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Audit needs a revolution

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Rather than audit quality meeting the ‘flawed’ standards of the regulator, Richard Murphy argues that accounting and audit requires an almost revolutionary reform to meet the needs of society.

6th Aug 2021
Founder and blogger Tax Research UK
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It has been reported that once more audit firms in the UK have failed to match the quality expectations of the Financial Reporting Council (FRC) in its annual audit quality inspection results.

KPMG, Mazars and BDO were rated worst, which is not good news for those hoping that smaller firms might transform the audit market. In total 29% of audits have been deemed unacceptable.

But what has interested me most about comments flowing from this year's announcement is that they reveal tensions within the profession on the subject of these audit quality reviews, and in turn (albeit implicitly) the crisis that exists about the nature of audit itself.

The standards are flawed

What the FRC is reviewing is compliance with their auditing standards, which in reality are those of the somewhat obscure International Auditing and Assurance Standards Board (IAASB). The difficulty is that these standards are fundamentally flawed.

In use since their EU wide adoption in 2006, what they require is that auditors express opinion on whether the accounts on which they report comply with the requirements of International Financial Reporting Standards (IFRS). If they do then they are deemed true and fair. And if they do not, then they are not true and fair. And that, in essence is all auditing has been reduced to. This criterion, though, is a false standard.

IFRS accounts are solely intended, according to the IFRS Foundation, to meet the short-term needs of investors in financial markets. That body says that they are only intended to provide the information that those in such markets require to inform their buy and sell decisions. It is stated that they have no other purpose. But in that case it is very apparent that these accounts are bound to fall short of society’s expectations of auditors.

Not only is such a narrow perspective in conflict with UK company law, it also means that many stakeholder’s expectations are not met, meaning that auditors are bound to fail as a result.

Outmoded shareholder focused approach

This leaves auditors in an invidious position. If they try to meet the expectations of society they fail the regulator. If they audit solely to the false standard of expectation that the regulator has created their audit quality will be deemed inappropriate.

I stress, I am not exonerating auditors here. I rather strongly suspect that there is much audit work that is of inadequate quality. I also suspect that there is much work required to remove inadequate audit partners from the ranks of audit firms.

But my point is that even if they do that the resulting audits will, if undertaken within the existing auditing framework, result in substandard audits that do not meet expectations. That is because IFRS reflects a shareholder focused approach to large corporate responsibility that is hopelessly outmoded and which does not reflect the spirit of society, whilst auditors are being forced to comply with standards that are wholly inappropriate.

A new purpose for accounting

The simple fact is that both accounting and audit now require almost revolutionary reform to meet the needs of society. IFRS has to meet stakeholder needs, and if it is to meet the demands of climate change reporting it has to both put that issue in the balance sheet and make the ability to survive the transition to net-zero carbon the criteria for being a going concern in the future.

The whole logic of accounting does then need transformation to support this goal. Its purpose needs to be redefined. As my colleague Prof Adam Leaver of Sheffield University Management School and I suggested in our submission to the government’s current audit review, a new purpose for accounting must be proposed. We suggested:

The purpose of accounting is to provide the stakeholders of a reporting entity with financial statements that include relevant, reliable and sufficient information which allow them to make informed decisions.’

We then related the purpose of audit to this purpose for accounting, suggesting that:

The purpose of the audit of a public interest entity (PIE) is to firstly report on whether the financial statements on which the auditor offers an opinion deliver relevant, reliable and sufficient information to users of those statements and to secondly, where there is a shortcoming, remedy that shortcoming or, if it is not possible to do so, to report why that is and what its consequences are.

This purpose would fundamentally transform audit. As it stands auditors are forced by regulation and regulators into a passive, box ticking role that confirms compliance with inappropriate accounting standards. In the approach that we suggest the auditor has a dynamic role in appraising what stakeholder need might be with regard to the entity upon whose accounts they are reporting. They would then be given the obligation to ensure that reporting need is met, whether the reporting entity wishes the required disclosure, or not.

Auditors need to meet expectation

Of course, there will be basic requirements to ensure comparability between financial statements. But the assumption that there is one set of disclosures that meets all stakeholder demands and that auditors can fulfil their obligations by meeting a basic criteria has to be consigned to history. Auditing’s history reveals that it was auditors who developed reporting frameworks and that they did, for many decades, act as agents to enhance disclosure. We need to return to that era.

