The Audit Oversight Board (AOB) recently issued its sixth annual report which covered its work and observations for 2015. While the report was predominantly aimed at the auditors of public interest entities (PIEs), it also contained observations and insights relevant to companies audited by the auditors concerned.
Hence, directors who are keen to enhance the quality of governance of their companies, particularly PIEs, should pay attention to the findings of the AOB.
In the context of the AOB, audit firms are divided into two groups: major audit firms and the rest. Why? The major audit firms consist of the larger firms that have more than 10 partners and audit close to 96% of public listed companies if measured by market capitalisation.
In addition to their reputation, their size and scale enables them to take larger and complex audit engagements. This is important for companies that have a significant presence in foreign markets. The other side of the coin is the 42 medium to small firms, which have only around 4% of the market share.
The skewed distribution of audit work creates different challenges for the firms. The larger firms have more work on their plate, thus stretching their resources in meeting deadlines. The type of clients they serve also requires them to deal with more complex accounting issues and make more challenging professional judgments.
As the smaller firms have a lesser amount of work, with a majority of them dealing with only one PIE client, their exposure to the complexities of auditing PIEs may be limited. If the enforcement actions taken by AOB are taken as an indicator, it appears that some firms in this category have issues in complying with auditing standards.
One of the key observations of the AOB for the major audit firms is the increase in the percentage of engagements requiring significant improvements, from around 10% in 2012 to around 18% in 2015. This means that close to one in five audit works of the major audit firms needed significant improvements.
Among the drivers of the findings are the inability of the firms to maintain consistent quality of work across all engagements, failure to consult their relevant experts in dealing with challenging matters and the need for further improvements in their systems to monitor work quality.
For other firms, while the percentage of engagements requiring significant improvements had improved from 80% in 2012 to 45% in 2015, the percentage of work in this category remained unsatisfactory. If the findings on this category of firms are analysed further, they would have more structural challenges compared to their larger cousins.
For example, the AOB highlighted gaps in the ways their partners’ performances are assessed, where quality is not being given adequate weightage, hence not providing enough incentive for them to ensure quality work is performed.
Other gaps identified include independence and ethical issues, failures to comply with the new client acceptance process properly and inadequate training, as well as the extent of involvement of partners in audit engagements.
Like prior years, there were common deficiencies in the audit work, which were noted across all the firms. They were in the areas of revenue recognition, asset impairment, group audit, sampling and reliability of information provided by management or experts.
Notwithstanding the remediation efforts made by the firms in response to the AOB’s findings in prior years, the effectiveness of those efforts seems to be questionable.
What do these findings mean to the board of companies audited by those auditors? There are a number of issues that the company boards need to give their attention to.
First, boards need to understand the strengths and weaknesses of the firms which they engage. What are the views of the leadership of those firms with regard to audit quality and what are their efforts to ensure the assurance provided to the board every year is reliable?
Given the findings of the AOB, boards are entitled to ask whether there are adverse findings against them and what they have done to rectify those shortcomings. While audit firms may play down the findings of the AOB, that view alone is already a red flag about the attitude of the firms regarding audit quality.
The second issue is about ensuring the firms have enough experienced staff, other than the partners, to deal with specific industry issues or complexities of the companies audited. While the partners are responsible for the whole audit, most of the work would be performed by more junior staff.
Questions around the efforts of partners in supervising the audit, and the experience and expertise of senior staff assigned to the audit engagement would provide ideas about whether the firms could handle the audit risks of the engagement.
Workload and tight deadlines are the third element which could influence the quality of an audit. Boards may also want to ask about resource allocations for their audit work and whether the firms are also committed to other large clients in the same period.
The AOB annual report provides good insights about the state of affairs of the auditing industry and possible shortcomings that could pose potential risks to the level of assurance provided to boards and shareholders. Those boards which are responsive to those findings would certainly be able to have better assurance and quality of work from their auditors.
This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/what-audit-firms-can-learn-aob-annual-report