Reaching Key Financial Reporting Decisions

How Directors and Auditors Interact

Stella Fearnley, Vivien Beattie, Tony Hines

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781119973751
• Edition: 1
• Topic: Business
• Subtopic: Auditing
• Index: Business

The regulatory framework for financial reporting, auditing and governance has changed radically in recent years, as a result of problems identified from the Enron scandal and more recently from the drive to implement global standards. In a key regulatory change, a company audit committee is now expected to play a significant role in agreeing the contents of the financial statements and overseeing the activities of the auditors. Finance Directors, Audit Committee Chairs and Audit Engagement Partners are required to discuss and negotiate financial reporting and auditing issues, a significant process leading to the agreement of the published numbers and disclosures, and to the issuing of the auditor's report which accompanies them, but which is entirely unobservable by third parties.

Reaching Key Financial Reporting Decisions: How Directors and Auditors Interact is a fascinating, behind-the-scenes examination of this closed process. The authors draw on the results of face to face interviews, and an extensive survey of finance directors, audit committee chairs and audit partners, and present nine company case studies highlighting the process of discussion and negotiation and the methods by which the agreed financial reporting outcome was reached. Detailed analysis of the case studies:

• Allows those involved in the process to benchmark their behaviours against those of others
• Enables a comparison between the previous and current regulatory environments to see what has changed, and sheds light on the sorts of behaviours the current regulatory framework encourages
• Evaluates the effectiveness of the changed regulatory regime, providing evidence relevant to current policy debates concerning the value of audit, IFRS and the relative merit of rules-based versus principles-based accounting standards in relation to professional judgement and compliance

The unprecedented access and unique insights offered by this book make it invaluable for audit firm staff and partners, audit committee chairs and company directors involved in agreeing the published financial statements, as well as those who have an interest in the financial statements, but do not have access to the negotiation process.

Part I

The Background

1

Introduction and Background

1.1 WHAT THIS BOOK IS ABOUT

This book offers important and unique insights into how the largely unobservable financial reporting and auditing process in UK listed companies actually works in the current UK regulatory environment, which has undergone significant change in the last eight years. It explores how finance directors (i.e. Chief Financial Officers (CFOs)), Audit Committee Chairs (ACCs) and Audit Engagement Partners (AEPs) interact with each other to reach agreement on key financial reporting issues as the financial statements are finalized. It also examines how the new regulatory regime is being implemented, by exploring corporate governance practices relating to financial reporting and auditing issues — part of the context within which these interactions take place. The governance practices mainly relate to the role of the audit committee and the audit committee chair.

By means of a wide ranging questionnaire survey and nine company case studies, we identify and analyse the interaction process involving these three principal parties in (a) discussing and negotiating financial reporting issues and (b) reaching the agreed financial reporting outcome of each interaction that took place. We also explore the key influences on the interaction outcomes. Key findings and conclusions are briefly summarized at the end of this chapter. The survey and company case studies were carried out in the UK in 2007/8. The changes to the UK's financial reporting, auditing and corporate governance regulatory frameworks were introduced in the UK in 2003/4 by the UK government (CGAA, 2003) after the collapse in 2002 of the US company Enron and the audit firm Andersen and the passing of the US Sarbanes-Oxley Act (SOX) (2002).

1.2 RECENT REGULATORY CHANGES

The UK-initiated post-Enron reforms include:

• The setting up of a new body, the Audit Inspection Unit (AIU), under the aegis of an expanded and reformed Financial Reporting Council (FRC),1 to inspect public interest audits and issue public reports on their findings.
• Changes to the UK Corporate Governance Code (previously known as the Combined Code for Corporate Governance)2 now require audit committees to engage with the audit and financial reporting process in a more formalized way (FRC, 2005)
• Change to the operations of the Financial Reporting Review Panel (FRRP),3 the UK's financial reporting enforcement body, from reactively responding to complaints and concerns about companies’ accounts to a pro-active role of systematically reviewing public interest company accounts and other outputs.
• Transferring the Auditing Practices Board (APB), the UK auditing standard setting body, to the FRC and giving it the additional responsibility for setting auditors’ ethical standards. The APB then adopted International Standards on Auditing (ISAs) amended for use in the UK (APB, 2004a) for 2005 year ends. These are based on ISAs set by the International Auditing and Assurance Standards Board (IAASB) and include ISA 260 (APB, 2004b) which requires the auditor to engage with the client's audit committee on audit and accounting related matters. The APB also issued a suite of Ethical Standards (ES) (APB, 2004c) which restrict the supply of non-audit services (APB, 2004c, ES 5) and require audit engagement partners to rotate off listed company audit every five years (APB, 2004c, ES 3).

