ANALYSIS: PROFESSIONAL SKEPTICISM: IN THE AGE OF FAIR VALUE MEASUREMENTS

Audit quality concerns raised by a spike in unsatisfactory results from firm/engagement inspections performed by the regulator and the possibility of audit firms being sued for corporate failures warrants a fresh look at professional skeptism.  Here is Brian Monegi’s take on this

ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing in paragraph 15 states that ‘the auditor shall plan and perform an audit with professional skepticism recognizing that circumstances may exist that may cause the financial statements to be materially misstated’.

Paragraph 13(l) of the same standard goes on to define ‘professional skepticism’ 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’.

This means the auditor needs to be alert to, among other things:

  • Audit evidence that contradicts other audit evidence obtained
  • Information that brings into question the reliability of documents and responses to inquiries to be used as evidence, and
  • Conditions that may indicate possible fraud

This, then, reduces the risk of overlooking unusual circumstances, over-generalising when drawing conclusions from audit observations, and using inappropriate assumptions in determining the nature, timing and extent of the audit procedures and evaluating the results thereof.

Perhaps the meaning of professional skepticism is a preserve of the technical experts in quality control or technical departments of auditing firms and not something an engagement partner should be concerned about in this age of auditing services becoming commoditised. With client pressures on firms with regard to lower fees, there is certainly no time for such luxuries as professional skepticism as opposed to ‘professional judgement’, which we seem comfortable to bandy around whenever our shortcomings in thought process are exposed. I would venture to say that professional skepticism will take centre stage in audits going forward, alongside fair value measurements.

The International Auditing and Assurance Standards Board (IAASB) released its Invitation to Comment called Enhancing Audit Quality in the Public Interest: A Focus on Professional Skepticism, Quality Control and Group Audits (ITC) on 17 December 2015 with the closing date for comments being 16 May 2016. What comes out of this process will be interesting, particularly with regard to the subject matter addressed in this article.

What is also interesting is the fact that International Education Standard (IES) 8 Professional Competence for Engagement Partners Responsible for Audits of Financial Statements (Revised) in paragraph 9 states that professional skepticism is one of the competency areas that an engagement partner is required to develop and maintain when performing the role of an engagement partner responsible for the audit of annual financial statements through Continuous Professional Development (CPD). This standard became effective on 1 July 2016.

This then ties in with one of the fundamental principles of professional ethics of a registered auditor  –  professional competence and due care, as set out in the Independent Regulator Board for Auditors (IRBA) Code of Professional Conduct, section 130.

Professional skepticism then becomes more important in the age of fair value accounting, with most of the recent accounting standards issued focusing on fair value measurements.

IFRS 13 Fair Value Measurement (IFRS 13) is the one with the most impact in that it applies to all other standards where fair value needs to be measured, for example IFRS 9 Financial Instruments, IFRS 10 Consolidated Financial Statements,  IAS 36 Impairment of Assets, IAS 40 Investment Property and IAS 41 Agriculture. Auditing of accounting estimates and fair value measurements are the case in point, particularly with regards to the audit of significant judgements and assumptions.

These can’t be measured with precision as they are prone to estimation uncertainty. ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures defines ‘estimation uncertainty’ in paragraph 7(c) as ‘the susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurements’.

A recent article in Business Day (8 June 2016) states that ‘the market capitalisation of the JSE is 16 times what it was in 1996, but the number of listed shares is down by more than a third’.

It is not difficult to decipher the reason behind this increase in market capitalisation, as a quick perusal of the balance sheets of the top listed companies reveals the impact of fair value accounting in this increase in market capitalisation. Similarly, the internal rate of returns for private equity funds was an average of 18,5% from 1 January 2005 to 31 December 2015 beating the JSE’s return of 14,1% in the same period, according to the recent report by the South African Venture Capital and Private Equity Association (SAVCA). These returns come mainly from valuation techniques (income approach, discounted cash flow and so forth) that are prone to the estimation uncertainty mentioned above.

Two separate events spring to mind – one of them recent and the other almost a decade old. They bring into sharp focus the importance of professional skepticism in the audit of annual financial statements:

  • The market meltdown in 2008 caused by collateralised debt obligation (CDO) or mortgage-backed securities, and
  • An article on 7 June 2016 in the New York Times relating to the buyout of Dell. In the article titled ‘Ruling on Dell buyout may not be the precedent that some fear’ it was pointed out that: ‘In the case of the Dell buyout, Glenn Hubbard [dean of Columbia’s Graduate School of Business and former chairman of the Council of Economic Advisers under President George W Bush] was Dell’s expert. He calculated fair value was $12.68 a share. Brad Cornell, a professor at the University of California, Los Angeles, was the expert for the dissident shareholders. He came out at $28.61.’

