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THE BOTTOM LINE

Higher audit costs are a price worth paying for the Big 4

WHENEVER big companies crash and burn - Enron in 2001, banks in 2008, Carillion last year - investors invariably demand, where were the auditors, and why didn't they warn us?

The Big Four auditors - PwC, KPMG, Deloitte and EY - equally invariably respond that investors and politicians have unrealistic expectations about what auditors do, given how much money and time they are given to do their work.

That did not stop the US from tightening the rules in the 2002 Sarbanes-Oxley corporate accountability act, including mandatory audits of internal controls. Companies and auditors complained bitterly about the costs of compliance.

European bank failures in the financial crisis sparked a further spate of new rules, and now the Carillion collapse has prompted the UK to consider going further still and forcing firms to split auditing from consulting. Concerns about rising costs are already starting to roll in.

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EY recently sent letters to all of its FTSE 350 clients warning that it would be boosting its audit fees due to "unprecedented market forces", while KPMG is scaling back its exposure to the building society sector partly out of concerns that smaller lenders cannot afford to pay for the additional work that now needs to be done.

Auditors say there are three main drivers of higher fees. First, the EU decided to require companies to tender their audits once a decade and change auditors at least every 20 years. Tendering and getting to know a new client adds costs, and shorter contracts mean investments in new people and technology can't be spread over many years.

Second, UK regulators and international accounting standards setters are demanding that auditors up their game by providing more sophisticated modelling of risks, as well as more documentation of what they have done to challenge management assumptions.

Third, if firms do have to split auditing and consulting, they must ensure audit businesses are profitable on their own, rather than being loss-leaders for the larger firm.

Most of the Big Four firms, and Grant Thornton, which is No 5, have announced or carried out big hiring pushes as they seek to bulk up on experienced auditors and modelling experts, as well as invest in artificial intelligence and machine learning.

At EY, that has led to the letters warning of higher fees. Head of audit Hywel Ball explains that the increases "reflect the significant investments we have already made in new technology, regulatory compliance and talent, plus recognising the tendering and switching costs. This is about delivering sustainable, high-quality audits".

BETTER OVERSIGHT

KPMG isn't sending out formal letters, but it is also warning clients about the cost impact of tougher standards and rethinking its fees. The firm, which used to audit half of all UK building societies, has dropped about a dozen clients in the sector. Part of this is due to mandatory rotation, but there is also a financial motive. "We are making sure that we are getting paid appropriately when more work is done," says Michelle Hinchcliffe, who heads audit at KPMG.

As the UK government gears up for a further crackdown, it is worth asking whether companies and investors are getting their money's worth from what has already been done.

In the US, once teething problems were sorted out, Sarbanes-Oxley became just another part of the regulatory landscape. And a 2017 study found that companies identified by auditors as having weak internal controls were 80 per cent more likely to have a future fraud revelation.

In the UK, the auditor-rotation rules are having an impact. PwC calculates that 287 of FTSE 350 companies have tendered their audits since 2012, and 73 per cent of those have changed providers. It is too soon to tell whether fresh eyes will lead to better audits in Europe, but American studies have found that companies with new auditors have significantly higher restatement rates than those which stayed with the same firm.

The UK needs auditors with backbone, who are willing to stand up to even the most difficult managers. Grant Thornton has made a start by telling regulators that it plans to quit as Sports Direct's auditor after the retailer revealed a 674m-euro (S$1.03 billion) tax bill just hours before the accounts were due to be signed off. If that costs a bit more, it would be well worth it. FT

READ MORE: Will Singapore audit landscape take its cue from UK if its audit shake-up leads to higher fees?