Home Golden RulesAccountability The (Ir)Relevance of the modern audit

The (Ir)Relevance of the modern audit

by Nigel Kendall

The audit used to be an opinion on whether the accounts reflected a company’s financial position – now it is just compliance to increasingly complex standards.

The Chairman of the UK Auditing Practices Board, Richard Fleck CBE, gave a thought-provoking speech to a group of Chartered Accountants earlier this year. He suggested that the traditional audit had been de-professionalised and commoditised, and, coupled with the progressive deterioration of financial reporting into incomprehensibility, had contributed to a major loss of trust in the accounting profession. He called for a rethink as to the purpose of the audit and the type of experience an auditor should bring to the task. It prompted me to consider the audit and the role of the auditor in relation to our own approach to good corporate governance.

What is an audit?

The traditional definition of the verb to audit, according to the dictionary, is “to make an official, systematic examination of accounts”. Traditionally, the auditor expressed an opinion as to whether the accounts showed a “true and fair view” of the company’s financial position as represented in the published accounts. The question to ask now is whether this is still true today. Unfortunately, over the past thirty to forty years the accounting profession has introduced more and more accounting standards, so that the audit report now essentially relates to compliance with those standards, and the auditor stays as far as possible away from expressing a view as to the underlying position, lest the firm be sued at a later date if the company gets into trouble. The legal dictum expressed in 1896 by Lord Justice Lopes in the Kingston Cotton Mill case about the auditor being “a watchdog, but not a bloodhound” is not regarded as a defensible position any more.

Who is an audit for, and what is its purpose?

Traditionally, an audit was commissioned by the shareholders to check on the stewardship of the directors. Now, however, all the major stakeholders would look to the auditor’s report to assure them that the company with which they were involved was being soundly run. This in itself, raises issues, as the requirements of the different stakeholding groups varies significantly in terms of the information they need.

Traditionally, the purpose of the audit was to express an opinion on the published accounts, accepting the fact that it might take up to six months to produce those accounts. Some companies would manage to produce a “flash” set of results within a month of the year end, but these were rare. Nowadays, financial results six months old would be regarded as of limited value for most users. Hence, public companies will inform the market of their financial position by issuing profit forecasts and banks will demand unaudited management accounts during the year to inform them of their customer’s solvency.

However, it is arguable that shareholders and potential investors, in particular, are much more interested in the continuing viability of the company’s business model, whether the company is being soundly run and whether it is exercising its responsibility for accountability in an open and transparent way than out-of-date financial reports. Moreover, there needs to be some assurance of its ethical trustworthiness. A brief look at Nat Rothschild’s involvement in Indonesia reminds us of the dangers here.

What are the problems?

Firstly, individual opinion has been effectively replaced by accounting standards. By contrast, the most useful contribution an audit report can make for the benefit of the stakeholder is the assurance which is provided by an independent, informed opinion on those aspects of the stakeholder’s relationship with the company which that stakeholder considers to be of most importance.

Secondly, financial reporting is not universally trusted. Worthy efforts have been made to standardise financial reporting around the world by introducing common definitions and ways of treating transactions. The aim is to improve understanding. But this has run alongside more regulation and complexity in company law and taxation. The result has been reports with a totally indigestible volume of information, much of it mere boilerplate, coupled with financial reports of such a degree of complexity as to baffle the average reader. We must add to this such fundamentally controversial accounting policies as “mark to market” which can produce results which are so threatening to the business that they can be legitimately challenged by business managers who arguably are better placed to judge the meaningfulness of those policies. Put all these together and we have the recipe for a major lack of trust in the financial reports to which the auditors are attaching their name and reputation.

Finally, arguably, the auditor’s report ducks two of the key matters on which the stakeholders would most value their opinion, namely the ethical soundness of the culture and the continued viability of the business model.

What is the answer?

For the audit to regain its value to stakeholders, the auditor needs to recapture the role of trusted adviser. Moreover, the audit should address the major interests of the stakeholders. So, expressing these in the terms which we use to define good corporate governance, the audit should address:

  • the honesty of the directors and management and their approach to business generally (ETHICS)
  • the viability of the business objectives and the business model and the business risks in relation to the interests of the key stakeholders (GOAL)
  • the soundness of the management and organisation (STRATEGIC MANAGEMENT and ORGANISATION)
  • the relevance of the information given to stakeholders in the company’s reporting and its truthfulness and accuracy (ACCOUNTABILITY)

These are the key elements in good corporate governance and if the accounting profession makes these the basis of its audit, it will start to regain its reputation as trusted adviser and independent professional. Perhaps it needs a corporate governance specialist to lead the team.

Feel free to give your opinion in the comments section below.

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