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Audit industry’s resistance to reform will do it no favours

Auditor silence at Patisserie Valerie, London Capital and Finance, and 3aaa continues to amplify public concerns about audit quality and regulation.

The Financial Reporting Council (FRC), the main audit regulator, has stated that around 27% of the audits carried out by major accounting firms fail to meet even its feather-duster audit quality standards. Audit failures at BHS, Carillion, Cooperative Bank and the 2007 banking crash did not persuade the audit firms or regulators to reform the audit industry; that task fell to parliamentary committees and other external parties.

Last December, the Competition and Markets Authority (CMA) published its interim proposals for improving competition, choice and audit quality. Sir John Kingman’s review recommended replacement of the ineffective FRC with another independent regulatory body. I also chaired a review of the auditing industry for the UK Labour Party. More recently, the UK House of Commons Business, Energy and Industrial Strategy (BEIS) Committee has published its report on auditing reforms. 

The BEIS report supports many of the recommendations made by the CMA, but it also diverges. For example, it calls for joint audits for the FTSE350 companies as a way of encouraging medium-size firms to enter the top end of the market. This would also reduce turbulence caused by the possible demise of a Big Four accounting firm. 

All reports attach importance to auditor independence. A common emerging position is that auditors should not be able to sell any consultancy services to audit clients; this would change the structure of the big accounting firms.

The CMA seemed to be content with an organisational split of the large audit firms, i.e. audit and non-audit parts of the business to be legally separate but could remain in common ownership. In contrast, the Labour report favoured a structural split of firms, i.e. creation of audit-only firms, with the audit and non-audit parts of businesses being owned by legally separate parties.

BEIS now adds: “We recommend that the CMA aims for a structural split, or at the very least implements its proposed operational split between audit and non-audit.”

For nearly 50 years, the auditing industry has diverted attention away from its failures by wheeling out the proverbial ‘expectations gap’ and claiming that stakeholders somehow do not understand the nature and purpose of an audit. People are chided for expecting auditors to report on financial fraud and irregularities, and whether the audit entity is a going concern.

Such a strategy was evident during the parliamentary hearings on the collapse of Carillion and the more recent BEIS inquiry into the future of audit. BEIS has not been persuaded by the industry’s self-serving strategy, and has sought to promote a meaning of audit which is closer to the public’s understanding of an audit. It recommends that the detection and reporting of fraud should be a priority within an audit, and that audits must demonstrate how potential fraud has been investigated.  

The second part of the ongoing controversy is about the auditor’s consideration of whether a business is a going concern. Such an assessment cannot be made with a consideration of a number of future scenarios focusing on a company’s forecast of profits, future cash flows, leverage and ability. The BEIS report adds: “Auditors are required to look ahead. We support work to strengthen the audit of and reporting on the going concern assumption and the viability statement.”

There are also glaring omissions in the BEIS report. For example, it does not even acknowledge that some part of audit work is offshored to entities beyond the reach of the UK regulator. There are no disclosures about the amount of work offshored and its implications for audit quality.

No one would seriously advocate that a food company must be owned by chefs or a pharmaceutical business must be controlled by pharmacists, and yet audit businesses are required to be owned by qualified auditors. This, inevitably, acts as a barrier to entry and deters external investment. The BEIS report does not examine these issues.

The Labour report argued that auditors enjoy too many liability shields, and that this reduces economic incentives for improving audit quality. This receives little attention in the BEIS report. Paradoxically, it seems to hint that more liability concessions may be granted in order to attract new players to the upper segment of the audit market. In the current climate, such a move is unlikely to materialise.

BEIS supports the Kingman recommendations for replacement of the FRC. However, it fails to take a broader perspective. For example, after the Kingman reforms, the auditing industry will still have five separate regulators. These are the successor body to the FRC plus four Recognised Supervisory Bodies (RSBs): the Association of Chartered Certified Accountants, Chartered Accountants Ireland, the Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants of Scotland.

Lack of independence from the regulated entities is considered to be a key factor for the FRC’s failures. This argument applies even more to the RSBs, which are somehow also exempt from the freedom-of-information laws. The BEIS report fails to consider the bigger picture.

The history of accounting is littered with opposition to reforms by accountancy trade associations. Unsurprisingly, the ICAEW was quick off the mark and has opposed the proposed structural split of the big accounting firms. It is also opposing the CMA proposal for joint audits.

Indeed, its history betrays a lack of thought leadership. The Labour report notes that the ICAEW opposed compulsory rotation of audit firms, disclosure of fees paid to auditors for non-audit work. In an earlier period, it opposed legislation requiring companies to publish profit and loss accounts, group and consolidated accounts, replacement costs of assets, movements on their reserves, and turnover, just to mention a few items.

All too often, reforms had to be imposed in the teeth of opposition, and the same will be necessary again, especially as a steady stream of scandals has shown audit quality to be woefully deficient, and that the status quo is no longer tenable. 

Prem Sikka is an accounting academic with professorships at two UK universities

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