Auditing Principles and Practices

• BUS165 - Assurance is the course title
• Richard Poole is the instructor
• Richard Poole has a BSc (Hons) in Accounting & Finance/FC CA
• Week 1 started on January 27th

Role of an Auditor

• The role is to audit an organisation

What is an audit

• An audit is a systematic and independent examination of an organization's records
• This includes books, accounts, statutory records, documents, and vouchers
• The purpose is to ascertain how far the financial statements and non-financial disclosures present a true and fair view of the concern

Statutory Audits

• All UK companies must have a statutory audit unless they meet 2 of the following 3 conditions
• Turnover doesn't exceed £10.2m
• Balance Sheet total doesn't exceed £5.2m
• Number of employees doesn't exceed 50

Statutory Auditor Responsibilities

• Form an independent opinion on the truth and fairness of the financial statements
• Confirm financials have been properly prepared per the Companies Act 2006
• Confirm the Director's report is consistent with the financial statements

Importance of Audit Report

• Investors, employees, the government, suppliers, customers, and the general public depend on financials
• People need to be able to rely on the information contained in the financial statements

BHS Collapse

• BHS collapsed in 2016

BHS Pension Scheme

• BHS had a pension deficit of £571m following the stock market crash in 2008
• Half of its pension scheme assets were invested in shares
• This deficit needed larger contributions into the scheme, spread over 10-15 years

BHS Properties

• In December 2001, BHS sold 12 stores to Carmen Properties Limited for £105.9m
• BHS then rented them back for about £12m a year from the Jersey-based company owned by Sir Phillip Green
• These rents were above market rates

BHS Dividends

• Sir Phillip Green and his family received £414m in dividends from BHS over four years
• That was £118m more than its pre-tax profits
• The payment wiped out £147.7m of reserves held in BHS

BHS New Ownership

• BHS was sold to Retail Acquisitions a year before it went into administration
• Dominic Chappell, the new owner, had twice declared bankruptcy
• Dominic Chappell was an ex racing driver with no retail experience

BHS Competitive Advantage

• Retail experts believed BHS had fallen behind its competitors
• The number of clothing shoppers and its share of clothing sales on the High Street were falling
• Neil Saunders of Conlumino states BHS had become something of an irrelevance

BHS Auditors

• PwC/senior audit partner Steve Denison signed off on a clean audit report days before the BHS collapse
• Steve Denison claimed the business would continue as a going concern
• BHS posted net assets of over £3m
• Loss of £69m would shrink to £30m following a projected 6.7% growth in sales

Financial Reporting Council's Report on BHS

• The audit had 114 hours of chargeable time
• Just 9 hours were done by a senior manager, and 2 hours by the audit partner
• Everyone else had less than 4 years of experience
• The audit fee was £355,000 (£2,300 per hour)
• The same audit partner charged £2.9m for non-audit services
• Sales were not audited
• Large parts of the cost of sales were not audited
• Going concern was not audited
• The auditor performing the work didn't know about the sale from Sir Philip Green to Dominic Chapell

Why did BHS fail?

• BHS couldn't pay wages or creditors
• BHS couldn't secure emergency funding
• BHS could not secure a business buyer, despite 30 expressions of interest

BHS Consequences

• PwC was fined £6.5m (less than 1% of its profit)
• Steve Denison was fined £355,000 and banned from auditing for 15 years
• There was a loss of 11,000 jobs
• There was a £571m pension deficit for workers

Key Syllabus Areas

• Audit framework and regulation
• Planning and risk assessment
• Internal Control
• Audit evidence
• Review and reporting

Carillion

• Carillion was the 2nd largest construction company in the UK
• Carillion employed 43,000 staff globally, around half these in the UK
• KPMG gave the company a clean audit opinion just 3 months before it failed
• Financial statements and annual report stated positive figures

Carillion Financial Statements

• Carillion reported revenue of £5.2bn, up 14% year on year
• Operating profit before tax was £172m
• Operating profit margin of 4.95% was slightly below the target of 5.3%
• Net borrowings were £218m
• Order book of £4.8bn

Carillion Liquidity

• Chairman Phillip Green said the Group continues to have substantial liquidity
• £1.5 billion of funding was available
• Chief Executive Richard Howson stated “Net borrowing remains well within the £1.5 billion of funding available to the Group"
• Financial Director, Zafar Khan states the Group had a strong funding position
• £1.4 billion of funding was available at the year end

Carillion Going Concern

• Financial Director Zafar Khan said The Directors confirmed the Company and the Group had adequate resources
• The Directors said the Group was able to continue in operational existence and there were no material uncertainties in relation to going concern of which they were aware
• For the above reasons, the directors confirmed that the Group adopted the going concern basis in preparing the financial statements

Carillion - Contract risk

• Chairman Richard Howson states winning high-quality contracts would improve the risk profile of the contract portfolio

Carillion - Risk Management

• The annual reports states the Group has maintained its comprehensive approach to contract management
• The reports said there has been no change in the nature of contracts being delivered by the Group"

What Went Wrong at Carillion?

