Audit Quality Crisis And Solutions

Introduction

Developments in auditing have always been driven by corporate scandals (Economist, 2018). Huge scandals such as Enron and WorldCom, that left the world without confidence for the audit sector, led the FRC to tighten regulations. Most recently, the collapse of Carillion and BHS and the almost failure of Patisserie Valerie have come to light. The FRC along with other major regulators and boards have had to start proposing further solutions to cracking down on the disaster that is Audit Quality.

Audit Quality

There is currently an audit ‘expectation gap’ between what the public and financial statement users believe auditors are responsible for and what auditors themselves believe their responsibilities are. (Lexicon/Financial Times, No date). It has been shown that the public expects a lot more from auditors than what they can actually achieve at an affordable cost.

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There is no set definition of ‘Audit Quality’. There are many factors that influence the quality of an audit and as a result, judging it can be subjective and challenging to both the auditors and external stakeholders. Achieving a high standard of audit quality allows clients and investors to build trust and confidence in the audit profession. They can do that by delivering an independent, understandable and reliable professional opinion.

Section 393 of the Companies Act 2006 requires accounts to “give a true and fair view of the assets, liabilities, financial position and profit or loss” of the company. The provide a quality audit, the auditors must then truthfully state whether the accounts represent the company truly and fairly. It must be noted however, that the auditor provides an opinion, not a guarantee. (ACCA 1, 2014)

The ISA 320, Materiality in Planning and Performing an Audit Act, aims to provide guidance on how materiality in audit should be approached. Materiality is a subjective concept and therefore it would be inappropriate for a standard set of rules to be set. This lenience means that accounts do not have to be 100% true and accurate. However, given the sheer size of the companies that undergo the audit process, analysis of the accounts in absence of the concept of materiality would be near impossible. The auditor will allow for a certain amount of error without it affecting their opinion, but in turn this means certain levels of fraud can be missed. (ACCA 2, 2015)

In the words of the Competition and Markets Authority (CMA): (Report) “Competition and regulation should work hand in hand to ensure that audit firms and individuals within those audit firms have the maximum incentives to carry out high-quality audits”

The current audit quality crisis

With scandals constantly being brought to public light regarding audit quality there is no denying that the auditing sector needs to drastically change. The Financial Reporting Council have been slammed for being far too content with only apportioning the blame once the scandal has been brought to light rather than proactively challenging and fixing the issues in present time.

The current audit quality issues:

1. Companies can choose their own auditors and as a result they pick those whom they have the best chemistry or ‘cultural fit’ rather than those that offer the toughest scrutiny.
2. There is lack of competition within the audit sector and for companies, the choice is very limited. The Big Four conduct 98% of the FTSE 350 audits and 99% of the S&P 500 companies audits.
3. Auditors focus on quality appears to be diluted due to the fact that over 75% of the revenue of the Big Four comes from other services such as consulting.
4. Conflicts of interest. Management hold influence over the auditor because they can harm their interest such as not appointing or reappointing the auditor, making the audit more difficult and costlier by being less cooperative and terminating their contract.(McLoughlin, 2018)

One of the most recent criticisms and scandals regarding audit was the failure of the Big Four spotting issues at Carillion before the construction fell into administration last year. The four collectively prioritised profits over proper scrutiny of the company during their internal and external audit. MP’s accused the four of ‘feasting’ on the carcass of Carillion after banking a huge £72m for consultancy work in the years leading up the firm’s collapse. (Makortoff, 2018)

Another scandal in recent years was the investigation launched into Grant Thornton’s audit of Patisserie Valerie between 2015 and 2017. The board discovered £10m of secret overdrafts and a total of £40m worth of fraud which in turn brought the company close to collapse. As a result Grant Thornton received its largest fine from the FRC totalling a rather insignificant £3m. (Morrison, 2018)

Further, The FRC sanctioned PwC and senior audit partner Steve Denison over the 2014 audit of BHS and Taveta Group, after Sir Philip Green sold the company for just £1 days after PwC signed off its accounts for the previous year. As a result, thousands of people were left without work and pensions were left in a £571m deficit. (Chapman, 2018)

Suggested solutions to improve audit quality and the benefits and limitations of each solution

In 2013, The Competition Commission announced stricter obligations for the accountancy sector, including requirements that FTSE 350 companies put their audit business out to tender at least every 10 years and rotated after 20. However, since then, the market share of the Big Four has significantly increased rather than fallen like CMA expected.

