Covid-19 has applied the ultimate stress test to companies whose sales have been slashed by lockdowns and other restrictions. Some, such as the retailer Arcadia, have already failed; others are hanging on thanks to lenders’ forbearance, government-backed loans and payment holidays.
This makes the current audit season for companies with 31 December year-ends hyper-sensitive. Financially stretched businesses are more likely to have ‘material uncertainties’ over their going concern status and managements under pressure are more likely to bend accounting rules.
David Rule, executive director of supervision at the UK’s Financial Reporting Council (FRC), wrote to heads of audit in December to remind them that ‘robust, focused and independent challenge is vital to a high-quality audit’. Ineffective challenge had been a ‘key driver’ of 80% of the audits deemed to require improvements in the past two years.
Things go wrong when auditors seek corroborative, rather than contradictory, evidence and rely too much on management information – witness the missing €1.9bn at Wirecard, the German payments company. Things go right when auditors conduct a strong risk assessment and factor in management bias, according to Rule’s summary.
Perfect excuse
It is helpful that Covid-19 provides the perfect excuse for managements to lay bare their companies’ troubles while blaming an external event. The auditor’s job is to ensure that this is done rigorously and in sufficient detail, particularly where forecasts are concerned.
Auditor’s reports to shareholders already draw attention to caveats by directors on going concern, principal risks and viability, and to crucial points in the notes. I would like to see more direct flagging of issues via ’emphases of matter’.
The difficulty lies in distinguishing between a dire set of results set out honestly and mis-statements due to error or fraud.
Things go wrong when auditors seek corroborative, rather than contradictory, evidence and rely too much on management information – witness the missing €1.9bn at Wirecard
They are linked when an auditor spots a problem, reports it to the audit committee and together they prompt management to rectify it. This process needs to be more visible in both the auditor’s and the audit committee’s reports.
Ring-fenced future
What does this mean for audit firms preparing for life as ring-fenced units within the Big Four groups?
First, no more scandals. Weak companies will fail but if there is no surprise, the risk of finger-pointing at the auditor is minimised.
Second, the ring-fence provides an opportunity to make a decisive shift in culture towards independence and scepticism. This will make the profession more attractive to public spirited and investigative young people.
Third, the firms should produce timely and meaningful annual reports. Less brochure-speak and more rigorous reporting of their own performance would be a welcome sign of change.
All this will be going on as proposals for audit reform from the Department for Business, Energy and Industrial Strategy are debated, including the FRC’s transformation into the Audit, Reporting and Governance Authority. Sentiment could be muddied by news on investigations such as Carillion in the UK and Wirecard in Germany.
Some in the audit profession might wish it could inoculate itself against such challenges after a difficult few years. This is impossible, so better to embrace change – and turn the word challenge into action.
Further information
Read the account of Kip Singh FCCA, one of the investigators in the Wirecard case
Watch the video of Jane Fuller interviewing Pauline Wallace, head of the new UK Accounting Standards Endorsement Board
