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Expectation Gap between Financial Statement Audit and Investor Perception Must Be Closed Says UK Audit Oversight Chief

By Jim Hamilton

The gap between what an independent audit of financial statements does and what investors expect it to do must be closed, in the view of Stephen Haddrill, Chief Executive of the UK Financial Reporting Council. The gap between what audit does and what users expect from an audit of the financial statements has been growing for the last 20 to 30 years, he noted, and now is the time for fresh thinking to address the expectation gap and to bring the value of audit closer to investor needs in the modern economy. Traditional historic accounting information is inadequate when investors want assurances that complex financial instruments on corporate balance sheets have been fairly assessed. More broadly, the FRC head emphasized that the fundamental flaw in the current financial reporting and auditing system, a flaw that must be ameliorated and otherwise dealt with on all levels, is that outside auditors are appointed by those they are appointed to scrutinize rather than those they are meant to serve.

In remarks at the European Commission Conference on Financial Reporting and Audit, he noted that the audit of the financial statement must give investors more information about the prospects of the company and a better picture of the future of the business and of the judgments made in the course of the preparation of the financial statements. Investors must also be given more insight into whether the preparation of these statements was contentious and subject to debate within the company or with the outside auditors.

The FRC is currently proposing a revised financial statement that provides a fuller narrative report by the company and says more about its prospects and risks, including a report by the audit committee explaining why the committee is satisfied that the annual report, read as a whole, is fair and balanced. Separately, the outside auditors would produce a report identifying any significant matters in the annual report that have been discussed with them and which they believe deserve special attention by the shareholders and a clear statement by the auditors on whether they agree with the audit committee?s report.

These requirements, explained the FRC head, are designed to allow investors to learn about the business and its future from the directors and at the same time empower the auditors to challenge management by requiring them to say whether the board has really given a balanced and fair view on these matters as well as on the accounts. He called on audit firms to be skeptical of management assertions made without apparent good foundation. The FRC chief executive cautioned companies to stop producing boilerplate text prepared by their lawyers to minimize their liabilities.

He called on investors to exert their authority on the relationship between the company and the auditor and on regulators to empower them do so. While shareholders do vote on auditor appointments, he noted, they almost always vote without questioning the quality of work being done or promised by the auditor. He urged the Commission to forge a better balanced triangle between companies, auditors and investor in a partnership in which each plays their full role.

Investor involvement in the financial audit process could be enhanced through their closer scrutiny of the appointment of audit committee members or through more direct involvement of the largest investors in the auditor appointment.

With regard to audit concentration and the Big Four, he said that the first principle is that audit quality must never be put at risk in the quest for increased competition. Compulsory joint audits would increase cost and could damage quality by creating confusion about who is responsible for what. It would also do nothing for competition if both of the auditors were Big Four firms. Mandatory rotation of audit firms could also play into the hands of the big firms if companies drop smaller partnerships when they retender.

He urged the Commission to consider proposals that the FRC feels could increase auditor choice. For example, financial institutions should be encouraged to use non-Big Four firms as a source of advice to their risk committees, which would beneficially expose them to large companies they might not otherwise have access to and may in time provide them with an opportunity to tender for
the audits of some of these companies. Also, current regulations on audit firm ownership could be amended to allow them to access external capital to fund expansion. Also, the FRC supports prohibiting the use of ?Big Four only? clauses in banking and loan covenants

Full post as published by Jim Hamilton's World of Securities Regulation on February 12, 2011 (boomark / email).