At present, the mindset of the Financial Reporting Council is to be content with apportioning blame once disaster has struck rather than to proactively challenge companies and flag any issues of concern to avert avoidable business failures in the first place. (From report)

The current audit quality crisis has led to a major discussion by multiple bodies about possible solutions to fix the broken audit sector and improve the quality of audit being given to clients.

Solution 1

The first solution proposed by the CMA is to introduce a French-Style system, by which audits of the FTSE 350 companies should be carried out by at least two firms, sharing equal liability; one of which will be from outside the Big Four. This proposal will give smaller accounting firms the access to auditing much larger clients which in turn will help them to develop experience and credibility.

Automatically, this means that there will be checks being done twice, by two different companies both with different views and opinions. This proposal should hopefully eliminate bias and conflicts of interest as it should be hoped that both the audit firms will not easily influenced by the management.

However, the smaller firm could struggle to keep up with the same level of expertise and capital needed to provide the level of service that FTSE 350 companies expect.

Solution 2

Another solution proposed and supported by both Deloitte and KPMG, is to split the audit and advisory businesses within the Big Four firms. The Big Four have been slated for making millions of pounds in consulting fees, advising failing companies on how to turn themselves around and then pocketing millions tidying up when that advice fails.

The FRC’s Ethical Standard (2016) already has measures in place to control the amount of non-audit services that an audit firm can provide to a company (Ashworth, 2018). However, by completely splitting the two sectors apart into separate businesses, it potentially opens up millions of pounds worth of fee income to smaller companies. Although it does not increase the amount of audit firms, it does mean they would no longer be conflicted by their consultancy sector, and so, more firms would be able to compete for the contracts out for tender.

As seen in the Carillion case, it is apparent that the Big Four can be biased to a client’s audit when they have a multi-million pound consultancy contract with them. The management can hold influence over the auditor because they know if the firm does not do as they wish, they can make the audit costlier by being less cooperative and/or terminate both their audit and consultancy contracts. By splitting the two sectors apart, conflicts of interest should be minimised.

*However, forcing the Big Four to split into separate audit and non-audit businesses could also have a negative effect on the audit quality. The Big Four rely heavily on their income from consultancy services. Removing this aspect will financially weaken the company meaning they may struggle to meet the needs of their clients during audit.

Solution 3

A controversial proposed solution is to break up the Big Four. The CMA has been put under increased pressure to break up the oligopoly as the audit sector has been deemed as failing due to its lack of competition.

Splitting up the four firms into eight removes the oligopoly situation and automatically brings twice as much competition into the sector without reducing the skill set and experience.

However, increasing competition does not always mean increasing quality. It is prohibitively expensive and rather difficult to convey to clients the differences in the audit you will provide in comparison to the competition, especially if there is 8 very large companies all providing similar services and expertise. This in turn may create a greater incentive to cut corners and break rules in order to get ahead of competitors. (From Report)

The other obvious dilemma of going ahead with this proposal is the complexity of going through with such measure. Due to the international size and scale of the Big Four it would be a long and difficult process to go ahead with.

Solution 4

Another proposed solution is to introduce US-style rules. There has been discussion of introducing a UK version of the Sarbanes-Oxely Act, which was brought into the US following the major Enron crisis. The act is in place to ensure that senior managers individually take responsibility for mistakes made in company accounts. The act holds much heavier penalties than the sanctions currently available in the UK. (Taylor, 2018)

BENEFITS AND LIMITATIONS

A highly talked about solution is the proposal of a new regulatory body being created to independently appoint auditors on behalf of FTSE 350 companies. The regulatory body is to be called the ‘Auditor, Reporting and Governance Authority’ who will restore new leadership and powers into the auditing sector. (From report) The FRC currently regulate the auditors, however, at present, the client will personally choose their own auditor.

