Auditors have a massive responsibility for the financial crisis

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AccountingWEB has published an article on auditing which is extraordinary for its naivet?©. Written, unsurprisingly by a partner in a firm of chartered accountants who no doubt wants to defend the quality of his product offering it basically says auditors made little contribution to the financial crisis, could not have been expected to have foreseen it and should not now be subject to sanction or reform because of it.

Nonsense I say. Auditors contributed massively to this crisis: indeed the Big 4 should be considered responsible for a significant part of it.

The reason is this. Until IFRS and the rules of the IAASB (International Auditing and Assurance Standards Board) came along auditing was about declaring that accounts showed a true and fair view. Not now they don’t. The IAASB says an audit is:

The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. In the case of most general purpose frameworks, that opinion is on whether the financial statements are presented fairly, in all material respects, or give a true and fair view in accordance with the framework. An audit conducted in accordance with ISAs and relevant ethical requirements enables the auditor to form that opinion.

The wording is not a chance: the emphasis is on compliance with the financial reporting framework first, the consequence of being true and fair is assumed to follow, but is consequential, not the goal.

I do not agree. I might have done under the rules that applied when Statements of Standard Accounting Practice were in operation. SSAP 2 required that accounts complied with four fundamental concepts:

¬? Going concern concept

¬? Accruals or matching concept

¬? Consistency concept

¬? Prudence concept

I accept Lord Hoffman and Mary Ardman could have used this as comfort in 1983 when saying that compliance with SSAPs meant a true and fair view was offered. The reason was simple: the accountant had under SSAP 2 the requirement to use professional judgement. The lower of cost and realisable value applied. Going concern was an issue. Profit could not be anticipated. And so on. Judgement prevailed in other words.

Under IFRS it does not. Profit not only can be, but must be anticipated in mark to market accounting. But, and this is the killer in the tail, losses cannot be. If an asset has a market price that must be used in IFRS even when it is irrational to do so and the price cannot be sustained by any fundamental worth.

Securitisation was used to sell sub-prime mortgages to banks. So long as a securitised debt was given a value by the market the debt had to be valued at that price, even if an auditor (doing what they used to do under SSAPs) might have realised that there was actually no substance to the value e.g. it clearly exceeded the value that could be attributed to a likely income stream when reasonable risk was applied if held to maturity. Form rules under IFRS, substance does not. Market data over-rules judgement.

So, auditors, working under rules they created through the IAASB to apply IFRS, which those same audit firms created, no longer had to anticipate losses. Indeed, whilst they allowed profits to be anticipated under IFRS they banned the anticipation of loss until the market as a whole recognised it.

But, of course, markets are irrational: we should know that (although economists deny it, and accountants don’t seem to know how to challenge them). In that case to require that market value be used unquestioningly in audited accounts as IFRS in combination with IAASB rules does, means bank accounts could always include unsupported credits increasing profit, but never include debits anticipating reasonable losses. Prudence has gone out of the window. Inherent risk has taken its place.

The consequence? Bank accounts that clearly did not show a true and fair view; overstated earnings; a stock price boom of no substance followed by potentially too large a provision for losses as market confidence in securitised debt collapsed giving rise to potential overstatement of losses. Now using exactly the same rules banks are declaring wholly unrealistic and unrealised profit again as the valuation of those debts is re-appraised upward once more demonstrating the complete disconnect between finance markets based on accounts that do not reflect the reality of what is happening and the real world where a very different story is playing out.

These accounting and auditing rules have without doubt significantly contributed to market turmoil, massive injection of tax payer funds into banks redistributing cash from the poorest in society to the most well off, and on, and on, and on.

Please don’t tell me auditors had no responsibility for this. Collectively they (the Big 4) set the accounting rules, collectively they set the auditing rules. Collectively they helped unleash market mayhem.   Collectively they have helped their clients collect the biggest tax payouts in history.

Oh yes they’re to blame. Very much so. And they need to pay the price.