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Audit expectations gap row reopens old wounds

How auditors handle corporate fraud concerns, and the public’s perception of these duties, is back in the spotlight.

10th Feb 2021
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The Pensions & Investment Research Consultants (PIRC) recently challenged a consultation from the International Auditing and Assurance Standards Board (IAASB) on whether the existing rules on fraud discovery are fit for purpose. 

The discussion paper from the New York-based international audit standard-setting body addressed the so-called expectation gap in auditing, and and questioned whether the public expect too much. 

The IAASB asked if auditors should have “enhanced or more requirements with regard to fraud in an audit of financial statements”. But PIRC said the courts and government had already made it clear auditors should be spotting fraud. 

Reviving the expectation gap spectre

PIRC founder and managing director Alan MacDougall wrote to the largest accounting firms telling them to reject the proposals, stating that they go too far, and the consultation is opening old wounds.

“The starting point for the common understanding the IAASB seeks should be on an informed legal position, not one based on the myth of a so-called ‘expectations gap’,” he said.

“If the public is wrong on expectations of auditors, it is more likely to be that they under appreciate their legal duties given the extent of misinformation over the years.”

The purpose of the consultation is to gather views from stakeholders about the role of auditors in relation to fraud and going concern during the audit of financial statements, the IAASB said.

“Many of the regulatory inquiries that have become commonplace in the aftermath of corporate collapses routinely highlight the importance of considering what more can be done by auditors on these two topics,” said IAASB chairman Thomas Seidenstein.

Multiple corporate failures in recent years such as Carillion, Thomas Cook, BHS and Wirecard have damaged the reputation of auditors, who were said to have missed warning signs or were negligent in their duties.

A long awaited white paper from the government expected this week is set to respond to these corporate collapses and could shake up the audit industry.

In April 2019, the UK Parliament’s Business, Energy and Industrial Strategy (BEIS) Select Committee delivered a stinging report on the future of the sector, advising that the detection of fraud should be a priority within an audit and audits must demonstrate how potential fraud has been investigated.

Not looking for fraud

One of the more controversial statements on who is responsible for calling out fraud was made by David Duckley, the chief executive of Grant Thornton in 2019, following the collapse of bakery chain Patisserie Valerie after enormous accounting breaches. Duckley told MPs it was not the auditor’s job to look for criminal activity. 

“Unfortunately, the statement made to MPs by the chief executive of Grant Thornton that ‘we’re not looking for fraud’ was just plain wrong,” said accounting expert Julia Penny, director of JS Penny. She told AccountingWEB an audit specialist rather than the CEO would have given lawmakers a different response.

“After all the objective of the auditor, according to the standards that must be followed is to ‘obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error’,” she said.

“The bit that can lead to an expectation gap is that ‘material’ means something that could influence readers of the financial statements, and for large companies this is therefore often a very big figure, well into the millions.”

None of the recent headline-making scandals and audit issues have been due to frauds which were too small to make a difference to the accounts, she said, as the issue has instead been one of a quality gap, not an expectation gap.

“Professional bodies and their member audit firms are investing a lot of time and money to understand why this arose and to correct it,” Penny added. “But audit is not easy and the results may take time.”

Reasonable assurance

Steve Collings, partner at Leavitt Walmsley Associates Limited, pointed to ISA (UK) 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements, paragraph 5, which states that the auditor is responsible for obtaining reasonable assurance. He said it may not be what some people expect, an absolute assurance, but it does lay the matter out. 

“This paragraph also acknowledges that due to the inherent limitations of an audit, some material misstatements may not be detected even though the audit has been planned and properly performed,” he told AccountingWEB. “Therefore, when a fraud in a public interest entity is discovered, it’s not unusual for the auditors to be called out as undertaking a defective audit. This isn’t always the case.” 

Often commentators are very critical of auditors and audit firms when a fraud is publicised and, quite often without having all the facts to hand, he said.  

In October 2020, the Financial Reporting Council, Britain’s audit watchdog, issued a proposed revised ISA (UK) 240 which will effectively bolster the auditor’s responsibilities in this area. This proposed standard is due to be effective for audits of financial statements for periods commencing on or after December 15, 2021. 

