Audit quality needs better judgement

Directors and audit committees must play their part to ensure the quality of the independent audit.

Architects at work

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Auditors have a critical role in ensuring that Australian investors can be confident and informed in making their investment decisions. High-quality audits support the quality of financial reports and let investors rely on the auditor’s independent assessment of financial reports.

ASIC’s audit firm inspections show a need to improve audit quality. In our view, auditors did not obtain reasonable assurance that the overall financial report was free of material misstatement in 18 per cent of key audit areas that we reviewed across audit engagement files in the 18 months to 30 June 2012. While the financial reports might not have been materially misstated, the auditors did not have a sufficient basis to support their opinion on the financial reports. As a result of our separate reviews of financial reports of listed and public interest entities, 4 per cent of financial reports we reviewed were changed materially.

If there is a corporate failure in circumstances where the financial report did not reflect the true financial position and performance of an entity, and the auditor did not perform adequate work or challenge the financial reports, the role of both the directors and auditors will be rightly questioned.

Directors must not rely on the external audit in forming their opinion on the financial report. But directors and audit committees should play a key role in ensuring the quality of the independent audit.

Firm business models

Over recent decades, there has been increasing complexity in company business models and in financial reporting requirements. There are more difficult judgements on asset values and accounting estimates, including asset values. Audit approaches require understanding the business, risk assessment and more judgement.

This poses a challenge for the traditional audit firm pyramid staffing structure with relatively few partners and many junior staff. Auditors also need to make more use of experts in areas such as valuations, actuarial, geology, financial instruments and IT.

Auditor appointments and ongoing fees

While the members of a public company appoint the auditor at an AGM, it is generally not practical for members of larger listed companies to be involved in assessing auditors and setting audit fees. Non-executive directors should manage the process of recommending the appointment of an auditor.

Management may have interests that are not fully aligned with quality audits and so may not be best placed to assess auditors and set fees. Incentives to achieve certain levels of financial performance might lead to setting low audit fees that could place pressure on audit quality.

Auditors must maintain quality, irrespective of the fees. However, inadequate fees can create a risk that audit quality is compromised and that auditors do not obtain sufficient and appropriate audit evidence to support their opinion.

Companies are required to pay reasonable audit fees. Reductions in audit fees generally do not have a significant impact on a company’s profit. In difficult economic conditions, auditors continue to be faced with more challenging judgements that might be expected to lead to increases in audit fees.

Assessing potential and continuing auditors

When directors and audit committees are assessing potential auditors and reviewing the quality of ongoing audits, they may consider matters such as assessing:

■ the firm’s commitment to quality and culture

■ resources used in the audit, having regard to the nature and complexity of audit, including partner time and industry expertise

■ the extent of use of experts

■ how the auditor obtains assurance on the work of other auditors

■ accountability for audit quality

■ the level of professional scepticism exhibited by the auditors in challenging estimates and accounting policy choices.

Facilitating audits

Directors can challenge whether management is planning the financial reporting process to minimise deadline pressures. Potential issues with accounting policies and estimates should be raised early.

Communication

Two-way communication between the auditor and directors helps the auditor to obtain information that is relevant to the audit and assists directors in overseeing the financial reporting process. This communication should include concerns and risks with financial and reporting processes, accounting estimates and accounting policy choices.

Other matters

Directors and audit committees of listed entities have a statutory responsibility to assess and report whether non-audit services have the potential to compromise the independence and objectivity of the auditor.

Directors should consider the results of any review of the audit by ASIC and whether issues raised from ASIC’s inspections and surveillances have been addressed.

More for Boards

The issues in this article are discussed in more depth in ASIC’s recent Information Sheet 196, Audit quality – the role of directors and audit committees (http://goo.gl/n3i9hV).

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Doug Niven - is senior executive leader, financial reporting and audit, at the Australian Securities and Investments Commission.
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