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It may be time to liberate auditors from the accounting profession

New report says auditors need to go beyond scepticism and become suspicious of clients.

A report by former head of the London Stock Exchange Sir Donald Brydon published in December says it’s time to split audit from accounting and establish it as an independent profession with its own standards and qualifications.

The new, improved audit should be a profession separate from accounting with its own governing principles, qualifications and standards. “At present it is an extension of the accounting profession, whose ethics and (arguably) mindset it largely adopts,” says the report.

It would embrace non-financial disciplines such as cybersecurity and environmental behaviour and provide more informative reports to different interest groups. Gone are the days of executives being responsible only to shareholders, as economist Milton Friedman suggested. Auditors need to go beyond scepticism and become suspicious, says Brydon.

There is unspoken acknowledgement in Brydon’s report that the audit profession is failing as a public watchdog.

Shareholders want to know how the watchdogs failed to pick up the signs of accounting fakery at Tongaat and Steinhoff, to name just two fairly recent examples.

Part of the problem is the nature of the audit itself: it is expected to provide a reasonable level of assurance that the financial statements are fundamentally true and fair based on a tiny sample of transactions. That said, audit teams are expected to identify areas of high risk and focus on these. New technologies are fast emerging which allows a far higher level of sampling and, aided by blockchain technology, we may soon be able to verify all transactions in real-time.

Many of these problems of the external audit could be improved by strengthening internal audit teams. But here again, there are difficulties: overbearing CEOs often surround themselves with weak internal auditors who can be bullied. Audit committees are supposed to buffer against executive bullying but this too is no guarantee of independence.

The profession has long been dogged by suspicions of corporate capture.

No matter how robust the audit standards, there is a perception that audit independence has been compromised by the accounting business model: the Big Four firms undercharge clients for audit services in the expectation of picking up higher-paying work elsewhere. As Richard Brooks points out in The Bean Counters: The Triumph of the Accountants and How They Broke Capitalism, every crisis is an opportunity for the Big Four accounting firms, whose profit and revenue growth barely skipped a beat during the 2008/9 financial crisis.

Various solutions have been proposed:

  • Breaking up the Big Four to separate consulting from audit (which would raise the cost of auditing);
  • Mandatory audit firm rotations; and
  • Establishing an independent body to appoint and reimburse auditors, rather than allow companies to select their own auditors.

Nicolaas van Wyk, CEO of the SA Institute of Business Accountants (Saiba), says the entire concept of the audit needs to be reformulated. “There should also be different audits for different users of information. As things stand, the audit is designed to satisfy all users of the information but it is severely lacking in the kind of detail different users require.

“For example, if the company wants to take out a loan with a bank, it should provide an audit that specifically addresses the kind of information that the bank requires.”

Rotation

The Independent Regulatory Board for Auditors (Irba) has introduced mandatory 10-year audit firm rotations (MAFR) as one method of maintaining audit independence. CEO Bernard Agulhas says as of September 2019, 21% of companies on the JSE had rotated auditors – with 41% of those companies citing the early adoption of MAFR as the reason for rotation. All listed companies have until 2023 to comply with mandatory audit rotation.

The Big Four accounting and audit firms – EY, PwC, Deloitte and KPMG – account for the vast majority of audits of the 40 largest JSE companies and 100% of FTSE 100 firms.

“The cost of MAFR will always be insignificant when compared to the cost to investors and pensioners when there is an audit failure, resulting in billions of rands lost, as illustrated by recent failures,” says Agulhas.

“The lead time allowed for the introduction of MAFR of five years has allowed companies and audit firms to plan for this process and for firms offering other prohibited services to cool off in compliance with the Companies Act in order to be eligible to take on audits where they previously did not audit.”

Joint audits

Irba is also in favour of ‘joint audits’ to allow smaller firms an opportunity gain experience and break the Big Four stranglehold. That, however, is easier said than done.

The overwhelming dominance of the Big Four as a repository of skills and know-how may take a generation to overturn.

