing to ascertain going-concern risk where intangibles exceed tangible assets.

Overstatement of a company’s financial position can result in financial loss for those who have relied on the figures, such as shareholders and creditors. Falsely creating the impression that a company is doing well, and overstating its financial position, allows bonuses to be paid to executives and dividends to shareholders.

Goodwill, which represents the present value of future profits an acquiring company expects to earn from an acquisition, is a much-abused and over-valued asset. So too are the other intangibles which should represent the present value of future income streams a company expects to earn from those specific intangibles.

However, goodwill also represents the difference between the purchase price and the net assets of a business. But how correct is this if the acquirer paid more than a business is worth? Even worse, the acquirer may issue shares at an inflated value in payment for the business.

Goodwill attaches to the business operations and cannot be sold as a separate asset. International Financial Reporting Standards allows goodwill to be amortised over a maximum period of 10 years. 

In my view, only intangibles (trademarks, copyright, patents) that have been separately purchased from an independent third party should appear on the balance sheet. Goodwill should be written off immediately.

In many acquisitive companies, the value of intangibles vastly exceeds the value of the assets. Hence, a material misstatement of these values would make a company which should fail the going concern test appear to be in good financial health.

One would therefore expect the auditor to take great care in critically assessing the value of goodwill and intangible assets, and impair the values if deemed necessary. The failure of auditors to properly appraise the value of goodwill and intangible assets has tarnished their own.

In an effort to increase public confidence in the financial information prepared by accountants, the International Ethics Standards Board for Accountants has published a 267-page ‘International Code of Ethics for Professional Accountants (including International Independence Standards)’.

In terms of this code, a professional accountant is expected to adhere to the fundamental principles of integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour. A professional accountant must adhere to these principles whether working as an accountant or an auditor. The code sets out additional requirements for professional accountants in business.

To my mind, there cannot be a separation between a code of ethics for business and professional engagements, and a code of ethics to be followed in one’s own time. The recent incident when a senior lawyer dumped the body of a dead dog in the road, and the public outcry this provoked, is a good example of this.

The code places importance on threats to independence. However, it does not touch on diversity. Surely diversity is an essential tool in breaking down the clusters of ‘boys clubs’, old school tie networks and group-think? How vigilant will an auditor be in impairing the goodwill of a business in which their best buddy is  CEO?

Another paper out for comment is that of Professional Scepticism – Meeting Public Expectations. The purpose of this paper is to explore which behavioural characteristics fall within the ambit of professional scepticism, and whether all professional accountants should have these traits.

The paper suggest that any accountant in the “financial reporting supply chain” should also exercise professional scepticism because it is not possible for auditors to detect and resolve all problems during the audit and at the end of the process.

However, if a professional accountant were to develop the behavioural traits of professional scepticism, in addition to skills and experience, perhaps this would cut down on errors in judgement. But can professional scepticism be taught?

The paper sets out certain steps to follow before making a decision:

  • Obtain and understand all relevant information to support facts
  • Make informed challenges of views developed by others
  • Be alert to any potential bias
  • Be able to withstand pressure to do otherwise
  • Make reliable judgements after careful consideration of all facts.

The paper goes beyond audit and assurance engagements, and promotes “integrity throughout the financial reporting supply chain”.

Unfortunately, judgements are subjective, and will be influenced by the prevalent moral compass, or the lack thereof. Where there are close ties between the auditors and the company that is being audited (if, for example, the company is staffed with ex-employees of the audit firm, who play golf together and interact socially), it must surely be difficult to avoid bias or group-think.

It will be a brave accountant who takes a stand that may well be their last. They will be accused of tunnel vision, lack of creative thinking, not being able to think beyond the box, and will be totally intimidated and beaten into submission. I haven’t sucked those accusations out of thin air – I was accused of all three when I was a young tax consultant.

Another way of tackling declining public confidence in accountants, auditors, and the financial information they prepare is to take a good hard look at the reporting standards that are used to easily perpetuate fraud, omission or negligence. What accountant is going to stand up, and, taking heed of “professional scepticism”, point out the flaws in these seemingly inviolate standards?

No wordy document trying to create a blueprint for ethical standards will be as strong a deterrent as simply removing the cause.

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Excellent article from one of the best commentators on MW.

It is going to take decades to get external auditors and Saica to see their massive weaknesses and correct them.

They have over the past 20 years become gutless and greedy and paid far, far too much. Something like government and Eskom employees.

Great Article – reminds me of Upton Sinclair’s immortal words:”It’s difficult for someone to understand something when his job depends on him not understanding it”.

As a CA(SA) you should know that it is NOT the auditors job to detect fraud.

Fraud is a element of risk that is part of an audit. And any fraud you detect is a consequence of audit not because of audit.

To go look for audit, you need forensic auditors who are skilled enough and look deep enough to find such things. There is no way there is enough time in a normal audit to dig things through to look for fraud.

NB on the material. As long as the over and understatement is within material bounds. The auditor will sign off on the audit.

Also your comment on goodwill. Auditors can’t do much about IFRS. If you want goodwill to be written off immediately, you need to do impairment testing to write it off per IFRS. You can’t write it off and tell the auditors to tell their clients to write it off because you feel like it.

I’d like to disagree. This is the technical view of the typical audit process and one that will merely see the status quo remain.
You say “…and any fraud you detect is a consequence of audit not because of audit.” On the contrary, fraud detected is because of good auditing that seeks the red flags and looks deeper.
Yes auditing is time constrained, but we need to break out of the mould of conventional auditing in a country that has become fraught with corruption. I’d like to see auditors asking some simple questions such as: “does your company do business with Government, municipalities or government agencies” and if yes, a the next level of questions such as “can I see the contracts, and compare the prices charged to open market pricing, or enquire about any commissions, consultant fees or finders fees linked to these transactions?”
Harder questions asset revaluations, independence, rationalé etc.
Business is the other side of the corruption coin when it comes to public sector spending. A slightly different approach to auditing will go a long way to uncover corruption. The industry must be seen to drive new initiatives, or be content with being part of the problem.

