I am sharing this note in the hope of attracting comment on it.
Although the readers of this blog, seemingly like the world at large, do not get overly excited by accounting issues they really do matter. The smooth operation of markets, the functioning of the mixed economy and the management of the macroeconomy of the country are all dependent upon the availability of reliable accounting data.
The problem with both accounting and audit is that there is good reason to believe that we have not had data of that quality. In fact, we have had nothing like it.
I am at present working on a project that does, at least in part, feed into the government's current consultation on audit reform. As part of that process I have prepared a note, part of which is reproduced below, on the purpose of audit.
My suggestion is that this purpose has historically been misstated. The focus it has had on solely meeting a supposed shareholder need that was only of relevance in a small proportion of companies has led to what has been called an expectation gap. Users have rightly felt that they have not received the assurance that they required from auditors because auditors have defined themselves as not having the responsibility to deliver it.
Now the government has said that audit is of concern in all public interest entities, and suggests defining these to include many organisations that do not have shareholders. At the same time it has suggested that shareholders must remain the focus of audit concern, which makes no sense.
I address these issues in this note, on which comments would be appreciated.
Background to this note
The government has said in its White Paper (WP) on audit reform[1] that “having a clear and unambiguous statement as to the purpose of an audit could help people understand the outcomes that are expected from the audit process”[2].
We think this an appropriate objective. Unfortunately, the White Paper does not offer such a statement. The purpose of this note is to suggest what that unambiguous purpose of audit might be.
Audit in the public interest
Audit is an issue of greatest concern with regard to what the government refers to in its WP as public interest entities (PIEs).
We welcome the suggestion within the WP that these need not just be public companies but that they might also, for example, be large private companies and what the government describes as ‘third sector entities with a public purpose'[3]. Examples of these that it has supplied include universities, charities and housing associations[4].
The implication of this definition of a PIE is twofold. The first is that the focus of accounting cannot solely be on the information that shareholders might require, although the WP states that in its opinion their interests remain of primary concern[5]. Given that there are no shareholders in the examples of third sector entities that the government suggests are PIEs it must follow that the information needs of other user groups for the accounts of PIEs must be of at least as much significance in those cases.
Second, this also means that whilst the WP defines the main shareholder use of corporate reporting is in making informed, long-term investment and engagement decisions[6] it must follow that this cannot be the universal primary purpose of this data since most third sector PIEs do not have shareholders whilst large privately owned companies rarely have shares that may be traded in the way that those of publicly quoted companies can be. This must mean that however important the information supplied to some groups of shareholders to assist with investment decision making might be this purpose cannot be the singular focus of accounting or audit, and a broader definition must be found.
The WP recognises this by accepting the recommendation of the Brydon Review of auditing that suggested that “auditors [should] act in the public interest and have regard to the interests of the users of their report beyond solely those of shareholders”[7].
It is our suggestion that much of the so-called expectation gap with regard to audit[8] arises because of the current lack of awareness that audit has to date been solely focussed on the singular needs of shareholders when considering issues relating to investment decisions when the broader public have expected it to meet the requirements that the wider definition of a PIE might now suggest to be appropriate.
Unfortunately the WP fails to close this expectation gap, as the Brydon Review also failed to do before it. As evidence, despite the comment from Brydon noted above on the public purpose of audit Brydon actually suggested that the purpose of audit should be:
“To help establish and maintain deserved confidence in a company, in its directors and in the information for which they have responsibility to report, including the financial statements.”
This definition, which the WP supports, does not embrace the wider concept of a PIE that the WP uses and as such is not appropriate for use. As a result another definition is required.
A new definition of the purpose of audit
We suggest that an appropriate definition of the purpose of audit that meets the test that the WP lays down noted in the first paragraph of this note is:
The purpose of the audit of a public interest entity (PIE) is to report that the reasonably anticipatable information needs of all the users of the financial statements of that PIE are met by those financial statements on which the auditor is asked to offer opinion and to remedy any defect in such supply if it is found to exist or to report that this has not proved to be possible.
