Integrity of the capital markets in the era of covid-19: auditors’ response

By Matt Rees, Director, Forensic Risk Alliance 

In any era, the reliability of published financial statements is a bedrock of global capital markets. This is even more vital in times of uncertainty, and the cloud of the COVID-19 pandemic brings more uncertainty than in any time in recent memory.  Investors are trying to distinguish between those corporations that will survive—or even thrive—and those whose demise will be caused or hastened by unprecedented and sudden crises, including dislocation of their supply chains, operations and markets. Every public statement and every disclosure will be seized upon and scrutinized as investors and other stakeholders make critical investment decisions.

Auditors are facing practical and technical challenges as they navigate through this extended period of intense disruption and uncertainty.

The Auditor’s Role

Frequently scrutinized by regulators and the public as a result of real and perceived audit failures, auditors will be expected by all stakeholders to raise their game even further to bolster the integrity of the capital markets. The UK Financial Reporting Council (FRC) has recently issued guidance to auditors highlighting the importance, in line with existing standards, of obtaining sufficient appropriate audit evidence to provide a reasonable basis for the auditors’ opinions.

At the same time, audit firms themselves are being significantly disrupted by the pandemic. While taking actions to ensure their own long-term survival, they are also protecting their employees through remote working and the cessation of any travel to client sites.

The Financial Conduct Authority has extended deadlines for publication of audited annual financial reports for listed companies from four to six months from the end of the financial year, so calendar year-end companies will be publishing annual reports in the summer. Companies and auditors should be mindful that taking advantage of the reporting extensions may not bring the hoped-for clarity, and instead lead to postponement of key considerations, as disruptions and uncertainties are likely to continue for a long time.

Practical Challenges

While there are many technical challenges confronting auditors, they face immense practical hurdles caused by the inability to physically meet client staff and observe the operation of critical financial controls. How, for example, can an auditor gain assurance over an inventory count that they cannot attend in person? How can they be certain that their client is not seeking to mislead them when communicating through a video conference facility?

To add another dimension to the challenge, client staff are likely to be working remotely. Risks of control deficiencies may be accentuated as a result of hastily reconfigured work flows and controls. In some cases, these controls will be operated by individuals who are unfamiliar with their purpose. Supervisory processes may be unclear or even missing. These altered processes may incorporate more manual steps and, therefore, undermine the ability of audit teams to rely upon previously tested control frameworks. Perhaps inevitably, such circumstances will drive the auditor to adopt a more time intensive, substantive testing strategy; although this will be made more challenging by the remoteness of the evidence and the additional time costs associated with this extra work.

Technical Challenges

Perhaps the most significant change in the challenge facing auditors will be the increased focus in the areas of greatest judgment. Given the uncertainties and disruptions posed by the pandemic, there will be intense scrutiny of those balances and disclosures which entail more subjective assumptions and estimates. Auditors may need to revise the related risk assessments and planned audit approach for these areas.

Central to this will be the audit procedures to address the fundamental issue of going concern. These procedures should include assessment of recognition and disclosure of post-balance sheet events which may be significantly affected and complicated by COVID-19. Auditors will need to assess the adequacy of these procedures as well as those that address other critical judgments, such as impairments of goodwill and intangible and long-lived assets, provisions for bad debts, valuation of inventory, and impacts of variable consideration and collectability on revenue recognition.

While considering the full range of risks facing corporations, auditors are dealing with changes in the nature and scale of inherent fraud risks. The prospect of large provisions being required, will present an opportunity for any past frauds, errors and misstatements to be obscured and perhaps hidden permanently. The FRC recently highlighted that, in response to COVID-19, auditors should consider whether their assessments of risks of material misstatement due to fraud need to be heightened and, as a result, whether additional audit procedures need to be performed.

Auditors will also need to consider adjustments to their audit reports. This may include explanatory language where there is substantial doubt about the ability of the company to continue as a going concern. And special attention should be paid to the discussion of key audit matters in the audit reports. These matters are those that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements, including those which had the greatest effect on the overall audit strategy, the allocation of resources in the audit, and directing the efforts of the engagement team.

The Auditor’s Response

Notwithstanding the practical challenges of obtaining audit evidence, the change in focus will place significant demands on auditors to gather and challenge evidence which will, by its very nature, be more judgmental and based on projections and estimations. Their approach should build on the basic auditing principles so that they obtain sufficient appropriate audit evidence to support the opinion on the financial statements. This response can be viewed from two perspectives.

First, engagement teams should continue to exercise due professional care and professional scepticism. This will include identifying the new risks of material misstatement, due to error or fraud, that are the result of current circumstances and developing responses to address all material risks through challenging the design of the nature, timing, and extent of audit procedures.

Where past strategies are now impossible to execute, new sources and approaches for obtaining audit evidence remotely must be identified. Creative thinking must be applied to overcome the constraints imposed by the absence of physical access to people and evidence. Engagement teams should continuously revisit the risk assessment based on audit evidence obtained, and modify planned audit procedures if required. Audits that are taking place now may have been planned in much more stable times and current circumstances are very different.

Second, audit firms may need to enhance their systems of quality control to address the supervision and support of engagement teams. This will be particularly important in more complex and judgmental areas of the audit. Quality reviews and escalations of issues to technical specialists are likely to be much more frequent and should, of course, be well-documented.

The FRC emphasised quality control aspects in its March 2020 Bulletin, including in areas regarding acceptance and take-on of new audit engagements and emphasizing compliance with all of the requirements in respect of UK quality control standards. The FRC also underlined that, in the current circumstances, auditors will need to document clearly how the direction, supervision and review process was structured and operated to overcome obstacles, and how communication with team members—in particular, key audit partners, engagement quality control reviewers and any technical reviewers—was maintained.

Professional Liability

Despite best attempts by auditors to exercise due professional care, including professional scepticism, and to gather sufficient appropriate audit evidence, there are situations in which allegations of professional negligence can be made. Proactive efforts by audit firms to enhance their quality control systems can help to demonstrate that the auditors have fulfilled their obligations and mitigate any negative consequences.

The auditor’s role in maintaining the integrity of the capital markets is critical, particularly in times of extreme uncertainty. With investors and other stakeholders scrutinizing financial statements to seek evidence to support their investment decisions, it is vital that auditors adequately assess risk and implement audit procedures to gather sufficient appropriate audit evidence to support their opinions. Also, in responding to the current environment, the importance of quality control system enhancements to ensure compliance with professional standards cannot be overestimated.