Make auditing a public service?

Most companies over a certain size require a full independent audit at least once a year and this has been the case for decades. The reasons are obvious, in that anyone who is not part of the company but relies on the company for income (such as lenders, employees and suppliers) has a right to know whether the company will be able to continue trading and paying its bills.

They also have a right to expect that the person telling them this is well-qualified and has no other interest in the company that may sway their opinion (independence of both thought and action). They expect that the auditor will be sufficiently remunerated to maintain that independence and does not rely on their client for any other income.

In this article, I will address only the situation of auditing companies listed on major stock exchanges.

This auditing market is totally dominated by four international accounting groups. They are, in alphabetical order, Deloitte & Touche (DT), Ernst & Young (EY), KPMG and PricewaterhouseCoopers (PwC). They are known as the Big Four. Years ago, there was a Big Nine, but due to mergers they have consolidated, or at least eight of them have done so.

The world's largest audit firm, Arthur Andersen, collapsed earlier this century after it was found that its audit of Enron was neither independent nor sufficient to give assurance to that company's investors, creditors and employees; it was found to have fraudulently covered up its deficiencies, knowing that the US authorities were investigating its audit.

There is no logical reason to question the dominance of four international firms in any major audit market. There is sufficient competition and they have access to huge resources. Limiting their access would be self-defeating.

The Enron scandal prompted a lot of regulation both in the United States and worldwide, given that most major corporations deal with the US.

For the accounting profession, it meant that, by and large, auditors were prevented from offering services to their clients other than what we now know as "compliance" services, which mainly cover financial statement audits, regulatory audits and tax submissions. There was real fear among the larger accounting firms that they would lose lucrative advisory business and that their income as a whole firm would nosedive. Several of them divested their advisory and accounting support arms, mainly in the area of computer systems' design and implementation.

On paper, this "Chinese Wall" between compliance services and advisory services exists today. However, as a direct result of the legislation which tried to ensure this division, the audit market for major listed companies has changed dramatically. The accounting firms were not split up to isolate audit services and their attitude to audits changed. They are aware that they cannot sell advisory services directly to their audit clients. But they are also aware that they can sell these services to non-audit clients, with no competition from the incumbent auditor. Importantly, they are aware that building relationships with their audit clients will lead to potential business in the future, when they are not their auditors. They are also well aware that they can sell additional "compliance" services to their audit clients, notably in the area of "regulatory compliance", which goes way beyond an independent report on the reliability of the published financial statements.

Securing a major audit in most jurisdictions cements a firm's reputation and allows enhancement of income. "Independence" is less of an issue. Thus we see in many countries the race to add audit clients of repute, but at a fee that is not commercial due to expectations of future business. In many jurisdictions, audit fees have been chased down to a level where proper oversight of standards is being lost.

Employees in audit know this and the chief reason for taking a job in audit after university or equivalent is to obtain a qualification, get a "name" on the CV and move on. Training standards in any area other than technical proficiency, whether in the classroom or on the job, are declining and audit firms refer to their audit employees as factory workers, rather than offering real career progression. They are cheap labour and can easily be replaced. Very few junior audit employees have ambition in their line of business - they all want to be consultants, that is, in advisory services, or join a client. The quality of audit management declines as a result, because the most qualified want to be elsewhere, so do not replace the retirees.

Currently, this is most obvious in the United Kingdom, but it is the same in other major countries. The Big Four in the UK are under considerable fire from the authorities.

The collapse of Carillion, a major outsourcer of government work, is the latest one to attract scorn. The auditor was KPMG, which was censured by many authorities for the quality of its audit, given that the auditors had signed a "clean" opinion virtually at the same time as the company made the profit warning that ultimately led to its demise.

The rest of the Big Four were seen to be picking at the pieces of Carillion, either through advisory work or, for PwC, gaining the lucrative receivership contract (which, of course, allows them to pay their own fees).

In the UK, an organisation known as the Financial Reporting Council (FRC) is supposed to be the watchdog for auditors. It has just released a report into the quality of audits conducted by the Big Four.

With regard to the FTSE 350, it says that half of KPMG's audits require more than "just limited" improvement, with 27 per cent of all audits similarly censured. Bank audits were picked out in particular for faults (I guess we do not need to revisit the horrors of 2007/8 - though, to be fair, auditors were least at fault when the banks, ratings companies and the regulators connived to almost destroy the financial system.)

PwC has just been hit with a record fine for its failings on the BHS audit, which exposed a pension liability which has ruined thousands of employees.

MY JOURNEY AS AN AUDITOR

I used to be an auditor. I went into the profession thinking that it was a guardian of financial probity. It was drummed into me from Day One that the auditor's chief asset (apart from having a questioning brain) is independence of mind. My sole task was to assess whether a company's financial statements showed a "true and fair" view of its activities over the last year, so that interested parties could rely on them. I was never pressured to add other business and fees - this was only something I experienced for the first time in Singapore and I guess led to my falling out of love with the profession - and becoming cynical, of course. It seems that the truly independent audit is a thing of the past.

Standards in accounting firms have slipped in pursuit of current income and personal futures and I would be wary of trusting any report on any financial statements of any major corporation. But, I am not alone in this - most analysts say the same thing.

Is there a solution to the need for really independent analysis of major financial statements? There is, but it is anathema to almost every regulator I have ever known. Audit requires bright minds and excellent experience from properly independent people who are well paid for it.

This will never come from the private sector. I would make it a public service, but only a country like Singapore that takes pride in the quality of its public services and pays accordingly could do it. Singapore is still too small to be a pioneer in such a major market. Pioneers are defined as the people who are in front of the masses, but have arrows through their hearts. It would be nice to see it though.

Just a thought.