For decades, audited financial statements have been accepted by investors and other external stakeholders as the primary window into a company’s financial performance and position. In addition to being a critical indicator of financial health, financial statements provide guidance for financial investors and influence capital allocation decisions across both public and private capital markets around the world. Auditors perform analytical and transactional level testing to gain comfort over a company’s reported balance sheet and income statements and assure that the financial reports are free from material misstatement and compliant with accounting standards. However, in recent years, doubts have been raised about the usefulness and material correctness of such audited financial statements to both private and public investors.

The matter has particularly been brought to fore with the very public default and distress of China’s real estate sector. The role of auditing firms is increasingly under scrutiny, with one firm facing a six-month suspension and hefty fines from the Chinese regulators for its role as auditor of one of the largest defaulted real estate developers. These repercussions have been one of the toughest penalties imposed on a Big Four accounting firm in China. Prior to this, in March 2023, another of the Big Four’s local China arm was fined RMB 211.9 million (US$31 million) and had its Beijing branch operations suspended for three months due to audit deficiencies in its work for one of the largest state-owned asset management companies. These fines are an outcome of the rigorous checks by the Chinese government’s Ministry of Finance, given financial distress in the real estate sector and its systemic impact on the overall economy.

In May 2023, the Public Company Accounting Oversight Board (“PCAOB”)[1], in an audit inspection report, found multiple audit deficiencies in the audit work of the local Chinese affiliates of two of the Big Four accounting firms[2]. The PCAOB inspects accounting firms whose audit clients are traded on national exchanges in the US, and therefore regulated by the SEC. For one of the firms, the worrying issue was the potential non-compliance with the role of an independent auditor. There were multiple instances in two audits where some of the audited company’s personnel had financial relationships with the audit firm, extending further than an investment. Continuing its review, in November 2023 the PCOAB announced for the first time several punitive enforcement actions against China-based registered auditing firms and their personnel. Enforcement actions included: 

• Penalties of US$7 million issued against the affiliates of two global audit firms for violating PCAOB quality control standards related to integrity and personnel management:

  • The first for a Shanghai-based affiliate (US$3 million fine)

  • The second for a Hong Kong-based affiliate (US$4 million fine).

• A financial sanction of US$940,000 on a mainland-based registered public accounting firm and four of its associated staff. The violations included issuing a false audit report for a company which provided data analysis software for companies and government agencies in China.

The PCAOB stated that the sanctions represented the highest penalties (cumulatively US$7.94 million in total fines) it had ever imposed against firms in China and Hong Kong, or even globally. This review was made possible after the passage of the Holding Foreign Companies Accountable Act, which threatened a trading ban on the Chinese audit clients that trade publicly on US exchanges.

The malaise is not just limited to China

India, another investor favourite, has also witnessed similar episodes where auditors’ roles have been questioned. In March 2024, the Institute of Chartered Accountants of India (“ICAI”), found gross negligence by the individual auditors of Byju’s[3] and recommended the Financial Reporting Review Board (“FRRB”) take punitive actions on the auditors concerned. The ICAI also mentioned that it was planning to review the role of auditors for the payments major Paytm[4]. Other major audit lapses highlighted by the regulators include:

• The National Financial Reporting Authority (“NFRA)[5] took action in April 2024 against a local audit firm (Pathak and Associates) for major lapses as the joint auditor for Reliance Capital, formerly an Anil Ambani group company.

• In 2019, the Reserve Bank of India (“RBI”) banned an Indian affiliate of one of the global audit firms from conducting audits for one year. Many of the large financial institutions in India, such as HDFC Bank Ltd., IndusInd Bank Ltd., and Kotak Mahindra Bank Ltd., had to change auditors due to the above sanction by the RBI.

• In 2018-19, the default of the Infrastructure Leasing & Financial Services (“IL&FS”)[6] resulted in the discovery of many similar audit irregularities (their auditor was another global audit firm). An investigation subsequently revealed that there were significant procedural lapses and that nobody foresaw the problem, whether it was statutory auditors, independent directors or credit rating agencies.

This is not a recent problem: in 2009 Ramalinga Raju, the sponsor of Satyam Computer Services Ltd.[7], a leading information technology company headquartered in Hyderabad, India, confessed to large-scale manipulations of financial earnings. Its audit firm (one of the Big Four) was banned from conducting audits for two years by the Securities Board of India (“SEBI”).  Multiple other cases have come to fore wherein audit lapses have been discovered when companies have defaulted, and investigations undertaken by financial regulators. 

Does this postmortem analysis of accounting lapses benefit anyone?

The critical question to be answered is whether audited financials present a ‘true and fair view’ of a company’s financial performance. Are the accounting standards applied to capture expenses valid, and is EBITDA a clear indicator of corporate performance? Can financial statements be fully relied on when making capital market or private investment decisions? Do they inspire investors with confidence to take a long-term view, confirm that operating cash flows will be sufficient to repay debt, and that capital growth is sustainable?

