In many cases, financial statements no longer give sufficient insight into companies’ changing fortunes. So auditors must evolve themselves in order to remain relevant as a profession.
In conversation with:
Rupert Bruce is an experienced financial copywriter. From the late 1980s to late 1990s, Rupert was a business journalist with some of Europe’s leading newspapers and periodicals, including The Independent, International Herald Tribune and Institutional Investor magazine.
Historically, the audit profession’s conservatism has been a strength. Auditing company accounts has required a cautious approach. Yet now the rapid change in the nature of how companies create value and how investors judge them demands change and innovation from auditors. In many cases, financial statements no longer give sufficient insight into companies’ changing fortunes. So auditors must evolve themselves in order to remain relevant as a profession.
All five KPMG partners interviewed for this chapter about the audit model and the profession express this view to some degree. They concur that at a time when quarterly investor conference calls may shed more light on the way companies are growing than the financial statements, the audit profession must widen the scope of the information that it offers assurance over in order to give the investor community – and other stakeholders – what they need.
How the profession might do this is a topic for debate. Some of our interviewees are in favor of giving assurance over non-financial measures such as drug pipelines, like-for-like store growth or website traffic. Others would like to communicate more information about some of the insights gained during an audit, such as the quality of controls or risk management.
In general our interviewees believe that the exponential increase in the complexity of accounting standards has resulted in the profession spending a disproportionate amount of time focusing on compliance. Training is perhaps the area where this is most apparent. In order to make sure companies are audited to a single set of rules and consistently high standards across the world, auditor training concentrates on compliance. Yet this approach can eliminate originality. Indeed, it may deter questioning people – who arguably make the best auditors – from entering the profession, in the view of one interviewee.
So what can be done? The sentiment from our interviewees is it’s time to act dramatically differently. The auditing profession must go out on a limb. It must suggest changes to the audit report and any supplementary information it could provide assurance over. There will be resistance to this from some constituents. But the profession must be brave if it’s to stay relevant.
Q. Has the quality of the audit improved since the 2007 financial crisis? If so, have stronger regulatory oversight and standards driven the improvement, or has the profession done so?
Larry Bradley (LB): In my opinion, there’s absolutely no doubt that audit quality continues to improve significantly. But the answer to your question is far more complex. We’ve recognized as a profession, and certainly at KPMG, that we have to step back and evaluate not just financial institutions but other companies from a more holistic risk perspective. The entire world learned what can happen if there’s a crisis of confidence and liquidity. But there’s much more work to be done. One of the knee-jerk reactions to the crisis was to increase our level of rigor over compliance and I’m not convinced that we’re focusing our efforts in all the right areas. We’re not getting the “biggest bang for our buck.” In addition to compliance issues, there are significant business issues that give rise to audit risk.
Larry Leva (LL): I didn’t see a big problem with the quality of audit in 2007. It was a market crisis, a bubble that burst. The significant improvement in audit quality started in the days of Enron and WorldCom. That was an accounting crisis that triggered the creation of the Public Company Accounting Oversight Board, which has been followed up by national accounting regulation in most large and mediumsized countries. That has been accompanied by a refocusing by the profession, which needed to regain credibility. All of this led to a tremendous improvement in the quality of audit, which has continued through the global financial crisis.
Mark Vaessen (MV): I agree that the quality of audit has improved since 2007. As a profession we’ve reflected and learned from the crisis. Commitment to quality excellence is an imperative because without this there will be no trust and no profession. Although audit quality didn’t contribute to the crisis, it has become clear that the outside world expects the audit profession to give early warnings of what’s happening in the system.
One of the criticisms we hear is that the profession was the watchdog that did not bark. The world expects more from us in terms of communication, both about our findings in individual audits and early warnings of what’s happening in the system as a whole. So, in my view, better and more communication about what matters to our stakeholders is the way in which we can improve our relevance and restore trust, and that’s what we are committed to do.
Jean-Paul Vellutini (JPV): One thing I say is that an audit cannot be more relevant than the information that is subject to the audit. In my view, the quality of the audit is one thing and the relevance of the information we audit is another. I think that audit quality has improved, to some extent because of stronger oversight and also because the profession has decided that quality is essential for driving our efficiency. What has not been addressed so far is the relevance of the financial information we audit. We were expecting a lot from the European Commission’s green paper, but it only challenged the independence of the auditors. In my view, the main question should have been what information independent auditors should look at.
Q. Do auditors have the capability to give anything more than a binary pass or fail audit opinion? Is the profession sufficiently sophisticated to deliver a more narrative-based opinion?
