Balancing the books: Give the auditors some credit

In every system of accounting, every debit must have a corresponding credit in order to balance the books.  When it comes to reporting on corporate scandals in South Africa, however, the audit profession “debit” column is well populated with few, if any, corresponding “credits”. 

The reality is that in today’s 24/7 new cycle, there is no time for balance and perspective.  “If it bleeds, it leads” remains the newsroom motto and a successful audit is simply not newsworthy.  To assume that the media reports of audit failures are representative of an entire profession, however, is simply wrong.  There are thousands of audit professionals who conduct numerous audits each year in a professional manner and without incident. 

So how did this once staid profession end up being the “fall guy” for these corporate failures and is it fair to blame the auditors for such failures?   

The credit column

The reality is that the perpetrators of accounting fraud know the auditors are coming.  By the time the auditors arrive at the scene, those that have committed the crime have had time to cover their tracks.  Often this coverup is done with the witting or unwitting assistance of a company’s other advisers, such as lawyers, bankers and corporate finance teams, whose actions often lend credence to transactions that would otherwise appear suspicious.  Yet rather than focus on the perpetrators of the corporate scandals, it is the auditors who are blamed for not uncovering the wrongdoings of their clients.  

It is worth remembering that an annual audit is not the same as a forensic audit.  In the case of JSE-listed companies, such companies must have finalised their financial statements within three months after the year end or face sanction.  Typically therefore, an annual audit is based on sampling and reliance on information supplied by management.  There is simply not enough time to kick over every rock, unlike in a forensic audit, which may last many months if not years. 

There is also a growing narrative that audit firms are turning a blind eye to issues with their clients to protect revenues they generate from non-audit services.  But few, if any, of the recent “audit failings” have been attributed to the audit teams trying to protect non-audit fee revenues.  Ever since the Enron scandal most companies limit the extent to which their auditors can provide non-audit services.  Yet the narrative persists, ironically driven by the audit regulators looking for an excuse to break up the large audit firms.

Clients also tend to regard auditors like cans of beans — no matter what the brand, variations in quality are minimal and so cost is the only issue.  The issue of cost becomes more acute when an audit is mandatory and not seen as revenue enhancing.  Audit firms are therefore constantly under pressure to reduce fees to retain clients.  This, in turn, puts pressure on the level of resources that an audit firm is able to apply to an audit to ensure their own survival.  The thinner the resources are stretched, the less likely they are to discover any wrongdoing.  Shareholders and investors, who place pressure on management to reduce costs, need to understand the unintended consequences when it comes to limiting audit fees.

Little if any attention has been given to the role and function of audit committees.  Large and listed companies are required to have an audit committee, whose role and function is to exercise oversight over the effectiveness not only of the audit function and services, but also the integrity of the financial statements of the company.  So why have these audit committees been largely ineffective in exposing and preventing the recent corporate scandals? 

In the first instance the Companies Act requires that only one third of the audit committee members need to have experience in one of the fields of economics, law, corporate governance, accounting, commerce, public affairs or human resource management.  Financial literacy is therefore a nice to have but not a requirement.  Secondly, King IV requires that all members of the audit committee be non-executive directors.  Non-executive directors cannot be expected to know the intricate workings of the company and are exposed only to a high level and often sanitised view of the company at board meetings.  Furthermore, there is the added problem of “over boarded” non-executives, who may serve on too many boards for them to apply their minds properly to highly complex financial reports. 

The net result is that often audit committees may lack the institutional knowledge, skills and time to query the integrity of the financial statements produced by the auditors, who themselves may have been duped by management.

The debit column

Turning now to the debit column, and aside from instances of gross negligence and incompetence, the audit profession is not blameless in inadvertently facilitating corporate accounting scandals.  Under pressure from the investment community, the audit profession has largely acquiesced in the move away from rules-based audit systems to a principles-based system known as International Financial Reporting Standards (IFRS).  Introduced in 2005, IFRS was designed to allow for easy comparison of companies for investors. Today, IFRS accounting standards are applied in about 140 countries around the world, including South Africa. 

The problem with a principles-based auditing standard is that it allows for different interpretations of the same transactions as opposed to a rules-based approach.  The net result is that managers can manipulate results by how they time their operating decisions rather than by how they are reported on. 

By way of example, under a rules-based accounting system (e.g. GAAP), revenue could not be recognised in a financial year if there was no way to measure the costs associated with such revenue.  IFRS now gives greater scope for companies to recognise revenue based on management’s assessment of the probabilities that the revenue will be realised.  

