How does audit add value to the capital markets?
In conversation with:
Caroline Biebuyck is a business writer and editor with extensive experience of communication in accounting, finance and related areas for her multinational client base. Earlier in her career she spent several years in audit and taxation. Currently located in the UK, her work has taken her to Hong Kong, India and Central Europe.
Beyond meeting legal and regulatory requirements, audit derives its value – perhaps even its legitimacy – from the quality of its processes, from the probing, independent and skeptical approach which auditors should take, and from the trustworthiness of its outcomes. The economic turmoil of the past half decade has led to serious questions over how those processes and outcomes could be improved.
In the following conversation, senior KPMG partners from countries with different experiences of the crisis give their frank and direct personal take on audit’s performance. But this piece isn’t just about looking backwards – the focus is really about seeing how audit can and should evolve to make it a higher value proposition for all involved. The partners have put forward some intriguing ideas for changes which they see as driving quality higher and their personal opinions on improvements, which can increase the relevance of the audit report and hence its value to the company, to its shareholders and to the wider communities in which the companies operate.
Can audit quality coexist with increased fee pressure? How can auditors engage better with users of financial statements? How can auditors ensure their unique insights can be best used to drive value within their clients? You may be surprised at some of the partners’ answers to these questions and at their visions for the evolution of audit – I certainly was. And yet while different individual threads and focuses run through their answers, one unifying theme abides: delivering what markets want.
Q. It’s being said that the quality of the audit process has not changed recently, despite the fallout from the financial crisis. What are your views on this?
Jim Liddy (JL): Over the last decade, I think our focus on audit quality – our emphasis on objectivity, independence and professional skepticism – has improved significantly. However, the financial crisis did teach us that a quality financial statement audit cannot be expected to address a flawed business model or less-than- robust risk management processes. For example, many companies had a “velocity business model,” with their business model and compensation schemes grounded in originating or acquiring assets, restructuring them for distribution, often in complex structures and derivatives, and getting them off the balance sheet as quickly as possible while retaining nominal amounts of residual risks.
While financial markets were receptive to these structuring and distribution activities, everything was fine. But the moment the market lost confidence, access to capital disappeared and it all came crashing down. Before the crisis, people generally assumed resilience of funding sources. Now people understand that this is not always the case and not all assets or structures are created equal.
Rod Devlin (RD): I think the quality of auditing has significantly improved over the last decade. Post-Enron we went through major regulatory upheaval and revision, and that contributed to an increase in the rigor of audits. There have been concerted efforts in revising standards, looking at the extent of work that auditors need to perform over risk assessment, the forward-looking information that underpins the preparation of financial statements and the judgments that underpin critical assertions in financial statements.
Ingmar Rega (IR): We are adopting a more stringent audit approach as we are moving towards a more standardized approach in which some things are being done automatically using data analytics, and others are being done by professionals or semiprofessionals in remote destinations. Many tasks are being done differently because we have found that certain audit procedures reveal no audit findings while others reveal much more. This change and investment is improving audit quality significantly.
Duncan McLennan (DM): There is a renewed focus on areas of judgment, which is where we are likely to see the biggest problems. Since the financial crisis, more senior and experienced personnel time is being spent on the audit, with more probing questions and discussions with companies around key assumptions and about where the business is going. Our training is better focused on how professional skepticism is demonstrated in the questions auditors ask and in the thinking they apply to a problem.
Benny Liu (BL): We are far more focused on risk now, and on the need for greater skepticism, especially when dealing with relatively unknown entities. We stress that our people need to consider the behavior of their clients – their motivation and business drivers. We cannot just listen to what clients tell us. We need to be robust about obtaining independent evidence.
Hideki Amano (HA): The financial crisis had less impact on Japanese financial institutions than on their European or American counterparts. But audit scandals had a very big impact on the audit practices of all Japanese audit firms. Our regulators have developed a new auditing standard requiring serious skepticism and more audit procedures focusing more on the possibilities of detecting fraud or mistakes in the preparation of the financial statements.
