For regulatory purposes, the Australian Securities and Investments Commission (ASIC) defines audit quality as matters that contribute to the likelihood that the auditor of a financial report will:
achieve the fundamental objective of obtaining reasonable assurance that the financial report as a whole is free from material misstatement; and
ensure material deficiencies detected are addressed or communicated through the audit report.
ASIC notes that this includes 'appropriately challenging key accounting estimates and treatments that can materially affect the reported financial position and results'.
As pointed to in Chapter 1, audit quality has been a matter of continuing concern to regulators and to this committee for a number of years. Discussion regarding audit quality in Australia has emanated primarily from successive findings of ASIC's audit inspection program, which show an apparent ongoing deterioration in audit quality (see Table 1.1).
With regard to its audit inspection program for the 12 months to 30 June 2019, ASIC found that in 26 per cent of the total 207 key audit areas reviewed across
58 audit files, auditors did not obtain reasonable assurance that the financial report as a whole was free of material misstatement. The corresponding figure for the 18 months to 30 June 2018 was 24 per cent across 347 key audit areas.
Adverse findings from ASIC's audit file reviews mainly relate to the adequacy of firms' audits of asset values and revenue recognition. Common deficiencies raised across ASIC's audit inspection reports include that auditors did not:
obtain sufficient and appropriate audit evidence;
exercise sufficient professional scepticism (particularly in relation to the impairment of non-financial assets); or
appropriately use the work of experts and other auditors.
ASIC's latest inspection report found that 'auditors need to improve audit quality and the consistency of audit execution', and 'the continuing overall level of findings needs to be addressed'.
The remainder of this chapter will examine matters relevant to the state of audit quality in Australia including: stakeholder perceptions on audit quality, particularly relating to ASIC's audit inspection findings; suggestions for improvement to ASIC's audit inspection approach; the importance of professional scepticism in audit and associated complexities as they relate to the valuation and impairment of non-financial assets; and the integral role that management and directors play in contributing to audit quality. Threats to auditor independence, as a key contributor to audit quality, are discussed in Chapter 4.
Perceptions on audit quality in Australia
Notwithstanding the findings of ASIC's audit inspection program, stakeholder perceptions suggest that, while there are opportunities for improvement, overall, the quality of audit in Australia is of a high standard.
In February 2018, the Financial Reporting Council (FRC) developed the FRC Audit Quality Action Plan which aims to continually improve audit quality by working with stakeholders to identify and understand issues and to undertake appropriate actions. In line with the objectives of the action plan, the FRC, in conjunction with the Australian Auditing and Assurance Standards Board (AUASB), conducted a survey of Audit Committee Chairs of ASX top
300-listed companies to gather their perspectives on audit quality in Australia. The survey found that 92 per cent of Audit Committee Chairs described their overall view of their external auditor as 'above average' or 'excellent'.
While in broad agreement that ASIC's audit inspection findings continue to indicate that improvements in audit quality are needed, the FRC reiterated its overall view on audit quality based on the findings its action plan to date as reported in its 2018–19 Annual Report; namely that:
Nothing has come to the FRC's attention from the other evidence to date from user surveys and targeted consultations that indicates external audits are not, overall, continuing to assist in maintaining trust and confidence in financial reports.
While the Group of 100 (G100) supported the FRC's objectives of continually improving audit quality, it nonetheless 'believes anecdotally that the audit quality experienced by Australian corporates is fundamentally of a very high standard'.
Similarly, the Australian Institute of Company Directors (AICD) submitted that, in response to consultation on the inquiry's terms of reference, 'on the whole, AICD members were of the view that the audit system is working well'. AICD further submitted that 'listed company directors reported a high degree of confidence in audit quality'.
The Accounting Professional and Ethical Standards Board (APESB) highlighted findings from the 2019 Australian Investor Confidence Survey undertaken by Chartered Accountants Australia and New Zealand (CA ANZ). That survey found that 87 per cent of retail investors are confident about the quality of audited financial information released by publicly listed Australian companies, citing reasons related to the involvement of an independent auditor. Based on this finding, the APESB contented that 'it is evident that the market perceives that most audits are performed well and in accordance with relevant standards'.
Mr Tony Johnson, Chief Executive Officer and Managing Partner, Oceania, EY, was of the firm view that, while there are areas for improvement, 'there is no substantial and sustained problem with audit quality and regulation of audit in Australia'.
Deloitte expressed the view that:
Australia continues to have effective, efficient and reliable audit services of good quality. At the same time, we acknowledge that audit in Australia can and should continually seek to evolve and improve.
Similarly, Mr Andrew Yates, National Managing Partner, KPMG, assured the committee that, in general:
…the capital markets in Australia are strong, and aligned with that I think the state of audit quality in Australia is strong. There are, no doubt, things that need to be improved, and we are working hard to improve those. We can talk about those as we go through this session. There are also things that we should be talking about in terms of what different stakeholders expect from an external audit and how the current standards actually determine what an audit does. So I think overall the audit quality in Australia is relatively strong.
Professor Allan Fels AO expressed a more subdued view on the state of audit quality in Australia, submitting that 'audit quality here and in major jurisdictions overseas is not bad', but 'there is, however, room for improvement, and no clear trend in the right direction'.
