PROVISION FOR AUDIT FEES
van Wyk, Anton
confirmation of history or enhancing future performance?
Great uncertainty exists at present among many practitioners in South Africa surrounding the provision for audit fees in the annual financial statements of their clients where the audits take place after the balance sheet dates of clients. This issue should not be taken lightly as practitioners have failed recent practice reviews, performed by the South African Institute of Chartered Accountants (SAICA), for having allowed the incorrect accounting recognition of such provisions.
One could of course argue that the amount of the audit fee is certainly immaterial and that therefore it does not really matter whether the provision is recognised or not in the financial statements of the client as the accounting standards only apply to material amounts in the financial statements. One should however take into account that materiality is not only based on quantitative factors but that an account could also be considered qualitatively material, thereby being regarded material due to the nature of the account and not necessarily the amount thereof. This article supports the latter viewpoint and seeks to justify the correct accounting treatment of the item in terms of International Financial Reporting Standards (IFRSs). The question could also be asked that, if the amount is to be considered immaterial, why authorities would fail a practitioner in a practice review for getting this principle wrong?
Furthermore, it should be kept in mind that the issue dealt with here does not relate to the recognition of a liability in respect of audit work already performed before the year-end of the client, as a present obligation certainly does exist for the client to settle the amount due to the auditor for work already performed. The past obligating event of this liability would be the performance of the audit work, which obligates the client to settle the amount due. It is however unlikely that this present obligation would be recognised as a provision anyway, as the uncertainty regarding the amount or timing of the settlement of the obligation would be sorted out there and then by the auditor. Such an obligation would therefore be a current liability (e.g. a payable).
Two very definite trains of thought exist regarding the recognition of a provision for the audit fee where such an audit is performed post-balance sheet. This article will consider each of these, focusing on the principles supporting them. In general, the first opinion is that the provision for audit fees should be recognised already at balance sheet date of the client despite the fact that the audit has not as yet been physically performed at that date. The other opinion is that there is no present obligation due to a past obligating event as at the date of the financial year-end of the client, should the audit not have been physically performed by that date. Hence in terms of this second opinion no provision for the audit fee is recognised in the annual financial statements of the client at balance sheet date.
Commencing the debate one should look at the literature and standards that have been supplied by the International Accounting Standards Board (IASB) in respect of liabilities and provisions and in terms thereof consult the Framework for the preparation and presentation of financial statements as well as IAS 37 Provisions, contingent liabilities and contingent assets.
Starting off with the conceptual framework, to which all practitioners are supposed to turn in their hour of need (i.e. when specific guidance on a transaction or account is not available in the form of an accounting standard), an element is recognised in the financial statements if it meets the definition of that element as well as both the criteria for recognition. The conceptual framework defines a liability as “a present obligation arising from a past event leading to an outflow of future economic benefits from the enterprise”. In order to be recognised, the inflows or outflows resulting from that element must be probable (i.e. more likely than not) to occur as well as having a cost or value that can be measured with reliability.
IAS 37 Provisions, contingent liabilities and contingent assets in turn defines a provision as a liability of uncertain timing or amount. It is therefore a liability (as defined in the conceptual framework) but with a difference. The liability has some degree of uncertainty attached to its amount (i.e. how much) or the timing (i.e. when) of the settlement of the obligation. Our general approach in solving this problem will therefore be:
1. Justifying or discrediting the liability in terms of the conceptual framework.
2. If the liability is found justifiable in terms of the conceptual framework, classify the liability in terms of IAS 37 Provisions, contingent liabilities and contingent assets.
Opinion 1 : The provision for the audit fee of a client should be recognised at balance sheet date.
Supporters of this opinion feel that a legal present obligation in respect of the audit fee exists already at the balance sheet date. In South Africa, it is a statutory requirement in terms of the Companies Act that all companies be audited annually by an independent registered auditor. This would therefore suggest that the requirement of being audited is of a mandatory and statutory nature, which would make the present obligation a legal one.
In terms of IAS 37 Provisions, contingent liabilities and contingent assets the past event is the event that results in the company becoming legally or constructively committed (obligated) to settling an obligation in the future. In terms of this opinion, the past obligating event (i.e. the past obligation-creating event) is the fact that the company traded during the past year, which obligates the company to be audited. The legal present obligation therefore arises due to the fact that the company has traded in the past financial year. It is especially in respect of this point that the supporters of the second opinion disagree.
