19 December 2018 by Peter Swabey
The aftermath of recent corporate financial failures has led many to question the audit process
There was a time when audit was seen as a quiet professional backwater – when auditors were seen as people who found accountancy too interesting – but that is no longer the case. Indeed, in many ways the audit profession has a higher profile than ever before. Unfortunately, that is not for comfortable reasons. Whether it be Tesco, BHS, Carillion or Patisserie Valerie, to name but a few, there have been plenty of corporate financial failures in recent years; and in each of these the cry has gone up ‘where were the auditors?’ or ‘how did the auditor allow this to happen?’
Announcing the Business, Energy and Industrial Strategy Select Committee review of the sector on 12 November, Committee chair Rachel Reeves commented that ‘Misleading audits have been at the heart of corporate failures over recent decades. Recent accounting scandals at BHS, Carillion, and at Patisserie Valerie have shown accounts bearing closer resemblance to works of fiction than an accurate reflection of the true financial performance of the business. Repeated accounting failures have contributed to the collapse of major businesses and undermined public and investor confidence. The audit market is broken.’ She went on to refer to the ‘concocting of accounts that fooled the markets yet satisfied the auditors.’
The profession and, indeed, the wider sector, has consequently come under enormous scrutiny, with the performance of the regulator, the Financial Reporting Council; of the market, with its dominance by the ‘Big Four’; and of individual auditors, even individual audit partners, coming under challenge. Heads must roll – and in this case it could begin at the top as the role and performance of the regulator itself is under challenge through the independent review led for the Government by Sir John Kingman to which ICSA responded in August.
At the same time, the Competition and Markets Authority (CMA) is ‘carrying out a market study into the statutory audit market, to see if the market is working as well as it should.’ I can’t help thinking that if the result of this study is to say that it is, the CMA will be sent away to think again. ICSA’s response to the invitation to commit focussed on governance rather than accounting issues, the principal of which were as follows.
We told the CMA that a review of the audit market is important, but should be focussed not only on what audit is supposed to achieve and how well it does so, but also on the difference between what audit is supposed to achieve and the press and public expectation of audit and of auditors. Who are the stakeholders of a statutory audit and what is its purpose?
The invitation to comment captures this issue quite well in its analysis of the ‘expectation gap.’ That is, that ‘Stakeholders’ expectations of statutory audit may differ from what it is required to provide by law. Sources of this gap may include expectations some stakeholders have of auditors in providing assurance on the business’s future viability.’
As we noted in our response to Sir John Kingman’s review, ‘There is an important education issue here – the political, press and public expectation of the role of audit is very different from what an auditor would perceive it to be. Whether this education should be undertaken by the FRC, perhaps through the Auditing Practices Board and funded by an increased levy on audit firms, which we believe to be the better solution or by the accountancy profession itself is a matter for them. Equally, whether the law or regulation should be changed to bring those two views into line is a matter for the government and/or the FRC.’
A number of the ‘accounting scandals’ that we have seen in recent years have at their heart, questions of judgement. It may be a naïve hope, but it seems to me that whether particular value could, or should, be regarded as crystallised in the accounts should be a question of fact rather than of opinion – either it is yours or it isn’t. As the ICSA response goes on to say, ‘It should not be possible for one accountant to draw up the books for a period and have them audited against current accounting standards and for another to perform the same exercise, for the same period, have it audited by a different auditor and find many millions of pounds difference. We cannot recall a single occasion when such a restatement has enured to the benefit of shareholders. In our view, a detailed examination of the appropriateness of the use of fair value accounting would be an extremely useful first step in improving the quality of audit.’
The appointment (and replacement) of the auditor is, together with ensuring the independence of the auditor, among the key responsibilities of the audit committee of the board. There is, however, a perception in some quarters that the role of the auditor equates to membership of a cosy club which will not be challenged. Indeed, the CMA invitation to comment asserted that ‘Audit is a service for shareholders, but is commissioned by company management.’ In our experience, this is not the case: the audit committee of most larger corporates consists of independent non-executive directors who have been appointed by shareholders to address this ‘principal-agent problem.’
The CMA invitation to comment looked, as you would expect, at competition in the audit market and, especially between the ‘Big Four’ and other firms. It refers to ‘the unwillingness of larger corporates to appoint the mid-tier auditors’ and goes on to state that ‘the majority of audit committee chairs for FTSE 350 companies would not consider a mid-tier firm to be a credible auditor for the scale and complexity of their businesses. In particular, for FTSE 350, or other large companies, with significant international operations, there is a perception that only the Big Four have sufficiently developed international networks to service such accounts.’