There has been recent criticism that financial statements are based on antiquated indicators of profitability and that assets and liabilities may fail to show the true value of an entity, providing limited decision-making criteria. The factors being:   

• Financial statements fail to capture corporate value relating to knowledge-based intangible assets or other concepts such as AI;

• Their publication is typically delayed, as opposed to analyst reports, analytical forecasts, technical/algorithm-based analysis, conference calls and corporate internet reporting, which offer more timely alternative sources of information;

• They are typically based on GAAP standards, which include irregular, non-cash or non-recurring expenses, and may not provide a true reflection of the overall financial health;  

• Increasing complexity and length, particularly in relation to note disclosures.

The book, The end of accounting and the path forward for investors and managers by Baruch Lev[8] and Feng Gu[9] published in June 2016, reinforces the above view and paints a bleak future for financial reports. Analysis undertaken by the authors highlights that ubiquitous financial reports have become useless in capital market decisions. Based on a comprehensive, large-sample empirical analysis, the book reports the continuous deterioration in relevance of financial documents to investors' decisions and lays out an actionable alternative of a Value Creation Report wherein new indicators focus on strategy and execution to identify and evaluate a company's true value-creating resources for a more up-to-date approach to critical investment decision-making.

So, what is ‘true value’ defined by?

For investors, the focus needs to be on ‘quality of earnings’ and not purely audited net income. A quality of earnings evaluates the true economic earnings of a company with the focus being on understanding the reported EBITDA and reflecting the normalised earnings of a company. It is important to note that EBITDA is not a term defined under GAAP and is therefore not specifically evaluated in an audit. The key differences between audits and independent financial analysis are:

• normalising reported earnings for various non-recurring, unusual, or one-time items, that arise from unexpected events and may colour the financial performance of the business; 

• evaluating monthly financial data, in addition to annual financial data, which may help to identify trends such as seasonality, or working capital cycles;

• understanding business drivers, identifying industry and market risks, which audits do not focus on;

• calculating net debt (total debt adjusted for cash), and short term and long-term debt repayments;

• reviewing the proposed growth plans, competition, investment needs, and identifying future capital expenditure requirements;

• calculating the free cash flows available to the firm.  

Overall, analysis should factor in other critical items such as intangibles, inter-group transactions, corporate structure (offshore vs onshore), secured and unsecured debt, and off-balance sheet liabilities such as guarantees and leases. It is critical for capital allocators to engage independent financial analysts who can standardise financial statements and validate their accuracy and integrity to make them relevant and useful for investment decision making, rather than basing their review solely on audited financial statements.

[1] The independent regulatory agency established by Congress to oversee the audits of public companies and broker dealers.

[2]  KPMG Huazhen LLP in China and PricewaterhouseCoopers in Hong Kong.

[3] The statutory auditors of Byju’s were also one of the Big 4 accounting firms. Byju’s, an Indian multinational education technology company, was a favourite of both private equity and credit investors. The company reached a peak valuation of US$22 billion in 2022, however, as of January 2024, it had a valuation ask of US$200 million and, is facing ongoing bankruptcy and insolvency proceedings from both offshore and onshore creditors.

[4] Paytm (an acronym for "pay through mobile") is an Indian multinational financial technology company, that specializes in digital payments and financial services. Paytm's parent company One97 Communications was listed on the Indian stock exchanges in November 2021 after an initial public offering, which was the largest in India at the time, and its current market cap is US$4.75 billion.

[5] NFRA is a regulatory body overseeing auditors and audit firms for listed and large companies.

[6] IL&FS was a Indian state-funded infrastructure development and finance company created by public sector banks and insurance companies. Its subsidiaries defaulted on their loan commitments in 2018 causing one of the largest financial crises in the Indian banking system and had to be rescued by the central government.

[7] The Satyam Computer Services scandal was India's largest corporate fraud until 2010. The founder and directors of India-based outsourcing company Satyam Computer Services, falsified the accounts, inflated the share price, and stole large sums from the company. On 7 January 2009, the chairman of Satyam, Byrraju Ramalinga Raju, resigned, confessing, that he had manipulated the accounts of INR  70,000 million  (US$ 834 million) in several forms. The global corporate community was said to be shocked and scandalised.

[8] Baruch Lev is the Philip Bardes Professor (Emeritus) of Accounting and Finance, at New York University Stern School of Business. He was formerly a Professor of Accounting and Finance at the University of Chicago, Tel Aviv University (where he served as Dean of the business school), and the University of California, Berkeley (where he was also a professor at the Law School).

[9] Feng Gu is the Chair, Professor of Accounting and Law, at the School of Management, University at Buffalo.