Mr Grant Heir, Auditor-General of the Australian National Audit Office (ANAO), noted that there is not any evidence that the audit work outsourced by the ANAO to external audit firms is of a lesser quality than that carried out internally by the agency:
You have to remember that we are the signing officer, and the signing officer and the audit manager take responsibility for managing the contracted audit. There isn't any evidence that we have that the level of engagement required in our outsourced audit by that review process is any greater than what we do for our internal processes. So there's nothing in what we do, and in any of the quality work that we do, which would lead us to our view that the quality of our outsourced work, in terms of the final audit outcome and the processes underpinning it, is any different from the internal work.
PricewaterhouseCoopers (PwC) pointed to the level of material changes required to net assets and profits of public interest entities as a result of ASIC's financial reporting surveillance program as an indication that the quality of auditing in Australia is generally of a high standard. Industry wide, ASIC has consistently found that four to five per cent of accounts reviewed require a material change, which is comparable to other major jurisdictions.
Elaborating on this point, PwC noted that a lot of the work undertaken by auditors to improve the disclosures ultimately made in companies' financial reports goes unseen:
It is difficult to entirely capture the day to day reality of a complex and challenging audit. For example, there are many cases where a company makes adjustments to its financial statements, or clarifies or enhances disclosures, before they’re published, as a result of the audit process. For example, in 2018, PwC audits of listed companies identified, on average, six potential adjustments per audit and ensured their appropriate treatment prior to finalisation of the company's statements. The market only sees a clean set of financial statements and an unqualified audit opinion, but there is often a lot of work behind the scenes by the auditor with the client to achieve this outcome.
Mazars also reflected on the 'unseen' work of auditors in considering the state of audit quality in Australia:
Our professional experience is that auditors contribute to a significant improvement in the quality of financial reporting as compared to an expectation of what would be produced without auditors reviewing the information before release to markets and regulators. Unfortunately, this activity happens quietly and behind closed doors and is subject to the principle of confidentiality which is at the heart of our profession. Accordingly, information regarding the number and value of pre-release adjustments identified and resolved by auditors is difficult to obtain.
Industry stakeholders also drew the committee's attention to the potential benefit that a partnership structure, under which the Big Four firms continue to operate, can have with regard to driving audit quality. For instance, Mr Matt Graham, Managing Partner, Assurance, PwC, stated that maintaining a partnership structure is seen to be for the public good as auditors are unable to 'hide behind the corporate veil of limited liability'. Mr Graham further remarked:
The fact that partners had joint and several, unlimited liability in a firm was seen as something that would improve audit quality. I can certainly say that, in the culture of our firm, the fact that we're in business together as partners and have that joint and several liability creates a culture where you're not just looking after yourself when you're making decisions about prioritisation of resources and investment in quality; you're doing it because not only are you looking after your fellow partner, you actually have joint and several liability with them. So there's an element of
self-interest in the broader partnership piece as well.
ASIC's audit inspection program—Process and limitations
ASIC's audit firm inspections are conducted on an ongoing basis throughout each year. Inspections include the review of key audit areas in files for selected audit engagements conducted by the largest six firms by market capitalisation. Typically, three to four key audit areas are covered in the review of each audit file, and these audit areas remain broadly consistent across inspections. ASIC provides feedback to audit firms following each file review, with firms given the opportunity to challenge or undertake remedial action to address preliminary findings.
As explained by ASIC, individual audit file reviews concentrate on the substance of audit work conducted and whether sufficient appropriate audit evidence was obtained to support the auditor's opinion. In carrying out audit file reviews, ASIC applies the presumption that if audit work is not documented, and in the absence of evidence to the contrary, then that work has not been performed. ASIC publicly reports a summary of the findings and observations from its audit inspection program, setting out the areas it considers auditors should focus on to improve audit quality. ASIC's latest audit inspection report, covering audit file reviews for the 12 months to
30 June 2019, was released in December 2019.
The audit engagements and key audit areas reviewed under ASIC's audit inspection program are selected using a risk-based approach. Unavoidably, this approach means that some of the more complex, demanding and challenging audits are selected for review, as well as some more significant and higher risk areas of the financial reports. ASIC readily acknowledges that, due to the risk-based methodology used, the results of its audit inspection program may not be indicative of the entire audited population of listed and unlisted entities. Indeed, ASIC advises in its Audit inspection report for 2018–19 that 'great caution is needed in generalising the results across the entire market' and also, that 'purely random reviews could result in a different level of findings'.
The AUASB agreed with ASIC's assessment that its inspection results cannot be generalised across audit firms, also observing that 'in any one review period, ASIC perform a small number of detailed inspections relative to the number of listed entity audits a firm conducts'.
The committee questioned ASIC as to whether it had considered conducting random sampling for its audit inspection process, rather than risk-based approach currently used, in order to provide better insight into the state of audit quality industry-wide. ASIC Commissioner, Mr John Price, responded:
The short answer is: yes, we have given some thought to random samples. I suppose there are a couple of issues there. First of all, we are custodians of taxpayers' money, so is it a better use taxpayers' money to focus on areas where we think there are problems or on a purely random sample? The other issue is—we did do some work around what would be required to generate a statistically significant population so as to have a greater level of confidence in our findings, and the figures actually required a very, very large number of audit files to be—
Mr Douglas Niven, Senior Executive Leader, Financial Reporting and Audit at ASIC, explained that ASIC would need to inspect a random sample of 660 audit files to obtain a confidence level of 95 per cent (that is, no more than five per cent misstatement). This represents a substantial increase on the number reviewed under its present risk-based approach.
