Auditing is not a sexy subject. But in recent years the auditors of our major businesses have let the public down to a staggering extent.
Let me start by restating why audits were introduced. In the 19th century, to encourage trade, businesses were allowed to become limited liability companies, meaning that the liability of the owners was limited to the investment they had made. But because they raised capital from third parties and banks they were made subject to an annual audit of their stewardship of the money invested by others. These auditors became businesses themselves but, crucially, were not allowed the protection of limited liability – they had to be personally liable if they gave a clean bill of health to a company that then failed.
Fast forward to today and the rules have changed out of all recognition. Most audits are carried out by only about 10 firms. The big 4 are the most well known, and they audit 99% of FTSE companies.
Of these companies, the number they have audited that have gone on to fail in the past ten years is staggering. RBS, HBOS, BHS, Carillion, and many more.
So why has this been allowed to happen and what should be done about it?
The reasons are complex but as they matter to all of us it’s worth examining them.
1. The concentration of power in the hands of just 4 firms has created a cartel. There is no effective competition. They all charge huge fees and their average partner earnings are in the millions. Worse, however, is that the partners now carry little or no personal risk. Incorporated as limited liability partnerships (LLPs) and with liability caps in their contracts financial ruin is no longer a risk they face as it was meant to be.
2. There is no effective regulation or sanctions when they mess up. In theory the Financial Reporting Council (FRC) investigates malpractice and can fine firms when a failure occurs, but the FRC is made up of their peers – some of whom are even ex-partners in the big 4 – and often decide that there is nothing to investigate. Even when they do sanction a firm the fines are often paltry and reduced on appeal. A single partner is usually singled out as a scapegoat (and allowed to retire with a generous pension pot) and no effective charges are brought to bear. This, by the way, ignores the fact that no one partner is ever solely responsible for an audit as all large firms have ‘second partner’ and peer review systems in place.
3. Audit firms have been allowed to take on lucrative consultancy and tax work. These contracts are often where the big 4 earn huge fees and are a direct result of the existing audit contract. Take the failure of BHS, for example, where PWC earned eight times its audit fee from consultancy work. Is the auditor going to stand up against an aggressive management, as they should, with these sorts of fees at risk? Similarly, the investigation into HBOS revealed an interesting insight into the audit process: junior audit staff had raised concerns that HBOS’s provisions against ‘bad’ loans (the problem that caused them to fail) were insufficient but these concerns weren’t even raised with management by the audit partners.
4. Auditing has moved in the last few years from being judgement to rule based. Back in the day, the primary focus of the auditor was to ensure that accounts showed a true and fair view of a business’s financial position. We were concerned about prudence above all else and not overstating the value of assets. The more recent approach has been to develop accounting rules that are often unfathomable to the layman but which are followed by today’s auditors without applying judgement to the result. I chair an audit committee which recently decided that the business should make a provision for the costs incurred on a contract that, when delivered the following year, would make a loss. Sensible and prudent accounting, but the auditors disagreed citing the rules which said such a provision was unnecessary. Bonkers. (We made the provision nonetheless).
5. Becoming a partner in a big 4 firm can be a ticket to considerable wealth. So what do these firms look for in their future partners? Sadly not good judgement, the ability to challenge management and a sound ethical basis for their decisions, as the public at large would expect. Instead those who are rewarded with a seat at the top table are those with the ability to follow the rules set by the standard setters (often the accountants themselves) and commercial skills to maximise the income they can generate from each contract.
Following the recent report by the, less than critical, FRC that 50% of audits carried out by KPMG of FTSE 350 companies required ‘more than limited improvements’, it is clear that the audit profession must be changed radically to meet the needs of those who are dependent on the companies they audit. But no one is speaking about this. Imagine if a surgeon failed to save the lives of half of his patients – he’d be struck off.
I’ll leave the last word to Professor Richard Murphy of City University:
“The Financial Reporting Council, which is itself fighting for its own survival, may be scapegoating KPMG. But it looks unlikely. There have been far too many KPMG client failures to think they are mere coincidence.
I am completely unconvinced by the Financial Reporting Council’s new zeal.
I am utterly unconvinced that PWC, EY and Deloitte are that much better than KPMG.
But I am quite sure that there is something seriously wrong with audit.
What is that something wrong? It is the fact that in essence these four firms don’t just control the profession and the whole large audit market. They also control the regulator. And they control the accounting and auditing standard setting processes so that financial statements no longer meet most user needs and the chance of suing an auditor has been reduced to the point of being negligible.
The Financial Reporting Council has been complicit in this capturing of public standards for private gain. But now, with their backs to the wall even they can’t ignore what is happening any more.
There’s something very rotten in the state of accounting, and let’s not just pretend it is KPMG’s audits, however bad they are. The problem is much deeper than that.”
It is time for reform of the audit process.