The Role of Big4 in promoting IFRS

The audit of IFRS reports is one of the major services provided by the international accounting networks. This is because they possess necessary knowledge and skills, which could be used all over the world. However, there are negative moments in this process, which could be illustrated by conclusion made by Sucher and Alexander (2002) in their research:

     “Given their power over both the production and audit of IAS accounts, the Big Five firms play a very large role in interpreting and implementing IAS standards in a particular country.  This raises issues of power and responsibility with respect to compliance with IAS that need to be addressed clearly by the IASB”

So this post is going to address this issue and point out on existing problem especially in emerging markets.

Illustrations

The issue was substantially researched by Sucher and Alexander (2002) based on the example of Russia and by Sucher and Jindrichovska (2004) in study of situation in Czech Republic.

The problem is that companies in emerging economies suffer from lack of knowledge and expertise in preparation of IFRS accounts. The probable solution could be to hire IFRS specialist or to outsource reporting process. But on the one hand there is a shortage of qualified and experienced professionals in emerging markets. On the other hand, outsourcing by one and afterwards auditing by another independent firm are seen as superfluous costs. Finally, these companies opt into simple solution – they ask audit firms both to prepare and audit their IFRS accounts. This state of things as honourable auditors we can’t tolerate, can we?

Sucher and Alexander (2002) illustrated the situation by remark of one of Big Five (at the moment of research) interviewees:

“As you know we do not prepare accounts for our clients – it is an independence issue….however, we do provide a degree of assistance….. Some accountants in enterprises crunch the numbers (for IAS) and others say, ‘look guys we pay you to do it.  It is a fairy tale’”

It is not only willingness to save money, the issue is also related with the perception of an audit as no-value-adding activity. Interviewees in Czech Republic complained that the earlier Big 4 audit firm provided such package of services while the latest Big 4 auditors refuse to do this (Sucher and Jindrichovska 2004). One of the Big 4 auditors (interviewee) added fuel to the fire:

“Some financial managers and accountants [in enterprises] do not know what is going on [with IFRS]. They are only the passive receivers. In [X audit firm], there are templates that transform Czech accounting to IAS. The knowledge is kept in the audit company. It is big business [for the audit firm]. You can train companies to do the supporting sheets hut the final bit is done by the audit firm.”(Sucher and Jindrichovska 2004).

Meanwhile, management of the companies would always be keen on saving costs on such things like audit. It is quite likely that such kind of cosy relations are more beneficial to audit firms. At least they could have separated audit and accounting team, but according to research it would be too costly for audit firms and they end up by assigning one team of people to do both jobs, which is a shame.

Problems

The basic issue which arises here is how far should we trust financial statements prepared in emerging markets? To what extent this practice spread in other emerging countries, where corporate governance and law enforcement are not developed enough? I think that it is highly probable that similar “reporting-auditng” is practiced in China, where local management is rather pushy in accounting issues (see Deloitte’s case).

The other question how can we deal with the issue in sensible way. For example, one is audit manager and one is doing audit of IFRS reports of Brazilian company. The resourceful Brazilian finance director provides auditor with financial statements (FS) essentially based on Brazilian GAAP, but with name of IFRS on its face. The trick is that you will do honest auditing, spot discrepancies from real IFRS and provide list of adjustments which need to be done J It is foxy tactic, isn’t it?

What do you think about truthfulness of IFRS accounts of companies from emerging markets listed on global stock exchanges? Have you faced approach mentioned above in your reporting or auditing practice? How to discourage auditors from doing that especially in the context of coming “pure-audit-firms” legislation? Please share your knowledge and experience.

References

Sucher, P. and Alexander, D. (2002) IAS: Issues of Country, Sector and Audit Firm Compliance in Emerging Economies (London: Centre for Business Performance of the Institute of Chartered Accountants in England and Wales).

Sucher P., and Jindrichovska I. (2004) Implementing IFRS: A Case Study of the Czech Republic. EAA, Accounting in Europe, Vol. 1, pp. 109-141.

