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Accounting – Auditing the auditors

Audit is all about judgement. And deciding whether an audit has been good
enough is all about judgement too. Until now there has been no mechanism to find
out what sort of job auditors are doing. The only system – apart from the firms’
own blandishments that all was well – was the blunt weapon of litigation. But
the failure of Enron and others put in train a series of reforms, including a
shiny new monitoring system for the audit of UK listed companies.

The Audit Inspection Unit (AIU) is part of the Professional Oversight Board
for Accountancy (POBA). In reality, the unit focuses on the quality of auditing
by the Big Four firms because they audit virtually all FTSE-350 companies and
nearly 83% of all listed companies. The AIU reassesses key audit judgements. And
its first verdict is a definite “could do better”.

All this must be a culture shock to partners in Big Four firms, who are used
to having to convince just the financial director and one or two partners that
they made the right call. Indeed, the AIU has complained that the firms did not
automatically follow an open-door policy. Not all the Big Four – although the
AIU didn’t name names – allowed access to detailed reports on individual audit
or allowed attendance at annual quality review closing meetings. The AIU says it
expects fuller co-operation in future.

A quality audit has two outputs. One is the right audit opinion to
shareholders, which is independent and supported by sufficient audit evidence
and objective judgements, and the other is a “complete and appropriate” report
to those in charge of governance.

Auditors have always hated the idea of partner rotation and fought tooth and
nail to keep the same audit partner on the job for as long as possible. They
don’t see the dangers of the long-serving audit partner going native. When
rotation rules force the key audit or audit engagement partner to hand over the
reins, they often stay on in roles such as relationship partner, advisory
partner or lead partner. While not officially part of the audit team, these
partners maintain relationships at the highest level with clients and even
attend audit committee meetings. Such arrangements give the impression that the
old partners continue to influence the audit and audit judgement, undermining
objectivity and independence.

Firms are still not documenting their work properly. Auditors find it hard to
commit to paper how and why they reached their conclusions. So concerned was the
AIU by two cases of non-documentation that it referred them to the FRC’s
Financial Reporting Review Panel to ascertain whether the accounting treatment
and the disclosure complied with UK GAAP. As only 27 audits were reviewed by the
AIU, that’s a high doubt rate. In fact, so poor was the written evidence
provided by the firms that the AIU frequently had to go and ask partners how
they had come to their conclusions.

Assuming no sinister motive to this lack of written audit evidence, it is
hard to see why firms record the reasons for their judgement so poorly. There
are two possible explanations. First, the decisions are made in meetings where
it is hard to make full and accurate notes – a rather lame excuse. Second, and
more likely, is that decisions are made when deadlines are looming and the audit
team is running out of time. At some firms the signoffs to evidence completion
and clearance of review points were sometimes dated after the audit report was
signed. That is certainly not in the procedures manual.

Reporting to audit committees is ropey. On some audits, key accounting
policies or critical matters affecting the accounts were not discussed in
sufficient detail with the audit committee. In some cases not all unadjusted
audit differences were notified to the audit committee. That points to a desire
by the auditor – maybe with the agreement of the FD – to stage-manage what the
audit committee hears, which doesn’t fit in with a quality audit.

The AIU is satisfied there are no systematic weaknesses in the overall
policies, procedures and systems of quality control operated by the Big Four.
But it is clear that there are serious issues of quality. The AIU is a typically
British solution. Its approach contrasts sharply with the US Securities &
Exchange Commission’s naming, shaming and fining of recalcitrant auditors. As
POBA chairman Sir John Bourn noted: “Where the firms do not follow their own
procedures, they expose themselves to risk that future audit opinions may not be
appropriate.” It’s a judgement that the Big Four auditors would do well to heed.

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