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Is the audit report fit for purpose?

Ian Welch, head of policy, ACCA

Audit reports are not fit for purpose. They are boilerplate and I don't read them. Who said this - some radical corporate governance activist?

Not quite. Nick Land, Board member of the UK's City regulator, the Financial Reporting Council (FRC), and chair of the FRC's Audit and Assurance Council. And former senior partner of Ernst & Young for good measure.

Land was speaking at the FRC's 'improving the auditor's report' public event in late March, held to discuss its consultation document which aims to require auditors to address risks of material misstatements, summarise the audit scope and discuss how materiality was applied in the audit.

The point, Land said, was to 'close the expectations gap'. These proposals, which should be seen as a package combined with the FRC's October 2012 enhancement of auditor communications to audit committees, were described by a Big Four auditor present as 'the biggest change to audit in 30 years'. So do they justify the big drumroll?

It is clear from the outreach carried out by the FRC ahead of its October proposals (and handily summarised in the latest document) that something needs to be done. There is a now familiar litany of comments from investors that audit reports have little value, and some point out that a report with more information on audit judgements, key risks, and areas of areas of focus for the audit would give a broader base for dialogue between shareholders and companies.

Some argue it should be audit committees that put out such information, rather than auditors. Investors at the public meeting seemed unconcerned who did, as long as it happened. It would be a shame if too much time was lost debating this point.

But readers may be getting a sense of déjà vu. Does this not all sound remarkably like the International Auditing and Assurance Standards Board's proposals on audit commentary, published six months ago (and before that, by PCAOB in the US)? Well, yes. And that is disappointing.

The whole point of international standards is that they should be just that - international. So if individual national regulators put out their own proposals, it will inevitably risk derailing that effort - ACCA has consistently made that point relating to accounting standards, in which regional carve-outs to IFRS have not helped.

Some sympathy is due, given the pressure for change to audit coming from policymakers in the UK and Europe. But it must be hoped that the outcome of this FRC consultation will also benefit the development of global standards and that convergence to them in the UK and Ireland will ultimately be to an enhanced common position.

ACCA supports the concept of auditor commentary, first mentioned in a 2011 research report and swiftly followed by the PCAOB, then IAASB and now FRC - the duplicative trend here surely suggests some aligning of regulatory initiatives is needed to avoid the same firms having to keep responding on the same subject. Commentary will provide an opportunity for the auditor to demonstrate their knowledge of the business and this is surely a good thing.

There is a downside - this naturally reduces the extent to which descriptions will be consistent and hence comparable. Without the benefit of dialogue with the auditor, users may find it challenging to understand technically difficult matters and interpret the qualitative descriptions deriving from subjective judgements made by the auditor. There is considerable scope for misinterpretation.

This surely argues for an unhurried implementation of the proposals, allowing sufficient time for all affected parties to develop a proper understanding. Once again this shows the danger of a national regulator moving in advance of global standards.

So will it provide those much sought-after 'hooks' for hard-to-engage investors to start a dialogue about the audit? Experience in Australia, where auditors attend AGMs is not conclusive. And some at the FRC event doubted investors would wish to do so, which would be a shame - although such reporting does not allow a firm conclusion to be drawn about the quality of the audit, it certainly adds to information relevant to that.

More importantly, by exposing the auditor's views on risks, it contributes to, and may focus, the users' understanding of the company's own disclosures. So surely it should be of interest to investors.

Some queried whether risks disclosed by the auditor would differ from the principal risks disclosed by the directors in the business review. But under the Corporate Governance Code, the audit committee's report should include 'the significant issues that the committee considered in relation to the financial statements, and how these issues were addressed'. Investors would surely expect to see some overlap between these and the risks identified by the auditor, especially as some of the issues may have been brought to the attention of the audit committee through the audit process?

Of course the ever-present question of litigation is never far from the surface. If an auditor did not include a particular risk of material misstatement which it became clear later had given rise to significant damage to the company, they might be sued.

Auditors may react to this risk in two ways: disclosing more, to mitigate this risk - or disclosing less to avoid criticisms of breaching confidentiality or causing unnecessary concern in investors. This tension has been present for some years in relation to an emphasis of matter regarding going concern.

As ACCA has said consistently, policymakers have to get this sorted out if innovations - like audit commentary - are going to stand a chance. Land said at the FRC event that firms could innovate, even with the current audit report format. But this seems a forlorn hope, without liability reform.

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