It may sound boring but auditing matters – and partially reforming big accountancy firms doesn’t go nearly far enough

Just how many times do we have to see the vital audit system fail – harming investors, employees and the public – before politicians and regulators decide to do something?

 

Ben Chu@Benchu_
Tuesday 18 December 2018 16:08
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The CMA report recommendations and the overhaul of the audit sector’s regulation by former Treasury civil servant John Kingman fall disappointingly short of any kind of radical restructuring
The CMA report recommendations and the overhaul of the audit sector’s regulation by former Treasury civil servant John Kingman fall disappointingly short of any kind of radical restructuring

Like the small print on an insurance document or a building’s fire evacuation procedures, the subject of auditing company accounts is inherently boring until it suddenly matters.

The transition usually occurs when an audited firm announces a black hole in its balance sheet and is forced to summon the administrators, putting thousands of jobs and pensions under threat.

It occurs when small suppliers to a failed company are left to whistle for the money they are owed.

The penny drops when a company that provides vital public services (perhaps even a bank) is unable to discharge its responsibilities and the taxpayer is forced to step in to prevent disaster.

That’s the point when we ask: how could auditors have missed the problem? What exactly were they doing? What’s the point of these bean counters?

The point, in theory, is clear. The law requires limited companies to subject their accounts to external audit in order to give shareholders, employees, suppliers and other stakeholders a degree of confidence in the firm’s financial statements.

This is one of the traditional legal checks and balances of our market economy. But it’s a mechanism that has been failing, as a steady flow of auditing scandals in recent years attests.

From Carillion to BHS to Rolls-Royce to Tesco to BT to more or less all of the private banks during the financial crisis, the story has been the same: huge balance sheet gaps have been missed by audit teams.

Most people accept there exists a conflict of interest when it comes to the audits performed by the “big four” accountancy firms, KPMG, Deloitte, PwC and EY.

Big firms hire auditors but also commission many other lucrative consulting services from these sprawling financial groups (not least advice on avoiding corporation tax). Auditors have an interest in rubber-stamping accounts rather than asking awkward questions.

So why not split up audit and consulting not only to tackle the conflict of interest but also to promote competition in an oligopolistic sector?

That’s the remedy touted by MPs from across the party spectrum. And it was one of the main proposals from an independent Labour Party report, led by the accounting expert Prem Sikka, on reforming the auditing industry published last week.

Yet the Competition and Markets Authority (CMA) pulled up short of this particular reform fence on Thursday as it released its own study into the state of audit, arguing that a breakup would be “protracted and complex”.

Instead, the CMA proposes a form of internal ring-fence for auditing arms, so they will have “separate management, accounts and remuneration”.

The hope that this will solve the conflict of interest problem seems rather heroic given the same executives of the big four groups would retain oversight of audit operations.

The reality is that only full, legal, separation of functions has a hope of delivering the shift in incentives required for a better functioning system.

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This needs to be combined with the introduction of proper legal accountability for individual auditors and auditing firms when they act negligently or fraudulently, another proposal in the Labour report. There is also a strong case for an independent, not-for-profit, public auditor of financial institutions, given their systemic importance for the economy.

The CMA report today, combined with the reforms of the sector’s regulation proposed in a separate report by the former Treasury civil servant John Kingman, fall disappointingly short of this kind of radical restructuring and oversight overhaul of a compromised and dysfunctional industry.

Yet at least this is not the last word. The CMA chair Andrew Tyrie, a former head of the Treasury Select Committee, suggests further reforms will be forthcoming “if it turns out that the proposals are not far-reaching enough”.

In one sense that’s good to hear. Yet it also raises some questions. Just how many times do we have to see the vital audit system fail – harming investors, employees and the public – before politicians and regulators decide enough is enough? What other sector would receive such epic levels of forbearance? What’s so special about bean counting?

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