During the past several months, the Global Economy has suffered a significant decline. Companies are falling like ninepins. Lehman Brothers is in administration. Northern Rock, Fannie Mae and Freddie Mac have been bailed out and the list of vulnerable banks is growing. Bear Stearns and Merrill Lynch have been sold at knockdown prices and HBOS has merged with Lloyds TSB. Governments are pouring in vast amounts of money to bail out financial institutions. Some economists predict a recession, which could result in further deterioration in internally generated cash flows and restrictions on the availability of capital.
Periods of economic uncertainty lead to challenging conditions for companies due to potential deterioration of operating results, increased external scrutiny, and reduced access to capital. These conditions can result in increased incentives for companies to adopt practices that may be incorrect or inconsistently applied in an effort to address perceived expectations of the capital markets, creditors or potential investors. Amidst the mayhem, we need to ask questions about the role of auditors, who may have been paid millions of rands to give opinions on company financial statements. Yet companies are sinking within weeks of getting a clean bill of health. This article is designed to remind auditors of issues to consider during these times. Auditors cannot afford to be blamed for the current economic crisis, as the auditing profession, fairly or unfairly, was held accountable for the recent corporate failures prior to those in the immediate past.
As a result of perceived external pressures, companies may be tempted to manage profitability through non-recurring transactions, or through changes in the method of calculating key estimates, such as fair values. Companies may also adopt inappropriate accounting practices, resulting in improper recognition or omission of financial transactions. Inappropriate transactions or accounting practices may result in premature recognition of revenue, failure to record returns, inflating inventories, failure to accrue appropriately for contingent liabilities that are probable and estimable, and failure to record “misplaced” or otherwise unpaid purchase invoices.
Impact on Audit Approach
During such times, professional skepticism should be heightened and the status quo should be challenged. ISA 240 P24 states that the auditor should maintain an attitude of professional skepticism throughout the audit. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Professional skepticism requires an ongoing questioning of whether the information and audit evidence obtained suggest that a material misstatement may exist. Although the auditor neither assumes that management is dishonest nor assumes unquestioned honesty, the auditor should consider the increased risk associated with the potential increases in external pressure faced by management in times of economic decline.
The appropriate level of professional skepticism is needed when corroborating management’s representations. Management’s explanations should make business sense. Additionally, the auditor may need to consider corroborating management’s explanations with other evidence when practicable, including discussions with members of the board of directors or the audit committee.
Other indicators of potential increased accounting and reporting risk calling for increased professional skepticism include:
1. Liquidity Issues
• The company is undercapitalised and is relying heavily on bank loans and other credit, or is in danger of violating loan covenants.
• The company is having difficulty obtaining or maintaining financing.
• The company is showing liquidity problems.
2. Quality of Profitability
• The company is changing significant accounting policies and assumptions to less conservative ones.
• The company is generating profits but not cash flow.
3. Industry Characteristics
• The company is registered in terms of the National Credit Act.
• The company is not a market leader. Companies that are not market leaders sometimes must sell products below cost to match competitors’ pricing.
4. Management Characteristics
• Management’s compensation is largely tied to profitability or the appreciation of stock options.
• The company appears vulnerable to the weakening economic conditions and management is not proactive in addressing changing conditions.
• Members of company’s management are selling their investment in company securities more than in the past.
• There are significant changes in members of senior management or the board of directors.
The following should be considered when conducting auditing procedures on classes of transactions and account balances:
• When auditing inventory, consider the following issues:
• The reason for an unusual increase in inventory balances.
• Reduction in revenue, increased backlog or a deterioration in ageing of inventories may be signs that the company has excessive inventory on hand.
• Whether or not the company’s product is technologically attractive to consumers. If not, consider the company’s plan to sell the inventory and at what cost.
• Whether or not declining prices and shrinking profit margins are causing inventory to be valued over market.
• Whether or not the reduced production at a manufacturing facility is leading to an over-capitalisation of inventory overhead rather than expensing the cost of excess capacity.
• Whether or not there are material or unusual sales cancellations and returns after year-end.
• Whether there are indications of “channel stuffing”.
• The auditor should also be aware of any:
• unfavourable purchase commitments, or
• unfavourable sales commitments or arrangements.
• When auditing accounts receivable, consider the following circumstances:
• An increase in the aging of receivable balances. This event may be indicative of weakening economic conditions.
• Internal controls over credit functions are weak. Consider a company’s policies for reviewing the amount of customer credit extended to each customer.
• Receivable amounts that are increasing at a faster rate than revenue.
• Concentration of receivables in one geographic area or economic sector.
• The existence of extended payment terms or return privileges.
• Significant decreases in accounts receivable confirmation response rates compared to the prior year.
• Compliance with IAS 18 – Revenue Recognition.
