The false economy

The false economy

Scandals and regulation lead to an auditing merry-go-round

Going round in circles. Joseph Kim | shutterstock.com

Tesco has parted ways with its auditors of 32 years, PricewaterhouseCoopers (PwC). This decision follows the £263m accounting scandal that engulfed the supermarket last year and it is moving its business to rival accountancy firm Deloitte & Touche.

Regardless of what happened at Tesco, there is a recent trend for companies to rotate auditors on a more regular basis. This has been encouraged by regulators in a bid to ensure the independence and best practice of auditors. But switching to another of the big four accountancy firms may not make a lot of difference.

The merry-go-round

Scandals and regulatory pressures have led to a recent merry-go-round of companies switching auditors. As well as Tesco, Barclays Bank recently ended its 120-year association with PwC, while British American Tobacco and HSBC have moved their business to KPMG after 17 years and 22 years with PwC, respectively.

Royal Bank of Scotland, meanwhile, ended its 14-year relationship with Deloitte, appointing Ernst & Young instead. These auditor changes are likely to accelerate as many other major companies are putting their audits out to tender. This is welcome.

Tesco got in trouble for not balancing its books properly in 2014. EPA/Andy Rain

By law, company auditors are required to give an independent opinion on a company’s financial statements. In practice, however, auditor independence can be compromised by numerous factors.

A key factor in independence being eroded is when a long-standing relationship leads to fee dependency on the auditor’s side and cosy relationships can develop with company management. This eventually erodes professional scepticism – a key ingredient for an effective audit.

Over the years, numerous scandal-ridden companies received a clean bill of health from their auditors. Critics called for a mandatory rotation of audit firms on the grounds that after a fixed-period auditors would lose the client and thus have little pressure to go along with shady practices. The incoming auditors would look afresh at the corporate financial statements and may be unwilling to support past dubious practices.

Big accountancy firms opposed these changes. But their opposition to reforms was weakened by the 2007-2008 banking crash, which showed that almost all major distressed banks had received a clean bill of health from their auditors and in some cases banks collapsed within days of receiving a clean bill of health.

Lack of competition

In reality, the market for audit of major companies is dominated by just four firms – PwC, Deloitte, KPMG and Ernst & Young. Between them they audit about 99% of the FTSE100 and most of the FTSE 250 companies. Successive governments have failed to break up the big four firms to increase competition and supply of auditing services to large companies. As the banking crash raised age-old questions about auditor independence and strengthened calls for auditor rotation, something had to be seen to be done.

The European Union called for listed companies to change their auditors every ten years. Auditor tenure could be extended by another ten years if competitive tenders showed that the incumbent firm is the best option. In response, the UK has not yet amended its legislation. The Financial Reporting Council (FRC), the UK’s auditing regulator, has opposed mandatory auditor rotation but supported tendering of audits every ten years, which may result in change of auditors.

While the tendering and rotation of auditors is well-intentioned, it will not address the shortcomings in audits. With the big four firms holding an oligopoly on the market, they are essentially swapping clients among themselves. Rotation also does not address the processes associated with the production of an audit.

As private sector firms, accounting firms will still be dependent on company directors for their appointment and fees. No member of the audit team can afford to alienate an audit client by being robust and ultimately lose that client. Auditor rotation does not address fee dependency and eliminate the commercial pressures to appease company directors.

The market pressures on auditors to deliver robust audits are weak. The market for auditing is unlike any other in that it is guaranteed by the state. In a normal market, producers of poor goods and services can be driven out of the market, but that does not apply to auditors as the law requires companies and other organisations to purchase an audit. Despite all the shortcomings, accountants have retained their monopoly of the audit market. In markets, producers of poor goods or services can be sued and put out of business, but auditors enjoy considerable liability shields.

Auditor rotation – though welcome in principle – cannot address the deep-seated problems of the industry.