Conclusion

Audits only seem to get noticed when things go wrong. A lot of emphasis on the issue of audit quality. The IAASB is making it clear that audit quality is something to be taken seriously. Higher quality audits and public confidence in audit reports issued should reduce the ‘expectation gap’

By emphasising the issue of audit quality in its current Work Plan, the IAASB is making it clear that audit quality is something to be taken seriously. Higher quality audits and public confidence in audit reports issued should reduce the ‘expectation gap’. However with audit firms coming under pressure to cut fees, produce competitive tender documents and provide ‘added value’ to the audit in the form of non-audit services, it is easy to see why audit quality is often compromised. Future changes to make the requirements of ISQC1 and ISA 220 more robust could help, as will promoting the use of professional scepticism in the conduct of all audits.

References

1. Economist (2018) ‘What is an audit for?’ Economist [Online] 26th May 2018 [Accessed on 19th January 2019] https://www.economist.com/finance-and-economics/2018/05/26/what-is-an-audit-for
2. Lexicon/Financial Times (No Date) Definition of audit expectation gap [Online] [Accessed on 20th January 2019] http://lexicon.ft.com/Term?term=audit-expectation-gap
3. ACCA 1 (2014) True and Fair statement published by FRC. [Online] [Accessed on 19th January 2019] https://www.accaglobal.com/uk/en/technical-activities/technical-resources-search/2014/june/frc-true-fair.html
4. ACCA 2 (2015) Performing effective (and effecient) audits – the importance of planning and materiality. [Online] [Accessed on 19th January 2019] https://www.accaglobal.com/us/en/member/discover/cpd-articles/audit-assurance/effective-audits.html?fbclid=IwAR0zTMwUEPQ9DjMufWVnNhg_FVWLEWizas1vZIWDDcI8beYkk4wUVPI2xTM
5. McLoughlin, B (2018) The CMA recommendations for audit reform are finally published. AccountancyAge [Online] [Accessed on 19th January 2019] https://www.accountancyage.com/2018/12/18/the-cma-recommendations-for-audit-reform-are-finally-published/
6. Makortoff, K (2018) ‘Big four accounting groups escape break up threat from CMA’ The Guardian [Online] 18th December 2018 [Accessed on 19th January 2019] https://www.theguardian.com/business/2018/dec/18/big-four-accounting-groups-escape-breakup-threat-from-cma
7. Morrison, C (2018) ‘Patisserie Valerie auditor Grant Thornton faces probe over financial irregularities’ Independent [Online] 21st November 2018 [Accessed on 19th January 2019] https://www.independent.co.uk/news/business/news/patisserie-valerie-finances-scandal-grant-thornton-watchdog-frc-investigation-a8644086.html
8. Chapman, B (2018) ‘PwC partner banned for 15 years and fined £500,000 over BHS audit’ Independent [Online] 13th June 2018 [Accessed on 19th January 2019] https://www.independent.co.uk/news/business/news/pwc-partner-bhs-audit-banned-fined-financial-reporting-council-a8396666.html
9. Ashworth, L (2018) ‘Deloitte calls for audit market cap and ban on selling extra services to audit clients’ CITY A.M. [Online] 8th November 2018 [Accessed on 19th January 2019] http://www.cityam.com/268807/deloitte-calls-audit-market-cap-and-ban-selling-extra
10. Taylor, M (2018) Big Four break-up: What does this mean in practice? AccountingWeb [Online] [Accessed on 19th January 2019]https://www.accountingweb.co.uk/business/finance-strategy/big-four-break-up-what-does-this-mean-in-practice