Saturday, January 15, 2011

UK FRC Proposes Expanded Independent Audit Reports as Part of Broad Reform of Financial Reporting

The UK Financial Reporting Council has proposed an expanded outside audit report on a company’s financial statements, including a new section on the efficacy of the audit committee report and the identification of matters in the annual report that the auditors believe are incorrect or in consistent with the financial statements or obtained in the course of their audit. The FRC, which oversees UK audit, also proposed greater shareholder involvement in the appointment of outside auditors. These proposals were advanced as part of a broader reform of the reporting and audit process.

The shortcomings of financial statements and the effectiveness of outside audits were cast into stark relief during the crisis when firms failed shortly after their financial statements received unqualified audit opinions. These events raised questions about whether the risks facing the firms were adequately described and whether accounting standards were effective. The FRC acknowledged that this may have been more a problem of technology overtaking the historical concept of an outside audit. At the inception of corporate reporting in the 19th Century, noted the FRC, the audit was developed to address the issue of whether past transactions and their impact on assets and liabilities were correctly recorded in financial statements.

Since then, technology has materially changed financial reporting. With computers processing transactions and allocating sale proceeds in accordance with accounting requirements, numerical issues are less problematic. Moreover, accounting has moved from historical cost to the market valuation of assets and liabilities, thereby increasing the value of financial statements while at the same time increasing the complexity of accounting standards and requiring preparers and auditors to exercise significantly greater judgment. This means that the outside auditors must consider the appropriateness of the accounting policies the company adopts and the methods and judgments made in valuing assets.

In the FRC’s view, investors and other users of financial statements have become increasingly aware that the matters that determine the scope and effectiveness of the audit, and which are therefore important to the auditors in reaching their opinion, are not expressly addressed in the audit opinion. Thus, the FRC proposes that auditors be required to report on the completeness and reasonableness of the audit committee report and, if necessary, set out any further information required to achieve that outcome.

According to the FRC, that would assure users that they were provided with a comprehensive report on the matters that the auditors considered important in reaching their audit opinion. Auditors should also be required to report, based on the work that they have done in the course of their audit, whether they are aware of any facts or matters in the annual report that are incorrect or inconsistent with the information contained in the financial statements or obtained in the course of their audit.

While reaffirming the appropriateness of having the audit committee appoint the outside auditor, the FRC would like to increase the role of investors in the appointment process. Among other things, investor involvement would reinforce the independence of the audit committee’s selection of the outside audit firm. Thus, the FRC proposes to require the audit committee to either report to investors on the process by which the committee reached its recommendation to appoint the company's external auditor and the reasons for their recommendation or discuss with a number of principal investors the approach to be taken to the appointment of the auditors, including the merits of putting its audit out to tender and then report on that consultation to shareholders generally.

Since audits could have been more effective if auditors had shown more skepticism, the FRC wants to ensure that the right environment is created for increased auditor skepticism when assessing material assumptions and estimates. Audit committees have an important role to play here by creating the appropriate environment for the audit team to challenge material assumptions and estimates in an effective way and to communicate their views in a forthright and constructive manner.

As part of this process, the FRC wants audit committees to set the appropriate expectations on the audit team and management. Auditors must have the capability of responding to such expectations, emphasized the FRC, and the effective exercise of professional judgment is fundamental to the quality of every audit and is required at numerous stages during an audit. If auditors are to exercise that professional judgment effectively, reasoned the FRC, they must approach issues with professional skepticism, which would be enhanced by opening auditor assessments to effective challenge by the audit committee and by investors.

Thus, the FRC proposes that the standards governing the provision of reports by auditors to audit committees (such as ISA (UK & Ireland) 720) be enhanced to ensure that they provide the information that is necessary to enable audit committees to understand the factors that auditors relied upon in exercising their professional judgment in the course of the audit and, in particular, in reaching their audit opinion, including the auditors’ views on the effectiveness of the company’s controls, the judgments made in the audit plan about what is of material significance, the appropriateness of the accounting policies, and the valuations of the company’s assets and liabilities provided by management.

In the FRC’s view, a greater awareness of such matters would enhance the quality of the auditor’s exercise of professional judgment, increase the transparency of the audit process to the audit committee and help the committee form its own view of the appropriateness of the presentation of the company’s financial performance in the financial statements. It would also provide important information to the audit committee when deciding what information to include in its report.