What do BHS, Carillion, Conviviality, Quindell, Aero Inventory, the Co-op Bank, and London and Capital Finance have in common? They were all audited by the big four accountancy firms – PwC, KPMG, EY and Deloitte – which audit 97% of FTSE 350 companies and collect 99% of audit fees. In each case, these firms collected huge fees and delivered little of any public value. Their failure to spot the fragility of those businesses resulted in the loss of jobs, savings, pensions and tax revenues.
Yet the victims of these failures have no legal recourse to seek compensation because auditors owe a “duty of care” only to the company that hires their services, not to any individual stakeholder or creditor.
Despite their inability to spot the flaws in the financial statements of banks which led to the 2007-08 financial crash, the auditing industry escaped meaningful reforms. After the BHS and Carillion failures, the government passed the buck to the Competition and Markets Authority (CMA). Yet its long-awaited report, published today, fails to address the fundamental issues about competition or audit quality.
Compare it with other businesses: anyone selling toffees has to ensure their product is fit for purpose and will not injure their customers. However, that logic does not apply to auditors, and the CMA does not even address this central issue. Without these potential liabilities, audit firms have insufficient economic incentives to improve the quality of their work.
The CMA calls for an “operational split” of the big firms, that is, audit and non-audit arms need to be separated internally by Chinese walls. The idea is that this would somehow dissuade auditors from selling non-audit services to big corporations and reporting on the very transactions that they themselves have created. But this will not work: the lure of profits is too strong. Big firms claim to have Chinese walls to prevent their tax divisions from targeting their audit clients for the sale of tax-avoidance schemes, but court cases have shown otherwise.
Instead of an operational split, a “structural split” is needed. Under this, audit firms would do audit only, and neither the firms nor any of their associates would be permitted to sell any form of consultancy to audit clients. Such a reform is called for in a report I worked on for the Labour party, and also in a report by the House of Commons business committee .
The CMA proposes joint audits for most FTSE 350 companies by a big four and a mid-tier firm. This may make a marginal difference to the market, but the authority shies away from removing barriers to entry to that market: the government requires that all auditing firms need to be under the ownership and control of licensed auditors. This prevents technology and other companies from entering the market and challenging the big accounting firms’ dominance. Despite a brief to promote competition and choice, the CMA has totally ignored the issues.
The big question is whether the authority’s new proposals would have made any difference to recent audit debacles at BHS and Carillion. BHS had been audited by PwC for over a decade before its demise in 2016. An investigation by the Financial Reporting Council, the audit regulator, showed that the PwC partner responsible for audit spent just two hours on the case. The work was left to junior staff, including one with one year of post-qualification experience, who failed to perform adequate tests to verify assets, investments, loans, income, costs and even whether BHS was a going concern.
KPMG audited Carillion for 19 years, and also sold consultancy services to the company. Carillion had worthless contracts of more than a billion pounds in its balance sheet. It had aggressive accounting policies and failed to recognise the falling value of assets such as goodwill.
Today’s CMA proposals would make virtually no difference to the audit of BHS or Carillion. Its report does not call for public information about the composition of the audit teams, time spent on audit by each grade of labour, the list of key questions to be asked by auditors and the required replies, or recent regulatory action against the firm or anything else that might dissuade auditors from being too close to management.
Many audit failures have shown that the longevity of auditors’ term in office results in chumminess with directors and impairs their scepticism. Yet the CMA is content with the current rules, which only require major companies to change their auditors every 20 years. The CMA washes its hands by saying that it wants to empower audit committees, consisting of non-executive directors, to deal with the appointment and oversight of auditors. It neglects to note that all the bailed-out banks, along with Carillion and BHS, had such committees. They failed, and the CMA does not ask why.
This is the third unsuccessful attempt by the UK’s competition authorities to tackle the dysfunctional auditing industry. Under the weight of lobbying and political interventions, previous reports in 2006 and 2013 shelved the long overdue reforms. Now, despite a stream of audit failures, meaningful reforms are once again being taken off the agenda. It is time to ask whether the CMA itself is fit for purpose.
• Prem Sikka is a professor of accounting at the University of Sheffield
