Banking Crisis - Treasury Contents

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 auditor's report

    "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 year,

(ii)  in the case of an individual profit and loss account, of the profit or loss of the company for the financial year,

(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 company;

    (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"[80] 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; and

(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 periods.

  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 statements.

  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"[81] 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 [1958] 1 All ER11 at 23, Lord Denning said that:

    "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 mind—not suspicious of dishonestly, I agree—but 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[82] advises auditors to be "passive" ie not plan the audit to look for any specific problems. For example, page 21 states that:

    "... 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 "going concern"[83] 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.

February 2009

80 Financial%20Reporting.pdf Back

81   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

82 Back

83   Auditing Practices Board (2004). International Standard on Auditing (UK and Ireland) 570: Going Concern. London: APB (available at ( Back

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