Audited financial statements are supposed to provide a solid foundation for financial markets. Yet, they increasingly appear incapable of delivering what is needed—a reliable assessment of an organization’s financial position. Is there any hope for change?
The recent history of professional accountancy and audit firms has been far from glorious. Audited financial statements are supposed to provide shareholders, investors and creditors with an independent and objective assessment of an organization’s health. The financial crisis of 2008, the aftershocks of which are still being felt all over the world, made audited financial statements look like they were not worth the paper they were written on.
How else could we explain the sudden and catastrophic failure of banks whose financial statements gave absolutely no indication of impending doom?
Yet, we knew that there was a problem with audited financial statements long before the 2008 financial crisis.
In 2001, less than a decade earlier, the Enron scandal resulted in the demise of the then Big 5 accounting firm Arthur Andersen—now we are left with a Big 4. In addition, there were a whole host of other accounting scandals in the early 2000 involving US companies like WorldCom, Tyco and Qwest. All of these made us call into question the usefulness of audited financial statements.
Britain too had its fair share of accounting scandals prior to the banking debacle of 2008. In the 1990s both Polly Peck and the Bank of Credit and Commerce International (BCCI) collapsed in spectacular fashion.
As such, while accounting scandals have occurred since the dawn of double entry bookkeeping, the past two decades have witnessed a significant increase in their numbers. This is due in no small part to the increases in both the size and complexity of businesses over the past 20 years.
Nowhere is this increase in size and complexity more apparent than in the banking industry. For example, when I joined Manufacturers Trust in 1987 it was just one of several major banks in New York. Other major New York banks included Chemical, Chase Manhattan and JP Morgan. Today these four banks have all been merged into a single entity known as JP Morgan.
The question is how can we address this problem?
If we don’t, then audited financial statements will become less and less relevant to all interested parties and that would only serve to further undermine confidence in the financial markets.
Here are a few suggestions.
1. Develop values-based audits
If the financial crisis has taught us anything, apart from the fact that the numbers clearly do not tell the whole story, it is that an organization’s values are far more important than its governance and controls. As such, given that traditional audits focus on numbers, governance and controls, then it is obvious that on their own they cannot be relied on to establish the state of an organization’s financial health.
For auditors to improve both their relevance and usefulness they should seriously consider adopting a values-based approach to assessing the financial health of organizations.
2. Establish an independent body for setting fees
Even as businesses and banks in particular have become larger and more complex, accountancy firms are under ever increasing pressure to reduce audit fees. Notwithstanding the fact that such behavior is inconsistent with the stated importance of the audit, it is difficult to see how auditors can perform at their best if their fees and by definition the time taken to perform their audit work are consistently being curtailed or reduced.
The only way to get around this would be by establishing an independent body for setting fees for major organizations. Auditors are by definition supposed to be independent. That independence is compromised each and every time that they have to haggle and negotiate over their fees.
3. Establish a statutory requirement for reporting on complexity
Many banks are simply too complex in terms of their organizational structures, operating procedures and products to audit with any real degree of confidence. Consequently, both internal and external auditors, have a tendency to audit to the limit of their competence and/or understanding of these elements. This cannot be a satisfactory state of affairs.
Further, the nature of complexity within organizations is such that even if by some minor miracle absolutely everything is working well and being properly managed during the audit, there is always the danger that something can and will subsequently go awry.
While auditors consistently maintain that it is not their duty to advise the management of an organization as to what they can and cannot do, the failure of auditors to challenge management on the issue of business and operational complexity can only undermine the value of the auditor and of the audited financial statements.
Having a statutory requirement for reporting on complexity and how it might affect the ongoing activities of an organization would not only provide readers of the financial statements with a greater understanding of the risks inherent within an organization but also force management to more adequately address those risks.
4. Place greater public reliance on internal audit
The reality is that for large and complex organizations the work of internal auditors is far more important than that of the external auditors. This is because the latter has far more time and resources at its disposal to thoroughly evaluate the systems and controls of the organization in question.
Thus by definition, even as external auditors place reliance on the role of internal auditors, the size and scope of the work performed by the latter is much greater than that of the former.
Organizations should seriously consider having the internal auditors provide their own in-depth public statement on the state of the organization’s systems, controls and overall financial health. This would provide far greater insights into the actual issues and specific concerns that might affect the continuity of operations.
5. Upgrade skill sets
Both internal and external audit place far too much reliance on the work of lower level staff, in the mistaken belief that the oversight provided by senior auditors and managers is sufficient to ensure that all aspects of risk will be properly covered. This state of affairs is a product of both the traditional approach to audits by accounting firms and the pressure that organizations have placed on audit fees as raised in point 2 above.
There is no question that the imbalance between the use of inexperienced and experienced staff needs to be altered in favor of the latter. In addition, there is still significant scope for improving the skill sets across the board.
How can this be achieved?
Traditionally, both internal and external audit have been considered a training ground and a conduit for young professionals to learn and then move on to something “better”—taking what they have learned with them. It is high time that audit departments attract and retain a much higher proportion of skilled and specialist staff. If organizations actually believe that the work of auditors is of absolutely vital importance then they should pay them accordingly.
Jonathan Ledwidge is the author of the book Clearing The Bull: The Financial Crisis and Why Banks Need a Human Transformation.