Auditing the the big accountancy firms

Investors rely on the big accountancy firms to pore over a company's books and warn them of impending disaster. Recent scandals suggest they are not doing a great job, says Simon Wilson.

Why are auditors important?

From an investor's point of view, they are vital chiefly because their work underpins trust in financial markets. Stockmarkets require listed companies to hire auditors to verify their accounts, and certify that the published numbers give a "true and fair view" of circumstances and income. Such a system isn't perfect: in practice auditors are accountable to executives rather than directly to shareholders, and are therefore less prone to challenge them.

Yet without a system of regulated auditors, investing would be even more of a lucky dip than it already is. Accountants are also important to the UK in that we breed an awful lot of them. Britain has 350,000 professionally qualified accountants, the world's highest number per capita (plus another 165,000 students registered with professional bodies). Some 12% of all the accountants in the world are here, though our economy accounts for 3.5% of global output.

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What's the problem?

There's a growing crisis of confidence in their ability to do the job properly, and in the capacity of regulators to make them. Fully 40% of riskier audits (for example, those involving M&A deals) inspected last year by a global watchdog had serious issues with them. And the big accountants have recently been rocked by reputational woes. The auditors' regulator, the Financial Reporting Council (FRC), is seen by critics as a very tame beast. It had to be pressed by MPs to investigate KMPG's 2007 audit of the bank HBOS (which got a clean bill of health a year before it went bust).

The FRC finally reported last year, but found no fault with KPMG's work. Similarly, when BHS collapsed in April 2016, PwC had failed to raise any red flags, despite the retailer's history of losses, a massive hole in its pension scheme and £1.3bn in debts. Then in January, the construction giant Carillion collapsed, also owing £1.3bn and with a pension deficit of another £1bn yet none of its auditors had spotted the brewing catastrophe.

Could they have?

Critics argue that of course they could and should have. All the "Big Four" did extensive and well-paid work for the company, raking in £71m in fees over the decade before its collapse, and KPMG signed off on the company's accounts just before the shock profit warning last July that first signalled Carillion was in real trouble (that audit is now the subject of investigation by the watchdog). Now PwC has raked in another £21.4m in its first three months of overseeing Carillion's corpse.

But what's the point of an audit that fails to give a true sense of the financial health of a company? "Auditors should be playing an important role in corporate governance," says Rachel Reeves, the chair of Parliament's business committee, "providing challenge to directors where necessary, not presenting company bosses with an ultimately worthless set of documents that can provide a fig-leaf for poor performance."

Is the audit market competitive?

No, it's an oligopoly of just four players. This week, the fifth biggest player, Grant Thornton, decided to stop bidding for audit work from Britain's largest listed companies, saying it is too difficult to compete with the Big Four. Between them, those four (PwC, Deloitte, EY and KPMG) audit 99% of the UK's biggest 100 listed companies, and 96% of the next biggest 250. Critics argue that this kind of set-up encourages cosy relationships between auditors and client chief financial officers (CFOs), discourages genuine competition and helps to muddy the waters as to whether auditors are working in the interests of shareholders or management.

The related, crucial, question is whether auditors come under pressure to nod through questionable accounting decisions because their consulting arms are earning massive fees for non-audit work like tax, IT advice and other consulting. These days the Big Four accountants earn 80% of their fees from things other than accounting. That's an obvious recipe for conflicts of interest, critics say.

A recent article by two academics at Canada's Simon Fraser University, published in March's edition of Accounting Horizons, a US academic journal, found evidence of such cosiness, finding that auditors were almost twice as likely to adopt a client's position when they are told that the client CFO used to work at their firm, for example. Given that professional scepticism is the most crucial attribute of an auditor, that's worrying.

What should be done?

Stephen Haddrill, the chief executive of the FRC, agrees not all is well and has called for the Competition and Markets Authority to investigate. The modest measures introduced the last time the market was investigated in 2013 included a requirement for FTSE 350 firms to put their audit business out to tender every ten years. But since then the market share of the Big Four has risen further. Haddrill suggests looking again at whether auditors should be forced to spin off their consulting arms.

What's the case against?

Splitting off non-audit business would not create any new auditors, points out Jim Peterson in Financial Times. And if auditors were split up by sector, say, the smaller firms "would struggle to amass the expertise, personnel and capital necessary to provide the level of service that big companies expect".

Other possibilities include making firms change their auditor more often; requiring auditors to provide more information of potential risks they uncover; and making engagement between shareholders and auditors the norm rather than the exception. A far more robust system of regulation, with the power to impose harsher penalties, may also be required. But that would require political will, energy and investment so don't bank on it happening anytime soon.