Auditor ethics on the rocks

MISREPRESENTATION: MANY CONSEQUENCES

Signing off on financial statements that overstate company’s financial position very damaging.

Auditors should be the last line of defence in detecting corporate accounting fraud, irregularities and unacceptable accounting practices. But sadly, accountants and auditors are hogging the headlines for all sorts of misdemeanours.

There are many areas of audit negligence but one of the most damaging is the signing off on financial statements that overstate the company’s position.

This includes inflating revenue, incorrectly accounting for profits from contracts, bringing future profits into the current period, not impairing intangible assets and failing to ascertain goingconcern risk where intangibles exceed tangible assets.

Overstatement of a company’s financial position can result in financial loss for those who have relied on the figures, such as shareholders and creditors. Falsely creating the impression that a company is doing well – and overstating its financial position – allows bonuses to be paid to executives and dividends to shareholders.

Goodwill, which represents the present value of future profits an acquiring company expects to earn from an acquisition, is a much-abused and overvalued asset. So, too, are the other intangibles which should represent the present value of future income streams a company expects to earn from those specific intangibles.

However, goodwill also represents the difference between the purchase price and the net assets of a business. But how correct is this if the acquirer paid more than a business is worth? Even worse, the acquirer may issue shares at an inflated value in payment for the business.

In my view, only intangibles – trademarks, copyright, patents – that have been separately purchased from an independent third party should appear on the balance sheet. Goodwill should be written off immediately.

In many acquisitive companies, the value of intangibles vastly exceeds the value of the assets. Hence, a material misstatement of these values would make a company which should fail the going concern test appear to be in good financial health.

One would therefore expect the auditor to take great care in critically assessing the value of goodwill and intangible assets, and impair the values if deemed necessary. The failure of auditors to properly appraise the value of goodwill and intangible assets has tarnished their own.

In terms of the International Code of Ethics for Professional Accountants, a professional accountant is expected to adhere to the fundamental principles of integrity, objectivity, professional competence and due care, confidentiality and professional behaviour.

To my mind, there cannot be a separation between a code of ethics for business and professional engagements, and a code of ethics to be followed in one’s own time. The recent incident when a senior lawyer dumped the body of a dead dog in the road, and the public outcry this provoked, is a good example of this.

The code places importance on threats to independence. However, it does not touch on diversity. Surely diversity is an essential tool in breaking down the clusters of “boys’ clubs”, old-school tie networks and group think? How vigilant will an auditor be in impairing the goodwill of a business in which their best buddy is CEO?