Freaky Thursday

Marcel Pheijffer is professor Accountancy, Nyenrode Business University and professor Forensic Accountancy, Leiden University

Marcel Pheijffer, is Professor Accountancy, Nyenrode Business University and professor Forensic Accountancy, Leiden University, elaborates on the often-discussed recent reports concerning the accounting profession, its findings and recommendations. He reflects on the issues surrounding the profession in the past years and discusses its future.

Recently, on the 25th of September 2014, three reports concerning the accounting profession were published. The first report, ‘Build to trust’, from the Erasmus University, is a report that refers to the evaluation of the Audit Firms Supervision Act (also known as: Wet Toezicht Accountantsorganisaties) and the operation of the Authority of Financial Markets (AFM), the supervisor of audit firms. The second report is written by this supervisor and concerns the ‘Findings inspection quality of statutory audits Big 4 firms’. The last report that was published that same day was titled ‘In the public interest’, written by the working group ‘Future Accounting Profession’ (hereafter: working group); a report with a large number of measures to improve the quality and independence of the audit.

The Financieel Dagblad, a Dutch financial newspaper, named the day of the publication of the reports ‘Freaky Thursday’, a day with a terrifying message for the accounting profession, namely that they do not deliver sufficient quality and that it should be improved. Later, I will discuss why quality needs to be improved, as evident from the above-mentioned AFM report. I will also discuss the measures that the aforementioned working group provided to solve the quality problem. Finally, I will finish with a short reflection.

AFM report
The AFM report outlines a gloomy picture of the quality of the audit within the Big 4 audit firms resulting from a review of several selected audit files at Deloitte, EY, KPMG and PwC. The companies incurred respectively 4, 3, 7, and 4 fails. An audit file is qualified insufficient if the external accountant has not obtained sufficient and appropriate audit information to underpin the audit report. Ultimately the AFM tested 40 files, of which 18 (45 percent) were qualified as insufficient, not a number to be proud of.

The qualitative analysis of the AFM is also rather depressing. The supervisor determined that, in several cases, external accountants performed insufficient proceedings to establish if the internal controls of the audit client work effectively and performed no or insufficient substantive tests substantive analytical procedures or relational checks for material accounts. Additionally, the external accountants did not evaluate the control information provided to them directly by management or experts sufficiently critically.

The AFM also outlines the causes of the failures. They requested the audit firms to analyze these failures. The Big 4 provided a number of explanations regarding the problem files, including the following:

-The external auditor insufficiently supervised the audit team and inadequately reviewed the work of the audit team;
-The external auditor himself was involved too little or too late in the execution of the audit;
-The external auditor relied too much on the internal audit department of the audit client, without performing sufficiently many activities himself;
-The external auditor and the Assignment Focused Quality Assessor (Opdrachtgerichte Kwaliteitsbeoordeelaar (OKB’er)) focused too much on the headlines and the final result of the audit;
-The external auditor focused on his general knowledge of the sector and the client, instead of on the actual and specific risks;
-The external auditor is only familiar with the operational processes of the client at a too high level;
-The external auditor did not involve experts (e.g. IT specialists) in the design of the audit at an early stage to keep the price of the audit low;
-The audit team lacked sufficient professional skepticism;
-There was no business culture in which people addressed each other on breaching agreements;
-During the audit the question asked often was ‘Is this correct?’ instead of ‘Is this the right thing to do?’;
-The external auditor was responsible for too many assignments at once;
-Because of further automation, there was less communication between senior and junior members of the audit team and less training on the job occurred;
-Solid project or process management lacked within the audit organization;
-The external auditor was not aware of the fact that the quality of his audits was insufficient, because his audits had always been reviewed relatively positively in OKBsand internal quality surveys.

Each cause can be removed by paying attention to the audit, the audit team, the client and the acquisition of knowledge. Each cause, if eliminated by quality-enhancing measures, would cost the owners of the audit firm, its partners, income.

Working group ‘Future Accounting Profession’
The constitution of the working group is the response of the Netherlands Institute of Chartered Accountants (also known as NBA) on the motion of Sir Nijboer, PvdA member of the House of Representatives. He requested the government to engage in conversation with the accountancy sector, in order to come up with a report containing proposals for improvements in the profession and to inform the parliament about these. The report should be published simultaneously with the report of the AFM in September.

The working group provided over fifty measures of various kinds. They proposed to limit the power of the partners at the largest audit firms (those with a so-called OOB permit) by setting a Board of Supervisory Directors with external members. This board appoints and evaluates management and, next to her general tasks, specifically supervises the safeguarding of the public interest, using control quality as a guiding principle.

Furthermore, the reward and earnings system of audit organizations is firmly addressed: profit independent remuneration directors, limited variable remuneration component and the introduction of a claw-back.The most important measure, however, is the redevelopment of the so-called ‘leverage model’ (the number of employees that a partner manages).

Measures are also taken in the field of culture and behavior. For instance, the introduction of a professional oath, similar to the oath bankers have made after the crisis. In addition, the terms ‘attitude of professional skepticism’ and ‘quality’ will be embedded in the rules of professional conduct and a system of quality indicators, intended to promote a culture in which quality is central, is prescribed. An independent research institute will be established that, among other things, conducts analysis into the causes of defects and incidents.

Furthermore, the working group wants to improve the relevance of the audit by the use of a “comprehensive audit report” and the auditor should report more clearly and explicitly on aspects such as fraud and continuity.

The recent AFM report is not the first report in which the quality of audits is being questioned. Since 2009 a series of similar reports was published (not only regarding the Big 4 audit firms, but also with respect to the smaller organizations).It is a fact that the accountancy sector has lingered in denial of the problems for (too) long.The AFM has too often been dismissed as a pedantic supervisor who stumbled on formalities, such as the lack of documents in the audit file of the auditor. Because of that denial, the sector failed to take adequate measures early on to resolve the situation. The sector has unintentionally contributed to the creation of an image in which the partners of audit firms look like auditors who are eager for money and therefore disregard the delivering of quality.

Hopefully the recent AFM report will turn the tide. Minister Dijsselbloem’s opinion is that this should happen. He described the findings in the report as ‘unacceptable’ and he is willing to take serious action if the sector continues to fail. He engaged into a conversation on this topic with the House of Representatives during a General Debate on the 13th of November 2014.

During this conversation it should become clear whether the politics trust the measures that the working group suggested. This is not easy. It is questionable whether the measures suggested by the working group are adequate responses to the causes construed in the AFM report. Moreover, the working group has not executed a very strong cause or problem analysis itself. And without knowing the problem, it is hard to define solutions. In preparation to the General Debate in the House of Representatives, several parties – in particular in the media – mention the weakness of the report of the working group, namely that the flaw in the accounting profession is not addressed at all. That flaw relates to the commissioning: the person who is audited by the auditor is also the one who has to pay his bill. This creates a mutual dependence and the existence of a perverted incentive, which is neither resolved by the introduction of a Supervisory Board with external members, nor the limitations in the reward system nor the introduction of a professional oath.

Optimists, who have faith in such measures, are confident that the accounting profession will learn from the past decades which culminated in critical AFM reports and ‘Freaky Thursday’. Pessimists – or are they realists? – undoubtedly believe that history will repeat itself. From their point of view it is a matter of time until the next accountancy crisis will happen, hoping that by then the time will be right to restore the flaws in our accounting profession.