There seems to be strong empirical evidence from inspection reports that a substantial majority of audit areas needing improvement or significant improvement relate to problems arising during closedown of the audit, when the risk of insufficient time to carry out audit work is at its greatest.
Many of these problems are linked to accounting standards that require forward-looking judgments that are uncertain by nature. Many accounting estimates and valuations involve the use of judgment and the evaluation of risks requiring consideration of the latest information about business performance and other variables that often only become available or emerge during the financial reporting closedown.
Recent FRC inspection reports across all the larger audit firms suggest that areas affected include:
- the evaluation of the going concern basis,
- the existence and valuation of pension scheme assets,
- estimates and assumptions relating to key areas of judgment, notably the determination of impairments,
- the audit of cash flow forecasts,
- revenue and long-term contracts,
- provisions including loan loss provisions,
- using the work of an auditor’s expert,
- valuations,
- recent audit and accounting standards, and
- the audit of inventory and the oversight of group audits.
It is astonishing that over recent years, almost half (46%) of FRC findings that have identified a need for improvement or significant improvement relate to just three areas: the impairment of goodwill and intangibles; provisions including loan loss provisions; and revenue and contracts, all of which require much work at the closedown of financial reporting and audit.
The regulatory response seems to be to blame the auditors, and the tone at the top in audit firms, for not delaying the audit sign-off or standing up to or challenging management when tough decisions need to be made. A related criticism is that auditors carry out ‘compliance’ box-ticking audits, with insufficient application of professional scepticism, by not seeking out contradictory as well confirmatory sources of audit evidence.
While auditors should take a tough stance against directors and management, there is also scope to improve auditor communications with management and directors at the planning stage, particularly in relation to the closedown of financial and business reporting, and in relation to what is required for audit closedown purposes. There is also a need to address datasets that may provide contradictory audit evidence.
Lessons from the legal profession include taking detailed minutes of all external meetings, including during the closedown of the audit, to rebut more easily allegations of a lack of challenge, and of key judgments being taken on the basis of ‘culture fit’.
It also needs to be recognised, however, that there are other ‘actors’ who contribute to the insufficiency of time, the inadequacy of audit evidence, and other problems that arise around the closedown of the audit. These ‘actors’ include the following:
Management not performing timely closedown procedures themselves
The FRC should produce clearer guidance on the procedures that directors and management need to put in place to make the necessary and full determinations of judgments and estimates, on a timely basis. Otherwise, there is a risk of ‘garbage in, garbage out’, and of delays and consequential problems in the closedown of both financial reporting and auditing.
A document in need of urgent updating and improvement is the FRC’s 2014 Guidance for Directors on ‘Risk Management, Internal Control and Related Financial and Business Reporting’. This document does not fully address closedown issues and the avoidance of over-optimistic judgments and estimates.
A key area where further guidance needs to be issued to management and directors is the ongoing maintenance of up-to-date cashflow forecasts, not just for financial management, but also for financial and business reporting purposes.
More guidance is also needed on a wide range of areas including:
- the evaluation of the going concern basis
- the determination of intangibles and impairments
- provisions including loan loss provisions
- climate-related financial disclosures including forward-looking judgments
- the determination of pension scheme disclosures
- revenue recognition and long-term contracts.
It should be made clearer that the going concern determination should be planned by management well in advance of the financial closedown, and that the latest information (good and bad) should be taken into account, that the evaluation process should be timely and not rushed, and that information used and judgments made should be consistent across all areas of financial and business reporting. In practice, egregious inconsistencies can happen.
There is also a need for improved guidance calling for proper stress-testing that takes account of relevant external as well as internal sources of data. and for the assessment of the relevant scenarios such as the impact of COVID-19 and macro-economic variables.
Directors and audit committees not focusing earlier and in more detail on the specific areas that cause difficulty and delay
Again, this is an area in which the FRC can and should take action by improving the International Standard on Auditing (UK) 580 ‘Written Representations’. This standard is not fit for purpose, is in need of urgent updating and is unhelpful in engendering sufficient debate between directors and auditors during and indeed before the closedown process. This is because the areas covered in the illustrative representation letter are overgeneralised and do not do enough to focus the directors’ attention on the necessary specifics.
In particular, there is a need to include specific illustrative wording in the standard on:
- the directors’ awareness of legislation relating to misleading the auditors
- provision of all evidence, whether contradictory or confirmatory, in key areas to auditors
- business combinations and joint ventures
- earnings per share
- the disclosure of all bank accounts, loans and debts
- the absence of bribery and corruption
- full disclosures relating to tax; the determination of executive remuneration and climate-related financial disclosures, including the proper determination of forward-looking judgments,
- valuations and impairment determinations taking account of all available information, including up to date cashflow forecasts and the latest trading performance,
- alternative performance measures,
- taking account of all realised profits and losses, net assets and economic factors in determining distributions
- the need to avoid over-optimism in making judgments and estimates
- the adequacy of the arrangements for preparing the group financial statements and for control over components of the group
- the adequacy of the time set aside for the closedown of financial reporting particularly in the areas identified by the auditor as significant risks
- the consideration of whether additional information or an override is needed to give a true and fair view.
Also, it would be useful if ISA (UK) 580 could – for public interest entities – require that the first draft of the written representations be supplied by the auditor to the board and the audit committee during the planning stage of the audit so that the necessary closedown procedures for financial reporting can be planned and completed as early as possible. This would also help ensure that the written representations are considered and debated comprehensively, so that any necessary consequential procedures are properly performed sufficiently early, rather than later in the closedown processes when this is more difficult.
The analysts who put pressure on directors and management to meet reporting deadlines
Analysts can trash a company’s stock if any delay in publication is hinted at. The FRC can and should therefore review the reporting deadlines for different sectors and companies, particularly those experiencing difficulties revealed by the Corporate Reporting Review. Is it right that higher risk companies and their auditors are ‘bullied’ by the market into meeting inappropriate reporting deadlines?
There is certainly a great opportunity for the regulator to do more in this area to advise relevant companies to extend their reporting deadlines and to start a dialogue with analysts on sectors where deadlines could be usefully extended.
The policymakers themselves
Policymakers have not done enough to assess the sheer magnitude and difficulty of proposed changes in legislation, codes, accounting standards, auditing standards and the impact they have on the time needed for financial reporting and audit closedown, particularly when so much must be done simultaneously.
There is also a need for regulators to take full account of time constraints during closedown. Unlike audit inspectors, auditors have to audit on a real-time basis and cannot cherry-pick higher risk audit areas or focus on a few themes at a time that suits them and their annual timetable. Policymakers should also engage more extensively with each other to prevent significant changes from coinciding.
So where does this take us? The good news is that waking up to and responding to ‘the elephant in the audit room’ can result in targeted measures that respond directly to the problems revealed by inspection reports. These have, not unsurprisingly, surfaced in various scandals. The measures suggested above do not require new legislation or a mountain of more auditing standards and checklists. With a more enlightened audit regulator and better engagement among all involved with the closedown process, including auditors, management, directors and analysts, much can be done to improve UK audit quality and restore trust in audit and corporate governance.
Martyn E Jones is Chair of the Advisory Board to the Department of Economics and Finance at Brunel University London. He was formerly an ICAEW President and Chair of its Board. The views expressed above are his own.