Why Audits Go Wrong: The 7-Step Audit Failure Timeline

When a company collapses shortly after a clean audit opinion, the same question always comes up: where were the auditors? But audit failure rarely starts in the audit file.

In this episode of Financial Reporting Conversations, part of the Why Audits Go Wrong series, we walk through the 7-step audit failure timeline, showing how audit failure develops from weak governance, management pressure, and flawed financial reporting long before the audit begins. We unpack how audit risk builds inside the entity, how it flows into the audit process, and why critical risks are often missed.

If you think audit failure is just about audit procedures, this episode will challenge that assumption and show how audit failure really unfolds.

Financial Reporting Conversations is brought to you by Basford Consulting helping professionals go beyond compliance and get financial reporting right.

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Transcript

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Welcome to Financial Reporting Conversations brought to you by Bas for Consulting.

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SPEAKER_01 0:18

Whether you're a preparer, auditor, director, or litigator, our aim is to help you get it right. When the company collapses shortly after receiving a clean audit opinion, the same question almost always appears. Where were the auditors? It's an understandable reaction, but that question may focus on the wrong place. Most audit failures do not begin in the audit file. They begin inside the company being audited. Welcome to Financial Reporting Conversations. In this series, Why Audits Go Wrong, we look at the conditions that make reliable financial reporting difficult and the situations in which audits can fail. In today's episode, we discuss where financial reporting failures usually begin, how management pressure affects financial reporting, and why risk assessment plays such an important role in the audit process. And as usual, I'm here today with Wayne Bassford. Wayne, let's start with a basic question. When financial reporting failures occur, where do they usually begin?

SPEAKER_00 1:21

Financial reporting failures start with the entity. So it's the entity, the directors that are responsible for getting the accounts right. And the failure to get those accounts right, it's with the board. And I would always point the finger at the audit committee and the chairman of the audit committee. Audit failure is we failed to spot the accounts were wrong. And you know, this comes about. Why do the accounts go wrong? It's poor governance. Something went wrong with the board, something went wrong with the audit committee. And in essence, why did what went wrong? They ran out of cash and the board didn't spot it. The audit committee didn't spot it. And that can most times it either is a failed business model or a failed funding model. And that just leads to this financial reporting problem. So you get issues with liquidity, there's more pressure, people manipulate the accounts, the audit committee chair doesn't uh spot it or doesn't stop it, the auditors then don't notice it, and then we've got audit failure.

SPEAKER_01 2:33

Thanks, Wayne. Now management teams often face pressure to present favorable financial results or to present financial results in to tell a story in a particular way. What kind of pressures tend to influence those financial reporting decisions?

SPEAKER_00 2:49

Well, there's two levels of pressure, and it's always going to be financial. So the biggest pressure on an entity, it needs to raise funds. It needs to either renew debt, get more debt, be successful in the share raising. If it doesn't get those funds, if it doesn't renew the debt, well it's going to run out of cash, and there's a lot of pressure. And there's also pressure on the CEO, pressure on senior management. You were hired in, paid a large salary, paid lots of bonuses to increase shareholder value to meet the target. You made all these decisions to spend shareholders' money acquiring these businesses? Well, there's a lot of pressure on that CEO to, yes, it was a good idea, I know what I'm doing, I've spent your money wisely, and that pressure on the CEO can permeate through the entire organization and put pressure on the finance team.

SPEAKER_01 3:52

Thanks, Wayne. And how does pressure that assist sort of interact with an organization that has weak governance and weak oversight?

SPEAKER_00 4:02

Well, it becomes a game that management, the executives, the they need to show a particular result. And the CFO, the finance team can get drawn into this. They play tricks. Let's we are desperate. How can we show the right result with actually out without making the sales, without making profit? So you end up with some very aggressive accounting practices, tricks to make things look good, missing disclosures, weak disclosures. And you're up you're part of the team, you're part of the finance team. Come on, what can we do to make budget? We need to make budget, we need to show this particular result, and the whole team, it becomes a group think within the executive, they are there to deliver the numbers, and then you get this weird thing: this interaction with the audit committee. Do their role as being independent of the exec? Are they asking the right questions of the exec of the finance team? Or are they into this world of don't ask, don't tell? I just want to hear good news. Have you got it under control, Judith? Oh, that's good. I'm glad to hear it. Is this right? Well, great to hear it. And they just don't ask about is this does this make sense? Are these assumptions reasonable? Does does this should we impair this? You sure we manage to get those period 12 sales we sold so much in period 12? Those questions aren't there. And they they don't focus on risk, they don't focus on internal control. How are we controlling large construction contracts? What's the cost to complete? You sure we've got this contract under control? The board is not asking those questions of the exec, the board is not asking whether we've got internal control, and the accounts go wrong. And against the background of we're gonna run out of cash.

