Further memorandum from Professor Prem
Sikka, University of Essex
At the Committee's meeting on 28 January 2009
there was some discussion of auditor obligations. The response
from some members of the panel was that examining business models
was no part of auditor's duties. This is somewhat misleading and
I would like add a few comments.
Auditor duties are not defined in any great
detail in the Companies Act 2006. Section 495 states that the
"must state clearly whether, in the auditor's
opinion, the annual
(a) give a true and fair view
(i) in the case of an individual balance sheet,
of the state of affairs of the company as at the end of the financial
(ii) in the case of an individual profit and
loss account, of the profit or loss of the company for the financial
(iii) in the case of group accounts, of the state
of affairs as at the end of the financial year and of the profit
or loss for the financial year of the undertakings included in
the consolidation as a whole, so far as concerns members of the
(b) have been properly prepared in accordance
with the relevant financial reporting framework; and
"True and fair view" is open to interpretation.
Accounting standards provide the framework for
financial reporting. The "Statement of Principles"
issued by the Accounting Standards Board (ASB) states (Chapter
1) that the
"The objective of financial statements is
to provide information about the reporting entity's financial
performance and financial position that is useful to a wide range
of users for assessing the stewardship of the entity's management
and for making economic decisions.
It adds (Ch 1, p 19) that
Present and potential investors need information
about the reporting entity's financial performance and financial
position that is useful to them in evaluating the entity's ability
to generate cash (including the timing and certainty of its generation)
and in assessing the entity's financial adaptability.
Subsequently it states (p 25) that
Investors require information on financial performance
because such information:
(a) provides an account of the stewardship of
management and is useful in assessing the past and anticipated
performance of the entity;
(b) is useful in assessing the entity's capacity
to generate cash flows from its existing resource base and in
forming judgements about the effectiveness with which the entity
has employed its resources and might employ additional resources;
(c) provides feedback on previous assessments
of financial performance and can therefore assist users in modifying
their assessments for, or in developing expectations about, future
Accounting standards are primarily aimed at
preparers of financial statements, but auditors cannot ignore
them because the Companies Acts require them to report compliance.
That task cannot be completed without an understanding of the
business model and inherent risks because it shapes any measure
of financial performance and financial position.
A pile of ornate wood in a junk yard is unlikely
to be worth a great deal of money. But the same in an art gallery
or an auction house would justify entirely different value. Without
appreciating the nature of the business, auditors cannot make
a meaningful assessment of the amounts appearing in financial
Auditors are required to satisfy themselves
that the reporting entity is a going concern, which may be interpreted
as "12 months from the balance sheet date". Auditing
standards have long been used to narrow auditor responsibilities
and encourage auditors to be "passive"
because that is economical of audit effort and enhances firm profits.
It has long been established that auditors should
approach each audit with an "inquiring mind". In his
judgement in the case of Fomento (Sterling Area) Ltd. v Selsdon
Fountain Pen Co Ltd  1 All ER11 at 23, Lord Denning said
"An auditor is not to be confined to the
mechanics of checking vouchers and making arithmetic computations.
He is not to be written off as a professional "adder-upper
and subtractor". His vital task is to take care to see that
errors are not made, be they errors of computation, or errors
of omission or commission, or downright untruths. To perform his
task properly, he must come to it with an inquiring mindnot
suspicious of dishonestly, I agreebut suspecting that someone
may have made a mistake somewhere and that a check must be made
to ensure that there has been none".
I would submit that auditors merely relying
upon management representations are not meeting the "inquiring
mind" standard. This standard requires auditors to understand
the nature of the business and its risks.
Auditors often seek refuge in auditing standards
without pointing out that they are formulated by committees and
structures controlled by the industry itself. The UK auditing
standard on going concern
advises auditors to be "passive" ie not plan the audit
to look for any specific problems. For example, page 21 states
"... when there is a history of profitable
operations and a ready access to financial resources, management
may make its [going concern] assessment without detailed analysis.
In such circumstances, the auditor's conclusions about the appropriateness
of this assessment normally is also made without the need for
performing detailed procedures. When events or conditions have
been identified which may cast significant doubt about the entity's
ability to continue as a going concern, however, the auditor performs
additional procedures ...".
Under the auditing standard, auditor might perform
additional procedures only when put upon inquiry, but offers no
justification as to why the auditor needs to be `passive' in the
first place and why bank auditors did not learn anything from
the recent financial banking problems. Once put upon inquiry the
auditing standard states (paras 11-12) that:
"in obtaining an understanding of the entity,
the auditor should consider whether there are events or conditions
and related business risks which may cast significant doubt on
the entity's ability to continue as a going concern. | The auditor
should remain alert for audit evidence of events or conditions
and related business risks which may cast significant doubt on
the entity's ability to continue as a going concern ..."
The auditing standard requires auditors to examine
company cash flow, profit and other forecasts, if any. It is difficult
to see how any such document can be understood or examined in
any meaningful way without a good understanding of the nature
of business and its risks.
Overall, my contention is that it is difficult
to see how auditors can make any meaningful assessment of risks
without understanding the business model of the client company
and the structure of its main assets and liabilities. Any auditor
just relying on management assertions and claims would be negligent.
Prem Sikka, "Audit Policy-making in the UK: The Case of "The
auditor's considerations in respect of going concern", European
Accounting Review, Vol 1, No 2, 1992, pp 349-392. Back
Auditing Practices Board (2004). International Standard on
Auditing (UK and Ireland) 570: Going Concern. London: APB
(available at (http://www.frc.org.uk/images/uploaded/documents/ACFAB2.pdf). Back