LB: Yes, because as the auditors of a company, we have broader access to a company than almost any other entity or profession. I’ve been an audit partner my entire career and I’ve been the lead signing partner on major global multinational companies, and in that role you look across so many different things – IT, HR, legal, compliance, finance, control, etc. So, to me there’s no question that we’re in a unique position to deliver more than a binary report. I think what we’re finding is delivering a binary report is not providing investors with all of the insight that they need in order to make their investment decisions.
Investors are making their decisions based on adjusted non-GAAP earnings and non-financial metrics. They’re making decisions based on a company’s pipeline, same store sales growth, oil and gas reserves, etc., all of which might be derived from the historical financial statements but they’re not in accordance with GAAP or necessarily derived from financial statements or systems. It’s those non-GAAP measures, both financial and non-financial, that are driving the market capitalization of the world’s biggest companies. But those metrics typically have no form of independent attestation. I think in the future the market and investors are going to need, or potentially demand, some form of independent assurance.
LL: We support providing more information relating to the audit. The International Auditing and Assurance Standards Board has just issued a formal proposal that would recommend moving away from a binary report and require the auditor to discuss the most important elements of the audit. Auditors certainly have the skills to provide more information. In the more difficult judgmental areas where ultimately you come down to a number, for example when there’s an exchange of one asset for another, informing readers of the financial statements about the key assumptions used gives a better idea of the key judgements in the accounts. Investors would like a seat at the audit committee table but that’s unrealistic. But it’s very hard in a one-way communication to replicate the discussion that goes on in the audit committee meeting.
CO’H: The training that auditors receive, coupled with their experience in their role as statutory auditors, gives us a unique position to provide independent assurance across a broad range of areas including, but not limited to, statutory audit.
The market for these services is growing as Audit Committees and management recognise that statutory audit has its limitations, yet they do require independent assurance on identified areas of risk in their business processes.
But in Ireland and the UK, audit reporting has itself evolved significantly in recent years.
For all large public companies, the audit report is now not just a binary pass/fail report, but one that includes a specific commentary by the auditor highlighting areas of heightened risk of material misstatement, and how the audit effort addressed those risks. This is but one step in an evolution which demonstrates that the profession is more than capable of delivering narrative based audit reporting that demonstrates the value in audit.
MV: I think we already do more than give a pass/fail. If you look at the views and insights we provide to audit committees about internal controls, risks and IT systems, we’re doing more. We also indicate where we think they’re on the aggressive side or conservative side in their accounting. But we don’t say any of that to the readers of our reports, who are principally the shareholders. So I don’t think we lack the sophistication to do more and we can comment on our findings and views during the audit. I think the challenge for us will be to make sure we say things that add value, rather than falling back to boiler-plate language.
Q. Does the common compliance-based training that auditors around the world receive encourage them to take a ‘tick-the-box’ approach, rather than the more inquisitorial approach that is required?
CO’H: It is disappointing, but perhaps not surprising, that auditors have allowed the perception of audit as a box-ticking exercise develop, as we have made very little effort to really communicate the added value in what we do. Yes, of course there is an explicit requirement to comply at a minimum with the extensive and proscriptive requirement of International Standards of Auditing (ISAs), but perhaps the most valuable attribute of a good auditor is the mindset of relentless scepticism. It is this more intangible attribute that requires an auditor to go beyond mere compliance with ISAs that we need to continue to emphasise and embed in the training of the next generation of auditors.
LL: We’ve been focusing on the importance of exercising professional judgment and skepticism, so that you don’t simply take information from the client as good. One needs to be a respectfully questioning business person and when the economics of a transaction don’t make sense you need to continue to dig until you understand what’s happened. At that point you understand whether the information is reasonable or not. Ultimately our work benefits the users of the financial statements – the investors. You need the respect and cooperation of the management, but you must respectfully challenge what they give you.
MV: I think we should not short change our people, because auditors have to have all-round skills. Nonetheless, there’s a perception that we have too much of a compliance mindset. For example, International Financial Reporting Standards have become more complex over time and people say we focus purely on the complexities of the standards. Similarly, we have introduced electronic tools to aid the audit – and there’s a risk that they become an end in themselves. But I would say that our people are more all round than they’re given credit for.
JPV: It’s not a question of formal training alone. It’s also on-the-job, informal training you get, spending time with people at your clients. We should not limit the training to what is provided formally. I think training has to evolve. In France we’ve done it. We’ve put more emphasis on internal control aspects and IT aspects. We believe our people need to have a much better understanding of IT and internal controls. I believe these two examples should be made a greater part of a normal auditor’s training.
