Bad audits and beleaguered auditors are symptoms of a cancer in the body corporate. The Financial Times investigation into the flawed audit market suggests accounting standards may be part of the disease.
Recent scandals — from fraud at Colonial Bank in the US to the collapse of Carillion, the UK outsourcing group — have drawn attention to the system’s inadequacies. Structural dependency on four big firms is one problem, to be addressed later in this series. Another is auditors’ seeming inability to prevent investors being misled or to curb aggressive, even criminal, reporting practices. It suggests the rules are no longer fit for purpose.
Accounting standard-setters have at least two laudable aims: to align rules globally and to close loopholes to abuse. Thirty years ago, it was easy for a bank to manipulate its profits by valuing loans and setting aside provisions for loan losses with little heed to economic reality. Some investors were delighted at the consequent smoothing of profits and dividends through the credit cycle. But the scope to minimise tax, inflate bonuses or simply obfuscate a decaying financial situation was great. Indeed, out-of-date numbers in US banks’ balance sheets were partly to blame for the savings and loans crisis of the 1980s and 1990s.
A key underlying principle of modern accounting is fair value. This method pegs asset valuations to current market prices with the aim that a company’s accounts reflect up-to-date economic reality, rather than historic cost. It was accepted as a fundamental basis of US accounting in the wake of the S&L crisis, after the Securities and Exchange Commission overcame initial doubts. By the early 2000s, International Financial Reporting Standards, which apply to accounts in Europe, had followed suit.
The idea springs from a valid maxim, that accounts should be “useful to users”. But it has made for volatile, or at worst fictitious, valuations. Companies can value illiquid assets with no verifiable market price, using questionable estimates based on “models”. They can account for long-term contracts with unprovable projections of income streams into the future.
Unscrupulous managers, increasingly rewarded with equity incentives linked to accounting measures, have exploited the system. By writing up asset values in line with market values — whether real or estimated — they could book profits, distribute dividends, boost share prices and make incentive payments. Consider investment bankers’ bonuses, distributed ahead of the 2008 financial crisis but based on asset values that tumbled only months later.
Fair value accounting is clearly based on logic. But for it to work in practice it requires auditors to play the crucial role of arbiter. Straightforward market valuations are one thing. But when models and estimates are used as proxies, an auditor’s judgment is crucial to the credibility of company accounts.
Yet the Big Four auditors have used their considerable lobbying power to hollow out their role, rather than accept that responsibility. As the fair value approach has taken hold, they have tweaked the rules to have judgment removed from decisions, reducing the auditor in many cases to little more than a tick-box administrator.
To return to the prudent, but equally manipulable, historic cost model would be a knee-jerk response. But it is certainly time to reconsider the latitude given to users of models, estimates and projections.
IFRS overseers responded to the financial crisis and the sudden glut of non-performing loans on European banks’ balance sheets by creating a new rule, IFRS 9. While abstruse, its core precept is that companies should set aside bad debt provisions early and prudently, rather than doing so only when they have already incurred losses. The rule combines fair value accounting with the more cautious approach of predecessor standards.
This pragmatic approach should be extended to all areas, and combined with a principle that profits hew close to cash flow, to curb the abuse of models and projected earnings. Simultaneously, regulators should restitute a more robust requirement on auditors to interrogate finance directors’ judgments. The audit market needs to recover its original purpose of assuring investors and the public of the truth and fairness of accounts. Reforming the rules would be a critical first step.