In my view it is now time to finally take a step back from external (financial statements) auditing. We need to, internationally, think about what this process was meant to achieve. In my view I think the current process needs to be abolished, or significantly reformed, based upon a basic re-imagining the underlying point of the process.
Well, what is it that auditing financial statements is required to achieve? First the logic goes that financial statements are used by ‘users’, a euphemistic term for, broadly, stakeholders of the business, and by stakeholders I do mean those with a genuine ‘stake’ in the business: shareholders; creditors; suppliers; customers; bankers; employees and regulators. These users require financial statements that meet their needs and allow them to have confidence in the statements of the business. This confidence and these statements then allow this multiplicity of needs to be met: for bankers to assess the creditworthiness of the business; suppliers and creditors the same; employees to decide whether the business meets their security needs and aspirations; shareholders to see whether their dividends and future cash flows deriving from the business are right and appropriate and to hold the management team to account.
So let’s analyse these claims for the usefulness of accounts. Take those parties that want to know how credit-worthy a business is. Modern financial statements are meaningless to the majority and confusing to the few. Financial accounts have been changed (certainly since the last time I audited a set) to new international reporting standards, the rules about format, classification and presentation of accounts. This means that the old rules by which an auditor or any party understood accounts has changed. It used to the case that accounts contained three things: a balance sheet; profit and loss account; and cash-flow statement. The balance sheet showed assets shown at historic cost, written off or valued up according to the length of time the asset was held and major shifts in value. Similarly liabilities were generally held at historic cost, the value when created unless it made obvious sense to change these. The profit and loss contained the summary of transactions for the period, usually a year, adjusted to match income to costs. The cash-flow statement let you know the different of effect between the accounting and cash values of these transactions. Between them auditing and interpreting the accounts was simple. The assets and liabilities could be evidenced by the historic transactions, revaluations were provided by professional parties and were infrequent and large in scale (typically buildings or large equipment), debtors and creditors were easily evidenced to the arm’s length transaction that created them. The profit and loss account could be checked to cut off, to check the income and expenses were in the correct period, sample tests of transactions and verification in the context of the business. The cashflow statement was a maths exercise derived from the statements themselves. Modern IFRS financial statements use judgements throughout, both to value assets and to recognise income.
There is, no longer, a lodestone of common sense, a fixed point, by which these things can be understood. They are a negotiated settlement based in 1000s of judgements between managers and their auditors. Very few people understand them and they provide no real narrative over business performance and fixed point of reference. Well-prepared and assessed financial statements are only available to the very big companies with deep pockets for their finance and audit teams. In short, I suggest that very few credit decisions are even partly based, and even fewer primarily based, on financial statements data. Add to this that most companies (by number) do not have audited financial statements I would say that this is pointless.
What about shareholders? Do they use the financial statements? Perhaps, a little. They will probably be interested in the ‘profit’ number, which is now more of a judgement than it has ever been. Most shareholders, I suggest do not. Most own shares as part of a fund and thus those decisions will be made by others.
What about the credit worthiness argument? Well given assets are valued according to third party assets in many cases (derivatives) and are not held at historic cost in a number of cases, I would suggest that assessing creditworthiness of a business is a matter of sentiment than calculated risk. In an age where personalities at the top make 20 percent plus difference to the valuation of businesses (reference the value of Stephen Hestor at RBS, or Steve Jobs at Apple, or the chief executives at Tesco and other major businesses, credit lines are more an act of faith than judgement.
You will have noticed that the one set of users conspicuously absent so far in my analysis are the ‘markets’. The logic I was taught at audit school was that share price was a product of the valuation of the future cash flows of a business. Thus a shareholder bought shares for two things. First the value of the current and future years’ dividends the share entitled them to, and second, the discounted present value of these cash flows to affect the valuation. Thus the dot.com shares were highly valued about assets held by these companies because of the large future value these companies would generate. The markets now seem to ‘trade’ and gamble on these shares. The ‘chips’ have no real value above the bets placed daily, hourly, monthly. Thus it is incongruous to me that the value of a company, say Tesco, can drop 5-10% in one day for having a 1-2% fall in their Christmas business. Or a company can be worth less because one chief executive changes role. The underlying businesses and their models do not change dramatically. Instead it is gambling on market sentiment. A slightly immoral approach to making money in my view that plays with all of our lives, through pension funds, and those in the businesses affected.
The final point I wish to make is that financial statements are a poor predictor of anything in the business, they do not hold the business to account. So very few accounts are qualified by auditors (based upon the rule that auditors need to certify that the business is a going concern i.e. will continue, for the next twelve months). Even when they are it is obvious to all, financially trained or not, that the business will fail. Credit has normally been withdrawn months before or worthiness downgraded before the accounts are qualified. Audit normally points out the obvious and the occurred. They deal in financial issues, not risks, if you will looking out of the back window of the car and pointing out the car’s crashed and stopped. Why is this? Financial statements contain no future data about the business, the operating and financial review is only audited by exception (i.e. if it lies based upon the numbers), the accounts are not risk-based, they contain no real performance review data. Most auditors (in my experience) have only a superficial understanding of the businesses they audit and the real risks they face.
Thus, to me it appears as if financial statements auditing and financial statements themselves perform a marginal role to the users they are meant to serve. I would suggest therefore that the deference to the external or financial statements auditors compared to the internal and risk based auditors, proffered by most audit committee members is misplaced. Perhaps it is time that we recognised that what business needs is an independent business risk assessment that is published. A counter (or independent) performance narrative around the real risks faced by businesses. Of course there would be challenges in this: internal auditors would need, as a profession, to get much better (which will be the subject of a future post); the publication of real risk data would present competition issues; and governance would need to markedly improve and be more independent and objective.
None of this is impossible and, given the current resources invested in financial statements auditing, perhaps it is not even new money needed. A useful point in the austere global world we live in.