August 13, 2024 Judgement and risk
Effectively running an organisation requires day to day decision making, using judgement and risk awareness to create strong outcomes. However, because they are so intrinsically involved in the running of their business, there is a danger that directors could find themselves too close to the problem or relying on risk assumptions which are no longer valid.
That is where auditor involvement can be so helpful; providing an outside viewpoint which may help directors to question assumptions or re-evaluate risks. However, sometimes those audits are not as rigorous as they might otherwise be, potentially leaving companies to continue to trade with a higher level of risk than might otherwise be the case.
In certain circumstances the Financial Reporting Council (FRC) steps in to review past audits; sometimes with a view to holding individuals or audit firms to account, but also to identify and share common audit failings. At the end of July 2024 the FRC published its Annual Enforcement Review. And although the review is aimed at auditors, by highlighting common failings its conclusions can also speak to companies.
One prominent company failure highlighted in the review, London Capital & Finance plc (LCF), was audited by three different firms. A number of audit failings were identified by the FRC, including the fact that inadequate investigations were carried out in respect of a single loan debtor which comprised the majority of the assets of the company.
Whilst the LCF model was fairly specific to its industry sector, the need to identify and be realistic about the valuation of assets and likely recovery of debts is one which all directors can relate to. For example, whilst due diligence may have been carried out on key customers at the start of the relationship, relying on that initial assessment several years down the line may leave companies exposed even to the extent of impairing a going concern assessment.
This ties in with another criticism, the way in which long term contracts are accounted for. In various instances either forecast cost savings or increases in business as a result of long-term contracts proved not to be realistic. The need for long term contracts to be regularly re-evaluated and existing assumptions questioned cannot be overemphasised in order to avoid mission creep.
One of the most common failures found by the FRC was a lack of professional scepticism on the part of auditors. This resulted in a “failure to challenge, or document the challenge to, management’s accounting treatment, key judgements or methodology.” Whilst rigorous challenges by auditors can be extremely beneficial to companies, such challenges to assumptions should already be taking place in the boardroom on a regular basis. This will help to ensure that directors are delivering strong governance, thereby enabling the company to remain dynamic in the light of changes in internal and external forces.