There have been several radical suggestions in recent years to strengthen the audit: Professor Piet Delport, retired professor of mercantile law at the University of Pretoria, suggests making the audit voluntary, with different stakeholders demanding more focused audits as and when they are needed. Asking audit firms to provide audits that satisfy all users is no longer feasible. If you’re a bank being asked to extend a credit facility to a company, you will want an audit that looks at the company’s realistic ability to repay the loan. Banks are already having to adjust published financial statements to firm up estimates and non-cash transactions – something accounting standards setters have battled with for years.

Auditors not paid enough?

Jodi Joseph, divisional executive at audit and financial software group CaseWare Solutions, says auditors simply aren’t paid enough to provide the kind of audit expected of them. “I think the auditors of the future are going to have to be well versed in data analytics, for the simple reason that technology is going to be a vital part of the audit going forward. The sample sizes are going to have to get bigger. Blockchain will form part of the solution since it can help verify what is a trusted transaction.”

One of the key changes recommended in the Brydon report is to redefine the audit as a means to “establish and maintain deserved confidence in a company, in its directors and in the information for which they have [the] responsibility to report, including the financial statements”.

Read: Audit firms up in arms over Irba’s possible search and seizure powers

Agulhas says Irba supports this redefinition and “in particular has been stressing the importance of aligning the audit function to investor needs”.

He explains: “Projects are underway to look at strengthening the fraud risk identification standard, as well as auditor competencies. It may be that more training and competency is required in the area of identifying fraud, which up until now has not been an auditor’s responsibility.”

Principles instead of rules

Another key recommendation from Brydon is the creation of a corporate auditing profession governed by principles rather than rules – for the simple reason that rules are too rigid and easily side-stepped, while principles (such as ‘Do not lie’) are more difficult to fudge.

Irba recently adopted an updated and strengthened code of ethics that was already principles-based. It is also looking at ways to expand the audit beyond financial reporting to provide assurance in areas such as environmental compliance.

Key recommendations from the Brydon Report and Irba’s response

Recommendation

Irba comment

A redefinition of audit and its purpose

Irba supports this and in particular has been stressing the importance of aligning the audit function to investor needs. Projects are underway to look at strengthening the fraud risk identification standard, as well as auditor competencies. It may be that more training and competency is required in the area of identifying fraud, which up until now has not been an auditor’s responsibility.

The current standards do not include a responsibility for the auditor to discover fraud – merely to develop procedures to address the risk of potential fraud.

The creation of a corporate auditing profession governed by principles

Irba has recently adopted a new code of ethics which has been updated and strengthened. The Code of Professional Conduct and auditing standards adopted in South Africa are already principles-based.

The introduction of suspicion into the qualities of auditing

This is not really new; essentially it is professional scepticism which the auditor is required to exercise as an element of independence. However, an auditor who has had a client for 100 years is not perceived to be independent and is not perceived to exercise professional scepticism sufficiently well if the auditor/client relationship becomes too cosy.

The extension of the concept of auditing to areas beyond financial statements

Irba has already been looking at ways in which it might be possible to audit non-financial information and what level of assurance the auditor could provide on this information. It is a new area of external audit and internationally there already are projects to develop assurance on non-financial information (other forms of external assurance).

Mechanisms to encourage greater engagement of shareholders with audit and auditors

Irba has already taken significant steps to engage investors, shareholders and audit committees. As the regulator, we see it as part of our mandate to educate the market on what they should expect from auditors and the audit product.

Irba has a good relationship with the Audit Committee Forum [a joint initiative between KPMG and the Institute of Directors in Southern Africa] and is working closely with them to better understand the audit and audit quality. One of the initiatives from Irba has been to develop a set of audit quality indicators to assist audit committee members in assessing audit quality and evaluating auditors.

A change to the language of the opinion given by auditors

Irba has already adopted the International Auditing Standard on the new audit report and Key Audit Matters have been reported since 2016.

The introduction of a corporate audit and assurance policy, a resilience statement and a public interest statement

We support more assurance provided by management and will do research on how auditors can provide assurance on these additional statements, once there is a framework for these statements.

