Regulation & Standards

Auditors under the spotlight as reforms fall short

Published: Mar 2022

Audit firms are under fire for a lack of competition, spiralling costs and missing accounting red flags. A reform process may not get to the heart of the problem of conflict of interest and limited choice.

Spotlight shines blue beam of light

The auditing industry, tasked with providing assurances on corporate information and reporting and giving confidence to the capital markets, is under fire for not doing its job properly. Audit firms have missed red accounting flags at an ever-growing list of corporate collapses, like retailer BHS in 2016, Carillion in 2018, Patisserie Valerie in 2019, German financial services group Wirecard and Greensill Capital in 2021. Against a challenging backdrop of evolutions in technology, changing business models and ESG integration, dissatisfaction with the industry that society relies on to inspect and challenge company accounts is at an all-time high.

It has led to ongoing and protracted calls for reform of the UK’s audit industry. In its latest manifestation, reforms include proposals to replace the Financial Reporting Council, the UK’s audit and accounting regulator, with a new watchdog with greater powers to police company directors, called the Audit Reporting and Governance Authority. Elsewhere, reform is expected to include the introduction of “managed shared audits”, requiring FTSE 350 companies audited by one of the Big Four to hand part of the work to smaller accounting firms to improve competition and impose extra governance requirements on companies.

Aside from painstakingly slow progress and legislation not slated until mid-2023 at the earliest, critics argue the reforms won’t address key challenges in the auditory process. For example, the conflict of interest inherent in auditors being contractors, paid by the companies they examine, remains unchallenged. “Audits are not independent,” says Prem Sikka, Professor Emeritus at University of Essex and University of Sheffield. “Companies appoint and renumerate their auditors in a fundamental flaw to the process that no proposals put forward by the government has thought to address.”

Secondly, reforms don’t address weaknesses in the International Accounting Standards used by auditors to oversee companies and which frequently mislead on corporate health, argues Tim Bush, Head of Governance and Financial Analysis PIRC Limited, the corporate governance and shareholder advisory consultancy. “International Accounting Standards aren’t fit for purpose. Until this is addressed, any technical reform is simply barking up the wrong tree.”

Gloss over

Treasury is closely involved in the audit process. Auditors rely on treasury to deliver well-supported and thought through cash forecasts, provide valuable insights into how the treasury function works; what systems the company has in place, valuations and the pension offering. Regulatory changes like the transition from LIBOR or knotty considerations around reverse factoring also bring auditors and treasury into close contact. Anecdotes from the frontline in one of the most complex touch points between auditors’ and treasury, hedge accounting, provide a snapshot of how auditors being in the pay of their corporate clients can go wrong.

Grappling with the complexity of hedge relationships is no easy task for audit teams while applicability – you cannot apply hedge accounting to every hedge relationship – and capturing and challenging fair values presented by the company is just as difficult. “Auditors will expect treasury to provide all hedge accounting documentation and data to support fair values and ask questions about why the company has put in place certain hedges,” explains David Passarinho, a treasury accounting expert at Huawei, who joined the global telecoms equipment maker from PwC’s Capital Markets and Accounting Advisory Services division to help Huawei develop a treasury accounting department to – amongst other things – support the audit.

Moreover, some accounting standards like IFRS, are principle rather than rules-based, giving leeway for interpretation. Companies may interpret information in a certain way, but it is incumbent on auditors to cast their own judgement and be sceptical, he says. “Auditors are aware of creative accounting and know bad management may use loopholes in their favour.”

Accounting firms have developed expert teams specialising in treasury to better get into the auditory weeds of hedge accounting and fair valuations. But crack teams of specialists deployed to deal with these complexities come at a price and sometimes auditors are reluctant to use them because the cost will push the price of the audit above the quote. It can lead to crucial red flags being missed, warns Passarinho. “Using specialist teams will increase the audit fees and could push them off budget. This can put the audit firm in danger of losing the audit unless the audit client understands the added-value of employing such specialists.”

It’s possible the problem of audit firms doing a lesser job to keep within budget is on the wane, given rising costs in the industry. The steady climb in audit fees in recent years – to the extent listed companies have experienced a fee increase of between 25-50% – suggests auditors are now pricing their work more accurately and charging more to audit complex transactions and intricate issues like hedge accounting.

