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The false economy

Big auditors must be made accountable to the public

But who will audit the auditors?, CC BY

What should we do with producers who routinely deliver faulty goods and services? Producers of cars, food, medicines, aeroplanes and even financial products are forced to compensate injured parties, recall their goods and face the possibility of being forced out of business. But such niceties do not apply to the auditing industry.

The silence of the auditors at distressed banks is well documented though this has resulted in little effective action. No auditing firm has returned the fees for dud audits. Earlier this year, nearly six years after the banking crash, a US auditing regulator reported that more than one in three audits inspected were considered to be deficient and did not provide enough evidence to enable auditors to reach a conclusion.

Now there is a more damning report from the International Forum of Independent Audit Regulators (IFIAR), an organisation representing audit regulators of 49 jurisdictions, including Australia, France, Germany, Italy, Japan Spain, UK and the US. The IFIAR report is compiled from the audit inspections carried out by national regulators and focuses on audits of major listed companies. The audit market for these companies is dominated by the Big Four accountancy firms – Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PricewaterhouseCoopers – and smaller rivals Grant Thornton and BDO. Their combined global revenue is around US$120 billion and the “too big to close” syndrome continues to prevent effective regulatory retribution.

The IFIAR report says that there are persistent deficiencies in critical audit areas. These relate to audit work on the controls within companies designed to prevent abuses, valuation of assets and liabilities, and disclosures of crucial information to the public. The report is concerned that auditors of financial institutions pay inadequate attention to the likelihood of losses and the valuation of investments and securities. The age-old response to any criticism is for the auditing industry to deny the problem or tweak auditing standards, audit reports, codes of ethics and promise tougher action against laggards. But none of these solutions is adequate.

Poor audits are a systemic problem. Auditing firms are the private police force of capitalism, but are not subjected to pressures and incentives normally associated with the private sector. The market for external audit is created by the state and guaranteed to accountants belonging to a select few trade associations. In the absence of effective accountability and liability, this rarely encourages reflection on poor practices.

Most markets need competition, but the auditing market is highly segmented and big firms dominate the sector. By colonising bodies such as the International Auditing and Assurance Standards Board and the UK’s Financial Reporting Council, big accounting firms control the production of auditing standards. Various international auditing standards, codes and related pronouncements, for instance, cover about 3,000 pages but remain silent on auditor accountability to the public.

The public bears the cost of audits and audit failures, but has no right to see audit files or to make an assessment of the quality of audit work. Legal cases show that, even despite an admission of negligence, auditing firms escape liability because under UK law they do not owe a “duty of care” to any individual shareholder, creditor, employee, pension scheme member, or any others affected by their negligence.

The post banking crash auditing reforms recently announced by the EU require that financial institutions and listed companies change their auditors every 10-24 years, something which will not prevent collusive relationships between companies and auditors. The EU will impose further restrictions on the auditor’s ability to sell consultancy services to their clients, rather than imposing a complete ban. So auditors will continue to audit the very transactions that they themselves have created.

The minimalist reforms are welcomed by the auditing industry, but do not address the problems identified above. For example, there are no additional suppliers of auditing services and the size of the big firms is not reduced. This could be done, for example, by delegating audits of all financial institutions to a designated state regulator and requiring it to conduct audits on a real-time basis and pass all information immediately to the regulators. This would increase the supply of auditing services, reduce the size of the big auditing firms, enable medium-size firms to compete and end the “too big to close” regulatory inertia.

The banking crash has shown that audits have an effect on the distribution of income, wealth and taxpayer funded bailouts. Therefore, only bodies representing a wide variety of interests should be involved in creating auditing standards. At the very least, all auditing standards should be approved by parliament. Auditors should owe a “duty of care” to all stakeholders who have reasonably relied on audit reports. The consumer rights revolution which applies to even mundane things like toffees and potato crisps also needs to apply to producers of audit opinions. All auditor files should be publicly available so that interested parties can make their own assessment by considering the composition of the teams, time spent, horse trading with company directors and conflicts of interests.

The above proposals can stimulate competition and public accountability and thus create incentives for accounting firms to escape the cycle of institutionalised failures. No doubt, auditing firms would oppose any proposals that strengthen their public accountability, but the reforms can save them from their own follies.

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