I recall reading a book entitled Company Auditing by Tom Lee over thirty years ago where he wrote words to the effect: “These days one cannot take the word of representatives as an officer and a gentleman”. So true today ,yesterday and in the future.

Auditors do ask those questions. And also yes to those follow up questions as well. And then they ask for supporting documentation as well. And yes they look at contracts, compare prices and scrutinize consultant fees, finders fees etc, etc. They go even further if it is high risk and with high risk items then the manager and partner sometimes jump in and do even more work. And sometimes consult legal department with issues if severe enough.

And auditors usually don’t sign on high risk clients, just not worth it. To get a proper audit report on a high risk client would just blow the audit budget, not profitable at all.

Also then how do you know its a corrupt contract? The CFO signed off on it, the CEO also signed off on it and then from the government side the procurement head and the department head signed off on the contract and have treasury approval as well? Unfortunately auditors don’t have the authorisation to go look over personal bank accounts or to look deeper. And you need to have approval from CEO, CFO to obtain independent bank confirmations. If the CEO and CFO omits a bank account and its transactions from the books, it would be near impossible for auditors to know about this bank account at all.

And most CFO, risk managers and Financial controllers are CA(SA), most of them have been through the audit route and know what the auditors ask and look for. Most audit work is done by trainees that just got out of university. If these guys commit fraud, it would be completely off the books, done through overseas, relative’s accounts/cash deals that a normal audit just would NEVER be able to pick up.

In a normal audit you are only ALLOWED to look over the related details/information that makes up the Financial Statement of the company. Only a idiot would commit fraud through the books of the company. The only fraud you would most likely be able to find is if the employees are stealing money or not.

To get off-book details, you will need the court to allow you to do lifestyle audits, for the police to do investigations into persons involved.

In private, the guys aren’t stupid enough for auditors to easily say “it’s corruption we need to report a Reportable Irregularity to IRBA”
Even after doing everything you suggested doing, the contract will look legit anyways.

For example: that Eskom-Mckinsy contract. The board of eskom approved it. The CEO and CFO approved it. From the audit point of view, it was a legitimate contract at first. Auditors would have know no clue at first that Guptas were involved at all, Mckinsy was a reputable firm back then and that was before the whole Gupta saga was reported on the news. It would look like a normal consulting contract which is the industry’s norm. And auditors from experience would know if the contract is outside the norm or not. In addition to that, Eskom has tens of thousands of contracts that they go through every year. The contracts that is Material would go into thousands. To do a proper, full, complete audit on all them would take tens of millions of rands in audit fees. It would take a small audit team months to years to go through all of them. And even then you have to realize that auditors aren’t lawyers, they are not trained to read legal contracts.

And I can tell you that most private companies don’t have government contracts. Issue with corruption with public funds usually dealt by Auditor General and government entities don’t even use IFRS. They use simplified gaap approved by treasury.

I can agree with you that there are issues in audit. But you are over estimating what auditors can do and pick up.

Agree with you fully. The comments show a lack of knowledge of the functions and ultimate purpose of auditing.

The function of exposing lack of governance lies with the internal audit function and the executive.

Is the fault with the auditors and accountants or the analysts who demand “better” numbers that they can plug into their spreadsheets and models?

Let’s not also forget — talking of goodwill — the mergers and acquisitions craze that has bloated listed companies, reduced the number of large audit firms to danger level and the number of, say, auto or cell phone manufacturers to a point where “free markets” fail due to barriers to entry, It is no coincidence that many on the Forbes Richest List are hedge fund managers.

Trying to establish value in a world where paintings sell for tens of millions of Dollars is an exercise in insanity. If financial statements were reliable, there would be no need for rating agencies.

Hi Barbara, I’d like to commend you on a great article. This lack of moral courage by the auditing industry (and yes I’m generalizing because this perception decrees this as the norm) has given rise to a loss in trust in company audits. Certainly as civil activists, we don the skepticism spectacles when unpacking financial statements these days – especially those of State Owned Entities.

I also blame the boards and CFOs of companies, for not adopting a view that challenges and encourages auditors to “find the misrepresentation or corruption” within their companies.

So what will it take to drive a new “high credibility” audit process that bold businesses will choose to adopt as the new normal? Looking forward to engage with you on this important topic.

If anything blame SAICA and IRBA and the ridiculous enforced compliance with IFRS that obfuscates financial results.

Revisit IFRS and chuck out the rubbish that companies need to comply with. More importantly force companies to shoe by way of notes the full effect of IFRS adjustments on the notes so that the IFRS effect can be stripped out and the factual AFS be shown.

Materiality is also a problem – simply set too wide.

But then again auditors can’t be expected to uncover fraud when the entire executive of a company, Steinhoff, plus the internal audit function are fully corrupt. Jooste could not have done it all on its own.

The last accountant who had the guts to take on SAICA is now approaching 80 and he has given up. There is no one to take up the baton from him. For decades Charles Hattingh kept the profession straight … he was truly a thorn on the side of SAICA.

Nice article. There is a book called Outliers which mentions how Korea airlines had a few accidents and a bad reputation in the 1990s. It was due to younger officers being submissive and not wanting to disagree or voice their opinion to captains due to Korean culture and respect for elders. I think in South Africa and other parts of the world, young accountants would fear losing their jobs, especially with high unemployment. News will also get out and finding a new job could be a struggle. Competition makes ethics difficult.

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