Are International Standards on Auditing (ISA) resilient and flexible enough to withstand the impact of economic downturns?
Turbulent economic times challenge auditors in more ways than one, not least because the expectations of the stakeholders who rely on our independent audit opinion are heightened during such times, with questions such as “are our auditors considering the macro side of our business?”, or “have our auditors adequately considered the risks pertinent to our business in designing their audit procedures?”
One may suggest that these very questions go beyond what an ISA audit of historical financial statements is all about, since they embody, to some degree, a look-forward mindset. The debate here revolves around “audit of the past versus audit of the future”.
Looking back and giving comfort on historical financial statements necessarily involves considering what has been accounted for. However, the increased use of fair values in measuring the carrying amount of assets and liabilities requires auditors to also assess, among others, forecasts of future cash flows in arriving at the recoverable amounts against which the carrying amounts of those elements of the financial statements are compared to at the reporting date or, where required by accounting standards, disclosed by way of a note to the financial statements.
The use, and perhaps relevance of such fair values continues to be at the centre of the debate relating to the development of accounting standards, particularly so during times of uncertainty and depressed market conditions. Some argue, for example, whether what is reported at a point in time should be adjusted for the effects of market conditions which may well reverse after such reporting has gone public.
Against such a backdrop, it is easy to conclude why modern-time auditors’ tasks are by no means limited to simple verification procedures, especially when financial statements are purported (unless otherwise stated) to be prepared on a going concern basis, which assumes that an entity will continue to operate in the foreseeable future. This focuses on conditions which may cast doubt on an entity’s ability to continue to operate as a going concern, by evaluating management’s expectations and the current and expected future economic conditions over the period which the enterprise has considered in making a positive statement in this regard.
Have our auditors adequately considered the risks pertinent to our business in designing their audit procedures?
Specifically, as also required by the new Audit Directive, the audit report for all statutory audits in the EU (i.e. not just statutory audits of Public Interest Entities – PIEs) will need to “provide a statement of any material uncertainty relating to events or conditions that may cast significant doubt about the entity’s ability to continue as a going concern”.
Assessing an entity’s ability to expand in the face of an adverse economic climate and the effect that such prevailing conditions may have on the current state of affairs of the entity, will be central themes during turbulent economic times, which those charged with governance will need to keep at the fore.
On their part, auditors must give serious consideration to an entity’s ability to continue as a going concern, recognising though that, while they should be familiar with the economic effects on the entity being audited, they are not responsible for predicting future conditions or events with certainty, even if adverse conditions are to then prevail.
Some commentators have pushed for auditors to report on the financial health of their audit clients, as if to say that an ISA audit gives a measure of assurance in this respect. That discussion may have been the precursor to the enhanced reporting by auditors which comes into effect with respect to the next wave of financial statements of PIEs. Such reporting now requires auditors of PIEs to communicate key audit matters in a separate section of their report – matters, which, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the period under review. These include the most significant assessed risks of material misstatement, including those due to fraud.
Major frauds coming to light have further propelled the financial storm, rendering it a challenging period. Management’s integrity remains a key element in the execution of an effective ISA audit. This is all the more the case when management comes under significant pressure to continue to secure funding and meet owners’ expectations. While weathering the storm, owner-managers will want to project a “business as usual” attire “until things get better”, and, in the midst of all this, some may well succumb to the pressure of questionable accounting.
The current economic environment will certainly test the robustness of ISAs when adhered to as intended, as one reflects on whether such standards are resilient and flexible enough to withstand the impact of economic downturns. ISAs dictate that auditors should not be satisfied with less than sufficient appropriate audit evidence, requiring additional attention to the determination of audit risk and materiality, placing reliance on management representations, and considering fraudulent reporting practices.
Intensifying professional scepticism (and documenting the auditor’s approach in this regard) may avoid unfortunate audit failures, particularly in times of economic turmoil. For example, the economic climate could play a significant role in determining impairment charges and/or provisions towards inventory obsolescence. A proper understanding of the audited entity and the industry in which it operates will go a long way towards an auditor being able to plan and execute an audit which will stand up to scrutiny.
The financial crisis has fuelled stakeholders’ demand for better reporting of business risks, based on the belief that an improved understanding of such risks should keep those responsible for the stewardship of companies more in step with what is expected of them and to a more efficient allocation of resources taking those risks into account. This, in my view, is an entirely legitimate demand, and risk reporting can and should be improved.
Looking beyond our mandate as ISA auditors immediately brings to mind assurance that the audit profession can provide to lend credibility to such reporting. And it is during turbulent economic times where such assurance becomes all the more relevant to the various stakeholders who look to the profession as another safeguard signalling where things can go wrong.
Hilary Galea-Lauri is a partner for audit services at KPMG in Malta.