A new role for auditors in the wake of the crash

With its strong focus on numbers, the auditing process is limited and is in need of an overhaul

BLAME FOR the collapse of the property market and the catastrophic impact it has had on the Irish economy has been laid at the feet of many professions.

Property developers, politicians, estate agents and bankers have all been called to account for their role in inflating the property market to dangerously high levels, but many would argue that auditors are also to some extent culpable.

After all, Anglo Irish Bank’s accounts were signed off on by Ernst Young each year – without the auditing firm apparently noticing the flow of directors’ loans in and out of the bank. But have auditors been negligible in carrying out their roles or is change required to empower them to fulfil what is actually expected of them?

In principle, the role of the auditor is to offer comfort to an investor or creditor of a company, by validating a company’s accounts.

“Audit is a simple concept; an independent person, appointed by the investors, but paid for by the company, provides investors with an opinion on how well the financial statements reflect the underlying business performance,” says Liz Hughes, head of ACCA Ireland.

However, what an audit does and doesn’t, cover is sometimes unclear. Auditors do not see themselves as “bloodhounds”, out to detect fraud, but rather as watchdogs, there to determine whether or not a company’s accounts are a realistic representation of its business.

Aidan Lambe, technical director with Chartered Accountants Ireland, puts some of the negative commentary down to a misunderstanding of the role of auditor.

“People think that auditors are essentially financial policemen for all stakeholders – but this isn’t their statutory role,” he says.

Indeed there may well be an expectation gap between what investors expect of auditors and what they are actually being hired to do. The auditing process is limited, it focuses on numbers and doesn’t address issues such as risk management and the effectiveness of corporate governance, or testing the assumptions underlying an organisation’s business model and its likely sustainability.

“The public perception is that the audit of quoted companies is failing too often and giving an answer to a question that nobody asked or understands,” says Hughes. “The audit report opines on whether the financial statements are ‘true and fair’; they do not mention anything about ill-conceived lending practices or how well the business was managed or whether the directors’ fees, expenses or Learjet were in fact justified.”

Another issue arises with regards to generally accepted accounting practice (GAAP), with the clue in the name. With many interpretations “generally accepted”, how can they all be both “true and fair”? For example, the US has different rules to Ireland and there are two different sets of rules allowed in Ireland – all of which give different answers.

“Not to put too fine a point on it, there are gaps in all of the GAAPs,” concedes Hughes. “We have seen companies go from massive profits to eye-watering losses in weeks and yet the financial statements were in accordance with GAAP and apparently true and fair.”

So is it time for a shake-up in the auditing profession?

There appears to be a growing consensus in favour of change, with the publication of an EU Green Paper on Audit expected in October or November.

“We believe it may be time to reassess the scope of an audit – everything can be improved,” says Hughes.

But what might be revised?

Unsurprisingly, given the damage the banking crisis has done to economies across Europe, how impaired loans are reported may be a focus of attention. Back in 2007 and 2008, annual reports were presenting the banks as being in relatively good shape – despite the massive losses they were soon to incur – with losses only being crystallised in accounts as late as 2009.

However, this method of financial reporting of impaired loans, on an “incurred” basis, is now deemed to be to inflexible, with a preference emerging for earlier recognition of losses by applying an “expected loss” model to financial reporting standards.

The scope of the audit is also an issue at hand, with criticism being levied at the retrospective nature of an audit, as well as its focus on numbers. Indeed while a treasury investigation into the UK’s banking crisis found no evidence of systemic failures by auditors, it did question whether or not the information presented by auditors in a company’s annual report is actually useful.

Now it is being proposed that auditors should provide their assurance on issues such as corporate governance, risk and corporate business models.

They could also provide a more narrative – and therefore subjective – comment on aspects of the annual report such as the chairman’s or directors’ statements, which is often the only section of a report that the public reads.

“I would like people not to rely entirely on the directors’ report, it doesn’t necessarily give all the information a stakeholder needs,” says Hughes.

However, while Lambe thinks auditors would be well placed to carry out this additional work, he suggests that they would need some kind of extra legal protection in order to do so.

Another issue is conflicts of interest. Given that companies pay for the services of an auditor themselves, conflicts can arise on

both sides, as companies can select auditors that they believe may treat them in a favourable fashion, while auditors themselves may not highlight certain aspects of the company’s accounts for fear of losing their business.

And it can be a lucrative business. Irish public companies can pay in excess of €10 million a year for audit services.

As such, there could be a role for the creation of a State regulatory body who would be responsible for quality assurance in the profession, as at present auditors are self-regulated by industry professions, with additional oversight coming from Irish Auditing and Accounting Supervisory Authority (IAASA). This would align arrangements in Ireland to those in other jurisdictions and is consistent with EU recommendations.

“It’s ultimately where we’ll get to,” says Lambe.

But, while change may be on the horizon for auditors, it is unlikely that this will mean they will start to act like the bloodhounds the public appears to desire.