The public interest, the supply of audit, proportionality and the position of RSM

This article examines what constitutes the public interest in matters of audit from the perspective of RSM’s Public Interest Committee (PIC). It begins with the Finance Reporting Council's (FRC's) definition, goes on to consider audit supply issues and proportionality, and then relates them to the strategic direction of RSM’s work.

Definition of the public interest

The public interest is a frequently used, but less frequently defined concept; it has both subjective and objective meanings.  It is important to be clear what constitutes the public interest with respect to audit as seen by the regulator, by professional bodies, by the regulated and by their clients: the audited bodies.

When used subjectively, the concept of the public interest can act as an umbrella to cover a multitude of objectives, not all widely agreed and often involving some kind of special interest. When used objectively its use should be confined to widely agreed and closely definable matters of collective responsibility. These may relate to the functioning of the economy as well as to wider social objectives.

In a recent paper, the FRC has set out its definition of the public interest, repeated below. These notes take the matters further, concentrating on two issues: first whether the FRC statement sufficiently covers the issues: and secondly the appropriate methods of applying its desiderata to auditing.  

Our remit and the public interest 
The various groups of society which constitute the public include investors, creditors, savers, insurance policy holders, pension scheme members, employees, consumers, suppliers, clients of professional accountancy and actuarial advice and taxpayers. Those groups benefit from a well-functioning and stable economy in which their individual and collective interests are respected. A well regulated system of corporate governance and reporting (supported by corporate governance, stewardship, accounting, auditing, actuarial and ethical codes, standards and guidance; the inspection and review of the application of those standards; the disciplining of any culpable failures and the oversight of the professional bodies) contributes to such a well-functioning and stable economy. January 2014: The FRC and its regulatory approach

The groups listed cover a wide range, which allows for a very wide interpretation of the public interest. This listing needs to be narrowed down when considering specific issues, for example, the public interest with respect to investment. It is also worth noting that audit is only one part of the public interest in matters of investment.

The phrase 'a well-functioning economy' should refer to its ability sustainably to raise living standards for the people.  This requires more than stability, particularly in the light of the inevitability of unforeseen economic fluctuations, in an increasingly global economy.   Many have argued that a well-functioning economy involves a 'gale of creative destruction', and that recessions are essential to the growth process.

A reference to 'a stable' economy is not enough: its use reflects inadequate attention to economic history. Innovation, both in products and processes is essential and may often be inimical to stability. This requires freedom for economic agents to make changes, based on their own, not government's, perceptions of future rewards. It requires freedom to make mistakes and to be accountable for them.

Studies of the accuracy of forecasting have shown that forecasts typically vary, often substantially, from outcomes. In particular, economic forecasts have consistently failed, and continue to fail, to predict turning points in the economy, even as they are occurring. 

Regulation may hinder innovation: a 'well-regulated system' may damage economic development. One of the lessons of the Industrial Revolution is that enterprise developed rapidly and sustainably on unregulated Birmingham not in the guild-dominated & trade regulated parts of the kingdom.

Because of their share of GDP, it may be appropriate to pay more public attention to large firms and to firms in a strategic position than to smaller and less strategic firms. It is still vital to pay due attention to the conditions and circumstances which enable smaller companies to prosper. The public interest should include audit issues pertinent to these smaller firms, who make a major contribution to innovation and to competition. It should also include entities such as not-for-profit bodies, who are meeting wider public interests.  

The term, 'the public interest', is used in the EU to refer to matters concerning companies trading on regulated markets. The FRC has used a much wider definition. 

Investors and the public interest     

It is argued that the public interest, going beyond the interest of those of the audited firm and its owners, may involve two separate issues. One is the quality of audit, in particular whether it is trusted by those who value the information. This may include investors, although it appears that most investors rely mainly on other information.   It is in the public interest for audit firms always to strive to enhance the quality of their audits. Making a true and fair assessment involves ethical considerations and adequate diligence as well as compliance with auditing standards. 