Property Plant and Equipment, including Goodwill and Intangibles
• Industry downturns and cash flow erosion may indicate an impairment of property plant and equipment, goodwill or other intangibles.
• Goodwill and intangibles should be analysed to consider whether or not the amortisation assumptions still appear reasonable. For example, if a company purchases a patent that is amortized over 10 years and the technology of the product has changed to the extent that the patent is no longer used, it may be necessary to write down or write off the asset.
• The auditor should consider whether the assumptions and expectations of future benefits of deferred tax assets and other deferred charges appear reasonable.
• In weighing positive and negative evidence for purposes of assessing the need for or amount of a deferred tax asset, weight should given to evidence that is commensurate with the ability to verify that evidence objectively. As a result, recent historical losses are given significant weight, while expectations about future profits may not be given so much weight.
• The auditor should consider whether the company has delayed making payments on its outstanding payables.
This may result from the company properly managing cash, but it may also be a result of the company experiencing cash flow shortages.
An increasing accounts payable balance with flat or decreasing sales may be evidence of cash flow concerns.
• The auditor should carefully review loan agreements and test for compliance with loan covenants. In this regard, an auditor should consider any “cross default” provisions; that is, a violation of one loan covenant affecting other loan covenants. The auditor should also keep in mind that any debts with covenant violations that are not waived by the lender for a period of more than a year from the balance sheet date may need to be classified in the balance sheet as a current liability.
• The auditor should review the debt payment schedules and consider whether the company has the ability to pay current debt instalments or, if necessary, to refinance the debt.
When making such an evaluation, it is important to remember that it is quite possible that the company will not generate as much cash flow as it did in the previous year.
• During times of economic uncertainty, the auditor should have a heightened sense of awareness in respect of a company’s ability to continue as a going concern.
• Negative trends, loan covenant violations and legal proceedings are examples of items that might indicate that there could be substantial doubt about the ability of an entity to continue as a going concern.
• When evaluating management’s plans to continue as a going concern, an appropriate level of professional skepticism is important. For example, the company’s assumptions to continue as a going concern should be scrutinised to assess whether they are based on overly optimistic or “once in a lifetime” occurrences.
• The auditor should consider the extent of procedures that may be necessary relating to unusual and significant transactions noted during the audit, including unusual or “non-routine” journal entries.
• Many times, these entries are made on the parent company’s books, or as part of a consolidating entry, or in the last few days of the month.
• The auditor should be aware of new developments in his or her client’s business.
• Analytical reviews, therefore, should emphasise the comparison of relationships with independent data.
• When expected fluctuations do not occur, or when unexpected fluctuations do occur, an auditor should investigate the reasons.
• It is also important to consider whether the relationships between financial and non-financial information make sense. For example, in a Satellite TV company, if the number of subscribers declined from the prior year, it would make sense, absent of a rate increase, that revenue also declined.
• The auditor should consider whether significant declines in share prices may result in option pricing changes or other compensation benefits being promised to employees.
• The auditor should consider off-balance sheet risks; for example, the risks related to the failure to perform a contract efficiently. Large fixed fee contracts can subject companies to very substantial risks.
• The auditor should consider a company’s ability to forecast and anticipate changes in market conditions.
• The inability to forecast and anticipate changes in market conditions should heighten an auditor’s professional skepticism.
• Companies that are proactive and lead market changes often perform better in times of economic uncertainty than those that are reactive.
• Professional skepticism relating to the above should also be maintained when reviewing quarterly financial statements for public companies.
• The auditor should not allow client or self-imposed deadlines to pressure him or her into accounting and auditing decisions that are not well thought out.
• The auditor should also consult with other professionals whenever appropriate – for example, on a complex accounting or auditing issue.
Auditing in times of economic uncertainty is challenging. As such, auditors need to maintain the appropriate levels of professional skepticism and due professional care. 102 years have elapsed since the Court of Appeal in England delivered a landmark judgment in the Kingston Cotton Mills case. Lord Justice Lopes (1896) in his judgment stated “It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion, or with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound.” Lord Justice Lopes created the watchdog mindset, which ensured that auditors adopted a passive and reactive approach to conducting an audit. Whatever the merits of this philosophy 100 years ago, the auditing profession has been increasingly seen to have fallen short in meeting the public interest, particularly over the past few years. The deluge of recent corporate failures and the demise of one of the largest auditing firms in the world have demonstrated convincingly the flaws of the watchdog-driven auditing philosophy.
For those auditors that still adopt the watchdog philosophy when conducting audits, the auditing profession cannot withstand the same old question from regulators and the expectant public: Why did the watchdogs not bark in the night when they were given sufficient guidance on how to keep watch?
Dr Steven Firer CA(SA), BCom, BCompt (Hons), MBA, DBA, IFRS DIP (ACCA), is a Registered Auditor and IFRS Advisor with the JSE.