Q. How can you quantify the commercial value of the audit – both to the company being audited and to the wider capital market?
RD: The bigger picture view of assigning a value to the audit is lowering the cost of capital. This cost is higher for entities that are not audited. There’s also the public interest angle, although it’s more difficult to place a precise value on that. If audits were not useful in reducing the cost of capital, and if there were no public interest value in doing them, they would have been abolished a long time ago.
DM: What would happen if there were not an audit? The audit plays an important part in giving people comfort and there is massive commercial value in that. If companies didn’t have somebody independent saying this company’s historical financial condition is what it says it is, then the level of trust around the business community would be much lower than it is.
HA: A clean audit opinion means the company should have at least fair or reasonable standards of corporate governance, management control and internal controls. If a company cannot be audited, or receive a clean opinion, this will have an effect on stakeholder’s perception of that company. From that point of view, I would estimate that a company with a clean audit opinion should be valued significantly more than one without.
JL: A company’s view is generally that if it’s audited by a Big 4 firm it’s going to get a quality audit, and there is value in that from investors’ and other stakeholders’ perspective. Having said that, we also add value by delivering insight and perspective across a wide array of financial, regulatory, operational and technology topics.
I’d like to get to the point where we have a continuous audit process and provide assurance on information on a contemporaneous or real-time basis. Say a company issues a press release or a financial data supplement containing information outside of normal financial statement information but entirely related to the financial performance of its products, business functions or geographical locations, should you attach an audit opinion to that? I think you can and should.
Q. How can audit quality be ensured in an environment where delivery costs are rising but prices falling?
IR: We tend to see a conflict between quality and cost. The reverse is true and this is something that can’t be overemphasized. In many cases where we have standardized, modularized and offshored procedures we are obtaining a much higher quality. Using these processes, we are on track to manage our costs effectively in Germany. If you go further down the road, to data analytics and looking at patterns from big data, I can see a quantum leap in terms of cost and what we provide, through benchmarking and much deeper insights into how a company functions. That will not only save costs but provide more value and increase the relevance of the audit.
DM: A quality process is one that can focus on the right things and which can be repeated. If you go from country to country and partner to partner, there are differences in how audits are executed. There is real scope for doing audits better by getting increased consistency around the thinking and judgments in how you do the audit. This should get rid of inefficiencies, cut costs and improve quality.
RD: I believe that audit quality is fully compatible with efficiency. It’s incumbent on the profession to drive efficiency throughout the process. Over the last decade developments in technology have reduced the costs of delivery at no detriment to quality. That is reflected in the fee structure. Some efficiency gains can be reinvested and distributed. But ultimately these gains find their way through into the marketplace and into firms’ fees.
JL: Our statutory mandate as auditors is grounded in having confidence in the quality of what we do. Declining profit margins cannot come at the sake of the quality of the product. That puts the onus on us to better demonstrate the value of the audit and to argue for and obtain a fair fee for the quality work we do. On the operational side, we need to explore and capitalize on opportunities to improve audit quality and drive efficiencies in how we execute an audit.
BL: The outside world sees China growing and many companies coming out and so they assume professional service firms must be earning a lot of money. But we have a problem here: professional auditors and accountants don’t get the same respect as in more developed countries. Chinese companies still need to understand the value audit firms can provide, and that quality service comes at a cost.
Q. What would auditors do differently if unconstrained by regulation and able to deliver solely what the capital markets want?
JL: Currently an audit opinion is given on past financial information. I’d like to get to the point where we have a continuous audit process and provide assurance on information on a contemporaneous or real-time basis. Say a company issues a press release or a financial data supplement containing information outside of normal financial statement information but entirely related to the financial performance of its products, business functions or geographical locations, should you attach an audit opinion to that? I think you can and should. Isn’t that the type of real-time information that investors want? I also think there is an opportunity to expand the nature and use of the audit and assurance product. For example, in industries like health care or financial services, there are new and evolving financial, demographic or salient business disclosures that the external auditor can and should be associated with.
