The Auditor

Quo Vadis?

Mervyn King, Linda de Beer

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781351020725
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The audit profession is at a tipping point. Without significant innovation in its business model, staff recruitment strategies and audit execution processes, the audit profession may not remain relevant in the 21st century. The number of claims against auditors has significantly increased over the past twenty years due to the spate of corporate and audit failures early in the 21st century (Enron, Worldcom, Parmalat, etc.). Regulation to monitor professional and ethical standards has increased, leading audit firms to feel under even more financial pressure. In addition, the investor community is calling for greater insight and foresight from auditors. These challenges, coupled with the unlimited liability regime of auditors still applicable in many jurisdictions, are making audit firms and regulators nervous as to the systemic risk of another one of the Big 4 failing.

And yet, the audit profession is in place to protect businesses, their wider stakeholder groups, including clients and investors, and society at large. Therefore, this book asks the important question about the profession's future and engages a broad readership in the discussion of audit failure and reform.

Intended to help readers to get up to speed with the issues and possible solutions quickly, this book assists directors, investors, business people and regulators, especially those with a non-financial background, to gain a greater understanding of the challenges and threats being faced by the audit profession, which in turn could disrupt the capital market and affect businesses across the globe. The book outlines the critical success factors needed for a sustainable audit profession.

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Part 1

The history of audit

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Chapter 1

History of accounting and the birth of the loan stock company

Financial record keeping, accounting and reporting

Jane Gleeson-White, in her book entitled Double Entry says that our urge to account, measure and record our wealth is one of the oldest human impulses and that we could account before we could write. At first, a simple token method was used to keep track of produce and exchanges. By 3300 BC these tokens were replaced with imprints on clay tablets, which were later replaced by drawing the shapes of the tokens with a stylus on tablets – the invention of writing – by accountants and for accountants.

Record keeping was further advanced by the Greek and Roman empires, where coins were used for the first time. Business dealings were carved into stone for public display, indicating the importance of accountability and transparency in the running of the world’s first democracies.

The first double-entry accounts were said to have been done by the merchants of Venice, in the 1300s. Double-entry accounting is recognised by a number of key features, namely:

• The concept of a proprietor/business partner as an accounting entity whose books record its financial relationships with others.

• Entries are made in a single monetary unit to enable their being added together.

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• Oppositions exist, namely increases and decreases in the physical holding of cash, goods, debt and the entity’s own assets and liabilities.

• Owner’s equity is the net effect of assets and liabilities.

• Profit (loss) is the net increase (decrease) in the owner’s equity.

• Profit (loss) is measured over a clearly defined accounting period.

In 1494, Luca Pacioli’s double-entry bookkeeping treatise, Particulars of Reckonings and Writings, was published as part of his mathematical encyclopedia. Pacioli included guidance to assist merchants by providing procedures they should undertake to account, create and order and thereby avoid confusion. Some of these procedures included taking inventory of everything owed. In order to assist, three books were needed to record business transactions, namely:

• A memorandum recording every transaction on a daily or even hourly basis.

• A journal to write up in an orderly fashion the details of each transaction recorded in the memorandum.

• A ledger to record two entries, namely a debit and a credit, for every journal entry. This allowed the merchant to know at a glance the precise state of his assets and liabilities and enabled him to find mistakes in his bookkeeping if the books did not balance. The ledger included a profit and loss account.

Pacioli also required that the merchant’s books should be registered with a mercantile officer who should authenticate the books and attach a seal to them to make them legal documents that could be presented in court.

It was, however, not until the industrial revolution, 400 years later, that Pacioli’s double-entry bookkeeping became entrenched in commercial activities and resulted in the profession of accountants.

Pacioli’s double-entry bookkeeping was, however, not uncontested. Edward Thomas Jones launched an attempt to overthrow it in 1796 by criticising the fact that there must be a debit for every credit and vice versa. He claimed that this was not only labour intensive, but could result in errors, false entries and was capable of being used to defraud without being detected. Ultimately though, the Jones English System was considered nothing more than a complex and cumbersome version of Pacioli’s. Even though Jones’ system failed, it brought accounting to the attention of the general public as his book became quite famous and was translated into numerous languages.

