Minority report: Does anyone read audit committee reports?

REPORTING on what’s happening in company audits has probably never been so much the focus of regulatory attention. It’s all with a view to giving investors more confidence in the quality of the annual reports being presented to them by company boards, but views are mixed as to whether they will achieve that end, or even the extent to which investors want this extra information. There is also some discussion as to whether auditors themselves should be required to disclose more or simply give tacit acknowledgement that what an audit committee says is not wrong or misleading.

Potentially one of the more interesting developments in audit reporting – indeed, in financial reporting overall – in recent years seemed to be on the way last summer with the publication of a discussion document by the International Auditing and Assurance Standards Board (IAASB). Its paper, Improving the Auditor’s Report, suggested that there perhaps ought to be an ‘auditor commentary’ to highlight matters that would help investors understand the financial reports better.

It was controversial stuff, moving the independent auditor’s report from being a more or less binary statement (ie. the accounts are ‘true and fair’ or they are not) to one that had some degree of subjectivity in it. The proposals last year contained a mock-up of an auditor report to help stakeholders understand the direction of the IAASB’s thinking. It contained the following example, relating to the goodwill in the accounts of company X:

“Due to the current economic conditions as discussed on page X of Management Commentary, there is significant uncertainty embedded in the future cash flow projections used in the impairment calculation … No impairment was recognised because the recoverable amount of the unit to which the goodwill was allocated marginally exceeded its carrying value at that date.”

This isn’t the sort of language that auditors are used to using – at least not in the full glare of publicity, though they might be expected to be this blunt with the board itself. And it may, after all, not be the sort of language that they will be expected to use in future. There are two reasons for this: firstly, the IAASB’s ideas are said to be developing in the wake of a not entirely enthusiastic response to its proposals, and moving more towards the proposals of the Financial Reporting Council; secondly, in the UK, the corporate governance model we have means that it will almost certainly be audit committees that have to report on the key issues relevant to the audit, not the auditors. So the auditors’ boilerplate may get an extra bit of spit and polish after all.

“If you look at the responses that came into the IAASB a number of stakeholders said they didn’t think it was appropriate for the auditors report to introduce truly subjective views,” says Diana Hillier, PwC standards partner. “There’s a difference between that and [on the other hand] providing insight into the areas of most significant risk from the auditors’ perspective. What did the auditor focus on? What did the auditor need to focus on?”

That, she says, is more the direction the IAASB is now exploring, “as opposed to the idea that there would be subjective views about how aggressive the accounting is”, she says. “You really have to think through the unintended consequences and how the markets would have interpreted that.”

Marek Grabowski is head of the audit team at the FRC. He highlights how the corporate governance framework in the UK means that the letter of the IAASB’s suggestions aren’t appropriate. “Auditor reporting has to fit with the law and regulation and in this country it has to fit with our governance arrangements where the [auditor’s] relationship with audit committees is way ahead when compared with practice in many countries,” Grabowski says.

The FRC is responsible for auditing standards in the UK, though it works very closely with the IAASB. This makes sense given how many UK companies are global operators and the fact that our capital markets are so international. So while IAASB standards might well form the basis of FRC auditing standards, Grabowski says, “we don’t simply adopt IAASB standards. But we don’t usually make many changes – relatively few.”

Difference or dilution

The situation is, then, that the IAASB has no authority to impose standards, but that in most markets in the world its only way of improving information about the audit is through standards governing what’s published in the auditor’s report. In the UK, with a stronger corporate governance structure, such developments will become manifest through the audit committee report.

Does that make a difference? Or does it dilute the original thrust of the IAASB’s proposals to have an audit committee report on the key issues and then for an auditor to simply ‘report by exception’ if they disagree with what an audit committee has said? “Based on all the input that we’ve had from stakeholders across the spectrum there is a general consensus – including from investors – that [audit committee reporting] is a better route,” Grabowski says.

