Author Archive for Will Rush

It is safe to say that the audit industry is currently under quite a bit of scrutiny.

Through my conversations with a cross section of accounting practices across the UK, Europe and North America there is a general consensus that audits are getting more complex at the same time as fees are increasingly coming under pressure. The amount of effort required to complete an audit is increasing, as the regulations become stricter and the risk of penalties more likely.

It is not just the audit firms themselves feeling the pressure, regulators are also under fire. The UK’s Financial Reporting Council (FRC) has received plenty of criticism over the past year or so for its perceived leniency. An independent review by Sir John Kingman at the end of last year recommended that the FRC be replaced with an independent statutory regulator, accountable to Parliament, with a new mandate, new clarity of mission, new leadership and new powers.

This criticism has caused the audit watchdog in the last year to nearly treble its fines against audit firms. In monetary terms this is an increase from £15.5m in 2017 to over £43m in 2018. The number of fines rose from 11 to 27.

The FRC’s clear message to the audit industry has not just come in the form of financial sanctions. The watchdog struck off six individuals from memberships of professional bodies and increased non-financial sanctions almost 250% from 11 in 2017 to 38 in 2018. “The significant increase in the number, range and severity of sanctions sends a clear message that where behaviour falls short of what is required, we will hold those responsible to account,” said Elizabeth Barrett, executive counsel of the FRC.

What does all this mean for audit firms? To state the obvious, with regulations getting tighter and sanctions more severe and frequent, there is a need for firms to adapt to this changing environment. One area that can help improve audit quality is leveraging technology. Paul Winrow, Director of Professional Standards at Baker Tilly Global said “We believe that our member firms around the world will be able to benefit from software to deliver high quality audit work.”

Faster adoption of technology won’t make the regulators reduce their scrutiny of audit firms, but it will certainly help a host of partners sleep better at night.

As a guest speaker at a recent, global accounting network event I was very interested to hear a robust discussion focused on the subjective area of “materiality”. The unsurprising, and somewhat unsatisfactory, conclusion from the room was that determining materiality depended on a number of different factors, and that there was no “golden rule”. Not the preferred answer for a room full of accountants. What is clear, though, is that to determine materiality one must first of all calculate the numbers before judging what is material or not.

From a financial instrument valuation perspective, my take on materiality is slightly different.

The complex nature of financial instruments means that auditors cannot simply rely on the client provided valuations and use these to judge materiality. It is a big assumption that the valuations are, indeed, correct. Valuations need to be cross-checked to ensure the starting point of deciding whether they are material is valid.

There are two important points to remember with this. Firstly, banks are often the source of clients’ valuations and they can, and do, get it wrong. The disclaimer at the bottom of any counterparty provided valuation is testament to this. The message that valuations should not be relied upon comes through loud and clear. There is plenty of scope for human error in the process of calculating financial instrument valuations. We see it regularly, when we are asked to check valuations. Despite the disclaimers it is understandable that companies do actually rely on the valuations for financial reporting purposes, particularly small and mid-size companies as they often don’t have access to the systems to value these instruments themselves.

So, as an auditor, you need to check the valuation. If not, what might at face value be regarded as immaterial might in fact be quite the opposite. The correct valuation may well be material. Again, we have seen plenty examples of this. Auditors need to look at the underlying transaction. If the notional amounts are large, or maturing a long way out into the future, then you need to check the valuation. The correct valuation is unlikely to be small due to financial market volatility.

Interest rate swaps are a good example of this. They tend to be large notional amounts and maturing in more than twelve months’ time, sometimes out 10 or 15 years. Equally, with foreign exchange contracts you need to look at the maturity date and the notional amounts being bought and sold to be able to make an informed decision on whether the results are likely to be material or not.

If there is found to be a material difference in the financial instrument valuation, it is better to find it before the audit is complete, rather than after. No one wants to have that discussion with the CFO or Finance Director about having to restate the accounts.

So next time you get involved in that riveting conversation about materiality don’t forget to look behind the numbers.