Auditing the auditors

IT IS NOW more than 50 years since the publication in 1969 by the late Professor Stamp of the University of Edinburgh of two influential articles, one of which had the effect of stopping the English Institute of Chartered Accountants annual conference and created vast change in the accounting professions.

There has been nothing like it since.

The main focus of Professor Stamp’s criticisms was the multiplicity of ‘accounting principles’ and the ambiguous concept of true and fair view, but his most trenchant criticism was to the effect that auditors could not be independent if they were paid by the company they were auditing. Related to his views was the criticism that the auditors in a different capacity provided tax, management consultancy services and, in a private communication to me, designing a golf course.

As a result of his stinging criticisms the accounting bodies formed a group and started to issue accounting standards.

Much later this led to International Reporting Standards and the current Financial Reporting Council which, among other matters, pronounces on the accounts of companies and has power to fine and discipline firms.

To date most of the larger firms have been subject to some form of censure and, in recent months, a firm outside of the top echelon.

This short article will address a number of issues: despite the events and publications of the last 50 years the number of financial scandals does not appear to have abated, although they are more publicised.

It will look at why, without looking at any case in particular.

Inevitably the problem is associated with income recognition of some form or another whether it is long-term work in progress, rebates from suppliers or some other recognition issue.

In addition, there are cases associated with some sort of fraud or misfeasance – see Wisecard in Germany.

One of the problems with accounting is the requirement to produce periodic accounts, in most cases annual accounts but in the case of quoted companies, interim six monthly accounts where the problems can be even greater.

The genesis of accounting is the accounts of ship owners and merchants of the fifteenth and sixteenth century.

Basically, matters were simple. A financier would finance a ship to explore the oceans and bring back a cargo which would be sold on landing back in England (or wherever). Matters were simple as there was no formal accounting period and all the transactions were completed once the voyage was complete.

There was no stock or work in progress left or any other outstanding questions as all of it would be sold on return to port.

Life got more complicated after the Industrial Revolution in the nineteenth century.

Production became more complicated and depended on the particular work in progress process and this item became a substantial asset in a company’s balance sheet.

Concomitant with this came the development of the limited liability company, which became permitted in 1862 (also known as the ‘rogues’ charter’), which led to limited liability companies being required to produce annual accounts. This became the problem. Many transactions remained uncompleted at the year end, which necessitated the valuation of such items as stock and work in progress and other items such as depreciation and in more recent times the valuation of intangible assets, including goodwill, which has bedevilled the profession since the author of a famous paper by P. D. Leake.

This is the key to many modern failures: the number of outstanding transactions at the year-end which in turn is a function of the complexity of the production process.

This is particularly apposite in the case of long-term work in progress. Indeed, one can say the longer the gestation period between the commencement of a production cycle and its completion, the more vulnerable the accounts are likely to be to accounting valuation issues.

This diagnoses the problem but does not offer a solution.

In the case of long-term production more could be stated in the accounts about the length of the production cycle and more importantly the effect on the accounts of a 10/20/30% error in valuation of the assets.

This might be extended to other valuation issues such as intangible assets such as computer software and research and development. In addition there might be more detailed evaluation of assets in the accounts.

While this would add to the length of accounts, they are already complex by definition.

Another improvement might be to prepare accounts on a two- or three-year basis in conjunction with the periodic annual accounts. This together with the sensitivity analysis discussed above might provide a more informed basis to evaluate a company’s performance.

The other issue raised by the late Professor Stamp and many commentators is the issue of independence.

At the moment auditors are paid by the companies they audit. Attempts at introducing more independence have been implemented by a more frequent change in partner auditing the accounts and audit committees.

Both are very valuable and their importance should not be underestimated.

It is recognised that there are moves to separate the audit function from the rest of the accounting firm, a move in the right direction.

This is not enough; the payment of the auditors should be separated and more encouragement should be given to the medium sized firms taking over the bigger audits.

In conclusion, what we can say is that most if not all problems in accounting arise from the nature of the accounting process and the compression of the outstanding transactions into a single short accounting period of one year. This article has argued that a more flexible approach should be adopted, based on some form of sensitivity analysis of key assets such as long-term work in progress and intangible assets.

The second issue has looked at the independence of auditors.

Some moves have been made in this direction but the payment of auditors should be separated from the directors of the companies they audit.

It is hoped the current moves in the profession will assist and accelerate this process.

However, what one can say is that many of the problems identified by the late Professor Stamp are still with us even after 50 years.

This article is dedicated to the late Professor Stamp, an inspirational mentor to this writer.