New Audit Order: Take 1

There would be demand for independent assessment of products made by humanity as long as human beings are not perfect. The Audit Society is a term used by Michael Power to name his book about role of audit in our life. So the major question I would address these days is as follows:

«Can audit of financial  statements accomplish its objectives

effectively and efficiently and still be profitable business with 

active competitive market?»

For productive discussion it would be useful to remind some elements of agency theory in illustration below:

Source: http://maaw.info/ArticleSummaries/ArtSumTiessenWaterhouse83.htm

As  recognized in previous post auditors were given  specific ‘societal mandate’, but stakeholders (principals) of auditors' (agents) activity are not satisfied with the work done.

I have some ideas, which I would like to share.

Addressing Independence Threat

Audit business is not only attesting business in the world. There are lots of firms around evaluate, assess and make opinions. Examples? Here are they:

·        Knowledge tests for students: GRE, GMAT, EITLS, Toefl;

·        Exams for professionals: US CPA exams; ACCA exams;

·        University system assessment of knowledge;

·        Peer reviewed journals: review of scientific articles

·        And so on, there are lots of them!

All of these businesses do similar thing – express opinion about quality/level of something. The key thing in independence here that markers (evaluators) do not know their concrete client (personalities) and clients do not know concrete people who check their  workings. In audit of financial statements it is not an easy to do thing.

However, we can eliminate influence of board of directors decision to switch an auditor on independence of audit firm. How?! I would  propose following model. For example, we are going to pay special attention on audit of global multinational companies (MNC) by audit firms. Given that assets and performance of MNCs are spread across the world it is difficult enough to observe independence of audit firms on local level.

Global (National) Audit Fund (GAF)

GAF could be established by G20/G40 countries to tackle the problem. The function of GAF would be to appoint external auditors for MNCs and pay remuneration to auditors. There would be list of MNCs which activity has national and global impact (addressing partly “too big to fail” issue). Criteria to include MNC in list are not a problem and could be easily established. GAF would be funded through following sources:

·        investor/shareholder tax, which could be withdrawn at the moment of purchase shares or could be part of dividend tax;

·        government budgets (with inevitable increase of MNC and/or individual taxes).

Thus, in our model we would align practice with theory: principals pay agents to act for their benefit. Agents care about their business and prosperity and would do anything to satisfy their customers-principals. MNCs’ financial statements (FS), which audit firm would have to audit under the contract are only subject of an agreement – more precisely it is kind of product produced by other agents (management of company) of principals. To say more allegorical FS are just peace of paper with student’s workings which are needed to be assessed.

Issues to concern about        

I would suggest following problems of model:

·        process of external auditor appointment: inevitable ‘red tape’, threat of corruption;

·        competition on audit market;

·        quality and nature of service rendered by audit firm.

I would be glad and grateful if guys reading my blog would provide their suggestions in comments and participate in discussion.

In the next post I am keen to address the expectation gap issue and nature of services provided by auditor. I suppose it might be partial solution to the problems of model identified above.

References:

Power, M. (1997). The Audit society: rituals of verification. Oxford: Oxford University Press. 

New Regulations for Auditors: European Revolt

Nowadays, when revolutions spread across Middle East and North Africa, the European Commission gently prepares revolutionary changes in audit industry. The cause, as you probably could guess, is financial crunch. Of course, usual "we can’t live like this any more" is also there...

So, how auditors are going to live in near future? What are new regulation ideas of industry? Would it harm our profession? I wish I new concrete answers on this question. Let’s just briefly outline what have happened.

European Commission fed up with current audit practice

In October 2010 European Commission met to raise questions about problems of audit and subsequently issued a document “Green Paper - Audit Policy: Lessons from Crisis”(click to see). The major issues discussed by Commission are as follows:

·        The role of auditor;

·        Ethical issues: governance and independence;

·        Competition in audit market;

·        Supervision of audit practices;

·        Small business problems.

Expectation Gap

I can’t say better than Commission has written: “Given that these stakeholders may be unaware of the limitations of an audit (materiality, sampling techniques, role of the auditor in the detection of fraud and the responsibility of management), this engenders an expectation gap”. 

Yes, there is an expectation gap! Most of people unrelated with audit mistakenly think, that clean audit opinion must give guarantee of financial soundness. Partly they are right. Even under current audit standards the audited entity can’t be totally financially unsound and still get clean opinion. In case of bankruptcy issues and if auditor has reasonable grounds to cast doubts about viability of an entity in nearest year there is an always possibility to issues modified audit opinion with emphasis on going concern issues.  