Q. What meaningful improvements or innovations in the audit has the profession made recently? What is the most meaningful improvement or innovation?
LB: I can’t tell you that we’ve been hugely innovative, but we have a mandate to be innovative now which is coming in part from the global financial crisis. Let’s look at one example – how we can use predictive data analytics. Is there a way that auditors can use external information to try and derive a predictive amount that they would expect to see in a company’s financial statements with respect to, say, revenue? Predictive analytics can test what the company’s telling you. If what it tells you is materially different from what the data has predicted, then you need to understand why.
LL: I think technology has greatly improved the efficiency of the audit. The focus on professional skepticism we have just talked about has been the most important improvement. Looking into the medium term, we are very excited about how we can use data analytics to help identify problems that more traditional techniques might not.
MV: I think we have been lacking in innovation and that’s why we’re reviewing what the audit of the future should look like. How should we make more use of data analytics? How can we assess risk to identify the next crisis? And how should we expand our role beyond the financial statement, if that’s where market demand will take us? I would hope we will see innovation now because otherwise the profession will be left behind.
JPV: If the question is in relation to the profession, I don’t see anything in terms of major improvements or innovations. Based on our skills, we can provide much more than a binary report. KPMG has some innovative vision. For example, our data and analytics initiative is critical. In my opinion we need to expand the scope of the audit.
Q. What is the single largest weakness remaining in the audit (or the profession) and what could be done to rectify it?
LB: As auditors, our primary product is based on a historical set of statutory financial statements. However, stakeholders are clearly increasingly basing their decisions on information that resides outside of those statutory accounts. That is the single biggest issue, I think, that we have as a profession. We have the opportunity to provide more significant insight to investors and other stakeholders.
LL: The single largest weakness is that the scope of the audit has not changed for 100 years and is limited to historical financial statements.
MV: The biggest weakness of the profession in my view is that we’re not communicating as well as we should do. We don’t show the outside world how much we add value. We have insights and knowledge, but we are not brave enough to share them with the outside world.
Q. Is there merit in extending the audit beyond the financial statements or even the annual report? If so, what would you suggest? Who wants this? Who will pay for it?
LB: I believe that we recognize we have a broader role to play in society and have to find a way to deliver on that. We can do so by giving broader assurance on information that matters to stakeholders. I apologise if I sound a little `Pollyannish’ but people have high expectations of us, so we have to broaden our service offering and delivery. We have to provide assurance on areas beyond the financial statements if we’re going to meet society’s expectations.
LL: The realm of opportunity is very great in terms of what more auditors could do. The key question is how do we remain relevant when a greater and greater part of a company’s value is either an intangible asset that’s on the balance sheet or some kind of intangible value that’s not even recorded? You take a drug pipeline in the case of a pharmaceutical company. If the auditors are going to remain relevant we have to provide assurance on some of these areas. We’re starting to identify these areas and talk to the regulators and folks in the public arena to see if there’s an interest. We do think there’s an interest. Ultimately the company will have to pay for this. But investors have to make clear they want this.
MV: I think there’s a growing consensus that the current financial reporting model has led to a narrow focus on compliance and not enough on broad communication. So part of the answer is to look at the reporting model. For example, looking at integrated reporting and how companies make money for the longer term in a sustainable way, what their key performance indicators are. That is my vision. If we do that I would say that it’s natural for the auditor to provide assurance on some of the information outside the financial statements, like risk management or the key performance indicators. I believe demand for assurance should develop because people believe that it really adds value. If we don’t change it’s a question of whether we will be relevant in ten years time.
CO’H: For audit to remain relevant, I think it is essential that we do extend the areas that we are asked to give comfort on. When you think about what types of public announcements from companies result in movements in its share price, they are as likely, if not even more likely, to be based on unaudited information such as trading updates than on the audited financial information in the two hundred page annual report. Yet the investor community tells us that it places more reliance on audited information. So there must be an opportunity for auditors to be asked to provide some form of assurance or comfort on critical financial information outside of the annual report. There is already precedent for this in certain capital market transactions.
JPV: Companies may be hardly willing to pay for more assurance if it is only compliance or regulatory driven. But I think investors will eventually demand they do so. The more sophisticated investors’ decision-making process is, the more they need to rely on information that’s not covered by the financial statements. If companies can only access capital or clarify their value to investors by providing this assurance, then they will do so. In addition, if we can demonstrate that bringing additional comfort on areas such as risk, internal control, contracts, etc. contributes to the company’s performance, they will seek out such assurance.