Further clarifying the approach used in undertaking its audit inspection program, ASIC noted that audits necessarily involve the application of professional judgement, which is subjective. As such, there are some instances where different individuals will reach different judgements on whether the audit work performed is sufficient. ASIC elaborated:
We are open to the possibility that we do not have all the facts, that there may be differing views on the requirements of auditing standards, or differing judgements. We have extensive due process with the firms and within ASIC to address any such concerns and ensure that findings do not include matters where, for example, reasonable professionals could differ in their views.
A number of inquiry participants, including ASIC itself, pointed out that where an ASIC audit file review identifies a matter that does not meet the required standard, this does not necessarily mean the audited financial report was materially misstated. ASIC clarified:
Rather, in our view, the auditor did not have a sufficient basis to support their opinion on the financial report. In these cases, there is a risk that the financial report was materially misstated, and that investors or other users were not properly informed when making decisions based on that report.
Reflecting further on this point, the AUASB noted that an adverse finding from ASIC's audit inspection program can result from:
deficient audit application;
a difference in professional judgements made by the auditor when compared to the ASIC inspector; or
a difference in interpretation of the Auditing Standards made by the auditor when compared to the ASIC inspector.
Enhancements to ASIC's audit inspection program
ASIC's audit inspection findings are an important and, arguably, the best available measure of audit quality in Australia. That said, as part of its
enhanced approach to supervision being adopted agency-wide, ASIC has committed to implementing a number of new initiatives to promote improvements in audit quality and its measurement. Some of these initiatives, (outlined below) have already been implemented. ASIC anticipates that work in relation to the remainder the initiatives will be commenced or completed during the 2019–20 financial year.
To enhance the transparency of its audit inspection program, ASIC published individual percentage findings from its audit file reviews at each of the Big Four firms in its latest audit inspection report. ASIC had previously only published aggregate percentage findings. Individual firm's findings for the
12 months to 30 June 2019 and 18 months to 30 June 2018 are replicated in
Table 3.1: Adverse findings from reviews of key audit areas in audit files at the largest four audit firms
Source: ASIC, Report 648—Audit inspection report for 2018–19, p. 7.
ASIC has also sought to promote audit quality by publishing a broader range of audit quality measures and indicators (Report 649—Audit quality measures, indicators and other information: 2018–19) supplementary to its audit inspection reports. In describing this initiative, ASIC cautioned that, while the broadened measures will assist in assessing audit quality, 'audit quality cannot be reliably reduced to a single figure or formula'. The expanded measures and indicators are relevant to the committee's recommendation in its statutory oversight report of the 45th Parliament (see paragraph 1.38).
Other new initiatives being undertaken to enhance ASIC's audit inspection program include:
an audit firm governance review looking at governance, culture, talent, conflicts of interest and accountability for audit quality at the largest six audit firms;
reviews of the effectiveness of the root cause analysis and subsequent action conducted by audit firms on adverse findings from ASIC's inspection and surveillance programs; and,
in light of the recommendations made by the FRC in its Auditor Disciplinary Processes: Review, a review of ASIC's criteria for acting on auditor enforcement and the types of outcomes sought, including the referral of matters to the Companies Auditors Disciplinary Board.
Stakeholder views on ASIC's audit inspection approach
The majority of inquiry participants, particularly the Big Four firms, were broadly supportive of ASIC's audit inspection program and the continued efforts to implement improved audit quality measures and indicators.
For example, KPMG believes ASIC's inspection process provides valuable insights to improve the quality of its audits, and commended ASIC for its 'continued willingness to engage with the profession about ways in which the audit inspection program can be improved'.
Similarly, Deloitte submitted that it benefits from the 'extensive dialogue' with ASIC during and as a result of the audit inspection process. Deloitte further stated:
We believe that the inspection process serves an important role in improving audit quality, and we value the insights it brings to both entities and the audit profession.
The committee also heard from Mr Tom Imbesi, Chairman of Deloitte Australia, that ASIC's audit inspection results have provided a valuable data point for the firm to draw on when looking at how to improve and enhance its audit methodology:
It's one input. We also have our own desire to increase and improve audit quality. We have our own programs in place, our own training in place. We have a global methodology that's continually enhanced and refined. The input of ASIC, along with other regulators around the world, helps us to continuously refine and improve our methodology, so it is valuable to us.
EY supported ASIC's work to identify and report on a broader range of audit quality indicators, expressing the view that this will provide a more balanced analysis and support ongoing confidence in financial markets. EY also reflected on the audit profession's response to ASIC's audit inspection regime, submitting:
…we believe the market has responded well to ASIC's regulatory involvement by undertaking root-cause assessments and making substantial changes to audit processes because of the regulator’s actions.
The AUASB noted the value that measuring a wider range of audit quality indicators will provide in terms of facilitating more informed discussion about the purpose and importance of audit. However, the AUASB encouraged further consideration as to the right indicators of audit quality as well as the role of the FRC in reporting these, given its mandate to provide strategic advice on audit quality.
Notwithstanding the overarching support highlighted above, some submitters and witnesses observed that the risk-based approach used by ASIC, as well as the manner in which audit inspection findings are reported, may result in a distorted view of audit quality.
