Monday 15 January 2018 will probably be seen as the UK audit industry’s ‘tobacco moment’ – a day that caused policymakers to wake up to the fact that an industry they once valued was, in fact, injurious to the nation’s financial health. It was the day Carillion went bust.
The Carillion collapse was the culmination of decades of poor-quality auditing by members of the Big Four. The last major exposure of the Big Four’s failings was the financial crisis of 2008, when a host of UK banks and building societies failed – all had been given a clean bill of health by their Big Four audit firms in their most recently published financial statements.
Splitting up the Big Four could involve one of two scenarios: dividing them into eight smaller firms that continue to do both consulting and auditing, or forcing the firms and their smaller rivals to form ‘audit only’ groups that have no ties to their consulting work.
Speaking at Chartered Accountants’ Hall in November, the chair of the House of Commons Business, Energy and Industrial Strategy Committee, Rachel Reeves MP, said: “The audit market is broken. The Big Four’s overwhelming market domination has failed to deliver audits that are fit for purpose. The lack of meaningful competition has bred conflicts of interest at every turn.”
Six months earlier, the Reeves-chaired committee delivered a devastating indictment of the Big Four in a report co-produced with the Work and Pensions Committee. The report accused them of multiple failures, all of which had contributed to Carillion’s collapse.
KPMG was singled out for special criticism: “KPMG was paid £29m to act as Carillion’s auditor for 19 years. It did not once qualify its audit opinion, complacently signing off the directors’ increasingly fantastical figures”.
There is currently only one company in the FTSE 100 that a Big Four firm does not audit – the Jersey-headquartered Randgold Resources. And yet it seems audit is not working as it should. At best, this represents poor value for money for the companies and their shareholders and, at worst, it will cause a further breakdown of trust, putting the capitalist system at risk.
So how did we end up with our leading audit firms – “the guarantors of the financial data on which the capitalist system depends”, as Financial Times columnist and author John Plender puts it – failing so publicly when it comes to audit?
The prevailing argument is that the rot set in when the larger accountancy firms decided to pursue scale. Audit-focused professional partnerships sought to transform themselves into globe-spanning, profit-hungry, business services supermarkets, eager to also sell consultancy, insolvency and even legal services to their audit clients.
This started in the 1980s and has been allowed to proceed unchecked over the ensuing three decades.
Being a business-services supermarket brings bigger pay cheques to the partners who run these firms, but it also results in unmanageable conflicts of interest, which the very same partners seem incapable of acknowledging. Invariably, this conflict causes audit partners to tailor their professional scepticism or even to become blind to risk. They are likely, for example, to swiftly sign off convoluted tax-avoidance schemes devised by their tax partners down the corridor, however dodgy, rather than challenge them.
Here’s an example. In 2014, PwC was paid £355,000 in audit fees by Taveta Investments, through which retail tycoon Philip Green and his wife controlled BHS, but £2.86m in non-audit fees – eight times as much. When BHS collapsed, the FRC found PwC had “failed to guard against the self-interest threat created by the substantial fees they generated in providing non-audit services” to Taveta.
According to the FRC, the PwC ‘engagement partner’ responsible for the audit of Taveta, Steve Denison, was so focused on dealing with non-audit projects for Green’s group of companies that he devoted just two hours to the Taveta and BHS audit as the annual results were being finalised.
It hasn’t helped that the Big Four have exploited their high-level political connections to engineer for themselves a highly favourable liability regime and a form of state-guaranteed impunity. Richard Brooks, author of Bean Counters: The Triumph of the Accountants and How They Broke Capitalism, says: “The big firms have persuaded governments that litigation against them is an existential threat to the economy.”
US legislators and regulators are less ‘captured’ and savvier to the potential conflict of interest involved in audit. They responded to the collapse of Enron with the Sarbanes-Oxley Act of 2002, which, among other things, prohibited firms from providing some non-audit services to their audit clients, and required public companies to disclose all fees paid to their auditors.
Could a similar approach work in the UK? Or do we need a public-sector ‘National Audit Service’ to ensure audits are undertaken in the national interest, as some experts have suggested (see box, right)? The precise solution is not yet clear. What is certain, however, is that something needs to be done.