There was also a major change at European level. A European Union (EU) Regulation (2002) required EU listed companies to adopt International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB), for their group accounts for December 2005 year-ends onwards. A major influence on the IASB standard-setting process has been the planned convergence of IASB standards with those of the US Financial Accounting Standards Board (FASB), (FASB and IASB, 2006). This convergence process commenced in 2002. The change to IFRS and the convergence plans have been subject to much criticism with concerns about convergence, the complexity of accounts prepared under IFRS (FRC, 2008a), the accounting model itself, particularly the fair value or mark-to-market principle, convergence with US GAAP and the rules-based nature of the standards (Fearnley and Sunder, 2007; Page and Whittington, 2007; Isaac, 2009, Beattie, Fearnley and Hines, 2009a).

1.3 CONTRIBUTION OF THIS BOOK IN THE 2010/2011 REGULATORY ENVIRONMENT

The insights from this book will be useful for policy makers in the development of the UK regulatory framework. The global financial crisis that hit in 20084 is the latest economic event to raise intense interest globally in financial reporting and auditing quality and further changes to the framework are under consideration. In its report on the banking crisis which sparked this global financial crisis, the UK Treasury Committee (2009) expressed concerns about the role of audit (based on the bank audits with 2007 year-ends). They concluded that audit was in danger of being ‘lost in a sea of detail and regulatory disclosures’ and identified this as a possible unintended consequence of the changed regulatory regime. The Committee also questioned the value of audit. In June 2010 the UK Financial Services Authority (FSA) and Financial Reporting Council (FRC) issued a joint discussion paper suggesting that auditors should be more sceptical and challenge management more (FSA and FRC, 2010). This was followed by an APB (2010a) discussion paper on the same topic. The Future of Banking Commission (Which?, 2010) has questioned the erosion of judgement in favour of a rules-based approach in the UK and calls for a restatement in law of the ‘true and fair view’ principle.

At the EU level, a green paper on the role of auditors has been published (EC, 2010). The objective of this green paper is to initiate a debate on the role and governance of auditors. The commissioner responsible, Michel Barnier, said ‘While the role of the main economic and financial actors (banks, hedge funds, credit rating agencies etc.) were immediately called into question following the financial crisis, the role of the auditors has not really been questioned until now’. Interest in financial reporting quality has, however, been ongoing for many years. This book will provide insights into a vital process which is normally inaccessible to all but its participants.

This book is a successor to Behind Closed Doors: What Company Audit is Really About by Beattie, Fearnley and Brandt, which was published in 2001 by Palgrave (Beattie, Fearnley and Brandt, 2001). Behind Closed Doors explored, for the first time, how finance directors and audit partners of UK listed companies interacted with each other in agreeing the contents of the company's financial statements. The analysis was based on six matched interviews with company finance directors and their audit partners. The authors were called in 2002 to give evidence based on the book to the Treasury Select Committee on the Financial Regulation of Public Limited Companies. The researchers received the prestigious Deloitte/American Accounting Association Wildman Medal in 2007 for the book. The Wildman Medal is awarded for research which is judged to have made the most significant contribution to the advancement of the practice of accounting. The researchers were the first non-US research team to receive this award.

