Sunday, September 05, 2010

UK Regulators Move to More Deeply Embed Auditors in Prudential Regulation, Professional Skepticism Targeted

As markets attempt to recover from the financial crisis, the UK’s financial and audit regulators have embarked on an initiative to involve the outside auditor more deeply in effective prudential regulation based on a belief that quality financial reporting and quality audit is the key to increasing market confidence. In addition, the Financial Services Authority and Financial Reporting Council noted that many firms face increasing complexity in their products, services, financial instruments, global regulation, and accounting requirements. In turn, this complexity increases the value of high quality independent audits.

In a joint report, the agencies said that first there is a need to clarify what is expected of a company’s outside auditors, to consider their effectiveness, how they fulfill their obligation to report to the FSA, and how they can enhance their contribution to prudential regulation. Against the backdrop of the role of the auditor in the financial crisis, the House of Commons Treasury Committee recently said that, while there was little evidence that auditors failed to fulfill their duties, the fact remains that the audit process failed to highlight developing problems, which calls into question exactly how useful audit currently is. The Committee urged the FSA to make more use of audit knowledge and consider ways in which the links between the FSA and auditors could be strengthened.

With regard to disclosure, the FSA and FRC call on auditors to look beyond whether management has complied with individual aspects of the accounting standards, and assess whether the accounts are fairly stated overall. Specifically, the auditor should ask if management has met the overall objective of relevant accounting standards to provide information to users to evaluate, among other aspects, the nature and extent of risks arising from financial instruments.

Further, in their audit work on valuation and impairment of financial assets, auditors should question management’s valuations and provisions for impairment. Specifically, the auditors should question whether management has provided sufficient evidence to justify the valuations of hard to value items and whether the valuations appropriately reflect the economic substance of the transaction. More broadly, the auditor should question whether management’s assumptions are consistent with the auditor’s own assessments of market conditions and observable inputs.

Then there is the complex and critical issue of professional skepticism. Accounting standards require auditors to plan and perform an audit with professional skepticism. The standards emphasize that skepticism includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence. The courts have sanctioned this approach. In a seminal opinion, Lord Denning held that, in order to properly perform the audit of company accounts, auditors must come to the task with inquiring minds, not suspicious of dishonesty, but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none. The auditor’s vital task, said Lord Denning, is to see that errors are not made, be they errors of computation, or errors of omission or commission, or downright untruths. Fomento (Sterling Area) Ltd. v. Selsden Fountain Pen Co., Ltd. (1958). 1 All ER 11. Lord Denning’s statement on auditor skepticism was recently cited with approval by the Singapore Court of Appeal in United Project Consultants v. Leong Kwok Onn (2005), 4 SLR 214.

The FRC has noted that the application of an appropriate degree of professional skepticism is a crucial skill for auditors. Unless auditors are prepared to challenge management’s assertions they will neither act as a deterrence to fraud nor be able to confirm, with confidence, that a company’s financial statements give a true and fair view. However, skepticism can be taken too far, said the FRC, since challenging everything in a well run company will slow down the publication of its financial statements and risk unnecessary costs.

Professional skepticism is particularly important when the auditor is faced with limited independent evidence to support valuations in the financial statements which are particularly subjective. In the case, for example, of complex financial instruments which are not traded on an exchange, applying fair value will often necessitate using valuation techniques that involve models to derive values. And, when there are significant unobservable inputs, it is likely that there will be a variety of assumptions and possible techniques that could result in a range of estimates for those fair values. According to the regulators, the auditor then has to assemble evidence and may need to use experts. Assessing whether the inputs, models, assumptions, range of estimates, and the particular estimate used by their client is appropriate demands a high degree of professional skepticism from the auditor.

The auditor’s objective is to evaluate whether management has made a reasonable and unbiased valuation consistent with the requirements of the accounting framework and with their approach to valuing other similar instruments, based on what could be a myriad of inputs. The FRC and FSA cautioned that it is not sufficient to simply conclude that the valuation is acceptable just because it falls within a range of values that valuation experts would generally consider plausible.

The auditor also has to evaluate whether management has provided sufficient disclosure of the key estimates and assumptions. In some areas, the accounting standards may not specify disclosures, noted the regulators, and in such circumstances the auditor must evaluate whether additional disclosures may be necessary to give a true and fair view. This means it is necessary for the auditor to challenge management accounting estimates and the appropriateness of disclosures. A skeptical mindset, combined with the audit firm’s knowledge of the range of possible approaches to accounting estimates and disclosures, should give the auditor a sound basis to do this.

The Financial Reporting Council has raised its concerns over insufficient auditor skepticism with the major global audit firms based on recent and previous rounds of inspections of major audits encompassing a sample of audits of large companies across the economy, not just financial services firms. The areas in which issues arose included hedge accounting, the appropriateness of the carrying value of certain assets, the appropriateness of loan provisioning assumptions and the basis on which the work of experts was relied upon.

Other regulators have expressed similar concerns about whether auditors are being sufficiently skeptical in their audit of key areas of management judgment. For example a recent audit inspection report from the Australian Securities & Investments Commission noted that in some cases auditors did not adequately document or challenge whether the key assumptions used by management provided a reasonable basis for measuring fair value and disclosures.

For its part, the FSA has identified a number of areas of financial reporting and disclosures where exercising auditors’ professional skepticism is particularly important, including fair value estimates, impairment provision estimates, disclosures on areas where there are diversities of approach in practice, as well as other complex accounting areas, in particular hedge accounting and one-off transactions structured to achieve a particular accounting treatment.

Both the FSA and FRC believe that outside auditors need to challenge management more on the quality of their disclosures. At the same time, the agencies accept that the auditor’s ability to carry through on a challenge depends on the availability of effective levers over management. The ultimate sanction available to the auditor is to qualify the audit report. However, depending on the seriousness of the matter, this may be disproportionate and may not therefore be a credible response. The regulators suggested that another lever the auditor can employ is to draw the matter to the attention of the audit committee.

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