The G100, for instance, noted:
…due to the limited amount of information regarding the findings, it is difficult to assess to what extent negative findings were from larger, systemically more 'risky' audits or smaller companies, or where lack of 'a basis to support their evidence' indicates a lack of proper documentation and evidence—as ASIC notes, 'ASIC's findings do not necessarily mean that the financial reports audited were materially misstated'.
Demonstrating this point, Mr Jamie Gatt, Managing Partner, Audit and Assurance, Deloitte, noted that of the 44 key audit areas reviewed by ASIC in the firm's audit files for the 18 months to June 2018, ASIC was of the view that for 14 of those areas, there was not sufficient appropriate audit evidence to support the auditor's opinion. This resulted in a 32 per cent finding rate.
Mr Gatt continued:
And I think it's important to note that whilst our score was 32 per cent none of the files that were looked at in the inspection needed to be restated. In fact, in the two previous inspections, which covered an additional 25 files, none of those required restatement either.
Further indicating how ASIC's inspection findings may give a misleading impression of the state of audit quality, PwC explained that, for the 12 per cent of cases where ASIC identified concerns with PwC audits for the
18 months to June 2018, 'there were no instances where the related financial statements required a subsequent restatement to market'.
Pitcher Partners also remarked on the risk-based approach used to select audit engagements and files for review, submitting that the final outcome of ASIC's audit inspection program is distorted 'by announcing results based on a skewed sample'. Additionally, Pitcher Partners observed:
…ASIC reviews focus on specific areas rather than standing in the shoes of the auditor, whom is required to provide an opinion on the financial statements as a whole. This is often done in relation to specific areas of judgement and with the benefit of hindsight, with some reviewers spending more time on these areas than the audit team are able to spend on the entire audit.
Suggestions for improvement
The committee heard a number of suggestions for improvement to ASIC's audit inspection approach. In particular, inquiry participants suggested that ASIC should adopt a system whereby its audit inspection findings are graded on the basis of severity. Additionally, some stakeholders supported the adoption of more balanced reporting on audit inspection findings as well as publication of individual firm inspection reports on ASIC's website.
Grading the severity of inspection findings
Submitters and witnesses advocated for a system whereby reported inspection findings are graded on the basis of severity or significance. Doing so, inquiry participants argued, would provide stakeholders with greater confidence in the quality of audit and better information on which to base their financial decisions.
The Bentleys Network submitted that while it finds the audit inspection process to be quite robust and detailed, it believes that ASIC's findings are not clearly understood by the broader community or accurately reflected by the media. The Bentleys Network attributed such misunderstandings to differences in professional judgements over what constitutes sufficient audit evidence and proposed that 'it would be beneficial if these were clearly reported as such, rather than as an adverse finding'.
KPMG shared a similar view:
We suggest a system of 'grading' or rating be introduced in order to help the public interpret ASIC's findings. This should help shareholders distinguish between findings that indicate an audit opinion may be unsupported and other, less significant findings such as areas for improvement in documented audit evidence.
The current system used by ASIC can result in inspection findings that vary markedly in terms of significance being presented as like-for-like. Formally stratifying or grading the significance of ASIC’s findings would help provide more clarity to all stakeholders.
Likewise, EY argued that applying a severity assessment to audit inspection results would facilitate greater confidence in audit quality through enhanced transparency and understanding of ASIC's findings.
Representing CA ANZ, Mr Amir Mostafa Ghandar, Leader, Reporting and Assurance, called for more clarity and transparency around the factors that constitute ASIC's audit inspection findings. On this point, CA ANZ recommended that ASIC develop a 'three-grade severity scale' for audit inspection findings.
Professor Ken Trotman described the deficiency rate (that is, total percentage of adverse findings) reported by ASIC as being 'very uninformative', arguing deficiencies found through the audit inspection process 'should be clearly described including the nature and extent of these deficiencies'. Further advocating for such an approach, Professor Trotman submitted:
It is much more likely that the deficiencies can be addressed by the audit firm if there is more transparency about the type of deficiencies, whether it is an omission or an alternative view on what is appropriate evidence, and where the inspectors disagree.
Adoption of more balanced reporting
Some inquiry participants suggested that ASIC adopt a more balanced assessment framework whereby positive findings, such as above average performance or improved audit procedures, are reported as well as audit deficiencies.
For example, Professor Trotman observed that by pointing only to audit deficiencies, the current assessment framework employed by ASIC emphasises penalties rather than rewards. Professor Trotman argued that stakeholders need to be aware of positive findings:
There is an opportunity for ASIC to more fully inform investors on audit quality. Capital markets should be given a more balanced assessment that describes both the positive and negative findings…The report could also include an update on new improvements made by the audit firms. The market needs to be aware of these enhancements and whether the policies are continuing to work effectively. Examples of innovative audit procedures and best practice also could be acknowledged so that firms are rewarded for these actions. ASIC has considerable data on the root cause analysis of the deficiencies reported and providing researchers with access to unidentifiable data would likely lead to insights to improve audit quality.
Similarly, PwC encouraged ASIC to report on the audit firm's perspectives on inspection findings as well as the firm's action plans to address identified deficiencies. PwC expressed the view that reporting on the firm's commitment to continuous improvement would provide stakeholders with better information to draw conclusions.