The users of financial statements
The definition of audit that we propose requires that the users of the financial statements of a reporting entity should be defined. We suggest that they shall be considered to be:
- Its shareholders;
- Its other suppliers of capital;
- Its past, present and future employees;
- Its trading partners;
- Its regulators;
- Its tax authority;
- Civil society that is likely to have an interest in its activities including those people living in the communities that it serves; their local, regional and national governments and those who serve in them or seek to do so; researchers, journalists and others who seek to hold the reporting entity to account for its actions and all those impacted by the economic, environmental and social externalities that the PIE creates as a result of its activities.
What the auditor must report on
In our opinion the auditor of a PIE must be required to proactively report on the following issues when submitting their audit report on the financial statements of a PIE:
- Whether the nature, extent, location, scale and identity of the reporting entity is appropriately recorded and reported within the financial statements;
- Whether the entity has maintained books, records and systems of internal control likely to both record and report the substance of all of its transactions and to properly identify the risk of error and fraud arising;
- Any material error or fraud identified within the PIE during the course of the period and the action taken to address the issue arising;
- Whether an appropriate accounting framework has been adopted for the preparation of the financial statements, in the process confirming whether any conflicts exist between the accounting framework used by the reporting entity and those used by its constituent entities; how any such conflicts that might have arisen have been resolved; and whether any necessary departures from the approved accounting framework have been considered or used in the course of ensuring that the financial statements do provide the information that meets the needs of the users of the financial statements, and what the consequences of that departure from that agreed framework might be;
- Whether the additional information not regulated by an agreed accounting framework that must be disclosed to ensure that the reasonably anticipatable information needs of all the users of the financial statements of the PIE is included in the financial statements;
- Whether having considered all these issues they are of the opinion that the reasonably anticipatable information needs of all the users of the financial statements of the PIE are met by its financial statements on which the auditor has been asked to offer opinion and that they do as a result present a true and fair view of its affairs.
[1] https://www.gov.uk/government/publications/restoring-trust-in-audit-and-corporate-governance
[2] Para 6.1.8
[3] Para 1.3.29
[4] ibid
[5] Page 17
[6] Para 7.3.
[7] Para 6.3.3.
[8] Para 6.1.3
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Most of us don’t understand accounting – hence our silence. But, given the explicit request for feedback i would say…..
First, I wholeheartedly endorse your point that accounts and other company data are for a broader audience. If I am about to engage with any company I want to understand who they are (and it is not just accounts). Yes, I DO go to Companies House to see what they have and yes it DOES matter. Eg. I was about to appoint a local moving company for a house move and found that the owners/directors had had a similar firm compulsorily wound up by HMRC.
Second, I think you capture all the points I can think of and more.
BUT>>>>>
“The purpose of the audit of a public interest entity (PIE) is to report that the reasonably anticipatable information needs of all the users of the financial statements of that PIE are met by those financial statements on which the auditor is asked to offer opinion and to remedy any defect in such supply if it is found to exist or to report that this has not proved to be possible.” is, I am afraid, a fairly ugly sentence.
My offer would be……
The purpose of the audit of a public interest entity (PIE) is to report on whether the financial statements (on which the auditor is asked to offer opinion) deliver the information that users of the statements can reasonably expect; to remedy any shortcomings that are found or to report that remedy has not proved possible.
Better drafting
Thanks
I understand what you are trying to achieve with the phrase “reasonably anticipatable information” but I feel that this is too loose a definition as it leaves the user to form their own interpretation of what is reasonable or not. I would prefer to see a much stricter definition of what must be reported.
I would also like to see the incorporation of a description of the whole organisation included in the financial statements, not just the part(s) which are being reported upon. Such that any reader is able to determine the overall structure of the organisation, where the financial flows are and where the responsibilities for each part of the organisation lie.