“However, it’s also got to be borne in mind that fraud, by its very nature, is designed to be concealed and so no matter what auditing standard is put in place, it won’t stop unscrupulous directors from committing fraud and I would also expect that many frauds will go undetected – even when the audit has been carried out in accordance with the UK auditing standards,” said Collings.

Another aspect which cannot be ignored is the many companies falling out of the audit requirement following a change in the threshold, he said. 

“Indeed, accountants have to comply with anti-money laundering regulations and report suspicious activity,” said Collings. “Seemingly the National Crime Agency (NCA) wants accountants to ‘pick up the slack’ where companies no longer have an audit. We already have a raft of regulations to comply with in the form of the Fifth Anti-Money Laundering Directive and accountants are complying with those. It’s difficult to see exactly what else the NCA expects from accountants.”

Replies (6)

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By flightdeck
11th Feb 2021 11:02

They do not seem to be fit for purpose: too may bad stories. But for me the question is if they can ever really be fit for purpose given the complexities in many large, multinational organisations? I'm not from this world so no idea what it's like behind the scenes.

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By tedbuck
11th Feb 2021 11:33

It all comes down to reasonable expectation. If I as a company director in control of a large plc want to fudge the figures there are so many ways with computerised systems that the chance of it being found in the short term is always going to be slim. It's only when it gets too big to miss that someone stumbles over it. How on earth do you discover an error in stock when it is scattered here and there accross the country and in vans etc between here and there and if it is the gaffer who is doing the pilfering you would stand no chance.
The same applies to reserves - often guesswork at best and subject to an opinion - a la Tesco.
Easy to criticise the auditors (I am not saying that criticism isn't due because it is) but sometimes the task is so difficult that one would not wish to undertake the work. Perhaps there should be a Statutory Auditor run by HMG - then we could all wait to have a good laugh as they made a complete mess of it as they do with most things like HMRC. Then the MPs could stop displaying the ignorance (or is it arrogance) and see how difficult the job really is.

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By adam.arca
11th Feb 2021 13:32

It's a long time since I was an auditor but I can remember wondering what (if any) value I was adding.

The benefit of hindsight, however, has convinced me that there is a role for audit, even if it's not something I would want to do, and it shouldn't just be a narrow focus on sniffing out fraud which special interest groups like this PIRC constantly bang on about because that's what suits them. Rather, the auditors' role is (or should be in my world) to hopefully be a deterrent, to "keep them [clients] honest" and "keep them on the straight and narrow" simply by being there and doing a bit of digging. This is effectively the "auditor is a watchdog and not a bloodhound" argument which now seems to be out of favour but, for me, perfectly sums up the nature of the job.

I already struggle to see why the big firms take on audits given all the risks. I think, going forwards and were PIRC and the like to get their way, they would be absolutely mad to take on that additional risk. Were the big firms all to withdraw from the audit market, that would focus users minds less on asking for the moon from their auditors and more on what can realistically be achieved. None of which is to say that the big firms are as pure as the driven snow on this subject: there's lots they could and should be doing better.

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Replying to adam.arca:
Hallerud at Easter
By DJKL
11th Feb 2021 15:37

The number of audit firms would continue to drop and fees would escalate if fraud detection becomes the main driver, the scope of testing and work would be vast and the fees would have to enormously increase to cover same.

( My last audit was 1999 so I am hardly current)

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By AndrewV12
12th Feb 2021 15:19

'The Pensions & Investment Research Consultants (PIRC) recently challenged a consultation from the International Auditing and Assurance Standards Board (IAASB) on whether the existing rules on fraud discovery are fit for purpose. '

I don't know why the Auditor has to carry the can, The FCA collects a levy on most investment companies (to protect investors when investments turn sour) the levy is rocketing up, and around 1Billion a year is collected as a contingency. Th reason its rocketing up is their is no real deterrent to combat fraud and poor judgement, nothing to do with the Auditor.

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Replying to AndrewV12:
Hallerud at Easter
By DJKL
12th Feb 2021 18:57

Maybe that is the audit answer, an audit levy all invested within a central compensation fund.

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