SINGAPORE (July 29): Shortly after starting my first job as an analyst in Kuala Lumpur almost three decades ago, one of my senior colleagues sat me down and explained how to navigate a public-listed company’s annual report. He went through the balance sheet, profit-and-loss statement and cash flow statement line by line, and gave me advice on how to interpret the notes to the accounts. He also walked me through the other sections of an annual report, and explained why they were there. When he got to the independent auditors’ report, he simply said, “This just tells you the books are okay.”
It would be several years before I gave the role of auditors another thought. The way I saw it, even when auditors were doing their job properly, they could not be relied upon to distinguish “good” companies from “bad” ones. And, it seemed that the seal of good housekeeping from independent auditors wasn’t difficult to obtain. Some of my industry colleagues who started out as auditors often told me stories of how they had mostly taken their former clients at their word, and had conducted only the most cursory of checks in the course of their work.
By contrast, as analysts, these same people seemed to try much harder to uncover the truth, simply because it was expected of them. They would gather information on companies they covered from the suppliers and competitors of those companies, and try to find explanations for why a company’s financial metrics were better or worse than other companies in the same field. From the perspective of investors, analysts played a much more important role than auditors, or so I thought.
It wasn’t long before my hubris was tamed. For one thing, in the 1990s, markets across the region were booming, and some of the hottest stocks in Malaysia were rigged. For many investors during those heady days, whether a company had garnered sober, in-depth coverage from an analyst mattered about as much as whether its books had been properly certified to be free of material misstatement by an independent auditor. More importantly, I came to realise that sell-side analysts were just as conflicted as auditors. While auditors earned fees from the very companies they were auditing, analysts were also often employed by firms that did business with the companies they covered.
These conflicts tend to come to light when companies land in trouble. The collapse of Enron almost two decades ago not only brought down its auditor Arthur Andersen, but also resulted in analysts employed by four Wall Street firms — JPMorgan Chase, Lehman Brothers, Credit Suisse First Boston and Salomon Smith Barney — being hauled up before a US Senate committee to explain why they had maintained bullish recommendations on the company until the bitter end. The analysts defended themselves by saying it was not evident to them that Enron was in serious trouble until it was on the brink of collapse, and that the company had withheld accurate and timely information.
My point is that investors have been known to be let down by auditors as well as analysts. If there is a difference, it is this: Public-listed companies are legally required to have their books audited, but they do not necessarily need to have any analyst coverage. While the Monetary Authority of Singapore (MAS) has taken to subsidising the salaries of analysts in a bid to widen the research coverage of smaller companies listed on the local market, I doubt there is going to be much demand for that research unless it proves useful to investors. On the other hand, public-listed companies are required to have their books audited every year, regardless of whether investors have any faith in those audits. In fact, a clean independent auditors’ report enables errant companies to deflect suspicion and even stave off investigations.
Case in point: Noble Group, the commodities supplier that is alleged to have inflated the value of its assets and understated its liabilities. Alarm was raised four years ago, not by the analysts at regulated research houses, but by Iceberg Research, an entity set up by a former employee of Noble. Yet, even as the market became more and more convinced that all was not well at Noble, regulators in Singapore felt unable to act because the company had been given a clean bill of health by its auditors.
On Nov 20 last year, the Commercial Affairs Department, MAS and the Accounting and Corporate Regulatory Authority finally said they were jointly investigating suspected false and misleading statements and breaches of disclosure requirements by Noble, and potential non-compliance with accounting standards by its subsidiary Noble Resources International. But the market value of Noble had by then shrunk more the 98%. In my view, it is time to rethink the role of independent auditors in protecting investors.
Crunch time in the UK
The winds of change already seem to be blowing in the UK. According to recent reports from the Financial Reporting Council, which oversees auditing firms in the UK, only 75% of audits of companies in the FTSE 350 conducted in 2018 met required quality standards. That was an improvement from 2017, when 73% of audits met the required quality standards, but far below the FRC’s target of 90%.
The substandard performance wasn’t due to just one or two auditors. On the contrary, none of the seven auditors reviewed, including the so-called Big Four — Deloitte, EY, KPMG and PwC — met the FRC’s 90% audit quality target. Stephen Haddrill, CEO of the FRC, was quoted to have said, “The FRC found cases in all seven firms where auditors had failed to challenge management sufficiently on judgmental issues.”