New Audit Order: Take 2. Remodeling audit services

The audit profession is very conservative by its nature but to survive any organism must be flexible, open for changes and new trends.

How can we modify meaning of “audit services” terminology? How could it influence audit firms market and multinational companies (MNC)?

New services – more analysis

Let’s be clear about it. Society demands from auditor to give the opinion about financial soundness and performance of listed companies, given that auditors have extensive access to information. Green Paper of  European Commission suggests that ‘forward looking analysis’ of ‘large listed companies’ might be ‘real value added to the stakeholders’.

So auditors are going to move to the business of credit rating agencies and financial/equity analysts. And I would suggest this is very good news! Auditors are extremely fit for this job: auditors have enough expertise, knowledge and analytical skills to provide sound analysis of companies, moreover they know degree of reliability and relevance of each line of financial statements.

Format of product: three-fold report

We have already had reports with two types of opinions: financial statements opinion and effectiveness of internal control (over financial reporting) opinion. Under SEC requirement Companies listed in US need to be audited in accordance with Public Company Accounting Oversight Board (PCAOB) standards (after enacted SOX legislation). See, for instance, extracts from Hershey’s financial statements audit report:

Source: http://www.thehersheycompany.com/investors.aspx?ICID=HCOMP1005        

Obviously, the third part could be added to this report. Brief paragraph about financial viability of company (going concern analysis) which must be accompanied by detailed analysis of company’s previous financial year performance and financial perspectives based on evidences  gathered as at  audit report date. The brief paragraph in the body of report together with detailed analysis should give unambiguous understanding of auditor’s opinion about the company financial and business perspectives.  

How to do – technique

Some words about audit team management. In my opinion, in the above case scenario the audit team should split at least in 2 parts: financial statements audit team and business audit team. The first one would be concerned with internal controls and financial statements. The business audit team would have to spend time on analysis. These split in two roles is necessary to avoid any eye-soaping of members of audit team and would encourage fresh look on business activity and company’s reports by business team.  Definitely, both team must work together and question each other on their findings, inconsistencies and misunderstanding. For example, such procedures like overall analytical review supposed to be carried out in cooperation.

Responsibility of auditor: less regulated more active and open?

Responsibility of auditors is very complicated issue to discuss. There are similar kind of services provided by other companies, but their responsibility is not as much auditors’. What does hold our profession from development? How does responsibility influence on competition?

I suggest responsibility should be limited to quality of services provided. In any case, dissatisfaction by work of auditors whether they failed to predict bankruptcy of Lehman brothers or failed to reveal fraud in Enron is caused by bad quality of audit work; non-compliance with audit standards or weak audit standards itself. If society is not satisfied by quality audit standards then it is time to change them, but there is no use to blame auditors, because they complied with wrong standards.

On the hand we have market, which is supposed to regulate audit business. If shareholders are not satisfied with quality of audit services they hire another auditor and bad reputation would not let providers’ of bad services to succeed.

Some considerations about other industries…

Let us look on credit rating agencies. There are no much regulations about them. They do not have such comprehensive quality standards as accountants do. But it is also quite oligopoly market (Big three:  Standard & Poor's, Moody's Investor Service and Fitch Ratings). The agencies also has faced severe criticism after financial crunch for not being accurate in their assessment of companies’ rating. This reminds me something…

There is another interesting industry which is worth mentioning: the higher education institutions. Suppose, I hired MBA graduated from Yale University with GPA = A+. After we signed one year labour contract it have been appeared that my new hire has had idea neither  about efficient market hypothesis nor net present value analysis. What should I do? Should I sue Yale University for that? Does it mean that there is unsatisfactory education quality control and attesting system at University? Or is there anything wrong with my  recruitment system?

Anyway I think it is time to make Porter’s five force analysis and PESTEL for regulators and audit professionals to assess:

1)      if legal, social and political barriers have been already rather high and suppress competition in industry;

2)      if lowering of those barriers might increase competition level;

3)      if increased completion level might positively impact quality of audit services and provide additional value for society.

There are lots of work to be done and long journey to be made. 

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.