Greater clarity around the role of the audit committee

Irba has already begun engagement with the Audit Committee Forum and aims to educate those charged with governance on the importance of their role in the lines of defence.

Suggestions to inform the work of the UK’s Business, Energy and Industrial Strategy Committee on internal controls and improve clarity on capital maintenance

n/a

A package of measures around fraud detection and prevention

See above

Improved auditor communication and transparency

Irba has launched two initiatives:

Audit Quality Indicators, which are standardised measures for audit firms to score their audit quality. This is the first set of indicators that audit committees can use in the evaluation of auditors. This will also assist in structuring communication between the audit firm and the client on issues around audit quality.

Further, Irba has issued a call for audit firms to produce transparency reports, which will also be an important means of communication with audit committees. This is currently voluntary and suggested guidelines for reporting have been provided. This will be refined in conjunction with feedback from audit committees as to what they find most useful. In future it may become mandatory.

Obligations to acknowledge external signals of concern

Extension of audit to new areas including alternative performance measures

Irba has already contributed to a project that seeks to determine how assurance can be provided on non-financial information, and what level of assurance could be offered.

The increased use of technology

This is an important area of audit quality advancement for Irba, and the advances in technology and the 4th industrial revolution are viewed as being a step forward in addressing the concerns that arise out of current methodologies. The ability to handle large volumes of data and transactions will become easier, and will improve audit quality.

 

 

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People that believe that others will look out for you – audit profession etc – will just loose money as fools should. Due diligence is no ones but the investor’s responsibility…

Steinhoff is the latest example; lots of merger and acquisitions (no organic growth) especially ones that involve share swaps (cashless) is a red flag. This lesson with accounting coverup has happened before (https://en.m.wikipedia.org/wiki/MCI_Inc.) and will always happen…

If you do not know how a business is making its money; do not buy a single share… as simple as that… otherwise you leave your self open to being swindled.

Amen: “If you do not know how a company makes money, do not buy a single share”. Also, if you cannot use IFRS earnings to determine Operational free cash flow, do not invest unless you have another way of determining operational FCF

People always want something for nothing. When the share price goes into free-fall, they blame the audit profession. This is like blaming the police force for the burglary at your house. Some people simply put up burglar bars, maybe use electronic surveillance and take out insurance.

If the investor does not have the skills or time to guard his asset, he can buy insurance to cover his losses. Investors can buy insurance cheaply in the form of out-of-the-money put options or even a zero-cost collar. It is acceptable though, not to spend the money and effort to take out insurance, and then when disaster strikes, to blame it on another innocent passer-by, an auditor, and force him to take out indemnity cover. We want something for nothing.

If I expect an auditor, who is a human being like myself, to spot an intentionally hidden irregularity, then why do I not expect the same level of competence from myself as well? It is my asset by the way.

I am not in the accounting profession by the way. I am a professional investor, and I don’t trust accountants, not because they are not trustworthy, but because the cunning auditors, who are in managerial positions at the company, receive enormous financial incentives to hide information from average auditors who work at audit firms.

The problem lies with SAICA and IRBA, both weak and run like government departments. SAICA is a glorified bursary scheme and IRBA an old boys club.

IMHO the primary issue is that shareholders have abdicated.

They are supposed to appoint their boards and executives. They are supposed to vote shareholder resolutions.

Instead what you have today is that the professional investors / fund managers hold proxy for shareholders and they now select boards, usually from their own peer group of finance industry people that have never run a business never mind run a business related to the industry of the company the fund managers are placing client money in. Look at the Steinhoff board?? They were there to serve Jooste and Wiese.

Asset allocation is NOT being made by the owners of capital, it is basically like betting with other people’s money while being paid a guaranteed slice of how much you bet.

I would bet that there is also a strong correlation between risk and hired help pay. What was RBS board and executive pay in 1985, 1995, 2005 relative to total savings and total lending?

Proof of my theory? Private, owner run businesses do not seem to have the sick company syndrome. Difference? Shareholder involvement.