The findings come in the wake of a number of corporate debacles that implicate some of the key auditing firms in the UK. For instance, KPMG’s audits of Carillion were investigated after the UK construction giant filed for liquidation last year. In July 2017, Carillion announced it had written off £845 million following a review of its material contracts. In November 2017, it warned it would be in breach of its financial covenants. Early this year, KPMG suspended Peter Meehan, the partner responsible for Carillion, on concerns over documents provided to the FRC.
In another case, the FRC fined PwC £6.5 million in June last year for failing to flag material uncertainty over the ability of UK fashion and homewares retailer BHS to continue as a going concern. Former PwC partner Stephen Denison, who handled the work, was fined £325,000 and effectively banned from auditing for 15 years. PwC had conducted an audit of BHS for the year to Aug 30, 2014, signing off on the books in early 2015, just before the company was sold for a token £1. BHS collapsed in 2016 with the loss of 11,000 jobs and a pension deficit of £571 million.
Meanwhile, last November, the FRC said it was investigating Grant Thornton’s audits of Patisserie Valerie. The UK confectionery chain suspended trading in its shares last October after discovering potentially fraudulent accounting irregularities that nearly sank it. Grant Thornton’s CEO David Dunckley did not do his firm or profession any favours when he told British Members of Parliament in January that there was an “expectation gap” on the role of auditors. “We’re not looking for fraud, we’re not looking at the future, we’re not giving a statement that the accounts are correct,” he was quoted to have said.
Against this backdrop, there have been all manner of calls for the system to be fixed. Earlier this year, the UK’s Competition and Markets Authority made a number of recommendations including the introduction of mandatory “joint audits” where so-called “challenger” firms work together with Big Four firms to audit FTSE 350 companies. The intent is to lower the barriers to entry for the challenger firms and create more choice and competition in auditing work of big companies. The CMA also recommended that audit committees be held more vigorously to account for the manner in which they appoint and supervise their auditors. On top of that, the CMA wants accounting firms to separate their audit and consulting services.
Even more significantly, following a review last year, the UK is now in the process of replacing the FRC with a new regulator called the Audit, Reporting and Governance Authority, which will have a new mandate and enhanced regulatory powers. Importantly, the ARGA will be able to make direct changes to accounts instead of applying to the courts, and demand rapid explanations from companies.
Noble never again
On the face of it, there doesn’t appear to be quite so much concern about audit quality standards in Singapore. ACRA, the body that oversees local auditors, said in its 12th Public Report under its Practice Monitoring Programme, dated October 2018, that “we remain on track to achieve the audit quality target to reduce by 25%, the proportion of inspected audits of listed entity engagements with at least one finding”. The target was set in 2016, and is to be achieved over a four-year period. It covers the work by audit firms such as BDO, Deloitte, EY, KPMG and PwC.
ACRA has also been proactive in reviewing and updating its provisions and standards, and introducing new initiatives. In 2015, for instance, it unveiled the Audit Quality Indicators Disclosure Framework, which essentially helps audit committees of listed companies better evaluate and select their auditors. The AQI framework comprises eight comparable quality markers that correlate closely with audit quality, including hours spent by senior audit team members involved in the audit, experience of the senior audit team members and results from internal and external inspections of auditors. ACRA notes that usage of the AQI framework has been increasing.
Nevertheless, there is trouble on the horizon for the auditing field. In January, the regulation arm of the Singapore Exchange said it would play a more active role in determining the scope of statutory audits. In particular, SGX said it would seek the power to appoint a second auditor, on top of an existing auditor, in certain circumstances and have both of them sign off on a company’s books. SGX also called on special auditors appointed to look into matters of concern to have the “gumption to take a professional stance on matters of concern”.
That was, in my view, a clarion call for ACRA and the major auditing firms to begin displaying bold leadership in recovering waning investor trust in the market. It is time for them to stop talking about professional scepticism as if it means something to anyone other than themselves, and realise that claiming that their role isn’t about keeping investors safe from fraud is simply unacceptable. They should instead be talking about how they are working to prevent the next Noble from happening. Most investors will probably never read the independent auditors’ report in a company’s annual report, but it is important that they never lose their confidence in the role that auditors play.
This story appears in The Edge Singapore (Issue 892, week of July 29) which is on sale now. Subscribe here