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The industrial revolution saw the rise of a vast number of new businesses, enabled by the introduction of the concept of a joint stock company in England. This created a new form of business relationships where the providers of capital (investors) were not necessarily the managers of the business. Accountability and stewardship became very important and the double-entry bookkeeping system served this purpose. It was also being used as an internal tool to analyse business accounts, costs and stock levels and became the foundation for management accounting.

The railway entities that sprung up during the industrial revolution called for significant upfront capital outlay to establish the required infrastructure. The joint stock company, as a form of collective investment, was used to fund this. Investors, of course, demanded a return on their investment. When the railway entities started struggling to honour these returns, the inevitable fiddling of the accounts started occurring, treating expenses as capital, thus inflating profits and using new investments to pay out dividends instead of funding new infrastructure (now known as Ponzi schemes).

These acts of fraud and corruption called for government intervention, together with wealthy families being unwilling to finance entities with unlimited liability, drove the British parliament to pass the Joint Stock Companies Act in 1844. The act had specific conditions in respect of company formation, but, most importantly, required the disclosure of financial information in the public domain. Furthermore, accounts were required to be audited by someone other than the company directors. The accounting profession was established.

These requirements were further supported by the Companies Act of 1862, which required the presence of accountants at every phase of a public company. This created jobs for accountants and the 24 accounting firms in Brittan in 1811 mushroomed to 840 by 1883.

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The Society of Accountants in Edinburgh was incorporated by royal charter in 1854 and the title ‘chartered accountant’ was created. The Society was established to set an entry examination for accountants and to regulate professional conduct. The Institute of Chartered Accountants in England and Wales (ICAEW) was incorporated by royal charter in 1880 and similar accounting societies were soon established throughout the British Empire as well as in Europe. The Institute of Accountants and Bookkeepers in New York was formed in 1882 and the American Association of Public Accountants in 1887.

Accounting and financial reporting standards and standard setters

The philosophy of accounting is the conceptual framework for the professional preparation of accounts. The discipline of accounting insists that transparency is achievable. Fairness has an important role in the practice of accounting. Therefore, matters such as social justice, ethical conscience, economic entitlement and concepts such as fairness, justice, equity and truth have a due place in accounting. Ultimately, accounting, and hence accounting standards, aim to establish a true and fair view and monetary value of an entity in order to meet the information needs of investors, employees and other stakeholders. It is a public interest profession.

Before most countries started moving to the international set of financial reporting standards, post the major corporate and audit failure of the early 2000s (Enron, Worldcom, Parmalat etc.), most countries had their own standard setting bodies, often housed and self-regulated within the accountancy profession. Despite this jurisdictional autonomy, the benefit of collaboration was recognised and the various standard setters founded the IASC in June 1973 in London to develop international accounting standards. The IASC had broad representation, about 140 member bodies from 104 countries. However, most countries continued to use their own sets of local accounting standards.

The IASC was superseded by the IASB in April 2001. The IASB was the first full time, independent board of experts tasked to “develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions” (IASB, (2017). These standards became known as IFRS. The IASB was also tasked to promote the use and rigorous application of its standards and to bring about convergence of national accounting standards and IFRS.

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The other major accounting standard setting body, in addition to the IASB, is the FASB in the US. The FASB was established in 1973 as an independent, private sector, non-profit organisation that establishes financial accounting and reporting standards for public and profit companies, referred to as US GAAP. The FASB is recognised by the SEC as the designated accounting standard setter for public companies in the US and therefore its standards are authoritative.

Financial reporting today

Today, financial reporting, especially at a listed entity level, is dominated internationally by these two sets of financial reporting standards, namely IFRS, issued by the IASB in London, and US GAAP issued by the FASB.

