The value of audit, or: meteor!!

Here’s a recent story from the UK Independent news site:

  • One month after the final departure of Thomas Cook flights, the auditors who signed off the travel firm’s accounts have admitted that £1.1bn “goodwill” was overstated.
  • PwC, which audited Thomas Cook’s accounts from 2007 to 2016, and EY, which took over the role until the firm collapsed in September 2019, were summoned by the Business Select Committee.
  • The chair, Rachel Reeves, challenged them on the value of the goodwill kept on the balance sheet for 11 years after Thomas Cook’s merger with MyTravel in 2007. It was finally written off in 2018.
  • She said: “It seems unlikely to me that goodwill could be worth £1.1bn less than it was previously.”
  • Paul Cragg, audit partner for PwC, said: “The answer has to be yes with hindsight.”
  • Ms Reeves also criticized the auditors for the way that “exceptional items” had been audited, in a manner that, she said, flattered Thomas Cook’s performance. In total, £1.8bn was stripped out over eight years.

I can’t imagine what the average non-technical reader must think of such stories. As we know, it’s easy to apply hindsight and to make IFRS-compliant financial statements (which, of course, include the explanatory information in the notes) seem senseless. Still, the UK does seem to have had its share of confidence-eroding failures lately. A recent release from the Financial Reporting Council noted that “Over the past two inspection cycles, the FRC’s Audit Quality Review team has referred 17 audits for potential Enforcement action and investigations have been opened in ten of those cases.” The release commented in particular that “auditors continue to struggle most with challenging management sufficiently, especially in more judgemental areas, such as long-term contracts, goodwill impairment or the valuation of financial instruments.”

Or put another way, you might think, they struggle most in exactly the areas where an experienced, independent-minded perspective on management’s determination would appear to be most necessary, and would most justify the startling value transfer they represent to the big audit firms. We’ve considered the value of the audit before, noting the odd lack of consensus regarding the most basic articulation of the value proposition. Sometimes though, it seems that auditors are at their happiest when feigning concern over the “existential problem” of the “expectation gap,” all the better to distract from the profession’s ever-escalating lucrativeness.

A recent speech by PCAOB board member J. Robert Brown, talking in a US context, expresses this possible existential problem in wondrously colourful terms:

  • …let’s begin by talking about a development that occurred a long, long time ago, in fact sixty-six million years ago, give or take an epoch.
  • That was the moment when a meteor struck the earth somewhere near, what is today, the Yucatan Peninsula, altering the climate and effectively wiping out the dinosaurs. The meteor presumably traveled over an observable path with predictable results. Scientists have labeled this the cretaceous-paleogene extinction event.
  • I’m not here today to talk about dinosaurs, but I do want to talk about extinction events. There is a metaphoric meteor heading in our direction and it is aimed squarely at the audit and the role of the auditor. It is observable and predictable.
  • …The onrushing extinction event is irrelevance and, like the climate changing meteor, the development is observable and predictable.
  • Investors and other consumers of the financial statements are increasingly relying on information not subject to the audit. The effect is the reduction of the significance of the audit and the role played by auditors.

It seems to me though that his main proposed solution to the threat falls somewhat short of this apocalyptic picture. He advocates a conversation about whether:

  • …the role of auditors in connection with Non-GAAP, KPIs, XBRL or sustainability metrics, should go beyond what is currently required under a standard that was issued before the proliferation of many of these measures. And in reviewing the information, the conversation would presumably want to include whether the (current standard that firms should “read and consider” the contents of the annual report for material inconsistencies with the financial statements) provides a sufficient level of auditor involvement.

Certainly, that’s a good idea, somewhat undermined by his comment that “a decision to hold a conversation does not presuppose an outcome. Perhaps after fully vetting the various issues, the “Other Information” standard will remain largely as it is.” But you could also see it more cynically, as positing that the way to solve the audit profession’s woes (such as they are) is to pay them more money (presumably quite a lot more money) for some add-ons. No doubt it may seem crass to raise compensation in such a context, but the profession’s recurring portrait of itself as a humbly besieged servant of transparency is one of its more tedious contrivances. An honest conversation would focus as much on the necessity for and virtue of the current billings as on the arguments for additional ones…

The opinions expressed are solely those of the author

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