Arguing in support of the need for more balanced audit inspection reporting, Professor Robyn Moroney noted research findings that audit regulation via ASIC's current inspection framework may have a detrimental impact on auditor commitment and turnover intentions. Professor Moroney explained:
We found that auditors are sensitive to the language used by regulators when reporting the outcomes of their inspections and the way that their firms respond by increasing their use of checklists to demonstrate compliance with standards to appease regulators. We reported our findings to the regulator, highlighting that it wasn’t their (negative) findings that had a detrimental effect on auditor commitment and turnover intentions but rather auditors reacted to the tone used when delivering their message. We reported to firms that their staff would prefer that their audit process not become more prescriptive, particularly if regulator was to use a conciliatory tone. Commitment and turnover are important as firms are keen to retain their highly skilled staff to ensure their capacity to deliver high-quality audits.
Publication of individual firm inspection reports
Another suggestion put forward to improve ASIC's audit inspection program is the publication of individual audit firm inspection reports. For instance, of the view that greater transparency is needed to give more insight into the quality offered by the audit sector in Australia, KPMG encouraged:
…the mandatory publication of individual audit firm inspection reports on the ASIC website to provide important context to the percentage finding. This would bring Australia in line with other jurisdictions including the UK and US.
Currently, ASIC's published audit inspection reports present an aggregate summary of the observations and findings identified during the relevant review period. However, the committee notes that during the course of the inquiry, each of the largest six audit firms voluntarily published their firm's individual ASIC audit inspection reports for 2018–19.
On this point, Mr Graham explained that PwC chose to publish its individual audit inspection report in the interest of transparency and building trust in the audit process:
What we were trying to do there was create balance. The transparency piece is that there has only ever been one statistic around one conversation and that has been for the whole market. We think transparency drives accountability. It is an unforgiving discipline. We put our own ASIC inspection findings to the market back in May in the full knowledge that frankly, because of the sample sizes and because the bar continues to rise, quite rightly, and because ASIC keeps looking at risky areas of risky audits, those numbers will be volatile. They will move up and down. But by being more transparent about them we hope that continues to build trust in the process so people can understand it more.
Professional scepticism is a cornerstone of the professional judgement an auditor must apply in obtaining sufficient audit evidence to support their opinion on the integrity of a financial report. That is to say, exercising an appropriate level of professional scepticism is fundamental to the critical assessment of audit evidence and, therefore, essential to achieving a
Australian Auditing Standards (ASAs) define professional scepticism as:
…an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.
In line with international standards, ASAs explicitly require that auditors plan and perform an audit with professional scepticism, recognising that circumstances may exist which cause the financial report to be materially misstated. ASAs also recognise that professional scepticism includes questioning contradictory audit evidence and the reliability of documents, responses to enquiries and other information obtained from management and those charged with governance.
AICD concisely summarised the important role that professional scepticism should play in the relationship between auditors and a company's directors and management:
Good auditors act as thought leaders and a strong relationship with an auditor and judicious use of their professional scepticism assists directors in their supervision of management.
Valuation and impairment of non-financial assets
Successive ASIC audit inspection reports have criticised audit firms for failing to exercise appropriate professional scepticism relating to the valuation and impairment of intangibles and other non-financial assets. In this regard, ASIC specifically stated in its submission:
We are concerned that some auditors may not apply enough professional scepticism and sufficiently challenge management estimates.
Several inquiry participants sought to highlight the complexities faced by the preparers of financial reports and, in turn, by the auditors of those financial reports with regard to the valuation and impairment of non-financial assets. The challenges facing auditors in this respect are increasing alongside the changing business environment in which they operate. As touched on in Chapter 1, companies are expanding and operating on an increasingly diverse and global scale. Changing business models have resulted in financial statements that include balances requiring greater professional judgement and estimation (including of future revenues and expenses), which is subject to uncertainty and considerable differences in opinion.
The AUASB neatly described the challenge of auditing non-financial asset valuations and impairments:
Accounting estimates, including the valuation and impairment of assets such as intangibles, are often highly complex, involving high levels of professional judgement. The estimates are often based on complex models that involve forecasting and assumptions about future business performance and events. As a result, the auditing of estimates is very challenging, as it is more difficult to gather sufficient and appropriate evidence for matters that have not yet occurred.
Professor James Guthrie also characterised how audit relating to non-financial assets has changed the nature and complexity of audit processes over time:
…These organisations are huge. There are millions or tens of millions of transactions a day. So the financial complexity is there, for sure. In terms of the accounting now, a lot of the accounting is not based on what I would be happy to call the cash system; it's based on estimates and ideas about what could be. It's about the future and making estimates and putting numbers on it, so it's so much more complex now compared to the good old sixties.
The non-financial asset valuation and impairment outcomes disclosed in financial reports are generally the product of numerous inputs and assumptions for which there are limited observable data points or that rely on considerable estimation. Small changes in these variables can result in significant variations in outcomes. Pitcher Partners highlighted how these conditions affect auditors' assessments in these areas:
In forming conclusions and auditing these judgement areas, auditors are required to settle on a single outcome as disclosed in the financial statements. However, these disclosed outcomes are the products of a wide variety of inputs, with varying values of themselves, together with predictions about future events.
Decision Science identifies that good decision-making processes do not guarantee successful outcomes. Where the financial statements turn out to be incorrect, auditors are often presumed to have failed to have exercised sufficient scepticism if any of the range of variables considered would have resulted in an outcome less favourable than the one disclosed.
