How useful can statutory accounts (and audit) be to investors?

The UK regulatory and legal landscape around statutory accounts and audit is being reshaped in the wake of a new EU directive and regulation. This article seeks to address the interest of the people we regard as influential stakeholders.

We want to play our part in an honest and open debate that takes views from investors and the management of the entities whose financial statements our audit firm effectively gives a reasonable assurance opinion on. That is the animus of what you will go on to read now, and in a sister publication that talks about the public interest, the role of the principle of proportionality in securing it, and encourages debate about what good regulation looks like in the 21st century.   

The authors took particular note of a development we thought seminal and important – the creation of The Investor Forum, whose purpose is to 'position stewardship at the heart of investment decision-making by facilitating dialogue, creating long-term solutions and enhancing value'. We saw in it our interest in taking views from the forum, so they might then inform internal discussions with the audit executive of the firm. Ultimately, although our most proximate focus is the audit firm to which we are appointed, we recognise too that the economy needs it to function optimally.

Points for discussion:

  • A company’s accounts are helpful to those making qualitative assessments of them and using them, but they need (as the Kay Report asks us to keep in mind) to have a significant predictive element, looking ahead; and
  • statutory audit needs to be complementary to the interests of stakeholders and the entities being audited themselves.

Conclusions

Traditionally, accounts were designed for stewardship, to deal with the split between ownership and management, indicating whether the managers of companies were taking proper account of the interests of owners. Legislative requirements were set and accounting principles devised to fulfil this stewardship function. 

In recent decades, further rules have been devised in order to serve a wider function, primarily to provide better information for investors, or other owners of financial capital, buying, selling and holding shares and other forms of derivatives. It was argued (and still is) that the provision of company accounting information and that audit, i.e. the issuing of "a true and fair" view or qualifications of such accounts, would improve the functioning of the capital market, and, as such, contribute to the public interest. 

Let us put these matters into context.

The need to help investors does not apply with the same degree of cogency to many entities which need accounts, and, in some circumstances, audit. They scarcely apply to charities, not-for-profit entities and many owner-managed entities; and they apply to a lesser extent to small, privately-owned companies.

Accounts, and audit, save for going concern considerations, are about the past, whereas investors need information about the future. The future value of a company, and its prospective profitability, are both imperfectly and inadequately measured in the financial data of the past. It is often said that the key assets of a company are its staff, but no valuation of their capability, or of their entrepreneurial skills appear in the balance sheet. Insofar as investors value these qualities, they may be reflected in the stock market valuation of the company, which may differ significantly from any historical record of its physical capital, however updated to current prices.

Market situations, and underlying human motivations, are too complex to be adequately modelled by developments in accounting principles. The markets for financial capital are influenced, to a significant extent, by the actions of traders who are primarily concerned with estimating the perceptions of other traders. This can lead to herd-like behaviour that exacerbates fluctuations in share prices.

The Kay Report drew attention to the failure of many company reports to look far enough ahead. It stressed the importance of incentives rather than a dash for data, and to the dangers of anchoring on selective, typically short term, information. That is not to say that, provided that accounts and audit opinions are looked at in the round, and over a number of years, they may not be helpful. But taken in isolation, they provide only one element in decision-taking and unless carefully used, can be misleading.

Accounts involve judgement; it is crucially important that such judgements take full account of the specification of the situation. Such judgements may involve ways of applying rules to take account of future events that are inevitably uncertain. 

Accounting principles promote qualitative characteristics as necessary elements in accounting – the concept of neutrality and freedom from bias, for example.  It is not enough simply to look statistically at the issues and adopt a middle of the road approach. Proper stewardship includes looking at what can go wrong. They do not, though, promote detailed analysis of all possible future events; accounting must be proportionate.

Accounting standards and market measures of income and capital  

Estimates of past levels of income and capital are not as unambiguous as they may seem. While they may be relatively straightforward when applied to a complete venture, the measurement of both income and capital involve significant difficulties in continuing businesses. They both involve considerations of the future as well as historical estimation of past flows.  

The definition of income during a particular period of time involves, among other things, allowing for the; 

  • maintenance of capital, i.e. situations where there is no ready market calculation,
  • the estimation of the value of work in progress when sales are subject  to the future uncertainties of the market and costs are lower than Net Realisable Value, and 
  • the valuation of inventories, when accumulated and when the lower of cost and value.

