Government must accelerate long-awaited audit reforms

READ MORE: Accounting watchdog finds one in three audits not good enough

However, the Financial Reporting Council found around a third of the audits completed by the giants that dominate the market were not good enough.

In a review covering the work of the seven biggest firms, experts found significant problems with 29 of the 88 audits checked. They highlighted shortcomings in the work of all the firms covered by the exercise.

One worrying aspect of the FRC’s findings was that problems seemed to crop up most often in the same areas. The FRC highlighted the frequency of issues in areas such as the valuation of intangible assets like goodwill and loan loss provisions.

These are areas in which auditors will have to make careful judgements amid the uncertainty caused by coronavirus.

The high failure rate raised questions about how good some of the judgements made by the well-paid professionals that work on audits are.

The FRC also highlighted a worrying reluctance on the part of auditors to ask awkward questions. It cited “insufficient challenge of, and standing up to, management in areas of complexity and forward-looking judgement”.

The FRC said standards have been improving.

However, the failure rate in the latest review was higher than the 25 per cent recorded in the exercise that preceded it.

READ MORE: Big Four accountancy firms condemned for 'feasting on Carillion carcass' 

The latest findings only heighten the concerns that have been caused by a series of high-profile corporate failures.

The FRC is investigating EY’s work on the audit of Thomas Cook for the year ended September 30, 2018.

It is also investigating audits completed by the other three members of the big four – Deloitte, KPMG and PwC – and the work of Grant Thornton from the second tier.

Since October 2017 it has imposed sanctions on all the big four firms, and second tier players including Grant Thornton.

The biggest, £6.5 million, was imposed on PwC in 2018 in respect of its work on Taveta Investments, which owned BHS.

The findings of the FRC have undermined confidence in the major audit firms during a period when giants have been making huge amounts of money.

These firms have prospered after developing lucrative consulting and advisory operations as well as by dominating the market to provide bread-and-butter audits for the UK’s biggest companies.

There have long been concerns that firms could use audits as loss leaders to help them win higher margin business.

The Government led by Theresa May felt it necessary to commission three reviews into aspects of the auditing business, all of which identified serious shortcomings with existing

arrangements.

The Competition and Markets Authority completed a probe into the dominance of the Big Four and concluded that the market exhibited deep-seated problems. It said the high concentration among four big audit

firms resulted in limited choice and a market that was not resilient, and lamented that audits were being carried out by firms whose main business was not auditing.

READ MORE: Competition watchdog calls for reform of audit market

The CMA recommended there should be an operational split between firms’ audit arms and other divisions with an end to profit sharing between audit and consultancy.

To help boost competition, the CMA also recommended that there should be mandatory joint audits, with challenger firms working alongside giants. It said this would increase the capacity of challengers, boost choice in the market and thereby drive up audit quality.

Sir John Kingman, who chairs Tesco Bank and pensions giant Legal & General, was tasked with completing a root-and-branch review of the work of the Financial Reporting Council amid accusations of timidity on its part.

After identifying a wide range of shortcomings, Sir John recommended that the FRC should be replaced with a new Auditing, Reporting and Governance Authority that should have an overarching duty to promote the interests of consumers of financial information, not producers.

READ MORE: Accountants to have new regulator as part of reforms

He said the body should also have a duty to promote competition; a duty to promote innovation; and a duty to apply proportionality to all its work.

Sir Donald Brydon, a Scots City veteran who became chairman of the London Stock Exchange, completed a review into the quality and effectiveness of audits and was highly critical of what he found.

READ MORE: Stock exchange chairman survives investor move to oust him

He raised fundamental questions about what the point of an audit was and concluded that it should be about much more than an attempt to verify that a company’s financial statements were true and fair at one point in time.

He recommended that the concept of auditing should be extended to areas beyond financial statements to ensure that auditors took account of the bigger picture influences on a company’s position.

This should include the obligation to acknowledge external signals of concern.

Sir Donald concluded that auditors should have some responsibility to detect and help prevent fraud.

He felt it necessary to call for the introduction of suspicion into the qualities of auditing, which one would have thought should already have included a degree of scepticism.

Sir Donald also recommended the creation of a corporate auditing profession governed by distinct principles.

He noted recently that coronavirus has heightened the importance of effective audits.

But how much has changed as a result of the reviews is not clear.

In December, the FRC barred firms from providing a range of services for companies that they audit and from playing any part in management decision-taking.

The Government has yet to introduce the white paper that will be required to create a replacement for the FRC.

While the FRC may be living on borrowed time its latest findings make clear that the Government must ensure that the shake-up of the auditing business that some have long called for finally happens. In considering what to do ministers must be prepared to be radical and to ignore the claims of those who say that we must live with the system we have because disruption would result from any attempt to make big changes.

Ministers might want to look again at recommendations made by Sir John Kingman in a letter to the then-business minister Greg Clark in December 2018 that were not included in his report on the FRC.

He concluded that in the case of large firms deemed Public Interest Entities auditors should be appointed by an independent body representing the public interest rather than the boards of the firms concerned.

The body should also set the audit fees concerned.

Sir John’s recommendations reflect the fact that auditors are effectively providing a utility service. Perhaps they should be subject to the same kind of regulatory limits on the returns they generate that apply to the likes of energy firms.

In his letter, Sir John delivered a withering assessment of the prevailing state of affairs.

Sir John wrote: “It is widely acknowledged that, across the board, we do not see anything like enough scepticism and independent challenge from auditors. I suggest this is not surprising when auditors’ incentives are, at best, blunted: The customers for their product are external users of accounts ... particularly investors, who clearly do want robust scepticism and challenge. But the customers are not buying the service.”

A spokesperson for the business department said: " “The quality and reliability of audit have come under the spotlight on too many occasions. We recognise it is essential that we rebuild trust and confidence in this vital business oversight.

“We are committed to legislating to create a tougher, stronger regulator, and will publish our proposals on audit reform in due course.”

Perhaps the Government could take the whole auditing business in-house.