Curious about the life after the Master Accountancy? In this interview we speak with two post-master students. Read about their experiences here!
19 November, 2019
The role of an auditor is to help outsiders to develop a true and fair view of a firm’s performance. In a more extended form, the true and fair view of a firm’s performance refers to the true and fair view of a firm’s strategy development and strategy implementation. For decades, the focus of auditors to enable the outsiders’ true and fair view was on the firm’s financial numbers. Such a financial audit happens within the boundaries of a standardized reporting format, implying that every firm, irrespective of its industry and strategy, reports the same financial metrics. As a result, deciding which metrics a firm should disclose to give a true and fair view is a competency that is not trained intensively among auditors during the last decades. The consequence of this evolution is that auditors lost sight of the link between a firm’s strategy and the financial numbers. Admittedly, educational institutions are guilty too! For instance, the link between a firm’s strategy and its management control system is a cornerstone in management accounting courses but is almost nonexistent in financial accounting courses.
During the last decade, the increased attention for corporate responsibility has increased the demand from shareholders and stakeholders for more non-financial numbers in order to develop a better view of the firm’s strategy development and implementation, to assess the non-financial risks of the firm and to assess the consequences of a firm’s behavior for society. Importantly, the relevance of non-financial numbers to develop a better insight into the firm’s strategy development and implementation is conditional on the firm’s strategy and is thus difficult to standardize. Stated differently, the demand for more non-financial numbers requires that auditors consider the firm’s strategy when judging the relevance of the non-financial numbers that the firm wants to disclose. Given the auditors’ focus on the standardized reporting format for financial audits, judging whether the disclosed non-financial metrics give a true and fair view is often a struggle for auditors.
“I would like to invite you to turn the question upside down and ask yourself what auditors need to do to reinforce their position when it comes to assessing non-financial risks.”
Next to the struggle that auditors experience when doing non-financial audits, progress in data science has given data science companies opportunities to exploit the auditors’ struggle. Specifically, data scientists exploit the possibilities of machine learning to develop tools that give a quantified estimate of a firm’s non-financial risks. For instance, Datamaran, which is a business intelligence tool developed by eRevalue, uses information from corporate reports, global regulations, social media, stakeholder surveys and online news to assess a firm’s non-financial risks. An easy conclusion could be that those data science companies will drive audit firms out of the market for assessing non-financial risks. Admittedly, when learning about the tools offered by several data science companies and working with their data, I was quick to make this easy conclusion.
At this point, I would like to invite you to turn the question upside down and ask yourself what auditors need to do to reinforce their position when it comes to assessing non-financial risks. A first answer could be that regulation can save the position of the auditor. I am not a big fan of relying on regulation to safeguard a particular competitive position. As an example, regulations have long protected the position of licensed cab-drivers and hotels but regulations have not been able to stop the success of companies like Uber and Airbnb. A second argument is grounded in the observation that the predictive validity of rankings for firms’ environmental, social, and governmental (ESG) activities, such as those developed by data science companies, is lower than usually claimed. For instance, many firms on Fortune’s Change the World List, which is a list of firms that are delivering profit-driven social impact, do not achieve top positions on ESG rankings developed by data science companies but outperform the MSCI World Stock Index by an average of 3.9 percent in the year following the inclusion in the Change the World List.
“Of course, the entrance and pressure of data science companies in the market for assessing non-financial risks should still be a wake-up call for audit firms. It is thus crucial that audit firms revitalize the link between a firm’s strategy and its non-financial and financial numbers.”
The reason for the lower predictive validity of ESG rankings is quite intuitive. Even though most rankings rely on machine learning, some standardization is needed to make such tools effective and efficient, which implies that the list of non-financial metrics used by machine learning tools requires standardization. As a result, most tools insufficiently capture the idea that assessing non-financial risks preferably happens conditional on the firm’s strategy. Importantly, the point is not that the ESG rankings are completely useless but that the conclusion that data science companies will drive audit firms out of the market for assessing non-financial risks is too far-stretched at the moment.
Of course, the entrance and pressure of data science companies in the market for assessing non-financial risks should still be a wake-up call for audit firms. It is thus crucial that audit firms revitalize the link between a firm’s strategy and its non-financial and financial numbers. Relatedly, audit firms could more clearly communicate their judgment regarding the relevance of the non-financial metrics chosen by the firm conditional on the strategy of the firm. Importantly, auditors should be trained in making such judgments, implying that the role of firm strategies should get a more prominent role in (non)-financial accounting courses. In the MSc Accountancy of Tilburg University, which runs in an updated form since the academic year 2019-2020, we are already training future accountants to make judgments regarding the relevance of non-financial metrics by offering a course focused on developing, auditing, reporting, and using non-financial metrics!
