Holding Auditors Accountable on Reports

MAY 8, 2014
By FLOYD NORRIS
Rolls-Royce the jet engine maker, not the car company used estimates and assumptions in
its financial results that resulted in mildly cautious profit recognition in an important part of its
business. On the other hand, the company was mildly optimistic in other assumptions,
resulting in a somewhat lower liability being recorded than might otherwise have been the
case.
Coming from almost anyone else, such observations might not be particularly notable. But those
comments came from Jimmy Daboo, the lead audit partner on the Rolls-Royce account at
KPMG, and are included in the companys new annual report.
Until now, auditors letters have been among the least interesting parts of annual reports. If the
opinions said the accounting was proper and virtually all did and did not voice concern
about whether a company could stay in business, the letters were basically the same. There was
no reason for an investor to read them.
In the United States, that is still the case.
Jimmy Daboo, a partner at KPMG in Britain, pointed out significant errors in calculations in
one audit. They were fixed.
But in Britain, there are new rules this year. Auditors are supposed to comment on the particular
risks that companies face and to say what they did to deal with those risks.
They are supposed to discuss how much of the company they actually audited, to disclose what
figure they deemed to be the lower limit for materiality, and to explain how they arrived at that
number.
Audit reports were seldom read, said Marek Grabowski, the director of audit policy for
Britains Financial Reporting Council, which required the new reports. It is evident that
investors are now reading them with interest.
The sad reality has been that investors in the past have had virtually no way to assess the relative
merits of any accounting firm relative to the others, at least among the Big Four firms that
dominate the auditing market for large companies.
Many people see the audit as a commodity that can be produced equally well by any team from
any firm with a recognized name, James R. Doty, the chairman of the Public Company
Accounting Oversight Board in the United States, said in a speech last week at Baruch College.

The board is considering proposals to require auditors to make disclosures somewhat similar to
those in Britain. It has faced opposition from auditing firms and companies.
The new disclosures open the way for the firms to indicate just how diligent they have been.
And they could also open the way for investors to assess different partners of the leading firms.
In Britain, but not in the United States, the names of the lead partners have been disclosed in the
past, but at most that could serve as a negative indicator: If an audit blew up because of
undiscovered fraud, that reflected badly on the lead auditor. But unless and until that happened,
an outsider had no way to assess what the auditor actually did. Investors certainly had no way to
form a positive opinion of a particular auditor
It holds them to account more, Mr. Grabowski said. It should give the individual partner a
chance to show they are doing a good job.
Continue reading the main story
Mr. Daboo seems to have seized that chance. In the audit report on New World Resources, a
troubled coal mining company listed in London but with big operations in Central Europe, Mr.
Daboo reported finding significant errors in calculations which were corrected in the final
financial statements.
One concern regarding the British rules, as well as the proposed United States ones, is that in the
end they might be filled with boilerplate, providing little if any useful information.
As a result, some analysts and investors are watching the extent to which that happened in
Britain in the first year under the new rules. Few reports went as far as Mr. Daboos did, and
Sarah Deans, an accounting analyst at Citi Research, spotted what she saw as boilerplate in
several audit reports signed by PricewaterhouseCoopers. Each of them highlighted the same
risks, potential fraud in revenue recognition and possible overriding of internal controls. We do
not think these standard disclosures, she wrote, are helpful to investors.
Without mentioning PricewaterhouseCoopers, Mr. Grabowski, in a recent speech, pointed to the
similar disclosures as examples of boilerplate, making it clear that was not what he wanted to
see. It may be noted that he is a former partner at PricewaterhouseCoopers.
When I asked the firm about the issue, it did not exactly promise to change, but Gilly Lord, the
firms head of regulatory affairs in London, hinted that was on the agenda. The new audit reports
are very different from their predecessors, and they will continue to evolve, she said. We
welcome all constructive feedback, which will be taken into account as we develop our audit
reports for the next reporting season.
My suspicion is that the praise KPMG has received will influence the other firms next year,
although it is possible some audit clients will not be eager to see frank discussions of their
accounting policies.