James
Completely fair point. The paper I quoted from says the following after the bit I quoted, and you may like to comment on these points as well:
The users of financial statements
The definition of audit that we propose requires that the users of the financial statements of a reporting entity should be defined. We suggest that they shall be considered to be:
a. Its shareholders;
b. Its other suppliers of capital;
c. Its past, present and future employees;
d. Its trading partners;
e. Its regulators;
f. Its tax authority;
g. Civil society that is likely to have an interest in its activities including those people living in the communities that it serves; their local, regional and national governments and those who serve in them or seek to do so; researchers, journalists and others who seek to hold the reporting entity to account for its actions and all those impacted by the economic, environmental and social externalities that the PIE creates as a result of its activities.
What the auditor must report on
In our opinion the auditor of a PIE must be required to proactively report on the following issues when submitting their audit report on the financial statements of a PIE:
a. Whether the nature, extent, location, scale and identity of the reporting entity is appropriately recorded and reported within the financial statements;
b. Whether the entity has maintained books, records and systems of internal control likely to both record and report the substance of all of its transactions and to properly identify the risk of error and fraud arising;
c. Any material error or fraud identified within the PIE during the course of the period and the action taken to address the issue arising;
d. Whether an appropriate accounting framework has been adopted for the preparation of the financial statements, in the process confirming whether any conflicts exist between the accounting framework used by the reporting entity and those used by its constituent entities; how any such conflicts that might have arisen have been resolved; and whether any necessary departures from the approved accounting framework have been considered or used in the course of ensuring that the financial statements do provide the information that meets the needs of the users of the financial statements, and what the consequences of that departure from that agreed framework might be;
e. Whether the additional information not regulated by an agreed accounting framework that must be disclosed to ensure that the reasonably anticipatable information needs of all the users of the financial statements of the PIE is included in the financial statements;
f. Whether having considered all these issues they are of the opinion that the reasonably anticipatable information needs of all the users of the financial statements of the PIE are met by its financial statements on which the auditor has been asked to offer opinion and that they do as a result present a true and fair view of its affairs.
The reasonably anticipatable information needs of non-shareholder stakeholders with a public interest in the financial statements of a PIE
Without being specific, because judgement is likely to be required in every case, it is reasonable to assume that in addition to the financial disclosure prepared in accordance with a recognised accounting framework that the audited financial statements of a PIE should also include the following audited information:
a. A detailed disclosure of data on those entities making up the PIE so that its boundaries can be correctly identified. This might include the name of each subsidiary, associated and related entity including information on:
i. Its country of incorporation;
ii. Its registered address;
iii. Its main place of business;
iv. The means by which it is controlled by, associated with or related to the reporting entity, and what proportion of control that provides the reporting entity with;
v. Any ambiguities or uncertainties that exist with regard to that control;
vi. The identity of any other entity that might also consider that it controls the entity in question;
vii. The nature of the entity’s trade;
viii. The turnover or other relevant indication of income (e.g. income from investments and other financial sources received) that provide an indication of the scale of the activity of the entity;
ix. The gross and net asset worth of the entity;
x. The number of employees of the entity;
xi. The country into which its activities are consolidated for country-by-country reporting purposes by the reporting entity;
xii. Its tax residence.
b. Country-by-country reporting data, providing a summary income statement that discloses both third party and intra-group trade, limited balance sheet data and data on current tax both due and paid prepared on a consolidated basis for each jurisdiction in which the PIE operates or has a tax liability arising; and such additional information as may be appropriate in the case of the extractive industries;
c. The impact within the financial statements of provisions for adapting to the demands imposed by climate change and becoming net zero-carbon, together with explanation as to how the company is to achieve this goal, over what time period and at what cost, with information on the sources of the funding required being provided;
d. Employee data by jurisdiction:
i. Number of employees;
ii. Gender mix of employees;
iii. Aggregate pay;
iv. Number of employees by locally appropriate pay bands;
v. Gender pay gap;
vi. Ethnicity of employees;
vii. Ethnicity pay gap;
viii. Cost of benefits in kind provided;
ix. Cost of pension provision;
x. Investment in training;
xi. Staff turnover and average length of employment;
xii. Percentage of workforce subject to trade union negotiated pay settlements;
xiii. Trade unions recognised.
e. Supplier relevant data by jurisdiction:
i. Average creditor settlement period at the year-end date;
ii. Average creditor settlement period during the course of the period;
iii. Value of contested liabilities at the year end date.
