Extended auditor reports restoring trust in audit in post-HBOS world

Extended auditor reports restoring trust in audit in post-HBOS world

Eight years after the failure of HBOS, the discipline of audit - and its real value to investors - continues to fuel debate, finds Chris Warmoll

THE DUST has settled on the Financial Conduct Authority (FCA) and Prudential Regulation Authority’s (PRA) mammoth report into the collapse of HBOS, leaving the profession and investors wondering how much the value of audit has improved since the lender’s demise.

The report found the bank had “kept its auditors under pressure” in a bid to keep provisions for bad loans down, while another disturbing finding was that HBOS attempted to defend impairment figures which were then increased to levels that the banks auditors KPMG viewed as “just within the acceptable range”.

Since then, regulators have shaken up the large-listed audit market by imposing the mandatory rotation of audit firms, an enhanced and extended auditors’ report, while the firms have ploughed millions of pounds into new analytics capabilities.

But has this translated into renewed confidence among investors about the value of audit? Jane Fuller, a CFA UK fellow and member of the FRC’s Audit and Assurance Council, says the issue of challenging management remains a key one for both auditors and non-executive directors, as HBOS and other recent cases of corporate failure demonstrate.

“The FRC has improved its monitoring of corporate reporting and auditing, and there is much more public information about the findings of audit quality reviews. On the Audit and Assurance Council, we often discuss the issues of professional scepticism and independence, which provide the foundations for challenging management,” she says.

“Reforms introduced in recent years – from the auditor’s report to rotation of auditors – provide a better context for challenge. But it will always be difficult to demonstrate how scepticism is executed when, obviously, conversations between auditor and executives take place in private.”

A more enlightened audit report

Despite the HBOS failure occurring seven years ago, the discipline of audit – and its real value to investors – continues to fuel debate given its seeming inability to spot glaring irregularities in the accounts of either supermarket giant Tesco or the Co-op’s banking arm.

In 2014, a damning report into the Co-op Bank’s failed bit to acquire hundreds of Lloyds bank branches slammed the mutual’s auditors, KPMG, for failing to uncover the bank’s capital shortfall “until it was too late”. KPMG has consistently defended its work. PwC, too, is facing scrutiny from the FRC over its audit work at Tesco after the retailer overstated its first half 2014 profits by £263m.

Iain Coke, head of ICAEW’s Financial Reporting Faculty, sauggests that while the status quo is still less than ideal, banks now provide “much better disclosures on risks and areas such as provisioning”.

“Better information is provided by audit committees on key judgements and in new audit reports which, for the first time, allow auditors to directly highlight areas they have particularly focused on,” Coke says.

“Things are still not perfect. The basic scope of the audit report has hardly changed in a century. In banking some of the most important information, like the capital ratio, remains unaudited – although we are working with the PRA to address this. Audits must evolve so they cover the areas stakeholders are most interested in if they are to remain relevant.”

And while banks must now follow accounting standards in preparing their financial statements, it had been a challenge, he added, to get international agreement on the best way to make provisions.

“It is important the new standard on this issued by the IASB), is endorsed by the European Commission (EC) as soon as possible, so European banks can get on with applying it.”

And lest we forget, Andrew Tyrie, chairman of the Treasury Select committee and the last Parliamentary Commission on Banking Standards (PCBS), stressed that it was abundantly clear from the report, and the conclusions of the PCBS, that the “audit process was an important part” of HBOS’s failure.

Tyrie said he will write to the FRC about the “misjudgement made of the scale of impairments on the balance sheet, and about whether the auditors allowed themselves to be influenced by undue pressure from senior executives and the board of HBOS”.

The FRC, for its part, has stressed that in response to the concerns raised by the PRA/FCA, the PCBS and the public at large, that it lacked “reasonable grounds to suspect that there may have been misconduct as defined under the disciplinary scheme for members of the accounting profession”.

It has however, somewhat caveated that by saying it “will review the full report to ascertain whether it contains any relevant new information”.

KPMG welcomed the recognition that it “provided robust challenge and delivered clear warnings” to HBOS, which resulted in a more prudent approach to provisioning than would otherwise have been adopted.

“We also welcome the FRC’s announcement that it has reviewed the audit work performed on loan loss provisions and concluded that there were not reasonable grounds to suspect misconduct by KPMG,” it said in a statement.

Liz Murrall, director of stewardship and reporting at the Investment Association, the body which represents UK investment managers whose 200 members manage over £5.5trn for their global client list, saysthat in the past investors had concerns about both the quality of the audit, the auditor’s accountability to investors and the transparency of the audit.

These were “largely a product of the fact that investors felt excluded from the audit process and real findings – they were largely invisible”, she explains.

“While there was a lot of communication between auditors and audit committees none of this was transparent to investors. The usefulness of the audit report was undermined by the binary opinion, pass or fail, and the fact it tended to include more details of what the auditor did not do rather than what he did. This did the profession a disservice and some investors questioned the value of the audit”.

And while this clearly needed to change, and trust in audit be re-established, Murrall says the FRC’s amendments to the audit report were a welcome part of the change to introduce “a more enlightened audit report”.

