Insight: The audit relationship - Strained Relations.

Earnings quality is of great significance to stakeholders in listed companies, but is not easy to identify. By earnings quality we mean the degree of aggression or conservatism that directors apply to their accounting policies and their interpretation of the regulatory framework.

Little is publicly known about directors’ policies in respect of earnings quality within individual companies, and even less is known about the auditors’ influence on earnings quality, because the process that leads to a company producing its audited accounts is private. Users get the end product but they do not know what goes on to get there.

We have just completed a major research study in which the finance directors and the audit engagement partners of six listed companies described to us how they reached agreement on key issues in their accounts.

Interviewees described 22 interactions which affected the accounting numbers. The cases provide strong evidence of the auditor’s contribution to accounting compliance.

Judgements about earnings quality emerged in five cases. In three companies – NS plc, CRA plc and TJ plc – the directors had particular reasons to show their results in as good a light as possible.

In the other two, MP plc and RC plc, earnings quality was a problem in companies they had acquired.

We first describe issues that arose and then make suggestions for change.

Real company names have not been used.

NS plc

FD Nick had joined the board of NS plc at a critical time. The group was too heavily geared, close to breaching its debt covenants, and on the verge of insolvency. More finance was needed. Nick found that desperate measures had been taken by the board to stay afloat: ‘Using up any provisions and justifying why they shouldn’t exist rather than why they should exist … The group was leasing out everything it could … there were operating leases which should have been finance leases.’

This happened before FRS5 tightened rules on off-balance sheet finance.

Nick believed what had been done ‘wasn’t absolutely wrong, necessarily, the area was grey’.

Nick and the new audit engagement partner, Simon, knowing the group needed to persuade lenders of its accounting respectability if it was to obtain more finance, tidied up the accounts.

As the institutions providing the funding insisted on boardroom changes, finance was delayed. Simon said he would qualify the accounts for going concern if funding was not in place by the time he signed off. Nick was unhappy: ‘It was a situation which would have destroyed the company if we’d let it happen.’

They survived because they were able to delay the preliminary announcement until after the deal was done. In this case, the tightening up of the regulatory framework by the Accounting Standards Board, and the need to raise more funds, enabled the FD and the audit partner to put a stop to previous aggressive accounting practices. These had been driven by the previous management’s desire to stay within debt covenants and keep the business afloat.

CRA plc

CRA plc directors were anticipating a hostile bid. Their audit engagement partner, Andrew, knew the group would wish to show the best possible results to deter the bidder. He had two concerns: an aggressive depreciation policy on newly acquired landfill sites and the charging of costs to a restructuring provision, which he believed should go through the p&l account.

Andrew was uncomfortable with the depreciation policy but was not in a position to ‘insist they should change it’ because ‘it was not prohibited by standards’.

Similarly, there was no clear regulatory guidance in respect of the restructuring provision, but he believed the treatment was wrong. But the impact was less than 1% of profit, and not material enough to justify an audit report qualification.

Colin, the FD, knew about the materiality issue: ‘It was not material enough for them to qualify the accounts. Andrew had a view and I wasn’t prepared to take his view.’

Andrew warned the audit committee and the board that aggressive accounting could harm the company’s reputation. Andrew wrote to the board about the restructuring provision: ‘While there is not an accounting standard that prohibits utilisation of provisions in this way, the impact is to keep out of operating costs an element of the normal establishment overhead. Operating profits are consequently flattered, and we do not support this practice.’

Despite this, the audit committee and the board supported the FD. In this case, the audit engagement partner did all within his power to dissuade the board from adopting these policies, but no rules were broken and he received no support from the board.

TJ plc

Although listed, this company was family controlled. Profitability was declining. The chairman was also the CEO and had been the driving force behind the company but was approaching retirement age.

James, the audit engagement partner, was aware the company could be put up for sale. Unlike our other case companies, there were no institutional shareholders.

The accounting records for stock had been poor and a new, computerised stock system showed a material overvaluation. In order not to hit the profits too hard in one year, the overvaluation was written off over three years. This was a contravention of SSAP 9, as the stock was not stated at the lower of cost and net realisable value. As it happened, the company was not sold until after year three, by which time the stock was properly valued.

In this case, the AEP made a poor judgement by not insisting that the whole of the over-valuation was written off when it was identified. He accepted that the adjustment was just too big: ‘You can’t eat an elephant.’

MP plc and RC plc

Both these groups had good reputations and conservative accounting policies.

Each had made an acquisition and, in both cases, significant additional provisions were needed to increase stock and bad debt provisions to a level compatible with group policies.

In RC plc, the directors of the acquired company were open about the lightness of provisions. FD Robert explained: ‘We asked Coreco’s management “What about your stock provision?” and they said, “Phoar, well, we haven’t got nearly enough.” Robert believed they wanted to show good results ‘as everybody knew we were looking at them.’

But Robert did not believe Coreco’s accounts were mis-stated: ‘It was all within the boundaries of materiality … I’m not in any way suggesting either Coreco or Coreco’s auditors were mis-stating the accounts’.

A more complex situation arose in MP plc. The acquired company, NS plc, had been experiencing trading difficulties. The need for extra provisions led to a long, hard negotiation between the AEP Paul, FD Michael and the management and auditors of NS plc.

Paul explained the reasons for the light provisioning: ‘A number admitted early on that they had had to present their accounts to comply with various lending covenants prior to their acquisition.’ Paul was so concerned about the low provisions that he qualified the accounts of the subsidiary on their opening position. Michael believed that the NS opening position was ‘at the edge of prudence’.

Conclusions

We have identified only one case (TJ plc) where higher earnings arose from a breach of the regulatory framework, although no harm was done.

In the others, earning quality varied, but the variation was within the boundaries of materiality and acceptability in the context of the regulatory framework at the time the transactions took place. It came down to corporate policy on earnings and judgements, both of which are difficult to regulate.

An interesting difference of opinion arises between auditors in MP plc’s subsidiary. Paul would not have signed off on the accounts the previous auditors of NS had accepted.

Two clear issues emerge from these cases, which we believe regulators should consider.

First, the need to stay within debt covenants can undermine earnings quality. We believe there is a case for the terms of debt covenants to be disclosed in accounts so users can see how close to the margin a company is. Second, an auditor’s only sanction against directors who refuse to adjust accounts is a qualified audit report. This sanction fails where adjustments are not considered material to the accounts, even though the auditor believes they are valid. So, poor accounting practices that affect the quality of earnings may never be revealed.

We believe there is a case for disclosure of such unadjusted items. Perhaps the threat of disclosure would itself bring about the necessary adjustments.

EARNINGS QUALITY IN PRACTICE

The case studies (left) on how auditors and directors interact to agree the contents of final accounts identify factors that influence earnings quality.

Direct evidence emerges that financial difficulties, the need to stay within debt covenants, impending sale and the possibility of a hostile bid can influence directors to pursue more aggressive accounting policies.

Where an issue is judgmental and there is no clear regulatory guidance, an auditor has no means of bringing aggressive or poor quality accounting to the attention of users unless the issue is sufficiently material to threaten or justify an audit report qualification.

In order for users to have a better knowledge of a company’s earnings quality, the researchers suggest that the terms of debt covenants should be disclosed in the accounts so that users can see how close the company is to the margin.

To improve the overall quality of accounting, it is suggested that – where an auditor believes an adjustment should be made and directors refuse to do – this should be disclosable.

The possibility of disclosure would lead to many adjustments being made. ?: