British regulators mull the future of audit

 

AUDITS EXIST to shore up trust in financial statements. Investors look to professionals to tell them whether companies’ managers are squandering their money. What happens when trust in auditors evaporates? Britain provides an illustration.

The country has seen a spate of high-profile company failures in the past year, most notably that of Carillion, a construction firm with many public-sector contracts. Angry lawmakers want to know why auditors did not raise the alarm. The result has been a number of official reviews. The Competition and Markets Authority (CMA), Britain’s antitrust agency, is assessing ways to improve the audit market. A separate review is looking at the Financial Reporting Council, the audit regulator. Both will publish initial findings by the end of the year. Three more reviews—by MPs, the opposition Labour Party and an accountants’ trade body—are also in the works.

The case against auditors is that the industry is cosy and conflicted. Listed companies must, by law, be audited, and the auditors are paid by the companies whose books they review. The market for auditing large listed firms is dominated by four accounting networks, Deloitte, PwC, EY and KPMG, which earn most of their revenue from consultancy. They are barred from providing many consulting services to audit clients. But the suspicion is that they may go easy in audits in the hope of netting more lucrative work in the future.

Not all extra work for audit clients is barred, and Karthik Ramanna of the University of Oxford suspects that audit staff are expected to do what they can to flog such services. Last year the Big Four made £329m ($ 424m) from selling these additional services to big clients. That amounts to 39% of their audit fees. Perhaps anticipating stricter rules, KPMG said on November 8th that it would stop providing large audit clients with extra services.

Regulators have tried to inject competition and enforce independence—with mixed success. European Union rules require companies to tender for a new auditor every ten years, and to switch after 20. Though churn has gone up, the Big Four have become more dominant, however. In 2016-17 they audited 97% of the FTSE 350. The Financial Reporting Council found that audits stopped improving in 2017.

The CMA’s most radical option would be to force the Big Four to separate their auditing and consulting arms. That would reduce conflicts of interest—and could increase choice: accounting firms cannot tender to audit a company they are consulting for. But it would make for weaker firms: auditing is a low-margin business.

Another option would be to cap auditors’ market share. That could guarantee smaller firms much-needed experience, and over time increase the number of serious players. But in the meantime some big firms would be forced to use smaller auditors. It is not clear that multinationals, in particular, could be properly scrutinised by an auditor with limited global coverage.

Also on the table is a change to how auditors are hired. If an independent body were to match auditors and companies, that could stop auditors from going easy in order to be reappointed. This option is backed by Grant Thornton, a smaller audit firm. But it has had a tepid reception from the others, who say that it would distance the auditor from a company’s board and from the investors it represents.

The CMA must try to minimise costs while maximising benefits. But for now at least its calculations ignore a basic question: whether auditors’ job descriptions are still fit for purpose. Research by the Association of Chartered Certified Accountants, a professional body, finds that the public expects auditors to do more to detect fraud and to stop companies failing than is required in their professional standards. Mr Ramanna thinks that reforming accounting standards—for instance, to encourage prudence—would give auditors more clout when challenging company managers. But such rules are multilateral, and there is little appetite for change in America or continental Europe. The overarching lesson from Britain may be that reforming audit is fiendishly difficult.

This article appeared in the Finance and economics section of the print edition under the headline “Quality assurance”