Improving Auditing – It’s Certainly Time

Readers don’t need to be reminded that many of the most damaging events for investors in public companies in recent years have arisen because of the failures of auditors to identify misleading accounts, if not downright fraud in some cases. The Kingman review of the FRC and the views of the Competition and Markets Authority (CMA) suggest that there is a widely recognised problem in the quality of work done by auditors and the regulation of the profession.

I have mentioned previously a report entitled “Reforming the Audit Industry” commissioned by the Labour Party which has advocated the break-up of the big four audit firms that dominate the audits of FTSE-350 firms. The report, co-authored by Prof. Prem Sikka et al (see https://tinyurl.com/yb68pfr5 ) is particularly good on the subject of how auditors have ducked any liability for their failings over the last 50 years – see Chapter 10.

If we want auditors to do a good job, then they need to be made accountable to both the companies who commission them and to investors who rely on the accounts that are published. That includes both audit firms and individual audit partners and managers. But we now have a situation where auditors have ducked both obligations by forming into Limited Liability Partnerships (LLPs), by writing contracts with their clients that exclude liability and by legal judgements such as that in the Caparo case. The aforementioned document spells out how this came about and is well worth reading. It shows how the FCA, FRC, and the Government have avoided their responsibility for ensuring that auditors are properly accountable with the result that one might expect – in essence shoddy work by auditors. One can only conclude that audit firms and accountants have had too much influence over the regulation of the audit profession. Or as the report puts it “the accounting cartel sets the rules”.

As the report says, “current liability laws do not exert sufficient pressure on auditors to be diligent or even exercise reasonable care and skill. In this environment, some audit partners cannot even be bothered to spend enough time on the job, or supervise audit staff”. It mentions that the PwC audit partner spent just two hours on the final audit of BHS and its parent company; while the Audit Senior Manager recorded only seven hours and was not involved in the final stages of the BHS audit. And at Quindell, auditors KPMG failed to obtain reasonable assurance that the financial statements as a whole were free from material misstatement, failed to obtain sufficient appropriate audit evidence and failed to exercise sufficient professional scepticism.

The reforms recommended in the report are:

  • Auditors must owe a ‘duty of care’ to individual stakeholders who have a reasonable justification for placing reliance upon auditors.
  • The incidence of liability must act as a pressure point for improvement of audit quality. Individuals and society must be empowered to seek redress from negligent auditors
  • There must be personal liability for audit failures upon partners responsible for audits.
  • Where a partner of the audit firm acts negligently, fraudulently or has colluded in the perpetration of fraud and material irregularities, civil and criminal liability must fall upon the partner of partners concerned and upon the firm jointly and severally.
  • Class lawsuits must be permitted to empower stakeholders as many stakeholders are not always in a position to seek redress from negligent auditors.
  • In the event of negligent and fraudulent practices, audit fees for the relevant years shall be returned to the audited entity.

These appear to be eminently sensible proposals to this writer.

The report covers the issue of lack of competition in the audit market as was covered by the CMA and their proposals are similar. Also covered are the failings of the FRC – lack of urgency, investigations abandoned and puny sanctions after audit failures. An example of the latter is that the fines imposed as a proportion of a firm’s global audit fees after major failings is a miniscule 0.016% on average. In other words, audit firms have no great incentive to avoid mistakes.

The concluding paragraph in the report says this: “History shows that much of the change in the world of accounting and auditing has been introduced in the teeth-of-opposition from accountancy trade associations and accounting firms. The same approach must be taken in order to make audit work for, and be accountable to, the many, and not the privileged few. Otherwise, there will be more avoidable scandals resulting in loss of pension rights, jobs, businesses, savings, investments and tax revenues, social instability and ultimately loss of faith in the ability of institutions of democracy to connect with the plight of the innocent bystanders”.

I hope everyone in the Government who has responsibility for company regulation reads this report. It is certainly time to make major changes in the audit profession.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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