What is the point of an audit?

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KPMG is in the news again for the competency of its audit standards over the collapse of Carillion. KPMG has previously been criticised over its audit of HBOS, Co-op and Rolls Royce. Arthur Anderson collapsed after its audit of Enron.

There are clearly issues around auditing standards but let’s be absolutely clear on one thing. It is the responsibility of company directors to ensure the accuracy and relevance of the published financial statements of their companies and to give an informed opinion of the future prospects of the business. For too long directors have hidden behind the role of auditors and sought to gloss over the short comings of their businesses. Directors who exaggerate the strength of their businesses in the Directors Report whilst being in possession of management forecasts which should fully show the future risks the business faces should be the ones that incur the ire of shareholders and not the auditors who will never be fully informed of all aspects of the business. It is entirely the responsibility of the directors to keep informed their shareholders and other stakeholders of the sustainability of the business and what actions they intend to take to maintain the business and its profitability. An audit shows a degree of compliance within the law of the preparation of the company financial statements. It contains an outsiders opinion on the short term sustainability of the business based on the numbers prepared by the Directors and the comments and opinions of those Directors. Beyond that the audit does not claim much else. If shareholders wish to elevate auditors to watch dogs then big changes would be needed.

Firstly, auditors would need to be independent of the company. Currently businesses appoint auditors and pay their fees. Much as Credit Ratings agents were paid by those seeking to get a rating this conflict of interest gives rise to a risk that auditors will err on the side of Directors opinion when it comes to explanations of the accounting data. Would the state take over the cost of company audits? Would companies need to be charged an audit levy to cover the cost? Who would set the price of audit services for each company?

Secondly, auditors would need to be safe from prosecution by companies where an audit opinion is given which damages the audited shareholder value of a company. Since business failure risk can never be 100% certain auditors would be required to give some subjective view of a company’s future potential performance. In nearly all cases this view would be wrong due to circumstances changing with time. An opinion given in January would almost certainly have changed by March if not sooner. Only company Directors and managers can fully be aware of the day to day changes in a Company’s fortunes. Many complete basket cases are rescued by either private or state intervention and it would be impossible for an auditor to comment with any certainty on the likelihood of such a future event or any other crystal ball type occurrence. How for example would an auditor rate the possibility of banks continuing or not continuing to support a business.

Audit opinion would become a major factor in market valuations which could cause big falls in share prices based on unsubstantiated views and those shareholders would be even more irate at the inadequacy of audit opinion then they are now.

It is clear even on just these two factors that it is almost impossible to create a foolproof audit system which captures the potential for business failure within the audit process. It is possible to criticise an audit opinion as being of limited value in evaluating the viability of a business. This criticism is perfectly valid and less emphasis should be paid to audit opinion. Auditors are not watchdogs and cannot be held responsible for not spotting failure any more than racing tipsters can be held responsible for not picking winners.

My view is that shareholders only ever consider the Audit Report when a business fails and largely ignore it up until that point. Shareholders put their faith in the statements of management and Directors when it comes to investment decisions and it is the management and Directors who should take responsibility when businesses fail.

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Politics is about story and narrative not economics

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Many believe that economics and the economy in general lead the political agenda. Economists have developed ever more complex mathematical theories in order to “prove” how society works and benefits from progress. Policy is formed from these economic insights.

But that is not how it works. Political parties have a set narrative and then seek justification for that narrative as a support to the story they want to tell. The story leads and facts and theories are sought to justify the policy narrative.

In the 80’s both Margaret Thatcher and Ronald Reagan had a narrative based around small government and individualism. Little matter that the size of government grew substantially over the period the story that the electorate wanted to believe was the one projected. To support the policy academics such as Hayek, Milton Friedman and the Chicago School of economics were pressed into service to give the narrative some gravitas but their theories followed the dynamic of the storyline offered by the politicians. There were many opposing economic theories to the monetarism of the day which could have supported a counter narrative. In many respect the political narrative came from an intuitive belief held by the chief protagonists. It was a gut view not one supported by hard evidence.

More recently Donald Trump gained success based on a narrative reasserting former national greatness and the resurrection of rust belt industries aimed at reinvigorating working class fortunes. The story is enhanced by a form a scapegoating of foreigners as being the source for the decline in working class fortunes whether that is Mexican immigration or a story of Chinese manipulation of world trade to the detriment of the US. There is no factual basis for these assertions but that does not matter. What matters is that the narrative is believable to those to whom it is aimed at. Trump has not sort to justify his position with any intellectual rigour or economic theory. His Presidency relies solely on his story narrative.

In the UK too we have Brexit. The leave campaign told a narrative that appealed to a large portion of the electorate. This narrative was one, like Trump’s, based on a story of former greatness now lost due to the unwelcome embrace of foreign powers taking away the sovereignty of the nation. As humans we are more susceptible to a story narrative than something based around numbers. The remain campaign lead with dry numbers and economic data in an attempt to show that economically leaving would be a mistake. But this was a mistake. We are a species of story tellers not mathematicians. There can be little doubt that on balance leaving will be economically detrimental but for voters that didn’t matter. What mattered was the affirmation of national pride and the promotion of a golden future free from foreign interference. The fact that the world does not work in this way did not matter. The narrative of the story was something the voter wanted to believe in irrespective of any counter narrative based on purported facts or economic numbers. The leave campaign found it easy to bat away these facts as “project fear” a narrative easily understood by voters who supported the central story of lost national power and lost cultural identity caused by immigration.

The way forward for politicians is clear. Have a strong spoken narrative for your policies otherwise voters will not connect with the message however strong the academic evidence backing it up.

For economics too the need to project a strong narrative outweighs the cleverness of the mathematical proposition. Only when economists grasp the fact that their discipline is only useful if people understand the story will it become truly relevant to our society.