Make sure that the audit records accurately the state of the employee’s pension fund and that this is being administered properly, so avoiding the fiascos of companies like Carillion and others that crash although they have had recent audits showing they are solvent but when the administrators go in find that thousands of employees pensions either don’t have the funds to pay in future or are much reduced.
Show accurately the range of pay scales in the company and the ratio between highest and lowest pay.
If the company trades overseas accurately record the proportion of revenue made in other countries.
Make sure any funds held in other jurisdictions are clearly shown and that the correct tax is paid whether the UK or overseas in order to prevent tax haven abuse.
Show accurately any activities that impact negatively on the local environment – pollution etc. that is not costed and show how it should be costed.
See one of my earlier replies that addresses some of these issues, I think
Not a comment on the proposal, which seems eminently sensible to me, but the experience of the Scottish Government with both Deloitte and EY perhaps adds to evidence of how the current rules don’t work.
“The Scottish Government has spent around £200,000 on financial advice from Deloitte over its agreement with Gupta’s Highland company, asking to be notified about “key risks” which could leave it exposed.
It comes amid fears that steel firms owned by Gupta, one of Scotland’s largest private landowners, could be at risk following the collapse of Greensill Capital, its biggest lender.
The contract with Deloitte was signed after the government approved a deal to effectively underwrite Gupta’s hydroelectric plant in Lochaber, having previously hired EY to carry out due diligence.”
https://archive.is/JwxmT
There used to be a concept in accountancy of “prudence” when managing a business and that “prudence” should be reflected in the financial statements. Auditors rarely if ever now consider this factor being more concerned that the financial statements have been prepared in accordance to certain rules that show a statistical proof but without considering the implications. Partly this is because those conducting the audit are inexperienced in both business and life and partly because their major concern is to complete exams that licence their future careers and incomes and then to move on.
Auditors must ensure that appropriate professional skills and experience are deployed into any audit and as part of that audit carry out some form of stress testing in terms of what would happen if an event happened that is not currently anticipated. That could be fraud, pandemics or anything that effects the long term viability of the business. What funding is in place in the event of unforeseen events? Is there a commitment from major shareholders to fund short falls? Will the company’s bankers provide additional lending in this event and if not why not? Banks with their attitude to risk should be able to give an opinion as to whether there is a long term viability in a company and a banks opinion should be part of the Directors Report. Maybe banks under the terms of their licence should also provide an opinion to auditors as to their view of a company’s balance sheet in light of their position as lenders and overseers of the risk in providing loan finance?
Thanks
Much to agree with
Richard,
One issue you do not consider is the matter of limited liability for auditors.
It does not seem fair (as in the wirecard affair) that investors carry all the risk while auditors walk away scot free.
Auditors are increasingly puppets of management and they should be the ones holding management to account. If the auditors carried full liability for errors and misleading statements it might give them more teeth in investigating companies.
This risk could be insured but would require an honest dialogue between the auditor and the insurer.
Plus I think that too much emphasis is given to the statement rather than the audit letter ; which should record a better discussion of the risks, uncertainties and difficulties encountered in an audit.
Auditors do carry full liability and only Andersen has ever gone bust to avoid it
It’s their professional indemnity insurance that carries the risk
Does that mean the insurers will pay up for the loss of value of my wirecard shares?
How do I claim?
No….
They compensate the claim from the liquidator