Enron, WorldCom, Carillion, BHS, Patisserie Valerie, Wirecard. The list of companies involved with ‘auditing scandals’ or ‘auditing failures’ is a lot longer than it should be. Audit failure has been a hot topic for the last two decades and is widely acknowledged as one of the most persistent, consequential and detrimental problems in the world of finance. Yet it seems that the next audit scandal is never too far away. It is accepted that it is only a matter of time before another large company ceases operations due to lacklustre auditing by the world’s largest auditing firms. So, how can such monumental scandals be avoided? Before exploring solutions, it is important to identify what factors are potentially the roots of the problem.
Roots of Auditing’s Bad Image
The “Big Four”, which consists of PricewaterhouseCoopers (PwC), Deloitte, Ernst & Young (EY) and KPMG is widely recognised as the four largest professional service firms globally. They offer a multitude of services, with auditing services being a major source of income for them. Seen as the ‘face of auditing’, these firms often secure the largest companies in the world as clients and have hence been involved with some of the largest auditing scandals in previous decades. Many argue that the market dominance of the “Big Four” is the driving force behind accounting scandals and failures, which is an argument with some credence.
Having four firms dominate the auditing market reduces competition due to significant barriers to entry. Smaller, yet established firms such as Grant Thornton or Mazars do not have access to the same level of industry connections, resource pools, cash reserves and expansion opportunities that the Big Four do. This is largely down to the Big Four having a long-lasting reputation as being the ‘crème de la crème’ of auditing companies, and therefore large companies are willing to pay the elite companies more money to conduct audits. For many years, The Big Four have been accused of colluding to obtain multi-million-pound contracts. In 2017, Italy’s antitrust watchdog fined the Big Four auditing firms £20.7m for collusion, as they were found to be rigging bids to provide services to Italy’s central public procurement operation. It is very plausible to assume that the Big Four may be colluding in some form, especially given the various number of investigations and probes that have taken place in previous years.
Additionally, there is an increased potential for conflicts of interest. Due to the majority of large companies being audited by the Big Four, there is an increased chance of material interests between clients, and this could lead to big issues, both ethically and legally. Auditors from the Big Four sometimes form strong relations with their clients and as a result, do not challenge them to preserve the relationship. This has led to the FRC to state that “the tone from the top at the firms needs to support a culture of challenge and to back auditors making tough decisions.” All of the factors above contribute towards a culture of inconsistency, complacency and comfort, despite the auditing profession being built on consistent financial expertise.
The Introduction of Audit Regulatory Legislation
In response to these glaring issues in the auditing sector, there have been numerous attempts by the FRC and other governing bodies to enforce legislation that would improve audit quality. In April 2014, the FRC announced that it will “focus on the expansion of its audit expansion work in line with recommendations from the Competition Commission”. In September 2014, the Competition and Markets Authority (CMA) published its final Order implementing reforms of the audit market in the UK. The final Order included a requirement for FTSE 350 companies to put their statutory audit engagement out to tender at least every 10 years. In October 2019, Paul Eagland, the managing partner of BDO, said he expected ministers to force FTSE 350 companies to appoint two firms to audit their accounts. These are just a few examples of action taken by the FRC and CMA over the last few years, yet there seems to be no sign of improvement whatsoever.
The Audit Quality Review (AQR) involves the inspection of large auditing firms including the Big Four, BDO, Grant Thornton and Mazars. The inspection takes place annually and provides a thorough understanding of the quality of audits at the largest auditing firms in the UK. Of the 88 audits reviewed in 2019/20, 29 (33%) of audits require more than limited improvements, a figure described by the FRC as “unacceptable”.
As shown in the chart above, the percentage of audits requiring improvements range between 16-25% over the last 5 years. Numerous other statistics exist that highlight the incompetency of the largest audit firms and this overwhelming evidence leads to one answer to fix this phenomenon: Audit Reform.
In December 2019, The Queen delivered the Queen’s Speech to MP’s. In the supporting notes to the Queen’s Speech, the government outlined plans to introduce “a stronger regulator with all the powers necessary to reform the sector”. The supporting notes also referred to “three independent reviews commissioned in 2018”. Two of the reviews referred to were:
Sir John Kingman stated in his review that he believed that the FRC should be replaced by a new regulatory body named the Audit, Reporting and Governance Authority (ARGA). A few months after the recommendation was published, the government confirmed that it supported this proposal, and intended to start preliminary discussions regarding the implementation of ARGA in coming years.
Sir Donald Brydon published his review the day before The Queen’s Speech, and his review detailed 68 recommendations to revamp the UK audit industry. Brydon emphasised that ARGA should be a catalyst in the separation of the audit profession and should be the regulator of it.
His report stated “Auditing is too important to be left to an adjunct of another profession: it should be an independent profession in its own right, with its own governing principles, qualifications and standards. At present, it is an extension of the accounting profession, whose ethics and (arguably) mindset it largely adopts… I recommend that ARGA should facilitate the establishment of a corporate auditing profession based on a core set of principles”.
Brydon’s words could not be clearer. Auditing as a separate profession with its own regulatory body and standards would place a magnifying glass on the Big Four and other underperforming auditing firms and would go a long way in repairing the image of an industry that once was regarded so highly. Whilst ARGA promises to bring about a culture of change and improvement, it remains to be seen if it can repair the tainted image of the auditing industry. Only time will tell.