In his 2018 article “The Silence of the Auditors”, Professor Janek Ratnatunga, CEO of the Institute of Certified Management Accountants (ICMA), called for a Royal Commission into the regulation, independence, politics, production and knowledge base of auditors. He stated that while banks were marched like lambs to the slaughter, to sheepishly admit their significant ethical and moral shortcomings in the Haynes Banking Royal Commission, those who audited these financial institutions appeared to have escaped scot-free.
A recent scandal at National Australia Bank (NAB), one of Australia’s Big-4 banks, triggered unanimous bipartisan support for a parliamentary inquiry into the potential conflicts of the big audit firms. Due to start in late 2019, the inquiry is not quite the Royal Commission that Professor Ratnatunga and others called for, but it is welcome and long overdue.
The NAB scandal erupted when a whistle-blower leaked a treasure-trove of documents to Australian newspapers. The documents made for disturbing reading and they shone an embarrassing light on the private workings of the bank and the cosy relationship it had with its auditor of 13 years, Ernst & Young (EY).
Professor Ratnatunga says, “external audits should act as trust mechanisms that assure the public that capitalist corporations and management are not corrupt and that companies and their directors are accountable. But audit is also big business.”
Auditors collect enormous amounts in audit and non-audit fees. In the past decade alone, the Big-4 auditing firms raked in more than $1 billion from the Big-4 banks. EY earned $286 million from NAB between 2008 and 2018. In that same period, ANZ paid their auditor (KPMG) $203 million, and Commonwealth Bank and Westpac paid PwC $330 million and $248.5 million respectively.
While the need to hold auditors accountable is recognised in many countries, Professor Ratnatunga says such calls have been largely ignored. A damning 2015 report issued by the International Forum of Independent Audit Regulators (IFIAR) stated that:
“…there are persistent deficiencies in critical audit areas relating to audit work on the controls within companies designed to prevent abuses, valuation of assets and liabilities, and disclosures of crucial information to the public.”
“In the financial services sector, it seems an independent report is whatever the client’s money can buy,” says Professor Ratnatunga.
The standard audit industry response to criticism is to deny the problem or issue new auditing standards, audit reports, codes of ethics and promises of tougher action. Professor Ratnatunga believes these solutions inadequate, as they all rely on tweaking accounting standards (IFRSs).
Professor Ratnatunga points out that the standards are issued by the IFRS Foundation and the International Accounting Standards Board (IASB) and that the Big-4 accounting firms exercise complete control over those organisations by stacking the Boards and controlling the development, production and modification of accounting and auditing standards.
Professor Ratnatunga says, “consequently, although the public bears the cost of audits and audit failures, it has no right to see audit files or make an assessment of the quality of audit work. It is only when a whistle-blower leaks documents that we become privy to what goes on behind the scenes. And it is not pretty.”
Professor Ratnatunga asserts that, “If the Australian Parliamentary inquiry results in an admission of negligence by auditing firms, they escape liability because under most jurisdictions they do not owe a ‘duty of care’ to any individual shareholder, creditor, employee, superannuation scheme member, or any others affected by their negligence.”
In many Western economies, regulatory retribution is often hampered by the ‘too big to close’ syndrome. However, in early 2018, PwC was banned from auditing listed companies in India for two years after accusations of negligence in its audit work. Indian regulators are also now pushing for a five-year ban on Deloitte and KPMG over allegations the firms helped conceal bad loans at a major infrastructure and finance group that subsequently defaulted in 2018 and triggered a credit crisis.
What Exactly is the Audit Report Telling Us About the Company?
The audit report of financial statements uses the term ‘true and fair’ to express the condition that financial statements are truly prepared and fairly presented in accordance with the prescribed accounting standards. The problem, states Professor Ratnatunga, is that it is the Auditors themselves who issue the accounting standards!
“It is time for an independent body, such as Parliament, to be responsible for setting accounting standards,” states Professor Ratnatunga.
Why the Audit Report is Totally Fictitious
Professor Ratnatunga states that there are two major reasons why the application of IFRSs results in flawed financial statements and meaningless and fictitious audit reports.
The first reason is that IFRSs are silent on how intangible assets can be shown in the financial statements. An intangible asset is not physical in nature. Goodwill, brand recognition and intellectual property are all intangible assets. Google’s ‘search algorithms’ and Facebook’s ‘social media power’ are good examples of intangible assets. These do not appear in the financial statements of those companies. Intangible assets are recognised by IFRSs only if there is an arm’s-length transaction that brings their value into existence at a particular date.
Ignoring intangible assets results in divergent shareholder values between what the stock market says the company is worth (market value) and what the audited financial statements say the company is worth (book value).
In knowledge economy companies such as Microsoft, Amazon and Google, the auditors book valuations are over 5-10 times less than market valuations. At Microsoft, this is a difference in value of US$686 Billion in 2018! Against market values, all IFRS valuations would get a fail grade, but Auditors are certifying them as ‘True and Fair’.
Professor Ratnatunga urges changes to the legislation and says, “legislation should be passed to reduce the scope of the traditional statutory financial audit to only reporting if transactions are correctly recorded and the financial statements are prepared and fairly presented in accordance with Generally Accepted Accounting Principles (GAAP). Asking auditors to provide a value is a costly and, ultimately, meaningless task.”
He also states that, “the belief that the addition of all fair-value of individual assets (less liabilities) will give an accurate reflection of the state of affairs of the company is totally flawed as most intangible assets are left out, and an organisation’s capability values completely ignored. Regardless, it is not necessary as this valuation can be provided by the market at any time.”
Institute of Certified Management Accountants, Australia
For further comment on the above topic, please contact:
Prof Janek Ratnatunga
CEO, ICMA Australia
About the Author
Professor Janek Ratnatunga is the CEO of the Institute of Certified Management Accountants, Australia. He has held senior appointments at the University of South Australia, Monash University, University of Melbourne, and the Australian National University in Australia; and the Universities of Washington, Richmond and Rhode Island in the USA. Prior to his academic career he worked as a chartered accountant with KPMG. He has also been a consultant to many large Australian and international companies and to the World Bank.