What About The Auditors That Do A Good Job?

20 Feb 2013

This article was first published in CFO/AFR.com, Fairfax Media Publications Pty Ltd, February 2013.

Auditors play a significant role in keeping business accountable, but theirs is often a thankless task. Regulators and the media only highlight the failures, while clients are unlikely to praise them for a qualified audit opinion.

In the lead-up to half-year reporting season, ASIC's latest Audit inspection programme report issued in December 2012 once again focused on areas that need improvement. There is little said in the ASIC report about what works well, but then this is not the regulator's mandate.

Further, media coverage that heralds a job well done by auditors is unlikely to sell papers. In contrast, a modified or qualified auditor's opinion is more likely to bring groans of displeasure, rather than appreciation of an early warning sign that particular issues need urgent attention.

There is a tension between the regulator and the auditors, positioned as co-regulators, which should be understood by the investor community.

In practice, auditors and the regulator work well together. There are thousands of audits completed each year which have minimal public attention. But it is the few high-profile failures resulting in significant loss that create the backlash of public opinion and the need to allocate blame.

If business is not going well, who is at fault? Is the regulator doing its job? Are the auditors as co-regulators doing their job? Are directors and managers fulfilling their responsibilities?

Warning notes

From time to time there is genuine failure in governance, but often there is a level of economic risk that cannot be mitigated - except by disclosure in the notes to the financial statements. These are the notes which effectively say "buyer beware!" which need to be identified and understood, for a proper communication of the risk.

Businesses generally enter into transactions that will be settled at some time in the future. Operating profit is based on the legal and constructive obligations that are associated with these transactions rather than the timing of the associated cash flows.

The cash flow statement provides a summary of cash movements and shows the cash inflows and outflows of the business that relate to these transactions when they actually happen. The cash flow statement also explains how the cash generated from operations has been used.

It is always interesting to compare "cash flow from operations" in the cash flow statement, with "profit" in the statement of comprehensive income as a prima facie indicator of the cash benefits flowing into the business now, in contrast to cash anticipated to flow into the business in the future, explained by the value created now.

Determining the legal and constructive obligations associated with transactions entered into by a business is often not a straightforward task.

The more complex the transaction, the more complex the estimate of when an entitlement to profit arises. Estimates, by their very nature carry a level of uncertainty. Actual outcomes will always vary from the estimated outcome, unless the future was to unravel exactly as predicted.

No one has a reliable crystal ball.

The notes to the financial statements contain a section on "critical accounting estimates and judgments" that point readers to amounts reported in the financial statements that have inherent uncertainty.

Half-year financial reports do not usually contain all the notes that appear in the financial report for the full financial year. The half-year report is more likely to reference the notes in the annual report. To understand the potential uncertainty in the numbers reported at the half-year, it is necessary to look back to the critical accounting estimates and judgments disclosed in the previous annual report.

The numbers reported needed to be considered in this context.

Financial reports prepared in accordance with IFRS (International Financial Reporting Standards), based on economic theory, are not factual statements of events. Rather they present an economic best-estimate of performance to date.

Estimate v actual

While preparers of financial statements continue to grapple with these concepts, auditors have an even more difficult task as they have no control over whether or not an entity will act in accordance with a stated course of action that underpins determination of those estimates.

A business plan is not set in concrete and, from time to time, directors and managers will change their intentions to align with changes in the business environment. In fact, we would expect this type of action from responsive management. However, these types of changes will almost always have an impact on the actual economic outcome of a transaction when compared with the estimated economic performance previously reported.

But in an electronic age, companies could do a lot more to make complex information easier to understand for both auditors and investors. Sequential formats following a paper-based tradition are not user-friendly. Readers need to trawl through pages of notes to find the information they need.

Imagine a financial report where information was hyperlinked and easily accessible. Imagine hovering over the reported revenue figure and finding options which provided access to an analysis of the different sources of revenue, segment information, the revenue recognition accounting policies and the critical accounting estimates and judgments in respect of revenue recognition for different revenue streams.

How much more useful would the 100 pages of information be to readers if they could navigate through quickly and easily? The technology is available now.

Author:  Dianne Azoor Hughes, partner, technical standards, at Baker Tilly Pitcher Partners (Australia). Dianne was previously a member of the Australian Auditing and Assurance Standards Board.




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