Beware your auditor

Three levels of labour

Accountants or auditors generally provide three levels of labour to companies.

Level one constitutes a simple compilation. The accountant assembles the financial statements and attaches what’s called a “notice to reader.”

This level of work produces financial statements that can be furnished to a potential lender or investor, but does not provide any assurance on the quality or reliability of the statements. The accountant takes steps to correct only the most obvious mistakes or misstatements.

Level two comprises a review, which includes higher level of disclosure and increased inquiry on the part of the accountant. The notes are more detailed, and there is greater adherence to accounting standards.

Analysis is generally limited to ensuring nothing seems out of the ordinary. When it comes to the level of probing involved, a review engagement essentially provides a level of negative assurance. In other words, nothing came to the attention of the accountant that would indicate a problem exists. It is plausible there are no material misstatements in the financials.

Level three is an actual audit, mandatory for public companies. An audit requires independent verification and a more thorough understanding of the business.

Company management prepares the statements and the auditors express an opinion. An audit is aimed at providing more positive assurance or so-called reasonable assurance that the financial statements do not contain any material misstatements and follow accepted accounting principles.

Watch out

Investors need to know what auditors can miss, even when they follow rules to the letter. For one, audits only provide reasonable, not absolute, assurance.

They don’t guard against all misstatements; they merely claim to protect against material misstatements. Audit procedures are carried out on a test basis, which means a sampling is taken, and the results extrapolated to the company as a whole.

Investors must grapple with gaps, such as the lack of substance in both accounting and auditing rules when it comes to related-party transactions—the biggest opportunity for management to defraud investors.

Auditors set their own rules. Despite efforts to instill a greater level of separation with oversight boards over the years, the rules are still heavily influenced by internal forces, either through financial control or direct persuasion.

Auditors can still ensure the rules don’t become too onerous, either in the amount of potential liability, or by way of additional costs they need to justify to their paying corporate clients.

It gets worse

Matters can get even worse for investors when auditors don’t follow their own rules, and the loose regulations get bent even more. The Canadian Public Accountability Board (CPAB), which is tasked with regulating audit quality, issued a report in February called “Auditing in Foreign Jurisdictions.”

The report, spurred by the 2011 scandals at Canadian-listed companies such as Sino-Forest Corp. and Zungui Haixi Corp, focused exclusively on Canadian companies with their primary operations in China.

It didn’t mince words: “CPAB is disappointed by the results of its review. In too many instances, auditors did not properly apply procedures that would be considered fundamental in Canada, such as maintaining control over the confirmation process.

“CPAB’s findings indicate that auditors often did not appropriately identify and assess the risks of material misstatement in the financial statements, through a sufficient understanding of the entity and its environment.

“CPAB also found a lack of professional skepticism when auditors were confronted with evidence that should have raised red flags regarding potential fraud risk.”

Half the companies examined by CPAB required additional remediation work by auditors in order to bring them up to snuff.

It was also revealed that for a quarter of the companies involved, the Board was unable to review the work performed by the affiliated audit firms in China, hinting that more problems may exist, but a lack of access restricted discovery.

Not surprisingly, there are always recommendations by regulators, lawmakers, and investors to improve auditing in jurisdictions around the world. These tend to be fought tooth and nail by the audit firms, so change comes at a glacial pace.

For years, auditors used to perform lucrative consulting work for companies while also expressing an opinion on their financial statements—a conflict of interest if ever there was one. Eventually some firms cleaved off their consulting divisions, but not without excruciating delay.

Half-baked solutions

Following the accounting scandals of the early 2000s, the next wave of ideas to reform the shortcomings of the audit industry included half-solutions like oversight boards, audit partner rotations, and peer reviews. With such quick fixes, the audit firms could easily circumvent the spirit of such requirements on the basis of “you scratch my back, I’ll scratch yours.”

In an effort to combat such approaches, the proposal that has gained most ground recently is the notion of legislated audit firm rotation, whereby companies would have to switch audit firms after a fixed term of, say, five years. While the learning curve for a new firm might come at an additional cost, it would stamp out the negative impact of long-term “familiarity” between company and auditor, which has cost investors so dearly in the past.

Both the U.S. and Europe have been seriously considering the issue over the past year. In November, the European Commission proposed limiting audit terms to six years for public companies.

In March, the U.S. Public Company Accounting Oversight Board (PCAOB) extended the comment period for its concept paper on auditor rotation as a result of overwhelming interest in the topic.

In response, the audit firms have mounted substantial lobbying efforts against the idea with significant help from their natural allies, the corporations themselves, who tend to resist increased regulation or oversight when it comes at any additional cost to the companies.

Canada’s surprising stance

As it stands, both sides have dug in for an extended fight across the U.S. and Europe. As for Canada—well, we’ve taken a somewhat different stance.

CPAB has actually issued its own official comment on the U.S. regulator’s concept paper. Rather than mandating audit rotation, CPA goes against the grain of regulators the world over, and suggests that the audit committee merely review the audit firm’s appointment annually and issue a report to shareholders explaining why the auditor has been reappointed.

Don’t worry—you’re not alone if you think this suggestion is weak to the point of being comical.

Hopefully, this doesn’t tip the hand of CPAB in terms of the vigour it will dedicate to following up other audit deficiencies. Its report on Canadian-listed Chinese companies was strongly worded, but the proof will be in the follow-up. Unfortunately, as long as lame-duck proposals keep getting hoisted in Canada, investors will need to take defensive steps.

Explain the resistance of auditors and regulators to clients to help them understand why audited financial statements provide very limited protection, and why having a proactive advisor, who uses an independent approach, is crucial to safeguarding their investments over the long term.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, run Accountability Research Corp., providing independent equity research to investment advisors across Canada.