Auditors must stand up and be counted

Published on Saturday 24 January 2009 12:41

THE banks' audit season is upon us and external auditors face the unenviable task of forming an opinion on the banks' financial statements.

Their decisions will be under greater scrutiny than ever before and on Wednesday members of the Treasury Select Committee will put auditors on the spot as they grill them on their role in the banking crisis. The Institute of Chartered Accountants of Scotland is one of the organisations that has submitted evidence for the committee to consider.

The global nature of the current financial problems means that this is the biggest test of the auditing profession since Enron. Auditors are already being blamed, at least in part, for not spotting significant financial problems before the crisis. Is this fair? In the context of the financial crisis, it is important to look at what auditors are required to do, as opposed to what people might think they do.

The audit opinion provides assurance that the financial statements of the business are "true and fair". This means they are "about right" and provide a reasonable representation of the company's performance and year-end assets and liabilities. Also, in most cases, the opinion is provided on the basis that the company is a "going concern" in the short term.

But the audit is not required to guarantee the health of a business in a wider sense. Nor is it required to vindicate the business model being used by the directors. In addition, the audit does not predict what performance will be like in subsequent periods. Thus, if asset prices fall dramatically after the year end and significant losses are incurred, this does not mean auditors were at fault if it can be demonstrated that the year-end valuations were appropriate.

But commentators are still bound to ask some big questions. Should auditors have predicted the liquidity and "going concern" issues which resulted in the recent Government bail-outs? Should auditors have foreseen the "big freeze" in the wholesale funding markets? Should auditors have expected the Financial Services Authority's imposition of additional capital requirements?

It would have been remarkable if they had done: most bank directors didn't see it coming and the same goes for rating agencies, regulators, economists, central banks and governments. There have been but a few lone voices – most famously Warren Buffett, who drew attention in 2002 to the build-up of "daisy-chain" and systemic risks and described derivatives as "financial weapons of mass destruction". To my mind, the role of the auditors in all this is clearly of second order. Bank management is first and foremost responsible for its business model and for understanding and managing the associated risks. If there was a looming problem, the first question to ask is: where were management's governance and risk management procedures?

There is also the role of the rating agencies to consider, for it was the agencies' AAA ratings on which management, and auditors, no doubt relied for many of their asset valuations. Equally, one may wonder where were the regulatory interventions which might have tempered some of the worst effects. It is only after you have worked through the answers to those questions that you can start to consider the role of the auditors. It is not obvious that the auditors have a case to answer – or if they do, they are a long way down the queue.

One of the big issues with which the profession is grappling is the huge burden of rules – rules on accounting, auditing and governance. Due to increasing regulation, auditors are required to spend much of their time filling out risk assessment forms, audit questionnaires and accounts checklists. On a large international audit, there are literally thousands of these documents. It is the legacy of Enron that audits now have to focus as much on risk management, namely for documentation to show in court if you happen to get sued, as on truly getting under the skin of the organisation

One of the big risks with the current crisis is that we have a repeat of the knee-jerk regulatory response which heralded Sarbanes-Oxley legislation. This legislation was enacted in the US as a direct response to Enron and requires any entity with a listing to fulfil specific governance requirements. While on balance this legislation has had a beneficial effect on most companies, it has not come without cost. The Securities and Exchange Commission's initial requirements were onerous and the profession interpreted these strictly.

The result was that what Sarbanes and Oxley had intended ended up being over-engineered and US regulators had to reissue the auditing standard on internal controls.

I have sensed a much more responsible approach this side of the Atlantic. That said, the profession would do everyone a favour if it stood up clearly for a more principled approach which requires less in the way of detailed rules and more in the way of professional judgment and real value added.

It is important to acknowledge that accountants did not cause the credit crisis. Jamie Dimon, chief executive of JP Morgan, is right when he asks us to focus instead on the people who did the transactions. However, the accounting profession is at a tipping point.

We risk burying ourselves for good in rules and checklists. The profession must guard against this and ensure that instead we take action to preserve the true professional who can stand back from the checklists and exercise judgment in the best interests of all relevant stakeholders. I am confident that we have the capacity to do this. Let us use the opportunity of this crisis to improve and strengthen the profession.

Hugh Shields is chief economic adviser, the Institute of Chartered Accountants of Scotland