Asset valuation methodologies have also changed under IFRS.  Under a rules-based system, assets would be valued at historical cost and a revaluation was prohibited except in the case of marketable securities.  In contrast, IFRS allows for a periodic revaluation of assets to fair value.  In theory this is supposed to yield a truer picture of the current value of the company’s assets.  However, management soon realised that so long as they could justify a fair valuation, IFRS standards would allow the auditors to sign off on these values even though they were far away from historical cost. 

The temptations under a principles based system are obvious when management teams are under constant pressure to deliver double digit performance.

Aside from condoning the change in audit standards, the auditing profession has done little to change the way in which it operates since the development of modern accounting practises in the late 19^th century.  Despite the fact that every line item in a financial statement is grounded in some or other legal transaction (e.g. buy/sell), you will be hard pressed to find a lawyer as part of any audit team.  Instead, chartered accountants, with a few semesters of company law under their belts, are often left to decipher complex legal transactions on which they need to report and where many of the scandals find their origin.  More often or not they defer to the company’s lawyers, who are employed to advocate their client’s interests rather than to objectively assess their client’s conduct.  Likewise, deep industry specialists and tax experts are seldom employed full time on an audit team. 

The resistance to restructure audit teams to include a wider range of specialists is hard to fathom if regard is had to the fact that most audit firms also offer forensic audit services and sell such services on the basis of a multi-disciplinary team of lawyers, industry experts, tax experts etcetera.  Why offer a different level of expertise when things go wrong than when looking to prevent such occurrences?

Aside from a lack of skills diversity, few auditors have run a complex business.  Many leave the profession to go into business, but few go the other way.  Although many will argue that they have gained intimate knowledge of the businesses they audit, there is no substitute for the pressures of running a business as opposed to merely reporting on its financial performance.  Challenging the judgment calls of management in a principles-based system of accounting becomes harder when real world business experience is lacking in the audit team.  The problem is more acute in younger members of the audit team, who do most of the ground work and who may miss things a more experienced member would have picked up.

The audit profession has another structural problem, namely mandatory partner retirement ages.  In large international practices, this can range from 60 to 65 years of age.  Historically this was designed to ensure that the partnership made space for new partners and was predicated on there being a ready pool of experienced professionals to take their place.  Today, however, few millennials and generation Z professionals are prepared to wait the 10 to 15 years that it historically took to make partner.  This forces audit firms to elevate younger professionals to partner status earlier than their experience levels dictate.  At the same time, experienced partners with institutional knowledge, who are able to pass on their experience are forced out.  This creates an experience gap and enhanced opportunity for audit failings.

The balancing item

So what are the balancing items for an audit profession that finds itself deep in reputational debit? 

Unfortunately for the audit profession, their relative silence in the face of allegations of audit failings has meant it is too late for them to own or shape the narrative that has developed around them.  Few are prepared to put their heads above the parapet in case they are the next target.  The professional bodies, South African Institute of Chartered Accountants (SAICA) and the Independent Regulatory Board for Auditors (IRBA), who regulate the audit profession, are not rushing to their defence and IRBA has actively pursued harsher powers to pursue errant auditors, even criticising its own disciplinary processes for being too lenient.  The longer audit firms, however, remain silent, the longer the public narrative will persist that they are failing in their duties.

In 2017 IRBA announced that it would introduce mandatory audit firm rotation (MAFR) with effect from April 2023.  In terms of MAFR, an audit firm that has been the auditor of a large company for 10 or more years would require to resign and would not be eligible for reappointment until after a period of five years.  In South Africa, IRBA’s ruling has the further object of addressing market concentration of audit services and to promote transformation by creating more opportunities for small and mid-tier audit firms to access large company audits, which have been dominated by the big four audit firms, PWC, Deloitte, Ernst & Young and KPMG 

Whether or not MAFR will have the desired effects is questionable.  It takes time for a new audit team to become familiar with a new client’s business, in addition to which smaller firms will lack the resources for complex audits and will need to team up with competitors.  The opportunities for things to fall through the cracks is thus arguably heightened by this intervention.

Audit firms need to accept that an audit is no longer just about the numbers, but also about more aggressively assessing management judgement calls, even if they comply with IFRS principles.  To do this they are going to need to examine the skills sets that they bring to bear on an audit.  They should also examine the extent to which senior resources can be usefully employed in mentorship programmes to reduce the experience gap rather than being forced into retirement.  In turn, the investor community is going to have to accept that with the call for greater vigilance on the part of the auditors comes the need for greater resources and additional cost.

Finally, those who report on the corporate scandals should examine more closely and appreciate the constraints under which the audit profession operates and not lose sight of who the real perpetrators of the corporate scandals that have become part of daily life in South Africa, are.