Auditors and accountants behaving badly

Auditors should be the last line of defence in detecting corporate accounting fraud, irregularities and unacceptable accounting practices. Sadly, accountants and auditors are hogging the headlines for all sorts of misdemeanours.

There are many areas of audit negligence, but one of the most damaging is the signing off on financial statements that overstate the company’s financial position. This includes inflating revenue, incorrectly accounting for profits from contracts, bringing future profits into the current period, not impairing intangible assets, and failing to ascertain going-concern risk where intangibles exceed tangible assets.

Overstatement of a company’s financial position can result in financial loss for those who have relied on the figures, such as shareholders and creditors. Falsely creating the impression that a company is doing well, and overstating its financial position, allows bonuses to be paid to executives and dividends to shareholders.

Goodwill, which represents the present value of future profits an acquiring company expects to earn from an acquisition, is a much-abused and over-valued asset. So too are the other intangibles which should represent the present value of future income streams a company expects to earn from those specific intangibles.

However, goodwill also represents the difference between the purchase price and the net assets of a business. But how correct is this if the acquirer paid more than a business is worth? Even worse, the acquirer may issue shares at an inflated value in payment for the business.

Goodwill attaches to the business operations and cannot be sold as a separate asset. International Financial Reporting Standards allows goodwill to be amortised over a maximum period of 10 years.

In my view, only intangibles (trademarks, copyright, patents) that have been separately purchased from an independent third party should appear on the balance sheet. Goodwill should be written off immediately.

In many acquisitive companies, the value of intangibles vastly exceeds the value of the assets. Hence, a material misstatement of these values would make a company which should fail the going concern test appear to be in good financial health.

One would therefore expect the auditor to take great care in critically assessing the value of goodwill and intangible assets, and impair the values if deemed necessary. The failure of auditors to properly appraise the value of goodwill and intangible assets has tarnished their own.

In an effort to increase public confidence in the financial information prepared by accountants, the International Ethics Standards Board for Accountants has published a 267-page ‘International Code of Ethics for Professional Accountants (including International Independence Standards)’.

In terms of this code, a professional accountant is expected to adhere to the fundamental principles of integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour. A professional accountant must adhere to these principles whether working as an accountant or an auditor. The code sets out additional requirements for professional accountants in business.

To my mind, there cannot be a separation between a code of ethics for business and professional engagements, and a code of ethics to be followed in one’s own time. The recent incident when a senior lawyer dumped the body of a dead dog in the road, and the public outcry this provoked, is a good example of this.

The code places importance on threats to independence. However, it does not touch on diversity. Surely diversity is an essential tool in breaking down the clusters of ‘boys clubs’, old school tie networks and group-think? How vigilant will an auditor be in impairing the goodwill of a business in which their best buddy is  CEO?

Another paper out for comment is that of Professional Scepticism – Meeting Public Expectations. The purpose of this paper is to explore which behavioural characteristics fall within the ambit of professional scepticism, and whether all professional accountants should have these traits.

The paper suggest that any accountant in the “financial reporting supply chain” should also exercise professional scepticism because it is not possible for auditors to detect and resolve all problems during the audit and at the end of the process.

However, if a professional accountant were to develop the behavioural traits of professional scepticism, in addition to skills and experience, perhaps this would cut down on errors in judgement. But can professional scepticism be taught?

The paper sets out certain steps to follow before making a decision:

• Obtain and understand all relevant information to support facts
• Make informed challenges of views developed by others
• Be alert to any potential bias
• Be able to withstand pressure to do otherwise
• Make reliable judgements after careful consideration of all facts.

The paper goes beyond audit and assurance engagements, and promotes “integrity throughout the financial reporting supply chain”.

Unfortunately, judgements are subjective, and will be influenced by the prevalent moral compass, or the lack thereof. Where there are close ties between the auditors and the company that is being audited (if, for example, the company is staffed with ex-employees of the audit firm, who play golf together and interact socially), it must surely be difficult to avoid bias or group-think.

It will be a brave accountant who takes a stand that may well be their last. They will be accused of tunnel vision, lack of creative thinking, not being able to think beyond the box, and will be totally intimidated and beaten into submission. I haven’t sucked those accusations out of thin air – I was accused of all three when I was a young tax consultant.

Another way of tackling declining public confidence in accountants, auditors, and the financial information they prepare is to take a good hard look at the reporting standards that are used to easily perpetuate fraud, omission or negligence. What accountant is going to stand up, and, taking heed of “professional scepticism”, point out the flaws in these seemingly inviolate standards?

No wordy document trying to create a blueprint for ethical standards will be as strong a deterrent as simply removing the cause.

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