Sikka doesn’t agree. High fees have been a characteristic of the industry long before the latest increase and should have more than enough for audit firms to deliver value and dive in deep, he argues. “I’ve seen invoices where audit partners are charged out at £1,500 an hour. When they say they need to be paid more, why can’t they deliver value for that kind of money?”

On a like-for-like basis, audit fees have increased substantially because of the limited choice and competition in the market.

David Herbinet, Head of Audit and Assurance, Mazars Group

Lack of competition

For other industry insiders like David Herbinet, Head of Audit and Assurance at Mazars Group, the recent price hikes are less to do with auditors charging more for a better job and more symptomatic of another deep industry malice: an acute lack of competition. “On a like-for-like basis, audit fees have increased substantially because of the limited choice and competition in the market,” he says.

A gradual decline in the number of auditors over the last 20 years means that over 90% of listed UK companies are audited by just four firms – which also audit the vast majority of the world’s 500 largest companies. That tiny pool of choice evaporates even more when companies steer clear of a particular auditor because they are already consulting for the business in another capacity. “Most of the time, companies have a choice of just one of the big four which is just not satisfactory from a quality perspective given the lack of incentive and competition to perform,” says Herbinet.

European and UK policy makers have come up with a variety of strategies to try and break up the dominance of the big four and ensure different firms take on new relationships. Organising a tender for a new auditor is a complex and costly process that companies tend to avoid, but now European rules prevent auditor-corporate relationships stretching over decades with mandatory once-in-a-decade re-tender rules and requests companies change their auditor at least every 20 years.

Critics argue this doesn’t get to the heart of the problem. Mandatory rotation has led to a merry go round of the big four still winning the big deals and has done little to enhance choice. For Clive Bellingham, a partner at PwC for nearly 40 years and Vice President of ICAS, the professional body for chartered accountants, mandatory rotation also results in the loss of valuable knowledge accumulated over time and long-term relationships. “I’m personally not convinced audit firm rotation is the right answer.”

The UK’s latest reforms attempt to boost the number of audit firms competing for work in another approach. Under the proposals, challenger firms will team up on an audit with a Big Four name to help build skills and experience in a supported environment that also brings new teams into long-standing relationships. It could lead to an estimated 20% of aggregate FTSE350 audit fees going to challenger firms after five years and 30% after seven years.

ESG

Climate change reporting could shake up the market. Companies the world over have made net zero claims and corporate reporting on sustainability and climate preparedness needs auditing to protect against greenwashing. Rather than give more work to the existing cohort, auditing ESG statements and accounts could be an opportunity to attract new players into the market. The European Union is currently considering prohibiting the audit of financial statements being conducted by the same firm auditing ESG reports.

It’s an approach that has divided opinion about whether it will complicate or facilitate an already challenging process. For example, auditing ESG accounts includes number crunching gaps like the timeframe companies use for calculating future cashflows tallying with their timeframe for emission reductions – given the latter’s impact on cash flows.

Collective response

It looks likely that the reform process will usher in more pressure on other stakeholders to verify company accounts in a collective response. Auditors argue they don’t have the powers of police or regulators and cannot be held solely responsible for poor internal corporate governance – corporate boards need to grasp their own risk management responsibilities and ensure the resilience of the business. Almost two-thirds of auditors believe the UK’s corporate governance code should give directors greater responsibility for promoting, monitoring and assessing their corporate culture, according to a poll by the Chartered Institute of Internal Auditors.

Although more far-reaching proposals modelled on the US’s Sarbanes-Oxley Act which require directors to sign off on companies’ internal controls over financial reporting have been dropped, calls are growing for management and boards to take more responsibility for the preparation of financial statements. It means the role of treasury, with its view on cash and early warning signals of corporate trauma, will come to the fore. “Auditors operate in an ecosystem where governance is key. It is important to ensure enough is being done from a governance perspective by the board and other stakeholders,” says Herbinet.

But the ability of treasury to do more leads PRICS’ Bush to highlight the original problem of the current reform process: treasury’s unique position to facilitate and support the audit process is stymied by current International Accounting Standards. Treasury is in pole position to help ensure corporate health and raise red flags, but treasury expertise has been squeezed out of the audit process, he says. “Sub-standard accounting models based on market value have squeezed out the basic tenets of treasury management focused on how a company has been, and is, funded,” he concludes.

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