PwC similarly noted that auditors' work relating to non-financial assets involves the assessment of cash flows that are expected to be generated by the asset in the future. PwC elaborated that the forward looking nature of such assessments 'involve considerable judgement in a range of matters and thus are inherently complex, and will be reviewed by audit inspectors and others at a later date with the benefit of hindsight'.
The Australasian Council of Auditors General (ACAG) pointed out that the sufficiency and appropriateness of evidence to support judgements and estimations concerning non-financial assets varies considerably. Consequently, ACAG noted that auditors require 'appropriate skill and expertise, in order to apply an appropriate level of knowledge, professional judgement and scepticism in the audit process'.
Both the Australian standard-setting bodies, the Australian Accounting Standards Board (AASB) and AUASB, have recognised the need for improvement in the area of valuation and impairment of non-financial assets, including intangibles. In this respect, the AASB noted that the International Accounting Standards Board (IASB) is presently undertaking a limited review of the standard applying to the impairment of assets, but the AASB is pressing the IASB to undertake a more fundamental review.
In addition, the AUASB released a revised version of Auditing Standard ASA 540 Auditing Accounting Estimates and Related Disclosures (ASA 540) in December 2018, which is operative for financial reporting periods commencing on or after 15 December 2019. The AUASB advised that it is 'currently developing implementation support for auditors and working with the Professional Accounting Bodies on educative initiatives to support auditors in the implementation of ASA 540'.
The role of management and directors
A common theme raised during the inquiry was the role of management and directors in supporting and contributing to audit quality. As underscored by several inquiry participants, audit quality does not exist in isolation. Rather, it is part of a financial reporting supply chain that involves interactions between a company's management, its governance (such as audit committees), auditors, the users of financial statements, and regulators.
Deloitte characterised these components as making up the 'financial reporting ecosystem' (Figure 3.1), with all parties having key roles to play and external audit providing 'a critical link between entities that prepare financial reports and the users who rely on them'.
Figure 3.1: Financial reporting ecosystem
Source: Deloitte, Submission 28, p. 14.
While acknowledging that auditors have the primary responsibility for audit quality, submitters and witnesses expressed the strong view that improving audit quality requires collective action by stakeholders in the financial reporting chain. This is because, as aptly put by Professor Stephen Taylor, audit quality is 'inexorably linked to the rules that govern financial reporting'. In other words, audit quality and financial reporting quality are not mutually exclusive, and auditing standards alone are not sufficient to achieve
ASIC emphasised this connection:
Audit quality supports financial reporting quality, which in turn enhances market confidence in a company's reported financial position and results. It is therefore in the interests of directors and audit committees to support the audit process.
Likewise, Professor Trotman told the committee that 'the quality of audit depends on the interaction between auditors and many other stakeholders in the financial reporting process', and characterised audit committees as playing a critical role in enhancing audit quality.
That view was supported by EY, who stated that 'an effective financial reporting chain sees directors, audit committees and management supporting quality audits through the production of quality financial reports'.
Likewise, BDO Australia (BDO) asserted that responsibility for the preparation of financial reports that comply with accounting standards and that present a true and fair view of a company's financial position and performance rests with the directors. BDO expanded on this view:
If the financial statements that are prepared and provided to audit better comply with the Corporations Act and Accounting Standards disclosure requirements the audit can be conducted in a more effective manner. This will allow audit to focus its efforts on key audit matters and areas of greater importance, rather than spending large amounts of time dealing with routine disclosure issues.
The ANAO pointed out that a company's management and those charged with its governance acknowledge certain responsibilities in preparing the financial report and importantly, that the audit of the financial report does not relieve them of those responsibilities.
AICD echoed this point, underlining that directors' obligations and duties include assuming primary responsibility and accountability for the quality of financial reporting by the entities they govern. AICD added:
In fulfilling this accountability, directors should have sufficient financial literacy to understand and assess financial statements, be able to challenge and test the accounting treatments and judgements applied by management and oversee the entity’s financial reporting processes.
As ASIC emphasises, a company must have its own systems and processes to produce high quality financial reports. Directors must not rely on the auditor when forming their own opinion of the financial report, as this would undermine the objective of independent assurance.
General-purpose and special-purpose financial statements
In conjunction with the views expressed above about the 'inexorable' links between the rules governing financial reporting and audit quality, the committee received evidence about the paucity of information contained in Special-Purpose Financial Statements (SPFSs) as opposed to General-Purpose Financial Statements (GPFSs).
SPFSs can be lodged with ASIC to satisfy legislative reporting requirements, rather than more detailed GPFSs. Current Australian Accounting Standards allow entities that do not classify themselves as 'reporting entities' to utilise SPFSs. The current test to determine which entities can produce SPFSs is a subjective test, not an objective test based on assets and revenue. The test is based on whether users are dependent on financial statements and whether they can acquire the information they require.
ASIC noted that certain information not contained in SPFSs would be useful for users. This includes information on consolidation, financial instruments and related party transactions.
The AASB indicated that the basis for preparing SPFSs varies significantly, compromising both their quality and comparability. The IPA–Deakin SME Research Centre noted that some academic research has questioned the quality of information provided in SPFSs.
The committee heard varying views on how common SPFSs are. Adjunct Professor Michael West and Mr Jeffrey Knapp suggested that the preparation of SPFSs is a common practice by large multinational companies.
