Enhancing Audit Quality: Lessons from Auditor Deficiencies and Accounting Restatements

In response to the financial crisis, the quality of bank audits has been in the regulatory reform spotlight. This is due to the issuance of unqualified audit opinions before the collapse of Lehman Brothers in addition to several banks across Europe and the U.S. that have been rescued or guaranteed. Auditors cannot be blamed for the financial crisis, nor can they be expected to perform the duties of equity and credit analysts. Nevertheless, the lack of any early warning signals related to the underlying financial health of banks (and failure in many cases) of financial statements to reflect the economic book value of these banks has been seen by many stakeholders as a glaring failure by auditors in their expected assurance role.

The perceived auditor shortcomings have underpinned the regulatory reforms being pursued by several authorities across the globe, including the European Commission, Public Company Audit Oversight Board (PCAOB), and International Auditing Assurance Standards Board (IAASB). The reforms have largely focused on the audit market structure (e.g., limiting auditor tenure through mandatory rotation and prohibition of non-audit services).

That being said, the preponderance towards ‘audit market’ structural reform could be occurring at the expense of addressing more fundamental issues of audit quality such as auditor capacity to provide greater assurance on forward-looking information and measurement under uncertainty (e.g., some estimates of fair value). The challenge of auditing measurement under uncertainty and forward-looking information is highlighted by a number of recent auditor inspection reports as well as by the level of accounting restatements.

Key Findings from Inspection Reports and Accounting Restatements

At the end of 2012, the International Forum of Independent Audit Regulators (IFIAR) published the results of a survey related to 961 audit engagements by 98 audit firms across a number of jurisdictions across the globe. The IFIAR report provides indicators regarding particular recognition, measurement, and disclosure issues where auditors could, in several instances, be failing to elicit adequate evidence to ensure there is no material misstatement of issued financial statements. The IFIAR survey findings touch on several key areas that involve some level of forward-looking information including:

• Fair value measurements (16%, or 169 of 1,072 total findings )
• Revenue recognition (8%, or 86 of 1,072 total findings)
• Audit of allowance for loan losses (4%, or 43 of 1,072 total findings)
• Going concern (2%, or 25 of 1,072 total findings)

Similarly, the U.K. Financial Reporting Council (FRC) – 2011/12 Audit Quality Inspections report affirms many of the weaknesses highlighted by the IFIAR survey. These include the auditing of loan loss provisioning and forbearance for bank audits as well as the adequacy of testing the going concern assumption across all sectors. The FRC also highlights auditor struggles with the impairment of goodwill and other intangibles. According to the FRC report:

Our findings suggested that audit teams did not always fully understand the accounting and reporting requirements in this area. This resulted in audit teams not identifying the mixing of pre and post-tax cash flows used to calculate value in use; accepting impairment reviews based on profit forecasts rather than cash-flows; failing to identify incorrect or incomplete calculations of the carrying value of assets being tested for impairment; and failing to understand the calculation and determination of appropriate discount rates.

As reported in another blog post, the audit of mark-to-model fair values was also one of the PwC audit deficiencies highlighted through previous PCAOB inspection reports.

The picture that emerges from the auditor inspection findings regarding challenging accounting areas is augmented by the profile of items with accounting restatements from U.S. registrants, as reported in the latest Audit Analytics report. As shown below, restatements frequently occur for the listed items, which are characterized by forward-looking information and/or measurement under uncertainty. Incidentally, these accounting items that are prone to auditor shortcomings and restatements have also been frequently identified as areas used by companies for earnings management (e.g., revenue recognition and the accounting for acquisitions).

Percentages of Total Restatements

Source: Audit Analytics

Enhanced Ability to Audit ‘Measurement under Uncertainty’ Should be a Top Priority

It might be tempting for some, including auditors, to yearn for accounting standards with minimal forward-looking information — so as to maximize the ease of the audit process. But such an approach would be missing the broader point regarding the need to prioritize and provide information that is relevant for investment decision making.

The incorporation of forward-looking measures into the accounting framework is warranted as it is the only way that a faithful representation can be made regarding the nature, risk, and sometimes high uncertainty of cash-flow patterns of highly complex contractual arrangements that the modern corporation enters into. The audit profession simply needs to step up to the mark and retool its capacity to effectively elicit evidence and test whether all the reported numbers are truly reflecting the economics of the business — especially as corporations are adopting ever-complex business models and contractual arrangements.

Photo credit: @iStockphoto.com/spectrelabs