Moving toward better auditing

We noted in Chapter 2 the overriding importance of ethical reasoning and ethical reporting for auditors. The preceding sections should make clear the importance of putting professional ethics and social norms in the form of the public’s expectation of the auditor’s role at the top of the reasoning hierarchy as outlined in Chapter 2. We have reviewed various concepts and principles that can help auditors achieve these objectives and thereby encourage greater accountability of auditors and the auditees that they audit. We have assumed throughout this book that auditing and auditability criteria for general-purpose financial reporting using GAAP are important elements of modern world accountability of firms and their managers. In this way we have fleshed out more fully modern world accountability of managers of firms to the capital providers as explained in Chapter 1. If legitimate expectations of firm behavior are not met, then many investor decisions may be suboptimal and society suffers in the long run. Thus accounting standards not following auditability criteria may leave key gaps in conceptual frameworks of fair presentation (non-misleading) financial reporting.

Standard setters and regulators should be held more accountable for poor guidance that allows fraudulent or unethical financial reporting. For example, DeFond et al. (2018) provide examples of how compliance with GAAP has been used to justify scandalous reporting in the past. Perhaps more importantly, however, standard setters need to identify broader schemes of argumentation to be used, starting with the role of auditors and the need for auditability criteria for accounting standards in a conceptual framework of financial reporting. Ideally such changes should be made at a global level and tied to a global conceptual framework.

In particular, the IASB conceptual framework for financial reporting should be completed with clear indications of a hierarchy of principles such as those in 1CAS (2006) but with an auditability criterion added. Also, there should be a principle based on a more complete financial statement auditing conceptual framework with a more complete development of suitable criteria of the broadest assurance framework of CSAE 3000 and 3001 in line with deterring reporting fraud. This audit framework should be integrated within the accounting framework as an example of suitable criteria in auditing.

The importance of risks of misstatements should be further developed in both the audit and accounting frameworks. If risks are deemed not important, then standard setters should be prepared to justify such a decision. Similarly, there should be more of a risk and materiality orientation in research in order to encourage more audit-centric research that is more useful to regulators and the profession. The constraints on financial reporting of relevance and reliability should be considered by auditors and standard setters/regulators and guided by the evidence. In an effort to improve audit quality, regulators have required auditors to disclose significant risk areas in the audit report to draw financial statement users’ attention to the uncertainty faced by the company. Perhaps this is where more empirical research can be most useful in preparing auditors for the challenges of auditing 21st-century financial reporting.

In this last chapter we have attempted to identify suitable criteria for fair presentation (acceptable PMM that incorporates both AudR and AccR) vs. compliance reporting (acceptable AudR). As auditing expands to new subjects, the suitable criteria used will also need to be expanded to the new forms of assurance engagements, and perhaps similar distinctions between compliance audit and fair presentation audits will need to be made for assurance involving sustainability reporting, internal control reporting, privacy audits, and others.

In summary, auditors, standard setters, and regulators should take into better account the realistic social expectations of financial reporting and their audits; what we call fair presentation reporting. At minimum this would require that estimates used in financial statement line items should conform to the logic of commercial law to be verifiably more likely materially true than not. This suggests that maximum acceptable PMM for a line item is less than .5. If AudR is planned at, say, .05, then max acceptable AccR should be less than .50. Of course, for specific line items such as cash, much lower risk levels could be expected. The point is all point estimates reported as line items should have acceptable PMM levels. A fallback position would be to rely on implementing conservatism and/or related auditable note disclosures in developing the necessary estimates to be used in the reporting system. The key is to be transparent about the reliability of the numbers in the financial statements. This would be the key to fair presentation reporting. Standard setters, auditors, regulators, and management should be trained to aim for such a transparent system of reporting so that users know whether the financial statements are more likely true than not. Compliance reporting does not require such transparency on estimation uncertainty.

In this book we have focused on audits of financial statements, but the principles of verifiable transparencies regarding risks of estimates can be extended to other subjects besides financial statement assertions. The main difference would be the assertions that are reported and the criteria used in the evaluation of the truthfulness of the assertions. This would allow verification of the extension of the fair presentation concept to such subjects as reports on sustainability, reports on internal controls, and assertions on privacy of information, to name a few. All this would be in the public interest of improving modern world accountability on these issues, as discussed at the end of Chapter 1.