Checking the checkers

Appearing in In The Black magazine, October 2019

Auditing faces an uncertain future

Independent auditing has long been one of the foundation-stones of business but the profession, in Australia and globally, is facing unprecedented challenges – as well as emerging opportunities. No-one can say with certainty where the path is leading but there is a sense that auditing as a profession and a process is under pressure.

Much of the current concern has been driven by events in the UK, after a series of business collapses, most notably the BHS and Carillion failures, following sign-off of the accounts by one of the Big Four audit firms – PwC, KPMG, EY and Deloitte. Regulators are now pushing the firms to clearly separate the audit and non-audit services they provide to clients, even to the extent of splitting off a separate company.

Speaking recently to a UK parliamentary committee, the heads of PwC, KPMG, and EY indicated that they would cease providing non-audit work for large audit clients within a year. PwC UK has been the first to make serious moves in this area, announcing in June that it will have one business to focus on external audits and another to deal with internal audits and issues such as cyber-security and technology risk. It also plans to recruit more than 500 auditors, introduce new training and technology initiatives, and increase the number of specialists in its audit quality control section. This will cost about £30 million a year, which is a good indication of the seriousness of the issues.

“Globally, the UK is leading efforts to improve Auditing 2audit quality and avoid conflicts of interest,” says Professor Ian Gow, Director of the Melbourne Centre for Corporate Governance and Regulation at the University of Melbourne, and co-author of the book The Big Four: The Curious Past and Perilous Future of the Global Accounting Monopoly*. “But in South Africa, India, and Ukraine, there have also been cases of Big Four firms being excluded from audit work due to sloppy practices.”

This raises the question of how auditing is faring in Australia, especially since the Big Four handle audits for over 90 per cent of the companies listed on the ASX. It appears that, generally, the situation does not directly compare with the UK. A survey recently released by the Auditing and Assurance Standards Board, Audit Quality in Australia: The Perspectives of Professional Investors, found that 93 per cent of respondents indicated that they saw audit quality as “average” or “above average”.

Related to this, a Financial Reporting Council survey, Audit Quality in Australia: The Perspectives of Audit Committee Chairs, revealed a high degree of satisfaction with the quality of external auditing, with 92 per cent of respondents rating them “above average” or “excellent”.

“We were very pleased to see these results but we can never be complacent,” says Matt Graham, Managing Partner, PwC Assurance. “For some time we have felt that the audit quality debate in Australia could be broader, more balanced and aided by increased transparency. This is why we released the country’s first-ever balanced scorecard on audit quality recently. That scorecard showed audit inspection results along with other key measures of audit quality such as internal inspection findings, restatement rates and adjustments to financial statements. We plan to release data like this on an annual basis.”

The corporate regulator supports greater transparency and is considering whether to publish individual firm inspection results in its next public report. ASIC is also continuing work on possible additional audit quality measures to complement inspection findings. Doug Niven, ASIC’s senior executive leader, financial reporting and audit, notes that ASIC’s audit inspection report for the 18 months to 30 June 2018 found that in 24 per cent of the key audit areas that were reviewed auditors did not obtain reasonable assurance that the financial report was free of material misstatement. This is slightly better than the figure of 25 per cent for the 18-month period ended 31 December 2016.

“Sustainable improvement requires a focus on culture and talent in firms,” says Niven. “Our inspection findings suggest that further work and, in some cases, new or revised strategies are needed.”

But he is wary about splitting large accounting firms into audit-only firms, believing that it could adversely affect audit quality.

Graham notes that PwC in Australia has no plans to hive off its audit business (and none of the other big audit firms have signalled intentions to do so). He sees the business and regulatory environments in the UK and Australia as very different, and believes that the discussion in Australia should be more broadly aimed at audit quality, independence, conflicts of interest, and the needs of businesses and their shareholders.

Professor Gow is pleased to see moves like PwC’s scorecard although he wonders where it will lead. He notes that all of the Big Four firms have recently started to reveal new information. “Clearly the incentives to reveal more are stronger if your numbers look better,” he says. “I suspect that this wave of disclosure will prompt some tweaks to the inspection process to make the numbers more meaningful. An issue with the reported numbers is that audits are selected for inspection because they are perceived to be ‘risky’ audits, which makes it difficult to draw general conclusions. But overall it seems to be a healthy conversation to have.”