There are no uniquely correct ways of allowing for these issues, the principal cause of difficulty being ‘fair value’ as a factor in creating volatility. Valuation assumptions and techniques can produce significantly different answers. In some circumstances, the use of infrastructure accounting and the assessment of individual fair values is appropriate. Future sales of work-in-progress is, in varying degrees, uncertain. The valuation of inventories has been a matter of dispute and different approaches are possible, with disputes generally being around provision for obsolete stock.

The valuation of capital at a particular time also involves allowing for;

  • perceptions of future events in capital markets,
  • the consequences of cumulative events that have taken place over a significant period of time in the past, during which input prices have varied.

Perceptions of prospects of the future are constantly changing; different economic stakeholders have differing perceptions which are subject to fluctuation depending on market sentiment. The prices of both inputs into the production process and of sales of outputs vary over past time, and can be expected to vary in the future.

Market valuations of the value of the shares that are derivatives of physical capital often differ significantly from what has been spent to create the underlying assets. The net stock market value of financial capital will also depend on the methods of financing that have been used in the past and which will be used in the future.  Different models, for example the capital asset pricing and dividend growth models, have been used to make valuations.

Tobin's Q (the relationship between the market value and the asset value of a business) focuses on important considerations, but the value of Q has proved both difficult to calculate and subject to significant unexpected variations. Other measures, such as the price/assets ratio, adjusted in a variety of ways are used too, but while all these measures (and others) may produce valuable insights, they are all subject to health warnings, and their use in particular situations involves considerable exercise of judgement.

In the early years of the 20th century, much confidence was placed in the efficient market theories developed during the 'great stability'.  The 'great stability', however, soon turned into the 'great crash'; efficient market theory was found to have little predictive power.  Macro-economic models have also been shown to have limited predictive power: they have consistently (and not only in the recent past) failed to predict turning points in the economy.

Applying economic principles to the construction of accounts, with the aim of making them more useful to investors, has introduced complexity, without always producing the desired results. For example, valuation of assets on a basis of 'mark-to-market', while it may be preferable to long delays in re-valuation of assets can, in volatile circumstances, have the unfortunate effect of further increasing volatility.

Valuations based on economic principles may be useful primarily because they reveal the uncertainties inherent in underlying accounts, pointing to the need to examine the reasons for such uncertainties and to use other sources of information, on both capital and product markets, to arrive at more widely-based judgements.

Implications for audit

The task of an auditor is to decide whether a set of accounts provides 'a true and fair' view of the financial statements of a business, or to qualify the audit opinion in one way or another.  As indicated above, there is no such thing as a unique true and fair view.

Achieving a true and fair view involves more than preparing the accounts in accordance with accounting standards; it involves judging whether they properly reflect the performance of the entity over a defined period of time, after taking such account of the external environment as is relevant.

Investors get much of their information relevant to their decisions from specialised analysts. These analysts will often build specific models of a sector of the economy.
The nature of the stewardship function depends on the objectives of the owners. These objectives will vary, depending, inter alia, on the closeness between owners and management . The objectives of owners will also depend on the nature and size of the business.

Proportionality

Both the accounts of a business; and the audit opinion of these accounts should be proportionate. What is right for a small charity will not be right for a major multinational business.
The needs of investors will vary with the nature and position of the audited entity. Where a business is listed on a major stock exchange, its accounts may provide some assurance to a wide range of owners, including small shareholders. This is but one element in the application of the public interest.

The position of charitable bodies, not-for-profit entities, owner managed entities and small businesses, either not listed or listed on a specialist market, such as the AIM market, are very different from each other and from that of large multinational business. In many of them, either there are no investors, or the relevant investors are already equipped with special information.

These differences between the situations of different types of enterprise should be recognised both in legal requirements for audit, and for supervision and inspection of audit, whether conducted by Professional Institutes or by public bodies such as the Financial Reporting Council (FRC), and in specifically tailored ethical standards.

Inspection should concentrate on outcomes not process; unnecessary complexity and over-concern with process can be counterproductive, making audit more expensive and reducing the demand for it. As we understand it, the FRC has taken this point on board voluntarily, for future inspection rounds.

Audit should be complementary to the interests of stakeholders and to the entities being audited themselves. Whatever helps them grow sustainably, and doing so meaningfully may mean sacrificing some regulatory totems, is where the country’s focus needs to be.

For more information contact Tom McMorrow or Roger Alexander