Audits Improve, but Must Adapt to Evolving Investor Needs
Practice Lead, Financial Accounting
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“The state of audit quality is very strong,” says Julie Bell Lindsay, Executive Director of the Center for Audit Quality (CAQ).
Quantitative data seems to support her view.
The CAQ’s annual main street investor survey in 2019 showed 83% of respondents saw public company auditors as effective in their investor protection goal, up from 81% in 2018. Additionally, public company financial restatements slipped to an 18-year low in 2018.
However, those metrics only reveal a slice of the much larger story. Investors are making decisions with information that lives outside of the audited financial statements, including non-GAAP and sustainability metrics. “I think it’s undeniable that when public companies report their earnings, that’s what moves the market. It’s not waiting for the Q or the K to come out. The markets are moving on the earnings release and the analyst presentation,” says Lindsay.
Ultimately, as Russell Golden stated in an interview with Bloomberg Tax at the AICPA Conference in December, “non-GAAP metrics are derived from GAAP information.” The foundation for commonly used non-GAAP measures, such as EBITDA and EBIT, are calculated using the high-quality, audited GAAP numbers. With equal prominence, there are counter-measures against non-GAAP reporting materially misleading investors regarding company performance. Other demand driven information doesn’t have the same luxury.
Nearly 95% of the millennial population is interested in sustainable investing, 85% of the general population feels the same way, according to a 2019 study by Morgan Stanley. More than half of the general population, including over two thirds of millennials, have adopted sustainable investing, according to the study.
Companies continue to produce higher levels of sustainability reporting as a result of that demand, widely known as Environmental, Social, and Governance (ESG) disclosures, but those disclosures and reports aren’t audited and according to PCAOB Chairman William Duhnke, sustainability is one of the areas “outside of our purview.”
“I’ve certainly heard the same thing from the PCAOB,” says the CAQ’s Lindsay. “Quite frankly, I’ve heard the same thing from the SEC. This type of expanding the role of the auditor from a regulatory perspective is not on their agenda. I get that. We get that. But you can’t stop what’s happening in the market.”
[Q&A with CAQ Executive Director Julie Bell Lindsay. Learn more.]
While earlier versions of accounting regulatory boards could dismiss the link between environmental, social, and governance concerns, and the financial performance of an organization, it’s going to be increasingly difficult for the boards to continue to do so. Over 85% of investors, according to the 2019 Morgan Stanley study, either strongly or somewhat believe ESG practices can potentially lead to higher profitability and better long-term investments.
Absent a uniform regulatory approach, companies have improvised their ESG reporting by commissioning accounting, and even engineering firms to provide assurance on individual components of their sustainability reports and disclosures.
“From our perspective here at the CAQ, is that really a solution that you want” asks Lindsay, where you have “engineering firms that don’t have the same standards and are not subject to the same regulation as the audit firms are with the PCAOB? That’s the question that we think should absolutely be considered.”
Lindsay still believes there is a role for auditors to play in the dissemination of sustainability information from companies to stakeholders. “It’s unquestionable that investors are asking for this information and they are getting the information, maybe not according to one standard like they would like. But you have to start looking at the reliability of that information.” Who is going to be “providing assurance on that information from a trust perspective?”
The evolution of the audit function would encourage us to believe that it could indeed play a central role in the transition of how the public values companies, financially and by other metrics. Technological advances, such as robotic process automation (RPA) have allowed firms to audit entire populations of data, instead of simply sampling individual transactions and deriving conclusions. Drones have permitted auditors to validate and prove the existence of property, plant, and equipment in remote areas of the world. It’s no wonder that financial restatements continue to fall with audit quality rising.
That evolution; however, will have to permeate more than the air and the web; it will have to fundamentally change how auditors view their role, moving beyond the core financial statements. If they don’t, investors and companies will transition without them.
The new class of information demands full participation or none at all. It can’t just be audited.