Stephen Sheen: Audits worsen as watchdog demands improvement

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The regulator’s efforts to upgrade audit is “piling up wreckage” in local government, according to Stephen Sheen.

I was presuming that I wouldn’t have to do this again. In several earlier articles, I have mourned the decline in local government audit quality. But in 2019–20, with firms under orders from the Financial Reporting Council (FRC) to improve, it looks like things are actually getting worse, and to a great extent because the firms continue to strive to meet the misplaced expectations of the FRC.

An inability to flex appropriately for the demands of local government is resulting in poor focus and over-auditing, exasperation of accounts preparers, demoralisation of junior audit staff being required to carry out work that has no value, and bewilderment of the experts that have contributed their opinions. And all with an expectation that authorities will pay for the privilege.

Can nobody sort out this disarray?

Materiality

Much of the problem has its root in materiality. There appears a great willingness to accept that auditors are experts in materiality. After all, materiality runs through every phase of their work as a core principle, from planning procedures to deciding whether the audit opinion needs to be qualified.

The fundamental point to remember though is that accountants and auditors are supposed to be working to the same practical definition of materiality set out in the Accounting Code: a misstatement, or omission, could influence decisions that users make on the basis of financial information. Authorities, knowing their (possibly hypothetical) readership, are actually better placed to judge if something is material.

Auditors, in contrast, are shackled by their firm’s methodology, which, for most, appears to take no notice of the circumstances of local government.

In the commercial sector, every pound counts equally for an investor, whether the increase is in profits or net assets. In local government, we do not have this equivalence. Some valuations on balance sheets (such as those for property, plant and equipment and pensions liabilities) do not feed into general fund balances and are not much more than just a bit of fun. They are capable of a far greater misstatement than, say, business rates income before readers of the accounts risk being misled.

An effective materiality level compliant with auditing standards would primarily be based on elements in the accounts that mean less to readers. It would then be reduced to target the components that people are most interested in, until it reaches very small figures for items such as officers’ remuneration.

But the audit firms appear to be locked into a policy of fixing materiality as a percentage of revenue expenditure, resulting in a number that is far too low for several elements on balance sheet. The result is expanded work programmes, excessive chasing of exceptions and promises of audit qualification for items that are unjustified given the definition of what is truly material.

Property, Plant and Equipment

Issues with materiality have probably had the greatest impact on the audit of property, plant and equipment (PP+E). Combined with an exhortation from the FRC that auditors should be more sceptical of valuations, the wreckage is piling up.

Whilst relative accuracy in valuations is more important for investment properties and housing revenie account assets (to the extent that depreciation charges will have a bottomline impact), PP+E figures provide broadly indicative information about the huge balance of assets under an authority’s stewardship. Consequently, the Accounting Code has been drafted to encourage authorities to do just enough and not too much in the preparation of figures for PP+E: five-yearly valuations, component accounting on an exceptional basis, that kind of thing.

Authorities will have developed accounting arrangements that take maximum due advantage of these expectations. If auditors apply an approach suitable for a commercial entity and lean too heavily on these “fit for purpose” arrangements, they are almost certain to flag up accounting failures where none exist.

Professional valuers have also been under the cosh. As there is no incentive for a valuer to inflate valuations (and no pressure from authorities for them to do so), auditors should be looking to trust valuations performed for an authority, even where valuations are in-house. Work would focus on confirming the valuers have the appropriate expertise and experience, and that the data with which they have been provided is complete, relevant and accurate. It would not be usual to question the judgements made by the valuer and signed off against the Red Book.

However, the experience of 2019–20 is that it has been easy for auditor scepticism to tip into disbelief. Valuers are being asked questions requiring them to justify what they have done, with the prospect that auditors might commission alternative valuations if they find opportunities to disagree. It is not clear what the benefit of doing this would be, as there is no reason why these valuations would be better, rather than just different. Your valuers might need to be ready to take a few uncalled-for bruises in defending their work

Going Concern

The Covid-19 pandemic appears to have increased auditors’ interest in going concern, despite it not actually having any particular relevance in local government. Going concern reporting is very specifically about ensuring that the correct accounting basis is being used, not about confirming whether an authority is running out of resources. Precisely because an authority cannot cease to be a going concern, the Accounting Code mandates the use of going concern accounting.

Still, auditors have been insistent that management assess an authority’s ability to continue as a going concern and report any material uncertainties related to events, or conditions, that may cast doubt upon this ability (as companies would be expected to do).

If you want a bit of fun with your auditors, add a statement to your accounts confirming that the authority is definitely a going concern and see how far they run in the opposite direction.

Negative Reserves

Auditors are also having problems with technical issues. Proper consideration of an authority’s judgement or interpretation is becoming a rare thing. A good example of an inability to engage with the niceties of local authority accounting is disgruntlement with the CIPFA Bulletin recommendations for education authorities with overspends against the schools budget. A negative earmarked reserve (within a general fund) for an amount carried forward as a charge against future dedicated schools grant is appropriate. There really is no argument here and it does discredit to your auditors if they think that there is.

Stephen Sheen is the managing director of Ichabod’s Industries, a consultancy providing a technical accounting support service to local authorities. He was previously the senior technical manager for local government at PricewaterhouseCoopers.

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