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February 17, 2020 09:01 AM

Better audits are possible, but do we want to pay for them?

Posted by Jan Bouwens

In the Netherlands the audit profession is under great pressure to deliver better audit quality. The expectation is that auditors always detect major errors when they are present in the unaudited financial statements. The same expectation exists with regards to fraud and bribery. In addition, a firm signed off by the auditor as a going concern should never go bankrupt.

The Dutch regulator that oversees the audit profession has a adopted an equally critical position and checks whether auditors performed all the tests the generally accepted audit principles prescribe them to perform.  According to the commentary in the Dutch newspaper NRC, the financial market regulator (Authority of Financial Markets (AFM)) concluded that in only two of the fourteen audits met the standard. Based on this finding, the newspaper concluded that an intervention by the ministry of finance into the work of auditors is now inevitable. However, that conclusion ignores the fact that the method the regulator of AFM applies was itself labeled unsound in June 2019 by a Dutch court. Unlike the AFM, the judge decided that auditors did collect sufficient evidence to sign off on the audits they performed.

Firstly, not every shortcoming in the auditor's file is an error that impairs the quality of the audit. The AFM, for example, accused a big four firm of having gathered too little information to attest to accounts receivable, because an insufficient number of clients had confirmed their debt to the firm. The auditor, however, argued that they tried to get these confirmations but only few clients responded. They therefore decided that they had to seek another way to get assurance and decided to create a receiving log. The auditor reviewed the receiving log to assess the time interval between the firm invoicing the clients and the time the client paid their dues. The auditor used this information to gauge whether an abnormal number of clients appeared by the end of the period, which would have suggested that the firm just served any client, including those that are not credit worthy. The data was also used to conduct a trend analysis where the auditor reviewed trend lines of sales and accounts receivable over different periods to assess whether there were any unusual trends. In addition, they measured the average collection period. In court, there were given many other examples of how auditors collected evidence to support their conclusions. The court decided that the auditors did collect sufficient information and that the AFM was incorrect in their conclusion that the auditors were in the wrong.

Secondly, does the magnitude of quality issues that arise warrant intervention by the legislator?  Auditors in the Netherlands perform around 21,000 mandatory corporate audits, of which 2,100 are of so-called "Public interest entities" such as Shell. How many misstatements should the auditor observe? Any? At the moment, auditors miss out in fewer cases than one out of 2,100 firms every year. If that number needs to be further reduced, the audit fees have to rise. That has to do with the
agreement underlying all contracts between accountants and companies. It states that the true financial statements may deviate from the ones presented in the firm’s financial statements. In practice this deviation is set at five percent of the firm’s reported income. This margin ("materiality") is set because society is prepared to allocate limited resources to acquire assurance over financial statements.

If we want auditors to discover more frauds, or to detect more mistakes in financial statements, we should not have the Minister of finance intervene,  but we need to probe whether the materiality level can be set at a more ambitious level.  This goes hand-in-hand with rising audit fees. The question is: are we as a society prepared to pay the required price!

 

Jan Bouwens is professor of accounting at the Amsterdam Business School of the University of Amsterdam and is research fellow at the Judge Business School of the University of Cambridge.

 

 

 

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About Jan Bouwens

University of Amsterdam & Cambridge University Judge Business School

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