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AFM inspections highlight need for fundamental improvement of audits

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The quality of audits must fundamentally improve, according to the AFM, following its inspections of the quality of audits and of quality control monitoring at the four largest audit firms in the Netherlands: Deloitte, Ernst &Young, KPMG and PricewaterhouseCoopers (the Big 4 firms). The inspections show that audits conducted by several Big 4 firms fell short in various business sectors. The AFM already concluded in December 2009 that audits in the financial sector required improvement. Now it has become evident that the work carried out by auditors in the construction/real estate, automotive and public sector also requires improvement. The AFM has concluded that a fundamental change of conduct is necessary to improve the quality of audits.

Several Big 4 firms will have to carry out a comprehensive analysis of the causes of the identified deficiencies and take appropriate action based on its outcome.

Inspections
In 2009 and 2010, the AFM carried out regular inspections of audits of 2008 financial statements of companies and institutions in sectors particularly impacted by the crisis, including the financial, construction/real estate and automotive sector. The audits reviewed by the AFM were conducted by the Big 4 firms, which have a total market share of about 80 percent in terms of revenue from statutory audits conducted in the Netherlands.

As part of its regular inspections, the AFM also focused on quality control monitoring at the Big 4 firms, including engagement quality control reviews, internal quality reviews and the compliance function. Internal quality control monitoring is designed to safeguard the quality of audits, both before and after issuance of an audit opinion. In addition to its regular inspections, the AFM investigated a number of incidents.

The AFM has established that quality has been given a higher priority by the Big 4 firms compared with the outcome of previous inspections. Awareness has clearly increased, as has the readiness to take action to improve quality. Partly as a result of the AFM’s supervision, progress has been made in these areas.

At the same time, the AFM’s review findings have highlighted systemic deficiencies in the quality of audits of more than one Big 4 firm. The deficiencies were not restricted to audits in the financial sector; they also occurred in the construction/real estate, automotive and public sector (municipalities and housing corporations). The AFM published the results of its earlier credit crisis inspections in December 2009, revealing that the quality of audits in the financial sector required improvement. The recent inspections show that the deficiencies are more widespread and systemic.

Principal conclusions
The key deficiencies identified at several Big 4 firms were as follows:

- External auditors failing to exercise sufficient and appropriate professional scepticism in the conduct of their audits. If audits are not conducted with professional scepticism, there is a risk of material errors in the financial statements going undetected and of incorrectly issuing an unqualified audit opinion. In the case of such uncertainties in an audit, there is insufficient
assurance that the financial statements are free from material misstatement.

- External auditors failing to apply, or apply sufficiently, auditing standards in too many cases. The AFM identified relevant weaknesses in 29 of the 46 audits reviewed in the context of its regular inspections. The most important findings related to insufficient and inappropriate audit evidence due to, among other things:

  • performing insufficient audit procedures to verify the existence and valuation of financial assets, work in progress, vehicles and property in the balance sheet;
  • performing insufficient procedures to assess whether there are indications of fraud or other non-compliance with laws and regulations;
  • performing insufficient procedures required when reliance is placed upon work carried out by another auditor, an internal audit department or expert;
  • performing insufficient procedures to assess whether the client’s going concern assumption is valid;
  • performing insufficient procedures to ascertain the completeness of revenue.

- Quality control monitoring at several Big 4 firms falling short in certain respects, resulting in situations where there were insufficient safeguards to ensure that audit opinions issued or to be issued were correct and sufficiently and appropriately supported.

- Audit firms accepting audit quality falling short within their own organisation, and failed to take appropriate action against infringements of laws and regulations by their staff. As a consequence, audit firms failed to adequately fulfil their duty of care regarding the quality of audits.

- Insufficient involvement of and direction by the external auditor in the conduct of the audit by the team.

The degree to which these deficiencies occurred varied both per Big 4 firm and per audit. There were therefore differences in audit quality across the audit firms reviewed.

At several Big 4 firms, the ‘tone-at-the-top’ and its impact on the firm’s behaviour regarding quality could be improved. The senior executives at the audit firm, the audit firm’s policymakers and co-policymakers and the external auditors in charge of audit teams set an important example in this respect. They will have to take the lead in order to bring about the necessary change in behaviour at the audit firms. In this context, the AFM notes that the supervisory boards and audit committees of audit clients can also make a contribution to improving audit quality. For example, they can draw attention to the quality of the audit by asking their own auditor for the AFM’s inspection findings or by initiating a discussion on issues raised. The AFM is not allowed to share its findings with audit clients due to its duty of confidentiality.

Following the AFM’s inspection reports, several Big 4 firms have now taken or announced measures. The AFM will monitor whether these intended measures are actually implemented.

The AFM intends to take formal enforcement measures against one or more Big 4 firms. Formal enforcement measures may include an instruction, an order for incremental penalty payments or an administrative penalty. Imposing a formal enforcement measure involves a certain amount of time. In addition, its findings have prompted the AFM to submit one or more disciplinary complaints to the Disciplinary Court for Auditors against one or more external auditors employed or previously employed by one or more of the Big 4 firms inspected.

In the second half of 2010 and in 2011, the AFM will carry out inspections at the Big 4 firms focusing on financial incentives and their impact on the quality of audits. The AFM will focus in particular on compliance with independence rules and policies regarding appraisals, remuneration, appointments and sanctions at the firms. The AFM expects to publish its inspection findings in 2011.

The ‘Report on general findings regarding audit quality and quality control monitoring’ can be downloaded in PDF format by using the adjacent button.

This is an English translation of the original Dutch text, furnished for convenience only. In case of any conflict between this translation and the original Dutch text, the latter shall prevail.

The AFM is committed to promoting fair and transparent financial markets.

As an independent market conduct authority, we contribute to a sustainable financial system and prosperity in the Netherlands.

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