Professor Peter Wells suggested that some firms were inappropriately using SPFSs. That said, EY observed that in the past two years, a significant numbers of its clients have moved from special-purpose to general-purpose financial statements.
Professor Stephen Taylor indicated that, in his view, progress is being made on resolving the issues associated with SPFSs:
The special purpose financial reports clearly have a long history in Australia. I think that at the moment the progress towards removing them is as fast as it could possibly occur. I think there is a clear path laid out for achieving that. We are heading towards a situation where special purpose financial reports, in the way they currently operate, largely will not. I think that is something that is being addressed and it is being addressed as well as it probably could be.
The AASB is undertaking work to align Australian standards with the IASB's Revised Conceptual Framework to limit the ability of entities to self-assess that they are not a 'reporting entity' and thereby elect to use SPFSs. The AASB indicated that it:
…started consulting in August this year on its revised proposals to prohibit for-profit large proprietary companies, small foreign controlled companies and unlisted public companies from preparing special-purpose financial statements. We are proposing they prepare general-purpose financial statements, whether tier 1 full financial statements or tier 2 with simplified disclosure requirements. Submissions close on 30 November, with a proposed effective date of 30 June 2021.
EY, Deloitte, KPMG and PwC all indicated they support the proposed changes.
The role and importance of auditing
The market allocation of capital to productive companies is fundamentally important to growth in a capitalist economy. Adequate information is vital for markets to function efficiently. In particular, investors require accurate, relevant, and comparable information to make decisions. The financial reports of listed companies are a primary source of financial information on which investment decisions are made.
It is evident, therefore, that investors—both large and small—are the key users of audited financial statements. In considering the regulatory framework for auditing, the committee has considered the needs of the users rather than just the needs of the preparers and auditors of financial statements. Getting this balance right also requires consideration of the costs and benefits of trying to reduce the scope and scale of errors in the system.
Responsibility for the accuracy of a company's financial reports lies, in the first instance, with a company's management and board of directors. In other words, good business practice and governance is critical. The committee is in no doubt that company boards play a vital role in ensuring that companies, and their financial statements, are honest and transparent.
Having said that, the committee acknowledges that, on occasion, company management and boards of directors fail in their duties. Either they are less than diligent, or more rarely, part of the company's management sets out to deliberately mislead with respect to the company's financial position.
It is important, therefore, that the integrity of the financial statements of listed companies is subject to external professional scrutiny. Rigor is achieved by ensuring that the scrutiny and testing is carried out by suitably independent and sceptical actors. In Australia, external audit provides an independent opinion on the integrity of the information contained in a company's financial report. Specifically, an auditor's opinion provides reasonable assurance as to whether a company's financial report complies, in all material respects, with relevant legislation and standards and gives a true and fair view of the company's financial operations. In sum, given important investment decisions are based on annual financial statements, auditing plays a critical role in ensuring the trust in the financial system and is a crucial part of the warning system that informs investors and other stakeholders.
In light of the above, the committee is mindful that the external audit function is part of a supply chain, and that the role of the auditor exists in the context of a broader system that includes management and directors. As such, the committee appreciates that any changes to the regulation of auditing may have consequences for other parts of the financial reporting system. Likewise, suggestions for improving the quality of financial reporting will have positive spin-offs, including a likely improvement in the usefulness of the audited financial statements.
In this regard, the committee notes concerns about the longstanding and sometimes inappropriate use of SPFSs, and the resultant decrease in disclosure and transparency. The committee considers that full and appropriate disclosure and transparency are of paramount importance to the users of financial statements. The committee therefore welcomes both the apparent reported reduction in the use of SPFSs and the AASB process to remove the loophole that effectively enables entities to elect to use SPFSs. The committee believes that the AASB process should address the transparency concerns.
Genesis of the inquiry and committee approach
The regulation of auditing and issues pertaining to audit quality are global issues. Some of the impetus for this inquiry derived from comments to this committee over a number of years by former ASIC Chairman, Mr Greg Medcraft. Mr Medcraft expressed his frustration and disappointment at what he saw as both unacceptably poor audit quality in Australia, and an apparent ongoing deterioration in audit quality. Further, Mr Medcraft made public statements to the effect that poor audit quality increased the risk that the type of malfeasance and corporate collapse typified by Enron might currently pass undetected by auditors in Australia.
Beyond these shores, audit quality is also a matter of intense focus and inquiry. In the UK, for example, three major reviews have been commissioned to inquire into, and make recommendations on, various aspects of auditing in the wake of the Carillion collapse.
While the reference by the Senate directed the committee to inquire into, and report on, the regulation of auditing in Australia, the committee acknowledges the broader international context to the debate about audit quality and the scope of potential solutions. With this in mind, at the first public hearing on
19 November 2019, the Chair set out his approach to the inquiry and requested that witnesses address the following questions:
What is the evidence that the practice of auditing in this country is flawed?
Are those flaws isolated or are they systemic?
If those problems are systemic, what is driving them?
What policy solutions are available to the government to address them?
What are the costs and benefits of those solutions?
If those solutions have been implemented elsewhere in the world, how did they work?
If they are entirely new, what justifies this novel approach?
It may be the case that the evidence base of a current problem of auditing in Australia is limited, but there is very good reason to believe it would be a bigger problem in the future. If that is the case, can you clarify why you believe that is so?
