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The big problems

01 November 2018 by John Stittle

The big problems

The Big Four auditors are coming under increasing amounts of scrutiny over financial reporting standards

It’s probably an understatement to highlight that statutory auditors are not having the best of times. Try as they might, the leading firms of auditors just can’t escape the continual torrent of bad news. The last decade has witnessed unrelenting criticism aimed at the auditing profession from the FRC, PRA, politicians, the government and, this autumn, the FCA chairman waded in to give auditors yet another kicking. Just how have these accounting firms who act as the audit watchdogs of company financial statements ended up being so unpopular?

Industry domination

The financial statements of listed companies (and many other large companies) are required to be externally audited every year. The FTSE 350 index clearly illustrates the tight grip that the leading international auditing firms have over many companies. Within this FTSE 350 index, between them, PwC, KPMG, E & Y and Deloitte sign off 98% of the financial statements of these companies. Indeed, after the collapse of Andersens – following their involvement in the Enron debacle – the audit market for large companies largely contracted to a choice from only these remaining ‘Big Four.’ 

This small group of large auditors claim that their size means they have the capacity, experience, technical expertise and resources to audit large and major multinational corporations. The prestige and perceived status of having ‘a Big Four’ signature on an audit report continues to be the major attraction. The lower tier of medium sized auditors find it all but impossible to compete with the elite Big Four auditors and have little more than a token presence in the large company audit market.

Quality control

However, over the last few years, the audit profession has come under increasing attack from all directions. In particular, politicians are becoming concerned that the failure of the Big Four auditors to sound the alarm bells about the financial stability of some leading companies’ financial statements. Industry and commercial regulators question whether some of these Big Four firms are always maintaining the highest standards of quality control; there is some evidence of poor adherence to auditing and financial reporting standards.

The Big Four are also often attacked for having a too close audit working relationship with their clients – which may have developed over many years. This relationship is sometimes believed to have the potential to compromise audit objectivity and tarnish independent judgement. Indeed, auditors may be perceived as being hesitant about raising accounting and auditing concerns if this later threatens the loss of additional and more lucrative consultancy work from the same client. Audit fees only represent around a quarter of the total fee income received by a Big Four auditor – so the additional fee income from consultancy forms a major part of their own business model.

“The EU have already attempted to bring more competition by audit rotation into the audit market”

More recently, auditors have been implicated in the failure of a number of high-profile companies. For example, in January this year, the construction contractor Carillion collapsed with questions being asked at to why the auditors failed to raise any concerns in their audit report. Indeed, a subsequent parliamentary inquiry was scathing about Carillion’s financial statements audited by KPMG. In another high-profile case involving the collapse of high street retailer BHS, it was reported that the senior PwC auditor who signed off the BHS financial statements, back-dated his audit opinion and spent just two hours working on reviewing the audit file.

Government intervention

For several years, the Big Four have operated under the lurking threat of a referral to the CMA. So, these auditors were not surprised this September by government intervention which might lead to their break-up. The Business Secretary, Greg Clark has now instructed the CMA to carry out a detailed review of the UK audit industry that will investigate competition in the audit market and any conflicts of interests.

In addition, the government and politicians for many years have been dismayed by the lack of intervention by the FRC, the audit regulator, to rigorously investigate and discipline a number of large auditing firms for alleged auditing failures. Under a possible threat to their own existence, the FRC has now begun to exercise its powers more vigorously in response to claims of being too slow, docile and complacent over the years, but the FRC has only sprang into action after its own role and future was put under the spotlight by the government. The FRC has recently became more determined to ensure auditing firms are more vigilant in enforcing auditing and accounting regulations.

Unfortunately, it is now probably too late. After disillusionment with the FRC’s lacklustre behaviour, the government has asked Sir John Kingman to conduct a ‘root and branch’ evaluation of the FRC’s governance, impact and powers. 

Meanwhile, against this background, the FRC has fought back and issued a particularly damning critical report. In its review of the audit quality of the Big Four, the regulator belatedly warned that these auditors ‘must improve the quality of their audits and do so quickly.’ Stephen Haddrill, CEO of the FRC, put auditors on notice: they must ‘address urgently’ issues such as their ‘level of challenge and scepticism’ particularly with areas such as auditing banks, group accounts and pension balances. 

Requirements and restrictions

The EU have already attempted to bring more competition by audit rotation into the audit market. Listed (and many other large) companies are now required to place their statutory audit work out to tender at least once every decade. They are also required to switch auditing firms every 20 years.

In addition, auditors of public interest companies now face further restrictions on the amount of fee income charged for non-audit services such as consultancy or tax advice, but politicians and regulators are now also questioning whether these regulations are strict enough.

On the 10th anniversary of the start of the global banking crisis, another market regulator has recently echoed a number of the FRC and politicians’ concerns about the Big Four.

Charles Randell, Chairman of the FCA highlighted that ‘most’ of the financial institutions in the US and UK that failed (in the banking crisis) were reporting ‘robust financial positions right up to the point when they did fail.’ Not only did these organisations fail but also their ‘financial statements had been signed-off by their boards and large audit firms.’

Likewise, Sam Woods, CEO of the Prudential Regulatory Authority has also highlighted his worries about audit quality – especially for banks.

Other critics of the Big Four suggest that auditors should solely concentrate on auditing and be totally prohibited from engaging in any form of additional consultancy and advisory services. The mid-tier firm, Grant Thornton believe that auditors’ independence would be enhanced and possible conflicts of interest avoided if auditors were appointed directly to companies by an independent and specially created public authority or by some form of a public audit commission.

However, time is now short for the FRC and the Big Four to satisfactorily reform. The government’s patience with both the FRC and the Big Four is exhausted. Greg Clarke is looking for recommendations from Kingman and the CMA urgently. Both the FRC and the Big Four may soon find themselves facing a very different future and both parties only have themselves to blame for being so unpopular. 

John Stittle is senior lecturer at University of Essex

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