The job of the auditor has to be to reach up to meet expectation, and not to dumb down to ensure compliance with the limited horizons of IFRS reporting. Then, and only then, might we get decent audits and, even more importantly, accounts that provide meaningful information on the role of our major corporations within society.

Replies (38)

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Teignmouth
By Paul Scholes
07th Aug 2021 14:56

A good introduction for accountants to the realities of the 21st century.

Short term & shareholder value give a huge clue to how economic norms and activities of the 20th century got the climate and nature in the mess we now face.

The 2006 Cos Act brought in the requirement for directors to occasionally remove their shareholder blinkers but it’s only now beginning to happen (with one eye) at the behest of the planet.

Much of this article could have been written when I trained in the 70s and was enthused into thinking that change was on its way.

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By carnmores
12th Aug 2021 08:40

ah yes the early 70s i was there as well with Current Cost accounting and Sources and Application of funds on which i was particularly keen. And of course deferred tax which i still rail against and many other non standard standards. One of the biggest brakes has been the ICAEW the hall of extreme vested interests

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Ivor Windybottom
By Ivor Windybottom
09th Aug 2021 10:50

Cannot be fixed...
(1) the companies pay their auditor, so conflict of interest
(2) the audit firms cannot recruit and retain enough competent staff to do the work, even at the current level, let alone at a better level.

Potentially point (1) could be fixed with some thought/law, but it is point (2) is the elephant in the room and computerisation/AI/blockchain/etc are not close to helping yet.

Sorry for my depressing view, especially as all our pensions are largely dependent upon audited listed companies.

Communism is the answer if you follow the logic through, which, of course, would be much worse.

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By carnmores
12th Aug 2021 08:42

in 2) you forgot cannot....are too greedy and cant be bothered.... to recruit

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By DJKL
09th Aug 2021 12:31

Seems we are back at either returning to more loose disclosure criteria re accounts in order that accountants can properly reflect the real business (introducing auditor subjectivity and difficulties with comparisons across industries) or we continue with the current more rules/box insertion approach where one size fits all when it really does not.

If we were say still back in the 80s I would say go for the former, accountants were used to subjectivity with true and fair and apart from a few rogues roughly dealt with its issues, but to ask the profession now, after all these box ticking years, to volte face in approach and use initiative (especially where subjectivity risks litigation if one's judgement is called into question) seems dangerous, to breed that independence of thought back into auditors will take a generation and during that generation there will be significant teething troubles.

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By AndyC555
10th Aug 2021 08:36

"make the ability to survive the transition to net-zero carbon the criteria for being a going concern in the future."

Might be a more interesting and informative article if this were expanded on. From his other writings, I believe Mr Murphy thinks companies should put the projected cost of reducing both upstream and downstream CO2 emissions to Zero on their balance sheet and if that makes them insolvent (which I guess it would for the vast majority of companies) the company has to be put down, like Geronimo the alpaca. Quite what would be left of the economy if this were to be implemented is anyone's guess.

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7om
By Tom 7000
10th Aug 2021 09:26

It always amuses me that the ICAEW exams require in depth knowledge of IFRS ( oh yes you can do UK GAAP but we dont teach it...) and yet here we are using FRS 102 every day...and never use IFRS.

Guess there are more big 4 trainees...

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By DJKL
10th Aug 2021 10:13

Does it really matter, everything you learn gets changed post being studied anyway, a few underlying concepts endure but all the details get overtaken.

So my plowing through the various SSAPs reasonably soon became redundant, Companies Act 1948 was replaced by consolidation into the 1985 Act just as I started my training contract (Part of that year of law at university 84-85 at that juncture seemed to have been a tad wasted) ,and then most of my tax knowledge re 1970 and 1974 acts got consolidated away into the 1988 Act just as I left training.

In fact the only parts of my studies that have endured intact are statistics and business finance (albeit the product range available/parceling/structures available have changed), economics is still like quicksand (MMT anyone or just read some Lewis Carroll instead -or should I say Charles Dodgson given nothing is what it appears))

An accounting training is merely step one in perpetual training for the rest of one's professional life until you step off the ride.

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By johnjenkins
10th Aug 2021 10:26

When to fiddle and when to completely change is always a problem.
Things change all the time and we adapt accordingly. However with the advent of MTD looming and HMRC wanting details of every transaction, which they will eventually have, you have to ask the question :- Will there be a need for Auditing after the next 10-15 years?