A present obligation (either legal or constructive) arises when an entity has no realistic alternative but to settle the obligation. A very valuable argument that is considered by supporters of this opinion is the possible avoidance of the obligation. IAS 37.19 states that only those obligations that exist independently from the future actions of the enterprise may be recognised as provisions. This means that when the company can avoid an obligation by doing (or not doing) something in future, that company is not yet presently obligated, as the obligation is then dependent on the future actions of the company. It is therefore vital to prove that the company cannot avoid an obligation by future action when establishing whether that company is presently obligated.
This would entail even going to the extreme of considering whether the company would be able to avoid the liability in the event of liquidating the enterprise (which is of course a hypothetical scenario enabling us to decide on present obligation only, and has nothing to do with the actual intention of the company). It is therefore evident that the company would not be able to avoid being audited even by liquidating its assets and liabilities and winding up the operations, the latter of course representing a liquidation, an “audit” of which takes place under the control of the Master of the Supreme Court.
Then, in terms of this opinion, the company therefore has a present obligation (no realistic alternative but to settle) of a legal nature, which is further enhanced by the fact that the company draws up financial statements on the going concern basis, assuming that the company is not considering liquidation in the foreseeable future (but even if it was, it would still be obligated as mentioned above).
Furthermore, IAS 37.15 states that situations where it cannot be decided whether the enterprise has a present obligation are highly unlikely to occur. When it is not clear whether there is a present obligation, it is assumed that a present obligation does exist if, taking account of all available and objective evidence, it is more likely than not (i.e. probable) that a present obligation exists. This statement in the standard effectively closes the back door for arguing that it cannot be determined whether a present obligation exists or not.
The last component of the definition of a liability is of course the outflow of benefits that are expected in terms of the liability.
This would entail proving that benefits will have to flow out of the enterprise when the obligation is settled (i.e. ensuring that it is not a fictitious amount that the company is providing for profit-smoothing purposes). Also this requirement is met as the auditor would eventually have to be paid for having performed the audit.
In terms of the first opinion, the definition of a liability therefore appears to have been met.
Regarding the recognition criteria, the company would have to assess how probable it is that the company will undergo an audit after the balance sheet date. With current legislation (Companies Act) it appears that the company would ‘more likely than not’ be audited on an ongoing basis as authorities such as the South African Revenue Services (SARS), financial institutions and other providers of capital (e.g. shareholders) would require the going concern to be audited as they place significant reliance on the audited financial statements in this respect. It is therefore probable that benefits will flow out in the future upon the settling of the obligation.
Regarding the reliable measurement of the amount of such a provision, IAS 37 Provisions, contingent liabilities and contingent assets requires the amount to be reliably measurable or, in the presence of uncertainty, at least be reliably estimable. It is just natural to assume that some uncertainty will surround the amount of a provision already when looking at the definition of a provision, being ‘a liability of uncertain timing or amount’.
It therefore appears that both recognition criteria would be satisfied under this opinion and that the provision would be recognised at the best estimate of the present value of the amount required to settle the obligation. The recognition would take place at balance sheet date despite the audit only commencing thereafter.
Followers of this opinion could also ‘philosophically’ justify the recognition of such a provision for audit fees in terms of the matching concept, a concept no longer forming the core focus of accounting standards (due to the existence of the ‘balance sheet bias’ in accounting), but still being a very important test of whether expenses have been appropriately matched to revenue in the income statement in the correct period. It could be argued that benefits arise due to the fact that the company has silently agreed on an ‘estoppel’ basis to subject itself to the annual audit and that the cost of such an audit, should therefore be matched to these benefits by expensing it in the year in which the obligation to be audited arises.
An audit certainly retrospectively ‘vouches’ or verifies that things are what they seem in the financial statements. Many practitioners could disagree on this point by saying that an audit would lead to future economic benefits for the company. But, realistically speaking, when last did the consumer undertake to acquire his or her weekly groceries only from a company that has an unqualified audit report? It therefore appears that the cost of the audit is appropriately matched to the benefits recognised in the financial statements by expensing it in the income statement in the year in which it is incurred. The question should be asked how the prior year’s audit fee would appear in the current year’s income statement – would it be relevant at all?
Another strong argument supporting this opinion is of course the raising of provisions for decommissioning of assets and environmental rehabilitation. These provisions for the settlement of these costs are widely accepted by the profession and recognised in many a balance sheet across the country. Is there however a difference between such a provision and a provision for an audit fee where the audit takes place after the balance sheet date? One would have to compare.
From the above it is evident that there are many similarities between these two classes of provisions. This certainly does add weight to the first opinion as to the justifiability of the provision for audit fees.
