The new style UK audit report is a big leap forward. Without doubt, it is the most significant advance in auditor reporting in decades. A challenge has been thrown down to auditors. While early examples of the new style reports are mixed – some good and some frankly disappointing – I am positive about the changes and look forward to comparing the depth and clarity of my own firm’s reports with those of others and more importantly, to opening a dialogue with investors to build on these advances.
This is an area in which the UK is leading the world; so what’s changed?
A new audit report should now tell shareholders which accounting rocks to look under.
A good new audit report will tell them what the auditor did when they turned over each rock. It will explain clearly how we brought our independent mindset to bear on the issues we identified (i.e. the key audit procedures). Coupled with the report of the audit committee and the disclosure of judgements and estimates, sensitivities etc in the financial statements, this information will improve shareholders’ ability to identify and understand the significant judgements made in preparing the financial statements. It will act as a basis on which shareholders might further challenge executive management and hold the audit committee and external auditor to account. Greater understanding should contribute to an effective stewardship relationship between management and investors and hopefully enhance trust, ultimately reducing the cost of capital for the company and increasing the value generated.
However, I am concerned that the novelty will wear off very quickly.
The significant risk areas in an audit are relatively consistent year on year unless there is a change in the economic environment or the business (an acquisition, a change in systems, a new product line etc). The key audit procedures that might address these areas are also unlikely to change significantly year on year.
Therefore, there is a risk that the new and improved audit reports will become less newsworthy (i.e. stale) over time and so become the new "boilerplate."
But a more significant question is: why have we stopped here when investors have asked for much more.
The new audit report will tell shareholders the key risks and how they were addressed. It is not required to take the next obvious step and answer the question "what did you find", for example in respect of the application and effect of the company’s judgements and estimates in these key areas?
A company whose estimates are always within acceptable bounds, but were cautious last year and aggressive this year, may get the same new audit report as a consistently cautious company that has the same key audit area. The Financial Reporting Council recently noted that "investors need to be able to understand the quality of profits reported by companies." I agree.
As auditors, we have a unique and independent insight into a company’s judgements and estimates both over time and how they compare to those of their peers. Auditors already discuss that insight with the audit committee and provide graduated views on the degree of caution or aggressiveness underlying the judgements year on year.
Put plainly, we tell them what we found under the rock.
In turn, they use this as input in their discussions with management on how they have applied judgement in preparing the financial statements.
I think investors would value this insight too. The challenge is how to deliver it.
There are some tricky barriers: commercially sensitive information, consistency of opinion and the inevitable push back from some managements. Directors too must be convinced of the benefits or we risk that only those that make consistent, conservative judgements would volunteer. But I think it would be a mistake to assume that the recent changes to audit reports are a long term solution.
I really hope we see enlightened firms field testing how this might be done as soon as this reporting season. We need an informed discussion about the next big leap forward. At the same time, investors need to be clear (and vocal) about which examples of new audit reports they value most, and why. This will complement the work of the FRC’s Financial Reporting Lab, as summarised in 'Lab project report: Reporting of Audit Committees', and help drive best practice.
Most importantly, I think it’s time for the audit profession to be bold and innovative if we are to deliver more of the value of our audit to shareholders.
Jimmy Daboo is a Partner at KPMG in the UK