Audit reporting : time to take control

Wednesday, 12th September 2018 10:03 - by Eric Chalker

Two months ago, I wrote here that “current audit practice is valueless” (27th Jul 2018).   This is the lesson of Carillion, which should never be forgotten.  KPMG certified as “true and fair” its last published accounts, showing shareholder value (total equity) at £730m, but just over four months later the company wrote off £845m of its certified but intangible assets.  Since then, Carillion has been called the canary in the coal mine, so beware.

In the earlier blog, I reported the language used by KPMG when vetting the values placed by Premier Foods’ directors on its intangible assets: it called them “acceptable”, the meaning of which I challenged at the AGM.  Since then, I’ve looked at other audit certificates, including two issued by KPMG neither of which uses the term acceptable for the intangible assets.  In Vodafone’s accounts, whose intangible assets while big are less significant to the balance sheet, different terms are used to describe their values: “within a reasonable (but unstated) range” and “supportable in the context of the Company financial statements as a whole”.  In NAHL Group, a small company, the intangibles like Carillion’s exceed its total equity, so their value really matters, but KPMG offers no specific opinion, merely describing its review procedure. 

Investors do not want formulaic audit certificates and what we get now is a vast improvement on the old, single page, all-is-well certificates.  But these differences raise questions, which ought to be asked, as do other elements of an audit report.  This is particularly so where audit certificates tell us that values depend on ‘judgement’ (sometimes ‘significant judgement’) and any element of ‘uncertainty’ is involved.  Such questionable values are not limited to intangible assets, but when these depend on fashion, or market position, or reputation (eg brands and goodwill), they cannot be confidently judged at a single moment in time.

A pressing need for reform

Since I last wrote on this subject, there has been quite a storm of newspaper articles and readers’ letters offering analysis of the problem and proposals for reform.  These include breaking up the big four accountancy firms, limiting the other services they can provide and reforming accounting standards.  Something of this nature may indeed help to get more reliable audits, but I think they all miss one crucial point: the fundamental reason why investors are ill-served by auditors is that the relationship is wrong.  The auditing profession is tied to its source of income – a company’s directors – instead of truly serving those it is meant to serve – the shareholders.

Nominally, shareholders appoint the auditors and auditors proclaim that it is only to the shareholders that their reports are addressed.  In reality, shareholders are expected to be a rubber stamp for an auditor’s appointment and auditors effectively rubber-stamp the accounts produced by directors (after duly challenging them, of course).  Earlier this year I came across two shocking illustrations of this.  One is i3Energy, which without any explanation asked its shareholders to sack Deloitte and appoint PKF Littlejohn instead.  The other is Idox, whose auditor resigned, to be replaced, ironically, by Deloitte.

In the case of i3Energy, it has to be assumed that Deloitte wouldn’t comply with the directors’ wishes; rather than allow Deloitte to report its opinion to the owners of the business, the shareholders, the directors looked for an auditor that would produce an acceptable opinion.  In the case of Idox, the original auditor, Grant Thornton UK, actually resigned, which meant it had to issue a letter of explanation.  In that letter, available in the RNS, it stated, “We resigned following challenges during the conduct of our statutory audit of the financial statements for the year ended 31 October 2017 which strained our working relationship with the Board.”  Full marks to Grant Thornton for not caving in to the directors, but it left the owners of the company not knowing what it was that prompted the challenges, or whether the issues raised should have been differently resolved.

The primary purpose of audit is protection of the owners, but as long as auditors remain beholden to management this is negated.  To overcome this, there must be changes. 

What needs to be done

• Auditors must be obliged to accept that they work for the owners of the business, not its managers with whom owners will always have potential conflicts of interest; auditors must accept that they should not be afraid of adversely affecting the share price by qualifying directors’ financial statements, but should recognise that failing to qualify accounts which deserve to be qualified is far worse.
• Currently, the auditor’s report is found within the company’s full annual report, usually just before the financial statements and after multiple pages of company information and narrative produced by the directors; this gives it the appearance of an afterthought, an optional item to read if there’s time and energy left, which is not at all how it should be.
• The auditor’s report should be published separately, to be read before reading what the directors have produced, to advise the shareholders how much confidence to place in what the directors say. 
• The auditor’s report should be the first item on an AGM agenda, to be taken separately, with the signing accountant standing before the shareholders to answer questions before the audit report itself is put to the meeting for adoption.
• Rather than simply require an auditor to publish a letter explaining why it is resigning, such an occasion should oblige the directors to call a general meeting at which the auditor can be questioned by the shareholders.
• The practice of allowing directors to set auditor remuneration must be stopped, because it embeds the wrong relationship: appointments and reappointments of auditors must be accompanied by shareholder approval of the terms of payment.
• Whenever a new auditor has to be appointed, shareholders with the largest holdings should be called upon, by the company secretary, to make a recommendation to the members as a whole, if necessary at a general meeting called for this purpose.

These are radical proposals, but it is clear to me that nothing less than this is likely to prevent continued audit failures from whatever cause.  

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016