Audit quality and ASIC's audit inspection reporting
In accordance with the approach set out above, a primary source of evidence about audit quality may be gleaned from the ASIC audit inspection reports that have been conducted by the regulator in Australia since the CLERP 9 reforms were introduced. Taken on their face, these reports paint a rather gloomy picture of audit quality in Australia.
Given that ASIC's audit inspection reports are a primary source of evidence about audit quality, it is prudent to examine the nature of the inspection reports themselves. ASIC has been clear about the nature and limitations of its inspection program and the caveats that should be borne in mind when interpreting the results. First and foremost, ASIC uses a risk-based sampling approach when selecting audit files for review. This means ASIC is targeting the more complex, demanding and challenging audits as well as the more significant and higher risk areas of financial reports. This inevitably biases the sample towards higher risk audit files that require a greater degree of professional expertise and judgment and, as such, may result in differences in interpretation and opinion. In turn, as ASIC itself points out, this means that great caution should be exercised in trying to extrapolate the results of ASIC's audit inspections from those higher risk audit files to the wider audited population.
On the other hand, the committee expects that both the audit firm and the audit client would, as a matter of due diligence and reputational risk, ensure that only the most experienced audit partners were allocated to the most complex and inherently risky audit files requiring the greatest professional judgment.
In short, there does not appear to be any way of quantifying the extent to which ASIC's risk-based inspection program may or may not provide a broad and reasonably robust indication of the overall state of audit quality in Australia.
While some witnesses expressed fears and some anecdotal evidence was presented during the course of the inquiry, the committee did not receive concrete empirical evidence of systemic issues with audit quality in Australia. That said, several stakeholders proposed improvements to the ASIC audit inspection program to improve its useability and, in turn, help drive improvements to audit quality. One of the key pieces of feedback received was the suggestion that ASIC improve the transparency and utility of its inspection program by grading the findings in its reports according to their severity or significance. Currently, ASIC presents more serious findings such as an unsupported audit opinion, as equivalent to other less significant findings, such as the need to better document audit evidence.
Similarly, the committee notes that audits necessarily involve the application of professional judgement. One of the more complex areas requiring professional judgment is the auditing of non-financial asset valuations and impairments. Auditing future estimates is challenging because it is more difficult to gather sufficient and appropriate evidence for matters that have not yet occurred, or if underlying assumptions or conditions change. Different individuals may reach different judgements on whether the audit work performed is sufficient. In such circumstances, an adverse finding from ASIC's audit inspection program could arise because of a difference in either:
the professional judgements made by the auditor when compared to the ASIC inspector; or
the interpretation of the Auditing Standards made by the auditor when compared to the ASIC inspector.
The subjective nature of these professional judgments lends weight to the argument that ASIC's inspection reports should clarify the basis on which findings of particular audit deficiencies are made.
Given the inherent complexity and challenges applying to the impairment of assets, the committee encourages the AASB to continue to press the IASB to undertake a fundamental review of the standard applying to the impairment of assets.
Another area of potential confusion regarding the ASIC audit inspection program relates to the extent to which ASIC finds a material misstatement in the financial statements that requires change. Evidence to the committee indicates that ASIC's financial reporting surveillance program has consistently found that four to five per cent of accounts reviewed require a material change. This is comparable to other major jurisdictions.
Several stakeholders also encouraged ASIC to publish individual firm inspection reports on the ASIC website. In this regard, the committee notes that, at varying stages during 2019, the Big Four accounting firms, BDO and Grant Thornton published their previously confidential individual ASIC inspection reports on their own websites.
Noting the above, the committee acknowledges that ASIC is working to enhance its audit inspection program. The committee welcomes ASIC's introduction of additional indicators of audit quality and encourages ASIC to continue to refine these indicators as they are monitored over time. The committee considers that measuring and monitoring the right indicators will provide further insights about audit quality and facilitate a more informed discussion about the purpose and value of audit.
In light of the above, the committee considers that ASIC should continually review its methodology with the aim of producing reports of greater sophistication and clarity. This would necessarily involve taking into account the subjective nature of some of the professional judgments made by both auditors and the ASIC inspectors.
The committee is also of the view that, having due regard to the need for greater nuance, the results of ASIC's individual audit inspections should be made publicly available on ASIC's website.
The committee recommends that ASIC:
formally review the manner in which it publicly reports the periodic findings of its audit inspection program, giving appropriate consideration to approaches used internationally; and
based on this review, develop and implement, by the end of the 2020–21 reporting period for its audit inspection program, a revised framework for reporting inspection findings, with a focus on the transparency and relative severity of identified audit deficiencies.
The committee recommends that the Australian Government introduce, by the end of the 2020–21 financial year, through appropriate legislation, a requirement that ASIC publish all future individual audit firm inspection reports on its website once ASIC has adopted a revised reporting framework referred to in Recommendation 1.
Noting the above recommendations, the committee encourages ASIC to maintain a focus on reviewing the effectiveness of the root cause analysis and subsequent action conducted by audit firms on adverse findings from ASIC's inspection and surveillance programs. The committee expects that the root cause analysis undertaken by the audit firms to rigorously address some of the persistent and more troubling findings of ASIC's inspection program. These findings include a failure by some auditors to apply enough professional scepticism and sufficiently challenge management estimates. The committee considers this process to be an important component of a positive feedback loop between the regulator and the auditors leading to actionable outcomes.