Guest Blog: How to Tackle Audit Failures

Auditors have been described as gatekeepers of capitalism, yet there is widespread concern that the current Coronavirus pandemic, and the global recession that will inevitably accompany it, reveals a pattern of audit failures similar to recent high-profile corporate failures which surfaced in the past two years. In this guest blog, researchers Adam Leaver, Leonard Seabrooke, Saila Stausholm, and Duncan Wigan discuss the findings of their new research paper, published today.

Moments of financial stress have historically revealed weaknesses in our systems of accumulation built up over time. Whilst it is well-recognised that central banks played a defining role in steadying markets after the 2008 crisis, the growing significance of the Big Four accounting firms, and the fair value accounting system they work within, is perhaps less well understood as a feature that has shaped our economy since the crash. A string of recent high-profile corporate failures in the UK – including Carillion, Thomas Cook and Patisserie Valerie – have already revealed the parlous state of auditing at many large corporations. Now, as we enter this new period of financial uncertainty amid the rapidly spreading Coronavirus pandemic, we may soon get a better idea of just how weak our systems of financial reporting have been. As U.S. billionaire investor Warren Buffet noted, “you only find out who is swimming naked when the tide goes out”.

Our new report ‘Auditing with Accountability: Shrinking the Opportunity Spaces for Audit Failure,’ released today, explores the causes of the recent high-profile audit failures and makes recommendations for reforming the sector.

It argues, if accounting creates, rather than merely reflects, financial realities, the job of auditing is to verify that financial statements produced by a company’s management present a “true and fair view” of a company or group’s assets, liabilities, financial position and profit or loss (UK Companies Act 2006, section 393). Ensuring that mission is adhered to, is not just a concern for company shareholders. Auditing performs a social function: we are all affected when that mission fails. Confidence in companies disappears, banks will not lend, shareholders will not invest, workers will not commit their labour, suppliers will not transact and consumers will not buy. If audit failures lead to corporate failure, the state may step in to provide support for the company, or the Pension Protection Fund may pick up the tab for a collapsing company’s pension fund. So audit failures are always also failures of public accountability.

The British government commissioned two independent reviews on this: the Kingman Review, to look at regulation and the Brydon Review to examine the effectiveness of audit.  At the same time, the Competition and Markets Authority (CMA) has examined competition and resilience in the audit sector; and the Business, Energy and Industrial Strategy Committee’s analysis, ‘The Future of Audit’ fed into these reports.

These reports raise serious questions about audit culture, the problems of market concentration in auditing services and conflicts of interest inside the Big Four accounting firms (BEIS 2018, 2019; Competition & Markets Authority 2019 (CMA); Kingman Review (2019). But our report begins from a different vantage point: that these failures indicate a public ‘accountability gap’: a shortfall between what the wider public might legitimately expect auditors to do, and what the audit process currently delivers.

We argue that this accountability gap is the product of economic, cultural, and regulatory arrangements which create ‘opportunity spaces’ inside which audit failures take place[i].  Specifically, for the UK we argue that the large opportunity spaces for audit failure emerge from the interaction of:

• shareholder value linked remuneration structures for senior managers,
• fair value accounting standards where valuations require some subjective judgement by those managers and
• International Financial Reporting Standards (IFRS) which encourage proceduralism over judgement

These spaces provide senior managers with the incentive and the room for manoeuvre to produce optimistic valuations, while the proceduralism of IFRS rules creates ambiguity for auditors as to where the rules end and where judgement begins, and this reduces their incentives to challenge.

In short, we see the post-crisis period in terms of a withering of the countervailing regulatory, legal and social forces that should act as a check on bad accounting practice. Many companies do act in good faith and will strive to post ‘true and fair’ accounts. But audit failures mean we cannot be sure which do, and which don’t.  

Our report asks whether the problems are caused by the Big Four and whether they have shaped the culture of auditing through their dominance, or whether the Big Four has emerged from, and merely institutionalised, a longer-standing culture that preceded them.

We argue that the cultures and practices long predate the current environment where the Big Four dominate. So a focus just on competition, while ignoring other reform options, would ignore the documented experiences when there were five or even eight large audit firms. For us, the original problems are cultural and institutional.

It is quite possible for different cultures to co-exist within the same organisation without one necessarily overcoming the other. But consulting is often the driver of profit within the Big Four, and we argue that the institutional logic of consulting is incompatible with those of auditing.  This tension leaves auditors compromised, when they should instead feel free to exercise scepticism fearlessly.  This may be made worse by the Big Four partnership system, which can promote non-audit services in ways that diminish the status and role of audit.

Historical efforts to reform the audit industry have, however, disappointed because the very process of audit reform has been captured by the industry – they possess exclusive, technical knowledge to assert ‘what works’ in a context where audit is of low political interest amongst the general public.

So our report recommends:

• To reassert the proper ​role ​of audit practice, the accounting framework should be amended to reinforce the 2006 UK Companies Act. It should also be stated in that framework that accounting rules are subordinate to law, and that the role of auditing is to exercise prudential judgement to prioritise capital maintenance.
• To reinvigorate a ​culture​ of scepticism and prudence, we recommend that audit and non-audit activities are legally separated
• To reduce moral hazard, limited liability privileges should be withdrawn from both audit and non-audit services
• The Financial Reporting Council (FRC) should be replaced with an Audit, Reporting and Governance Authority (ARGA,) as the Kingman Review recommended. 0
• To shrink the harmful “opportunity spaces”​, we recommend a government review into the role of fair value accounting rules in audit failure. Specifically, whether IFRS rules – with their combination of subjectivity and proceduralism – create an ambiguity as to where rules end and judgement begins for auditors.
• Finally, to address the relative lack of countervailing forces, we recommend the inclusion of civil society representatives in key regulatory bodies and bodies involved in the audit reform process. We also see a role for civil society bodies in creating new networked alliances between academics, public intellectuals and seasoned campaigners to build an effective civil society check on audit failure.

Read the full report here

[i] We define an opportunity space as: ‘the room for manoeuvre within a valuation process, where opportunities to overstate accounting items are taken because auditor judgement is compromised or constrained, leading to information asymmetries between the acting party or parties and those seeking accounting accuracy and accountability.’