It is a curious development in professional auditing circles that being sued for negligence has almost been overtaken in the “nightmare-stakes” by the threat of a regulatory mauling. Widely broadcast findings that an auditor’s work has been negligent lead to severe reputational attrition and massive fines – and unlike judgments in case law, none of this money is used to compensate the victims of that negligence. Instead it may be paid to the professional body that lodged the complaint in the first place – which strikes me as a suspiciously commercial arrangement.

Regulators are publicly funded and are hardly driven by efficiency measures or cost control. It is no wonder that their findings may relate to events that occurred up to 10 years previously and thus border on technical irrelevance. It is also clear that Big-4 audit firms can bear their fines that have virtually become an overhead of their business.

Regulatory procedures are not subject to the usual common law difficulties of establishing “proximity” or “causation”, such that losses are shown to be directly attributable to the auditor’s negligence rather to any other cause.

Case law is a minefield

We can see that court cases are a veritable minefield – a lawyer’s paradise and a claimant’s lottery – and the amounts involved are now truly astronomic. Claims against auditors in earlier days were often brought by smaller companies that would possibly be exempt from audit altogether under current criteria.

accounting distortions

 

A decline in the number of massive lawsuits has not, however, been accompanied by any discernible improvement in standards of audit work. Indeed, the accounting misrepresentations that auditors consistently fail to detect have a disastrous impact on the wider investing community. Those misrepresentations, whether attributable to outright fraud or excessively optimistic accounting judgements, contribute to the cynicism surrounding the reliability of quoted share prices. The distortions embedded in negligently audited accounting data therefore strike at the foundations of the economic system on which we all depend.

Audit reports – masking the truth

Changes in the drafting of audit reports themselves betray an undercurrent of responsibility shifting. Not long ago audit reports stated: “In our opinion the financial statements on pages … to … have been prepared in accordance with generally accepted accounting principles and give a true and fair view of the state of the company’s affairs as at [date] and of its profit/loss for the year then ended.”

Compliance with the accounting principles referred to would, on its own, have gone a long way towards affirming truth and fairness. Those principles, after all, determine that (i) revenues and costs have been allocated to the correct accounting period; (ii) the amounts at which assets and liabilities have been stated assume the company will continue in operational existence for the foreseeable future; (iii) assets have been included at the lower of cost and net realisable value, while liabilities and expected losses have been prudently determined; and (iv) only realised profits are available for dividend payments.

That was then!

Audit reports now inform readers that the accounts have been prepared “in accordance with International Financial Reporting Standards [IFRS]”. Compliance with IFRS has enabled the technocrats in standard-setting bodies to expand the length of the average annual report by 50% over the past 10 years. These are now, typically, 140 pages long, and living proof of form triumphing over substance.

Realised profits – the key measure

No wonder that stock exchanges around the world are pleading for the “decluttering” of published accounting reports. These abstruse concoctions are beyond human comprehension, and probably beyond audit too. Technical departments in audit firms are stuffed with wizards of cryptology rather than clear expression.

Indeed, IFRS-compliant accounts of large companies will often offer half a dozen measures of earnings. Not only does this IFRS-compliant clutter fail to identify true earnings, but it also gets the figures completely wrong, as was brought home in a report by the Department for Business, Energy and Industrial Strategy (BEIS) in April this year. One of the most crucial measures for investors is the amount of profit available for distribution by way of dividend. Yet the BEIS Report is explicit in asserting that IFRS diverges from the law, chiefly by disregarding the overarching principle of prudence when determining realised profits for the purpose of distributions.

“realised in cash”

 

The BEIS supports a definition of realised profits as “realised in cash or near cash” and it states that “ the principle of prudence should be made explicit in the law and its interpretation.” The Report adds: “Auditors and directors need to be reminded that compliance with accounting standards does not fulfil all legal obligations, and that the law comes first.”

Auditors share the blame for the consequential travesties, but their reporting job remains impossible for as long as our regulators acquiesce in rules that are patently unfit for purpose.

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Emile Woolf 23-5-19