FRC doubts over audit quality: Should you worry about your covenant assessment?
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With audit quality found to be lacklustre in some cases, what does this mean for pension schemes? What role do audited accounts play in covenant assessments?
The pensions world has so far refrained from commenting on likely reforms of the audit sector, including a new regulator, following high profile scandals – despite pensions having played a prominent role in the demise of companies like BHS and Carillion.
What role do audited accounts play in covenant assessments?
Many trustees – though by no means all – rely on covenant assessments when considering their parent company’s ability to continue funding the scheme.
For Richard Farr, managing director at covenant advisory Lincoln Pensions, audited accounts are no more than a hygiene factor in scrutinising covenant.
“If you haven’t got a report, that’s a massive red flag, but if you have one it doesn’t mean anything,” he observes.
He says audited accounts contain historic information rather than being forward-looking like covenant reviews. They have some forward-looking elements, which the Financial Reporting Council has indicated might be strengthened, but at the moment, audits are no more than a tick box for covenant assessments, certainly for pension funds, according to Farr.
“If you want a case study of why audit reports are irrelevant to covenant assessment, look at Carillion,” he notes. The outsourcer had been signed off as a going concern in its annual accounts to the end of 2016, before being liquidated in January last year.
Farr says none of the three key aspects of covenant assessment – the actual prospects of the company, the scheme’s position if the company became insolvent, and its powers to enforce its debt – rely on audited accounts.
“There is a recognition that the audit world needs to change,” says Nick Gibson, a director in Lincoln and former auditor, although he does not think that auditors have to spot every single thing that might be wrong in accounts but determine whether accounts are fair and reasonable.
He agrees that a covenant adviser challenges a company’s management in a different way to an auditor, being more focused on scrutinising the forecast as well as on longer-term risks. Such focus on downside risk has not always been well received by company managers, but Gibson says over the past few years, managers’ attitude has changed.
TP funding level in company accounts
Lincoln is calling for inclusion of schemes’ funding levels on technical provisions, buyout and PPF basis. Additionally, Farr says a dependency or self-sufficiency basis would be welcome, as would best estimate and a LIBOR-based discount rate assumption to assess the cost of using liability-driven investment.
But not everyone in the pensions world agrees. Zahir Fazal, a director at trustee firm Bestrustees and Fellow of the Institute of Chartered Accountants, would not like to see TP funding levels in company accounts as they are calculated on many different bases, going against the principle that accounts should be comparable.
“I do believe there is a case to be made that s75 liabilities could be disclosed in the accounts... and there would be some comparability,” says Fazal, but “technical provisions I am not in favour of, because that is then making some statement in a public set of documents about a subjective view of the covenant”.
Why are pension funds silent on audit reform?
The role of audits in covenant reviews is key, but audits also have a broader impact on pension funds, says Peter McDonald, an independent trustee at PMC Pension Trustees. He names the pricing of illiquid funds by auditors and audits of pension funds themselves.
These different contact points mean trustees should in theory be interested in the quality and processes of audits – raising the question why pension funds have so far kept quiet in the debate around audit reform.
“There are multiple points of concern for trustees about the effectiveness of the audit process, and it is surprising there is not more of an industry voice with [the] FRC and new regulator on this,” he adds.
