AUDIT

Towards greater reliability and precision in the auditing world

Audits have important implications for an organisation’s strategy, management, and investors. Performing a high-quality audit is therefore essential, and in the best interest of the client as well as the audit firm. However, periodic reviews by regulatory authorities on the work performed by audit firms conclude that audits are not always of high quality.

This article provides some insight into why audit firms sometimes compromise audit quality, while also giving examples of how this happens, and relaying the implications of inconsistent audit quality for the profession as a whole.

Areas of Concern

The International Auditing and Assurance Standards Board (IAASB) has issued two documents relating to quality control. ISQC 1, Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance and Related Services Engagements applies to all firms of professional accountants with respect to audits and reviews of financial statements, as well as other assurance and related services engagements. It should therefore also be applied to non-audit engagements such as reviews of prospective financial information, along with engagements to perform agreed upon procedures.

ISA 220 is specific to audit engagements, and contains specific requirements that should be adhered to in the performance of any audit. ISA 220 contains requirements in relation to:

  • Leadership responsibilities for quality on audits
  • Relevant ethical requirements, in particular independence
  • Acceptance and continuance of client relationships and audit engagements
  • Assignment of engagement teams
  • Engagement performance, meaning the direction, supervision and review of an audit, including consultation and engagement quality control reviews
  • Monitoring and documentation

There are numerous other requirements as per ISA 220, however we shall mainly limit ourselves to the above list for the purposes of this article.

Recent Audit Scandals

Audit scandals have recently emerged involving Big Four firms and their clients, raising serious questions related to auditor independence and audit quality.

a. Colonial Bank

The failure of Colonial Bank was traced back to negligence on the part of a Big Four audit firm, which was in turn assessed US$625 million by the Securities & Exchange Commission (SEC). This sum for damages is one of the largest ever imposed for audit malpractice. Colonial Bank’s own internal auditor had previously settled for $60 million. An attorney for the Federal Deposit Insurance Corporation (FDIC), which had to pay billions to Colonial Bank depositors, stated, “We are pleased that the court recognized there are consequences when an auditor breaches its duty to the investing public.” But that case isn’t the only recent example raising concerns about audit quality.

b. General Electric

A Big Four audit firm received negative publicity about ethical missteps and poor audit quality. The two biggest U.S. proxy advisory firms, Institutional Shareholder Services (ISS) and Glass Lewis, recommended that shareholders of General Electric (GE) vote against its board of directors’ recommendation to reappoint its current auditors (a Big Four firm) for the 110th consecutive year. This advice came in response to “the apparent extent of GE’s previously undisclosed liabilities and accounting issues,” including a surprise charge of $15 billion necessary to bolster GE’s insurance reserves. Although 64.9% of GE shareholders accepted the corporation’s current auditors for reappointment, ISS noted this was only the fifth time in the last 1,500 meetings of S&P 500 companies that an external auditor won less than 90% of the vote.

c. Carillion PLC

Carillion PLC (UK) is a construction company which collapsed in 2018 without warning, with liabilities of nearly £7 billion and hundreds of millions of pounds in unfinished public contracts. The collapse resulted in over 2000 job losses and saddled UK taxpayers with vast ongoing costs to keep essential services running.

The resulting inquiry found the auditing firm to be complacent, failing to exercise professional scepticism towards Carillion’s accounting decisions during the course of its 19 years as Carillion’s auditor.

 

Why does this happen?

The regulatory bodies play a role in promoting the quality of audits, which in turn increases public confidence in the audit process and financial reporting. It is therefore surprising to casual observers that when inspections are carried out regarding the conduct of auditors, the regulatory bodies come across many instances where audit quality is lacking. These investigations tend to reveal pressures which may lead auditors to compromise on audit quality, including tight deadlines and restrictions on audit fees, issues relating to competence, ethical dilemmas, and the extensive levels of judgment that is required when auditing certain balances and transactions.

Audit fee – A substantial fee reduction may lead the auditor to reduce the scope or depth of their audit work and therefore compromise audit quality. Such corner-cutting measures may include reducing sample sizes and increasing materiality levels, especially in group situations. Moreover, certain audit work is sometimes performed by audit personnel who are not ‘full’ members of the audit team; they may be located in a foreign country where the labour costs are lower.