Lastly, it is important to remember that the ultimate goal of a set of financial statements is to provide decision-useful information to the user thereof, which is among other things achieved by means of fair presentation (incorporating faithful representation) in the development and design of all accounting treatments. Would fair presentation be achieved by not recognising the provision for the audit fee in the annual financial statements of the company purely because the audit activities have not yet physically commenced? This is a case of the much feared professional judgment having to be applied. Supporters of the first opinion certainly feel that fair presentation can only be achieved when the provision for the audit fee is recognised in the financial statements of the company at balance sheet date. This would provide much needed information to the user of the financial statements as to the true financial position of the company. We know the company must be audited and realistically speaking the company is a going concern. So where is the audit fee? It is sometimes necessary to take a step back and decide whether what we are doing in financial statements makes sense!
Opinion 2: The provision for the audit fee of a client should not be recognised at balance sheet date
Followers of this approach are mainly of the opinion that the provision for audit fees relating to the year-end audit of an entity should not be recognised at balance sheet date where such audit work is only performed after the end of the year.
This viewpoint rests on the fact that there is no past obligating event leading to a present obligation, which would warrant such a provision being recognised in the financial statements of an entity at its year-end. The main argument here is based on the fact that no physical audit work has been done by year-end. This would mean that the physical audit work performed by the auditors would be seen as the actual past obligating event that would lead to the company having a present obligation at year-end and not the statutory requirement for companies to be audited, as per the first opinion discussed earlier. Taking into account that such audit work is most often performed after the end of the year, there is therefore no present obligation at year-end.
It is however important to consider a few aspects of this approach very carefully.
The provision for the rehabilitation of the environment or the decommissioning of assets is an acceptable provision in the financial statements of an entity (as discussed earlier in this article). This provision is justifiable in terms of IAS 37 Provisions, contingent liabilities and contingent assets. In such a provision, it should be taken into account that none of the activities [i.e. the physical rehabilitation of the environment (e.g. clean-up/restoration) or the decommissioning (removal) of the asset], the costs of which are provided for, have physically taken place by year-end, and the entities responsible for physically performing these activities may very well also not have been determined, which is very similar to the fact that the audit activities have not as yet been physically performed by year-end.
Once again, consideration should be given to IAS 37.19, which states that only those obligations that exist independently from the future actions of the enterprise may be recognised as provisions. This independent test should therefore be performed by asking: “Can the audit fee be avoided?”
It is clear from the above that the audit fee for a company, whose financial statements are based on the going concern principle, cannot be avoided and that the company is therefore already liable (obliged) at the end of the year for the audit fee.
Another very important point to consider is that of a constructive obligation. The abovementioned arguments have so far discounted the existence of a present legal obligation due to the fact that the physical audit work, leading to the actual payment, has not yet been performed. Present obligations are, however, either legal or constructive in nature. IAS 37.10 defines a constructive obligation as “…an obligation that derives from an entity’s actions where:
* by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
* as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.”
Surely when applying the above theoretical guidance from IAS 37 Provisions, contingent liabilities and contingent assets one could argue that, even in the absence of a legal present obligation, a constructive obligation could exist in respect of the audit fee. Through past practices (i.e. having been audited, having settled the audit fee) it can be realistically accepted that this practice will continue in the foreseeable future – and what better indicator of intention than past actions? Yet another critical point that could weaken this opinion.
When looking at the matter purely from a presentation viewpoint, one would have to consider whether not recognising the audit fee enhances the concept of fair presentation in financial statements, which is certainly the overall objective thereof? It once again comes down to whether the audit merely confirms history or enhances future performance of the company – this would determine where the audit fee expense would appear more appropriate – in the income statement of the current year or that of the past year?
Considering all the arguments, viewpoints and opinions in this article, it would appear that the issue is still very much conceptually undecided, yet very rigidly applied in practice without a sound conceptually justifiable basis. It is therefore important that the issue be debated and decided upon, for we cannot let the surrounding uncertainty be swept under the comfortable carpet of ‘immateriality’.
International Accounting Standards Board (IASB). 2006. IAS 37 – Provisions, contingent liabilities and contingent assets.
Anton van Wyk BCom (Ace), MA, CA(SA)1 lectures on the BCom (Hon)/CTA program in Accounting at the University of Johannesburg.
Anton van Wyk is a senior lecturer in the Department of Accountancy at the University of Johannesburg. He completed his articles at one of the big four firms in Johannesburg. Anton holds a Masters Degree in Financial Management and lectures on the BCom (Honours)/CTA program in Accounting at the University of Johannesburg. He is also a regular speaker at both national and International conferences. This month he writes on the provision for audit fees.
Copyright South African Institute of Chartered Accountants Aug 2007
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