The bad thing, that even these kind of issues were not emphasised (see e.g. Lehman brothers case described by Sikka).

EU would consider extension of the auditor’s mandate and going to decide whether to enable them to provide economic and financial outlook of audited company or not.

 Competition

Big Four audit firms do audit for 90% of listed companies in vast majority of EU states. Looks like oligopoly, doesn’t it?! EU says that in case of ‘demise of systemic audit firm’ it would raise ‘to big to fail’ situation. There is also potential risk of complete lose of trust by investors and deep crisis of audit profession. European Commission does not have unambiguous answers. Probable ideas to consider: joint audit, mandatory rotation of auditors, reassessment of actual quality of services provided by Big4 and addressing existing bias of perception of Big4 ( European Commission 2010, pp. 15-17).

 Independence  

Green paper clearly states: “The fact that auditors' responsibility is to the shareholders of the audited company and other stakeholders although they are paid by the audited company creates a distortion within the system”.  One of suggested solution to this problem  would  be introduction a third party into ‘auditor-company’ relationships: ‘remuneration and duration of the engagement would be the responsibility of a third party, perhaps a regulator, rather than the company itself’.

Non-audit services also impair auditors’ independence. The tone of document shows that Commission would like to remove any business interest of audit firm in the company being audited. ‘Pure audit firms’, so called, ‘inspection units’ – this is the language used by European Commission.      

Call for help

European Commission asked for response on its Green Paper and promised to announce proposals in 2011. By the 8^th of December 2010 preliminary public consultations (click here for proposals) had been ended and on 10^th of February 2011 high level Conference was held to discuss Green Paper (pls. click link to read about Conference and materials).

I am going to follow European Commission discussions and I will provide some suggestions concerning raised issues in my further posts. Moreover, I would be pleased if you provide me with your ideas in comments.    

  References:

European Commission. (2010). Green Paper - Audit Policy: Lessons from Crisis

Sikka, P. (2011).The EU man cometh. PQ Magazine. No. 1, p. 27.

Smith, P. (2010). Under Pressure. Accounting and Business. Vol. 13, Issue 10, pp. 13-14

ACCA

ACCA results have been issued this week.
Congratulation to everybody who passed at least one paper ) You deserve it for your hard work and ability to communicate an idea.
Preparation for next session have to be started as soon as possible.
I am going to start reading study text in coming week. Good luck to your preparation!

PS If any US CPA candidate is reading this blog, good luck to you also! ))) I have been doing CPA exams and know what you fill )

Goodwill vs Business Reputation

Have your reputation been ever written off? It is probably disaster, isn’t? However, it is quite usual thing for accountants to review reputation of the company and decide whether to leave it or write it off.

Surely, I am talking about Goodwill (GW). According to Oxford Dictionary of English, goodwill is the established reputation of a business regarded as a quantifiable asset and calculated as part of its value when it is sold. Not too "accounting -accounting" definition : )

IFRS 3 sounds much better: GW – is an asset representing the future economic benefits from  other assets acquired in a business combination that are not individually identified and separately recognized.   

To understand better,  mathematically simplified it is just purchase consideration minus fair value of net assets of acquired company. My old Becker CPA book have good illustration of that:

Here starts the story… Two years ago I met my former colleague who was in charge of  corporate reporting in her company and encountered audit that period. She told me, that new fashionable audit idea of the season is to write off GW, because of crisis…

On September 2010 I came across interesting article in Financial Times “Goodwill games”. Guys from investment bank  Houlinah Lokey have carried out remarkable survey.

According to US GAAP and IFRS, GW is subject to annual review and recalculation. Recalculation is based on discounted cash flow which acquiree able to generate in future. If cash flows fall, the GW is written off. Quiet reasonable.

The FT, Lex Column constitutes:

‘What seemed strange is how little effect the unexpected recession has had on the value of GW. Between the boom years of 2005 and 2008, Europe’s top 600 companies spent 1,700bn euro on acquisitions and booked about 900bn euro of GW in the process. Those deals were based on expectations of steady growth in  real gross domestic product; as late as 2008, the International Monetary Fund forecast GDP would be 15% higher in 2013 than in 2007.

As of the end of 2009,  that forecast of GDP was below 5%. Logically that should have triggered a big fall in the potential earnings for acquired companies. But since the recession  began, barely 4% of companies’ GW has been written down,  excluding the 32bn euro write-off at Royal Bank of Scotland’.

   Just look at this illustrative figure about GW write-offs and IMF’s GDP forecasts provided by Houlinah Lokey:

Good looking charts aren’t they! In the end of the article authors suggest that “cosy relationships” between auditors and their clients are reason for such  insufficient conservativeness in accounting for GW.