Focus shift

Discussions on ways to improve audit quality are important but there is an even more crucial question: in the current environment, what is auditing actually for? In an era when Big Data allows for real-time tracking of all of a company’s transactions, does the idea of checking and re-checking historical financial data make sense anymore?

Auditing 1Professional investors and audit committee chairs may be reasonably satisfied with the work of auditors but there are other stakeholders in the mix as well. There is certainly a bloc of investors who are concerned with a company’s non-financial performance as well as the traditional metrics.

While Big Data has the potential to take over many of the mechanical, repetitive tasks associated with auditing it is likely to push the profession into non-financial fields and towards predictions and business analysis.

Matt Graham says: “The industry has to evolve the audit in line with market demands, as well as engaging more effectively with stakeholders along the way. For example, should an audit include new levels of coverage such as fraud, going concern and cybersecurity? Could it provide assurance over non-financial measures such as culture, sustainability and the control environment? Should it look forward as well as back and provide comfort over forecast information?”

In this context it might be noted that the Australian Accounting Standards Board and the Auditing and Assurance Standards Board recently released a Practice Statement, Climate-related and Other Emerging Risks Disclosures: Assessing Financial Statement Materiality. The Practice Statement is not mandatory but it points auditing towards an integration of financial and non-financial data.

A key problem with this is that auditing financial statements is largely about providing assurance that the statements were prepared in accordance with accounting standards. When auditing begins to look at issues such as the environment, fraud and cyber-security there are no widely-accepted standards that can be used to assess and check performance, and even if there were it is not clear that understanding accounting standards provides a basis of relevant expertise.

“The Big Four firms are definitely trying to claim a future stake on auditing things such as sustainability, environmental risks, and even privacy,” says Professor Gow. “But skills-wise it is a real stretch. Auditors still graduate with accounting degrees that focus on standards and the like. The auditor of the future is likely to be someone who is comfortable with advanced data analytics.”

Doug Niven counsels caution about moving too quickly into the non-financial field. “Investors and other users of annual reports may benefit from independent assurance over non-financial information in an operating and financial review, integrated reporting, sustainability reporting and climate change reporting,” he says. “But at present, there are no detailed reporting frameworks to audit against and many of those promoting innovation by companies in non-financial reporting suggest that independent assurance is premature.”

Competition pressure

Another issue relates to competitive pressures. Professor Gow points to his current research showing that audit fees generally increase slightly over time, and then often decline markedly when a new auditor is appointed. This suggests that some audit appointments are based on price.

“This could be a concern,” he says. “I suspect that the Big Four would rather compete on quality. The problem is that audit quality is very difficult to measure, so it is hard to prove that you are adding sufficient value to justify the costs.”

There is also the possibility that competition may come from smaller, more nimble firms that can offer quasi-auditing services in non-financial areas.

So what might the future of auditing look like in Australia? In short, while financial review is likely to remain at the essential core of auditing practice it might cease to be the reliable source of revenue that it has long been for the large firms. Regulators and stakeholders are likely to demand greater division between audit and non-audit functions, although pressure for complete separation is unlikely. Auditing firms will have to go further into non-financial issues, requiring a significant change in corporate culture. At the same time, they will face increasing competition from new entrants, especially in fields such as the environment.

“One is always hesitant when trying to predict the future, as so many past predictions turned out to be wrong,” says Professor Gow. “But one thing is clear: it’s going to be a very different profession from what it is now.”

 

* The Big Four: The Curious Past and Perilous Future of the Global Accounting Monopoly by Stuart Kells and Ian Gow (LaTrobe University Press, 2018). This book won the 2018 Ashurst Australian Business Literature Prize. A copy of the book is available at the CPA Library.

https://www.auasb.gov.au/admin/file/content102/c3/InvestorSurveyReport.pdf [Audit Quality in Australia: The Perspectives of Professional Investors]

http://www.frc.gov.au/documents/publication/audit-quality-in-australia-the-perspectives-of-audit-committee-chairs   [Audit Quality in Australia: The Perspectives of Audit Committee Chairs]

https://download.asic.gov.au/media/4990650/rep607-published-24-january-2019.pdf [ASIC Audit inspection program report for 2017-18]

https://download.asic.gov.au/media/1338902/info184-published-19-August-2013.pdf [ASIC Information Sheet – Audit transparency reports]

https://www.auasb.gov.au/admin/file/content102/c3/AASB_AUASB_Joint_Bulletin_May2019.pdf [Australian Accounting Standards Board and Auditing and Assurance Standards Board Practice Statement]

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