HA: During our audit we recognize several risk areas and we focus on these in our procedures. I think the stock market would appreciate it if we were to prepare a longer report in which we explain risk areas which came to our attention during the audit. This is not yet being discussed in Japan but I think that if different reporting around the audit which is being discussed elsewhere, such as in the US or in Europe, is brought in, then our regulators will consider implementing it.
IR: Currently we say yes or no in our audit opinion. We could express our opinion on many more things if the liability regime and regulation were different. It would be good for the capital market to have an additional statement on the robustness of the model and the risks and opportunities associated with the business model. Maybe, like a rating agency, we could give a grading on the company itself. These things would help audit become more relevant again and enable audit to be the institution that people trust, because of auditors’ independence and professionalism.
BL: Auditors need to understand a company’s management, controls and business strategy. But under existing standards we don’t need to mention these in our audit report or in any of our deliverables to the company. I think some think some kind of assurance or more detailed report on these would be helpful to the market.
DM: In my experience, capital markets are more interested in cash flows than anything else. They are also more interested in the forward-looking than in the backward-looking figures, so assurance work over projections might be appropriate. Can we verify the information the company is putting into the market about its prospects? I’m not sure our current regulatory structures make it easy to do that without creating another set of legal issues for everybody. But we should beware: it’s dangerous for anyone to assume that the auditors should be reporting on how well the company is being run. That’s asking too much.
RD: People point to regulation and say because of the standards we can’t do things differently. I think that’s wrong. There’s nothing in regulation which precludes innovation around the audit process and audit delivery. There’s nothing in regulation which constrains you from providing insights and added value to shareholders through audit committees. The insight one gains from performing audits really does need to be shared with audit committees and through expanded reporting to audit committees – that’s where companies get real value from the audit.
Q. Of all the parties that have an interest in an audit, which do you think feels most short-changed by the value it provides, and why? Are their concerns justified, and how can they be addressed?
DM: I think institutional investors understand that the world would be a very different place without an audit. They understand that if things go wrong it is not the auditor making decisions around business activities. Retail shareholders don’t understand that. They don’t read audit reports or understand what an audit is. The question with retail shareholders is: do they actually care? I don’t think they do until something goes wrong. If they don’t care, then it’s hard to improve engagement with them.
RD: Shareholder relations could improve by strengthening audit committees and by ensuring a healthy dialogue between the audit committee and investor groups, and between the audit committee and the auditor. Audit committees often don’t play the role they should: understanding what their investor groups want and then challenging the auditor and providing investors with that information. The profession is relatively unconstrained in providing expanded audit reporting to audit committees around risks and controls based on the work they have done in the audit. If the audit committees play their role properly then we should have happier shareholders.
IR: Because of confidentiality rules, we cannot provide wider stakeholders with information other than the audit opinion, so they may feel short-changed. The IAASB is currently discussing whether we could say more in our opinion. This is not easy. If we were to include more judgmental matters in the audit opinion, there would be a natural conflict with clients who might not want us to express certain things. Will we then be better off or will our statements be watered down to nothing? This will depend on how strong the profession is, and how tough the regulators are on us and on the companies as well. But we are in the sensitive position here and it’s not a good place to be!
JL: The biggest issue we face is a lack of understanding of what we do as auditors and how to interpret our audit opinion. Far too many people look on the audit as an insurance policy – a “guarantee” against all things of a financial, risk, management or regulatory nature that may befall a company. We have an opportunity to better communicate what exactly we do in an audit and what our opinion really means. There may be an opportunity to describe more prominently matters that warranted a substantial amount of audit attention, including significant estimates and judgments made in the preparation of financial statements that are subject to interpretation and the work we performed in relation to them.
In the current model we do report on these items to the audit committee and management, but there may be an opportunity to better communicate those matters to external stakeholders. The regulators in the US are looking at this topic and I am interested to see how this debate will take shape.
BL: One of the reasons we are talking about this is because of the financial crisis when people started pointing the finger at auditors wondering why they did not give a warning that some of the banks were facing problems. This all stems from the fact that many people don’t understand our responsibility and our role. This is what needs to change.
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