Counting on accountants: What investors need to know about the latest report from the audit watchdog
On 5 November, the UK’s Financial Reporting Council (FRC) published its annual report on “Developments in Audit”.
On 5 November, the UK’s Financial Reporting Council (FRC) published its annual report on “Developments in Audit”. In the light of several high profile corporate scandals and collapses, including BHS, Carillion and Patisserie Valerie, the report was highly critical of the performance of auditors. But its findings are also relevant to investors.
Poor quality audits
A key point from the FRC’s findings was that only 75% of FTSE 350 audits were assessed as good or requiring limited improvement. This compares to a target of 90%, and means that 25% of assessed audits are below an acceptable standard. It appears that poor quality audit work remains unacceptably common.
Sixteen of the audits reviewed had been referred for possible enforcement action. Of those, eight investigations have been opened. Shortcomings identified included the valuation of financial instruments, such as bonds and loans, revenue recognition and analysis of long-term contracts.
It goes without saying that the quality of audits is a critical issue for investors. The audit is the primary information source that investors rely on to provide a true and fair reflection of the business that they are assessing. A careful review of a company’s report and accounts can reveal specific issues or shed light into the firm’s financial governance.
Given the findings from the FRC, investors should tread carefully. They need to be on the look-out for any “unusual” items, such as a specific transaction or impairment. The key material accounting judgements, estimates and areas of subjectivity also need to be understood.
Perhaps most importantly, investors need to give consideration to the risks to the financial statements and what the auditor and audit committee have done to respond to those risks.
We address those risks for the UK Dynamic Fund by conducting a systematic analysis of key corporate governance items and accounting policies. These include whether the chairman and chief executive are independent, the degree to which profits are converted to cash and revenue recognition measures. In total we look at more than a hundred potential ‘red flags’ when considering the purchase of a security.
John Baker is a portfolio manager for the JPM UK Dynamic Fund. Find out more>