MARKET MELTDOWN OF 2008

The CDOs or mortgage-backed securities were listed instruments with a quoted price in an active market. IFRS 13 paragraph 77 would require an auditor to use the quoted price as it provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value whenever available. This is a Level 1 input according to this standard. Then it stands to reason that an auditor that relied on these quoted prices can’t be at fault when the company subsequently collapses on the back of the fact that these instruments were not fairly valued, as this was what IFRS required.

However, if you take a step back and look into the meaning of professional skepticism, the following questions arise: Was the auditor not supposed to have taken into account the other contradictory evidence that was publicly available at the time that showed that these instruments were overvalued –  that is, consumers were losing their jobs and their houses with the unemployment rate in the US being at its highest in a decade in 2007? Shouldn’t they have had a questioning mind and critically assessed the evidence, in which case an adjustment to the quoted price would have been the more logical conclusion.

But, then, how would you counter the fact that the traders that made a fortune during that financial crisis used publicly available information that contradicted the evidence obtained by the auditors?

Clearly, the conflict of interest the rating agencies had in this episode is also important to note with the likes of S&P, Fitch and Moody not downgrading these instruments in a time when it was clear that there was contradicting evidence that these instruments were overvalued. The lack of independence was due to the fact that they were being paid by the same banks that needed these lofty ratings. They were subsequently charged in court and fined for this, with S&P agreeing to pay a fine of $77 million. These are the same rating agencies that four days prior to Enron imploding were rating it investment grade.

What was the responsibility of the auditor in this regard? Could this be defined as the auditor having failed to obtain reasonable assurance that the financial statements are free of material misstatements, meaning the auditor failed to meet the objective of an audit? And also improper conduct in terms of the Code of Ethics?

DELL BUYOUT

The difference in valuations of the two respected individuals quoted above, Glenn Hubbard and Brad Cornell, is huge. Can it be argued that who are we as auditors to question these respected experts? Or professional skepticism asks of us to look for other information, including any contradicting evidence to narrow the point range of these valuations.

Should we be of questioning minds and consider evidence that contradicts the evidence obtained and critically assess it? For instance, instead of accepting aggressive revenue growth forecasts in a discounted cash flow model in an industry in decline –  for example the steel industry –  we should question management’s assumptions. Perhaps by doing so we might expose that essentially what lies behind these discrepancies is lack of independence or conflict of interest (that is, bias).

An Allan Gray publication says: ‘Forecasts may be useless, but the act of forecasting helps us understand what is possible for a company. We look at what the “fair value” for the company shares would be if the future unfolded in a certain way. We recognise that “fair value” is a wide range rather than a single number. The share price is likely to hover somewhere within that range most of the time.’ I am reminded of this quote by a colleague of mine when I raise these issues.

I could go on about banks that collapse with loan books not being impaired; meanwhile, there is contradicting information that these loans cannot be fairly valued –  that is, there has been an increase in the number of customers that are not able to meet their monthly debt repayments.

Fair value measurements are susceptible to management bias and there are often very different views of how the future might unfold. Where there is a range of possibilities for an assumption, you can be sure that management will go for the most favourable – especially if a bonus depends on it! In addition, the increasing complexities of accounting standards, financial products, taxation, etc, open opportunities for misuse and misunderstanding. This, coupled with time and budget pressure, may result in auditors being tempted to accept management representations without sufficient challenge.

Our professional skepticism can’t be hampered by the fact that in the end we have to maintain relationships with our clients, as they are the ones paying us, and also have to avoid disagreements with management on accounting/auditing principles that could lead to losing the audit.

CONCLUSION

In any market crash, the question that gets asked is: where were the auditors? This is a fair question to ask as we are charged with the responsibility of protecting the public when issuing auditor reports on public interest entities. The age of auditing as a box-ticking exercise to comply with the regulators is long gone. The auditor today should take a step back and think hard about the evidence he/she obtains –  and what that evidence says. It won’t be long before the regulators question how professionally skeptical are we. In my opinion, it is time we sharpen our professional skepticism to stay ahead of the curve.

AUTHOR |Brian Monegi CA(SA) is Partner Audit at BDO South Africa Incorporated

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