Are Annual Audits still “Fit for Purpose?”

Editorial Note: We are delighted to present the following editorial column by Nick Shepherd, President of EduVision. Nick currently chairs the CPA Canada Committee for developing Statements in Management Accounting.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Annual reports together with various supplementary requirements and filings are important for boards, investors, rating agencies and others as a foundation to assess and determine the financial health of an organization. Historically this has worked reasonably well; up until the 1970’s most of the corporate value – an average of 80% – was reflected on the balance sheet. If the audit revealed the integrity of assets and liabilities, there was a reasonable expectation that the business was healthy.

Fast forward to today. Most corporate value for owners, investors and others is now intangible with only an average of 15% represented by financial assets. While certain intangibles can be capitalized and included on the balance sheet, the majority are nowhere to be seen, nor are they assessed or reported on through the audit. If an audit is designed to provide reasonable assurance of organizational health and integrity, doesn’t basing this on the verification of only 15% of the value seem high risk?

There is continuing criticism of auditors and the profession for failing to alert investors and others to potential risk when organizations fail – yet how can the profession shoulder the blame when its scope and mandate are determined by compliance with standards that focus principally on tangible assets and liabilities? Apparent failures in oversight and governance approaches are not attributable to the profession alone, but the profession does have a responsibility to reflect on its own role and determine whether the principles that were initially established for audits are still meeting their goals. When significant “sea change” occurs, it requires re-invention rather than improvement. Is society changing the expectations and rules that make an audit relevant? Or are we “re-arranging the deck chairs on the Titanic?”

Customers of the audit profession are increasingly asking for additional information to enhance their risk assessments; this has resulted in regulatory changes as well as voluntary supplemental reporting. In certain jurisdictions, certain supplemental reporting – such as environmental and social issues – are now mandatory. A major thrust is being implemented by those adopting “integrated reporting,” but in most cases, this is not mandatory, audited or based on strongly established standards. A “sea change” it is not! The financial profession does not appear to be front and centre in driving fundamental change, apparently believing that its focus on financial capital remains adequate. Yes, changes are being made, but progress is much too slow; thus, the risk of “surprises” continues to increase.

The profession must start asking some fundamental questions in order to drive governance and accountability changes so that audits are fit for purpose. As a start, let’s consider the drivers of sustainable corporate value creation, and try to “peel back” corporate performance in the areas that might give investors an increased visibility into risk.

From a financial perspective, two sources of cash flow are critical to a sustainable business. First, for most organizations, more than 60% of expenditures are driven by employee costs; yet employee productivity and effectiveness are hard to measure, other than at the macro level. However, we do know that most employee costs are traditionally considered period expenses that convert inputs to outputs.

This is no longer the case, with large portions of employee expense related to building “capacity,” i.e. the contribution of intellectual capital that provides history and process capacity, as well as innovation in process improvement, new products and services, and relationship building with third parties. Only “motivated” employees will do this continually and effectively. To be a sustainable business in the future, the audit should reveal:

    • The overall level of expense committed to employee costs, with a split showing (hopefully) a declining share going into repetitive conversion costs, and a growing share committed to building “intangibles for the future.” Key indicators might also include “strategic reassignments” that give perspectives on whether management is committed to redeploying staff as a result of change versus firing them (which does not create motivation).
    • Levels of employee engagement at a depth of detail that is more than just a general percentage. What is needed is visibility into alignments of individuals, teams and departments with organizational purpose, both in “task” (the work of the business) and also critically in behavior (the stated conduct of the business that is driven by its culture and its understanding of ethical compliance).
    • Leadership effectiveness. Disengagement comes from a gap between what organizations state they do, versus what employees see from leaders. The effective development of internal leadership, accompanied by the results of 360° assessments based on corporate values, would start to identify areas of concern if they exist. It might have been interesting to see what indicators of this type would have shown for some of the banks involved in recent scandals.
    • Focus on “behavioral based” internal controls. Process controls are no longer adequate in an environment where high levels of delegation take place, leading to individual autonomy (this also applies to controls and relationships with third parties. such as outsourcing providers). Stronger reporting is needed on ethical hiring, leadership values and behavior, whistle blowing, levels of employee stress, illness (especially mentally related issues), and other behavioral aspects.

Overall, what users need to know is whether approaches to the workforce are protecting human capital sustainability through effective nurturing and development of people.

The second core cash flow is “cash flow in from customers.” Areas such as retention rates, repurchasing patterns, repeat customers and others are all important, but especially critical are relationships. One factor that could be more fully implemented into annual reporting is the stability of brand value.

The attached table shows 2018 data regarding the year end and most recent brand valuations by either Interbrand or Brand Finance (we used the higher valuation). This table demonstrates that, although the “pure audit” of financials provides insight into book values (i.e. balance sheet / shareholder equity), the shareholders value of their investment (i.e. the market value) is much greater.

Several key questions should be of interest to the investor. Using the traditional audit, is the integrity of the balance sheet acceptable? Is the brand value, as calculated by independent third parties, increasing or decreasing? If so, why? And what is the impact on this for the future? For instance, was a potential “auditable” cause the diversion of human capital resources away from customer support activities to enhance financial capital results? Finally, what makes up the ‘other intangible assets’ that contribute a key part of an investment valuation, but that are not being assessed or audited?”

One key failure of the accounting profession is to grasp and modernize the assessment of goodwill. On a sale or purchase of a business entity, it is the “market value-based intangibles” that end up on the acquirer’s balance sheet that must be assessed for “impairment.” How can an auditor do this effectively if the drivers of this value have not been clearly determined?

As can be seen from the table, book values range from 5.9% of value to 24.4%, and it is these underlying valuations of “financial capital” that a traditional audit discloses. If these are examples of the impact on financial capital of the growing knowledge economy, then one can only conclude that audits that remain focused on financial capital alone are not “fit for purpose.”