Audit under fire: Is the worst yet to come?

The Financial Reporting Council (FRC) recently announced plans to overhaul corporate governance in the UK and in addition published guidance for auditors – the first of its kind in the UK – to help improve how they exercise professional judgement. These have been issued when progress is being made on the long-awaited reform of audit regulation and corporate governance.

The FRC’s earlier consultation on ISA600 (group audits) with a focus on “misstatement at the financial statement level” and the “need for robust communication between group and component auditors” was accompanied by the International Auditing and Assurance Standards Board’s (IAASB) review on ISA 570 (Revised), “Going Concern”, which aims to, among other things, to “enhance transparency with respect to the auditor’s responsibilities”.

Reviews such as these are timely and welcomed. Those audits which have made headlines recently in the UK are from accounts filed before the pandemic took hold in early 2020, supposedly when all the necessary checks and balances were in place and working practices firmly established.

Consultations such as these, and revisiting standards at regular intervals in general, provide an opportunity to learn from past experiences and improve guidance for the future, particularly if they were found to be lacking in guidance or to be inadequate at addressing situations that were not envisaged when the standards were drafted or last updated, which in some cases can be a considerable time ago.

Pandemic pressures

In terms of lessons learned, the pandemic didn’t just appear all at once, it moved around the globe and with it so too did the various restrictions, which posed significant challenges for auditors of groups with international operations who were unable to visit relevant management, counterparts and assess physical assets. Instead, they were forced to work remotely, relying on video calls and telephone conversations with senior management.

Working practices changed and with it controls, checks and balances were altered, replaced, or ripped up altogether by auditor clients’ management teams and staff, often in an incredibly short space of time, increasing the risk of errors and potentially fraud, intentional or otherwise. Looking further back, during the Great Financial Crisis (GFC) of 2007/8, there was a significant rise in middle management committing fraud as they fought to maintain their living standards as bonuses fell and jobs were lost.

Whose fault is it anyway?

This raises the important question of whether the existing expectations of auditors and regulators are reasonable in these extreme situations, and is there a widening gap between the heightened expectations on audit quality, particularly where public interest entities (PIEs) and their statutory auditors are involved?

Perhaps there is a new level of uncertainty which has to be reflected in accounts which is not currently in line with existing guidance, scepticism and stakeholders’ expectations. Or do they need to be reminded that management and auditors alike do not have crystal balls, and simply because a company fails doesn’t necessarily mean that someone was negligent or failed to be sceptical?

Where the industry did respond to the sudden change in operating conditions, guidance for companies and auditors was arguably rushed out, without an adequate review process. For example, on the accounting guidance for leases and government Covid-19 support.

With the added benefit of hindsight, there may be an opportunity to develop a blueprint for fast tracking other technical matters or updates when required with future black swan events.

The new normal

The frequency of black swan events does appear to be on the rise, with the first major war on the European continent since 1945 and its subsequent impact on supply chains and energy prices, coupled with economic sanctions.

From an audit perspective, there may be an opportunity here to implement lessons learnt as a result of the pandemic and sudden changes to operating conditions. The industry now has far more experience of companies that have succeeded, failed or been kept alive by government support, fund raising or drawing on cash reserves. We have also learnt that businesses struggled for a variety of reasons including disruption to supply chains and a lack of workforce due to many factors including illness and early retirement.

Both the global pandemic and war in Ukraine make the case for additional guidance highlighted by the ICAEW’s recent guidance for auditors in response to the Ukraine crisis.

Auditors went into the pandemic with a focus on “Going Concern” due to the uncertainty that existed and the 12-month forward looking “rule” in particular now seems outdated as the future becomes increasingly difficult to forecast, and past performance no longer provides any degree of certainty. To this point, the FRC has recognised that this process has been “particularly difficult” during the last couple of years for listed companies.

The events of the past couple of years have also shifted the debate on the previously “unacceptable” nature of modified audit opinions which arguably have a much greater role to play as a result of the disruption caused by the pandemic.

Looking ahead, the increasing prospect of an economic recession and the potential for an increase in the number of corporate failures strengthen the argument for reform.

Whatever the outcome of the reviews into ISA600 and ISA 570 (Revised) and the impact of new guidance, the audit industry finds itself in a very different position to that which it went into the pandemic and much-needed change is on the horizon.

Phil Crooks is an audit and accounting advisory and testifying expert and managing director of global consulting firm Berkeley Research Group.