Case in point: Old Mutual board (no experience, skill or qualification to understand life insurance or the accounting thereof). Now ask yourself who selected that board and why? Clue: CEOs select, not shareholders (as it should be). Another clue: in a dying industry (pun intended), there’s much money to be made in the short term, not long term. Another clue: not Just PM

Biggest problem is that a Company CHOOSES their own auditor based on which auditor will be the most lenient and accommodating. With such a strained economy even the Audit Firms are desperate for clients. There is no interest for an Audit Firm to publicly expose their clients wrongdoings.

A possibility is that a central body is created to randomly allocate Audit Firms to Companies and regulate the price…. However this will NEVER happen

Scrap IFRS. Any number of suspect transactions and balance sheet values can be hidden. Auditors spend way too much time trying to understand the machinations of IFRS application and miss the real business.
Making auditors government inspectors is a possum answer- an extension of AGSA !!! AGSA results have now proved to be substantially better than what the firms’ produce. Certainly they are respected and “feared” by the entities they audit.

Accounting should not be a creative profession.

You can’t out regulate or out govern greed. Also, the new profession this guy is suggesting, it already exists – it is called Internal Audit…

Very very true! Only issue is that internal audit is roughly in the power game of corporate politics what the middle rear passenger air vent is on a car. Put internal audit as a direct report to shareholders in the AFS and maybe things change!

“New report says auditors need to go beyond scepticism and become suspicious of clients.”

And bite the very hand that feeds them ???

Never gonna happen !

Thats why we find this happening decade after decade

Corruption starts at Government and goes down the chain even to the Audit profession. i know of one client who changed auditors because the new auditor was more “creative”

Auditing is simply the biggest BS profession in history

The question is; who appoints the auditing firm and to do what? Obviously a company appoints the auditing firm to confirm that books are kept according to the rules/expectations of the company. To then expect a different outcome than what we currently get, is rather naive. The only way around this, is to change the rules to have auditing done in such a way that you protect investors, government, individuals, or whoever needs protection. But who will pick up the tab?… and trust me, it will be a hefty tab when an auditor have to redo the books of a company to ensure that no massaging happened. Interestingly enough, auditing in SA (with all the crooks, bribers and other low level skelms around) is already done way more thoroughly than in countries such as the USA or UK, where auditing is still done very superficially.

” Rien ne réussit comme le succès’’ (Nothing succeeds like success)
Ange Pitou by Alexandre Dumas (1854)

KPMG – at the heart of the ‘’cover up” – and brilliantly described by the late Barry Sergeant in his ‘’Kebble Collusion’’
The KPMG Services, forensic report for JCI, dated May 8, 2006 was destined (as it has) to become the most controversial document in the entire aftermath of the Kebble saga.
KPMG successfully redefined the meaning of ‘’conflict of interests’’, hence the minority Randgold shareholders will have to ‘’reverse’’ this view and conduct in court against Investec, JCI, Western Areas and T-sec!

CEO’S bullying weak auditors has been around for decades. Steinhoff and the Nic Georgio /Pickvest mess are only one of many examples
Greed will allways be the main culprit
MONEY MONEY MONEY Extensive amendments to the Acounting and Audit profession needs to be made without delay

In my experience as a director, the increasing incompetence of those leading the audit teams, as well as the quality of the education of recent beancounters (who are auditing), are also key factors to consider in this deteriorating situation.

Quis custodiet ipsos custodes?

(Roman poet Juvenal from his Satires (Satire VI, lines 347–348)

Clearly those professional and regulatory bodies, with oversight. are sleeping on the job

Yesterday I sat with an auditor and had to explain the basics of what it is I do so that the auditor could audit a transaction from end to end. I realised that what I do is as easy as breathing and that I can’t convey nearly 2 decades of experience in a few minutes – but how does ab auditor mark my homework if they don’t even know what language it’s in. Another practice that makes the hair on the back of my neck stand on end is – this transaction must be off balance sheet…

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