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Looking at companies through the wrong lens

DO INVESTORS, non-executives, audit committees, FDs and auditors look at a given company and see it in the same way? If they do not, what are the differences and to what degree do they matter? After having worn all of those hats at different times over the last 30 years, I see these questions as important and the answers as far from trivial. Much has been written about “expectations gaps”, especially in relation to auditors, but perception gaps or biases seem just as important.

It is all too easy for companies to fall into the trap of seeing the world through the prism of the business in its current incarnation. The everyday operational pressures on executives can lead them to look at the world exclusively in terms of what the company does; how the company does it; and why things are done this way. Not that understanding how the company has got to where it is, and why, is a bad thing. Clearly, an appreciation of a company’s history should be an advantage to a board and to management, as well as to auditors and advisors. At the very least, such knowledge can help them avoid repeating past mistakes.

Investors, on the other hand, are more likely to start by asking where a company fits in the world economy, where it should and could be, and what it needs to do differently in order to get there. This is a very different mindset, and it is where most boards and managements set out to be. Many succeed in staying there. Many don’t.

No black swans
Examples of companies failing to keep the bigger picture to the fore include many of the recent financial services company failures. There have been failures to notice changes in wholesale funding opportunities; failures to spot changes in regulatory interpretations or nuances, leading to big fines or compensation; failures to appreciate the consequences of new environmental standards on the company’s outputs or operations, not dealing with replacement technologies or coming applications based on cheaper or better raw materials; and failure to deal with poorly performing businesses that have been absorbing too much scarce capital – and many more like that.

Such occurrences often reflect a focus on how things are usually done in a given company, as well as an over-reliance on strategies that have always worked in the past. Omitting to challenge such preconceptions is more common than it should be. After all, not every bit of bad news can be dismissed as a so-called black swan that could never have been predicted.

If auditors were able to maintain the same kind of focus that an investor has, would they as often be accused of failing to maintain their independence from management? Would they be more likely to (and be better placed to) challenge management’s assumptions, valuations and assertions, if their audits were built on foundations of investment analysis and a view of where a company fits into the world economy, and where it could or should be?

Reflecting on the quality of analysis I see as an investor in listed equity markets, and the experience and skills required to produce that – and recalling how audit files on understanding the business used to be (and may well still be) assembled – I can more easily understand why auditors too often come to see the world through the eyes of the client company. They may still be able to tick all the compliance boxes on auditor independence, but if they depend on the client management for the lens through which they look at the company, the auditors are taking a big risk. And they are not doing their job, as many investors would say [for more, turn to page 46].

This is at the heart of the issues discussed in the recent Audit Practices Board briefing paper on the central role of professional scepticism in delivering audit quality. If you set out with the wrong mindset or limited vision, the rest of the audit journey will be very difficult. ?

Eric Tracey is a former finance director and chartered accountant

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