The other is the public desirability of preserving (and encouraging) an adequate supply of audit resources, this could be damaged by the exit of a major audit firm. Avoiding such an eventuality would be a complex matter going well beyond the possible remit of an Independent Non-Executive (INE) or member of a Public Interest Committee (PIC) - (see para. 24 below). It may, however, be possible to devise forms of ring-fencing to deal with risks emerging from the non-UK audit parts of the wider firm.  Encouragement to supply is also discussed in the section below. 

Proportionality and the supply of audit

The public interest includes an adequate supply of audit and of audit skills. The FRC is concerned about the danger that audit will become a declining share of the business of audit firms. This may not be of concern if it arises simply because of expansion of other activities, some of which may involve the supply of audit-like activities, such as assurance and due diligence. But it would be of concern if it resulted from a decline in audit capability, including any reduction in the quality of audit. Public policy should seek to identify whether such concerns result from market forces or from government regulation.

Audit quality, particularly with respect to smaller firms, including those in the AIM market, could be improved by greater participation by audit firms. Audit can play a role analogous to that of non-executives, providing both support and challenge. In the case of smaller entities, too rigid a distinction between audit and assurance may inhibit better quality audit. Rather than strive for complete independence between these activities, it may be better to develop appropriate arms-length relationships.

Elaborate audit is costly and not all firms are willing to pay for it.  It may be appropriate for large firms, but too expensive for smaller firms, and for non-profit entities, who, quite rightly, may prefer something simpler, more in tune with wider company objectives.  Audit is becoming increasingly expensive, because of increased requirements, some arising from regulation, while becoming less profitable for audit firms.  Bureaucratic impositions are usually more onerous for SMEs, with the risk of damaging a vibrant and innovative part of the economy.

An audit is designed to certify that a set of accounts for a particular year shows a 'true & fair' view. This view will always rest on judgement, based on careful analysis. This is crucial to outside perceptions of a company; qualification of the accounts is usually inimical to a firm's prospects. However elaborate the audit, certification of a true & fair view must always be based on perceptions of uncertainties that that will usually be challengeable by someone. The key issue in judging this is whether the certification of 'true & fair' has resulted from an honest, perceptive and sufficiently comprehensive evaluation of the financial position in the market circumstances of the audited body. What is appropriate for a large Plc is often both appropriate for smaller firms, especially for owner-managed firms and for non-profit entities.

In considering proportionality the FRC should consider whether, in creating obligations, it is raising costs unduly. If audit is to prosper, it must remain reasonably profitable. New obligations often involve imposing additional costs that audited firms may be reluctant to meet. FRC should help to promote the supply of audit services by estimating the cost of any new obligation before taking decisions.

Considerations of proportionality include considering what audit does not and cannot do, as well as considering what it can do. An audit provides a recent snap-shot of the financial position of a firm.  While it may help forecasting by providing a base, it is only a relatively small aspect of making a projection. Investors may find audited accounts provide essential information, but they cannot and could not provide all that is required for effective due diligence.  In particular, due diligence requires taking a view about the future, looking at (uncertain) information not available in the accounts of a previous year.

Due diligence requires considerable skilled judgement. Such judgement requires skills comparable to those of an auditor, but an outside body could/would/should provide them in the context of assurance rather than audit.  In a market economy the costs of collecting and analysing information required for due diligence should be borne by those wanting it, including investors and potential investors.

Other economic agents may require assurance of various kinds that can provided in specific ways.  It is better to regard them as forms of diligence rather than audit. Such assurance may take account, inter alia, of audited accounts, but would not be confined to such accounts. Because of the varied needs for and nature of such assurance should be at the discretion of the client and not be regulated by an outside body.

Regulators have an important role to play in strengthening audit. The FRC should emphasise the value of audit as part of overall good corporate governance. It should also say that companies and organisations should be prepared to embrace the costs of good governance and remind them that their approach to management and procedures can be the cause of failure to meet public interest. Recent revelations such as Tesco’s overstatement of profits appears to result from the actions of the management responsible for good governance and public interest.