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Replying to johnjenkins:
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By DJKL
10th Aug 2021 10:43

Yes there will, HMRC getting every transaction is all very well (if they so do), treating them correctly is quite another as one person's treatment of something as capital is another's treatment as revenue ( or as Shakespeare should have said, "A debit to assets or a debit to expenses, that is the question")

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By johnjenkins
10th Aug 2021 11:02

Yes totally agree about perception, however (and this is the bit I really like) HMRC will be coming up with all the wrong answers and it will be our job to put them right. So the audit bit will come when HMRC tells us the accounts are wrong, which will negate the need for an audit prior to accounts and tax comps being presented.

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By bobsto12
10th Aug 2021 10:47

All society wants is to be able to rely on audited accounts as being accurate. That is not the case and needs fixing before anyone goes off on stakeholder flights of fancy.

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By bobsto12
10th Aug 2021 10:48

All society wants is to be able to rely on audited accounts as being accurate. That is not the case and needs fixing before anyone goes off on stakeholder reporting flights of fancy.

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By DJKL
10th Aug 2021 12:53

They can only be accurate when compared to a benchmark, where that benchmark is fixed and inflexible they may not produce what we need from them, when it is flexible it may have insufficient rigour to be of any use re comparisons and benchmarks.

The big question is what should be measured and what is its most appropriate unit of measurement, for a long time the answer has been economic activity via money, the question is should this continue to be what we measure or should accounts measure more than one thing?

Once society decides what accounts ought to measure accountants can work out how to best do said measuring.

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By TJC
10th Aug 2021 10:57

It requires a far higher level of basic common sense and the ability to ask pertinent & relevant questions - an area of expertise that is seemingly in short supply as part of accountancy training.
What would also help the poor loves in their quest for audit glory would, perhaps, be to read the business pages - especially the excellent 'commentaries' - of The Times and The Telegraph every day.

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By johnjenkins
10th Aug 2021 11:04

To do a proper audit requires a near criminal mind. Those that have that potential will not be doing audits.

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By DJKL
10th Aug 2021 12:54

"Latent" criminal minds preferred.

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By cbarling
10th Aug 2021 11:23

I thought Ivor Windybottom's post (second from top) was pertinent. Effectively the auditors are marking the directors work but the directors in reality appoint the auditors.

I would say it's from this conflict that most of the problems with audit that are often quoted arise - Carillion etc.

And I speak as someone who has sat on some fairly high profile audit committees, although fortunately never associated with anything dodgy to date.

Making sure that the books aren't being cooked, or at least are no more than lightly warmed, surely is the #1 priority for auditors?

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By DJKL
10th Aug 2021 12:57

cbarling wrote:

And I speak as someone who has sat on some fairly high profile audit committees, although fortunately never associated with anything dodgy to date.

That you know about.

Personally I think auditors have an impossible job, then again I worked that out over 30 years ago when I more staring concentrating on other areas (Likely my need to be loved, clients really do not value auditors but they do value those who can reduce their tax bills etc)

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By johnjenkins
10th Aug 2021 12:58

Directors are not only responsible for the day to day running of the Company, they are also required to present the audited accounts. It's up to the auditors to "qualify" the accounts if necessary. No conflict at all.

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By DJKL
10th Aug 2021 13:57

Except re who appoints them and negotiates their fee.

When a client's fees pay the partner's school fees, when one's bonus depends on one's GRF's, there is pressure to "accommodate" when things kick off re differences of opinion.

My personal view is that there possibly needs to be an audit lottery re public interest, larger quoted companies etc, to rotate appointments, this end of auditing likely also needs to be a distinct profession not part of mainstream accounting and defining what an audit ought to be doing ought to be distinctly different for different size/type entities, however how you accommodate this into some structure without cliff edges and impediments to corporate growth I have no idea.

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By johnjenkins
10th Aug 2021 14:36

If auditors don't do their job properly then their licence should be taken away. I agree with the rotation of auditors but then you start messing with market forces and as HMRC are constantly finding out, that is not the way to go.
Because people of this country use common sense and flexibility, there is no room for compliance and rigidity, so a conflict occurs. Time for the whole sorry mess to be sorted :- welcome MTD.

