Financial Reporting Failure and the Limits (Ep. 19)

When an audit goes wrong, the problem is not always that the auditor missed the issue. Sometimes, the issue was known but not communicated early, clearly, or to the right people.

In this episode of Financial Reporting Conversations, we unpack audit communication failures. Wayne and Judith discuss why communication with management, those charged with governance, shareholders, creditors, and regulators matters, and how delayed escalation can create pressure to sign an audit opinion without sufficient appropriate audit evidence.

🎧 In this episode, you’ll learn:

• Why audit communication failures can undermine audit quality
•  Why issues must be escalated beyond the finance team
• How internal control deficiencies, audit adjustments, and modified opinions should be communicated
• Why late communication can increase pressure on auditors and directors
• How the audit report becomes the final communication to stakeholders

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

For technical insights, training, and resources that make the unknowns in financial reporting known, visit basfordconsulting.com

🔗 Connect with us:
LinkedIn: Wayne Basford & Judith Leung
YouTube: @BasfordConsulting
Website: basfordconsulting.com

Transcript

SPEAKER_01 0:00

Welcome to Financial Reporting Conversations brought to you by Baster Consulting.

SPEAKER_00 0:04

We're here to make the unknown anonymous of accounting, auditing and climate standards known so we can avoid the blindfredding mistakes and do financial reporting better.

SPEAKER_01 0:13

Each episode will unpack what the standards really say, what they mean in practice.

SPEAKER_00 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 always appears: where were the auditors? But audit failures rarely have a single cause. They're usually the result of pressures, decisions, and behaviours that develop long before the audit opinion is signed. Welcome to Financial Reporting Conversations. In this series, Why Audits Go Wrong, we explore the deeper causes of audit failure and the conditions that can undermine order quality. In today's episode, we're examining the failure to communicate. As usual, I'm here today with Wayne Batsford. Wayne, let's start with the fundamental question for this episode. Why is communication so critical to the audit process?

SPEAKER_01 1:07

Okay. Communication is the purpose of an audit. So we're supposed to come with an opinion as to whether the accounts are true and fair, whether the accounts have been prepared in accordance with accounting standards, and we're supposed to communicate any issues. And when you're looking at communication, it is the big issue of who lost because of the accounts being wrong. And I will always say, and repeatedly say in this series, it is the director's responsibility to get the accounts right. If the accounts are wrong, that's the fault of the directors, that's the fault of the audit committee chair. What finger can be pointed at the auditor, and it's communication. And you get two aspects of failing to communicate. The auditor either failed to communicate to those charged with governance, the auditor failed to tell those charged with governance, including the audit committee chair, I'm not happy with this, I'm not getting the right evidence, I'm really, really worried about your internal control, I don't think you've got the information to do your oversight. Or the ultimate communication is we communicated to shareholders, we communicated to creditors, we communicated to lenders via an incorrect audit opinion. And when it gets to causation, well, directors looking at the auditor and saying, Well, if you'd have told me this, I'd have done something about it, and therefore it's your fault I didn't spot it. And there's validity in that argument, and this expectation gap who relies on our audit opinion, and this really weird, this very, very difficult position auditors tightwritte work. No, we are very, very important. We protect the shareholders, and then when anybody tries to sue us, it's uh well, it's not our job to protect you. You don't understand the limitations of an audit, but we like taking audit fees, but we don't like taking responsibility, and it's communication via the audit opinion.

SPEAKER_00 3:17

So you many of this you talk about is failing to communicate to people outside a finance team. So why is it so important that they shouldn't um auditors should not only stop commun should not communicate just within the confines of the finance team?

SPEAKER_01 3:35

The people that sign the accounts off are the board. We should, and everything when you look through our communication, it's to management and those charged with governance. And when we don't communicate to those charged with governance, you've we all auditors know we have got a problem with the finance controller. The finance controller is delaying us, maybe the finance controller really gets gives us the impression they don't know what they're doing, but why keep on asking that finance controller, why not say to those charged with governance, we're having problems getting evidence on this? And then you get this problem. If we failed to tell those charged with governance, we are A being unfair to those charged with governance, and B putting ourselves under a load of pressure. We have been asking for weeks to get an impairment model. We are saying we don't believe the uh recoverable amount, we don't believe the assumptions, but we've not escalated that to the audit committee. One week to go, we're still not in a position to sign off. Now we tell the audit committee we've got a problem, and they rightly explode. Why didn't you tell this earlier? It is if we get suspended, the consequences are going to be X, we're gonna run out of money, we're gonna lose customers, we're not gonna be able to raise finance. And the auditor has now just put themselves under a massive amount of pressure to sign because they've not communicated promptly enough.