“Investors are very positive about this in that they enable them to compare the depth and clarity of different audit reports,” she says.

Murrall, a trained accountant, says that while the UK has made great advances with audit, its regulation and transparency, “investors invest in global markets and we would like to see these reforms embraced internationally”.

A major element of the new audit reporting framework, she believes, is that it informs investors “the main risks of misstatement the auditor identified”.

“It tells us how the approach was modified in relation to those risks and gives a summary of the audit scope, such as key audit procedures. In this context, the FRC did not require auditors to take the next obvious step and answer the question ‘what did you find’, for example in respect of the application and effect of the company’s judgements and estimates in these key areas?

Such an approach means that a company whose estimates are within an acceptable range, but was cautious last year and aggressive this, could technically receive the same new audit report as a company that was consistently cautious in the same area.

Murrall welcomes the fact that a number of firms are looking to go one step further and report on their findings. When coupled with the audit committee’s report and the disclosure of judgements and estimates in the accounts, the combined power of the information will help investors identify and understand the significant conclusions made in the accounts.

“They can then further challenge executive management and hold the audit committee and external auditor to account,” says Murrall.

Black box

Fuller, a cheerleader for extended auditor reporting, is adamant about its ability to improve confidence in audit.

“Before there was a black-box approach,” she explains, “with information limited to belated warnings in the rare cases where the going concern assumption was under threat.

“Now risks of mis-statement are spelt out and there is an explanation of how the auditor has tackled them. Overall, this creates a feeling that the auditor is reporting to us – investors and other users of accounts – rather than just providing a service to the corporate client. What I like best is the identification of risks of mis-statement, notably where the numbers are the result of sensitive and subjective assumptions”.

While KPMG has been lauded for “blazing a trail” with the scope of its audit reports, not many of its clients have had the courage to go for this approach, posits Fuller.

“Bearing in mind that there is often a range of ‘acceptable’ outcomes, it would be good to see more experimentation in ways to express where in that range the published number lies. What disappointed me when auditor reports first appeared were the typically crude reported measures of materiality”.

Though EY has led progress in reporting the lower, performance materiality number, Fuller says it’s worth remembering that “users of accounts are interested in factors that move the share price, which means qualitative, as well as quantitative, judgment and better reporting of different approaches to materiality for different parts of the business”.

This makes it another area ripe for further improvement.

Better dialogue

Standards are another key driver for enhancing quality, and one Fuller believes, aside from raising the bar across the industry, “prompts for greater independence from the audit client and better communication with users of accounts”.

But “ultimate responsibility for the highest standards of professional behaviour lies with the firms and with individual auditors”.

From a Big Four perspective, “it’s the problems that create the headlines”. That’s the view of James Chalmers, PwC’s head of assurance.

“There are thousands of audits being done all the time that are not attracting this scrutiny despite accounts being looked at by multiple groups of stakeholders,” he says. “And quite rightly, it’s the exception that causes the consternation, but it’s worth keeping front and centre that the trust in the London markets is in a huge part down to the number of audit opinions and quality reports that are out there actually getting things right.”

To further underscore his point, Chalmers points to the fact that the FRC reviews around 250 sets of accounts each year with some 70 letters written to companies asking further questions about their accounts, but only around six out of 250 “actually result in some sort of formal public notification”.

He also praises the extended audit report for delivering improvements to investor insight into “where the auditor thought they should be focussing their time and what they have actually done to address it”.

Anyone now looking through a report can quickly see the specific areas where the auditor was sceptical about the work management did – and also see what they did to resolve it – a genuinely insightful development, posits Chalmers.

Previously much of “the best work audit did was buried”, “done in private discussions with the company” with the end result that the annual report would “reflect whatever the auditor had requested and standard opinion would arise”.
Chalmers believes that now the market is moving with “investors asking more questions, and companies and audit firms are thinking about it and enhancing the disclosures the year after”.

The assurance chief added: “If you put that alongside the audit committee’s requirements to report their view of risk – that is creating a better dialogue between the audit committees and the auditor about their perspectives on risk – where they are similar, where they are different and why”, which… “improves the quality of discussion and an investors ability to see what’s happening. And if you link that with materiality and scope it’s possible to develop a much more significant picture of what is happening.”

When gazing back at the state of the atypical annual report in 2008, and contrasting them with their contemporary counterparts, Chalmers says the fair, balanced and understandable requirement is now firmly at the front, with a stronger obligation on companies to articulate their view of risk to aid reader navigation.

He cites the potential prospect of public companies publishing their annual reports in a digital format as a distinct advantage for all, as they can be tailored to specific stakeholder audiences – whether employees or investors – and garner deeper engagement.

PwC – while an LLP and not subject to the same constraints as publicly listed companies – did just that this year and reported much wider audience interaction than a typical linear tome.

And what hope for the future of audit?

“If you look at the external regulators there’s still a continuing trend of improved quality, which is really positive and I think technology and technological development – including data – will allow everyone to get more effective at understanding what is happening in markets and auditing it,” Chalmers concludes.

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