Monday, April 18, 2011

European Accountants Federation Comments on Proposals to Improve Audit and Quality of Financial Reporting

The responsibility of the outside auditor of financial statements is secondary to that of the client’s company’s management, said the European Federation of Accountants, but the current model for auditor’s communication could lead to an expectation gap to how the auditor discharges the responsibilities for the work being done. These comments were made in a letter to the UK Financial Reporting Council on the FRC’s recent discussion draft on the quality of outside audit and enhanced corporate reporting.

A company’s management is responsible for the preparation of financial statements and other financial information in accordance with national or international accounting standards, said the federation, while the auditor’s responsibility is to express an opinion on such financial statements. But this model is not written in stone. To benefit investors and other users of financial statements, more transparency and communication could be considered. For example, management could, in a proportionate way, report on the assumptions on which the company’s ability to continue as a going concern is based by disclosing additional information on key risks to the company’s business model and its longer term sustainability as well as how the audit committee discharges its duties.

The federation believes that the role of the independent auditor can be expanded in the future. In this context, it is important to note that audit is only one part of the financial reporting system, and therefore auditors should only assume responsibility for their own role and actions without
excessive and disproportionate liability attaching to them.

Considering communication in the broadest sense, the federation urged regulators and oversight bodies to carefully consider whether investors in fact would like information on the company’s performance from the company itself in the form of extended public reporting from the audit committee, or whether the auditor should be involved in providing information on such matters. It may well be that the audit committee is best placed to provide the information potentially requested by investors, and not the auditor. However, if so requested and if suitable criteria exist, auditors could provide a certain level of assurance on the information provided by the audit committee.

Further, when considering how to improve communication, noted the federation, regulators must strike a proper balance and avoid both information overload that would reduce the relevance of key information and self-fulfilling prophecies that would have counterproductive effects threatening the company’s existence.

The federation said that auditor professional skepticism should continue to be reinforced. This could be done by further training, said the group, and by application of international auditing standards since the application of these standards clearly underlines this concept. This was essentially an endorsement of ISA 200.13, which defines professional skepticism in auditing standards as an attitude that 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. At least two global audit firms, KPMG and Baker Tilly, have found that the ISA definition is consistent with professional skepticism as described by Lord Denning, who said that auditors must come to their task with an enquiring mind, not suspicious of dishonesty, but suspecting that someone may have made a mistake somewhere and a check must be made to ensure that there has been none. Fomento (Sterling Area) Ltd. v Selsdon Fountain Pen Co. Ltd. (1958).

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.

The federation supports shareholder involvement in the process of appointing the outside auditor since this would contribute to safeguarding the independence of auditors which is an essential part of the trust and integrity of the audit profession. Such additional safeguarding of auditor independence could be done through initiatives such as increased independence of the auditors’ selection process, enhanced shareholders’ engagement and increased transparency of the auditors’ selection, appointment and compensation process.

While reaffirming the appropriateness of having the audit committee appoint the outside auditor, the FRC proposed requiring 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.

In the federation’s view, there are significant potential benefits to the use of technology for the accessibility of the annual report and financial statements. In this context, the group supports the use of electronic applications in financial reporting such as XBRL. However, there are challenges to using XBRL, in relation to financial reporting as well as auditing, such as in relation to the inclusion of extensions and the responsibility for such extensions and with regard to the audit of XBRL generated financial statements.

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