A key change for financial reporting and audit quality since Behind Closed Doors was published is the enhanced engagement of the company's audit committee, particularly the audit committee chair, with the auditing and financial reporting process. Our main reason for writing a new book in this area is that our research results reveal that the process for reaching agreement on financial reporting outcomes has changed significantly under the revised UK framework. In a book we can offer readers both an analysis of behaviour in the recent pre-financial crisis environment and compare it to the previous research, thus providing insights into the impact of the changed environment. Given the ongoing pressures for further changes emanating from the current economic climate, this will be highly topical and policy-relevant.

1.4 RESEARCH APPROACH

The book reports on two unique datasets, using a mixed methods research design (Creswell, 2009). First, we report on the results of the 2007 survey of finance directors, audit committee chairs and audit partners of UK listed companies. The survey asked which financial reporting issues the three parties had discussed and negotiated. It also asked about the functioning of the audit committee and sought views on the effectiveness of the UK regulatory framework relating to audit quality. An exceptionally high response rate for surveys to these groups of 36% was achieved, making the results authoritative. This large-scale survey allows the extent, nature and outcome of interactions to be assessed for the population as a whole. A summary of the findings from this stage is presented in Chapter 3.

The major part of the book consists of nine company case studies where the researchers conducted face to face interviews with CFOs, ACCs and AEPs of companies with different attributes including size, industry sector and ownership structure. The researchers’ reputation enabled them to obtain unprecedented access, hold frank and open discussions with the interviewees and record all the interviews verbatim. The interviews explored the financial reporting and auditing interactions which had taken place and how each party perceived his or her role in the resolution of the issue. The analysis of individual case studies and the cross-case analysis will provide the only publicly available evidence of how financial reporting outcomes are achieved in the recent UK regulatory environment. The comparative analysis in Behind Closed Doors offers a unique opportunity to review the differences between two regulatory environments. This will enable the researchers to draw valuable conclusions about the overall impact of the recent changes (1996–2007) on the quality of financial reporting and auditing in the UK and the implications for public policy going forward.

Although the cases relate to a particular point in time, and hence a specific economic and regulatory environment, some of the issues that emerge, such as inventory valuation, are shown to be generic and insensitive to the passage of time, while others, such as financial instruments and intangibles, are a product of the prevailing regulatory setting.

1.5 OUTLINE OF BOOK

This book has been organized in three parts, as follows.

Part I comprises Chapters 1–3. Chapter 1 provides an introduction and background to the accounting regulatory framework in the UK. Chapter 2 reviews the relevant academic literature relating to the auditor–client relationship. Specific areas covered are: regulation theory; IFRS; audit quality; enforcement; corporate governance and the role of the audit committee; interactions and negotiation in non-audit settings; and interactions and negotiation in audit settings, including the grounded theory model developed in Behind Closed Doors. Chapter 3 summarizes the results of the questionnaire which provided the introduction to the nine case companies. This first stage of the study shows the frequency of discussion of 35 accounting issues; the frequency of negotiation about these issues; and the frequency of resulting changes to the accounting numbers and disclosures.

Part II comprises Chapters 4–13. Chapter 4 begins by explaining how the case companies were selected and approached, and the interview techniques employed. The broad approach taken to the analysis is then set out, including a brief explanation of grounded theory and how we use it on the cases, together with details of how each case was written up. This is followed by a description of the preliminary within-case analysis, and a tabular summary of the general context and the interaction issues in each of the nine cases.

Chapters 5–13 present the findings from the interviews. These nine chapters tell the story of each case as described by the interviewees, including numerous direct quotations for seven of the cases. Each case is presented using the same structure, beginning with an overview of the background setting in which the interactions take place. This is followed by the interviewees’ perceptions of the corporate governance structures and processes relating to financial reporting and auditing which are in place within the case company. The third main section introduces the key interaction issues to emerge before each is considered in depth. The process of interaction and resolution for each issue, seen from the perspective of each party, is documented. The fourth section presents the within-case analysis, beginning with the key contextu...

Table of contents

• Cover
• Title Page
• Copyright
• List of Figures
• List of Tables
• Foreword
• Preface
• Acknowledgements
• Abbreviations
• Part I: The Background
• Part II: The Case Studies
• Part III: Cross-Case Analysis and Conclusions
• References
• Index