Audit inspectors optimistic despite firm shortcomings

THE TOP SIX accountancy firms were subjected to their annual grilling this week, as the Financial Reporting Council’s Audit Inspection Unit published its verdict on each.

There were many criticisms to choose from but some were repeated time and again, painting a worrying picture of professional culture at the top of the audit market.

All six were found guilty of drawing conclusions without substantial evidence to back them, particularly in tricky areas such as goodwill impairment, going concern and asset valuations.

AIU director Andrew Jones said worse than this, auditors displayed a lack of scepticism even when evidence was provided, being too ready to swallow management assertions without proper investigation.

A number of firms were accused of failing to follow their own procedures, leading to audit weakness. Deloitte “did not properly fulfil its responsibilities” as group auditor of an AIM-listed client, slipping up on the impairment testing of assets due to a failure to correctly apply its own procedures, the AIU concluded.

Ernst & Young also had problems with group audits; in one case, a partner did not visit the client’s main overseas location, despite it being a requirement of E&Y’s methodology.

One area where the firms all received a thumbs-up was on policies and procedures. The AIU universally concluded that these were appropriate for firms’ size and client base, and approved their systems of quality control.

However, the firms’ failure to follow their own procedure means that even if the AIU gives it the thumb’s up, auditors’ slack adherence nullifies this important safeguard, with potentially serious consequences for audit quality.

Non-audit services caused more headaches for the top six, as several were accused of inappropriate focus on the sale of non-audit services to clients, something which is prohibited in ethical guidelines.

BDO was warned about its business plan, which outlined the sale of non-audit services as one of four strategic goals. This could “lead to an inappropriate focus” on sales if sufficient emphasis is not placed on auditor independence, the AIU warned.

Andrew Jones pointed out that auditors are prohibited from selling non-audit services only to their own clients, not those of their colleagues. However, staff appraisals also contained “inappropriate objectives” to squeeze non-audit revenue from existing clients, as did those at KPMG.

One PwC audit director outlined his success in selling non-audit services when applying for a partner position, indicating the high regard with which the skill is held in an industry where the two disciplines are supposedly separate.

Taken together, some could suggest there exists a culture of viewing audit clients as fertile ground for the sale of more lucrative non-audit services, something that firms consistently deny.

Risk management is another area where the firms have insisted on the rigour of their mechanisms, yet the AIU found cause to quibble. Grant Thornton failed to step up its review of journal entries despite concluding there were “weaknesses in controls”, implying a wholly deficient response to audit risk.

E&Y was picked up for failures to improve evaluation of risk management despite past AIU criticism. It also fell short in managing the risk of fraud, as did PwC, Deloitte and BDO.

Risk has been a buzz word since a shell-shocked audit market regrouped following the credit crunch, and this evidence of failings – even where firms themselves identified higher-than-usual risk – is embarrassing.

But perhaps such criticism is too harsh. If the AIU maintains exacting standards, it is reasonable to expect a few slip-ups on the firms’ part. If all six received perfect reviews, stakeholders would question the rigour of investigations, and there is always room for improvement.

The AIU concluded results are “as good, or slightly better, than those of last year”. Andrew Jones pointed out FTSE350 audits in particular were stronger, suggesting the top six firms performed better than their smaller peers overall.

Vernon Soare, ICAEW executive director of professional standards, said the AIU reports are “good news” and claimed isolated incidents of poor practice are “not worrying; things happen now and then, auditors are human”.

Soare said it is “more important to work out if there’s a systemic issue”, arguing the reports “certainly don’t indicate this”.

However, some might argue the breaching of even basic audit procedure hints at a failure to ingrain post-crisis regulations at the root of firms’ operations.

KPMG and Ernst & Young were pulled up for signing and dating issues on audit reports. Two of E&Y’s were signed prior to the completion of review procedures, and KPMG – although it had made improvements – was still not up to scratch.

Overall, just two of the six (KPMG and Deloitte) managed to squeak the majority of audits reviewed into the ‘good’ category, while BDO had four in eight and PwC clocked up seven out of 15. E&Y placed five in 13 audits in the top band, while GT managed a dismal two in ten.

The vast majority were in the ‘acceptable but requiring improvement ‘ category, and all firms had at least one audit that needed significant improvement – a decline on last time when BDO, Grant Thornton and E&Y avoided this ignominy.

So what does this mean for quality at the top of the market? The AIU is satisfied that improvements have been made, and there is no doubt that firms have jumped to action recommendations from last time. However, this year’s inspections yielded 37 ‘good’ audits, compared with 38 last time, while the number of poor audits leapt from five to eight.

Admittedly, the AIU looked at fewer audits this year – 72 compared to 76 – yet 11% were poor, up from 6.5% last time, and 51% were good, fractionally higher than the 50% seen in the last report.

Stakeholders must now decide whether this underwhelming result is satisfactory for a profession that has had several years to learn from the credit crunch – and indeed, has been evolving for two hundred.

In some cases, recommendations from the last AIU report have not had the time to filter through to this year’s reviewed work, meaning firms are justified in saying they need more time to deliver results.

The top six firms may also be victims of their own success – huge and de-centralised, it takes time for changes to dissipate, and improvements to training in particular can be slow to make their mark.

However, this is no excuse for another batch of of major audits requiring significant improvement, and should rightly be of concern to management, shareholders and the public, all of whom are relying on auditors to help companies navigate the path to high-quality financial reporting.