Considerations of proportionality must take full account of the unpredictability of the future: the need for continuous change if the economy is to deliver sustainable growth: the damage of heavy handed or inappropriate regulation in an ever-changing world economy:  the special circumstances of individual sectors of the economy, such as the non-profit and owner-managed: and of firms of different sizes and histories. Unless sufficient attention is paid to proportionality, regulation becomes a straightjacket.

Proportionality also applies to the remit of a Public Interest Committee (PIC). Members of a PIC should keep their eyes open to risks to the audit business they are observing and advising. But this should not involve being party to the decisions of managers: this would involve a conflict of interest. Nor should members of a PIC be expected to identify the full range of risks to which the firm may be subject, particularly those that could arise in the firm's international networks; to do so would involve large resources and specialist knowledge

As audit firms have always sought to fulfil the public interest, it is in the interest of audit firms to develop ways of doing so in the sectors where they may concentrate their activities. Such consideration should also be relevant and helpful to the development of their businesses.

Position of RSM

RSM has a special position in the market, mainly auditing the accounts of non-profit businesses and public bodies and owner-managed, non-listed companies. 

There is a public interest in encouraging these sectors of the economy for both economic and social purposes. Fostering the growth of smaller firms is essential to the encouragement of innovation and a culture of enterprise and self-employment.  Encouraging not-for-profit bodies is essential to the development of bodies with social objectives operating outside the constraints of the public sector. These issues are critical for proportionality; inappropriately heavy handed regulation will be economically and socially damaging.

RSM undertakes client reviews to ascertain the quality of the audit service it provides. The reviews are conducted on the largest clients (by fee income), clients who are systemically important and clients where there could be issues with the relationship e.g. a new Financial Controller. 

Reviews are conducted by a Regional Audit Managing Partner, a Business Development Manager or a Senior Partner who has had no previous relationship with the client. Generally these are done face to face with all key contacts at the client. Occasionally they take the form of telephone interviews.

The results of the individual reviews are fed back to the team. This results in an action plan to improve client service for that particular client. 

Themes coming through from the reviews are fed to the Audit Management Team so that action can be taken as necessary. 

The results of the client reviews are used to improve quality throughout the firm. The audit management team will use a variety of sources to assess the quality of our audit service including regulator reports and marketplace surveys. These are all used, along with client feedback, to create processes, procedures and training courses to improve audit quality.  

RSM UK Audit LLP has a well-developed and well-staffed Quality Assessment Department (QAD). It makes regular monthly assessments that are reported to top management and seen by the PIC. Management then makes decisions on implementation, including future practice and such action as is needed, including mentoring of the audit staff concerned and for the training of staff and partners, and their career development.

The PIC meets the Senior Partner three times a year at the time of RSM UK Audit Management Board meetings. It will also presents its key messages in writing to the partners and will meet with the RIs each quarter.  

The PIC will publish its own annual report in the RSM transparency report, taking responsibility for its style and content.  This will include both its observation and judgement on the behaviour of management and on any specific work undertaken by the committee during the year.

Conclusions

Five main conclusions are drawn from this analysis:

  1. Audit has a crucial, but limited, role to play in furthering the public interest in a market economy. Auditors should be competent and well-trained; but the key responsibility for the scale and coverage of an audit should rest with the audited firm.  Regulation of audit should be proportional. 
  2. Government regulation should encourage the supply of audit, both positively, by commending good audit practice, and negatively, by refraining from putting onerous burdens on audit or failing to recognize the limitations of the role of audit in a vibrant market economy subject to open global trade. The FRC should examine the costs of their recommendations before imposing any new obligations on audit activity.
  3. Considerations of judgement and proportionality are crucial: i) to coming to an audit judgement: ii) in assessing its quality, iii) in considering its importance to the wider economy and: iv) in assessing the public interest.
  4. Standards of auditing may requires outside inspection; but such inspection must be proportionate to the firm audited and its situation in the global economy. Audit firms as well as their regulators and professional bodies have a role to play in defining the public interest - and in meeting it by developing and improving audit quality.
  5. RSM operates systems for maintaining and enhancing audit quality and has strengthened these arrangements by the formation of a Public Interest Committee.

For more information contact Tom McMorrow or Roger Alexander