As the severity of the global financial crisis was exposed to the world, questions shifted from the troubled institutions themselves to the auditors that provided assurance over their financial statements. As auditors, we have been repeatedly asked: Why wasn’t any warning given? How could this happen? And headlines such as “Why Didn’t the Watchdog Bark?” started to appear. The events that shook the world in 2007 and 2008 created the largest economic crisis since the Great Depression and will be forever known as the “global financial crisis”; even warranting the creation of a now well-known acronym – the “GFC”.
As someone that has been proud to be an auditor in a Big Four firm for more than 30 years, these criticisms stung. The reaction of the profession to such questions was familiar and completely accurate. Our role is to provide an opinion on a set of historical financial statements that report on past events – which is true. Auditors do not predict future events – again correct. The GFC brought to light many weaknesses and practices. And one thing that was certainly brought to light is the fact that the role of the auditor was largely misunderstood.
Frankly, this is not new. Over the years, the disconnect between what an auditors’ responsibilities are in expressing an opinion on a set of historical financial statements and the perception in the minds of many people of what we are or should be doing, has been termed “the expectation gap.” The expectation gap has been debated since I entered public accounting three decades ago. The difference here is that the scope and the depth of the global financial crisis shook the world to its core and very nearly resulted in an economic catastrophe. The scars of the crisis are still fresh and will be felt for many years. Interestingly enough, there were relatively few (if any) financial statements of major financial institutions that had to be subsequently restated from the events of the global financial crisis, which appears to offer prima facie evidence that it was not a failure of adherence to Generally Accepted Accounting Principles (GAAP) that caused the economic events.
But we hear the criticisms of the profession loud and clear. Gradual changes to address the historical expectation gap will no longer be sufficient. We must drive more significant changes. The audit profession must take seriously important questions about how our role could and should change, not only to benefit investors and other stakeholders, but society at large.
The lessons of the global financial crisis have shown us that to meet the expectations of investors and other stakeholders, we must make broad changes to what we audit, not necessarily how we audit. It was Winston Churchill that famously remarked, “Never let a good crisis go to waste.” The most important question we need to ask now is:
What needs to change to ensure the lessons of the global financial crisis are not lost?
Part of the frustration for investors is that they were probably looking for assurances on items beyond the historical financial statements that were being used to assess value. For too long, the audit profession has been focused on compliance with complex accounting standards in those financial statements, which is necessary, but no longer provides the same value to where investors are looking.
The historical financial statements still remain the bedrock used by stakeholders to form their own decisions about a company’s future performance. But more and more, stakeholders are making decisions on drivers of value that increasingly lie outside of those financial statements, many of which are non-financial in nature. For example, quantitative metrics such as backlog, pipeline and the like are driving assessments of value.
Investor demand for broader information has prompted companies to place greater emphasis on non-financial measures in communicating a company’s health. More and more, companies are disclosing non-GAAP measures of financial performance that may, or may not be, derived from the historical financial statements, but that are disclosed in other parts of the annual reports. However, auditors still do not assess the processes or controls over these processes that produce those critical non-financial measures that investors are using. Our current audit report is based on a set of historical accounts that will continue to provide value to investors since it is the bedrock from which many judgments are made, but it is also clear that it is no longer enough.
Auditors are in a unique position to provide broader assurance to investors, stakeholders and the organizations we audit on both elements of the process for non-financial measures used by stakeholders, as well as adjusted, or non-GAAP measures of financial performance disclosed by companies and craved by investors. There can be wide disparity in how non-GAAP measures are presented from company to company. And non-financial measures are many times created by processes and systems that are not tested as part of the auditors’ work on the financial statements, yet those same measures are used by investors to a very large extent. Our unique position as auditors gives us access and knowledge of so many parts of a company. This access enables us to look at a broader scope of information, rather than information that reflects a snap shot of historical data.
The first step in evolving our role, however, is to provide stakeholders with increased clarity regarding the scope of the financial statement audit, and the value it provides, as well as what it cannot provide. Far too many people perceive the audit as an insurance policy against company pitfalls, which is not possible. Changing the auditor’s reporting model to enhance the level of disclosure about salient and important matters is critical.
Last summer, the International Auditing and Assurance Standards Board (IAASB) released an exposure draft containing proposals that would require an auditor to include in the auditor’s report a description of matters that they consider to be of most significance in the audit. As a result, communication between those charged with governance, a company’s shareholders and the auditor would be enhanced. We are very supportive of this recommendation and believe it’s an important step in improving investors’ confidence in the audit. In order to stay relevant as a profession and meet the needs of investors, I believe we must offer more than just a “yes” or “no” opinion on historical financial data.
Offering a holistic risk perspective—assessing the non-financial information of a company and the non-GAAP measures it discloses, can also do this. While maintaining our independence, we can also improve stakeholder relations by fostering a healthier dialogue between the audit committee, investor groups, and the auditor.The proposals, if implemented, will represent a significant change to the information provided in today’s auditor’s report and are an important first step towards meeting the needs of users who want more insights from auditors than what is provided under today’s pass or fail model.
Financial statements are like looking in the rear view mirror of a car. It can be interesting to learn about a place you’re never going to see again. But it doesn’t always tell you where you’re going. Recognizing this, the real goal is to learn about the information that matters most to stakeholders, and for us to evaluate how we can provide assurance that will truly provide value to society.
Whether this means providing assurance to other statements and metrics that companies publish, or other drivers of value, identifying new ways to add value to help meet the expectations of investors and other stakeholders should be our objective. The biggest driving force in realizing these changes is not the auditors themselves, but the investor community.
As dust settles and the global economy stabilizes, it’s important that the lessons of the financial crisis don’t go to waste. The time to engage in debate and discussion around the value of audit – its current state and its future – is now. Together—auditors, investors, company stakeholders and the companies themselves—must all engage in this discussion.