“Repeated accounting failures have contributed to the collapse of major businesses and undermined public and investor confidence”
This is important but, we believe, unfair insofar as it places responsibility on larger corporates alone. In our view, the chief weakness of the audit market is the lack of confidence, not just on the part of companies, but also on the part of investors and, we understand, some regulators, in the ability of auditors outside the Big Four to provide an audit of an adequate standard for large, particularly multi-national, companies.
In some cases, this perception may be unfounded but in others, especially more complex international companies, there is some evidence to suggest that only the very largest audit firms have the range to carry out an audit of an appropriate standard. We suggested that ‘the accuracy of this perception should be tested by an independent body and the CMA may be well placed to undertake this task. If it can be shown that mid-tier firms are up to auditing the very largest companies then we believe that companies, investors and regulators will welcome them with open arms.
If, on the other hand, it is shown that they are not, alternative solutions will be necessary.’ There is no certainty that the next tier of audit firms would be willing to make the necessary investment to encourage the development of the confidence in their ability to provide an effective audit for larger corporates that is so conspicuously lacking at present. Even if they were, would this be the perception?
This is probably one of the most important issues affecting the competitiveness of the audit market. Following the intervention of the Competition Commission, it seems that larger corporates have been more willing to consider a mid-tier firm as part of the audit tender process but, as Grant Thornton have publicly stated, no more willing to actually move to one. The attitudes of their shareholders and regulators inevitably play a part in this reluctance and there is much truth in the aphorism that ‘no-one was ever fired for hiring IBM.’
In theory, then, a company can choose any of the Big Four or any mid-tier firm that is up to the job. In practice, in some cases, we are told that there is little or no practical choice when those Big Four firms which are otherwise conflicted, whether through consultancy work or prior relationship with executive or non-executive directors, and those mid-tier firms that do not have the capability have been ruled out. This problem is exacerbated where a larger corporate with multi-national interests is concerned where even one of the Big Four may lack the necessary scope. We have been told of at least one case where two of the Big Four provided significant consultancy services for a FTSE company, leaving them with, potentially, a choice of one auditor other than the incumbent who they perceived able to do the work.
Much commentary seems to focus on the need to break up the dominance of the ‘Big Four’ as if that will be some sort of panacea. In our view, the fundamental requirement is to improve the quality of the work done by the appointed auditor. Part of this, is a training issue to foster a greater spirit of professional scepticism among auditors, moving beyond what Lord Denning described as ‘an enquiring mind’ but also revisiting accounting standards to give greater clarity on where judgement has been applied by both the preparer and auditor.
The invitation to comment proposed a number of ‘solutions’ to the problem of audit quality, but we were sceptical as to their effectiveness. For example, one proposal is to separate the audit from the non-audit practices of audit firms. There is a considerable body of evidence that in many cases non-audit services are more remunerative than audit services, particularly as we rightly see greater restrictions on the former. But the natural tendency within firms will, therefore, be for the ‘brightest and best’ to move towards the better remunerated consultancy roles and leave the basic audit work to others.
We do not see how this will serve to improve the standards of auditing. We have heard some anecdotal evidence that partners in other areas of practice within Big Four firms are becoming irked by damage to the brand associated with the exposure of deficient audits and the need for them to defend audit scandals when they are pitching for business. Internal pressure of this kind brings a commercial imperative for audit firms to improve their own quality and this will be lost if the businesses are separated.
The concept of joint audit has been suggested, notably by those who have a commercial interest in this model, but we have seen no independent evidence that joint audit is effective and are concerned that it will inevitably increase costs for companies, both financially and in terms of management time, and create confusion. What will be the position if the joint-auditors disagree about a particular treatment?
The questions of who are the stakeholders of a statutory audit and what is its purpose are fundamental to a review of the statutory audit market. The law is clear that directors owe duties primarily to shareholders, albeit with an obligation to ‘have regard’ to stakeholders amongst other factors. This suggests that the primary purpose of the statutory audit should be to give assurance to investors. However, as the invitation to comment notes, ‘Stakeholders’ expectations of statutory audit may differ from what it is required to provide by law.’ It seems to us that there is an increasing focus on a company’s obligations to its stakeholders and, to that extent, that auditors should have some accountability towards them. But is it reasonable to expect auditors to shoulder the burden of responsibility for the future performance of an audited organisation as the press, public and politicians sometimes seem to expect? Unless and until the directors’ duties under the Companies Act are changed, we would suggest not. It seems to us that the increased focus on the responsibility of the audit committee for ensuring the quality of the audit received and more proactive enforcement by the regulator in the event that audits are found to be sub-standard will be more effective.