SPEAKER_01 6:04

If you're finding this discussion useful, please take a moment to click like, subscribe, and share. It helps others in the financial reporting community discover financial reporting conversations and keeps you up to date with every new episode. So, Wayne, these conditions you've talked about can exist, you know, long before an auditor begins and an auditor steps into the room. So with governance, financial, financial pressure, uh aggressive accounting. How do these conditions translate into audit risk for an auditor?

SPEAKER_00 6:37

Well, they definitely are audit risk. This pressure, this bias, poor governance, weak governance, incentives to manipulate accounts, that is audit risk. You know, nice simple in the simple world, and it is true, you know, 99% of boards are honest, accountants are honest, they don't play accounting tricks, or it's only minor accounting tricks. But there's the auditor's problem is spotting that scary 1%. And they need to spot that scary 1% from client acceptance reacceptance. You look scary, I'm not sure about your integrity, I'm not sure about your business model. Please, please go and look for another audit firm. Or, hmm, you do look risky, you you're gonna be an interesting company to audit, therefore, I'm gonna have to put more effort into your audit, the fees go up. So it's that client acceptance, and we all auditors, we're supposed to be sceptical, we're supposed to understand the business, the business environments, the control system, the integrity of management. But yeah, it's an audit, an audit, an audit is an audit, I'll do an audit, and we get it wrong, and then we get into the risk identification, we don't understand the real risks. We get into the fraud identification, we don't understand the real pressures, and we don't understand the real opportunities. We have this weird world. The checklist in all audit firms, are you satisfied with the integrity of management? Are you in satisfied with the integrity of those charged with governance? And whatever file I'm looking at, the answer's yes, but I really rarely see the documentation to see why you the auditors come to that decision. And it's I've described it and you may have seen an infographic that I've been playing with, which is the cascade of audit failure. So the cascade of audit failure, you accept the wrong audit. You do not understand the business that you're auditing, you don't identify the risk of material misstatement. And as soon as you got there, if you not identify the risk of material misstatement, you don't do the work to respond to those risks. If you don't do the work to respond to those risks, you don't spot the error. You don't report the error to management and those charged with governance, you issue an unmodified audit opinion, the company typically collapses or has a massive restatement of revenue or a major impairment not long after you've signed the audit report and you're into audit failure.

SPEAKER_01 9:32

Thanks, Wayne. So I think you've already briefly touched on this, but um I'm gonna sort of delve into a bit more detail because I think it's quite sort of important. Is why is risk assessment sounds quite central to the audit process? Why is that?

SPEAKER_00 9:48

Because it is. We all sit there, we do a risk-based audit approach, which we have to. We do not tick every document, we cannot afford to tick any doc tick every document. So we are supposed to do a risk-based. What is the risk of material misstatement? I'm gonna focus in on the risks, and this is ISA 315, ASA 315. In order to focus in on the risks, we need to understand the business. What could go wrong or the inherent risks, what could go wrong, and then we design an audit around addressing those risks, and you know, this foundational thing. We've missed the risks, therefore, we don't design any procedures, we don't get any audit evidence, we are just continuing ticking, ticking, ticking and not moving to where the risk should be.

SPEAKER_01 10:44

Thanks, Wayne. So, final question: when a corporate failure occurs shortly after a clean audit opinion, what questions should we ask?

SPEAKER_00 10:54

What should have been known at the site, the time of signing the audit opinion? So, who got it wrong? And it's ultimately, as Mike always pointing the finger at the audit committee chair. But the question to ask is why didn't the auditor identify the risk? Why didn't the auditor design procedures to address that risk? And again, you have this real problem that the best thing to audit is a company with strong governance, strong internal controls. That is the client that you should be accepting. And if you accept the right client, there is nothing to find. But the problem is you accept a client that has got a weak business model, that you've got poor governance, poor internal controls, you've managed to pick that 1% of problem, and you just didn't adopt your audit approach for it. And everybody's looking at were the estimates reasonable? Did we disclose going concern appropriately? As soon as you see an audit failure, a collapse within a month of a clean audit opinion, you go and read, was there an EOM on going concern? And then you, if there was, did that going concern note absolutely describe what went wrong or what could go wrong, the material uncertainty? And did they reverse revenue? Did they impair goodwill? Has ACIC caused them to restate something? And those would you know the analysis that goes through that should go every through everybody's minds looking at audit failure? Whether you do it from professional interest, whether you do it from uh therefore the grace of gotta go eye, what can I learn from it, or from the litigation funders, ah, is there somebody to sue? Did somebody take a loss? Why did the auditor get it wrong?

SPEAKER_01 13:02

Thanks, Wayne. So when financial reporting fails, attention often focuses on the audit procedures, what went wrong there. But many of the underlying courses begin inside the organization itself. Governance structures, internal control, management incentives, and organization culture or play a role in shaping financial reporting. Understanding those conditions helps explain both reporting failure and audit failure. And this is some of the things that we discuss in why audits go wrong. So thank you for joining us in this episode of Financial Reporting Conversations, and we hope you'll join us next time as we continue to examine the pressures and risks that influence financial reporting and audit quality.

SPEAKER_00 13:48

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SPEAKER_01 13:59

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