Search to quantify quality

The Financial Reporting Council (FRC) is on a mission to discover whether the quality of audits is being maintained and improved within the existing legal and regulatory framework. And if audit quality is slipping, it wants to know what should be done about it.

In a discussion paper, Promoting Audit Quality , the FRC has identified the drivers it feels are central to the maintenance and enhancement of audit quality, and examined whether those drivers are under threat.

The FRC has an objective of promoting and maintaining confidence in the audit process and the resulting audit report. It sees this as a key component of the corporate reporting and governance regimes and as a way of promoting an effective capital market.

It defines the achievement of audit quality by stating that users of financial reports must be able to rely on an audit report to give “a robust and objective opinion” and that the financial statements should give:
• A true and fair view; and
• Have been prepared in accordance with the applicable accounting framework and the relevant legal requirements.

Lacking confidence
While there have been a number of significant developments in the audit process over the past few years, mostly as a result of the Enron scandal, there are still issues that impact confidence in the audit process. These issues include:
• Complexity of financial reporting, which is increasingly reliant on estimates and valuations;
• The possibility that audits will not detect management fraud;
• The relationship between executive management and auditors;
• A lack of transparency of the work of auditors and the judgements they make; and
• The effect of an increasingly prescriptive approach to audit.

Agreed definition
An unanswered question remains over how to determine audit quality. The problem for both auditors and for those interested in the audit product is that there is no single agreed definition of audit quality that can be used as a standard against which actual performance can be assessed. An auditor’s opinion as to whether the financial statements are true and fair is subjective. Different views may be held as to the extent and nature of audit evidence required to support the opinion.

Despite all the changes in company law, corporate governance, the regulation of audit firms and auditing standards, there is limited transparency of the work that audit firms actually do on individual audits and that makes an assessment of audit quality difficult. The audit report – which although extended in recent years – is essentially boiler plate and does not provide users with enough information to assess the underlying quality of the audit.

While audit committees have taken a greater role in corporate governance over recent years, users continue to play a limited to non-existent role in appointing and instructing the auditor.

However, despite the difficulties, the FRC has defined four main drivers of audit quality:
• The culture within the firm;
• The skills and personal qualities of the audit partners and staff;
• The quality of the audit process; and
• The reliability and usefulness of audit reporting.

A number of attempts have been made at defining audit quality. The ICAEW’s audit faculty said in its publication, Audit Quality: “At its heart [audit quality] is about delivering an appropriate professional opinion supported by the necessary evidence and objective judgements.”

The Audit Quality Inspections report from the Audit Inspection Unit adds: “A quality audit involves appropriate and complete reporting by the auditors, which enables the Audit Committee and Board properly to discharge their responsibilities.”

The FRC says that based on the AIU’s inspection it believes firms do attach considerable importance to quality orientated cultures and do invest in promoting audit quality.” But there are threats to that culture. The FRC says that economic pressures change and that a firm’s culture is threatened by:
• The leaders of the audit function having too little input into the firm’s management decisions;
• Too much emphasis on winning and keeping audits;
• Too much emphasis on non-audit services and related under-investments in audit;
• Excessive cost cutting – such as reducing partners and staff – in downturns; and
• Internal training that focuses on client service at the expense of investment in technical competence.

Threats to skills and personal qualities include lack of effective mentoring, failure to retain staff with the necessary experience and expertise, allocating capable staff to prestige clients rather than on the basis of audit risk and insufficient or ineffective training.

An effective audit process is threatened by increased use of computerised audit methodologies that may distance auditors from the company and switch focus to coping with technology rather than evidence gathering.

The FRC also says that over-prescriptive standards and regulations can inhibit judgement and stop audit procedures being tailored to specific circumstances. There is also the danger of client capture where the auditor is too close to the client.

In terms of the reliability and usefulness of audit reporting, some have questioned whether auditors are properly fulfilling their legal responsibilities to consider the adequacy of companies’ accounting records and whether auditors’ reports should be more informative about key audit issues.

Audit quality is not all down to auditors – management, audit committees, shareholders, litigation, regulators and the accelerating reporting regime all play their part. Auditors are likely to tell the FRC that all is well. What FDs and others will say is much harder to predict.