Why you can’t rely on auditors

Powerful conflicts of interest mean that you can't always take a company's annual report at face value. So, what are the solutions? Tim Bennett investigates.

Financial statements are supposed to come with a quality stamp their books are approved every year by a professional auditor. Yet massive public firms, from energy giant Enron to Lehman Brothers bank and countless smaller companies, regularly go belly up despite having received a clean bill of health. So what do auditors actually do?

By law, all companies have to have their annual accounts signed off by a firm of qualified auditors. As a rule of thumb, the bigger the company, the bigger the firm of auditing accountants employed will be. Once you get to the FTSE 100 level, the chances are that one of the Big Four' names will provide the audit: KPMG, PricewaterhouseCoopers (PWC), Ernst & Young and Deloitte. The FTSE 100 is dominated in particular by PWC, which audits nearly half the companies on the list.

After lots of number checking and discussion with management, the end result is a statement that appears just ahead of the profit and loss account. A clean' report is quite short and confirms two basic things: that the accounts have been prepared in the right legal format (to comply with the UK Companies Acts, for example); and that, in the auditor's opinion, they show a true and fair' view of the firms' profits and cash flows.

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An opinion?

Already you may have spotted two problems. Auditors are careful to cover themselves legally. So they only ever give an opinion, not any sort of guarantee. That opinion has a limited scope true and fair' translates as free from huge errors and reasonably unbiased'.

So on the true' side, auditors work to a level of tolerable error' or materiality'. To give you an idea of just how big these errors can be, I used to be an auditor, and with one global oil client we worked to an acceptable error level (materiality') of $100m. In short, a mistake smaller than $100m would be let go.

What about the fair' bit? Management teams make all kinds of subjective judgments when they prepare accounts such as how long their long-term (fixed') assets will last, or whether a legal case will be settled in their favour or not. So the auditors say the best they can do is make a judgement call themselves as to whether or not management's judgements are right.

This might seem a bit vague. In their defence, auditors claim that the nature of a complex modern business doesn't allow them to do much more than they already do, unless audit fees were to go through the roof. They are already pretty high.

For example, on page 105 of the 2012 Tesco accounts, you'll see that the fee paid for audit services' was £4.6m. However, it's further down page 105 that you start to get an idea about one of the other big problems with the way the market for auditing business works.

About halfway down the page you hit this line: "fees payable to the company's auditor and network firms for other services". That's another £2.5m. The biggest chunk, after services relating to taxation' (tax advice) and services related to information technology' (systems advice), is just labelled other services'. I'll take an informed guess that these are consultancy services. The auditors none other than PWC also happen to have a hugely profitable consultancy arm.

You can see the difficulty here. Most auditors also want to win other subsidiary business from clients. And you are hardly going to land that juicy IT contract if you don't sign off on your client's accounts. On top of that, who pays the auditors? The directors of the company, of course. They usually do it via a separate board, but make no mistake, it's the executive directors who ultimately make the call.

So what are the solutions?

Audit firms are full of clever, well-paid people. It's a highly self-serving closed shop. So although there are several ways the system could be changed to shareholders' advantage, don't hold your breath for it to happen voluntarily. The good news is that the Competition Commission is looking into the sector to find ways to make it function better.

Auditors could be rotated on a more regular basis. There's a trade off here between achieving independence and having the necessary knowledge of a firm to be able to audit it effectively. But given that on average FTSE 100 firms change auditor once every 48 years, it's clear the pendulum has swung too far.

Also, a system where management appoints and pays auditors and awards extras on the side is just wide open for abuse. The government could set fixed rates based on the size of firm being audited and insist that separate consultancy work be done by a different firm.

A good start would be to reduce the influence of the Big Four. The Chinese have taken some steps to ensure audit work is parcelled out amongst smaller firms. But why stop there? Just as the big banks should be split into retail and investment banks, so big audit firms should be required to be auditors or consultants, not both. The commission reports its provisional findings later this year. Let's hope it has some teeth.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.