SPEAKER_00 5:17

From what I understand, auditors also need to communicate internal control deficiencies. Can you explain a bit more about that, like in terms of the auditing requirements?

SPEAKER_01 5:28

ACER 265 and ASA 260, if we see a weakness in internal control, we're supposed to promptly notify management and those charged with governance. Going back to when we're talking about what goes wrong, why did an audit fail, sorry, not the audit failed, the f the financial report failed because there was weak governance, there was weak internal control. The board were not properly monitoring construction contracts, the board were not properly monitoring liquidity, the board was not given information that we're going to incur loads of penalties on that contract, we've messed up our cost to complete estimates, that's a weakness in internal control. And when you try and link financial reporting failure back to the auditor, well, if we, the auditor, believed there was no controls or weak governance, we should have reported that to gov to those charged with governance. If we've not done that, we're starting to be part of the collapse. Why did the audit fail? Why did the accounts fail? Well, they hadn't got internal control to prepare the accounts properly, and we the auditor didn't report that to anybody, and then it starts to come back on us.

SPEAKER_00 6:49

And as auditors, auditors also need to communicate audit adjustments, and why is that important?

SPEAKER_01 6:56

Well, if we found anything, so it is we are obliged to under ACER 450, we have found an error. Now remember, we auditors are not responsible for the accounts. We auditors have to be very, very careful on independence. So it's not a case of we found an error, we calculate the error, we do the journal, and we give the client the journal. That is not what 450 says. We find an error and we ask the client to quantify that error and ask them to correct the error, and then we look at how they've quantified it because we are not responsible for doing calculations. We look at how they've quantified it and we get we test it to make sure that that correction is appropriate.

SPEAKER_00 7:48

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. Early communication can actually prevent a modifier audit opinion. How does that work? Can you explain too?

SPEAKER_01 8:09

This is where causation, and again, it's the auditor's fault, it wasn't the audit committee's fault. Causation says under ASA 260, ASA 330, I am really not happy with the evidence I've got. I have said a key audit matter is impairment, I've said a key audit matter is uh recoverability of that amount or revenue recognition. And the evidence I've been given, look, I just don't know whether it's right. You've come up with this hockey impairment model that's been prepared internally, and I'm I'm not happy with it. So, and this is me talking to the audit committee chair, unless you do it properly, I'm gonna issue a modified audit opinion. Now, this conversation needs to be as early in the audit process as it can be. Unless you give me sufficient appropriate audit evidence, I am gonna have to issue a modified audit opinion. If the auditor has been diligent and asked for it repeatedly, most diligent boards, most diligent audit committee chairs will try and get the evidence that the auditor is requesting. And also often the auditors ask for the right evidence, and when the evidence has been prepared correctly, it's identified a problem. It's identified that the assumptions were not reasonable or supportable, and therefore there should be an impairment right down of this. It's identified that we've got a problem on that cost to complete, we really should not be recognising that amount of revenue. Maybe we should be recognising an owner's contract, or yes, that revenue didn't meet the five-step approach in IFRAS 15, and we need to back out all of those sales in period 12. If the auditor had asked for the evidence early enough, most likely the error would have been corrected. When they don't ask for the evidence, or they ask for it too late. Well, why didn't you ask me for this a week ago? Why didn't you ask for this in August? I can't prepare that information in three days. There's so much pressure then on the auditor to sign despite not having sufficient appropriate audit evidence.

SPEAKER_00 10:40

Actually, communication can actually improve the quality of financial reporting and and the and the audit process and get to a better outcome.

SPEAKER_01 10:49

If there is a value in audit, you know, you know, again, talking positively about the auditor professional or auditor proud, we are there to help the financial reporting process. We don't prepare accounts, that's the directors, it's the audit committee. But we communicate to the directors and the audit committee, your internal controls are weak. You've not got if I the auditor am not happy with that estimate, if I the auditor am not happy with your Revrec, well, you, the audit committee, should have the same problem as me. Go and get that evidence, which by the way, you, the audit committee, should have anyway, and you you you spot errors and you prevent misstated financial reports.

SPEAKER_00 11:35

The audit report, you've touched on this at the beginning of this episode, is also part of the communication process. Ultimately, is the final stage of this communication process. Can you explain a bit more about the role of the audit report?