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By chasmeehan
10th Aug 2021 22:50

Some very to the point comments above. My concern with Richard Murphy's solution is that "stakeholders" and "society" is so wide a group with potential conflicts of interest among its membership that it makes defining what they need too difficult. Taken at it lowest , currently directors are made by society to buy a form of soft insurance against their own misbehaviour , negligence and pure bad luck (along the lines of an MOT ) and that really only works if the criteria applied are well defined, easily checked and designed to ensure minimum failsafe outcomes. That suggests to me that only quite limited , "hard" facts can be verified in an audit - which amounts to placing a salvage value rather than a going concern value on the business. This might be socially acceptable if businesses large enough to have to file full statutory accounts were also required to exhibit certificates of hard insurance from approved financial institutions which would pay employees, customers , vendors and holders of debt what they were owed in the event of the failure of the business and underpin the claimed market value of the business. It would also help if auditors prime responsibility were to those groups who are the ones exposed to the consequence of failure. Of course some businesses would be unable to obtain that insurance but those are likely the ones which are going to eventually fail anyway. Auditors themselves would have to buy significant insurance cover for potential claims from those groups but their narrower focus of work should make it less risky and reduce that cost. Also, the price of audit needs to be regulated as there is clearly market failure when measured in terms of outcomes to the exposed groups - however, again a narrower focus of work should allow a manageable price to the business for what is recognised to be just a salvage value - investors will form their own views and take risks but they are essentially gambling with a hopefully diversified portfolio and will at least be assured of what is the minimum recoverable value in the business.

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By DJKL
11th Aug 2021 14:54

Of course no free lunch, if listed company investment carries much lower risk then returns to shareholders will correspondingly need to reduce, what they currently receive carrying a premium for risk.

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By Iamarobot
10th Aug 2021 23:10

The only revolution required is for Audit firms to actually do the job that they are paid to do properly.
They could start by not laying off experienced auditors at the wrong point in the economic cycle.
The big firms promote newly qualifieds to manager level too early. They are lambs to the slaughter against battle hardened Finance Directors.

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By David Gordon FCCA
11th Aug 2021 12:51

This illustrates the inflation in expectation over recent years.
Accounting is if nothing else a practical art.
An appointed public practice "Accountant" is solely and exclusively responsible to the (Companies) directors to provide services ensuring the accounting administration function of the business works, and produces information necessary to the proper administration of that business, including if appropriate what we used to call "Internal control"
Accountants employed directly by the company are similar.
Anything else is not Accountancy in this context
The point is that it works because whether the business is a sole trader, or a Mega-international corp, it is based on a tangible unit of measurement, actual money.
Anything else is not Accountancy. It is Management advice, Investment advice, Market value advice, Forensic advice, and so on. Each of those "Advice" subjects uses different criteria an or expertise.
What happens to the information provided by the Accountant is solely and exclusive down to the directors.
Anything else is asking him "What is the length of a piece of string". The answer depends on what you want to use the string for.

Audit at its core is a test of systems. The auditor goes to work on the assumption that his client is not a crook, but is liable to make errors.
The auditor is not a detective, but increasingly those whose responsibility is to ensure that ethical honesty prevails within a organisation, are happy or desperate to throw that responsibility onto the auditor.
To be a detective requires an entirely different training and or mindset. Ask your local policeman.

The Big Four have put themselves in this bog by their own acquiescence to almost every demand of the so-called authorities. It is simply not within the powers of [***] Sapiens to provide the assurances now wished for.
Not least because an "Independent Auditor" cannot spend the time required to meet those hopes except and unless he spends so much time with the company (of any size ) that inevitably he loses "Independence".
Except and unless the leaders of the profession take a stand on this principle, they will continue to receive ever bigger wallopings whatever the rules say.

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By DJKL
11th Aug 2021 15:09

David Gordon FCCA wrote:

it is based on a tangible unit of measurement, actual money.
Anything else is not Accountancy. .

Sorry , just as money is a man made concept so are other measurements.

You cannot readily benchmark money's worth unless against another currency/asset, it is (except in our confidence in its ability to be accepted for something else) no more objective than say the measurement of a carbon credit (or any other man made/devised measure).

Accountancy can be more than just a recording of money, it is really more a system of recording rights and obligations, the units of measurement have traditionally been money but as we all know the past does not of necessity foreshadow the future.
EDIT
As a thought experiment I devise a financial system (call it fitbit) where everything gets recorded and measured based upon mass/energy /heat expended and mass/energy/heat consumed, Newtonian laws of thermodynamics being the foundations of our new accounting system, is it any more or less valid than a system that depends on a man invented construct , money?