Sue Harding, director of the Financial Reporting Lab at the Financial Reporting Council, says that an exercise is underway to try to identify best practice in how audit committees are reporting. The plan is to have some findings available by the autumn so as to help shape the next big wave of audit committee reports coming out in spring 2014. She says that several audit committee chairs argue that the board, not the auditor, is responsible for the primary disclosure: “Then we go to audit committee reporting which talks about having kicked the tyres and the process that they went through. Then, ideally, the auditors are left with nothing to say because they’re happy.”

The IAASB said in its paper last June that “investors and analysts have been leading the call for change”. But the evidence is perhaps more mixed. A survey by PwC noted that only 7% of so-called ‘mainstream analysts’ always read the audit committee reports of the companies they follow. Almost all of the rest (86%) disagreed or strongly disagreed with that proposition (7% were neutral).

However, corporate governance specialists were far more likely to always read audit committee reports. Indeed, 57% agreed that this was the case while a further 29% were neutral (suggesting that they read some but not all, perhaps).

Some have argued that it is purely “the corporate governance industry” that is interested in these things but not the sort of fund managers who are looking at balance sheets, industry trends and earnings forecasts. On the other hand, the PwC report quotes shareholders saying things such as, “I’ve never seen one [audit committee report] containing interesting information.” Maybe change will make them more interesting.

Simon Laffin has had a rich and varied career as a non-executive director, company chairman and chair of various audit committees since he left Safeway as CFO nine years ago when it was acquired by Wm Morrison. He is currently chairman of the audit committee at media group Aegis and at property company Quintain Estates. “I write our [audit committee report] as a letter and I sign it. We put quite a bit of information in there, especially if you read it carefully,” he says. “But nobody has ever asked me about anything in there.”

He says that there is pressure from some institutional shareholders “to get somehow more involved in the audit process, but I have never been asked by a fund manager about the auditors. I think that this is the experience of most companies.”

Dismissive attitude

There is an odd irony that, while standards-setters are increasing the reporting requirements on the part of audit committees (not least because of the valuable role they play in the UK corporate governance framework), the Competition Commission’s recent provisional findings on the audit market “are almost completely dismissive of audit committees”, Laffin says. He quotes from paragraph 25 of the report: “‘It appeared that shareholders, despite their legal rights, played very little role in any decision to appoint an auditor, while in contrast executive management was very influential.’ This is portrayed as a battle between management and shareholders, with no mention of either independent non-execs or audit committees.” But as Laffin has himself shown – as have other companies – the audit report can be very informative. “Audit committee reports have improved,” he insists.

Whatever the Competition Commission’s views of audit committees, it is looking to enhanced audit committee reporting to “override the reluctance of management to disclose information about the audit process”. It recognises that the FRC and the IAASB are already working on enhanced reporting. Intriguingly, however, the Competition Commission sees this as a way of addressing an adverse effect on competition arising out of a claimed restriction on “the ability of companies and shareholders to judge audit quality”. Audit quality doesn’t seem to be the issue that anyone is concerned about.

As Grabowski puts it, “[Investors] are very clear in conversations they’ve had with us that they’re not looking for something that sets out enough about the audit for them to judge whether it is high-quality or not, but something that sets out the key issues that the auditor saw in executing the audit: the key judgements in deciding how the audit should be done … and what they see as the areas where they should be spending most of their time.”

There’s a plethora of initiatives and consultations on reporting about the audit process and you can add the European Commission to the mix (though that particular juggernaut is trundling slowly, professional advisers say). This may seem to fly in the face of any efforts to reduce the volume and complexity of annual reports. One recent example: HSBC’s 2012 offering is a mighty 548 pages, though its audit committee report was specifically mentioned by one expert as a good example of the genre – so perhaps the future lies in better reporting, with little hope of there being less reporting: less boilerplated, more informative.

“When you move away from boilerplate, the difference between a good and a bad report is much more obvious. It puts the onus on the audit chairman to report better,” concludes Laffin. “But does anybody else ever read them?”