Competence – If auditors are not technically competent to perform audit work, impacts on audit quality are likely to result. Indeed, the IAASB comments in its 2015–16 Work Plan that audit inspections have found instances where engagement quality control reviews were performed by persons who were not competent to do so. This organisational failure creates potentially serious hazards for the audit firms involved, for which an inappropriate opinion could be issued.

Ethical dilemmas – These may occur when the audit firm provides non-audit services to the audited entity. Audit firms should be familiar with the concept that providing non-audit services creates a threat to objectivity, in particular a self-review threat. Audit firms should also be accustomed to assessing the significance of this risk, and responding with the use of appropriate safeguards – or with a decision to not provide the non-audit service.

Extensive use of judgment – Audit inspectors often comment that key judgmental balance, particularly in areas such as fair values and impairment, is lacking in quality. The FRC’s 2014 Annual Report on Audit Quality Inspections states: “Limited evidence that audit firms have robustly challenged management particularly in respect of the appropriateness of key assumptions and other judgments was a key concern. Firms, with the assistance of audit committees, should ensure they appropriately challenge management.” The report comments that audit firms often fail to challenge the feasibility of business plans prepared by management, as well as assumptions relating to fair value, impairment, and the valuation of tangible and intangible assets.

The above list gives some examples of where audit quality has been compromised, as identified by audit inspections. The objective of the inspections is to highlight the weaknesses in audit quality and to recommend improvements. It is up to the audit firm whether or not they respond to the recommendations – but it is in their interest to do so, and there are calls by the IAASB to formalise the means by which audit firms demonstrate that they have taken such recommendations on board.

Measuring audit quality 

While Carillion’s troubles were crystallising, other oversight bodies were already making moves to overhaul parts of audit regulation and standard setting to address perceived shortcomings in audit quality.

The International Forum of Independent Audit Regulators (IFIAR), which comprises independent audit regulators from 52 jurisdictions, aims to improve audit quality globally. IFIAR conducts an annual inspection findings survey and, following persistently high negative audit inspection findings, has agreed with the six largest global network audit firms to reduce negative findings reported in 2015 by 25 per cent by 2019.

While this is an admirable goal, the comparability of percentages between years and the validity of any extrapolation from the results across all audits may be questionable.

Action on audit quality

The dissatisfaction of regulators with audit inspection findings has filtered down through the International Organization of Securities Commissions (IOSCO) to the Monitoring Group (MG), an oversight body of the International Auditing and Assurance Standards Board (IAASB), on which IOSCO has a board position.

IAASB continues to revise standards and issue new standards to improve audit quality. One significant and recent change involves enhanced auditor reporting, which includes reporting of key audit matters for listed entities, as well as structural and informational changes to all auditor reports. Standards on auditing estimates, risk assessment and quality management have also been revised or are in the process of being revised. 

The International Ethics Standards Board for Accountants (IESBA) has addressed threats to auditor independence by amending the code of ethics to increase the cooling-off period for key audit partners. IESBA is also looking at the impact of fees on audit quality, including the level of audit fees, the importance of those fees to the partner, office or firm, the ratio of non-audit services fees to audit fees paid by an audit client, and the provision of audit services by a firm that also has a significant non-audit services business.

Will these efforts fix audit quality? 

Before developing a plan to fix issues regarding audit quality, each element needs to be reliably and consistently measured, in a comparable manner. At the same time, a benchmark for acceptable audit quality needs to be set. Where audit quality falls short, the underlying root causes need to be analysed and addressed.

At present, however, it seems that current measures of audit quality are either not representative, not reliable, or not comparable, as each jurisdiction collects different data. The underlying context for each problem has not yet been clearly identified – yet solutions are being implemented regardless, with no reliable way of knowing whether or which are effective.

While the hope is that the current understanding of audit-related issues is sufficient, it nevertheless remains true that remedial actions come at a cost and it is currently impossible to know whether those costs are justified. For all concerned about audit quality – and for the well-being of the economy in general – a responsible and comprehensive approach to fixing outstanding issues must remain a top priority.

 

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Jaseem