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By David Gordon FCCA
12th Aug 2021 17:00

People get so,so emotional!
"Audit" does not need a "Revolution",
It needs us to remind ourselves what an "Audit" is
2)
What is Directors' responsibility
2)
What is physically possible for an Audit firm
3)
What reasonably we may expect clients to pay for the service.
4)
What is shareholders' responsibility

If we continue down the "Road to Hell is paved with good intentions" Auditors may end up finding themselves responsible for ensuring that directors wipe their bottoms in an approved manner. (In order to save the planet?)

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By johnjenkins
12th Aug 2021 17:28

Unfortunately so called "auditors" have charged extortionate fees and haven't done their job properly. Perhaps the smaller business they may have got it right but certainly the larger concerns are way above their heads. The one thing you can't change in a set of accounts is the Auditors Report.

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By zebaa
13th Aug 2021 12:40

As a former director I always regarded the audit report as poor value. Any FD worth his salt will do far better. IMO audit will go the way of gas lamps and top hats & is well on its way. As an earlier post has mention it is the directors who are responsible & the comfort that some directors & investors get from auditors is simply an illusion.

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By johnjenkins
13th Aug 2021 12:58

The main problem for you would be that the person(s) putting the Accounts together may have a lot more experience than the person(s) doing the Audit. Then you pay for the privilege.

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By David Gordon FCCA
16th Aug 2021 12:47

Dear JohnJenkins
I suggest your comment misses the point.
It is not a matter of the relative experience of the "Accountant" vis a vis the "Auditor"
The accountant presumed to know his/her trade, acts (Within the law) for and on behalf of his client, exclusively and strictly to according to client's instructions. To do otherwise would render the professional accountant liable to a charge of professional misconduct. I believe there is case law wherein an accountant who acted from best of motives was nevertheless found in breach of rules because he did not follow this principle.
Even if the client is an unprincipled cur, this principle stands.

The Statutory Auditor is a quite different species. His or her responsibilities are set out in law. The Persons in Substantial Control and or the shareholders, of the entity do not have any jurisdiction over what the Statutory Auditor may or may not do in order to meet audit requirements.

Opining that the accountant may be more experienced than the auditor, may be true in a particular case, but is irrelevant. It is comparing apples to pears.

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Replying to David Gordon FCCA:
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By johnjenkins
16th Aug 2021 14:10

I understand what you are saying, however, with respect, you have missed the point I was trying to make. It can be very relevant, especially if the Accountant has been an auditor or even an internal auditor. Just as HMRC and ourselves have different interpretation of tax laws and even tribunal decisions. I remember banks writing off all loans that had a late payment just to appease those that were saying banks were making huge profits in the recession of the 1990's only to have to write them back in the following year. Auditors said it was a provision. So your provision could well be different to my provision and both could be within the law.

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By Paul Crowley
19th Aug 2021 20:15

Oh come on guys
This is really simple
A compensation fund is set up
Half on all fees received by the audit firm for any audit client is paid into the compensation fund
Shareholders of companies that fail, despite having clean audit reports, get to share in the compensation fund
Audit fees may increase but the shareholders get compensated for the problems with the auditing skills just not being good enough.

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By NOTICIAS Salamanca
30th Aug 2021 11:10

Seguridad Documental es una empresa de Salamanca dedicada a la digitalización, custodia y destrucción de todo tipo de documentos y archivos con respeto del medio ambiente y con altos estándares de calidad. Confidencialidad garantizada.

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By NOTICIAS Salamanca
30th Aug 2021 11:10

Seguridad Documental es una empresa de Salamanca dedicada a la digitalización, custodia y destrucción de todo tipo de documentos y archivos con respeto del medio ambiente y con altos estándares de calidad. Confidencialidad garantizada.

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By NOTICIAS Salamanca
30th Aug 2021 11:10

Seguridad Documental es una empresa de Salamanca dedicada a la digitalización, custodia y destrucción de todo tipo de documentos y archivos con respeto del medio ambiente y con altos estándares de calidad. Confidencialidad garantizada.

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By AndrewV12
01st Sep 2021 11:08

extract above
The standards are flawed
What the FRC is reviewing is compliance with their auditing standards, which in reality are those of the somewhat obscure International Auditing and Assurance Standards Board (IAASB). The difficulty is that these standards are fundamentally flawed.

MMMMMm or is it Auditing partners personal interpretation of Auditing standards that's the problem, these standards take years to become legislative and legally binding, are all of those years work floored ??, if they are its a sad indictment, years of work is floored from Day one.

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