SPEAKER_01 11:51

Well, you the audit report, when you read it, so you've got an unmodified audit opinion, and I'm giving reasonable assurance that this financial report is not materially misstated. I'm giving an opinion, it's true and fair. Then you get the next one, which is an interesting one, which is this emphasis of matter, which would when we go into going concern. So without modification, I draw your attention to note 2B that says we might run out of cash. Now that is an amazingly useful emphasis of matter for anybody that's intending to invest in that company, to anybody that's intending to join that company or do business with that company. You've told me it's an unmodified audit opinion. These are true and fair. You've given me reasonable assurance, it's reasonable assurance, not absolute assurance. But I'm a reason I'm an educated user of financial report. Auditor said it's okay. Auditor has said there is no uncertainty as to going concerned. Now that is a massive amount of communication. And then we've got the next three levels of communication that would be extraordinarily useful if you ever saw them. But in the real world, we should be avoiding these next three. The qualified. Everything is reasonable, everything is materially misstated, but I'm not able to get sufficient evidence on that number there. Qualified opinion, but that qualified the number that I'm just not able to perform an opinion on is not the world we've got this pervasive idea, so everybody has to get into the world of what's pervasive. So I've qualified on that number. Either I don't know whether that number is right, I've not been able to get sufficient appropriate audit evidence to opine whether or not it's right, or I'm telling you that number is wrong, it's not in accordance with accounting standards, but that error is not pervasive to understanding the accounts as a whole. You then have a disclaimer, well, I've done this audit, you've not given me sufficient appropriate audit evidence. I do not have a clue whether these accounts are right or wrong, and therefore I'm gonna disclaim I'm not issuing an audit opinion. And to be honest, it's a very informative opinion, but it's not nobody could rely on I've disclaimed it. I've got no idea whether these accounts are wrong, therefore I've disclaimed my opinion. Or the ultra-ultra one is these accounts are wrong. These accounts are not prepared in accordance with accounting standards, these accounts do not give a true and fair view, and I tell you that. That's what my adverse opinion is. Now that also means the directors have breached the Corporations Act, and the auditor is obliged to issue a section 311 to ASIC to say the directors have breached the Corporations Act because they've not prepared their accounts in accordance with accounting standards. Now, this is an ultra ultra the ultimate communication to stakeholders, to shareholders, creditors, lenders. So that's our communication.

SPEAKER_00 15:24

So you've touched on communication with the regulators at SIG. So in those situations, there that that's an example where you need to communicate with regulators. Are there any other examples and then why?

SPEAKER_01 15:40

We live and breathe by section 311. So if we've aware of breach of the law, then we have to report to the the appropriate authority. Now, one of the areas I think quite correctly ASIC are picking up on now is the company has not lodged accounts, which is the auditor actually knows whether we've signed the audit report off on that entity. And I've always been facetious in the past. Well, shouldn't ASIC know whether or not lodged accounts have been lodged? But we've just come out of this grandfathering situation, folks. So for years there were large proprietaries, large groups that didn't lodge accounts because they had a special rule to allow them not to. That rule's been removed. So ASIC are blind as to which groups, large proprietary companies need to lodge accounts. Their auditors are aware of that and they need to be communicating if the accounts have not been lodged on time, then the auditors need to notify the regulator.

SPEAKER_00 16:49

Thanks, Wayne. So to wrap up, uh, one final question. What happens when auditor fails to communicate? What are the consequences?

SPEAKER_01 16:57

It's which this level of communication. So if I communicate if I do not communicate promptly enough to those charged with governance, and then I'm not got sufficient appropriate audit evidence, then there's so much pressure on the auditor to issue an opinion despite not having sufficient appropriate audit evidence, that's a real risk both for the directors and for the auditor. And ultimately we communicate via the wrong audit opinion, and it turns out the accounts were materially misstated. Then there can be litigation, investigation for the poor engagement partner, that can be the end of their career. We live our career is based on retaining our registered company auditor status, and you fail to communicate, you issue the wrong opinion, you might be looking for another career.

SPEAKER_00 17:57

Thanks, Wayne. So audit failure is rarely the results of a single mistake. It usually reflects a combination of judgment, pressure, organization culture, the systems that support the order process, communications. And so understanding those factors is central to understanding why audits go wrong. Thank you for joining us for 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 order quality.

SPEAKER_01 18:28

Thanks for listening to Financial Reporting Conversations. For guidance on applying accounting and auditing standards or to access our online training programs, please visit batsfordconsulting.com.

SPEAKER_00 18:39

Don't forget to like, subscribe, and share this episode with your colleagues and contacts. We'll see you next time where we make the unknowns in financial reporting known.