The objective of, what is referred to as, ‘general purpose’ (hence for a broad capital markets user/investor group), financial reporting is stated as to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments and providing or settling loans and other forms of credit. In order to achieve this, financial statements provide information regarding:

• The nature and amount of the entity’s economic resources and claims (financial position) and changes thereto, to assist the user of the information to identify the entity’s financial strengths, weaknesses, liquidity, solvency, need for additional financing and how successful the entity is likely to be in obtaining that financing. It also assists the user to predict how future cash flows will be distributed among those with claims against the entity.

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• Financial performance of the entity in order to assess the entity’s past and future ability to generate cash. Financial performance also indicates to what extent changes in market conditions have affected the entity’s financial position.

• Past cash flows, to assess the entity’s ability to generate future cash flows as this indicates how the entity obtains and spends cash and provides information to assess solvency and liquidity.

Despite financial reporting as we currently know it being well developed and becoming embedded in decisions made by capital markets, the current financial reporting model suffers various limitations. The most fundamental constraint of financial reporting is its strong leaning towards historical financial information, with a limited view on the future and a lack of taking a holistic view on the entity and its use of and impact on other capitals, such as natural and social. It also does not deal with future threats, material risks and other aspects that impact economic decision making.

Also, the variety of measurement models, such as historical cost, fair value accounting, amortised cost and other valuation techniques used to determine a fair market value for all assets and liabilities in the preparation of financial statements leaves the user with a mixed bag of values for assets and liabilities.

Further, the sheer complexity and volume of financial reporting rules complicate the ability of the average investor or user to properly understand and interpret the financial statements. As a result, many users are constantly either seeking additional, clearer and more simplistic information, or are making their own adjustments to financial statements in order make it more user friendly for decision making.

Another factor in regard to existing financial reporting frameworks is that they are not entirely supportive in the valuation of an entity. Additional steps, beyond the review and analysis of the financial statements are required to value an entity before a decision can be made on ‘actual/enterprise value’. A key gap in financial information is that a large portion of assets, such as intellectual capital, brands and other intangible assets, are not recognised on the traditional balance sheet.

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As a result of the limitation of financial reporting and stakeholders’ need for a more holistic and comprehensive view of an entity to enable informed decision making, various supplementary and revised forms of reporting emerged. The objective of such enhanced or additional reporting is to include information on:

• Long term prospects of the entity.

• The impact of external factors such as market conditions, political stability, labour matters, climate change and others on the entity’s business model.

• Risks and how these are managed by the entity.

• The entity’s use of and impact on the various stocks of capital, beyond just financial capital, namely natural, manufactured, human, intellectual as well as social capital, which includes the entity’s ongoing relationships with stakeholders.

Many of these aspects are subjective and of a qualitative nature, hence it is not possible to assign a quantitative value to them, as in the case with current financial reporting models.

Beyond financial reporting

The concept of sustainability as a business principle (sustainability being an entity’s ability to build and maintain a business model that will survive and thrive in a resource-deprived world in the longer term) emerged in the 1980s. Many debates were held in the 1970s and 1980s and very polarised views existed between the followers of Milton Friedman on the one hand (who was of the view that the social responsibility of business is to increase profits) and the followers of John Elkington on the other (who recognised the impact of the environment, the local community and the larger society as well as an entity’s governance practices on its long term viability as a business).

Throughout history examples exist where investment decisions were not purely based on financial considerations, but where other criteria also played a role. Some examples of criteria which are taken into account are political and ethical considerations, as seen in the decision making by Free Traders and the Quakers. Trade unions in the 1950s and 1960s, through pension funds, started flexing their muscles in regard to the impact of entities’ business models on social and environmental aspects.

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Over time the consideration of other matters (adding sustainability, governance and the ethical impact to financial consideration) when deciding to invest in an entity or not, albeit from an asset/portfolio investment management or an individual investor, became known as ‘socially responsible investing’.

There was another specific phenomenon that called for what later became known as ‘ESG reporting’. The 1989 Exxcon-Valdez oil spill in Alaska, with its significant environmental impact, as well as the apartheid regime in South Africa in the 1970s, with its ethica...