Personally, I think that if GW is not written off because of “cosy relationships” it is not good. Potentially it could harm not only goodwill of client, but also business reputation of audit firm.      

      

References:

Becker CPA Review. (2008) Financial Accounting and Reporting. DeVry/Becker Educational Development Corp.

Financial Times. (2010) Goodwill games. 28^th of September 2010, p. 16  

Audit Opinion and Share Prices

How often have you heard (working as auditor) or told (being client) “what is the value in all your audit procedure”?

Actually, there is the value of audited company at the stake! To keep our clients from such comments, we can now offer scientific dispute :)

Nowadays I am busy with preparation of my research proposal in the audit area. I have reviewed and read sufficient number of research articles dedicated to subject of relationship between share price and audit opinion announcement effect.

It is interesting that while working in audit firm I was not aware that there were lots of researches in this area. Of course, my colleagues and I assumed that audit opinions are able to communicate additional valuable information to investors, public, and regulatory authorities, but I could not imagine that topic is rather popular among researchers in economics and statistics.

So, the main questions which researchers ask: “Is there any information content in audit opinion announcement for investors?”; “Do audit opinions really influence share prices?”. The researches in this area started in 1970-s and still are carried out. There are different research methods are applied: event study statistics with models, sociological interviews, modeling situation based on group of investors.

Based on what I have already read I can say that the results are controversial.

Number of studies (pls. see Firth (1978); Dopuch et al (1986); Chen et al. (2000); Menon and Williams (2010)) present sufficient evidence that share prices significantly decrease after announcement of qualified (modified) opinions as oppose to non-modified. Chen et al. (2000) illustrated his research with interesting figure showing distribution of share returns as a result of reaction on clean and modified audit opinion (MAO) in Shanghai Stock Exchange.

No very much need in comment. MAO announcement effect is rather negative and significant on event date.

On the other hand there are number of researches that do not prove hypothesis that investor reaction towards audit opinion is statistically significant. Studies are carried out by Chow and Rice[different results for API and types of qulafications] (1982); Martinez et al (2004); Ogneva and Subramanyam (2007); Al-Thuneibat and Nedal (2008)). Probably figure provided by Al-Thuneibat who tested same idea in Jordan market describes behavior of return in this case.

As seen from the figure above behavior of returns on shares of companies’ which have received qualified audit opinions is rather controversial and does not maintains single pattern.

Conclusion

Finally, I personally think that statistical research depend on quality of data you get and appropriateness of method applied. For example, in event study researches it is important to pick up right date. Moreover, attitude of investors towards audit opinion varies from country to country depending on development of markets, institutes, legal relations and culture. Probably cross country research needed to be carried out based on the unified elaborated methodology by group of scientists. So, I would not be much creative if I say: “further researches to be carried out in this area” ;)

Articles mentioned in post:

Ali A. Al-Thuneibat, Basheer Ahmad Khamees, Nedal A. Al-Fayoumi, (2007) "The effect of qualified auditors' opinions on share prices: evidence from Jordan", Managerial Auditing Journal, Vol. 23 Iss: 1, pp.84 - 101

Chen, C.J.P., Su, X. and Zhao, R. (2000), “An emerging market’s reaction to initial modified audit opinions: evidence from the Shanghai Stock Exchange”, Contemporary Accounting Research, Vol. 17, pp. 429-55.

Chow, C. W., and S, J, Rice. 1982. Qualified audit opinions and share prices — An investigation. Auditing: A Journal of Practice and Theory 1 (Wmter): 35-53.

Dopuch, N., R. Holthausen, and R. Leftwich. 1986. Abnormal stock returns associated with media disclosures of “subject to” qualified audit opinions. Journal of Accounting and Economics 8 _June_: 93–117.

Firth, M, A. (1978). Qualified audit reports: Their impact on investment decisions. Accounting Review 53 (3): 642-50.

Martinez, M., Martinez, A. and Benau, M. (2004), “Reactions of the Spanish capital market to qualified audit reports”, European Accounting Review, Vol. 13, pp. 689-711

Menon, Krishnagopal; Williams, David D (2010). Investor Reaction to Going Concern Audit Reports. Accounting Review, Nov2010, Vol. 85 Issue 6, p2075-2105, 31p

Ogneva, M., and K. R. Subramanyam. 2007. Does the stock market under-react to going concern opinions? The evidence from the U. S. and Australia. Journal of Accounting and Economics 43 _July_: 439–452.