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.”
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?”