• Carillion racked up £1.5bn of debts
• Banks and the government were unwilling to bail them out
• They wrote down the value of contracts by over £1bn and had ~£600m pension deficit
• Specific failing projects included:
• The £350m Midland Metropolitan Hospital in Sandwell, hit with delays
• The £335m Royal Liverpool Hospital, cited for delays and reports of cracks
• The £745m Aberdeen bypass, cited for potential environmental pollution
• An unfinished £5.5 billion development in Doha, Qatar, hit a £200m dispute for unpaid work

Why were the Carillion Issues Concealed?

• Independent directors put their pay first
• The chairman, Richard Howson, was earning £1.5m a year (including bonuses)
• Richard Howson was visiting Qatar ~10 times annually to chase up the money

How could the auditors have missed these issues?

• KPMG received £29m in audit fees
• MP Peter Kyle characterized the audits as a colossal waste of time/money
• MP Peter Kyle stated he would not trust KPMG
• The auditors were too willing to accept what they were being told by management
• The auditors did not challenge management's overly aggressive/optimistic treatment of long-term contracts

Fate of the Carillion Team

• Peter Meehan, the KPMG Carillion Audit Partner, was fined £250,000
• Peter Meehan was banned from auditing for 10 years

Fate of KPMG

• In September 2021, the U.K. Financial Reporting Council (FRC) issued a disciplinary formal complaint against KPMG
• The complaint cited KPMG for allegedly providing "false and misleading” information during inspections into the firm's audit of Carillion
• In July 2022, KPMG were fined £14m

Key Syllabus Areas

• Audit framework and regulation
• Planning and risk assessment
• Internal Control
• Audit evidence
• Review and reporting

Assurance Assignment

• An assurance engagement has a practitioner who expresses a conclusion
• Aims to enhance the degree of confidence of the intended users
• Intended users are those other than the responsible party
• Conclusion is about the outcome of the evaluation/measurement of a subject matter against criteria
• Key elements include:
• 3rd party involvement
• Subject matter
• Suitable criteria
• Sufficient appropriate evidence
• Written assurance report

Assurance Assignment Example

• Buying a house is an example
• Practitioner = Surveyor
• Intended user = Buyer
• Responsible party = Seller
• Subject matter = House
• Suitable criteria = Buildings regulations/Best practice
• Sufficient evidence = Physical inspection
• Written assurance report = Surveyors report

Levels of Assurance

• Limited Assurance:

• Moderate/Low levels of assurance

• Conclusion is expressed negatively

  • Example: "Nothing has come to our attention which causes us to believe these assumptions do not provide a reasonable basis for....."

• Reasonable Assurance:

• High but not absolute assurance

• Opinion expressed positively

• Audit of the Financial statements

  • Example: "In our opinion the financial statements give a true and fair view"

Reasonable assurance vs limited assurance:

• Reasonable assurance involves more regulations / standards
• Includes more thorough procedures
• Requires higher quality evidence

External Audit

• A common type of assurance engagement
• It is the audit of a company's financial statements
• Audits are governed in the UK by:
• Companies Act 2006
• International Standards on Auditing (ISAs).

ISA 200 Overall objectives of an independent auditor:

• Obtain reasonable assurance financial statements are free from material misstatement
• Express an opinion on whether the financial statements are prepared per financial reporting framework
• Report audit findings

Why do we have an audit?

• Shareholders are often not involved in the day-to day running of the business
• Management needs to give an account of their stewardship
• Directors prepare the accounts, and the accounts themselves have to be prepared so there are no incentives to manipulate financial statements
• Auditors provide an external verification

Auditor Requirements

• To comply the auditor must:
• Comply with relevant ethical requirements
• Plan and perform the audit with professional skepticism
• Exercise professional judgement
• Obtain audit evidence that is sufficient and appropriate to base their opinion

Professional Scepticism

• Includes a questioning mind
• Includes being alert to conditions that may indicate possible misstatement (due to error/fraud) and a critical assessment of audit evidence

Professional Judgement:

• Is the application of relevant training, knowledge and experience
• The skill is in making informed decisions

Benefits of an Audit

• Higher quality information giving investors confidence
• Independent Scrutiny
• Reduced risk of management bias, fraud and error
• Enhances credibility of those financials for all stakeholders
• Highlights deficiencies in the internal control system

Limitations of an Audit

• Financial statements include subjective estimates and judgement
• Internal controls may be relied upon by the auditors
• Representations from management are not always reliable Evidence is conclusive
• Do not test all transactions, only samples

Explore auditing roles, statutory audit requirements, and the significance of audit reports. Examine the BHS collapse, pension scheme deficits, and lessons learned regarding financial practices. Also, consider the Carillion case and failures in financial reporting.