NSFM opinion: Develop a parallel audit system

Jonathan Hayward writes: Accountants say, quite correctly, that the legally required purpose of audit is to give an opinion on financial statements prepared in accordance with accounting standards.  Much of the rest of society thinks (and not unreasonably) that audit should contribute more to economic stability by helping to communicate something about the risks inherent in a company’s business model and how they are managed.  For decades, this “expectation gap” has not merely remained unclosed but has widened.

Why is this problem so hard to fix?  Because it is a systemic problem, not a failure of any of the individual parts.  Auditing and accounting standards; the low information value of unqualified audit reports; the business model of audit firms; the liability regime; the individual interests of investors, lenders, management and audit committees: these and other features all work together to give a system which favours consolidation and discourages innovation and competition, and whose output is increasingly what might be labelled as “compliance” with a reporting regime which meets the public’s expectations to only a partial extent.  You won’t change this by incremental adjustments to individual elements.

But it’s unrealistic to suppose that it can be reconstructed wholesale. Instead, allow a more useful system of audit to develop in parallel.  Leave the financial statement audit regime largely untouched, except for fixing the most egregious shortcomings of accounting standards.  Meanwhile, in recognition of the fact that the expectations gap relates largely to qualitative and forward-looking information, develop the requirements for narrative reporting by management.  It should describe, “through the eyes of the board”, how the strategy exploits opportunities, what are the key risks to the business model, and how those risks are addressed. This narrative reporting should be audited, but not by the financial statement auditor.  This audit’s output should be a long-form report giving a qualitative commentary on the board’s report, rather than a “yes or no” opinion.  Liability should be restricted, so as to encourage effective communication around difficult issues for which there is often no clearly right or wrong answer.  Regulation should focus on ensuring that the quality of this review is apparent through the report’s content.

Doing this type of audit would require objectivity, expertise and experience, but not in enormous numbers. So it would create a new market in which innovation and specialist smaller firms would be able to flourish, so long as the visible quality of their work justified it.

Jonathan Hayward is the Founder and Partner of Independent Audit Ltd., United Kingdom.

This article is part of our NSFM opinion series, in which participants propose specific steps towards real and sustainable market reform. Contributors write in a personal capacity. NSFM participants are invited to contribute to the series. Please contact Ebba Schmidt or Frank Jan de Graaf for further information.