It will be interesting to see whether auditors are willing to make clear that a company engaged in
aggressive, though legal, accounting. That has not happened yet, but it is possible that a threat
from an auditor to make such a statement could lead a company to revise its accounting before
the figures are released.
At a recent discussion of new auditor reporting rules, Lew Ferguson, a member of the
P.C.A.O.B., noted that, on balance, the Rolls-Royce report was positive, and he suggested that
auditors might heap praise on clients as a way to compete for new ones. Nick Land, an official
from the British regulator, said he did not think that would be a problem, in part because
investors were watching.
Tony Cates, the head of audit at KPMG in Britain, said during the P.C.A.O.B. discussion that in
20-odd years of auditing, he had never seen so much interest from investors in what Im
doing. The change, he said, was a real positive.
The British accounting environment, it should be noted, differs from the one in the United States
in a number of ways. It is less litigious and the regulator has less power than the Securities and
Exchange Commission does in the United States.
Continue reading the main story Continue reading the main story
Continue reading the main story
That showed up at Rolls-Royce well before the annual report was released. The company
engages in some unusual accounting in which it sometimes reports profits years before any cash
comes in, and some critics have questioned that treatment. The British regulator asked for
accounting changes, and while the company made one change, it did not go nearly as far as
originally requested.
In the United States, the S.E.C. could simply have decreed what the accounting rules required,
and a company would have been forced to follow if it could not persuade the commission to
change its mind. In Britain, however, the council can force a change only if it goes to court,
something it has never done and chose not to do in this case.
In that context, the KPMG reports conclusion that the accounting was proper may have been
especially welcome by management, and the evidence of auditor independence made that
conclusion appear more credible.
One benefit of the new reports is the clear demonstration that earnings numbers are subject to
many assumptions and estimates and that radically different numbers could be permissible. That
is not news to accountants, but it may not be well understood by many investors.
An international group that sets auditing standards for many countries has indicated it will adopt
something similar to the British system. What remains to be see is whether the United States will
resist the trend.

Philip Johnson, a former Deloitte partner and a former president of the Federation of European
Accountants, a trade group, told the P.C.A.O.B. it needed to act, and quickly.
It would be nonsense, he said, if the largest capital market on earth provided the least amount
of information to the investor community on the key matters influencing the financial
information upon which those investors are making their decisions.

Credible Accounting Is the New Essential

February 01, 2002|James Flanigan
The current rage on Wall Street over accounting and the quality of corporate earnings is a little
like a hangover victim swearing never to touch another drop. Big investors have known for years
that company accounts have been mildly or even seriously fictional. And yet that made little
difference in their investment decisions.
But clear and credible accounting is making a difference now, in the wake of Enron's collapse
amid disclosures of hidden debts and overstated profit.
Investors this week dumped stocks of companies deemed guilty of obscure accounting or
understating liabilities in their financial reports.
And those investor reactions already are forcing changes in corporate reporting and in the
accounting profession. Some of these changes:
* Companies will have to end or severely limit their use of off-balance-sheet partnerships that
hold debt or assets away from their reports to shareholders and the Securities and Exchange
Commission. Enron had used such partnerships extensively to make its financial situation look
better than it actually was.
* Accounting firms will get new regulation, and they will have to separate auditing of company
books from other services to clients, such as management and information technology consulting

Survey Finds Audit Flaws by the Big

Accounting Firms
By REUTERSAPRIL 10, 2014
WASHINGTON Public company and bank audits conducted around the globe by units
affiliated with the worlds six largest accounting firms are persistently riddled with flaws, a
group of international regulators have found.
The finding, released on Thursday in the results of a survey conducted in 2013 by the
International Forum of Independent Audit Regulators, raises major policy questions about
whether global regulators have done enough to improve audit quality since the 2007-9 financial
crisis.
Leading up to the crisis, many publicly traded banks portrayed a rosy financial picture of their
corporate books, only to suffer huge losses later on subprime mortgage securities in their
portfolios.
Critics have questioned why independent auditors responsible for reviewing the accuracy and
quality of public company financial reporting failed to spot the problems sooner.
The high rate and severity of inspection deficiencies in critical aspects of the audit, and at some
of the worlds largest and systemically important financial institutions, is a wake-up call, said
Lewis H. Ferguson, a board member of the Public Company Accounting Oversight Board, which
polices auditors in the United States.
More must be done to improve the reliability of audit work performed globally on behalf of
investors, he said.
The findings discussed Thursday stem primarily from inspections conducted at firms affiliated
with the six largest accounting firms. They include the Big Four PricewaterhouseCoopers,
KPMG, Deloitte and Ernst & Young as well as BDO and Grant Thornton.
The survey looked at inspection results for audits of public companies and large financial
institutions considered systemically important to the global economy.
With public company audits, regulators found problems related to auditing fair value
measurements, internal control testing and procedures used to assess how financial statements
are presented.
The regulators also said that audits of systemically important financial firms often had
deficiencies stemming from allowances for loan losses and loan impairments, and the auditing of
investment valuation.

Cindy Fornelli, executive director at the Center for Audit Quality, said on Thursday in reaction to
the survey that her groups members recognized there was still work to do.
At the same time, she noted that accounting reforms enacted in the United States in 2002 have
led to improvements in audit quality, financial reporting, and internal controls over financial
reporting.
A spokesman for PricewaterhouseCoopers International said that the firm remained committed to
improved audit quality, and that it would carefully study the report to see how it could best
address the issues.
Representatives of the other large accounting firms either did not respond to requests for
comment or declined to comment.